WikidFranchise

with the difficult concrete task of resolving franchising disputes on the basis of incomplete contracts I focus first on the economic dynamics created by uncertainty, sunk costs and the allocation of control within the franchise relationship. I argue that these dynamics structure the central commitment problems facing franchisee and franchisor as they endeavor to secure their exchange. Consequently, judicial efforts to identify the obligations created by the franchise contract should be directed at determining if and how these commitment problems have been addressed by the parties. It is at this juncture that the norms of the franchise relationship become important: Where there is no explicit contractual term supplying commitment, where the written contract appears incomplete, courts must look to the norms of the relation itself to see if they functioned to supply needed commitments. Relational norms should not be imposed on a particular relationship simply because such norms overcome commitment problems.11 But the courts should determine the likelihood that the contracting parties themselves implicitly or explicitly relied on the relational norms to supply the commitments they could not reduce to written form. Thus relation becomes important because it contributes directly to the obligations exchanged by franchise and franchisor at the formation of their contract; respecting the parties’ control over their relationship means that obligations must be understood to have arisen not only from the written document but also from the relation itself. By integrating economic and relational analysis, this paper argues that courts systematically enforce franchise contracts in a manner that diminishes rather than augments their appropriate function as a means to overcome the central commitment problems that threaten the creation of franchise relationships. In particular, court enforcement systematically defeats the relationally reinforced expectations of franchisees as to what commitments they acquire from the franchisor in exchange for their own commitments. Courts can adequately promote the use of contracts to structure these relationships only by incorporating the relational and economic structure of the franchising arrangement directly into the interpretation and enforcement of contractual commitments. The organization of the paper follows directly from this emphasis on the need to integrate the economic, relational and doctrinal features of franchising. Section I examines the institutional features of the franchising industry, answering the question, “What is franchising?” Section II analyzes the formal legal structure of franchising, focusing specifically on the contents of written franchise contracts. Section III then moves to the economics of franchising, elucidating the fundamental economic features of the relationship and its attendant bargaining and commitment problems. Section IV shifts to the informal content of the franchise relationship. Here, the paper extracts “relational” norms of franchising relevant to dispute resolution. Section V examines the nature of the franchising disputes that courts resolve, relying on the institutional, relational, and economic analyses of the previous sections to illuminate the problematic features of these disputes. Section VI critiques the current method of resolving these disputes and analyzes how a relational approach to contract interpretations can aid in their resolution. I. THE FRANCHISING INDUSTRY A. Definition The threshold problem of defining “franchising” plunges us immediately into the complexity of this modern organizational form. Franchising is a method of structuring a productive relationship between two parties in which both contribute to the production or distribution of the product or service.12 There are, of course, many such relationships. Here I consider the continuum of such relationships along two key dimensions: ownership and control.13 At one end of the continuum is the ordinary employment in relationship, representing a concentration of both ownership and control. In the typical employment relationship, the employer owns essentially all of the assets that produce the fruit of the relationship (except for the employee’s personal assets) as well as the products of the relationship, either tangible goods or revenues. In addition, the employer exercises complete control; she decides what actions both parities will take in the course of the relationship and how the assets of the relationship will be employed. At the other end of the continuum is the ordinary, independent contracting relationship, representing a diffusion of both ownership and control. In this relationship, the parties each own some of the assets that contribute to production. Both parties exercise control as independent decisionmakers with respect to their own assets and actions. The contract creating the relationship sets out concrete obligations on the part of both individuals, which will, of course, influence how each exercises authority. As is readily apparent from the definition of these endpoints, relationships can quickly blend into a combination of the two. Sometimes an employment contract objectively defines specific employee obligations, making the employee more of an independent contractor along the control dimension: The employer is no longer free to determine employee actions. In comparison, the independent contractor becomes more like an employee along the ownership dimension when the only assets owned by the contractor are personal assets, such as a consultant’s know-how, or along the control dimension when the obligations created by the contract grant the other party significant discretion over the contractor’s actions. Franchising relationships characteristically lie in the intermediate range between employment and independent contracting. With respect to control, franchising relationships are closest to the employment end of the continuum: the franchisor typically exercises significant amounts of relatively unrestricted decisionmaking authority.14 With respect to ownership, however, franchising is much closer to the independent contracting model: the franchisee typically owns the bulk of the assets that contribute to producing the fruit of the relationship. Often the franchisor contributes nothing beyond the design for the product and relationship, perhaps represented by a trademark, and organizational capital.15 A “pure” franchising relationship would be one in which ownership resided completely in the franchisee and control completely in the franchisor. This characteristic allocation of ownership and control is the key feature of franchising that a coherent legal framework must recognize. B. Background Firms engaged in franchising16 made sales of $591 billion in 1987,17 approximately one-third of all retail sales made that year in the United States.18 The bulk of these sales occurred through the franchise system with the longest history: auto and truck dealerships, accounting for $306 billion.19 The retail sale of gasoline, another long-standing franchise arrangement, accounted for $95 billion. 20 The type of franchise that most readily comes to mind for most people, fast-food, accounted for $58 billion when combined with other franchised restaurants.21 Franchised convenient stores made $13 billion in sales; soft drink bottlers, $20 billion; franchised auto products stores, another $13 billion.22 What may be surprising is the size of the residual “other retailing” category: $87 billion in sales in 1987.23 It is in this category that much of the growth in franchising now occurs.24 While 2.5 percent of franchisors, mainly fast-food outlets, car dealerships, and gas stations, account for 48 percent of sales and 49 percent of outlets in franchising,25 the adoption of franchising has spread to a wide variety of products and services. Some observers, such as the U.S. Department of Commerce,26 classify any relationship in which a retailer operates under its supplier’s trademark as a franchise. Under this definition, many distributorships – of snack foods, beer or soft drinks, for example – are “franchises.” In many of these cases, however, the distinctive separation of ownership and control that I identified above is missing. For example, a soft drink bottler who has acquired exclusive rights to distribute a given brand may retain almost total control over the distribution assets it owns: where to locate, how often to deliver, or how much to advertise. For the purposes of this article, such a relationship (often referred to as product or tradename franchising 27) will not be considered a franchise. The type of “franchising” that is characterized by a separation of ownership and control is known as “business-format” franchising.28 As its name suggests, in this type of franchising the franchisee operates under a business format structured entirely by the franchisor. The franchisor provides the marketing concept, product ideas and design; it develops procedures for delivering the product; it creates operating manuals; and it sets quality standards.29 The franchisor may or may not supply the actual product; the distinguishing characteristic is that the franchisee is under the control of the franchisor and thus is instructed how to run her business much as an employed manager would be. At the same time, however, most franchisees are not simply managers; they are also owners and investors. While the bulk of franchisees own a single franchise outlet,30 a small percentage31 are master franchisees with rights to sub-franchise within their (normally larger) territory. Other franchisees own several outlets directly and hire managers to operate their outlets. Some may own multiple franchises, each with different partners and other investors. Most notably, franchisors do not bear a significant share of the capital cost or risk setting up franchised outlets: Franchisees report that their own savings are the most frequently used source of funds for their first franchised unit. However, banks which are employed as a source of funds by 56% of franchisees are a source of a larger proportion of the total funds initially invested than are personal savings, 40.2% compared to 28.1%. Franchisors contributed, in the form of notes on equipment, signs, supplies, and so on, an unexpectedly low portion (8.7%).32 The franchisee purchases or leases virtually all of the franchised outlet’s capital equipment. The franchisee also typically owns or leases both the land and the space from which the outlet operates,33 although several franchise companies – notably some fast-food restaurants such as McDonald’s – own the land on which the outlets sit and lease it to the franchisees. 