David Griffith Law

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THE ‘REVOLUTION’ IN FRANCHISING
FRANCHISORS FACE NEW REGU-LATIONS AND A RISING WAVE OF FRANCHISEE DISCONTENT

By David M. Griffith, Esq.

That the franchising industry provided a huge helping hand in boosting America out of one of its worst recessions in the Twenthieth Century is hardly news. Over 540,000 franchise outlets account for over one-third of all retail sales in the United States, employ over eight million people and have provided 400,000 new jobs since 1990. A new franchise opens somewhere in the U.S. every 16 minutes in this $800 billion business, which is projected to grow to over $1 trillion in sales by the year 2000. While gross national product barely edged up in recent years, franchise sales of goods and services by the nation’s over 3,000 franchising companies are experiencing annual growth in the 13-14% range. But an industry that started in the 1950’s, gained momentum in the 1960’s and 1970’s, and matured in the 1980’s is under a surprising attack from all sides in the 1990’s, and major changes are underway that promise to shake franchising to its very core.

The New Franchisees

The huge and growing franchise industry has been swelled by the ranks of thousands of laid-off corporate managers with no small business experience who are counting on franchisors to train and guide them. Many of these individuals are former middle managers who experienced corporate downsizing and are not turning back to the corporate fold, but are instead turning to franchising. The new crop of franchisees is coming armed with years of managerial experience and capital provided through generous termination packages. The new arrivees to franchising are bringing new ways of doing business and a reluctance to play by the old rules. This in part seems to be adding increased tension to the natural strain between franchisors and their franchisees.

Points of Franchisor/Franchisee Conflict

Contrary to popular belief most franchise systems are not run by big corporations like McDonald’s. Many of the problems now emerging are tied to the new franchisees who are risking their life savings, often several hundred thousand dollars or more, on franchises that they know little about, and that seem to have sprung up from nowhere. Coupled with the fact that the number of franchise offerings has risen dramatically in recent years in response to the demand, with Entrepreneur magazine’s cover in January 1994 pronouncing ‘over 777’ different opportunities, and thus it comes as no small surprise that the industry has become ripe for a number of frauds being perpetrated by fly-by-night franchisors, as recently reported in The Los Angeles Times and The Wall Street Journal.

The Franchisee ‘Bill of Rights’

While the vast majority of franchises being offered today are legitimate, there are numerous heated battles being fought by franchisees against major American franchising corporations on issues like encroachment, transfer and renewal rights, supply sources, and markups on products supplied to franchisees. (Collectively these issues are often referred to as the ‘franchisee bill of rights’). The net result has been an intensive effort by franchisors to police themselves through their own trade association, the International Franchise Association (IFA), a flurry of federal and state adminstrative and legislative activity, and the creation of two new franchisee trade associations designed to even the ‘balance of power’ in the industry.

A Short History of Franchise Regulation

Regulation of franchise sales is relatively new, first having been adopted by the State of California in 1971 with its “Franchise Investment Protection Act.” The Federal Trade Commission followed later in 1979 with its own regulations which mandate disclosure as a prerequisite to sales of franchises. The so-called “FTC Rule”, however, does not require federal registration for sales of franchises (franchisors are not even required to file their disclosure document with the FTC). This is left to the states and so far only California and 14 other states require pre-registration. Generally, franchisors selling franchises in the State of California comply with both federal and state law by filing a Uniform Franchise Registration Application with the Department of Corporations, which contains the required disclosure document, known as the Uniform Franchise Offering Circular (UFOC) and key exhibits such as the franchise agreement and financial statements, all of which must be given to a franchisee prior to the time that a franchise agreement is executed. Sales of franchises are not allowed in California until the Department of Corporations reviews this application and the UFOC, the franchisor makes any requested changes, and the registration is declared effective.

The New Uniform Franchise Offering Circular (UFOC)

The first major change in the UFOC format since 1975 was recently approved by the Federal Trade Commission after a three year drafting effort by the North American Securities Adminstrators Association (NASAA), the national association that represents state securities agencies regulating the sale of franchises in their states. The changes will take effect on January 1, 1995, or sooner if the 15 states requiring pre-registration of franchise sales programs approve the new guidelines. California adopted the guidelines earlier this year and has given franchisors an option to comply with either the old or the new guidelines until December 31, 1994, after which they will be required to meet the new standards. The new guidelines were a direct result of the recent intensifying scrutiny of the franchising industry by state legislatures. They represent a middle of the road approach that hopes to avoid more instrusive so-called ‘relationship’ laws that have been adopted in certain states and are under consideration by numerous others, including California.

New Items Required by the Revised UFOC

Some of the new items required by the revised UFOC: a list of marketing agents in the franchisee’s state; a list of state laws or pending bills that could affect the business; information on past franchisor litigation and bankruptcies, if any; notice of advertising and purchasing cooperatives; notice of restrictions on products or services, which were required before only if franchisors received the revenues; an estimate of initial fees and start up time; a more detailed account of site selection procedures; a chart outlining fees collected and imposed by the franchisors; a chart outlining franchisee obligations; and a previewing of the operations manual before agreement. Interestingly, no projected earnings claims are required, but NASAA is now reviewing a mandatory earnings claim requirement.

New International Franchise Association Code of Ethics

The IFA worked closely with the FTC and NASAA in the preparation of the new disclosure requirements. Additionally, in an attempt at self-policing, the IFA adopted a code of ethics for the first time in its thirty-two year history in 1992. This document, labeled the “Code of Principles and Standards of Conduct”, covers such areas as encroachment, renewal and termination, franchisee advisory councils, and transfer rights. The IFA also named an ethics committee to evaluate complaints, which meets twice a year or more to recommend specific enforcement actions to the IFA’s executive committee. This panel is charged with the responsibility of resolving complaints and disputes without litigation, and includes two franchisees and two franchisors. Within the last six months, the Code was quietly amended, however, to declare that no new franchisee rights were intended by this document. This recent controversial action has given partial rise to the latest Congressional hearings and state activities examining the franchising industry.

