A recent article in the Franchise Times discusses the rising costs of opening and operating a franchise. According to the article, “[d]evelopment and buildout costs across the board have increased, and it’s led a majority of franchisors to bump what’s financially needed for a franchisee.” As the article goes on to explain, in a recent survey, “93.9 percent of franchisors indicated inflation has forced them to increase cost estimates in . . . Item 7[ of their Franchise Disclosure Document (FDD)].”
If you are a franchisee and you are facing costs that are higher than expected, what does this mean for you? National franchise lawyer Jeffrey M. Goldstein explains:
Franchisors Have a Legal Duty to Provide Accurate Start-Up Cost Estimates In Their FDDs
Under the Federal Trade Commission (FTC) Franchise Rule, franchisors have a legal duty to provide accurate disclosures in their FDDs. State franchise laws require franchisors to provide accurate disclosures as well, and, generally speaking, making false or misleading representations in an attempt to induce contract execution is a form of fraud.
The disclosures in Item 7 are, by definition, estimates. As a result, they do not need to be exact. Additionally, the FTC’s Franchise Rule Compliance Guide states that, “[i]f the amount of a payment is unknown, then franchisors may use a low-high range based upon the franchisor’s current experience.” So, to a degree, imprecision is to be expected.
With that said, there are limits on how imprecise franchisors can be when making their Item 7 disclosures. Franchisors cannot be intentionally misleading in Item 7, and if their Item 7 disclosures become inaccurate, then updates may be required. This is true even if the inaccuracies are due to circumstances beyond their control (i.e., tariffs or market forces). While most franchisors update their FDDs annually, they must also make intra-year updates when their FDDs no longer accurately reflect the details of their franchise offerings.
There is precedent for holding franchisors accountable for inaccuracies in their Item 7 disclosures. In the case of Motor City Bagels, LLC v. American Bagel Company, for example, the court held that a jury could reasonably find that a cost estimate that was approximately 20 percent lower than the actual cost of opening for business was fraudulent. With costs rising steadily—and with cost increases routinely making national headlines—today’s franchisors may need to take particular care to ensure that they are not misleading prospective franchisees during the buying process.
What About Operating Costs?
Part of the reason why franchisors are required to provide start-up cost estimates in their FDDs is that these costs can reasonably be estimated at a particular point in time. Operating costs over the term of a franchise agreement, in contrast, are much more difficult to predict. As a result, franchisors are not required to provide broad ongoing cost estimates (though they must accurately disclose their royalty rates, advertising fund contributions, and certain other expenses)—and, as long as they don’t provide inaccurate estimates voluntarily, this generally isn’t likely to give rise to a disclosure violation.
However, there are other ways that franchisors can get into trouble when franchisees’ operating costs start to become unmanageable. In particular, if a franchisor requires its franchisees to purchase specific items or to make purchases from a designated supplier (including from the franchisor itself), the franchisor may need to ensure that the costs of these purchases remain in line with market forces. Giving franchisees no choice but to overpay for necessary purchases can give rise to claims for various types of unfair franchise practices.
Otherwise, however, franchisors are likely to argue that cost increases due to inflation, tariffs, and other outside forces are simply a risk of doing business that franchisees assume when they sign their franchise agreements. Absent any evidence of fraud, franchisees who are facing cost increases due to forces outside of their franchisors’ control may have few (if any) legal options available.
Protecting Yourself When the Costs of Opening or Operating a Franchise Become Unmanageable
With all of this in mind, what can you do if the costs of opening or operating your franchise have become (or are at risk of becoming) unmanageable?
The short answer is, “It depends.”
From disclosure violations to unfair franchise practices, franchisees who are facing unexpected costs may be able to pursue claims against their franchisors on various grounds. However, franchisees’ rights in these cases are often state-specific, and, as discussed above, franchisees won’t necessarily have grounds to take legal action in all cases.
But if your franchise is in jeopardy, learning what legal options you have available (if any) will be well worth it. If you have grounds to pursue a claim against your franchisor, you may be entitled to rescission (cancellation of your franchise agreement), damages, and/or other remedies depending on the circumstances involved. Negotiating a resolution with your franchisor may be an option as well. Importantly, even if your franchisor hasn’t violated the law, it may be willing to work with you to help you find a sustainable path forward—provided that you handle the situation appropriately.
In any case, making sound decisions requires a clear understanding of your legal rights—and this means that you will need to consult with an experienced franchise lawyer who can provide advice based on the specific circumstances at hand. If you have grounds to take legal action, taking legal action promptly could be important; and, in any case, you will want to act before you breach your franchise agreement and give your franchisor grounds to pursue termination (assuming it’s not already too late).
Request a Free and Confidential Consultation with National Franchise Lawyer Jeffrey M. Goldstein
Are you facing higher-than-expected costs as a franchisee? If so, national franchise lawyer Jeffrey M. Goldstein can help you understand your legal options and make informed decisions about your next steps. To request a free and confidential consultation, give us a call at 202-293-3947 or tell us how we can reach you online today.
