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Debate This: Franchises
Chapter 30, p.739
Carlos Del Rey decided to open a fast-food Mexican restaurant and signed a franchise contract with a national chain called La Grande Enchilada. Under the franchise agreement, Del Rey purchased the building, and La Grande Enchilada supplied the equipment. The contract required the franchisee to strictly follow the franchisor’s operating manual and stated that failure to do so would be grounds for terminating the franchise contract. The manual set forth detailed operating procedures and safety standards, and provided that a La Grande Enchilada representative would inspect the restaurant monthly to ensure compliance.
Nine months after Del Rey began operating his restaurant, a spark from the grill ignited an oily towel in the kitchen. No one was injured, but by the time firefighters put out the fire, the kitchen had sustained extensive damage. The cook told the fire department that the towel was “about two feet from the grill” when it caught fire, which was in compliance with the franchisor’s manual that required towels to be at least one foot from the grills. Nevertheless, the next day La Grande Enchilada notified Del Rey that his franchise would terminate in thirty days for failure to follow the prescribed safety procedures. Using the information presented in the chapter, answer the following questions.
What type of franchise was Del Rey’s La Grande Enchilada restaurant?
If Del Rey operates the restaurant as a sole proprietorship, who bears the loss for the damaged kitchen? Explain.
Assume that Del Rey files a lawsuit against La Grande Enchilada, claiming that his franchise was wrongfully terminated. What is the main factor a court would consider in determining whether the franchise was wrongfully terminated?
Debate This:All franchisors should be required by law to provide a comprehensive estimate of the profitability of a prospective franchise based on the experiences of their existing franchisees Sole Proprietorships and Franchises
“Why not go out on a limb? Isn’t that where the fruit is?”
Many Americans would agree with Frank Scully’s comment in the chapter-opening quotation that to succeed
in busi- ness one must “go out on a limb.” Certainly, an entrepre- neur’s primary motive for “going out on a
limb” to start a business enterprise is to make profits.
An entrepreneur is one who initiates and assumes the financial risks of a new enterprise and undertakes to
pro- vide or control its management. Keep in mind that many of
726
Frank Scully
1892–1964 (American author)
the biggest corporations today, such as Apple, Alphabet (Google), and Amazon, were originally very small
companies. Jeff Bezos, founder of Amazon, and Steve Jobs, founder of Apple, started their companies in their
garages.
One of the first decisions an entrepreneur must make is which form of business organi- zation will be most
appropriate for the new endeavor. In selecting an organizational form, the entrepreneur will consider a
number of factors, including (1) ease of creation, (2) the liability of the owners, (3) tax considerations, and
(4) the ability to raise capital. Keep these factors in mind as you read this unit and learn about the various
forms of business organization. In considering these business forms, remember, too, that the primary motive
of an entrepreneur is to make profits.
Traditionally, entrepreneurs have used three major forms to structure their business enterprises—the sole
proprietorship, the partnership, and the corporation. In this chapter, we examine sole proprietorships. We
also discuss franchises. Although the franchise is not, strictly speaking, a separate business organizational
form, it is widely used today by entrepreneurs.
Mark Summerfield/Alamy Stock Photo
30–1 Sole Proprietorships
The simplest form of business is a sole proprietorship. In this form, the owner is the business.
Thus, anyone who does business without creating a separate business organization has a sole proprietorship.
More than two-thirds of all U.S. businesses are sole proprietorships. Sole proprietors can own and manage
any type of business from an informal home office or Web-based undertak- ing to a large restaurant or
construction firm. Most sole proprietorships are small enterprises, however. About 99 percent of the sole
proprietorships in the United States have revenues of less than $1 million per year.
30–1a AdvantagesoftheSoleProprietorship
A major advantage of the sole proprietorship is that the proprietor owns the entire business and has a right to
receive all of the profits (because he or she assumes all of the risk). In addition, starting a sole proprietorship
is often easier and less costly than starting any other kind of business, as few legal formalities are involved.
Generally, no documents need to be filed with the government to start a sole proprietorship.1
Taxes A sole proprietor pays only personal income taxes (including Social Security and Medicare taxes) on
the business’s profits. The profits are reported as personal income on the proprietor’s personal income tax
return. In other words, the business itself need not file an income tax return. Sole proprietors are allowed to
establish retirement accounts that are tax-exempt until the funds are withdrawn.
Like any form of business enterprise, a sole proprietorship can be liable for other taxes, such as those
collected and applied to the disbursement of unemployment compensation. The unpaid unemployment
compensation taxes of a sole proprietorship were at issue in the following case.
1. Sole proprietorships may need to comply with certain zoning requirements, obtain a business license or other appropriate license from the state, and the
like.
Case 30.1
Sole Proprietorship The simplest form of business organization, in which the owner is the business. The owner reports business
income on his or her personal income tax return and is legally responsible for all debts and obligations incurred by the business.
