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Bucking the system

Lessons from Bores v. Domino\'s Pizza


How franchisors can make money off of sales to happy (not angry) franchisees

The practice of franchisors making a buck off of sales to franchisees has always been the proverbial red flag in front of a bull. In its list of the 12 worst franchise agreement provisions, the American Franchisee Association identifies “sole sourcing requirements” that force franchisees to purchase products solely from their franchisor. Forbes.com published in October 2006 its “Ten Good Reasons Not to Buy a Franchise.” No. 7 is “inflated pricing on supplies” because “almost all franchisors receive kickbacks from the vendors.”

The practice of franchisors selling products or services at a profit or receiving a commission, rebate, or supposed “kickback” from suppliers has also been grit for lawsuits. A number of franchisees filed a class action arbitration proceeding against the Blimpie’s franchisor for allegedly taking “kickbacks” that produced inflated prices for products. A group of New England franchisees of D’Angelo’s Sandwich Shops filed suit in Massachusetts claiming that “kickbacks” paid to their franchisor by affiliates on franchisee purchases violated the Robinson-Patman Act. Lawsuit-embattled Quiznos also faces class actions in several states by franchisees who contend that the franchisor required them to purchase products from it or its affiliates at inflated prices while, at the same time, setting retail prices so low that franchisees cannot make a profit.

Balanced against the interests of franchisees in buying at the cheapest possible price are the interests of franchisor and franchisee alike in the sale of quality products and services. Even where franchisees have the right to alternative sources, the franchisor is still responsible for maintaining uniformity and quality and must therefore devote resources to the approval of alternative suppliers of significant products and services. The Dairy Queen franchisor learned a few years back in the Collins v. American Dairy Queen litigation that allowing franchisees the right to alternative suppliers can backfire, when some of its franchisees filed a class action claiming that the franchisor so delayed and obstructed the product approval process that it had effectively forced franchisees to buy from it.

Bill Killion and Renee Dotson are members of the Franchise and Distribution Practice Group in the Minneapolis office of Faegre & Benson.

Franchisor and franchisee alike also share an interest in having a franchisor that is profitable. No franchise system will long survive if the franchisor is not profitable, and income from the sale of products or commissions is one route to profitability. There is nothing wrong in the abstract with a franchisor making money off sales to franchisees, in addition to upfront franchise fees and ongoing royalties.

Although they may not like it, franchisees have little legal recourse where the franchise agreement spells out the right of the franchisor to make money off of sales to franchisees. As the franchisor learned in the Bores v. Domino’s case, the devil is ultimately in the details of the franchise agreement.

The Domino’s franchise agreement promised franchisees that the franchisor would provide them with specifications for a variety of items, including software and hardware — specifications that the franchisees could then use to buy the items from “any source.” When Domino’s told its franchisees that they had to buy hardware from IBM and software from the franchisor for its new “PULSE” point-of-sale system, a number of franchisees balked and filed a lawsuit. The court held that franchisees had the right to alternative sources for the hardware and software and rejected Domino’s argument that its right to establish specifications and system standards modified the franchisee’s apparent contract rights. The franchisees did not challenge Domino’s right to sole source ingredients, but argued that Domino’s reservation of this right for ingredients proved that it did not have the same right for hardware and software.

The question is whether there is a way to make everyone happy when it comes to franchisors making money off of sales to franchisees. Probably not, but here are some ideas for franchisors to put a grin on most franchisees’ faces.

Reserve broad rights: The franchisor should reserve in its franchise documents the right to designate a sole source for products or services, including itself, even if it has no present plan to sell to franchisees. Things change. Domino’s probably didn’t think it would ever sell software to its franchisees when it drafted its form franchise agreement. And while at it, the franchisor should draft the agreement to say that the price will be the posted price (or price then in effect), which provides a safe harbor from claims of unreasonable prices under the Uniform Commercial Code.

Include commissions: Income from sales to franchisees comes in the form of direct sales and commissions. Commissions are much cleaner and avoid all the burdens of the sales process. Franchisors should spell out in the agreement their right to make a commission from sales and state that the commission may or may not be related to services provided by the franchisor.

Be transparent: The more information a franchisor provides to franchisees about its revenues in this sensitive area, the better. If a franchisor is embarrassed to tell its franchisees what it is getting in commissions, then maybe it is getting too much. Besides, some states, like Washington and Hawaii, require a level of notice to franchisees, as do the current UFOC Guidelines. We are not suggesting disclosure of the least possible information, but essentially the most practical.

Have a “Catcher in the Rye”: Holden Caulfied, the protagonist in J.D. Salinger’s book, “Catcher in the Rye,” dreamed that he roamed the rye grass in the outfield to “catch” children playing ball from falling off a cliff at the edge of the park. Someone within the franchisor’s organization with authority (general counsel, perhaps) must “catch” management from falling off the cliff into excessive margins and commissions. The old saw is true — pigs eat, but hogs get eaten. Besides, profitable franchisees are happy franchisees and reasonable costs of goods is an essential part of profitability.

Get buy-in: Smart franchisees want their franchisor to earn a reasonable return on its investment. Don’t assume that franchisees will necessarily balk at commissions or margins that produce a reasonable return.

Consider alternatives: The two ways to make money in a business are to increase revenues and reduce costs. Contributions by suppliers to programs that the franchisor would otherwise finance reduce costs and are thus the equivalent of commissions. Programs eligible for supplier contributions are conventions, market studies, product development, and the like.

Think consideration: Supplier payments to franchisors for doing nothing are the least satisfying to franchisees. One state — Indiana — precludes franchisors from taking payments from suppliers except for services rendered. The more the franchisor contributes value in exchange for the commission, the better. And providing services in exchange for commission helps in defending claims of supposed “kickbacks” under Section 2(c) of the Robinson-Patman Act. Franchisors should use a supplier agreement that captures the services they are providing to “earn” the commission.

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