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The Federal Fair Franchise Act of 2015 – Not So Outrageous After All

On Behalf of | Sep 2, 2015 | Franchise Law News

The Federal Fair Franchise Act of 2015 – Not So Outrageous After All

At least some franchisor advocates have indicated outrage at the idea that federal legislation such as the Fair Franchise Act of 2015 has been introduced (not passed, but simply introduced) to regulate the relationship between franchisees and franchisors. Even a quick look at the history of franchising and the history of federal legislation demonstrates that the idea of the federal government protecting small businessmen, small investors and everyday citizens from abuse by larger entities is not so outrageous after all.

First, the federal government already regulates the sale aspect of franchising to some extent. The Federal Trade Commission Act, and the FTC’s Franchise Rule enacted pursuant to that Act, have regulated the sale of franchises since 1979. The Franchise Rule has been amended a number of times over the past 36 years. The FTC, a federal agency, has long required that franchisees receive a prospectus-like document (now called a Franchise Disclosure Document, formerly called a Franchise Offering Circular) that contains 23 specific items involving pre-sale disclosures.  The sudden great concern of franchisors and their advocates that the federal government might become involved in franchising comes a tad too late – approximately 36 years too late.

It is not surprising that the first efforts at federally regulating franchising called for a prospectus-like document, because it is generally agreed by people who study the history of franchising that the FTC’s regulation of franchising was patterned after the Securities and Exchange Commission’s regulation of securities sales. Such regulation by the SEC goes all of the way back to the Securities and Exchange Act of 1933 enacted during the Great Depression.

Congress decided in 1933 that the federal government was going to do something about fraudulent sales of securities to investors.

This decision to pass federal legislation was made even though the victims to be protected from the securities scams that had occurred in the 1920s and 1930s would have been people of substantial financial means and not middle class workers investing in 401K retirement plans (the first 401K plans did not come into being until the 1980s, prior to that time most citizens had no personal investment in the stock market at all).

In 1979, 46 years after its regulation of securities sales, the federal government made the same decision with respect to the sale of franchises to franchisees; the federal government wanted to do something about fraudulent franchise sales.

Both federal securities laws and federal franchise laws prohibit improper disclosures and prohibit false and misleading statements, and both the SEC and FTC have enacted rules that are written in a manner such that they can be read as forming the basis for a private party’s complaint against a fraudulent seller. One key difference, however, is that the federal courts limited the ability of franchisees to sue in court while permitting a defrauded securities purchaser to sue in court.

In other words, a securities investor who feels defrauded can sue in court under Rule 10b-5 enacted by the SEC, but a franchisee who feels defrauded is NOT allowed to sue under the FTC’s Franchise Rule.

This shift in the federal judiciary’s willingness to imply a “private right of action” in a federal statute (unfortunately for franchisees, the shift began around 1979), has left franchisees with a federal right for which the franchisees cannot generally pursue a remedy in court. A franchisor sued for a violation of the FTC Act or the Franchise Rule can win in court with this argument: “Even if we did violate the FTC Franchise Rule, there is nothing the franchisee can do about it.”

When amending the Franchise Rule in 2008 the FTC’s Office of the General Counsel stated that it had conducted an extremely minimal number of enforcement actions against franchisors since 1979 (the number stated was well under 100). In roughly 30 years, the FTC had enforced its FTC Franchise Rule….well, almost never. A franchisee who is harmed by a violation of his or her federal franchise law rights cannot sue in court, and the franchisee’s complaint to the FTC will almost certainly never result in an enforcement action. (We at Dady & Gardner used to report violations to the FTC in the mid-1990s. No enforcement action was ever brought, and if the franchisor learned of the report to the FTC it would use the FTC’s inaction to argue that “the FTC investigated this and said that we did nothing wrong.” Reporting matters to the FTC was actually counterproductive to our representation of franchisees. Therefore, we stopped the practice after a few years.)

The Fair Franchise Act of 2015 seeks to remedy this ridiculous situation of having a federal law that is almost never enforced.

The Act allows franchisees the same right that securities investors have had for 82 years – the right to sue to enforce a federal anti-fraud statute. How revolutionary is that? Not very. Franchisees should have a right that others who are similarly situated were given when FDR first became President.

