Seven Strategic Steps to Avoid Franchisor Liability

by Jaburg Wilk

One of the hallmarks of franchising is consistency of the brand and operations across the franchise system. If well executed, that consistency gives the  public the impression that the franchise system is a centrally-owned operation. Most people don't know the difference between business operations that are centrally owned and those that are franchises. In fact, most people erroneously assume that certain centrally-owned operations are franchises and vice versa.

One of the key differences between centrally-owned operations and franchise systems is that franchised units are independently owned and operated by either mom & pop operators or large multi-unit operators. The franchisee is a "person" distinct from the franchisor, licensed by the franchisor to use its trademarks, proprietary information and other features of the franchise system. To maintain the good will of the franchise brand, the franchisor typically requires compliance with the features that make the franchise system unique and successful, as well as quality controls and standards. That "control" has led to claims that the franchisee's operations are in fact controlled by the franchisor and, therefore, the franchisor should be liable for the franchisee's operations.

With the rise in franchising over the years (despite the recent plateau due to the economy) and the increasing zeal of plaintiffs' lawyers (augmented by the economy), franchisors are increasingly being sued in connection with their franchisees' operations.  The "deep pocket" theory of recovery motivates plaintiffs' lawyers to sue the better-capitalized and better-insured franchisor in addition to the franchisee that may be responsible for the harm suffered by his or her client.

In cases seeking to hold franchisors "vicariously liable" for their franchisees' operations, courts have historically focused on whether the franchisor controlled, or had the power to control, the franchisee's business. More recently, courts have narrowed their focus to whether the franchisor controlled, or had the power to control, the particular instrumentality or activity causing the harm suffered by the plaintiff. A recent Arizona case, Courtland v. GCEP-Surprise, LLC, 119 Fair Empl.Prac.Cas. (BNA) 806 (D. Az. 2013), followed this trend. In that case, a Buffalo Wild Wings® franchisee's employee sued both the franchisee and the franchisor, claiming that the franchisee's manager's actions constituted sexual discrimination, harassment and retaliation. The court found that, although the franchisor imposed strict guidelines on the franchisee's restaurant's manner of presentation and operations, the franchisor had no control over the franchisee's management or its employees' conduct. Accordingly, the court held that the franchisor was not liable for the franchisee's manager's actions.

Although the Courtland case does not break any new ground, it is a firm reminder of the advice that experienced franchisor lawyers have long been giving their clients:

1. The franchise agreement should disclaim a principal-agent relationship between the franchisor and the franchisee and affirmatively state that it is the franchisee's right and obligation to hire, fire and supervise its employees.

2. The franchise system design should be consistent with those franchise agreement provisions and the franchisor should act in a manner consistent with those provisions. The franchisor should mandate the standards of performance with respect to product and service presentation and standards of operation, which should be results-oriented, but not mandate the means of performance. Human resources (HR)-related issues should be left to the franchisee. For example, franchisees should have the latitude to hire, fire, supervise, discipline, assign work, set schedules, establish working conditions and determine the rate and method of compensation, perquisites and vacation policies. Direction with respect to the means of performance should be recommendations or advisory only, not mandatory. For example, a franchisor might require its franchisees to comply with applicable law with respect to its employees and provide its franchisees a template employee manual. However, a wise franchisor would direct its franchisees to consult its own local lawyer for advice on how to comply with applicable law with respect to its employees and tailor the employee manual to reflect applicable local law and HR-related policies adopted by the franchisee.

3. The franchisee's corporate or LLC name should not include the franchisor's name or the name of the franchise brand. The franchisee's marketing brochures and related materials, business cards, stationery, payroll and other checks, purchase orders, invoices, contracts and other documents should be in the name of the franchisee, not the franchisor or the franchise brand. For example, a business card might include the franchisor's logo, but have the franchisor's corporate or LLC name. A contract might refer to the franchisee as "XYZ Inc. doing business as the franchise brand name."

4. The franchisor should require that the franchisee post a conspicuous notice informing its customers and guests that the franchisee's operations are owned and operated by the franchisee, not the franchisor. The franchisor should monitor the franchisee's compliance with this requirement on an ongoing basis.

5. The franchisor should not unnecessarily assume responsibility for certain of the franchisee's operational duties by reserving the right to control certain activities (particularly activities that entail significant legal exposure), but failing to do so or failing to exercise reasonable care in discharging those duties. For example, if a franchisor required that franchisees comply with the franchisor's premises security policies, but failed to adopt those policies or adopted inadequate policies, the franchisor might be responsible for the harm suffered by franchisees' customers or guests. A wise franchisor would require that its franchisees provide adequate security and refer the franchisee to third parties specializing in designing that function for the franchisee's particular unit or providing that service.

6. The franchisor should take the necessary steps to ensure that the risk associated with the franchisee's operations remains with the franchisee. For example, the franchise agreement should contain appropriate indemnification and contribution provisions. The indemnification provision should permit the franchisor to engage its own lawyer in defending against a claim based upon the franchisee's actions, as the franchisor's and franchisee's interests in such litigation are not the same and having separate counsel is consistent with the franchisor's position that it is distinct from the franchisee.

7. The franchisor should require the franchisee to maintain adequate and appropriate insurance policies with financially sound carriers, with the franchisor named as an additional insured on those policies, with a waiver of subrogation with respect to the carrier's claim against the franchisor and without an exclusion for claims between insureds.

Although it is a statistical probability that a franchisor will at some point be subject to litigation, it is a wise franchisor who strategically takes the steps necessary to reduce the statistical likelihood of litigation and enhance its likelihood of success in that litigation.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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