The advances in technology have undoubtedly opened opportunities for franchisors and franchisees to enhance their business, enhance productivity, improve sales. However, such opportunities carry additional burdens and are not free of risk. Two recent examples of franchisor’s potential liability arising out of technological advances highlight the need to be vigilant.

Data Hacking

The Wi-Fi networks of over 100 Subway stores were the subject of a data-hacking scheme that resulted in $10M charged to customers’ credit cards. [Reported on QSR Magazine (Dec. 12, 2012)]. Although it may not be possible to protect against every threat, the following can help minimize the risks:

• frequently patch holes in store networks

• limit access to in-store internet services (for example, create unique accounts and strong passwords)

• consider encryption techniques to protect credit card data

• seek expert advice on firewall service and security management

• recommend that franchisees post a sign advising customers not to send confidential or sensitive data over the internet from the franchisee’s premises

Even though the liability for credit card data theft may not result in an out of pocket loss to the customer, merchants are duty bound to protect the data, and a breach can create enormous ill-will.

Unsolicited Text Messages

Another example involved potential liability of Papa John’s, as the franchisor, because a franchisee illegally sent out unsolicited text messages. [Maria Agne et al. v. Papa John’s International et al, Case No. C10-1139-JCC (U.S. District Court for the Western District of Washington)]. Subject to certain minor exceptions, federal law prohibits making calls to any cellular telephone number using an automatic telephone dialing system. Several courts have found this applicable to text messages, which can be subject to $500 for each call. Although the responsibility of Papa John’s for the actions of its franchisee has not yet been established, this case serves as a wake up call for franchisors to advise franchisees about the risks of sending unsolicited faxes and text messages.

Check Your Insurance

New insurance products (such as cyber insurance) and old standbys (such as personal and advertising injury insurance) may provide important protection, so it is important for franchisor and franchisees alike to frequently review their coverage with a knowledgeable agent to be sure that their policies are up to date and that they provide coverage for potential risks.

In 1986, California enacted the Safe Drinking Water and Toxic Environment Act popularly referred to as “Proposition 65.” Cal. Health & Safety Code § 25249.6 (West 2012). Proposition 65 requires that any product or services which contain certain chemicals with the potential to cause cancer or reproductive toxicity to give a “clear and reasonable warning” that the product or services contain such chemicals. The breadth of Proposition 65 is comprehensive applying not only to California business, but also to any other companies that sell products or engage in activities that could result in potential exposures in the State of California. Hence, any company which distributes products or performs services which have the potential to end up in California commerce should be aware of the Act and comply with its terms if necessary.

A distributor of a product or provider of services must provide a clear and reasonable warning to any consumer, worker or person who may be exposed to a wide ranging list of chemicals contained within the product or released during any services. Specific chemicals have been identified by California’s Office of Environmental Health Hazard Assessment (“OEHHA”) as having the potential to cause cancer or reproductively toxicity. OEHHA is routinely adding chemicals to this list of chemicals for which a warning must be given.

The Act provides for enforcement not only by state attorneys but also by private plaintiff attorneys who can seek stiff penalties and payment of their attorney fees if a violation of the Act is found. According to a report published by OEHHA, in 2011 alone, distributors paid approximately $30 million to settle more than 300 Proposition 65 litigation cases with private plaintiff attorneys. Litigation involving the failure to warn has been extensive and involved a wide range of defendant distributors including manufacturers, retailers, hotels and intermediary distributors. Recent lawsuits have been brought against coffee retailers, distributors of children’s costumes and manufacturers of medical supplements.

Greensfelder has assisted clients in evaluating their products and services to assess compliance with the legal requirements of Proposition 65. If you would like further information regarding Proposition 65 and its requirements, please contact a member of our Franchise & Distribution Practice Group.

Franchisors often include a “no reliance” clause in their franchise agreements, in which the franchisees acknowledge that they have not relied on any information or representation not expressly stated within the franchise agreement itself. The intent of such clauses is to help protect against a claim based on alleged oral or written representations made outside of the franchise agreement. Although several federal courts have found that such “no reliance” clauses preclude franchisees from proving fraudulent misrepresentation cases, many state courts have been hesitant to bar fraud claims based on such clauses.

