Author
Victor P. Goldberg, Columbia Law School
Document Type
Article
Publication Date
1979
SUMMARY OF HOW THE ARTICLE’S ECONOMIC THOUGHTS IMPACT ON FRANCHISING
Insights and Discussions on Franchising, Franchisees, and Franchisors: Roles, Relationships, and Legal/Economic Implications
- Definitions and Nature of the Franchise Relationship
Franchising encompasses various retail arrangements, including “business format franchising,” where a trademarked product, service, or method is licensed to a franchisee (e.g., fast food, muffler shops, convenience stores), and “traditional franchising,” which involves specialized retail services (e.g., automobile dealerships, service stations) where dealers often specialize in a single brand’s products, making the franchisee’s business identity heavily reliant on the franchisor relationship.
Conversely, “franchise” agreements can also be extremely casual, resembling routine retailer-manufacturer transactions, such that the label “franchise agreement” may be attached to loose or minor arrangements.
The franchise relationship is best understood as a long-term “relational exchange,” not as a discrete, one-off transaction; it involves parties entering an ongoing arrangement, partially insulated from market forces, with behavior within the relationship (not just market outcomes) being a key concern.
- Roles and Interests of Franchisors and Franchisees
The franchisor typically designs the franchise agreement and presents it to franchisees, often on a take-it-or-leave-it basis. While franchisee interests may be considered to some extent, the franchisee plays a relatively passive role in the formation and structuring process.
Franchisees invest in inventories, signage, promotion, and otherwise become closely tied to the franchisor’s business, sometimes making relationship-specific investments that lack value outside the franchise arrangement.
Franchisors provide initial and ongoing training, specialized knowledge, and support systems to franchisees.
Franchise agreements commonly include vertical restrictions, such as resale price maintenance, territorial/area clauses, exclusive dealing, long-term contracts, and tie-ins, imposed by franchisors to influence franchisee actions and maintain distributional efficiency.
- Structure of Franchise Relationships and Barriers to Exit
Franchise arrangements often involve contractual mechanisms raising or lowering “exit barriers”—costs or penalties associated with leaving the relationship. These barriers can be functional, supporting enforceability, reliance on sunk investments, or governance (by making disciplinary threats more credible and facilitating monitoring and authority structures).
Examples of exit barriers include nonrefundable franchise fees (increasing the appeal of staying), subsidized or essential assets provided by the franchisor (e.g., pump leasing), contractual covenants not to compete (deterring franchisees from leaving and setting up competing businesses), and sharing contracts (royalty-based revenue sharing or rent per unit sold).
Franchisees often accept high exit barriers because they receive compensation for doing so in the form of attractive streams of earnings or support from the franchisor.
Franchisors may try to keep their own exit costs low (enabling credible threats of termination), which can discourage franchisee investment and efforts.
- Legal Implications: Antitrust, Contract, Termination
The legal framework has struggled with vertical restrictions in franchising, oscillating between per se illegality (e.g., resale price maintenance) and rule of reason (e.g., location or area restrictions, exclusive territories), with the Supreme Court’s GTE Sylvania decision marking a shift toward more flexible analysis for many vertical restrictions.
Courts have been particularly concerned with power imbalances in the franchise relationship, especially regarding the franchisor’s ability to impose termination or discipline. Judicial attention often goes beyond the formal legality of restrictions, focusing on perceived inequities, business independence, and the need to protect franchisees from opportunism or unfair treatment.
Franchisee vulnerability is greater where their business identity and capital are highly dependent on the franchisor. This has led to state and federal legislative interventions, as well as judicial doctrines of good faith and unconscionability, providing some protection against abusive or arbitrary termination.
Nonetheless, franchise agreements are typically presented to franchisees on a standard form, but franchisors have reasons to tailor terms to attract franchisees, especially as franchisees usually have other options at the formation stage unless they possess highly specialized skills or capital.
The courts’ rationale for protecting dealers has not always been clearly articulated, and sometimes protection is extended on the basis of contract “status” or public policy (e.g., prohibiting at-will termination in the face of gross bargaining power imbalances).
- Economic Rationale and Policy Considerations
Vertical restrictions imposed by franchisors aim to enhance marketing and distributional efficiency—solving problems like free-riding, misaligned incentives, quality assurance, and providing incentives for retailer investment and point-of-sale effort.
These restrictions may also be used as mechanisms for enforcing compliance among franchisees and deterring opportunistic or disfavored behavior.
There can be tension between fostering efficient internal arrangements (private efficiency) and achieving optimal outcomes for society as a whole (social efficiency). Concerns include the risk of cartelization, entry barriers for new competitors, product differentiation’s effect on competition, and the inflexibility or rigidity created by widespread vertical integration by contract.
