WITMER, KARP, WARNER & THUOTTE LLP
TELEPHONE (617) 248-0550
December 21, 1999
Via FedEx Airbill No. 8144 7111 3509
Donald S. Clark
Dear Mr. Clark:
Thank you for this opportunity to provide comments concerning the Notice of Proposed Rulemaking (NPR) issued by the Federal Trade Commission of October 15, 1999.
I am a franchise attorney who represents franchisees and franchisee associations. I have represented clients in the following franchise systems: McDonalds, Little Caesars Pizza, Domino's Pizza, Pearle Vision, Ben & Jerry's, 7-Eleven, SpeeDee Oil Change & Tune Up, Pepperidge Farm, Better Homes and Gardens, Prudential Real Estate, Johnny Rockets, California Closets, H&R Block, White Hen Pantry, Beverly Hills Weight Loss and Wellness, Jackson Hewitt Tax Service, Great Clips, Colors on Parade and many more.
I am a Director of the American Franchisee Association (AFA). I served as the Program Chair of the 1999 AFA Franchisee Legal Symposium.
In June, 1994, I testified before the U.S. House Small Business Committee on "Self Regulation of Franchising: The IFA Code of Ethics." An elected delegate to the 1995 White House Conference on Small Business, I have twice testified before the Joint Committee on Commerce and Labor of the Massachusetts Legislature on franchise issues. Since 1996, I have served on the Franchise Project Group of the Franchise and Business Opportunities Committee of the North American Securities Administrators Association.
I submit the following comments in no particular order of priority.
A. Scope of the FTC's Unfairness Jurisdiction
The NPR perpetuates the FTC's stance that its unfairness jurisdiction should not be extended to address the substance of the franchisee-franchisor relationship. The NPR opines that franchisees can avoid harm by "comparison shopping for a franchise system that offers more favorable terms and conditions". This view does not take into account the reality of the marketplace and the nature of the resulting franchise agreements that have been developed and offered since the Rule was first promulgated exactly 21 years ago.
This year, we conducted a first of its kind comprehensive comparison study of the franchise agreements and franchisee offering circulars of the top eight pizza chains in the United States.
The study was first released to the public at the AFA's 1999 Franchisee Legal Symposium held May 6-7 at Hilton Head, South Carolina under the title: "Holding A Gun To Your Head: Marketplace Monopoly-How Pizza Franchisors Play The Game" (The Pizza Study). Dr. Frank Wadsworth, Assistant Professor of Marketing at Indiana University Southeast, provided a foreward. A copy of The Pizza Study is attached as Appendix B .
We undertook this study in part because in my practice we so often hear the tired refrain in response to the franchisee that complains of a franchise agreement that reserves all rights to the franchisor and precious little to the franchisee: "nobody held a gun to your head" compelling the execution of a franchisee agreement.(1)
Implicit in this overworked phrase is the assumption that the marketplace has created meaningful choices for franchisees who seek a franchise relationship marked by a fair balance of financial and legal rights, responsibilities and rewards. The Pizza Study tells us that this assumption is false.
The top eight pizza franchisors, whose sales exceed $10.7 Billion per year, control over one third of the entire ready to eat pizza market. They sell a combined One Billion pizzas per year. Approximately 65% of their locations are franchised. Collectively, they account for 85% of the sales of the top 27 franchised pizza chains. This means that the top eight wield enormous market power, functioning as a de facto monopoly in the presentation of franchise contract terms.
The franchise agreements offered by the top eight pizza franchisors are remarkably and disturbingly similar in content. Three themes permeate the agreements studied: unbridled discretion in the hands of the franchisor, unlimited calls on the franchisee's capital, and asymmetry of the rights and obligations of the parties.
Unbridled Discretion - The vast majority of the franchisors' purported obligations must only be provided if and to the extent the franchisor deems, in its sole discretion, appropriate. Thus, very little is, in fact, promised. In addition, each franchisor reserves the right to unilaterally modify its operations manual, from which the franchisee receives the majority of its marching orders and with which the franchisee must always comply, no matter the cost or the affect on the business.
Unlimited Calls on Capital - The ongoing investment that may be required of the franchisee is limitless. All of the top eight pizza franchisors reserve the right to restrict suppliers, potentially creating captive customers in its franchisees. They all reserve the right to change the very essence of the business, their trademarks, and none compensates its franchisees for lost revenues due to resulting customer confusion or dissatisfaction. Moreover, five of the top eight require that the franchisee pay for of all new signage, products, advertising, and the like.
Asymmetry of Rights - Examples include the franchisor's unrestricted right to assign its interest in the agreement compared to the franchisee's heavily restricted right; the franchisor's right of first refusal with respect to sale of the franchised business compared to the absence of a right of first refusal for franchisees on the purchase of new restaurants the franchisor intends to open; the unilateral right of the franchisor to litigate any matter arising out of the contract in a designated location of its choice and under a designated law of its choice; and the requirement that the franchisee indemnify the franchisor for all claims of negligence against the franchisee without any reciprocal obligation on the part of the franchisor.
