Ronald K. Gardner

Imagine a client walks into your office wanting to get out of a contractual arrangement that they entered into three years ago. They explain that they are losing money, and that the contract makes no sense for them any longer.

In probing them, and reading the contract, you learn your client's business is essentially controlled by the other party. The contract dictates the most basic aspects of the business—the hours of operation and the training requirements of the employees. It gives the other party approval rights over who the manager will be; the layout and appearance of the location; and controls what products and services your client can sell. Digging further you find that your client had to buy all of the original FF&E from the other party, and once open, is required to continue buying all inventory from the other party and its wholly owned affiliates, all at prices that are above what your client could get on the street for the exact same products. And, beyond controlling the price of goods (by being the only seller of those goods your client is allowed to purchase from), the contract also allows the other party to control the retail price of the goods and services your client may offer as well. In sum, your client has little to no control of their own profit margin.

The financial terms surprise you. Your client paid $75,000 to be in this one-sided relationship, and continues to pay 8 percent of their gross revenue to stay in the relationship, irrespective of whether they are making any money.

The boilerplate terms are no better. Your client is required to indemnify the other party for anything that happens at the location, even if it is the fault of the other party (and the indemnification is not reciprocal). The contract expressly disclaims any obligation the other party has to act in good faith. The dispute resolution provisions give the other party the right to bring injunctions, but your client does not have that right. Your client's right to bring a claim is subject to a one-year statute of limitations, but there are no such limits on the other side. Venue and choice of law both favor the other party. And the attorney fee provision is also unilateral; the other party can get theirs if they win, but your client has no such stated right.

Finally, getting to the reason your client came in, you turn to the termination provisions. The agreement, which is for a 20-year term, while allowing the other side to terminate, inexplicably gives your client no right to terminate for any reason. And, if your client "breaches" by terminating because the deal just isn't working, your client is required to pay "future losses" equal to the amount they would have paid for the remaining 17 years of the agreement.

Welcome to my world. My name is Ron Gardner and I am delighted to have an opportunity to begin writing in these pages about franchising from the franchisee lawyer perspective. It's a perspective that readers here would occasionally get a glimpse of in the writings of my dear passed friend Rupert Barkoff. It's a perspective not shared by my good friend and world-class franchisor lawyer David Kaufmann. But it is real.

The agreement I just described to you is a very typical franchise agreement. And while franchising works for a lot of people, when it doesn't work, the system has evolved to a place where it is the franchisee that carries the vast majority of the financial risk—for it is the franchisee that holds the lease or the mortgage, the franchisee that owes the taxes, and the franchisee that signs the personal guarantees with the lenders, the SBA, and, almost always, the franchisor. When a franchise location doesn't work, even if everyone recognizes that it has nothing to do with whether the franchisee ran the business in a prudent manner, the franchisor loses one location that was paying a royalty. The franchisee, on the other hand, loses not only their income and their business, but they stay on the hook for the debts that mounted while the business was failing. Bankruptcy is typically the predictable outcome.

Surprisingly, legislators and regulators in most states and at the federal level have done little to address this problem. Only 13 states regulate the franchise relationship after the agreement is signed (approximately 16 have some sort of requirements for disclosure before signing—more on the weakness of that process in future columns). And the applicable federal regulation, known in franchising as the FTC Rule (16 CFR Parts 436 and 437), has no private right of action. That is important because the FTC hasn't seriously pursued over-aggressive franchisors for over 15 years. In other words, no one is minding the regulatory store.

Despite all of this, what one does see in the headlines are claims by defenders of franchisors that recent potential protections for independent contractors "threaten" the franchise model. In the past few years, this claim has been asserted around the issue of an expanded definition of a "joint-employer" and more recently, the effort by California to protect Uber drivers by classifying them as employees.

In its 2015, in an attempt to expand the definition of a "joint-employer," the National Labor Relations Board, in BFI Newby Island Recyclery, 362 NLRB No. 186 (2015), adopted a change to the definition of who was an "employer" to include anyone who exerted "indirect control" over the activities of an employee. Arguably, this meant that franchisors, whose franchise agreements give them all sorts of rights to control the activity of franchisees' employees, could be found to be joint-employers if the employee made a workplace-type claim against the franchisee (e.g., wage and hour claims, harassment claims, etc.). But rather than recognize that an easy solution would be to loosen the reins that they have over the operation of the "independently owned and operated" businesses of their franchisees, franchisors have worked feverishly in an attempt to lessen, and ultimately reverse the "indirect control" standard. See Browning-Ferris Industries of Cal., v. NLRB, No. 16-1028 (D.C. Cir. 2018). This effort all came despite the fact that the indemnification clauses in most franchise agreements would have insulated them financially from any negative impact of this classification.

The same sort of hue and cry is beginning to arise as a result of the passage last week in California of Assembly Bill 5. Under this legislation, which Gov. Gavin Newsom has signed, an effort is being made to redefine independent contractors, such as Uber and Lyft drivers, as employees unless: (1) the individual is free from the control and direction of the other party in connection with the work, both under contract and in fact (franchisees are typically not so unencumbered); (2) the individual performs work outside the usual course of the contracting party's business (franchisees are most often required to engage in no other business but that of the franchise); and (3) the individual is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed (franchisees are virtually always prohibited by in-term and post-term non-competes from being independent in any way). But again, rather than seizing the obvious solution of letting franchisees actually be independent and run their own businesses as they see fit, franchisors and their advocates are again ramping up their claims that the world will come to an end if this legislation is not promptly mitigated.

From where I sit, the efforts to avoid any type of regulation will ultimately backfire. The overreach in the typical franchise agreement will cause a need for correction at some point, and as is the case with most corrections that come from legislation and regulation, over-correction is a real risk. Franchisors and their lawyers would be well advised to consider that as they continue to exert more and more control over their franchisees.

Ronald K. Gardner is a partner at Dady & Gardner, P.A. He limits his practice to the representation of franchisees, dealers and distributors when they are in disputes with their franchisors, manufacturers and suppliers.