CHAPTER 30: Sole Proprietorships and Franchises
727
A. Gadley Enterprises, Inc. v. Department of Labor and Industry Office
of Unemployment Compensation Tax Services
Commonwealth Court of Pennsylvania, 2016 WL 55591 (2016).
Background and Facts Julianne Gresh operated Romper Room Day Care, as a sole
proprietorship in Pennsylvania. Gresh owed the state’s Department of Labor and Industry Office of
Unemployment Compensation Tax Services $43,000 in unpaid unemployment compensation
contributions, interest, and penal- ties. Because she was about to lose her license to operate, Gresh
sold her business to A. Gadley Enterprises, Inc. A. Gadley agreed to pay Gresh $38,000 for her
business assets—$10,000 for the use of the name “Romper Room,” $10,790 for a covenant not to
com- pete, and $17,210 for items on an “Inventory List.”
The state’s unemployment compensation law contains a “bulk sales provision.” It requires a buyer
of 51 percent or more of an employer’s assets to obtain a state-issued certificate from the seller
showing that all amounts owed to the state have been paid. A failure to obtain the certificate
renders the buyer liable for any unpaid amount. A. Gadley did not obtain this certificate from Gresh.
As a result, the Department of Labor and Industry notified A. Gadley that it was liable for Gresh’s
unpaid debt. A. Gadley asked a Pennsylvania court to review the assessment of liability.
(Continues )
Learning Objective 1
What advantages and dis- advantages are associated with the sole proprietorship?
In the Words of the Court
SIMPSON, Judge. *** *
Purchaser [A. Gadley argues that the state] erred in construing the term “assets” in the bulk sales
provision to include only busi- ness assets when determining whether a sale met the 51 percent
threshold. Purchaser asserts the provision does not differentiate between business and personal
assets of an employer and there is no legal distinction when the employer is a sole proprietor.
*** *
* * * The definition of “employer” [in the Unemployment Compensation Law] includes a sole
proprietor like [Gresh]. The word “assets” is not defined in the Law. [In Section 788.3(a)] the term
“assets” precedes a list of examples, followed by the phrase “including but not limited to.”
*** *
* * * The examples * * * indicate that the term “assets” refers to business assets. This conclusion is
buttressed [reinforced] by the context of the statute as a whole, which pertains to employ- ers
operating businesses and paying employees as part of their business operations.
The factual circumstances surrounding the sale also indicate the term “assets” means “business
assets.” Here, the context is the sale of a business, in the childcare industry, to another business
engaged in the same industry that intends to operate a childcare facility at the location of the former
business. The Agreement reflects the intention of the parties that Purchaser would operate the
childcare facility as a satellite location. [Emphasis added.]
*** *
Moreover, Purchaser’s interpretation does not consider the purpose of the bulk sales provision. That
purpose is to ensure an employer does not divest itself of assets without satisfying outstand- ing
liabilities, either itself or by the purchaser. [Emphasis added.]
Decision and Remedy The Pennsylvania state court affirmed the Department of Labor and
Industry’s decision that A. Gadley was liable for the unpaid taxes. Gresh’s sale of her business assets
triggered the certificate requirement. A. Gadley’s failure to obtain the certificate rendered it liable
for Gresh’s unpaid unemployment compensation contributions.
Critical Thinking
• Legal Environment What action can A. Gadley take now to avoid suffering the loss of the funds
required to cover Gresh’s unpaid taxes?
• Ethical Did A. Gadley act unethically by not obtaining from Gresh the certificate required by the
state’s unemployment com- pensation law? Discuss.
Ethical Issue
728 UNIT FIVE: Business Organizations
Flexibility A sole proprietorship also offers more flexibility than does a partnership or a corporation. The
sole proprietor is free to make any decision she or he wishes concerning the business—including whom to
hire, when to take a vacation, and what kind of business to pursue. The sole proprietor can sell or transfer all
or part of the business to another party at any time without seeking approval from anyone else. In contrast,
approval is typically required from partners in a partnership and from shareholders in a corporation.
Can the religious beliefs of a small business owner justify
the business refusing to provide services to members of the LGBT community? In recent
years, American society has come a long way in accepting that persons in the LGBT (lesbian, gay,
bisexual, and transgender) community should be treated fairly. Nevertheless, many business
owners’ religious beliefs prevent them from wanting to have these individuals as customers. In a
number of cases, business owners refuse to provide services to gay or lesbian couples based on
their religious beliefs. This is particularly apparent in the wedding industry,
when same-sex couples are planning to marry.
For example, the owners of a wedding-photography business in New Mexico refused to photograph a ceremony held by clients who were gay. They based this refusal on their religious beliefs.
New Mexico’s highest court ruled against the owners. Additionally, a New York court imposed a
$10,000 fine on the owners of a small business that refused to rent a wedding venue to a gay couple
for their ceremony.2
Currently, federal law does not provide protection against discrimination based on sexual orientation in the same way that it protects against discrimination based on race, color, and some other
“protected” characteristics. Many states, though, do have laws prohibiting discrimination based on
sexual orientation, as do many cities.