34 Often, the franchisee also pays an up-front franchise fee to the franchisor for the privilege of operating under the franchise system. Altogether, the initial capital investment required to become a franchisee ranges form a few thousand dollars to set up a tax service to over half a million dollars for a fast-food outlet to several million dollars for a hotel. Table 1 sets out some estimates of initial capital requirements for a range of franchises: TABLE 1 INITIAL CAPITAL REQUIREMENTS FOR VARIOUS FRANCHISES 35 Franchise Estimated Initial Capital AAMCO Transmissions $85,000 Dunkin’ Donuts $16,000–32,000 5 Minute Oil Change $6,975 7-Eleven $23,560 Western Auto $50,000 Ernie’s Wine and Liquor $100,000 Dollar Rent-A-Car $100,000 Old Uncle Gaylord’s $70,000-125,000 Kenneth of London $60,000-95,000 Arthur Treacher's $140,000 Best Resume Service $5,000-25,000 Burger King $150,000 H&R Block $1,000-2,000 Domino’s $36,000-64,300 Telecheck Services $195,000 My Pie International $300,000 Ron’s Krispy Fried Chicken $350,000 Wendy’s $500,000 The Athlete’s Foot $77,500 Fat Fighters $29,950 Modern Bridal Shoppes $12,000-35,000 Nutri-System $51,500 Kwik Kopy $58,500 Snap-On Tools $5,000 Century 21 Real Estate $10,000 New England Log Homes $100,000-125,000 Mary Moppet’s Day Care $45,000 Barbizon Schools of Modeling $25,000-50,000 Acme Personnel Service $9,000-19,500 Dootson Driving Schools $20,000 Manpower $50,000 While franchisors do not generally share in the investment in an outlet, they do share in its revenues in exchange for their contribution of a trademark and business format. The franchisor can collect revenues in several ways. If the franchise involves the outright sale of products to the franchisee, the wholesale price will ordinarily include a mark-up over cost representing the manufacturer’s return. Often, the franchisor collects an up-front franchise fee from new and renewed franchisees. Many franchisees pay ongoing royalties to the franchisor, normally based on gross revenues. 36 Franchisors also can collect fees from franchisees for specific services, such as advertising, bookkeeping, management consultation, employee training, location selection, or providing the location itself. 37 In addition, franchisors may receive commissions from approved suppliers of their franchisees. 38 Franchisors may also profit from franchising by directly owning and operating a fraction of the outlets in their system.39 In 1987, the U.S. Department of Commerce counted 90,952 company-owned outlets out of a total of 498,495 outlets.40 The percentage of company ownership varies considerably by industry, as may be seen in Table 2. TABLE 2 COMPANY OWNERSHIP OF OUTLETS41 Industry Percentage Company-Owned Convenience Stores 58 Restaurants 30 Non-Food Retailing 23 Auto-Truck Rental 22 Hotels 14 Auto Products 13 Bottlers 10 Construction-Home Improvement 4 Auto & Truck Dealers 0 Additionally, company ownership of outlets has increased significantly over time. In the fast-food industry in 1960, franchisors owned only 1.2 percent of outlets; by 1968 the figure had grown to 6.6 percent. Franchisors owned 11.3 percent of outlets by 1971,42 and fully 32 percent by 1986.43 Interestingly, company-owned outlets may be more profitable than franchisee-owned outlets.44 Turning from the structure of the franchise relationship to its duration, most franchises are intended to be long-term arrangements. A large fraction of franchises are long-term by virtue of contractual length.45 Contracts of shorter length often result in long-term arrangements through renewal.46 Table 3 shows the duration of franchise contract in 1986. TABLE 3 CONTRACT LENGTH47 Contract Term Length Percentage of Franchise Contracts 1 year 1.8 3 years 2.1 5 years 16.3 10 years 31.7 15 years 10.9 20 years 21.1 25 years 1.1 Perpetual 12.9 Others 2.1 Actual duration is determined by how the relationship ends. The relationship may simply end with the expiration of a nonrenewable contract. More commonly, the relationship will end at the expiration of a renewable contract term with an explicit decision not to renew by one of the parties. In some cases, the franchisee’s decision to transfer the franchise to another individual before the expiration of the contract with or without the required approval of the franchisor may terminate the relationship.48 Franchises also commonly end before their term expires as a result of termination initiated by either party. One of the key legal issues in franchising is what constitutes cause for termination.49 Finally, franchise relationships end when either franchisor or franchisee fails. One of the most difficult characteristics to assess about franchising is the rate of business failure. The Department of Commerce consistently reports a failure rate within five years of start-up for franchise outlets of 5 percent, much below the over-50 percent failure rate of small businesses generally.50 One would expect established franchise systems to exhibit a lower rate of failure than ordinary, single outlet small businesses because the business format of the franchise has already been subject to trial use in the market. Many writers, however, question the validity and significance of the 5 percent figure, pointing out that the Department of Commerce figure is developed from franchisor self-reporting,51 and that the figure only accounts for total bankruptcy and not for failures to earn a normal rate of return on the franchise investment.52 Moreover, among those franchisees who secure federal assistance from the Small Business Administration, the failure rate exceeds the average for all small businesses.53 One congressional report found [b]etween 1969 and 1979, franchisees of the top 30 “major” franchisors, such as Shell Oil, Gulf Oil, Texaco, Subaru, Sheraton Inns, Tastee Freeze, and Mercedes Benz, had a failure rates between 11.6 and 33.3 percent on SBA loans, and loan guarantees. The failure rates for the 30 non-major franchisors, such as Crazy Horse Campground, American Speed Center, Chicken Delight, Mayflower Transit, El Taco, and Duraclean, varied from 35.7 to 100 percent.54 II. THE LEGAL STRUCTURE OF FRANCHISING With this background in place, this section turns to the nature of the franchise contract. Before doing so, however, it is important to note that although franchising arrangements have traditionally been largely creatures of contract, they have become increasingly regulated. Efforts to introduce general legislation to regulate franchising continue.55 The statutory scheme affecting franchising, however, is piecemeal. Separate legislation governs automobile dealerships as well as retail gasoline franchises.56 Many states have their own general regulatory statutes that, like the federal automobile and gasoline legislation, focus primarily on controlling terminations and renewals.57 But there is no comprehensive or uniform system of regulation.58 Either because current regulation is piecemeal or, more fundamentally, because franchise relationships are too complex to reduce to precise statutory term,59 the heart of franchising’s legal structure is still contract. Indeed, as Section VI.A suggests, the statutes, even while ostensibly limiting contractual powers of termination or nonrenewal, in fact may have only a minimal impact on the legal treatment of franchising. Consequently, the legal structure of franchising is still largely determined by the nature of the contracts struck between franchisee and franchisor. A. The Frequency of Contract Clauses In order to illustrate the legal structure of the franchise organization, this section examines the common types and frequency of contract clauses. Unfortunately, empirical research on the content of franchise contracts is limited. The research that does exist generally dates back fifteen to twenty years, or is current but limited in scope.60 One particular study of the fast-food industry, submitted as a report to the Senate Select Committee on Small Business in 1971, illuminates the frequency of various types of contract clauses.61 While it is difficult to assess how these frequencies may have changed over the years, the types of clauses identified by this report continue to be used in many franchise contracts today.62 Table 4 presents an overview of the contract clauses found in the fast-food industry in the 1971 study by Ozanne and Hunt.63 TABLE 4 CONTRACT CLAUSES64 Clause % of Contracts Comments Termination 100 Franchisor has right to terminate. 