Faegre & Benson LLP
John Edward Connelly
William L. Killion
What's New in Franchise Law
Arbitration remains the hot topic in franchising. The 9th Circuit again found a
commitment to arbitrate procedurally and substantively unconscionable (and
unenforceable), this time in an employment setting. A California state court followed suit
and struck down as unconscionable the arbitration commitment in the Cold Stone
Creamery franchise agreement.
In contrast to the west coast's jaundiced view of arbitration clauses in franchise
agreements, a Connecticut federal court compelled a Subway franchisee association to
arbitrate claims against Doctor's Associates, Inc. (DAI), although the association itself
had not agreed to arbitration.
The other significant decision this past quarter came from a Minnesota federal court that
summarily rejected the efforts of Domino's to sole-source its point-of-sale (POS)
As an added bonus in this issue of FaegreFranchiseForeword, we share with our clients
and friends "Faegre & Benson's Top Ten Rules for Franchisors to Reduce Litigation
Unconscionability: The big news last quarter was the 9th Circuit's en banc decision
refusing to enforce an arbitration commitment in Nagrampa v. MailCoups, Inc., 469
F.3d 1257 (9th Cir. Dec. 4, 2007) (analyzed in our Feb. 21, 2007, issue). A 9th Circuit
panel again struck down an arbitration commitment, this time in the employment context.
The plaintiff in Davis v. O'Melveny & Meyers, 2007 WL 1394530 (9th Cir. May 14,
2007), alleged that the O'Melveny law firm violated the Federal Fair Labor Standards Act
by failing to pay for her overtime work as a paralegal. The plaintiff claimed that her
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promise to arbitrate was unconscionable. The 9th Circuit, following the California two-
step approach to evaluating unconscionability (the existence of procedural and
substantive unconscionability), voided the entire arbitration commitment. According to
the court, enforcement was procedurally unconscionable because the arbitration
commitment was not negotiable. The court acknowledged that the "marketplace
alternatives" theory might save an arbitration agreement from procedural
unconscionability. (Under this theory, a contract party with a reasonably available
alternative source of supply of a good or service may not claim procedural
unconscionability.) Relying on Nagrampa, however, the 9th Circuit rejected O'Melveny's
claim that the employee had marketplace alternatives. Like the franchisee in Nagrampa,
the employee in O'Melveny, according to the court, was not a sophisticated party to the
agreement, thus precluding application of the marketplace alternatives theory.
Having found procedural unconscionability, the court next examined substantive
unconscionability. Under this test, the court looks for terms that are so one-sided as to
"shock the conscience" and be "unduly harsh or oppressive." The court found that four
dispute resolution provisions met the test: (1) the requirement that the employee demand
mediation within one year of actual or constructive notice, which the court likened to a
one-year limitations period; (2) the requirement of confidentiality, which allowed
O'Melveny to remain the only party informed about the history of other employment
dispute resolutions; (3) the right of O'Melveny to seek equitable relief to protect
confidential information, a right which was not mutual; and (4) provisions that had the
effect of voiding statutory rights. Finally, the court concluded that the number of
unconscionable provisions (four) was so great as to preclude severance of the offending
provisions, thus making the commitment to arbitrate as a whole unenforceable.
What are some lessons that franchisors can draw from the O'Melveny decision? First, the
court does state that a party may have an exclusive right to resort to a judicial remedy
(such as injunctive relief) as long as the right is based on a legitimate commercial need or
business reality. Most franchisors would undoubtedly consider the protection of
confidential information sufficient justification, but the court held otherwise in
Nagrampa and reiterated in O'Melveny that "protecting against breaches of
confidentiality alone does not constitute a sufficient justification." Notwithstanding this
admonition, franchisors should not give up on persuading a California court that interim
relief is indeed essential to the continued preservation of the franchise system, including
avoiding disclosure of confidential information. After all, once the proverbial cat is out of
the bag (namely, confidential information), there is no getting it back in again.
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A second lesson from O'Melveny is that abbreviated limitations periods will jeopardize an
arbitration commitment, at least under California law as interpreted by the 9th Circuit.
