AB 2305, “The Level Playing Field for Small Businesses Act of 2012” - What is going on in California today?

By:  Michael Seid, Managing Director, MSA Worldwide

Franchise Law News - 2nd Quarter Edition, 2012

You have to be concerned about what the folks in California’s state capitol of Sacramento are thinking about these days.  The California economy is in the tank with statewide unemployment nearing 11% and minority and youth unemployment even higher than that.  People and businesses are leaving the state because of record-high taxes and California’s history of excessive regulation, and get this, Governor Brown’s solution is to raise both the sales tax and the income tax to try and balance the state’s budget. Please tell me you’re kidding, Governor? Apparently not. The last time Jerry Brown did something this foolish was when he stopped dating Linda Ronstadt back in the 70s.

In what can only be described charitably as a misguided undertaking, an Assemblyman in California has decided that one of the few bright economic stars still shining in California – its strong and relatively problem-free franchising economy, needs to be restrained. It is curious, given the state’s depressed economic climate, that anyone in California would think now is a good time to propose a sweeping anti-franchising measure like AB 2305, “The Level Playing Field for Small Businesses Act of 2012”.  According to the International Franchise Association, California has 83,000 franchised locations generating $94 billion in economic output and employs 925,000 workers.  Franchising is a large, growing and relatively problem-free part of the California economy.

Now what can be driving the Assemblyman? It can’t be the results of any empirical research showing that there is an endemic problem in California franchising.  None exists.  It can’t be that there is an increase in franchisee litigation or complaints in California either.  There are relatively few franchisee complaints and a very small percentage of lawsuits filed against franchisors in California, especially when compared against the number of franchisees in the state.  It certainly can’t be that franchising is under-regulated in California.  After all, California’s CFIL and CFRA are some of the strictest franchise disclosure, registration and relationship laws in the United States.  

So, what can it possibly be?  It could be that the handful – and it's a relatively small handful - of franchisee advocates that have been pushing for increased relationship laws throughout the United States for many years, have the Assemblyman’s ear and have told him about “their perception” of relationship problems in the franchising industry.  Perhaps they forgot to mention to the Assemblyman that the Federal Trade Commission completed a decade-long review in 2007 and revised the disclosure laws in the United States.   When asked by these same franchisee advocates to establish franchise relationship laws in the United States the FTC replied that federal relationship laws were not needed as there was inadequate “evidence to support a finding of prevalent acts or practices that meet each of the three prerequisites for unfairness….”   Franchise regulations work quite well in California and in the rest of the United States.  Relationship laws like the one being proposed in California are simply not needed.

Quite possibly, the Assemblyman may simply not understand the dynamics of franchising.  A clue to what he knows and understands might be found in a recent interview he gave.  According to the interview, the Assemblyman seems to think that most franchisors are large businesses with legions of lawyers.  Most franchisors in California are small businesses and with the exception of mega-large franchisors such as   IHOP and The UPS Store (both California-based), which are not the target of this regulation, franchisors in the United States on average have less than 100 locations in total.  

 
The Assemblyman may not fully understand that California’s franchisee centric CFIL and CFRA laws were originally put into place to reduce conflict in the franchise relationship and that the existing laws already require franchisors to clearly detail the duties and responsibilities of the parties in a California mandated disclosure document. Under both federal and state law, that information is provided to prospective franchisees weeks before they make their investment decision.  The franchise regulators in California are widely considered to be some of the most diligent in the United States and they review each franchise offering before franchisors are allowed to register and begin offering franchises in the state.

There are so many problems with this law it’s hard to find a place to begin and my space in this article is very limited.  But clearly, the premise of the law is mistaken – a “Level Playing Field”.  For the protection of consumers, franchisees and franchisors, franchising can never and should never be a level playing field.  As the owners of their intellectual property franchisors have the right, and under federal law, the obligation to control how their brand is licensed.  Franchisors are required under federal law to control how others use their intellectual property.  To meet these requirements franchisors establish, monitor and enforce standards.  The reason the Lanham Act was enacted and why franchising cannot be a level field is that the consuming public needs to be protected.

Another problem with the bill is that its author does not seem to comprehend that an investor can choose from many active and passive investment opportunities including becoming a franchisee or opening their own independent business.  This is the same decision all franchisors have to make at some point in time when they were beginning the business that they later might choose to franchise.  If investors choose to become franchisees they have the opportunity to select from thousands of franchise opportunities available in California and they can make their business decisions based on the abundance of publicly available information.  Some of this information is included in the disclosure document mandated by the State of California that details each party’s rights and obligations.  Many people choose not to become a franchisee because the terms contained in the franchisor’s offerings do not meet their investment requirements.  Others don't become franchisees because of the restrictions and obligations required by the franchisor over the use of the franchisor’s personal property.  Some don't become franchisees because they have an idea and wish to risk going it alone so down the road they can become franchisors.  Franchising is simply one method in which to get into business but it’s not right for everyone.  

The bill mandates terms that all franchisors will be required to include in their California contracts and grants new and expansive rights to franchisees including a perpetual right to use a franchisor’s property, the elimination of post term covenants and restrictions on a franchisor’s right to place locations where customers shop. The bill fails to address the economic harm caused as it strips from franchisors significant personal property rights without any compensation.  I am very uncertain as to why anyone would think this is either fair or creates a level playing field, or that it is wise to dramatically limit a franchisor’s rights to enforce its standards, and by doing so create unintended risks for consumers in California.

