In my previous column, I introduced readers to the often shockingly one-sided and overly aggressive nature of a vast number of franchise agreements. Ronald K. Gardner, Franchising From the Franchisee Lawyer Perspective, Law.com (Sept. 27, 2019). In my next few columns, I want to explore the "undisclosed" or less obvious issues that exist in franchising. And while there are many places I could start, none is more critical, or more often abused, than vendor rebates.

For the uninitiated, a vendor rebate is exactly what it sounds like—i.e., a payment by a vendor based on purchases made from that vendor. Most frequently, this payment is made to someone in compensation for bringing volume purchases or exclusivity (or both) to the vendor. In essence, in exchange for meeting certain criteria, the vendor shares its profit with the customer to incentivize continued or higher volume business.

The Purpose of Uniformity

One of the putative benefits of franchising is uniformity. Customers learn to expect the same type of products and services from one location to the next, and through this type of uniformity, franchise systems can build loyalty and goodwill associated with the brand across locations.

This desire for uniformity lends itself to virtually all franchise agreements containing provisions that require franchisees to buy products and services from franchisor-approved suppliers of products. Indeed, this requirement is often packaged and sold as an advantage to buying a franchise, as prospective franchisees are told (sometimes in the franchise agreement itself) or otherwise led to believe that the franchisor uses the power of bringing many purchases as leverage with vendors in maintaining quality and getting the best price for franchisees through combined volume pricing. Often, the language of the agreement provides that the franchisor negotiates these deals "for the benefit of the system."

And, when franchisors actually go out and negotiate prices that are lower than an individual franchisee could get on her own, the system works as advertised. No franchisees complain about paying less for products, even if some of the money they are paying is being rebated back to the franchisor as part of the franchisor's deal with the vendor to make them an approved or exclusive supplier.

Profiting Off Other People's Money

Too often, however, "for the benefit of the system" ends up meaning "for the franchisor's profit at the expense of franchisees."

The abuse comes in several forms. First, and most obviously, franchisors will require franchisees to buy from "approved suppliers," and then will go to market seeking to sell this customer volume to the highest bidder, with little regard for either the quality or best pricing to the franchisees. Instead, the franchisor seeks out the vendor who will pay the highest rebate, irrespective of the price to the franchisees. This frequently results in franchisees paying higher prices than they could get on their own, as they end up paying the vendor its entire profit margin plus an additional amount that the vendor then "rebates" to the franchisor.

Another related avenue that is often abused is the direct or indirect sale of products and services to franchisees by the franchisor or its affiliates. When a franchisor makes itself or one of its affiliates the exclusive source for products and services, at a minimum, that means franchisees are paying a "hidden royalty" to the franchisor for the privilege of being in the system. It also removes the transparency that an open market typically brings to pricing and profit, increasing the likelihood for abuse. While franchisors will claim that the exclusivity requirement is necessary to maintain quality control, it is, in reality, a rare product or service that is not actually made better and less expensively in a competitive environment.

Finally, and perhaps most insidious, is the practice of franchisors acting as the sole source of supply for products and services that they acquire and resale to franchisees. Essentially doing nothing but being a middleman who is making a mark-up on the product, franchisors who engage in this practice can be tempted to make transactions with the franchisees a profit center at the expense of individual franchisees and overall system health.

For instance, I recently represented a group of franchisees in a small restaurant chain who faced the devastating consequences of this approach. At the outset of the system 30 years ago, the franchisor required franchisees to buy a few high-quality proprietary products from the franchisor, often products actually manufactured by the franchisor or containing special ingredients that were unique to the brand (think "11 herbs and spices."). Over time, however, the list of what the franchisor considered to be proprietary expanded to include every ingredient for every menu item, as well as the paperware used in the restaurant. And rather than manufacture and control the quality of products, the franchisor instead merely became a warehouse for all products and services the franchisee needed to run a restaurant. Quality on many issues slipped or was immaterial (think napkins). Eventually, the company was acquired by private equity and, later, went public. Demand for profit at the franchisor was intense. What happened then seems to be the obvious next chapter in this story.

In order to satisfy the need for more profit, the franchisor raised prices on all goods. Repeatedly. By the time the franchisees came to me, growth in the number of units had completely stopped, and franchisees were closing their doors at an alarming rate. A review of the franchisor's financial statements (which are required to be published as part of a franchisor's annual Franchise Disclosure Document (FDD)) quickly revealed that the franchisor was making roughly 400% more on franchisee purchases than on initial franchise fees or ongoing royalty payments. Working with a consultant, we determined that the average mark-up for generic products in this system was an astonishing 37% above the price franchisees could have gotten on the open market for the exact same products. And, when confronted with this evidence, the franchisor sheepishly admitted that while they knew this was likely bad for the long-term health of the system (it's bad when a franchisee is paying 40% more for white napkins than they would pay at Costco), the franchisor had become completely dependent on this profit center. The system was (and is) in peril.

A Regulatory Loophole Ripe for Abuse

While an existing franchisee has little recourse against this type of conduct, as courts have regularly rejected anti-trust tying claims related to these types of issues (see Queen City Pizza v. Domino's Pizza, 124 F.3d 430 (3d Cir. 1997); Bishop v. GNC Franchising, 403 F. Supp. 412 (W.D. Pa., 2005)), and the contract expressly allows it, one would hope that prospective franchisees would be told about this "hidden royalty" before committing to signing the franchise agreement. Unfortunately, because of the opaqueness of the system, and the virtually non-existent requirement of disclosure around this practice, one rarely gets the full picture before it is too late.

While Item 8 of the FDD does require that franchisors tell prospects that they may be required to purchase some products and services from the franchisor, franchisors are not required to disclose precisely which ones or what the price will be for such items. Nor are franchisors required to reveal the amount of mark-up on any particular product or the average amount paid by a particular location to the franchisor. Instead, what is required is a single number: the amount of money the franchisor collects, in the aggregate, from all of the franchisees' required purchases. That number is wholly unhelpful in determining the effect a franchisor's required purchases and pricing policies will have on a franchisee's profitability.

Franchisor advocates will tell you that franchisees can get this type of information on a more granular level from other franchisees. But this too is folly. In essence, what this suggests is that a complete stranger can call up any franchised business, tell the franchisee that the caller is considering buying into the system, and then ask questions about the franchisee's profit and loss statement, e.g., a business' most intimate details. Anyone who truly believes this leads to adequate disclosure is not being honest with themselves about the way the world works, or, more likely, doesn't want those looking to find the true details about what is transpiring underneath the singular number that is being provided in Item 8.

Currently, the FTC is considering a review of the Rule governing the sale of franchising. And while many of the current disclosure requirements are adequate for their purpose, Item 8 is in woeful, urgent and desperate need of revision. Vendor rebates have become an integral part of franchising and as noted above, in many systems, the primary way franchisors extract money from franchisees. Far more thorough disclosure of these practices is necessary to make informed decisions about committing to a long term venture like buying a franchise. Failure of the regulatory system to adjust to this reality will do nothing but invite further abuse.

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.