Breaking News — FDD Violation by Teapresso

In today’s episode, Steve discusses the risks associated with violating the FTC Franchise Rule and shares some recent news in the world of franchising. Teapresso, a boba milk tea and coffee franchise allegedly granted 26 Teaspresso Bar franchises in Hawaii without distributing its FDD to the prospective franchisees. The franchise bros cover this malfeasance and discuss instances where FranSource had to step into a situation to help get franchisors out of a sticky mess.

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Transcript

Mark Vandegrift 
Welcome to the latest episode of FranSimple, the podcast designed to make the concepts of franchising simple. I'm your host, Mark Vandegrift, and with me is my franchise bro and an all-time expert in franchising, Steve Vandegrift. Steve, welcome to another episode.

Steve Vandegrift 
Thank you, Mark. Great to be here.

Mark Vandegrift 
So on the last episode, we talked about FDDs, franchise disclosure documents. What they are, how they're created, the timing, some of the nuances, some of the challenges, and our perspective on them. And believe it or not, we have some great timing on something. There's a recent story about a franchisor and their FDD. And I sent you the article about Teapresso Bar and how they're offering franchises without distributing their FDD to prospective franchisees. So I want to get your initial reaction because I'm sure you were like, Ahhhhh. So, tell our listening audience why this is a problem.

Steve Vandegrift
Well, again, as we discussed in our last episode, that ultimately franchising is regulated by the Federal Trade Commission under the FTC franchise rule. And franchisers are required to prepare that document, but not just prepare it, but they need to distribute it to prospective franchisees. There's actually disclosure periods. In other words, franchisees are required to hold the document as an example for 14 days before they can make any payment or sign an agreement. Further, if there's some blanks in the agreement because it's customized for each franchisee, maybe they have varying franchise fees based on the territory. When that franchisee is ready, they've committed, they've been accepted as a franchisee, then the franchisor will prepare what we call the franchise closing documents. Well, again, if there are blanks that are considered material like franchise fees, then the franchisor must ensure that that prospective franchisee still has seven days, the first day doesn't count, so they need to wait another eight days before they sign the agreement and make any payment. And ultimately, that's the cooling off period in franchising. It's before you sign the agreement. And so ultimately, by not complying with that very simple requirement, they in essence were illegally offering franchises.

Mark Vandegrift
Interesting. Well, what was your initial reaction to the story? Like, how do you look into something like this when you read an article like that?

Steve Vandegrift 
Well, first of all, it's usually a case of them just literally making the decision that they're not going to comply. The most basic law, and maybe they don't have competent legal counsel, I don't know. But any franchise attorney would make sure that they understood the 14-day rule, the 7-day rule, and in fact, the attorneys that we work with will not even begin preparing the disclosure document for signing until they've received what's item 23. We did not talk about on our last episode simply because it's the receipt. The receipt simply acknowledges, I'm acknowledging to the franchise company by signing and dating it that I have received the entire franchise disclosure document. It will list every document in that any exhibits, et cetera. And so ultimately, that's the way the attorneys ensure that their client is not making the illegal sale of a franchise.

Mark Vandegrift 
Well, it's been interesting because over the years I've heard you say that people walk into a concept and they go, I'd love to buy a franchise. Do you offer one? And the owner might say, well, yeah, we're thinking about it or we're doing it. And I know I've heard you multiple times talk about this idea that you've cautioned the owners to say, hey, be careful what you say and be careful what you give them. And when you're doing that, what's kind of the counsel around that? What are you telling an owner? Cool your jets, follow the process. What are you doing there?

Steve Vandegrift 
Well, basically, under that rule, cannot base the basic way to say it is you can't make an offering of a franchise. Now, to you and I, if I offer you a ride, I'm offering you a ride under the FTC franchise rule. If I start talking to you before I have that FTC compliant franchise disclosure document and I start talking to you about territories and what that looks like in franchise fees and what the total investment will be. There are many registration states and even the FTC franchise rule would prohibit that. But in essence, you're illegally making an offer before you're permitted to do so. And as I mentioned in the last episode, it's not that you get permission by filing that with the Federal Trade Commission. There is no filing. But ultimately, it just takes one franchisee to contact a state if they're in a registration state and contact that franchise department, whichever division it's under, whatever department it's under, or contact the FTC directly.

