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FRANCHISE LAW ARTICLES

AMERICAN ASSOCIATION OF FRANCHISEES & DEALERS

2004 ANNUAL MEETING
“WIN-WIN” FRANCHISING
April 28 - May 1, 2004
Philadelphia, Pennsylvania

TEN LEGAL ISSUES FACING NEW AND ESTABLISHED INDEPENDENT FRANCHISEE ASSOCIATIONS

Presented in conjunction with the National Franchisee Leadership Conference and the seminar:

“HOW INDEPENDENT FRANCHISEE ASSOCIATIONS CAN EFFECTIVELY INFLUENCE FRANCHISOR BEHAVIOR”

Carmen D. Caruso

Schwartz, Cooper, Greenberger & Krauss, Chtd.
180 North LaSalle, Suite 2700
Chicago, IL  60601
(312) 516-4489
ccaruso@schwartzcooper.com

INTRODUCTION

 SEQ CHAPTER \h \r 1Some independent franchisee associations[1] are dramatically more effective than others in recruiting members, addressing issues, staying “on message” and effecting change.  Obviously, the most effective associations have the greatest potential to positively influence franchisor behavior for the greater good of the entire system.  Consistent with its Total Quality Franchising mission, the AAFD believes that every association can become more effective regardless of system size.  As a starting point, every current and future association leader and every franchisee should have a working understanding of the legal principles that govern associations.  To that end, we present short answers to ten key questions:[2]

1.      Why have Associations been limited in their effectiveness, thus far?

2.      How do we get our Association off the ground?

3.      Should franchisors be permitted to participate in the Association’s affairs?

4.      How can the Association gain recognition by the franchisor?

5.      Do franchisees risk liability merely by joining an Association?

6.      What are the legal protections for franchisees who wish to join but fear retaliation?

7.      What are the antitrust restrictions on the Association’s actions?

8.      Are there practical or legal limits on collective bargaining?

9.      What other actions are lawful and worthwhile?

10.  How does an Association protect its members in litigation?

CONCLUSION:  Reaching the WIN WIN!

***

1.      Why have Associations been limited in their effectiveness, thus far?

For better or worse, franchisees often compare their associations to fledging labor unions in the early days of the Industrial Revolution.  At heart is the sentiment that better days must surely lie ahead, and that someday, association membership will approach 100%, and franchisors will routinely bargain with association leaders.  We regret to report that the labor union analogy is faulty.  Long ago, labor unions won a legislative exemption from the federal antitrust laws as well as statutory protection for the rights to organize and collectively bargain, which is backed up by the threat of a strike or walk-out.

By contrast, only eleven states have enacted statutes that (to varying degrees) protect a franchisee’s right to join an independent association.[3]  None of these statutes are recent, an indication that legislative momentum has stalled, at least for the moment.  None of these statutes come remotely close to the rights granted by the federal labor laws.  The future success of independent franchisee associations will come from the efforts of dedicated leaders, and from improved communication in forums such as the AAFD so that the secrets of success can be disseminated and shared.

2.      How do we get our Association off the ground?

Associations are usually formed when a core group of leading franchisees resolve to do so, often in response to a crisis or festering dissatisfaction, and often as a system’s earliest franchisees near the end of their initial terms.  There is always a gap between talk and action.  In this process, the leaders must communicate to all existing franchisees, stating the desire to form the association and inviting participation.  The communication should be framed with the knowledge that this communication will almost certainly reach the franchisor, and thus, this is the first opportunity to present an upbeat message, which is going to be the first step to a WIN WIN relationship.  Assuming the communication generates interest, an organizational meeting is scheduled, after which someone must actually create the association. 

Independent associations are typically incorporated as not-for-profits corporations.  The benefits of incorporation include the insulation of individual members from corporate liabilities.  However, every fledging association has the option of organizing in the first instance as an AAFD Chapter, with incorporation to follow as the association grows.  Once a decision to incorporate is made:

§           The incorporators must select a state in which to incorporate, which may be the state with the largest number of franchisees, or where the first leaders reside; or the decision may be based on tax issues (as single brand associations are not exempt from income tax, which generally means that associations do not want to have significant income in excess of expenses).

