|January 31, 2000
Mr. Donald S. Clark, Secretary
Dear Mr. Clark:
Please include these rebuttal comments for consideration as the Federal Trade Commission (the "FTC" or the "Commission") commences its rulemaking to amend its Trade Regulation Rule entitled "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures (the "Franchise Rule" or the "Rule")."
The American Franchisee Association (AFA) is a national trade association of small business franchisees, representing 16,000 individuals who own over 30,000 franchised outlets in 65 different industries nationwide.
Specifically, the AFA is responding to Comment 24 submitted by the American Bar Association Section of Antitrust Law on [the] Proposed Small Business Franchise Act.
As the primary proponent of the Small Business Franchise Act (SBFA), HR 3308, introduced on November 10, 1999 by Congressmen Howard Coble (R-NC) and John Conyers (D-MI), our members are interested in keeping franchising a safe haven for new small business entrepreneurs.
We are aware that the Commission's rulemaking to amend the Franchise Rule has little if anything to do with the Small Business Franchise Act (SBFA). The Franchise Rule itself has no bearing on post-sale activities of franchisors and their franchisees. Unfortunately, however, because the Commission has published the Section on Antitrust's comments regarding the SBFA, we are compelled to rebut the obvious discrepancies and totally overblown statements submitted by the Section on Antitrust.
Overview of Franchising
Despite the dominant role that franchising plays within the U.S. economy, there are fundamental flaws in its basic structure. A gross disparity in economic strength and bargaining power between franchisors and franchisees has led to increasingly onerous provisions and allowed some franchisors to engage in unscrupulous business practices. Such agreements are impeding entry into markets and stifling free trade and competition.
An individual wishing to enter or advance within an industry has two choices: join a franchise system or go it alone and compete with franchise systems, which possess an overwhelming advantage. However, when determining which system to join, franchise agreements are substantively so alike that there is no real choice to be made. These agreements strip the prospective franchisee of many of the protections one would assume to be built into any normal business relationship.
Provisions allow unscrupulous franchisors to deny their franchisees the realization of goodwill and value they may have invested many years and their life savings to develop.
In this respect, franchising today most resembles indentured servitude. In the Middle Ages, people would "freely" choose to bind themselves to the land, work it for a number of years and pay a large portion of the profits to the landowner. During this period, you could not leave the feudal manor, seek work elsewhere or even take a night job for a neighboring lord to get a little further ahead. When the indenture period was up, you were faced with a choice, re-pledge yourself to the feudal lord, even if he demanded twice his prior share, or simply walk away from the home you built and the crops you developed.
Similarly, if a franchisee is subjected to unfair treatment by his or her franchisor there is little recourse. The franchisee generally has no relative strength to negotiate effectively. Because the contracts are so one-sided in favor of the franchisor, there is generally no legal recourse available. Because of non-competition covenants contained in most franchise agreements, the franchisee is not even free to leave the system and compete individually or associate with another franchise system that provides value or deals fairly with its franchisees.
If a franchisee has the resources to challenge a franchisor's conduct in court, he or she is subject to highly subjective and inconsistent treatment within the legal system. Because there is no federal legislation establishing consistent standards, franchise agreements often contain choice of law and venue provisions which allow the franchisor to control the substantive law which will control any dispute including the place the matter has to be resolved. This means that a Nevada franchisee could be forced to litigate in Maine and be subject to Illinois law. This "forum shopping" allows franchisors to insulate themselves from a good number of lawsuits because of the great expense and inconvenience a small business person would have to incur to vindicate his or her rights even in the most egregious of cases.
The courts are a costly and ineffectual alternative to resolving the inherent flaws in franchising. Despite the many inconsistent legal rulings, some courts have clearly identified the current inequities within franchising. For example, a California court described many franchise agreements as contracts of "adhesion," containing "unconscionable" terms (Postal Instant Press, Inc. v. Sealy, 1996, 43 Cal. App. 4th 1704). A United States Court of Appeals comment went so far as to refer to a franchisor's agreement (which is similar in many material aspects to that of many franchise systems) as "commercially unreasonable." Unfortunately, the franchisee who was the beneficiary of this ruling was already forced to file bankruptcy due to the franchisor's bad faith tactics (In re Vylene Enterprises, Inc. v. Naugles, Inc., 9th Circuit, 1996, 90 F.3d 147).
While the FTC pomotes adequate pre-sale disclosures, the FTC refuses to become involved in and has been totally ineffective in promoting fairness and free competition in franchising. The FTC does not review any of the representations contained in franchisors' offering circulars. A 1993 United States General Accounting Office Report found that the FTC acted on less than 6% of all franchise complaints brought to it (Report to the Chairman, Subcommittee on Oversight of Government Management, Committee on Governmental Affairs, U.S. Senate, Federal Trade Commission Enforcement of the Trade Regulation Rule on Franchising, July 1993).