The top eight pizza franchisors have attained pervasive and unilateral control over franchise terms and conditions, with unheard of bargaining and negotiation power rarely seen outside the world of franchising.
Furthermore, based on my experience as a franchisee attorney, it does not matter whether the franchise offered involves the sale of pizza, hamburgers, eye glasses or tax preparation services; the same kind of take-it-or leave-it, non-negotiable and grossly one-sided agreements are the norm. These agreements do not benefit consumers or competition; to the contrary, the squeeze on franchisee costs and profits often forces them to pass those burdens on to the public in the form of higher prices.
In promulgating the Rule the FTC stated as follows:
Needless to say, the Commission's prediction did not come to pass. The Courts have consistently held that no private right of action exists for even the most blatant and brazen violations of the Rule. While this void can now only be filled by the Congress, the Commission does have the option to use the power granted to it under 15 U.S.C. §45(n) to address the grossly one-sided and predatory nature of the franchise agreements that are now the norm. Market forces and pre-sale disclosure have not stemmed this tide and are unlikely to do so in the future.
B. Elimination of First Personal Meeting Disclosure Trigger
Proposed § 436.2(a)(1) would eliminate one of the most important bright line rules of disclosure that currently exist under the FTC Rule and under the laws of many of the disclosure/registration states.
It is certainly true that in the information age, much of what was once done in person is done by e-mail, through overnight carriers and websites and by telephone. It is also true that many franchise sales are initiated without personal contact between the franchisor and the prospective franchisee. At the same time, there is no basis to believe that personal meetings will completely become a thing of the past.
The elimination of the first personal meeting disclosure trigger is a dangerous and unnecessary move that will increase the opportunities for fraud in the sales process. It will allow the franchisor to conduct discussions with the franchisee about the purchase of a franchise over an extended and theoretically unlimited period of time. These discussions will include information about the franchise which is required to be included in the disclosure document. During this period, the franchisee is likely to become heavily invested in the transaction and will be induced the make the purchase decision without the disclosure document. The 14 day cooling off period will then start when the franchisee has already decided to make the investment. The disclosure document will become only an afterthought. This undermines the central purpose of the Rule which is to give the prospective franchisee the information needed to make an informed choice before deciding to invest.
Moreover, the first personal meeting disclosure trigger presents no real or extra burden to the franchisor. The disclosure document should be ready and available at the time of the first personal meeting, if there is one. There is no rational reason to allow the franchisor to begin the sale process while withholding the disclosure document that is designed to give all the information needed to conduct the franchisee's due diligence process.
The proposed elimination of the first personal meeting trigger does not streamline the Rule. It eviscerates one of its most important provisions. We urge the Commission to retain the first personal meeting trigger.
C. Large Investment Exemption
We oppose the Large Investment Exemption reflected in proposed §436.9 as not reasonably tailored to its stated objectives and unnecessary in any event.
First, the proposed Exemption would be of little benefit to a franchisor unless 100% of its franchise sales involve a transaction of $1.5 Million or more. For any franchisor not meeting this standard, with some but not all of its sales reaching that plateau, there would be a continuing need to prepare a disclosure document. Delivering the disclosure document to all of its prospective franchisees, and not just those whose investment exceeds $1.5 Million, creates no additional burden.
Second, footnote 255 of the NPR suggests that if the franchisee obtains bank financing, the lender "...may require equity of several hundred thousand dollars..." before making the loan. This will insure, according to the NPR, that "...as a practical matter, the proposed exemption will apply to sophisticated investors only." There is no support in the record as to what amount of equity a bank might require on franchise investment of $1.5 Million. This assumption also ignores transactions where the franchisee obtains financing from the franchisor or its affiliates or from a selling franchisee; in such instance, far less equity may be required.(2)
Third, the NPR suggests that several hundred thousand dollars of invested equity is the appropriate standard for determining if the franchisee is a sophisticated investor. This is an invalid assumption for a variety of reasons. The de facto several hundred thousand dollars of equity standard does not take into account the prospective franchisee's source of those funds. Did she re-mortgage her residence? Did he borrow from a friend or relative? Did they cash in their retirement funds? The standard also does not consider what other assets, liabilities and income the prospective franchisee has from which one can estimate his or her financial sophistication and tolerance for risk.
The Securities and Exchange Commission approach on this issue is instructive.
In its Regulation D(3), the definition of an Accredited Investor includes the following:
The SEC approach properly focuses on the qualifications of the investor, not the size of the investment. The NPR does the opposite. The fact that a franchisee may be ready to invest in a highly leveraged $1.5 Million franchise investment does not prove that such a person is so sophisticated that a disclosure document would be of no benefit.
Moreover, the fact that a person is an Accredited Investor under the Regulation D criteria does not give the seller carte blanche to engage in an unlimited number of sales without registration. Rules 405 and 406 under Regulation D limit the aggregate dollar value of sales made to accredited investors to limits of $1,000,000 and $5,000,000, respectively. The NPR places no limits on the number of franchises that can be sold under the proposed exemption.
