Peter Singler Oversight Hearing

If a franchisor opposes Federal fair franchising legislation and protections being afforded small-business owners, the motivation behind such an objection should be scrutinized. More likely than not, those in opposition will be the franchisors currently engaging in unscrupulous practices and taking unfair advantage of their disparate bargaining power.

USHouseofRepresentatives.png

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

Oversight Hearing on the Franchising Relationship
Peter A. Singler, Jr., attorney

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

PETER A. SINGLER, JR.

Testimony

Hon. Henry J. Hyde, Chairman
Committee on the Judiciary
House of Representatives
2138 Rayburn Building
Washington, D.C. 20515

Re: Subcommittee on Commercial and Administrative Law/ Oversight Hearing on Franchising.

Dear Chairman Hyde:

Thank you for your invitation to appear before the House Subcommittee on Commercial and Administrative Law. I believe this is a great privilege and look forward to testifying about the current status of franchising in our Nation. The influence that franchising has, and will continue to have, on our economy is indisputable. It is currently estimated that by next year, 50ยข of every retail dollar spent in the United States will be through a franchised outlet. Franchised outlets account for billions of dollars and millions of jobs in our economy.

I am a business lawyer. The majority of my practice is devoted to representing franchisees and franchisee associations. I am also a director and major shareholder in a company my father started over 35 years ago, whose primary business is the operation of Round Table Pizza Restaurant franchises. As both a lawyer and a small business owner, I have three general concerns regarding the enactment of legislation:

(1) Will the legislation create more litigation or standardize legal premises to alleviate legal disputes?

(2) Will the legislation promote free-trade?

(3) Will the legislation interfere with my freedom to contract or make reasonable business choices?

As discussed below, establishing fair standards of conduct for franchise relationships will reduce litigation, promote free-trade and efficient competition, and protect my ability as a small business owner to contract freely with regard to my business.

Despite the dominant role that franchising plays within our economy, there are fundamental flaws in the basic structure of the institution. A gross disparity in economic strength and bargaining power between franchisors and franchisees has led to increasingly onerous contract provisions, and allowed some franchisors to engage in unscrupulous business practices. Such agreements and unfair practices are impeding entry into markets and stifling free-trade and competition. This is because an entrepreneur wishing to enter or advance within an industry has two choices: join a franchise system, or go it alone and compete with franchise systems which possess an overwhelming advantage. However, when determining which system to join, franchise agreements are substantively so alike that there is no real choice to be made. These agreements strip the prospective franchisee of many of the protections one would assume to be built-in to any normal business relationship. Onerous contract provisions allow unscrupulous franchisors to deny their franchisees the realization of the goodwill and value they may have invested many years and their life savings to develop.

In some respects, franchising is analogous to present day indentured servitude. If a franchisee is subjected to unfair treatment by his or her franchisor, there is little recourse. The franchisee generally lacks the relative strength to negotiate effectively. Because the contracts are so one-sided in favor of the franchisor, there is generally no legal recourse available. Because of non-competition covenants contained in most franchise agreements, the franchisee is not even free to leave the system and compete individually or associate with another franchise system which provides value, or deals fairly with its franchisees.

If a franchisee has the resources to challenge a franchisor's conduct in court, (s)he must face highly subjective and inconsistent treatment within the legal system. Because there is no Federal legislation establishing consistent standards, franchise agreements often contain choice of law and venue provisions which allow the franchisor to control both the substantive law which will control any dispute, and the place the matter has to be resolved. This means that a Nevada franchisee could be forced to litigate in Maine, and be subject to Illinois law. This "forum shopping" allows franchisors to insulate themselves from a number of meritorious lawsuits just because of the great expense and inconvenience a small business person would have to incur to vindicate his or her rights — even in the most egregious of cases.

