Gathering Storm

There is an insidious trend developing in the franchise sales arena: Lawyers are being sued when bad things happen to a franchisee as a result of alleged defects or misdeeds in the franchise sales process.

As reported in the franchise press, most prominently by Janet Sparks in Franchise Times, several suits are now pending where, when a franchisee failed, the franchisee has named the outside law firm for the franchisor as a defendant. Sparks indicates that in these cases, there have been points ' often not well-delineated ones ' where lawyers, in addition to acting incompetently as lawyers, have crossed the line and have become actively engaged in the franchise sales process ' that is, in promoting franchise sales and otherwise acting more like a franchise sales person than a legal adviser.

To go on record, I do not believe that lawyers should be given full immunity when they participate actively in the franchise sales process in roles that are generally played by others. The problem, as so often is the case, is defining the boundaries to which the lawyer must adhere. I am particularly troubled about this trend to expand the boundaries beyond historical expectations.

Lawyer-Client Process

Readers of this publication are quite familiar with the process for preparing a Franchise Disclosure Document (“FDD”) so that a company can sell franchises. In the course of preparing the FDD, the lawyer will elicit certain information from his client, either through questionnaire or personal interview. As to some matters, such as the status of the franchisor's trademark or pending litigation, the lawyer will, in addition, examine extrinsic documents to confirm what the client has told him. What is the registration number of the trademark? Are there any proceedings challenging the franchisor's marks? What is the status of any pending litigation against the franchisor, and what were the results of certain past proceedings that are now resolved?

In other areas, such as financial statements disclosures, the lawyer will look to third parties, in this case accountants, for comfort. The lawyer will inform the accountants and his client as to what financial statements must be included in the FDD and of the requirements that the financial statements must conform to U.S. generally accepted accounting principles. But the lawyer's due diligence investigation has historically ended at that point. The lawyer will not go out and do an inventory of the company's assets, and he will not investigate the client's credit arrangements with its lenders, or most of the other matters that appear in the financial statements or related footnotes. These are the roles of the auditors.

The FDD includes financial performance representations (“FPRs”), and that is where the battles between franchisors and franchisees are generally fought. Typically, the franchisee alleges that the franchisor has either made FPRs outside of the FDD (a clear no-no under the FTC Disclosure Rule and state franchise sales laws), or the FPRs presented within the FDD are materially misleading. Keep in mind that the propriety of an FPR will always be judged in hindsight, giving the franchisee a one-up on the franchisor (and thus being one of the few situations where a franchisee may have an upper hand in litigation). FPRs are never accurate when compared with the results of operations that a new franchisee will achieve. They are either too low or too high. When they are too low, there will be no lawsuit. But when they are too high, they may provide a basis for legal proceedings. The key questions here are the lawyer's obligations in connection with the preparation of the FDD, and to whom do those obligations run?

Obligations

Much of franchise law is based on securities law, and in the context of securities law, especially violations of the Securities Act of 1933, it is clear that a lawyer has a duty to perform due diligence, and if he does not, there may be liability to the purchasers of the securities being floated.

In contrast, the history of the lawyer's responsibilities in franchise sales regulation and the lawyer's responsibilities are not as well defined, either by law or in practice. Many lawyers believe that the standards that franchise lawyers must follow are not as stringent as those imposed on their securities laws counterparts. Few lawyers will doubt that there is a duty of competence owed to the franchise lawyer's client, but does this duty extend to prospective franchisees? ( See Courtney v. Waring , 191 Cal. App. 3d 1434, 237 Cal. Rptr.. 233 (1987). In this case, the court said yes.) And, at the same time, we must ask what does competence entail?

The Dream Dinners case, currently pending in the state of Washington courts, presents a casebook example of the issues delineated above. Among other claims, the plaintiff franchisees stated that the franchisor's outside counsel failed to examine the sufficiency and accuracy of the FPRs, and thus were liable to the franchisees who purportedly relied upon these FPRs in making their franchise purchases. But the allegations further suggested that the lawyers stepped out of the traditional lawyer role and became more actively involved in the franchise sales process, going so far as themselves making FPRs that were not included in the FDD to prospective franchisees. Dream Dinners Capital Region, LLC et al. v. Dream Dinners, Inc. et al., Summons on Amended Complaint No. 08-2-04004.4, Superior Court of the State of Washington for Snohomish County, filed Dec. 1, 2008.

