Managing a Franchise System When 'Game-Changers' Arise

Few in the audience had done so ' and so far, those delays appear to be justified. “It's not a game-changer ' yet,” said Pearce, and he explained why. In the years since Leegin, it's become clear that federal and state authorities want to limit the scope of the decision. The U.S. Department of Justice, for example, has outlined strict tests for manufacturers and retailers to justify a minimum price through rule-of-reason analysis, and Maryland passed a law to specifically prohibit retail price maintenance programs. Given the push-back at the federal and state levels, franchisors are probably better advised to continue with “Minimum Advertised Price” programs, Pearce said.

Kevin Adler is associate editor of this newsletter.

One of the difficult balancing acts encountered by all franchise systems is between the relatively static nature of the franchise agreement and the dynamic, impossible-to-predict changes that occur in the real world. At the 34th Annual ABA Forum on Franchising, held in Baltimore on Oct. 19-21, two industry veterans with perspective as senior in-house counsel spoke about how in-house counsel can identify potentially “game-changing” developments and lead their organizations' response.

There are good reasons why franchise contracts have fairly long terms, said Joel Buckberg, formerly executive vice president and deputy general counsel for Cendant Corporation, and currently of counsel to Baker Donelson Bearman Caldwell & Berkowitz, P.C., in Nashville. Franchisees need to amortize the cost of purchasing a franchise and making bricks-and-mortar investments without undermining the short-term cash flow needed to grow the business. Also, franchisees find it easier to obtain necessary loans if they have a long-term contract in place. “But at the same time, markets are dynamic,” Buckberg said. “[Court] decisions change the landscape. Technology is constantly evolving. Consumer preferences change. Who would have thought five years ago that social media would be a major form of marketing for franchises?”

Franchisors need to reserve their ability to adjust in a competitive environment, while simultaneously providing franchisees with a level of stability represented by the franchise contract and strong brand. “How do you tell a franchisee who just signed a 15-year agreement that he has bought into a system that will be a different business model in five years?” asked Ted Pearce, vice president and general counsel, Driven Brands, Inc.

Driven Brands, which owns Meineke, Maaco, EconLube, Aero Colours, and other car-care brands, is a perfect example, Pearce continued. “We started in mufflers [Meineke]. People used to change their mufflers every three years ' not any more. Our business changed,” he said.

In the case of mufflers, change occurred because muffler technology improved. Other changes arise from alterations in the legal landscape, and in-house counsel must be especially attuned to those matters. Using as examples recent high-profile court decisions, as well as changes in state laws that might be copied by other states, Buckberg and Pearce engaged the ABA Forum attendees in a discussion of how to assess if a “game-changer” has arrived, and how to respond to it.

Sales Tax Reporting

One change that has not received a great deal of attention, but which potentially carries immense impact, is a tax statute enacted in New York state in 2009. The basic concept is franchisors must annually file information with the New York Department of Tax and Finance regarding their transactions with franchisees (which are considered vendors required to collect state and local sales tax in New York). Franchisors must collect and remit ownership and location information about every franchisee in the state, as well as each franchisee's gross sales, royalty payments, and state and local tax collections. “New York has essentially made each franchisor a tax auditor,” said Buckberg.

If the data collected and remitted by the franchisor conflict with tax information that franchisees have filed, substantial penalties can be imposed. In essence, the rule is putting franchisors in the position of “telling the state that a franchisee is a scofflaw and, possibly, opening them to criminal indictment,” said Buckberg. “As if the franchise relationship doesn't have enough tension already ' “

Complying with the law might conflict with language in the franchise contract, said Pearce. “Does your FDD promise confidentiality to franchisees about sales information, and does it conflict with this law?” he asked. “Does your compliance-with-all-laws provision in the contract allow you to do what New York requires?”

Franchises that do not have adequate point-of-sale (“POS”) systems might not even be able to collect the information adequately, despite the state's assumptions about the POS systems in use and that the franchisor's definition of gross sales is matched with that of New York state, said Pearce. To the extent New York's law opens the door for states to increase their sales tax collections, franchisors should be prepared for similar laws to be enacted elsewhere, he added.

