- Front Page
- Biz Tools
On April 6, I faxed this support letter on California's need for the The Level Playing Field for Small Businesses Act (AB2305) to the honorable Jared Huffman, assembly member of the California State Assembly. I was one of two experts invited to testify at the hearing of California's Judiciary Committee on the need for Assembly Bill 2305
Dear Assemblyman Huffman:
I write in support of AB 2305 as an attorney who regularly represents franchisees regarding issues they have with their franchisors. I first became involved in the field in 1979 as one of the initial staff attorney enforcing the Federal Trade Commission Franchise Disclosure Rule. Since going into private practice I have represented hundreds of franchisees in individual, group and class actions. I have also counseled franchisees and their associations regarding franchise offerings and I have reviewed hundreds and hundreds of franchise agreements over the past three decades. In this letter I will first address some of the realities of franchising in California today and then discuss some of the proposed amendments to the current franchise statutes in California and why these changes are needed.
Under federal law, and that of several states, the proposed franchise agreement offered to prospective franchisees must be included in the franchise disclosure document. See, 16 CFR Part 436.1, Corporations Code Section 31,000, et. seq. For this reason franchisors, and their counsel, must and do prepare their franchise agreements in advance. Franchise agreements are accordingly written by and for franchisors and are invariably one-sided adhesion contracts favoring franchisors.
For many years some franchise salesman often would tell prospective franchisees that the terms of the franchise agreement contained in the offering circular were non-negotiable. This statement was false then as now. A contract is always negotiable and nothing prohibits an offered franchise agreement from being altered. At most a negotiated change in a franchise agreement may require that the franchisor to amend its registration and disclosure documents.
A leading franchisee commentator, the late Harold Brown, described franchising problems way back in 1969 which still exist today:
"There is a marked, intentional, and constantly emphasized disparity in the positions of the parties – the franchisor combining the roles of father, teacher, and drill sergeant, with the franchisee relegated to those of son, pupil and buck-private, respectively. At the core of the franchise relationship is the contractual control exercised by the franchisor over every aspect of the franchisee's business. Starting with the advertisement which calls for "no experience," the franchisor inculcates the franchisee with the necessity of being taught, guided, and controlled not only during the initial training period but through-out the existence of the franchise. The franchisor controls the site, commissary purchases, purchases from other vendors, method of business operations, labor practices, quality control, merchandising, and even record keeping. This control is buttressed by the contractual requirement that the franchisee must obey the commands of the Operating Manual as unilaterally amended from time to time and as expounded by the franchisor's supervisor, on pain of losing the franchise if he disobeys them and under constant threat of such termination. And upon termination, or failure to renew, the franchisee is confronted with the covenant not to compete and forfeiture of this equity in the business. — Harold Brown, Franchising: Trap for the Trusting (1969) (emphasis added).
Yet most one-sided franchise agreements are not negotiated by franchisors at all. In franchise after franchise our law firm has been involved; the predominant response to requests to change the proposed franchise agreement is that we do not negotiate our franchise agreements. Even in the minority of franchise systems where negotiation occurs, only a few provisions are typically negotiated with limited changes.
One California Court of Appeal described the one-sided franchise relationship in 1996 as follows:
"Although franchise agreements are commercial contracts they exhibit many of the attributes of consumer contracts. The relationship between franchisor and franchisee is characterized by a prevailing, although not universal, inequality of economic resources between the contracting parties. Franchisees typically, but not always, are small businessmen or businesswoman or people like the Sealys seeking to make the transition from being wage earner and for whom the franchise is their very first business. Franchisors typically, but not always, are large corporations. The agreements themselves tend to reflect this gross bargaining disparity. Usually they are form contracts the franchisor prepared and offered to franchisees on a take-or-leave-it basis. (Emerson, Franchising and the Collective Rights of Franchisees, 43 Vand.L.Rev. 1503, 1509 & fn. 21.) Among other typical terms, these agreements often allow the franchisor to terminate the agreement or refuse to renew for virtually any reason, including the desire to give a franchisor-owned outlet the prime territory the franchisee presently occupies.
