Jun 05, 2023
On June 1, The Capitol Forum hosted a conference call with Stanley Dub, a lawyer who specializes in franchise law and who has extensive experience representing franchisees, to discuss our reporting regarding Xponential Fitness as well as Dub’s views on ways that state and federal regulators can better protect franchisees and consumers. The full transcript, which has been modified slightly for accuracy, can be found below.
KIM GEIGER: Good morning. Thanks for joining our call. I am Kim Geiger. I’m a Correspondent at The Capitol Forum. With me today is Stanley Dub, a lawyer who specializes in franchise law.
Before we get started, I’d like to go over a few housekeeping items. You’ve joined the presentation listening through your computer speaker system by default. If you’d prefer to join via telephone, just select telephone in the audio pane and the dial in information will be displayed. If you have questions for us, please email them to editorial@thecapitolforum.com or submit them into the questions pane of the control panel. We’ll collect questions throughout the call and address them during the Q&A session at the end of this conversation.
Okay. So, as some of you are probably aware, The Capitol Forum has reported extensively in recent months on Exponential Fitness, a fitness franchiser that operates ten boutique studio brands, including some well-known ones like Club Pilates, Cycle Bar and Pure Bar, as well as others that are in the earlier years of franchising like Row House, AKT and Stretch Lab.
Since the company went public a couple of years ago, Exponential has repeatedly told investors that it has never had a franchise unit permanently closed, even during the COVID 19 pandemic. The company has also been touting growing studio revenues and is projecting a continuation of its rapid expansion across the U.S. and globally.
The Capitol Forum has interviewed dozens of current and former franchisees, studied the franchise disclosure documents of the exponential brands and reviewed many, many legal records relating to Exponential, its brand acquisitions, disputes with franchisees and other matters. Our reporting has raised a number of questions about the true health of Exponential franchises, about this claim of having had no studio closures and about the company’s practices and disclosures.
We thought we’d have this call to go through some of those findings with an expert who can put them into context for us. We’re at a moment when the FTC, which regulates franchise owners, appears to have renewed its interest in issues surrounding franchising. So now seems like a good time to take a deep dive on these issues.
Stan Dub is a 1975 graduate of Case Western Reserve University Law School and has practiced law since then as in-house counsel for publicly traded corporations and in private practice for law firms. In 2006, he started his own law firm in Cleveland, Ohio, specializing in franchise law matters. Stan’s first involvement in franchise law came in 1989 when he wrote the franchise documents for a small pizza business, East of Chicago Pizza Company, which grew into a chain with 150 outlets in five states. More recently, his practice has focused on representing franchisees. He’s brought dozens of claims for franchisees, and some have resulted in establishing important pro franchisee precedents in state and federal courts.
Stan is a member of the American Bar Association Forum on Franchising, which is the national organization of Franchise Lawyers. He has published articles in the organization’s journal, the Franchise Law Journal, and has been a presenter at their national conference. Stan was the primary author of the revisions to Ohio’s Franchise Related Law, which went into effect in 2012. Since 2016, he has been Adjunct Professor of Franchise Law at Case Western Reserve University Law School, teaching an annual course on franchise law. This is one of only a handful of franchise law courses taught in the U.S. Stan has frequently been consulted or hired as an expert in franchise law. Stan, thank you so much for being here today.
STANLEY DUB: Thank you, Kim.
KIM GEIGER: So to start, can you please just sort of walk us through the high level view of how franchising is regulated in this country and how the rules end up actually being enforced?
STANLEY DUB: Certainly. It sounds like what I tell my law school students on the first day of class. We have very little in the way of franchisee protection law in America, and it’s very spotty. So what the background looks like is that since 1979, there has been a trade regulation of the Federal Trade Commission, which applies to all franchise sellers in the country, with some exemptions that are in the law.
It requires that the franchisor owner, before he sells any franchise or takes any money, provide the franchise purchaser with a lengthy disclosure document called the Franchise Disclosure Document. There are 23 mandatory disclosure items and it can run two to five hundred pages with exhibits. It used to be that people would provide it in print and then you could read it or not read it. But nowadays, it’s common to provide it electronically. And in my experience, a large number of people never print it and so never really study it very carefully.
Anyway, that is the federal regulatory scheme. That’s it. And the FTC does not follow up on violations. It does not require that a franchisor submit the document to them. It only requires that the franchisor, if not exempt, provide this to its franchisee.
You may be familiar with the environment for different areas of the law or the playing field from a legal point of view. In particular, we can compare this to securities law and to environmental law. And in both those cases, we have laws that establish regulatory agencies, the EPA and the SEC, and those agencies have issued regulations. And in the case of the environmental regulations, the law specifically provides for citizens suits, for injured citizens to sue individually on their own behalf without going through the agency.
In the case of securities law violations, the law does not say that. But the courts have implied that. And it’s very common—nowadays, it’s very well accepted—that individual shareholders who buy stock and are victimized by a fraudulent scheme have a right to sue individually without going through the regulatory agency.
When the FTC passed its regulation authorizing and requiring the Franchise disclosure document, they expressed the hope that courts would similarly allow individual franchisees to sue for violation of the FTC rule. But courts have not done that. Courts have, in fact, done quite the opposite. They have focused on different language in the authorizing statutes creating the FTC, as compared to the Securities and Exchange Commission. And they have concluded that it was not the intent of Congress to permit a private right of action for violation of FTC regulations.
