Problematic Relations: Franchising and the Law of Incomplete Contracts

Although the franchise relationship may appear unremarkable on the surface, it has in fact a highly distinctive structure. Unlike either an employment relation or an ordinary independent contracting relation, the franchise relationship is characterized by the fact that franchisees own the bulk of the capital assets of the franchise and franchisors retain the right to determine how franchisees will use those assets.

Stanford Law Review
Volume 42:927
April 1990

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Problematic Relations: Franchising and the Law of Incomplete Contracts
Gillian K. Hadfield

Reprinted without Endnotes

Commitments to take or refrain from taking certain actions are indispensable elements in most forms of interaction and exchange. Even the purest form of spot-market transaction rests on commitments: the commitment of the state to value a piece of paper in future exchanges, and the commitment of the individual not to steal back what has been sold. As transactions spread out over time and become more complex, however, more is needed to ground the exchange than the mere stability of currency and property: The solidity of contract is also required.

In the case of the complete contract, which specifies in a manner immediately verifiable by a third party precisely what performances are required for all possible future conditions, classical notions of contract enforcement serve well to secure the commitment supporting the transaction. In this case, courts stand ready to examine the contract and, going no further than the balance reached in this private ordering, hold the parties to their commitments.

In reality, few contracts can be complete. Accordingly, classic contract law has always provided for the accidental failure of completeness resulting from linguistic ambiguity, or from the absence of provisions specifying the performances required under certain, perhaps unanticipated, conditions. More recently, however, contract scholars have recognized that the failure of completeness is not always a mere stumble on the classical path.2 Often, contracts are necessarily and intentionally incomplete because mutual desires for flexible, but bounded, responses to uncertain future conditions limit the scope and precision of verifiable terms. Moreover, incomplete contracts often exist deeply embedded in an ongoing relationship. The parties are not strangers; much of their interaction takes place “off the contract,” mediated not by visible terms enforceable by a court, but by a particular balance of cooperation and coercion, communication and strategy.

The confluence of contract and relation makes commitment problematic. Contracts modify an existing relational balance, incorporating the legal system into the relationship.3 Yet precisely because the relational balance is difficult to alter privately, incompletely specified contractual commitments are vulnerable to unintended modifications; the private relational balance is there to insinuate itself back into place through the gaps in the incomplete contract. To the extent that courts cannot distinguish between the derogation of a commitment in an incomplete contract and an exercise of the flexibility which is a part of that commitment, incomplete contracts cannot fully function in their role as anchor for many complex transactions.

It is in this world of contractual incompleteness and relational complexity that franchising4 exists. Franchise contracts are the basis of a unique organizational form, in use in the last forty years,5 that now accounts for one-third of all retail sales.6 The franchising structure combines elements of integration and delegation, control and independence. The franchise contract creates neither an employment relation nor an independent contracting relationship. It operates in markets subject to rapid change and high levels of uncertainty. It engenders multi-leveled relations: personal and economic, corporate and political. Finally, it poses enormous commitment problems. Although franchisees often make very large sunk investments in their franchises, an exercise of franchisor control may easily threaten a franchisee’s investment. In turn, franchisees can reduce, sometimes significantly, the accumulated reputation capital of the franchisor by failing to maintain quality controls.

Such an odd-shaped beast tangles in many areas of the law. Franchising is a significant and problematic force in such areas as anti-trust, product liability, intellectual property, securities and agency law. Most importantly, however, franchising is problematic for contract law. Commentators have attacked franchise contracts as unconscionable and adhesive, and they have urged that exceptional standards of good faith and fiduciary duty should apply to such contracts.7 Additionally, doctrinal and statutory efforts at both state and federal levels have sought to limit the contractual powers of termination and renewal.8 Each of these approaches, addresses some aspect of the unusual nature of the franchise contract, yet none satisfactorily strikes at the heart of the problem: the incompleteness of the contracts that structure such a complex relationship, one which requires high levels of commitment to protect large sunk investments against opportunism.

This paper explores an alternative approach to the analysis of franchise contracts which takes seriously their unavoidable incompleteness. The point of departure is the fundamental insight of relational contracting theory, namely that when a contract is embedded within an identifiable relationship, such as the franchise relationship, contractual obligations are often modified, supplemented or completely supplanted by the norms of the ongoing relation.9 Thus far, the explication of this insight has been along largely theoretical lines.10 My objective in this article is to further develop the theoretical analysis of the importance of relational elements in order to fashion operational guidelines for courts faced with the difficult concrete task of resolving franchising disputes on the basis of incomplete contracts

I focus first on the economic dynamics created by uncertainty, sunk costs and the allocation of control within the franchise relationship. I argue that these dynamics structure the central commitment problems facing franchisee and franchisor as they endeavor to secure their exchange. Consequently, judicial efforts to identify the obligations created by the franchise contract should be directed at determining if and how these commitment problems have been addressed by the parties. It is at this juncture that the norms of the franchise relationship become important: Where there is no explicit contractual term supplying commitment, where the written contract appears incomplete, courts must look to the norms of the relation itself to see if they functioned to supply needed commitments. Relational norms should not be imposed on a particular relationship simply because such norms overcome commitment problems.11 But the courts should determine the likelihood that the contracting parties themselves implicitly or explicitly relied on the relational norms to supply the commitments they could not reduce to written form. Thus relation becomes important because it contributes directly to the obligations exchanged by franchise and franchisor at the formation of their contract; respecting the parties’ control over their relationship means that obligations must be understood to have arisen not only from the written document but also from the relation itself.

By integrating economic and relational analysis, this paper argues that courts systematically enforce franchise contracts in a manner that diminishes rather than augments their appropriate function as a means to overcome the central commitment problems that threaten the creation of franchise relationships. In particular, court enforcement systematically defeats the relationally reinforced expectations of franchisees as to what commitments they acquire from the franchisor in exchange for their own commitments. Courts can adequately promote the use of contracts to structure these relationships only by incorporating the relational and economic structure of the franchising arrangement directly into the interpretation and enforcement of contractual commitments.

The organization of the paper follows directly from this emphasis on the need to integrate the economic, relational and doctrinal features of franchising. Section I examines the institutional features of the franchising industry, answering the question, “What is franchising?” Section II analyzes the formal legal structure of franchising, focusing specifically on the contents of written franchise contracts. Section III then moves to the economics of franchising, elucidating the fundamental economic features of the relationship and its attendant bargaining and commitment problems. Section IV shifts to the informal content of the franchise relationship. Here, the paper extracts “relational” norms of franchising relevant to dispute resolution. Section V examines the nature of the franchising disputes that courts resolve, relying on the institutional, relational, and economic analyses of the previous sections to illuminate the problematic features of these disputes. Section VI critiques the current method of resolving these disputes and analyzes how a relational approach to contract interpretations can aid in their resolution.

I. THE FRANCHISING INDUSTRY

A. Definition

The threshold problem of defining “franchising” plunges us immediately into the complexity of this modern organizational form. Franchising is a method of structuring a productive relationship between two parties in which both contribute to the production or distribution of the product or service.12 There are, of course, many such relationships. Here I consider the continuum of such relationships along two key dimensions: ownership and control.13

At one end of the continuum is the ordinary employment in relationship, representing a concentration of both ownership and control. In the typical employment relationship, the employer owns essentially all of the assets that produce the fruit of the relationship (except for the employee’s personal assets) as well as the products of the relationship, either tangible goods or revenues. In addition, the employer exercises complete control; she decides what actions both parities will take in the course of the relationship and how the assets of the relationship will be employed. At the other end of the continuum is the ordinary, independent contracting relationship, representing a diffusion of both ownership and control. In this relationship, the parties each own some of the assets that contribute to production. Both parties exercise control as independent decisionmakers with respect to their own assets and actions. The contract creating the relationship sets out concrete obligations on the part of both individuals, which will, of course, influence how each exercises authority.

As is readily apparent from the definition of these endpoints, relationships can quickly blend into a combination of the two. Sometimes an employment contract objectively defines specific employee obligations, making the employee more of an independent contractor along the control dimension: The employer is no longer free to determine employee actions. In comparison, the independent contractor becomes more like an employee along the ownership dimension when the only assets owned by the contractor are personal assets, such as a consultant’s know-how, or along the control dimension when the obligations created by the contract grant the other party significant discretion over the contractor’s actions.

Franchising relationships characteristically lie in the intermediate range between employment and independent contracting. With respect to control, franchising relationships are closest to the employment end of the continuum: the franchisor typically exercises significant amounts of relatively unrestricted decisionmaking authority.14 With respect to ownership, however, franchising is much closer to the independent contracting model: the franchisee typically owns the bulk of the assets that contribute to producing the fruit of the relationship. Often the franchisor contributes nothing beyond the design for the product and relationship, perhaps represented by a trademark, and organizational capital.15 A “pure” franchising relationship would be one in which ownership resided completely in the franchisee and control completely in the franchisor. This characteristic allocation of ownership and control is the key feature of franchising that a coherent legal framework must recognize.

B. Background

Firms engaged in franchising16 made sales of $591 billion in 1987,17 approximately one-third of all retail sales made that year in the United States.18 The bulk of these sales occurred through the franchise system with the longest history: auto and truck dealerships, accounting for $306 billion.19 The retail sale of gasoline, another long-standing franchise arrangement, accounted for $95 billion. 20 The type of franchise that most readily comes to mind for most people, fast-food, accounted for $58 billion when combined with other franchised restaurants.21 Franchised convenient stores made $13 billion in sales; soft drink bottlers, $20 billion; franchised auto products stores, another $13 billion.22

What may be surprising is the size of the residual “other retailing” category: $87 billion in sales in 1987.23 It is in this category that much of the growth in franchising now occurs.24 While 2.5 percent of franchisors, mainly fast-food outlets, car dealerships, and gas stations, account for 48 percent of sales and 49 percent of outlets in franchising,25 the adoption of franchising has spread to a wide variety of products and services.

Some observers, such as the U.S. Department of Commerce,26 classify any relationship in which a retailer operates under its supplier’s trademark as a franchise. Under this definition, many distributorships – of snack foods, beer or soft drinks, for example – are “franchises.” In many of these cases, however, the distinctive separation of ownership and control that I identified above is missing. For example, a soft drink bottler who has acquired exclusive rights to distribute a given brand may retain almost total control over the distribution assets it owns: where to locate, how often to deliver, or how much to advertise. For the purposes of this article, such a relationship (often referred to as product or tradename franchising 27) will not be considered a franchise.

The type of “franchising” that is characterized by a separation of ownership and control is known as “business-format” franchising.28 As its name suggests, in this type of franchising the franchisee operates under a business format structured entirely by the franchisor. The franchisor provides the marketing concept, product ideas and design; it develops procedures for delivering the product; it creates operating manuals; and it sets quality standards.29 The franchisor may or may not supply the actual product; the distinguishing characteristic is that the franchisee is under the control of the franchisor and thus is instructed how to run her business much as an employed manager would be.

At the same time, however, most franchisees are not simply managers; they are also owners and investors. While the bulk of franchisees own a single franchise outlet,30 a small percentage31 are master franchisees with rights to sub-franchise within their (normally larger) territory. Other franchisees own several outlets directly and hire managers to operate their outlets. Some may own multiple franchises, each with different partners and other investors.

Most notably, franchisors do not bear a significant share of the capital cost or risk setting up franchised outlets:
Franchisees report that their own savings are the most frequently used source of funds for their first franchised unit. However, banks which are employed as a source of funds by 56% of franchisees are a source of a larger proportion of the total funds initially invested than are personal savings, 40.2% compared to 28.1%. Franchisors contributed, in the form of notes on equipment, signs, supplies, and so on, an unexpectedly low portion (8.7%).32

The franchisee purchases or leases virtually all of the franchised outlet’s capital equipment. The franchisee also typically owns or leases both the land and the space from which the outlet operates,33 although several franchise companies – notably some fast-food restaurants such as McDonald’s – own the land on which the outlets sit and lease it to the franchisees. 34 Often, the franchisee also pays an up-front franchise fee to the franchisor for the privilege of operating under the franchise system. Altogether, the initial capital investment required to become a franchisee ranges form a few thousand dollars to set up a tax service to over half a million dollars for a fast-food outlet to several million dollars for a hotel. Table 1 sets out some estimates of initial capital requirements for a range of franchises:

TABLE 1
INITIAL CAPITAL REQUIREMENTS FOR VARIOUS FRANCHISES 35

Franchise Estimated Initial Capital
AAMCO Transmissions $85,000
Dunkin’ Donuts $16,000–32,000
5 Minute Oil Change $6,975
7-Eleven $23,560
Western Auto $50,000
Ernie’s Wine and Liquor $100,000
Dollar Rent-A-Car $100,000
Old Uncle Gaylord’s $70,000-125,000
Kenneth of London $60,000-95,000
Arthur Treacher's $140,000
Best Resume Service $5,000-25,000
Burger King $150,000
H&R Block $1,000-2,000
Domino’s $36,000-64,300
Telecheck Services $195,000
My Pie International $300,000
Ron’s Krispy Fried Chicken $350,000
Wendy’s $500,000
The Athlete’s Foot $77,500
Fat Fighters $29,950
Modern Bridal Shoppes $12,000-35,000
Nutri-System $51,500
Kwik Kopy $58,500
Snap-On Tools $5,000
Century 21 Real Estate $10,000
New England Log Homes $100,000-125,000
Mary Moppet’s Day Care $45,000
Barbizon Schools of Modeling $25,000-50,000
Acme Personnel Service $9,000-19,500
Dootson Driving Schools $20,000
Manpower $50,000

While franchisors do not generally share in the investment in an outlet, they do share in its revenues in exchange for their contribution of a trademark and business format. The franchisor can collect revenues in several ways. If the franchise involves the outright sale of products to the franchisee, the wholesale price will ordinarily include a mark-up over cost representing the manufacturer’s return. Often, the franchisor collects an up-front franchise fee from new and renewed franchisees. Many franchisees pay ongoing royalties to the franchisor, normally based on gross revenues. 36 Franchisors also can collect fees from franchisees for specific services, such as advertising, bookkeeping, management consultation, employee training, location selection, or providing the location itself. 37 In addition, franchisors may receive commissions from approved suppliers of their franchisees. 38

Franchisors may also profit from franchising by directly owning and operating a fraction of the outlets in their system.39 In 1987, the U.S. Department of Commerce counted 90,952 company-owned outlets out of a total of 498,495 outlets.40 The percentage of company ownership varies considerably by industry, as may be seen in Table 2.