Finally, it is no accident that none of the registration or disclosure states have ever enacted an exemption based on the financial qualification of the prospective franchisee or the amount of his or her investment. The proposed exemption is antithetical to the purposes of the Rule.
D. Disclosure of Franchisee Associations
We agree with the comment at footnote 209 of the NPR that many franchisors greet the creation of independent franchisee associations with outright hostility and in some cases attempted retaliation. The reasons for this conduct was ably described by a U.S. District Court judge more than 21 years ago:
The access to a franchisee trade association that the McAlpine Court sought to protect is currently secured by statute in eleven states: Arkansas, California, Hawaii, Illinois, Iowa, Michigan, Minnesota, Nebraska, New Jersey, Rhode Island, and Washington.
Attached as Appendix A is a summary of what the undersigned believes to be all of the court decisions which deal with retaliatory conduct by franchisors relating to franchisee associations. While courts and juries seem to have little difficulty identifying dealing appropriately with such conduct, it does not seem to abate as franchisors do not wish to allow franchisees to benefit from the collective sharing of information that an association can facilitate.
For these reasons, the proposed §436.5(t) is an important advance in allowing prospective franchisees access to a crucial source of information about the franchise system that will enhance their ability to fully investigate the franchise opportunity.
However, the following clarifications are suggested:
1. Require the inclusion of the franchisee association's fax number, E-mail address and internet home page address(6) if provided by the association; this mirrors the information that franchisor must disclose on the Cover Page under proposed § 436.3 (b);
2. State that the franchisor must accept the representation of the franchisee association that it is incorporated and that it may not require any collateral documentation;
E. Item 20 Issues Generally
Item 20 of the disclosure document is one of the most important sources of information about the franchise system for a prospective franchisee. It should provide an easy to follow set of charts that allow the franchisee to assess the growth of the system and track changes in the number of outlets, both franchised and company owned. The current UFOC format is plagued by a double counting problem that makes the charts misleading.
In addition, in this era of sophisticated computerized spreadsheet programs and databases, franchisors have access to and use for their own purposes a wealth of data concerning outlet growth trends which can and should be shared with prospective franchisees.
The proposed §436.5(t) does not fully resolve the double counting issue and does not go far enough in utilizing important data that prospective franchisees should have at their disposal.
1. System Wide Snapshot
The Item 20 charts should begin with a system-wide snapshot of total outlets over the previous three years. Such a chart would consist of the following:
Table No. 1
SYSTEM WIDE OUTLET SUMMARY
Transfers of franchised outlets do not change the number of franchised outlets. They should not be counted as a termination even if the franchise agreement is in fact terminated as part of a sale in which the buyer actually signs a new franchise agreement, as is the usual practice. Accordingly, transfers should be recorded in a separate chart that would not only list the number of transfers but also the number of requests for approval of transfer denied by the franchisor. This will help the prospective franchisee determine the likelihood of being able to realize his or her equity in the franchised business in the future.
Chart No. 2
3. Franchised Units
The charts reflecting the status and trends of franchise outlets should be marked by the following attributes:
Chart No. 3
Status of Franchise Outlets
4. Company Outlets
Chart No. 4
Status of Company Owned Outlets
5. Turnover Rates
We urge the FTC to seize the opportunity to create an industry-wide definition of turnover rates to end the controversy over this vital statistic and create the ability to compare systems in a meaningful fashion.
Chart No. 5
Franchised Outlet Turnover Rates
6. New Outlet Projections
One of the areas in disclosure documents where franchisors often take unwarranted liberties is in their projections of new outlets in the current year. These projections amount to a species of Item 20 claim in that they seek the franchisee's reliance on the promised rate of growth.
The undersigned recently reviewed the 1998 UFOC of a publicly held franchisor. The Item 20 charts showed that the outlets at the end of the previous three years had numbered follows:
In the same UFOC, the franchisor was projecting 63 new franchises in 1998, although at the end of 1997 there were no franchises for which agreements had been signed but were not operational. When I inspected the UFOC for the previous year, I found that the franchisor had also projected 63 new franchises for 1997. This may be an extreme example but many UFOCs have predictions on growth that seem to have no basis in fact or reality.
The only way to compel franchisors to use reasonable projections is to allow the prospective franchisee to track what the franchisor has previously predicted against what actually transpired. A chart to accomplish this task would be as follows:
Chart No. 6
Projected New Franchised Outlets
7. Franchisee Rosters
The nature of the required roster of franchisees under proposed §436.5(t)(4) should be amended in two ways. First, by deleting the last two sentences of that section that allow the franchisor to list as few as 100 outlets. Even franchisors with thousands of outlets typically provide a list comprised of every outlet in the system. There is no reason to impose any limit in the number of outlets to be listed. If the Commission is inclined to place any limit, the floor should be 500 units.
