What Franchisor Mistakes Lead to Lawsuits? What to Watch For

In franchising, systems and documents are key to mutual success for the franchisees and franchisors. However, when things go sideways, what was once an optimistic business relationship can turn into legal trouble, and franchisee attorneys will collect as much evidence as they can to support their client’s claim against the franchisor. With a strong foundation, many brands can avoid litigation altogether or at least insulate themselves if the situation does escalate.

“Many times in the franchise world, litigation is avoided. Franchisors want what’s best for their franchisees, and franchisees generally act rationally. And when there are disputes, sometimes we go to mediation. We have a great mediator, and it's resolved,” said Charles Internicola, founder and managing partner of The Internicola Law Firm. “So the good news is that, from an industry perspective, for good franchisors, litigation can be managed and is completely controllable.”

Common mistakes

For franchisors, staying aware of common missteps can support franchisee success and satisfaction while also helping manage legal risk. Here are the top mistakes franchisors should look out for — and what can be done about them.

The FDD is crucial to franchise success, and it can’t be a “set-it-and-forget-it” type of thing. It requires annual updates and strict adherence to both federal and state-level laws. The FDD must be updated annually, and some states require it to be filed or registered.

“We want to be aware that you're registered in the registration states when you disclose your FDD, and sometimes franchisors make mistakes,” Internicola said. “Maybe a franchisee is going to open up a location in Florida where registration isn't required, but we find out that the franchisee is a resident of the state of Maryland… in which case, registration in Maryland was required.”

Keeping the FDD up to date and ensuring you’re in compliance in all necessary markets allows you to pursue the sales cycle with confidence.

“Compliance violations are low-hanging fruit,” he said. “They're not generally the reason the lawsuit started. But for franchisee attorneys, it's the first point of attack. They're going to be scrutinizing your compliance, and the way you avoid it is to have a thorough compliance system — your FDD, your FDD updates, your FDD disclosure, how you document and send franchise agreements, how addendums are prepared and how the process itself is documented.”

Recruitment pitfalls

When recruiting new franchisees, it can be tempting to openly discuss the financials of the business. Many will want to know; they’re evaluating what their return on investment may be. However, if you make financial performance representations that aren't documented in Item 19 of your Franchise Disclosure Document, you are playing with fire. Even a casual conversation can turn into a major liability later on.

“You can't make any financial performance representations. The only financial information you can give is what you properly disclose in FDD Item 19,” Internicola said. “So if you have a salesperson or outsource sales organization that's making claims that rise to the level of financial performance reps, operating margins, profit, unit costs, how long it takes to become successful or profitable… It opens the door to litigation.”

If a franchisee begins to struggle and pursues litigation, their lawyer will look for any statements made that fall outside the bounds of legal, FDD-backed disclosures. To avoid this, franchisors have to be brutally honest about startup costs and the capital reserves actually required to stay afloat. Consider incorporating a buffer, especially for build-out and marketing, so franchisees aren’t surprised when costs exceed what’s shown in the FDD.

Support obligations

Franchisees buy into a system and pay ongoing royalties for a reason. They’re looking for a roadmap to success and ongoing support in exchange. If a franchisor stops providing training, previously agreed-upon marketing support or regular coaching, the franchisee may feel they’re not getting what they paid for. That can even mean enforcing the support cadence with a franchisee who seems checked out or believes they have everything under control.

“Franchisor-franchisee — it’s a relationship. There’s a parent-child component to this,” Internicola said. “You want to create and train franchisees at an early stage that this is a mutually beneficial process, and we need to adhere to it.”

Franchisors may be especially at risk of this as the brand grows. If the leadership team doesn’t pace support team growth with system growth, the infrastructure may begin to crumble. And franchisees may claim that the franchisor is no longer upholding its end of the deal.

You want to sell franchises and grow the system, but you shouldn’t do it in a way that will put the brand at risk. One failed deal is likely far less expensive than the costs — monetary and otherwise — of doing things improperly or bringing a bad-fit franchisee into the fold.

Many franchise lawsuits aren’t born out of malice. They come from misaligned expectations, sloppy paperwork and even a genuine mistake here and there. Franchisors can drastically reduce risk by keeping the FDD accurate, up to date and properly filed and registered, communicating clearly with prospective franchisees about costs and profits within legal bounds, and adhering to the franchise agreement.