TABLE 2
COMPANY OWNERSHIP OF OUTLETS41

Industry Percentage Company-Owned
Convenience Stores 58
Restaurants 30
Non-Food Retailing 23
Auto-Truck Rental 22
Hotels 14
Auto Products 13
Bottlers 10
Construction-Home Improvement 4
Auto & Truck Dealers 0

Additionally, company ownership of outlets has increased significantly over time. In the fast-food industry in 1960, franchisors owned only 1.2 percent of outlets; by 1968 the figure had grown to 6.6 percent. Franchisors owned 11.3 percent of outlets by 1971,42 and fully 32 percent by 1986.43 Interestingly, company-owned outlets may be more profitable than franchisee-owned outlets.44

Turning from the structure of the franchise relationship to its duration, most franchises are intended to be long-term arrangements. A large fraction of franchises are long-term by virtue of contractual length.45 Contracts of shorter length often result in long-term arrangements through renewal.46 Table 3 shows the duration of franchise contract in 1986.

TABLE 3
CONTRACT LENGTH47

Contract Term Length Percentage of Franchise Contracts
1 year 1.8
3 years 2.1
5 years 16.3
10 years 31.7
15 years 10.9
20 years 21.1
25 years 1.1
Perpetual 12.9
Others 2.1

Actual duration is determined by how the relationship ends. The relationship may simply end with the expiration of a nonrenewable contract. More commonly, the relationship will end at the expiration of a renewable contract term with an explicit decision not to renew by one of the parties. In some cases, the franchisee’s decision to transfer the franchise to another individual before the expiration of the contract with or without the required approval of the franchisor may terminate the relationship.48 Franchises also commonly end before their term expires as a result of termination initiated by either party. One of the key legal issues in franchising is what constitutes cause for termination.49

Finally, franchise relationships end when either franchisor or franchisee fails. One of the most difficult characteristics to assess about franchising is the rate of business failure. The Department of Commerce consistently reports a failure rate within five years of start-up for franchise outlets of 5 percent, much below the over-50 percent failure rate of small businesses generally.50 One would expect established franchise systems to exhibit a lower rate of failure than ordinary, single outlet small businesses because the business format of the franchise has already been subject to trial use in the market. Many writers, however, question the validity and significance of the 5 percent figure, pointing out that the Department of Commerce figure is developed from franchisor self-reporting,51 and that the figure only accounts for total bankruptcy and not for failures to earn a normal rate of return on the franchise investment.52 Moreover, among those franchisees who secure federal assistance from the Small Business Administration, the failure rate exceeds the average for all small businesses.53 One congressional report found [b]etween 1969 and 1979, franchisees of the top 30 “major” franchisors, such as Shell Oil, Gulf Oil, Texaco, Subaru, Sheraton Inns, Tastee Freeze, and Mercedes Benz, had a failure rates between 11.6 and 33.3 percent on SBA loans, and loan guarantees. The failure rates for the 30 non-major franchisors, such as Crazy Horse Campground, American Speed Center, Chicken Delight, Mayflower Transit, El Taco, and Duraclean, varied from 35.7 to 100 percent.54

II. THE LEGAL STRUCTURE OF FRANCHISING

With this background in place, this section turns to the nature of the franchise contract. Before doing so, however, it is important to note that although franchising arrangements have traditionally been largely creatures of contract, they have become increasingly regulated. Efforts to introduce general legislation to regulate franchising continue.55 The statutory scheme affecting franchising, however, is piecemeal. Separate legislation governs automobile dealerships as well as retail gasoline franchises.56 Many states have their own general regulatory statutes that, like the federal automobile and gasoline legislation, focus primarily on controlling terminations and renewals.57 But there is no comprehensive or uniform system of regulation.58 Either because current regulation is piecemeal or, more fundamentally, because franchise relationships are too complex to reduce to precise statutory term,59 the heart of franchising’s legal structure is still contract. Indeed, as Section VI.A suggests, the statutes, even while ostensibly limiting contractual powers of termination or nonrenewal, in fact may have only a minimal impact on the legal treatment of franchising. Consequently, the legal structure of franchising is still largely determined by the nature of the contracts struck between franchisee and franchisor.

A. The Frequency of Contract Clauses

In order to illustrate the legal structure of the franchise organization, this section examines the common types and frequency of contract clauses. Unfortunately, empirical research on the content of franchise contracts is limited. The research that does exist generally dates back fifteen to twenty years, or is current but limited in scope.60 One particular study of the fast-food industry, submitted as a report to the Senate Select Committee on Small Business in 1971, illuminates the frequency of various types of contract clauses.61 While it is difficult to assess how these frequencies may have changed over the years, the types of clauses identified by this report continue to be used in many franchise contracts today.62 Table 4 presents an overview of the contract clauses found in the fast-food industry in the 1971 study by Ozanne and Hunt.63

TABLE 4
CONTRACT CLAUSES64

Clause % of Contracts Comments
Termination 100 Franchisor has right to terminate. 76% require franchisee to agree that violation of any condition of
contract is material breach. 68% give grace period for curing defaults (10 days); 79% indicate
bankruptcy automatically terminates and all rights revert to franchisor.
47 Franchisee must cease operations on termination. 33% require discontinued use of trademark; 47% require building alterations.
44 Franchisor option to purchase equipment. 50% set depreciated value; 30% indicate market value.
Royalty Fees 90 75% require royalties monthly on gross receipts; median rate is 4%.
Insurance 88 Franchisee required to hold. 70% requiring full public liability insurance;
64% requiring indemnification of franchisor.
Duration 88 Specifying fixed duration. 59% make the contract renewable at expiration conditional on
absence of franchisee default.
Franchise Fee 83 Required up-front. 35% specify sole consideration is license to operate; 48% require
nonrefundable deposit before execution.
Transfer 83 Franchisor approval required. 75% do not indicate basis for refusal.
46 Franchisor right of first refusal in sale of outlet.
Training 77 Formal start-up training at headquarters or outlet. 47% report receiving.
34 On-the-job training. 71% report receiving.
45 Franchisor will provide assistance in opening. Franchisor bears expense in 62%; 99% of franchisees report receiving start-up supervision
Median Length of all training is 2 weeks.
Standards 82 Food quality.
76 Operations.
61 Cleanliness; product line control.
56 Maintenance.
27 Franchisor right to control inventory.
Inspection 79 Franchisor right to inspect premises.
Trademark 77 Franchisee has no ownership rights in trademark.
Audit 76 Franchisor right to audit books.
62 Franchisor approval of bookkeeping method.
30 Franchisor right to order certified audit.
79 Require periodic reports; 25% require submission of tax return.
40 Franchisee required to pay for audit if underreporting discovered. 5% pay bookkeeping fee to franchisor.
Enforcement 74 Franchisor’s failure to enforce is not waiver.
Separability 73 Invalid clauses separable from remainder.
Noncompetition 67 Covenant not to compete with franchisor after termination or expiration. Time (60%) and
area (52%) restrictions. 38% prohibit franchisee from hiring franchisor personnel.
Physical Layout 64 Approval of layout. 96% of franchisors report they retain right of approval/control.
Trade Secret 64 Franchisee agrees operation/procedures are trade secret.
Inheritance 64 Transfer to heirs possible on assumption of franchisee obligations.
Agency Status 64 No agency relationship created by contract.
Operating Manual 61 Franchisee to receive. 35% of contracts distribute on loan/trade secret basis only; 16%
specify compliance with manual at all times. 38% give franchisor right to revise at any time.
Territory 60 86% of franchisors report assigning some kind of exclusive territory.
Venue 60 Specification of venue for litigation.
Hours 55 Days outlet to be open.
63 Hours to be kept.
Advertising 53 Franchisor right of control over franchisee advertising (ad approval).
29 Franchisor required to advertise. 38% require contribution but no control for franchisee;
62% administered jointly.
42 Contribution of percentage of gross sales to advertising fund required. Franchisors report
57% require contribution to national ad fund; 47% require minimum local advertising; 81%
reserve right to approve ads.
Supplies 58 Franchisor approval of suppliers required.
43 Operating supplies equipment to be purchased from franchisor.
33 Paper goods to be purchased from franchisor.
33 Sign to be purchased from franchisor.
Building 47 Franchisor builds, leases to franchisee in 60% of these: franchisee constructs in 40%.
Construction
Site Selection 45 66% give franchisor right to select location; 33% allow franchisee to select subject to
franchisor approval; 54% of franchisors select location and then offer to franchisees; 97% reserve right to approve location.
Management 45 75% of these “require” advice only when franchisor judges it necessary; 25% at Consultation franchisee’s request.
Start-up Date 39 Required date of operation.
Alteration 36 Approval required for changes to building or layout.
Lease 35 Specifying rental base for lease from franchisor; 50% based on dollar amount plus
percentage sales; 20% on dollar amount only; 33% percentage-only sales.
18 Approval of third-party lease required.
Sign 34 Specifying dimensions.
Employees 32 Conduct requirements. 39% specify employee uniforms.
Arbitration 23 Disputes to be arbitrated.
Pricing 14 Franchisor right to control prices. 13% restrict prices that franchisors can charge
franchisees; 50% of franchisors report specifying retail prices.
Performance 12 Franchisee posts performance deposit.
Deposit
Self-Employment 12 Require franchisee to manage full time. 9% require approval of manager.
Renewal Fee 7 Additional fee on renewal.

This overview exhibits a number of features. First, note the breadth of coverage: The contracts contain clauses pertaining to nearly every detail of operation. Indeed, the franchisor’s operations manual itself will ordinarily carry an extensive set of requirements on small details of operation.65 Second, consider the great weighting of the clauses towards the obligations of the franchisee. Nearly all of the clauses pertain to commitments made by the franchisee: to build or to lease buildings, equipment, or supplies; to maintain standards; to meet layout requirements; to maintain hours; to contribute to advertising funds; to pay royalties; and to adhere to bookkeeping guidelines. When one incorporates the operations manual into the contract, the franchisee’s obligations increase dramatically. On the other hand, the franchisor’s contractual obligations extend only to training, to advertising, and to the provision of an exclusive territory. Ongoing management support, promised in about half the contracts, is normally discretionary. Few franchisors undertake firm obligations with regard to the nature, extent, and quality of advertising.

Third, observe the number of clauses pertaining to the trademark and licensing aspects of the relationship. Trademark and licensing clauses include: ownership of the trademark; cessation of operations on termination; royalty fees and franchise fees; audit authority; and trade-secret status for procedures and operations manual. Thus, the property rights of the franchisor are often a primary interest of the contract.

Fourth, note the nature of the provisions regarding a cessation of the relationship. Franchisees generally must agree that any violation of any term of the contract, including, in many cases, the details of the operations manual, constitutes material breach and is a basis for termination. Several conditions or events may arise upon termination. The franchisor often has an option to purchase all equipment at a depreciated value. The franchisee must cease operations and perhaps alter the building. Franchise contracts often prohibit the franchisee from continuing in a line of business in competition with the franchisor for a period of time – two years is common – and over a distance often measured as a radius from any outlet operated by the franchise system. If the relationship ends with a decision to transfer the franchise, the franchisor typically retains the right to approve the transfer; rarely does the contract place restrictions on the exercise of that right. Nearly half of franchisors retain a right of first refusal should the franchisee wish to sell the outlet.

Finally, observe that there are essentially no clauses creating any obligation for the franchisor to develop the system, to continue in operation, to continue to advertise, or to maintain the trademark. Outside the exclusive territory for the trademark, the franchisor is free to compete with the franchisee through the development of another system or through the establishment of competing outlets. The franchisor may withdraw its system from a region or the entire market. There are no restrictions on what operating procedures the franchisor may adopt, what layout or building alterations it may require, or what forms of promotion it may require the franchisee to undertake.

