Sep 21, 2019 - Franchise Articles by |

The Washington Supreme Court has recently ruled Franchisors cannot exceed ‘fair and reasonable prices’ in selling products and services to their franchisees. Specifically, the Court held that under that state’s Franchise Relationship Act that it is an unfair or deceptive act or practice for any person to “sell, rent, or offer to sell to a franchisee any product or service for more than a fair and reasonable price.”  The Washington Supreme Court proceeded to define prolific components of a definition of “fair and reasonable price” for such products.

The Washington Court explained:

The plain language and the legislative history of the FIPA make clear that a broad understanding of the market and market forces must inform a fact finder determining whether prices are fair and reasonable under the FIPA. A fact finder must take into consideration market forces writ broadly. This includes what the district court relied on—the price at which the franchisor acquired the products or services—but reaches beyond. The prices of competitor franchisors should be taken into account, including whether the prices of all franchisors are the same. So, too, should the statements of profit margin made by the franchisor.

Other relevant factors include the franchisor’s charges to other franchisees for the same or similar products or services; what other similarly situated franchisors charge similarly situated franchisees for the same or similar products or services; business and industry practices; the price the franchisor pays for the products or services; and the price at which the franchisee could obtain the same or equivalent products or services elsewhere, including in an arm’s-length deal on the open market. There are other, less tangible market forces at work as well. For instance, the fact finder should consider the value that the franchisor adds to the product or service, if any.

Other market forces can apply; this list is not exhaustive. Nor is it exclusive or mandatory; not every, factor need be referenced or used.

These factors allow the finder of fact to take complex scenarios Into account. For example, if the franchisor obtains a product for price x, and the franchisee could only obtain it on the open market for 5x, then selling it at the price of 2x might not be unfair or unreasonable—but if all other similarly situated franchisors are selling it for 1.5x, then the price of 2x may be unfair or unreasonable.

Short Candid Random Comments from Leading Franchise Law (Franchisor-Side) Practitioners: Panic

Non-Goldstein Comment from Franchise Lawyer #1 — Many of these factors may not be able to be assessed without expensive discovery and expert testimony.  For example, are other “similarly situated franchisors” going to give up their pricing information without a fight in a case involving one of their competitors?  You can expect the subpoenas to start flowing regardless, and the ancillary fights in litigation are going to go up. And if competitors’ pricing is a relevant consideration, it seems to suggest that franchisors should set uniform prices across industries.  This seems to be anticompetitive and could raise serious antitrust concerns. To make a long story short, any product or service offered or sold to a franchisee now can be challenged as “unfair” or “unreasonable,” and the cost of disposing of such claims is going to go up as the parties fight about what constitutes a “fair and reasonable price.”  Franchisors doing business in Washington need to reevaluate product/service sales to franchisees as a result of the new risks associated with these sales.

Non-Goldstein Comment from Franchise Lawyer #2 — Is the result of this approach that the judiciary in the state of Washington has the right to set pricing in franchise relations by determining what is fair and reasonable, rather than allowing market forces to find the right balance?  If so, this is extraordinary.  And if a price is considered fair and reasonable today, will it be considered fair and reasonable tomorrow?  How is this not completely unworkable?

Non-Goldstein Comment from Franchise Lawyer #3 —  Here darn near everything is identified as relevant, and in a macro sense that is  correct. But as has been said it has the potential to generate  a LOT of expensive discovery and I do not see how even an arbitrator can reasonably refuse that. What this means is as usual the party with the deepest pockets has the advantage. While litigation costs may go up, one would think this is a small price to pay for franchisees that get stuck in tying arrangements that are now OK’d by the court, where the price of goods is so high that the franchisee faces YEARS of inflated prices or bankruptcy or both. Franchisors should keep that in mind as the temptation to make mark-ups to their franchisees the primary source of their profits.

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Jeffrey M. Goldstein Comments Franchisor Supply Prices:

Whenever a government agency steps into the fray of a free market dispute in the absence of a market failure, we’re all usually the worse off for it. And, when the government agency’s tool of choice to carry out the ‘required’ regulation focuses directly on the price-setting mechanism, everyone’s hair should stand on end – as the independent establishment of prices by sellers is one of the most venerated and necessary aspects of a free market system. In this context, however, the primary and dispositive question is whether there exist any market failures that would justify such an extreme regulatory response — controlling the price setting ability of independent franchisors; and, the answer is both yes and no.