§           The incorporators (or the founders of an AAFD Chapter) must select a name, which ideally will incorporate the trade name of the franchise, which ideally will be obtained by consent of the franchisor.  If consent is not obtained, the name should not be usurped.

§           The incorporators must state the purpose of the Association (or Chapter), which is generally to engage in lawful activities to promote and protect the economic and legal rights of its members.

§           The incorporators must select the first directors, who should be selected with some measure of democracy among franchisees. 

§           The initial Board of Directors must adopt bylaws, which will serve as a constitution.  They establish the rules that the association must live by, a dues structure, membership criteria, and voting rights.  Bylaws should be drafted by a lawyer and should be given careful thought.[4]  If there are ever disputes within the group, the bylaws should be followed without exception.

§           The Association will need officers including, at a minimum, a president, treasurer and secretary.  The officers need not necessarily be franchisees.

§           The Association must hold annual meetings and comply with all corporate formalities.

§           The Association (or Chapter) must also implement good communication procedures such that members are kept informed of Association issues and progress.

3.      Should franchisors be permitted to participate in the Association’s affairs?

Speakers at the most recent ABA Forum on Franchising reported that there is some historical precedent for allowing the franchisor to participate in an Independent Association, either by having a reserved seat on the Board of Directors or by allowing company-owned stores to join as members.  See, Spandorf and Barkoff, “Close Encounters:  Franchisee Association and Councils”, 2003 ABA Forum on Franchising (hereinafter cited as “Spandorf and Barkoff”).  This is generally not advisable from the franchisee viewpoint, as it inevitably threatens the association’s independence.

4.      How can the Association gain recognition by the franchisor?

Recognition by the franchisor is critical to the success of an association, and that recognition is usually obtained despite any initial reluctance.  Franchisors typically create Franchise Advisory Councils (FACs) in an effort to provide franchisees with a voice in the system, in the hope that an independent association will never become necessary in the eyes of the franchisees.  Nonetheless, Spandorf and Barkoff report that when presented with an independent association as an accomplished fact, most franchisors have been willing to acknowledge the association, particularly when they understand that the association has support beyond its organizers (and even if membership is less than 50% of the franchisees).  Enlightened franchisors are willing to engage in at least some degree of communication with the association.

5.      Do franchisees risk liability merely by joining an Association?

Most emphatically, the mere fact that a franchisee joins an association, attends meetings and joins in association activities does not, in itself, create any risk of liability to the franchisor (or to anyone else).  Even if the association as a whole were determined to have acted illegally, the resulting civil or criminal liability would not extend to any individual officer, director or member of the association absent proof that the individual had actual knowledge of, and participation in, the violation.

6.      What are the legal protections for franchisees who wish to join but fear retaliation or liability?

Franchisors lack the power to prohibit association membership.  In eleven states noted above, the right to join is statutorily protected.  Franchisees in these states are naturally emboldened and could be expected to take the lead in organizing their associations, although this is not always the case in practice.  More importantly, the United States Supreme Court has recognized a fundamental right of individuals to associate for lawful purposes, and therefore, any contractual attempts to preclude franchisees from associating for lawful purposes through the inclusion of “no association” clauses in the franchise agreement arguably violate public policy.  For that reason, such clauses are now rare.

The more realistic fear often held by franchisees is that the franchisor might retaliate against the organizers and leaders of a franchisee association in making a myriad of discretionary decisions such as the enforcement of system standards, audits, expansion, renewal, or placement of new outlets.  The fear of retaliation has caused some associations to keep the identity of its members a secret from the franchisor.  Certainly this is a sign of an unhealthy relationship, and is not desirable – and it is not inevitable.