As a result, there is a great need for fair, universal baseline standards of conduct for franchising. The SBFA will alleviate the inconsistent treatment of franchisees within the states. It will also ensure that the basic tenants of fair and responsible business practices are a part of franchising. The result will be a reduction in costly and unproductive litigation and encourage continued domestic involvement in franchising, a way of doing business which plays a vital role in our nation's economy.
HR 3308 is Pro-Competition
The SBFA, HR 3308, prohibits current exclusionary and anti-competitive practices of certain franchisors. This makes good business sense because having competing vendors producing conforming goods always results in lower prices to consumers.
The lawyers in the Antitrust Section are not interested in promoting competition. They are not interested in protection of the marketplace. They are interested in protecting their clients' kickbacks, rebates and promotional fees.
The main effect of Section 10 of the SBFA will be to increase franchisee's freedom to contract with honest suppliers at fair prices. Section 10 will end franchisors' ability to designate a single supplier for goods and services franchisees are required to purchase "unless otherwise agreed to by both the franchisor and a majority of the franchisees." It will also require the franchisor disclose and distribute to the franchisees any "benefit" it received from such vendors. This section prevents franchisors from designating a supplier for a good or service in return for a "rebate" or "discount" which benefits the franchisor but the cost of which will obviously be passed along to the captive market of franchisees in the price they pay.
There is a statutory basis to guarantee competition across non-proprietary products. For example, the Indiana Deceptive Practices Act, in existence since 1985, states it is unlawful for any franchise agreement in Indiana to contain a provision (Sec.1(1)) "requiring goods, supplies, inventories or services to be purchased exclusively from the franchisor or sources designated by the franchisor where such goods, supplies, inventories, or services of comparable quality are available from sources other than those designated by the franchisor. This does not apply to the principal goods, supplies, inventories or services manufactured or trademarked by the franchisor."
Section 1(4) of the Indiana Deceptive Practices Act goes on to say that it is unlawful for any franchise agreement in Indiana which allows "the franchisor to obtain money, goods, services or any other benefit from any other person with whom the franchisee does business, on account of or in relation to, the transaction between the franchisee and the other person, other than for compensation for services rendered by the franchisor, unless the benefit is promptly accounted for and transmitted to the franchisee."
Another example is contained in the Iowa Franchise Act, in existence since 1992. Sec. 12(1) of the Iowa Franchise Act states " a franchisor shall allow a franchisee to obtain equipment, fixtures, supplies and services used in the establishment and operation of the franchised business from sources of the franchisee's choosing, provided that such goods and services meet the standards as to their nature and quality promulgated by the franchisor." Sec. 12 (2) continues, "Subsection 1 does not apply to reasonable quantities of inventory, goods or services, including display and sample items, that the franchisor requires the franchisee to obtain from the franchisor or its affiliate, but only if the goods or services are central to the franchised business and either are actually manufactured or produced by the franchisor or its affiliate, or incorporate a trade secret owned by the franchisor or its affiliate."
The Antitrust Section has provided no empirical evidence to show that franchisors--their clients--have ceased to do business in either Indiana or Iowa since these two statutes became law. There has been no documented mass exodus of franchising businesses from these two states. There is no brand name franchisor, which refuses to do business in these states because of their independent sourcing provisions.
Within the parameters of HR 3308, the SBFA, if the franchise offering is positioned and disclosed as a product franchise, then it is legal. For example, if you are buying a yogurt franchise and the proprietary product is the yogurt, the franchisee has to buy the yogurt from the franchisor or its designated supplier at whatever price the franchisor determines.
However, if you buy a pizza franchise, and the franchisor (or its supplier) charges 30% more for the cardboard box that carries the pizza to the consumer, then that would be illegal under the SBFA. The cardboard box is not a proprietary product. The consumer does not eat the cardboard box. The consumer does get the bill, however, in paying the 30% extra mark-up in the price of the pizza they just had delivered.
Section 11 of the SBFA does not prohibit franchisors from expanding and encroaching upon their franchisees. It does, however, state that consideration must be paid to the existing franchisee if the impact is 5% or greater on the established unit.
If you took action that was the direct cause of your partner losing money, you would need to make him or her whole. The SBFA is merely asking for a percentage of monies lost over a limited period of time to make the franchisee whole.
Who in their right mind with true freedom to contract would enter into an agreement under which they pay the franchisor to allow him or her to open a business only to have the franchisor accept another fee from another franchisee to open the same business next door?