B. A McDonald’s Contract: 1959-1977

An examination of the evolution of the basic elements of the contract – the quality standards and termination provisions – for a particularly visible franchise organization provides another perspective on the legal structure of the franchise contract.66

In 1959 the McDonald’s Corporation provided for contract termination in the event that a franchisee violated the following: provisions requiring operation at maximum capacity and efficiency over specified days and hours “in accordance with the standards and business practices and policies presently in force and, from time to time, promulgated by Licensor”; provisions on employee uniform and behavior; provisions on the use of specified packaging materials, flavorings, and garnishments and on approved suppliers; and provisions regarding the approval of local advertising.67 Notably, upon termination, the contract required McDonald’s to buy out the franchisee’s interest in the equipment and furnishing of the outlet for a specified depreciated sum.68 Moreover, the contract, while requiring the franchisee to acknowledge the general importance of uniformity and compliance with the entire McDonald’s “system,” set out explicitly the standards on which termination could turn.

In contrast, by 1964 McDonald’s had converted the required buyout term into an option to be exercised by McDonald’s69 and introduced a clause requiring franchisees to supply “best efforts” in complying with the franchise system.70 Termination could, as in 1959, turn on the violation of any explicit contract provision, and now it could also result from a failure to supply the undefined level of “best effort.” By 1970 McDonald’s had explicitly incorporated the entire Operations Manual into the contract,71 thereby extending the scope of franchisor control. The 1970 contract reiterated the vaguely defined requirement that ”operation shall at all times be conducted in accordance with the standards and business practices and policies presently in force and from time to time promulgated by Licensor”; violation of this provision “shall be deemed to be a substantial breach of this Agreement and shall give the Licensor the right to terminate this Agreement.” 72

By 1977, the obligations of McDonald’s franchisees were even more detailed. This contract ostensibly limited the parties’ intent to ensuring the franchisee’s compliance with those obligations, rather than to creating a set of mutual commitments. The contract stated:

The foundation of the McDonald’s System and the essence of this License is the adherence by the Licensee to standards and policies of Licensor… The provisions of this License shall be interpreted to give effect to the intent of the parties stated in this paragraph…so that the restaurant specified in this license shall be operated in conformity to the McDonald’s System through strict adherence to Licensor’s standards and policies as they exist now and as they may be from time to time modified. 73

In contrast, the contract left the franchisor’s duties relatively undefined, a difficult-to-quantify duty to “advise and consult.” 74 Thus the franchisee paid fees for a service that the service-provider retained full discretion to define in content and duration.75 In the McDonald’s contract, as in many franchise contracts, the contract frames franchisor obligations in terms such as “reasonable,” “periodic,” and “from time to time.” The franchisor had no contractual duty to employ prudence or consideration in the making of decisions that directly affect the profitability of the franchisee.76

C. Incompleteness and the Content of the Franchise Contract

Ideally, one would like to have a full-fledged empirical survey of franchise contracts, drawn from several industries and franchisors, as the basis for general conclusions about the nature of these contracts. Unfortunately, such a survey does not appear to exist. Nonetheless, the evidence produced by the McDonald’s contracts, sample franchise contracts,77 franchise buyers’ guides,78 and a general overview of franchise cases in the courts,79 does permit some basic generalizations. A court must of course ultimately interpret and enforce a particular contract; my objective in looking at generalizations is to lay the groundwork for a set of theoretical guidelines to aid a court in that task.

The basic picture that emerges is that franchise contracts are long-term, standard form contracts. They grant the franchisee the right to operate under the franchisor’s trademark and to use a system designed by the franchisor, often in an exclusive territory, in exchange for the payment of a franchisee fee and royalties. The contract does not specify the details of the many transactions that will take place within the framework of the basic exchange. Rather, it structures the long-term relationship, much as a constitution does, by delineating the basic function of each party. In short, franchisors are responsible for making decisions about details such as inventory, outlet and product design, location, uniforms, hours and bookkeeping; franchisees are responsible for complying with the franchisor’s decisions. Franchisors have some responsibility to provide training, advertising, and management advice, but franchisees do not possess the authority to determine the quantity or quality of these services. Franchise contracts focus almost exclusively on setting out the range of franchisee obligations and protecting the franchisor’s ownership of its trademark.

For purpose of the theoretical analysis I will develop, the key characteristic of the franchise contract is its incompleteness. While roles and areas of responsibility are laid out, a court has little concrete guidance from the contract in deciding issues such as whether a franchisee’s failure to build a new showroom,80 or a franchisor’s decision to discontinue marketing its product in a franchise’s territory,81 violates the terms of the contract. All that will be clear from the written contract is that the franchisor has discretion over decisions regarding showrooms or marketing; the typical contract will be silent about how this discretion is to be exercised. Moreover, the subject of franchisor discretion will often be undefined. Franchisors are responsible for developing the franchise system as they see fit over time.

Thus many of the standards with which a franchisee must comply will not even be articulated until well after the contract has been signed. As a result, in many cases there will be no language in the written document to assist the court in determining whether a particular franchisor demand is legitimate and whether the franchisee’s behavior is in compliance or in violation of that demand. It is the absence of contract terms answering these questions that identifies the franchise as incomplete.

The significance of incompleteness is not merely that any particular franchise dispute will be complex to resolve. Rather, from a long-term perspective, what is important is whether incompleteness can be avoided, and therefore ultimately cured, by an appropriate rule. Many traditional rules of contract interpretation, such as the parol evidence rule, can be understood as forward-looking judicial efforts to discourage incomplete contracting. But if incompleteness is unavoidable, then such efforts will prove futile. In such a case it becomes important to approach the problem of incompleteness as a basic characteristic that must be addressed directly.

The franchise contract presents such a case. While contracts could be drafted more completely than they are now, ultimately they will still be incomplete.82 Few contracts are called upon, as is the franchise contract, to accomplish so complex a task as to structure an entire ten-to-twenty year productive relationship, especially under the conditions of significant uncertainty displayed in retail markets. To write a complete contract for this purpose would be to attempt to reduce to written form a complete listing of all the different business decisions that the franchisor could undertake under all possible future circumstances, and also to specify the range of compliance responses available to the franchise in each case. Franchisee and franchisor would have to negotiate today over how best to respond to the long-term vagaries of the automobile industry, or the fast-food market, or the demand for tax services.

Because this is an essentially impossible, task, the franchise contract that we see in use is necessarily an incomplete one. Rather than spelling out every decision ex ante, it designs a decisionmaking structure and assigns to the franchisor responsibility for responding to market conditions as they arise and to the franchisee responsibility for compliance. A court must recognize, however, that this allocation of roles does not necessarily reflect a desire to assign unfettered authority to franchisors and unquestioning compliance to franchisees. Given the impossibility of substantially more precise contracting, broadly defined responsibilities are the only alternative available short of abandoning the relationship entirely. Consequently, a court called upon to “interpret” a franchise contract and determine whether it has been breached must look more deeply into the entire structure of the contracting relationship. As I will demonstrate in the next section, an understanding of the nature of the economics of franchising and the commitment problems involved can, as a first step, guide a court in this deeper analysis.83 As I will also demonstrate,84 however, ultimately it is necessary for a court to examine the nature of the franchising relationship itself to interpret and enforce the incomplete franchise contract.

III. THE ECONOMIC STRUCTURE OF FRANCHISING

This section examines the economic dynamics of the franchise relationship to elucidate the nature of the planning and commitment problems that it poses. These are problems that the franchisee and franchisor must overcome to make their arrangement an economically sensible one. Isolating these problems provides a basic analytical framework for examining the franchise contract. Within this framework the incompleteness of the contract is seen more vividly. Furthermore, we can identify the “missing links” of commitment that we would expect to find within the structure of the relationship itself.85

There are two major difficulties inherent in the franchising relationship. Both flow from the basic structure of franchising.86 First, because the franchisor owns the basic franchise system and its trademark and the franchisee owns and operates the retail outlets that deliver the system and display this trademark, the franchisor faces problems of controlling the quality of the franchisee service. Conversely, also because of this structure, the franchisee faces problems related to a franchisor’s opportunistic use of this control power. As a result, the franchise relationship is structurally centered on conflicts of interest. Overcoming these conflicts is the primary challenge of franchising.

A. The Franchisor’s Problem: Quality Control

From the franchisor’s perspective, the franchising relationship poses a substantial problem with respect to quality control. The franchisor has normally created a differentiated product or service or system with the expectation that consumers will be willing to pay for the added benefits of this creation. If the franchisor is to fulfill this expectation, that product or service or system must be implemented at the retail level as designed by the franchisor. A formula for a soft drink must be mixed correctly; a method of losing weight must be taught correctly; a procedure for serving food quickly must be followed correctly. The trademark encapsulates these concerns of the franchisor. The value of the trademark gauges the success of the franchisor in assuring that franchisees provide an otherwise valuable product or service or system according to the franchisor’s plan. The more valuable the trademark, the greater the price at which franchises can be sold and the greater the royalties collected.

The value of the trademark is, however, vulnerable to franchise free-riding. This is a problem that has already received considerable attention from scholars and the courts.87 A franchisee is inclined to make decisions about how much effort to put into the business based on the profits that will accrue directly to her in her own outlet. She is not inclined to take into account that, because customers will make judgements about the quality of the entire franchise system based on their experience at an outlet, cost-saving reductions in quality at her outlet will affect the overall value of the trademark and thus the profits of other franchisees and the franchisor. If all franchisees, facing the same incentives, act in this way, the value of this trademark will suffer dramatically.88

Free-riding is an example of the problem of control, known as the principal-agent problem in the economics literature.89 It pervades almost all organizational forms to a greater or lesser extent. If, for example, the franchisor decided to operate as a vertically integrated firm, owning the outlets itself, it would still face the problem of controlling its managers. The franchise arrangement changes the nature of the control problem but it does not eliminate it. To some extent, franchising simply trades one control problem- overcoming the incentives to “shirk” that face the salaried employee but not the profit-collecting entrepreneur- for another- overcoming the incentives to minimize cost that face the entrepreneur but not the employee.

At the heart of the control problem is a divergence in interest between franchisee and franchisor. A franchisee wants to maximize her profits from the operation of the outlet; she does not wish to undertake any efforts or expenditures that will not compensate the undertaking. On the other hand, once a franchisor establishes a particular franchise, it aspires to sell more franchises and increase royalty revenues. These objectives make the franchisor less sensitive to the costs of operating an outlet and prompt the franchisor toward maximizing revenues rather than profits.90 The greater the volume of sales under the trademark, the greater the likelihood that a consumer has had direct or indirect contact with the trademark, increasing its value. The greater the revenues of outlets, the greater are the royalties collected as a percentage of sales.

This divergence in interest goes beyond the basic free-riding problem to touch almost every aspect of the operation of the franchise. Franchisees, seeking to exploit their trademark license, want to limit the number of franchises granted: franchisors, having sold the first round of franchises, may want to saturate the market with franchises. Franchisees want to locate outlets in profitable area: franchisors, seeking to advertise the trademark and create the image of being on every street corner, may want to license additional franchisees in areas that will contribute to this reputation, even if a particular outlet may not be profitable. Franchisors may wish to have stores operate twenty-four hours per day in order to develop the trademark’s reputation for consumer convenience; franchisees, making few sales at night, may wish to save operating costs and close for a number of hours. From the franchisor’s perspective, bringing the franchisee’s interests in line with its own is the central difficulty of this method of doing business.

B. The Franchisee’s Problem: Opportunism

If controlling franchisee interests were the only problem within the franchising relationship, its solution would be relatively straightforward, albeit costly. Franchisors could, for example, retain the authority to dictate required behavior for franchisees and hire squadrons of field people to monitor compliance daily. However, the problem of divergent interests cuts both ways. An unrestricted exercise of control by the franchisor will favor the franchisor’s interests over the franchisee’s and create an equally significant problem for the franchisee: risk of opportunism.91

For the franchisee, the most significant economic feature of franchising is the allocation of capital investments. Franchisees are distinct from ordinary employees because they have made capital investments in the business.92 These investments, however, are normally highly idiosyncratic, meaning that a large fraction of the franchise assets often have a greatly diminished value if employed in another line of business. Consequently, the costs of establishing a franchise are effectively sunk costs, which, once expended, are not easily recovered if the franchise goes out of business.93

Sunk costs play an important role in creating the incentives that operate within an established relationship.94 This is best understood by considering the difference between fixed costs (overhead or up-front costs) that are sunk and those that are recoverable.95 For example, consider a business in which a variable cost of production has increased dramatically, so that the highest price in the business can charge for its product covers only the marginal cost of producing it, leaving nothing to contribute to fixed costs. Although the business can cover its variable expenses, such as wages and ingredients, it is making negative profits because it has nothing left over on its investment in overhead assets. If the business can resell these assets to recover its fixed costs, then the business can raise its profits to zero by shutting down and selling off the assets. If, however, these assets are sunk assets, then, by definition, their sale will not recover their full cost; shutting down will still leave the business with negative profits. If the business has any revenue left after paying variable costs to defray the cost of these assets, the profit-maximizing decision is to continue to operate, instead of junking the assets entirely and losing the whole investment. The key difference is that a business with recoverable fixed costs will shut down as soon as it shows losses, employing its capital more profitably elsewhere. A business with sunk costs, on the other hand, will continue to operate even though it has never recovered its investments in fixed costs, and it will not shut down until the amount it is losing exceeds what it would lose by simply abandoning the investment.96

The incentive that causes a business with sunk costs to stay in operation despite losses makes franchisees vulnerable to franchisor behavior known as “opportunism.” 97 Because the franchisee will continue to operate even if it is not recovering its sunk investment, the franchisor can make decisions that induce such losses without the franchisee going out of business. When these decisions benefit the franchisor at the expense of the franchisee, the franchisor opportunistically extracts a portion of the franchisee’s sunk costs. A franchisor can potentially extract this value from the franchise directly in a number of ways: it can raise the price of goods sold to franchisees, increase rent, boost royalties through an increase in the required volume of a franchise, levy fees, or divert advertising funds to general corporate uses. Extractions can occur indirectly as well. To increase the price of new franchises, a franchisor could require franchisees to make excessive advertising investments, to participate in promotional programs which are not cost-effective, or to undertake unnecessary renovations.