Even in the thirty-nine states that lack statutory protection, abusive and retaliatory discretionary decisions can be successfully challenged under the implied covenant of good faith and fair dealing.  Where the retaliation is provable, the franchisee will have a very good case that would appeal to judges and juries alike.  Only a foolish franchisor would allow itself to be caught in an act of retaliation.  Nonetheless, any franchisee association has a vested interest in selecting the best and brightest of the franchisees for leadership and spokesperson positions.  The strongest franchisees, who are in compliance with system standards, are in the best position to not only withstand potential retaliation, but to deter retaliatory efforts in the first place.  Even more, selecting the best and brightest franchisees for leadership roles is a key step on the road to WIN WIN relationships, as the franchisor will have a strong incentive to deal with those franchisees that are its greatest source of profit.

To be sure, the fact that a franchisee has established legal remedies for retaliatory conduct may be small comfort for any franchisee whose investment is at risk in the first instance.  Therefore, the AAFD believes that it is critical for franchisee associations to present themselves as part of the WIN WIN solution to the problems of the particular system and not as a band of troublemakers who seek to usurp the franchisor’s role.

7.      What are the antitrust restrictions on the Association’s actions?

In general, the antitrust laws seek to prohibit conduct by competitors in the marketplace that is deemed to have an anti-competitive effect at the consumer level, either by causing the consumer to pay higher prices, or restricting the consumer’s choices, or otherwise forcing the consumer to pay more and receive less.  The antitrust laws in the United States seek to protect competition at the consumer level as opposed to protecting competitors from each other.  Antirust violations fall into two broad categories:  per se and “Rule of Reason” cases.

“Per se” violations

The courts have recognized that certain conduct, by its very nature, is anti-competitive, and have held that such conduct is a “per se” violation of the antitrust laws.  Where per se illegal conduct is alleged and proven, the antitrust violation is established without requiring proof of an actual anti-competitive effect.  The following type of conduct must be avoided at all times by any group of franchisees, whether or not they are organized as an association:

a.       Price-Fixing:     Franchisees must not set their retail prices in concert with each other.[5] 

b.      Market Allocation:          Since each franchisee is a “horizontal” competitor of each other, franchisees may not divide territories or customers among themselves, and likewise the associations cannot allocate the market among its members.  

c.       Group Boycotts against the franchisor or suppliers:        Where horizontal competitors agree among themselves that they will not do business with the franchisor or a particular supplier, they are at risk of either per se or “Rule or Reason” liability (discussed below).[6] 

“Rule of Reason” Violations

Beyond the per se prohibitions, other conduct may or may not be illegal depending upon the circumstances, which are assessed in a complex legal analysis known as the “Rule of Reason” which seeks to determine whether the anti-competitive effects of the practice outweigh its pro-competitive effects.  “Rule of Reason” violations are difficult to prove and such claims are rarely brought.  Nonetheless, franchisee associations and their leaders should obtain competent legal advice before proceeding in these sensitive areas:

a.         Group Boycotts against other franchisees:          Associations must be careful in refusing to admit an unpopular franchisee to membership, if the excluded member is able to identify a competitive disadvantage (e.g. access to favorable terms from a supplier) from the exclusion.  Membership criteria, admission and expulsion practices are suspect.

b.         Collaboration on Business Methods such as methods of distribution, or terms or conditions of sale.  These discussions are more appropriately conducted through the franchisor.

8.      Are there practical or legal limits on collective bargaining?

The AAFD Fair Franchising Standards are predicated on the belief that a strong independent association has the best opportunity to negotiate fair agreements and related system standards on behalf of its members.  Contrary arguments that any collective bargaining would violate the antitrust laws appear to be unfounded in light of the purpose of the antitrust laws as well as the lack of any such adverse action taken against the franchisees. 

It is no secret that franchisors often resist an association’s attempt to collectively bargain, and there is no law to compel cooperation.  As a practical matter, franchisees that are united can force a collective negotiation even if the franchisor wants to pretend it is negotiating “one at a time.”  The success of this strategy may depend on the existence of courageous franchisees who are willing to make themselves the “test case” and to allow the association (or its attorney) to speak on their behalf.[7]

As a caution, franchisors may challenge attempts at collective bargaining as a threatened group boycott, i.e. a threat by the association members to withhold royalties, or to leave the system if their demands are not met.  Such threats could also constitute interference with contract.  Prudence cautions, therefore, that associations should not be threatening the equivalent of a “strike” or “walk-out” by all the franchisees.  Such a threat is likely to be empty, anyway. 