Some courts and commentators have stressed the bargaining disparity between franchisors and franchisees is so great that franchise agreements exhibit many of the attributes of an adhesion contract and some of the terms of those contracts may be unconscionable. "Franchising involves the unequal bargaining power of franchisors and franchisees and therefore carries within itself the seeds of abuse. Before the relationship is established, abuse is threatened by the franchisor's use of contracts of adhesion presented on a take-it-or-leave-it basis. (See, e.g., Ungar [v. Dunkin' Donuts of America, Inc. (3d Cir. 1976) 531 F.2d 1211, 1222-1223]; Semmes Motors, Inc. v. Ford Motor (2d Cir. 1970) 429 F.2d 1197, 1207; see generally Note, Fairness in Franchising: The Need for a Good Cause Termination Requirement in California (1980) 13 U.C. Davis L.Rev. 780, 785, fn. 18 . . .) Indeed such contracts are sometimes so one-sided, with all the obligations on the franchisee and none on the franchisor, as not to be legally enforceable. (Brown & Cohen, Franchising: Constitutional Considerations for 'Good Cause' State Legislation (1978) 16 Hous.L.Rev.21, 33 . . .)." (E.S. Bills, Inc. v. Tzucanow (1985) 38 Cal.3d 824, 835-36, 215 Cal.Rptr. 278, 700 P.2d 1280, Mosk., J., concurring.) — Postal Instant Press v. Sealy, 43 Cal.App.4th 1704, 1715-1717 (1996).
Another of the leading commentators and franchise attorneys described the typical franchise model as "power franchising" consisting of "heavily one-sided contracts that lock the franchisee into an unknown future determined by the unilateral decisions of the franchisor management." Andrew C. Selden, Organizational Design for Successful Franchising, 20 Franchise Law Journal 1 (2000).
In 2002, I decided to study ten franchise agreements I selected at random from the public records of the California Department of Corporations. The results from my analysis were published in an article entitled "Franchising in California: Uniformity in California Franchise Agreements, 21 Franchise Law Journal, p. 136 (Winter 2002). Among my conclusions: "The franchise agreements surveyed for this article reflect a substantial degree of uniformity. Most agreements include the same or similar versions of nearly all of the forty-seven pro visions under review. Franchisor obligations are few and sharply circumscribed. … In contrast to the limited carefully qualified obligations of the franchisor, franchisee obligations are many and often unqualified. … Moreover, many provisions under review are designed to deprive franchisees of legal rights and remedies that they would otherwise have." Id., at p. 142.
The one sided nature of franchising is not only not getting better it is regressing. Let me provide you with several examples:
2.2 Term and Renewal. [Among many other provision to renew] Franchisee shall sign Franchisor's then-current standard form franchise agreement no later than six (6) months before the expired date of this Agreement. The new form of agreement may contain terms and obligations that are different than what is contained in this Agreement …
5. Duties of Franchisee. Franchisee understands and acknowledges that compliance with the System and consistency with respect to every aspect of the operation of the Franchised Business is critical to Franchisee, to Franchisor and to the other … Franchisees.
7.1.1 Confidential Manuals. Franchisee shall adopt and use the programs, services, methods, standards, materials, policies and procedures set forth in the Manuals, as they may be modified by Franchisor from time to time.
13.2 Default with Fifteen (15) Day Opportunity to Cure. … B. If Franchisee fails to maintain any of the standards or procedures prescribed by Franchisor in this Agreement, the Manuals, or in any other agreements between the parties.