As an aside, the FTC has recently made a big deal out of trying to regulate non‑competes in the country and I wish them a lot of luck with that. But they are going to be stuck with this same limitation that applies to the FTC franchise rule, namely that individual people are not going to be allowed to file lawsuits for violation even if the FTC passes this earth shattering rule prohibiting non competes.
So getting back to the franchise field, we have an FTC rule that applies nationally which individuals who are damaged by failure to comply with cannot enforce directly. They are only allowed to, in theory, call the FTC and complain. And the FTC has been very, very lax and has not pursued any of these complaints. There was a study of the FTC’s enforcement in 2001 by the General Accounting Office, which concluded that most complaints of franchisees to the FTC are never investigated, much less anything done on them.
In past years, I have tried to get them interested in pursuing a claim. Certainly, the Xponential case would be a possible situation where they might like to do that. And we know that they just did this once, after decades of inaction, in the Burger IM field.
So I have tried to, you know, I have spoken with an FTC enforcement attorney and said, I have a case for you on a platter. Please take it. My client doesn’t have any money to pay me to pursue this. And they have said, no, we don’t do that. We’re not interested. We don’t have the staff to do that.
So putting aside the FTC’s role, which has been limited to preparing these regulations that require everyone issue a disclosure document, there is the possibility of state law that might have more suitable consequences for injured franchisees. In fact, we have 15 states that require that the franchise disclosure document be registered with a state agency and these states have state agencies that might have enforcement attorneys and might be interested in pursuing these things in those states. California is one of them and they have been active. And Maryland is one. And there are others. But some of these 15 states really don’t do any enforcement. And they simply have a law that says you must submit a document to us and pay us an extra fee, but we don’t really do anything with it.
And then in addition to those 15 states, there are a handful of states—and I shouldn’t even use the word handful, because in my experience, having written on this topic, it’s really only the State of Ohio in the whole country—in addition to registration states, which has a viable law that protects franchisees from disclosure violations.
And our law in Ohio is written strangely. I was involved in rewriting it in 2012. But rather than start from scratch, we were hoping not to attract organized opposition. And so we took a minimalist approach and only changed ten or so things as opposed to rewriting the whole thing.
But in many cases, if a franchisor violates the FTC rule in connection with sale of a franchise in Ohio or is an Ohio franchisor that sells a franchise to somebody outside Ohio and violates the FTC rule, in many cases, the Ohio law provides the right for the franchisee to sue and get its money back and get attorney’s fees. It’s a beautiful thing, and it’s been the basis for many of my lawsuits.
If you’re in a state other than Ohio and it’s not a registration state, that leaves you in one of 35 states that have no law that protects franchisees regarding disclosure. Pennsylvania, for example, West Virginia, they have no laws, and Arizona and 35 states. Pennsylvania is the most populous state that has no franchise protection law.
If you’re in those states, you are pretty much out of luck if a franchisor sells you a transaction that should be covered by the FTC rule and they violate it, in any of the ways that Kim is going to talk to you or has written about in terms of Xponential. And it can be even more grievous than that.
There can be situations where a franchisor sells a transaction and pretends it’s a license agreement and isn’t subject to the franchise law, and just says this is a license agreement. It’s not a franchise. That doesn’t work as a practical matter, and it could easily be a violation of the FTC rule. And it’s been the basis for lawsuits that I brought in Ohio successfully.
So in those 35 states, your rights are very limited. You’re limited to a lawsuit for fraud, which is very difficult to bring and prove. Because you have to prove not only that you were misled, but you have to prove that the misleading was intentional and you have to prove that your damages were caused by the fraud. So the standard to bring an action and recover for fraud are very difficult.
Whereas in Ohio, in the suits that I bring, I don’t have to prove that the failure to give me a disclosure document caused my losses. I only have to prove you failed to give it to me and I had losses. So I get to undo my transaction and get my money back and recover my damages plus attorney’s fees.
So there are other attempts to recover for disclosure violation kinds of things in these 35 states with no laws. And I’ve heard that there have been cases that succeeded based on a little FTC Act, for example. Every state has laws that mimic the FTC Act at the federal level and the Sherman Act which covers things like price fixing. They’re called little FTC and Little Sherman acts because they’re the state law equivalent of this national scheme of protection for antitrust violations. And I’ve been told, although I’ve never seen, cases in these states that might argue that a violation of the FTC rule constitutes an unfair trade practice for purposes of a state’s little FTC Act. I’m pleased that I don’t have to make that argument in Ohio because I have the Ohio Act. In my mind, and when I teach this in my course to my students, it’s essentially in these 15 states, you have some protection against disclosure law violations. In the other 35 states, you’re out of luck.
There are some other laws that I want to touch on briefly, if I may. One is the protection against termination, unreasonable termination, and non-renewal. And generally speaking, every state in America has a law that protects car dealers and gas station owners, and in some cases, liquor dealers, from what is called unreasonable termination or non-renewal. But general franchise laws generally do not exist like that. They may exist in some of the registration states. California is a leader in protecting its franchisees. But in most states, there are no such laws, and I think there need to be those laws. There’s a reason a car dealer should be able to go into court if the manufacturer wants to terminate them and say that it’s unreasonable. But a restaurant franchisee doesn’t have that right. I think that needs to be done. I’ve written articles suggesting that states need to have such a law.
