Franchising Reform On Horizon?

More Mom-And-Pops Seek Federal Protection
By Kenny Butler, Reporter

Investor's Business Daily, National Issue, Friday, July 30, 1999

Patrick Leddy, Jr. has run a Baskin-Robiins franchise for 13 years in Newhall, California.  Two years ago he was horrified to learn that Baskin-Robbins was planning to open a new store less than two miles away.

Despite his protests, the new site opened.  Sales in Leddy's store plunged.  When he tried to sell the store, he had trouble attracting buyers for it.

A number of franchisees point to stories like Leddy's in arguing for a federal law to prevent what they call widespread unfair treatment by franchisors.  And some lawmakers are listening.

From lodging to security services, franchising has become a dominant force in the economy.  Pizza Hut, Jiffy Lube and H&R Block are just a small sample of well-known franchises.  By 2000, industry analysts figure, 50 cents of every retail dollar will be spent in a franchise.

The Federal Trade Commission requires franchisors to maintain elaborate disclosure forms to ensure that would-be franchisees know what they're getting into.  These forms detail the names and phone number of franchisees and financial statements, as well as the parent company's litigation history.

Robert Zarco, a leading franchisee lawyer, says that's not enough.  He claims contracts are onerous, incomprehensible and can be widely interpreted to trample on a franchisee's rights.

"There are no federal laws that govern the relationship between the parties after the contract is signed," Zarco said.

Grab a Bucket and Mop:

Top Franchise companies, by units:

Name                                                     Units

McDonald's Corp.                                    18,361

7-Eleven, Inc.                                        13,819

Subway Sandwiches and Salads                13,300

Burger King Corp.                                     7,495

Pizza Hut, Inc.                                        7,200

Jani-King International, Inc.                      6,700

Cendant Corp.                                       5,600

International Dairy Queen, Inc.                 5,347

Taco Bell Corp.                                      4,600

Coverall North American, Inc.                   4,500

(Source: International Franchise Association)

Reformers are pushing the federal legislation that's modeled after an Iowa law.  Iowa's measure tries to limit "encroachment," which occurs when a parent company opens a new franchise "too close" to an existing outlet, as Leddy claims.

Iowa's law gives franchisees the right to sue when their sales decline by 5% or more a year after their parent company opens a new outlet nearby.

Franchisors say a federal law would halt expansion and hurt franching's ability to establish band names, ultimately harming franchisees.

The bill was first introduced by Rep. Gary Ackerman, D-N.Y., in 1997.  It would let franchisees sue if their sales dropped by 10% after a new outlet opened in an "unreasonable proximity" to an existing one.  The bill doesn't define "Unreasonable."

Other lawmakers are considering franchising bills.

It may seem implausible that a franchisor would hurt his own franchisee by opening another outlet across the street.  But Brent Appel, a franchise lawyer in Iowa, notes that franchisors make their money by taking a share of their outlets' gross sales rather than a share of their profits.  More outlets mean more sales and more money for the franchisor - even if each outlet becomes less profitable as a result.

"Whether a franchisee is profitable or not is not terribly important to the franchisor," Appel said.  "What the franchisor wants is increased sales so they can get their royalty cut."

Franchisors say encroachment problems can most easily be solved by entering into contracts that set territorial limits for the franchisee and the parent.  If the Iowa law is applied nationally, franchising will stagnate, they say.

Franchisors point to an American Legislative Exchange Counsel study.  It argues that Iowa's law caused its 1995 franchising growth rate to lag at 6%, while growth in neighboring states hovered in double digits.

David Kaufmann, a New York franchise lawyer, says anti-encroachment efforts are really an attempt by franchisees to keep potential rivals out of their territories.

"At the end of the day, they're saying. 'I have the only great restaurant of this kind in town, and I want to keep all the money for me'," Kaufmann said.

Michael Adler, president and CEO of Moto Photo, Inc., worries that encroachment laws may slow franchise expansion.  That would hurt market presence and stunt the development of brand name recognition, he says.

And brand name - like McDonald's - is what gives franchisees' outlet value in the first place, because it brings in customers.

"It's a joke in the industry that every franchisee basically wants a franchisor to have heavy penetration of the marketplace, because they'll know in the long term they do better," Adler said. "And then they turn around and say, 'But don't put a store within 30 miles of me.'"

Like other franchises, Moto Photo offers its franchisees an exclusive territory provision setting limits on how close a new outlet can be to an existing one.

Adler remembers one market where Moto Photo gave away large territorial protections.  A rival entered that market and opened three stores for every one of Moto Photo's, making his franchise a minor factor and hurting store values.

"(Franchisees) want to be sure that their business in not impaired (by encroachment)," Adler said.  "And in the sort-term, I think they're probably right.

"But the reality is that if competition comes in and opens a store there, they now have advertising dollars to promote their brand that don't go to support ours."

But backers of franchisees say these business owners never thought they would be in cutthroat competition with their own system.

"The last thing you expect is for your partner to cut you off at the knees," Zarco said.

Zarco says Iowa's law did not hurt franchising in the state.  "Any dip in growth rates is due to market saturation," he maintains.

"The reason that franchisors have no choice but keep expanding is because that's how those public companies provide returns to their stockholders," he said.

Few analysts expect a measure like Iowa's to get through Congress.  Still, squabbles over encroachment are driving other moves to reform franchising contracts.

Franchisees are pushing another federal bill that would establish a legal duty of good faith in franchising.  The bill is sponsored by Rep. John LaFalce, D-N.Y.  He's the top Democrat on the House Banking and Financial Services Committee.

Right now, the implied covenant of "good faith and fair dealing" is used by courts to resolve disputes when a contact is vague or silent on a certain issue - in this case, the territorial rights of franchisees.

Still, courts are reluctant to use the concept to halt abuses if they don't explicitly violate the contract.

According to Appel, franchisees say that protection is a paper tiger.

Susan Kezios, president of the American Franchisee Association, agrees.  Because dense, vague franchise contracts are offered on a "take-it-or-leave-it" basis, they give unfair advantages to the franchisor, Kezios says.

"A more expanded version (of the duty of good faith) is necessary to protect the business interests of the franchisees," she said.  "Right now, if you con someone into signing a contract they don't understand, and you enforce the terms of that contract, you are dealing in good faith."

Others say that good-faith reforms are just an attempt by franchisees to get out of their contracts.

"I think their particular definition is not good faith," Says Erik Gordon, professor of marketing at the University of Florida and a former franchisee.  "It’s an ability to rewrite a contract if you later become unhappy with it."

If a franchisee signs a contract, he should have to abide by it even if it was an uniformed investment decision, Gordon says

"We're not talking about protecting 4-year olds who are watching Saturday morning television here," he says, "We're talking about people who are sophisticated enough to go into a business."

Franchisor lawyer Kaufmann fears that the duty of good faith is being misused by some courts to substitute their notions of fairness for what a contract actually allows.

"I'm not going to say, there are no abuses by franchisors," he said. "But leaving that aside, what I’m seeing is franchisees going to court seeking to rewrite their contracts, and that's increased over the past 10 or 15 years."

As an example, franchisors point to a 1996 ruling in a federal court in California that found a franchisee liable for violating the good faith duty by encroaching on one of its outlets, even though the franchise contract had no exclusive territory provision.

Iowa franchisee lawyer, Appel responds that a number of states already have good faith rules and that, if properly tailored, the federal law will not be used to skirt contracts.

Zarco denies that the reforms will increase lawsuits.

"It's not going to open up any more lawsuits that are being filed right now," he said.  "There are more good faith suits because there's an awareness of the franchisee that they have rights."