Role of disclosure in reducing risk for both parties
Risk management by franchisors is an essential part of their international strategy and roll-out process. Those who fail to identify, reduce, and then manage the remaining risk do so at their peril. They should anticipate spending large amounts of time and money seeking to extricate themselves from the quagmire of litigation.
Author: Mark Abell, International Franchise Consultant
The judiciary are notoriously unsympathetic towards franchisors when they litigate against their franchisees. Perhaps Lord Roskill, the chairman of the Fraud Trials Committee, best typifies their approach in his 1986 report. He stated that:
“Fraudsters induce investors to buy franchises …. holding out the prospect of large returns on the investment. But once a payment has been made, the franchise proves worthless….”
Despite the reality of the situation, the court generally sees master franchisees and developers as “the little man” and franchisors as large corporate entities, focused more on profit than fair dealing. They are, therefore, usually only too willing to accept the suggestion that the franchisor has encouraged the hapless master franchisee or developer to invest in the franchise by making gross misrepresentations of the truth.
The reality is, of course, somewhat different. Whilst some franchisors may make over-inflated claims when recruiting master franchisees and developers, the breakdown of the relationship and any resulting litigation is usually due to a mismatch of expectation between the franchisor and the master franchisee/developer, and not any misrepresentation by the franchisor. In other words, the franchisor has failed to undertake appropriate risk management.
Nobody likes to take the blame for their own failure. Master franchisees and developers are no different. If their franchised business fails, the natural reaction is for them to try and blame the franchisor, rather than themselves for this failure.
Franchisors, who have failed to properly implement a risk management strategy and who are found to have made misrepresentations to prospective franchisees, can find themselves subject to substantial awards of damages. It is, therefore, in the franchisor’s very best interests to make sure that it manages the risks by implementing an appropriate disclosure system when recruiting franchisees.
The implementation of an appropriate risk management strategy will mean that prospective franchisees are given relevant, quality information about the franchise in good time before they execute the franchise agreement.
In all jurisdictions, franchise agreements are subject to the law of contract, and a master franchisee/developer can sue a franchisor for breach of contract if it does not fulfil its obligations under the agreement, if it makes false representation, and/or breaches an implied term, warranty or representation. UK franchisors usually ensure that their master franchise and development agreements are subject to English law and the jurisdiction of the English courts. They must, therefore, be aware of how English law regulates such things.
The Misrepresentation Act 1967 and the Unfair Contract Terms Act 1977 may also afford redress to the franchisee in certain circumstances. The franchisee can sue for damages for loss of the bargain and also in certain circumstances for specific performance.
If a franchisor fails to fulfil his obligation under the franchise agreement he may well be liable not only for breach of contract, but also for negligence, or even breach of fiduciary duty in which case the franchisee also has a right against the franchisor in both damages and specific performance.
One particular source of protection afforded to franchisees which is often overlooked is that provided by the Company Directors Disqualification Act 1986. Section 56(1) of this is a complicated piece of legislation, but in basic terms it provides that a director of an insolvent company can be disqualified from being a director for a period of two to 15 years if he can be proved to be unfit to manage the affairs of a company. There is not a great deal of case law upon this point.
The Natural Life Health Foods case held that in some unusual cases the court might be willing to “pierce the corporate veil” and hold the director of a franchisor company liable for negligent mis-statements. However, on appeal the House of Lords found that this could only happen in exceptional circumstances which did exist in the Natural Life case.
The relevant point to note is contained in section 741 of The Companies Act 1985, which provides that a “director” includes any person occupying the position of director by whatever means, including a shadow director. A shadow director is defined as a person in accordance with whose directions or instructions, the directors of the company are accustomed to act.
Case law also uses the term “de facto director” which is basically the same as a shadow director. This means that it is quite possible that the franchisor could, in certain circumstances, be deemed by the court to be a shadow or de facto director of a franchise company, and if the franchisor behaves in a commercially culpable manner (e.g. does not perform his obligations under the franchise agreement) it may well be that he could be disqualified as a director.