Congressional Legislative Activity (The LaFalce Bills)

The IFA’s rewrite of its Code of Ethics has been severely criticized by its most ardent Congressional foe, Representative John LaFalce (D-N.Y.), who presently has three bills pending in Congress regarding fair franchising, disclosure and data collection. Congressman LaFalce believes that the FTC, the states and the IFA have not gone far enough to redress current franchisee grievances. His disclosure bill would add additional items to the revised UFOC, and his relationships bill would ensure the so-called ‘franchisee bill of rights’ and a private right of suit making it easier to substantiate franchisor misconduct than proving fraud in court under current FTC disclosure rules. In hearings held this summer, Representative LaFalce’s House Small Business Committee reviewed the IFA Code of Ethics and blasted the rewrite, saying that the IFA had restricted the applicability and enforcement of the Code and that the revised Code eliminates or waters down discussion of supply sources, termination rights, encroachment, and other critical issues.

New Federal Legislation Needed to Correct Past Abuses?

Congressman LaFalce’s Legislative Assistant, Dean Sagar, stated in a telephone interview that “a lot of abuses were pioneered by the bigger companies and have now become entrenched in the industry....the bills introduced by the House Small Business Committee are a direct result of this.” Sagar noted the Congressman’s position that self policing is not working because the only sanction available is expulsion from the IFA, and that is not considered sufficient to deter franchisor abuses. Sagar mentioned that about 25 states, including California, are now considering new legislation regulating the franchisor/franchisee relationship and that action in key states may occur before it does in Congress, which has not really focused on the franchising area because of other agenda items considered higher on its priority list, like health care and crime.

Franchise Relationship Laws - The Iowa Model

Along with the registration and disclosure laws, California and 16 other states have enacted so-called relationship laws to protect franchisee rights regarding arbitrary non-renewal of their franchise, encroachment by the franchisor or other franchisees, assignment rights and so forth. The most far-reaching franchise relationship law was passed in 1992 by the Iowa legislature, but has yet to spread to other states, although the list of states considering such an act is growing. California’s version, Assembly Bill 1920, was introduced in March, 1994 by Assemblymember Peace and is a set of amendments to the California Franchise Relations Act (Business & Professions Code Section 20000-20043).

Criticism of the Iowa-Style Franchise Legislation

The new Iowa law has many critics. The argument goes that while the franchisee may appear to be receiving more protections, the long term result will be increasingly complex regulations that will impact both franchisors and franchisees, and slow down the franchising process. They are concerned about tinkering with a system that been a very dynamic economic generator for four decades. In their view, adding new layers of controls may very well put a ‘chill’ on a true American success story. Their position is backed up by a 1993 study conducted by the United States Small Business Administration (SBA) which concluded that Congress and the states should go easy on franchising. The SBA study forecast that franchise sales will grow in the 1990s unless there is another major and prolonged recession, or unless regulatory curbs reduce the incentive for entering franchise relationships. The study further emphasizes the growing role of franchising in the economy and concluded that wider government regulation may have a negative ‘chilling’ effect on the industry.

The New Franchisee Trade Associations

Franchisees have not been content to wait for legislative action. They have formed two major trade associations in the last two years. The American Franchisee Association, an advocacy group headquartered in Chicago, held its first annual convention in Las Vegas this past spring and now claims to represent 13,000 outlets and over 6,000 franchisees. The American Association of Franchisees and Dealers, based in San Diego, was formed in May 1992 and claims 7,000 members. Both associations are intended to act as a counterweight to the IFA, located in Washington, D.C., which claims to represent over 700 major franchisors and recently opened its membership to franchisees for the first time in 1994.

Franchisee Advisory Councils

One of the approaches that savvy franchisor organizations are utilizing to retain good working relationships within their franchisee networks is setting up ‘advisory councils’ that usually meet on a quarterly or semi-annual basis to discuss issues of major concern such as menu items, pricing, equipment changes, marketing and advertising and legislative developments impacting both the franchisor and franchisees. Applebee’s is a good example of how such councils can work to keep the franchisor/franchisee relationship healthy. A nine member committee composed of seven franchisees and two members of senior management meet every 90 days to seek input from both sides. The result has been an unusual partnership that has kept franchisee complaints to an absolute minimum and resulted in a strong per unit sales performance of over $2.2 million per store. Other industry stalwarts like McDonald’s also employ an ‘ombudsman’ program where franchisees with complaints can be heard by a responsible corporate employee paired with a similarly situated franchisee who is available to act as a mediator. The results of such an approach have been a fair and impartial hearing for the aggrieved franchisee.

National Franchise Mediation Program

Along with the franchise advisory councils certain progressive franchisors established the National Franchise Mediation Program 1993, which has been used to successfully forestall litigation and claims over 15 major successful dispute resolutions to date. Franchisors run this program which operates as an alternative dispute resolution program to head off lawsuits over issues such as territorial encroachments. One franchisor has even gone so far as to establish a ‘democratic’ system similar to Congress for electing officials to a ‘national executive committee’ or board of directors. For the Paul W. Davis Systems Company, a 185 member insurance restoration franchise in Jacksonville, Florida, before any major changes can be made to company operations a two-thirds majority of both its board of directors and franchisees must approve it. Additionally, this firm has set up arbitration committees in each operational district elected and staffed by franchisees to resolve disputes between franchisees and the company. The net result has been that litigation costs have dropped by 90 percent in the last two yearand at least for this company the adversarial relationship between franchisor and franchisees seems to have been eliminated.