Updates on Franchise Law
October 14, 2014
Now more than ever, it is important to understand brand standards: why they are set; how they affect franchisors, franchisees, and customers; and what the boundaries of brand enforcement policies should be.
Why now? Legal developments over this past summer have placed brand standards at center stage in a national debate. In July, the Office of the General Counsel of the National Labor Relations Board (“NLRB”) asserted that franchisor McDonald’s and its franchisees could be deemed joint employers for purposes of claims under the National Labor Relations Act, based on the franchisor’s perceived exercise of broad control over its franchisees. (See the August 5th issue of the Franchise POST for a full report on this development.) In August, the California Supreme Court took the opposite view in a sexual harassment case that drew national attention, Patterson v. Domino’s Pizza LLC. The California court held that franchisor Domino’s Pizza was not a joint employer with its franchisee, concluding that the franchisor had the right to take actions intended to protect its trademark and ensure a uniform experience for customers of its franchise system.
The NLRB General Counsel and the California Supreme Court have taken dramatically different positions on an issue that goes to the heart of the franchise relationship: a franchisor’s ability to control and protect its brand.
A franchise concept is defined by the goods and services it offers to customers under its unique trademark or service mark. As the trademark gains recognition, the goodwill associated with the mark grows, for the benefit of the franchisor and its franchisees. Federal trademark law, the Lanham Act, governs the rights and responsibilities associated with owning a trademark. The trademark owner must police the use of its mark to protect its rights in the mark and to protect consumers from being confused about the source of goods or services offered under the mark. The franchisor, as the owner of a system’s trademarks is responsible for protecting the marks. But the franchisor shares with its franchisees the responsibility to enhance the strength of the marks by providing a consistent and favorable experience for customers of the system.
Brand standards are necessary to ensure that trademarks are being used properly. In the franchise context, brand standards may be found in both the franchise agreement and the operations manual provided to franchisees when they enter the system. The franchise agreement typically gives the franchisor broad latitude to control its brand, including its trademarks, authority to enforce its brand standards, and flexibility to change those standards from time to time. The following language, found in many franchise agreements, illustrates the franchisor’s control and discretion to modify brand standards:
The franchisee agrees that changes in the standards, specifications, and procedures may become necessary and desirable from time to time and agrees to accept and comply with such modifications, revisions, and additions to the operations manual, which the franchisor, in good faith exercises of its judgment, believes to be desirable and reasonably necessary.
The operations manual will articulate brand standards in greater detail through instructions on how to market the products and services of the franchise concept and how to operate the franchised unit. A franchisee’s failure to abide by these standards can result in a wide range of responses by the franchisor, ranging from remedial training to termination of the franchise license.
The enforcement of brand standards benefits the franchisor and its franchisees alike. For the most part, franchisees understand that the consistency of products and services that form the basis of the franchise concept enhances customers’ experience, which translates to higher revenues for the franchisees and the franchise system. Franchisees depend on the franchisor to enforce the standards that ensure this consistency. Indeed, franchisees expect their franchisor to enforce its brand standards against other franchisees in the system. In some cases, franchisees have even sued their franchisor – although not successfully – for failing to enforce brand standards against their fellow franchisees.
Brand standards that affect health and safety of customers will likely be unilaterally mandated and enforced by the franchisor, without flexibility. These mandated standards are common in the food and beverage industry, where there is an emphasis on sourcing, quality of ingredients, handling of food and drink, hand washing by employees, preparation methods, avoiding food borne illness, and safe responsible service of alcohol. Additional health and safety standards will include security and insurance requirements. All of these standards are geared toward protecting the customer’s brand experience. Failure by a franchisor to enforce these standards can have far reaching consequences for the brand.
Other brand standards relate to how the franchisor wishes to operate its system. These standards may include the look of the facility, the uniforms worn by employees, and how the franchisees offer the system’s products and services to customers. The philosophy of the franchise model is that a customer can expect the same quality of goods and services at each franchised location within the system. The way to ensure this uniform quality is by enforcing the system’s brand standards. Some of these standards will be stated as mandates, while others will be stated as recommendations or suggestions. From the franchisor’s perspective, a franchisee that fails to comply with these standards risks diluting the brand and hurting the prospects of success for itself and for other franchisees as well.
Franchisees expect their franchisor to enforce brand standards, but they also assume that the franchisor will enforce those standards in a consistent, non-discriminatory manner. In other words, the franchisee anticipates that the franchisor will uniformly enforce its standards throughout its system in a reasonable and non-arbitrary manner. The franchise relationship is grounded on predictability. If the franchisor makes unilateral pronouncements about standards without a reasonable basis, it risks franchisee resistance – even if the standards make abundant sense. For the franchisor, there is always a delicate balance between the enforcement of brand standards and maintaining a positive relationship with franchisees.
As the franchise relationship is grounded in a long-term contract – often 10 to 15 years – maintaining brand standards also will require franchisees to make periodic upgrades to their franchised units. These obligations often will be found in both the franchise agreement and the operations manual, which likely will undergo many modifications during the term of the agreement. Because required upgrades may be expensive, it is important for franchisees to understand these obligations before they enter into a franchise agreement. In some cases, there may be a cap on the amount a franchisee is required to spend on upgrades during the term of the franchise agreement. It is also more than likely that, as a condition of renewal, a franchisee will be required to undertake additional upgrades to the franchisor’s business model to match the then-current market for the system’s products or services. From the franchisor’s perspective, these upgrades are important for keeping its brand fresh. But franchisors must be sensitive to the fact that franchisees often have limited financial resources to make such upgrades. Therefore, franchisors sometimes offer financing alternatives to franchisees to make the upgrades.
From time to time, a franchisor may see the need to change material aspects of its business model. In some cases, the brand may even change its name to adapt to changes in its products and services, or it may change its hours of operation to better position its services within the marketplace. Whatever these changes may be, the franchisor expects franchisees to comply with them.
Franchisees can be blindsided by the imposition of new standards. Therefore, best practices suggest that the franchisor begin the process of changing standards by convincing the franchisees that the changes will be beneficial to their business. The franchisor also may want to phase in the changes, to give franchisees ample time to mentally absorb and physically implement them. Some franchisees may reject even the most reasonable efforts to implement changes. In that case, the franchisor may be required to resort to invoking the language in its franchise agreement to enforce those standards.
The controls that a franchisor uses to enforce system standards may place the franchisor in the cross-hairs of a third party claim asserting that the franchisor is jointly liable for the acts of its franchisees. Whether there is enough control to establish a joint-control relationship, rather than the independent contractor relationship that franchisors assert exists, will be a question of fact. The question should be analyzed by focusing on how the franchisor’s enforcement of its brand standards relates to the specific acts that form the basis of a claim. The jurisdiction where the claim is heard may influence the result as much as the qualitative tests put forth to determine control. The wording in the franchise agreement, which is drafted to exclude any joint legal relationship between the franchisor and the franchisee, is not dispositive. For example if the claim relates to an injury blamed on the security provided at a franchise location, beyond the franchise agreement, the inquiry will focus on the control exercised by the franchisor over security at the location. These specific control factors may be found in the franchisor’s operations manual. The tighter the controls placed on the franchisee, the more likely that a franchisor may be found liable for the acts of the franchisee. If brand standards are expressed as suggestions rather than mandates, this may reduce the risk of a finding of control.
Franchisors should examine both the mandates and the suggestions they issue to their franchisees, to determine whether the rewards of uniform enforcement of system standards outweigh the risks of potential liability for joint control with their franchisees.