Franchisee protection from termination often emerges not from individual bargaining but from collective action—through franchisee associations, unions, or legislative efforts. Collective action can help realign bargaining power or shift terms toward greater job security for franchisees, particularly as the average franchisee in an established relationship values security more than a new entrant would.
Suggested reforms include shifting franchisee protection out of the antitrust context and into contract/business law, or via regulatory agencies, with proposals for arbitration and semi-private dispute resolution mechanisms overseen by public bodies like the FTC.
Terminations can cause inefficient and destructive conflicts (both legal and extralegal), which may justify extra-contractual protections for franchisees in certain industries with high vulnerability (e.g., auto dealers, gas stations), while in other areas less intervention may be warranted.
- Power Dynamics and Evolution of Case Law
Courts and policymakers have sometimes used the franchise relationship as a vehicle for addressing relational power imbalances, especially where perceived dealer vulnerability or inequity is high.
The evolution from strict per se rules toward greater focus on actual economic effects (rule of reason) reflects both changing judicial philosophy and growing recognition of the relational and economic complexities in franchising.
There have been calls for clearer articulation of the goals underlying judicial interventions, instead of reliance on ill-defined notions of independence or status.
Conclusion:
Franchisors and franchisees are engaged in long-term, complex relationships wherein franchisors structure agreements to guide dealer behavior, maintain efficiency, and preserve the brand, often relying on vertical restrictions and exit barriers. Franchisees, while potentially vulnerable to franchisor power, typically enter these relationships by choice, investing in the franchisor’s business identity for expected returns, but may seek greater protection collectively, especially against termination. The legal landscape is characterized by evolving antitrust scrutiny and case law, with an increasing focus on the nuanced balance between efficiency, fairness, and power in the franchise system.
SUMMARY OF HOW THE ARTICLE’S ECONOMIC THOUGHTS ON VERTICAL RELATIONS IMPACT ON ANTITRUST AND DISTRIBUTION
- Introduction to Vertical Restrictions and Relational Exchange
Distribution systems, particularly those involving franchises, are characterized by vertical restrictions—contractual controls imposed by the manufacturer or franchisor on the behavior of dealers or franchisees. These include resale price maintenance, territorial assignments, exclusive dealing, long-term contracts, and tie-in arrangements. The primary debate, especially in the context of antitrust law, centers on whether these restrictions foster efficiency or stifle competition. The document emphasizes the need to move beyond traditional, “discrete transaction” models and instead analyze these arrangements as “relational exchanges”—long-term, evolving relationships between firms that are structured not just by market forces but by ongoing, complex interactions and adaptations.
- Relational Exchange vs. Discrete Transactions
Traditional (Discrete) Analysis:
Standard economic theory sees exchanges as one-off, perfectly enforced market transactions. The contract is assumed to specify and allocate rights and obligations clearly, with the state costlessly and perfectly enforcing them. Any long-term arrangement is reduced to a sequence of spot market exchanges, insensitive to the ongoing relationship between parties.
Relational Exchange Perspective:
In reality, distribution contracts—especially in franchising—embody ongoing relationships subject to adaptation, reputation effects, strategic behavior, and incompletely specified terms. The identity of parties, investment in relationship-specific assets, and long-term coordination are critical. Parties are not just exchanging goods, but entering into enduring arrangements that are structured to address information asymmetries, enforceability challenges, flexibility needs, and ongoing governance. Behavior within the contract—such as quality of service, adaptation to changing conditions, and conflict resolution—becomes essential.
- Economic Functions and Justifications for Vertical Restrictions
Vertical restrictions in distribution systems emerge primarily to solve economic problems not addressed by market transactions alone. Principal economic rationales include:
- Enforceability and Quasi-Rent Protection
Long-term contracts expose parties to “hold-up” risks, because investments in specialized assets (quasi-rents) make them vulnerable if the counterparty acts opportunistically. Vertical restrictions can be used to raise exit barriers (the cost of leaving the relationship), thereby discouraging opportunism and helping ensure fulfillment of obligations. - Reliance and Investment Incentives
Dealers and manufacturers invest in brand-specific promotion, training, or equipment whose value depends on the relationship enduring. Restrictions (like non-compete clauses, termination penalties) help assure both parties that their investment will not be appropriated or wasted by premature termination. - Governance and Efficient Coordination
Because contracts are not self-enforcing or self-adjusting, governance mechanisms (e.g., policing, authority, and “voice” mechanisms) are inserted to monitor, discipline, and coordinate actions. High exit barriers make punishment for breach credible and encourage parties to resolve disputes rather than simply exiting the relationship. Franchisors can retain the power to impose costs (like termination or loss of preferential terms) to assure compliance with vertical restrictions. - Reducing Free Riding and Achieving Efficient Marketing
A major reason for vertical restrictions is to address free-rider problems—where dealers may not invest in services or promotion if they cannot capture the returns, instead “riding” on the efforts of others. Resale price maintenance, territorial exclusivity, and limited distribution enable dealers to retain some of the benefits of their own promotional/investment efforts, thus incentivizing provision of valuable services and brand promotion. - Facilitating Monitoring and Enforcement
Restrictions simplify the problem of detecting and penalizing deviations (such as price cutting or unauthorized sales), making enforcement more tractable and ensuring that the overarching marketing strategy of the franchisor is followed. - Mechanisms and Tools in Relational Governance
Parties use a wide range of devices to alter incentives and improve relationship stability:
Franchise fees + earning streams: Combine upfront fees with strong ongoing incentives to continue the relationship.
