Thursday, January 1, 2009

The Twelve Worst Franchise Provision Agreements

I've told you my story, and it is one that will continue for some time. Currently, I am working on a legal action against Cold Stone Creamery, but it will be a long arduous process. Hopefully, you will find this blog both entertaining as well as informative.

There are hundreds of us within the Cold Stone community that have been affected greatly by the actions of Cold Stone Creamery. I realize that there is a larger community out there, composed of many franchise opportunities, and tens of thousands of franchisees. Not all franchisors are dishonest, or use deceptive practices to recruit franchisees. Take McDonald's for example. The relationship between its franchisees, and its suppliers is the model for quality franchising. But, you must always do your due diligence when examining a franchise opportunity. With that in mind, lets take a look at a list of the twelve worst franchise provision agreements within any UFOC (Unified Franchise Offering Circular) document. As you examine the UFOC document you may have received from a franchisor, look for any of these franchise provisions within the UFOC. If you find any of them, try to negotiate these provisions out of the UFOC document. If the franchisor is unwilling to do so, do not move forward! And remember, the UFOC offers you almost no protection. Essentially it is designed to protect the franchisor, and to give them almost unlimited latitude when dealing with their franchisees. Ok, so what are the top twelve worst provisions? You can link to them if you want a copy, using the link to the right, but let me cover all twelve. I'll give you my take on each of them:

1. Gag Rules. Some franchise agreements now prohibit franchisees from discussing any aspect of their franchise experience with anyone outside the system. This defeats the FTC rule and other state disclosure laws which require lists of terminated franchisees to be provided to prospective franchisees. It may even prevent ex-franchisees from discussing any issues that caused them to leave the system, at least for a period of time.

2. Franchisor Venue Provisions. These provisions require franchise disputes to be litigated or arbitrated in the home state of the franchisor. This not only increases costs for the franchisee, but also allows the franchisor to litigate, arbitrate or even mediate on their home turf. Some agreements only allow for mitigation for the franchisee, while allowing the franchisor the right to seek legal action in a court of law! There has been a ruling recently in California that may allow the franchisee the right to seek legal remedies through the court system, even with the mediation provision in the UFOC document. I will post that court decision in the sidebar to the right later this week.

3. Lack of Reciprocal Cure Periods. Many franchise agreements give the franchisor 30, 60, or 90 days to cure any alleged defaults; some even do not allow the franchisee any remedy if the franchisor defaults. On the other hand, some franchise agreements provide for no cure periods for any alleged default by the franchisee. What is good for the goose is certainly good for the gander! It has been my experience that the franchisor rarely gives the franchisee enough time to cure any default, and in fact, wants the franchisee to default! This way, the franchisor can come in and acquire an asset for virtually nothing, and resell it over and over again. This process is known as "churning".

4. Nonreciprocal Noncompetition Covenants. Many franchise agreements have oppressive post-term noncompetition covenants, both in terms of duration and geographical scope. At the same time, many franchise agreements allow the franchisor to place competing units pretty much where they want. If the franchisor wants protection from the franchisee after the agreement expires or terminates, why shouldn't the franchisee be entitled to the same protection during the franchise agreement? The franchisor, many times is more interested in their royalty fees and service fees than the financial health of their franchisee. Look, if they have one unit making $400,000 per year, making say, 9% in fees, they collect about $36,000. If they open a second unit 2 miles away, and the second unit grosses $300,000, and due to the close proximity of the second unit to the first, the first now only grosses $300,000, the franchisor now generates about $54,000 from the combined gross sales of both units! If break even for the units are about $350,000, you can see how this strategy damages the franchisee, but adds an additional $18,000 in revenue for the franchisor!

5. Sole Sourcing Requirements. Many product-oriented franchise systems require the franchisee to purchase products solely from the franchisor or from suppliers designated by the franchisor. No allowance is given to purchase from alternate sources even if the quality standards are upheld. This leaves the determination of the gross margin achieved by the franchisee solely in the hands of the franchisor. Cold Stone Creamery actually states in the UFOC/Franchise agreement, that you may submit Vendors for their approval, but if Cold Stone has an exclusive arrangement with its vendors, the issue becomes moot, and you will be faced with "out of compliance" issues. In many cases, Cold Stone Creamery also receives "kick backs" from the vendors (known as FMP dollars). These "kick backs" become a large revenue stream for Cold Stone Creamery, and, generally, are not shared with the franchisee community that paid the often exorbitant prices for the goods they are forced to buy from the vendors!

6. Mandatory Subleases with Rent Overrides. Many franchise systems require the franchisee to sublease the franchised premises from the franchisor who has in turn leased the premise from the landlord. This places the franchisor in the real estate business and able to net a profit essentially without risk. In addition, the fact of these overrides and the amount of them are rarely disclosed in the franchising offering circulars. Cold Stone Creamery basically derives an income by charging the franchisee a 6% fee (for the life of the rent, usually 5 years), which they like to call an "administrative" fee. This fee is paid up front, and can cost you between $6,000 to $20,000! So, tell me, what is their incentive for negotiating the best possible rent for you? The more rent you are charged, the larger the "administrative" fee they receive!