Illinois cases routinely enforced such clauses in securities cases, and recently, an Illinois Appeals Court, held that a “no reliance” clause can bar a plaintiff from establishing a fraud claim in any case. Schrager v. Bailey, 973 N.E.2d 932, 937 (Ill. App. Ct. 2012)] The Schrager court stated that “it is hardly justifiable for someone to rely on something that they have agreed not to rely on.” Instead, the court stated that “[r]educing the possibility of faulty memories and fabrication are important considerations in the drafting of any contract and is not limited to contracts involving securities transactions.” (emphasis supplied).

Although no published Illinois court decision has yet expanded Schrager’s holding to the franchise context, the move is likely imminent. Thus, franchisors in Illinois may be able to defend against fraudulent misrepresentation claims by pointing to the “no reliance” clause in their franchise agreement.

Based on these developments, Illinois franchisors should have counsel review their current franchise agreements to determine if they should be revised in light of this recent ruling. Of course, franchisors should still avoid making any oral promises and/or representation that differ from the terms of the franchise agreement and keep in mind that court decisions are often fact-specific and no one can predict how a court or jury will rule. Most importantly, fair business practices should always govern and franchisors should train their personnel not to make promises that are not included in the written franchise agreement.

Leonard Vines (a blog contributor) shares below his insights – both positive and negative – a franchise system should consider when entertaining the idea of a private equity investor. The full article (found here) includes the observations of other industry leaders about private equity’s impact on franchising.

“The increasing control of franchise systems by investment groups has affected franchising both positively and negatively. On the positive side, since these groups provide owners a vehicle for succession and exit planning, franchising as a business model may become more desirable as investors can see a way to cash out. Conceivably, some of those who sell will devote funds to develop new, innovative concepts.

 In addition to providing necessary funds for expansion, private equity groups can bring skilled expertise and a high level of sophistication. Cost-cutting measures and improved efficiencies, along with the opportunity to forge new relationships, can enhance the value of the system. The franchise can become more competitive and profitable and thereby focus on growth and innovation without the looming cloud of financial pressures. Opportunities to expand both nationally and internationally also can help the overall economy and create more jobs.

 On the negative side, however, there is a risk that the culture of the franchise will change for the worse. Franchisees who once felt they were part of a benevolent “family” may feel like employees or “just a number” with little control over their destiny. If the culture changes too dramatically, many franchisees could become unhappy, which is bad not only for the system, but for franchising in general. Finally, some franchisors simply are not prepared to give up control and are not wiling to accept the inevitable changes that will be made to their system.”

On December 3, 2012, the Eighth Circuit reversed a district court’s decision that a Missouri state law claim was completely preempted by the Petroleum Marketing Practices Act (PMPA).

A Missouri plaintiff filed a class action against gasoline station operators, including MFA Petroleum, Casey’s General Stores, and QuikTrip, regarding the grade of motor fuel dispensed with single hose dispensers. The case was filed in state court alleging a claim under the Missouri Merchandising Practices Act (MMPA). Casey’s General Stores removed to federal court on two grounds: (1) the claim was preempted by the PMPA and (2) there was diversity jurisdiction under the Class Action Fairness Act. The district court in the Western District of Missouri, relying on a similar Ninth Circuit case, denied the plaintiff’s motion to remand concluding that the state law claim was completely preempted by the PMPA.

On appeal, the Eighth Circuit addressed the issue of whether the PMPA, specifically Section II pertaining to octane disclosure, completely preempted the plaintiff’s Missouri state law claim. The Court pointed out that Section II of the PMPA, unlike Section I regarding termination and nonrenewal, does not provide a private right of action, but is enforced by the Federal Trade Commission. Discussing the United States Supreme Court’s decisions on preemption and its own precedent, the court emphasized that complete preemption only exists where the federal statute “completely displaces” state law by creating the exclusive cause of action. Quoting Beneficial Nat’l Bank v. Anderson, 539 U.S. 1, 8, 11 (2003), the court noted that “complete preemption exists only where federal preemption is so strong that ‘there is . . . no such thing as a state-law claim,’” which is different than the issue of whether there is a federal remedy. The court reasoned that since Section II of the PMPA does not even create a federal cause of action that could substitute for the plaintiff’s Missouri state law claim, it certainly is not exclusive and, thus, not completely preempted.