And finally, there is another provision that I think is very important and that needs to be in the law and isn’t, and that’s protection against choice of law provisions in contracts. Contracts invariably say that in the event of a dispute—and there’s a lot of language in franchise agreements about limitations on the ability of the franchisee to file a lawsuit. They may require arbitration. That’s a simple one, and that’s enforced.
But more generally, the classic case is there was an envelope stuffing franchise in California, which required a $5,000 initial investment, and the franchise owner was in Boston. And in the event of a dispute, the California franchisee, and any franchisee in the country, was required to come to Boston to file their lawsuit, which had to be dealt with in Boston.
And this kind of thing is typical. The franchisor says we sell in all the states. We want to have our litigation where we live. You’ve got to come to us if you want to sue us. But there are states that fight back and say, no, no, no. We’re going to have a law that says you’ve got to litigate in my state if you want to sell franchises in my state.
And in the registration states, they have the ability to say you can’t get a registration unless your agreement has an amendment that says that. It’s not unusual. In fact, every franchise package has a section on state‑specific amendments. And the registration states require that they include these things. And Ohio has language like that too. So anyway, does that answer your question? That’s as much as we have in the way of protecting franchisees.
KIM GEIGER: Yes, that’s helpful. Thanks so much, Stan. I understand that there is no right of private action with the franchise federally and that there’s sort of a patchwork of opportunity for people in various states. I do kind of just want to go through what we found with Xponential. I’ve brought a number of questions to you over the past few months, and you have been patient enough to continue answering them. So I know some of this will be very repetitive for you. But I kind of want to tick through, starting with the issues that we found in the Xponential FTC. And I’ll just sort of go through them item‑by‑item in the order that the items appear, not necessarily in order which is more serious or less serious.
But starting with item three, the litigation section where franchisors are supposed to disclose litigation that it had with other franchisees, we found a couple instances, and we’ve been told of others, in which the franchisor was involved in arbitration or litigation with a franchisee, but did not disclose that information for the relevant year or at all. Is this a violation of the franchise rule? And who ensures that franchise lawyers disclose something like arbitration, which often isn’t otherwise publicly available, but which is commonly the required venue for legal disputes in franchise agreements?
STANLEY DUB: Obviously, nobody ensures that they do it properly. And you focused on, you know, you’ve discovered lots of circumstances where it seems like they have not done it properly. The insurance, if there is any, is the possibility that somebody will file a lawsuit based on their failure to comply. That doesn’t help the franchisee discover cases of noncompliance.
But as we’ve discussed, they don’t have to disclose litigation which is ordinary routine litigation incidental to the business. They do have to disclose litigation which relates to the franchise relationship or claims fraud or those kinds of things. And they do have to disclose arbitrations that fall into these categories.
So with all of these things that you’ve identified, a number of them, which we’ll see going through that appear to be violations. In Ohio and in other locations where you do get a right to sue, for example, if the FTC were to sue, they would only be actionable if the violation could be shown to be material. If it’s not material, then, sorry. We made a mistake. But it wasn’t important. So it doesn’t rise to the level of something which can be actionable in a lawsuit. Material is defined as something which would influence the decision to buy or not to buy, generally speaking.
So I don’t know. I mean, litigation is important and it’d be hard to argue that wasn’t material. And if there were violations, it’s a violation.
KIM GEIGER: Okay. So moving onto item seven, initial investment. This is a topic that definitely would be material. This is how much a franchisee should expect to spend in order to open a unit. So we’ve heard from franchisees across Xponential brands that the initial investment for their studio was far higher, sometimes more than two times higher, than represented in FDDs. And they often point to things like equipment, materials, architectural services, which involve preferred vendors who pay the franchisor like a kickback or rebate on the amount spent by the franchisees, which suggests that the franchisor can and should be aware of how much franchisees are actually spending on their build out and should have that information available to be able to update their FDDs to reflect those figures. Yet, we’ve seen fairly consistent cost estimates in the FDDs for these brands over the years. They’re not adjusting them significantly upwards to reflect what the franchisees are saying that they’re actually spending. Is there any mechanism for ensuring that the initial costs represented by a franchisor is accurate?
STANLEY DUB: First off, let me not let you pass by the issue of kickbacks and commissions. These are very common in the franchise industry. And even though they sound nefarious they are permitted, if disclosed, in item eight or eight and ten, I can’t remember which one requires the disclosure of the amount of money that somebody has received through those kinds of arrangements. So it sounds bad, but it’s perfectly legal. It’s common.
So getting back to the question you raised, first off, item seven, disclosure of investments, is always very wishy washy and has a wide range. And the rule doesn’t really limit the range that the franchisor can use. It’s not unusual, in my experience, to see a range that looks like $150,000 to $900,000. I mean, they put big ranges in. Looking at the Pure Barre FDD that you provided, it says on page one that the total estimated investment necessary is $218,000 to $488,000. And it’s an estimate. And the language clearly has disqualifying information saying it’s an estimate.
But I will say that when somebody comes to me in Ohio, where we fortunately have this Ohio disclosure law, the conversation typically runs differently than you might imagine. Or if you think about it. The franchisee walks in and says, I’ve done this for two years, and they made me all these promises when we started. And they don’t support the brand with advertising that helps me, and I don’t know why I’m paying them anything. I wish I’d never done this. And I’m losing money and I want my money back.
