Answers To Common Franchise System Insurance Questions

February 23, 2016Articles Law360

Reprinted with permission from Law360. (c) 2016 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

For franchise systems, establishing satisfactory insurance standards at the outset is particularly important in order to determine appropriate coverage for the franchiser and set minimum requirements for franchisees, but when conducting systemwide franchise coverage analyses, there are some major areas where confusion and questions often arise.

The Additional Insured Concept

When conducting analyses for franchise systems, it's useful to provide a markup of the franchiser’s form franchise agreement with suggested edits and comments. By far the most confusing area is the “additional insured” provision. Many franchise agreements require only a “certificate” as evidence of a franchiser’s additional insured status. Certificates of insurance confer no rights to the holder, and clearly state this across the top of the certificate. They are therefore useless for the purpose of confirming that a franchiser is an “additional insured” and a franchiser cannot rely on it in a dispute about coverage.

An additional insured must always receive an endorsement to the policy from the franchisee clearly listing the franchiser as an additional insured. Otherwise, a franchiser could later be deemed to be without coverage under its franchisees’ policies. In addition, a franchiser should always ensure it is requesting the broadest “form” of additional insured endorsement from its franchisees. The form should extend to negligence, errors and omissions of the franchiser and should not be limited to vicarious liability. A franchiser should also verify that the form of franchise agreement does not inadvertently limit coverage. Many forms of additional insured endorsements state that coverage is no broader than what is required in the underlying agreement or contact. Therefore, if a franchise agreement limits a franchisee's obligation to providing additional insured coverage for only vicarious liability, then the endorsement will not provide broader coverage for negligence, errors or omissions.

Finally, keep in mind that an additional insured endorsement is typically not available for employment practices liability insurance (ELPI), errors and omissions (E&O) coverage and cyber insurance coverage. In almost all cases, a franchise system won’t be able to obtain coverage under its franchisees’ EPLI, E&O and cyber policies. Therefore, it is critical that a franchise system’s operations manual and franchise agreement require its franchisees to implement and have in place fulsome and current risk management policies to decrease the likelihood that a claim will arise requiring coverage in the first place.

The Need for Cyber Coverage

Another “hot issue” right now is the question of cyber insurance. Franchise systems will ask whether cyber coverage should be a requirement for franchisees. Most franchise agreements require a franchiser to maintain at least a few million dollars of “general liability insurance.” General liability insurance covers such perils as property damage, personal injury, advertising injury and products liability. It is considered the general business insurance that covers most risks. A franchiser will also likely require separate automobile policies, worker’s compensation and an umbrella or excess policy. None of these policies however, typically covers data breaches without an endorsement specifically covering the risk. As most businesses now know, “cyber liability” is a form of coverage that has developed over the past decade to protect against identity theft and data breaches. Unfortunately as technology advances, criminals continue to create new ways to steal identities and information. Cyber liability coverage can protect both losses suffered by franchisees and losses suffered by customers or other third parties. Without proper and adequate coverage, the costs to remedy a serious data breach — including notifying all possible affected customers under state law, hiring consultants to determine the extent of a breach and possible damage claims — could put a franchisee out of business.

Therefore, the answer to whether a franchisee needs cyber coverage is typically yes. Cyber coverage is becoming less cost-prohibitive as additional providers enter the market and policies can be tailored to fit the needs of a franchisee’s business. The first step is always to assess what coverage is critical by evaluating the likely threats. Do your franchisees collect a considerable quantity of credit card data? If so, then coverage for Payment Card Industry (PCI) fines and penalties is critical. Is data collected by franchisees backed up and held by the franchiser? If so, then significant data restoration coverage may not be necessary. Consider the cost of including cyber extortion. More and smaller companies are experiencing cyber extortion events where information is held hostage but is typically released upon the payment of small ransoms — $2,500 to $5,000. Calculate the risk exposure against the additional premium.