Second, the roster should include the effective and the expiration dates of the franchise agreement for each outlet. In his or her due diligence, the prospective franchisee will benefit from determining whether a franchisee has had a short or a long tenure in the system. Existing franchisees may have had very differing experiences based on the date they entered the system. This data is readily available to franchisors for their own purposes; there would be little, if any, added burden to a franchisor if required to include this information.
In addition, the former franchisee roster under proposed §436.5(t)(5) should include the reason or event that caused the franchisee to exit the system. The event should be keyed to one of the enumerated events in the Status of Franchise Outlets Chart No. 4. In this way, the prospective franchisee can utilize this roster of former franchisees on a more focused basis and seek an elaboration of the events leading to the exit of the former franchisee is free to or chooses to do so.
F. Expansion of Item 3 Disclosures
We strongly support the proposed §43.6.5(t)(c) that requires the disclosure of franchisor initiated lawsuits concerning the franchise relationship. The extent to which a franchisor has filed lawsuits to collect unpaid royalties from franchisees or to enforce a non-competition covenant or has filed a pre-emptive complaint for declaratory judgment(8) is important information for a prospective franchisee. The race to the courthouse should not be the determining factor as to whether the litigation should be disclosed.
We do not support the idea that franchisor-initiated litigation need only be disclosed if it reaches some arbitrary threshold of a number of cases or as a percentage of the franchisees in the system. The prospective franchisee should make his or her own determination as to whether the number of lawsuits is at a level that indicates a problematic franchise system.(9)
There are many circumstances in which lawsuits with third parties are material to the franchise relationship. If a franchisor were to sue a supplier of goods or services it sells to franchisees, over issues relating to quality or efficiency of supply or to block sales not authorized by the franchisor, the prospective franchisee would have good reason to want to know about that claim. A blanket statement suggesting that lawsuits with third parties are, per se, not material is thus over broad and could prevent the prospective franchisee from receiving important information.
Finally, we reject the notion that it would somehow be an unfair burden for a franchisor to be required to disclose all lawsuits and all settlements that have any bearing on the franchise relationship. The reality is that these lawsuit are very expensive. The additional cost associated with writing a single paragraph to describe the lawsuit in the manner required by proposed §436.5(c)(2) would in every case pale by comparison with the money and other franchisor resources devoted to the litigation itself.
We are of the view that the use of the term "Renewal" in the context of the typical franchise relationship is inherently misleading. In substantially all of the current franchise agreement now in use, the franchisee does not have the right to renew the franchise agreement at the end of the term. It may have the right, provided he or she agrees to the conditions of "renewal" in the agreement, to enter into a new franchise agreement based on the then-current form of agreement being offered to new franchisees, which almost always contains starkly different terms and conditions(10).
The dictionary definition of the verb "renew" is to "make like new...to begin again...to grant or obtain an extension of or on...."(11) In the world of commercial leasing, when the tenant has a right to renew a lease, all of the terms and conditions of the tenancy during the renewal are set forth in the lease agreement. The exact opposite is true in franchising; none of the terms of "renewal" are known in advance.
Nearly all franchise agreement provide a path to an extension a franchise relationship, albeit on terms sometimes unrecognizable from those in the first agreement. Virtually no current franchise agreements allow for the renewal of that agreement. They do provide for what amounts to no more than a right of first refusal to enter into a new franchise relationship based on very different terms and conditions, including, in many case, higher royalty, advertising and renewal fees, shorter duration agreements and a host of other changes, making the new agreement ever more one sided in favor of the franchisor.
For this reason, the portion of proposed §436.5(q) that requires a statement of "renewal or extension" rights should be amended to make clear that those terms are not synonymous.
H. Gag Clauses
The inclusion of a reference to and disclosure of gag clauses in proposed §436.5(t)(6) as that term is defined in proposed §436.1(k) is an important advance in favor of the goal of providing material information to a prospective franchisees. The difficulty behind the typical confidentiality provision of a franchise agreement is that it is so broad as to defeat the purposes of the mandated disclosure of franchisee rosters, both as to existing and former franchisees. It is of no use to a prospective franchisee to receive such a list if the current and former franchisees contacted do not feel free to speak openly about their experiences as a franchisee.
Proposed §436.1(k) excludes from the definition of a Gag Clause "...confidentiality agreements that protect the franchisor's trademarks or other proprietary information." This definition is problematic for two reasons.
First, there is nothing about a franchisor's trademark that needs to be or is in fact capable of protection. The mark is by its nature in the public domain and thus not secret or confidential.
Second, franchise agreements generally declare as confidential and proprietary anything and everything the franchisee knows or learns about the franchise, no matter the source. In the typical confidentiality agreement found in most commercial transactions other than franchisee agreements, there are reasonable limits around the definition of confidential materials. These include (a) the requirement that the information be treated as and labeled confidential by the disclosing party when and as disclosed; and (b) exclusions for information (i) which is in or enters the public domain; (ii) was already known to or in the possession of the receiving party; or (iii) is received from a third party without violation of the rights of the owner of the information.
