Research Trends and Conclusions: Franchise 2010
Richard Noakes
The feeling among interviewees based in the US and Europe is that, as a result of the recession, the domestic franchise market has contracted. At the same time, clients are demanding more from their lawyers.
The franchise industry continues to perform better than most. The franchise sector contributes $2.31 trillion to the US economy annually and in 2009, during the height of the economic crisis, created an estimated turnover of €138.17 billion in western Europe. The franchise model also continues to be highly attractive. It provides potential clients with the opportunity for domestic and global expansion without considerable risk, making it easier for companies to expand and increase profits when economic conditions are not ideal.
Nevertheless, the global recession has tested claims that the franchise industry is counter-cyclical. Despite higher unemployment levels in the United States and Europe that should in theory mean a rise in franchisee recruitment as those out of work look to start their own businesses, franchisees in these jurisdictions continue to face difficult economic circumstances.
International Growth
A significant trend this year has been the growth of international work for franchise lawyers. Clients are aware of the lack of available credit in the United States and Europe, which is contributing to a slower comeback for these economies. The 2010 Coleman Franchise Report revealed that the US Small Business Administration made 2,464 franchise loans in 2009 while 1,467 loans failed in the same period. A difficult economic climate in addition to a reduction of available credit means a lack of opportunities for potential franchisees and a smaller market particularly for small to medium-sized franchisors. There is also a feeling among clients that while large franchise markets such as the US are saturated, there exists a significant capacity for expansion elsewhere. Penny Ward, head of Baker & Mckenzie’s Australian and Asia-Pacific franchise practice, suggests that “clients are looking to put franchises into economies with a pulse”. Lawyers are now experiencing an increasing number of enquiries regarding expansion into China, India, Canada, the Middle East, Mexico, Brazil and Australia. According to a report released by PricewaterhouseCoopers, franchisor profits in Australia grew by 19 per cent between 2009 and 2010. The Franchising Association of India expects the industry to grow at an annual rate of 30 per cent, and the Brazilian economy will grow by 7.5 per cent this year. This demonstrates the capacity for growth in those economies that have not been as severely affected by the global recession and helps explain why a number of clients are investing internationally.
International investment has also created new pressures for franchise lawyers. Franchisors that are expanding worldwide are now demanding that their lawyers come up with an efficient way to create a general disclosure document that can be particularised to any individual country and franchisee. One source noted that “this is strongly tied in with the increased pressure on rates as our clients are looking for one stop shops that they can partner with for the long term. As with other industries in the current climate, potential clients are looking at what value a law firm can bring to the table”. This indicates that in the future we can expect to see increasing competition for international work as firms across the legal market react to the escalating demand from international clients. Firms will only secure this kind of work if they can demonstrate their added value and their ability to establish long-term relationships with clients.
Franchise Litigation
There was a mixed response again this year as to whether there has been an uptick in franchise litigation. A number of contributors noted that franchisees are increasingly forming associations and this has been pushed along by the recession as they look to gain from each others’ experiences during a difficult economic period. Some lawyers reported that they are getting more calls from anxious clients that need legal advice, so their volume of work has increased. Michael Gray of Gray Plant Mooty in Minneapolis states that “you might think the relationship between franchisors and franchisees is bad in the current economy, but franchisees that are surviving understand they need the franchisor’s support and ideas to stay competitive in the marketplace”. Likewise, franchisors are trying to be creative in renegotiating agreements and payment timetables and so are more receptive to mediation and working alongside franchisees to avoid disputes. In the current economic climate some franchisors are content as long as their franchisees are able to survive and pay their royalties. Franchisees are still very wary of the costs involved in litigation and so there are fewer large cases as the volume of class actions has slowed. These factors are creating downward pressure on the number of cases going to court.
So in what circumstances are lawyers litigating for their clients? Prior to the recession the main bulk of litigation arose from franchisees. According to the lawyers we spoke to, franchisors are now starting more lawsuits. This is understandable in the current economic climate as there are principles that franchisors are unable to compromise on and that must be maintained across the franchise system. Our research identifies that franchisors are going to court to collect amounts that are owed by the franchisee and where the latter abandons the franchise system to avoid paying royalties. As the US and Europe begin to come out of the recession, litigation is expected to pick up as franchisors will no longer be content with their franchisees just creating cash flow. In addition, franchisees will increasingly have the financial capital to take a case to court.
It has been reported that employment claims are surfacing from those franchise systems where franchisors exert significant control over franchisees’ operations, such as the commercial cleaning and package delivery industries. In most cases it is the franchisor that controls the relationship with the customer and the franchisee merely provides the service. Consequently, franchisees are banding together to make the point that they are more like employees because of such control and so should be protected by various employment laws and benefits. In March 2010, the United States District Court for the District of Massachusetts held in Awuah v Coverall North America, Inc that a group of janitorial franchisees were misclassified as independent contractors and were reclassified as employees. Michael Gray suggests that “if the plaintiffs in these cases are ultimately successful, it could have a significant effect on a number of other franchise systems that operate in a similar manner and fundamentally alter the nature of the franchisor/franchisee relationship”. While the number of such employment related cases is not yet sizeable enough to warrant significant concern, this is a development that franchise lawyers need to keep in mind when advising clients on how they approach their relationship with franchisees.