Our courts have proved to be a costly and ineffectual avenue for resolving the flaws inherent in franchising. Despite the many inconsistent legal rulings, some courts have clearly identified the current inequities within franchising. For example, a California Court described many franchise agreements as contracts of "adhesion," containing "unconscionable" terms. (Postal Instant Press, Inc. v. Sealy (1996) 43 Cal.App.4th 1704). A United States Court of Appeals opinion went so far as to refer to a franchisor's agreement (which is similar in many material aspects to those of many franchise systems) as commercially unreasonable." Unfortunately, the franchisee who was the beneficiary of this ruling had already been forced to file bankruptcy due to the franchisor's bad faith tactics. (In re Vylene Enterprises, Inc. v. Naugles, Inc. (9th Cir., 1996), 90 F.3d 147)

Although the FTC Rule is designed to promote adequate pre-sale disclosures, the FTC has been totally ineffective in promoting fairness and free competition in franchising. The FTC does not review any of the representations contained in the Uniform Franchise Offering Circular, and it investigates less than 6% of complaints alleging substantive violations of the rule. Furthermore, the Rule has no bearing on post-sale activities.

There is a great need for fair, universal standards for franchising. Federal legislation will alleviate the inconsistent treatment currently suffered by the application of piecemeal state law. Federal legislation will also ensure that the basic tenets of fairness and responsible business practices are a part of franchising. These results should encourage domestic investment within franchising, an institution which plays a vital role in our National economy.

Below, I have taken the liberty of discussing several issues which are prevalent throughout franchising. The gross disparity in bargaining power and the lack of meaningful choice franchisees are given when entering into industries dominated by franchise systems has led to wide-spread discontent and litigation. The contentious environment arising from these factors will chill continued investment and could eventually threaten our National economy.

A. Post-Term Restrictions on Competition. Most franchise agreements contain noncompetition covenants which prohibit a franchisee from competing with a franchisor (directly or indirectly) or investing in or seeking employment from a competitor after the franchise relationship ends. The effect these types of covenants have upon free-trade and efficient competition is self-evident. Although a franchisor may have a legitimate interest in protecting its trademarks and brand image, there are already adequate protections in this regard, such as the Uniform Trade Secret Act. The very nomenclature of these types of covenants "restrictions on competition" indicate that they are an affront to this Country's strong policy favoring competition. The basis of free enterprise is to encourage innovation and allow entrepreneurs to move freely within the market place. We already have laws restricting the use of trade secrets. We need not prohibit franchisees from engaging in their livelihood to protect a franchisor's dominance in a particular market. Once a franchise is terminated, the franchisor is free to license a new franchisee in the same market area. The franchisee should be allowed to compete against its former franchisor.

B. Duty of Good Faith. There is nothing more basic in any relationship than the premise that each party will act reasonably and in good faith with each other party. It seems unimaginable that anyone would enter a relationship if they believed the other party would act contrary to this basic precept. Courts have commonly described the duty of good faith as follows:

There is implied in every contract a covenant by each party not to do anything which will deprive the other parties thereto of the benefits of the contract…. [T]his covenant not only imposes upon each contracting party the duty to refrain from doing anything which would render performance of the contract impossible by any act of his own, but also the duty to do everything that the contract presupposes that he will do to accomplish its purposes. Harm v. Frasher (1960) 181 Cal.App.2d 405, 417.

The Restatement 2d of Contracts (section 205) agrees that the covenant (similarly described) is part of every contract, and lists examples of good and bad faith performance. The covenant of good faith and fair dealing is not only common sense, but a long-standing legal construct. However, as a myriad of recent litigation has demonstrated, this basic principle is not readily followed in the franchise context.

The covenant of good faith is "implied" into every contract. However, a general rule of contract interpretation is that an implied covenant will not overrule an express contractual term. Franchising is plagued with one-sided, oppressive contracts which completely favor the franchisor at the franchisee's expense. These agreements "expressly" reserve various rights for the franchisor, often including the right to establish a competing franchise in close proximity to an existing franchisee and to unilaterally determine the source of goods and supplies the franchisee must purchase. In effect, the franchisor expressly reserves the right to deny the franchisee the fruits and benefits under the franchise agreement, thus nullifying the effect of an "implied" covenant of good faith and fair dealing.

