Franchise & Distribution Newsletter – Summer 2010

Federal Reserve Board Releases New Gift Card Regulations

The Federal Reserve Board recently released final regulations governing the use of gift cards and customer loyalty programs under the Credit Card Act of 2009. The new regulations take effect on August 22, 2010 and will significantly impact current gift card programs offered by many businesses.   

The new regulations apply to gift cards, customer loyalty programs, customer or employee award programs, and sales promotions that incorporate gift cards. They do not apply to gift certificates issued in paper form only. Any person or entity in the chain of sale must comply with the new regulations. In practice, this means the new rules will apply to everyone from the initial issuer to the retail seller of a gift card.

The new regulations address a number of issues relating to gift cards but three stand out – expiration dates, gift card fees, and customer disclosures. The regulations require that the funds stored on every gift card or gift certificate remain valid for at least five years. In addition, the regulations prohibit charging any kind of dormancy fee, activity fee, or service fee for at least the first year after the purchase of any gift card. Businesses must make clear and conspicuous disclosures of the expiration date and any possible fees associated with gift cards, both before the customer purchases the card AND on the card itself. These disclosure rules apply regardless of whether the customer purchases the gift card online, by telephone, or in person.

Loyalty card programs and sales promotion card programs also fall under the new regulations. Business will be required to disclose all expiration dates and potential fees connected with the cards. Companies must also maintain a toll-free telephone hotline (and in some cases a website) that will allow customers to obtain card-specific information at no cost.

Persons subject to the regulations will be required to retain evidence of compliance, including proper disclosures, for at least two years.  The new regulations do not preempt state laws that offer consumers greater protections. Thus, review of applicable state laws is still important.

Gift cards, customer loyalty programs, and related sales promotions are important to many businesses – large or small. The detailed nature of these new regulations will require franchise companies using such programs to take a hard look at any existing or proposed programs to ensure full compliance by August 22, 2010. Failure to comply with the new regulations may subject a person to civil or criminal penalties, including fines up to $5,000 or possible imprisonment of up to one year, and potential civil litigation (including class action lawsuits).


Are You My Friend? Facebook Community Pages Causing Brand Owners Headaches

In spite of its young age, social media has already had a tremendous impact on how businesses interact with their customers. Facebook has been at the center of attention in the social media revolution for the last two years. Initially created for individual users, it has long been criticized for not being business-friendly. Facebook took a big step in improving its relationship with the business community by adding “fan pages” (fans have since been renamed “likers”) geared at businesses and brands.

Facebook is now adding “community pages,” which may be a step backwards in that relationship. A community page can be created by anyone and is intended to be devoted to a popular topic. Currently, community pages simply draw content from Wikipedia. But they are intended to have a broader use in the future. Anyone who is interested in a topic will be able to become a contributor – a potential headache for trademark owners and other brand owners who would have limited control over a page’s content, even though it may relate to their trademark or brand. Typical restrictions on third party use of a trademark would apply, but harm to a brand may go beyond the use of a specific trademark or its likeness. Any contributor to the community page will be able to post comments – positive or negative. The postings may be protected under the First Amendment making it difficult for the brand owner to remove or restrict negative content.

The community pages may also have a clogging effect on Facebook searches. Currently, a search on Facebook for a popular brand or business will often generate several hits, but the official page of the brand or business will usually appear first in the list of search result. It is unclear if the official page for a brand or business will continue to appear as the first result if many different community pages are devoted to one brand. Someone searching for a brand’s official page may have to sift through many different pages to find the right one. Research on typical search behavior shows that few people will go beyond the first page of search results. Thus, community pages may lead to less traffic to the official brand pages, decreasing their effectiveness as a marketing tool.


Maryland Changes Franchise Disclosure Timing Requirements

Maryland’s franchise disclosure timing requirements will change effective October 1, 2010. After that date, franchisors will be required to provide appropriate disclosures to prospective franchisees in Maryland at the earlier of 14 calendar days before execution of any binding agreement between the franchisor and franchisee or payment of any consideration relating to the franchise relationship, or a reasonable request by a prospective franchisee to receive a copy of the FDD. Currently, franchisors are required to make the disclosures at the earlier of the first personal meeting or ten business days before those occurrences. The new law brings Maryland in line with the disclosure timing requirements set by the Federal Trade Commission (16 C.F.R. § 436.2 (2010)).