A mere distributor or licensee could obviously show that any directions were given under a bona fide arm’s length commercial agreement. The franchisor, however, is far more intimately involved with the franchisee and has power to control most aspects of its business, including management and accounting procedure, coupled with powers of inspection.
Indeed, most franchise agreements provide for the franchisor to manage a franchisee’s outlet in certain circumstances, such as the franchisee’s incapacity or even death. This would mean that not only could an individual franchisor be prevented from being a director of his own company, he could also be disqualified from being a shadow director of another company, and therefore from being a franchisor.
This bar is not restricted to individuals, but extends also to corporate franchisors. Thus, the UK law arguably goes further than most others in this respect in providing protection for franchisees.
If it could be shown that the franchisor, in acting as a shadow director, has lacked commercial probity, or even been merely negligent, he could become subject to a disqualification order. This grey area of law really requires some clarification; ideally by franchisors being expressly excluded by statute.
However, until such amendment passes into law, the franchisor must take steps to monitor carefully its franchisees and ensure that it avoids acting without commercial probity or is negligent. It should also be noted that any dishonesty by the franchisor could be an offence under the Theft Act 1968, punishable by fines and penal sentences.
Legal regulation of franchisor disclosure
In a growing number of jurisdictions, the risk management process is in part proscribed by legislation. The legislature takes the view that appropriate disclosure is so important that it is something that needs to be specifically provided for in the law and cannot be left to voluntary codes, enforced by toothless trade bodies. Even though the agreement may be subject to English law, the franchisor must still comply with the local disclosure law.
The protection afforded to franchisees in the U.S. is often held up as a model which the UK should adopt by those favouring a statutory regulatory system. In the U.S, where franchise sales are seen as basically dealings in securities, there is a complex web of federal and state laws imposing differing requirements upon the franchisors.
At federal level, there are the Trade Commission’s “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures”, which have recently been amended and updated. These require franchisors and area developers to provide would-be franchisees and sub-franchisees with the franchise agreement, or related documentation, and a disclosure document.
Matters included in the disclosure document are:-
the franchisor’s litigation and bankruptcy histories
the histories of the franchise to be purchased
details of any initial and continuing payments
details of any obligations to purchase goods
details of available finance
the precise nature of the franchisee’s participation and,
a summary of the termination, cancellation, training, site selection and reporting provisions of the agreement.
It is common practice to use the Franchise Disclosure Document (FDD) developed by the American Securities Administrators’ Organisation in place of the actual disclosure document. Timing is crucial and disclosure must be made at the earlier of either the first “personal” meeting, or the time for making the disclosure (at least 10 business days prior to the execution of a binding agreement or the payment of consideration by the franchisee).
All related documentation, including the agreement to be executed by the franchisee, which is materially different from the standard form of agreement must also be registered within five working days before execution. Further, unless the FDD is used for disclosure purposes an “earnings claims document” must also be delivered to the franchisee if the franchisor makes projections of earnings or incomes of the franchisee or discloses history or information concerning the company and/or franchise operations. However, if the claims are made in the media the separate earnings claims document is compulsory, even if a FDD is used.
Most states also have registration/disclosure requirements as well as provisions for covering such things as termination and renewal. These requirements are many and various, and the interface between state and federal laws requires a great deal of consideration and keeps the American franchise lawyers well supplied with highly remunerative work. At present there are a number of proposals to increase this level of regulation still further.
The problems in such a system for UK and other foreign franchisors is that they find it difficult to deal with the administration and the highly technical rules tend to gain a momentum all of their own. The rules continually change as their shortcomings become evident.
In Australia, a specific franchise law was first proposed in 1986 along the American lines. However, at the time the development of Australia’s common law, which is basically the same as that of England, was thought to afford more than adequate protection to franchisees and so the proposed law was abandoned. A voluntary regulatory code was established following the recommendations of a parliamentary working party headed by David Beddell M.P. Its lack of success has been well documented. As a result, in June, 1998 a new franchise law, providing for mandatory disclosure by franchisors to their franchisees, was adopted. This has become a heavy burden for franchisors.