The proposed definition will allow and indeed encourage franchisors to treat all information relating to the franchise as confidential and will legitimize the practice of frustrating the efforts of prospective franchisees to have meaningful discussions with current and former franchisees. It should be refined to include a definition of the word proprietary in accordance with normal commercial practices.
We endorse proposed §436.10(e) which makes it a violation of Section 5 of the FTC Act to disclaim or require a franchisee to waive reliance on any representation made in the disclosure. A number of court decisions in this area have permitted reliance on the terms of a disclosure document to gain an understanding of or to interpret the provisions of a franchise agreement.(12) Indeed, the FTC itself has stated that their purpose of the Rule as it relates to territorial rights is to fully inform the prospective franchisee of the exact nature of such territorial protection.(13) However, franchisors routinely plead their integration clauses to prevent the consideration of the disclosure document as well as any other promises made outside the document. Allowing a franchisor to use an integration clause to bar proof of the warranties and representations in the disclosure document defeats the purpose of the Rule.
Moreover, proposed §436.10(e) should go one step further in a direction wholly consistent with proposed §436.10(a) which makes it an unfair or deceptive act to make a representation that contradicts the text of the disclosure document. It makes little sense to make such conduct illegal under Section 5 without insuring that evidence of the transgression will not be blocked by an integration clause in the franchise agreement. In this manner, the purpose of the Rule in requiring the franchisor to make disclosures under the Rule and not undermine those representations with oral or written statements to the contrary. This issue is of particular concern should the proposed elimination of the first personal meeting trigger become part of the final Rule. In that case, there will be an extended period of time between the first communications and meetings and the time of formal disclosure under the Rule. This interim period will provide ample opportunity for extra-disclosure document warranties and promises. Only by extending the prohibitions on the use of waivers and disclaimers to conduct that violates the existing prohibitions on contradictory will prospective franchisees reap the full benefit of proposed §436.10(e).
J. Financial Performance Information
The absence of financial performance information in the typical UFOC creates a vacuum that allows and even encourages representations as to income and profits. No disclaimer within the UFOC will prevent this inevitable disclosure as it is human nature to desire an answer to the central question about any potential business: "What will it take in and what will I earn?"(14)
Based on the review of the UFOCs that have come across the desk of the undersigned, there has been of late a modest increase in the number of Item 19 Earnings Claims. We believe that this trend was the result of the news articles over the past two years indicating that NASAA was at work crafting a proposal to make such disclosures mandatory. There was also some indication that the NPR might include such a provision. I know that prior to the release of the NPR, some franchisor lawyers had told their clients to prepare for the need to make such disclosures. However, with the Commission's decision not to mandate financial performance information in the NPR, we believe that there will be a reduction in the number of Item 19 disclosures.
The Pizza Study discloses that 6 of the top eight pizza franchisors make no Item 19 disclosures. Only Round Table Pizza and Chuck E. Cheeses, which rank 6th and 7th respectively in market shares, make such disclosures, but in each case provide only top line sales figures. Note that the 6 top franchisors that make no Item 19 disclosures control 94% of the top eight market share and more than 30% of the entire national ready to eat pizza market.
These results are mirrored by the statement of one author that "...less than 20% of all franchisors currently supply earnings claims to prospective franchisees".(15) We believe that the actual rate of earnings disclosures is lower than 20%.
The fiction that franchisees can and should buy a franchise without receiving this most elementary data is well outside the norm in commercial practices. Virtually every publication one might consult on how to appraise a business starts with the production of multiple years of financial statements. Indeed, most franchisors now require franchisees to provide detailed financial performance data on their business but then purport to withhold that same data from prospective franchisees.(16)
IRS Revenue Ruling 59-60, the foundation of business appraisal methods for 40 years, specifies that an assessment of the value of any business starts with 5 years of financial statements and tax returns for the business.
In Vines, supra, the due diligence checklist for the purchase of a franchise company includes financial statements of the company (audited where available) as well as state and federal tax returns, each for the last 5 years.(17)
In his book, Shannon Pratt, to many the dean of business valuation, specifies that to appraise any business, one begins with 5 years of financial statements and tax returns and interim financial statements as well.(18)
At a meeting the undersigned attended approximately 2 years ago with a number of franchise lawyers present, most of which primarily represent franchisors, I asked each lawyer in the room to raise his or her hand if they would allow a client to buy any business without at least three years of financial statements to review.
There were no takers. But this is what we expect franchisees to do every day of the week.
The Commission has a valuable opportunity here to bring franchise sales into compliance with the normal and customary standards that govern the sales of business and end the withholding of this vital data that franchisors collect and use for their internal purposes. It is time to end the prevailing practice of earnings claims being made with deniability.
We hope that the foregoing comments will be useful to the Commission as it proceeds with the Rulemaking process. We trust that you will not hesitate to contact us if there are any questions concerning these comments or it we can provide you with any additional materials or information.
