If you are a businessperson, sooner or later you will have to deal with a lawyer. In the franchise world, it helps – tremendously – to deal with attorneys who understand franchising and franchise law. It doesn’t matter whether you are a franchisor or a franchisee; no matter which side of the transaction you happen to be on, you will want an experienced franchise attorney to be on the other side.
Surprisingly, the level of franchise law knowledge among attorneys who actually get involved in franchise transactions varies considerably. The majority of the time, lawyers who are knowledgeable in franchise law are on both sides of the transaction. But that is not always the case. Sometimes, the attorney on the other side is inexperienced, and “dabbling,” in franchise law.
This is the second of a two-part piece on why attorneys who are inexperienced in franchise law can hinder a transaction, or worse, do harm to their clients. To read part one, discussing the problems that inexperienced franchisee counsel can cause for their clients, please click here.
This article explores the problem of inexperienced counsel from the point of view of the franchisor, which is using an attorney that has little or no familiarity with franchise law (or, even worse, the company is using a consultant who is not a lawyer).
Why Franchisors sometimes use Inexperienced Legal Counsel
If a company is considering franchising its business (a “start-up” franchisor), one of the first things the company does is look for legal counsel. Finding an experienced franchise attorney is not a simple task; there are only a few hundred attorneys in the country that specialize in franchise law. A start-up franchisor may look to its local business attorney to help the company draft its franchise agreement and franchise disclosure document (“FDD”), and otherwise help the company comply with its legal obligations.
The business attorney may be tempted to do the work, instead of referring it to another lawyer. After all, form FDDs and franchise agreements are relatively easy to find, and many of them look similar to one another. But the problem is that franchise contracts and FDDs aren’t “one size fits all” legal documents, and the franchise relationship isn’t a typical business relationship. It is critical for attorneys who work in franchising to understand the documents they draft, the legal requirements for disclosure (both federal and state), and how the pieces of the documents need to fit together.
For example, an experienced franchise lawyer will understand the types of fees that are typically charged, and how those fees can be tailored to the client. The lawyer will know how fees can be used effectively to encourage compliance by the franchisee, and in what situations liquidated damages could be used effectively to decrease legal costs in the event of a dispute between the parties, and when those same fees should not be used. The experienced attorney will know where and how those fees must be disclosed in the FDD.
Counsel experienced in franchising will also understand the interplay between territorial protection (or territorial exclusivity) and the areas in which the franchisee will and won’t be permitted to sell. Whether a franchisor offers exclusive or protected territories, and how those territories are defined, will depend on the type of franchise system, the franchisor’s expansion plans, the nature of the business the franchisee will conduct, and the franchisor’s internal franchise sales goals.
An attorney with little or no understanding of franchise law can inadvertently harm the client’s business by failing to understand whether a protected territory even makes sense for the client and, if so, how the territory can or should be determined. Moreover, an inexperienced attorney may not understand the types of carve-outs from the scope of territorial protection that may be necessary or useful to protect the franchisor and its possible future expansion plans.
I could easily keep going – there are a multitude of areas that need to be addressed in the franchise agreement and FDD where the attorney must have a substantial background in franchising to adequately represent his or her client.
The Problems Caused by Inexperienced Franchisor Counsel
When an attorney who lacks franchise law experience drafts the start-up franchisor’s FDD and franchise contracts, it can cause a number of substantial problems for the company.
First and most significantly, a poorly-drafted FDD can lead to significant liability for the franchisor. The form and content of the FDD is controlled by both federal and state law, and a franchisor can be held liable for an FDD that does not comply with those laws. A number of state laws give their regulators significant power to address franchisors’ failure to comply with registration and disclosure requirements. These powers can include steep fines (that may be multiplied by each infraction or unlawful sale); the power to order a franchisor to rescind the franchise agreement of any franchisee who has been unlawfully sold a franchise; or, worst of all, the right to assess criminal penalties (including imprisonment) against the individuals who control or have decision-making power for the franchisor.
And that’s just on the regulatory side. A franchisor can also face significant liability to its franchisees if it has sold them franchises without complying with federal or state law. Although the Federal Trade Commission’s Franchise Rule does not give individual franchisees a private right of action against a franchisor for its failure to comply with the Rule, many state laws do create a separate cause of action that can be used by an aggrieved franchisee.
Even in the states where the franchisee does not have the right to sue based on a disclosure law violation, state common law will often provide a remedy to the franchisee through fraud claims. If the franchisee relied on a material representation made in the FDD that was false or misleading, and was reasonable in doing so, the franchisee can likely sustain a legal claim against the franchisor for that misrepresentation. Inexperienced counsel can lack the experience to provide his or her franchisor with the guidance needed to avoid inadvertently making a misrepresentation or false statement.
For example, an attorney who dabbles in franchise law may not have a full understanding of what is required of a franchisor who makes financial performance representations in Item 19 of its FDD. Without a full understanding of the guidelines for making an earnings claim, it is possible for a franchisor to make a misleading representation without intending to do so (by, for example, presenting an unreliable, misleading, or unreasonable subset or using numbers without a reasonable basis or written substantiation). This type of mistake could easily lead to significant liability for the franchisor – and, indirectly, for the dabbling attorney.
Even more troubling is the problem of franchise consultants – who are not attorneys – preparing FDDs and franchise agreements without the consultation or assistance of an experienced franchise lawyer. These individuals and companies risk substantial liability through an unauthorized practice of law claim in any jurisdiction where their documents are used.
These risks are not merely theoretical. There are a multitude of reported cases where a franchisor has been held liable for mistakes made in its FDD, with the imposition of significant damages. Often, liability could have been avoided with a more carefully-written FDD. Several other cases have also resulted in a lawyer or non-lawyer franchise consultant being held liable for malpractice or the unauthorized practice of law where material errors were made in the FDD that led to liability for the franchisor.
For these reasons, franchisors should avoid hiring attorneys who dabble in franchise law, and instead seek out experienced franchise counsel. Both franchisors and franchisees benefit when knowledgeable counsel is involved on both sides of the transaction.