The intersection of business owners’ religious beliefs and the rights of gays and lesbians is certain
to be an area in which there will be continuing litigation, and additional laws may need to be
created.
30–1b DisadvantagesoftheSoleProprietorship
The major disadvantage of the sole proprietorship is that the proprietor alone bears the burden of any losses
or liabilities incurred by the business enterprise. In other words, the sole proprietor has unlimited liability, or
legal responsibility, for all obligations incurred in doing business.
Case Example 30.1 Michael Sark operated a logging business as a sole proprietorship. To acquire equipment
for the business, Sark and his wife, Paula, borrowed funds from Quality Car & Truck Leasing, Inc. Eventually,
the logging business failed, and Sark was unable to pay his creditors, including Quality. The Sarks filed a
bankruptcy petition and sold their house (valued at $203,500) to their son, Michael, Jr., for one dollar but
continued to live in it.
Three months later, Quality obtained a judgment in an Ohio state court against the Sarks for $150,480. Quality
also filed a claim to set aside the transfer of the house to Michael, Jr., as a fraudulent conveyance. The trial
court ruled in Quality’s favor, and the Sarks appealed. A state intermediate appellate court affirmed. The
Sarks were personally liable for the debts of the sole proprietorship.3 ■
Personal Assets at Risk Because of the sole proprietor’s unlimited liability, creditors can go after his or
her personal assets to satisfy any business debts. Although sole proprietors may obtain insurance to protect
the business, liability can easily exceed policy limits. This unlimited liability is a major factor to be considered
in choosing a business form.
Example 30.2 Sheila Fowler operates a golf shop near a world-class golf course as a sole proprietorship. One of
Fowler’s employees fails to secure a display of golf clubs, and they fall on Dean Maheesh, a professional golfer,
and seriously injure him. If Maheesh sues Fowler’s shop and wins, Fowler’s personal liability could easily
exceed the limits of her insurance policy. Fowler could lose not only her business, but also her house, her car,
and any other personal assets that can be attached to pay the judgment. ■
Lack of Continuity and Limited Ability to Raise Capital The sole proprietorship also has the
disadvantage of lacking continuity after the death of the proprietor. When the owner dies, so does the
business—it is automatically dissolved.
Another disadvantage is that in raising capital, the proprietor is limited to his or her personal funds and any
loans that he or she can obtain for the business. Lenders may be unwilling to make loans to sole
proprietorships, particularly start-ups, because the sole proprietor risks unlimited personal liability and may
not be able to pay. (See this chapter’s Adapting the Law to the Online Environment feature for a discussion of
one court’s refusal to discharge a loan made to a sole proprietor who had declared bankruptcy.)
2. See Elane Photography, LLC. v. Willock, 2013 -NMSC- 040, 309 P.3d 53 (2013); and Gifford v. McCarthy, 137 A.D.3d 30, 23 N.Y.S.3d 422 (Dept. 3 2016).
3. Quality Car & Truck Leasing, Inc. v. Sark, 2013 -Ohio- 44 (Ohio Ct.App. 2013).
“Always tell yourself: The difference between running a business and ruining a business is I.”
Anonymous
CHAPTER 30: Sole Proprietorships and Franchises
729
Can a person who owns a logging business as a sole proprietorship avoid liability for the business’s debts?
Protasov AN/Shutterstock.com
730 UNIT FIVE: Business Organizations
A Sole Proprietorship, Facebook Poker, and Bankruptcy
O
ne major downside of a sole proprietor- ship is that it is more difficult for a sole proprietor to
obtain funding for start-up
and expansion. Moreover, if funding is obtained through loans, the sole proprietor is exposed to
personal liability.
Personal Liability Exposure for an Online Start-up
A case in point went before the United States bankruptcy court in Massachusetts in 2015.a Michael
Dewhurst, living in Raynham, Massachusetts, sometimes did computer work for Gerald Knappik.
Dewhurst decided to start a new business venture—the com- mercial development of an online
poker- playing application. Dewhurst envisioned an application that would enable multiple individuals to play poker together over the Inter- net through Facebook. Dewhurst informed Knappik
of his business plan and predicted that his Facebook poker application “was going to be something
very big.”
a. In re Dewhurst, 528 Bankr. 211 (D.Mass. 2015). See also, In re Zutrau, 563 Bankr. 431 (1st Cir. 2017).
Knappik initially loaned $50,000 to Dewhurst for the project. The loan agree- ment stated, “The
sole purpose of this loan agreement is to provide funds on a per- sonal level for the start-up of said
business project, in conjunction with borrower’s per- sonal funds, not limited to start-up costs,
operating expenses, advertising costs.” That was the first of a series of personal loans that
ultimately totaled $220,000.
Dewhurst had repaid only $9,000 on the total outstanding debt when he filed for bankruptcy.