Franchisors currently registered in Maryland will have to revise the receipt pages of their FDDs to reflect this change. The Maryland examiners' office has indicated that the receipt page changes can be made before October 1, 2010 and that no material change amendment filing will be triggered by that change alone. No action will be taken against franchisors who make such changes early as long as the current disclosure requirements and other requirements of Maryland franchise law are complied with.

After October 1, 2010, only four franchise states will impose different disclosure timing requirements than the FTC Franchise Rule. New York and Rhode Island require the franchisor to make disclosures at the earlier of the first personal meeting or ten business days before the execution of any agreement or the payment of any consideration relating to the franchise agreement. Michigan and Washington require that the disclosure be made at least ten business days before the execution of any binding agreement or the payment of any consideration, whichever occurs first.

In addition, to claim a franchise exemption, two states with business opportunity laws have disclosure timing requirements that differ from the FTC Franchise Rule. Iowa requires disclosure at the earlier of the first personal meeting or 14 calendar days before signing any agreement or paying any consideration. Oklahoma requires disclosure at the earlier of the first personal meeting or ten business days before signing any agreement or payment any consideration.


Reminder of New York Tax Reporting Requirement for Franchisors

For nearly a year, New York's Department of Taxation and Finance has been implementing a tax reporting requirement on franchisors (whether in-state or out-of-state), and it appears that at least one other state is looking to follow New York’s lead.

By March 22, 2010, any person who granted a franchise in the state of New York should have either filed an informational return to the Department or requested an automatic 90-day extension. The obligation to file this return exists if the franchise was granted to a franchisee whose business requires the franchisee to register as a sales tax vendor and was operating between September 1, 2009 and February 28, 2010.

The law (Subpart G of Part V-1 of Chapter 57 of the Laws of 2009) was enacted by the New York legislature in 2009 and requires these informational returns each March 20th. The return must include identification information for each franchise location in New York, as well as financial information about the gross sales and royalties reported and paid by each of these locations. A complete list or requirements is available online at http://www.tax.state.ny.us/pdf/memos/sales/m09_9s.pdf. The Department of Taxation and Finance has created an Excel spreadsheet template that should be used when filing the return. The spreadsheet is available at http://www.tax.state.ny.us/enforcement/audit/fran.htm.

The law also requires that prior to each March 20th filing deadline, franchisors give each franchisee included in the return a statement showing the information reported for that franchisee. There is no required format for the statement to franchisees.

More recently, North Carolina appears to be contemplating a similar tax reporting requirement in Section 4 of House Bill 2001, introduced on May 26, 2010. Both the New York law and the proposed legislation in North Carolina are designed as a means to cross-check the accuracy of income and sales tax returns filed by franchisees.


Federal Court Concludes that Franchisees Qualify as Employees Under the Massachusetts Independent Contractor Statute

According to one federal court, franchisees who operate commercial cleaning businesses qualify as employees of the franchisor under Massachusetts’ Independent Contractor Statute. On March 23, 2010, the United States District Court for the District of Massachusetts held that commercial cleaning franchisees of Coverall North America, Inc. (“Coverall”) qualified as employees (rather than independent contractors) under Massachusetts’ Independent Contractor Statute (“ICS”), Mass. Gen. Laws, ch. 149, § 148B. See Awuah v. Coverall North America, Inc., Case 1:07-cv-10287-WGY 2010 U.S. Dist. LEXIS 29088 (D. Mass. Mar. 23, 2010).

Coverall has developed and owns a distinctive system relating to the establishment and operation of janitorial cleaning service businesses. It licenses various aspects of that system to over 5,000 commercial janitorial cleaning franchises in North America. The plaintiffs, Coverall franchisees, brought suit alleging that Coverall had misclassified the franchisees as independent contractors and committed unfair or deceptive trade practices. The plaintiffs moved for partial summary judgment on the misclassification claim.

