Dennis Wieczorfek Oversight Hearing

At the end of the day, oppressive legislative restrictions on the operation of franchise relationships, and the litigation that is sure to follow, will simply stop franchising in its tracks.

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U.S.A. House of Representatives
June 24, 1999

Oversight Hearing on the Franchising Relationship
Dennis E. Wieczorek, attorney

United States of America
House of Representatives
Subcommittee on Commercial and Administrative Law

DENNIS WIECZOREK

I am pleased to have the opportunity to appear before the Subcommittee on Commercial and Administrative Law of the Judiciary Committee of the U.S. House of Representatives.

I am a partner with the law firm of Rudnick & Wolfe in Chicago, with additional offices in Dallas, Tampa and Washington, D.C. Rudnick & Wolfe has what we believe is the largest franchise law practice in the US and probably in the world. Close to 50 out of Rudnick & Wolfe's 340 lawyers concentrate in franchise law. Along with 10 of my partners at Rudnick & Wolfe, I am listed in the International Who's Who of Franchise Lawyers. I have practiced as a franchise lawyer for 22 years and I have attached a biography and list of publications and speeches.

Our firm represents more than 400 franchisors and licensors and is general counsel to the International Franchise Association. Our clientele ranges in size from the largest franchisors in the world to development stage companies that may have only 1 or 2 units. I believe that the wide range in the size of our clients and the scores of industries they represent is a good sample of franchising as a whole.

FRANCHISING IS A BUSINESS STRATEGY IMPLEMENTED IN NUMEROUS INDUSTRIES
It is inappropriate to call franchising an "industry." It is a business strategy or concept whereby a franchisor can expand its brand with the efforts of its franchisees. Over 60 industries have used franchising as a strategy for expansion. These industries come in all shapes and sizes - from the multimillion dollar investment for a hotel franchise to the $5,000 - 10,000 investment for an at-home travel business franchise. Of necessity, the franchise programs for these disparate types of opportunities are shaped and formed based on the unique needs of each industry. In addition within each industry that uses franchising as a method of distribution, there are significant variations between companies in the way they do business and in the documentation of the franchisor-franchisee relationship. Finally, the type of franchisee and the size of his/her investment will make a vast difference in the structure of the franchise relationship.

For example, a small, start-up franchisor may be more willing to negotiate terms with prospective franchisees in order to be competitive with established franchisors. But even a large franchisor may be willing, and in some cases compelled, to be flexible if the franchisee is experienced and well-capitalized. As a lawyer, I have been involved in negotiations with franchisees on behalf of large and small franchisors and I have drafted franchise agreements that range in length from 10 pages to 100 pages. In some cases, the franchisee across the table from me was larger than my franchisor client. You cannot use a cookie-cutter approach when it comes to structuring a franchise program, even if the programs being structured are for 2 different franchisors that compete with each other in the same industry.

INDUSTRY-SPECIFIC LEGISLATION IS INAPPROPRIATE FOR FRANCHISING
Since franchising companies represent a plethora of industries, any attempt to legislate the terms of the franchisor-franchisee relationship fails to account for the vast differences in the programs and systems used by franchisors. Some have referred to other federal legislation, such as the Petroleum Marketing Practices Act, 15 U.S.C. §2801 ("PMPA"), and the Automobile Dealer-Day-in-Court Act, 15 U.S.C. §1221 ("ADDCA"), as supporting the argument that legislation is appropriate for relationships that involve the distribution of products or services and the licensing of brand names. In my view, such existing laws do not provide any principled basis for the creation of general franchise relationship legislation.

First, each of these statutes deals with a single industry - in the case of the PMPA, petroleum dealers and their suppliers; in the case of the ADDCA, automobile dealers and their suppliers. Each of the laws was drafted to deal with problems and concerns arising in a specific industry. Also, in each industry, suppliers were few in number and there were significant barriers to the entry of dynamic new rivals with innovative distribution programs and concepts. Contrast this with the fast food industry, where there are hundreds of competitors and new entrants appearing on a regular basis. Even within the fast food industry, there are sub-markets (e.g., hamburgers, chicken, Mexican) and sub-sub-markets (e.g., sit-down versus carry-out versus delivery pizza and combinations of same).

