in reference to: Doctor’s Assoc., Inc. v. Stuart

This above case from 1996 illustrates many of the horror stories you read on this blog, particularly site selection and mandatory arbitration clauses.

Site Selection:
Several Subway franchisees sued Subway corporate for basically screwing them on site selection.

First a little insight into Subway’s site selection process described in the court’s opinion.

After a Subway franchise is purchased, Subway helps the franchisee to find a site for the Subway shop. If Subway approves the site, it requires each franchisee to sublease the premises from one of several real-estate leasing companies that are affiliated with Subway (red flag!).

In 1990, Defendants opened their first Subway sandwich shop in Granite City, Illinois. Later they bought a second Subway franchise. Subway corporate allegedly promised to approve any appropriate site Defendants found for the second franchise in Bethalto, Illinois. After locating two potential spots in Bethalto, Defendants asked Subway corporate for approval, but were told that both sites were too close to another Subway sandwich shop located in Wood River, Illinois.

Subway corporate then allegedly permitted another franchisee to open a Subway shop in Bethalto, at or near the spots picked by Defendants. Despite Defendants’ objections, Subway corporate made Defendants locate their second Subway store in Granite City, less than two miles from Defendants’ first store. The opening of this second shop cut into the sales of Defendants’ first Granite City shop.

Subway corporate is your landlord. They can dangle an eviction notice in the face of franchisee to compel desired behavior. If Subway had the franchisee’s best interests in mind, that franchisor-landlord relationship could work in theory. Intuitively, you would think that maximizing the franchisee’s profits would maximize Subway’s profit, right? Wrong. (see The hidden ways franchisors make money off franchisees)

Arbitration Clause:

So you think, "If they try to screw me, I"ll sue them!", right? Well, you can’t because like most franchise agreements, the Subway franchisees agreed to settle disputes using an arbtration service instead of the government courts:

Any controversy or claim arising out of or relating to this contract or the breach thereof shall be settled by arbitration

Convincing a judge the arbitration clause is unconsciounable is a very high hurdle, but can be done as Rob Boulter has done recently in California representing Mail Box Etc. franchisees.. That means you have to argue your case in front a “unbiased” private arbitration company. Ironically, arbitration companies compete verociously for Subway’s business. If Subway thinks the arbitration company is unfair, it can contract with another arbitration company. In arbitration, there is no jury, few evidenciary and discovery rules, and the outcome is binding. You can sue them if you find a technicality in the contract (which the case above found in the Sublease Agreement which did not contain an arbitration clause like the Franchise Agreement).

It looks like the Quiznos franchisees are not standing by in the face of apparent fraud:

The primary allegations of the complaint are that the franchisees were harmed by the company’s "deceptive recruitment practices" and "failure to deal in good faith" when it took franchise fees from the plaintiffs, but refused to approve locations to open Quizno’s stores. In addition, the complaint charged, Quizno’s has refused to return any portion of the franchise fees, even though the plaintiffs paid more than 18 months ago and are now being threatened with termination.

and more general comments…

Commenting on the lawsuit, Susan P. Kezios, President of the American Franchisee Association, said, "This lawsuit is a classic example of a popular franchise chain using its brand name recognition to deceive hard-working Americans into investing their dollars to grow a franchise. Bob-the talking baby in Quizno’s current media campaign-is definitely talking out of both sides of his mouth in this case."

Added Klein: "It is unfortunate that not enough people are aware of the abuse that franchisees often endure at the hand of their franchisors. Too many entrepreneurs automatically assume that buying a franchise is a safe investment. We are confident that we will prevail in our lawsuit, and are eager to finally bring justice to the franchisees who were victimized while also alerting people who are interested in purchasing a Quizno’s franchise to make an educated decision.

I don’t have a comment from Quiznos, but I’d assume they deny the allegations. Still, Quiznos claims to open a new franchise every 16 hours. Have those franchisees all done enough due diligence to uncover these allegations of fraud? I fear they are too eager to hand over the $25,000 franchise fee.

Even if this lawsuit turns out to represents a relatively small percentage of franchisees, I would never buy a franchise from a company who would keep an entire franchise fee after refusing to timely approve site selection. Perhaps Quiznos has a logical explanation, but I find it hard to believe so many franchisees in the same city would have the identical claims of fraud. Our legal system allows freedom to contract even if the terms are unfair, but those contracts are not enforceable if one can prove fraud or unconscionable terms.

So what is the problem?

• management’s ego and greed
• salesmen training and guidelines
• commission/bonus structure

The salemen’s compensation is composed of mostly commission and bonuses on total franchise fees. There is virtually no regard for franchisee’s site selection wished or oversaturating the geographic market. Management is certainly aware of the complications, but do nothing so long as the franchise fees keep rolling in. These circumstances seem obvious to me. What do you think?

Law suits between franchisors and franchisees happen regularly. The outcome of the litigation, however, is rarely known if a settlement occurs. As a condition of settlement, franchisors usually require the franchisee to sign a statement admitting liability. In exchange, the franchisor will pay a premium settlement. With the signed admission of liability, the franchisors can claim victory in the matter and possibly scare away other law suits.

Franchisors are required to accurately and clearly disclose litigation events with past and present franchisees. 16 C.F.R. §436.1(a)(4)(ii). Of course, disclosures will usually be technically accurate but, whenever possible, will put a positive spin for the franchisor. One way this is accomplished is with the liability admission mentioned above as a requirement of settlement. Even when the franchisor was clearly at fault, the “admission” of liability by the franchisee can shade the actual events. More info here.

