It's interesting how the more things change the more things stay the same. Case in point is a recent blog post by an opponent to California's Assembly Bill 2305, "The Level Playing Field for Small Businesses Act of 2012."  I have heard this kind of rambling rhetoric before, some ten or (is it closer to) twenty years ago?! Might not have come from the same pulpit, but it definitely has the same preachy tone.

Much to our opponent's dismay California Assemblymen Jared Huffman and Tom Ammiano have introduced fair franchising legislation. California is once again ahead of the curve when it comes to the rules and laws that govern franchising. California enacted its California Franchise Investment Law (CFIL) even before the Federal Trade Commission (FTC) promulgated its franchise rule (FTC Rule 436) (16 CFR Part 436). Californians are once again taking the lead in closing some of the loopholes and procedural devices that frustrate franchisee investors both in the CFIL and in the California Franchise Relationship Act (CFRA).

LEVEL PLAYING FIELD

Where to begin? Let's start with "a level playing field." The California legislature is beginning to understand that franchising as we know it is built on control. Contracts between the parties to a franchise are intentionally designed to exploit the superior bargaining position of one of the parties to the contract—the corporate franchisors and their skilled lawyers. For the majority of franchise purchasers there is no equal bargaining power in a franchise contract.

That by its nature means a one-"seided" contract.*

There is no freedom of contract when one party holds all of the cards. There is no freedom to contract when one party can arbitrarily change the terms of the contract. And, there is no freedom of contract when one party can disavow a duty to act for the best interests of both parties. So, it becomes obvious that a duty of good faith and a duty of competence might be just as prudent for California franchise investors when dealing with contracts predicated on unequal bargaining power as it already is in most other commercial relationships.

DUTY OF GOOD FAITH

By the way, many franchisors seem to operate just fine in the State of Washington which has had the Washington Franchise Investment Protection Act since 1972 (Wash. Rev. Code Chapter 19.100). Its relationship section contains, among other things, a general obligation of the parties to act in good faith. From what I understand there are less than 30 reported appellate cases in Washington under the Washington Franchise Act. The vast majority of these claims have to do with franchisors' failure to comply with the registration and disclosure provisions of the Act. Relationship claims are pretty obvious violations such as opening a competitive store within 100 yards of the franchisee's store and materially impacting the franchisee's sales and profits.

So, it seems the risk of massive amounts of litigation is self-policing. Franchisors tend to mind their 'p's' and 'q's' when the threat of litigation by the victims hangs over their heads.

One other thought--the Uniform Commercial Code (which is in force throughout the 50 states and governs contracts for the sale of goods)--also requires minimum standards of conduct and good faith in the performance of these contracts. It can hardly be argued that the adoption of the UCC has caused any harm to the sale of goods throughout our nation. Unfortunately the UCC does not apply to franchise relationships.

IT'S THE SAME CONTRACT

So, if you don't like one contract just find a different contract the blogger writes: "There are thousands of franchise opportunities available in California and they can make their business decisions based on the abundance of publicly available information." Actually, there were 1850 franchise opportunities listed with the California Department of Corporations at the close of 2011. But, how different are those contracts, really?

A study of the top 8 franchisors that controlled more than 1/3 of the multi-billion dollar market for ready-to-eat pizza, found that they all offered nearly identical contract terms. Because there is no competition, franchise investors must enter into an unfair and unreasonable one-sided contract to be a franchisee. The same is true whether the goal is to sell hamburgers, eyeglasses, tax return preparation or any other product that is sold in a franchised business.

In other words, someone wishing to enter or advance within an industry has two choices--join a franchise system, or go it alone and compete with franchise systems, which possess an overwhelming advantage. However, in determining which system to join, franchise agreements are substantively so alike that there is no real choice to be made. The franchise agreement removes the prospective franchisee of any of the protections one would presume to be built-in to any other normal business relationship.

ENCROACHMENT

What Starbucks learned a long time ago (Wall Street Journal, Jan. 21, 1997) was that there were negative economic ramifications to existing locations as its expansion marched steadily onward. "As we add more stores, we increase our total business, but we cannibalize our existing stores," Starbuck's said at the time. For a chain of company-owned stores like Starbucks to continue expanding even while understanding the detrimental effects it was having on sales at existing units is one thing. For a franchised chain to continue expanding (via bricks-and-mortar or otherwise) while its franchisees lose both gross and net revenue is another thing altogether. Why is it a good idea for a franchisor to be its own franchisees' greatest competitive threat? Isn't that 'bad faith?' Isn't that a conflict of interest?

If you took action that was the direct cause of your partner losing money, you would need to make him or her whole. AB 2305 is merely asking for a percentage of monies lost over a limited period of time in an attempt to make the franchisee whole or at least mitigate the harm caused.

