Franchise Supply Programs: Maximizing Payments to Franchisors and Minimizing Risk
An obvious topic of interest to any franchisor is how much money can be made by operating its business. A smart franchisor will recognize its suppliers as an important source of revenue that can contribute directly to the franchisor’s bottom line. Recently, I discussed the law applicable to supplier payments with Kenneth A. Goss, Esq., Senior Counsel for a leading franchise system. The following is Mr. Goss' guest post on this important topic:
Franchisors can, and often do, enjoy the fruits of an effective supply program by receiving payments from suppliers based on the goods and services purchased by the franchise system. Payments from suppliers, which can be a significant source of revenue for a franchisor, are generally regarded by regulators and the courts as an established franchise industry practice based on the contractual rights each franchisor reserves in its franchise agreement. However, franchisors should be mindful that plaintiffs’ counsel in franchise litigation cases often look to exploit any weakness in a supplier payment program arguing that the franchisor has unfairly benefited from payments at the franchisees’ expense. The lesson to take away is that a well-structured supply program can ensure that a franchisor obtains maximum revenue from suppliers while minimizing the potential risk from franchisee claims.
Franchisors realize revenue from suppliers in many ways. Federal regulations recognize that payments from suppliers include all revenue and other material consideration, whether direct or indirect, that franchisors receive from suppliers based on purchases by franchisees. Direct payments may take the form of an ongoing rebate, an ongoing marketing allowance or an up-front contract signing bonus. Additionally, franchisors may receive indirect payments, for example, when a supplier sells a certain good or service to units owned by the franchisor at a lower price than the supplier sells the same good or service to units owned by franchisees. In the case of an indirect payment, the franchisor is deemed to have received the cash value of the discount or other benefit to the franchisor. Simply put, a payment from a supplier is the value the franchisor receives for allowing a supplier to participate in the franchise system’s restrictive sourcing program.
Federal trade commission regulations governing the offer and sale of franchises are concerned primarily with imposing upon franchisors the obligation to disclose payments from suppliers in the franchisor’s disclosure document. Specifically, federal regulations state that each franchise disclosure document should disclose whether the franchisor or any of its affiliates have the right to receive payments from suppliers and, if so, require franchisors to further disclose: (a) the precise basis by which the franchisor or its affiliate derives such revenue; and (b) the total revenue, either as a flat dollar amount or percentage of the franchisor’s total revenue, that the franchisor and its affiliates receive from the purchase and lease of required products and services by franchisees. Franchisors must also disclose the identity of suppliers that contribute to the franchisor’s advertising fund in each case where the franchisor collects payments from a supplier for that purpose. As long as a franchisor complies with its disclosure obligations under federal regulations, the franchisor is largely free to enter into whatever payment relationships with a supplier it wants.
A franchisor’s right to receive payments from suppliers, and any limitation on that right, is primarily a contract matter between the franchisor and each of its franchisees. Courts have traditionally held that the parties to a franchise relationship are independent contractors, free to pursue their own business interests including free to agree to the disposition of payments from suppliers as the parties deem best. This means that, on the one hand, a franchisor may reserve in its franchise agreement the right to receive payments from suppliers without restriction whatsoever. Because most franchisors provide services in connection with payments from suppliers, for example, by investigating and evaluating suppliers, negotiating supply agreements, collecting franchisee orders and otherwise administering its supplier program, it may make sense for some franchisors to keep all of the revenue it receives from suppliers. On the other hand, franchisors may agree to deposit some or all of the payments received from suppliers into a marketing fund or otherwise use such revenue for the benefit of franchisees. This latter approach can be useful in growing the system while heading off certain equitable challenges to the franchisor’s practice of collecting payments from suppliers.
Attacks on a franchisor’s rights to receive payments have traditionally and consistently been rejected by the courts. Such attacks are usually based on a contract theory of an implied covenant of good faith and fair dealing and on a variety of antitrust theories, such as unlawful tying under the Sherman Act, unearned brokerage, commercial bribery, and racketeering. So far, these claims tend to not be resolved in favor of franchisees. For example, a typical equitable argument in cases where a franchise agreement is silent as to whether the franchisor may accept payments from suppliers, is that a franchisor is bound by an implied covenant of good faith and fair dealing. An implied covenant of good faith and fair dealing would preclude the franchisor from deciding how best to use payments from suppliers and would obligate the franchisor to turn the revenue from suppliers over to franchisees in most situtations. Courts tend to disagree with this approach. Instead, courts generally hold that there is no right to share in payments from suppliers where a franchise agreement is silent because silence simply means that the parties have not reached an agreement as to the distribution of revenue from suppliers.
Taking into account the legal aspects as briefly described above is only part of structuring the right supplier payment program. Franchisors and their counsel must also consider important business implications in trying to strike the right balance for a franchise system. By doing so, a franchisor can strive to obtain maximum revenue from suppliers while minimizing the risk from franchise claims.
