May 7, 2015 - Franchise Articles by |

Disclosure And Accountability In Franchise Marketing Or Advertising Fund

There should be greater Franchisor disclosure and accountability concerning the expenditure of marketing and reservation fees collected from Franchisees that are held in a franchise advertising fund. On an annual basis, Franchisors should disclose how the marketing and reservation fees are spent, including identifying the specific products and services that are paid for with the fees. A Franchisor should not profit directly from the marketing and reservation fees it collects from the Franchisees, or use such fees to pay for marketing and advertising related to a Franchisor’s sale of hotels.
Franchisors should have their books and records audited on an annual basis concerning the collection and disbursement of marketing and reservation fees, and should share the results of the audits with the Franchise Advisory Councils (FACs), or the designated audit committees of the FACs.

Putting the Cards on the Table

Almost all franchise agreements establish advertising and marketing funds into which franchisees make regular periodic payments. Some franchise agreements also require franchisors, in addition to their franchisees, to make contributions to these funds, and others do not.

In contrast to most other obligations of franchisors in franchise agreements, the duties and obligations assumed by franchisors in administering and spending monies in the fund are delineated with much greater certainty. This is for two reasons.

First, UFOC disclosure rules require that franchisors describe in their disclosure documents all aspects of their advertising programs by answering a list of very detailed questions, including: what media the franchisor may use; whether media coverage is local, regional, or national; which source of the advertising (for example, an in-house advertising department or a national or regional advertising agency); and whether the franchisor must spend any amount on advertising in the area or territory where the franchisee is located.

The UFOC disclosure rules also require that franchisors indicate whether there is an advertising council composed of franchisees that advises the franchisor on advertising policies, and if so, to disclose: how members of the council are selected; whether the council serves in an advisory capacity only or has operational or decision-making power; whether the franchisor has the power to form, change, or dissolve the advertising council; whether the franchisee must participate in a local or regional advertising cooperative, and, if so how much the franchisee must contribute to the fund and whether other franchisees must contribute a different amount or at a different rate; who administers the fund; whether the fund is audited and when it is audited; whether financial statements of the fund are available for review by the franchisee; how the funds were used in the most recently concluded fiscal year, including the percentages spent on production, media placement, administrative expenses, and a description of any other use; and the percentage of advertising funds, if any, that the franchisor uses principally to solicit new franchise sales.

Second, in addition to the UFOC rules just described, court decisions over the last decade have pushed franchisors to meticulously draft the advertising duties and responsibilities in their franchise agreements in unusual and incredible detail. This is because courts, in essence, have held that the greater the specificity with which the franchisors set forth their advertising duties, the more likely it is that a court would find the franchisor’s advertising obligations to be contractual and not fiduciary. The distinction between the two is crucial, as absent a fiduciary duty owed by a franchisor to his franchisees for administering an advertising fund, the franchisee will be left solely with a run-of-the mill contract claim, which, at the end of the day, will usually drown in the sea of prolific contractual verbiage regarding advertising funds. (La Quinta 2007 UFOC “We do not act as trustee or in any other fiduciary capacity with respect to the NAF.”)

Understanding Advertising Fund Rules

From a franchisee’s point of view, the most damning advertising contractual language is that which explicitly reserves to the franchisor the full and sole discretion to administer the advertising fund. Once inserted in the agreement, the “sole discretion” language taints every other franchisor advertising obligation, such that, absent rank fraud, the franchisor’s advertising acts will be immune from suit and effective criticism. This language reserves to franchisors the unfettered discretion over choices of advertising fees, concept, placement, and format. (La Quinta 2007 UFOC “we may use NAF contributions in our sole discretion for any purpose …”); (Red Roof 2007 UFOC “we will spend a portion … in our sole discretion.”); but see (Comfort Inn 2007 UFOC “[advertising funds] will be used as we reasonably determine to be appropriate for the system.”) In fact, this reservation of rights regarding advertising programs can run to the very existence or termination of an advertising program itself. (Le Meridien 2007 UFOC “we…reserve the right to discontinue the Marketing Fund …in our discretion.”)