76% require franchisee to agree that violation of any condition of contract is material breach. 68% give grace period for curing defaults (10 days); 79% indicate bankruptcy automatically terminates and all rights revert to franchisor. 47 Franchisee must cease operations on termination. 33% require discontinued use of trademark; 47% require building alterations. 44 Franchisor option to purchase equipment. 50% set depreciated value; 30% indicate market value. Royalty Fees 90 75% require royalties monthly on gross receipts; median rate is 4%. Insurance 88 Franchisee required to hold. 70% requiring full public liability insurance; 64% requiring indemnification of franchisor. Duration 88 Specifying fixed duration. 59% make the contract renewable at expiration conditional on absence of franchisee default. Franchise Fee 83 Required up-front. 35% specify sole consideration is license to operate; 48% require nonrefundable deposit before execution. Transfer 83 Franchisor approval required. 75% do not indicate basis for refusal. 46 Franchisor right of first refusal in sale of outlet. Training 77 Formal start-up training at headquarters or outlet. 47% report receiving. 34 On-the-job training. 71% report receiving. 45 Franchisor will provide assistance in opening. Franchisor bears expense in 62%; 99% of franchisees report receiving start-up supervision Median Length of all training is 2 weeks. Standards 82 Food quality. 76 Operations. 61 Cleanliness; product line control. 56 Maintenance. 27 Franchisor right to control inventory. Inspection 79 Franchisor right to inspect premises. Trademark 77 Franchisee has no ownership rights in trademark. Audit 76 Franchisor right to audit books. 62 Franchisor approval of bookkeeping method. 30 Franchisor right to order certified audit. 79 Require periodic reports; 25% require submission of tax return. 40 Franchisee required to pay for audit if underreporting discovered. 5% pay bookkeeping fee to franchisor. Enforcement 74 Franchisor’s failure to enforce is not waiver. Separability 73 Invalid clauses separable from remainder. Noncompetition 67 Covenant not to compete with franchisor after termination or expiration. Time (60%) and area (52%) restrictions. 38% prohibit franchisee from hiring franchisor personnel. Physical Layout 64 Approval of layout. 96% of franchisors report they retain right of approval/control. Trade Secret 64 Franchisee agrees operation/procedures are trade secret. Inheritance 64 Transfer to heirs possible on assumption of franchisee obligations. Agency Status 64 No agency relationship created by contract. Operating Manual 61 Franchisee to receive. 35% of contracts distribute on loan/trade secret basis only; 16% specify compliance with manual at all times. 38% give franchisor right to revise at any time. Territory 60 86% of franchisors report assigning some kind of exclusive territory. Venue 60 Specification of venue for litigation. Hours 55 Days outlet to be open. 63 Hours to be kept. Advertising 53 Franchisor right of control over franchisee advertising (ad approval). 29 Franchisor required to advertise. 38% require contribution but no control for franchisee; 62% administered jointly. 42 Contribution of percentage of gross sales to advertising fund required. Franchisors report 57% require contribution to national ad fund; 47% require minimum local advertising; 81% reserve right to approve ads. Supplies 58 Franchisor approval of suppliers required. 43 Operating supplies equipment to be purchased from franchisor. 33 Paper goods to be purchased from franchisor. 33 Sign to be purchased from franchisor. Building 47 Franchisor builds, leases to franchisee in 60% of these: franchisee constructs in 40%. Construction Site Selection 45 66% give franchisor right to select location; 33% allow franchisee to select subject to franchisor approval; 54% of franchisors select location and then offer to franchisees; 97% reserve right to approve location. Management 45 75% of these “require” advice only when franchisor judges it necessary; 25% at Consultation franchisee’s request. Start-up Date 39 Required date of operation. Alteration 36 Approval required for changes to building or layout. Lease 35 Specifying rental base for lease from franchisor; 50% based on dollar amount plus percentage sales; 20% on dollar amount only; 33% percentage-only sales. 18 Approval of third-party lease required. Sign 34 Specifying dimensions. Employees 32 Conduct requirements. 39% specify employee uniforms. Arbitration 23 Disputes to be arbitrated. Pricing 14 Franchisor right to control prices. 13% restrict prices that franchisors can charge franchisees; 50% of franchisors report specifying retail prices. Performance 12 Franchisee posts performance deposit. Deposit Self-Employment 12 Require franchisee to manage full time. 9% require approval of manager. Renewal Fee 7 Additional fee on renewal. This overview exhibits a number of features. First, note the breadth of coverage: The contracts contain clauses pertaining to nearly every detail of operation. Indeed, the franchisor’s operations manual itself will ordinarily carry an extensive set of requirements on small details of operation.65 Second, consider the great weighting of the clauses towards the obligations of the franchisee. Nearly all of the clauses pertain to commitments made by the franchisee: to build or to lease buildings, equipment, or supplies; to maintain standards; to meet layout requirements; to maintain hours; to contribute to advertising funds; to pay royalties; and to adhere to bookkeeping guidelines. When one incorporates the operations manual into the contract, the franchisee’s obligations increase dramatically. On the other hand, the franchisor’s contractual obligations extend only to training, to advertising, and to the provision of an exclusive territory. Ongoing management support, promised in about half the contracts, is normally discretionary. Few franchisors undertake firm obligations with regard to the nature, extent, and quality of advertising. Third, observe the number of clauses pertaining to the trademark and licensing aspects of the relationship. Trademark and licensing clauses include: ownership of the trademark; cessation of operations on termination; royalty fees and franchise fees; audit authority; and trade-secret status for procedures and operations manual. Thus, the property rights of the franchisor are often a primary interest of the contract. Fourth, note the nature of the provisions regarding a cessation of the relationship. Franchisees generally must agree that any violation of any term of the contract, including, in many cases, the details of the operations manual, constitutes material breach and is a basis for termination. Several conditions or events may arise upon termination. The franchisor often has an option to purchase all equipment at a depreciated value. The franchisee must cease operations and perhaps alter the building. Franchise contracts often prohibit the franchisee from continuing in a line of business in competition with the franchisor for a period of time – two years is common – and over a distance often measured as a radius from any outlet operated by the franchise system. If the relationship ends with a decision to transfer the franchise, the franchisor typically retains the right to approve the transfer; rarely does the contract place restrictions on the exercise of that right. Nearly half of franchisors retain a right of first refusal should the franchisee wish to sell the outlet. Finally, observe that there are essentially no clauses creating any obligation for the franchisor to develop the system, to continue in operation, to continue to advertise, or to maintain the trademark. Outside the exclusive territory for the trademark, the franchisor is free to compete with the franchisee through the development of another system or through the establishment of competing outlets. The franchisor may withdraw its system from a region or the entire market. There are no restrictions on what operating procedures the franchisor may adopt, what layout or building alterations it may require, or what forms of promotion it may require the franchisee to undertake. B. A McDonald’s Contract: 1959-1977 An examination of the evolution of the basic elements of the contract – the quality standards and termination provisions – for a particularly visible franchise organization provides another perspective on the legal structure of the franchise contract.66 In 1959 the McDonald’s Corporation provided for contract termination in the event that a franchisee violated the following: provisions requiring operation at maximum capacity and efficiency over specified days and hours “in accordance with the standards and business practices and policies presently in force and, from time to time, promulgated by Licensor”; provisions on employee uniform and behavior; provisions on the use of specified packaging materials, flavorings, and