Franchisees may argue that a one-year period is substantively unconscionable in light of
O'Melveny, but the counterargument is that the O'Melveny court was concerned about
"continuing wrongs" that may arise in the employment context. Similar concerns may not
apply to franchising. Nevertheless, the prudent franchisor doing business in California
may want to use a contractual limitations period greater than one year from actual or
constructive notice of a claim.
Third, take-it-or-leave-it contracts are not per se procedurally unconscionable. If the
plaintiff is "sophisticated" and if there are marketplace alternatives to signing an
agreement, then a non-negotiable contract is not procedurally unconscionable. The
sophistication of the franchisee thus becomes a threshold issue when dealing with a claim
A final lesson is that enforceability is apparently a numbers game. Four unconscionable
provisions precluded severance of the offending sections in O'Melveny. In the Cold Stone
Creamery case summarized below, a total of three was enough. So far, California courts
have provided little guidance on when an arbitration commitment is so offensive that it is
beyond saving. Here are some drafting tips, however, for lawyers writing arbitration
commitments subject to challenge under California law:
An arbitration commitment may properly define procedures that will control the
The arbitration clause should not deprive a party of substantive rights under a statute.
To the extent a court might conclude that a clause effectively deprives a party of a
substantive right, do not put the provision in the commitment to arbitrate. Place it in
other parts of the franchise agreement.
On a more positive note, the court in O'Melveny, as in Nagrampa, does express
skepticism over claims of a "repeat player" effect, namely, that arbitration is suspect
because an employer (or franchisor) knows more than the other side about the pool of
arbitrators available to hear a dispute. According to the court in O'Melveny, the "repeat
player" effect is offset by the ability of the employee to learn about other arbitration
against the employer. Where, as in O'Melveny, the proceedings must be kept confidential,
the ability of the employee to level the playing field by learning about past arbitration is
lost, according to the 9th Circuit.
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A California state court also refused to enforce a commitment to arbitrate contained in the
Cold Stone Creamery franchise agreement. The court in Meyers v. Conehead
Investments Inc., No. BC358836 (Los Angeles Co., Calif., Super. Ct., filed April 18,
2007), first found procedural unconscionability because the plaintiff had demonstrated
both "oppression" and "surprise." The oppression consisted of "an inequality of
bargaining power of the parties to the contract in an absence of real negotiation or
meaningful choice on the part of the weaker party" because the agreement was presented
on a take-it-leave-it basis. Further, according to the court, "surprise is a function of
disappointed reasonable expectations of the weaker party." Here, the franchisee "did not
reasonably expect that the arbitration provision therein to amount to a unilateral
agreement to arbitrate on her part."
The court addressed the "unilateral" nature of the agreement as a part of its discussion of
substantive unconscionability. The court found that the agreement completely lacked
mutuality by requiring only the franchisee to arbitrate claims. In fact, Cold Stone
Creamery was contractually bound to arbitrate claims, although it did have the right to
seek provisional and injunctive relief from the court. The court nevertheless deemed this
"tantamount to a unilateral agreement to arbitrate on the part of plaintiffs, which is
unconscionable," citing the Nagrampa decision.
The court buttressed its finding of unconscionability based on an "unconscionable waiver
of statutory rights," namely, the right under the California Franchise Investment Law
(CFIL) to seek consequential damages. The arbitration provision purported to waive
consequential damages. Finally, the court found the arbitration commitment substantively
unconscionable because the plaintiff had to pay a filing fee of $8,000, plus a case service
fee of $3,250, as well as face exposure to costs and expenses of the arbitration should she
not be the prevailing party. "The amount of this ‘entry fee' effectively precludes
franchisees, such as Meyers, from seeking legal redress of her claims, including any
claims under the CFIL," said the court. Because of the "multiple substantively
unconscionable terms," the court struck the entire commitment to arbitrate as "permeated
with substantive unconscionability."
Carried to its extreme, the decision stands for the proposition that any franchise
agreement that is not subject to negotiation is procedurally unconscionable, plus anytime
the franchisee is required to pay filing fees and is exposed to costs and expenses, the
commitment is substantively unconscionable. Further, like the 9th Circuit's decision in
O'Melveny, enforceability of the commitment as a whole in California is about counting
the number of unconscionable provisions in the commitment to arbitrate. In O'Melveny,
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four unconscionable provisions compelled the court to obviate the entire arbitration
commitment; three met the test in the Cold Stone Creamery case.