They never talk about a disclosure violation because it never occurs to them that, you know, they might not even have read it, as many people don’t. And what I say is, well, that’s all very good. But our best line of defense is a disclosure violation. So let’s look at the disclosure package and we’ll talk about the financial representations they made when you started and think about disclosure violations.
And I always look at item seven because that’s a fertile area to look at. It could well be, it’s not uncommon, to have underestimated the investment, and that’s a violation. I have never had a case that rested solely on that, but I’ve certainly always looked at it. And people have always—it’s always been an issue. I don’t find it’s the best issue for litigation purposes because of the wide range and the estimate language. But yeah, I mean, there are violations there. There could be lots of violations.
One of the things that that has characterized my discussions with you about the Xponential, and I’ll just restate it here, is that when I get involved in representing a franchisee in such a case, talking about disclosure violations, if I find one or two or three, I don’t need to find seven or eight. I had a case where people had invested $1,000,000. And in a mediation, we got half of their money in a settlement where the only disclosure violation—I say only—the vice president of franchising had declared bankruptcy some years ago and his bankruptcy was not disclosed in the document. And I didn’t discover this. It was one of my clients that told me this had happened and he had discovered it. And that was the basis of getting our money back. We didn’t go through this process of needing to have violation after violation after violation. When we found one good one, that’s typically all that I need to pursue the franchisee’s right to undo the deal. So anyway, item seven disclosures are a fertile area to look at and they might have understated.
KIM GEIGER: What about item 19, financial representation? This one, what we found is a little bit different. It’s not necessarily a disclosure – well, the issue around the item, the financial representation has been that there are numbers provided in the FDDs. And then separately, franchisees have told us that they’ve received these spreadsheets as part of the sales process where they’re interactively filled out with salespeople from the franchisor that show projections that are far higher than what’s actually contained in item 19. And my understanding is that to put financial representations in item 19, theoretically, you need to have been able to substantiate with some sort of actual past performance status. Whereas, the spreadsheets are more forward looking projections. And so franchisees end up being sold on these ideas that they’re going to generate revenues that are far higher than what’s actually listed in item 19. But my understanding is also that the franchisor is not really supposed to be providing financial representation to prospective franchisees outside of the FDD. They’re only really supposed to be providing numbers that they’ve put in the FDD. Can you kind of walk us through that?
STANLEY DUB: Sure. Item 19, financial performance representations are an extremely fertile area to look for violations. There are obviously areas where you can say, if I hadn’t been told that I could expect to make this much money, I certainly wouldn’t have made this investment. And it was wrong. Let me just read to you the language from the FTC compliance guide on how to prepare these FDD’s. And it says that one of the things that is impermissible is making any financial performance representation that is not included in item 19 of the disclosure document. I mean, I suppose I could have just told you that without reading it.
So it used to be that they would not have—years ago, franchisors didn’t make any Item 19 disclosures. It was common that 90 percent would say we do not make any financial performance disclosures at all. And it’s up to you to figure out whether you want to buy this. You can talk to our franchisees and ask them about their results.
Over the years that has changed and more and more franchise owners have included financial performance representations, very carefully I might add. Typically, the most common form is typically, you know, we have 500 franchisees and we collect their information and we have packaged it in this way. And the top quartile did this well and the bottom quartile did this well. And they just give you a compilation of the actual information from their franchisees. And that’s fairly well accepted.
The issue with what you—let me just read a couple of words. It’s important to notice—I’m looking at the compliance guide and it says, “To define financial performance representation, you need to understand that it includes any representation, including any oral, written or visual representation, of the specific level or range of actual or potential sales”.
I don’t think there is any reason why an interactive chart could not be used if the wording that described it was carefully delivered. If it was said, here is a chart that demonstrates how much money you’ll make at different levels of sales, if you are lucky enough to achieve them. We don’t say you’re going to achieve them, but we do know the relationship between your costs and your sales. And this chart will illustrate that. I think an interactive chart could be used without being a representation that somebody would actually achieve those levels.
I can tell you, I had probably my most famous case, and it was famous for a different reason. If we have a chance, I’ll tell you about a couple of my cases. But in one case where I represented four hearing aid franchisees, four Ohio Hearing Aid franchisees, and the franchisor was in Arizona. The franchisor had a practice of inviting everybody to Arizona for what franchise owners usually called Discovery Day, a day of meeting with the folks and they take you out to dinner and you meet the President and you meet other franchisees, and a whole day of various activities where they woo you.
And during the process of this wooing in my hearing aid franchise case, they paraded everybody through their most successful unit, which had sales which were wildly higher than the average. They didn’t talk about it. but there was a blackboard that tracked their sales and profits on a monthly basis. And the results of the past year for this unit were displayed on the blackboard and nicely displayed with colored chalk and large numbers. And every single person that was a candidate to buy a franchise was taken past this blackboard.
And in my case, my clients were told you can even take a picture if you want. And one of them did. He took a picture. And that became, in our case, the basis of our claim, which generated some very favorable case law eventually and a monetary settlement. And some nice attorney’s fees for me. So that was the violation. That was the only violation. The only violation we alleged for any of these four people was that they were marched past this disclosure.