Just as the risk of free-riding makes control a central concern for the franchisor, the risk that franchisors will extract sunk costs makes opportunism a central concern for franchisees. These concerns meet head on: Where franchisors seek to expand their control, franchisees seek to erect boundaries. In some circumstances a franchisor’s decision to require increased advertising by franchisees, for example will reflect a legitimate exercise of franchisor control to overcome free-riding. But in other circumstances, it will reflect only opportunism.

The difficulty of distinguishing between a legitimate exercise of control and an opportunistic one provides another perspective on why franchise contracts are necessarily incomplete. It is this distinction that must be drawn, in writing, to complete the franchise contract. Clearly this is an enormous task, one requiring the franchisee and franchisor to anticipate every detail of the long course of their relationship in a highly uncertain environment. As a result of the enormity of this task, franchise contracts leave many of the problems at the interface between legitimate quality control and opportunism unsolved.98

C. The Normative Consequences of Unsolved Problems of Quality Control and Opportunism

Determining whether the consequences that flow from the failure of the incomplete franchise contract to control free-riding and opportunism justify particular rules of contract interpretation and enforcement first requires that a court adopt a normative framework for analyzing those consequences. I will briefly mention two possible frameworks before turning to the one on which my own analysis rests.

Fairness is one potential normative stance. This is the stance adopted by those who seek franchise regulation because they perceive franchisor opportunism as unfair action that uses superior bargaining power to take advantage of a franchisee’s vulnerability.99 Judicial reliance on doctrines of unconscionability or adhesion100 to regulate franchisor behavior also stems from fairness concerns. The duty to avoid defeating the reasonable expectations of one’s contracting partners is another possible fairness justification for contract rules that control free-riding and opportunism.

Economic efficiency, the stance adopted by most adherents of the law and economics movement, 101 is another normative framework that courts could use to justify contract rules. The inefficiencies created by failures to control the divergent interests of two interdependent agents are well documented in the economic literature.102 The use of franchisor control to overcome free-riding improves efficiency as franchisees are forced to provide a level of quality that takes account of the effect of their action on other franchisees and the franchisor.103 Judicial action to prevent opportunism promotes efficiency by lowering the transaction costs associated with it: the private resources expended “perpetrating and protecting against opportunism.”104

The possibility of unrestrained opportunism can diminish efficiency as franchisees choose not to enter into otherwise profitable franchise arrangements for fear of losing their investment in sunk assets;105 alternatively, if franchisees fail to foresee the danger of opportunism, they may be led to invest in essentially unprofitable schemes that merely operate as devices to transfer wealth to franchisors. Even with efficiently formed franchising relationships, there may still be ex post inefficiencies because of opportunism. During the course of the relationship, the franchisor makes hundreds of investment decisions, most of which are shouldered by franchisees.106 If the franchisor opportunistically fails to take into account the cost of these decisions for franchisees, it will be led to make too many of these investments relative to the efficient level.107

Despite their wide appeal, both the fairness and the efficiency rationales remain problematic. What is fairness? Why should courts pursue economic efficiency? While these are essential questions to explore, this normative task is not one that I undertake here. Instead, since my immediate objective is to improve the resolution of current franchise disputes, I choose to rest my analysis on a narrower normative rationale, that which undergirds traditional contract doctrine.

As most judges today would see it, the traditional function of contract law is to enforce the private commitments reached by contracting parties in structuring their exchanges.108 From this normative stance, the central issue is the actual content of the commitments reached by the franchisee and franchisor. If courts mistakenly interpret gaps in the incomplete franchise contract as absences of commitment about either free-riding or opportunistic conduct, then either franchisees or franchisors may find the franchise arrangement a less attractive one. Consequently, they will tend to eschew a voluntary exchange that they would otherwise adopt, and the courts will have failed to facilitate their decision to form a franchise. Alternatively, if franchisees and franchisors do not anticipate that courts will fail to enforce their implicit commitments to refrain from free-riding or opportunistic behavior, then franchising may indeed arise as a choice but the exchange enforced will no longer be the one voluntarily entered into by the parties.

The analysis of the franchise relationship by a court interested in performing the traditional function of facilitating exchanges by enforcing private commitments must focus on identifying those commitments in the absence of a feasibly complete contract. The twin problems of control and opportunism structure this analysis. By beginning with the hypothesis that neither franchisee nor franchisor would choose voluntarily to form a franchise relationship in the absence of legally enforceable commitments preventing free-riding and opportunism,109 a court can examine the details of a particular franchise relationship to determine if the hypothesis holds. If so, then these commitments must be counted among those that the court should enforce.

Some of these commitments will indeed by found in the written contract; others may be inexplicably absents. My main objective, however, is to demonstrate that many of these commitments arise within the franchise relationship itself, as that relationship is understood by its participants. Developing this analysis requires an examination of the “relational” structure of franchising, to which I now turn.

IV. THE RELATIONAL STRUCTURE OF FRANCHISING

Contract literature has made much of the importance of “relational elements” in franchising.110 It is difficult, however, to define precisely what is meant by the term “relation”, since “relation” exists at many levels. It can encompass the actual exchanges or bargains that occur within the arrangement, that is, exchanges that could be made the subject of separate, simple, short-term contracts. “Relation” can also be understood as the balance of economic power within the arrangement, the bargaining positions of the parties and their respective vulnerabilities to exchanges they do not like but cannot prevent. “Relation” can embrace the set of perceived obligations and rights of the various parties in the relationship, as the objectives and options of the parties and the boundaries they face or must respect. It can entail the balance of elements more relevant to analyses of individual personality or class structure than modern economic theory: balances of power and autonomy, and of dignity and exploitation.111

My purpose in exploring the “relational” aspects of franchising is to demonstrate that economic tools can elucidate an understanding of “relationship” grounded in particular attributes of exchange, bargaining, control and sunk costs. Guided by the commitment problems illuminated by the economic analysis of control and opportunism, relational analysis can focus on identifying those features of the relation between franchisor and franchisee that address these problems. Such an application of relational analysis, consonant with the private commitment model of contact ostensibly employed by the courts, provides an avenue for introducing the analysis of relation into the resolution of current contract disputes in the courts.112

Relation enters the examination of franchising through the incompleteness in the franchise contract. Classical contract doctrine claims to look only to the “four corners of the document” in identifying the content of the contractual relationship between the parties.113 Doing so in the franchise context would define a relationship almost exclusively in terms of the franchisor’s interest in protecting its trademark and the broad range of control that it assumes to pursue that interest.114 As Stewart Macaulay has documented, 115 however, the real life of the franchise is found not in the contract but in its operation.

We should nonetheless be clear about the importance of the contract in structuring the “real life” of the franchise. The contract supplies starting points: the frequency of payments, expected training levels, and advertising responsibilities. It also applies boundaries: some supplies must be forthcoming, some sales must be made and royalties paid, and some distances must be preserved between outlets. However, the incompleteness of franchise contracts consists in either the absence or the intense ambiguity of these starting points and boundaries: How expensive can promotions be? How often can outlet refurbishing be required? What measures to boost sales can be required? The franchise contract sketches only a bare outline, one which is then filled in by the ongoing balance- the beliefs, powers, and incentives that comprise the relationship.

The incomplete contract that courts see is precisely that: incomplete. A rational decisionmaker, aware of the problems of control and opportunism, simply would not enter into a contract so incomplete if it represented the entirety of expected obligations and commitments. Instead, I argue, franchisee and franchisor enter into a “franchise relationship” in reliance on commonly understood features of that relationship which fill in the gaps of the written contract and create an understanding of the full range of commitments involved. Thus the importance of the relational elements is not merely of descriptive interest. These are not merely details that are irrelevant for the basic economic issues of planning, incentives, and commitment.

Getting at the “relationship,” however, is a slippery task. What I report here are only general comments about the relationship – perceived obligations, limitations, bargains and abuses- accessible from popular books and trade journals on franchises.116 Nevertheless, the comments capture a view of the norms, beliefs and exploits of franchising117 and paint a different picture of franchising than that accessible from a mere examination of contract structure.

A. The Nature of the Exchange

One of the first issues to explore is the perception within the industry of the content of the franchising exchange. What, in other words, do the participants expect “franchising” to be? One franchise consultant offers the following definition:
Franchising is a continuing relationship in which a franchisor provides a licensed privilege to do business, plus assistance in organizing, training, merchandising, and management, in return for a consideration from the franchisee.
..A franchisor then is fulfilling his obligations to his franchisee only when he provides continuing assistance toward the solution of his franchisee’s many problems- to their mutual benefit and profit.118

This perspective reflects the view that franchising is fundamentally about the purchase of a trademark license and a management consulting service, making the obligations of the franchisor vital to the exchange. As another franchisor describes it, “the basic concept of franchising revolves around the franchisor’s ability to satisfy the desires of the franchisee. [The manager] must understand that the franchise company sells service to the franchisee and that the franchisee represents the cornerstone upon which the industry rests.”119 This view stands in sharp contrast to the de-emphasis of franchisor obligations in the standard franchise contract.120

Another definition of franchising emphasizes the mutuality of the relationship. The mutuality perspective understands franchise contracts as “any contract under which interdependent retailers or wholesalers are organized to act in concert with each other or with manufacturers to distribute given products or services.”121 This view again contrasts with the contractual view that emphasizes the franchisor’s interest.

Most definitions emphasize that franchisors are in the business of figuring out how to build a better mousetrap while franchisees are in the business of building it:
Franchising is now an industry in its own right and as such is based largely on the concept that there is money to be made by creating and perpetuating business opportunities for others.122

But in these definitions it is nonetheless clear that the franchisee is expected to do as he or she is told:
Franchising is a chain of small businesses bound by the image and policies of a parent company. The person buying a franchise does not buy his own business. He buys a success package from a company who shows him how to use it.123

More bluntly:
Running a franchised business means giving up your independence and playing by someone else’s rules.124

You are the “manager-owner” of the franchise, but the emphasis is always on the “manager.” You must take orders from headquarters. Will you be able to do this?125

It’s your business [says one franchisor], but I control what you do.126

But despite the fact that franchisees are expected to act as if they were only managers, franchisees repeatedly assert that they entered franchising because they wanted to own their own businesses:
The franchise merely gives the individual one major right, that of owning his own business and having that pride of independence which accompanies being his own boss to a greater rather than lesser extent. In exchange, he must give up certain things - such as the inalienable right to mismanage his own business.127

Franchisors direct their advertising campaigns to this point:
OWN YOUR OWN BUSINESS….No boss…no clock to punch…just a great sense of independence.128

IF NOT NOW, WHEN….are you going to be your own boss?129

Franchisees and franchisors alike also seem to view the exchange as a low-risk alternative to an independent small business:
[T]he prospective franchisee visualizes the “franchise package” as a group of devices which contribute to reducing his risk of failure…rather intensive fears of failure were evident among franchisees who had seriously considered an independent business venture versus a franchised business.130

The very fact that the successful franchise is “packaged success” lies at the very heart of the franchise boom. “If we know a man is on his way down…we’ll do everything possible to bail him out. We don’t want a bankruptcy.”131

As industry observers have recently begun to recognize, however, the risks of franchising go beyond the reduced likelihood of bankruptcy. One observer suggests that the 5 percent failure rate reported by the Department of Commerce132 “may be moot, because troubled franchised outlets rarely go out of existence. They are often sold back to the franchisor or to another operator at fire-sale prices.”133 As one buyer’s guide cautions:
We hear success rates of 95 percent to 99 percent being thrown around. The government seems to support these figures.

