We hear from a lot of franchisees who are disappointed with their investment, and from others who have gone out of business. These are tough times for all businesses, not just for franchises. But when a franchise owner struggles, his thoughts often turn to ways that his franchisor might help him if he were so inclined. Many find their franchisors more concerned with improving their own bottom lines than with helping their franchisees survive.

Many examples could be given, but lately a troubling trend among restaurant franchises has been to impose low priced promotions on franchisees, such as the $5 menu at Subway and similar promotions at Burger King and Wendy’s (to name just a few). We don’t know the details of those companies’ arrangements, but generally franchisees are forced to pay for an advertising campaign that promotes these bargain prices to the consumer. Then franchisees are expected to lower their sales prices on the featured items, even though their food costs don’t go down. If everything works out well, franchisees get more business because of these special prices, and the increased volume makes up for the reduced profit per item. When it doesn’t work out well, the franchisee doesn’t get enough new business to make up for his lower profit, so he loses money. How does this affect the franchisor? In many cases this increases the franchisor’s profits, though perhaps he loses a few more franchisees as a result. This occurs because most franchisors get paid a percentage of gross sales, so they benefit from higher sales volume even if products are sold at a loss. Most franchisors also get rebates from food vendors, so the more money franchisees spend on food purchases, the more the franchisor receives in rebates.

Well, what is a franchisor supposed to do, one might ask, in a world where all his competitors are implementing these low priced promotions? How about sharing some of the pain with franchisees by temporarily lowering franchise fees, or distributing some of these increased product rebates to franchisees? Somehow these obvious steps rarely get taken.

So what can a franchisee do when he can no longer afford to keep his business open? And can anything be done later for the former franchisee? Can they look to the franchisor to recover their franchise fees or their business losses? Will they also be liable to their franchisor for unpaid franchise fees or liquidated damages after termination, and will they be prohibited from competing with the former franchise after termination?

In many cases the franchisee will simply be out of luck. He will not be able to recover his losses from the franchisor and he will be obligated to live with the noncompete restrictions in his franchise agreement. But in some cases, a franchisee may be able to bring a claim against the franchisor, recover some or all of his financial losses, and avoid the noncompete obligation.

Pre-Sale Disclosure Violations as the Basis for Financial Recovery

Remember that UFOC or FDD you got before you signed your franchise agreement? (If you didn’t get one, that’s a violation of law). Your franchisor was required to comply with complex federal regulations regarding the content and delivery of that document. Unfortunately, individuals are not permitted to sue directly for violation of these regulations; only the FTC has the right to enforce them. However, many states have their own laws covering the sale of franchises or “business opportunities” (a term generally used to describe similar arrangements that do not involve use of a trademark).

Ohio’s law has an exemption for companies that comply with federal disclosure rules. But if a company makes mistakes in their disclosure documents, or otherwise violates the rules regarding preparation or delivery of the disclosure documents, the exemption would not be satisfied. Assuming no other exemption applies, the franchisee can sue the franchisor within five years of the agreement (and in some cases even longer). If the franchisee wins, he can undo the deal and presumably get his money back and avoid any future noncompete obligation. He might also be entitled to recover his business losses. In some cases he can even recover triple damages and attorney fees.

How do we know that disclosure violations occurred? Obviously, we don’t. But the rules are extensive and complex, and sometimes franchisors get sloppy. Violations occur frequently. A common type of violation involves financial performance representations made prior to sale of the franchise. Franchisees need to be persuaded to invest, and they ask a lot of questions about how much they can expect to earn. Disclosure rules limit what the franchisor can say, and if franchisors make financial representations, these must be explained in detail in the disclosure document. Frequently the franchisor decides not to make any representations to avoid the disclosure obligation. But this presents challenges in persuading the franchisee to invest, especially where the franchisee intends to borrow money to pay for his investment. In one case, a franchisor had a policy of not making any financial representations, and his disclosure document stated this. However, the franchisee’s bank required him to submit a budget and statement of cash flow in connection with his loan application. Not knowing what to include in this, the franchisee got some suggested numbers from his franchisor, and he later had the budget reviewed by the franchisor before submitting it to the bank. That involvement by the franchisor seemed like a clear violation of federal disclosure rules, and it was enough to get the franchisee a significant cash settlement from his franchisor.

Not every state allows recovery by franchisees for franchise disclosure violations, but this can be a valuable weapon for a franchisee in states that do allow such recovery. It’s not always obvious which state’s laws apply to a franchise relationship. Usually it will be the state which is specified in the “choice of law” section of the franchise agreement, but sometimes the law of the state of the franchisee can be applied instead.