Simply stated, many courts have held that as long as a franchisor reserves a right, it need not act fairly or in good faith. Federal legislation can install a duty of good faith and fair dealing into the franchise context, thus protecting a basic tenet which is so obvious in our other business relationships that we often take it for granted.

C. Duty of Due Care. Franchisees, whether first time entrants into the market-place or sophisticated refugees from down-sizing corporate America, often invest their life-savings and commit themselves to long hours of labor when they purchase their franchised business. When making the business selection, a prospective franchisee relies upon the business acumen of the franchisor, and the systems the franchisee will receive in exchange for the initial and ongoing fees (s)he will pay to the franchisor. Because of this, a franchisor should have to disclose its experience and skills within the industry. If the franchisor does not have the knowledge and skills commonly found within the industry, it should have to disclose that fact.

Requiring such a disclosure will allow prospective franchisees to make an informed decision regarding the franchisor and system to which they will pledge their livelihoods — Such disclosures will also give pause to the unscrupulous franchisor who attempts to sell franchises based upon hype rather than substance.

D. Limited Fiduciary Duty. Many franchisors undertake to provide accounting services or administer advertising funds under the terms of their franchise agreements. Franchisors generally acknowledge that the monies they are handling in these situations do not belong to the franchisor. Yet, at the same time, they also disavow any duty to account for these funds or deal in good faith. In the most basic legal terms, whenever one party undertakes to hold or manage the property of another, a "trust" is establish.
The law imposes a standard of conduct upon anyone holding property in trust for another. Black's Law Dictionary defines a fiduciary as one "having a duty, created by his undertaking, to act primarily for another's benefit in matters connected with such undertaking." To ensure fair dealing and that franchisees' monies are handled properly, franchisors should be subject to the same standards and duties applied generally when one holds or manages the property of another. A limited fiduciary duty should apply when: (A) a franchisor performs bookkeeping, collection, payroll, or accounting services on behalf of the franchisee, or (B) where it administers or controls an advertising, marketing or promotional fund to which franchisees are required to, or routinely, contribute.

The recent Meineke case (Broussard v. Meineke Discount Muffler Shops, Inc., 1998 WL 512926 (4th Cir. (N.C.)) aptly demonstrates the necessity for the limited protection suggested above. In the Meineke case, the trial judge was clearly disturbed by Meineke's use of the advertising fund (collected as mandatory contributions from franchisees). Meineke created an in-house advertising agency, and paid it significant commissions (over $17 million), essentially paying itself twice (administrative costs and commissions) with franchisees' contributions. The lower court found that Meineke as collector and administrator of the ad fund had a fiduciary duty to the franchisees not to enrich itself at their expense. The appellate court reversed, holding that under North Carolina law a franchisor has no fiduciary duty to its franchisees.

Commonly, franchise agreements disavow any duty regarding advertising funds, and the franchisees have no right to audit or check on how this money is being spent. On the other hand, these agreements also state that the money is not the franchisor's, but belongs to the "entire system." This is evidenced by the common practice of not taking advertising fees into income for tax purposes. If the money is not the franchisor's, then it is necessarily someone else's. This is the common definition of a "trust," holding or administering someone else's money or property. In all trusts, there is a fiduciary duty imposed upon the trustee to act fairly and reasonably with the trust funds, not to self deal, and to be accountable to the beneficiaries. Again, these same basic tenets should be applied in the franchising context when a franchisor is entrusted with franchisees' money.

E. Transfer of a Franchise. Franchisees and advocates of fair franchising legislation do not question a franchisor's interest in assuring that qualified operators own the franchised business within its system. However, if reasonable standards for experience, financial strength and ability to operate the franchise are met, a franchisee should be free to transfer the franchise according to the same terms and conditions under which the franchisee operates. Currently, if a franchisee wishes to retire, pass the business to his or her children or a key employee, (s)he is faced with burdensome and often capricious obstacles set by franchisors. Because a franchisor may expressly reserve the right to approve any transfer of the franchise, or any equity interest in the franchisee, the potential market of available buyers is greatly reduced. The smaller the market, the less the franchisee will realize on a sale of the business.