In Japan, the Ministry for International Trade and Industry (MITI) has agreed a voluntary code with the Japanese Franchise Association which, if complied with, exempts JFA members from extensive laws covering distribution in general. The Fair Trade Commission has issued guidelines on desired disclosure by franchisors.
The Franchise Association of Southern Africa (FASA) has been given powers to consider complaints by franchisees under the Consumer Code for Franchising introduced by the South African government. This approach has much to commend it as it combines the “teeth” of legislation with the flexibility and industry knowledge of a national franchise trade association. A new law is currently being considered.
It is widely stated that the Loi Doubin was the first franchise specific law in any EU member state. That is not technically correct. The Loi Doubin does not specifically refer to franchising. Rather, it focuses on networks which operate under a common brand. This neatly avoids the courts becoming embroiled in highly technical arguments over what is a franchise and what is not.
The Loi Doubin was adopted in 1989. It was enacted by Decree Number 91-337 of 4 April, 1991 and makes pre-contractual disclosure mandatory for most franchising operations. Although the law does not actually mention the word “franchise” its main impact is upon the franchising sector. It provides that any chain that is licensed to use a trade name, mark or sign on an exclusive or non-exclusive basis must comply with the disclosure requirements.
Disclosure must be made at least 20 days prior to the signing of the franchise agreements. Breach of this will render the franchisor liable to a fine. It is not necessary to prove bad faith on the part of the franchisor to establish liability. If bad faith is established then the franchisor may be convicted of criminal fraud. Failure to comply with the disclosure requirements can lead to an order for damages being made by the courts.
By and large the Loi Doubin has been successful at ensuring that franchisors impart relevant information to potential franchisees before they sign up. This success has inspired Spain and Italy to take a similar approach to the regulation of franchising.
The story in Spain is somewhat different to that in France, even though the laws are partly based on the French law.
Despite the fanfare that heralded the introduction of Spain’s franchise laws in 1988, 13 years on they can only be seen as a failure and underline the need for any franchise law to be based upon rational assessment rather than emotional self-righteousness.
There is a disclosure and a regulation law.
The disclosure law applies to all franchises being sold in Spain, including master franchises. The disclosure requirements are detailed in Article 3 of the Royal Decree 2485/1988 and under Article 62 of Law 7/1996 of January 15, 1996.
The franchisor is required to provide basic information 21 days before closing a deal with a franchisee. By and large this law is complied with.
The Franchisors’ Registry was set up in 1988 as a national registry to guarantee the centralisation of all relevant information about franchises operating in more than one autonomous region of Spain. The law aims for a transparent system, which enables potential franchisees to identify reputable franchise systems by reference to the register. However, to date this aim has not been achieved.
The original idea was to create a registry in each region under the jurisdiction of the Central Registry based in Madrid. This has yet to be achieved nationwide and several regions do not have a local registry.
Further, a lack of uniformity in criteria has meant that the registries have been operating without proper admission rules. As a result, the registries have admitted and, therefore, given credibility to systems which are not business-format franchises. This in turn has lead to the registries failing to achieve their aims of establishing a list of quality franchise systems.
Thus, ironically, a system designed to make life more difficult for disreputable franchisors is currently endorsing some of them as ones in which potential franchisees can safely invest.
To address some of these issues, the Spanish legislature recently passed Royal Decree 419/2006 which introduced amendments to the previous Royal Decree. The new decree creates additional disclosure requirements regarding the length of time the business has been active and any master franchise agreement.
Foreign companies will have to translate all legal documents into Spanish and register them. Further voluntary requirements will include registering the company’s quality certifications, any mediation or ADR in use in the network, any observance of the Spanish Code of Conduct and any consumer complaints system.
In addition, the new decree creates procedural red tape such as an obligation to notify the Spanish Registry of changes of registered office, the closing or opening of franchise establishments, and an obligation to supply the Registry with an annual report on the franchise network.
A more considered approach to the practicality of the law before it was enacted could have avoided these problems. Other European jurisdictions should study and learn from the Spanish experience.