The facts of the case are complex, and as is so often the situation where there are numerous factual disputes, it is not predictable at this point what will be the grounds on which the lawyers could be held liable, if at all. Thus, while Dream Dinners may become at some point a primer for lawyers who advise clients on franchise disclosure matters, at the moment, it is only a scary ' but very scary ' sign of things that might come to pass, should the plaintiff franchisees prevail.

When people do bad things, they should be held accountable. If the FPRs were false, if the lawyers actually knew that, and if the lawyers were in fact actually engaged in the sales process, lawyer liability is not a troublesome concept to this author. However, there are certain steps along the way to this outcome where, as a transaction lawyer, I worry about the consequences of this result. Does this mean that I cannot answer a question raised by a franchisee or his lawyer about the document? Does this mean that I have to go beyond the FPR delivered to me by my client for inclusion in the FDD and test its accuracy? How much of an inquiry must I make to ensure that there is a reasonable basis for the FPR?

Unlike the situation with audited financial statements, outside, independent accountants rarely review the accuracy of FPRs. And unlike financial statement presentations, with their highly detailed requirements in order to meet generally accepted accounting principles and auditing standards, the official rules for FPR preparation are less detailed than the recipe for carrot cake. The FPR must be in the FDD, it must have a reasonable basis, and the franchisor must supply substantiation for the FPR if so requested. With limited exceptions, that's it.

Consequences

Franchisors (as well as the franchise community generally) should be troubled that poorly thought-out legal decisions may significantly affect the attractiveness of franchising as a method of doing business, as well as the role of the lawyer in connection with the franchise sales process. I am not going to contend that this is a Chicken Little situation, where franchising will dry up and thereby deny the public of many of the opportunities for the “little” person to become a successful, independent businessperson. But there will be consequences, at least to the legal community ' and they may be significant and costly.

First, let's note that franchise law, as a professional discipline, has not historically been nearly as attractive as the practice of securities law from a lawyer's financial standpoint. The “deals” are not nearly as lucrative, and the benefits to the client resulting from the deals are usually received over time rather than at the closing table, as in an initial public offering. Unlike the securities issuer who walks away from the closing table with seven, eight, or even nine digits of dollars in its bank account, the franchisor has to earn its take over time ' engaging in transactions that might pull in only $30,000 or $75,000 up-front per deal, with the gravy coming over time, manifested in the royalty income stream.

Given that few franchisors will sell even 50 franchises per year, it will take a long time, if ever, for the rewards from franchising to come close to the level of proceeds that will be received in an IPO. Since the rewards to the franchisors are not as great as the rewards received by a securities issuer, their willingness to pay very large legal fees will be less.

Second, if the risk of liability to the lawyer has been enhanced, the legal community's reaction will be to correspondingly increase the role of the franchise lawyer in the due diligence process. This, in turn, means either higher costs to the franchisor if the lawyer can pass these costs on to his client in the way of higher billing rates for those operating on the billable hour model, or higher quotations for those lawyers who have moved to fixed-fee arrangements.

Third, it is likely that the cost of malpractice insurance will increase as the number of claims paid out and the magnitude of those claims increase. Errors and omissions policies for franchisors, once an attractive concept, have become much more difficult and expensive to obtain as the exposure to lawsuits increases. I sense that the same trend could be seen in the legal malpractice insurance industry, although admittedly, and particularly in large firms, it may be difficult for underwriters to easily separate and quantify the risk to lawyers resulting from a franchise practice from the risks associated in other areas.

And finally, think about the strategic effects of suits against lawyers. Often, by the time litigation by franchisees is commenced, the franchisor has become insolvent. In that situation, plaintiffs' lawyers will be looking for financially sound pockets from which their clients can be compensated for their losses, and the franchisor's lawyer will certainly become a prominent target. While the lawyer may ultimately prevail if the matter goes to trial, the dollar expense in defending a claim, not to mention the distraction it creates for the lawyer trying to pursue his or her trade, is likely to lead to settlement, perhaps more for nuisance value rather than compensation for wrongdoing. And it is here that I see the tragedy to the franchise legal profession if the trend to name lawyers as defendants continues.

We can only hope that courts and juries are sensitive to what it takes to counsel a franchise company into the marketplace. Unfortunately, lawyers are not sympathetic defendants, and I can envision that lawyers would ' and, ironically, rather ' settle than fight. Let's hope the judicial system does not adopt the philosophy that it is better that the innocent suffer than the guilty survive.

This article first appeared in the New York Law Journal, a sister publication of this newsletter; it was revised for publication in FBLA.