Second, even outside of the securities context (securities laws, it should be noted don’t just deal with initial fraud in sales situations, the securities laws also includes restrictions on insider trading, short swing trading, initial public offerings, reporting requirements, record keeping, etc.) the federal government also regulates various aspects of commerce every day. Certainly innkeepers and restaurateurs in the South in 1964 were surprised to learn that they had to open their doors to African Americans. Having been allowed to do business in the same manner since at least the end of Reconstruction, these business owners certainly had to be shocked that the federal government could question the way they did business or treated actual or potential customers. Yet the federal government regulated them, and Congress has also passed laws requiring businessmen to limit their commercial activities in many other ways. For example, we have federal prohibitions on unfair housing practices, discrimination against those with disabilities, and clean air and/or clean water violations. Each of these federal laws regulates commerce and prohibits certain actions that a business person might want to take. The federal government also regulates conduct toward employees, including employee retirement plans, and tax withholding. For franchisors (who are already regulated by the federal government both through the FTC Rule and otherwise) to claim some sort of “overreach” through the enactment of the Fair Franchise Act of 2015 is, at best, disingenuous.

It is clear that franchising in a great many ways is already regulated by the federal government. Then what exactly is the complaint of franchisors about the newly proposed federal legislation that has been introduced? That the Act is somehow grossly unfair to the franchisor?

Let’s review some of the specific provisions in the Act.

Under the Fair Franchise Act of 2015, Franchisors cannot:

1.) Hinder the formation of or participation in franchisee associations
2.) Charge “excessive and unreasonable” renewal fees
3.) Impose a “standard of conduct or performance” on franchisees unless the franchisor can prove that the standard is “reasonable” and “necessary”.
In addition, Franchisors
4.) Must deal “fairly” and “in good faith” and exercise “due care” with franchisees, and
5.) Cannot sell a product or service to a franchisee unless the price is “fair and reasonable” or unless the franchisor has a “reasonable expectation” that the sale will be profitable for the franchisee’s business.

Let’s stop here and try to recap – are franchisors fighting this legislation because the franchisors want the absolute and unquestionable right to A) prohibit franchisees from having an association and talking with one another, B) charge excessive and unreasonable fees, C) act in an unnecessary and unreasonable manner, D) act in bad faith and without due care, E) sell products to franchisees at a markup so high that the franchisor knows the franchisee will not make a profit upon resale?

Are these really the inalienable rights for which franchisors are fighting? If this is the case, then we know that the California Court of Appeals was correct when it described the oppressive nature of the franchise relationship way back in 1996:

The relationship between franchisor and franchisee is a significant issue, and growing more important each year.

As recently explained, “Franchising is rapidly becoming the dominant mode of distributing goods and services in the United States. According to the International Franchise Association, one out of every twelve businesses in the United States is a franchise. In addition, franchise systems now employ over eight million people and account for approximately forty-one percent of retail sales in the United States. Even conservative estimates predict that franchised businesses will be responsible for over fifty percent of retail sales by the year 2000.”

Although franchise agreements are commercial contracts they exhibit many of the attributes of consumer contracts. The relationship between franchisor and franchisee is characterized by a prevailing, although not universal, inequality of economic resources between the contracting parties. Franchisees typically, but not always, are small businessmen or businesswomen or people like the Sealys seeking to make the transition from being wage earners and for whom the franchise is their very first business. Franchisors typically, but not always, are large corporations. The agreements themselves tend to reflect this gross bargaining disparity. Usually they are form contracts the franchisor prepared and offered to franchisees on a take or-leave-it basis. Among other typical terms, these agreements often allow the franchisor to terminate the agreement or refuse to renew for virtually any reason, including the desire to give a franchisor-owned outlet the prime territory the franchisee presently occupies.

Some courts and commentators have stressed the bargaining disparity between franchisors and franchisees is so great fn. 8 that franchise agreements exhibit many of the attributes of an adhesion contract and some of the terms of those contracts may be unconscionable. “Franchising involves the unequal bargaining power of franchisors and franchisees and therefore carries within itself the seeds of abuse. Before the relationship is established, abuse is threatened by the franchisor’s use of contracts of adhesion presented on a take-it-or-leave-it basis.”

