Research Trends and Conclusions: Franchise 2009

• August 2009

• Franchise

Tom Barnes - Editor, Who's Who Legal

Conventional wisdom holds that the franchise industry is quite robust in a recession, with some even going so far as to classify it as counter-cyclical.

Some of our sources report that, from their perspective at least the sector is "good in good times and better in bad" and able to offer a level of protection in difficult trading conditions. Lawyers we spoke to suggested that where 85 per cent of small business start-ups fail, the same proportion of franchises succeed.

Franchises form a significant part of the economies of most major countries. The Economic Impact of Franchised Businesses report commissioned by the International Franchise Association calculates that franchised businesses create nearly 21 million jobs in the US alone, which equates to over 15 per cent of the national private-sector workforce. As familiarity with them grows, franchise systems are spreading worldwide, and many people have bought franchises with their redundancy pay-offs, helping the economy to recover. In the words of one source, franchises are "ready-made self-employment but without the risks related to being self-employed", and have proved popular in hard times as a result.

However, the current recession is different from its predecessors, and is taking its toll on the industry and its advisers. Franchises in some industries are suffering badly across the world, with real estate and the car industry both singled out - the latter has been the subject of state bailouts in a number of countries. The effect on the franchise industry can be gauged relatively easily as many US states require registration and keep trackable records. The Wall Street Journal reports that filings of new franchises in California from January to April 2009 fell nearly 20 per cent compared with a year earlier, while New York's first-quarter registrations dropped 22 per cent to the lowest number in five years. The downturn in business has obviously had a knock-on effect on the market for legal advice.

The single largest factor in this drop-off is the lack of available credit. Franchisees in many countries cannot obtain financing from conventional sources, and in many cases have to look to secondary, and often more expensive, means of financing. There is less capital available for people to open new franchises, or to purchase struggling ones. This lack of financing limits the growth of existing systems, which is further undermined by declining revenues from franchisee sales. In addition, some of the more developed markets are seeing a saturation of concepts, making a difficult market even more inhospitable.

However, the picture is not universally bleak: some industries are thriving despite, or in some cases as a result of, the downturn. Several of our sources reported the strong performance of franchisor clients in the fast-food industry. McDonald's is one of only two companies in the Dow Jones industrial average whose share price rose in 2008, and the sector as a whole is said to be thriving as consumers look for lower cost alternatives. Other sectors such as fitness, home improvement, health care, and car repair and maintenance were also reported to be busy.

What work are Franchise lawyers doing? and for whom?
This shift in the landscape has inevitable ramifications for the expert legal counsel listed in this book. The transactional slowdown has led to a tightening of belts, with fees under ever increasing scrutiny. Some lawyers reported developing their practices and expanding the services they offer into other areas, such as labour law. Overall, the nature of the practice has also begun to shift. Some lawyers continued to report a certain amount of residual M&A work, but the focus is now on helping clients to adjust to the economic situation. Outside counsel are called on to help secure financing, liaise with banks and renegotiate rents.

We received mixed reports on whether an increase in disputes work - an unsurprising consequence of an economic downturn - had occurred. Overall, the level is "certainly not down" in the words of one source. Many had found that more sophisticated franchisors wish to avoid litigation, and are keen to avoid the cost as well as the potential damage to their reputation in the market and with other franchisors. That said, several of our sources noted a rise in class action litigation. The nature of franchising lends itself to such an approach, "as if one franchisee has been wronged it is likely that others will have been affected in a similar way." The - in some cases - relatively new-found ability of attorneys to act on a contingency basis has contributed to this surge in activity. Alternative methods of dispute resolution are also gaining in popularity. In local matters mediation is often popular, with some jurisdictions setting up franchise-specific centres, while arbitration is well suited to the resolution of international disputes.

An increase in smaller disputes was also noted, often arising from the failure or underperformance of franchisees. An inevitable result of the downturn, lawyers representing franchisors are spending more time on standards enforcement and breach of contract work when franchisees cannot meet sales targets. However, this is balanced against a general desire to work through issues, as terminating contracts and the ensuing disputes constitute an expense both sides can ill afford.

Although the downturn has caused a slowdown in many types of work, some areas have picked up, with restructurings and workouts foremost among them. Lawyers are called on when the franchisor restructures - GM's complicated restructuring is a case in point - or becomes insolvent. Elsewhere, higher levels of activity from international franchisors were reported, with inbound transactions into the US noted as well as moves from established franchises into markets in the Middle East, Latin America and Asia. However, the painful reality for all concerned is that the increase in such work does not make up for the shortfall in others, and levels are down overall.

Franchise Regulation
Levels of franchise regulation vary greatly across the world: Greece and New Zealand, for example, have recently decided not to enact franchise-specific legislation, preferring a laissez-faire approach. Some think over-regulation is a growing problem that could lead to jurisdictions being seen as "franchise-unfriendly". But the evidence on regulation's effect on franchising is equivocal. The US, the home of franchising and the jurisdiction with the most sophisticated regulation in the world, continues to attract franchise business. In the United States, franchise is seen as part of securities law, and, accordingly, is heavily regulated: many states require registration, and there is a requirement for federally mandated disclosure documents for franchisees. Regulation, provided that it is well thought out, needn't be a hindrance.

The FTC's amendments of 2007 to the Franchise Rule are a good example of this, changing a law that was perceived to be a barrier into one that facilitated an easier environment in which to do business. Amendments to disclosure rules in particular had a liberating effect.
Of course, wider legal and economic factors also affect the success of the franchise sector, perhaps to a greater extent than franchise-specific rules. The law and economics of distribution, IP, tax and foreign investment are crucial in defining whether a jurisdiction is attractive. And much of the US sector's recent activity can be attributed to weakness of the dollar and companies' growing experience of the franchise model.

What Does The Future Hold?
The sector's relative resistance to the economic downturn makes it an attractive one for law firms, and we received some reports of firms trying to establish or develop franchise practices. Our research identifies leaders in boutiques and international firms. Specialist firms, though they are well suited to representing smaller franchisors on a domestic basis with lower fee levels, have historically challenged full-service firms for international work. Some sources, however, noted a subtle marginalisation of boutiques in certain jurisdictions and a growth of the practice area in larger, national and international full-service firms, who can go on to offer franchisors a wider range of services. Furthermore, franchise remains a small practice area compared with other fields of commercial law, and the limits on the amount of work and number of specialists leads to law firms in certain jurisdictions dominating the market.

Franchise lawyers are constantly aiming to identify future sources of activity. There is hope that certain industries such as healthcare will begin to more fully embrace the franchise model. Franchise is becoming increasingly international, with US clients in particular finding success by expanding into new jurisdictions. Investors from emerging markets are taking a more active interest. Overall, the greatest source of work may be further changes to regulatory regimes and more comprehensive legislation in jurisdictions worldwide.

Positive Signs
While times may not be as good for franchise lawyers as they have been in recent years, it still remains a healthy area in the wider context of commercial law. Franchising is thought to be doing better than the economy as a whole, and the sector is well placed to reap limited advantages from the downturn. Higher unemployment means the quality of franchisee applicants has improved. Rents and interest rates are low. Franchised businesses can avoid fixed expenses such as sales forces, and can offer a means of entry into less afflicted international markets. Major opportunities exist for those with money to spend or access to financing. Historically, franchised businesses have weathered economic storms better than most, and signs remain that, once again, this sector and its lawyers could pick up quicker than most.

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