Have you seen this clause in your franchise agreement? I bet you have. It goes by several names, but usually it is headed as “Entire Agreement” or “Merger Clause”. Unfortunately, franchisees often underestimates the power of this clause in their contract:

Entire Agreement: This Agreement and the Attachments hereto constitute the entire agreement between Franchisor, Franchisee and Franchisee’s Principals concerning the subject matter hereof. All prior agreements, discussions, representations, warranties and covenants are merged herein. THERE ARE NO WARRANTIES, REPRESENTATIONS, COVENANTS OR AGREEMENTS, EXPRESS OR IMPLIED, BETWEEN THE PARTIES EXCEPT THOSE EXPRESSLY SET FORTH IN THIS AGREEMENT. Except those permitted to be made unilaterally by Franchisor, any amendments or modifications of this Agreement shall be in writing and executed by Franchisor and Franchisee.

I know the franchisee sales reps are funny, confident, smart and seem trustworthy, but they earn a commission for selling you a franchise. Unless a claim they made is specifically written in the franchise agreement, they probably won’t deliver on it. If you ask the sales rep to include a claim or promise they made in writing and they refuse (and say, “Legally we can’t put it in writing, but don’t worry…we’ve been around a long time and you can trust that we’d never do anything to hurt our franchisees”), you can bet your goat they won’t make good on it.

Courts almost always enforce the above Entire Agreement clause even if the franchisor made different claims before the contract was signed. Most of the rules governing franchises are state specific (except the FTC rules), so speak to a franchise lawyer in your state and get informed! Call your local or state bar association and ask for a list of attorneys practicing franchise law.

I’ll write a post on how to select a good franchise lawyer soon.

Franchisors can make money off their franchisees in several ways:

1. Upfront Franchise fees
2. Monthly royalties on gross revenue
3. Deposits on equipment
4. Ongoing “hidden” cut on the mark-up of equipment, products, services, extra training and support, and supplies (many use Vistar Corp as a distributor)
5. Advertising, art and signage fees
6. Kickbacks and commissions for real estate deals (from landlords and brokers)
7. Kickbacks from financial lenders (similar to finder’s fees)

Usually the skimming is minimal and is serves the purpose of offsetting lower upfront costs for the franchisee. But, many of these extra “fees” and “commissions” earned by the franchisor are not disclosed and purposely obfuscated during sales process. Too often franchisees do not have enough accurate information to estimate these.

Also, franchisors often do not disclose the total related expenses and costs of a full site build out. They know that once you paid the upfront franchise fee, you will make the extra investments needed to get your building up to par and ready.

Franchisors also make nice profits on the resale of franchises. Franchisees who want out can’t just sell their franchises to their neighbor. Usually there are breakup fees and all sort of other hoops the corporate headquarters will impose on the seller.

Entrepreneur Magazine has an interesting article about whether franchisors are vicariously liable for their franchisees’ actions or incidents happening at their franchisees’ locations. The answer is "maybe but probably not". Naturally, a plaintiff’s attorney whose client slipped and fell in a McDonald’s is going to want to go after the parent company as well as the individual franchisee. Or, a client who feels they were discriminated against will want to sue the corporate headquarters of McDonald’s, not just the franchisee. The plaintiff victim would have to argue that the franchisor’s training and standards of operations contributed to the injury.

For example, if a customer burned themselves using a self-serve coffee station at a Panera Bread, and the coffee pot’s dangerous position was directed by Panera’s operations manual, then an argument can be made that Panera Bread contributed to the burn and is financially liable.

Hat Tip Franchise Law Blog

As a follow up to my post on eBay drop offs, eBay is fighting new government regulations and licensing requirements on people selling things though auctions. An interview with eBay’s Director of Government Regulations describes and how they are fighting federal, state and local Internet auctioneering regulations and taxes, like the one passed in Ohio. Ohio passed a law that says if you conduct auction online or over the phone, you need to buy a license from the government. eBay is set up an information site for their members on what’s being done to fight governent regulation on auctioneering. The government is eyeballing online auctions as a new revenue stream for government, so watch out!

Stories like the one on QuiznosSucks.com make me sad because they could have been prevented if a franchise lawyer was representing the franchisee during the transaction. QuiznosSucks describes a father’s ordeal with Quiznos and all the “unanticipated” problems with parking, protected territory, equipment installation, leases, misrepresentations, location selection and support. Could those problems have been forseen? Yes, they all most likely would have been avoided or mitigated if a lawyer were representing Mr. Sauls throughout the process.

The story illustrated the importance of having a knowledgeable lawyer looking out for your best interests during the ENTIRE franchise purchase (not just look over a lease). Lawyers have an ethical obligation to look out for you, and if they don’t, it is easy to sue them for damages and they can loose their license to practice law. “Consultants”, on the other hand, will provide you little legal recourse against either the consultant themselves or the franchisor.

Part of the expense of buying a franchise must include competent legal representation working for YOU (not the franchise). Don’t sign or pay anything without consulting with hiring franchise lawyer. I find it amazing that people will mortgage their house, commit their life savings to their dreams, and yet try to save a few bucks by not having a lawyer represent them every step of the way. There is reason sophisticated business folks have lawyers negotiate and handle business transactions.

Problems are going to happen in the franchise relationship. Some will stem from the Franchise Agreement but won’t rear its head for a few years (like the franchise changing their mind and opening up another one down the street from you). Franchisors will say something you rely on and interepret as a promise, but in reality it is not enforceable even if its in writing.

It’s worth repeating again -> if you are going to buy a franchise, you need legal represenation to look out for you best interests. Just read Mr. Sauls story at QuiznosSucks if you think buying a simple franchise like a sandwich shop should be problem free.

Some franchisees are suing, but you usually can avoid entering into bad relationships with more due diligence on the front end.