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Regulating Franchising

Regulation

Lexington, Ky. — Law professor Elizabeth Crawford Spencer argues that more intelligent regulation is needed to address franchising abuse, a message that is gaining traction in the franchise world. Why? Spencer explains that having no regulation or having a hodgepodge of regulation results in costly market inefficiencies.

A member of the state bar of Texas since 1996, Professor Elizabeth Spencer has worked in law in various parts of the world. She practiced law in Dallas and served on the staff of Southern Methodist University. She was the editor for Kluwer Law International in The Hague. Assistant Professor Spencer has lectured in business and franchise law since 2001 at Australia's Bond University, just outside of Brisbane. Last year she finished writing The Regulation of Franchising in the New Global Economy, a book that lobbyists, attorneys and franchise advocates will no doubt be poring over.

"It is my perception that we often regulate by reaction," observes Atlanta-based franchisor attorney and regulation expert Rupert Barkoff. Spencer agrees and has devoted considerable effort to categorize various approaches to regulation so that those pushing change can think holistically about how to regulate as opposed to reacting in jumbled fashion. Barkoff adds: "The book is a very comprehensive view of what is regulation in the broadest sense and how we regulate it [franchising] — subjects that many attorneys do not give much thought to."

Franchisee attorney Andrew Selden, an expert on franchise law and adviser on regulation, thinks such scholarly work is important. "Any sentient franchisor should encourage regulation, if only because it tends to exclude the riff-raff from the marketplace," Selden declares. "The challenge is to keep the regulation effective, and short of suffocating."

Spencer's timely book comes out as major legislation to curb franchising abuse has emerged from New England to California, from Canada's Manitoba to South Australia. The idea of regulation is currently being opposed by franchisor groups in various states and is likely to continue. Meanwhile franchisees and their advocates are taking a momentary pause to consider how best to reform the franchise industry in order to curb widespread abuse.

Professor Spencer gave an exclusive interview to Blue MauMau about her study of regulation and why it is necessary. The following is part one of a two-part interview.

BMM: After so many years, does franchise regulation really need to be updated?

Spencer: I think so. First of all, it needs it because a great deal of franchise regulation is the result of cut-and-paste from regulatory approaches of other sectors, like the financial sector for disclosure, for example, or even other jurisdictions. Internationally, Vietnam borrows heavily from Australia and other countries. It fails to represent the results of proper regulatory process that bubbles up from their own locality. So that's the first flaw, which is the process of arriving at what's appropriate franchise regulation. Second, regulation is mostly procedural. Currently it relies heavily on the capacity of the parties themselves to play very significant roles in the regulatory process. Disclosure is heavily reliant on the ability of the participant to use it to provide accurate and reliable information and then to act on that information, and very often they can't.

Finally, I would say that the regulation that we have now in most countries in the world tends to borrow from others and rely on the same old tools. It fails to avail itself of a full range of modern regulatory tools that are available to deal with specific problems that arise in franchising. I just think that we have a long way to go in regulatory process generally in franchising. Do the laws need to be revised and do they need to be changed? Franchise laws need to evolve because we know a lot more about the regulatory process and what should be happening.

The laws still reflect what came out in the '70s and the '80s and the '90s. That's a while ago now.

BMM: As the saying goes, "if it ain't broke, don't fix it." What's wrong with our current franchise laws? Why should the typical franchisee be concerned that franchising regulations need to be updated?

Spencer: It is broke. Franchise law is put into place in a hodge-podge fashion. On the one hand, if you take the laissez faire approach and argue that people are grown-up business people entering into contracts who know what they're doing, the pain is that you have less efficient markets. You have franchisees going bust because of warped processes and information that obfuscate how their money is being used. You have franchisees committing suicide. You have franchisors becoming insolvent, while leaving a path of unchecked financial destruction in their wake. I'd say that if we don't improve regulation, we will see more failed businesses, less efficient business interactions that create unnecessary costs due to the lack of understanding of the parties and the inefficient -- there is an inefficient shifting of risk that is inherent in franchising. There will be a reduction of confidence in franchising. As that happens, everyone suffers.