Yes, for two reasons. First, the franchisee, in making his or her decision to purchase a franchise, suffers from multiple cognitive defects; regardless of the rote response from franchisors that franchisees make independent and reasonable decisions, the burgeoning empirical work on this issue shows that franchisees are critically hobbled in the franchise purchasing process – accordingly, their decisions to purchase made in this environment are not consistent with allocative efficiency, which negatively impacts everyone in society. [And, this issue is distinct from the sometimes-present issue of tying under federal law where the crux of the problem is whether the franchisee was privy to the tie-in before he or she purchased the franchise]. Second, to the extent putative state law doesn’t cabin-in the price-setting discretion of supply prices under the covenant of good faith and fair dealing, opportunistic pricing will frequently naturally result. Although some of the opportunistic price differential is merely a transfer of the surplus created by the franchise relationship (and therefore not an allocative efficiency issue), some of it is not; accordingly, it has effects on allocative efficiency, although not those traditionally identified by current federal antitrust analysis (which recognizes only allocative efficiency losses flowing directly from market power).

No, for one main reason. The format franchisor is not usually in the business of selling ‘supplies’ primarily. It is in the business of selling the franchise opportunity; this is much more expansive than selling solely the marks, and includes training, supplies, etc. Accordingly, the franchisor, as an independent market participant in the free market itself, using its own assessment of market forces, prices out and apportions its fees and expenses; in so doing, it allocates how to collect its ‘price’ for the franchise opportunity – whereas one franchisor might sell supplies at its cost to its franchisees and charge $100 for its franchise fees, another franchisor might sell supplies at a markup that garners it a $50 profit but charges $50 for its franchise fees. Arguably, this allocation decision belongs solely to the independent market seller absent any market defects (which as noted elsewhere, clearly exist). While franchisors might make the abstract argument that their pricing is limited already (before any examination by a government agency or court) by their vigorous competition with other competing franchisors, this argument falls prey to the facts. Franchisees qua franchise purchasers at the end of the day have far too little accurate pricing or revenues information as a result of the disclosure process, and this cloak of silence insulates many franchisors from direct rivalry with other franchisors for sales of their units. Ditto as to why FDDs are not readily and publicly available to every person interested in the prospect, and, ditto as to the failure of every franchisor to include an Item 19 in their FDD.

However, at the end of the day, it can be said that franchisors’ relative callousness to supply prices, as well as a tendency (regardless of the lawfulness or rationality of the decision) to engage in opportunism on the issue of supply prices, all but created the likelihood of this limited intervention occurring. This court decision grew indirectly out of the overall dissatisfaction with myriad forms of franchisor opportunism (spanning far beyond supply prices), many of which still exist today, long after the initial enactment of the putative Washington legislation.

As for the litigation consequences of the decision itself, it appears that it could have been much worse (for franchisors). The court could have adopted the inane argument of the franchisee that ‘2x cost’ was unreasonable per se, and if that had resulted, franchisees could then have begun to retain retired ‘advocats’ from Moscow who practiced law during the 1960s. Yes; the court’s decision opens-up supply pricing to intense scrutiny; yes, it will be costly for the few franchisees who have the resources to launch such a litigation battle; and yes, franchisors’ litigation bills will, in the short run, increase on average in Washington. And, if this decision creates the efficiency-distorting effect that franchisors are required to employ less efficient forms of price allocation (between ongoing fees, initial fees, and profits from supply sales), then one can argue that this is because the chickens have finally come home to roost – at least in Washington. We shouldn’t cry when from time to time opportunism, with no direct efficiency-augmenting justification, is reigned in.

Last, arguably, the negative effects of this court decision on franchisors will be less than the positive effects of their continuing to charge supra-competitive supply prices to franchisees; if so, this means that business will merely continue as usual, supply prices will remain the same, and there will merely (and primarily) be a transfer of opportunistic profits from franchisors ‘back’ to certain franchisees. Those who predict dire consequences to franchising from this decision should be directed to examine successful overall franchise operations in California where post-term non-competes are prohibited by statute.

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