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.