Another common provision in franchise agreements allows the franchisor to condition its consent to a transfer upon the buyer's signing the "then current" franchise agreement. The economic terms of franchise agreements have, across the board, become increasingly burdensome. Thus, the value of a franchisee's business will be greatly reduced if the buyer will have to pay higher fees, pay more for supplies or have other increased costs dictated by the franchisor. A prospective buyer will decrease the purchase price by the increased risk or cost associated with the new agreement, risks or costs which have, in effect, been created by the franchisor because of the proposed transfer.

The net effect of overreaching restrictions on transfer is to deny a franchisee the goodwill that (s)he may have spent years developing. In non-franchised businesses, an owner may offer to sell part or all of his or her business and the market will determine the selling price. In franchise systems, it is often the franchisor who determines who the buyer will be and, through the use of burdensome restrictions, the price that will be paid.

Federal legislation can promote market freedom and protect a franchisee's ability to freely contract for the sale of his or her business at a true market price. This can be done by establishing a franchisee's right to transfer his or her business upon substantially similar terms and financial requirements as in the franchisee's current agreement. The franchisor will retain the flexibility to alter the form of the agreement to address changing markets and conditions. At the same time, the franchisee's goodwill and the true value of the business will be protected from arbitrary manipulation. By allowing a franchisee to transfer his or her business upon the same economic terms under which (s)he operates, a franchisor will be receiving the same consideration for which it bargained when it entered the agreement. Without such protection, the franchisor receives a windfall at the franchisee's expense.

F. Independent Sourcing of Goods and Services. Many franchise agreements provide that the franchisor may designate the supplier and brands of goods and services used in the system. In effect, this creates a monopoly for the supplier to the system and often eliminates price competition. In addition, it is common practice for franchisors to receive kickbacks from suppliers to the system. Once again, these payments constitute a windfall to the franchisor at the franchisees' expense. By logical necessity, this de facto price fixing affects the franchisees' profitability, and at least to some extent, higher costs are passed-through to the consuming public. This current reality is exactly the type of situation that anti-trust legislation was designed to protect against. However, courts have been reluctant to apply such standards to the franchising relationship.

Once again, franchisees do not argue against the franchisor's legitimate interest in controlling quality and maintaining the secrecy of proprietary products. Reasonable standards for product quality may, and should, be established to protect these interests. However, if multiple suppliers can meet these standards, then franchisees should be free to contract with any qualified supplier and procure the best available pricing.

In addition, franchisors should be required to disclose and return to franchisees any rebates or payments received from vendors to the system. Payment of these kickbacks inhibits a franchisee's ability to obtain the best free-market price. Again, this situation hurts the franchisee's bottom line, but also increases prices to the consuming public.

G. Encroachment. There has been a great deal of litigation, ill-will and unproductive strains placed upon the franchisor/franchisee relationship due to encroachment — the practice of a franchisor opening or licensing a competing business under the same brand name in close proximity to an existing franchisee. As discussed above with regard to the covenant of good faith and fair dealing, franchisors commonly reserve the right to operate or license a business anywhere they want. Because of the contractual reservation or right, courts are often unwilling to intercede on the franchisee's behalf, even when the franchisor's conduct effectively drives a franchisee out of business. This was illustrated by the court's statement in Camp Creek Hospitality Inns, Inc., v. Sheraton Franchise Corp. 130 F.3d 1009 (C.A. 11th Cir., 1997): "By the express terms of the contract, therefore, Sheraton could have authorized a competing franchise directly across the street from the Inn, and Camp Creek would have little recourse."

The inequality between franchisors and franchisees has resulted in franchise agreements in which franchisors reserve their rights to locate new franchises wherever they decide. Who, with true freedom to contract, would agree to pay a franchise fee for the right to use a brand name and system, only to have the franchisor accept another fee from another franchisee to open the same business next door? Where parties have some equality they can negotiate a reasonably balanced relationship. Where one party has all the power, it can impose an agreement which reserves all the power for itself. This currently happens in many franchise systems.

