Latest / Franchise Conversations with Fexingo: Buying, Running, and Scaling Franchise Businesses / Why Franchise Litigation Is Spiking in 2026
Transcript
- Lucas: So franchise lawsuits are up about 40 percent year-over-year in 2026. That number comes from the American Arbitration Association, which handles the bulk of franchise dispute cases because almost every franchise agreement has a mandatory arbitration clause. Luna: Forty percent is a big jump. What's driving it? Lucas: Three things, mostly. Royalty underpayment accusations — franchisees allegedly underreporting revenue. Territory encroachment — franchisees claiming the franchisor opened a company store too close. And non-compete enforcement, which has gotten messier since the FTC tried to ban them last year and then the courts pushed back. Luna: Let's start with royalty underpayment. That feels like an accounting fight — how do these cases actually surface? Lucas: Usually through an audit. Most franchise agreements give the franchisor the right to audit a franchisee's financial records once a year. If the audit finds a discrepancy of more than, say, two percent of reported gross sales, the franchisee often has to pay for the audit itself. That creates a real incentive for franchisors to dig. Lucas: There's a fast-casual brand — I won't name them because the case is still in arbitration — that sued twelve franchisees in a single filing in March. The claim was systematic underreporting, about seven hundred thousand dollars in underpaid royalties over two years. The franchisor had installed POS software that tracked every transaction, but some franchisees were running a separate cash register off the books. Luna: So the POS data was the smoking gun. Were those franchisees independent operators who just got greedy, or was there a culture issue? Lucas: From the filings, it looks like a subset of franchisees in one region who'd been in the system for years and felt the royalty rate — eight percent — was too high for the support they were getting. Their argument was that the franchisor's marketing fund wasn't delivering local traffic. So they decided to self-help by skimming. Luna: That's a dangerous logic. Once you start picking which contract terms to follow, it's a slippery slope. Lucas: Exactly. And the arbitration panel will likely side with the franchisor because the contract language on royalty calculation is usually airtight. But it does highlight something: if franchisees feel the value proposition has eroded, some will try to renegotiate unilaterally through non-compliance. That's a symptom of a relationship problem, not just a legal one. Luna: Now territory encroachment — that's the one where franchisees feel betrayed. They buy a territory, build the business, and then the franchisor opens a location nearby. How is that even allowed? Lucas: It depends entirely on how the territory is defined in the franchise agreement. Some contracts grant an exclusive territory — a specific radius, like three miles. Others grant a 'protected area' that's more loosely defined, sometimes based on zip codes or census tracts. And some give no territorial exclusivity at all, just a right of first refusal on nearby locations. Lucas: A fitness franchise got hit with a big ruling last fall. A franchisee in Atlanta claimed the franchisor opened a corporate-owned studio less than two miles from his location, inside his protected radius. The arbitrator awarded the franchisee one point two million dollars in damages, plus legal fees. The franchisor had to buy back the franchisee's location. Luna: So the franchisee won. That's unusual, right? Most arbitration rulings favor the franchisor. Lucas: Statistically, yes. About 70 to 80 percent of franchise arbitration cases go in favor of the franchisor. But when the contract language is clear and the franchisor violates it, arbitrators do hold them accountable. The key is the definition of 'protected territory' in the Franchise Disclosure Document — Item 12, specifically. Luna: Item 12. That's the one that outlines territories. What should a prospective franchisee look for there? Lucas: Look for the difference between an exclusive territory and a protected area. Exclusive means no other outlet — franchisee or company-owned — can operate within the defined boundary. Protected area usually means the franchisor won't open one, but they can still sell through third parties like delivery platforms or mobile units. Also check whether the territory can be reduced later. Some agreements let the franchisor shrink it if the franchisee underperforms on sales benchmarks. Luna: That seems like a hidden landmine. You buy a three-mile radius, and three years later it's two miles because you didn't hit a target you never fully understood. Lucas: Right. And that brings us to non-compete enforcement, which is probably the most volatile area right now. The FTC's proposed ban on non-competes last year created a lot of confusion. Some franchisees started arguing that their post-term non-competes were unenforceable, and a few courts agreed. But then a federal judge in Texas blocked the FTC rule, so