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In addition to unveiling the new iPhone and Apple Watch, Apple’s CEO, Tim Cook, also recently announced that the approximate 500 million iTunes users would also be receiving a free digital copy of U2’s latest album, Songs of Innocence. The album would be automatically downloaded and appear in each user’s iTunes library without the person having to do anything.

Analysts are estimating that this deal with U2 cost Apple approximately $100 million dollars. Apple likely calculated that the publicity and good will they expected to receive far exceeded this cost.

However, Apple’s marketing team did not anticipate the negative backlash sparked through social media and other outlets. Here is an article that refers to Apple’s approach as “invasive.”

Angry iTunes customers demanded to know how they could remove this U2 album that they did not ask for or want. Even fans who wanted the album complained about Apple downloading it onto their account without asking for their consent. In response, Apple had to develop a separate website which details the process for users to remove the U2 album from their library.

In addition to upsetting its customers, Apple also had to deal with unwanted media coverage criticizing Apple’s decision to download the music directly onto user’s iTunes library, rather than making the free download available for anyone who was interested, i.e., giving their customers a choice in the matter.

Apple’s misstep can serve as a lesson to franchise companies. Many franchise executives have the same thought process as Apple. They expect their franchisees to be thrilled by some new initiative that is going to increase their profitability, increase their sales, increase brand awareness, etc. What they do not take into account, is that franchisees, like Apple’s customers, want to feel they have a say in the process and that they are not being dictated to.

Successful franchise systems have strong franchisor-franchisee relationships. One of the quickest ways to weaken this relationship is to take steps where the franchisees feel that something is being force fed to them. A franchisor advising of a new initiative, without any input from its franchisees should expect results similar to what Apple received from their customers.

In Naik v. 7-Eleven, Inc., (U.S. District Court. D.N.J., Civil No. 13-4578), certain 7-Eleven franchisees in New Jersey alleged that they are employees, not independent contractors, of the franchisor, and that the franchisor violated the federal Fair Labor Standards Act (FLSA) and other New Jersey statutes.  7-Eleven made a motion to dismiss, which was denied by the court.

Each plaintiff entered into a franchise agreement with 7-Eleven.  Despite clear language in the franchise agreement indicating that the franchisees operated independently owned and operated businesses, the franchisees claimed that the “economic reality” was that they were employees of the franchisor and entitled to protections under the FLSA, New Jersey Wage and Hour Law and the New Jersey Law against Discrimination.

In an effort to support their claim, the franchisees relied on numerous factors, including:

  • The Franchisor asserts a high level of control over vendor and suppliers, product pricing and advertising;
  • Payroll is processed through the franchisor’s payroll system;
  • Franchisee’s required to wear uniforms designated by Franchisor;
  • Franchisor’s managers oversee Franchisee’s locations on a daily basis;
  • Franchisor controls the volume of store televisions and thermostat from their corporate headquarters;
  • Franchisees are prohibited from having active business interests in other ventures;
  • Bookkeeping and accounting is done by the Franchisor and the Franchisee cannot withdraw money without the Franchisor’s consent.

In denying the Franchisor’s motion to dismiss, the court noted that the issue of the classification of an independent contractor vs. an employee for purposes of New Jersey wage claims was still unsettled and the issue was in the process of being examined by the New Jersey Supreme Court.  However, the Court did take note that the Franchisor has exerted significant and pervasive control over the Franchisee’s operations.

While the court has yet to issue a final decision on this case, it certainly serves as a stark reminder for Franchisors  to evaluate whether the controls it exerts over its franchisees are necessary to protect brand standards or whether the controls go above and beyond this need.

The recent decision of Yogo Factory Franchising, Inc. v. Edmond Ying, et al., (US District Court D. New Jersey 2014), has been the subject of prior blog postings. We have discussed the court’s enforcement of the arbitration provision contained in the franchise agreement and the court’s re-affirmation that the New Jersey Consumer Fraud Act does not apply to the sale of franchises. Another noteworthy aspect of the court’s decision is the discussion of the heightened standard under New Jersey law to successfully assert a fraud claim.

In this case, the franchisee alleged that the franchisor made various misrepresentations during the sales process, including misrepresenting potential earnings, profits, the amount of start-up costs, and the type of support that the franchisor would provide.

Franchisee did not plead fraud claims with particularity

The court noted that when asserting fraud under New Jersey law, it must be pleaded with particularity. This is a heightened standard that requires the claimant to be very specific when alleging fraud, and does not permit general and broad claims. For example, when asserting fraud, a franchisee would not only need to assert the substance of the alleged misrepresentation, but also the date, time and place of the misrepresentation.

In this case, the court held that the franchisee’s fraud claims did not meet this standard. The franchisee did not specify which member of the franchisor made the misrepresentation and when. The court also noted that the franchisee claimed that the franchisor made material financial performance representations but did not specify exactly when and where they occurred. The court generally viewed the franchisee’s fraud claim as just asserting legal conclusions, leaving the franchisor to guess as to the ‘who, what, when, where and how of the events at issue”.

