Supply Chain Control - Law - Economics - Countervaling Forces

Author Richard Solomon is a conflicts and crisis management lawyer with 50 years of experience in business development, antitrust and franchise law, management counseling and dispute resolution including trials and crisis management.

Other than outright misrepresentation about how a franchised business relationship really operates and incompetence, what most impacts the prospect for franchisee profitability is control of the supply chain.

Back in the 1960s, the applicable law didn't allow the unfettered insistence that franchisees purchase their supplies from the franchisor or by the franchisor's designation unless a judicial determination could be made that the tied products were so integral a part of the franchise identity itself that supplies could not be said to be separate from the franchise. Illustratively, the soft ice cream mix is an integral part of the Dairy Queen franchise model. Unlawful tying required that there be two items, in this instance the franchise and the supplies. If the tied products were identity integral, tying was not unlawful.

Illustration of how this rule of law worked may be seen in instances of secret formulae, usually things like secret sauces, breading mixes and seasoning blends. The McDonalds practice of requiring its franchisees to buy/lease a franchise location and construction package from the franchisor was decided not to be unlawfully tied because the location/construction package was deemed an essential aspect of the franchise license itself the trade appearance if you will.

Conversely, tying of supply chain control to the franchise was unlawful when generic products were tied in for the obvious reason that the practice generated an extraneous revenue stream for the franchisor. The Chicken Delight case was the popular reference for that scenario.

The economic organization of business began morphing from local market structure considerations to national and international constructs. With the economic universe so expanded, the amount of commerce required for a finding of sufficient anticompetitive impact expanded with it. What was formerly sufficient quantitative impact to be cognizable as a "not insubstantial" amount of trade in the tied products (as opposed to a substantial amount of trade) was expanded accordingly. Yes, I know it sounds like a word game. What's the difference between requiring a showing of a substantial amount of commerce versus a showing of a not insubstantial amount of commerce in the tied product? In my mind there is no difference and it was a bloody word game. Nonetheless, that was how the standard was expressed.

Under that standard, requiring a significant number of franchisees to buy chickens from a designated vendor was an unlawful tying practice such that any one franchisee cold claim antitrust injury from it.

Under the then new view of how the markets functioned, the amount of tied product involved in any franchise system was no longer sufficient to establish a cognizable antitrust tying practice claim. The lead case establishing that new rule was the famous Jefferson Parish case. In that case the court decided that substantiality was to be measured not in terms of how much commerce there was in the chickens purchased by an entire chain of franchisees, but whether that amount of product was a substantial portion of the entire USA market for chickens. Viewed in that context, no franchise chain's volume of tied products/services would ever amount to a sufficient portion of the market for that product for illegality to attach.

That change exonerated the use of tying practices by all USA franchisors. The foundational franchise documentation need to be changed to an explicit provision in the agreement that established the tie in and the disclosure in the FDD that tying of supplies was part of the franchise relationship and that the franchisor expected to derive revenue from the use of that practice. There may have been minor nuanced drafting grace notes over the years, but that is essentially the way it works today.

In some franchises the use of supply chain tie ins by the franchisor was limited in its impact to permit the franchisees to make a decent return on their investments. In many, however, the opportunity to aggrandize greed was irresistible, and franchisee financial success became less of a concern than the money to be made by the practice. Anything worth doing is worth doing to excess became the mantra of many franchise chains. That is legal unless the courts recognize a standard of illegality based upon elimination of the opportunity for investment return is accepted by the courts. This is essentially a claim for breach of contract by predation. No one has yet made the resource investment in the preparation of that case yet. That is, nonetheless, at least an appealing direction in the face of widespread franchise financial failure coupled with aggressive tying practices. As it is unlikely that a single franchisee could provide sufficient resources for the project/case, and there is no franchisee organization with the ability to provide them, the suggestion of that approach through litigation is theoretical only at this point.

If no investment is to be made in promoting that line of analysis to tying practices, there remains for franchisee relief only self help. What can franchisee do by way of self help that does not jeopardize their status as franchisees? First consideration is that franchise agreement appearances to license prohibition of joint franchisee action do not provide the power they claim to have. They are there to scare the timorous. But no matter what the franchise agreement may say, or the enforceability of various of its provisions, group self help requires really serious commitment based upon the recognition that failure to do so will result in business failure anyway. The more predacious the impact of the tie in practice with no push back at a seriously threatening level, the more likely it is that the practice will only increase in its impact. From sourcing of supplies to requirements of unwanted and unnecessary equipment, to separately licensing for a fee new improvements to the system, the list goes on and on about how to extract additional revenue from the franchise relationship. The longer franchisees defer getting started, the less likely that they will be viable and capable of dealing with it anyway. Reluctance to commit is sure death in this situation.

The method required to deal effectively with thwarting abusive supply chain control is not new. Whether it is called an independent franchisee association or is recognized as a potential litigation group in formation is immaterial. The franchisor will perceive the threat to its extraneous revenue stream and treat the group members as pariahs who must be destroyed. That inherent abrasive interface has to be accepted as part of the territory. This is usually where franchisee resistance collapses.

Franchisees will continue to be party to their own financial destruction by a predatory franchisor simply because bravery is seen to accelerate their demise and they would rather go slowly into financial oblivion than take material risks seen to be beneficial as much to those who do not support the effort as it may be to those risking everything in the effort. Additionally, confrontational bravery has been bred out of most people in this day and age even more so than in time of real inescapable conflict. The final nail in this coffin is the knowledge that nothing can be done secretly in any franchisee effort. There will always be at least one member of any group, no matter how small or select, who will inform on the group in the hope of favorable individual treatment.

Lawyers wishing to be retained to assist in doing these projects never inform the prospective clients that there is no possibility of confidentiality. The reason for this omission is that it will probably cause them to abandon the work and not hire the lawyer. So much for fiduciary relationships.

Unable to assemble a sufficient base for confrontation, and incapable of individual action, nothing is done. Group financing to support one franchisee's actually stepping up to be the nominal plaintiff has never been accomplished.

Where does all this leave franchising? It is of no effect. Long view franchisors will always take into account the need for limitation of tying practices in order to make the franchise system profitable over that long term.

The problem is not one of franchising. There are always predators in every group; short term, quick buck people who are into franchising for a quick hit and quick exit with substantial wealth for their effort. No code of ethics of any franchisor association will ever be enforced in this context. Codes of ethics are always just window dressing anyway, no matter who is using them.

There will always be an army of franchise investors who will believe they can be taught to operate profitably some business in which they have no experience if they just sign here and write a check. No matter the attrition, another is born a minute from now.

Pre investment due diligence, even when performed with the assistance of a lawyer, almost never addresses the quality of supply chain management. Yet that is perhaps the greatest effective risk factor involved other than the fact that a concept may simply not be investment worthy for several reasons, which also go unaccounted for. Investors do not know about the significance of supply chain management. Neither do most lawyers, Investors should learn to ask their lawyer whether the lawyer knows how to vet that.

Franchisors will take great comfort in the just about certain knowledge that they have little risk in using supply chain management aggressively, other than the potential failure of the system as a going concern. One might posit cynically that franchises have shorter life expectancies today from so many factors that you might as well make all that hay while the sun shines. In any event, it is more just a question of sophistication in configuring management of the supply chain than of risk of retaliation. Royalties and advert funds requirements are by far not the only components of franchise investment risk. Without sorting out the manner of management of the supply chain in pre investment due diligence, most franchise investments today are no more likely to produce significant returns on the investment than a trip to Las Vegas.