Ultimately, the bankruptcy court ascertained that at least $120,000 of the loans that were supposed
to be used exclusively for the Facebook poker project had been used for other activities. Furthermore, Dewhurst kept “no contemporane- ous records of his disbursements and uses of this cash, no
cash journal, ledger, or disbursement slips of any kind.”
The Lender Objects to a Discharge of the Debt in Bankruptcy
During bankruptcy proceedings, Knappik requested that the bankruptcy court
deny discharge of Dewhurst’s debts to him. Upon review, the court stated that “Dewhurst’s failure
to keep and preserve adequate records makes it impossible to reconstruct an accurate and
complete account of financial affairs and business transactions.” The bankruptcy judge ulti- mately
denied discharge of $120,000 of the debt owed to Knappik. Thus, a sole proprietor’s failed attempt
to create an online poker-playing application led to personal liability even after he had filed for
bankruptcy.
Critical Thinking
Sole proprietorships, as well as other busi- nesses, routinely seek funding for online projects. How can
the individuals involved avoid personal liability?
Adapting the Law to the Online Environment
Franchise Anyarrangementin which the owner of a trademark, trade name, or copyright licenses another to use that trademark, trade
name, or copyright in the selling of goods or services.
Franchisee Onereceivingalicense to use another’s (the franchisor’s) trademark, trade name, or copyright in the sale of goods and
services.
Franchisor Onelicensinganother (the franchisee) to use the owner’s trademark, trade name, or copyright in the selling of goods or
services.
30–2 Franchises
Instead of setting up a completely independent business, many entrepreneurs opt to purchase a franchise. A
franchise is an arrangement in which the owner of intellectual property—such as a trademark, a trade name,
or a copyright—licenses others to use it in the selling of goods or services. A franchisee (a purchaser of a
franchise) is generally legally independent of the franchisor (the seller of the franchise). At the same time, the
franchisee is economically dependent on the franchisor’s integrated business system. In other words, a
franchisee can operate as an independent businessperson and choose any business form but still obtain the
advantages of a regional or national organization.
Today, franchising companies and their franchisees account for a significant portion of all retail sales in this
country. Well-known franchises include McDonald’s, 7-Eleven, and Holiday Inn. Franchising has also become
a popular way for businesses to expand their operations internationally, as discussed in this chapter’s Beyond
Our Borders feature.
CHAPTER 30: Sole Proprietorships and Franchises 731
Franchising in Foreign Nations
Beyond Our Borders
I
n the last twenty-five years, many U.S. companies (particularly fast-food chains and
coffeehouses) have successfully
expanded through franchising in nations around the globe. Targeted locations in- clude Asia and
Central and South America, as well as Canada and Mexico in North America. Franchises offer
businesses a way to expand internationally without violating the legal restrictions that many
nations impose on foreign ownership of businesses.
Cultural and Legal Differences Are Important
Businesspersons must exercise caution when entering international franchise relationships,
however. Differences in language, culture, laws, and business practices can seriously complicate
the franchising relationship. If a U.S. franchi- sor’s quality control standards do not mesh with local
business practices, for instance,
how can the franchisor maintain the quality of its product and protect its good repu- tation? If the
law in, say, China does not provide for a high level of intellectual prop- erty protection, how can a
U.S. franchisor protect its trademark rights or prevent its secret recipe or formula from being
copied?
The Need to Assess the Market
Because of the complexities of international franchising, a company seeking to fran- chise overseas
needs to conduct thorough research to determine whether its business will be well received in the
target country. It is important to know the political and cultural climate, as well as current
economic trends. Marketing surveys to assess the potential success of the franchise location are
crucial.
Because compliance with U.S. disclo- sure laws may not satisfy the legal require- ments of other
nations, most successful franchisors retain attorneys knowledgeable
in the laws of the prospective location. The attorneys can draft dispute-settlement provisions (such
as an arbitration clause) for international franchising contracts and advise the franchisor about the
tax implica- tions of operating a foreign franchise (such as import taxes and customs duties).
Critical Thinking
Should a U.S.-based franchisor be allowed to impose contract terms and quality control standards on
franchisees in foreign nations that are different from those imposed on domestic franchisees? Why or
why not?
30–2a TypesofFranchises
Many different kinds of businesses now sell franchises, and numerous types of franchises are available.
Generally, though, most franchises fall into one of three classifications: distributor- ships, chain-style
business operations, or manufacturing or processing-plant arrangements.
Distributorships In a distributorship, a manufacturer (the franchisor) licenses a dealer (the franchisee)
to sell its product. Often, a distributorship covers an exclusive territory. Automobile dealerships and beer
distributorships are examples of this type of franchise.