garnishments and on approved suppliers; and provisions regarding the approval of local advertising.67 Notably, upon termination, the contract required McDonald’s to buy out the franchisee’s interest in the equipment and furnishing of the outlet for a specified depreciated sum.68 Moreover, the contract, while requiring the franchisee to acknowledge the general importance of uniformity and compliance with the entire McDonald’s “system,” set out explicitly the standards on which termination could turn. In contrast, by 1964 McDonald’s had converted the required buyout term into an option to be exercised by McDonald’s69 and introduced a clause requiring franchisees to supply “best efforts” in complying with the franchise system.70 Termination could, as in 1959, turn on the violation of any explicit contract provision, and now it could also result from a failure to supply the undefined level of “best effort.” By 1970 McDonald’s had explicitly incorporated the entire Operations Manual into the contract,71 thereby extending the scope of franchisor control. The 1970 contract reiterated the vaguely defined requirement that ”operation shall at all times be conducted in accordance with the standards and business practices and policies presently in force and from time to time promulgated by Licensor”; violation of this provision “shall be deemed to be a substantial breach of this Agreement and shall give the Licensor the right to terminate this Agreement.” 72 By 1977, the obligations of McDonald’s franchisees were even more detailed. This contract ostensibly limited the parties’ intent to ensuring the franchisee’s compliance with those obligations, rather than to creating a set of mutual commitments. The contract stated: The foundation of the McDonald’s System and the essence of this License is the adherence by the Licensee to standards and policies of Licensor… The provisions of this License shall be interpreted to give effect to the intent of the parties stated in this paragraph…so that the restaurant specified in this license shall be operated in conformity to the McDonald’s System through strict adherence to Licensor’s standards and policies as they exist now and as they may be from time to time modified. 73 In contrast, the contract left the franchisor’s duties relatively undefined, a difficult-to-quantify duty to “advise and consult.” 74 Thus the franchisee paid fees for a service that the service-provider retained full discretion to define in content and duration.75 In the McDonald’s contract, as in many franchise contracts, the contract frames franchisor obligations in terms such as “reasonable,” “periodic,” and “from time to time.” The franchisor had no contractual duty to employ prudence or consideration in the making of decisions that directly affect the profitability of the franchisee.76 C. Incompleteness and the Content of the Franchise Contract Ideally, one would like to have a full-fledged empirical survey of franchise contracts, drawn from several industries and franchisors, as the basis for general conclusions about the nature of these contracts. Unfortunately, such a survey does not appear to exist. Nonetheless, the evidence produced by the McDonald’s contracts, sample franchise contracts,77 franchise buyers’ guides,78 and a general overview of franchise cases in the courts,79 does permit some basic generalizations. A court must of course ultimately interpret and enforce a particular contract; my objective in looking at generalizations is to lay the groundwork for a set of theoretical guidelines to aid a court in that task. The basic picture that emerges is that franchise contracts are long-term, standard form contracts. They grant the franchisee the right to operate under the franchisor’s trademark and to use a system designed by the franchisor, often in an exclusive territory, in exchange for the payment of a franchisee fee and royalties. The contract does not specify the details of the many transactions that will take place within the framework of the basic exchange. Rather, it structures the long-term relationship, much as a constitution does, by delineating the basic function of each party. In short, franchisors are responsible for making decisions about details such as inventory, outlet and product design, location, uniforms, hours and bookkeeping; franchisees are responsible for complying with the franchisor’s decisions. Franchisors have some responsibility to provide training, advertising, and management advice, but franchisees do not possess the authority to determine the quantity or quality of these services. Franchise contracts focus almost exclusively on setting out the range of franchisee obligations and protecting the franchisor’s ownership of its trademark. For purpose of the theoretical analysis I will develop, the key characteristic of the franchise contract is its incompleteness. While roles and areas of responsibility are laid out, a court has little concrete guidance from the contract in deciding issues such as whether a franchisee’s failure to build a new showroom,80 or a franchisor’s decision to discontinue marketing its product in a franchise’s territory,81 violates the terms of the contract. All that will be clear from the written contract is that the franchisor has discretion over decisions regarding showrooms or marketing; the typical contract will be silent about how this discretion is to be exercised. Moreover, the subject of franchisor discretion will often be undefined. Franchisors are responsible for developing the franchise system as they see fit over time. Thus many of the standards with which a franchisee must comply will not even be articulated until well after the contract has been signed. As a result, in many cases there will be no language in the written document to assist the court in determining whether a particular franchisor demand is legitimate and whether the franchisee’s behavior is in compliance or in violation of that demand. It is the absence of contract terms answering these questions that identifies the franchise as incomplete. The significance of incompleteness is not merely that any particular franchise dispute will be complex to resolve. Rather, from a long-term perspective, what is important is whether incompleteness can be avoided, and therefore ultimately cured, by an appropriate rule. Many traditional rules of contract interpretation, such as the parol evidence rule, can be understood as forward-looking judicial efforts to discourage incomplete contracting. But if incompleteness is unavoidable, then such efforts will prove futile. In such a case it becomes important to approach the problem of incompleteness as a basic characteristic that must be addressed directly. The franchise contract presents such a case. While contracts could be drafted more completely than they are now, ultimately they will still be incomplete.82 Few contracts are called upon, as is the franchise contract, to accomplish so complex a task as to structure an entire ten-to-twenty year productive relationship, especially under the conditions of significant uncertainty displayed in retail markets. To write a complete contract for this purpose would be to attempt to reduce to written form a complete listing of all the different business decisions that the franchisor could undertake under all possible future circumstances, and also to specify the range of compliance responses available to the franchise in each case. Franchisee and franchisor would have to negotiate today over how best to respond to the long-term vagaries of the automobile industry, or the fast-food market, or the demand for tax services. Because this is an essentially impossible, task, the franchise contract that we see in use is necessarily an incomplete one. Rather than spelling out every decision ex ante, it designs a decisionmaking structure and assigns to the franchisor responsibility for responding to market conditions as they arise and to the franchisee responsibility for compliance. A court must recognize, however, that this allocation of roles does not necessarily reflect a desire to assign unfettered authority to franchisors and unquestioning compliance to franchisees. Given the impossibility of substantially more precise contracting, broadly defined responsibilities are the only alternative available short of abandoning the relationship entirely. Consequently, a court called upon to “interpret” a franchise contract and determine whether it has been breached must look more deeply into the entire structure of the contracting relationship. As I will demonstrate in the next section, an understanding of the nature of the economics of franchising and the commitment problems involved can, as a first step, guide a court in this deeper analysis.83 As I will also demonstrate,84 however, ultimately it is necessary for a court to examine the nature of the franchising relationship itself to interpret and enforce the incomplete franchise contract. III. THE ECONOMIC STRUCTURE OF FRANCHISING This section examines the economic dynamics of the franchise relationship to elucidate the nature of the planning and commitment problems that it poses. These are problems that the franchisee and franchisor must overcome to make their arrangement an economically sensible one. Isolating these problems provides a basic analytical framework for examining the franchise