There is presently a lack of judicial authority on the extent to which franchisee associations can attempt to negotiate “price” (i.e. royalties) with the franchisor.  Franchisees have an argument that such conduct would not be illegal, since there is no horizontal price-fixing involved in a negotiation with the franchisor.[8]  However, franchisees lack the remedy of going on strike, and are subject to group boycott charges in this sensitive area.

9.      What other actions are lawful and worthwhile?

a         Lobbying:   Our right to “freedom of speech” under the First Amendment to the U.S. Constitution has given rise to the “Noerr-Pennington” doctrine (from Supreme Court cases with those names), which allows associations to petition the government on matters of concern, such as the passage of franchising laws or changes to the FTC Rule.  The same principle allows franchisee associations to litigate (i.e., petition the government through its courts), as discussed further below.[9]

b        Trade Shows:  Franchisee associations may sponsor trade shows.

c         Exchanging Information:   Franchisee associations may publish newsletters or otherwise disseminate information about their industry.

d        Joint research:         Franchisee associations may engage in research that does not lead to price fixing.  Many effective associations have sponsored both franchisee and customer surveys that have led ultimately to improved communications between the association and the franchisor.

e         Joint Advertising:      Franchisee associations may sponsor joint advertising and marketing programs for the benefit of all members.

f          Cooperative Purchasing:  The prohibition on group boycotts does not preclude an association from negotiating favorable terms from suppliers.  The extent to which franchisor involvement may be required will vary.

g         Mentoring:  Many associations develop effective mentoring programs to build the quality within the franchise systems, and these programs can often lead to cooperation and respect between the franchisor and the association.

10.  How does an Association protect its members in litigation?

There are three ways in which franchisee associations have attempted to protect the interests of franchisees in litigation or arbitration (collectively “litigation” for the purposes of this presentation):

a.         Funding individual litigation:  The Association may decide to provide funding for the defense of one or more individual franchisees, who litigate in their own name as either the plaintiffs or defendants, or both.  The Association may determine, for example, that the issues raised by the individual litigation have implications for the entire system, thus justifying system-wide funding.  This type of funding is often discussed, but in practice it is usually difficult to convince other franchisees to fund someone else’s fight.  In situations where this has worked, litigation trusts have often been created.  This allows the collection of funds that are earmarked for the litigation.  The AAFD has served in this capacity as trustee over such funds.  There is not a uniform contract or trust document that would apply to all situations.  Inevitably, the relationship between the litigating franchisee and the Association (or other funding franchisees) would have to be negotiated, with issues such as the extent of the contribution, as well as the allocation of any proceeds of victory, and possible sharing of the risks of defeat, would have to be determined.  In this situation, legal counsel for the Association would have a conflict of interest with the litigating franchisee, resulting in the likely need for outside trial counsel.

b.         Standing of the Association to sue or be sue as the representative of its members.  Association standing depends generally on three factors:  (1) Whether the members of the Association would have standing to sue in their own names; (2) Whether the issues presented are germane to the Association’s purpose in protecting and enhancing the economic rights of its members; and (3) Whether the claims asserted or the relief requested by the Association requires the participation of individual members (in other words, is the Association capable of adequately representing the interests of its members in the case).  Applying these rules, association standing is particularly appropriate where the association seeks prospective relief such as a declaration of rights under the applicable franchise agreement or applicable laws, as opposed to seeking damages for claimed breaches of contract or for other wrongful conduct. 

It is critical, however, that all members have the same language in their franchise agreement with respect to the particular issue(s) in the case, as well as any interrelated clauses.  If the franchise agreement has evolved over time, as is very common, it may be much more difficult for the association to assert standing on behalf of different members with different agreements, who would have to make different arguments or seek different relief.