Mark Vandegrift
Interesting. So in that case, if they're convicted or they're whatever the term is, what's the penalty for this type of franchise law violation?

Steve Vandegrift 
It's pretty substantial. And the thing about violating the FTC franchise rule is it's not just at the company level. So in other words, I'm insulated because I'm not my entity. My entity is my entity. Under the FTC franchise rule, and we've experienced this, we had a client come to us years ago that had bought a company they thought was a franchise. It turned out it wasn't. That owner ultimately was enjoying from ever selling a franchise again. And they had to pay, I believe it was an $85,000 fee. Now this is probably 12 or 14 years ago. I can only imagine how high those fees get. And the other problem with that is clients that begin making offers in registration states when they haven't actually filed with that state. And they go to file eventually. And somebody that they had talked to way back when becomes a franchisee, it goes terribly wrong. And so they sit down with the franchise attorney. They say, walk me through the franchise sales process. And in that case, they're going to say, when were you first contacted? Well, I was contacted three years ago. Oh, well, the FDD says they just registered in that state six months ago. So in essence, that attorney might even stop at that point and say, OK, we have enough. We can get you out of this. But of course, they're going to take a deeper dive because more they can find, the more it's an ironclad case. So that is ultimately what can happen.

Mark Vandegrift
So this happened in Hawaii, right?

Steve Vandegrift 
This particular situation happened in Hawaii. A single state 

Mark Vandegrift 
Yeah. And they're a registration state.

Steve Vandegrift
but they are registration state. Exactly right.

Mark Vandegrift
So give us an example. Tell us what probably happened if there wasn't detail and how Hawaii would have chased down the franchisor or franchisor in quotes.

Steve Vandegrift 
Right. And what I surmise is simply that it only takes one. So I believe they were at 26 or something like that. Franchises. It only takes one that has a bad experience and they sit down with the franchise attorney and the attorney says they didn't even provide you a franchise disclosure document. No, they just gave me an agreement. I signed it I was off to the races. Well, right there is a major violation of not just the FTC franchise rule, but a wise franchise rules and regulations. You have to register in that state. So it was just a montage of various things that they did wrong that it's so simple to comply with the rule that it was mind-boggling when I read this article.

Mark Vandegrift 
Do all the franchisees then if they're found in violation, will they all have to shut down?

Steve Vandegrift 
Great question. Franchisees themselves are not responsible for the failure of the franchisor to follow the rule. What would typically happen in that case, and again, I always like the caveat that I'm not a franchise attorney. I've just dealt with enough franchise attorneys in the laws that I understand this. But ultimately, a state can literally make the franchisor issue a rescission letter. And that rescission letter basically says, if you would like, you can rescind your franchise agreement. And the franchisor has to make you whole. So any monies that they invested that were quote unquote lost, the franchisor is now on the hook for that payment. And so what it does is it opens the door. If they had 26 franchises, there might have been five or six others that were struggling. And they're like, why did I ever get into this thing? Well, they can step in line. And at that point in time, they're also going to receive some type of compensation, potentially, from the franchisor for that violation. So it's pretty substantial when that occurs.

Mark Vandegrift
So let's say the franchisor is not enjoined necessarily, but in this case, if they were to keep operating, did they lose any rights or what happens in this case?

Steve Vandegrift 
Well, it's going to vary. Excuse me. That's where it really comes down to what the violation was, who knew about the violation, and obviously the officers, owners, et cetera, they're on the hook for that. But ultimately, each state's going to be a little different in how they handle that. They might get a fine. If they're willing to fall on the sword, it could be a very substantial fine. If they go ahead and comply with the rule, the state may, in fact, allow them to continue to operate. But in the worst violations, and I shared an example already about that, they can enjoin any owner officer from ever selling a franchise again or offering a franchise. So again, it's going to vary state by state.

Mark Vandegrift 
OK, so I think recently there was a client of ours that already had they were operating multiple locations and then they decided to franchise. That is a legal conversion, right? So there's a difference between operating as a franchise and then later converting to a franchise with existing locations. Is that correct?

