Franchising | November 2010 | By Daniel P. Smith

Lessons Learned

Reflecting on a decade of franchisee-franchisor litigation provides important insight. What can you learn?

Whether it’s started by the internationally renowned franchisor or the ma-and-pa franchisee, litigation stands an unwelcome event in a relationship desperately needing trust, respect, and the singular, shared aim of bottom-line success. Over the last decade, however, a litany of franchisor-franchisee disputes have made their way into the courtroom, proving to be a time- and cost-consuming process littered with stress and frustration for both sides.

While at first glance the franchisee-franchisor relationship might appear to be a creature of contract, wherein the franchisor can exert control with its unilateral rights to govern, reality has painted a different portrait far more based in the colors of collaboration and responsiveness. Successful franchise relationships result from transparency and honesty running through all phases of the relationship—often well beyond any contractual stipulations—and, furthermore, a shared recognition that each needs the other to achieve productive results.

“The franchisor-franchisee relationship [is] really a complex partnership of balanced mutual dependence,” says Florida attorney R. Alan Higbee, a noted expert on franchise matters. “The key to most franchisor-franchisee relationships, like most partnership relationships, is trust and communication.”

From some of this decade’s most notable court cases, important lessons can be gleaned that highlight and emphasize the importance of finding a sincere and honest middle ground that keeps the ultimate focus on food, customers, and profitability.

“At the end of the day, the common lesson learned from all of the disputes … is that franchisors need to find a way to maintain a level of trust and communication with their franchisees that prevents major disputes from arising in the first place,” Higbee says.

The Quiznos Case:
Misrepresenting ‘Material Facts’

A quartet of lawsuits dating back to 2006 placed Denver-based Quiznos in a defensive position. All four cases, originally brought to four U.S. district courts, alleged violations of U.S. racketeering and corruption statutes revolving around the system’s supply chain, food costs, marketing funds, and unpaid royalties.

Quiznos franchisees, including many who had never opened a store, charged that the company had “systematically defrauded” its franchisees by misrepresenting material facts during the franchise sales process and pairing inflated product prices with low retail prices to resist franchisee profit. The lawsuits also cited encroachment issues, as well as Quiznos’ slow response to approve sites and open stores. Accusations swirled that Quiznos failed to act in good faith and looked to buoy the brand’s value at the expense of its franchisees.

In November 2009, all four class-action suits reached a preliminary settlement, albeit sans any finding or admission of liability on Quiznos’ behalf. The settlement called for Quiznos to make administrative changes and concessions to franchisees, as well as contributions to the chain’s advertising and marketing trust funds.

In addition, the proposed settlement demanded Quiznos recognize an independent association of franchisees, create a franchisee advertising advisory council, introduce a formal resolution process for addressing franchisee grievances, and identify a clear program to assist franchisees who wished to sell their stores or acquire additional locations.

A Lesson Learned:
“Prospective franchisees should examine the economics of the individual franchised unit, but should also familiarize themselves with the business model of the franchisor. Franchisees should be concerned when the franchisor makes their profits up front before the individual units are successful.”
former McDonald’s
corporate franchise executive
Richard Adams,
now head of the San Diego–
based Franchise Equity Group
The Dairy Queen Case:
The Necessity of Modernization?

As International Dairy Queen pushed for a 21st century image, longtime franchisees pushed back.

While Dairy Queen pledged that its modernized DQ Grill and Chill concept would revitalize the chain’s dated image and increase profits, many franchisees expressed concern over store conversions, purchasing restrictions, and enforced sales of ice cream cakes and hot dogs of a certain brand.

Both sides appeared to have legitimate and rational arguments. Corporate claimed that it needed to rejuvenate its look and operations to maintain a relevant standing in the quick-service arena, while franchisees, particularly single-unit operators already doing strong business, expressed concern that the investment would fail to yield a profitable return.

By early 2008, the lingering tensions turned into litigation when owner associations with members in 10 states brought suit against Dairy Queen, claiming that they were being forced to accept the unproven new concept—at a cost of $275,000–$450,000—or lose their franchises.

Dairy Queen, however, contended that no one was being forced to change to another concept, let alone one that had limited viability. Additionally, Dairy Queen countered that the required modernization existed as a standard feature of most contracts and that the investment was capped to protect franchisees.

A Lesson Learned:
“Franchisors desiring to make changes to their systems by asking their franchisees to make significant additional capital expenditures are best served by answering the ‘why are these expenditures necessary and appropriate’ question of their franchisees. Not with a ‘because we can’ response, but rather with a ‘because this investment will likely give you a reasonable return on your investment’ response backed up with the results of successful testing of the proposed capital expenditures at the store level. Absent that testing and successful ROI experience, franchisors should make the business decision to not try and impose such capital expenditures on their franchisees, even if their lawyers advise them they have the legal right to do so.”
Minneapolis-based attorney
J. Michael Dady,
a franchise law specialist
The Burger King Case:
Dictating Franchisee Life

Over the last decade, franchisee-franchisor relationships have been particularly tense at Burger King, as the Whopper purveyor has found itself on the defendant side of a number of franchisee-generated lawsuits.

In 2008, several franchisees filed an amended lawsuit—following the earlier dismissal of a similar claim—protesting Burger King’s mandate to extend operating hours. In addition to being prohibited by the franchise agreement, which plaintiffs said allowed for reducing operating hours but not extending them, 57 Burger King franchise-agreement holders said the extended operating hours were both costly and risky for staff. Burger King held firm, saying it had the right to demand stores be open a minimum number of hours.

