General Practice, Solo & Small Firm DivisionMagazine

Franchise Law

A Critical Analysis of the Small Business Franchise Act of 1998

By Erik B. Wulff

On October 14, 1998, a comprehensive federal franchise disclosure and relationship law, entitled the Small Business Franchise Act of 1998 (Act), was introduced by Representative Howard Coble (R-N.C.). Although the bill was introduced at the end of the 105th Congress with little opportunity to be considered, Coble said he would reintroduce the bill during the next Congress.

The American Franchisee Association (AFA), a franchisee rights group, is pushing hard for this bill and has had significant influence on its scope and the protections it affords franchisees. Moreover, AFA may get support from its rival franchisee association, the American Association of Franchisees and Dealers (AAFD), which at least until the introduction of this bill, considered negotiated solutions through collective bargaining preferable to legislative solutions.

There is a strong likelihood that the Act will be given serious consideration as a result of the bipartisan support reflected by its sponsors and their strong presence on the House Judiciary Committee, the committee that has legislative jurisdiction.

Proponents for the bill will base the need for this type of legislation on anecdotal evidence of franchisor abuse. A number of franchisees will likely be asked to testify about the abuses they have suffered, and these instances are likely to be characterized as the tip of an iceberg of widespread problems that existing law does not adequately address. Proponents are also likely to point to a number of lawsuits that they think franchisees should have won, but did not, asserting that the existing body of common law inadequately protects the franchisees’ legitimate interests.

Opponents of the bill, including the International Franchise Association (IFA) and the National Franchise Council (NFC), will assert that there is no hard evidence of widespread franchisor abuse. They believe the bill is an effort to dictate legislatively terms of franchise agreements that are more favorable to franchisees than the free market allows, and that an existing body of law exists to address whatever problems that arise. More specifically, opponents are likely to proffer a rationale that so far has been effective in defeating this type of legislation at the state level, i.e., the most effective solution to problems in franchising is presale disclosure of franchise practices. They will assert that prospective franchisees, armed with information mandated by law about the background and practices of a franchisor (including details about its standard form of agreement) will choose not to buy the franchise if the relationship is perceived to be unfair. They hold also that this disclosure scheme imposes a sufficient marketplace driven discipline on the franchisor to be fair to its existing franchisees.

Policy arguments like those described above will have significant effect on whether this bill, or perhaps some amended version, eventually becomes law. But to have a full measure of the legislative proposal, the debate also will have to consider specifics. What do sponsors have in mind when they assert that "this Act is necessary to restore freedom to contract, and to remove restrictive barriers impeding entry into industries and markets dominated by franchise systems"? How will the Act accomplish its stated purposes? Will franchisors have to change their practices to comply with the Act, and what legal risks will they face? What is likely to be the reaction of would-be franchisors, as they evaluate the risks and rewards of franchising in light of available alternatives for expansion?

The Small Business Franchise Act of 1998 is grounded in the assumption that the following process necessarily, or at least typically, takes place in franchising. Prospective franchisees are insufficiently familiar with franchise practices when they enter into the relationships, despite existing franchise disclosure laws. The relationships are documented by agreements that reflect an imbalance of the parties’ respective rights and obligations; franchisees unwittingly sign these agreements not knowing that they fail to protect their legitimate interests. When confronted with problems with their franchisors, franchisees discover that their agreements confer inadequate rights to address the problems, they face contractually imposed procedural obstacles in pursuing judicial remedies, and courts generally are not sympathetic to their claims.

The Act addresses the assumption that small business owners do not understand the contracts they sign by imposing disclosure obligations on the other party to the contract, but then goes beyond that by mandating changes to those very contracts. In doing so, the Act is said to be necessary "to restore freedom to contract," a concept commonly understood to mean letting parties decide for themselves what their relationship should embody. Yet it imposes a wide array of government-mandated requirements on franchisors, big and small, that are vague, harsh, and ignore the legitimate interests of franchisors. Moreover, the Act repeatedly rejects a fundamental precept of commercial law: that parties to a contract need to be able to clearly understand their obligations to each other. Sanctity of contract is disrespected, giving franchisees the ability to claim rights and obligations not reflected in the agreements and creating an environment that fosters constant litigation.

The Act also is said to be necessary "to remove restrictive barriers impeding entry into industries and markets dominated by franchise systems," antitrust parlance for monopolistic practices. The assumption that franchise systems dominate their markets has no factual basis, for even a large and successful franchise system such as McDonald’s operates in a highly competitive market and has no market power. Moreover, the ostensible purpose of making restricted markets more competitive is not accomplished by encouraging new entrants to compete against "dominating franchisors." Instead, it is used as a ruse to encourage franchisee breakaways and misappropriation of the franchisor’s intellectual property rights in the process. The Act distorts the meaning of freedom of contract, tosses out the wisdom of years of commercial law, and makes a mockery of antitrust jurisprudence on market analysis and monopoly power.

This Act is destructive to franchising. If enacted in its current form, new franchising activity is likely to stop stone cold. Existing franchisors undoubtedly will test the limits of the constitutional protection of impairment of contract with respect to their existing relationships as they are renewed or transferred. Would-be franchisors will seek other means to expand their businesses. Surely, there are less draconian ways to address the ostensibly unfair process by which small business owners are "duped" into "bad deals."

In his remarks to Congress, Representative Coble explained that the problem is the inadequacy of the current disclosure scheme, particularly at the federal level. The FTC rule does not confer on aggrieved parties a private right of action. The FTC itself is said to be able to act on only 6 percent of the complaints it receives and, according to Coble, "much of the information disclosed, while detailed, may be misleading." It would behoove the industry to address the concern he raises, rather than to allow this to be used as a platform to rewrite franchise agreements in a manner that pleases franchisee lawyers.

To the extent that there is a substantial problem with the completeness or accuracy of franchise disclosure documents used in states without protective statutes, the solution may be as simple as providing for a private right of action for violations of the FTC rule.

Erik B. Wulff is a partner with Hogan & Hartson in Washington, D.C.

- This article is an abridged and edited version of one that originally appeared on page 133 in Franchise Law Journal, Spring 1999 (18:4).

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