Functional Dissolution of Franchise Systems

The circumstances of franchise system management 35 years ago were such that, if a franchisor engaged in abusive tactics toward its franchisees that had the potential to destroy their profitability, they left the system.

Serious franchise breakaway litigation tore franchise systems apart in many segments of the franchising business.

The disenchanted franchisees simply banded together and left, often to form their own new group of retailers doing the same thing under a new name. Properly represented, they overcame the threat of post termination covenants not to compete, used the federal antitrust laws to deal with certain kinds of franchisor conduct, especially the tying in of vendors and the use of that practice by the franchisor to extract an additional royalty stream through commissions, kickbacks and pseudo licensing arrangements. Territorial encroachment was another threat often met with breakaway. Franchisees had viable avenues of self defense and would use defense tactics to their advantage when they deemed themselves to be seriously threatened.

Then the world changed for franchisees, and those options were eroded by contract changes adopted throughout the franchise world and by changes in laws to the detriment of franchisees. The new and now universal contract language was primarily the liquidated damages clause that provides that any termination of the franchise triggers the right of the franchisor to “liquidated damages” in the lesser amount of at least

$ 100,000 or the average monthly royalties out to the end of the franchise term specified in the franchise contract. This gave franchisors the appearance of a viable counterclaim in any litigation regarding franchisees taking a hike on the franchise contract based upon a claim of franchisor abuse or franchisor breach of contract.

The provision assumes that any early termination of the franchise is due to a default by the departing franchisee. It is an automatic claim or counterclaim for the franchisor and a bargaining chip with significant perceived in terrorem effect. It has not yet been widely tested in franchisor abuse litigation/arbitration.

Since the famous Chicken Delight case, the law changed, mainly with the decision in the Jefferson Parish case, in that tying practices no longer are deemed a violation of the Sherman Antitrust Act. Simply put, goods and services sold to any franchisee chain of retailers no longer represent a substantial amount of trade in the tied in products and services sufficient for recognition under the Sherman Act. Products and services sold to a franchisee system population is functionally not the tied market, as that trade is merely part of the greater market consisting of all trade in those products and services. There are rare exceptions that are of little or no use in the normal franchise setting.

There had always been a debate in antitrust circles about whether tying arrangements should be treated as per se violations of the Sherman Act. Under the older cases, so little had to be tied in that any not insubstantial amount of tied in trade would suffice. Language in court opinions suggested that tie ins would be dealt with as per se offenses, but it wasn’t actually deemed to be that in the case law. Jefferson Parish ended that debate.

Encroachment litigation developed a body of case law in which a franchisor’s “impact study” done before the encroachment seemed always to lead to exoneration of the placement of new store locations hard by the established locations of existing franchisees. Those impact studies were a joke, and “expert witnesses” made nice fees swearing that “analysis” showed little or no likelihood of the placement of new store locations having any impact upon existing franchisees. Significantly, the franchisees claiming to have been harmed by the encroachments seem to have scrimped on the hiring of similar experts to opine that the encroachment really was a competitive threat, making the encroachment issue the subject of a line of case law greatly favoring franchisor interests.

In the present tense, franchise breakaway litigation seems no longer to be a functionally available option for franchisees who, as a group, never muster the intestinal fortitude to form early, competently guided franchisee associations. They always wait until the barbarian really is at the gate, and even then the requisite resources rarely are put forth to fuel what must be done. Accordingly, most serious predatory franchisor conduct is confronted by one or a small group of franchisees at a time, always under funded. The result is usually the result one would anticipate under those conditions.

