May 7, 2015 - Franchise Articles by |

Franchise Supply Restrictions

Franchise supply restrictions exist in almost every franchise system. They are so important that they have been given “item status” in Franchise Disclosure Documents. In addition to meeting all of the necessary disclosure requirements, supply arrangements must not collide with the prohibitions of the antitrust laws. Purchasing requirements must also steer clear of the few state franchise laws that regulate them.

Economic justifications for and against such purchasing requirements abound. Many times these finely nuanced economic analyses vary based merely upon the particular phraseology used to formulate a given sub-issue associated with supply arrangements.

A few of the prolific issues raised by purchasing requirements include:

  • whether the relevant restricted products are so specialized that they should and can be purchased from only one source;
  • whether a preferred supplier is charged a fee that is or is not kept by the franchisor;
  • whether a significant portion of the franchisor’s revenue comes from its franchisees’ purchases of the identified products;
  • whether the relevant products are priced ‘fairly’ and ‘reasonably’ and do not provide an ‘unfair profit’ to the franchisor (whatever those terms mean);
  • whether the dictated standards are reasonably related to the professed need for product uniformity;
  • whether the required products are supplied directly by the franchisor or affiliates of the franchisor;
  • whether the final decision as to the specific products is made by the franchisor alone and with or without franchisee input;
  • whether the franchisor permits franchisees to source reasonably equivalent products or services;
  • whether purchasing cooperatives have been established;
  • whether rebates are provided by the suppliers of the products or services;
  • whether the franchisor conditions the sale of the product on the purchase of another product; and
  • whether the supply restrictions are applied in a non-discriminatory manner by the franchisor.

The Federal Trade Commission’s view of how to regulate source requirements is to pump more information into the market to allow actors in the franchise arena to make more efficient decisions. This is the theoretical economic framework upon which the entire FTC Rule is based. More information will always achieve the most optimal allocation of resources. Although it is difficult to dispute the argument in its abstract theoretical form, there are those who believe that the FTC Rule fails miserably in applying this principle.

Application of the FTC Rule has become so esoteric and complex that most non-franchise lawyers will certainly give out long before reaching Item 7 of the FDD. Every nook and cranny created by these esoteric regulations provides merely another dark corner in which franchisors can secrete questionable aspects of their franchise systems. The information program allegedly achieved by the FTC Rule is severely compromised by the enigmatic rote formulations regularly pumped out of the word processors of franchisors’ lawyers in preparing FDDs.
In recently reviewing the Federal Register of the FTC’s adoption of the franchise rule, it became readily apparent that the FTC fell notably short of achieving its self-defined goal of ensuring the provision of full and accurate information to potential franchisees. My needs that day took me to the discussion of Item 8. As I read this section, it became readily apparent that the FTC incredibly was using an unvarnished outcome-determinative analysis in reaching its conclusions. Instead of providing sound analysis for requiring the disclosure of very important information, the FTC came up with sophomoric excuses for not requiring the disclosure of very pertinent information. I will provide only two examples below.

First, one attorney suggested that the rule include “more information about [franchisors’] practices and intentions with respect to the provision of competitive alternative sources of supply.” The FTC, which includes the largest single group of economists and attorneys devoted solely to regulating completion in our economy, threw its hands up in the air and said: “Well, since the attorney offered no specific language for the Commission’s consideration” the FTC couldn’t figure out by itself language to address this concern.
Then, when one other attorney actually proposed some language the Commission quoted it and then wholly failed to address it in any way. Instead, the FTC  in what appeared to be a non sequitur stated merely the rudimentary principle that “the Commission agrees that full disclosure of source restrictions and purchasing requirements is warranted.” Did I miss something? Apparently not. I guess that means that they rejected the proposed language.

Second, the FTC turned to the suggestion that franchisors be required to disclose their past practices regarding approving alternative supplies or their future intentions regarding how they planned to consider franchisees’ requests to approve alternative vendors. Wouldn’t this certainly be highly relevant and important information to a potential franchisee? Not according to the FTC. Without any analysis whatsoever, despite its having spent years and years and millions of dollars enacting the new rule, the FTC simply said “no.”

Instead, the FTC incredibly again repeated merely the same economic principle above: “It is sufficient to warn prospective franchisees about source restrictions … without requiring franchisors to disclose their past practices regarding approving alternative suppliers.” For anyone who had any questions about how the FTC had arrived at this massive conclusion with only two sentences of explanation, the FTC came through: “Item 8 strikes the right balance between pre-sale disclosure and compliance costs and burden.” I stopped reading, and went back a page, thinking that perhaps I’d missed a page or two of analysis leading up to these conclusory statements. Certainly there must be some analysis of the “costs and benefits and how the right balance had been struck? I was wrong again.

But this time, the FTC was ready with the perfect answer: “Prospective franchisees can always ask existing franchisees or trademark associations about a franchisor’s history of approving alternative suppliers, if this issue is important in their decision-making process.” This time, however, to its credit, even the FTC could not bring itself to say that it is more cost-efficient for prospective franchisees to spend what could be months of time and money trying to contact numerous current franchisees to put together a statistical analysis of past history regarding franchisor supply approvals rather than having franchisors put two additional two sentences into their FDDs.

Perhaps franchisee lawyers should be taking the FTC's advice and tell their clients to undertake this fruitless endeavor of contacting all of the former franchisees operating under confidentiality agreements. As is obvious, franchise supply restrictions will continue to plague franchisees regardless whether they are banned by the antitrust laws. 

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