The Italian law defines franchising as a contract by which one party grants to the other, for a consideration, the use of a combination of intellectual property and/or industrial rights, know-how, and technical and commercial assistance, as well as the opportunity to be part of a franchising network.
The law stipulates that the contract must be executed in writing (otherwise is null and void), and the franchisor must have previously tested its formula in the market. The duration of the contract must take into account the time necessary for the franchisee to recoup the investment and, in any event, must be at least three years, except for early termination in case of breach of the agreement. The contract must specify certain basic matters. The franchisor must deliver a disclosure document to the franchisee at least 30 days before the date of execution of the contract.
After several years of contemplating a wide variety of proposals – some bordering upon the bizarre – the Belgian Parliament has followed the lead of France and Spain by requiring franchisors to make formal pre-contractual disclosure to their potential franchisees. The proposed new franchise law came into force in February, 2006.
It requires franchisors to deliver a formal disclosure document to potential franchisees a month before they enter into it. Failure to do so will potentially render the franchise agreement unenforceable. The document comprises two separate sections, the first summarises the main terms of the agreement, and the second details “information relating to the correct evaluation of the commercial partnership agreement”.
In the event that the franchisor fails to comply with the disclosure requirements, the franchisee will have the option to have the agreement become null and void within a period of two years of the date of the agreement. If the disclosure document fails to properly summarise the terms of the franchise agreement, those terms will not be enforceable.
Both parties are placed under a duty of confidentiality as regards information that they obtain “with a view to entering into a franchise agreement, and may not use the information, either directly or indirectly, other than for the purposes of the commercial partnership agreement to be entered into”.
Romanian law also requires pre-contractual disclosure to franchisees. Unfortunately the law was adopted without a great deal of thought as part of a general attempt to present post-communist Romania as a modern country subject to the rule of law. As a consequence, the law has many shortcomings.
After many attempts in the Swedish Parliament to enact a franchise law, a pre-contractual disclosure law was passed in 2006.
A franchise disclosure law was adopted by the Dutch government after heavy lobbying by franchisees. As a result it is one of the more arduous franchise laws in the EU.
What should UK franchisors embarking upon an internationalisation programme be doing as regards risk management? If there is a disclosure law in the target country the franchisor has no choice but to comply with it.
However franchisors must take responsibility for their own situation and properly manage the risks involved in recruiting master franchisees/developers, regardless of the absence of statutory disclosure obligations in many countries.
If the franchisor is at fault, then it should take the blame. Sharp practice amongst franchisors damages the reputation of franchising as a whole. However, legitimate franchisors must also accept responsibility for their own actions. They must take pre-emptive steps to ensure that there is no mismatch of expectation between them and their prospective master franchisees/developers, whilst at the same time not putting the latter off all together. It is a delicate balance. An art rather than an exact science. An international franchise disclosure document is, therefore, essential.
The master franchisee for its part must take proper legal and financial advice on the franchise and speak to as many of the franchisor’s existing master franchisees as possible before entering into the agreement. The master franchisee must also be brutally honest with itself as regards to whether or not it is cut out for the role.
The franchisor must make sure there is as little scope as possible for misunderstanding. This means identifying the risk to which it is exposed through any alleged misrepresentation, reducing that risk as much as possible by implementing an appropriate disclosure procedure as a key part of its recruitment process, and managing the remaining risk by ensuring that the disclosure process is properly implemented on an ongoing basis.
So, in conclusion when UK franchisors decide to take advantage of foreign markets they must come to terms with the need for proper disclosure, not only in countries such as Italy, France, Spain and Belgium with “franchise laws”, but also in countries such as Germany, Austria and Switzerland which have so-called “soft” franchise laws that afford franchisees a level of protection that is far higher than that offered in the UK and other jurisdictions.
By mastering the gentle art of disclosure, UK franchisors will save themselves both time and money.
About the author
Dr Mark Abell LLB has been acknowledged as a world leading expert in franchising for over 40 years. Abell now works with a select portfolio of world leading franchise brands on the development and implementation of their international and domestic strategies.