14.2 Right to Continued Operation of Franchised Business. In the event this Agreement is terminated, Franchisor may, at its option, immediately enter the premises of the Franchised Business and continue to provide services to clients or customers of the Franchised Business and apply receipts to debts owed by Franchisee. Franchisee hereby assigns all receivables to Franchisor without recourse. …-
26. Arbitration. Except as specifically otherwise provided in this Agreement, the parties agree that any and all disputes between them … shall be determined solely and exclusively by arbitration under the rules of the American Arbitration Association … [by] a single arbitrator who shall be a member of the Texas Bar in good standing for at least fifteen (15) years. The Arbitrator shall hear the dispute within two (2) weeks of the date of the meeting of the representatives. … The Arbitrator shall hear the dispute in Dallas County, Texas. … shall be commenced within one (1) year from the occurrence of the facts giving rise to such claim or action, or such claim will be barred. The parties waive to the fullest extent permitted by law any right to or claim for any consequential, punitive or exemplary damages against the other and agree that in any dispute they shall be limited to the recovery of any actual damages sustained. …
None of the above provisions are unique; in fact most of them are typical provisions in many if not most franchise agreements in California. In sum, franchising in California today is characterized by increasingly one-sided and non-negotiable franchise agreements.
In most cases franchisee investment in their California businesses is not only substantial, it is total. For a typical fast food franchise, the franchisee starts out with an up-front franchise fee to the franchisor often of $25,000 or more. Next the franchisee typically must buy signage, refrigerators, stoves, and other required equipment. Similarly, the franchisee must build-out the store to the franchisor's specifications. These expenses are usually six figures sometimes ballooning into hundreds of thousands of dollars. But there is usually more often in the form of a long term commercial lease costing thousands of dollars per month for years ahead.
Franchisees often borrow this money from relatives or from lending institutions. In the latter case they have loans they invariably personally guarantee. Sometimes franchisees pledge their homes with mortgages in order to secure the financing for their franchise businesses.
Many franchisees also look to their franchise businesses for their livelihoods. They view the franchise investment as buying a job. Sometimes this is literally true when they have been laid off employment, take early retirement, or seek a job for their children. As their livelihoods many look to their franchise business for income to pay their personal expenses for themselves and their families. But a franchise differs from a job in that there is no guaranteed paycheck from an employer. Sometimes a franchise business does not generate income, instead franchise businesses can sometimes lose money.'
The ultimate problem in franchising is when the franchise business loses money especially when the franchisee has expected the franchise business to support their family with income. Not only is there no income, but the franchisee must put in money to cover the expenses of the business including buying merchandise, paying rent, paying royalties to the franchisor, paying employees, and paying loans. Nor can the franchisee easily close down the franchise business. With no cash flow the franchisee cannot pay off rent and the loan, as well as other obligations. At least keeping the business open there is some money to cover these expenses, although not enough to cover all. The franchisee is literally trapped and cannot even close the business. Unfortunately this happens repeatedly in franchising. When the funds completely run out the only remaining recourse may be bankruptcy. Our firm has had many franchisee clients who have had to file for bankruptcy because of loses in their franchise businesses.
The Small Business Administration has lending programs for individuals seeking to buy franchises. A published report, found dozens of franchise systems with over fifty percent of franchisees failing to pay back their SBA loan obligations. Some have failure rates of over ninety percent. See, SBA Franchisee Failure Rates by Brand, 2011. Our firm is aware of multiple systems in which many if not all franchisees were unprofitable and systems where the franchisor failed and went out of business.
Comparison of a franchise investment to securities investment, employment and consumer transactions is illustrative. When one purchases a stock there is risk capital involved. Thus the stock investor has the amount of money invested in the stock. But that is ordinarily the total amount at risk, and if the stock goes bad the upfront risk capital investment is lost. Not so with franchising. The initial franchise fee is the beginning. Substantial build-out and other expenses occur, but this too is only the beginning. As ongoing businesses losses may continue, long term debt from leases and loans may continue to multiply. A franchise has some similarity to employment in that the franchisee is told in extraordinary detail what to do, how to do it, and the performance rules may be changes on an ongoing basis just like employment. But unlike employment, the franchisee is not guaranteed a paycheck. In addition unlike employment, the franchisee must pay rent and other expenses personally if income is not sufficient. Many courts state that franchises are business to business transactions. But the dictation of controls, the lack of negotiation of contracts, and the tremendous economic and informational imbalances more closely resemble consumer to business transactions.
