Is it a more level playing field?

"It is an abomination that at this late date there is a sector where good faith and fair dealing should not apply and where it is even debated as to whether it should," Sagar stated.

Nation's Restaurant News
October 14, 1996

Is it a more level playing field?
Courts, other groups push equality
Robin Lee Allen

While the scrimmaging between franchisors and franchisees remains contentious and emotional, a growing awareness of the cratered field they play on has yielded the underdogs some big points in recent months.

A landmark court decision beneficial to franchisees and new franchise loan terms drafted by the U.S. Small Business Administration show a broadening recognition of inequities first acknowledged mainly in the legislative arena. In addition, the serious attention paid by franchisors to several fairness in franchising documents recently unveiled by different franchisee groups points to a slight recalibration in the scales of power between the interdependent groups.

That's not to say either side is declaring victory or conceding defeat. Franchisors by and large remain resistant to many changes and reluctant to welcome the shifting environment. Meanwhile, franchisees still see a level playing field as a faraway ideal.

"In a roundabout way there's been a great deal of improvement," said Dean Sagar, an aide to Rep. John LaFalce, D-N.Y., of the House Small Business Committee. LaFalce has been considered a champion of franchisee causes since he began investigating the regulatory and legal problems in franchising in 1989.

"Unfortunately, even as more fair-minded franchisors change their policies, there are still some enormous systems prospering in the same old ways," Sager added.

"One of the most positive changes, however, is increased public awareness of franchising's problems, Sager said. The growth in membership and media presence of tow national franchise organizations, the 4 year old American Association of Franchisees & Dealers, and the 3-year-old American Franchisee Association has contributed to that awareness, he noted.

And although legislation designed to stem franchisor abuses introduced by LaFalce in the past few sessions of Congress had eluded passage, his scrutiny nevertheless has spurred several important changes in the industry, including a revamping of the International Franchise Association's no franchisee policy and its code of ethics. Scrutiny also has largely eliminated the use of phony success rates in advertising materials, Saga continued.

Because LaFalce's ultimate goal is to see that the franchise industry is governed by the same concepts of good faith and fair dealing as most mother industries are, he again will sponsor franchise-related legislation in 1997, Sagar added.

"It is an abomination that at this late date there is a sector where good faith and fair dealing should not apply and where it is even debated as to whether it should," Sagar stated.

Nevertheless, while LaFalce was able to hold several franchise-related hearings before Republicans swept him from his chairmanship of the Small Business Committee in 1994, his agenda has since been obscured. And even the hotbed of legislation activity in the states following the 1992 passage of Iowa's renowned "Franchisee Bill of Rights" has cooled. Most recently, judges, not lawmakers, have moved the franchise industry toward a more equitable realm.

Last August a federal appeals court added punch to future franchisee lawsuits against franchisor abuses by acknowledging that a covenant of good faith and fair dealing exists within contracts whether it is expressly stated or not.

Specifically, in Vylene Enterprises, Inc., v. Naugles, Inc., the Ninth Circuit Court of Appeals found that Naugles, a now-defunct chain of Mexican restaurants, had breached that covenant by building a competing company-owned unit 1.4 miles from Vylene's Long Beach Calif., location even though Vylene's contract did not specify territorial exclusivity.

"It represents the highest appellate decision yet, approving the concept of how the covenant of good faith and fair dealing may operate in the franchisor-franchisee relationship," said Phillip K. Fife, the Seal Beach, Calif., attorney representing franchisee Debra Vylene Green during most of the case's 11-year voyage through different courts.

In the decision the Ninth Circuit panel of judges upheld the 1991 ruling made by a federal court in Scheck v. Burger King, stating that although Scheck was not entitled to an exclusive territory, he could expect that his franchisor would " not act to destroy the right of the franchisee to enjoy the fruits of his contract." The panel also let stand a previous bankruptcy court ruling awarding Vylene more than $2/2 million in damages and $550,000 in attorney's fees.

While there are no longer any Naugles units in operation, the responsibility to pay the award rest on former Naugels owner Sizzler International, which is now in bankruptcy protection. The Ninth Circuit has since denied a petition to rehear the case, said William T. Rintala, a partner in the Los Angeles firm of Rintala Smoot Jaenick & Rees, which represented Naugles. The defendant could request the U. S.
Supreme Court to hear the case, although no decision has yet been made in that regard, Rintala said.

Regardless, the Vylene-Naugles decision has set the franchising world abuzz.

"There's a real debate in the franchise bar about what Vylene stands for," said Neil A Simon, an attorney representing franchisors in the Washington D.C., office of Hogan & Hartson L.L.P. "Certainly, it's likely to make some mischief. It's already being cited in some complaints."

Vylene's interpretation varies from lawyer to lawyer.

Robert Zarco of the Miami firm Zarco & Pardo P.A., who represented Scheck in the decision cited by the Ninth Circuit, was ecstatic. He is one of many attorneys' eager to point to the Vylene decision as precedent.

