Joining Forces Against Goliath

Small franchisees are flexing their muscles through pressure groups, lawsuits, and legislation
By Maria Shao, Globe Staff

The Boston Sunday Globe, Business, July 18, 1993

Steven A. Scheck thought he was buying a piece of the American Dream.  After working 10 years in the hotel industry, including a stint at Marriott Corp., he started his own business in 1980, opening four Burger King franchises in western Massachusetts.  In 1985 Scheck learned that Burger King had approved the conversion of a Howard Johnson's on the Massachusetts Turnpike into a Burger King.  The problem: It would compete with Check's restaurant in Lee, just 1-1/2 miles away.

When the new Burger King opened in 1987, Scheck says, sales at his store plunged from $1.1 million a year to $800,000.  The sales cannibalization, combined with heavy debt he had incurred to buy the property from Burger King, pushed Scheck into bankruptcy, he says.

Scheck sued Burger King, alleging it violated his franchise agreement by approving an outlet too close to his.  A federal judge in Miami, where Burger King is based, recently decided to send the case to a jury, which will decide if Burger King defrauded Scheck and breached its contract with him.  His attorney Robert Zarco, expects a trial in late 1993.

For Scheck, 44, franchising has turned out to be a "heartache", not the American Dream.  "In effect, I've lost everything," he says, although he still runs the four stores under bankruptcy trustees.  At Burger King, a spokesman says: "We are going to defend ourselves vigorously when it goes to trial."

In the world of franchising, David's such as Scheck are increasingly taking aim at Goliath-line franchisers such as Burger King.  After years of operating under what franchisee say is a lopsided power structure, they are trying to win more control in the franchising relationship.

Their weapons: filing lawsuits, organizing pressure groups, lobbying Congress and state legislatures for fair-franchising regulations.  And they are starting to win some concessions from franchisers.

"The pendulum is starting to swing," says Carl Price, president of Franchisee Resources Group, Ltd., a Haddonfield, N.J., consultant to franchisees.  "We want to put things on an even playing field."

Squabbling between franchisees and franchisors is nothing new, but lately the battle has become louder and more intense.  Major franchise chains, including Burger King, McDonald's, Diet Center, PIP Printing and Subway Sandwich Shops, have recently been embroiled in legal battles with franchisees.  The issues have included charges that a franchiser was opening too many competing stores or forcing franchisees to buy supplies at inflated prices.

It wasn't supposed to be that way.  Franchising is a business partnership that has helped create countless millions of jobs and enriched franchising legends like Ray Kroc, founder of McDonald's, or Colonel Sanders, founder of Kentucky Fried Chicken.  The franchiser offers an aspiring entrepreneur a proven brand name and a complete formula for doing business.  Franchisees pay royalties and make it possible for franchisers to expand distribution quickly.

Franchising accounts for a big slice of the U.S. economy.  Sales in more than 400,000 franchise outlets--excluding gasoline stations, auto dealers and bottlers---grew 7 percent in 1992 to an estimated $248 billion, according to the International Franchise Association, which represents franchisers.  About 11 percent of the nation's retail sales are made at franchise outlets, the group estimates.

While large corporations are shedding workers in droves, franchises are creating more than 100,000 new jobs a years, says the IFA.  It estimates that franchises in more than 60 different industries employ 7.2 million workers.

What's fueling the latest franchise revolts?  The economic slowdown and financial pressures from takeovers and leveraged buyouts during the 1980s have caused some franchiser groups to squeeze franchisees, says Dean Sagar, an aide to U.S. Rep. John J. LaFalce, a New York Democrat who has led a campaign against abuses by franchisers.  What's more, Sagar says, today's franchisee is often a sophisticated businessperson unwilling to put up with unfair practices by franchisers.

Last October franchisees formed their own trade organization.  The Chicago-based American Franchisee Association represents 5,200 franchisees who own 10,400 outlets, says Susan P. Kezios, executive director.  Last week a national coalition of 7-11 operators presented Southland Corp., franchiser of the convenience store chain, with a proposed franchise agreement they hope will improve relations with the company.