But even that disclosure could have been handled in a way that would not have made it actionable. I suppose they could have said, here is a demonstration of this particular unit. And we will provide substantiation of this particular unit’s results as listed on the blackboard upon request. But please understand this is our best unit and it’s not necessarily indicative of what you can hope to achieve. I mean, that would have undercut it and protected them from being in violation or including an Item 19 representation that was very different than this blackboard stuff. So this interactive discussion might or might not rise to the level of a violation, depending on what materials were provided, what was said. And if I were the franchisor and I wanted to use such a thing, I would require my people to use a script and not allow them to say anything that wasn’t on the script. But I don’t know what they did.
KIM GEIGER: Interesting. Okay, So, Item 20, which is the next one I wanted to talk about, which we’ve talked about several times. This is the part where you disclose the names of the franchisees in the system and you also disclose the names of franchisees who have departed the system. We found more than 73 instances in which a franchisee was listed as having an open studio or having signed a development agreement in one year, but then disappeared from the list in a subsequent year without ever being identified as having left. My understanding is that the purpose of this disclosure is so that a prospective franchisee can contact someone who’s left the system and try to get an honest assessment of what their experience was like.
I think you told me repeatedly that not including this information is a violation of the franchise rule. But I’m wondering, are omissions like this fairly typical? How serious are they? And also, given that franchisors can require franchisees in the process of them actually being in the system to sign non-disclosure agreements, non‑disparagement agreements? How useful is it even to be listing people’s contact information if they’re barred from talking honestly about their experiences anyway?
STANLEY DUB: Well, the information is useful, if accurately described, if only to show the numbers. In terms of the nondisclosure agreements, in a lawsuit, presumably you could overcome that with a subpoena. A court subpoena would be an exception to most—to all confidentiality agreements in this context. The court would order them, essentially, if needed, to provide the information.
It clearly would be a violation to misdescribe this information. And not only because of the contact information, although that’s a primary reason, but also because the general picture that the disclosure provides would be misleading. And that’s the point of it is to be able to see what the experience has been. This representation that they have never had one that failed seems to me to be sort of a leaky ship that on discovery in a lawsuit would fall apart for them and they would be made to look very bad on the stand about how they categorize different occurrences. So I think that’s a fertile area for violation also.
KIM GEIGER: The last FDD item I wanted to highlight is Item 21. This is the area where the franchisor discloses the audited financials of the franchising system itself, not individual franchisees or individual units, but the actual franchise company. In the past, Xponential has made use of this allowance under the franchise rule to use an affiliate brand’s financials rather than to provide the financials for the brand itself. So in past years, because Xponential has some, I believe—I don’t actually know why they do this, but I’m assuming—that because they have some brands that are well-established, have been existing as franchise concepts for many years, and then they have some newer brands that are just emerging as franchise concepts. They use the older brands as affiliate guarantors. Then that way they provide just the financials for those brands in place of the financials for the emerging concept.
So if you’re buying into, say, a Row House franchise two years ago, what you would have gotten in the FDD was financials for one of the more established brands. I can’t remember which one it was, but one of them. And then in this year, they went a step further where they created entire new companies for each of the brands, and then they created this overarching holding company. And because that holding company had only been in existence for maybe a couple of weeks before they filed their FDDs, they provided just an opening balance sheet for that holding company. So this FDD does provide really the most limited financial picture that has ever been provided. And I’m wondering if you’ve ever seen this before. And aside from it being an obvious red flag to a prospective franchisee, is there any consequence for doing this? Or is this another thing where you go ahead and do it and then maybe if somebody sues you, they bring it up in court, but there’s no real enforcement?
STANLEY DUB: I’m not sure there’s a violation here at all, but let me explain my take on what’s happening and what the background of it is. In my experience, imagine a guy, the little guy, somebody’s got three stores and he wants to franchise and sell a new one. And he comes to me and we write these documents. I tell them we need a new entity to be the franchisor because we don’t want to have to provide audited statements for your three existing stores. Whether they’re good or bad, we don’t care. They haven’t been audited before. They might have your wife’s car on the asset list. We just don’t need to go there.
So we create a new entity to be the franchisor and we sign documents letting the new entity have rights to license the trademark. And this new entity is the franchisor. And hopefully, it grows to be a big entity. But when it starts, there’s a phase‑in of the financial results, which for the first two or three years allows them to use skimpy things, skimpy results. And certainly at the very beginning, the first year, you get to include a balance sheet that says my bank, my cash is $500 that was given to me by my affiliate. If that’s the situation, that’s sufficient disclosure.
Now, along with that, imagine that it would be a bigger company. I had a publicly traded company that wanted to franchise one of its little parts, a paint manufacturer that wanted to franchise the opportunity to sell and service contractors that use their products. So they started a new company to do that. And the new company had a few hundred thousand dollars and had some operations.
But the FTC rule allows them, rather than to provide the financial statements of the franchise owner—I mean, initially, it says you can use, you must use, the financial statements of the franchise or the specific entity which is signing the franchise agreement. That must be the firm that that gives you financial statements. And we don’t care about the parent. That’s essentially what the rule says to start with. And then it says, oh, but by the way, we will allow you alternatively to use the financial statements of the parent entity or the affiliate if that affiliate or parent guarantees the performance of the franchise agreement in a separate guarantee document, if they are going to be financially responsible for all the obligations, primarily training is the one that that states worry about.
And you must understand that in 35 states, there is no state agency that ever looks at this, and the federal agency never looks at this. So it’s self-executing. So you have a brand new franchise or which has never operated before and has a balance sheet that says $500 are in the bank and that’s fine. That complies with the law. And I have prepared documents that say that for the first year.