We’re not sure where they get their statistics from but we can’t agree with them. The figures don’t tell you about the franchisee in Des Moines who invested $100,000 in his business and then had to sell it to someone else for $15,000 because that was all he could get. The business is still operational, as the “statistics” indicate; the $85,000 loss, however, is not reflected anywhere.134

Modern buyers’ guides, in contrast to earlier guides that portrayed franchising as “fail-safe,”135 now start off by immediately debunking the “myth” of financial security.136

As the above comments demonstrate, the precise exchange taking place in franchising is ambiguous. Nonetheless, certain characteristics can be identified. For example, the franchise relationship is clearly no merely an arm’s length trademark license between a passive trademark owner and an essentially independent small business operator. Nor is the franchisor’s power exercised merely to protect its trademark. The relationship is, instead, a much more active mutual exchange. Franchisees purchase more than trademark rights: They purchase the franchisor’s expertise and management advice. Franchisor control not only protects the trademark; it must also provide these basic risk-reducing services to the franchisee. Franchisees are expected to act as if they are employed managers strictly following franchisor direction. But at the same time they are clearly operating “their own” businesses in the sense that, despite franchisor advice, they run the ultimate risk of bankruptcy or poor performance. Thus, as I will explore further below, the exchange involves obligations on both sides.

B. The Reliance Relationship: Superiority and Inexperience

The mutuality of the exchange in franchising does not mean that it is an exchange between equals. Instead, the reliance relationship created by the franchisor’s relative superiority and the franchisee’s relative inexperience is an essential component of the typical franchise exchange.

One way in which the franchisor’s necessary superiority is expressed is in the perception of the importance of the standard form nature of the franchise contract. There is a strong perception in franchising that the standard form contract, designed by the franchisor, is a necessary part of the peculiar nature of the franchise relationship:
The reputable company will not change its contract; it will rarely let it be examined until the prospective purchaser has made a deposit towards the purchase. It will not compromise or negotiate any part of it. The attorney representing a prospective purchaser need only determine with him if the client can live within the framework of the franchise agreement. If it is oppressive or confiscatory, the client is best advised not to sign. If the franchise company offers to negotiate away any of its requirements to make the sale, it can only be an indication of the weakness of the company. The intangible that the purchaser seeks in joining the franchise network is the organization and power of a professional management group; if that group is willing to give away any part of its basic contract it can only indicate a fatal weakness in the structure and philosophy of the company.137

This advice represents a clear ethic of non-negotiation, not merely to boost the bargaining power of the franchisor, 138 but also to define what, fundamentally, it is that the franchisee is purchasing. In other words, franchisors use the standard form contract to signal aspects of the relationship that the franchisee can expect- the relational elements of company structure and philosophy. Buyers’ guide authors echo this same norm.139 The clear message is that the refusal of the franchisor to negotiate- the superior position of the franchisor- is a hallmark of the relationship that the franchisee is purchasing.

On the other side of the scale is the franchisee’s inexperience. Both franchise participants and observers note that the typical franchise relationship is aimed at those who “don’t have a product or the skills to establish [their] own company.”140
The franchisee whom the Colonel knew in the beginning had been a man without funds. All the prospect had was the spirit and the emotion and the guts. The prospect knew he wanted to be in business and he intended to sell Kentucky Fried Chicken. The Colonel never looked at the prospect’s financial statement. As a matter of fact, many prospects did not even know what the word meant.141

It should be remembered that despite the fact…that more and more franchisees are professionals, the nature of the franchising industry continues to attract the individual of modest means and limited business experience. Franchising still offers the uninitiated and inexperienced their first opportunity to establish businesses of their own.142

[T]he majority of franchisors [63%] say that they prefer to enroll a franchisee with no experience in their line of business. This preference exists in spite of our finding…that experienced franchisees operate more profitable units.143

An advertising directory published in 1985 by franchisors notes “previous self-employment is not necessarily an advantage when considering a franchise… The problems concern your sense of business autonomy.”144 And despite the fact that “franchises are growing in size and sophistication,”145 a recent article still notes that “[f]ranchising has always attracted mom-and-pop operators because it offers a relatively cheap way to own a business. And franchisees have always been at the mercy of franchisors whose decisions about new products, markets, and capital spending can determine whether the franchisee’s life savings go up in smoke.”146

The presumed, and preferred, inexperience of the franchisee introduces the reliance of the franchisee on the franchisor into the very heart of the franchise relationship. This imbalance is not just a consequence of imperfections in bargaining. Rather, it is in the very nature of what is being exchanged. Franchising centers on the franchisee following the franchisor’s rules, while the franchisor advises and assists the fledging small business operator. Those services on the part of the franchisor are what the franchisee purchases and what makes the imbalance in the relationship appropriate and valuable. As one franchisor assured its franchisees: “Remember, everything we do is calculated to make your store more profitable, make you more successful.”147

As a generally inexperienced businessperson in a reliance relationship, the franchisee’s commitment is often simply to work hard.148 In exchange for hard work, the franchisor relieves the franchisee of responsibility for the types of mistakes that cause most small business failures:
Our quota clause is designed mainly to prevent someone from buying a Chicken Delight business for the sake of running the business into the ground in order to destroy the company’s good name, or in order to make it possible for a competitive operation to get a start in one of our areas while they tool up to move into that area. But if you [prospective applicant] were making every conscientious effort and consistently failed to meet your quota, we try to find out why and do everything possible to help you, even to the point of moving you to a new location if we should deem it necessary.149

True, you must be on solid financial ground to begin with. But if you make up for lack of financial assets with drive and stamina, and if you are hungry enough, and we recognize that, we reach for you. We’ll help you get started.150

Franchisors often characterize those who fail as lazy, cavalier about quality, or lax about exercising the good sense of a diligent worker. Success or failure is within the direct control of the individual franchisee:
Many who started and grew with the industry, franchisor and franchisee alike, have prospered beyond imagination, beyond dreams of dreams. Some whose dedication, determination, character or imagination was not real enough, have not achieved.151

The emphasis on the franchisee’s obligation to work hard underscores the basic reliance relationship between an inexperienced but diligent small businessperson and a superior, experienced franchisor responsible for making the remaining business decisions that will determine the success of the venture.

C. Intimacy and Interdependence

Not only is franchising a relationship between unequals, it is a highly intimate and interdependent one. The franchise contract hints at the extent of this intimacy. The norms and beliefs of the relationship go much deeper. In the early days of franchising, franchisors were surprisingly unabashed in their use of family metaphors to describe the relationship:
Being a franchisor is pretty much like being a parent. If there’s a squabble amongst the kids you try to get in there and solve it. You have to handle it with diplomacy.152
His [the franchisee’s] responsibility to you is to perform like you say to. When you sell the franchise, the franchisee is buying your leadership. You are not buying his. The function of the franchisee is to follow the wisdom and system of the franchisor….[T]ell him, ‘Look, partner, we are both playing a role, and the role I’ve got is the Daddy, and the role you’ve got is the son, and I’m going to tell you how to do it. If you do it right we’re going to do it better.’153

For one franchisor the parental metaphor was insufficient. At one time, the then-president of Kentucky Fried Chicken noted that
franchising has been described many different ways, but actually what it is, is a wedding. Lots of music, lots of flowers, money exchanging hands and lots of kisses. The couple is from the best of two worlds; one of the partners is experienced, with plenty of good know-how, and the other partner is a virgin, who hopefully has never been in business before. The vows they exchange are almost the same as you exchanged when you married your wife. The virgin bride must have a burning desire to be “his” own boss and to run “his” own business.154

Even today, modern franchising guides caution: “Are you a ‘confirmed bachelor’ who is on the verge of a ‘business marriage?’” 155

Other franchisors and industry observers echo the intimacy of the relationship and its extension, like a marriage, beyond the recognized legal form, but do so without the use of marriage or family metaphors: “In the relationships of franchisors and franchisee- in fact, in any relationships- we are talking about human relationships…And these relationships are not merely contractual; they do not begin or end with signed agreements, or with legal limitations.”156

Sometimes the intimacy of the relationship is perceived as a windfall for the franchise company:
When you sell this gentleman the license, and he gives you $10,000, it is like sitting around a poker table. There are seven or eight of you, and he puts down $10,000 for his seat. He does not put his name in the ante, he won’t get that back. He is giving that to the house. Marvelous industry, this franchising! Can you imagine a fellow paying you $10,000 for the right to pay you royalties for the rest of his life? And that is what the franchising industry is all about! He, the franchisee, pays you $10,000 for the right to pay you for the rest of his life! And sometimes in perpetuality?157

For others, however, the intimacy of the relationship is seen as a foundation for the responsibility that accompanies interdependence within an unequal relationship:
In analyzing the relationship, I would suggest to you that the time has passed where any franchising company can operate on a “take it or leave it” basis, I believe a franchisee, having a substantial investment in his business, is entitled to an increased amount of Tender Loving Care. He has every right to expect empathy and a genuine understanding reciprocated by the franchising company to whom he is paying substantial fees.158

D. Conflict

These portrayals indicate that the franchise relationship is set of mutual obligations embedded in an intimate interdependence between unequals. And is often the case with intimate relationships, observers can subscribe to the view that the relation is inherently harmonious.159 But more realistically- and as evidenced by litigation, popular observation, and efforts to obtain regulation- the intimacy and inequality inherent in the relationship make it vulnerable to conflict and abuse. Increasingly observers have recognized the fundamental divergence of interest within the relationship and the need for ongoing efforts to control such divergence.

Franchisors have for some time recognized the ways in which franchisee interests can diverge from their own. The basic quality control problem is well recognized,160 as is the broader problem of free-riding.
[H]ow do you control your hostility toward the franchisee- usually the well-established, old-friend sort of franchisee-who has made it so well he could not care less about making it even better? You sit in your office and hunger for that unrealized potential - while he is out on his yacht, on a sea of complacency and self-satisfaction!161

[T]here is the problem that many franchisees have reached a comfort index and are saying , in effect, “I don’t want to expand. I’ve got enough. My taxes are so high that there is no reason for me to make additional investments.” This may leave us with territories that are not fully developed- with markets where we have a substantial untapped potential. Again, this is a gap we must close by finding means to encourage existing franchisees to go beyond their comfort index or to sell off a part of the territory they have not developed.162

However, the extensive powers specified in the contract, as well as the understanding within the
relationship that quality control is a key feature that justifies constraints on franchisee behavior,
seem to enable the franchisor to control the franchisee’s divergent interests. Franchisors have not
been among those lobbying for change or regulation.163

Franchisees, on the other hand, have long seen a need to control franchisor abuses.164 Franchisees and industry observers have recognized the essential problems of franchisee sunk costs and franchisor opportunism.
There have been instances of franchisees who, having invested their life savings in building-up a business, find upon termination, that all they can take out (if they are lucky) is their original franchise fee. The plight of the franchise may be especially pitiful when he is subject to a restrictive covenant which prohibits his reentry into the only business he knows. He may be left with a “distinctive” piece of real estate – say a hamburger stand shaped like a donut which may not be used to sell hamburgers (or donuts). Under these conditions, the sale of equipment and real estate at a “fire-sale” evaluation (perhaps, back to the franchisor) may be the only alternative for the franchisee…. The assumption seems to be that all goodwill is solely traceable to the franchisor’s trademark.165

The right to approve the sale of the franchise or to approve the incoming franchisee can be a potential weapon against the franchisee. The franchisor can withhold approval in order to obtain concessions or in order to force the introduction of his new, often more stringent, franchise agreement.166

More than one person has learned very expensively that the “unreasonable withheld” clause [for transfer or location approval] is largely meaningless and offers not protection to the franchisee whatever. In fact, it is a universal escape hatch for the franchisor.167

Franchisees also find that “[t]he most common cause of conflict comes under the catchall term lack of support [:] …failure to provide promised or necessary expertise.”168 Complaints concerning the quality of operational and financial guides and the knowledge of franchise field people are common.169 Aware of the potential for lack of support, one franchising guide counsels prospective franchisees to ask:
[W]hat happens if I’m not successful due to my efforts? Suppose it’s your fault – introducing products that don’t sell, or picking the wrong location?
…[O]bserve carefully for your obligations couched in terms like “shall”, “must,” “will refrain from,” “will be required to maintain, to pay, and to do” versus a franchisor bound only by “might’s” and “maybe’s.” 170

Franchisors can abuse the relationship most directly through manipulation of the price or quantity of products or services sold to the franchisee.171 A buyer’s guide cautions prospective franchisees to “[b]e aware that a franchisor may create additional fees or require additional purchases when it has excessive inventories or needs a quick infusion of cash for any reason.”172 Similar abuses occur in connection with the allocation of the advertising fees collected from franchisees. Observers note that it is “tempting for franchise companies to use these advertising dollars to boost their profit margins.” 173 Many franchisees complain that “they do not receive advertising support commensurate with their payments of advertising fees.” 174 Franchisors can also directly extract the franchisee’s capital value by forcing the franchisee to forfeit either the capital equipment – sometimes purchased from the franchisor – or the initial franchise fee.175 Franchisors are also accused of extracting profits by attempting to buy out (perhaps by finding “cause" for termination) successful franchisees.176

More subtle forms of extraction occur when the franchisor pursues its own otherwise legitimate interest at the expense of the franchisee. Examples of this type of behavior include increasing the exposure of the franchise name or changing the franchise image for the purposes of increasing the value of the franchise system overall without taking into account the cost to franchisees.177 In addition, franchisors may make subtle use of franchisee investments, in the franchise itself or in on going supply purchases, to experiment with locations and products. By encouraging franchisees to take on products or locations with which it wishes to experiment, franchisors can shift the cost of the experiment to franchisees. One critic suggests that
For many chain builders franchisees serve as cannon fodder, foot soldiers to be expended in battle. If the company thinks there might be a market for a product in a certain area it can find operators who will invade the community. If the experiment fails and the franchisees go bankrupt, well, that’s too bad – in business there are always risks. In this way tens of thousands of individuals have lost their investments. As long as some outlets survive, they can continue trying new areas. It is out of the trial and error financed by many franchisees that a few successful chains and franchisees emerge.178

Over time, as the litany of franchisor abuses has mounted, franchising observers have come to recognize that the danger of abuse is inherent in the structure of franchising. The degree of franchisor control, coupled with the presence of franchisee investments, sets the stage for conflict.179 As one buyers’ guide notes, “as long as your interests do not conflict with their best interest, franchisors will indeed help you….Should your interests fail to converge with theirs, however, any franchisor will look out for itself first.” 180 Asked, “Can’t I trust the franchisor to do right by me,” this guide answers, “Most franchisors will do right by you, according to their definition. However, their definition is not likely to coincide with your definition of what is ‘right’’.181

V. CONTRACT DISPUTES IN FRANCHISING

As both the economic and relational analyses of the previous two sections make clear, franchising is structurally vulnerable to conflicts. In this section I will present a basic overview of the variety of the contract disputes that are brought into the courts.182 Section VI will then develop a general analysis of the interpretation and enforcement of franchise contract.