One way to deal with cases like Nagrampa, O'Melveny, and Meyers is to put limitations
on remedies in parts of the franchise agreement other than the commitment to arbitrate. In
this way, the arbitrator determines whether a particular provision is unconscionable and
the limitation does not count when the court decides substantive unconscionability. The
selection of the franchisor's home state as the venue/locale for arbitration and the
preclusion of joinder of parties should remain in the arbitration clause.
Cold Stone has appealed the order denying its petition to compel arbitration. Faegre &
Benson plans to file on behalf of the IFA an amicus brief supporting reversal of the order.
Non-Parties to Arbitration Agreement: Doctor's Associates, Inc. (DAI), was back in
court again seeking to compel arbitration in its Subway franchise system—this time not
against individual franchisees, but against a franchisee association. Doctor's Associates,
Inc. v. Downey, Bus. Franchise Guide (CCH) ¶ 13,580 (D. Conn. Feb. 12, 2007).
DAI created the Subway Franchisee Advertising Fund Trust (SFAFT) in 1990 to fund
group advertising and promotion of Subway sandwich shops. The trust agreement placed
control of marketing dollars and programs principally in the hands of Subway
franchisees. Prior to 2006, the standard Subway franchise agreement required that
franchisees pay marketing fees into the SFAFT. Beginning with the 2006 form of
franchise agreement, DAI required that new and renewal franchisees make the marketing
contribution directly to it. The obvious upshot of requiring such franchisees to make
payments to DAI is the eventual shifting of control of such funds from franchisees to the
The change did not sit well with some franchisees. In fact, the North American
Association of Subway Franchisees (NAASF) started a lawsuit in Connecticut state court
claiming that DAI's modification of the form franchise agreement constituted a breach of
the SFAFT. DAI responded by filing a petition to compel arbitration, naming as
defendants franchisees who were also members of the NAASF Board of Directors. The
petition came before Judge Peter Dorsey, the same federal judge who has authored other
Subway decisions involving commitments to arbitrate. Judge Dorsey had no problem
rejecting the franchisees' claim that they had not filed the underlying action and that the
party that did, NAASF, had not agreed to arbitrate disputes. According to the judge, a
petition to compel arbitration turns on whether the claims in dispute are covered by the
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arbitration commitment, not on the identity of the parties. Because the claims in dispute
fell within the broad commitment to arbitrate "any controversy or claim arising out of or
relating to" the franchise agreement, the court held that all the claims are subject to
arbitration. Further, the judge said that the association was suing in a representative
capacity, and as such, any arbitration agreement that binds individual members also binds
the association. Lastly, the court enjoined further proceedings in the state court action
pending the conclusion of the arbitration proceeding.
FAA Jurisdiction: Most of us know that the Federal Arbitration Act (FAA) does not
raise federal question jurisdiction. A federal district court must have an independent basis
for subject matter jurisdiction to entertain a proceeding under the FAA. The obvious basis
for jurisdiction is 28 U.S.C. § 1332, diversity jurisdiction. But what if the two parties are
from the same state? What does it take to establish federal question jurisdiction under 28
U.S.C. § 1331?
For those interested in the answer, the 11th Circuit decision in Community State Bank v.
Strong, 2007 WL 1225343 (11th Cir. April 27, 2007), makes a good read. Particularly
instructive is the lengthy concurring opinion that outlines the split in the circuits on the
question. The focus of the decision is on Section 4 of the FAA, which governs petitions
to compel arbitration. The question is whether, under Section 4, the court must find a
federal question within the four corners of the specific claim for which a petition seeks to
compel arbitration. The 11th Circuit follows the minority view, the so-called "look
through" doctrine. This doctrine "looks through" the theories actually advanced by the
defendant to the petition to compel and asks whether the defendant could have raised a
federal question based on the facts and theories alleged in the challenged proceeding. The
majority view is that the court focuses solely on the claim of the opposing party to
determine whether it raises a federal question. Of particular interest is that the underlying
decision and the concurrence are written by the same judge, who suggests that the full
court should consider the question en banc.
