Governor Brown’s Veto of the Franchise Legislation, Cold Turkey Legs, Churning and Mud-Slinging

Governor Brown’s recent veto of the proposed California franchise legislation was momentously stunning in light of his political background, the legislature’s strong support for the proposal, and the relatively unthrusting additional functional protection that the legislation would have provided to franchisees. Why did he veto the legislation? Where better to look for an answer than in the Governor’s Veto Message that accompanied the veto. In that document, the Governor provided three reasons for his veto. None of the asserted justifications withstands minimal scrutiny.

First, the Veto Message concluded cursorily that a change of the franchise termination legal standard from “good cause” to “substantial and material breach” would require the franchise industry to abandon a “common and well understood good cause standard” in favor of a “new and untested substantial and material breach standard.” This assertion not only turns legal history on its head, but also perverts prevailing relevant franchise law.

In reality, the term “material breach” -- and not the phrase “good cause” -- is common and well understood. The common law of contracts has from time immemorial embraced the perspicuous and indispensable principle that a contract may be terminated by one party only upon a material breach by the other party. In this regard, a very basic, quick, and unscientific legal search on Westlaw for the term “material breach” readily brings up a case from as far back as 1837. The anticipated niggling observation that the proposed California standard consisted of two words (“substantial and material” breach), not just one word (“material” breach), does not bolster the Governor’s off-base excuse on this issue. It is beyond dispute that the terms material and substantial are in almost every context legal synonyms; they are merely flip sides of the same coin. Very simply, a party who is in substantial compliance with his or her obligations under a contract cannot simultaneously be in material breach of that contract.

In the Veto Message, the Governor could have made another argument regarding the alleged clarity of the proposed standard, but he did not: that the “material breach” standard is itself inherently ambiguous. Although true, this observation cannot be a reason for refusing to use the ubiquitous and well-understood standard. Almost every “standard” in the law has some inherent ambiguity; that is why we have judges and juries, and, unfortunately, lawyers. Furthermore, in the case of material breach, the Restatement (Second) of Contracts sets out with notable particularity the explicit factors that the fact-finder must take into account in determining whether a breach is material or there has been substantial performance. Moreover, the identified indicia in the Restatement as a package are “crowd pleasers” in that they encompass economic and populist teachings.

In contrast to the term “material breach,” which is legally entrenched, the term “good cause” lacks a uniform or consistent meaning in the franchise world. For every statutory scheme that utilizes the term “good cause” in one way, there is another statutory scheme that uses the term in a different manner. Quite simply there is no historical lineage for “good cause” under the common law of contracts. Indeed, the term has shown itself to be infinitely malleable. The prolific statutory-based standards have been uniquely defined by legislative drafters to meet the idiosyncratic and self-interested business goals of those who have forced adoption of the particular legislation.  

Accordingly, depending upon the strength and ideology underlying the particular franchise statute, good cause could in one statute allow a franchisor to terminate a franchisee for merely having spoken “too long” to the franchise owner’s wife during a cocktail party, and it could in another statute prohibit a franchisor from terminating a franchisee unless the franchisee served fried swine as a ‘featured item’ (a non-approved menu item). Contrary to the Governor’s suggestion, pervasiveness is not equivalent to uniformity. In the franchise industry there are as many meanings of “good cause” as there are breeds of cat (natural and man-made).

Further, although California’s Franchise Act was one of the earliest pieces of franchise legislation adopted in the country, the Act is in a significant way extraordinarily miserly in terms of the protection it provides franchisees in a termination context. All other things being equal, on an “Ease of Termination” scale (“EOT scale”) spanning from 1 to 10, with 10 being the most restrictive on the ability of franchisors to terminate franchisees, California’s current “good cause” standard registers at only a 3 or 4. As a benchmark, a statute embodying a “material breach” requirement would fall on the scale at about a 6.  And, on the other end of the scale, at a 9 or10, there are those few statutes that embody a more restrictive franchise termination yardstick requiring that any such termination be carried out in “good faith” by the franchisor with reference only to the existence of alleged misconduct of the terminated franchisee.

Finally, on this first point, a review of the legislative history shows that, despite the very specific criticism in several of the legislative committee memoranda that the proposed legislation contained an “ambiguous” standard that would be too costly to enforce, it was not used by the authors of those documents with reference to “material breach”; instead, it was asserted only with regard to the standard of  “good faith” -- a different standard, which had early in the legislative process been ejected from the proposed legislation. In other words, the author of Governor Brown’s Veto Message appears to have simply ‘lifted’ an historical critique from the legislative history that was intended to apply specifically to one particular term that no longer existed  (“good faith”) and then applied it to a completely different term that was later substituted (“material breach”).