Example 30.3 Black Snow Beer Company distributes its beer brands through a network of authorized
wholesale distributors, each with an assigned territory. Marik signs a distributor- ship contract for the area
from Gainesville to Ocala, Florida. If the contract states that Marik is the exclusive distributor in that area,
then no other franchisee may distribute Black Snow beer in that region. ■
Chain-Style Business Operations In a chain-style business operation, a franchise oper- ates under a
franchisor’s trade name and is identified as a member of a select group of dealers that engage in the
franchisor’s business. The franchisee is generally required to follow standardized or prescribed methods of
operation. In addition, the franchisee may be required to obtain materials and supplies exclusively from the
franchisor.
McDonald’s and most other fast-food chains are examples of chain-style franchises. This type of franchise is
also common in service-related businesses, including real estate broker- age firms such as Century 21 and
tax-preparing services such as H&R Block, Inc.
If these brands of beer are sold through authorized wholesale distributors only, can a potential distributor obtain an
exclusive territory?
alaincouillaud/E+/Getty Images
Learning Objective 2
What is required by the Franchise Rule, and why?
732
UNIT FIVE: Business Organizations
Know This
Because a franchise involves the licensing of a trademark, a trade name, or a copyright, the law governing
intellectual property may apply in some situations.
Manufacturing or Processing-Plant Arrangements In a manufacturing or processing- plant
arrangement, the franchisor transmits to the franchisee the essential ingredients or formula to make a
particular product. The franchisee then markets the product either at wholesale or at retail in accordance
with the franchisor’s standards. Examples of this type of franchise are Pepsi-Cola and other soft-drink
bottling companies.
30–2b LawsGoverningFranchising
Because a franchise relationship is primarily a contractual relationship, it is governed by contract law. If the
franchise exists primarily for the sale of products manufactured by the franchisor, the law governing sales
contracts as expressed in Article 2 of the Uniform Com- mercial Code applies.
Additionally, the federal government and most states have enacted laws governing certain aspects of
franchising. Generally, these laws are designed to protect prospective franchisees from dishonest franchisors
and to prohibit franchisors from terminating franchises without good cause.
Federal Regulation of Franchising The federal government regulates franchising through laws that
apply to specific industries and through the Franchise Rule, created by the Federal Trade Commission (FTC).
Industry-Specific Standards. Congress has enacted laws that protect franchisees in cer- tain industries, such
as automobile dealerships and service stations. These laws protect the franchisee from unreasonable
demands and bad-faith terminations of the franchise by the franchisor.
An automobile manufacturer-franchisor cannot make unreasonable demands of dealer-franchisees or set
unrealistically high sales quotas, for instance. If an automobile manufacturer-franchisor terminates a
franchise because of a dealer-franchisee’s failure to comply with unreasonable demands, the manufacturer
may be liable for damages.4
Similarly, federal law prescribes the conditions under which a franchisor of service stations can terminate a
franchise.5 In addition, federal antitrust laws sometimes apply to prohibit certain types of anticompetitive
agreements involving service-station franchises.
The Franchise Rule. The FTC’s Franchise Rule requires franchisors to disclose certain material facts that a
prospective franchisee needs in order to make an informed decision concerning the purchase of a franchise. 6
Those who violate the Franchise Rule are subject to substantial civil penalties, and the FTC can sue on behalf
of injured parties to recover damages.
The rule requires the franchisor to make numerous written disclosures to prospec- tive franchisees (see
Exhibit 30–1). All representations made to a prospective franchisee must have a reasonable basis. For
instance, if a franchisor provides projected earnings figures, the franchisor must indicate whether the figures
are based on actual data or hypo- thetical examples. If a franchisor makes sales or earnings projections based
on actual data for a specific franchise location, the franchisor must disclose the number and percentage of its
existing franchises that have achieved this result. The Franchise Rule does not require franchisors to provide
potential earnings figures, however.
State Regulation of Franchising State legislation varies but generally is aimed at pro- tecting
franchisees from unfair practices and bad-faith terminations by franchisors.
4. Automobile Dealers’ Franchise Act of 1965, also known as the Automobile Dealers’ Day in Court Act, 15 U.S.C. Sections 1221 et seq. 5. Petroleum Marketing
Practices Act (PMPA) of 1979, 15 U.S.C. Sections 2801 et seq.
6. 16 C.F.R. Part 436.
CHAPTER 30: Sole Proprietorships and Franchises 733 Exhibit 30–1 The FTC’s Franchise Rule Requirements
REQUIREMENTS
EXPLANATION
The franchisor must make numerous disclosures, such as the range of goods and services
included, as well as the value and estimated profitability of the franchise. Disclosures can be
Written (or electronic) delivered on paper or electronically. Prospective franchisees must be able to download
disclosures
Reasonable basis for
any representations
Projected earnings
figures
Actual data
Explanation of terms
or save any electronic disclosure documents.
To prevent deception, all representations made to a prospective fran- chisee must have a
reasonable basis at the time they are made.
If a franchisor provides projected earnings figures, the franchisor must indicate whether the
figures are based on actual data or hypo- thetical examples. The Franchise Rule does not
require franchisors to provide potential earnings figures, however.
If a franchisor makes sales or earnings projections based on actual data for a specific franchise
location, the franchisor must disclose the number and percentage of its existing franchises that
have achieved this result.
