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From the beginning of business format franchising in the 1950s, franchisees and their advocates have expressed the need for protection against franchiser fraud, abuse and uneven bargaining power. In response, starting in the early 1970s, two types of laws have emerged: (1) disclosure and registration laws and (2) relationship laws. Disclosure laws were enacted to ensure that a prospective franchisee is provided certain important information about the business, the contract (franchise agreement) and the franchiser, before making its investment decision. By requiring a presale disclosure document, the opportunities for fraud decrease and the franchisee can make an informed decision before making a life-altering investment. Disclosure of the mandated offering circular is required to be made pursuant to the Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures (FTC Disclosure Rule). No federal filing or registration is required or permitted. In addition to the FTC Disclosure Rule, 14 states have passed legislation imposing some form of registration prior to the sale of a franchise. In an effort to protect its citizens from unsafe selling practices, these states require that the disclosure document be approved by state examiners prior to the franchiser being permitted to offer franchises for sale. The FTC Disclosure Rule pre-empts state disclosure laws which are inconsistent with the FTC Disclosure Rule or which provide less franchisee protection. To cover the period following sale, 19 states, including New Jersey, have adopted legislation regulating the ongoing franchise relationship in areas such as termination, renewal, standards of conduct, encroachment and choice of law, venue and forum. To date, no franchise relationship law of general application exists at the federal level. However, such legislation has been proposed a number of times, as early as 1971. Certain industries, such as the automobile and petroleum industries, do have federal legislation addressing specific areas of concern. In both the 105th and 106th Congressional sessions, the Small Business Franchise Act (SBFA) — which proposes a franchise relationship of general application at the federal level — has been introduced with bipartisan support. The SBFA was most recently introduced on Nov. 10, 1999, as H.R. 3308 by Howard Coble, R-N.C., and John Conyers, D-Mich., with 51 co-sponsors (27-R; 24-D). The SBFA addresses a number of areas, including (i) termination, (ii) covenants not to compete, (iii) duty of good faith, (iv) sources of supply and (v) encroachment, each of which this article will briefly discuss. PRIVATE RIGHT OF ACTION The SBFA creates a private right of action for anyone injured from a violation of the SBFA and anyone injured from a violation of the FTC Disclosure Rule. (Currently, courts do not recognize a private right of action for violations under the FTC Disclosure Rule.) Successful franchisees may recover not only damages, but also reasonable attorneys’ fees and expert witness fees from “any person found liable.” Liability extends to every person who directly or indirectly controls a person liable, which may mean officers, directors and principal shareholders of the entity. Like many of the state relationship laws, the SBFA prohibits a franchiser from terminating a franchise agreement without “good cause.” Good cause is defined as a breach of a material provision of the franchise agreement or other conduct by the franchisee, such as voluntary abandonment of the business or a felony conviction. Good cause also includes a franchiser’s decision to withdraw from the franchisee’s marketing area, provided it awards the franchisee appropriate damages. Although this rule may protect some “innocent” franchisees against termination, franchisers argue that the effect may be an inability to terminate inefficient and nonperforming franchisees, which would undermine the value of the franchiser’s trademark. NON-COMPETE CLAUSE One of the most significant sections of the SBFA eliminates non-competition covenants upon expiration of the franchise agreement. Most franchise agreements contain a provision that, following termination, the franchisee will not compete with the franchiser by using the methodology and know-how taught by the franchiser for its own benefit at the same location or in the same geographic area of the franchised business. Detractors argue that this section of the SBFA is too broad and will encourage misappropriation of franchiser intellectual property rights at the former franchised locations. Allowing the franchisee to compete at the same or nearby location could incentivize franchisees to break away from the franchise system and utilize the franchiser’s know-how. Franchisees assert that it is unfair to be told at the end of the franchise relationship, after committing many years and dollars to develop a business and creating valuable local goodwill, that they may not continue to operate in their marketplace. Rather than voiding