The decision leaves little question that, in the Eighth Circuit, an available federal cause of action is a prerequisite for complete preemption. The court did not resolve whether the case could be removed on the alternative grounds for removal under the Class Action Fairness Act, and that question was remanded for the district court’s consideration.

The case is Johnson v. MFA Petroleum Co., et al. (8^th Cir. December 3, 2012).

Congratulations to our Franchise & Distribution practice group. The group was recently honored in the 2012 edition of the International Who’s Who Legal of Franchise Lawyers. The publication dubbed our group a “Midwestern Powerhouse”, which includes John Baer, Leonard Vines, Beata Krakus, and Chris Feldmeir. See the excerpt from the publication below:

“Greensfelder, Hemker & Gale, P.C. sees four of its lawyers honored in our rankings, among whom Chicago managing partner John Baer stands ‘pre-eminent’. One of the most highly regarded lawyers in our research overall, Baer brings extensive transactional and corporate law experience to his work on behalf of national and international franchise and distribution clients, and, until this year, was chair of the Illinois attorney general’s franchise advisory board. An additional listing in Chicago, alongside a further two in St. Louis, justifies the firm’s reputation as a “Midwestern powerhouse”.

For more information on the selection criteria, see http://www.whoswholegal.com.

Learn more about our practice group.

For the past year and a half, various lawsuits have alleged that daily deal coupons, such as those offered by Groupon and Living Social, violate Regulation E’s rules for gift cards because such coupons expire too quickly. Regulation E, found at 12 C.F.R. § 205, et seq., is the Treasury’s official regulations enforcing the gift card provisions of the Credit Card Responsibility Act of 2009. It requires the funds underlying all gift cards to remain valid for at least five years.

Originally, when Living Social first started issuing its daily deal coupons, the entire amount of a Living Social coupon would expire on a particular date, and that date was often far less than five years from the date of its issuance. After the first wave of lawsuits were filed alleging that daily deal coupons violated Regulation E, however, Living Social changed the terms of its deals. Specifically, Living Social created a two-tiered expiration formula, whereby a Living Social coupon actually has two separate expiration dates. The first expiration date is for the “paid value” of the coupon (the amount of money the consumer paid), and is typically set at least five years after the coupon’s issuance, in theoretical compliance with Regulation E. The second expiration date is for the “promotional value” of the coupon (the amount of money the coupon is worth above and beyond the paid value), which expires in a much shorter window, almost always less than a year after the coupon’s issuance.

What this two-tiered expiration formula means in practice is that if a consumer pays $50 for a Living Social coupon that is “worth” $100, the consumer will have five years to redeem the coupon for the $50 he or she actually paid, but will only have a few months to redeem the other $50’s worth of the coupon. Thus, this two-tiered expiration formula ends up meaning that consumers must use the entire Living Social coupon in far less than five years if they want to get the full $100 value of the coupon.

Now, nearly six months after Groupon settled a class action for a reported $8.5 million following allegations that its daily deals violated Regulation E’s expiration rules, Living Social has followed suit and settled its own class action alleging similar violations. Living Social will reportedly pay $4.5 million dollars to settle, and will alter its terms and conditions to make the expiration dates clearer for consumers.

What Living Social did not agree to do though, at least apparently, is change its two-tiered expiration formula. And by settling the case, Living Social has not only at least temporarily avoided a court from ruling on whether the two-tiered formula complies with Regulation E, but it has also avoided a ruling on whether such daily deal coupons are subject to Regulation E at all. Thus, gift card consumers (and issuers) will have to wait to find out if daily deal coupons are subject to Regulation E, and if so, if the practice of expiring the “promotional” value of the coupon complies with the law.

Disclosure obligations may be as light as a one-page document, but the rule is now broader.

The Federal Trade Commission Business Opportunity rule used to be so limited in scope that it rarely posed an issue for franchisors or those distribution systems structured to avoid franchise laws. If it did apply, the business opportunity seller had to prepare a disclosure document as broad in scope as a franchise disclosure document. This was a major hassle for low-investment business opportunity systems. A significantly revised federal business opportunity rule (the “FTC Business Opportunity Rule”) went into effect March 1, 2012. 16 C.F.R. 437 (2011). It flips the old rule on its head: Disclosure obligations may be as light as a one-page document, but the rule is now broader and will cover some distribution systems and even franchise systems that have previously been able to avoid federal disclosure regulation.

Read the article to learn more.