Video Transcription

Hi. My name’s Jeff Goldstein of the Goldstein Law Group. We represent franchisees in states around the country. We represent only franchisees in litigation, as well as counseling aspects. What I’d like to speak to you today about is what’s called the franchise system standards manual or operations manual. This is, in essence, the Bible of how a franchise is to be operated according to the franchisor. We see a lot of these operations manuals at our practice as we represent only franchisees in states around the country. The franchise system standards manual can involve very, very basic ideas as to color of shirt, whether the franchisee-employee wears a hat, the wattage of a microwave, to things like whom the supplier would be for a franchisee or whether a franchisee is permitted to source his own products so long as they’re competitive. And it can go all the way up to very significant aspects of the franchise relationship concerning pricing as well as upgrades, remodeling and renovations.

With respect to a franchise system standards manual, there’s always a tension as there is in almost any other aspect of a franchise relationship. The franchisor attempts to impose as much control over the situation as it can in terms of uniformity of its system. The franchisor also, since it’s not footing the bill for meeting many of these requirements and standards, has way more standards than they would if they were otherwise forced to internalize or pay for these themselves. The franchisee, on the other side of these rules and regulations, doesn’t want these things too ambiguous. He wants very specific standards and rules that he can follow, and he also doesn’t want them to change over time, and he also doesn’t want these things to impose an unreasonable burden or expense on his business.

So, when you look at system standards manual, you can take three different views. At least the way I look at it, you can have a pro-franchisor view that says there should be almost no limits on the standards that they can impose. The franchisee wanting as few standards as possible, wanting to get away as inexpensively as possible in operating the business. And then you’ve got an in-between ground, and this is what you might call a cost-benefit ground or a reasonableness program where you would balance the costs of that standard or regulation on the franchisee’s business. You can see these three, what might be called competing positions, throughout state statutes of which there are a few on this issue and court decisions.

In regard to those competing conditions, and you’ve got three different competing considerations that’ll run through almost every area of franchise law, they manifest themselves, in this case, in one question, and that’s how much discretion does a franchisor have to modify or enact new franchise regulations or rules and put them in the operations manual? You’ve got a few states that have some regulations or rules that might apply to this issue of operations manual and you’ve got many states that don’t explicitly or even implicitly. There’s no federal legislation that addresses this and, other than those few state statutes that I’ll mention in a minute, all you have is court decisions which the majority, I would say the overwhelming majority of those cases, also go in favor of the franchisor, allowing him the utmost discretion in terms of enacting or changing operations manual standards and rules.

If we take a look at California, California has a Disclosure Act that says that if there are any material modifications drawn up by the franchisor, he must give them to the franchisee and disclose them. Now, the franchisee, who’s invested all this money over time is getting ready to renew and all of a sudden he sees a new system standards manual that imposes or increases his cost by 20%. Now, in most statutory realms, if there’s a violation a franchisee is able to sue for his damages, which would be the 20%, theoretically. Here, the California statute gives the franchisee a choice, and it’s really a Hobson’s choice because he can either keep operating with that new costly standard or can he simply not sign up and leave his business. Not a very good alternative, however, as I say, that’s a small bit of consolation that you get out of a state California statute.

In Hawaii, that state’s statute permits modifications to the franchisee’s obligations only if they’re not material. And then you get into the factual question as to whether those obligations created by the new or modified system standards regulation are going to be material, and you’ve got a lot of case law in that through the common law and through material breaches in contracts law. New Jersey has a really good component and, in my opinion, one of the very best. It doesn’t permit the franchisor to impose unreasonable standards of performance, and the question is what is that? There have been a few court cases that have interpreted that. However, this unreasonableness does allow the franchisee to get in front of a court and say, “These particular new regulations and rules are unreasonable because my costs are increased disproportionately, or because some franchisees are harmed more than others with regard to the burden of the cost.” So at least you can get into court in New Jersey, whereas you can’t in almost every other state in terms of challenging a new operations manual standard.

There’s a case, ConocoPhillips, and I’m not gonna give you sites and statutes during this but I’ll refer to that case briefly. It was a service station where the franchisor changed his actual fees and cost to the franchisee, to the dealer. Franchisee challenged it and the court held that damages wouldn’t be allowed to the franchisee, he could either stay in the system or leave. Again, a Hobson’s choice, not all that great, but at least the franchisee was able to get into court on that.

There’s another case, Bird Hotel versus Super 8. This had to do with a promotional program that it previously used to cost the franchisee 2%, then it went up to 10% if I recall the number. The franchisees challenged it because this was, in essence, a change to the franchise agreement. One of the major components of a franchise agreement is the fees that the franchisee is gonna pay. This wasn’t a change as to the color of a shirt, as to a name tag, this was a change as to an actual fee. This is one of the few cases where the court appeared to have had enough of the discretion of the franchisor, said, “Look, this modification, you can make modifications in your operations manual but when they hit the concept of fees and costs,” and more I think about it, it’s really fees because costs have been…courts have allowed to go unbridled, “We’re gonna view that as a change in the franchise agreement.” So you do have one end of the spectrum, this Bird case where the court said that this operations manual change was not permissible because the operations manual basically changed one of the fundamental components of the franchise agreement.