contract. Within this framework the incompleteness of the contract is seen more vividly. Furthermore, we can identify the “missing links” of commitment that we would expect to find within the structure of the relationship itself.85 There are two major difficulties inherent in the franchising relationship. Both flow from the basic structure of franchising.86 First, because the franchisor owns the basic franchise system and its trademark and the franchisee owns and operates the retail outlets that deliver the system and display this trademark, the franchisor faces problems of controlling the quality of the franchisee service. Conversely, also because of this structure, the franchisee faces problems related to a franchisor’s opportunistic use of this control power. As a result, the franchise relationship is structurally centered on conflicts of interest. Overcoming these conflicts is the primary challenge of franchising. A. The Franchisor’s Problem: Quality Control From the franchisor’s perspective, the franchising relationship poses a substantial problem with respect to quality control. The franchisor has normally created a differentiated product or service or system with the expectation that consumers will be willing to pay for the added benefits of this creation. If the franchisor is to fulfill this expectation, that product or service or system must be implemented at the retail level as designed by the franchisor. A formula for a soft drink must be mixed correctly; a method of losing weight must be taught correctly; a procedure for serving food quickly must be followed correctly. The trademark encapsulates these concerns of the franchisor. The value of the trademark gauges the success of the franchisor in assuring that franchisees provide an otherwise valuable product or service or system according to the franchisor’s plan. The more valuable the trademark, the greater the price at which franchises can be sold and the greater the royalties collected. The value of the trademark is, however, vulnerable to franchise free-riding. This is a problem that has already received considerable attention from scholars and the courts.87 A franchisee is inclined to make decisions about how much effort to put into the business based on the profits that will accrue directly to her in her own outlet. She is not inclined to take into account that, because customers will make judgements about the quality of the entire franchise system based on their experience at an outlet, cost-saving reductions in quality at her outlet will affect the overall value of the trademark and thus the profits of other franchisees and the franchisor. If all franchisees, facing the same incentives, act in this way, the value of this trademark will suffer dramatically.88 Free-riding is an example of the problem of control, known as the principal-agent problem in the economics literature.89 It pervades almost all organizational forms to a greater or lesser extent. If, for example, the franchisor decided to operate as a vertically integrated firm, owning the outlets itself, it would still face the problem of controlling its managers. The franchise arrangement changes the nature of the control problem but it does not eliminate it. To some extent, franchising simply trades one control problem- overcoming the incentives to “shirk” that face the salaried employee but not the profit-collecting entrepreneur- for another- overcoming the incentives to minimize cost that face the entrepreneur but not the employee. At the heart of the control problem is a divergence in interest between franchisee and franchisor. A franchisee wants to maximize her profits from the operation of the outlet; she does not wish to undertake any efforts or expenditures that will not compensate the undertaking. On the other hand, once a franchisor establishes a particular franchise, it aspires to sell more franchises and increase royalty revenues. These objectives make the franchisor less sensitive to the costs of operating an outlet and prompt the franchisor toward maximizing revenues rather than profits.90 The greater the volume of sales under the trademark, the greater the likelihood that a consumer has had direct or indirect contact with the trademark, increasing its value. The greater the revenues of outlets, the greater are the royalties collected as a percentage of sales. This divergence in interest goes beyond the basic free-riding problem to touch almost every aspect of the operation of the franchise. Franchisees, seeking to exploit their trademark license, want to limit the number of franchises granted: franchisors, having sold the first round of franchises, may want to saturate the market with franchises. Franchisees want to locate outlets in profitable area: franchisors, seeking to advertise the trademark and create the image of being on every street corner, may want to license additional franchisees in areas that will contribute to this reputation, even if a particular outlet may not be profitable. Franchisors may wish to have stores operate twenty-four hours per day in order to develop the trademark’s reputation for consumer convenience; franchisees, making few sales at night, may wish to save operating costs and close for a number of hours. From the franchisor’s perspective, bringing the franchisee’s interests in line with its own is the central difficulty of this method of doing business. B. The Franchisee’s Problem: Opportunism If controlling franchisee interests were the only problem within the franchising relationship, its solution would be relatively straightforward, albeit costly. Franchisors could, for example, retain the authority to dictate required behavior for franchisees and hire squadrons of field people to monitor compliance daily. However, the problem of divergent interests cuts both ways. An unrestricted exercise of control by the franchisor will favor the franchisor’s interests over the franchisee’s and create an equally significant problem for the franchisee: risk of opportunism.91 For the franchisee, the most significant economic feature of franchising is the allocation of capital investments. Franchisees are distinct from ordinary employees because they have made capital investments in the business.92 These investments, however, are normally highly idiosyncratic, meaning that a large fraction of the franchise assets often have a greatly diminished value if employed in another line of business. Consequently, the costs of establishing a franchise are effectively sunk costs, which, once expended, are not easily recovered if the franchise goes out of business.93 Sunk costs play an important role in creating the incentives that operate within an established relationship.94 This is best understood by considering the difference between fixed costs (overhead or up-front costs) that are sunk and those that are recoverable.95 For example, consider a business in which a variable cost of production has increased dramatically, so that the highest price in the business can charge for its product covers only the marginal cost of producing it, leaving nothing to contribute to fixed costs. Although the business can cover its variable expenses, such as wages and ingredients, it is making negative profits because it has nothing left over on its investment in overhead assets. If the business can resell these assets to recover its fixed costs, then the business can raise its profits to zero by shutting down

. Franchisees are somewhat locked into the relationship by high sunk costs or invested funds that cannot be recovered if the franchise relationship ends. The franchisee continues to be at a disadvantage

: en économie et dans l'analyse de la décision, les coûts irrécupérables (sunk costs en anglais) sont des coûts qui ont été payés définitivement ; ils ne sont ni remboursables, ni récupérables par un

, No franchisor support, Opportunism: self-interest with deceit , Raining litigation, Rebranding usually hides real objective, Sabotage, Stores shuttered, Sunk costs: franchisee's trapped capital keeps them chained to treadmill, United States, 20080509 Franchisees see

the lawyer Sue the lawyer that created the disclosure document Sue the regulator Sue the sales agent Suicide Suicide committed in franchised store Sunshine is the best disinfectant Sunk cost Sunk Cost Fallacy

selling than operating system, Public perception of sleaze and greed, Robber baron, Royalty payment reductions can be negotiated, Sincerity, Sunk costs: franchisee's trapped capital keeps them chained

stores get better deal than franchisees, Termination of franchisee, mass, Can't afford to fight, Dispute resolution means franchisee goes broke, Sunk costs, Life savings gone, Terrorizing franchisees, 2 per cent of valid claims make it to Trial, Immigrants as prey, Canada, 20000308 Vijay Kawatra

