At What Cost?
When it comes to profit, the power lies in the pricing
“Law logic—an artificial system of reasoning, exclusively used in courts of justice, but good for nothing anywhere else.” —John Quincy Adams
Amidst a sea of obligations to consistently operate their businesses to their franchisors’ brand standards, at least franchisees could always point to an island of independence: the prices they charge customers.
As a result of the Sherman Act in 1890, Dr. Miles Medical Company v. John D. Park & Sons Co. (1911) and United States v. Colgate & Co. (1919) the federal government thought it was protecting the general public by controlling businesses and eliminating their ability to establish prices in their downstream distribution channel. These laws against price fixing have been around so long they have become part of our business DNA.
As businesspeople, we have become comfortable with the “manufacturer’s suggested retail price,” and including “at participating locations” in our advertising. We do not talk about pricing and when we do, it is only under the strict supervision of our lawyers. After all, based on the Sherman Act, Dr. Miles and Colgate retail price maintenance plans (RPM) were considered inherently illegal. Then came State Oil Co. v. Khan (1997), followed a short decade later by Leegin Creative Leather Products Inc. v. PSKS Inc. (2007), when the Supreme Court pivoted and said “maybe setting prices is not bad all the time.” Given this new power, will franchisors begin to set resale prices for their franchisees? Will “at participating locations” go the way of Air America and Lehman Bros? Probably not. At least, not soon. That is, unless Burger King gets its way.
For nearly a century, RPM agreements (agreements between a manufacturer and its resellers on resale pricing) were found to be “per se” (inherently or automatically) illegal. Congress and the courts felt that price controls limited competition and were therefore not in the public’s best interest. Khan and then Leegin changed that by allowing companies to set maximum and minimum prices that could be charged to the public by their downstream participants. But now, instead of businesses knowing that establishing pricing was always illegal, the Supreme Court made it possible—so long as the policy met the “rule of reason.”
Through their rulings, the Justices finally came to grips with three basic business principles: 1) Companies should have the right to define their own method of downstream distribution; 2) retail price maintenance can be both anti-competitive and pro-competitive; and 3) the legality of an RPM strategy should be judged based on each company’s downstream strategy and the particular circumstances of their business.
Moving from per se to a rule of reason standard has been around since Colgate, but its practical implication is that it substitutes a definitive position with one that is a highly subjective and requires a fact-based review to determine whether doing so is in the public’s interest. Even though there are precedents to look at for guidance, the rule of reason is fraught with the potential for continuing litigation and is the type of doctrine designed for litigators.
The power of pricing
So why haven’t franchisors exercised this new pricing power? For a number of reasons: There’s the threat of litigation. Baby Sherman Acts exist at the state level, modeled after the Sherman Act. Congress will likely revisit Sherman, Miles, Colgate, Khan and Leegin in the near future and try to modify or undo the Court’s decisions. Existing franchise agreements may not give franchisors the right to establish prices. There is a well-founded fear that doing so risks disrupting franchise relations. The complexity in establishing pricing in multi-brand segmentation environments where, the offerings may overlap or compete (think hospitality brands). And there are the simplest of questions: Is establishing prices for franchisees even a good business strategy? Does the franchisor have the knowledge and capability to do so? And if so, what is the beneficial impact on the bottom line, short-term and long-term, for the franchisee and the franchisor? Burger King is embroiled in a price-setting squabble with the National Franchisee Association over its requirement that franchisees sell the double cheeseburger for $1. Burger King is relying on its franchise agreements and Khan in setting its promotional pricing policy.
But with the NFA bringing the lawsuit instead of the Burger King franchisees, this case addresses a second issue of importance to franchisors and franchisees. Does a franchisee association have the requisite legal standing to sue a franchisor? Franchising is, after all, a contractual relationship between a franchisor and each of its franchisees—it’s a personal relationship. This is not the first time the issue of association standing has been addressed by the courts, and the NFA will need to meet some tests to determine if it can sue as a representative of the franchisees. But should they meet those requirements, it could have much broader and far-reaching implications for franchisors.