Supreme Court to Hear Case: The main problem franchisors have with arbitration is
the courts' extremely limited review of an award under the default provisions of the FAA.
Under the language of the FAA, a court may vacate an award where there is evident
partiality on the part of the judge. In addition, the courts have grafted two other grounds
for vacating an award onto the FAA—manifest disregard of the law and violation of
public policy. We have recommended that franchisors consider creating additional
grounds for review in the arbitration clause, including: (1) requiring courts to follow the
contract and apply the law, thus allowing the parties to argue that the arbitrator abused
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her discretion by not following the contract or applying the law; (2) craft a provision in
the agreement for an ADR form of appeal (e.g., a panel of arbitrators that acts like a court
of appeals); and (3) creating grounds for vacator beyond the default provisions of the
FAA (e.g., errors of law and capricious findings of fact). The problem with expanding
review beyond the FAA default provisions is that is a split in the federal circuit courts
over the enforceability of such a clause. The U.S. Supreme Court has now agreed to
resolve the conflict in the circuits.
The court accepted cert in Hall Street Associates, LLC v. Mattel, Inc. The arbitration
commitment in Hall stated that a district court judge could vacate, modify, or correct an
arbitration award "where the arbitrator's conclusion of law are erroneous," a standard of
review not set forth in the FAA. The 9th Circuit said that the FAA outlines the exclusive
grounds for review and erroneous conclusions of law is not one of them. The 9th Circuit
position is aligned with that of the 10th Circuit, but it conflicts with rulings of the 1st,
3rd, 4th, 5th, and 6th Circuits. We should know the answer in the next several months.
The cases continue to teach us just how critical a detailed and specific disclaimer is to a
franchisor's successful defense of a franchisee's fraud claim. Not just any disclaimer will
do. Although the standard integration clause may well preclude a contract claim based on
the parol evidence rule, almost all courts hold that the parol evidence rule does not
preclude claims of fraud and misrepresentation. The key to winning these cases is to
focus on the element of reasonable reliance. Most courts hold that state franchise acts,
like common law fraud, require reasonable reliance upon an alleged representation.
Where the representation is contradicted specifically and directly by a disclaimer, the
great majority of courts find, as a matter of law, that the plaintiff could not have relied on
the alleged misrepresentation. A quote from Lady of America Franchise Corp. v.
Malone, Bus. Franchise Guide (CCH) ¶ 13,562 (S.D. Fla. Feb. 13, 2006), published in
the most recent CCH Business Franchise Guide, makes the point in a most effective
In this case, Malone asserts that the integration and disclaimer clauses contained in her
Franchise Agreement do not bar her from alleging reliance on statements made by LOA
regarding the past performance of other LOA franchises. However, like the disclaimer in
Hall, Malone's Franchise Agreement contains an extremely comprehensive and
unambiguous disclaimer that directly addresses all the statements Malone seeks to
introduce. The clause expressly disclaims any representations received regarding profits
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and successes. The clause also states the risk associated with entering into the franchise.
Malone does not allege that this was anything but an arms-length transaction. The
contract contained both a merger and integration clause and a complete disclaimer. The
disclaimer appeared in all capital letters and there is no indication that LOA attempted to
conceal its importance. It allowed for Malone to conduct an independent investigation.
Malone has not alleged any facts which could lead the court to believe that LOA induced
her to sign the agreement before conducting an independent review of LOA and its
franchises. Additionally, the disclaimer provided an opportunity for Malone to expressly
list any representations she received from LOA. Malone did not list the information she
received via the internet or in-person meetings. Malone therefore disclaimed any reliance
on these statements. Following the test in Travelodge, Malone cannot now establish that
she relied on them to her detriment. Based on the narrow use of the parol evidence rule
exception, Malone has failed to establish any set of facts which circumvent the
unambiguous disclaimer contained in the Franchise Agreement. Therefore, Malone's
claim for violation of the FFA is dismissed.