by the franchisor, the franchisee now faces these two choices: "I can stay in the business, I've made my $100,000 investment, but if that's a sunk cost, if that is gone, I can't recoup that. I get $50,000 a year in salary if I stay, I get $50,000 a year in salary if I leave. I've lost my $30,000 return on my $100,000 investment but there's nothing I can do about that." That's what makes a franchisee vulnerable. You can look at that risk of opportunism and you can think a lot of things about it, like it's unfair and shouldn't be allowed, it's outrageous, whatever you want to think in terms of that risk. I'm going to focus on why we should be concerned about it, what is the public interest in doing something about the risk of opportunism, which I should say is a standard risk in many long-term relationships. The reason we have contract law is to deal with the problem of opportunism. I want to talk a bit about what the efficiency considerations are with respect to doing something about opportunism and those risks. Franchising is what modern retailing looks like. From varying statistics, I think it's about 45% of the retail market in Canada and it has the potential to become even more so. The reason that franchising is the way of the future, the way it has been for some time now as well, is because franchising takes the value you get from having a large-scale operation, the returns to scale of bulk buying, of collecting information, of being able to manage inventories, of large-scale advertising, it takes all of those benefits that are available to a large-scale operation and parcels them out to small-scale operations. That's also why you want to be in a franchise, because the franchisor can do the marketing studies and do the research and analyze the data and come up with the fancy advertising campaigns that a single operator can't. This is going to be especially true in our brave new world of the digital age where information has become terribly important in retail in particular. The reason we have the large, big-box stores is because the large stores can aggregate massive amounts of information they collect from those UPC codes that are flashing through the checkout machine. They're keeping track of the inventories, they're keeping track of how demand is shifting on a daily basis and they're moving product around in ways that dramatically reduce costs and respond much more quickly than has ever been true in the past to shifts in demand. That's a value that comes with large scale, and that's where franchising comes in. That benefit of large scale, aggregating all that information, can then be parcelled out to small operators who can't compete otherwise. The days in which you could open up the local store and not have access to that information and not be able to respond in the same ways are very, very quickly disappearing. That's also true, of course, with Internet sales. The risks that franchisees face, the risks I enumerated earlier, the risk of misrepresentation and the risk of opportunism, are costly for the economy. When franchisees end up getting into a franchise that doesn't deliver on its promises and invests those funds, and those funds then disappear, that's wasted investment funds in the economy. That's not a good thing. That's one of the reasons we don't want that in the stock market. We don't want people taking their investments and putting them into fly-by-night stocks. We'd rather have those investments in legitimate businesses and operations that are going to be around. We want people to be able to make wise investment decisions. This is really emphasized by one study. Francine La Fontaine, another Canadian, although she's at a US university now, demonstrated there was a 77% failure rate for franchisors over a five-year period in the United States; that is to say 77% of the franchise operations systems that came into existence disappeared within five years. Now, of course that means the franchisees' investments went with them. The risks of franchising are also costly because even though it's at 45% of the economy now, we may be looking at too little franchising in the economy. If franchising is risky and potential franchisees understand those risks, they understand the risks of misrepresentation, but more importantly they understand the risk of opportunism, that they're going to be vulnerable, that $30,000 is going to be vulnerable, they can be kind of over the barrel-"Well, what can I say? I can't walk away from this thing even if that amount is being extracted by decisions the franchisor is making"-then some people are going to decide not to become franchisees, not to get into this relationship. That can mean, from the point of view of the economy, we don't have enough of it going on. By "enough," the technical way of thinking about it would be, we don't have the efficient scale. The volume of franchising can be too low because we don't have enough people going into it because they don't get enough protection against the risks and they know they can't protect themselves through their contracts. It may also be that we're not getting the right mix of people in franchising, we're not getting the best potential franchisees, which is to say we're getting people who have few opportunities on the outside but not the people who have better opportunities on the outside who nonetheless may be the most productive people as franchisees. And, in fact, you hear franchisors speak frequently about the difficulty that they feel they face in identifying good franchisees. One of the things I talk quite a bit about in my work in a lot of different areas is-and this is one of the main lessons of this combined field of law and economics that I'm in-it's frequently the case that people see law and free markets as being opposed to one another, that introducing law into markets disturbs free markets. It's important to really focus on the fact that free markets require a legal structure. This is the mistake that has caused a lot of problems in eastern Europe and Russia, to sort of say, "OK, let's open up to free markets," but there wasn't the legal structure in place to support those free markets and they haven't taken off. You need legal structure to support free markets. You need contract law, you need property law, and as I've been drawing the analogy, with securities, regulation and corporate law. In securities you need a way of protecting owners and investors from the abuse of their funds by managers and brokers through their control. By doing that, that's what makes that free market start to work. The New York Stock Exchange promulgates a thick book of rules and regulations privately, overseen by the securities commission, but privately generates those rules because they know that those rules are what will attract investment and that's how you get the efficient scale. Corporate law establishes that there are fiduciary duties on the part of managers and directors so that when managers and directors are handling those funds of the stockholders, they're under an obligation to manage those funds in the interests of the stockholders. That's law that generates and supports an efficient market. In the sort of comparative work these days, one of the reasons it is thought that the US and North American markets are doing so well is because the securities regulation and corporate law have developed in much better paths than in Europe, for example, and it's the legal structures that are supporting the growth in these areas in North America. I've mentioned the types of risk that are out there in franchising, emphasizing the opportunism problem. There are a variety of places in which you can come in and regulate, structure the market, the various types of things you can do to support these relationships. One is basic contract law. Obviously, you need basic contract law. The second one is disclosure law, like we have in Bill 33, which I think is an essential and very important component of that proposal. This is also what you see in the Federal Trade Commission rules in the United States-that's federal law-in California and in Alberta. California disclosure law has been there since 1971. You can then move on to registration law, where you require franchisors to register with an agency of the government. That has been true in California since 1971 as well, and is an aspect of Tony Martin's Bill 35. You can then take another step down, or up, and introduce substantive relationship law, by which I mean rules and regulations about behaviour within this relationship once it has started so we can deal with the misrepresentation problem at the outset through disclosure law. Registration law also addresses that kind of problem. But then we've got this relationship that's now supposed to last for 15 or 20 years. What do we do about the opportunism problem? That's where we start looking at substantive relationship law. That's where you start looking at putting in provisions that govern or can impinge on termination and non-renewal decisions, such as requiring that there be termination or non-renewal only for good cause. That's where you can find legal provisions requiring that there be notice of a potential default under the franchise agreement and an opportunity for the franchisee to cure that default. This is where you find phrases or obligations set in terms such as "good faith and fair dealing." Substantive relationship law has been around in the US in the auto and petroleum marketing area since 1956. The Automobile Dealers Day in Court Act was 1956 in the US. In California it has been around since 1981. Again, it is an aspect of Tony Martin's bill, which actually contains a lot of the best features of what you can find in North America in terms of thinking about how to handle franchising. Good faith and fair dealing terms are in all US contracts. It's an implied term in any contract in the United States, in any industry, no matter