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Tension Rules Franchisor-Franchisee Relationships

On Behalf of | Mar 3, 2010 | Franchise Agreements, Franchise Law News

Attorney J. Michael Dady claims that restaurant chain discounting ruins franchisees’ profits and insists more disclosure would keep franchisors honest.

By David Farkas, Senior Editor — Chain Leader, March 3, 2010

J. Michael Dady of Dady & Gardner has been arguing case law on behalf of franchisees for more than 30 years. Today, Dady’s list of adversaries includes just about every major restaurant brand including Starbucks, McDonald’s and Burger King. Chain Leader recently asked the Minneapolis-based attorney to bring us up to date on legal issues currently affecting franchisees.

Can you offer a brief overview of restaurant franchisor-franchisee relations?

Across the board today there is an unusually significant emphasis on discounting to get people through the front door or to the drive-thru. There are pluses and minuses to that strategy from a franchisor’s perspective. They make their money based on a percentage of total revenues. But my clients make their money based on bottom-line profitably. You can’t lose a little on every deal and expect to make it up on volume, which is one of my criticisms of Burger King’s $1 double cheeseburger.

What are the legal implications of that situation?
There is attached to the franchisor-franchisee relationship a two-way street called the covenant of good faith and fair dealing. This means franchisees in their relationship with franchisors, and vice versa, have to act in a way that is fair and reasonable and is not discriminatory and in a way that does not deprive the other party of the fruits of the relationship. [Franchisees] buy into a franchise opportunity because they expect a franchisor will help them on the road to profitability. To the extent franchisors are imposing obligations on [franchisees] to sell goods below their actual costs, it violates that contract.

Has there been good news from a legal standpoint for franchisees lately?

We like the Randall, et al. vs. Lady of America case that came out recently in federal court in Minnesota. It says a franchisor may not disclaim the protections afforded to a prospective franchisee by applicable federal or state laws — be they statutory or common law principles — by a [written] disclaimer.

Can you elaborate?
I’ve said often that despite doing this for 30-plus years, I’ll still bet one of these super salesmen could probably talk me into signing just about anything. What the law says, and it varies some from state to state, but in general it says that when you are selling someone a franchise, you’ve got to do it like they did after the ’33 and ’34 [Securities Exchange] Acts were passed for selling stocks or bonds. You have to do it with full and fair disclosure so buyers can make informed decisions based on good information.

And the fact that you might oversell somebody, and the in process get them to sign some kind of disclaimer that says we didn’t say or do anything unlawful, that doesn’t work. If you indeed do or say something unlawful, you can’t avoid liability because as a great salesman you got them to sign the disclaimer. That’s a very important point. Before that case, which incidentally is mine, there were cases that suggested the contrary.

Has there been good news from a legal standpoint for franchisors?
I like to talk about my wins. Let someone else talk about my losses.

Let me put it this way, then. In your article “Calling a Penalty on Your Partner,” you mention that some franchisees forced to close early are still responsible for future royalties. Do franchisors easily get away with that?
It’s the number one point I raise with potential clients. People think intuitively, “If I enter into this franchise opportunity, I’m optimistic things will work out with my good effort and my franchisor’s partnership. But if after three or four years, I have lost lots of money, I will be able to shut my business down and go to law school without further liabilities to the franchisor.”

Lo and behold, if they have assets apart from what they poured into the business, franchisors will say, “You signed up for a 20-year franchise. You closed after five years. I have 15 more years of royalties coming. You’re obligated to keep your doors open and fund your operating losses so I can get my royalty check. Send me a check for 15 years worth of royalties. You owe me hundreds of thousands of dollars.”

And there are cases out there that say that’s right. I say to prospective franchisees that you want to have the express right to get out early if you can’t make it despite your best efforts.

How likely is it that a national franchise brand would require those royalties?
It varies dramatically, much more than you’d think. Let me ask this: How would you like to be a CEO of a company that says to prospects, “Whether you make money or not, you’ll be on the hook for royalties for 20 years”?

Granted, that company won’t have many people signing franchise agreements.
Right. What the law should say is, “Only if [the franchisor] fully and fairly discloses that if [a franchisee] closes early, they will be on the hook for 20 years of royalties.” Because when [franchisors] are silent, [prospective franchisees] will understand the opposite. It’s been only within the last 10 years that franchisors have started to assert that claim.

Before, franchisors acted the way franchisees thought they would. In other words, this [franchisee] tried hard and he lost a lot of money. We’ll sell the franchise to someone else. They didn’t chase people for a lot of money. I say you should tell people that [you’ll chase them for the royalties] and a lot of cases agree with me, but some don’t. Those cases scare the heck out of me.