Little FTC Acts
Many of us know that the FTC Act does not establish a private cause of action for a
franchisee. Although a franchisor may well incur the wrath of the enforcement division of
the FTC when it fails to comply with the FTC Rule, franchisees are without a remedy
unless the FTC acts. The hooker here, however, is the "Little FTC" Act adopted by a
number of states, also known as Deceptive Trade Practices Acts. Claims under state Little
FTC Acts may, in the words of the Florida statute, "be used based upon . . . any law,
statute, rule, regulation, or ordinance which prescribes unfair methods of competition, or
unfair, deceptive, or unconscionable acts or practices." The same court that gave us the
nice decision on reasonable reliance, Lady of America Franchise Corp. v. Malone, Bus.
Franchise Guide (CCH) ¶ 13,562 (S.D. Fla. Feb. 13, 2006), also found that the franchisee
had a cause of action under the Florida Deceptive Trade Practices Act by reason of the
alleged failure of the franchisor to comply with the FTC Rule. The key to the successful
defense of these cases is to focus on the parties protected by the Little FTC Act. The act
is designed to protect consumers and not businesses, and franchisees are more business
Franchise cases and legislature often come down to whether a court views the franchisee
as a business, a consumer, or a type of employee. Cases like O'Melveny may make sense
when they protect employees from unfair contracts, but when this paternalistic view is
applied to franchising, it creates absurd decisions like Nagrampa and Meyers/Cold Stone
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Creamery. This same attitude is sometimes evident when it comes to franchise
noncompete cases, like the California Snelling cases where the noncompete is analyzed
as if contained in an employment agreement as opposed to the sale of a business.
It looks from Zeidler v. A&W Restaurants, Inc., 2007 WL 723460 (N.D. Ill. Mar. 5,
2007), like A&W may finally be done with the Zeidler boys.
Russell Zeidler was the first of the two brothers to sue A&W. Russell Zeidler, along with
his wife, opened an A&W restaurant in 1993 and promptly lost money every year of its
operation. Finally, in March of 1999, Russell closed shop, claiming that A&W's bad faith
threats of termination because of the quality of operations made it impossible for Zeidler
to run the business. A few days later, A&W issued a letter formally terminating the
The big issue in Russell's case was whether A&W's alleged "bad faith" in calling him to
account for the condition of his restaurant excused his breach of the agreement by
abandoning the restaurant. Concluding that Russell had offered no evidence of bad faith
on the part of A&W, the 7th Circuit held that Russell's closing down of the restaurant
barred him from alleging wrongful termination in violation of the Illinois Franchise Act.
Zeidler v. A&W Restaurants, Inc., 301 F.3d 572 (7th Cir. 2002).
In a twist on the old saw that the fruit does not fall far from the tree, Russell's brother
James also lost money in his restaurant from the start. Like Russell, James ultimately
abandoned the franchise business, laying blame at the feet of A&W. The problem with
A&W this time was that it had supposedly duped James into purchasing the franchise at a
time when A&W knew freestanding restaurants could not survive. Finding that A&W's
view of the likely success of its restaurants had nothing to do with James' decision to
become a franchisee, the court affirmed summary judgment, holding that a franchisee
who abandons his restaurant by closing it before the end of the term of the franchise
agreement cannot, as a matter of law, prevail on a wrongful termination claim under the
Illinois Franchise Act.
In many ways, the Zeidler decisions do little more than repeat fairly well-established law.
Where the decisions may be particularly helpful is in dealing strategically with PIP
problems. As we have observed in prior issues of the Foreword, the California Court of
Appeals in Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704 (1996), found that a
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franchisor could not recover lost future royalties because the cause of its loss was its
decision to terminate the agreement, as opposed to a suit to specifically enforce payment
of royalties. (PIP is addressed in each of our first two issues of the FFF.) The Zeidler
case stands for the proposition that where a franchisee abandons a franchise, the
franchisor cannot be liable for wrongful termination. Franchisors facing franchisees who
have abandoned the franchise and wanting to preserve their right to recover future lost
royalties should consider dispensing with a formal termination and merely confirm that
the franchisee, through its abandonment, has effectively terminated the agreement. Then
the cause of the loss of future royalties is unmistakably the franchisee's abandonment, not
the franchisor's termination.