Franchisors are required to explain termination, cancellation, and renewal provisions of the
franchise contract to potential franchisees before the agreement is signed.
State Disclosures. A number of states have laws similar to the federal rules requiring franchisors to provide
presale disclosures to prospective franchisees.7 Many state laws also require that a disclosure document
(known as the Franchise Disclosure Document, or FDD) be registered or filed with a state official. State laws
may also require that a franchisor submit advertising aimed at prospective franchisees to the state for
approval.
To protect franchisees, a state law may require the disclosure of information such as the actual costs of
operation, recurring expenses, and profits earned, along with data substan- tiating these figures. State
deceptive trade practices acts may also apply and may prohibit certain actions on the part of franchisors.
Requirements for Termination. To prevent arbitrary or bad-faith termina- tions, state law may prohibit
termination without “good cause” or require that certain procedures be followed in terminating a franchising
relationship.
Case Example 30.4 FMS, Inc., entered into a franchise agreement to become an authorized dealership for the
sale of Samsung brand construction equipment. Samsung then sold its construction-equipment business to
Volvo Construction Equipment North America, Inc., which was to continue selling Samsung brand equipment.
Later, Volvo rebranded the construction equipment under its own name and canceled FMS’s franchise.
FMS sued, claiming that Volvo had terminated the franchise without good cause in violation of state law.
Because Volvo was no longer manufacturing the Samsung brand equipment, however, the court found that
Volvo could legally terminate FMS’s franchise. If Volvo had continued making the Samsung brand equipment,
it could not have terminated the franchise.8 ■
7. These states include California, Florida, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South
Dakota, Texas, Utah, Virginia, Washington, and Wisconsin.
8. FMS, Inc. v. Volvo Construction Equipment North America, Inc., 557 F.3d 758 (7th Cir. 2009). See also Southern Track & Pump, Inc. v. Terex Corp., 618
Fed.Appx. 99 (3rd Cir. 2015).
Can a construction-equipment franchisor terminate the franchise of an authorized dealer after a change in equipment
brands?
Smereka/Shutterstock.com
734
UNIT FIVE: Business Organizations
“Business opportunities are like buses, there’s always another one coming.”
30–3 The Franchise Contract
The franchise relationship is defined by a contract between the franchisor and the franchisee. The franchise
contract specifies the terms and conditions of the franchise and spells out the rights and duties of both
parties. If either party fails to perform the contractual duties, that party may be subject to a lawsuit for breach
of contract. Generally, statutes and case law governing franchising emphasize the importance of good faith
and fair dealing in franchise relationships.
Because each type of franchise relationship has its own characteristics, franchise contracts tend to differ.
Nonetheless, certain major issues typically are addressed in a franchise contract.
30–3a PaymentfortheFranchise
The franchisee ordinarily pays an initial fee or lump-sum price for the franchise license (the privilege of being
granted a franchise). This fee is separate from the various products that the franchisee purchases from or
through the franchisor. The franchise agreement may also require the franchisee to pay a percentage of
advertising costs and certain administrative expenses.
In some industries, the franchisor relies heavily on the initial sale of the franchise for realizing a profit. In
other industries, the continued dealing between the parties brings profit to both. Generally, the franchisor
receives a stated percentage of the annual (or monthly) sales or volume of business done by the franchisee.
30–3b BusinessPremises
The franchise agreement may specify whether the premises for the business must be leased or purchased
outright. Sometimes, a building must be constructed or remodeled to meet the terms of the agreement. The
agreement usually specifies whether the franchisor supplies equipment and furnishings for the premises or
whether this is the responsibility of the franchisee.
30–3c LocationoftheFranchise
Typically, the franchisor determines the territory to be served. Some franchise contracts give the franchisee
exclusive rights, or “territorial rights,” to a certain geographic area. Other franchise contracts, though they
define the territory allotted to a particular franchise, either specifically state that the franchise is
nonexclusive or are silent on the issue of
territorial rights.
Many franchise cases involve disputes over territorial
rights, and the implied covenant of good faith and fair dealing often comes into play in this area of franchising.
If the franchise contract does not grant exclusive territorial rights to a franchisee and the franchisor allows a
competing franchise to be established nearby, the franchisee may suffer a sig- nificant loss in profits. In this
situation, a court may hold that the franchisor’s actions breached an implied covenant of good faith and fair
dealing.
30–3d QualityControlbytheFranchisor
The day-to-day operation of the franchise business nor- mally is left up to the franchisee. Nonetheless, the
franchise agreement may specify that the franchisor will provide some degree of supervision and control so
that it can protect the franchise’s name and reputation.
Richard Branson
1950–present
(British entrepreneur)
William Hamilton/The New Yorker Collection/www.cartoonbank.com
Means of Control When the franchise prepares a product, such as food, or provides a ser- vice, such as
motel accommodations, the contract often states that the franchisor will estab- lish certain standards for the
facility. Typically, the contract will state that the franchisor is permitted to make periodic inspections to
ensure that the standards are being maintained.