The California Franchise Investment Law ("CFIL") is a forty year old statute in need of revisions to fulfill its purposes. Corporations Code Section 31000, et. seq. Those purposes include requiring truthful disclosure of material information to prospective franchisees and prohibiting misrepresentations and material omissions in the offer and sale of franchises. Corporations Code Section 31001. Registration and disclosure is essential because of the informational imbalance in franchising. A franchisor has operated its business and knows every facet of its business its franchises and its franchise agreements. Typically a franchisee has never been in the franchised business, does not know the industry, and may never have been in business. The franchise does not know the industry. Indeed that is why the franchisee buys a franchise.
The CFIL was modeled after the securities laws with government registration and also with a private right of action. The later provision was and is important because government enforcement of these statutes has limited resources. No action may be taken in many cases due to a lack of resources and other limitations. In franchising, the federal regulation by the Federal Trade Commission has repeatedly been held to allow for no private right of action.
The statutory language and damages remedies borrowed from securities laws, and over forty years old is strengthen and clarified by the proposed amendments in AB 2305. The amendments clarify the damages remedies, provide for attorney's fees for prevailing plaintiffs, and extend the statute of limitations to mirror contract and fraud statute of limitations. These changes are essential because unlike securities investors, franchisees typically have much more at risk. Not only is their initial investment typically higher for them, but they face substantial and ongoing losses. In addition many franchisees look to their franchises for their livelihoods.
The proposed amendments of AB 2305 also seek to clarify what they statute already provides (in our view) but which federal courts do not always apply. These provisions clarify the reliance requirement as well as efforts to negate the entire statute by franchisor disclaimers and fine print. In particular franchisors have come up with contract provisions and disclaimers to negate the application of the CFIL to their franchise disclosure and sales tactics. Thus most all franchisors include the following in their disclosure documents and contract fine print: 1. integration clauses: the contract is as written no additional provisions; 2. no representation clauses: nothing else was said in the sales process then what is in the contract; 3. no reliance clauses, i.e. that the franchisee buyer did not rely on anything said to him or her other than what is in the contract. Here is a typical such disclaimer by a franchisor from a franchise agreement:
BEFORE SIGNING THIS AGREEMENT, THE FRANCHISEE SHOULD READ IT CAREFULLY WITH THE ASSISTANCE OF LEGAL COUNSEL
24.1 THE FRANCHISEE ACKNOWLEDGES THAT:
THE SUCCESS OF THE BUSINESS VENTURE CONTEMPLATED HEREIN INVOLVES SUBSTANTIAL RISKS AND DEPENDS UPON THE FRANCHISEE'S OR THE OPERATING PRINCIPAL'S ABILITY AS AN INDEPENDENT BUSINESS PERSON AND ITS ACTIVE PARTICIPATION IN THE DAILY AFFAIRS OF THE BUSINESS, AND
NO ASSURANCE OR WARRANTY, EXPRESS OR IMPLIED, HAS BEEN GIVEN AS TO THE POTENTIAL SUCCESS OF SUCH BUSINESS VENTURE OR THE EARNINGS LIKELY TO BE ACHIEVED, AND
NO STATEMENTS, REPRESETNATIONS OR OTHER ACT, EVENT OR COMMUNICATION, EXCEPT AS SET FORTH IN THIS DOCUMENT, AND IN ANY OFFERING CIRCULAR SUPPLIED TO THE FRANCHISEE, IS BINDING ON THE FRANCHISOR IN CONNECTION WITH THE SUBJECT MATTER OF THIS AGREEMENT, AND
FRANCHISEE ACKNOWLEDGES THAT FRANCHISEE HAS CONDUCTED AN INDEPENDENT INVESTIGATION OF THE FRANCHISE SYSTEM AND RECOGNIZE THAT THE BUSINESS VENTURE CONTEMPLATED BY THIS AGREEMENT INVOLVES BUSINESS RISK AND WILL BE LARGELY DEPENDENT UPON THE ABILITY OF FRANCHISEE AS AN INDEPENDENT BUSINESS PERSON. FRANCHISOR AND FRANCHISOR EXPRESSLY DISCLAIM THE MAKING OF, AND FRANCHISEE ACKNOWLEDGES THAT IT HAS NOT RECEIVED, ANY WARRANTY OR GUARANTEE, EXPRESSED OR IMPLIED, AS TO THE POTENTIAL VOLUME, PROFITS, OR SUCCESS OF THE BUSINESS VENTURE CONTEMPLATED BY THIS AGREEMENT.