Where parties have some equality they can negotiate a reasonably balanced relationship. Where one party has all the power, it can impose an agreement, which reserves all the power for itself.
The Antitrust Section's position is particularly disingenuous when coupled with the non-competition covenants that they seek to protect which is discussed below. Most franchise agreements contain both non-competition covenants and a reservation of the franchisor's right to directly compete under the same brand name anywhere it wants. This double standard exemplifies how onerous current franchise agreements can be, as well as the threat that these agreements pose to the continued growth and prosperity of franchising as a whole.
Duty of Due Care
Section 5 (b), Duty of Due Care, requires that a franchisor have at least a minimum level of skill or knowledge in the field in which it is offering franchises. This is a logical requirement because most if not all franchisors sell their skill and knowledge to potential franchisees. The SBFA nonetheless offers a franchisor without such skill or knowledge several means to avoid violating this requirement.
Subsection (b)(1) allows a franchisor to "conspicuously disclaim that it has skill or knowledge" and therefore avoid the requirement. Section (b)(2)(B) allows a franchisor to satisfy the requirement by showing that "it contracted for, hired or purchased the expertise necessary ". Finally, the franchisor can "limit in writing the nature and scope of its skill and knowledge provided that no inconsistent representation, whether written or oral, is made to the prospective franchisee ".
Any potential for liability under this section can easily be avoided by a clear disclosure of the franchisor's level of skill and knowledge. The Antitrust Section's concern that this clause will have a "potentially chilling effect on market entry and innovation" is overblown. At worst this provision will give the unscrupulous pause before they misrepresent their level of skill. Anyone who has developed and operated a successful concept before offering it as a franchise opportunity or any franchisor who honestly discloses or describes its level of skill or knowledge has no reason to be chilled by this section. Only someone desiring to defraud franchisees should have any concerns about this provision.
Duty of Good Faith
Section 5(a) confirms the common law doctrine that every contract imposes an implied duty of good faith on the parties. As stated in the SBFA, this is a reciprocal duty for both the franchisor and franchisee. This clause mirrors the language courts have used to describe the duty of good faith: "There is implied in every contract a covenant by each party not to do anything which will deprive the other parties thereto of the benefits of the contract [T]his covenant not only imposes upon each contracting party the duty to refrain by any act of his own, but also the duty to do everything that the contract presupposes that he will do to accomplish its purposes (Harm v. Frasher, 1960, 181 Cal. App. 2d 405, 417)."
The Restatement 2nd of Contracts (section 205) agrees that the covenant (similarly described) is part of every contract and lists examples of good and bad faith performance. Contrary to what the Antitrust Section stated in their comment to the Commission, there is nothing new or novel about Section 5(a)'s codification of this duty.
Post-Term Restrictions on Competition
Section 4 c) makes unenforceable the common franchise agreement's prohibition against engaging in a similar business after the franchise agreement expires. The section also, however, contains clear exceptions for narrowly drawn prohibitions which prevent the former franchisee from continuing to use the franchisor's proprietary system, or from giving the impression that it is still a franchisee.
Subsection 4c)(2)(A) clearly recognizes the franchisor's right to prevent a former franchisee from using "intellectual property owned by the franchisor ". This section also in no way reduces the benefits to a franchisor of owning a trademark, trade secret or other intellectual property. It merely prevents the franchisor from granting itself the benefits of ownership where none exists by unilaterally asserting ownership in the franchise agreement. Actual ownership, which is certainly provable independent of a franchise agreement, will not suffer under the terms of this section.
Further, the very type of covenants the Antitrust Section wants to protect--restrictions on competition--is contrary to the United States' strong policy favoring competition. The basis of free enterprise is to encourage innovation and allow entrepreneurs to move freely within the marketplace. We already have laws restricting the use of trade secrets. We do not need to prohibit franchisees from engaging in their livelihood to protect a franchisor's dominance in a particular market.
Once a franchise is terminated, the franchisor is free to license a new franchisee in the same market area. Similarly, the franchisee should be allowed to compete freely against its former franchisor.
It is illogical for the Antitrust Section to oppose legislation, which seeks to raise the level of honesty and reduce the opportunity for deception in franchising. The Small Business Franchise Act does not handicap honest franchisors who do not mislead potential franchisees to make their systems grow. Instead, by raising the credibility of franchisors as a group, it will aid growth and efficiency, as franchisors will not need to expend time, energy and money convincing franchisees that they are trustworthy.
I would like to personally thank Peter Singler, Jr., Esq., Carter & Singler, LLP, Sebastopol, California, for his contributions in preparing this response.
Susan P. Kezios