where you are. There's an implied duty of good faith and fair dealing. So it's nothing special. You don't need it in a piece of legislation; it's always there. In fact, when I started doing research on franchising back in 1986 or 1987, what I was doing at the time was reading thousands of franchising cases and looking at how the term "good faith and fair dealing" was being interpreted in those settings, and to what extent was it addressing the problems of opportunism, to what extent did the courts understand what was happening in a franchise relationship, and therefore what "good faith and fair dealing" might mean in that context. The Vice-Chair: You have about 10 or 11 minutes left. Dr Hadfield: Yes, OK. You have the modes of enforcement in the handout there, so I'm just going to move on to the next one so that I can talk specifically about what I think is necessary here. Interjection. Dr Hadfield: There should be one that says, "What's necessary?" It's missing from the pile. That's too bad. This is the one I think is most important. There are different ways in which you can achieve the goal of getting the kind of commitment you need in franchising. One of them is through reputation, and for a lot of people who feel that there's not a need for any kind of regulation here that's what there's an appeal to: "We don't need to worry about franchising because franchisors won't treat their franchisees badly because it's bad for business to treat their franchisees badly." To some extent, that's true. What that requires is that the information about what franchisors are doing to franchisees has to be free-flowing, available and low-cost. When I put on my last slide here, which you can look at in the handout, there are two main things I think it would be a good idea to focus on in terms of what might be added to Bill 33 to better achieve the goal of supporting franchising as an economic activity. This isn't exhaustive. These are just the two I've chosen to focus on here that I think are most important. One is this term of "good faith and fair dealing," a substantive obligation as to how the franchisor can exercise discretion. You can call it whatever you want. Currently, we have the term "fair dealing" in Bill 33. You can call it "good faith and fair dealing." You can call it "commercial reasonableness," as has been suggested by some other people who testified before you. Opportunism Test [editor emphasis added] What's important here is not what you call it but what you understand it to mean and what eventually courts or other enforcers understand it to mean, including what franchisors understand it to mean. What I'm going to suggest to you is that what it needs to be understood to mean is that franchisors are explicitly obligated to exercise their discretion as if it were their own assets at risk. Because if they're not, that means they're taking advantage of the fact that there is a separation of ownership and control and making a decision that, if they were the ones who had to renovate the outlet, would not be a good business decision. Sometimes it will be, but how do you decide if it's a good business decision or if it's advantage-taking? You ask, "Would the franchisor have done it with their own outlet?" The second thing I think you need to focus on is low-cost enforcement because all the legal rules in the world are not going to make a difference unless there's an ability to make use of those. I've suggested a few ways here in which you can achieve low-cost enforcement. One is to give associations a class standing in civil litigation. That's a feature of Tony Martin's bill which I think is important to look at in terms of making it possible to hold the franchisors to that obligation. Again, why do you want to hold the franchisors to the obligation? Because that's how you generate efficient volume of franchising. That's how you get people in franchising. Another way of getting some low-cost enforcement, and take the emphasis off "enforcement" there, is to put in place dispute resolutions that are low-cost, like mediation, non-adversarial approaches, to say, "Wait a second. I don't really understand why you're asking me to renovate like this," or "This is high-cost," or "Maybe you don't understand how this is going to impact on the outlet." Third, and I want to emphasize this one in particular, government can do something important in supporting the private mechanisms that are out there to give franchisees the kind of commitment from franchisors that they need, and that franchisors want as a whole in order to generate interest in franchising. They can support the reputation mechanisms and can do that by supporting the flows of information, by allowing information to flow. It's important for the stories about what franchisors have done and what franchisees have experienced to be out there and available at low cost to potential franchisees, so that they can make judgments about what to do, because that's what provides the check on franchisor behaviour that will in the end probably be most effective. That's really what makes the reputation mechanism that says, "Look, a franchisor's not going to cheat their franchisees because they won't be able to sell franchises." For that to work, that information has to be flowing. That's what you want franchisors to be doing, is paying attention to that. For example, I think there should be a real push for the government to make sure that information is flowing, that it's not made confidential by confidentiality agreements, that franchisees are protected against lawsuits in the event they talk about what's happened to them as franchisees. I'm not going to go into detail because of the time, but there are ways in which the government could play a role in structuring these mechanisms; for example, by mandating participation in an Internet Web site that publicizes information about the experience of franchisees with particular franchisors, that prospective franchisees could then access in order to assess, just as they're assessing investment levels and how you've been in this, so that the information is there. At the end of the day, I think that's one of the most effective things we can do. Thank you. The Vice-Chair: Thank you very much, Dr Hadfield. We've got about five minutes for questions here. First of all, the Liberal caucus. Questions Mr Richard Patten (Ottawa Centre): First of all, welcome to Ottawa Centre. I gather you've had a good trip flying down from Sault Ste Marie. I guess you're ready to- Mr Tony Martin (Sault Ste Marie): Another fine city. Mr Patten: Another fine city. Thank you for that presentation. I thought that was excellent. I'd like to come back to one thing you mentioned, and that was that one of your colleagues pointed out the 77% failure rate for US franchisors. (1) I wonder if you have any more recent information on what the situation is in the Canadian context and (2) could you elaborate on your comment that perhaps there's "too little franchising" in Canada? Dr Hadfield: I don't think there's more recent information in Canada. This is not an industry that's been studied very extensively at all in Canada, so that data has just not been collected. In terms of there being too little franchising, the only way we could know what the amount of franchising could be is to say, "Theoretically, have we made this as attractive as it could be?" We know that in any industry, in any economic relationship, if there's a risk of opportunism, of being taken advantage of, then one of the things that's going to happen is fewer people will go into it. Saying that there could be too little franchising is to say that to the extent that there are unaddressed problems of opportunism and it's risky, people will stay out of it. Anecdotally, you can know that because, for example, I would say that I wouldn't go into it because the risks are there. It wouldn't be that I would worry that I was getting in with a fly-by-night operator. I just know there's no protection against the exercise of that control power in those ways. It's just not there, and you can't write it into the contract. It's not going to work to write it into the contract. So that's where the prediction comes from. Mr Martin: We do have a couple of articles written by Professor Hadfield that we'll make available to the committee and to the people who are here today. One is Problematic Relations: Franchising and the Law of Incomplete Contracts; the other is The Price of Law: How the Market for Lawyers Distorts the Justice System. There are a couple of pieces of research that I've had done - Richard, I've been handing this stuff out as we've gone along - by Susan in legislative research. It's a summary of an article on franchise contract terms, like what it says and what it doesn't say, and another article that was put together by the American Franchisee Association, Avoiding the Traps-Boilerplate that Bites: The 10 Most Dangerous Contract Terms. I'll be handing those out in a few minutes. I wanted to ask Professor Hadfield to maybe expand a little bit on the issue of mediation and dispute resolution mechanisms. There's been the suggestion that what's already in place in Ontario that forces people into mediation before they go to the courts would catch this and deal with it. What's your view on that? Dr Hadfield: The problem with mandatory mediation as it's now