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Litigation between franchisors and the business owners that buy into their brand is on the rise as franchisors becomes more aggressive about enforcing contracts and a growing number of franchisees find new ways to assert their rights. Add to that recent California court decisions in favor of franchisees, increased franchisor disenchantment with arbitration, and new Federal Trade Commission rules requiring more disclosure by franchisors, and it’s clear there’s a contentious mix brewing. Overall, intrabrand bickering is climbing in tandem with the sheer increase of franchising in the U.S. economy. Not only are the number of outlets for franchises such as Subway and Jiffy Lube rising at a 23% rate annually, new concepts for franchises are popping up at a faster clip than in the past, according to Arlington, Va.-based Franchise Information Services Inc. Litigation will rise with the expansion of franchising because there is an inherent tension between a franchisor, whose income is based on the franchisees’ top-line revenue, and the franchisees, who only benefit from their bottom-line profit, said John Dienelt, a DLA Piper attorney in Washington who is chairman of the firm’s franchise litigation practice group. “There has been an increase in disputes, whether they’ve been litigated in court or in arbitration,” said W. Michael Garner, an attorney at Minneapolis-based Dady & Garner, which represents only franchisees. “My view is that franchisors are tending to take a harder line with franchisees these days.” Chasing for payments While most of the evidence for a rise in litigation is anecdotal, seven of 10 attorneys in the area interviewed for this story said they have seen an increase, and none had seen a decrease in this type of work. In the past, if a franchisee was hurting financially and wanted to close up shop, that business owner could go to the franchisor and work out an arrangement for ending a contract early, but today the franchisor will chase them for the lost years of royalty payments, said Garner’s partner, J. Michael Dady. “To me, that’s just tremendous over-reaching,” Dady said. Dady earlier this month helped several franchisees win a lawsuit against Domino’s Pizza Inc. that they brought in order to fight the pizza chain’s insistence that they buy new computer systems developed by the franchisor. A federal judge agreed with the franchisees that their contract with Domino’s didn’t allow it to mandate installation of the new system, and that the parent must provide specifications for the system so that the franchisees could get the equipment elsewhere if they preferred. Bores v. Domino’s, No. 05-2498 (D. Minn.). Jump in disputes Carmen Caruso, a Schwartz Cooper attorney in Chicago who represents both franchisors and franchisees, is seeing a jump in disputes following a lull earlier in the decade. There was a lot of franchise litigation in the 1990s concerning franchisors allowing outlets to encroach on each other’s turfs, but they tweaked contracts to stop the practice and litigation ebbed until now, he said. “I can’t keep up with it right now,” said Caruso, who is representing stereo-equipment dealers in six states in litigation against a company they considered their franchisor, and is also working with prefabricated wall dealers in several states who have claims against a franchisor. Increasingly, lawyers for franchisees are using state consumer-protection laws to take franchisors to court over alleged unfair practices, said David Harris, an attorney who leads the litigation group of St. Louis-based Greensfelder, Hemker & Gale. Instead of a simple breach of contract dispute, it becomes a fairness issue that can be brought before a jury, said Harris, who represents franchisors. For instance, Harris is representing BP America Inc. against franchisees who allege unfair pricing, he said. “Plaintiffs are using these alternative state law theories to change what we think are claims that ought to be resolved under the contract,” Harris said. When franchisors sue, it’s usually for missed royalty payments, underreporting of sales or a flunked inspection of the franchisee, Caruso said. These days there’s more likely to be counterclaims by franchisees than in the past, he said. California courts are giving some support to the franchisee challenges, calling some provisions of the franchise contracts “unconscionable,” or too unfair to be enforced. In Nagrampa v. MailCoups Inc., No. 03-15955, last December, a divided en banc 9th U.S. Circuit Court of Appeals sided with a franchisee and found that a requirement to arbitrate in her franchise agreement was unconscionable under California law. “The courts have lost patience with franchisors coming to court to enforce arbitration agreements that are so one-sided,” said attorney Fredric “Ric” Cohen, who recently left DLA Piper with Amy Cheng to form Cheng Cohen, a Chicago firm specializing in corporate and franchise law. The Nagrampa ruling and similar California decisions could be a precursor for courts in California or elsewhere to extend that line of thinking to invalidate other aspects of franchise contracts, Caruso said. About 45% of major U.S. franchisors mandated arbitration in the agreements they signed last year with franchisees, according to a preliminary research by Christopher Drahozal, a law professor at the University of Kansas. That’s about the same as the figure Drahozal found based on 1999 data in earlier research, he said. Throwing stones? Some franchisors and their attorneys believe that arbitration can preclude class actions, ensure a dispute is handled in a franchisor’s home state, limit remedies and generally provide faster and cheaper resolution, among other things. While some attorneys, such as William Killion of Faegre & Benson in Minneapolis, believe that franchisors will simply fine-tune arbitration clauses to conform with recent decisions, others believe the tide is turning against the alternative forum. “It seems that the franchise bar is starting to throw stones at arbitration,” said Rupert Barkoff, an attorney in Atlanta at Kilpatrick Stockton who mainly represents franchisors. “There are a lot of people who are not happy with the process of the American Arbitration Association or its rules.” Another change in July 2008 that could add to the contentiousness is the implementation of new Federal Trade Commission rules that will require franchisors to disclose more information to potential new business owners, including past and current franchisees, the cost of setting up the franchise and past litigation. “You’re going to see some pushing and pulling over what those actually mean,” Garner predicted.

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