There are also unique issues relevant to each of these existing laws that starkly contrast with prior versions of proposed general franchise legislation. The PMPA is a very narrow law focused only on restricting the grounds for terminating or refusing to renew a gasoline dealer. In addition, the PMPA is preemptive; it overrides all state laws that deal with the same issues. The general franchise legislation that has been proposed in prior years is not preemptive and covers a broad range of subject matter. The ADDCA is likewise narrowly drawn and has been little used in recent years. By my count, there have been only an average of 2 reported ADDCA opinions per year over the last 10 years. Apparently, state automobile dealer laws have largely supplanted ADDCA as the remedy of choice for dealers.

THE CURRENT STATE OF FRANCHISE REGULATION
The burdens of regulation are now quite heavy for franchisors. Extensive pre-sale disclosure is required by the Trade Regulation Rule on Franchising issued and administered by the Federal Trade Commission. In addition, 15 states require pre-sale disclosure, 12 of which mandate administrative review and approval before a franchisor can do business in the state. Also, 18 states have enacted laws that regulate the relationship between franchisor and franchisee. This patchwork quilt of regulation has created significant compliance costs for franchisors. These laws have forced franchisors to retain lawyers like me to help navigate the treacherous shoals of federal and state franchise regulation.

On the disclosure front, a franchisor must prepare what is known as a Uniform Franchise Offering Circular (or "UFOC"), which contains extensive information about the franchisor, the franchise program and the franchise agreement. If the franchisor has any negative information to report on things like litigation, bankruptcy, unit turnover and financial performance, it must do so for the world to see. Every prospective franchisee is given this information, and has at least 2 weeks (and in practice usually several months) to review it. The prospect can compare the disclosure documents of several franchisors, side by side, and make an assessment of the pluses and minuses of each franchise.

The UFOC format was completely overhauled 6 years ago and the FTC is now considering additional changes to modernize and update the UFOC. This disclosure improvement process has been carried out on a cooperative basis, involving representatives of government, franchisors and franchisees. As a member and current Chair of the Advisory Committee to the North American Securities Administrators Association Franchise Project Group, I have been intimately involved in the disclosure modernization process, and have seen the work that has been done to ensure that prospective franchisees receive an extraordinary quantity of information to evaluate a franchise opportunity. For example, a franchisor that has been involved in extensive litigation with its franchisees must reveal this, and a prospect should be careful to evaluate this fact in assessing the attractiveness of a franchise offering.

In my view, the disclosure process is here to stay and will continue to be improved and updated. If this Subcommittee or others desire to make additional disclosure improvements, I have no doubt that they will be supported by the franchising community.

Additional legislation or regulation mandating new or improved franchise disclosure is far different from legislation affecting the relationship between a franchisor and its existing franchisees. In fact, legislation altering or negating the terms of existing contracts would be problematic as a constitutional matter. Thus, any legislation that modifies contractual terms can be prospective only and therefore would be applicable only to future franchisees. In my view, it is appropriate to ensure that those future franchisees make fully informed investment decisions as a result of a fully realized disclosure process. This is a more practical and achievable goal than to create relationship legislation that puts franchisors, from numerous disparate industries and in various stages of development, in contractual straitjackets, exposes then to undefined liabilities and subjects them, and the already overcrowded federal courts, to the burdens of a new wave of litigation. In addition, a potentially more damaging effect of relationship legislation is the impediments it creates to the enforcement of system standards. If a franchisor cannot enforce quality controls, the brand is damaged at the consumer level and the entire franchise system, including franchisees, will suffer.

IMPACT ISSUES - HOW CLOSE IS TOO CLOSE?
Some of the prior bills proposing to create franchise relationship legislation have included provisions prohibiting franchisors from "encroaching" on franchisees. Simply stated, if a new outlet is in "unreasonable proximity" to an existing outlet, the franchisor has violated the law.

How close is too close? In downtown Washington, D.C., you may be able to put 2 outlets within a few blocks of each other and neither would have an impact on the other. In an enclosed shopping mall, you may have one outlet in a food court and another one 100 yards away on an out lot of the shopping mall and neither would have an impact on the other. On the other hand, in a rural area, placing 2 outlets within 10 - 20 miles of each other may be too close. If you expand these examples to the scores of industries represented by franchising, the complexities and difficulties of assessing impact grow exponentially. How close can you place 2 hotel franchises or 2 real estate brokerage franchises or 2 sales training franchises? How large or small can you make the territories for a carpet cleaning franchise or a lawn care franchise or an insurance sales franchise?

