| Licensing, Technology Transfers, |
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any franchisee chain of retailers no longer represent a substantial amount of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
www.BlueMauMau.org, 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
www.FranchiseRemedies.com
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.