noncompetition agreements, several states’ franchise relationship laws require a franchiser to compensate a terminated or nonrenewed franchisee for its sunk costs related to inventory, equipment and supplies. Under the SBFA, the franchise agreement will impose on each party a duty to act in “good faith” in the performance and enforcement of the contract. Good faith is defined as honesty in fact and the observance of reasonable standards of fair dealing in the trade. Thus, a cause of action may be maintained by a franchisee for a breach of good faith in the absence of an express contract provision being violated — which is contrary to the established law of many jurisdictions. The SBFA further provides that no provision in the franchise agreement can override the duty to act in good faith or otherwise allow a disparate result in the franchise relationship. The good faith section of the SBFA also contains a duty of care or competence imposed on the franchiser. The definitions and exceptions are fuzzy standards, which, if adopted, will certainly result in litigation. In many franchise systems, the franchiser will prescribe sources for supplies. The restrictions vary from guidelines or specifications to a pre-approved list of suppliers to mandatory purchases from the franchiser or its affiliate. The rationale for these “sourcing restrictions” is to provide for a uniform level as to the quality of goods delivered by the franchisee. Other advantages include more competitive pricing based on volume purchases. Some franchisers receive commission payments or rebates from suppliers, which may or may not be passed onto franchisees. SUPPLIERS The SBFA permits a franchisee to purchase goods and services from any supplier so long as the supplier meets “reasonable established uniform systemwide quality standards” set by the franchiser. If the franchiser designates a specific vendor of goods or services, it must approve no fewer than two vendors. If a franchiser receives any rebates or payments from suppliers due to franchisee purchases, such payments must be distributed directly to such franchisees. The franchiser is permitted to select an item for mandatory purchase only if the item is “central” to the franchise business and incorporates a proprietary trade secret. The purpose behind this section is to address franchisee complaints that purchase requirements are not appropriate when the same goods are often available from competitive sources at the same or better quality and at lower prices. Franchiser proponents argue that sourcing restrictions promotes competition against vertically integrated chains that do not have the same restrictions. ENCROACHMENT The SBFA also addresses the issue of encroachment — an area of law that has seen much litigation in recent years. It is a violation of the SBFA if a franchiser places a company-owned or franchised outlet within “unreasonable proximity” of an existing franchised unit, and the existing unit experiences a decrease in sales of at least five percent, within the first 12 months of the new outlet opening. A franchiser can avoid liability by offering the “encroached” upon franchisee 50 percent of the sales of the new outlet for 24 months. The burden of proof that the decline in the franchisee’s sales resulted from reasons other than the new outlet opening falls on the franchiser. From the franchisee’s perspective, the SBFA would alleviate some of the burdens in what are often one-sided contracts favoring the franchiser. In response to the argument that the franchisee must understand its investment because it received the mandated disclosure document, franchisees counter that the lengthy, complicated disclosure document only legitimizes the abusive provisions. In addition, the problem is exacerbated by the fact that the franchisee has no private right action for violations of the FTC Disclosure Rule. Franchisees assert that the vast disparity of economic power and bargaining strength cries out for governmental intervention. Franchisers argue vociferously that, if enacted, the SBFA will cause an increase in consumer prices, limit the variety of competitive goods and services and ultimately make franchised businesses more expensive for franchisees. Franchisers also submit that there has not been a sufficient demonstration of franchiser abuses of the franchise relationship to justify such broad legislation. Antitrust, trademark, common law contract and state laws are already in place to deal with any misconduct. If specific abuses are prevalent in a particular industry, then narrowly drafted legislation may be appropriate, but the SBFA, which supersedes private contracts in almost every aspect of the franchising relationship, unduly interferes with the right to freely contract. The SFBA will most likely be proposed in the 107th Congress and the debate will surely continue. Mark D. Shapiro is an associate at Ballard Spahr Andrews & Ingersoll LLP in Voorhees, N.J. His practice areas include franchise law.

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