Franchisors almost inevitably mount a vigorous challenge to association standing on one or more grounds, including contentions that the Association does not adequately represent all of the franchisees or dealers.  For example, if the Association represents less than 100% of the franchisees, the franchisor might obtain affidavits from non-members, who assert disagreement with the Association’s position.  Or, the franchisor might obtain such affidavits asserting disagreement from members of the Association who happen to dissent on the particular issue.  However, there is generally no requirement of unanimity, and the standing should be permitted so long as the Association’s actions were duly authorized by its board of directors acting in accordance with its bylaws.[10]  The franchisor is also likely to argue that the claims are individualized, making the presence of individual members essential, which would defeat associational standing.[11]  In an effort to overcome these objections, franchisee associations must plan their litigation strategy very carefully in an effort to distill the exact relief that will withstand scrutiny on the standing issue, while providing enough benefit to make the effort worthwhile.  Once the association succeeds in its lawsuit, the result would be binding on the franchisor, and individual franchisees could then bring their own claims for damages, as appropriate, taking advantage of the Association’s victory.

c.         Class Actions are a third way for an association to fund litigation on behalf of its members.  A discussion of class action litigation is beyond the scope of this presentation.  Suffice it to say that class litigation and association standing cases are both very complex, and require a commitment to the intricacies and expenses of procedural warfare.  Drawing from the lessons of the Meineke litigation in the late 1990’s, it is critical for franchisees to carefully examine proposed “classes” of franchisees at the outset of the case and determine that the representative members can adequately represent all class members, and that there are no conflicts of interest between the classes or subclasses.

CONCLUSION

REACHING THE WIN-WIN!

As lawyers, we believe that Teddy Roosevelt’s famous carrot and stick approach to negotiation is particularly applicable to franchising.  For the carrot, the most successful associations will  offer value not only to their franchisee constituents, but also to the franchisor including:

§           Economic incentives in the form of a system that will be more profitable for the franchisees, thus generating more royalties and likely increased franchise sales.

§           The prospect of resolving disputes at the bargaining table instead of the courtroom, and thus an ally in reducing unwarranted tensions in the system

§           A shared commitment to building the value of the brand.[12]

For the stick, the threat of litigation will remain the inducement to bring reluctant franchisors to the negotiating table.

Beyond these truisms, we the lawyers must learn from you the leaders as we go forward together on the WIN WIN path. 

CARMEN D. CARUSO

Carmen D. Caruso is a Chicago trial and appellate lawyer who engages in complex franchise and distribution litigation throughout the United States.  He has represented or advised franchisees and dealers in more than fifty (50) brands and systems in numerous industries including hospitality, restaurant, automotive aftermarket, automotive dealership, retail, convenience store, health care, Internet, education, and insurance restoration.  He has also represented select franchisors and distributors including McDonald’s Corporation, Pillsbury Company (Godfather’s Pizza), General Binding Company and Petland, Inc.  He has successfully litigated franchise law claims including statutory violations, fraud, contract, trademark, and antitrust claims arising in myriad areas, for example, in the areas of disclosure, site selection, encroachment, advertising funds, national account referrals, franchise sales, transfers, terminations, renewals and the enforcement of post-termination non-compete clauses.

Carmen has represented Independent Franchisee Associations and significant franchisee and dealer groups in both litigation and non-litigation matters, in the following brands:  Naked Furniture, Verlo Mattress Factory, Merlin Mufflers, Jake’s Pizza, Bang & Olufsen, and (as local counsel) Culligan.

Carmen was admitted to the Bar in 1983 after his graduation from Loyola University of Chicago School of Law (J.D. 1983) and Marquette University (B.A. 1980 cum laude).  He is a member of the Chicago and American Bar Associations (Section of Litigation and Forum on Franchising) and the Association of Trial Lawyers of America (Section on Commercial Litigation).  

Carmen is now a Principal in Schwartz, Cooper, Greenberger & Krauss, Chtd., a full-service business  law firm in Chicago.