But when you take that same document and you go into a registration state and try to register it, the registration state says, we won’t let you do that. You need to do something different. We need to make sure that the money that you collect is going to be used to do your obligations, training and everything else. And so we will require, as a condition of registration, either that you escrow your franchise fees until some period in the future, or that you have some other solvent entity which is your guarantor. And that’s a function of needing to register in states like California and Illinois and other registration states.
So I actually had a case once where the franchisor had taken this to an extreme and they had a guarantee language in the agreements that guaranteed their subsidiary’s results in any state that required registration. But the language of this half page guarantee was so poorly written that they forgot about the State of Ohio, which is not a registration state. So in the State of Ohio, they were selling a franchise that had the financial statements of the parent company, did not have the financial statements of the subsidiary and had a guarantee that didn’t reach the subsidiary for the State of Ohio. And that was a violation—it was one of the violations—that we focused on to get our client out of the deal.
But now, what this company has done is turn that regulation on its head. They have said, because we’re allowed to have minimal disclosure of financial statements for these new entities, we’re going to create these new entities. You know, we could start a new franchise company. They can do the same thing again next year. They can say, oh, we’re going to reorganize again next year. So that the entity that sold franchises last year is now one year old but doesn’t exist anymore. And the entity that is franchising now is another new entity and can give us this ridiculous franchise statement or financial statement. But that’s permitted under the language of the FTC rule.
KIM GEIGER: Would that even be in Ohio?
STANLEY DUB: As long as they get a guarantee, yes, it would be permitted in Ohio. And Ohio’s law is very different, and we probably shouldn’t go there. But essentially, Ohio has a law which says you’ve got to do something strange that nobody does. But there’s an exemption if you comply with the FTC rule in all material respects. And so it comes down to do they comply with the FTC rule, but only secondarily after we show they didn’t do this strange thing that they could have done to avoid that. Ohio is a different case. But yes, it would work in Ohio. They could say we’re complying with the FTC rule. Therefore, we comply with Ohio law based on the financial statement disclosure we’ve given you, which is scanty. Because we’re a new entity and we’re allowed to be a new entity.
KIM GEIGER: So that sounds to me like some sort of a loophole, and a use of the loophole that wasn’t even intended.
STANLEY DUB: The FTC Rule is a good rule. But understand that the FTC rule is not necessarily intended to be perfect, and it has not, I mean, nobody claims it is. What it is, is a requirement that there be a disclosure document which ends up being 300 pages long, which, if you look at it, will give you guidance about whether you should buy this investment or not. In this case, you look at the Xponential document and you have red flag after red flag after red flag.
And it doesn’t matter that this particular disclosure is not a violation. It’s a red flag. And somebody who is proposing to buy this should look at all these red flags and go, oh, my God. Why do I want to do this red flag thing? This is crazy. There’s enough red flags to tell me I don’t want to do this.
That’s what the FTC rule is about. It’s not about fly specking individual violations. I mean, I use it to fly spec because I want to create a legal right for my client to get his money back. And I need to show that rules were violated. But from the FTC’s point of view and from the overriding rationale of having this disclosure, it’s about having people understand whether this investment makes sense for them or not. And they should see all these red flags and they should run for the hills to not do this.
KIM GEIGER: So along those lines, I have one last question I want to ask you that’s sort of a more broader, conceptual one. Looking at the way the Xponential brands in particular are, you know, many of them only became franchisees after they were acquired by Xponential. They were unproven as franchise concepts. And the franchisees definitely took a leap of faith on the idea that what was one highly profitable concept in one specific location would be scalable and successful elsewhere. It seems like this risk, though, is borne entirely by the franchisee. There don’t seem to be laws or regulations that would share the risk with the franchisor to market or sell the concept.
And, in fact, we’re aware of multiple instances in which franchisees who bought into these unproven concepts want to get out and move on. But they say they’ve been prevented from doing so by the franchisor who is insistent on holding them to their contract to operate these studios, even though they’re not profitable. And the franchisees who would presumably have the most incentive to get them profitable, are convinced that they’re just throwing money away by continuing to operate them. So do franchisors share in any responsibility for taking an unproven concept to market in the event that it fails?
STANLEY DUB: No, they don’t.
KIM GEIGER: And is there any sort of state law?
STANLEY DUB: There is no state law. This is a very important point. There is no duty of franchisor competence that is imposed by a state law or regulation. And what we have, I mean, there’s room for better laws, don’t get me wrong. And in my case, I’ve written that there should be the equivalent of the Ohio law in every state. There shouldn’t be 35 states that don’t have any requirement for disclosure at all. But we’ve lived with the concept for 50 years that this disclosure obligation protects people. I mean, it’s not perfect, but it’s better than not having it. And yet, in 35 states, we don’t even have it.
But you seem to want, and there’s plenty of room, to tighten the rules that protect franchisees better. But stand in line. And in terms of order priority, those kinds of things requiring a duty of franchise or competence, there’s no chance, no snowball’s chance in hell, of getting that enacted into any law.
Because, of course, if you try to regulate franchises, you’re faced with the national franchise organizations and even the lawyers. I mean, in my organization of lawyers, franchise lawyers, the vast majority of them are either in-house attorneys for franchises or work in big firms where they represent franchisors. And hardly any represent franchisees, because that’s not where the money is. It’s very hard to pass legislation that makes franchisors do anything because they have associations and lobbyists and franchisees are not organized and don’t have associations and lobbyists. But there is no duty of franchisor competence.
