Feb 3, 2019 - Franchise Articles by |

Should Franchisees Foot the Bill for Franchise Remodeling and System Standards Modifications?

By: Jeffrey M. Goldstein

Franchise remodeling disputes have recently littered the franchise litigation landscape; but this is nothing new. The source of conflict in franchise remodeling disputes is not the ‘control’ issue (e.g., whether franchisees, not franchisors, should exercise final control over the type and amount of the franchisee’s business investments). Instead, the essence of the discord (at least from a static franchisee perspective) is whether a proposed or required remodeling is ‘worth it’ from a dollars and cents point of view. No more, no less. This same conflict that underlies remodeling disputes appears repeatedly in the franchise arena and also undergirds disputes associated with all significant franchise system modifications. Some of the more notable franchise system modifications that regularly give rise to disputes and litigation include menu item changes, new price ‘value programs’, price caps or maximum pricing, distribution channel supplementation, new computer system swaps and new marketing programs.

If franchisees were able to trust the business decision-making acumen, motivations and goals of their franchisors, clashes regarding remodeling, like most other significant franchising disputes, would tend to be a ‘non-issues.’ And, of course, if franchisors had a track record of making globally rewarding investment decisions, such trust, as well as an efficient means for resolving breaches of that trust, would already exist. Most franchisees, to the extent they are good businessmen, merely attempt to ensure that each of their franchise-related investments – not just remodeling – reaps at least a fair market return. Indeed, most franchisees would not take issue with the general concept that, to successfully compete dynamically over time, franchisors must have some flexibility to reasonably modify their products and services so that they can respond to new and changing competitor strategies and consumer tastes.

On the other side of the equation, most honest franchisors would acknowledge that franchisees cannot be expected to perpetually make ongoing investments and modifications with negative or below market returns. Indeed, some enlightened franchisors have in the past provided their franchisees various forms of indirect cost-mitigation or financing programs to assist them in carrying out the newly-demanded system modifications.

In this regard, even the best of franchisee lawyer demagogues would have trouble convincing groups of franchisees that an annual return of 50 cents on each dollar invested in constructing a new kitchen is coercive, oppressive and unscrupulous simply because the franchisee – not the franchisor – took control of the decision on that issue. And, similarly, even the least talented of franchisee litigators would have no trouble convincing a group of franchisees that an annual return of negative 25 cents return on each dollar invested in constructing a new self-service kiosk would be a financially unpalatable debacle, at least at the store level.

Given the seeming reasonableness of the respective competing positions, as well as the fact that both sides seem somewhat able to understand the views of the other side, it is not clear why there appears to be omnipresent franchisee-on-franchisor violence over system modification requests. The answer is three-fold. First, jurisprudence in the franchising area has evolved to a point where contracts and tort rules (those that are court-created, called the common law) exist based on their ability to minimize court and legal costs, rather than their ability to achieve other more emotional equitable goals. Interestingly, such cost litigation minimization rules do not always promote allocative efficiency. Second, prolific economic market failures plague the three relevant temporal franchise markets: pre-franchise purchase, during the franchise term, and post-termination or expiration of the franchise period. Third, opportunistic or less experienced franchisee litigators too-regularly mislead franchisees regarding accurate assessments of franchisees’ potential claims and defenses. Each of these failures will be examined seriatim below.
Market Failures Underlying Franchise System Standards Demands

First, franchise dispute resolution laws (common law rules) in the United States in 2019 are antiquated and inconsistent with the underlying economic realities of franchising. In the name of ‘the free market,’ many legal rules bring about a distorted laisse faire justice, and even then, serve to promote the efficiencies of litigation costs rather than the efficiencies or equities of the underlying challenged conduct – here franchise system modifications. The fatal historical turning point for franchisees in the jurisprudential realm was when court decisions began restricting the natural and intended reach of the covenant of good faith and fair dealing. Initially, free-standing good faith claims were prohibited; then bad faith conduct and motives by franchisors was given the green light; and then, in some cases, good faith duties during the relationship were ruled out unless some measure of discretion relating to very specifically articulated conduct was clearly evident in the relevant agreement. Another unfortunate and pivotal jurisprudential common law moment for franchisees was the liberal use of the ‘parol evidence rule’ to prevent franchisees from introducing evidence at trial to show that they had been defrauded by franchisor salesmen. In addition to these damaging common law substantive rules, myriad other canons of ‘contract interpretation’ have through legal evolution become jurisprudentially and systemically toxic to franchisees (e.g., using the ‘plain meaning’ doctrine and refusing to allow consideration of surrounding circumstances).

Second, prolific economic market failures lace the franchise relationship; these failures are qualitatively diverse, cloaked and esoteric. The impact of these uncorrected market failures (directly on franchisees and indirectly on franchisors and consumers) is enormous financially, socially, personally, economically and legally. I will briefly identify these economic failures by analytical time period, anchored on the time of execution of the franchise agreement: pre-purchase, during term, and post-term.