A number of lawyers we spoke to, particularly in the US, noted that there has been an increase in the number of transactions compared to last year. One source explained that “as underwriting standards are so high, unorthodox methods of finance are being used”. It is clear that private equity groups are stepping into the franchise market. In September 2010 it was announced that Burger King would be sold to 3G Capital in a deal valued at US$3.3 billion. This trend may be a source of contention in the coming years. In Minnesota, Ronald Gardner, managing partner of Dady & Gardner PA states that “looking forward I expect to see an increasing number of disputes as franchisors will be pushing franchisees to expand to make up for the lack of growth during the recession. In addition, as more private equity groups come into the market there will be more pressure on franchisees to make a bigger return and this may be a source of disputes for the future”. While the number of work-outs has risen as a result of the recession, litigation looks set to pick up when economic conditions improve.
Franchise Regulation
Regulation of the franchise industry continues to vary greatly across the world. In recent years, some countries that have seen the franchise industry increase in size have sought to regulate it. Between 2007 and 2008 the Indonesian government introduced regulations relating to the definition, registration, disclosure and sanctions regarding franchise agreements. On the other hand, countries such as India have yet to establish franchise-specific legislation but franchises are still governed by a number of different statutes and codes. As the franchise industry grows in an increasing number of jurisdictions, the question of regulation will be revisited and this is likely to increase the demand for effective local counsel required by those lawyers advising international clients looking to expand their operations.
A number of jurisdictions are continuing to take a more relaxed approach to the regulation of franchises. On 20 April 2010 the European Union exempted vertical agreements, which include franchising agreements, from competition laws particularly in relation to price, territory and non-compete obligations. The experience of the European Commission and national competition authorities is that there are rarely any anti-competitive effects where there is an agreement concluded between companies with a market share of less than 30 per cent and this is considered to be an element that is common to the franchise industry. The UK has not adopted franchise legislation and the industry is regulated by the British Franchise Association that has laid down an ethical code of conduct and a disciplinary, complaints and appeals procedure. Similarly, Hong Kong does not have legislation governing franchising operations.
The lack of any international agreement or organisation to regulate the global franchise industry, or perhaps the demand for it, means that the level of franchise regulation remains diverse and country specific. This challenges lawyers to remain up-to-date with ongoing regulatory developments in those jurisdictions where current and future clients may look to invest.
Applying the Franchise Model
When questioned on the industries that will increasingly adopt the franchise model in the coming years, those services that cater for an ageing population were highlighted by interviewees. Home health in the US is an industry that is expected to expand and is likely to involve an additional layer of regulation. The Oxford Institute of Ageing states that over the next fifty years, the age composition of nearly every country is expected to move to one whereby the old outnumber the young. By 2030, half the population of western Europe will be over the age of 50. This illustrates that services that provide care for the elderly will be in significant demand and lawyers expect that businesses will increasingly adopt the franchise model as this sector expands in the future.
According to the research conducted in Europe, as governments on the continent make budget cuts to reverse their deficits, elements of the public sector are expected to see the franchise model implemented. Health and education are untapped sectors that may benefit significantly from the franchise industry. One contributor noted that it has been proposed that existing hospitals may grant franchises to private health companies whereby a smaller sum is provided by the government for the company to run the hospital and the government secures a percentage of any profit that is made. In the education sector, there are an increasing number of institutions seeking to use their name as a brand and adopt the franchise model to open schools internationally. As governments deal with falling budgets, franchising is likely to provide an opportunity to effectively streamline public services.
The legal market itself is opening up to the franchise model. QualitySolicitors in the UK has embarked on an aggressive policy of expansion with 50 new branches launched in November and by January 2011 the franchise will consist of a total of 115 firms. Law firms that use the brand pay an annual membership fee based on the size of the geographical area they cover. QualitySolicitors intends to open a branch on every high street by October 2011. It remains to be seen whether this will be a growing trend elsewhere.
In a post-recession economy the franchise industry looks strong. The franchise model is growing significantly on an international scale, and continues to be adopted in new industries, even in those countries that have suffered as a consequence of the global downturn. In this context, international firms point out that they have the upper hand as they can offer a one-stop shop for clients. However, boutiques can compete on legal fees and argue that they have the freedom to refer work to local firms that they know provide an optimum service in the jurisdiction in question. This competition will continue in the franchise legal market whereby it is ultimately the nature of clients’ own franchise operations and needs that will dictate the kind of law firms that will be in demand. Lawyers who are able to demonstrate that they provide value beyond the normal documentation service and can solve problems related to the domestic and international development of their clients, in addition to effectively explaining the value of the franchise model to companies that show an interest, will be more than capable of securing long-term custom.