KIM GEIGER: So the FTC has been soliciting comments from the public about franchisors and they extended the comment period on that. I checked earlier this morning and it looks like there’s about a thousand comments that were received in about 300 that have been published in the public record. I also know the franchise rule has been under regulatory review for some time, and the FTC had solicited comments a few years ago and had a public workshop. So you’ve been in this business for a long time. What do you make of all this activity? Should we be expecting substantial new protections for franchisees or major changes to the way things work on the federal level?
STANLEY DUB: Well, two answers. One, will the FTC make changes? I have my doubts. I certainly have no basis for believing that the FTC can be successful at protecting franchisees. Secondly, even if they made changes, they’re not able to change the language of the FTC Act that authorizes the creation of the FTC and stands behind the regulations that they might write. So that any regulations they might write, even if they passed, would only be regulations that the FTC could enforce. They would not be regulations that individual franchisees could file suit on.
But I guess, I’m sorry to report that I have lost track of that request for the RFI of the FTC, and I intend to comment. And I did give a program to the American Bar Association franchise forum lawyers on the unfairness of franchise agreements and how they are getting worse and worse and are very one sided. And I will certainly comment to the FTC on its RFI myself in the next few days and call to their attention this symposium that we gave on this point. And our written materials are about 150 pages long and I think they should be part of the record. But I have no confidence that the FTC will do anything positive as a result of this process.
KIM GEIGER: We have a few questions from callers. One is, do arbitration agreements and the franchise agreements preclude effective litigation in states when franchisees do actually have some protection?
STANLEY DUB: Unfortunately, from my perspective, arbitration clauses are enforceable and there’s nothing anybody can do about that. It’s enforceable at the federal level and in every state. So that unless you can argue that the arbitration clause is unconscionable because of the content, if a franchise agreement has an arbitration agreement, then you must live with the arbitration agreement. Which is not to say you can’t bring your claim. You do have the right to bring the exact same claim that you would bring in a court. Only you need to do it in an arbitration.
It does suggest a case I want to tell you about, a case called Tropical Smoothie, that I brought about ten or fifteen years ago in federal court in Dayton. My franchisee operated a Tropical Smoothie franchise in the Dayton area, and he was given false financial representations by the fellow franchisee who was receiving a commission on his purchase. And we thought that was actionable under the Ohio law and he had a good case. And he was going to be able to get the franchisor to pay him his money back.
But the franchise agreement had an arbitration clause. He was in Dayton, Ohio. He was bankrupt. And the arbitration clause said that any dispute had to be arbitrated in Atlanta with three arbitrators and that the costs of the arbitration initially had to be borne entirely by the franchisee. And if the franchisee won, years down the road, the franchisor might be obligated to give him his money back.
But the way these franchisees arbitrations work is that you go to the Arbitration Association and they say how much money is in dispute? And you say $500,000. And they say, oh, my. Let’s see. On our chart, that means we have to charge you $5,000 to be our administrator. So then they send out lists of arbitrators and you pick them and they’re all charging $300 an hour or $275 or $400. And you pick, in this case, three arbitrators. Then you ask the sides, how much time is this going to take? And the side that wants to keep you from doing this says, oh, my. This is complicated. It’s going to take a week of trial.
So we take a week of trial. And what is that? Forty hours times three people, 120 hours times $300 an hour. That’s $36,000 for the arbitrators. And the arbitration association says you have to pay this in advance before we schedule this.
So my bankrupt client was being asked to pay $40,000 to start an arbitration in Atlanta where he would have to pay to support himself and also pay to bring me down to Atlanta. Rather than arbitrate we filed a lawsuit in Dayton. And when they tried to remove the case and compel arbitration, we said that was unconscionable and therefore not enforceable. Then reason we said that was because the contract required my client to pay 100 percent in advance as opposed to 50 percent. If they had just not been so greedy and said, of course, the costs are split, we would not have had a leg to stand on.
But we brought this case and we had this argument in federal court about whether we had to arbitrate or whether it was unconscionable. And the federal court said that, in Ohio, you need to prove both procedural and substantive unconscionability to win on this. And substantively, this is unreasonable. And you’ve proved that. But procedurally, we will not let you prove procedural unconscionability because you didn’t hire a lawyer and you didn’t read this arbitration clause on page 42 before you signed the contract. Therefore, you lose. And you cannot argue that this arbitration clause, no matter how unreasonable, should be invalidated. So I lost the case. I should have appealed it. I did appeal it, actually, to the Sixth Circuit Court of Appeals, which affirmed without a decision. I should have pursued it, but didn’t. Of course, I wasn’t being paid. I had the case on a contingency. So yeah, arbitration clauses are enforced.
KIM GEIGER: Okay. I have a couple more. I’ll read them both out here and then let you answer. The first one is what types of penalties are common, likely or possible in the event that the FTC brings a suit or if a suit is brought in Ohio? I think this is relating specifically to Xponential. And then the second one also related to Xponential. Do you have any sense of why the FTC has been relatively ineffective in this space? It seems like a number of franchises are being harmed and there are blatant violations of the FTC’s rules out there.
STANLEY DUB: The FTC would tell you that they don’t have the manpower to pursue franchise violations in the country. It’s not a big agency and they have a lot of things to cover. They have mergers to govern and banking regulations and consumer protection. They have a lot of areas that they are involved in regulation for, and they don’t have much manpower that they do devote or are able to devote to franchising.