Second, the Governor in his Veto Message indicated that he was concerned that a “change” in the law, by itself, would negatively affect California’s “vast franchise industry” in a way that would be unusual and unacceptable. In so stating, the Veto Message fails to identify the specific costs about which the Governor was apprehensive. From the context, I would assume that the Veto Message on this point was referring in general to increased compliance costs, and not termination costs.

Initially, it is important to note that there is undeniably nothing qualitatively different in franchising that would make those impacted by a modification in governing law more costly (from a compliance perspective) than in other industries. Understandably, certainty is a commodity that every business owner – franchisee or independent – craves, and uncertainty is a phenomenon that every business owner eschews. In this regard, a new termination standard would increase compliance costs arising from the need of market participants to modify their marching orders, goals and to prepare new legal documents. And, of course, there would be some associated litigation to clarify with more certainty the contours and boundaries of the new standard. However, these types of compliance costs would afflict the participants of every industry subjected to a new legal standard of conduct and performance.

Interestingly, the unhelpful Veto Message does not address the elephant in the room -- how much more would the legislation have added to the cost of franchisors to terminate franchisees? These termination costs, not technical compliance costs, are what ultimately must be evaluated; they are, in large measure, understandably, what seem to persuade legislators, and governors, to vote against franchise legislation. Economically, the general ability of a franchisor to terminate at reasonable cost plays a vital role in the dynamic franchise model; this is because these costs are directly tethered to the franchisor’s ability to achieve a given level of franchisee compliance with system standards and regulations – the sine qua non of the success of any franchise concept and system.

In this regard, contrary to franchisee advocates’ attacks, there is nothing abstractly improper with franchisors striving to legitimately limit and minimize termination or any other costs of operations and sales. There is no need for franchisee advocates to run from this academic truism, and the continuing overall failure to fully recognize and evaluate how particular proposed legislation will increase these costs will markedly hamper franchisees’ future efforts to enact franchise legislation. On the other hand, franchisor advocates should recognize that because economic incentives in franchise markets are infested with externalities and information failures, and given the humungous sunk costs almost always made by franchisees in franchise-specific infrastructure, the myopic pursuit of “termination cost minimization” will leave scores of franchisee cadavers littered along the side of the road to operational perfection. This is neither equitable nor efficient. The lack of equity gives rise to prickly franchisees, lower sales (of franchise product and franchise opportunities) and stultified investment by franchisees (and third parties) in the system. In addition, the attendant sub-optimal efficiency prevents societal resources from being used in their most efficient manner, thereby harming society and consumers.

Last, on the issue of termination costs, it is faulty reasoning to simply and myopically examine only the “direction” of the of the cost impact that a new termination standard would have on franchisors; indeed, in almost every case, the new proposed standard would lead to a higher number on the EOT scale, bringing with it the relatively higher costs of termination, identified above. (An interesting type of case arises, however, where the EOT for a statute is far below the 6 associated with a material breach, but the statute has not explicitly abrogated ‘other common law causes of action’, which, of course, would still permit the franchisee to have his or her termination governed by the material breach standard).

The blanket observation that a new proposed termination standard increases a franchisor’s termination costs – which is the inveterate, hypocritical and omnipresent cry of franchisor advocates -- is by itself statically useless from a genuine legislative policy point of view. The correct question, which is frequently absent in debates surrounding proposed franchise legislation, is ‘how much’ more protection will be purchased for the increased cost. Is the increased protection proposed too substantial or too meager in light of the costs, benefits, market failures and externalities in the franchise market? The key missing question is whether the marginal costs of moving up the EOT scale by a hypothetical and theoretical discrete quantity will justify the marginal benefits resulting from passage of the legislation with the new EOT level. In contrast, historical and even current franchise legislative battles focus unhelpfully on anecdotes relating to “who usually hits whom first”, “whether franchisors are liars”, “whether franchisees are cheaters”, and “whether franchisees deserve to be hit.” Some of the legislative lobbyists in fact have themselves come close to fisticuffs in personal skirmishing over similar meaningless assertions. This “finger-pointing” anecdotal approach to analyzing (and lobbying for) franchise legislation is not only messy, demeaning and costly, but it also leads to more franchisee defeats than are warranted under a societal cost-benefit analysis.

Unfortunately, this has been the way franchise legislative battles have been fought since the beginning of time; accordingly, the intellectual studies that would normally be associated with such challenging theoretical economic and societal conundrums are notably absent. Such studies haven’t been viewed by legislators, lobbyists or advocates to be helpful or necessary. Like any commodity, where there is no demand, there is no supply. Worse yet, the dearth of fleshed-out and persuasive theoretical models has created a fierce vacuum of industry-specific empirical studies. Those few empirical evaluations with any gravitas are ancient themselves, or rely for their statistical data on information obtained from the Flintstones.