Certainly Californians will be inconvenienced, as franchisors will be unable under the law to open locations throughout the state.  Companies like Starbucks, which are not franchised, are free to place their locations wherever they think they are needed to best serve their existing and prospective customers, but that will not be possible for franchisors in California if this ill-advised bill is passed.  Even with mandated pre-sale disclosure of the territorial rights granted to franchisees, AB 2305 prevents franchise systems from doing the same thing.  This will take away the franchisor’s ability to establish critical mass in markets in California, which will put them at a competitive disadvantage with other brands.

The rule does not even make sense economically as under the law a new location cannot have more than a six percent impact during the first 12 months on an established franchised location.  As franchising is used in over 120 different industries and many of those industries do not even have fixed locations, it is unclear how this type of fungible approach could even work.   The law certainly does not seem to recognize that initial locations usually do extremely well and the second location will always have impact on them when they open.  The law does not tell what the correct sales a business should even have.  For example, if a restaurant system averages $100,000 sales a month per location and the first franchisee in a market achieves $500,000 in sales, if the second location opens and the combine sales of the two locations remain at $500,000, under AB 2305, the franchisor can’t have two locations.  Under this example the market might hold five locations but the franchisor would be limited to only one since they could not impact the first location by opening the second location.  I am not sure how that is a level or fair playing field either.

Imagine if AB 2305 was the law in California back to the 1950s.  In addition to having only one baseball team and one football team in Los Angeles, you would have only one Marriott hotel, one McDonald’s and if they were a franchisor only one In-n-Out Burger.   Territorial rights granted by a franchisor in California should simply state what is clearly disclosed in the offering documents provided to franchisees as it is elsewhere.  If the prospect does not like the terms, then they don't have to become a franchisee or can choose another franchise offering from another brand.  
 
AB 2305 also requires that a franchisor must be competent, which sounds so reasonable.  But this requirement is unsupported by any empirical studies that there is any problem with franchisor competence today.  When Congress looked at this issue a decade ago, they found it was not needed.  Besides, competency is not even defined or measurable and therefore is simply not good public policy.  This duty will result in massive amounts of litigation, and likely creates such a risk that it may effectively stop all franchising activity in California.  Let’s consider that the bill does not answer any of these truly simple questions.
•    Will there be big franchisor competency standards and small franchisor competency standards and does the industry matter?  
•    Will the standard be the same for new and mature franchisors?  If they are the same for all, how will a new franchisor meet the same standard as achieved by IHOP, The UPS Store or McDonald’s?  Under the law would Pinkberry have been allowed to offer franchises in California since it did not have the same competency as Baskin-Robbins when they began to franchise?
•    Will the state accept the Certified Franchise Executive designation issued by the International Franchise Association as an indication of competency?  If not the IFA, who will determine if a franchisor is competent?  Franchisee advocates?  Franchise regulators? The courts?

This bill also contains prohibitions and limitations on termination, renewal rights and post-term covenants.  It has the unintended consequence of cutting the benefits franchisees look for in any franchise system and puts franchisees and their equity value at heightened risk from the actions of other franchisees.  It takes from franchisors substantial value they have in their personal property and transfers that value to some franchisees, without any compensation.  It is a radical departure from how business is conducted in the United States.  

 
Where are the limits under the law and how far will California go to dictate the terms of the franchise offering?  Will regulators next want to determine the length, curriculum, cost and who is required to attend initial training?  Clearly training is very important.  Will regulators be able to mandate the frequency and scope of franchisor provided field support visits?  Field support is also important.  Perhaps the regulators will want to determine fees and mandate a minimum acceptable return on investment before a franchise is even offered.

California is an important market and franchisors will most likely continue to expand in California, but I suspect that they will first look elsewhere for growth and possibly limit their California expansion to non-franchisee owned locations (in other words, company-owned stores).  Franchisees will be seriously damaged, as opportunities for investment available in other states may not be available to them in California.  The bill puts consumers at a higher risk because of the restrictions on a franchisor’s ability to maintain and control their standards and will certainly limit their convenience.

Because of these and other problems, I trust that sane heads in California will understand the problems with AB 2305 and following the scheduled hearing, decide not to advance the measure.  

The franchising industry continues to grow in the United States despite a still sluggish and uneven economic recovery, with nearly 825,000 establishments, supporting nearly 18 million jobs (direct and indirect) and $2.1 trillion in economic activity, representing 3% of overall U.S. GDP. The reason? It’s a proven, structured and a very scalable model.  More important it is fair. The terms of the franchisor’s offering is clearly defined and presented to the prospective franchisee, for their evaluation and determination, well in advance of their making any decision about becoming a franchisee.  That is the law in the United States, including California.   

Clearly it’s time to begin to understand why relationship laws are even contemplated and for franchising to do a better job of educating elected officials on why they are not needed or beneficial.  The real facts are that relationship laws have not been a positive addition to franchising and franchisees, franchisors and consumers have been negatively impacted because of them.  

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