Very truly yours,
Eric H. Karp
TO FRANCHISE RULE COMMENTS
DECEMBER 21, 1999
SUMMARY OF CASES INVOLVING
A. Attacks on collective action by franchisees
The oldest such decision arose in the AAMCO Transmission franchise system two decades ago. In that case, substantially all of the franchisees in the Detroit market bolted from the system, took their signs down and began to operate independently. The franchisor sought money damages from the franchisees for destroying the goodwill associated with its rights as franchisor to those locations. The court endorsed the legitimacy of collective franchisee activities; however, the franchisees were held liable for damages of $412,000, but the responsibility for this verdict was shared among 12 franchisees.(19) The decision is generally regarded as a clear victory for the franchisees.
More recently, a Massachusetts Subaru automobile dealer was accused by his franchisor of engaging in illegal activities in support of a franchisee association. The dealer had originally brought suit against the franchisor for granting another dealership within his retail trading area. Massachusetts has an automobile dealership statute which prohibits the improper granting of a competitive motor vehicle franchise in the relevant market area previously granted to another franchisee.(20) The same statute also provides that "...every franchisee shall have the right of free association with other franchisees for any lawful purpose."(21)
The Subaru dealer had participated in and became the president of the New England Subaru Dealers Council, created to deal with what the Council believed was an unlawful effort to expand the number of dealerships in New England. The franchisor alleged that the association was an illegal combination or conspiracy in restraint of trade. The association pooled resources to gather information about the franchisor's business practices, obtained legal counsel to provide advice on ways to deal with those practices and supported, through financial assistance, documentary evidence and oral testimony, litigation brought by members against the franchisor for violations of state and federal automobile dealer protection statutes. The court rejected the franchisor's contentions, stating that an association of automobile dealers formed for the purpose of processing mutual grievances against their common franchisor and safeguarding their market areas is a legitimate activity. The trial court's determination that the franchisee's rights had been violated through the establishment of the competing dealership in his market area was affirmed by the appellate court.
B. Making an example of the Franchisee; infliction of emotional distress
In a California case decided in federal court in 1989, the franchisor was assessed punitive damages of $1,000,000 for conduct designed to cause a Pepperidge Farm franchisee severe emotional distress, to make an example of the franchisee so as to deter other franchisees from joining an association.(22) This case demonstrates the very substantial risk a franchisor takes if it attempts to intimidate a franchisee from joining or supporting an association.
C. Attempts to harass and intimidate franchisees
The conduct of the franchisor in the Carvel ice cream chain was deemed by a New York state court to amount to overt intimidation and harassment. The franchisees had organized to support legislation. The franchisor's response was to demand to address the group and to be provided with a list of members, and to confront franchisees at the meeting with threats of termination of their franchises. The franchisor's Motion for Summary Judgment was denied by the trial court based on its egregious conduct and the appellate court affirmed on appeal.(23)
D. Attempts to deny renewal and expansion rights
In a recently settled case brought in federal court in Missouri, a Taco Bell franchisee was able to demonstrate that there are serious consequences when the franchisor engages in retaliatory conduct towards a franchisee leader.(24)
Franchisees from around the country had banded together to form the International Association of Taco Bell Franchisees. The mission of the association was to bring issues of concern to the franchisee community to the attention of the franchisor. The association communicated its positions on certain issues concerning member franchisees to Taco Bell. It also discussed to their concerns with the media and the United States Congress. The plaintiff franchisee became a member of the association and later the Chairman of its Executive Committee. Taco Bell did not appreciate these activities, including the media attention brought to them. It referred to the association leaders as "renegades and scum".
Taco Bell publicly stated that the leaders of the franchisee association would not be granted expansion rights within the system.
Taco Bell had a previously established a three step process for approving a request by a franchisee to establish a new location. The franchisee alleged and was able to demonstrate that a fourth ad hoc step to this process was added just for him because of his "attitude problem". Although the franchisee had previously been approved for a new location on the basis of operational and financial criteria, his requested was denied. Taco Bell admitted that no franchisee in the system had ever been denied expansion rights for "attitude problems." In addition, Taco Bell refused to approve the renewal of the franchise agreements for another of the franchisee's locations.
Taco Bell's motions to dismiss and for summary judgment on various of these claims were denied by the Court, with the court stating that Taco Bell's exercise of discretion might well have been in bad faith and based on evil motives.
Counsel for the franchisee informs the writer that during the pendency of the litigation, the franchisee was able to sell all of his locations to a third party for fair value. The new franchisee promptly secured the renewal of the franchise agreement that Taco Bell had refuse to renew. In addition, Taco Bell paid the franchisee $500,000 as a settlement.
