Should franchising be regulated?

This was the subject of a recent podcast show, in which Fieldfisher's co-head of Franchising & Distribution, Gordon Drakes participated.

You can view the podcast episode via this link, and below is a summary of Gordon's thoughts on this topic.

1.      Overview

Franchising is regulated in a significant number of countries that have franchise specific laws, whilst others impose a complex and challenging regulatory environment through the application of more general commercial laws.

These laws regulate the franchise sales process, the content of the franchise agreement and some require that the documentation be filed on a public register.

These compliance issues can impact on commercial timelines for doing deals and opening sites and they should be identified at the planning stage.

In the UK, franchising is "unregulated" in the sense that there is no franchise-specific regulation or regulator, but there are several laws and common law principles which affect the franchise relationship. There is also the strong voice of the British Franchise Association (BFA), which purports to have the majority of the sector as members, who in turn agree to operate in accordance with its code of ethics. So, in that sense, there is a strong element of self-regulation in the UK.

In other markets, like the US, franchising is heavily regulated.

2.      What is the purpose of franchise regulation?

Here are some reasons why governments do decide to regulate franchising:

• Protection: There is a perception of franchisees as a vulnerable class of business owners, who can be exploited by unscrupulous franchisors.
• Trust: Enhancing consumer trust and brand reputation through standardisation: Regulations can create consistency and a level playing field.
• Clarity: Avoiding disputes between franchisors and franchisees
• Stability: Regulation can contribute to the stability of the franchise market by preventing the proliferation of low-quality or unviable franchise systems, which could otherwise harm both franchisees and consumers.

3.      What are the arguments in favour of self-regulation?

• Flexibility: Self-regulation allows franchisors and franchisees to tailor their practices to their specific needs and circumstances without being bound by rigid government regulations. This flexibility can enable quicker adaptation to market changes and innovations.
• Industry Expertise: Franchisors and franchise associations possess deep industry knowledge and understanding. Self-regulation allows them to develop standards and guidelines based on this expertise, ensuring that regulations are practical and effective.
• Responsive to Market Needs: Self-regulation can be more responsive to the evolving needs of the market compared to government regulations, which may take longer to implement. Franchise associations can swiftly adjust standards and guidelines to address emerging issues or trends.
• Promotes Trust and Collaboration: Self-regulation fosters a sense of trust and collaboration within the industry. Franchisors and franchisees are more likely to comply voluntarily with standards and guidelines developed by their peers, leading to better relationships and cooperation.
• Avoids Government Overreach: Self-regulation allows the industry to address concerns and maintain standards without government intervention. This autonomy preserves the entrepreneurial spirit of franchising and avoids burdensome regulatory requirements that may stifle innovation and growth.
• Cost-Effectiveness: Self-regulation can be more cost-effective than government regulation. Franchise associations can pool resources to develop and enforce standards, reducing the financial burden on individual businesses.
• Maintains Competitive Advantage: Self-regulation can help maintain the competitive advantage of established franchisors by setting high standards for entry into the market. This can deter less reputable operators and protect the reputation of the industry as a whole.

4.    What are the main challenges for self-regulation?

• Loose practice/greater potential for exploitation: The lack of an independent body overseeing the sector creates conditions for sharp practices. Some operators will use the fig leaf of an association with the likes of the BFA to gain credibility in the market, but without a serious commitment to standards. It is a failure of self-regulation when these bad apples are not rooted out, but part of the problem relates to how such associations are funded and that the sanctions are often inconsequential, or inconsistent.
• Lack of uniform standards/understanding around "norms"/"best practice": The lack of standardisation in contracts and the varying degrees of experience of those drafting them can prolong negotiations and increase costs. It also means that a franchisee can experience a very different legal environment from one brand to the brand.
• Lack of voice when it comes to applicable regulations: For example, the franchising sector struggled to make its voice heard when the UK and EU block exemptions were renewed recently. It was a missed opportunity for the sector, and the rules remain hard to navigate.
• Lack of government backing can arguably hold back the growth of the franchise sector.
• Courts are not always well-equipped to deal with franchise cases: Judges do not always understand the dynamics of franchising, and the court process is very long and expensive, which favours the rich and powerful. This creates asymmetry in access to justice. There is a lack of a clear alternative, although the BFA and similar associations elsewhere are attempting to address this through a mediation scheme.

