basics track best practices in franchise administration · best practices in franchise...

International Franchise Association 44th Annual Legal Symposium

Washington, D.C. May 15-17, 2011

BASICS TRACK

Best Practices in Franchise Administration

Meredith Flynn

Vice President of Financial Services & Franchise Compliance

Allegra Network

Sandra A. Trenda Chief Legal Officer

Great Clips

Sarah J. Yatchak Special Counsel

Faegre & Benson LLP

TABLE OF CONTENTS

I. INTRODUCTION .................................................................................................. 1

II. FRANCHISE SALES ............................................................................................ 1

A. Disclosure and Registration Requirements ................................................ 1

B. Compliance with Franchise Sales “Best Practices” .................................... 2

C. Use of Forms and Checklists to Ensure Compliance ................................. 3

D. Responsibility and Recordkeeping ............................................................. 4

III. FRANCHISE RELATIONSHIP .............................................................................. 4

IV. EFFECTIVE USE OF TEMPLATES ..................................................................... 6

V. CONCLUSION ...................................................................................................... 7

APPENDICES: Appendix A: FDD Item Summary Appendix B: Franchise Disclosure Document Questionnaire Appendix C: Due Diligence Questionnaire (Officers & Directors) Appendix D: Item 8 Officer Declaration Appendix E: Item 8 Revenue Worksheet Appendix F: 2011 FDD Timeline Appendix G: FDD Tracking Summary (Sample 1) Appendix H: FDD Tracking Summary (Sample 2) Appendix I: 2011 Franchise Sales Compliance Guidelines Appendix J: Final Interview Call Approval Information (Operations) Appendix K: Franchise Sales Process Overview Appendix L: Pre-Purchase Checklist Appendix M: New Franchisee Application Appendix N: Applicant and Territory Summary Appendix O: Franchisee Acknowledgement Addendum Appendix P: Franchisee File Checklist Appendix Q: Renewal Release Agreement (Form) Appendix R: Transfer Checklist Appendix S: Change of Ownership Agreement (Form) Appendix T: Notice of Default (Form) Appendix U: Termination Checklist Appendix V: De-identification Checklist Appendix W: Termination and Take-over Checklist

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I. Introduction

Franchise administration is the backbone of all franchise systems. An effective franchise administration program must be well organized and consist of efficient processes and certain “best practices” aimed at addressing a number of issues in the life cycle of a franchise system, from franchise sales matters to termination as well as everything between.1 This paper thus provides an overview of recommended franchise administration procedures and practices relevant to some of the more common franchise sales and franchise relationship matters. While the implementation of these “best practices” can be complex depending on the number of franchise offerings promoted by a franchisor, a well organized internal process complete with checklists and templates can be a valuable component of any franchise administration effort.

II. Franchise Sales

The franchise sales process encompasses all pre-sale activity, from preparation of the Franchise Disclosure Document (“FDD”) in the first instance, to registering the FDD with certain states and interacting with potential franchisees, to finally closing the deal. Not surprisingly, this process is a highly regulated at both the federal and state level. Because serious penalties can result from improper franchise sales processes and techniques (including criminal penalties in certain states), franchisors must maintain internal controls necessary to ensure compliance with these laws.

A. Disclosure and Registration Requirements

Every franchisor must ensure that the initial FDD, as well as all renewal and

amended FDDs, accurately reflect key information about the franchisor and the franchise system. (A list of the required 23 topics of disclosure appear in Appendix A to this paper.) Providing responses to these questions will require, among other things, a detailed review of franchisor operations, its litigation and bankruptcy histories (as well as those of its officers, directors and other key individuals having management responsibility), and its relationships with suppliers. This can best be accomplished through the use of one or more questionnaires aimed at eliciting responses to these and other important categories of information. For example, one questionnaire might contain questions focused on the specific 23 items of disclosure relevant to the franchisor entity. Because the FDD also must contain information about the franchisor’s officers, directors and other key individuals, another questionnaire might focus its questions on employment histories, litigation and bankruptcy matters for those individuals. As the Amended FTC Rule now requires franchisor officers to disclose in Item 8 whether they own interests in any approved supplier, a separate questionnaire might be distributed only to officers for this purpose. Finally, and also relevant to Item 8 supplier disclosures, is a form aimed at determining how much revenue the franchisor earned from franchisee purchases – both from franchisee purchases directly from the

1 Although beyond the scope of this paper, an effective franchise administration program also will address a variety of other matters such as trademark registrations and renewals, real estate matters (e.g., leases, franchisee lease addenda), and other general business issues that impact a franchise system.