Most franchise disputes appear in court as wrongful termination suits. Terminations follow from two different types of events: franchisee violation of an established operating requirement or franchisor modification of the operational environment.183 I will deal with these types of disputes separately.

A. Franchisee Violations of Established Standards

The most straightforward termination cases involve the franchisor’s central concern – a franchisee’s unambiguous failure to maintain quality standards – and a contract clearly providing for termination upon a finding of such failure. Cases of this type involve such questions as whether the contract justifies terminating a fast-food franchisee whose failure to comply with detailed requirements from an operations manual (“cover all food items” and “control pests”)184 resulted in health citations, or terminating a hotel franchisee who received successive “unacceptable” ratings in routine quality inspections governed by a detailed list of standards.185 In such situations, courts must inevitably apply broad contract terms to particular facts. Photographically documented exhibits of rotting food, uncleaned equipment, improperly stored ingredients, and stray animals in the kitchen weigh against general contract requirements to maintain cleanliness.186 Courts call upon generalized “best efforts” and possibly implied “good faith” standards to justify termination when franchisees mislead highway motorists about gasoline prices,187 sell a generic brand of ice cream in trademark containers,188 or pump substitute gas from trademarked pumps.189 Such termination cases present the paradigm of franchise disputes.

An otherwise paradigmatic termination case becomes problematic when the franchisor apparently had an opportunistic reason for terminating the franchisee, indicating that the seeming violation merely provided a pretext for termination. In one such case, a franchisee ostensibly violated a 24-hour clause in this franchise contract by shutting down overnight during a period of federal gasoline rations. During that period the franchisor had attempted to induce the franchisee into the unprofitable position of posting a “no gas” sign during the day and taking it down when a competing gas station closed at night.190 In another case, a franchisor sought termination upon a franchisee’s default of less than 2 percent in royalties; the franchisor planned to transfer the franchise to a new franchisee able to distribute goods more profitably without compensating the original franchisee for its lost investment.191 In another example, a franchisee failed to meet sales quotas devised by its franchisor while also threatening the success of a competing franchisor-owned oulet.192 General “inadequate performance” leads to termination in some cases where the franchisor’s true complaint appears to be the franchisee’s failure to maintain suggested resale prices.193 A final example of this type of dispute includes the case in which a fast-food franchisee bought into a fledgling system and agreed to open ten outlets in ten years. When the franchisee had only nine in place after ten years, the now highly successful franchisor terminated all nine, thereby allowing the franchisor to resell the franchises at higher prices, and depriving the franchisee of the upside of its earlier gamble.194 In all of these more problematic cases, the franchisor appears to be “enforcing” a minor or curable contract violation not to promote the quality of its franchises but to achieve some other, opportunistic goal at the franchisee’s expense.

The hardest cases of franchisor opportunism involve ambiguous motives on the franchisor’s part. In one such case, the franchisor terminated the franchisee after the franchisee sold below his quota and refused to comply with the franchisor’s demands for additional salespeople and increased inventory.195 On the one hand, the franchisee had a clear obligation to meet the quota; on the other, the franchisor, perhaps facing region-or nation-wide declines in sales as well, had a potentially opportunistic interest in shifting inventory and the cost of boosting sales to the franchisee.196 Another example involves the termination of a franchisee who had failed to disclose, as required by contract, the identity of franchise shareholders. The franchisee, ailing financially, contracted to sell the franchise to a new franchisee. The franchisor disapproved the transfer, committed the franchise to a third franchisee in settlement of an extraneous dispute, and terminated the franchise.197 The potential for opportunism here rests in the franchisor’s interest in transferring the franchise at a low price to the third franchisee as consideration for settlement of another dispute. Again, however, an otherwise legitimate ground exists that might ordinarily prompt termination, and identifying the franchisor’s true motive is often complex.

In all of the above cases, courts face the question of whether the franchisee’s violation of an established obligation justifies termination. The importance of a franchisor’s more or less ambiguous ulterior motives depends on the court’s resolution of a relational question: Are there limits on the use of the power to terminate, the power of quality control?

B. Changing the Franchise Environment

The second type of dispute raises a slightly different relational question: What are the limits on the franchisor’s power to structure the franchisee’s obligations in the first place, the power of design? When the franchisor exercises this power and modifies the franchise system in some way, litigation arises after the franchisee’s refusal to comply results in termination or when the franchisee alleges that the franchisor has breached its obligations by abusing the design power.

A large number of cases of this type involve franchisor efforts to induce franchisees to terminate voluntarily in order to transfer the franchises to more profitable franchisees or to convert the outlets to company ownership. In one such case, the franchisee had taken on a Mazda automobile dealership when the company was selling only the GLC, a relatively unpopular model.198 When Mazda introduced its successful RX-7 model, it sought to reduce its inventories of the less popular GLC by allocating RX-7’s to old franchisees on the basis of GLC sales. Mazda then adopted a policy of “drastic action” to achieve the voluntary termination of existing franchisees. Under this scheme, new franchisees received RX-7s on the basis of RX-7 sales. Because older franchisees held GLC inventories, which Mazda would not repurchase after termination, older franchisees were unable to compete effectively with the new dealerships which could count on the availability of RX-7s to attract new customers.

In other cases, the franchisor will take steps in response to a changing market environment that raise the possibility that the franchisor is attempting to reduce the value of the franchise in order to bring about voluntary termination. Modifications such as delays in delivery, price and credit-rate increases, and required retail discounting may reflect such an effort.199 In one extreme case, a franchisee purchased Fotomat film distribution franchises from the franchisor at an early stage in the development of the system, paying a relatively low franchise fee.200 Discovering that the franchises were more profitable than expected and that profits from company-owned stores were higher than those from franchised stores, the franchisor began setting up competing outlets close to particularly successful franchises and ceased providing contractually required pick-up and delivery services thereby cutting the profits of the franchisees in half. These and other steps drastically reduced the price at which the franchisor could buy back the outlets.

In a related set of cases, the franchisor limits the profitability of a franchisee by preventing it from competing effectively with the franchisor’s own nearby location. In one such case the franchisor refused to increase fuel supplies to a franchisee seeking to expand, designating the franchise as a “no-growth” distributor.201 In another, the franchisor allegedly manipulated the franchisee’s territory in order to take over its successful distribution network.202

The Fotomat case demonstrates another opportunistic use of the design power: franchisor experimentation. Many franchises, like the Fotomat franchise, involve new products or processes, the success of which is still uncertain; all franchises involve uncertainty about the potential success of a particular location. This uncertainty creates the danger that the franchisor may use its power to terminate or devalue a franchise in order to seize the upside of the franchisee’s gamble, leaving the franchisee only the downside. Burger King203 is another example in which the franchisor attempted to terminate a franchisee who had been with the system since its early days, possibly to resell the franchises at higher prices. The franchisor might also seek to take advantage of a successful location gamble by invading a franchisee’s territory.204 When a location is not successful, the franchisee bears all of the costs of the failure.205 Franchisors may also experiment with operational changes, such as staying open twenty-four hours,206 or introducing limited-offer menu items. Franchisees bear the costs of these marketing experiments, distorting the franchisor’s assessment of whether an experiment is cost-effective.

The franchisor often makes explicit changes in the franchise system when presenting the franchisee with a new contract containing modifications in terms. The facts of Arnott v. American Oil Company 207 provide an example of how contract modification may be employed opportunistically. Amoco persuaded Arnott, a service station franchisee, to purchase a carwash from Amoco for installation at his station. In exchange for the installation, Amoco attached a rider to franchise contract which entitled Arnott to a minimum monthly rebate on the car wash, provided he met a prescribed level of sales. Four months after Arnott installed the car wash, Amoco cancelled the existing contract and presented Arnott with a new contract which essentially cut the rebate in half.

Less blatant examples of opportunistic contract modification also occur. In one case, the franchisee refused to sign a new agreement giving the franchisor new powers to relocate to franchise and set hours and transferring to the franchisee utility costs previously borne by the franchisor.208 In another case, the new contract would have created more onerous sales, price, and hours requirements and established new grounds for termination.209 Other cases involve modifications which require the franchisee to convert traditional gasoline service stations into streamlined “gas & snack” operations without repair services,210 or to implement formulaic increases of as much as 300 percent in the rent charged to gasoline franchisees.211 The complexity in these cases derives from the conflict between the franchisor’s legitimate interest in responding to a changing market and its illegitimate interest in shifting the costs of change onto franchisees or in masking purely opportunistic changes as market-induced.

“Dual-distributor” cases often raise this issue. In one such case, an automobile franchisor selling a fairly popular model adopted a formula whereby franchisees could only obtain this model if they agreed to take on a less popular model the franchisor was promoting.212 In this case the franchisee refused, citing competition with another existing line in its showroom, and was terminated. In another case, a franchisor terminated a franchisee for selling a second, unrelated line of automobiles.213 The contract nowhere proscribed such dual distribution – a standard and easily specified clause. The franchisor rationalized that decision by virtue of its contractual right to establish standards for the showroom layout, but the facts did not indicate whether the showroom had been detrimentally affected by the new line. The franchisor’s interest in the decision is clear enough, but so is the cost to the franchisee. A case involving the removal of a long-standing leasing component of a truck dealership, in order to create space for display of the franchisor’s products and to create additional amenities for customers,214 raises the same issue of whether franchisors are entitled to make design decisions solely in the franchisor’s interest, regardless of the cost to franchisees.

These questions, which require the evaluation of the contractual status of apparently legitimate but divergent interests between franchisor and franchisee, arise prominently in the context of the franchisor’s exercise of its authority to approve a franchisee’s transfer of the franchise to a new franchisee. On the one hand, this approval authority reflects a strong, legitimate interest on the part of the franchisor to choose with whom it will enter into the franchise relationship. In order to ensure the financial success of the new franchise, the franchisor has an interest in overseeing the details of the transfer. On the other hand, prospective franchisees are the only purchasers for whom the otherwise idiosyncratic assets of the franchise – the trademarked signs, inventory, and building design – have full value. Thus, the franchisor may reduce competition for the outlet and thereby reduce the purchase price by restricting the pool of potential franchisees available to the departing franchisee. Often it appears that the franchisor has a single buyer in mind and consequently will not consent to transfer to any other buyers with whom the departing franchisee may be negotiating;215 this potential franchisee is then in a good position to bargain for a low price from the departing franchisee. Many franchisors also exercise their control to reduce the transfer price by refusing to approve a sale at a price above a certain value.216 Other conflicts arise when the franchisor either requires the franchisee to obtain written consent from the franchisor prior to consideration of potential transferees, leaving the franchisee in a poor bargaining position,217 or refuses to waive a right of first purchase which the franchisor has declined to exercise, thereby leaving a cloud over the franchisee’s negotiations with potential buyers.218

The above cases all deal with franchisor efforts to “tinker” with franchisee obligations. Beyond these are issues that arise in connection with basic restructuring of the franchise system. What, if any, obligations to recent franchisees does the franchisor have to continue to invest in and support the franchise system? In one example, Holiday Inn decided to withdraw entirely from the business of promoting its TravL-Park system in which franchisees had recently invested.219 In such a case, resolution of the franchise dispute requires the court to determine whether it is sufficient that withdrawal is in the franchisor’s interest, or whether the franchisor is obligated to support the system so long as the franchisee could remain successful. Other such cases turn on the question of what responsibility lies with the franchisor to disclose to new or continuing franchisees its future plans for the system. Is a fast-food franchisor required to disclose to prospective franchisees viability studies that indicate that the system is in financial trouble?220 If the franchisor does not disclose the studies, is the franchisor entitled to tell franchisees that it remains committed to a strategy to do “whatever it takes” to support system growth?221

Questions about the franchisor’s power to restructure the entire franchise system can reach a high water mark when the franchisor decides to sell the system to a new franchisor.222 Attempts to alter the franchise relationship, in an effort to achieve a level of profitability that eluded the previous franchisor, can accompany the change in franchisor. The new franchisor may wish to terminate franchisees it determines are “unprofitable,”223 which compete with the new franchisor’s own distribution,224 or which it determines are in any way “dissatisfactory.”225 The new franchisor may seek to alter the terms of the franchise by changing the formula for computing wholesale prices226 or by altering the duration and royalty rates that had governed the franchise in the past.227 The new franchisor may also attempt to modify advertising policy and require renovations in existing outlets.228 Finally, the franchisor may change the product by substituting pre-packed ice cream for “ice-cream made fresh daily on the premises,”229 or frozen fishcakes for fresh fillets.230 These cases present particularly difficult questions of identifying the contractual balance between the interests of the new franchisor and the franchisee.