Franchisor Designation of Single Supplier of Products/Services
The ability of a franchisor to designate a single supplier of a product—especially itself—
has been a bone of contention between franchisor and franchisee for a long time. Judge
Richard Kyle of the Minnesota Federal District Court handed down the most recent
decision on the subject.
At issue in Bores v. Domino's Pizza LLC, No. 05-2498 (D. Minn. May 23, 2007), was
whether Domino's could, consistent with its standard franchise agreement, require its
franchisees to purchase computers and software for its POS system called PULSE from a
single source. As a part of the program, Domino's required that all of its franchisees
purchase the hardware from IBM and the software from Domino's. A group of
franchisees responded by filing a lawsuit, arguing that their franchise agreement
specifically allowed them to purchase computers and software meeting Domino's
specifications from "any source."
Judge Kyle defined the dispute as a "garden variety" breach of contract case. He said the
franchise agreement gave franchisees the right to an alternative source of computers and
software meeting Domino's specifications, and that is what they were going to get. The
judge granted the franchisees summary judgment declaring that "Domino's must provide
them with specifications for the PULSE hardware and software and that they may acquire
hardware and software meeting those specifications from ‘any available source.'"
Particularly compelling to the court was a provision in the franchise agreement that gave
Domino's an express right to be the only source of some food products. According to the
court, the preservation of the right to sole-source some products indicated that it did not
have the right to do so for others.
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The court's decision seems simple enough. The court certainly found no complexity in
the issues. Domino's was not, however, without legal arguments supporting its position,
including language in the franchise agreement requiring franchisees to comply with
system standards and its establishment of a single line of computers and software as just
such a standard. In any event, the implications of the decision are far reaching. An
effective POS computer program is critical to the ability of most quick-serve franchises
to compete today. There is certainly nothing uncommon about franchisors (inside or
outside the quick-serve business) requiring franchisees to use proprietary software sold
by a single supplier. There are also a number of compelling reasons for a franchisor to
require the use of a single supplier of hardware and software. So, what is a franchisor to
Where the franchise agreement contains language seemingly allowing the franchisee to
seek alternative sources of a product, the franchisor is stuck between the proverbial rock
and a hard place. The franchisor may have compelling arguments for single sourcing (as
did Domino's in the Bores case). The problem is getting a busy judge to look beyond the
most simple language in the franchise agreement. The best approach, of course, is for the
franchisor to have helpful language in the franchise agreement. We recommend that the
franchisor preserve in its franchise agreements the right to designate a single source of
any product or service, and specifically state that it may be the sole source. Further, the
franchisor should give the franchisee notice that it may profit from the sale of a product
or service and that the price of any product or service it may sell will be the "price in
effect" or similar such language. The benefit of a phrase like "price in effect" is that it
creates a safe harbor from an attack on the reasonableness of a price under the UCC.
Even if the franchisor does not intend to use the right to sole-source now or in the
foreseeable future, things change.
Even if this sort of language is not in existing agreements, starting to include it now will
bind future new and renewal franchisees. Most existing franchisees will likely be content
to purchase from the franchisor, and only the most aggressive will typically ask for an
alternative supplier (especially if pricing is not out of line). Requiring the franchisee to
sole-source may serve as a red flag in front of a bull. The combination of existing
franchisees willing to buy from the franchisor-designated source and the requirement that
new and renewal franchisees do so may have the same effect as compelling purchases at
Where the franchisor's existing agreement clearly gives the franchisee the right to
alternative suppliers of hardware and software, the difficult issue for the franchisor will
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be creating specifications for the software. The franchisor may have to share the software
source code with third-party suppliers to assure the necessary uniformity or assure that
the price of the software is so attractive that the franchisee has no reason to seek an
alternative supplier. Franchisors creating proprietary software would do well to make
sure that they in fact own or otherwise control the source code in case they must give it to
franchisees to comply with their franchise agreements.
As a special bonus, we attach the Faegre & Benson Top 10 Rules for Franchisors to
Reduce Litigation Risks.
FaegreFranchiseForeword - June 2007