Franchisors no longer perceive grave danger of breakaways, and they tend to see themselves as having a license to do pretty much as they choose, regardless of the consequences of their acts upon franchisee chain profitability, so long as they disclose that they intend to do it in their disclosure documents and provide the right to do it in their franchise agreements. With the advent of, one may witness the development of franchisor abuse scenarios in franchise chain after franchise chain. Franchisees are consumed one after another and never seem to appreciate what must be done to counter the attacks. There are the rare exceptions, but in the main franchisee associations are more social clubs than functionally competent armies of effective resistance. Dues are inadequate, and support is never pervasive amongst the population of a chain’s franchisees. Most believe they can lay back and reap any benefit that the activists obtain. The result is usually the result one would expect. The field is strewn with the corpses of bankrupt franchisees.

The significance of this phenomenon lies in its implications for franchise pre investment due diligence. The only real protection from an abusive franchisor today is to discover the franchisor’s inclination to be abusive before you buy the franchise and then decline to invest in it. Unfortunately, “business lawyers” without extensive franchise experience haven’t a clue about this level of pre investment due diligence. Franchisee after franchisee today signs the draconian agreements and obliviously marches to his financial demise.

Investing all you have in this world, plus all you can borrow, and then signing an agreement that is abusive and that is based upon disclosure documents that are largely fictitious is a very stupid thing to do. Lawyers who charge small fees to “read the documents” and “explain their legal meanings” are a complete waste of money when it comes to appreciation of investment risk profiles. Lawyers are taught not to get into the giving of investment advice for fear of malpractice litigation. Their malpractice carriers may refuse coverage if the client later claims that the lawyer gave ineffective investment advice in addition to legal advice. General business lawyers are taught to answer the question about whether a particular franchise is a good investment by telling the client that it might be if everything they are telling you is true. This is utterly worthless to the investing franchisee. It is worse than nothing, as it is seen by the client in most instances to be an affirmative endorsement of the proposition.

The truth of the matter today is that franchisees are investing in franchises that are part of largely dysfunctional systems. The franchisor in so many cases is engaging in practices calculated to maximize franchisor profitability at the expense of the franchisees. These include tying arrangements with vendors that deprive franchisees of access to competitive supply; cheek by jowl encroachment; the adoption of alternative distribution channels that make the franchise system merely one of many stores offering the core products of the franchise system instead of the exclusive source of those products; predatory inspections and “audits of franchisee operations that find issues that are frequently not fundamental breach of contract issues and then claiming that the errant franchisee is harming the good will of the system and violating the laws applicable to the operation of the franchised business. Franchisees are ground out like grist in a mill. Their total investments are lost. They lack, one at a time, the financial resources for competent dispute resolution representation. The list of profit prohibiting abuses is long, much longer than what you see here.

There is only one way to avoid investing in this kind of abusive franchise system. Pre investment killer due diligence by experienced franchise lawyers who are not afraid to vet the deal from a business as well as a legal perspective is simply indispensible. The money you save buying incompetent pre investment due diligence that does not address these outcome determinative business issues is chump change compared to the loss of your total investment and a trip to the bankruptcy court.

To access competent franchise pre investment due diligence, the potential franchisee must go on any search engine and do a search using the words “franchise lawyer”. Then he should call every lawyer he finds on the first two pages of the search results and ask the following questions. Do you focus on franchise pre investment due diligence in your practice? When you do franchise pre investment due diligence, do you vet the business issues as well as the legal issues? If the answer is not YES to both those questions, you have not yet found the right due diligence assistance. You can expect to spend upwards of

$ 3,000 to $ 5,000 for this level of due diligence assistance. That will always be less than 3 % of your initial investment and less than 1 % of your investment risk over the life of any franchise agreement. To risk hundreds of thousands of dollars, and millions when measured over the life of the contract you are about to sign without this level of due diligence is unreasonable. You odds would be better to take the money and go to Las Vegas. Aside from abusive franchises, there is still the enormous population of fraudulent franchises masquerading as real business propositions that no general business lawyer can sort out. Other articles in the Franchise Fraud Symposium series on deal with those problems.

The law does not presently protect franchisees as it once did. Only seeing the trouble before you get into the middle of it with no effective way out can prevent financial disaster for potential franchisees.

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