In sum, there are two basic types of contract disputes in franchising. First, there are those that involve a clear failure on the part of the franchisee to comply with an established operating requirement. Second, there are disputes that involve the franchisor’s efforts to change the franchise system’s operating requirements or design. In the first type of dispute, courts must establish the relevance of a franchisor’s ulterior or additional, and potentially opportunistic, motives for termination. In relational terms, the question is, what are the limits on the use of the power to terminate for quality control violations? In the second type of dispute, courts must delineate the franchisee’s obligations to comply with new franchisor directives. Put relationally, what are the limits on the power to redesign the franchise system? In the next section, I turn to a general approach to analyzing these questions.

VI. RESOLVING FRANCHISE DISPUTES

A. Interpreting an Incomplete Contract

Recalling the analysis of the central commitment dilemma of franchising,231 we can see why the two types of questions identified in the previous section emerge as the fundamentals of franchise disputes. It is along these dimensions that the franchisor’s interest in quality control and design comes into direct conflict with the franchisee’s interest in preventing opportunism. Only by defining the limits of franchisor control and discretion can the two interests reconcile in a way that provides each party with the commitment necessary to justify entering into the franchise relationship.232

In a world of complete contracting- the classical world envisioned by standard contact law- the fundamental questions in franchise disputes would be easy to resolve. The franchise contract would define explicit limits on the quality control and design powers, using written terms to correspond to the particular facts of each potential set of circumstances. For example, the contract would specify what actions Amoco could and could not require from a 24-hour gasoline franchisee in the event of gasoline rationing,233 it would specify the market conditions under which Holiday Inn could decide to withdraw permanently from its Trav-L-Park system.234 It would specify how much and what kind of advertising the franchisor had to do, given the various possible changes in the competitive franchise environment. The contract would also specify whether a new franchisor could switch from handmade to pre-packaged ice cream235 or require alterations in outlet design or equipment long before existing capital wears out.236 In this classical world there might be the occasional definitional difficulty,237 but by and large the courts could resolve franchise disputes passively, employing standard tools of contract interpretation.

The reality, as demonstrated in Section II, however, is that franchise contracts are extraordinarily and necessarily incomplete. Rarely do they, nor can they, spell out the details of the myriad transactions between the franchisee and franchisor. Instead these agreements read like miniature constitutions, setting out the parameters of each party’s duties in general terms. Franchisors are to design and maintain the system. Nowhere does the contract specify whether the franchisor may terminate the franchise simply because a better franchisee appears.238 For an automobile dealership franchise, the contract may be silent on the question of whether the franchisee is entitled to receive the franchisor’s popular new model of automobile in the same quantity as new franchisees.239 Nor do fast-food restaurant franchise contracts typically mention whether the franchisee can refuse to participate in a promotional “free fries with every burger” program which costs the franchisee far more than it brings in the way of new customers.240 In the absence of even poorly drafted terms covering such situation, courts are faced with non-classical contract interpretation.

To properly “interpret” the franchise contract one must read the written document in the context of the franchise “relation.” Faced with the silence of the agreement, a court has only two options: Either it can refuse to decided the dispute, finding the contract invalid and unenforceable, or it can resolve the case, filling in the contract’s silences. Early in the development of franchising, courts routinely took the first, “classical,” route. Today, however, almost all courts choose the second.

Having taken this second route, a court has no choice but to look beyond the document and identify a configuration of commitments patterned not in the words of the contract but in the underlying relation itself. If a court is to decide that an auto dealership warrants termination by refusing to build a new showroom, it can only do so by discerning in the relationship and obligation on the part of the dealer to comply with a manufacturer'’ request for a new showroom. In deciding that a fast-food franchisor incurs no liability to potential franchisees when it fails to disclose its plans to dismantle the system, it must see within the franchise relationship no franchisor obligation to share with franchisee relevant available information necessary to make successful business decisions. Courts, in resolving franchising disputes, do exactly this: they supply a theory of the relationship in order to identify the commitments they must enforce. But the theory they supply is, I will argue, inappropriate.

B. The Business Judgement Approach

Essentially, the courts get half of the story right. They understand well the franchisor’s interests in quality control and design and the vulnerability of these interests in franchisee failures.241 Thus, they see the franchisor’s problem in enforcing the franchisee’s commitment to maintain quality and adhere to the franchisor’s system. Consequently, in the paradigmatic franchise dispute in which the franchisee has, for example, failed to observe practices set out in an operations manual, and where there is no evidence of improper franchisor motive, the courts easily find the obligation that makes such behavior a contract violation and basis for termination.242

Where the courts go astray, however, is in treating the franchisor’s interest as if it represented the entirety of the relation. As one court expressed this view:
[T]he substantiality of a franchisee’s noncompliance, as a legal concept, must be gauged in light of its effect upon or potential to affect the franchisor’s trade name, trademark, good will and image which, after all, is the heart and substance of the franchising method of doing business.243

Although correctly recognizing the effect of franchisee and noncompliance on the franchisor’s trademark, the court quoted above errs in adopting the view that this effect constitutes the “heart and substance” of the franchise. Even calling franchising a “method of doing business,” and thus portraying it as the franchisor’s choice of a distribution method, obscures the basic exchange aspects of the arrangement. Franchisors and franchisees alike perceive franchises as packages of services that promote the profitability of the fledgling small businessperson.244 It would be just as erroneous to portray this aspect of franchising as the entirely of franchising. The point remains, however, that both franchisor and franchisee perspectives reflect components of the exchange.

The theory that the franchise relation centers exclusively on protecting the integrity of the franchisor’s system and the value of the trademark leads to what I call a rule of “business judgment” in resolving cases that go beyond the simple paradigm of a franchisee violating a standard operating requirement. Facing the more problematic cases in which a franchisor terminates a franchisee,245 the courts routinely adopt the view that since the franchise relationship is a “business” relation the franchisor needs only to articulate a plausible business justification.

For example, when Holiday Inn eliminated its Trav-L-Pack system after the plaintiffs had entered into a long-term franchise arrangement, the court refused to impose any liability on the franchisor. The court simply stated that the “franchise relationship is inherently a business relationship.”246 In another example, when the Burger Chef system went into decline, franchisees who had relied on the franchisor’s brochures and assurances to do “whatever it takes” to build the system into an industry leader sued on the basis of Burger Chef’s failure to disclose the viability studies that foretold the decline of the system even as the franchisor made the assurances and sold new franchises. The court, however, held that the statements about the future growth of the system “could only be characterized as ‘puffing’ ” and that “although [the franchisees] may in fact have relied on the representations of the defendants, they had no right to rely on them.”247 And in a final example, when Leyland Motors terminated a franchisee for refusing to take on an additional line of motor vehicles because the new line would compete unfavorably with another of the franchisee’s existing lines, the court upheld the franchisor because the termination was
based upon a rational business decision… The evidence clearly demonstrates that it was in the best interests of Leyland to market its Triumph and Rover lines in the United States through dual dealerships…When [the franchisee] declined to accept such a dual dealership Leyland had a perfectly legitimate reason to refuse to renew its Triumph franchise.248

The “business judgment” theory evidenced in these cases amounts to filling in the gaps in the incomplete contract by according the franchisor unfettered discretion, much as it would enjoy if it were a vertically integrated corporation. According to this view, if Holiday Inn does the calculation and finds it would be better off withdrawing from the Trav-L-Park market, it can do so; Burger Chef is not required to disclose its business judgements to anyone; Leyland Motors is free to select whatever distribution scheme it decides will serve its interests best.

But Holiday Inn, Burger Chef, and Leyland Motors are not vertically integrated firms. Rather, they have chosen to have independent franchisees make all or most of the sunk capital investments in the retailing end of the business. In exchange they have to be understood to have taken on an obligation not to make “business judgements” that take advantage of those investments. Would Holiday Inn or Burger Chef invest in new outlets knowing what they did about the future of the system? Would they have chosen to withdraw when they did if their own investments were at risk? Would Leyland Motors have established a Triumph dealership standing alone or invested in another line to increase the customer base, only to have that investment wiped out by the introduction of another untried model?

It is simply not sufficient to look for a plausible story about why a particular franchisor decision is the result of the franchisor’s “business judgement.” As the courts employ this rule, any franchisor decision which does not appear “vindictive”249 or the product of “improper motive”250 is a legitimate business judgement. The business judgement rule does indeed protect franchisees against “arbitrary”251 decisions or blatant fraud. Thus the courts will reject efforts to terminate a franchisee when it is evident that the franchisor is simply trying to transfer the rights to a franchisee better placed to maximize sales.252 Stereotypical antitrust violations - such as resale price maintenance253 or predatory behavior to achieve a low-cost buy-out of the franchisee254 - also fail the “business judgement” test. So do obviously opportunistic efforts to change contractual terms to capture the value of a franchisee’s specialized investments,255 or to exact higher prices and sales requirements.256 But inside these limits, under the business judgement rule the franchisor possesses unrestricted discretion in making decisions about quality control and the design of the franchise system.

Essentially, this view frees the franchisor to behave opportunistically in making those decisions. The business judgement approach rejects any scrutiny of whether the decision results in the extraction of sunk costs from the franchisee, or of whether the franchisor’s decision is one that is profitable to the franchisor only at the expense of the franchisee’s investments. The problem with this approach should now be clear: By enforcing the franchise contract in this way, courts fail to protect fully one half of the interests necessary to support the franchise relationship.

What are the consequences of this failure by the courts? There are a number of ways to approach this question. It seems clear that franchisees generally enter the franchising relation expecting to exchange conscientiousness, investment, and hard work for a successful management package. Thus, from a relational perspective, courts undermine the exchange by routinely ignoring this expectation in resolving contract disputes. Courts fail to appreciate that franchisees did not enter into the exchange as if they were purchasing stock in the franchisor’s company, that is, putting up their money and taking all risks short of fraud, self-dealing, or other failures of corporate responsibility. Franchisees make large, undiversified, long-term investments; normally there is no “meeting of the minds” granting the franchisor power to issue directives that profit the franchisor only at the direct expense of the franchisee despite covenants which require the franchisee to obey all directives. Treating franchisees as if they made deals they did not in fact make offends the traditional rationale for contract enforcement.257

Under this rationale, contract law should provide a contracting instrument that enables parties to devise their own arrangements privately and enforces the commitments underlying those arrangements.258 In the world of classical complete contracting, courts read the contract and compare it with what has occurred. In franchising’s world of incomplete contracting the courts must strive to identify the entirety of the commitment structure that underlies the franchise arrangement and then to enforce those commitments.259

The incompleteness of franchise contracts is neither an accident nor a failure of adequate draftsmanship. Given this, parties, and courts cannot merely pursue rules of interpretation intended to spur better drafting and competition among franchisors in designing a standard form contract. They must instead grapple with the difficult issues of relational interpretation.

C. A Relational Approach to Interpreting Franchise Contracts

The business judgment approach relies on a flawed theory of what the franchise relation is about; it thus inevitably generates flawed contract enforcement. How can the courts use enforcement to create an incomplete contracting instrument that better serves the needs of franchising? The answer lies not in a change in doctrine but in a change in approach.

The doctrinal tool necessary to bring the resolution of franchise contract disputes into line with the realities of the franchise relation is the convenant of good faith and fair dealing. Already, the covenant of good faith and/or a requirement of good cause for termination is implied in most franchise contracts.260 “Good faith” and “good cause,” however, are extremely open terms. Ironically, it is in stating the content of such terms that courts have been most explicit about their appreciation of the business judgement approach.261 Although the doctrinal tools necessary to introduce relational considerations into the interpretation and enforcement of franchise contract disputes exist, they have been essentially buried by the business judgment theory.262

Relying on the good faith doctrine as a method of introducing more accurate relational considerations requires that courts routinely look beyond the written franchise contract and examine the relationship in which that contract is embedded. A relational interpretation should first determine the significance of the written terms. For example, particular and explicit clauses setting out franchisee obligaitons263 should receive presumptive force, since normally the franchisee and franchisor both know and understand their respective roles: the franchisor sets out such obligations and the franchisee complies with them.264 Vague general clauses or clauses that attempt to transfer broad sweeping powers to the franchisor,265 on the other hand, should not be enforced so as to free franchisors to behave opportunistically, absent evidence that the franchisee truly negotiated and understood the full implications of the terms, or that, unlike typical franchisees, the franchisee is neither inexperienced nor reliant on the franchisor.266 Such terms simply do not accord with the typical structure of the franchise relationship: more evidence is needed about a particular relationship to demonstrate a true intent to leave the franchisee, as these terms literally would, with no protection against franchisor opportunism. General “interpretation guides,”267 declaring that the contract is only concerned with ensuring franchisee compliance with quality control provisions and, by implication, not with controlling franchisor opportunism, should be treated with similar skepticism.