Burger King claims the issue of maximum pricing has previously been litigated and that the court found the franchisor had the right to require adherence to a value menu with maximum prices by its franchisees. The NFA disputes that assertion. According to the facts set out by Burger King in its filings, corporate has not established a fixed price for the promotion, but instead set the maximum price at $1. The NFA claims Burger King set the price at $1, and by doing so has caused its members to lose money. But under the rule of reason, does maximum pricing need to ensure that an individual transaction be profitable, and, if it does, how should that profit be determined? If profits are essential under the rule of reason, do you measure costs at the gross profit level or do you include all costs associated with operating the business? If it is the latter, how do you deal with franchisees who have high salaries, high debt and high rents, who might lose money even if the product was sold at a non-discounted price? There is a market ceiling that can be charged on any product; profitability of a business is never assured. Further complicating this analysis is the very nature of promotions and the basics of marketing. Promotions are generally geared to increase traffic by introducing or re-introducing your brand to customers. Promotional strategies are also tied to an assumption that when customers buy the discounted item, they also buy full-priced companion items—and that friends who accompanied them will buy also.
If through tests at company-owned locations, marketing studies and the actual performance of the campaign, Burger King can show the benefits of its approach (after all, the promotional strategy may yet prove to stabilize or increase profit performance overall), under a rule of reason analysis, that measures total impact rather than individual product profits. most lawyers I have spoken with expect Burger King to prevail.
And finally, there is an underlying question of whether franchising should be bound by different rules of marketing than vertically integrated companies (company-owned enterprises like Starbucks, Sears and Wal-Mart) which routinely present a consistent promotional message to customers—one which has always included the ability to set promotional pricing. The argument against this has centered on the franchisees’ ownership and investment in their businesses, but is that argument sufficient for the courts to treat franchising differently than its non-franchised competitors?
Will a Burger King win create an opportunity other franchisors will choose to follow? It could if the case can be made that the benefit of a clear consumer brand promise requires consistency, regardless of who owns the ultimate end of the distribution chain or the profit on the individual item in the promotion. Remember, the four “P’s” of marketing: product, place, promotion and price. Whether the basic business strategy of consistency includes a franchisor’s ability to control its promotional message, including a maximum price, is the issue this litigation will ultimately decide.
Assume for a moment that Burger King wins. Does that mean franchisors will routinely set prices for non-promotional offers, or will they instead limit themselves to promotional offers? As it relates to pricing in general, the likely answer will be “no.” Franchising is a mature business strategy based on the premise that franchisees are individual businesspeople who maximize the potential for success of their business because they take the beneficial aspects of the franchisor’s system and execute superbly based on their knowledge of their local markets. If for no other reason than such a move would be confrontational, I don’t see a wholesale move by franchisors to set everyday pricing for franchisees.
If, however, they are able to set maximum pricing under Khan, will that result in franchisors taking the next step and requiring their franchisees to adhere to minimum prices a la Leegin? I doubt that will occur either. With maximum pricing the franchisor can at least easily argue that the maximum price limit is pro-consumer because it keeps prices low. Even if the case could be made under the rule of reason that minimum pricing protects a brand because allowing low prices could result in the devaluation of the brand as a whole, franchisors will surely have to explain to a judge why they are trying to raise the prices consumers pay for their product.
But for promotional offers, my guess is that other franchisors will adopt a similar approach over time. We already have significant promotional consistency, even with “at participating locations,” as evidenced by a multitude of promotional campaigns such as Subway’s $5 foot-long promotion, value and combination meals offers and the affinity promotions used in the hospitality industry. But franchisors will first need to understand their rights under the baby Sherman Acts, assess the impact and potential disruption to franchisee relations and the probability of litigation if a prescribed price is included in a marketing campaign. They will also have to examine cost to determine, in advance, if the business case under the inexact science of an ill-defined legal theory such as the rule of reason can be made.
Khan and Leegin did not give franchisors the per se right to set pricing, it only cracked open the door a bit. Let’s hope that the ruling in Burger King gives us guidance to clarify the issue. If the decision is not clear, franchisors will likely continue to manage their systems and promotions within the traditional boundaries we have been used to. Maybe other brave souls will test the limits, resulting in other lawsuits. But, with a clear and transferable BK win, as with all new tools, the promotional landscape as we know it is certainly going to change.
Michael Seid is founder and managing director of Michael H. Seid & Associates, an international franchise consulting firm with both established and new franchisors as clients. He can be reached at firstname.lastname@example.org