the landscape is fragmented. Luna: Franchise non-competes are different from employee non-competes, though, right? Courts tend to uphold them because the franchisee is buying a business, not just taking a job. Lucas: That's the traditional view, and it still holds in most jurisdictions. But there's been a wave of cases where franchisees who left the system and opened a similar independent business were sued, and they fought back by claiming the non-compete was overbroad in geographic scope or duration. One case in California — where non-competes are basically void — a former franchisee of a home-services brand successfully argued that the one-year, fifty-mile restriction was unreasonable because the business was mostly online. The court reduced it to six months and ten miles. Luna: So the trend is that non-competes are getting challenged more, and sometimes narrowed. That changes the calculus for a franchisee thinking about exit options. Lucas: Absolutely. If you're buying a franchise today, you should assume the non-compete is enforceable, but also know that if it's truly excessive — like three years and a hundred miles for a sandwich shop — you might have room to negotiate or challenge it later. But that's expensive litigation. Better to negotiate it upfront. Luna: What else in the Franchise Disclosure Document predicts litigation risk? You mentioned Item 12 for territories. What about Item 20? Lucas: Item 20 is the litigation history table. It lists all lawsuits involving the franchisor for the past ten years. You want to look at two things: the number of cases filed by franchisees against the franchisor, and the number filed by the franchisor against franchisees. A high ratio of franchisor-filed cases — say, more than three to one — suggests a litigious culture. Also check the outcomes. If a lot of cases are settled with confidentiality clauses, that's a red flag. You can't learn what the dispute was about. Luna: And Item 21 — the financial statements. Can that predict litigation? Lucas: Indirectly, yes. If the franchisor's revenue is declining or they're carrying a lot of debt, they may be more aggressive in enforcing royalty payments to protect cash flow. A stressed franchisor is more likely to audit and sue. So look at the trend in the audited financials over three years. If same-store sales at the company level are down and legal fees are up, that's a pattern. Luna: That's practical. So before signing, a prospective franchisee should read Items 12, 20, and 21 with a lawyer who specializes in franchise law. Lucas: Yes. And also ask the franchisor directly: how many disputes went to arbitration in the last five years? How many were resolved in your favor? They have to answer truthfully. If they're evasive, that's a data point. Luna: You know, this episode is the kind of thing that could save someone tens of thousands in legal fees. Honestly, if it was worth a coffee to you, the link is buy me a coffee dot com slash fexingo. That kind of support is what keeps the show ad-free. Lucas: Yeah, it really does. We don't run ads, so listener support makes this possible. And we're grateful to everyone who's chipped in. Luna: Alright. Back to the litigation landscape — what about mediation? Some franchise agreements require it before arbitration. Is that helping? Lucas: It helps screen out the weaker cases. Mediation settles maybe 30 to 40 percent of disputes before arbitration. But if a case goes to arbitration, it's usually because one side feels strongly that they're right, or because there's a principle at stake. The cost of arbitration itself is significant — often fifty to a hundred thousand dollars per side. So the decision to litigate is not taken lightly. Luna: So the spike in cases might also reflect that the stakes are higher. Maybe unit economics are tighter, so every percentage point of royalty matters more. Lucas: I think that's exactly right. When margins are under pressure — and they are in 2026 with labor costs up and some commodity prices still elevated — both sides get more aggressive. Franchisees look for ways to cut costs, and franchisors look for every dollar of royalty they're owed. That friction generates litigation. Luna: Last question: if someone is already in a franchise and worried about a dispute, what's the first step? Lawyer up immediately? Lucas: First step is to read your contract's dispute resolution clause. Many have a 'cure period' — typically 30 to 60 days — where you can fix a breach before they can file. If you've underpaid royalties, you might be able to pay the difference plus interest and avoid litigation. Second step is to document everything: all communications, all financial records, all marketing fund reports. If you end up in arbitration, your case lives or dies on the paper trail. And yes, consult a franchise attorney early. A two-thousand-dollar consultation is cheaper than a fifty-thousand-dollar arbitration. Luna: Good advice. Thanks, Lucas. Lucas: Thanks, Luna. And to our listeners — if you're thinking about buying a franchise, spend the money on a lawyer before you sign. It's the best investment you'll make.