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Franchise Regulation

Regulation History

Franchise legislation per se does not appear until around 50 years ago, but it is rooted in a shift in American jurisprudence dating back around the turn of the last century.

In the aftermath of the Civil War, expansion of the railroads and urban manufacturing led to a shift in US law. There were quite a number of injuries and deaths caused by the new economy, coupled with concern over the ability of powerful individuals and corporations to affect the economy. This led to the development of such things as antitrust laws, labor laws, and other examples of remedial and prophylactic regulation which are relevant to a discussion of modern franchise law, and the legal framework within which the franchise industry operates.

As discussed previously, the early 1900's saw the development of a more urban society which necessarily freed opportunistic actors from the constraints of pre-industrial societies where everyone knew each other and where social pressure made reputational risk a serious factor pressuring people (and companies) to behave. People change gradually, and so even today much behavior that served us well is not compatible with modern law and economics; this has been referred to as "time-shifted rationality " and is closely related to such concepts as "heuristics" (our internal paradigm for quickly processing complex information; the science behind your 'gut reaction') "bounded rationality" (which says that human heuristics limit the "rational economic actor" model which underlies much modern American law) and "kin selection" as a formerly adaptive behavior now exploited by modern franchise salespeople.

For many years, franchisors were not concerned about reputational damage, because in our mobile modern society, there was always a new (often immigrant) franchisee who had not heard of the f'zors reputation. The very idea of the Internet as a "community" is part of what has enabled f'zees to begin to make reputational damage a constraint on abusive f'zors; there are several Internet discussion boards about franchising .

Automobile sales was one of the first areas in which franchising was used. Auto dealers tended to be upper income and influential members of their communities, and so when the franchisors got aggressive, the auto dealers were able to get the first federal franchise legislation passed in 1956. That law remains on the books today, and it is worth reading the law's definition of 'good faith' .

Three years later, franchisors led by Dunkin' Donuts founder Rosenberg formed the IFA in Chicago (it subsequently moved to D.C.) and despite significant abuses in the franchise industry, f'zors were successful in forestalling federal legislation until the Franchise Rule took effect in 1979 (plain-language overview of Rule here ). The notable exception was petroleum franchisors: those of you old enough to remember the 70's know how unpopular Big Oil was, and in 1978 the Congress passed legislation protecting gas station franchisees .

The Auto and the Gas legislation regulates the franchise relationship, but the Franchise Rule regulates only disclosure. Franchisee advocates maintain that simply requiring disclosure does not work since the franchise relationship lasts for many years and f'zee advocates say that it is necessary to have relationship legislation covering matters such as encroachment and termination. Franchisors respond that relationship legislation would result in courts becoming involved in operational matters. A famous example of relationship legislation is the Iowa statute , in particular the provisions relating to encroachment and termination/renewal.

Two Authorities

There are 2 sources of authority for the FTC to regulate franchises: the Franchise Rule and Section 5 of the FTC Act. While Section 5 would potentially cover aspects of the franchise relationship, the FTC takes the position that it lacks a Congressional mandate to use Section 5 to effectively get into the operational decisions of a franchisor, particularly since the law provides [15 USC 45(n)] a three-pronged test: (1) substantial injury (2) not reasonably avoided by the affected party and (3) not outweighed by countervailing benefit. Additionally, the contract between zor and zee is a commercial one and not a consumer. Since there is no private right of action to enforce the Franchise Rule, only the government (and not franchisees) may bring an action in federal court if a franchisor does not comply with the Rule. While f'zee groups maintain that a private right of action is necessary given the perceived lack of FTC enforcement, such a right is unlikely to be granted soon.

Most states do not have franchise-specific legislation, although they may have law of more general applicability and if you have a complaint you can contact your state regulator ; however you should be aware that most regulators regard franchise contracts as being between sophisticated business parties and although the same office normally regulates complaints about other investments such as stocks, the law is quite more protective in the latter case than for f'zees.

In the 1960's the negative media attention caused many prospects to not buy a franchise, and many f'zees of the 70's and 80's were immigrants; this is especially true in segments such as roadside hotels and QSRs. By the 90's, the franchise industry began to look to retirees, laid-off middle-management (who have 401K money to buy a franchise ), and in recent years to young people and to persons leaving the military .

Although the LaFalce and Coble-Conyers legislation failed to pass Congress in the 1990's, as the franchise industry becomes a more central part of the economy there has been concern as to negative externalities caused by the industry: at root, franchising is a method of purchasing capital and labor. As early as the 1990's, analogies were being drawn to regulation of labor and capital markets, and those analogies have continued to be made. That, and the increasing number of franchisees who are middle-class voters, has led to recent interest in regulation of the franchise industry at the state level and some commentators have wondered if the industry's lobbying group can adequately address state legislation since the interests of franchisors may be different from franchisees.

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About Paul Steinberg

Paul Steinberg's picture

Public Profile

Attorney. Former franchisee. Co-author of Beguiling Heresy: Regulating the Franchise Relationship (Penn State Law Review, 2004). Paul primarily represents small business clients and franchisee litigation in the state of New York. Contact the Law Office of Paul Steinberg, NY, NY at 212-529-5400.

Area of Interest
Franchise Operations