The encroachment issue is only exacerbated when one considers the other provisions commonly found in current franchise agreements. For example, most franchise agreements contain both non-competition covenants and a reservation of the franchisor's right to directly compete under the same brand name anywhere it wants. Thus, the franchisor can compete with its own system, but the franchisee cannot. If the franchisee finds the relationship too burdensome, (s)he is free to leave after the franchise agreement expires, however, (s)he may not engage in the only trade or industry in which the franchisee can make a meaningful living. This is despite the fact that the franchisor is free to re-franchise the area and continue to operate its business in the franchisee's former market. This double standard exemplifies how onerous current franchise agreements can be, as well as the threat that these agreements pose to the continued growth and prosperity of franchising as a whole.

In conclusion, Federal legislation establishing fair and reasonable standards of conduct for franchising is urgently needed to protect a vital facet of our National economy. These standards will ensure that entrepreneurs and small business owners have a meaningful opportunity to freely contract and enter into various industries upon commercially reasonable terms. These standards will also promote free-trade and efficient competition within the economy, affording both franchisees and the consuming public the benefit of best-market pricing. Federal standards will eliminate the disparate treatment caused by piecemeal state legislation in the franchise area. Clear standards of conduct will also greatly reduce the amount of costly and unproductive litigation by franchisees desperately seeking recourse from oppressive and unfair treatment by certain franchisors.

There should be little objection to fair National standards for franchising by franchisors who deal fairly and honestly with their franchisees. If a franchisor opposes Federal fair franchising legislation and protections being afforded small-business owners, the motivation behind such an objection should be scrutinized. More likely than not, those in opposition will be the franchisors currently engaging in unscrupulous practices and taking unfair advantage of their disparate bargaining power.

I would again like thank Chairman Hyde, Chairman Gekas and the distinguished members of this Subcommittee for allowing me the privilege of submitting this statement and offering testimony on this important subject. I hope that the Subcommittee will carefully consider fair franchising legislation once proposed, and will move expeditiously to refine the legislation and forward it to the Judiciary Committee for further hearings and action. If I can be of any further assistance to the Subcommittee or staff, I will be happy to make myself available.

Thank you.

cc: Hon. G. Gekas

House Subcommittee on Commercial and Administrative Law

Peter A. Singler, Jr., Lawyer and Counselor at Law

Mr. Singler represents business of all sizes, from sole proprietorships to publicly traded companies. While his firm handles a wide range of business and litigation cases, Mr. Singler's personal expertise is in transactional matters, including entity formation, financing and franchising work. Mr. Singler is one of the few business lawyers in the country who represents exclusively franchisees with regard to franchise matters. An Officer and Director of a multi-unit franchisee, Mr. Singler has a truly unique perspective regarding the changing relationships and dynamics of franchising. Mr Singler also sits on the American
Franchisee Association's Board of Directors, giving him a wide perspective on issues facing franchisees across the nation. Although his franchisee clients are predominantly in the food service and hospitality sector, Mr. Singler also represents franchisees and associations in the auto service, travel, health-care and financial services industries. A graduate of the University of Pennsylvania Law School, Mr. Singler also received formal business education from the Wharton School.
Disclosure Statement (House Rule XI, clause 2(g)(4)).

Neither I, nor any entity I may represent at the relevant hearing, have received any federal grant, contract or subcontract during the current or the last two preceding fiscal years.

http://judiciary.house.gov/legacy/sing0624.htm


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Risks: U.S. Oversight Hearings on the Franchise Relationship, 1999, Monopoly, Lawyers, American Franchisee Association, AFA, Non-compete restrictions, Futility of taking legal action, Bad faith and unfair dealings, Gouging on supplies, Must buy only through franchisor (tied buying), Encroachment (too many outlets in area), Secret kickbacks and rebates, Indentured servants, Refusal to renew contract, Imbalance of information and power, Contracts across systems are virtually the same, Courts misunderstand relationship, New buyer must sign current, often less favourable, contract, Resale permission unreasonably withheld, Anti-trust provisions not applied to franchising, United States, 19990624 Peter Singler

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