Subsidized inputs: Example: Leasing equipment (e.g., gas pumps) at below-market rates, making exit costlier for dealers.
Non-refundability, service cost upon termination: Dealers lose out on free/subsidized services if relationship ends.
Covenants not to compete: Prevent the ex-franchisee from easily leveraging acquired goodwill/knowledge.
Sharing contracts (royalties tied to performance): Align interests, reduce incentives to terminate.
Cross-relationships, collective action: Franchisor can increase exit costs by linking multiple relationships, or dealers may band together to raise cost of termination.
These mechanisms can be customized based on context, desired forms of dealer effort, and risk allocation needs.
- Economic Risks and Public Policy Issues
While vertical restrictions can improve contractual efficiency, they may also create anti-competitive side effects:
Cartelization: Dealers or manufacturers may use vertical restrictions to facilitate collusive price or territory agreements, especially if multiple competing manufacturers collude.
Entry barriers: Exclusive dealing and other restrictions may raise costs for new entrants by requiring them to enter both manufacturing and distribution simultaneously, thus raising capital needs and coordination costs.
Product differentiation: Restrictions may reinforce artificial differentiation and higher prices without commensurate consumer welfare gains.
Dynamic/inertia effects: The interlocking mechanisms and high relationship-specific investments may make it costly to unwind inefficient arrangements, slowing innovation and market adaptation.
- Legal Treatment and the “Rule of Reason”
Historically, the legal system vacillated between per se illegality (striking down most vertical restrictions) and the more nuanced “rule of reason” analysis. The latter approach, now favored after GTE Sylvania, takes relational and efficiency concerns into account, weighing potential harms against recognized economic benefits. However, courts must still consider whether the private efficiency achieved by such restrictions aligns with social welfare, especially regarding competitive effects.
- Relational Governance: Dealer Protection and the Scope of Regulation
Courts and legislatures sometimes intervene to correct perceived power imbalances in franchise relationships, particularly concerning termination protection. The law increasingly recognizes that purely contractual, efficiency-based outcomes may not adequately protect legitimate long-term expectations, investments, or broader social interests, and may need to impose additional safeguards, especially for highly dependent and vulnerable dealers (e.g., automobile or gas station franchises).
- Conclusion
The economics of distribution in franchising and analogous systems are shaped fundamentally by the need to structure and sustain complex, relationship-specific investments. Vertical restrictions arise as tools to manage enforcement, reliance, free-rider problems, and governance. While they often contribute to economic efficiency in private relationships, such restrictions must be scrutinized for potential competitive harm and managed within a legal framework that can distinguish between beneficial relational contracting and socially harmful exclusion or collusion.
Abstract Verbatim from Law Review
Vertical restrictions between franchisors and their dealers have long been a thorny problem in antitrust law. Richard Posner’s characterization of the case law as a “fiasco” and a “doctrinal shambles” is echoed by many other commentators. Perhaps partly because of the intellectual confusion in the area, the Supreme Court recently made an apparently sharp change in direction. In Continental T.V., Inc. v. GTE Sylvania Inc. the Court reversed the decade-old Schwinn per se doctrine, holding that at least some vertical restrictions deserve a rule of reason test. Whether this decision will prove a more durable precedent than Schwinn remains to be seen. Robert Bork, an enthusiastic supporter of the overthrow of Schwinn, has counseled caution in projecting the implications of GTE Sylvania,and the FTC’s interpretation of the case in its decisions regarding territorial restrictions by soft drink bottlers suggests that the magnitude of the change from the Schwinn standard indeed might have been exaggerated. Even if GTE Sylvania is not subsequently overturned, the next few years will see a continuing flow of litigation to define the boundaries of the rule of reason test as applied in this new context.