The State of Iowa enacted a franchise relationship law in 1992 that contained a detailed encroachment provision (the only state franchise relationship law with a comprehensive encroachment section). That provision proved to be so difficult to interpret and apply that it was completely overhauled by the Iowa legislature only 3 years later in 1995. Every year since then there have been strong efforts to modify the provision yet again.

Legislative efforts to regulate the siting of new outlets are unworkable. However, individual franchisors have made great strides in recent years in formulating and implementing impact policies. Those policies take into account the competitive aspects of the relevant industry and, more importantly, the unique features of each franchise program and even variations within the program. For example, a hamburger chain's impact policy must not only deal with the impact of a new standard unit on an existing location, but also assess the different competitive effects of a unit in a mall food court or a co-branded unit operating within a gas station/convenience store or an express unit located in a discount department store. Those judgments, and impact relief if warranted, are best made within a single franchise system.

SOURCING ISSUES AND CUSTOMER EXPECTATIONS
Federal and state antitrust laws provide a panoply of remedies to franchisees aggrieved by illegal sourcing restrictions imposed by franchisors. However, prior proposed franchise relationship bills have sought to go far beyond the scope of the antitrust laws.

Why do franchisors impose restrictions on the sources available to franchisees for the purchase of products and supplies? The primary motivation is creating a uniform brand image and satisfying customer expectations of franchise chain-wide quality and consistency. In addition, many franchisors enter into arrangements with suppliers to achieve economies of scale, to provide one-stop shopping to franchisees and to ensure that product specifications are met by a national or regional supplier. In other cases, sourcing restrictions may be critical to guarding trade secrets or other proprietary information.

Some franchisors do sell products to franchisees and profit from same. In some cases, a franchisor charges little or no royalties to its franchisees; its sole or primary income stream is from product sales to franchisees. Of course, the other side of the coin is that some franchisors sell nothing to franchisees, their sole source of revenue being royalties. These matters are fully disclosed in the UFOC and prospective franchisees can weigh this factor in assessing the overall franchise opportunity. If there is an antitrust violation arising from a franchisor sourcing program, franchisees have viable statutory bases for obtaining redress.

FRANCHISE TRANSFERS
Another recurring feature of prior franchise relationship legislative proposals has been the inclusion of detailed provisions on franchise transfers. These provisions essentially allow franchisees to sell all or part of their franchise rights to third parties, sometimes without allowing the franchisor any evaluative role in the process.

First, a franchisor should have the right to approve a transfer of a franchise; it would be unprecedented to require a franchisor to deal with a "stranger" to its contract. In addition, prior proposals provide no guaranties that the franchisor's standards of quality would be adhered to during the transition period of a successor franchise. Also, free transfer rights would allow competitive chains to buy interests in franchisees and obtain access to trade secrets and proprietary information.

The need for such legislative proposals is surprising since most franchise agreements appear to contain an undertaking by the franchisor not to unreasonably withhold consent to a transfer. In my experience, a franchisee that is interested in selling his or her franchise is helped by the franchisor in searching for buyers for the franchise. Once a franchisor learns that a franchisee wants to leave the system, it is in the franchisor's best interests (both for its own self-interest and the brand image expected by customers) to facilitate the process, find a qualified replacement and oversee a smooth transition process. The need for legislation in this area appears to be unwarranted, particularly in light of the fact that these issues have rarely been the subject of litigation in the 1990's.

PRIVATE ENFORCEMENT OF FRANCHISE REGULATION
One of the elements consistently included in the general franchise legislation that has been proposed in prior years is that franchisees should have a private right of action to enforce any of the elements of such legislation. While on its face this appears to be an unremarkable proposition, the implications for enforcement of an extensive, detailed regulatory scheme are complex and difficult. Such proposed general franchise legislation usually states that a violation of the FTC Trade Regulation Rule on
Franchising is actionable by a private party.