Another case involves Dominos Pizza. I was involved in this initially, and this case had to do with a massive new computer point of sale system that Dominos was requiring that all of its franchisees put in place. It was very expensive and the franchisees reading the agreement felt that they had the alternative to source this product from an equally competitive computer manufacturer. Dominos argued, “No way, even though you have alternatives on certain other supplies, we’re making this a new system standards operations manual.” The courts sided with Dominos and said that the franchisor could, through a system standards manual, require that the franchisee put in this incredibly costly system without being able to source it from another qualitatively equal competitor.

There’s another, Burger King, several Burger King cases actually. One where the Burger King franchisor required its franchisees to change the amount of meat that they put into a particular hamburger. The court said that since franchising meant to achieve uniformity, that it was gonna allow Burger King to go ahead make that qualification even though it was costly, and they made it through the operations manual. There were also service station cases. I remember one where the franchisor had a new program that if the customer paid cash, he would get a discount on that gallon of gas even though the franchisee, otherwise, would have had control over the pricing. The franchisee objected, the court said that a franchisor does have the discretion even to put together a discount pricing program and force it on the franchisee through an operations manual modification.

There’s another case, La Quinta, which is a hotel case. And in there, the computer system standards which is a very big cost in hotels, for instance, that they were required to buy this entire new system, tens of thousands of dollars it could come out to be. The courts, in response to a challenge by franchisees, said that, La Quinta did have the option and the discretion to impose such a heavy duty program renovation upgrade on franchisees in the franchise system standards manual.

Now, one thing I may not have mentioned is that the way this becomes legally enforceable, you might say, “Hey, this thing is a foot long, foot wide sometimes or two inches thick. How can the franchisor get the franchisee to follow these things as though it’s a franchise contract?” It’s a really simple one-sentence provision that you can put in a franchise agreement by the franchisor that says, in essence, that the franchisee agrees to follow the system standards manual that’s promulgated by the franchisor, including any changes that are in the sole discretion of the franchisor. So when you’ve got that provision, the court looks at that, then looks over the franchise systems standards manual, and many courts, again, will look at those regulations almost as though they’re written into the contract. And again, theoretically, the problem there is that you’ve got a constantly changing contract, which is exactly what common law of contract says you shouldn’t have. You should have a very firm exchange of consideration in a contract, and everybody know what they have to do, and what they’re gonna be expected to do and what they can get from the person. And by incorporating the system standards manual, you’re basically taking the contract and making it into a living, evolving document which really doesn’t help anybody and certainly doesn’t help the jurisprudence in this area very much. Other cases that I had jotted down, I can come back to a few of those later.

What I wanted to talk about for a minute is the middle ground on these, whether a franchisor has discretion and how much to modify the system standards manual. Now, remember, we looked at the pro-franchisor view, that it needs uniformity in its system and it needs to have upgrades from time to time, and it needs to keep up with the market dynamic changes. The franchisee’s position, we discussed. Almost everything changed by the franchisor is a surprise, they didn’t work it in their budget. And many of the rules and regulations could, in fact, impose unreasonable costs on the franchisee. There are a few courts in some of the statutes that I mentioned above that will take a, sort of what you might call, a third view and that’s franchisor’s discretion is limited by the reasonableness of the new regulation. And this, basically, would go to the financial hardship or financial cost that would be imposed on a franchisee as a result of the modified regulation or the new regulation that’s put into the operations manual.

In hotel cases, there’s a fair amount of upgrading, usually on the turnover of a hotel. So, when a new franchisee comes in for a particular facility or a new brand for that facility, a franchisor will come in and do a punchless which basically requires the franchisee to meet certain updated or then current provisions that franchisees in that particular system, whether it’s Super 8, Holiday Inn, whatever, are required to meet. There’s a case, and I’m thinking of a Holiday Inn case, where a franchisor came in and required a complete new punchless during the tenure of the franchise agreement. The franchisee argued that it was impermissible for the franchisor to come in and make that change during the term of the franchise agreement. The court permitted it, saying that it’s only modernization and upgrading, and the franchisor needs the discretion to be able to do that. The court, in that case, did look quickly and mention that newly-adopted standards would have to increase profits of the franchisor at the expense of franchisees. And if that were the case, it could be invalid. However, that was not part of the holding, the main part of the case, so it’s difficult to take that language and try and apply it later for a franchisee trying to stop the burdensome operation standard manual from going into place.

There was another case, and this is a New Jersey case that I had mentioned before. New Jersey’s got a good franchise statute that says that a franchisor can’t impose unreasonable standards of performance on the franchisee, and that could touch on evolving system standards manuals, operations manuals and things of that nature. In this case, it was a dealer of auto parts and the restrictions were on territories. So, previously, the franchisee had a bigger exclusive territory, and later on it was taken away through modifications of the relationship. It actually had the impact of decreasing, I think, the revenues or the profits of the franchisee by 40%, that modification by the franchisor. And that was challenged by the franchisee with respect to it being an unreasonable standard of performance, and the court did buy into that argument but it would not permit damages. So, again, if you’re in New Jersey, you’ve got a much better shot than anywhere else to prevent these adopted standards.