structured-and this is happening throughout; there's nothing special about franchising here-is that it is done in the context of lawsuits that have already been filed and an adversarial structure that's already been put in place. You've hired lawyers. You've filed a complaint or made an application; you've had an answer. So the positions have generally been hardened at that point, and most franchisees are probably not taking that step until things have gotten to an extreme point, like they've been terminated. The idea of a low-cost form of resolution that supports this relationship would be a mediation mechanism that would kick in at a point at which the relationship can still be saved, at which we can deal with problems at an early stage so that the mediation would be low-cost and would not involve lawyers and legal suits. It might involve calling up, for example, the mediation arm of a private organization and saying, "I've just received this letter that says I have to make these changes to my outlet or the royalty rate is going up 2% next year, and I don't like this," doing nothing ahead of time other than getting that information out and then having a structured way in which you can talk with the other side. As a way of comparison in a very different setting, in family law, the less legal structure that you have up front, the more likely it is that the mediation is going to be effective, because the positions haven't been hardened. You want to keep this out of that adversarial approach, really, to think about doing something quite different, very problem-solving oriented rather than litigation oriented, which is the way mandatory mediation is structured right now. The Vice-Chair: We have a quick question by Mr O'Toole. Mr John O'Toole (Durham): Thank you very much for your expert presentation. We've heard from a couple of people slightly different interpretations of some of this stuff. I think we all understand that there are sort of dominant-subordinate roles with the franchisor and the franchisee. Some have clearly described it as, "One takes the money out of the top and the other takes the money out of the bottom, if there is any." It's an unusual, rather risky position to be in. I'm more interested in having you explain the way we've described fair dealing. That is something I'm interested in. I'm surprised that you would say that it's implied, so why put it in there? In most contracts, people would want to be going in with unencumbered integrity, so there's an implied element to it. The presenters on previous days asked us to strengthen it. One of them suggested putting "commercial reasonableness" in its place and said it's very much defined in case law. It's not a case that it's ambiguous or untested in court. You've said quite the opposite. You say that not only is it not necessary-it's implied-but it's no stronger than "commercial reasonableness." I'm not in a position academically to question you, but I want that clarified. If we moved at all to improve it, I would suspect that might be one thing, to clarify fair dealing and not end up with a whole book of regulations of what fair dealing is and wait for the courts to define it. They said "commercial reasonableness" has gone through the discipline of being defined in property matters and other issues. Just one other thing, and this isn't related to what I've just said. The right to associate— The Vice-Chair: Where has that one-minute question gone? Mr O'Toole: She's an expert. We've got to hear from them more importantly than the others, perhaps. If you looked at the Internet and you had these associations-and just think of what's actually going on today at the academic level. You can get your PhD on-line. Do you understand? It's emerging as one way of chatting around the world about McDonald's. You don't have to be too brilliant to figure out that whole exposure will be part of the right to associate. They'll say: "This is my horror story," and "This is my success story." You figure it out. I would think that would be automatic and implied. The right to associate would imply the technology association as well. But I think more important is the commercial reasonableness question. Dr Hadfield: Let me clarify what I meant when I said it's implied. In the United States, it's part of contract law that it's implied. That is not part of Canadian contract law, so it is not implied in Canada. I don't mean to say that it would not be a good move, if that's where you're going. To strengthen the language to put in commercial reasonableness would be better than just saying "fair dealing." These are terms that have some legal meaning. My point was to say that if what you're hoping to accomplish by putting language like that in there and then potentially strengthening that language-if your goal is to deal with this problem of opportunism, because that is what is costly, that's the risk that we need to address in franchising-then "commercial reasonableness," all of these terms, when they get interpreted by the courts-I remember what I did when I did this work 15 years ago. I would go and look at, what does "good faith" mean in the franchising context? Even if you've seen it in other areas, it ends up having an industry-specific meaning. In the US cases, for example, what "good faith" and "fair dealing" came to mean was that the franchisor could exercise business judgment. That is to say, the franchisor could make the decisions without taking into account the impact on the franchisee, and the reason for that was the courts did not understand the nature of this relationship. They saw it like an employment relationship. They said: "Look, the franchisor is the one in charge. They're the company. They're the one that makes the decision about whether to change the number of lines of automobiles in this dealership or whether or not to discontinue this branch of the business." They were missing the opportunism problem. They were missing the essential feature of the franchising relationship. My concern would be that you could strengthen the language, certainly, from "fair dealing" to "good faith" to "commercial reasonableness," but what's going to happen in the courts is the term of "commercial reasonableness" will be defined in the franchising industry, in the franchising context. That is not currently there in the law; there isn't an established meaning for that. My suggestion to you is that the best thing to do to deal with this problem would be to make explicit what that means in this setting, and what it means in this setting is the franchisor should be making decisions with respect to those assets as if they were their own; that is, to take into account-you can fill in that, whatever language seems to work from that point of view. To be clear, I would say, yes, "commercially reasonable" would be a better term, would give the courts a little bit more to work with in accomplishing this. But again, if you don't want to just leave it up to the courts and then 10 or 20 years from now say, "What have they done with that term?"-they could take that term and it could end up being exactly the same as it is now, with that problem having not been addressed. The Vice-Chair: Thank you very much, Dr Hadfield. It's a pleasure to have you here with us this morning. This document is a verbatim copy of this witness’ oral testimony. To review the original transcript: http://www.ontla.on.ca/web/committee-proceedings/committee_transcripts_details.do?locale=en&Date=2000-03-08&ParlCommID=1&BillID=&Business=Bill+33%2C+Franchise+Disclosure+Act%2C+1999&DocumentID=19724 Copyright (c) 2000 Office of the Legislative Assembly of Ontario Toronto, Ontario, Canada Risks: Investments in franchising will stop & be lost if law passed, Insider trading, Outright scams, Ontario Public Hearings, Canada, 2000, Don’t buy any franchise, Industry “Better Business Bureau, Professor Gillian K. Hadfield, Les Stewart, I own the assets but the franchisor controls them, Misrepresentations, Fraud, Opportunism (self-interest with deceit), Appropriate franchise law, Gag order (confidentiality agreement), Tony Martin, Franchisor takes store and converts to corporate, Sunk costs: franchisee's trapped capital keeps them chained to treadmill, Investor confidence crushed, no trust or buying, Lower quality franchisees, Fiduciary duty, Relationship legislation, Industry “Better Business Bureau”, Commercially reasonable exercise of discretion, Mediation, Internet information sharing, Affordable, early and non-legal dispute resolution mechanism, Courts misunderstand relationship, Vacuum of information favours dominant party, Risk much higher for franchisee than independent business, Power to publish offenders name, Open source franchising, Appropriate franchise law, Opportunism Test: If asset ownership were reversed, would decision likely change?, Toothless law, Universities provide unbiased expert knowledge and pursue objective truth, Canada, 20000308 Gillian Hadfield

sue for losses also, Sub-prime lending practices done in franchising, Suicide, Sunk costs: franchisee's trapped capital keeps them chained to treadmill, Sunshine is the best disinfectant, Supplier

experience. People look for a solution. Within the relationship, it's fear of losing everything you've put in, your sunk costs, being trapped by your own decisions. Afterwards, it's fear of being prosecuted