That's the reason why we should have appropriate business regulation.

It's always easier for regulators to say, "Hands off. We'll do as little as possible. We won't be accused of paternalistic approaches. We won't be accused of getting it wrong. We just will go along with the old common law idea of people entering into contracts and the sanctity of contract. The government shouldn't intervene."

BMM: But the free market is made up of both winners and losers. The sizable moneys dished out to franchisors, lenders, consultants, suppliers and others from failed franchisors and franchisees that are replaced by new, eager investors help fertilize the marketplace and grow the economy, doesn't it?

Spencer: Years ago a head of a franchise association said that. He said to me that you need to understand that our economy is built on the failure of small businesses. I said, "Really?"

And then I went to a conference with accountants, lawyers and other professionals. There is a whole industry trying to nurture new businesses and feed it. If it goes broke, then you get to nurture more new businesses. And then I went to a conference of economists in France one year. They were mostly of the Austrian School of Economics thinking.  I started to talk about disclosure and how franchisees were impacted by an inefficient shifting of risk and so on.

One of the economists walked up to me afterwards and said, Liz, you need to understand, economists don't care about this. We don't care that franchises go well or if franchisees suffer. Economists are looking at the overall health on a macro level.

If franchisees fail over and over again, it's still good for the economy.

They talk about destructive capitalism. The fact that these small businesses go in and out of business; they invest all of their money and so forth, well, unfortunately, that destruction is part of the thing that feeds our capitalist system. They say that's a good thing. Those are lessons. Business owners go on and learn different things, so there is no harm in franchises going belly up or small businesses going belly up. The economy is built on such things.

BMM: You point out in your book that we can't seem to get away from regulation, even when it seems no regulation is there. Although we typically don't think of it that way, courts regulate franchising when they interpret and enforce contracts. There is also self-regulation. In understanding regulation, you describe different types for different occasions — for example, prescriptive and procedural regulation. What is that?

Spencer: There is also performance-based regulation. I see those two as probably the more important category.

Prescriptive regulation is actually more command and control. Prescriptive often involves standards that the regulated interest has to meet. A certain measure has to be undertaken, a certain method, a certain technique, and a certain outcome. It might be that a provider has to provide certain warranties with products. It might be prescribed contents of an agreement; for example, minimum contract duration or unfair contract terms legislation, such as legislation that prescribes unilateral variation of the contracts.

The Regulation of Franchising and the New Global Economy by Prof. Liz SpencerSo confidentiality perhaps is a requirement, the minimum requirement of a franchisor with respect to perhaps latent things — how long a franchisor has to be in operation. Some of those — there's not always a very dark and easy-to-see line, but prescriptive is setting goals, setting standards and saying the franchise needs to hit them. We look at outcomes. And so as I say, mandatory contract terms: a franchisor has to provide ten days curing period before exiting the relationship

And then we have on the other hand, procedural standards. And they're a bit more hands off and they say you need to go through the following procedures. So we're not going to measure that you hit a certain target. We're not going to say a franchisor needs to provide for X or Y or Z provision in its franchise contract. Rather, we're going to say that a franchisor needs to go through certain processes. A classic one is information disclosure [Franchise Disclosure Document]. The franchisor needs to go through this process of licensing and registration. In some countries there are dispute resolution processes and public franchise education programs.

Prescriptive measures are considered to be less well adapted to self-regulation. They require a greater role for their regulator and greater monitoring and involvement of a regulator and external measurements. Regulators find them more expensive and they don't like them. They want to stay away from those prescriptive measures. A lot of laws are relationship laws. For example, the unfair contract term types of provision. Regulators don't really want to go there because they require them to be more actively involved, and then they can make mistakes and they can be called on the carpet for making those mistakes.

The procedural tools from the point of the view of the regulator are often used where performance and compliance are hard to measure, or where government agencies don't want to get involved, lack the motivation or the financial support for a more hands-on approach. Procedural tools are preferred by regulators. And also I think procedural tools are used because of our approach in the common law world to contract law, where we have a tradition of not second-guessing what parties include in their contracts.