As a means of controlling quality, franchise agreements also typically limit the franchi- see’s ability to sell the
franchise to another party. Example 30.5 Mark Keller, an authorized Jaguar franchise, contracts to sell its
dealership to Henrique Autos West. A Jaguar franchise generally cannot be sold without Jaguar Cars’
permission. Prospective franchisees must meet Jaguar’s customer satisfaction standards. If Henrique Autos
fails to meet those stan- dards, Jaguar can refuse to allow the sale and can terminate the franchise. ■
Degree of Control As a general rule, the validity of a provision permitting the franchisor to establish and
enforce certain quality standards is unquestioned. The franchisor has a legitimate interest in maintaining the
quality of the product or service to protect its name and reputation.
If a franchisor exercises too much control over the operations of its franchisees, however, the franchisor risks
potential liability. A franchisor may also occasionally be held liable— under the doctrine of respondeat
superior—for the tortious acts of the franchisees’ employees.
Example 30.6 The National Labor Relations Board (NLRB) received nearly two hundred employee complaints
that certain McDonald’s restaurants had engaged in unfair labor prac- tices. Employees alleged that the
restaurants had fired or penalized workers for participat- ing in protests over wages and working conditions.
Investigators found that at least some of the complaints had merit. The NLRB ruled that McDonald’s USA, LLC,
could be held jointly liable along with several of its franchisees for labor and wage violations. The NLRB
reasoned that McDonald’s exerts sufficient control over its franchisees to be found liable for the franchisees’
employment law violations. ■
30–3e PricingArrangements
Franchises provide the franchisor with an outlet for the firm’s goods and services. Depending on the nature of
the business, the franchisor may require the franchisee to purchase certain supplies from the franchisor at an
established price.9 A franchisor cannot, however, set the prices at which the franchisee will resell the goods,
because such price setting may be a violation of state or federal antitrust laws, or both. A franchisor can
suggest retail prices but cannot mandate them.
30–4 Franchise Termination
The duration of the franchise is a matter to be determined between the parties. Sometimes, a franchise will
start out for a short period, such as a year, so that the franchisor can determine whether it wants to stay in
business with the franchisee. Other times, the duration of the franchise contract correlates with the term of
the lease for the business premises, and both are renewable at the end of that period.
30–4a GroundsforTermination
Usually, the franchise agreement specifies that termination must be “for cause” and then defines the grounds
for termination. Cause might include, for instance, the death or disability of the franchisee, insolvency of the
franchisee, breach of the franchise agreement, or failure to meet specified sales quotas.
In the following case, a franchisee contended that its franchisor did not have good cause to terminate the
franchise.
9. Although a franchisor can require franchisees to purchase supplies from it, requiring a franchisee to purchase exclusively from the franchisor may violate
federal antitrust laws.
Know This
Under the doctrine of respondeat superior, an employer may be liable for the torts of employees if they occur
within the scope of employment, without regard to the personal fault of the employer.
CHAPTER 30: Sole Proprietorships and Franchises
735
Learning Objective 3
What might happen if a franchisor exercises too much control over the operations of a franchise?
736 UNIT FIVE: Business Organizations Case 30.2
S&P Brake Supply, Inc. v. Daimler Trucks North America, LLC Montana Supreme Court,
2018 MT 25, 390 Mont. 243, 411 P.3d 1264 (2018).
Background and Facts S&P Brake Supply, Inc., was the sole authorized dealer of Western Star
Trucks in Yellowstone County, Montana. S&P operated its franchise under an agreement with
Daimler Trucks North America, LLC. The agreement required that S&P sell a certain number of
trucks in its area of responsibility (Yellowstone County). Over a three-year period, S&P sold only
two trucks. Daimler advised its franchisee to use more effective mar- keting strategies and to hire
more sales staff, among other things.
The next year, primarily because of S&P’s failure to meet its sales goals, Daimler notified S&P that
the franchise was being ter- minated. S&P objected, but the Montana Department of Justice, Motor
Vehicle Division, ruled in Daimler’s favor, and a state court upheld the department’s decision. S&P
appealed to the Montana Supreme Court.
In the Words of the Court
Justice Jim RICE delivered the Opinion of the Court. *** *
S&P argues * * * the [lower] court erred in its assessment of the [Montana Department of Justice,
Motor Vehicle Division’s] determination.
*** *
S&P argues that an analysis of its sales performance [should have been] restricted to evidence
related to Yellowstone County. Daimler established that S&P had failed to meet new truck sales
objectives * * *, which are set for all Western Star dealers using an algorithm that considers market
factors and the population of a dealer’s area of responsibility. * * * Daimler offered its analysis of
S&P’s “dealer market share,” which compared how many trucks S&P sold in its AOR [area of
responsibility] to how many Western Star trucks were annually registered in Yellowstone County,
to measure how well S&P was reaching and serving local customers. Of the seven Western Star
trucks registered in Yellowstone County [during the last four years of S&P’s franchise,] only two
had been sold by S&P, an indicator to Daimler that S&P was not well serving
its market, as the majority of customers were purchasing their Western Star trucks elsewhere. This
evidence was premised upon S&P’s performance in Yellowstone County.
