March 18, 2016

California’s New Franchise Act Has Unintended Consequences

By Rupert M. Barkoff, Kilpatrick Townsend & Stockton LLP

The enactment of California’s new franchise relationship law, which amends the California Franchise Relations Act (CFRA), Cal. Bus. & Prof. Code §20000 et seq., is a monumental event in the history of franchise law for several reasons.

First, this is the first state relationship law enacted since Iowa adopted its relationship law in 1992—24 years ago. Most of the state franchise relationship laws (and most of the state franchise sales and disclosure laws) were in place by 1975, in the formative years of franchise law. Although franchisee advocates have made many attempts to enact relationship laws over the years, virtually all have failed. Thus, the regulatory scheme we have today is not that different from the one I saw when I began to practice franchise law back in the last century.

Second, the California legislation may be the first time when franchisor and franchisee advocates together decided to “reason” with each other regarding the enactment of franchise relationship legislation. The International Franchise Association (IFA) has historically adopted what I will call a scorched earth approach to new franchise legislation—that is, no concessions to the other side. This strategy was successful until 2015, when California Governor Jerry Brown made it clear that the success of the current legislation (unlike prior legislation that he vetoed the year before) depended on a more collaborative approach. This no doubt prompted the IFA to move closer to the middle of the relationship spectrum. (Some might argue that the enactment of Iowa’s relationship law was another exception to the scorched earth approach, but in that case, the franchisee interests propelling the legislation simply ambushed the IFA before it had enough time to gear up for battle.)

There is a third reason why the enactment of the California law is significant in franchise law history: Although it may be an aberration in the development of franchise legislation, it may also be a trendsetter.

Does this End All Hope for an Overhaul?

During my all-too-many years of practice, I have advocated that the franchise regulatory system in the United States needs to be overhauled, regardless of whether one is on the franchisor or franchisee side of the table. With the exception of the Federal Trade Commission’s (FTC’s) Franchise Rule, franchise law has been a creature under the control of the states. There are solid reasons for franchise law to be the product of the state legislatures; nevertheless, our system of franchise law and regulation has become a monster. In the franchise sales area, the laws of each state differ. The definition of a franchise differs from one state to another. The registration procedures also differ. Even today, what may be acceptable in California may be verboten in New York. And then, there is the challenge created by the examiners.Their philosophies about franchise regulation differ, as do their skills as examiners.

All this, added to the partial pre-emption of state law by the FTC’s Franchise Rule, has resulted in a patchwork of regulation, not only in the area of franchise sales, but also with respect to franchise relationships.

What is the solution? Complete pre-emption.Interestingly, Australian franchise law is largely based on the U.S. experience, but Down Under they have avoided most of the pitfalls we have encountered in the United States, primarily by having, de facto, only federal legislation and no registration process. (Only one of Australia’s states has adopted franchise relationship legislation.)

But can federal pre-emption become the law in this country? Federal legislation is now pending before the U. S. Congress, but it does nothing to eliminate the problem created by two levels of regulation. To the contrary, it specifically provides that state law is not pre-empted—thus cementing the problem of two-level regulation. Regardless of what one thinks about the substance of the pending federal legislation, it clearly suggests that federal pre-emption is not in the cards in the near future.

CFRA: A Setback to Pre-Emption

The California law represents a major setback to complete pre-emption because it may lead to a proliferation of state legislation. We should not be surprised to see similar laws adopted in numerous states in the next three to five years. This would make franchise regulation in the United States even more of a patchwork, and even more complex.

Beyond complexity, what are the effects of having two levels of regulation? First, it is an inefficient way to regulate. In several states, it now takes a minimum of two months to be able to offer franchises for sale. In other states, it might take even longer.

Second, having two levels of regulation is not cost effective. Again using Australia as an example, the cost to become a national franchisor Down Under is limited to the cost of preparing documents. In contrast, in the United States, a start-up franchisor will incur those same costs but will also have to pay registration fees ranging from $250 to $750 per state, renewal fees annually, and in most cases legal fees for handling the registration. And if a three-level franchise is involved (such as one with a franchisor, subfranchisor, and subfranchisee), these costs can easily double or triple.

Finally, the regulatory system in the United States may well affect the level of competition in some industries and in the franchise community. Both domestic and foreign franchisors, fearing our system, may decide to offer their franchises for sale in countries other than the United States. This reduces the number of franchise systems that are operating or want to operate here. Fewer franchisors likely means less competition.

Do not get me wrong. Nowhere have I suggested that the substance of the amended CFRA is “good” or “bad.” But is the lack of pre-emption, with franchising controlled by the state governments, good for the franchise community?

For us as lawyers, the current system may be good because it means more work. But for our clients, it is bad. Franchise regulation adds cost, inefficiency, and complexity to franchising. And, sad to say, most of the problems with the system could be easily resolved through complete pre-emption.

At a limited-invitation conference sponsored in 2012 by the Franchise Law Institute (a not-for-profit entity that I created to study and compare franchise regulation throughout the world), all stakeholders present including private-firm attorneys who represent franchisors, franchisees, or both, in-house attorneys, consultants, and regulators—all favored full pre-emption, except for one state regulator. The reasons for franchisor attorneys’ support are obvious. From the standpoint of franchisee lawyers, the current system makes it too expensive for their clients to prosecute wrongdoing through the courts or arbitration.

Despite the problems with our current patchwork of franchise regulation, however, absent a passionate advocate in Congress and strong and vocal support from the franchise community, I am likely to be drooling my Jell-o® at the old folks’ home by the time total pre-emption is seriously considered.

By Rupert M. Barkoff, Kilpatrick Townsend & Stockton LLP