How, When and Why a Franchisor Should Buy Franchisor's E&O Insurance
By Doug Imholte
May 1, 2013
I am often asked, “How, when and why should a franchisor purchase Franchisor’s Errors & Omissions insurance coverage?” While the answer isn’t exactly simple, I thought it would be a good time to go over the basics of Franchisor’s E&O, what it intends to protect and the appropriate time to purchase it.
The franchise industry is dynamic and evolving, and its unique business model brings about certain risks not faced by other businesses. Whether you are a new franchisor, an emerging system or a mature franchisor, you should know and understand how a Franchisor’s E&O policy can help protect your business through your lifespan.
The primary intent of a Franchisor's Errors & Omissions policy is to protect the franchisor from a variety of claims filed against them by current, former and prospective franchisees. Here are a few examples of issues that may apply.
- Alleged misstatements and misrepresentations in the FDD: These could be an item 19 representation, a promise of a certain amount of territory, a "misrepresentation" in the cost to open, or all of the above, along with other issues. Typically it is not a black and white issue concerning a single misrepresentation in the FDD but a combination of factors. Franchisor's E&Oessentially provides coverage for alleged misstatements made in good faith in the FDD.
- Statements made during the franchise development process: As new prospects are researching your concept, they speak with sales representatives of your organization and will likely document "promises" or representations made during this process. They will compare these against the FDD and with their own perception of reality once they become franchisees. We have experienced disagreements of what was said after the fact, or allegedly said during this process that have resulted in financial claims against the franchisor.
- Non-compete claims: Sometimes things don't work out; that is just the nature of owning a business because there is risk involved. With franchising, however, you add the fact that sometimes franchisees want to continue in business but just not with that particular franchise. For example, because of real or perceived issues with the franchise brand, a franchisee may prefer to stop franchising and re-open with the same business concept but under their own name. You have the right to restrict this from happening per the terms of your Franchise Agreement. However, this can also lead to a franchisee making multiple claims in an effort to get out of their non-compete.
These claims for damages can stretch into the hundreds of thousands of dollars so it imperative to address these issues early. Typically, but not always, these issues occur with newer, emerging growth franchise systems because they are running hard to grow and improve their system and support services, and validate their concept nationally. So while I recommend every franchise take a serious look at this coverage, it is nearly imperative to have it in force prior to any significant upcoming business events, i.e. fast growth, changes in personnel, operational changes, etc.
Franchisor's E&O is an ever-evolving coverage type, and can now be tailored more to the risks you face today. Here are a few suggested tips for enhancing your Franchisor's E&O coverage.
- Understand fully the policy you are purchasing: As with most insurance purchases, the true value lies in the details of the policy. Franchisor's E&O has traditionally been written on Miscellaneous E&O forms and hasn’t always contemplated the franchisor business model. It is important to adapt the policy definitions, language and exclusions to more fit the franchisor business model. There are a few select insurance markets that understand and can effectively underwrite this risk. Therefore it is important that your insurance broker know who these markets are. You have greater exposure if you are not with a carrier that has a policy designed to protect you from the risks inherent to your business.
- Enhance language to include some expanded vicarious liability coverage: As you've seen from some of my previous articles, the best and most efficient way to reduce your vicarious liability concerns as a franchisor is ensure compliance with the FDD insurance requirements (provided they are written properly). However, you should also seek some vicarious liability coverage within your E&O policy to account for unexpected gaps in coverage at the franchisee level. Instances where a court or jurisdiction favorable to franchisees may bring a franchisor into what may typically be seen as a franchisee claim.
- Network Security/Cyber Liability coverage: As a franchisor you are holding a lot of personal data from prospects and franchisees, such as financial, banking and family information, etc. You could be held liable should something happen to this information. Franchisor's E&O can be amended to include coverage for your obligation to protect this confidential data. The policy can be updated to provide protection for third party claims and also be endorsed to provide first party coverage for such things as crisis management and the obligation to notify if there is a data breach.
As you can see, Franchisor's E&O is important and specialized coverage. Written correctly it will provide you the proper and adequate coverage if your organization is sued. The last few years have been a testament to the importance and value of this coverage. Just as you would have a franchise legal expert craft your FDD, so, too, should you have a franchise insurance broker craft your Franchisor's E&O policy.
--Image used under Creative Commons from Shashi Bellamkonda.