Franchisee’s allegations did not rise to level of fraud

Even if the franchisee had properly asserted its claim with particularity, the court concluded that it still failed to make a proper fraud claim. The court noted that the crux of the franchisee’s fraud claim was that the franchisor misrepresented the amount of money it would generate and the amount of support it would provide.

In rejecting the fraud claim, the court pointed out the following:

  • Two of the three franchise agreements contained an integration clause stating that the agreement constitutes the entire, full and complete agreement between the parties and the agreement supersedes all prior agreements;
  • The agreements contained a provision stating that no other representations induced the franchisee to execute the franchise agreement;
  • The franchise agreements clearly state that the investment and any success is speculative; and
  • The franchisee executed a disclosure questionnaire stating that the franchisor did not make any promise concerning revenue, profit or operating costs of the franchised locations, except as set forth in Item 19 of the Franchise Disclosure Document.

Based on these factors, the court did not see any basis for fraud. The court also concluded that under established New Jersey law, a party cannot maintain a fraud claim based on the other party’s failure to perform under a contract. The remedy is to bring a breach of contract claim – not a fraud claim.

This case underscores that if franchisors engage in some fairly common best practices (integration clauses, disclaimers to Item 19 financial performance representations, utilizing a disclosure questionnaire, etc.), they can reduce the likelihood of a franchisee maintaining a viable fraud claim under New Jersey law.

A common question that we receive from our franchisor clients is, “Can we update our FDD and franchise agreement permitting the franchisor to impose fines on franchisees for non-compliance?” The simple answer is that while you can update your documents to permit the imposition of fines, the real question franchisors should be asking is, “Are fines an effective tool to minimize instances of non-compliance with System standards?”

Recently, a hotel received unwanted attention for its policy of imposing wedding couples a $500 fine for every negative Yelp or other social media site review posted online by their guests.

As part of the policy posted on the hotel’s website, the rationale behind the fine was explained as follows:

Please know that despite the fact that wedding couples love Hudson and our inn, your friends and families may not,”… “If you have booked the inn for a wedding or other type of event . . . and given us a deposit of any kind . . . there will be a $500 fine that will be deducted from your deposit for every negative review . . . placed on any internet site by anyone in your party.

In response to the attention that this policy has generated, the hotel owners have responded that the policy was posted on its website as a joke, was never enforced and the policy has subsequently been removed from the hotel’s website. The reason this story has gone viral is the irony that a business could think that imposing fines is an effective way to limit negative reviews, rather than working to fix the service and operational issues that may prompt such negative reviews.

This story serves as an over exaggerated example of the ineffectiveness of using fines rather than resolving the underlying issue that is resulting in the behavior the fines are seeking to curtail. In the case of franchise systems, if a franchisor is considering implementing fines, it is usually because they are trying to stop a wide spread issue, and is not in response to some isolated instances involving “rogue” franchisees. This suggests that the franchisor should be focused on why the instances of non-compliance are increasing, rather than hoping that it can ignore the underlying problem and simply levy fines. While imposing a fine may result in short term results for increasing System compliance, it is difficult to imagine that it will achieve long term or permanent results if the underlying issues are not addressed.

Franchisors should also remember that when addressing non-compliance, there is not a “one size fits all” solution. If a franchisee is not following System standards because they are undercapitalized or struggling financially, it seems that imposing a fine would just be piling on to their problem. In that instance, the franchisee would view the franchisor as having no empathy and the relationship would further deteriorate. Similarly, if a franchisee is not following System standards because their business is struggling and they have become despondent and no longer keeping a close eye on their operations, imposing a fine may just lead to a franchisee’s sense of despair and increase their non-compliance.

While the use of fines may be effective in certain instances, it is difficult to see how a wholesale and indiscriminate use of fines would serve as a “silver bullet” to increase overall System compliance with brand standards. It is also difficult to see how fines could be effective in the long run, if the franchisor is not also focused on addressing the underlying behavior and issues that are resulting in the non-compliance.

The National Labor Relations Board Office of the General Counsel has created a firestorm in the franchise community with its recent decision that McDonald’s and its franchisees will be treated as joint employers with respect to allegations that they violated the rights of employees. The NLRB’s decision strikes at the heart of the franchising business model, which is based on franchises being independently owned and operated businesses.

If upheld, the NLRB’s decision could have a substantially adverse impact on the franchise industry and the overall economy. Franchise development leads to economic and job growth. One would expect business owners to be reluctant to expand through franchising if they could potentially be responsible for their franchisee’s employees. This decision could also result in increased pricing of goods and services, as a franchisor would likely need to increase its revenues to deal with this new potential liability. Increased pricing could ultimately result in decreased consumer spending and stall economic growth.