Be mindful of all sublimits and policy exclusions. Any covered party should attempt to claw back or narrow exclusions when possible. Cyber coverage typically places sublimits on things like breach response services. Make sure those sublimits are high enough to cover likely needed costs. For example, a cyber policy may provide an overall aggregate limit of $1 million, but limit crisis management and public relations expenses to $50,000. Scrutinize broad exclusions for failing to follow minimum required practices and look to carve out cyber terrorism from the typical blanket exclusion for war, invasion or insurrection. Work with your insurance professionals to determine the appropriate overall limits based on the size and type of franchised business and other factors.

Remember that defense costs and expenses are included — and are not in addition to — the policy limit. These costs can erode the policy limit very quickly. Finally, understand the conditions of coverage. Some policies require an insured to utilize service providers from its own preapproved list of vendors. This typically includes legal counsel and public relations firms.

Given the growing risk of cyber theft, the cost to franchisees of the annual premium for such coverage is likely to be well worth it. Insurance counsel, together with a knowledgeable cyber insurance broker, can work with your franchise system to evaluate what coverage is most important for a franchisee.

Protecting Against Joint Employer Claims

In light of the National Labor Relations Board’s complaints against McDonald’s and other recent decisions, many franchise systems are concerned about insuring against violations of the National Labor Relations Act. Most EPLI policies exclude any coverage for such claims, so a franchiser is therefore unlikely to find coverage to insure against this risk. A franchise system must continue to ensure that its franchise agreements and operations manual contain appropriate language to allow a fact-finder to conclude that the franchiser and franchisee are not “joint employers” in the event of a claim. Wage and hour claims under the Fair Labor Standards Act and similar state laws are typically excluded from coverage as well although policies may provide a defense sublimit, typically in the $100,000 range. A franchiser should carefully review a franchisee’s EPLI coverage and insist upon wage and hour defense coverage, when possible.

Setting Franchisee Minimum Coverage Requirements

Many forms of franchise agreements require a certain dollar amount of insurance coverage. For example, a franchise agreement may say that a franchisee must have $1 million in general commercial liability coverage. Many additional insured endorsements limit coverage to the lesser of (i) the amount required by the agreement or (ii) the policy limits. A franchise agreement should always state that any dollar coverage limit is a minimum requirement. Often a franchise agreement form does not provide enough flexibility to change coverage requirements. Franchise agreements should always include a provision that coverage requirements can be increased or decreased upon the franchiser’s prior notice as set forth in the operations manual or other writing. Surprisingly, many franchise agreements outline detailed requirements and coverage limits but do not specifically provide that the franchiser can change these standards as it deems necessary during the franchise term.

In addition, a franchise agreement often requires the franchisee maintain insurance only during the term of the franchise agreement. Professional liability policies and certain other policies are typically “claims made,” not “occurrence” based. To protect against claims brought after the franchise agreement terminates or expires under claims made policies, the franchise agreement should require the franchise maintain insurance during the term and for such period after as necessary to provide coverage required for events occurring during the term of the franchise agreement.

Remember that the insurance sections in a franchise agreement are not “boilerplate” provisions. How these sections are drafted will very much affect a franchise system’s right to coverage. Do not unnecessarily limit your recovery rights by using insurance provisions that are not properly vetted and reviewed by counsel knowledgeable in this area of law.

Approving and Auditing a Franchisee’s Policy

Finally, another major issue is lack of compliance by franchisees and a failure of franchisers to detect such noncompliance. Often, a franchisee’s policy will exclude coverage required by a franchise agreement or have much lower limits than required. This is true even when a franchise system has a recommended broker or vendor who purports to custom build the coverage package for franchisees to purchase. Franchise systems should always have a review by someone who understands insurance policies and can cross check both the system’s coverage and each of the franchisees for the purpose of confirming the coverage meets the system’s minimum requirements. The franchise agreement should disclaim any reliance by the franchisee on the franchiser’s minimum insurance requirement as being sufficient or adequate in the event of a coverage event. The franchise agreement should also clearly state that the franchiser’s review or verification that the franchisee’s coverage complies with its contractual requirements does not reduce or eliminate franchisee’s obligation to confirm its policies are in compliance with the franchise agreement.

Reprinted with permission from Law360. (c) 2016 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.