Daimler also argued S&P’s “dealer market share” was low compared to Western Star’s “regional
market share,” a factor which is compiled from national truck registration data to compare S&P’s
sales performance in its AOR with Western Star’s regional performance. While this assessment
included evidence from out- side the Yellowstone County franchise location, the [lower] court
properly noted that limiting the evidence to only Yellowstone County would not allow a comparison to
other dealers where there is only one dealer in a county, reasoning that “when only one franchisee
exists in a market, expanded data must be consid- ered. Otherwise, a lone franchisee could never be
terminated.” [Emphasis added.]
* * * The Department found, “The bottom line is that S&P’s sales were deficient no matter which
way one analyzed the data,” and this determination was supported by substantial evidence.
Decision and Remedy The Montana Supreme Court affirmed the judgment of the lower court.
The court concluded, “The evidence focused on S&P’s performance in Yellowstone County and was
properly considered.” Thus, Daimler had the grounds to terminate S&P’s franchise.
Critical Thinking
• Economic The department concluded that S&P’s failure to use more effective marketing strategies
and to hire more sales staff breached the franchise agreement. S&P argued that these were not
material breaches because the agreement’s fundamental purpose was to sell trucks. Is S&P correct?
Discuss.
• Legal Environment Considering that S&P was the only Western Star truck dealer in Yellowstone
County, did discontinu- ing the franchise injure the public interest? Explain.
Notice Requirements Most franchise contracts provide that notice of termination must be given. If no
set time for termination is specified, then a reasonable time, with notice, is implied. A franchisee must be
given reasonable time to wind up the business—that is, to do the accounting and return the copyright or
trademark or any other property of the franchisor.
Opportunity to Cure a Breach A franchise agreement may give the franchisee the right to attempt to
cure an ordinary, curable breach within a certain period of time after notice so as to postpone, or even avoid,
the termination of the contract. Even when a contract contains a notice-and-cure provision, however, a
franchisee’s breach of the duty of honesty and fidelity may be enough to allow the franchisor to terminate the
franchise.
Case Example 30.7 Milind and Minaxi Upadhyaya entered into a franchise contract with 7-Eleven, Inc., to
operate a store in Pennsylvania. The contract included a notice-and-cure provision. Under 7-Eleven’s usual
contract, franchisees lease the store and
equipment, and receive a license to use 7-Eleven’s trademarks and other intellectual property. 7-Eleven receives a percentage of the store’s gross profit (net sales less the cost of goods
sold).
A 7-Eleven manager noticed a high rate of certain questionable transactions at the Upadhyayas’ store and
began investigating. The investigation continued for nearly two years and revealed that the store had been
misreporting its sales to 7-Eleven so as to conceal sales proceeds. Evidence indicated that nearly one-third of
the store’s sales transactions had not been properly recorded.
7-Eleven sent a “non-curable” notice of material breach and termination of the franchise to the Upadhyayas.
The franchisees argued that they had not been given an opportunity to cure the breach. The court found there
was sufficient evidence of fraud to warrant immediate termination without an opportunity to cure. 10 ■
30–4b WrongfulTermination
Because a franchisor’s termination of a franchise often has adverse consequences for the franchisee, much
franchise litigation involves claims of wrongful termination. Generally, the termination provisions of
contracts are more favorable to the franchisor. This means that the franchisee, who normally invests a
substantial amount of time and funds to make the franchise operation successful, may receive little or nothing
for the business on termination. The franchisor owns the trademark and hence the business.
It is in this area that statutory and case law become important. The federal and state laws discussed earlier
attempt, among other things, to protect franchisees from arbitrary or unfair termination of their franchises by
the franchisors.
30–4c TheImportanceofGoodFaithandFairDealing
Generally, both statutory law and case law emphasize the importance of good faith and fair dealing in
terminating a franchise relationship. In determining whether a franchisor has acted in good faith when
terminating a franchise agreement, the courts generally try to balance the rights of both parties.
If a court perceives that a franchisor has arbitrarily or unfairly terminated a franchise, the franchisee will be
provided with a remedy for wrongful termination. When a franchisor’s decision to terminate a franchise was
made in the normal course of the franchisor’s business operations, however, that weighs in favor of the
franchisor. In that situation, a court gener- ally will not consider termination wrongful as long as reasonable
notice of termination was given to the franchisee.
The importance of good faith and fair dealing in a franchise relationship is underscored by the consequences
of the franchisor’s acts in the following case.
10. 7-Eleven, Inc. v. Upadhyaya, 926 F.Supp.2d 614 (E.D.Penn. 2013).
