Hot Topics in Franchising

January 15, 2004 Published Work
The Franchise Handbook, Spring 2004

As a successful and popular method of distribution, franchising has its advocates and its detractors, its success stories and its failures. These opposing viewpoints create a number of legal and business issues that occupy franchise executives and lawyers alike.
Fast Food Furor. One of the biggest stories in franchising this year has very little to do with franchising as a distribution process. Instead, the story is about "big food" and its role in America's obesity epidemic. In a lawsuit instituted last year, two teenagers alleged that their obesity could be traced back to one principal source – McDonald's. Alleging that they ate at McDonald's an average of 10 times per week, the teenagers claimed that McDonald's made a series of misrepresentations and that their weight problems, as well as the weight problems of an entire class of individuals, are attributable to McDonald's products.
The lawsuit touched off a firestorm of debate among politicians, businesspeople, and consumers about the role of big business in protecting consumers and consumer tendencies to blame big business for a host of maladies caused by consumer conduct. The argument that "food made me fat" quickly became the subject of parody and was regarded by some as a perfect example of the lack of personal responsibility that now defines a litigious American culture. The big food companies, however, were not laughing. After watching tobacco companies face multi-million dollar verdicts and endure lawsuits instituted by state governments, big food companies responded to the threat almost immediately. While denying any link between their products and obesity, franchisors and food manufacturers alike began to study their products and marketing strategies and sought ways to offer healthy alternatives to consumers.
In September, a Manhattan federal judge dismissed the lawsuit against McDonald's for the second time and denied plaintiffs leave to amend the complaint. The court indicated that the law was not designed to protect consumers from their own excesses and that plaintiffs failed to allege that they were deceived by any McDonald's advertising or that McDonald's products caused their injuries. While this case appears to be over, the effects on the food industry, franchised or otherwise, will likely linger with respect to the profitability of big food, the interest of potential franchisees, and the marketing and development of fast food products, especially those strategies geared toward children.
The Franchise Definition. It's Franchising 101 – the definition of a franchise under federal and state law. Under the FTC Rule, a franchise is a commercial relationship defined by three essential elements: (1) the franchisee offers goods or services under the franchisor's trademark or system; (2) the franchisor exercises control over or offers significant assistance to the franchised business; and (3) the franchisee makes a payment to the franchisor in connection with starting the business. This definition has several state counterparts and involves a number of gray areas in which manufacturers often find themselves caught up in a morass of franchise regulation that they never considered in creating their distribution systems. While some companies specifically set out to franchise their systems, others fall into franchising in the process of creating successful distribution networks. The latter would-be (or wouldn't-be) franchisors face a host of legal and business issues as they grapple with franchise regulations and their effects on the distribution systems. Specifically, some manufacturers may find that despite efforts to avoid franchise statutes, their licensed dealers are entitled to certain franchise protections, including state "good cause" termination requirements. Manufacturers may also find themselves subject to substantial government sanctions for not registering their systems as franchises. Given this potential liability, distributor networks that meet the franchise markers often face a complicated decision in determining whether to (a) declare themselves as franchises after years of non-compliance with franchise laws, (b) deny their franchise status and continue to operate as if franchise laws do not apply to them, or (c) find some middle ground where they attempt to minimize their exposure without registering their systems as franchises. In the absence of any easy answers, manufacturers continue to choose different paths and the definition of a franchise remains a core issue in franchise legal analysis.
Large Franchisees and the Balance of Power. While mom-and-pop franchisees still represent the majority of franchise owners, some franchisees (especially of larger franchise systems) operate a significant number of franchise units, and in some cases, are publicly-traded companies. As these franchisees grow in both profit and sophistication, franchisors may find a large portion of their revenue coming from a smaller number of franchisees. This relatively new brand of franchisee not only creates a different dynamic between franchisees and their franchisor, but also may have a significant effect on the franchisor's operation. In some cases, large franchisors are compromising in ways they have not considered since they were fledgling franchise concepts, including the elimination of in-term and post-term covenants not to compete for these mega-franchisees.

Franchisors may also discover, however, that their success becomes substantially intertwined with the success their mega-franchisees. Last year, Ameriking, Inc., one of Burger King's largest franchisees (operating 361 Burger King franchises), filed for Chapter 11 protection in the same month that Burger King's parent, Diageo, attempted to close the sale of the franchise company. While the Ameriking franchises represented only a small part of the 8,000-unit chain in the U.S., the chain ultimately failed to meet certain performance requirements and Diageo was forced to reduce its asking price from $2.2 billion to $1.5 billion.
Notwithstanding the risks involved, multi-unit franchisees continue to be franchisor favorites as systems grow with known operators. As franchisors look to build their systems, large franchisees will continue to wield power and effect changes to the benefit or detriment of the franchise system as a whole.
Franchisors for Sale. With franchise company sales occurring on a regular basis (Burger King, Seattle's Best, Meineke), the consequences of selling brands continue to present challenges for both exiting and incoming franchisors. For the exiting franchisor, the biggest question is often disclosure: When does a franchisor know that a sale is a sale for purposes of disclosing potential franchisees? Franchisors are required to amend their franchise offerings to reflect material changes in the information presented, including ownership of the franchise company. Failure to amend may expose franchisors to "little FTC Act" claims by franchisees who signed on without knowing about the impending sale. For publicly-traded companies, the disclosure analysis is complicated by SEC limitations on the type of information which can be disclosed.
Incoming franchisors, on the other hand, face substantial challenges in rallying support from franchisees, dealing with disgruntled operators, meshing two franchise systems together without encroaching on existing territories and changing trademarks and trade dress. The radical changes that often accompany new ownership, especially in franchise mergers, may result in a tremendous franchisee backlash and require strong franchisor leadership and franchisee participation in resolving the conflict. The potential for franchise success or failure in such cases continues to hold the attention of the franchise community looking for lessons in the harmonious transfer of franchise systems.
Encroachment. Whether created by a franchise merger, the installation of a new franchise or a franchisor's distribution of products on the Internet, encroachment concerns always rise to the top of franchisees' general list of complaints about franchise expansion. While franchisees recognize the value of brand awareness and support expansion generally, they often adopt a "not-in-my-backyard" attitude toward expansion efforts. Despite studies showing that an increased brand presence results in increased sales, franchisees continue to worry about cannibalized sales from encroaching franchises. As a result of franchisee concerns and litigation, many franchisors have developed sophisticated encroachment policies and review boards to address potential problems with franchise placement.
These policies, however, often do not address issues of franchisor Internet encroachment. In recent years, while traditional encroachment claims have waned, franchisees have instituted a greater number of lawsuits against their franchisors for direct distribution of products to the consuming public. The Internet provides a system for many companies to deal directly with consumers outside traditional locations operated by franchisees. From the franchisees' perspective, this practice pits the franchisor against its own franchisees to compete for customer business and arguably deprives the franchisee of the benefit of the franchise by making the franchised location obsolete. As a result, encroachment issues continue to arise as courts struggle to balance a franchisor's express rights to distribute product against its duty to act in good faith toward franchisees.