Another relatively deadly provision for franchisees is where the franchise agreement explicitly states that contributing franchisees have no right to receive any guaranteed level of benefit from the programs. Thus, a franchisor’s decision to spend the fund in emerging, suffering or highly competitive markets to the detriment of others will be immune from attack by franchisees. (La Quinta 2007 UFOC “…we cannot assure you that your Facility will benefit directly or pro rata from the placement of advertising..”) In addition, in cases where the hotel franchisor itself operates corporate-owned hotels, franchisors have even recognized that the franchisees’ marketing dollars can be used to benefit the company hotels. (Le Meriden 2007 UFOC “allocations for regional marketing may benefit company-owned Brand Hotels disproportionately.”) And, there are even those franchise agreements that permit the franchisor to use the fund to finance its sales efforts to sell new franchises.

Given the legal landscape above, franchisees are left with few weapons to actively ensure fairness from their franchisor’s administration of advertising funds. However, to the extent franchisees have been successful in this area, their successes have taken the form of requiring franchisors to report or account for the receipts to and payments from the advertising fund. In this regard, some franchisors have specifically addressed this issue by setting forth in the agreement how such reports should be made; to whom they should be made; whether they should be independently audited; and, if so, by whom. Unfortunately many other franchisors are silent on the reporting and accounting issue.

Without such an accounting it is virtually impossible for franchisees to provide any meaningful advice to the programs. Unaudited annual statements with aggregate numbers certainly cannot be viewed as helpful to franchisees. (La Quinta 2007 UFOC “we will prepare annually a statement of monies collected and costs incurred…) (Red Roof 2007 UFOC “we will provide an annual report of the receipts and expenditures … but we are not required to audit that report.”); (Le Meridien UFOC 2007 “we may [but are not required to] cause to be prepared an annual unaudited statement of contributions collected and costs incurred.”); but see (Choice UFOC 2007 “audited financial statements for the Fund are prepared each year.”)

Even where some rudimentary disclosure is required, most franchise agreements deny franchisees any role or input in the operation of the fund. Some of the more mature and well-known franchises have created advisory groups consisting of both franchisor and franchisee representatives to make recommendations regarding the fund; however, these recommendations are usually not binding on the franchisor. (Red Roof 2007 “[the Franchise Advisory Council] is not an advertising council…and has no authority to impose changes or establish policies..”);(Le Meridien UFOC 2007 The “Owners Advisory Counsel… is an advisory board” and the franchisor “reserves the right to change the composition of the OAB …or replace it with a different advisory board.”)

There are also many other issues regarding advertising funds that are significant. For instance, under most agreements franchisors are permitted to reimburse themselves for costs associated with the operation and administration of the programs. Often there are issues that arise between actual out of pocket costs and allocated administrative or overhead costs. Issues sometimes arise where the contributions to the fund are made by third party suppliers. (Le Meriden UFOC 2007 “[contributions to the Marketing Fund] can be used to defray reasonable salaries, administrative costs, travel expenses, agency fees, market research and overhead as we may incur in activities related to the operation and administration of the Marketing Fund.”)

Finally, another thorny issue rarely, if ever, addressed, concerns the situation where some franchisees fail to meet their individual monthly advertising or marketing contributions and are sued. When the franchisor sues for these delinquent payments, it expends money from the advertising fund on attorneys, for which the franchisor later seeks reimbursement; and, when a compromised amount of the debt is accepted, a legitimate question arises whether it is proper for the franchisor to deduct from the amount received its attorney’s fees, and the more important question, whether the franchisor then places the remainder in the advertising fund. In the hotel franchising world, where liquidated damages run into the tens of millions of dollars, the disposition of these funds after collection by franchisors can have a direct impact on remaining franchisees in the system.

How a Franchise Lawyer Can Help

Learn about how franchise lawyer Jeff Goldstein at the Goldstein Law Firm can help you. We want to understand your situation. Call our law firm at (202) 293-3947 to explore your legal options. 

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