By Thomas W. France
The franchise business model currently faces intense scrutiny and challenges from a variety of sources that could significantly impact the operations of franchise systems and the value of franchised brands. Congress, for instance, is considering legislation to establish a “joint employer” standard that would expand the liability of franchisors for certain actions taken by their franchisees and that would make it easier to unionize franchisee employees.1 The U.S. Federal Trade Commission (FTC) is gathering information about franchise agreements and franchisor business practices in connection with a regulatory process that could result in federal regulation of franchise relationships.2 State legislators are pursuing changes in laws that would impose additional restrictions or requirements on various aspects of the franchise relationship, including non-compete agreements, required capital investments, rebates and commissions, mandatory sourcing of goods, labor and wage practices, and dispute resolution mechanisms.3 And franchisees are becoming more aggressive in seeking changes to franchise agreements and the franchise relationship that would strengthen their rights and increase their leverage over franchisors.4 These actions could materially impact the legal and regulatory oversight of the franchise relationship and significantly disrupt the franchise business model.
Legal and regulatory changes to the franchise relationship would have significant implications for the hospitality industry, as around one-half of the U.S. lodging industry’s more than 62,000 properties are franchised. The franchise relationship in the hospitality industry requires significant capital investment and a long-term commitment, and hotel franchisees increasing have been seeking to “rebalance” the rights and protections under franchise agreements, as evidenced by franchisee groups like the Asian American Hotel Owners Association (AAHOA) supporting legislative initiatives in states such as New Jersey to strengthen the rights and leverage of franchisees in the franchise relationship. Even if proposed legislative or regulatory changes that would benefit franchisees are not enacted, hotel franchisees likely will continue to be aggressive in negotiating more favorable terms under franchise agreements, particularly as hotel franchisors become more asset-light and franchise focused and face more intense competition for getting their flags on lodging product. Changes in material franchise agreement terms, such as default and termination rights, renovation and capital expenditure obligations, and sourcing of goods and resources, could undermine the ability of franchisors to manage their franchise systems and protect their brands.
Effective communication is essential in any relationship, including the franchise relationship. To build a successful franchise business, franchisors must implement robust means of communication with all the various parties in the franchise ecosystem, including franchisees and their employees and agents, third-party management companies and their employees, vendors and services providers, franchisor employees and agents, and customers. This communication must involve every material aspect of the franchise business, including franchisee and employee training, implementation and enforcement of brand standards, capital investments, technology, marketing, and customer preferences, experience and relationships. It also must encompass legal and compliance obligations and risks, particularly as franchisors seek to manage and respond to the challenges presented by proposed changes in franchise laws and regulations and increased pressure from franchisees to negotiate the rights and obligations under franchise agreements.
There can be a tendency for businesses not to involve legal counsel in operational matters or business relationships until there is a dispute or potential for legal action, but successful franchisors reject this impulse and involve their legal counsel as early as possible in operational matters and in the design and implementation of communications with franchisees and the other parties in the franchise ecosystem. In most instances, in-house counsel will be involved most directly in these matters, but outside counsel can also play a role depending on the circumstances of the franchisor’s business. Integrating counsel into the decision-making, design and implementation process for internal and external communications, as well as critical operational matters, enables a franchisor not only to respond more nimbly and effectively to evolving legal and compliance challenges and risks, but also allows it to better manage its day-to-day business and operations and its relationships with its franchisee community.
Effectively integrating counsel into the franchisor’s operational matters and franchise relationships requires transparent and honest communication among the businesspersons and counsel. The franchisor’s business team must clearly communicate the business objectives and core operational functions to counsel and view counsel as a partner in the decision-making and communications process. Counsel should be expected and encouraged to embrace this partnership and to employ their expertise in a manner that minimizes legal and compliance risk but also accomplishes business objectives. This partnership approach will need to be innovative and subject to regular evaluation and revision to address changing circumstances, including legal and regulatory changes.
Utilizing counsel in the franchisor’s decision-making and communications process can add value to the franchise relationship in many critical areas, including the negotiation of franchise and related agreements, the enforcement of remedies for default under a quality assurance program, and the exercise of termination rights. These areas are under increasing scrutiny from franchisees. The AAHOA, for instance, has identified termination rights, quality assurance inspections and guest surveys, and dispute resolution as key aspects of franchise agreements in which it is seeking changes for the benefit of franchisees. Goals of the AAHOA and its franchisee members regarding these matters include limiting the calculation of liquidated damages in connection with a termination, giving franchisees a termination right if the hotel is not satisfying pre-negotiated performance guarantees, conducting quality assurance inspections in a fair, reasonable and unbiased manner, and giving franchisees the right to consent to binding arbitration as the process for resolving disputes.5 These issues present unique challenges for franchisors because these rights under the franchise agreement can be critically important to the franchisor in protecting its brand. Although the default and termination rights and other protections under the franchise agreement typically are very favorable to the franchisor, these rights are its most important leverage for ensuring that franchisees comply with the brand standards and diluting these rights could significantly undermine the ability of franchisors to manage their franchise systems and protect their brands. Maintaining these rights without antagonizing and damaging the business relationships with franchisees requires effective communication on the part of the franchisor, as well as flexibility and creative thinking in resolving issues and disputes. Counsel will be central to the negotiations with franchisees on these issues and they will be better positioned to understand where there may be flexibility to negotiate if they have a clear understanding of the business objectives or, if the franchisor needs to remain firm in the negotiations, will be able to more effectively communicate the franchisor’s position to a franchisee if they have been intimately involved in the franchisor’s decision-making and communications process.
A franchisor also will be better positioned to respond and adapt to legislative and regulatory changes to the franchise model if it has integrated counsel into its day-to-day decision-making and communications process. For example, if Congress or federal regulators impose a joint-employer standard that expands the liability of franchisors for actions of franchisees and their employees, franchisors will have to assume a much more active role in the communications with franchisees and their employees and in the oversight of the employment relationship. Counsel, as a result of its knowledge and expertise with the legal requirements and compliance risk, will need take a lead in this more active role and the changes in the franchise relationships and operations are likely to be less disruptive if counsel already has a clear understanding of the business objectives and operational dynamics and has experience with the design and implementation of communications with franchisees.
Incorporating counsel into the franchisor’s decision-making and communication process will facilitate the franchisor’s ability to quickly and effectively respond and adapt to legal and regulatory changes to the franchise model, manage successful relationships with franchisees and maintain franchisee buy-in and support for the system while protecting important contractual rights. These benefits not only will minimize the disruptions to day-to-day operations and franchise relationships, but also will allow the franchisor to protect the long-term value of its brands and franchise systems.
1The Protecting the Right to Organize Act (H.R. 842).
2Federal Trade Commission, Solicitation for Public Comments on Provisions of Franchise Agreements and Franchisor Business Practices, Request for Information (March 10, 2023).
3See New Jersey Assembly Bill 1958; California Fast Recovery Act (AB 257); Oregon House of Representatives Bill 2946.
4See Asian American Hotel Owners Association, 12 Points of Fair Franchising, An Educational Primer (2022).
5See Asian American Hotel Owners Association, 12 Points of Fair Franchising, An Educational Primer (2022).