E. Attempts to Deny Access to Sources of Supply
In a 1983 case(25), the First Circuit of Appeals affirmed a jury's determination that an automobile dealer had been denied a sufficient number of automobiles by the distributor in retaliation for his activities as president of a franchisee association. The dealer had participated in the presentation of a list of demands presented to the distributor. There immediately followed a series of retaliatory actions which included wrongful accusations of misconduct in sales promotions and knowingly filing a false complaint against the dealer with the state Attorney General. Most significantly, the manufacturer disregarded its own allocation formula and "shorted" cars to the dealer.
The dealer's claim for the profits lost on the cars he was denied the opportunity to sell went to the jury, which awarded $1.419 Million in damages, exactly the sum demanded by the dealer. The distributor was unable to offer any explanation of why it had shorted the dealer. On appeal, the First Circuit affirmed the jury verdict but reduced the amount damages by $950,000, still leaving a judgment of over $1 Million including interest.
The lesson for franchisors here is clear: juries have little patience with franchisors that retaliate against franchisees for exercising their rights of free association. In this case, the conduct was especially blatant.
F. Attempts to Terminate
A Polar beverage distributor in Massachusetts utilized the theories of breach of the implied covenant of good faith and fair dealing, tortious interference with advantageous relationships and violation of the state unfair and deceptive practices act to win a jury verdict against the manufacturer that had terminated the distributor on just four days notice.
In this 1996 case(26), the plaintiff distributor had an unwritten distribution agreement. The president of the distributorship had written a letter to other distributors inviting them to attend a meeting to discuss the possibility of forming an association to negotiate with Polar. The notice of termination was timed to be effective precisely on the eve of the scheduled meeting. The vice president of Polar admitted that the grounds for termination cited in the notice to the dealer, that his letter of credit had expired, was a pretext.
The appellate court stated that the there was ample evidence from which the jury could have found that the notice of termination was "calculated to put the dealer out of business and thereby discourage other distributors from attending the organizational meeting". The court referred to Polar's "opportunistic timing", as "more than a mere coincidence". After correcting a mathematical error by the judge, the appellate court affirmed a $225,000 judgment in favor of the distributor.
G. Denial of Consent to Transfer
The Popeyes Chicken franchise chain(27) was the setting for a dispute between the franchisor and a multi-unit franchisee over the refusal of consent to transfer the franchise. The franchisee alleged that the refusal to grant consent was the result of an apparent dislike of the franchisee due to his ethnic background and his activities on behalf of a Western Franchise Association within the Popeyes system. The franchisee cited the termination of options under development agreements with the franchisor, revisions to store evaluation reports and derogatory remarks made to other franchisees to discourage them from supporting the association. The franchisor's motions for summary judgment on the franchisee's claims based on breach of contract and the implied covenant of good faith and fair dealing were denied. While the court was not favorably disposed toward the implied covenant claims, it did state that based on the evident hostility toward the Western Franchisee Association, the franchisee could present to the jury the question of whether the franchisor had acted reasonably in withholding consent to the sale.
H. Attempts to Intimidate Counsel for a Group of Franchisees
In bitter litigation in the federal court in Illinois involving Oil Express(28), this quick oil change franchisor named the franchisees' attorneys as proposed defendants in the litigation, claiming that those attorneys had induced a group of franchisees to breach their franchise agreements by refusing to pay royalties and advertising fees. The franchisor alleged that the attorneys had made a demand that it lower its royalty rate from 5% percent to 1% percent and that this conduct amounted to extortion.
In 1998, the court was called upon to decide whether claims against the franchisees' attorneys, on the basis of alleged tortious interference with contract and on antitrust grounds, could be added by way of amendment to the then existing claims. The court denied the franchisor permission to add these claims on the basis that the franchisees had already decided to breach their franchise agreements before they had contacted the attorneys. By this time, 25 of the franchisor's 58 franchises had joined the alleged boycott.
The court pointed out that by the time the royalty reduction demand been made, the franchisor had already terminated the franchise agreements in question. There was thus no way for there to be any threats against franchisor.
Finally, the court stated that attorneys act under a qualified privilege when advising clients on matters pertaining to contracts which shield them from claims of tortious interference when that advice results in their clients breach of contract. The only way to overcome that qualified privilege is to prove that the attorneys acted with actual malice; this requires proof of the attorney's desire to harm the opposing litigant unrelated to be actual interests of the attorney's client. As there was no allegation or proof that the attorneys had any independent interest in or relationship to the franchisor, the franchisor's claim failed.
1. This statement was made by a least one the witnesses sponsored by the International Franchise Association at the Hearing held by Chairman Gekas of the U.S. House Subcommittee on Commercial and Administrative Law, Committee on the Judiciary on June 24, 1999.
2. For example, Item 10 of the UFOC of Pearle Vision, Inc. dated February 6, 1999 offered to finance "...up to 90% of the total purchase price of the ...store...".