Who in their right mind with true freedom to contract would enter into an agreement under which they pay the franchisor to allow him or her to open a business only to have the franchisor accept another fee from another franchisee to open the same business next door, or, on-line?

Where parties have some equality they can negotiate a reasonably balanced relationship. Where one party has all the power it can impose an agreement which reserves all the power for itself and all the risk is for the other guy.

WE'RE NOT DONE WITH YOU YET

This position is particularly disingenuous when coupled with the non-competition covenants that our opponent bemoans. Maybe he's forgotten that post-term covenants not-to-compete are already unenforceable in California (under a non-franchise statute).

Non-compete clauses are contractual devices used to ace the franchisee out of his/her public policy ownership and intangible goodwill of the franchise. In many states post-term covenants not-to-compete are enforced vigorously. The end result is that the franchisee is not allowed to become an independent business owner in a similar business after expiration of the contract. This has the effect of appropriating to the franchisor all of the equity built up by the franchisee with no compensation. The franchisee's business is confiscated by the franchisor! At the very least franchisees should be allowed to preserve their sweat equity and engage in a similar business provided the franchisee ceases using the franchisor's trademarks and trade secrets.

Remember that most franchise agreements contain both post-term non-competition covenants and a reservation of the franchisor's right to directly compete under the same brand name anywhere it wants. This double standard exemplifies how onerous current franchise agreements can be, as well as the threat that these agreements pose to the continued growth and prosperity of franchising as a whole not to mention the California economy.

EMPIRICAL EVIDENCE

Reasonable legislation like what is being proposed in California Assembly Bill 2305 has never harmed franchising-- in any state. There is no empirical evidence to suggest otherwise. Franchisors threatened to leave Iowa after the enactment of its relationship statute in 1992. Other than a brief diminution of franchise activity in Iowa (that was more the result of an orchestrated boycott by 2 large multi-national corporations rather than spontaneous activity by many franchisors) the reality is that since 1992 Iowa's franchise growth and job creation has continued unabated to this day.

At one point the United States Small Business Administration (SBA) reported the number of franchise loans guaranteed by the SBA actually increased after Iowa's legislation. Lenders felt Iowa provided a climate of stability (i.e., a greater likelihood that franchises would be around to pay off their loans).

Further, I have yet to see a 10-K from any publicly held franchise chain that describes franchise disclosure or relationship laws as being a problem. To the contrary, usually what is in the 10-K reads something like: "XXX Company must comply with various state laws that regulate the franchisor/franchisee relationship. To date, XXX has not been significantly affected by any difficulty, delay or failure to obtain required licenses or approvals." If franchise relationship laws were a problem, the corporation would have to say so in its 10-K.

So much for empirical evidence.

STANDARDS

By the way, franchisees have no problem with franchisors enforcing their standards. The objection of most franchisees that I speak with is that the standards are unfair and unreasonable. They are as concerned--if not more so--with subpar performers as is the franchisor.

WEALTH TRANSFER

Franchisees purchase something they can never sell---the trademark, trade name and trade secrets of the franchisor. They pay ongoing fees for the entire term of the contract to use these and other proprietary rights from the franchisor. They are dependent upon the franchisor acting in good faith both during the term of the contract and while exiting the system.

Once they're ready to exit the system the franchisee can't sell what they own. They cannot sell their franchise agreement to a new franchisee. Instead the new franchisee will sign the 'then current' form of franchise agreement. That new agreement always contains substantially different material and financial terms thereby reducing the value of the current franchisee's business (i.e., higher royalties, expensive remodeling requirements, new restrictions on sourcing of supplies, etc.).

The fear of not being renewed permeates every franchisee's relationship with the franchisor. Franchisees agree to excessive advertising and promotional expenses, equipment upgrades, changes in hours of operation, remodeling schemes, and employment practice mandates—you name it—during the term of their franchise contract all to remain in the good graces of the franchisor.

In some chains the franchisor actually uses the time after it denies a renewal--while the exiting franchisee is trying to sell the business to an 'approved buyer'--to reduce the value of the franchise. Is that fair? Is that operating in good faith? Unfairness is a concept that most children learn in kindergarten, if not earlier. Many franchisors (and their bloggers) must have missed that lesson.

When the United States Congress looked at all of these issues a decade ago both parties—Republican and Democrat alike--agreed on the substantive issues facing franchisees. The prior failure of franchise legislation at the federal level says little about the merits of such legislation and more about the financial and political clout of those opposing the legislation at the time.

California's AB 2305 ensures that the basic tenets of fairness and responsible business practices are a part of franchising. Increased investment within franchising in the State of California by franchisees will be encouraged as a result.

*The opposition blogger’s last name is Seid, which rhymes with "side."

Related Reading:

• Assembly Bill 2305 Is Good for California Business