Pre-franchise-purchase, the following market failures exist: franchisees obtain palpably suboptimal information about the franchisor and its costs, revenues and profits, despite the FDD requirement; franchisees suffer from rampant systematic cognitive defects and clearly are unable to rationally assess individual franchise opportunities even if and when presented with adequate and material information; adverse selection leads incapable candidates to present themselves to franchisors as capable operators; information asymmetries between franchisors, franchisees and lenders abounds; supra-optimal levels of equity for purchasing franchises exists due, in part, to the SBA’s guaranteed loan program and access to 401k funds; franchisors, hiding comfortably behind government regulations and laws, do not actively compete publicly for sales based on material inter-franchisor metrics; and gag-order agreements (both in franchise agreements and associated with disputes) regularly blind franchisees to material relevant information.

In addition, during the term that a franchisee operates its business, significant other market failures proliferate: franchisees may from time to time not always invest their full efforts into the business; the ability to monitor such franchisee efforts by franchisors can be costly and challenging; efforts by franchisors to impose unreasonable uniformity stultify franchisees’ creative abilities and fail to use their franchisees’ unique knowledge of local markets; franchisors frequently impose supra-optimal penalties for alleged franchisee shirking or other non-opportunistic behavior; because franchisees are not able to recoup their fixed investments substantially or at all in their next best alternative uses outside of the franchise system, franchisors opportunistically tend to extract franchisee profits or revenues to which they are not otherwise entitled absent such asset specificity; franchisors tend to over-saturate geographic areas (and distribution channels) as they grow their systems since their normal prototypical profit maximization equation is different from that of their franchisees; franchisors too frequently focus myopically on the short run and not the long-run thereby turning franchisees into guinea pigs for purposes of testing new products and entering new geographic areas; the costs of investments and expenses demanded by franchisors is debited against the cost functions of franchisees, not franchisors; and, moral hazard failures from time to time lead to churning of franchisee businesses.

Even after the termination or expiration of a franchise agreement, market failures in the franchise market continue to diminish efficiency. Most notably, this damage arises out of the enforcement of post-termination covenants not to compete in situations in which no confidential or unique information is in the possession of the former franchisee. Such restrictions, in conjunction with the related issue of franchisee penalties upon termination that are far too large to claim a connection to the promotion of any efficient remuneration, are heavily inefficient from an opportunity cost perspective. Last, there is the issue of uncompensated franchisee goodwill, which although related to the former issue, is different to the extent that it covers a qualitatively unique investment made by the franchisee that is never compensated upon termination or expiration. Such supra-optimal penalties, when imposed in the face of asset-specificity, encourage additional opportunism by franchisors.

Third, franchisee lawyer miscalculations (and misinformation) regarding the viability of franchisee system standards claims are regular, notable and costly. Because franchisees have little ability to inexpensively ‘check’ on such lawyer views, the actual probabilities of franchisees’ potential claims regarding modification and system change demands are often not discovered by franchisee association litigants until after hundreds of thousands of dollars have been expended on joint franchisee lawyer efforts. Franchisee litigation lawyer haranguing and myth peddling to groups of franchisees and franchisee association groups is ever-present in the franchise world. In one unfortunate and ironic sense, franchisee “Pump and Dump” litigation lawyers many times seem to play the very same opportunistic informational games with their franchisee potential clients that franchisors played with franchisees when selling franchises to franchisees to begin with. While it is true that not every lawyer has good litigation handicapping abilities, it is also true that very many franchisee groups or associations regularly fail and refuse to seek out and obtain legal analyses from lawyers other than those pushed on them by antiquated franchisee associations whose leaders are incentivized, directly and indirectly, financially and emotionally, to do so. “Pump and Dump” chants in front of groups might be good for bonding; however, they are notoriously ineffective and counterproductive in resolving long-term market failures in the franchise marketplace.

Conclusion

The most problematic issues in franchising are caused by information market failures and distorted incentives. Two of the potential solutions – court created rules and lawyer handicapping – are not alone or together effective, at least over the short-run. The redesign of private agreements through modification of franchise agreements cannot realign the distorted incentives in the face of the other extant market failures as noted above.

This leaves two other available potential forms of market intervention: legislative action and information provision. However, to make headway in these two areas it is necessary for franchisee advocates to embrace and employ relatively newly-developed intellectual tools that cut in their favor. In so doing, franchisees should also consider obtaining and adding new leadership on the franchisee advocacy side; this leadership needs to be more academically inclined, less concerned about controlling who receives self-created accolades, not continually distracted with how franchisee clients are allocated to contributing lawyers, and more motivated to mastering, or at least trying to learn, current theoretical doctrines. (Compare the AAFD – the American Association of Franchisee Dealers – whose Franchisee Bill of Rights has not been adopted completely by even one of the tens of thousands of franchisors that have existed over the AAFD’s 25 year history; with the CFA – the Coalition of Franchisee Associations – which appears to recognize that legislative change is indispensable for franchisee survival.) “Pump and Dump” lawyers, who are not all necessarily franchisee advocates, should not be in charge of calling the plays of these organizations.

The fact that the IFA continues to easily rebut current franchisee advocates’ theories and arguments by recycling and publicizing stale theories from 30 years ago is an absolute crime. And, it is indeed ironic in this regard that some franchisee advocacy institutions are able to hide their shoddy and ineffective efforts in the cracks of the same market failures that historically have hidden the opportunistic conduct of franchisors, which itself created the need for franchisee advocacy to begin with.

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