3. See 17 CFR §§ 230.501-230.508
4. See 17 CFR § 230.501(a) (5-7)
5. McAlpine v. AAMCO Automatic Transmissions, Inc., 461 F. Supp. 1232 (E.D. Mich. 1978).
6. The author is counsel to the Independent Association of Jackson Hewitt Franchisees, Inc, which maintains an extensive web-site, www.iajhf.org. It includes the e-mail address of all of its officers and directors and a message board reflecting the latest concerns of and issues facing Jackson Hewitt franchisees. This site would be a valuable resource for a prospective franchisee of that system.
7. The author serves on the Board of Directors of the American Franchisee Association, which also maintains and active and extensive website at www.franchisee.org. It includes information that would be of value to a prospective franchisee such as a presentation on "Buying a Franchise: How to Make the Right Choice."
8. The Item 3 of the April 1, 1998 UFOC for Great Clips, Inc. discloses that it successfully sought a Declaratory Judgment against one of its franchisees who contended that the franchisor's mandated whole dollar pricing policy violated the franchisees rights under applicable antitrust laws. This lawsuit and its result is an important item of information for a prospective franchisee of Great Clips who can conclude that the franchisee does not have control over the retails prices it charges and that the franchisor is willing to sue a franchisee that questions the legality of the franchisor's policies.
9. Indeed, the due diligence standard for the purchase of a franchisor includes the disclosure and investigation includes "...any pending lawsuits or controversies and any known claims asserted by or against third parties...or any facts which may reasonably give rise to such claims". See Mergers & Acquisitions of Franchise Companies, Leonard D. Vines, Editor, American Bar Association Forum on Franchising, 1996, Appendix A, Section VII.
10. This true of seven of the eight top pizza franchise agreements reflected in the Pizza Study. The only exception is market leader Pizza Hut which does not grant any renewal rights in its franchise agreement. See Appendix B . In many way this is a more forthright way of dealing with the possible extension of the franchise relationship at the end of the term. The other pizza franchisors and franchisors generally suggest that there is a right to renew when that is not really the case.
11. Webster's New Collegiate Dictionary, G & C Merriam Company, 1974.
12. See TCBY Systems, Inc. v. RSP Co., 33 F.3d 925, 929 (8th Cir. 1994) (finding that it is proper to look to a franchisor's brochure as evidence of the meaning of the site selection provision of the parties' Franchise Agreement); Brenan v. Carvel Corp., 929 F.2d 801 (1st Cir. 1991) (finding that it is proper to look at a franchisor's disclosure statement in determining the intent of the agreement); Chicago Premium Yogurt, Inc. v. Yogurt Ventures, U.S.A., Inc.,No. 91 C 0209, 1992 WL 3705 at *2 (N.D. Il. Jan. 2, 1992) (UFOC properly considered in assessing whether failure to approve assignment of franchise was a breach of the Franchise Agreement); Peterson v. Mister Donut of Am., Inc., No. 87-3205 (AET), 1988 WL 71734 (D.N.J. July 6, 1988); Thompson v. Atlantic Richfield Co., 663 F. Supp. 206, 209-10 (W.D. Wash. 1986).
13. Statement of basis and Purpose Relating to Disclosure Requirements and prohibitions Concerning Franchising and Business opportunity Ventures, 43 Fed.Reg. 59621-733 (Dec. 21, 1978),. Bus. Franchise Guide (CCH) ¶6330.
14. For a persuasive statement of the position in favor of mandatory earnings claims, Mandatary Earnings Claims: They're As American As Motherhood And Apple Pie!, Rupert S. Barkoff, ABA Forum on Franchising, 1997.
15. See Robert E. Bond, Franchising: The Bottom Line, Source Book International, 1995.
16. For example, see the Pizza Study, Section I(A).
17. See Preliminary List of Legal Due Diligence Materials, Section XII, page 235.
18. See Shannon P. Pratt, Robert Reilly and Robert P. Schweihs, Valuing a Business, Third Edition, Irwin Professional Books, A Times Mirror Company, 1996.
19. McAlpine, supra
20. See M.G.L. c. 93B, §4(3)(l).
21. See M.G.L. c. 93B, §10.
22. Pepperidge Farm, Inc. v. Mack, Bus. Franchise Guide (CCH) ¶ 9530 (S.D. Cal. 1989).
23. State of New York v. Carvel Corp., Bus. Franchise Guide (CCH) ¶ 7780.
24. Darrell Dunafon v. Taco Bell Corp., Bus. Franchise Guide (CCH) ¶ 10,919 (W.D. Mo. 1996).
25. Jay Edwards, Inc. v. New England Toyota Distributor, Inc., Bus. Franchise Guide (CCH) ¶ 7986 (First Circuit 1983).
26. Cherick Distributors, Inc. v. Polar Corp., Bus. Franchise Guide (CCH) ¶ 10,997(Mass. Appeals Ct. 1996).
27. Popeyes, Inc. v. Yuzo M. Tokita, et al., Bus. Franchise Guide (CCH) ¶ 10,384 (E.D. La. 1993).
28. Oil Express National, Inc. v. John D'Alessandro, et al., Bus. Franchise Guide (CCH) ¶ 11,400 (N.D. Ill. 1998).