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franchisor as well as indirect in the form of supplier rebates or other consideration paid to the franchisor. Attached to this paper as Appendices B, C, D and E, respectively, are samples of each type of questionnaire/form.

Eliciting the information necessary to update the FDD requires various departments and individuals within the franchisor’s organization to take ownership of the FDD (or portions of it) to ensure the timely provision of accurate information. Appendix F is a sample FDD responsibility and timeline chart, which illustrates one franchisor’s breakdown of departmental FDD responsibilities and applicable timelines. Further, after the FDD has been finalized with the requisite disclosures, franchisors wishing to offer franchises in any one of approximately 13 states must then register the FDD or complete a notice filing with the requisite state authority prior to discussing the opportunity with residents of those states.2 Notably, as Appendix F reveals, FDD responsibilities do not stop once the renewal filing has been completed. Rather, the franchisor must ensure that important post-FDD filing tasks are completed – e.g., updating web sites and other sales materials with new fee information, bringing the development up to speed with the new disclosures and so on. In addition, once registered, franchisors must track renewal and expiration dates to ensure that subsequent filings are timely made. Variations of charts used to track this type of information are included as Appendices G and H.

Beyond tracking effective dates, records detailing the year-to-year FDD changes,

including amendments, must be meticulously maintained. This type of information often is most easy to track when it is maintained electronically as a redlined document showing all changes to the FDD over the prior version. Not only is tracking this type of information helpful from an historical perspective, the information may be called for in a legal proceeding that can occur as many as 20-years later, depending upon the duration of the franchise agreement particularly if disclosure violations are alleged as part of the dispute.

B. Compliance with Franchise Sales “Best Practices”

Ensuring that the franchisor has a properly drafted (and, if necessary, registered)

FDD is the first of many steps in the franchise sales process; actually discussing the opportunity with prospective franchisees is the next key step—and also one that is highly regulated. While franchisors must track the obvious sales process components such as timing of FDD delivery to prospects and obtaining and maintaining receipt pages, franchisors must not under-estimate the importance of franchise sales compliance.

A key goal of any franchise administration program should be to develop and

enforce a “culture of compliance” within the franchisor’s organization. This means that,

2 Franchise registration and notice filing states include California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Washington and Wisconsin. Filings also must be completed in certain other states to obtain an exemption from the applicable state business opportunity law, and these filings vary from one-time to annual filing requirements.

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while each franchise sales team member must have a keen understanding of applicable franchise sales restrictions and requirements, every individual within the organization likewise should have a basic understanding of the same. Communication is key to this objective. In addition to sales compliance training for franchise sales team members, the franchisor should consider requiring each employee within the organization to review annually its “franchise sales compliance guidelines.” These guidelines, a sample of which is attached as Appendix I, should provide an overview of applicable franchise regulations, offer clear guidance with respect to the various types of franchise sales issues that arise, and invite employees to follow up with key personnel should they wish to discuss any questions. Further, and consistent with the culture of compliance, employees should be encouraged to report any concerns with respect to franchise sales matters to a key individual tasked with following up on such matters.

It is important to involve other key departments and individuals within the

franchisor’s organization in assessing whether to award a franchise to a particular prospective franchisee. In fact, the ideal review of any prospective franchisee candidate should include a presentation of the prospect’s qualifications (e.g., financial, experience, and other key factors) by the development team after a comprehensive list of items and screenings has been completed. Sample information, including an internal questionnaire geared toward assessing whether to award the candidate a franchise, that might be considered is attached as Appendix J. Inclusion of team members from operations and marketing (and other departments) ensures that, beyond the candidate’s financial qualifications, any aptitude concerns can be adequately addressed and planned for to ensure the prospect’s greatest chance for success once as a franchisee.

C. Use of Forms and Checklists to Ensure Compliance

As evidenced by Appendices K and L, the franchise sales process (for new and

existing businesses) often is a complex, multi-tiered process. In addition to internal franchise sales compliance guidelines, franchisors can use a variety of other checklists and data management practices to help ensure compliance with important protocol. For example, an internal candidate checklist can be useful in terms of tracking key information and dates, such as (i) candidate residency and territory interests, (ii) date of FDD delivery, (iii) date of FDD signing or payment of money by the candidate, (iv) in certain states, dates of first personal meeting, and (v) franchisee entity and guarantor investor information. This type of information can be tracked in a variety of ways, including on the initial franchise application and other forms, samples of which are attached as Appendices M and N, respectively.