And there are governmental initiatives to strengthen franchisee rights in an industry known for light regulation and tax enforcement.

In March, LaFalce, who heads the House Small Business Committee, introduced three bills to protect franchisees.  A "Truth-in-selling" measure would beef up requirements on franchise sellers to disclose information about their businesses to prospective buyers.  Another LaFalce bill would establish standard for fair franchising practices.  Another bill would direct the federal government to collect data on franchise practices and performance so operators could better evaluate a chain's prospects.

The Federal Trade Commission is also stepping up efforts.  A 1979 FTC rule requires franchise sellers to provide buyers with a document containing 21 categories of information, including financial statements and management experience of the franchiser.  The seller must substantiate any earnings claims made to the prospective buyer.

The FTC has brought legal action in only eight franchising cases so far this year, compared with 12 in 1992 and 5 in 1991, says a spokeswoman.  Still, given the widespread problems, the FTC action has often been too little, too late.

Meanwhile, the drive for regulation is gathering steam in states, too.  In July 1992, Iowa enacted a tough bill that spells out the responsibilities of franchisees and franchisers.  Twenty states are considering similar bills, including Massachusetts, where state Rep. Mary Jeanette Murray of Cohasset introduced one in April.  State Sens. Lois G. Pines and David P. Magnani recently introduced another measure that would bar franchise terminations except for good cause.

But franchisers contend that self-regulation, not legislation is the answer.  "Franchising works because of entrepreneurship, not because of bureaucrats and regulations," says Stephen Lynn, chairman of the IFA and head of Sonic Corp., a chain of nearly 1,300 fast-food outlets contaminated by "an occasional bad apple."

Still, in hopes of heading off regulations, franchisers have made some concessions.  Last month the IFA voted to admit franchisees as members for the first time in the association's 38-year history.  That followed a move by the trade group last November to establish an advisory council of franchisees and adopt a code of ethics.  To reduce litigation, the IFA plans to set up a mediation and arbitration system.

Nonetheless, many franchisees gripe that franchise contracts, which can run up to 70 pages, still sharply curtail their rights.  "Franchisers have an overwhelming imbalance of legal and financial power," asserts Erick Karp, a Boston lawyer who represents franchisees.  "This leaves them free to create extremely one-sided documents that are handed to franchisees on a take-it-or-leave it basis."

"Franchisees," he adds, "can't even negotiate a change in punctuation."

Among the pitfalls and restrictions frequently cited by franchisees:

Encroachment/saturation. Because franchisers collect royalties on a sale, not profits, it's in the interest of a franchisers to open more outlets, even if they cannibalize existing outlets, critics say.  Most franchise agreements do not vie franchisees absolute protection from encroachments.

Purchase of supplies and services. To control quality and consistency, franchisers typically require their operators to buy directly from the franchiser or franchiser-approved vendors.  But some franchisees say they can buy comparable goods and services at lower prices from independent suppliers.

Real Estate.  It's common for the franchiser to control and negotiate leases on behalf of its franchise shops, which then sublease from the franchiser.  Such arrangement increases the chance of a franchisee ending up in uneconomic leases or in complicated rent disputes, some franchisees say.

Sale or transfer of franchise.  Many franchisers have the right of first refusal when a franchisee tries to sell his business.  Karp says some franchise arrangements contain so many restrictions on the transfer that the franchisee, in effect, can sell only to the franchiser.

Dispute resolution.  Because many franchise agreements contain arbitration clauses, franchisees in effect sign away their rights to sue.  It's also common for the contract to require that any lawsuits be brought in the home state of the franchiser, a financial and logistical hardship for small businesses.

So franchisees must be wary.  After all, the interests of the franchisee and franchiser aren't always the same.  Scheck, who says he has run up $250,000 in legal costs in his Burger King suit, contends that franchisers "are more concerned with selling stores than with the individual making it."

He adds: "You have to go into [franchising] with very open eyes, and a lot of legal advice.  There are a lot of pitfalls."