Covenant Not to Compete

In 2009, in Atlanta Bread Company International, Inc. v. Lupton-Smith , 679 S.E.2d 722, 725 (Ga. 2009), the Georgia Supreme Court affirmed an appeals court holding that Atlanta Bread's broad in-term non-compete clause was too restrictive, and therefore not enforceable. The court cited the Georgia Constitution in voiding the covenant. Quickly, the Georgia legislature acted to negate much of the impact of a ruling that was seen as damaging to businesses in the state. In 2010, a constitutional amendment was passed by the legislature and ratified by voters to enact the new rights for businesses to impose restrictive non-compete covenants under some circumstances and to grant judges some “blue-pencil” discretion to modify non-compete restrictions (judges had not been permitted to blue-pencil the covenants previously).

The key take-home point for franchisors is that they cannot assume that brand-protection covenants will be enforced as written, said Buckberg. To be prepared, franchisors have to look at other options for protecting their system. Buckberg suggested that confidentiality agreements are one path to take, but he acknowledged the real-world difficulties in enforcing them. Better strategies might be to control the customer database and supply chain for the system's critical products, and to engage in continuous improvement of the system and support of the brand.

Franchisors As Employers

All franchise attorneys are familiar with the series of Coverall cases that have been decided in the last few years that have determined that some franchise formats in Massachusetts are really employer-employee relationships. Franchisors who believe that Coverall is the result of a unique set of circumstances ' a specific franchise model and a specific state ' should think again, said Pearce. “Brick-and-mortar franchises are probably not affected by a Coverall-type analysis, but franchises that are service businesses in which the franchisee is untethered to a location and for which the franchisor 'owns' the customers and provides back-office services might be seen in the same light,” he said. “These types of franchises become vulnerable, even as they become popular new business models.”

As an example, Pearce pointed to two decisions in Oregon courts, Gross d/b/a Rent-A-Nerd v. Employment Dept. , 240 P.3d 1130 (Or. Ct. App. 2010), and Employment Dept. v. Nat'l Maint. Contractors of Oregon, Inc. , 204 P.3d 151 (Or. Ct. App. 2009). In Gross/Rent-A-Nerd, a franchisee applied for unemployment insurance when he decided to stop operating his franchise. Franchisor Rent-A-Nerd challenged his claim of being an employee, but the court found that the franchisor exercised enough control over the franchisee that he could be considered an independent contractor. It noted that Rent-A-Nerd set the rates for its technicians, required that its invoices be utilized, and prohibited the franchisees from having direct contact with customers. The court called the franchise system “a functional equivalent of a sub-contract.” In Employment Dept v. National Maintenance Contractors, the janitorial franchisor NMC was held to be an employer of its franchisees, again based on how NMC controlled the client accounts.

For franchisors, the message is that trying to control every aspect of the system might tip the balance to an employer-employee relationship, notwithstanding disclaimers in the franchise contract. “Be careful how much control you exercise over day-to-day operations,” warned Pearce. “Also, it's probably not a good idea to be in the same business as your franchisee, and you might require franchisees to have corporate structures to create another layer between you and them.”

Resale Price Maintenance

Sometimes, a high-profile court decision leaves open the possibility of creating major change in commerce, but the change does not occur as quickly as anticipated. That seems to be the case with Leegin Creative Leather Products, Inc. v. PSKS, Inc. , 551 U.S. 877, 885-86, 127 S.Ct. 2705, 2712-13 (2007), a retail price maintenance decision that has not yet reached the status of a “game-changer,” according to Pearce. Leegin removed the consideration of minimum pricing from a per se argument to a rule of reason argument, a higher bar for opponents of minimum pricing to meet.

Initially, Leegin was viewed as a significant victory for franchisors (as well as manufacturers, distributors, and others) because it gave them the right to set minimum retail prices that their franchisees could charge; the question would be whether those prices were pro-competitive, such as through generating enough revenue to keep the franchise system strong. “Under Leegin, it appears that you can require a franchisee to charge a minimum price,” said Pearce. “Have you taken that information to your franchise's management?”

Few in the audience had done so ' and so far, those delays appear to be justified. “It's not a game-changer ' yet,” said Pearce, and he explained why. In the years since Leegin, it's become clear that federal and state authorities want to limit the scope of the decision. The U.S. Department of Justice, for example, has outlined strict tests for manufacturers and retailers to justify a minimum price through rule-of-reason analysis, and Maryland passed a law to specifically prohibit retail price maintenance programs. Given the push-back at the federal and state levels, franchisors are probably better advised to continue with “Minimum Advertised Price” programs, Pearce said.

Kevin Adler is associate editor of this newsletter.