Postal Instant Press v. Sealy, 51 Cal.Rptr.2d 365 (Cal. App. 2 Dist. 1996)(citations omitted)

Franchisor advocates have also complained that the proposed Fair Franchise Act of 2015 addresses the parties’ rights with respect to transfers, renewals and terminations. One of the stated complaints here is that the Act regulates contract provisions that “the parties take for granted.” What the proposed Act prohibits is unfair terminations and non-renewals without good cause. It also prohibits denial of transfer rights without a valid reason. Who are the “parties” that routinely take for granted that they will be able to impose upon the other contracting party the absolute right to terminate an entire long-standing business in the community without good cause, or non-renew the long term 10 or 20 year contract without good cause, or prohibit transfers to a qualified party of a multi-million dollar business that constitutes the seller’s sole asset, all without good cause?   Apparently, the set or subset of “parties” who expect this sort of right = only franchisors. Why is that? It is because franchisors have always enjoyed the ability to impose unfair take-it-or-leave-it contracts upon their franchisees. The Fair Franchise Act of 2015 would remove this disparity of bargaining power.

But one might ask “how will franchising ever survive if franchisors are required to actually treat their franchisees in a fair and reasonable manner”?

Certainly no distribution system could ever work in this manner, correct? Incorrect.

Automobile dealers in all 50 states enjoy significant statutory rights that prohibit the franchisor (generally called the “manufacturer” or “supplier” in the state auto dealer statutes) from taking unfair actions against these dealers. The rights of auto dealers are so substantial that the when GM and Chrysler made the decision to cut the number of dealers in their dealer network in light of the Great Recession, they each felt the need to first file for bankruptcy protection and only then “rejected” these dealer contracts in bankruptcy, hoping that federal bankruptcy law would override state dealer protection acts. What was the reaction of Congress to these dealer terminations (all of which were permitted by the bankruptcy courts and at least tacitly encouraged by the Executive Branch)? Congress almost immediately passed a law by a unanimous vote allowing the auto dealers to file for arbitration and to seek the return of the product line(s) to the dealers if the dealer was successful in the arbitration.

Since 2002, Congress has also provided automobile dealers with one additional right also sought now by franchisees – the right to not be forced to arbitrate legal claims. In 2002, Congress passed the Motor Vehicle Franchise Contract Arbitration Fairness Act which created a narrow exception to the Federal Arbitration Act. The new law allowed auto dealers to invalidate arbitration provisions in motor vehicle franchise agreements. See 15 U.S.C. § 1226(a)(2).

Again, despite the federal government becoming significantly involved in the dealer/ manufacturer relationship, and staying involved since at least 2002, there are still thousands of car and truck dealers in the nation. The world has not ended over the past 13 years because dealers are allowed to sue in their own states for statutory and contract violations.

What should strike one as odd is that a husband and wife who own one franchised Subway shop in Colorado currently have to arbitrate all of their legal disputes in Connecticut in Subway’s back yard, while a hypothetical multimillionaire football quarterback who owns car dealerships in Colorado can sue in Colorado to redress any dealership issues he has. Certainly franchisees should be treated no worse under federal law than are auto dealers.

None of the lawyers at Dady & Gardner were even born at the time the federal government started enacting regulatory systems that limit the overall discretion of business owners to operate. Legislation that would create a fairer franchisor-franchisee relationship is certainly nothing new. While the federal Fair Franchise Act of 2015 will upset certain franchisors who claim some sort of “divine right” to impose unfair and burdensome contract terms upon their franchisees, this is to be expected. No one who has always had an unfair advantage likes to play on a level playing field.

Both Democrats and Republicans claim to be supporter of the small business owners of America.

If that claim is indeed true, then all elected representatives should desire to provide tens of thousands of small businessmen with protection from unfair treatment and unfair contracts. To suggest that these small business owners should be hung out to dry and treated worse than securities investors and automobile dealers is, in reality, the idea that should be so far outside of the political mainstream that it should be rejected immediately and out of hand.

By Jeff Haff