On the other hand, I have not seen them try or complain about that or try to argue with Congress that they need more. They just have sort of given up on it. It’s not sexy. It doesn’t get press. So they have been unsuccessful. And I think they’re going to continue to be unsuccessful. The penalties, they get nice penalties. But they don’t bring cases. So it’s irrelevant. I don’t actually know offhand what the limits on their penalties are, but I’m sure they’re substantial. They can get injunctions. They can get civil damages.
In terms of the Ohio law, the Ohio law has teeth. And it says that for three years after the deal starts, you can rescind. You can tear up the deal and get your money back and get your attorney’s fees. I had a case in Ohio where somebody sold a restaurant concept and called it a license agreement. And we had a jury trial and we won on the jury trial. And unfortunately, we recovered only $20,000 in the jury trial because that was the franchise fee. And my stupid client built out the restaurant completely before he ever signed this agreement. And then he signed the agreement for $20,000. And so he got his $20,000 back. And then the court awarded $108,000 in attorney’s fees, which was nice.
But attorney fees can be substantial. In Ohio, I count on them. You get rescission. You get your money back. You get to tear up the contract and not be stuck with the non-compete. And you can recover up to three times the amount of your actual damages. Of course, many of these cases are settled in any case. So, what you get in a settlement is what you get in settlement, whatever you agree to. Presumably something less than you would get if you won the case.
KIM GEIGER: Okay. So that’s our question. I don’t know if there’s anything you want to add or cover that we didn’t get to. I focused pretty specifically on the stuff that we had reported about Xponential. I don’t know if there’s other topics we wanted to discuss.
STANLEY DUB: Yeah, I want to talk about two more cases that I’ve been involved in that I think are generally relevant and interesting to people. I touched on the Zounds case I brought where I represented four hearing aids franchisees against an Arizona franchisor. And the violation was that they marched them past this blackboard. What I didn’t talk about is why the case is famous, if you will, what precedent it established.
Because what we had in the case was an argument, a claim that our four people were victimized by a violation of the Ohio statute, the Ohio law. And the Arizona franchisor had a contract that said Arizona law applies. And so the issue was, does the Arizona law apply? In which case, my guys don’t have any case because our case is based on Ohio9 law? Or does Ohio law apply? Because my guys were in Ohio and Ohio has a law that says Ohio law applies.
So two years down the road, actually a federal judge in Cleveland, after we filed it, the Arizona franchisor asked to transfer to Arizona. And the federal judge in Cleveland granted the transfer because he was wrong and because—I don’t know, you know. So he was wrong.
And so we went to Arizona and we argued this case in Arizona. And in Arizona, the Arizona court said the Cleveland judge had the right to do that, but he was wrong to do it. And Ohio law applies. And he wrote a long and scholarly opinion on which state’s law applies in these situations. And generally speaking, the law specified in the contract applies unless—I mean, the specified law that the contract says applies, actually applies, unless the state has a law that says our state’s law applies, which takes precedence. That’s the general rule. And we proved that in the Zounds case. And it was big stuff when it happened.
The second case I want to talk about is a pending case that I have now against Marco’s Pizza in federal court in Toledo. And the relevant point—and I don’t want to talk about this at length. We might settle it fairly soon. But I had a client in Alabama who signed a franchise agreement with Marco’s, who lives in Ohio, and the franchise agreement said Ohio law applies. And so we are arguing this in federal court in Ohio.
It did not have an arbitration clause. So we’re in federal court in a regular court suit. And the discussion is about whether they terminated my client’s rights to operate his Marco’s restaurant wrongfully or whether the violations of his agreement gave them the right to do that. And he had signed general releases on two occasions. He had signed two general releases. And when we said to them, your client violated the implied covenant of good faith and fair dealing, they said our releases protect us. And therefore, you can’t have this lawsuit. And we had this big argument about whether the releases worked or not. And generally speaking, they do.
But we won a motion to dismiss in federal court on the argument that the releases bar my client from bringing our case. And we haven’t had a discussion about the fact that when you have all these settlement agreements with people, you certainly have lots of releases signed. The documents, the settlement documents, include a special document or a paragraph that says, in consideration of signing the settlement and our letting you go, you’re going to be confidential, you agree to release us from every claim that you can think of from the beginning of time until now, whether you thought about it or not. And those are so ubiquitous that they’re a problem in every instance of franchise litigation.
But in our case, we got a favorable opinion from the judge, which is going to get some attention, that the releases were not binding in our case, that they were arguably coerced or there was no meeting of minds about whether the claim that we had was subject to these releases. And for those two reasons, we were able to defeat the franchisor’s motion to dismiss based on these releases, which is big stuff.
KIM GEIGER: That’s fairly unusual.
STANLEY DUB: Right.
KIM GEIGER: Wow. Okay. Let me see, is there anything else? I don’t see any other questions here. I think that pretty much covers it.
STANLEY DUB: Well, very good. Thank you for inviting me.
KIM GEIGER: Thank you so much for taking the time and for answering all my questions here. And also over the past few months as I’ve been peppering you with them repeatedly. Really appreciate you sharing your time with us.
STANLEY DUB: My pleasure. Thanks very much.
KIM GEIGER: Thanks so much. Take care.
STANLEY DUB: Bye.
KIM GEIGER: Bye.