"I think what it's going to do is make certain that franchisors tread more cautiously in balancing franchisee rights vs. their own profit-driven greed." He remarked. "Franchisors must make the decision on where to place competing units for existing franchisees in good faith and in a commercially reasonable manner; that's the test."

Simon agrees that franchisors must now be more vigilant.

Others see a judicial system growing increasingly impatient with bad-faith actions by either side.

"What I see is an evolution in judicial thinking about the balancing of the rights of franchisors and franchisees," said H. Stephen Brown, an attorney with The Bogatin Law Firm in Memphis, Tenn.

In an effort to improve and clarify the element of fairness in franchising contracts, Brown joined other attorneys, franchise consultants, franchisees and franchisors in creating a set of fair-franchising standards for the American Association of Franchisees & Dealers. Based in San Diego, the AAFD is a franchisee group committed to solving franchise industry problems thought market-place, rather than legislative solutions.

The standards, which were introduced in July, are intended, as a framework for future franchise agreements into their agreements will receive accreditation from the AAFD. The association chairman Robert L. Purvin, hopes that prospective franchisees will in time use the group's accreditation as a means of weeding out respectable, fair-minded franchisors from more dubious ones. Although critics contend franchisors will not embrace the standards, about 12 of them are now considering them, he noted.

Because the standards committee has grappled with many of the most explosive issues-such as the use of advertising funds and transfer-consensus still must be reached on several topics. Nevertheless, the standards are causing quite a stir.

"The response to our standards has been jubilant from franchisee groups." Purvin said. "The AFA called them naïve, and said they undermined the effort to reach a legislative solution. The IFA was very respectful of the effort, but disagreed with the parts they felt were noting the franchisor's interest. And the staunchest disagreement came from franchisors on bargaining."

Meanwhile, the Chicago based AFA in May unveiled a Model Responsible Franchise Practices Act.

Based on existing statutes in 20 different jurisdictions, acts governing different industries, franchise codes of ethics from other countries and parts of LaFalce's proposed bills, the model act is intended to create uniformity in the franchise laws state to state-especially if federal legislation is not achieved, said Eric H. Karp of the Boston firm Witmer, Karp Warner & Thuotte, which helped develop the model.

"The high degree of inconsistency is something not good for either franchisors or franchisees," he explained. "It creates a legal thicket that raises franchisor costs and makes the rights of the franchisee more dependent on the state they are located in than on the system they are a member of."

The AFA plans to have the model available when state governments resume their sessions early next year, Karp said.

In July, the U.S. Small Business Administration unintentionally stepped onto the franchise industry battlefield when it proposed new terms franchisors would have to meet in order for their franchisees to get agency loans. The proposed supplemental agreement required, among other things, that franchisors designate a specific territory for franchisees to be strictly enforced under the terms of the SBA loan.
The draft was seized on immediately by franchisee advocates as a victory and reviled by franchisor representatives as a subversive way to achieve administratively what has yet remained unachieved legislatively.

"If adopted, all but the most desperate franchisors would refuse to sign the agreements and prospective franchisees would not longer be able to apply for SBA loans," Simon remarked. "It's terribly, terribly short-sighted."

The SBA had no idea it had touched on such a vituperative subject, according to Ronald Matzner, the SBA's associate deputy general counsel.

"Our objective was to streamline and simplify our application procedure so that it would be easier for prospective franchisees to obtain SBA assistance," he said. "We felt it would be a benefit to the industry, including franchisors, because a significant number of franchisees are funded with SBA guaranteed loans."

While one standard supplemental agreement would ease the load of SBA loan officials, who now review an estimated 10,000 agreements annually, it also would ensure SBA loans go to appropriate applicants, Matzner said.

"It's also a question of control and who the SBA can lend to," he explained. "We can only provide assistance to small businesses. We are not permitted to provide assistance to large businesses. If a franchisor imposes so much control upon a franchisee that a franchise is not an independent operator but just a branch of the franchisor, then we are not able to assist in that franchise business. That' what was most misunderstood by members of the industry."

To defuse some of the misunderstanding, franchisee, franchisor and lender representatives met Oct. 1 to discuss the draft agreement and subsequent comments received from interested parties. They will meet again Oct. 30.

"I just see an enormous improvement in awareness and responsiveness," Purvin commented, "this summer in particular with the judicial environment and judges understanding the plight of franchisees. What has happened with the SBA is accidental, but it embodies a better understanding that franchising automatically is not the golden egg everybody thought it was."

But there is a long way to go and more urgency to get there, Karp said.

"As franchise systems mature, we have an increasing number of franchisees rolling up for renewal, and they are not being renewed but getting completely new contracts." He said. "And franchisees are going to die, retire, want to sell out or give their businesses to their children. These are areas where conflicts are going to arise, and we have made no progress solving these issues."

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