The “franchisee acknowledgement questionnaire,” often included as an

attachment to the FDD, also tracks certain of this important information from potential franchisees. Importantly, the acknowledgement questionnaire also contains important representations from each potential franchisee, including whether unlawful financial performance representations or other unauthorized representations or promises have been made. In short, the acknowledgement questionnaire acts as another checkpoint in

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the franchise sales compliance process. A sample franchisee acknowledgement questionnaire is attached as Appendix O.

D. Responsibility and Recordkeeping

No compliance program, checklist or acknowledgement form is effective unless it

is routinely used and policed. Accordingly, before any franchise sale is finalized, franchisors should appoint one or more compliance persons to be responsible for carefully reviewing all information obtained from the forms and checklists in the franchisor’s compliance toolkit. Each of these people must share the common goal of compliance through open communication and diligence in carrying out their duties. The ideal compliance person to oversee franchise administration is someone that is detail-oriented and has the depth to understand the organization’s varied functional areas. Moreover, they must be able to balance the priorities of both the legal and development interests against the inherent risks.

Recordkeeping is an important aspect of any franchise administration program as

it provides the franchisor with an accurate roadmap of each franchisee business relationship. The recordkeeping process typically begins with the establishment of a file containing the development team’s diligence and investigation of the prospect’s qualifications as well as the executed franchise documents, a copy of the FDD provided to the franchisee, and signed FDD receipt pages. As the relationship progresses, other key documents are added to the file, including amendments, key correspondence and so on. A sample checklist of items that might be included in franchisee files is attached as Appendix P. Notably, many franchise systems have migrated away from paper files and now maintain electronic records, which allows remote employees (such as field representatives) to contribute to the franchisee’s record as key communications or events occur. Capturing this information can become critical if the relationship hits a “bump in the road” during the term of the franchise agreement.

III. Franchise Relationship

A proper franchise administration program will include protocol that helps

address what happens in the business relationship after the deal is penned. Franchise systems of all sizes experience challenges brought about by internal changes within the organization, external factors (such as the economy), the franchisee and its organization, or some combination of all three. These changes directly and sometimes significantly impact the business relationship between the franchisor and franchisee, including by leading to default and termination of the franchisee in certain cases. Other changes in the franchise relationship—such as changes in franchisee ownership, franchise renewals and transfers, and mutually desired contract amendments—generally are not adversarial but nonetheless must be properly documented to ensure that the franchisor has a continuing, accurate roadmap of all of its franchise relationships.

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Franchise administration efforts should place special emphasis on ensuring that all decisions (and subsequent actions) involving franchisee defaults, termination and renewals are conducted in a manner that is both compliant with the franchise agreement and applicable law. Approximately 22 states regulate whether and how franchisors may default and terminate franchisees.3 Often these statutes prohibit franchisee terminations unless the franchisor first establishes that (1) good cause exists to terminate the franchisee, (2) the franchisee has failed to cure, within a specific cure period, the default after receiving the franchisor’s written notice of detailing the nature of the default and how cure must be effected, and (3) actual delivery of the notice of default and termination complied with applicable law. In special cases, the franchisor may be able to terminate the franchisee immediately under the agreement and applicable law, in which case, it will want to act accordingly to best protect its interests. A franchisee’s right to renew its franchise rights often also is controlled by statute. Many of these statutes provide that franchisees must receive advance notice of the franchisor’s decision not to renew the franchise, and even then, restrain the franchisor’s decision to instances where “good cause” exists not to renew (meaning, the franchisee is in default of its obligations under the existing franchise agreement and/or cannot meet the conditions necessary to renew). Like other franchise relationship matters, a condition of successful renewal may be that the franchisee executes a release of known and unknown claims against the franchisor, a requirement that may not be enforceable in every state. As with defaults and terminations, franchisors must have a basic understanding of how these laws work and the issues they bring so that the franchise renewal process can be administered accordingly. Sample “renewal release” templates are attached as Appendix Q.