The court granted partial summary judgment because Coverall failed to prove that the services performed by the plaintiff franchisees were part of an “independent, separate and distinct” business. Coverall argued that it was in the franchising business because it merely sold franchises and trained and supported franchisees. By contrast, Coverall suggested, the franchisees engaged in the commercial cleaning business because they provided cleaning services. The Court rejected this argument, finding:

[F]ranchising is not in itself a business, rather a company is in the business of selling goods or services and uses the franchise model as a means of distributing the goods or services to the final end user without acquiring significant distribution costs. Describing franchising as a business it itself, as Coverall seeks to do, sounds vaguely like a description for a modified Ponzi scheme – a company that does not earn money from the sale of goods and services, but from taking in more money from unwitting franchisees to make payments to previous franchisees.

Such a description is not applicable to Coverall. Coverall developed ‘as the result of the expenditure of time, skill, effort and money’ and the System used by its franchisees. Coverall trains its franchisees and provides them with uniforms and identification badges. Coverall contracted with all customers, with limited exceptions, until May 2009, and Coverall is the party billing all customers for the cleaning services performed. Finally, Coverall receives a percentage of the revenue earned on every cleaning service. These undisputed facts establish that Coverall sells cleaning services, the same services provided by these plaintiffs. Because the franchisees did not perform services outside the usual course of Coverall’s business, Coverall fails to establish that the franchisees are independent contractors.

The case was tried to a jury in May 2010. Prior to trial, the court dismissed all claims relating to the misclassification of the plaintiffs as independent contractors because the plaintiffs produced no evidence that they had suffered damages as a result of the misclassification. One plaintiff dismissed its claims at the close of the plaintiffs’ case, and the court granted directed verdict as to another. The jury subsequently rendered a verdict in favor of Coverall on all remaining claims.  

The court's characterization of the franchise as a "Ponzi scheme" likely shocks most franchise professionals, and few would accept that view. Nevertheless, the case does present issues to be reckoned with. The opinion’s precedential value may be limited by the specific facts and law at issue in the case. On the other hand, the court’s sweeping language could be read to suggest that franchisees can never perform services as part of an independent, separate and distinct business from the franchisor. This generalized conclusion may have grave implications in other circumstances, particularly in vicarious liability cases, when litigants attempt to hold franchisors responsible for the activities of independent franchisees.


Colorado Appellate Court Allows Claims for Nondisclosure of Parent Company Financial Losses

A Colorado appellate court recently held that general language in three exculpatory clauses contained in a franchisor’s UFOC did not bar potential franchisees from reasonably relying on nondisclosures of the financial losses of the franchisor’s parent company. Colorado Coffee Bean, LLC v. Peaberry Coffee, Inc., 2010 Colo. App. LEXIS 210 (Colo. App., Feb. 18, 2010). The court concluded that unlike financial performance at company stores, which lacks predictive value because of differences in location and management, parent company losses may foreshadow insolvency that could destroy the franchise’s value. Additionally, the court held that the FTC’s Franchise Rule (16 C.F.R. §§ 436.1 to 436.11) did not preempt a Colorado state law requirement that the franchisor disclose financial information about the parent company, namely that it had been unprofitable. Determining that the FTC Rule only dealt with “financial statements,” the court observed that the Rule would not preclude general comments especially if provided “in separate literature.” For example, “The franchisor is the wholly owned subsidiary of [company], which has not shown a profit during its [#] years of operation” would not be precluded. Finally, the court concluded that the FTC Rule did not preempt a common law claim that a franchisor was required to disclose a parent company’s financial status because such disclosures would not mislead potential franchisees and would not be contrary to the information in the disclosure statement. 


Greensfelder News

Several Greensfelder attorneys participated in the IFA Legal Symposium and the IBA/IFA Joint Conference on international franchising in Washington, D.C. in May. John Baer moderated a panel at the IBA/IFA Joint Conference titled “Avoiding and Managing System-Wide Litigation in International Franchising.” Beata Krakus moderated a panel at the IFA Legal Symposium titled “Social Media: Best Practices for Franchise Systems.”

John Baer and Leonard Vines who were recently named "Legal Eagles" by the Franchise Times magazine. Mr. Vines was also interviewed and quoted for an article about attorneys giving business and legal advice.

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