This entire Agreement, including corrections, changes, and all Attachments and addenda, will only be binding upon the Franchisor and Licensor when executed or initialed by the Franchisor's and the Licensor's authorized representative."
These clauses and disclaimers should not be effective to stop misrepresentations or omissions made by the franchisor in their offering circulars or in the sales process. That is because the CFIL does not require "justified" reliance for recovery as currently written, and also has an anti-waiver provision.
See, Corporations Code Sections 31300, 31301, 31512. Stated differently the prospective franchisee should be entitled to rely on their franchisor and what is said in the sales process.
While the above interpretation of the CFIL is also consistent with the rule that it is to be liberally to protect franchisees, some federal courts have interpreted the CFIL differently. For example in California Bagel Co. v. American Bagel Co., 2000 WL 35798199 (C.D. Cal. 2000), a federal judge used such disclaimer clauses to bar a CFIL claim.
The proposed statutory additions clarify that such cases are wrong in that:
In addition because statute is tedious and borrowed from securities law
The California Franchise Relations Act ("CFRA") was enacted later in the 1970s as one of the first state statutes to address the franchise relationship covering terminations and non-renewals in franchising. But the statutory protections are weak and the remedies provided are limited.
Franchisees need further legislation because they have substantial investments and livelihoods at risk, and they are locked in and cannot leave their franchise businesses. One economist, Professor Gillian Hadfield, described the result of franchise agreements and relationships being imbalanced. G. Hadfield, Problematic Relations: Franchising and the Law of Incomplete Contracts, 42 Stan. Law. Rev. 972 (1990). Professor Hadfield concludes that once a franchisee invests and builds out their franchise business they are vulnerable to economic coercion due to the incomplete contracts and the franchisee's sunk costs. This is an understatement in our experience. Franchisors with the threat of termination or simply on renewal are able to extract new terms and economic concessions from franchisees which may range from unfair to devastating.
Currently the CFRA authorizes termination for breach of any lawful provision of franchise agreement. The proposed amendments of AB 2305 require that the breach be substantial and material. Given franchisee investment of time and labor building their businesses in their communities, they should face terminations only for substantial and material breaches.
Currently the CFRA provides no right to renew. This is remedied by proposed amendments in AB 2305 providing a statutory right to renew. Franchisors are protected from renewing bad franchisees by the same language from the termination provisions. Namely a franchisor need not renew a franchisee which has substantially and materially breached the franchise agreement.
Currently the CFRA has limited remedies. Again in one federal court case these remedies, a limited amount of damages to buy back the inventory of a wrongly terminated franchisee, were held exclusive. Boat & Motor Mart v. Sea Ray Boats, Inc., 825 F.2d 1285 (9th Cir. 1987). The proposed amendments provide for damages remedies, attorney's fees for prevailing plaintiffs, and preliminary injunctions to stay in the franchise business.
Other states including Hawaii, Indiana, Iowa, Washington, and Wisconsin, have enacted other franchise relationship provisions to prohibit unfair practices in the franchise relationship. AB 2305 borrows from those provisions primarily already law for many years in Hawaii and Washington to protect franchisees from such practices as: encroachment, kickbacks in required purchases, lack of good faith and competency, and interference with the right of association of franchisees. All of these problems exist with California franchisees currently.
California franchises work hard in all of our communities in California. The proposed revisions seek to address franchisors which act unfairly and deceptively. Franchisors which comply with the law in the sale of franchises should join in efforts to provide effective remedies to weed out those that act deceptively and unfairly. We encourage adoption of AB 2305.
Very truly yours,
Peter C. Lagarias