Volume 109 Issue 1 Dickinson Law Review - Volume 109, 2004-2005 6-1-2004 Beguiling Heresy: Regulating the Franchise Relationship Paul Steinberg Gerald Lescatre Follow this and additional works at: https://ideas.dickinsonlaw.psu.edu/dlra Recommended Citation Paul Steinberg & Gerald Lescatre, Beguiling Heresy: Regulating the Franchise Relationship, 109 DICK. L. REV. 105 (2004). Available at: https://ideas.dickinsonlaw.psu.edu/dlra/vol109/iss1/5 This Article is brought to you for free and open access by the Law Reviews at Dickinson Law IDEAS. It has been accepted for inclusion in Dickinson Law Review by an authorized editor of Dickinson Law IDEAS. For more information, please contact [email protected]. Beguiling Heresy: Regulating the Franchise Relationship Paul Steinberg* & Gerald Lescatre** I. Introdu ction .............................................................................................. 10 6 II. P re-Sale Issues .......................................................................................... 125 A. Fictive Kinship: The Franchise "Family". ............................................... 125 B . P artnersh ip ................................................................................................ 13 1 C . Franchise Success/Failure Rates ............................................................... 139 D . E arnings C laim s ........................................................................................ 146 E. Targeting Prospective Franchisees ............................................................ 152 F . L ab or Issu es .............................................................................................. 159 III. Post-Sale Relationship Issues ................................................................... 174 A. Sourcing Requirements: Fiduciary & Antitrust Issues ............................ 174 B . E ncroachm ent ........................................................................................... 18 1 C . Franchise Inspections & A udits ................................................................ 198 IV . Post-R elationship Issues ........................................................................... 209 A . Selling the Franchise ................................................................................. 209 B . Franchise "R enew al". ............................................................................... 213 C . G oodw ill ................................................................................................... 2 16 D. Good Faith and Goodwill: Hartford Electric v. Allen-Bradley ................ 225 V. Issues During and After the Relationship ................................................. 228 A. Good Faith and Relational Contracts: Fruits of the Contract ................... 228 * B.S., Univ. of Maryland, J.D., St. John's Univ. School of Law. From 1996- 2003, a franchisee of Doctor's Associates Inc., the franchisor of SubwayTM Sandwiches & Salads. The author may be reached at [email protected]. The authors acknowledge: Prof. Robert Zinman for his invaluable advice, Brian Peterson, Esq. and Subway Development Agent Paul Landino for their comments and spirited discourse, and Paul Jones, Esq. for his helpful insights regarding global franchising regulation. ** Gerald Leonard Lescatre (1958-2003) passed away before this article was completed. A 1984 graduate of the New York Institute of Finance (A.S. Finance), Gerry was a Registered Securities Principal and Registered Options Principal. He specialized in the food service industry and participated in the Initial Public Offerings of franchisors Manhattan Bagel and New World Coffee. At the time of his passing, Gerry was a kind and generous operator of a SubwayTM in New York City for seven years. Gerry's concern for his employees is fondly remembered, as is his belief that fair franchising provides opportunities for all. He would acknowledge his parents Robert and Clarisse Lescatre of Manchester, N.H. 106 PENN STATE LAW REVIEW [Vol. 109:1 B . G o od Faith ................................................................................................ 2 34 C . Franchise L itigation .................................................................................. 244 D. Arbitration Clauses Can Encourage Abuse ............................................... 248 E . State Law W aiver ...................................................................................... 260 V I. R egulatory Issues ...................................................................................... 265 A . R egulatory C apture ................................................................................... 265 B. FTC Regulation: Statutory Basis For Enforcement ................................. 278 C . G A O 200 1 R eport .................................................................................... 280 D . S B F A ........................................................................................................ 2 84 E. Beguiling Heresy: Equitable Principles of Good Faith & U nconscionability ................................................................................ 286 F. Cognitive Process and The Disclosure Document: Proposal for C h an g e ................................................................................................. 2 92 G . Red H and of D isclosure ............................................................................ 298 H. FTC Disclosure: Shield for Franchisors .................................................... 302 I. E lectronic D isclosure ................................................................................ 304 V II. C onclusion ................................................................................................ 30 7 I. Introduction As franchising' grows both in the United States and abroad, cases of franchisor 2 opportunism continue to increase. The franchise industry and many regulators insist that there is no evidence of systemic problems with franchising, and that any historical problems were addressed by the disclosure regime implemented with the passage of federal disclosure 1. The legal definition of "franchise" depends on local law. See FRANCHISE DESK BOOK: SELECTED STATE LAWS, COMMENTARY & ANNOTATIONS (W. Michael Garner ed., 2001). Frequently, the distinction between a franchise and a distributorship is the payment of a franchise fee. See, e.g., Cambee's Furniture, Inc. v. Doughboy Recreational, Inc., 825 F.2d 167, 169 (8th Cir. 1987). However, this is not dispositive, especially where payments are required as a condition of continuing the business. FTC Informal Staff Advisory Opinion 00-2, Jan. 24, 2000 at Bus. Franchise Guide (hereinafter BFG) (CCH) 6506. In some cases, the courts use "franchise" and "distributorship" interchangeably; although, where a distributor does not qualify as a statutory franchisee, the arrangement may not fall within the reach of franchise statutes. E.g., Upper Midwest Sales Co. v. Ecolab, 577 N.W.2d 236 (Minn. Ct. App. 1998). In some Commonwealth cases, courts use the term "independent contractor" for what would be regarded in the U.S. as a distributorship or franchise. In the U.S., the term "business opportunity" may be used to describe a distributorship arrangement, and is often a pejorative term when used by regulators. The regulatory creation of a "Fractional Franchise," which is defined in section 436.2(h) of the FTC Rule makes matters more confusing. See BFG 6080, 6173. 2. The franchisor is the company which licenses the trademark, and the franchisee is the licensee. Some franchisees are also franchisors, such as AmeriHost Hotels. Julie Bennett, Hotels and Franchising-IsAdding a Hotel to Your Portfolio a Good Idea?, FRANCHISE TIMES, Feb. 2000 at 24, 25. The largest Burger King franchisee, Carrols Corp., is also a franchisor of Taco Cabana and Polio Tropical. CarrolsHalves 2nd-Q Net on 10.5% BK Comp-unit Slide, NATION'S RESTAURANT NEWS, Sept. 1, 2003, at 11. 2004] BEGUILING HERESY requirements thirty years ago. This paper sets forth a wide range of abusive practices found in hundreds of legal cases from around the globe and across franchise systems. The majority of cases cited are recent cases. Virtually all of the cases cited deal with abuse occurring after signing of the franchise contract; abuse not covered by federal disclosure rules. Franchisors use arbitration clauses and forum selection clauses to minimize franchisee claims of abuse and ensure that any claims made are kept out of publicly available records. In the face of these abuses, there is regulatory inaction and constraints on the ability of courts to rectify the abuses permitted under contracts of adhesion.3 Regulatory capture and the limitations of judicial intervention ex post are significant impediments to reining in franchisor abuse which must be addressed in the United States, as they have been in some foreign countries, by franchise relationship legislation. Any analysis of franchise regulation must take into account franchise realities, both with respect to the contract itself and the sophistication of the parties entering into the contract. As one court observed: 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