Steve Vandegrift
Well, it yeah, it really comes down to the legal structure and over 30 years you can imagine we've had a number of clients come to us that their well-meaning business attorney said, hey, you don't need to do this franchise thing. You know, it's very legalistic. It's costly. You can just license the right. Under the FTC franchise rule, simply put, we like to say if it tastes, smells and looks like a duck, it's a duck. In this case, if it looks like a franchise. Well, how does it look like a franchise? Well, what the FTC would do or any state a registration state is they would simply look at the terms and provisions of the franchise agreement. And if there's three key elements and under the FTC franchise rule, it's that easy. You have three elements that make you a franchise. If you have all three, you're definitely a franchise. If you have two, you may be a franchise. And ultimately that's simply your license and the right to use a trademark or a trade name. You're exerting significant control or providing assistance. Significant control is telling them what they must offer, the products they must buy from certain suppliers. You're giving them the benefit of franchise training. And the final element is a required payment element. If a franchisee or a licensee is required to make a payment of $500 or more, either prior to opening the business or during the first six months of operation, that meets a required payment element. And so we've had clients come to us that were in that situation. Now, thankfully, we work with very, very competent, knowledgeable franchise attorneys. And in every single case, we were able to correct that before it blew up. So in other words, changing the structure. It may be that they were having family members operate those other businesses. Well, if the franchisor owns those businesses and simply is employing their relative as an operating partner, that's legal. OK? But sometimes our attorneys had to do a little bit with the structure. They had to change some of those agreements a little bit to make sure that they fully were operating not as a franchise, but in essence as a corporate entity. And they were opening all the individual locations. So again, the best thing is to certainly seek competent legal counsel when you're considering any type of business expansion method, especially when you're debating between can we franchise or do we need to franchise or can we do a license? A license is great. You mentioned in our last episode, you brought up dealerships and distributorships as an example of an expansion method. That works great for a product. If you're a company, you're not worried about controlling the day-to-day operation. Toro would be a great example. They license dealers all over the country to sell Toro mowers. They can exert control over their trademark, the use of their trademark, they can provide training and assistance when it comes to the Toro Motors. That dealer is authorized to service them. But as soon as they start saying, we're going to require you to advertise. We want you to set up your store this way. We want you to do this with your POS system. Now they're starting to potentially cross over into the franchise space. And so those are things that are just so important to figure out right up front.

Mark Vandegrift 
So we know the Tearesso story. Do you have an example? I mean, 30 years of clients, you've seen a lot of stuff. What would you say was your most egregious FDD that you inherited and had to fix? What was the violation? How quickly did you fix it? And what was the resolution? Don't disclose the client, but give us the details.

Steve Vandegrift
Well, there's two sides of that. One is what we were talking about, and that is a client coming to us. We've had a client come to us with 20 plus locations. And the way their legal structure was set up, it would have been very difficult not to say that it was an illegal franchise. So again, our attorneys handled that, right? So that's a little bit different than what you're asking now. In terms of clients coming to us, we do get clients, existing franchisors ask us to, and usually it's provide us services to redo our operations manual would be a great example, which requires us to review their franchise disclosure document. Well, at that point in time, we can we will notice that they did not completely follow the FTC franchise rule. It might have been one item. It might have been five items. Whatever the case is, it's not compliant with the FTC franchise rule. So we gather up with our attorneys. We go through it in detail. Obviously, at that point, we make recommendations to what needs to what needs to be modified 100 % of the time, our clients elect on their own that they're going to switch attorneys. They want to go with someone that actually stays up on franchise law, which is critical. The FTC and through the affiliated organizations will issue opinions sometimes on certain items. You really want to work with a competent franchise attorney that stays in the game. In other words, they're aware of changes. And one we'll talk about on another episode is some of these states that are implementing stronger and stronger telecommunication laws. Texas is an example, and we'll talk on another broadcast or another podcast about that. Basically, they're mandating that if you are going to market through text to any consumer in the state, you have to have a permission and opt in by that consumer before you do it. Further, you may potentially have to register with the state of Texas to be able to text, especially if you haven't done any opt-in, etc. And so at the end of the day, you need an attorney that's going to be able to advise you. We sent out a notice to all of our clients when this came about, excuse me, in Texas last September. It was critical that they knew that this was in place, and then certainly we referred them to speak with their business attorney who can certainly make sure they're compliant, they do any registration, file any bonds that they need to file, et cetera.

