Franchisor Prevails at Trial Despite Finding of Technical Disclosure Violation

A decision hot off the press of the United States District Court for the Southern District of ‎Georgia, Massey, Inc. v. Moe’s Southwest Grill, LLC, No. 1:07-CV-0741, 2015 U.S. Dist. LEXIS ‎‎12281 (Feb. 3, 2015), has several lessons for franchisors. First, it demonstrates how franchisors ‎can successfully avoid liability for technical disclosure violations by proving that franchisees ‎actually benefitted because of the policy about which they complain. Second, it demonstrates ‎that even when franchisees can make out a violation, franchisors can still prevail at trial. Third, it ‎proves that careful drafting of a franchise disclosure document (FDD) by counsel experienced enough to anticipate changes in ‎the business is critical to a young franchise system.

Moe’s Southwest Grill, LLC (Moe’s) was formed in July 2000. H. Martin Sprock, III, served ‎as the CEO of Moe’s. At some point in 2000-2001, Sprock, and an employee of another Sprock ‎concept, Tony LaGratta, discussed the development of a food services company to handle Moe’s ‎accounts. Sprock and LaGratta informally agreed that LaGratta would create a company; and ‎furthermore, that Sprock would be involved and may receive revenue. LaGratta solicited Chain ‎Reaction Marketing (CRM), a food-supply and distribution broker, to assist in Moe’s ‎distribution process. CRM selected a regional distributor that would pay CRM a ‎customary two percent brokerage commission. LaGratta, with Sprock’s approval, would receive half of ‎CRM’s commissions. Sprock supported CRM’s involvement because CRM had significant ‎purchasing power that allowed it to obtain reasonable prices for Moe’s franchisees.

In August 2002, LaGratta formed an LLC (SOS) to handle Moe’s accounts. SOS became one ‎of Moe’s approved food brokerage suppliers. Thereafter, CRM paid commissions to SOS rather ‎than directly to LaGratta. SOS organizational documents made Sprock a member and gave him a ‎‎one-half interest in the company. Sprock would not, however, receive his first distribution from SOS ‎until an operating agreement was established in August 2004. Distributions made to Sprock ‎included monies paid by CRM to SOS.

In the meantime, in October or November 2002, a prospective franchisee in Tennessee ‎received Moe’s FDD. The FDD did not identify SOS as an affiliate of Moe’s, nor did it disclose ‎that Sprock had an ownership interest in SOS. The prospect became a Moe’s franchisee.‎

Years later, franchisees (including the Tennessee franchisee) brought a lawsuit that prominently ‎involved Moe’s distribution program. The Tennessee franchisee brought a claim under the ‎Tennessee Consumer Protection Act (Act), arguing that the Act incorporated and Moe’s violated the Federal Trade Commission’s Amended Franchise Rule‎. Specifically, the franchisee claimed that, ‎by not disclosing that Sprock may later derive income from the franchisee’s purchases through ‎his association with LaGratta, the franchisor violated 16 C.F.R. § 436.5(h)(6), which ‎requires an FDD to disclose:‎

Whether the franchisor or its affiliates will or may derive revenue or other ‎material consideration from required purchases or leases by franchisees.

Federal regulations define “affiliates” to include “an entity controlled by, controlling, or under ‎common control with, another entity.” The court interpreted 16 C.F.R. § 436.5(h)(6) as requiring a ‎‎“forward-looking disclosure.” In other words, if the receipt of the revenue was a “possibility” ‎that was contemplated at the time of disclosure, it must be disclosed. (Most practitioners were ‎surprised by this aspect of the case as an FDD is, for the most part, a snapshot of the current state of ‎the franchise system and not a projection of future events.)

Applying this standard, the court concluded the FDD provided to the Tennessee franchisee ‎failed to disclose Sprock’s and LaGratta’s agreement that revenues of SOS would ‎eventually be paid to Sprock. (Interestingly, the court also held that Sprock was an affiliate of ‎Moe’s, even though affiliate is defined to include only entities.) Disclosure was required even ‎though (1) there was no agreement at that time that Sprock would receive any part of the monies ‎paid by CRM to SOS, and (2) it would be nearly two years before Sprock would receive a ‎distribution from SOS.

Although the court concluded Moe’s disclosure was unlawful, it nevertheless held that the ‎franchisee failed to prove damages, a necessary element under the Act. Moe’s persuaded the ‎court that CRM and SOS saved the franchisees money by using purchasing power and industry ‎knowledge to obtain lower prices and freight costs and arranging for efficient ‎deliveries. Moe’s also persuaded the court that Sprock created the supply chain to help assure ‎the success of Moe’s franchisees. As it was most likely that Moe’s actually saved the franchisees ‎money through participation in the supply chain, judgment was entered in favor of Moe’s.‎

Massey shows that young franchisors should carefully consider whether they or their affiliates ‎will in some way derive revenue from required franchisee purchases and whether that relationship must be ‎disclosed, as a court may hold an FDD unlawful even if there is only a possibility revenue may be ‎derived in the future. Best practices probably suggest leaving this possibility open in every ‎system. But just as importantly, Massey proves why, in some cases, franchisors should go to trial ‎against disagreeable franchisees to protect the system, even where the franchisor may have ‎technically violated a statute through the disclosure process. At trial a franchisor can persuade a ‎court that the policy about which the franchisee complains actually benefits the franchisee, an ‎argument courts are receptive to. When a violation exists, and there is no reasonable way to ‎settle the matter, going to litigation may be the only way to vindicate a franchisor that was ‎otherwise acting in the best interests of franchisees.