One year later, in the spring of 2009, Burger King encountered another legal tussle when 850 Burger King franchisees representing about 6,300 outlets sued Burger King corporate, Coca-Cola, and the Dr Pepper Snapple Group. Franchisees claimed that Burger King was withholding restaurant operating funds that came from Coke and Dr Pepper and were traditionally earmarked for store repairs. Burger King dismissed the lawsuit’s merit, contending that the company had the right to reallocate funds from the soft-drink suppliers as it deemed fit.

The courtroom battles didn’t end there, however.

By November 2009, Burger King was again a target when its franchisee association filed suit charging that the company’s $1 double cheeseburger offer, a promotion that drew the ire of operators earlier in the year, was forcing franchisees to lose money. The suit held broad implications for a quick-service world running toward value offerings in a sagging economy: Could a franchisor force a franchisee to sell product below cost?

Burger King again planted its feet, claiming that it had the right to require Value Menu program participation. Later, a leaked e-mail from Burger King executive Charles Fallon surfaced, in which Fallon warned operators that the negative publicity would only harm everyone’s business value.

A Lesson Learned:
“Franchisors are best served by collaborating with their franchisees to arrive at pricing programs that make sense for the franchisor, the franchisees, and the consumers—i.e., prices that provide high-quality goods and services at a fair price to the consuming public while at the same time allowing the franchisees the opportunity to make a reasonable profit for providing these goods and services.”
J. Michael Dady
The Little Caesars Case:
Protecting the Brand’s Long-Term Health

On the heels of a 2001 class-action lawsuit settlement that afforded franchisees greater say over their individual operations and resulted in the establishment of a franchisee purchasing cooperative, Little Caesars’ corporate office turned from defense to offense in 2004.

Seeking a mandate to stop some operators from using ingredients that did not meet Little Caesars’ quality standards, the Detroit-based chain sued 40 franchisees operating about 300 stores with trademark infringement. While the operators’ cooperative insisted it used only approved ingredients and vowed to continue business as usual, Little Caesars’ complaint argued that the sale of “nonconforming products now and in the future” would weaken and taint the pizzeria’s “distinctiveness, effectiveness, and value.”

As the suit unraveled, the two sides traded ironically similar verbal jabs. While Little Caesars stated it was only protecting the brand’s long-term viability and image, operators cited the 2001 case settlement as proof that they, too, were only targeting future success with a high-quality product.

A Lesson Learned:
“Such disputes often rise from franchisees’ suspicions that the franchisor is getting kickbacks or other profits from approved supplies and suppliers. Much of this distrust can be prevented with complete transparency in all the franchisor’s business relationships and income streams. This includes, as much as possible, disclosure of off-the-books income of the franchisor’s executives.”
Richard Adams
Noble Roman’s Pizza & Raving Brands:
Feeling Duped

Eight former and two active Noble Roman’s Pizza franchisees felt so duped and discarded in 2008 that they filed a 29-page lawsuit calling the brand’s roll out of a complementary restaurant concept operationally flawed and too complicated to operate profitably.

The $6 million suit alleged that Noble Roman’s, an Indiana-based chain with more than 1,000 units, provided no support services or marketing push, let alone market testing, with its Tuscano’s Italian Style Subs concept, a dual-concept plan that required up to $400,000 in franchisee investment.

Noble Roman’s denied the grievances, saying it never turned its back on operators and threatening counterclaims to defend its name.

Also in 2008, the same fraudulent claims were levied against Raving Brands, the Atlanta-based operators of various quick-service players such as The Flying Biscuit Cafe and Doc Green’s Gourmet Salads.

A pair of franchise groups with the Doc Green’s concept in their portfolio filed a lawsuit against Raving Brands, alleging fraud and breach of contract. One franchisee litigant claimed that Raving Brands sold the Doc Green’s franchise as an established brand, when, in fact, the barely five-year-old brand remained unproven—a “mirage,” he termed it.

Raving Brands, the plaintiffs said, did not possess a comprehensive franchise business plan as it shopped Doc Green’s to potential operators and polished its one corporate-owned location to appear successful to would-be franchisees.

A Lesson Learned:
“Prospective purchasers of all franchise systems are entitled to expect that the franchisor will indeed at least ‘meet the basics’ as a franchisor, including having previously tested, and having a reasonable plan to implement and appropriately publicize an effective, uniform system for delivering goods or services to the consuming public. If the purchasers of the franchise opportunity believe they have not received that, legal challenges and other stressors within the system are indeed likely.”
J. Michael Dady
The Green Burrito Case:
Kickbacks and Competition

In December 1998, three Green Burrito franchisees sued the Santa Barbara Restaurant Group (SBRG), accusing the multichain operator of taking more than $1 million a year in cost-inflating kickbacks from vendors, as well as creating unfair competition as a result of recipe shortcuts made to accommodate cobranded units with Carl’s Jr.

A resolution came in May 2000, when the SBRG was forced to pay more than $1.2 million in loans to existing franchised restaurants to finance a new image, menu, and name change. In addition, the SBRG agreed to restructure its Green Burrito division leadership, which included the executive hiring of a former franchisee litigant.

Following the case’s conclusion, one SBRG executive said that food preparation and other operational aspects at cobranded locations differed from Green Burrito’s stand-alone units. The acknowledgment offered credence to the plaintiff’s claims that the divergent guidelines posed a threat to Green Burrito’s overall health and potential profitability.

A Lesson Learned:
“Prospective franchisees should inquire, before deciding whether to become a franchisee in a particular system, whether their prospective franchisor will commit to not take money from vendors based on their required purchases and whether the franchisor will in addition commit, in writing, to work with its franchisees to get the best possible pricing for the goods and services they are required to purchase. Absent those two assurances, prospective franchisees should consider looking elsewhere for opportunities with franchisors who will provide these two assurances.”
J. Michael Dady