5.      What are the main challenges for regulation?

• Cost: The compliance burden of disclosure documents, registration and annual updates can make deals unviable.
• Lack of nuance: All types of activity get caught by the same regulations: For example, rules and regulations which are clearly designed to protect "mom n pop" franchisees also apply to big corporates/cross border franchisors. This leads to unnecessary delay and transaction costs.
• Overreach: For example, franchise regulations in France require a foreign franchisor to prepare a local market study (isn't that meant to be for the franchisee to know?), or a requirement under the Dutch Franchise Act to obtain a simple majority of franchisees before making a substantial change to the system (arguably, this makes franchise systems less agile in the face of market changes).
• Acting as a trade barrier: For example, local manufacturing requirements in Indonesia, restrictions of royalty rates (bank approval required in South Africa), requirement for minimum trading history of the franchisor, 2 + 1 rule (Saudi and China).
• Ineffective enforcement bodies: Interminable delays in the registration process in some markets, and the complexity of the rules in others mean that some brands simply pretend that the relationship is something other than a franchise.

6.      Examples of Regulation

a.      The Impact of General Commercial Laws on Franchising

Franchising is regulated by a variety of general laws such as the duty of good faith, anti-trust law, unfair competition law, agency law and consumer law which must be taken into account.

In civil law jurisdictions, such as most of Europe, all commercial agreements must be conducted in accordance with the commercial civil code. These codes will imply a number of general principles into a franchise agreement, such as a duty of good faith and a requirement for balance and equity. This is why civil law franchise agreement are often shorter that common law agreements, and lack some of the teeth that a common law franchise agreement might include around issues such as breach and termination.

Competition law has a significant impact on the franchise relationship, regulating issues such as exclusivity (sales and supply), online activity, non-competes and pricing.

In some jurisdictions, franchisees may qualify for protection under applicable commercial agency laws, or even consumer protection laws.

b.      Regulation of the Sales Process

Countries such as the USA, Canada, Australia and China require a prescribed form pre-contractual disclosure.  Key disclosure issues include the how and when the disclosure must be made, mandatory cooling off periods before the deal can be finalised and the scope of the content of the sales and disclosure documentation.

The consequences of a failure to comply with disclosure requirements vary. Non-compliance generally entitles the franchisee to walk away from the agreement without restrictions provided it acts within a reasonable period of entering into the agreement.  The franchisee can also sue the franchisor for damages.  Some jurisdictions also impose fines for failure to comply.

c.      Regulation of Contractual Terms

Franchise specific laws in certain countries impose mandatory contractual terms in the franchise agreement.  These often include a minimum term, a duty of good faith, restrictions on termination and restrictions on post termination non-competition clauses and so on.  These mandatory provisions may impact on the proposed business model and change the terms of the commercial deal on offer.

d.      Registration Requirements

Some jurisdictions require the franchisor to register only relevant details whilst others require registration of all the documentation.  In developing markets this is to enable the government to monitor franchisors doing business in the market whilst in more developed economies (such as the USA and Spain) it is to ensure transparency and maintain a certain level of quality.

In some countries, there are multiple registration requirements.  For example, franchisors in China who sell franchises in just one province, must file the information at the local office of the MOFCOM of that province, whereas for cross-province franchising the papers have to be filed with MOFCOM itself.

7.      Conclusion

Some might say that no regulation is better than bad regulation and in the context of the UK, I am inclined to agree, given that there are several checks and balances which regulate the franchise relationship in the absence of specific regulation.

Regulation or no regulation, the reality is that there will always be instances where franchisors and franchisees fall out and litigate.

In the UK, whilst franchising is an embedded part of the economy, its share of economic activity is still relatively small, and it seems unlikely that a new Government is going to prioritise a UK franchise regulation any time soon. Nevertheless, if I had the opportunity to propose a new franchise regulation for the UK, these are some issues which I would like to be addressed.

• Minimum criteria before a business can franchise.
• Mandatory short form disclosure documents (but no registration requirement).
• Mandatory training courses for new franchisees, and franchise advisors.
• Mandatory rights and obligations for franchise agreements.
• A franchise-specific block exemption, to bring greater clarity around how competition law impacts on franchise systems.
• A dedicated mediation forum for resolving franchise disputes.

Striking the right balance is key. The objective of the regulation must be to provide trust in and certainty for the sector which will drive growth and innovation. This could be achieved through a mixture of new regulation, government or sector sourced funding, and evolved roles for national franchise associations. A regular review of the efficacy of the regulation must be part of the solution.

It would be helpful if the EU considered harmonising its approach to franchise regulation, but that's another article for another day!

If you would like more information on this topic, please contact Gordon Drakes.