Courts should stop conceiving of the franchise relation as one solely dedicated to protecting the franchisor’s trademark and goodwill. The franchise relation is a mutual exchange. Franchisees make large, sunk investments in operating outlets- investments the franchisor would otherwise have to make in order to retail its product or service in the franchisee’s area- to reduce the risks of operating their own small business. In turn, franchisors obligate themselves to promote the profitability of franchisees. Franchisors risk the value of their trademarks in exchange for shifting sunk investments to franchises. Franchisees commit themselves to complying with franchisor directives in anticipation that they will receive sound products, sound business advice, and support. The relation makes little sense unless the “contract” between franchisor and franchisee balances these mutual arrangements, establishing commitments on the part of both franchisee and franchisor.

The relational approach to contract interpretation requires sensitivity to the particularities of any one relation. The features of the abstract franchise relation should only be used as a guide to identify the features of a concrete franchise relation. In some cases, a “franchise” relation may differ in important respects from an abstract franchising relation. Using the abstract model as a guide, however, a court can distinguish those arrangements in which the typical franchising problems of control and opportunism are potential problems from those in which they are not.268

Courts facing a dispute between a “franchisor” and a “franchisee” should first determine whether the arrangement includes sunk investments, a necessary prerequisite for opportunism. Many distributorship arrangements, for example, lack sunk investments: distributors may take on a manufacturer’s product but make very few investments in distribution facilities and equipment specific to the product. In other cases, the franchisor agrees to purchase all of the franchisee’s assets at market prices- that is, prices that included a component for the franchisee’s future profits as a franchisee- in the event of termination. In these two types of cases, the franchisee needs little protection against opportunistic behavior which reduces the value of sunk investments. Therefore, there is no reason to believe that the relationship includes limits on manufacturer behavior other than those explicitly set out in the contract. If the court finds sunk investments, however, it must determine whether the challenged action falls within the scope of the relationship.

There are no hard-and-fast rules for accomplishing this end. Relational interpretation is a fact-specific exercise of attention, insight and judgment. Consider a recent case in which Volkswagen terminated a franchisee after it distributed Fords in the same dealership.269 The written contract contained a provision giving Volkswagen the right to prescribe standards for the showroom layout, but it did not prohibit a dual dealership. Manifesting a business judgement approach, the court upheld the termination, suggesting that the Ford line affected the showroom layout and finding that Volkswagen had made a valid business judgement that it was not in its interest to have dual dealerships.270 From a relational perspective, this resolution is troublesome. Volkswagen involves the typical scenario in which the franchisee has made large sunk investments in capital with the attendant danger that the franchisor will make “business judgements” that fail to take these investments into account. The court needs to ask: What prompted the franchisee to take on the Ford line? Is it possible that sales of Volkswagens had declined to such a level that the scale of business no longer generated a reasonable return on the franchisee’s investment in showroom space. Why was there no explicit clause prohibiting a dual dealership? It is possible that Volkswagen was unable to get franchisees to take on dealerships with such a prohibition at the time the contract was formulated, because of uncertainty about the popularity of the automaker’s models and thus the wisdom of making sunk investments. Did the additional Ford line in fact substantially affect the showroom layout? Did the franchisee have an opportunity to make changes to the showroom in order to maintain the amount of space previously devoted to Volkswagens? Did the prohibition of a dual dealership benefit only the franchisor’s interests, such as by promoting tangential trademark concerns at substantial cost to the franchisee, without promoting the franchisee’s interest in selling more cars or creating a more profitable dealership? The court should have attempted to determine, in light of the particular relationship at hand, whether the franchisor’s judgment took advantage of the franchisee’s commitment of sunk resources.

Finding that the franchisor does not have a unilateral contract right to prevent a dual dealership does not forever doom the franchisor to this unhappy course. The point is that, like any other business, it may have to pay for achieving this result. The franchisor could have renegotiated with the franchisee, compensating the franchisee for giving up the Ford Line, or it could terminate the franchise and pay damages calculated to compensate the franchisee for its loss, including repurchase of inventory and showroom and damages for lost future profits.271

Looking more closely into the franchising relationship, courts should be sensitive to the ways in which franchisor and franchisee interests diverge.272 Only then can they assess whether the franchisor’s interests should trump the franchisee’s. Franchisor policies or promotional programs that produce a profit for the franchisor, but only because franchisees must bear the cost, are an example. There are numerous others. A franchisor may prefer a particular location because its high visibility promotes consumer recognition of the trademark, but a franchisee might find that the same location’s inaccessibility fails to generate a profitable volume of customers. Franchisor image advertising of the trademark may generate revenue from secondary licensing (such as T-shirts and movie releases) but produce very little in the way of business for the franchisees. Franchisors generally seek to increase gross volume per outlet because they receive royalties based on volume and because volume generates consumer recognition. On the other hand, franchisees, who must bear the cost of increasing volume, seek to increase profits, which requires operating at a volume somewhere below the maximum possible. When deciding whether to sell their franchise systems, franchisors have an interest in maintaining high sales and trademark value by keeping such plans quiet, whereas potential and existing franchisees can make better investment decisions and evaluate the risks if they have access to the franchisor’s plans. In a declining franchise system, large corporate franchisors with alternative uses for resources may have an interest in withdrawing those resources at a time when franchisees with sunk investments are still able to earn a reasonable return from the system. A franchisor has an interest in transferring the assets of an existing franchise to a new franchisee at a low price or to a particular candidate, but the outgoing franchisee has an interest in recouping as much of its sunk investment as possible.

Accompanying these divergent interests is the franchisor’s control power. This power allows the franchisor to pursue its interest at the expense of the franchisees. When a franchisor decides to terminate and buy out a successful franchisee, is it taking advantage of a gamble that turned out well but not compensating the franchisee for the loss of future profits? When a franchisor withholds approval of the transfer of a franchise, does it do so in order to grant the franchise to a specific transferee it prefers, who will pay a lower price for the franchise? If a franchisor disapproves of the transfer price, does it do so because it reasonably fears that the proposed transfer price will overburden the new franchisee? By keeping future plans for the franchise system a secret, has the franchisor induced franchisees to make decisions, such as putting up investments or foregoing alternative arrangements that a reasonable businessperson with the information would not have made? Are plans to alter the system in an effort to bolster a declining organization overly risky in light of the cost to franchisees? Is the decision to terminate old franchisees or to seek, voluntary termination by changing the terms of the franchise an effort to take over the franchises at low cost or an effort to eliminate obsolete inventory?

Proponents of a business judgment approach to resolving franchise contract disputes are likely to protest that the courts are not competent to ask, much less answer, these types of questions. First, I believe courts are capable of answering these types of questions; for the most part the questions simply involve widening the judicial lens to include the full landscape of events. Courts can guide their inquiry with a relatively simple analytical structure, one developed from an understanding of the nature of commitment, sunk costs, and opportunism.273 Second, even conceding that the courts will make mistakes in carrying out this inquiry, courts should be at least as competent in understanding franchise disputes as they are in analyzing medical malpractice cases, product liability issues, and antitrust suits, or in reviewing the decisions of modern administrative agencies, assessing the employment decisions of public and private organizations, or making determinations about the deals struck between large, equally sophisticated firms. Although the courts may be more or less flawed in performing many of their functions, the relative competence of the courts is a fixed feature of the modern judicial system and one of the costs of administering that system.

Third, while courts may err and see opportunism where it does not exist or fail to see it where it does, these errors should be largely random. Any bias resulting from the relational approach is likely to be far smaller than the bias we would expect to emerge if the franchisor were handed the judge’s gavel. But a business judgment approach, by deferring to the franchisor’s assessment of the decision to terminate a franchisee, does essentially this. Given the inherent difficulty of writing incomplete contracts and the central difficulty of balancing franchisors’ interests like quality control against franchisees’ interests in protection against opportunism, the franchise relationship needs an unbiased dispute resolution mechanism. The business judgment approach, because it will always be more biased than even a flawed relational approach, fails to provide this mechanism.

Finally, unless the courts wish to abandon their traditional role in enforcing the exchanges actually reached by contracting parties, there is no escaping relational interpretation in a world of incomplete contracts. The business judgment approach does not respect the basic franchising exchange and thus undermines it. Complete contacting is simply not feasible. Consequently, despite the difficulties of administering incomplete contracts, the judicial system must either grapple with this task or else deny accurate contract enforcement to arrangements such as franchising.

VII. CONCLUSION

In a complex economy the judicial system faces increasingly complex tasks of developing and enforcing the various legal rules and instruments that structure the economy’s relationships. Enforcing the incomplete franchise contract is such a complex task because it requires coming to terms with the unique attributes of the franchise relationship.

Although the franchise relationship may appear unremarkable on the surface, it has in fact a highly distinctive structure. Unlike either an employment relation or an ordinary independent contracting relation, the franchise relationship is characterized by the fact that franchisees own the bulk of the capital assets of the franchise and franchisors retain the right to determine how franchisees will use those assets.

This distinctive separation between the ownership of the franchise assets and the control over those assets has enormous consequences for the nature of the exchange in franchising. It structures the central commitment dilemma of franchising: On the one hand, the franchisor has a strong interest in exercising control over the product quality decisions and over the design of the overall system; on the other hand, the franchisee has a strong interest in ensuring that the franchisor’s exercise of control is not opportunistic. Understanding the economic dynamics of the relationship identifies this basic commitment problem and provides some insight into the types of disputes that arise between franchisor and franchisee.

In classical contracting settings, such commitment problems are addressed in a written contract. The writing serves to guide courts in resolving disputes. But an examination of the written franchise contract uncovers an important non-classical feature: The contract is highly incomplete. While broad in scope, it is short on detail, necessarily so, given the uncertain and long-term nature of the relationship. The written contract defines general powers and responsibilities, but it does not, and probably cannot, specify how the parties are to exercise those powers. Moreover, the written contract appears to address only one half of the underlying commitment problem in the relationship – specifically, the franchisor’s problem of quality control. It fails to address the franchisee’s problem of controlling franchisor opportunism. Instead, the contract leaves to the franchisor’s discretion the exercise of both the powers of quality control and design.

The necessary incompleteness of the franchise contract prompts examination of the norms and practices – the relational structure of franchising – to identify the complete content of the franchisor and franchisee’s exchange. Guided by the commitment problems elucidated by economic analysis, this examination reveals that the exchange in franchising is a mutual one. The typical franchisee is an inexperienced businessperson, seeking to set up a small business but seeking also to reduce the risks of that enterprise. The franchisor, usually an experienced and sophisticated business entity, provides the franchisee with a package of corporate services, a product with a proven track record, and the advantages of a common trademark. As a result, the relationship is essentially a reliance relationship between unequal parties. The franchisee relies on the franchisor’s superior business knowledge and perceives its obligations as following the franchisor’s directives. The franchisor, in a sense burdened by its superior position in a nonetheless mutual exchange, is obligated to develop a successful system and to share its expertise with the franchisee. Even the drafting of the standard form written contract is, because of the relational imbalance, almost necessarily left to the expertise of the franchisor.

Predictably, the franchise disputes that appear in court center on the franchisor’s exercise of its significant, relationally constrained but formally unfettered powers. And unfortunately, drawn to the model of the complete contract, courts tend to view the formal written contract as representing the entirety of the commitments structuring the franchise relationship. In practice, this approach amounts to a “business judgment” rule of enforcement: Provided that franchisor articulates some plausible business rationale for its actions, courts will not interfere. In doing so, however, the courts fail in their traditional task of enforcing the true exchanges reached by the contracting parties.

Courts can remedy this failure by bringing an understanding of the true relational structure of franchising to bear on their task, and by developing an alternative, relational approach to the interpretation of franchise contracts and the resolution of franchise disputes. The highly incomplete franchise contract requires analysis in a manner distinct from the ordinary, complete contracting approach of classical contract law. Franchise contracts are embedded within an identifiable, discoverable relation. The commitments that support the relationship stem not only from the written document, but from a common understanding of this relation. As a consequence, to interpret the franchise contract is to read it in the context of this relationship, to test the written terms against the basic sense of the relationship and the commitment problems facing both franchisee and franchisor. Only by so doing can courts ensure that the exchanges they enforce are indeed the exchanges that constitute a franchise.

Reprinted without Endnotes

Stanford Law Review
Volume 42:927
April 1990


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