In addition, franchisees sometimes request that the franchisor permit certain changes to the franchisee’s ownership structure or allow a full transfer of rights to a new franchisee. Each of these scenarios implicates the franchisor’s recordkeeping systems and processes for bringing new individuals and entities into the fold (whether via a change of ownership or as the result of a full transfer of rights to a new franchisee). As to changes of ownership, the franchisor must consider (among other things) whether the new individual(s) gaining ownership in an existing franchisee entity meet its minimum qualifications generally for franchisee principals and whether they must sign personal guarantees. The franchisor will consider these same issues with respect to any new franchisee resulting from an outright transfer, but it also must ensure that the remainder of its franchise sales compliance program is followed with respect to the transferee/buyer. Often as a condition of any transfer (including changes of ownership interest in an existing franchisee), the franchisor will require a release of claims which, 3 See e.g., ARK. CODE ANN. § 4-72-201 et seq.; CAL. CORP. CODE § 20000 et seq.; CONN. GEN. STAT. § 42-133e et seq.; DEL. CODE ANN. tit. 42 § 2551 et seq.; D.C. CODE ANN. 28-3901 et seq.; HAW. REV. STAT. § 482E-6; IDAHO CODE § 29-110; 815 ILL. COMP. STAT. ANN. § 705/18 et seq.; IND. CODE § 2.7; IOWA CODE § 523H et seq. and § 537A.10; KY. REV. STAT. ANN. § 436.165; MD. CODE ANN. COMMERCIAL LAW § 11-301 et seq.; MICH. COMP. LAWS § 445.1527; MISS. CODE ANN. § 75-24-51 et seq.; MO. REV. STAT. § 407.400 et seq.; NEB. REV. STAT. § 87-401 et seq.; N.J. STAT. ANN. § 56:10-1 et seq.; TENN. CODE ANN. § 47-18-101 et seq.; VA. CODE ANN. § 13:1-557 et seq.; WASH. REV. CODE §§ 19.100.180 and 19.100.190; WIS. STAT. § 135.01 et seq.

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as noted above, may or may not be enforceable in every state. An effective franchise administration program will obtain and maintain a continuing awareness of the contractual and statutory rights and obligations incident to these and other franchise relationship matters, and will develop and implement processes intended to address them with ease, efficiency and accuracy. Appendix R is a transfer checklist used by one franchisor, which details key information and notable “triggers” associated with administering transfer requests, including everything from pre-transfer considerations to post-closing details. A sample change of ownership agreement is attached as Appendix S.

IV. Effective Use of Templates

Templates should be used as they are intended—that is, as one of many tools to

help guide the franchisor’s decisions and actions with respect to franchise sales and relationship matters. Templates indeed can be helpful starting points for processing defaults/termination, renewals and transfers, as well as the “form” text associated with contract amendments (e.g., choice of law and forum, integration, and so on), but in all cases the templates must be modified to fit the facts at hand. For example, while the facts leading up to each default and termination situation are unique, the form of default notice/termination notice used always should contain certain key language intended to (1) put the franchisee on clear notice that the defaults are serious, (2) precisely outline the steps that the franchisee must take to cure each default, and (3) state in unambiguous terms that if the franchisee fails to cure the default, franchisor will terminate the franchise agreement in accordance with the agreement’s terms and applicable law. A sample written notice of default template is attached as Appendix T.

Some franchisors likewise have found that annotating the templates with key

issues can be especially helpful when using the forms as a guide. For example, Appendix T includes a reminder to confirm the residency of the franchisee entity and its principal owner to determine the applicability of franchise relationship laws, and includes additional notes intended to reiterate the importance of clearly identifying each step the franchisee must take to cure the cited defaults. Appendix T also reflects how annotations can help prevent the franchisor from overlooking smaller issues like notice protocols that, if not properly addressed in the first instance, can impact the validity of the notice of default or termination. Finally, Appendices Q and S, each of which contains a release, also includes drafting notes intended to increase the likelihood that the release will be deemed enforceable if ever challenged.

Once the decision to terminate has been made, the franchisor must have

processes in place to ensure that the former franchised location ceases operating when required and that all applicable post-termination obligations are enforced. Some franchisors find termination and de-identification checklists to be helpful as they provide an easy-to-understand internal road map of the franchisee’s post-termination compliance expectations. Appendices U and V are sample termination and de-identification checklists. As is sometimes the case, a franchisor may wish to operate the terminated franchised location as a corporate location to prevent damage to the

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brand and associated goodwill in the local market. In this event, Appendix W provides a detailed overview of the events, actions and considerations that occur when assuming control of a terminated franchised location.

V. Conclusion

Efficient and organized franchise administration practices are necessary for

every franchisor, as the standardization of various internal processes helps ensure compliance with applicable laws and regulations, thereby reducing the risk of contractual and statutory oversights. Prudent franchisors will periodically audit the sales compliance and relationship components of their franchise administration practices to ensure the continued integrity, efficiency and effectiveness of its practices.

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