It is worth noting that the NLRB’s decision represents the first step in its administrative process. McDonald’s will have the opportunity to defend itself in an administrative hearing and will also have the opportunity to appeal that decision to the NLRB Board. Even if the NLRB upheld a decision against McDonald’s, it would then need to be enforced by a federal court.

Whether the NLRB’s Office of General Counsel’s decision withstands the scrutiny of its entire board and the federal court system remains to be seen. While this process plays out, a franchisor should take this as a cautionary reminder to regularly review its operations manual and other policies to ensure that it is not unnecessarily exerting too much control over its franchisee’s employees. Unless a policy is absolutely essential to the health of the brand and System, a franchisor should err on the side of being suggestive vs. required when creating policies that impact a franchisee’s employees.

In last week’s blog posting we discussed the recent decision of Yogo Factory Franchising, Inc. v. Edmond Ying, et al., US District Court D. New Jersey 2014), in which the court enforced the arbitration clause contained in the franchise agreement. Also notable in this case was the court’s decision reaffirming that the New Jersey Consumer Fraud Act did not apply to the sale of franchises.

In this case, the franchisee alleged that the franchisor committed fraud during the sale of the franchises. In particular, the franchisee claimed that the franchisor misrepresented the amount the franchisee would earn from the operation of the franchised locations and misrepresented the start-up costs. The franchisee asserted that the franchisor’s actions were a violation under the New Jersey Consumer Fraud Act. The court held that the New Jersey Consumer Fraud Act did not apply to the sale of franchises.

In reaching its conclusion, the court noted prior Third Circuit decisions which concluded that franchises are not deemed consumer goods or services under the Consumer Fraud Act. "Franchises are not purchased for consumption but rather purchased for either present value of cash they are expected to produce in the future…and bear no resemblance to the commodities and services listed in the statutory definition of "merchandise" or the rules promulgated by the Division of Consumer Affairs."

If a franchisee was able to convince a court that a franchisor committed a violation of the Consumer Fraud Act, it could result in a court awarding a franchisee treble damages. For this reason, I would anticipate that franchisees will continue to assert claims under the New Jersey Consumer Fraud Act. However, as the Yogo Factory Franchising decision illustrates, these types of claims will likely not prevail in the Third Circuit.

In Yogo Factory Franchising, Inc. v. Edmond Ying, et al., US District Court D. New Jersey 2014), the court enforced the arbitration clause and held that the arbitration clause should be applied to all the franchisee’s claims arising from the franchise agreement. 

In this case, the franchisee alleged breach of contract, tort and statutory claims against the franchisor. In addition to contending that the franchisor breached the terms of the franchise agreement, the franchisee also alleged that the franchisor committed fraud during the sales process, and did not comply with the FTC disclosure requirements. The franchisee argued that the arbitration clause should be construed narrowly to only apply to the breach of contract claims and not the tort or statutory claims. The franchisee agreed that its claim that the franchisor breached the franchise agreement would be subject to the arbitration clause, but contended that its claims that it was fraudulently induced to enter into the franchise agreement, that the franchisor did not comply with the FTC disclosure laws, etc., were not subject to arbitration. The court disagreed and reasoned that the arbitration clause should be interpreted broadly to apply to all the franchisee’s claims, not just the breach of contract. 

Had the court applied the franchisee’s reasoning, then it would have created an end run for franchisees to avoid arbitration provisions by simply including tort or statutory claims in its complaints. The court’s decision re-affirmed a "presumption in favor of arbitrability when determining both the existence and scope of an arbitration agreement". 

In sum, if a franchise agreement contains an arbitration clause, the parties should continue to expect a New Jersey court to broadly enforce the arbitration provision to all claims arising out of the franchise agreement.

The New Jersey Appellate Division recently held that insurance agents were not considered "franchises" under the New Jersey Franchise Practices Act (Mario DeLuca v. Allstate New Jersey Insurance Company (Superior Court of New Jersey, Appellate Division No. A-2724-11T4 (2014)).   

The Plaintiff insurance agents were independent insurance agents for Allstate. The court noted that "relationship between Allstate and plaintiffs did not constitute a franchise under the Act because there was no "community of interest" and plaintiffs did not maintain a "place of business" as those terms are used under the Act."  

Under the Act, a franchisee must maintain a fixed geographical location to offer or sell the franchisor’s goods or services in order to establish a "place of business" under the New Jersey Franchise Practices Act (the "NJFPA"). In concluding that the plaintiff’s did not maintain a "place of business," the court reasoned that the plaintiffs were merely agents and not insurers, authorized to sell insurance in the State of New Jersey. Since the plaintiff agents were not permitted to sell the insurance product themselves, they could not meet the "place of business" requirement under the NJFPA.

In this podcast, Adam Siegelheim, Shareholder in Stark & Stark’s Franchise Group, discusses the differences between franchising and licensing a business, and which option may be best for you. 

You can listen to the full podcast online below.

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