Mark Vandegrift
Okay. Well, we haven't seen this type of violation thrown at us over the last 30 years because of our compliance. And part of that is we feel like because we're a one-stop shop for franchising, we understand the entire picture, not just the little bit that is legal oriented. Can you explain why hiring a full service one-stop shop like FranSource really is the advisable way to go.

Steve Vandegrift 
Well, and I think I mentioned in our last podcast, it's so critical that each and every component of that entire franchise operation and the opportunity itself sing off the same song sheet. You need that consistency. In fact, FranSource, when I co-founded this with a franchise attorney back in 1997, we did so because there was no other company out there that actually had that cohesiveness between it. And so in doing so, we were able to ensure and really ensure our clients that both the franchise disclosure document, the franchise operations and policy manual, the franchise marketing materials, all of them were consistent. And inconsistency, first of all, it's going to confuse franchise prospects. Second of all, can get you into legal trouble. So if you're saying one thing in your franchise disclosure document or your agreement and another thing in your operations manual, that can be right for disaster.

Mark Vandegrift 
Well, it does boggle my mind those franchise concepts that think they can go to market with just an FDD and not an operations system because franchising is all about buying into a differentiated operations system, which, by the way, needs a differentiated marketing system. So all those things go together. Yep. And if we aren't buying something differentiated, then it would seem to the prospect, well, I've seen that before or I can replicate that or I can do whatever. They're not giving me anything that's special in terms of operations or marketing or IP. So why wouldn't I go do my own thing? And I think that's what happens a lot of times is when you don't have that stuff locked down, you're telling a prospect without telling them, hey, go do this on your own because it's not hard to replicate.

Steve Vandegrift 
We'll sign the agreement and then you go figure everything out. People buy franchises because they don't want to figure it out. And in fact, nowadays, Mark, I would bet that 99.9 % of those companies that elect just to have a franchise disclosure document drafted never does anything with it because prospective franchisees they're knowledgeable nowadays. It's too easy to research on the internet. Find out what you need to find out. What are the important questions to ask? What's your marketing program like? Do you do top-down marketing where you have a qualified third-party marketing agency like Innis Maggiore, who's going to actually assist your franchisees with that? Do you offer site selection assistance? Do you work with a master real estate broker? That's another example of a company that we'll introduce our clients to so that they have top level, this company's national and international, and they'll work with our startup franchisors. They love to start at the beginning with them, and they're able to provide that expert level of assistance that you wouldn't expect from a startup franchisor. And that's just one example.

Mark Vandegrift 
Excellent. Well, I think that kind of covers our topic for today. I just thought Teaspresso was a real interesting conundrum for them and a great topic for us to cover.

Steve Vandegrift 
To say the least, yes. Big time. And it's amazing to think that those things still happen today. It just shocked me when I read that. It's so easy to comply.

Mark Vandegrift 
Doesn't it seem like it's happening more frequently though? It's almost like people haven't learned very well that it's easy to monitor more so than ever. And yet they try to get away with things out of, I don't know if it's laziness or wanting criminal activity or what the deal is, but it doesn't seem to be going well.

Steve Vandegrift 
I call it greed. I call it greed. They want those franchise fees. And we still have a lot of companies out there today like that. And that's one thing I would always caution anyone, relatives, friends, or strangers. They're looking at a franchise. One of the things you want to look at is how rapidly are they growing? And are they losing franchises every year that they're granting franchises? Item 20 that we didn't talk about that last time, lists the number of corporate locations, the number of franchise locations, eventually over a three-year period. And it'll show you net gain, net loss. And that's very critical. know franchise attorneys definitely have their clients look at that as one of the considerations. Do I want to join a company that added 10 franchises last year and lost nine of their existing franchises? Something's going on behind the door there. And it needs to be investigated before someone would make that decision.

Mark Vandegrift
Excellent point. Well, Steve, let's wrap up today's episode of FranSimple. Thanks for joining us. And as always, please subscribe, subscribe, subscribe, like, share and tell your friends all about the FranSimple podcast, the one designed to make the concept of franchising simple. Until next episode, may your business expand through the power of franchising.