We say lawmakers, regulators and the courts can look at contract formation. But once the parties have formed their contracts, they've made their bid and they've signed it and we don't look at the deal. Whatever the party has bargained, the courts and government should honor because regulators shouldn't get in and say what is a fair deal.

That's another reason why governments and regulators favor procedural standards. But they don't always accomplish what we need to get done, because then you must be sure that the parties are able to carry out their particular roles in those procedural standards. And that's where I get into in the book, for example, why disclosure as a procedural regulatory tool is deficient in my view, because the parties aren't capable of disclosure functions. In most franchise contexts the parties very often do not function properly because they aren't carrying out their roles as well as they could or don't even have the capacity to carry out their roles. They may not have the interest or the capacity to carry out their roles in those self-regulatory procedural types of measures.

BMM: Right. In cases that I research as a reporter, I see critical information from franchisors that mysteriously don't end up being published in the Franchise Disclosure Document, despite U.S. federal and state regulation that requires the procedure of filling out a template for disclosure. The federal government and most states don't even ask for these to be filed with them. And no government entity monitors them for accuracy. The truth is that these Franchise Disclosure Documents depend on a sort of franchisor honor code, but unfortunately some have no honor.

Spencer: And how is a franchisee to know of the accuracy of the franchisor statements? For example, if the franchisor says its systemwide sales is $234 million, a franchisee is going to be very hard pressed to know if those system numbers are real.

BMM: So what should be done to improve the real world holes in disclosure law?

Spencer: I haven't even summarized the problems with disclosure. We shouldn't put the cart before the horse. I think you should always — in proper regulatory process, one should always go through the step of identifying problems, issues and agreeing on them before starting — before getting to what is needed to do to fix them.

I talked about the functions that are necessary for the establishment of an effective information disclosure strategy. You need to gauge the risk. Prospective franchisees need to get reliable information. Regulators need to make sure that the information can be disseminated in a form that's usable and accessible to prospective franchisees. It needs to be useful to ensure that the target audience can act. In franchising, the needed information isn't always provided about franchising or the nature of franchising. I love Professors Roger Blair and Francine Lafontaine's definition in which they describe a franchise contract for what it is. It is an agreement of limited duration that gives the franchisees the right to use a franchisor's intellectual property, limited by the scope of the grant or the contract.

If franchisees do not understand even that, then they don't understand what the nature of the agreement is. Franchisee prospects don't understand what's happening in the specific franchise system. They don't get enough information about the nature of franchising generally, its standard form, the franchisor-franchisee relationship and the nature of what they're getting into. They don't.

Then they don't get information about the franchising system. Prospective franchisees don't get information about specific contractual terms that relate to concrete issues. The quality of the information is compromised because there is no monitoring and enforcement. That's because regulators expect the parties to do all that by themselves. The franchisees are in a poor position to do that.

There are only two ways that the information is usable: one is for the user to negotiate a better contract for themself and the other is to walk away and find another deal. The first problem is that they can't negotiate because these aren't negotiable contracts. Secondly, prospects often don't walk away and find better deals because they're already psychologically committed, if not actually legally committed when they're getting disclosure. There is also the use of legalese and lack of sufficient expert advice, inappropriate timing and so on. All those are problems. Disclosure can generate huge problems if information is inaccurate, [or] doesn't address or identify existing concerns. It can promote fears or create a false sense of security and so on.

So what is needed to be sure that the franchisors provide accurate information?

We need better monitoring [of the Franchise Disclosure Document].

Registration can also help [where disclosure documents are left on file with the states]. It's resisted like crazy in Australia and I know that people in the U.S. feel that it adds another layer of expense and difficulty in the whole process. I know regulators don't want to be involved because they feel that then it provides some sort of rubber stamp. But there needs to be some sort of repository [like California's Cal Easi database or Minnesota's CARDS of online filings and access of disclosure documents] where all those disclosure documents could be placed so that these documents can be easily accessed.

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