First, the FTC administers numerous Trade Regulation Rules and I am not aware of any that are enforceable by private parties. Even Rules intended to protect "true" consumers, who receive none of the disclosures and have fewer resources than prospective franchisees, do not allow for private actions. Also, the FTC's interest in redressing "public" injury and in achieving quick administrative relief could well be at odds with the interests of private parties and their lawyers. Private enforcement will often take the form of a counterclaim filed by a franchisee in litigation where the franchisor is seeking to collect money or stop a violation of quality control standards. Finally, the FTC Franchising Rule is comprised of a set of complex regulations, supplemented by Interpretive Guides, a Statement of Basis and Purpose and Interpretive Opinions. Giving a right to enforce these hundreds of pages of rules will wreak havoc with the FTC's enforcement mission and well overwhelm the federal courts with claims revolving around minor and technical issues. For example, is it appropriate to burden the courts with claims that a franchisee received a UFOC only 9 business days before he/she bought a franchise, rather than the mandated 10 business days. This is one of hundreds, even thousands, of technical requirements which could turn into a "federal case." Further, such private actions in federal court would potentially conflict with interpretations of state disclosure law which, unless specifically preempted by federal law, would create additional confusion and litigation burdens.

GOOD FAITH AND THE RISKS OF LACK OF CERTAINTY
It has been suggested in prior proposed general franchise legislation that parties to franchise agreements be required to deal with each other in "good faith." As a general precept, such a requirement is consistent with the common law of almost every state, where courts have stated that good faith inheres in every commercial contract. However, the proposed legislation goes much farther than the generally accepted definition of good faith. The courts have treated the duty of good faith as a "gap-filler"; i.e., if a contract does not cover a specific issue or it fails to fully explicate a particular term, then the courts will use the duty of good faith to fill the gap to discern the parties' intentions. Under the judicial interpretation, the duty of good faith cannot be used to alter the express terms of contracts.

Prior proposed general franchise legislation has treated good faith as a means of subverting and avoiding contractual obligations and undertakings. These proposals have broadened the duty of good faith to go far beyond the common law interpretations, and even beyond the Uniform Commercial Code. In the end, if this broadened interpretation is enacted, the terms of franchise agreements can be ignored and the concept of contract finality will be a nullity. Every dispute will be left to a judge or jury to determine whether a party acted "in good faith." Obviously, there will be little incentive for parties to reach accommodations to resolve a dispute, when it may be more worthwhile to "roll the dice" with litigation and argue that a particular act or practice violated a vague and amorphous duty of good faith.

WHY TALK WHEN WE CAN LITIGATE?
There can be little doubt that prior proposed franchise relationship legislation created numerous opportunities for trial lawyers to find profitable employment fomenting litigation within franchise systems. In some of these prior proposals, there were scores of new causes of action that could be filed in the already overcrowded federal courts, without even any minimal amount in controversy. These proposals, with available awards of attorneys' fees and costs, create every incentive for the parties to litigate rather than work out the problem on a face-to-face basis.

At the end of the day, oppressive legislative restrictions on the operation of franchise relationships, and the litigation that is sure to follow, will simply stop franchising in its tracks. Under legislation similar to what has been proposed, how can a franchisor compete with a vertically integrated competitor who operates all of its own retail outlets, a competitor that has complete and total control over its stores? Why should a company make franchises available to franchisees when a legislative regime risks the viability of its brand image and existing customer satisfaction? What will happen to entrepreneurial opportunities for women and minorities who have become an integral part of franchisor expansion programs?

From a personal perspective, how do these legislative proposals affect my practice as a lawyer? I am a transactional lawyer, not a litigator, and initially I can see numerous inquiries from franchisors about the impact of such new legislation. But over time, I can see my clients moving away from aggressive franchise development and focusing more heavily on company-store openings. I can see the sources of new franchise programs drying up, in particular from larger corporations who previously had sought to trade on a valuable brand image by opening retail outlets and creating new forms of distribution. I can see the value of existing franchised businesses being significantly diminished because franchisors will be unwilling to continue franchising. In the end, I am confident that I will be busy, but I will be busy in court on behalf of clients facing an onslaught of litigation.

I would be happy to provide the Subcommittee with any additional requested information. Thank you for the opportunity to appear before you.

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Risks: U.S. Oversight Hearings on the Franchise Relationship, 1999, Lawyers, International Franchise Association, IFA, General Counsel, IFA, Bad faith and unfair dealings, Lawsuits, individual, No numbers to back up dire predictions, Refusal to renew contract, Gouging on supplies, Knows more than is saying, Encroachment (too many outlets in area), Refusing franchisee resale, Industry muscle, Subservient intellectual class, United States, 19990624 Dennis Wieczorfek

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