7. Lack of Accountability of Advertising Fund. Over the years, franchise agreements have increasingly been drawn in a manner to give the franchisor maximum discretion over the use and application of advertising funds. Agreements are often drafted in such a way as to allow franchisors to not spend advertising dollars in the market where franchisees have contributed to ad funds. This has been just another way in which Cold Stone has misused, or worse, misappropriated the franchisees money to cover its own expenses. Many times at our local Co-Op meetings, we've asked for an accounting of these funds, only to be given promises of disclosure which never happened.

8. Lack of Reciprocal Legal Fee Provisions. Many franchise agreements require the franchisee to pay all of the franchisor's legal expenses in the event of litigation between the parties. However, if the franchisee wins the litigation, the franchise agreement does not provide for legal fees. The only way a franchisee can obtain legal fees is if a state statue allows such recovery or in the unlikely event the franchisee prevails on a RICO claim. The language of the early franchise agreements with Cold Stone Creamery did allow for reciprocal legal fees. But please, thoroughly read the sections dealing with how disputes will be resolved.

9. Kickbacks. Some franchise agreements openly acknowledge that the franchisor has the right to make deals with vendors who sell goods and services to franchisees that are mandated by the franchise agreement. Very often, these vendors provide kickbacks, promotional fees, and commissions to the franchisor in return for being allowed to sell their products and services to a captive market. Instead of passing these kickbacks, promotional fees and commissions on to the franchisees to reduce their cost of goods sold and increase their margins, these payments are pocketed by the franchisors. Now, while these kickbacks are not necessarily illegal (they, in fact, are described in the UFOC document that each of us signed with Cold Stone Creamery), there are arguments within the judicial system, that these kickbacks may be illegal if they meet certain per se requirements, and as such, may violate some state and federal anti-trust laws.

10. Mandatory Arbitration Provisions. While arbitration is a faster and presumably cheaper, it has major disadvantages to franchisees. Arbitration is private, with the resulting decisions not creating any precedents. In addition, the ability of the franchisee to obtain documents from the franchisor and to take depositions is severely limited. When you signed your franchise agreement with Cold Stone Creamery, you basically waived your right to trial by jury, and agreed to arbitration if a dispute arises. Recently, there was a court decision in California that set aside that provision, and allowed for a trial by jury.

11. Radically Different Franchise agreements on Renewal. Many franchisees find that when it is time to renew, they are not really renewing their existing franchise agreement, but are entering into a wholly new franchise agreement, often with materially different financial and operational terms. Cold Stone Creamery has taken it one step further. When you sign a new franchise agreement for a new location, the terms and conditions of that new agreement supercedes your origional agreement!

12. Unilateral Admendments to the Franchise Agreements. Many franchise agreements provide that the franchisor can change its operations manual or other company policies from time to time without notice to or with the consent of the franchisee. Thus, the franchisor has the right to unilaterally change the franchise agreement. Moreover, the franchisee is rarely given the opportunity to inspect the franchisor's operating manual in advance of the sale of the franchise. Cold Stone Creamery clearly outlines this policy in Provision 24 of the franchise document. They can also change things like royalties, or advertising fees without consulting the franchisee!

This is why it is so important to read the UFOC document thoroughly. Have a qualified franchise attorney go through the document, and using these twelve franchise agreement provisions, evaluate your documents.

For most, the financial aspect has been the biggest issue.

1 comment:

  1. Hi Ed,

    This is very important. Thanks for putting it out there. One of the mistakes we made was signing the UFOC and all of our loan paperwork without having a lawyer review it first. We didn't see the point because we didn't think that we could negotiate any of the terms anyway, that it was a take-it-or-leave-it deal. We also, mistakenly, assumed that if we signed anything that later turned out to be illegal, we would be protected by the law.

    We thought that if any part of the contract was illegal, it would be null and void. It turns out that when we went to court over the provision to arbitrate in Arizona vs. our home state (point #2 above), the judge basically said, "Well, you agreed to it when you signed it," even though there have been other courts (like the 9th Circuit Court-Nagrampa vs. Mailcoups, Inc.) that have ruled that this provision is unenforceable because it grants unfair advantage to the franchisor.

    If I signed an agreement to sell my vintage Rolls Royce collection to someone for consideration of their first born child, and they signed the agreement as well, wouldn't it be null and void based on the fact that the transaction was illegal to begin with? It doesn't matter that both parties agreed to the terms if the terms are illegal. We thought this line of reasoning would protect us from anything that Cold Stone might try to impose on us that was illegal or unenforceable, but it did not. Granted, there was nothing so blatantly illegal as human trafficking in our UFOC, but the judge in our case didn't seem interested in anything as piddly as legality or enforceability. She just wanted to know whether or not we signed the UFOC. And we had. Lesson learned.