Third, the Governor states that he would have been moved to sign the legislation if he had been presented with evidence of “unacceptable or predatory practices.” The assertion that there was no evidence of unacceptable or predatory practices does not jibe with the record; there appeared to be plenty of relevant evidence. Moreover, even if there had been no evidence whatsoever of pure predatory conduct presented to the Governor, this should not have been a sufficient basis on which to reject the needed legislation. The argument that only predatory behavior can or should justify the enactment of franchise legislation is a clever straw man. Franchisees are in need of legislative assistance not solely because of predatory or churning conduct by franchisors, but also because of the existence of copious other unreasonable franchisor conduct that does not fit neatly into the “predatory” or “churning” categories. Quite simply, there are sub-optimal terminations – those that are societally and economically inefficient – that cannot be characterized as ‘predatory’ but that should nevertheless be limited or prevented.

Making matters worse for franchisee advocates on this point is that the fear of harm from predatory terminations (under the “churning” moniker) nowadays spans far beyond the actual existence of churning. The folk-lore in the industry is that there were, and are, rampant terminations by franchisors for the sole purpose of appropriating for themselves the value and profits of the terminated franchisees. The story goes that after franchisees work hard to develop their stores and the markets, franchisors contrive a termination so that they may expropriate the value and profits of the terminated stores. In turn, under this view, the franchisor then either keeps and operates the terminated store and collects the ongoing profits, or the franchisor resells the franchise and collects the big-ticket sales price and an extra franchise initial fee.

My sense, however, is that the bark of the existence of the predatory or churning termination is worse than its bite. Although predatory terminations do in fact occur, and are sufficiently numerous to warrant protective legislation, churning does not appear to be the foremost motivating factor for the majority of terminations. Nor should it be argued that predatory terminations in particular are the sole reason for protective legislation by franchisee advocates; under this myopic justification for legislation, franchisees will almost always come out on the short end. Indeed, my experience as one of the few remaining franchise lawyers who truly represents only franchisees, and not franchisors, suggests that the overwhelming number of terminations occur with regard to unprofitable units (due to underperformance based on a defective franchisor sales model, lack of training, little sales talent or poor location) or modified marketing plans by the franchisor. Plenty of evidence of such wrongful terminations is available for the picking by franchisee advocates. Why do they continue to invite legislators to a Filet Mignon and Lobster dinner and then serve them only a cold overcooked turkey leg?

Very simply, if predatory terminations comprised the bulk of terminations, there would be a pattern over time that evidenced on average increasing proportions of franchise systems being owned by franchisors vis-à-vis franchisees. Further, because it is in general more costly, ceteris paribus, for franchisors to operate a corporate store versus a franchise store (hence the original reason for franchisors to establish a franchise system rather than fully vertically integrating downstream), an excessive number of franchisee terminations based on “churning”, would theoretically saddle the franchisor with “too many” higher-cost locations. Although churning is a profitable course of action for shortsighted or cash-starved franchisors in the short run, it is a losing proposition for franchisors in the long run.

In truth, we do not know the actual reason for the veto -- whether it was anticipated unemployment, cognitive-dissonance (in the face of the bizarre lobbying marriage of big-labor and franchisee advocates), family connections, lack of understanding, political payback, a hang-over, too-little sleep, poor analysis, distraction, or boredom we will unfortunately never know. We do know, however, that the genuine reason for the veto was not set forth in the Veto Message.

At the end of the day, the free market by itself has failed to provide the most efficient outcome in franchise markets. Moreover, franchisor advocates have shown themselves to be remarkably adept at stultifying the majority of legislative efforts to correctly calibrate market incentives. So long as franchisor advocates’ resources continue to dwarf those of franchisee advocates, and so long as franchisor advocates continue to successfully bait the majority of franchisee advocates into slinging mud rather than wielding thoughtful analytical studies regarding market failures inherent in franchise markets, franchisees will suffer and make relatively little notable progress. Ironically, it is not just franchisees, but also franchisors, the natural and voracious market predators of franchisees, who would partly benefit from more efficiently configured economic incentives in franchise systems.

Jeffrey M. Goldstein
Goldstein Law Firm
Washington, DC

www.goldlawgroup.com

[email protected]

202 293-3947

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Comments

Well said. Glad I'm no longer

Well said. Glad I'm no longer subject to predatory behavior.

No Predatory Practices?

Moonbeam either lived up to his nickname or he was bought off. Prospective franchisees better make sure they're looking at systems with strong franchisee associations and co-ops. Even in California franchisee rights is a joke.