There’s another Burger King case, as I had mentioned earlier. I’m gonna look through, quickly, some of my cases here and give you a short snippet of the ones I think that are applicable. There was another Burger King case, I think it was the value menu, and the franchisees argued that it wasn’t in the contract and that it was burdensome. Burger King argued, “Hey, we’re allowed to change this stuff over time. It’s in the operations manual. And even if it’s not in the franchise agreement, we’re permitted to keep up to date and compete with other franchisors.” The court, in that case, looked to a clause in the franchise agreement that said that the franchisee had agreed in advance to accept and comply with modifications and revisions. And again, I’ve discussed briefly above how amorphous and unspecific that is, and doesn’t allow franchisees to budget in anything with regard to a solid business plan. if the franchisor is permitted, over time, to make modifications whenever it chooses to. And one of those was the value menu here, but the court did find that Burger King had the authority and power to make that change.

Now, there was a subsequent Burger King case that also dealt with a component of that value menu, and that was the dollar cheeseburger. And the franchisees, I think that was a class action, were able to focus on a small component of the value menu and it was the cheeseburger that was a dollar. And they argued that, with respect to that one item, that the franchisor had evidenced bad faith and it was reasonable to the extent the law wouldn’t permit the franchisor to force it on the franchisee. Because it did, in fact, cost more to produce that dollar cheeseburger than they were selling it for. The court basically said that that’s a fact issue, and the franchisees could bring that claim forward and the court would consider it.

Now, the Federal Trade Commission has a franchise rule that focuses on disclosure, and I can do another set on that at a different time. But one of the requirements of the FTC and state laws that follow the FTC rule is that the franchisor must either give to the franchisee, in the disclosure document, a table of contents of the system standards manual or of the operations manual, or give it to the franchisee and allow him a reasonable period of time to review it before he signs. Personally, I think that that standard is not helpful whatsoever. If you look at 100 as being as helpful as you can get on that issue, 0 to 100, I would give this about 5. Let’s take a look at the first concept, that you can give the table contents to a franchisee. Look, you can give the franchisee a five-inch binder and put it into the disclosure document. It’s not going to help the franchisee to figure out what can be changed, what each of those regulations is requiring now in terms of cost. So, a syllabus or a table of contents is worse than useful because that lulls the franchisee into a false sense of complacency, thinking that there are only these fifteen general categories dealing with uniforms, and shoes and things of that nature, where it can be much more prickly as it’s used by the franchisor.

The other choice that franchisors have under the FTC rule is that they can give it to the franchisee so he has an opportunity to read it. It’s difficult for me to imagine that anybody could sit in a room and read one of these manuals. It’s actually impossible to read one of these full manuals in less than a day and a half, two days. And if you read them and you weren’t a franchisee to begin with, they’re as good as useless. And they’re worse than useless, again, if you’re gonna go through these and read a manual, or try and read a manual like that, to determine where major cost can be modified over time and try and protect yourself. So, although the FTC rule requiring some disclosures has some benefit, it’s a system that can be vastly improved, especially with its requirements on disclosing operations manuals.

As we’ve seen with regard to some of the issues I had discussed a little bit earlier, a franchise system standards manual can help everybody in a franchise system. It allows the franchisee to be competitive with all competing franchisees in other systems. It also allows up-to-date technology to be placed in and used by franchisees. However, on the other side, it also can drive particular franchisees into bankruptcy and taking away their entire investment. At the end of the day, when you’re reviewing a franchise agreement, you should always ask for the system standards manual. And if you go through the internet, you can see franchise lawyers saying to franchisees, “Make sure you read this thing before you buy a franchise.” It’s really ridiculous advice because lawyers can’t even read through an entire system standards manual and put it in context because nobody’s operated the business yet. There’s got to be some type of questioning that, if you get a good franchisee lawyer he can question the franchisor, or the salesman or the broker, and try and get answers to the question as to what kinds of system standards have changed over time, what have the costs been, and pin the guy down, or pin the woman down and ask them, specifically, what were the modifications. One thing you really should focus on, pointedly, has to do with renovations, upgrades, system standards regarding computers, point of sales, architecture. These are the big ticket items that, when they change, they really have the ability to wipe out your investment and your franchise.

This is the end of this section for today. I’ll also be having two other videos on operations manuals, and their impact on franchisees and how courts look at them. The next tape I’m gonna address very quickly has to do with a recent case, a Kentucky Fried Chicken case, dealing with remodeling requirements that were imposed on the franchisee that weren’t in the franchise agreement, that became part of the system standards or operation manual requirements of the franchisor. Thanks for watching today and again, my name’s Jeff Goldstein from the Goldstein Law Group. Give us a call if you have any questions on this. Thank you.

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