From a franchisor’s perspective, it is important that all customers receive the same quality product and service offering regardless of what outlet they may visit. The menu of product offerings must be consistent, and the procedures for customer service correctly followed. The value of the franchisor’s brand depends on this consistency, and the more valuable the brand, the more likely it is that customers will purchase goods and services from a franchisor’s outlets. A valuable brand benefits both franchisors and franchisees.
But there is a well-known problem with franchising that works against consistency, and this problem is great enough to cause some brands to avoid franchising as a method of operation. Specifically, this is the problem of free-riding. As one commentator noted:
The value of the trademark is, however, vulnerable to franchise free-riding. This is a problem that has already received considerable attention from scholars and the courts. A franchisee is inclined to make decisions about how much effort to put into the business based on the profits that will accrue directly to her in her own outlet. She is not inclined to take into account that, because customers will make judgments about the quality of the entire franchise system based on their experience at an outlet, cost-saving reductions in quality at her outlet will affect the overall value of the trademark and thus the profits of other franchisees and the franchisor. If all franchisees, facing the same incentives, act in this way, the value of the trademark will suffer dramatically. (Hadfield, Stan. L. Rev. 917, 949-50 (1990).)
Economists have long said that one way to deal with this problem is through contractual controls that tend to dissuade free riding, citing most often the contractual right to terminate a shirking franchisee’s franchise. Termination, however, is for many practical reasons a “last-ditch” tool, reserved for only the most severe situations, and this is especially so in jurisdictions with franchise relationship statutes that restrict a franchisor’s ability to terminate a defaulting franchisee.
Franchise agreements may include provisions calling for late fees and/or default interest rates to encourage prompt payments. In some cases, where the franchisor provides an essential service (such as a hotel reservation system) or an essential product, the franchise agreement may authorize a franchisor to suspend its performance. Otherwise, not a lot of franchise agreements contain provisions specifically designed to encourage a franchisee’s full compliance with system standards, or discourage its non-compliance. The fact is that a lot of franchisors (and franchise lawyers) tend to be copy-cats, borrowing the same essential contract terms from one agreement to another.
It should be possible to craft contractual provisions designed to nudge compliance. It only takes a little imagination and a willingness to experiment on the margins. I know a few that have tried. For instance, there is a franchisor that grew weary of seeing franchisee employees out of uniform, or driving dirty vehicles required by the franchise. To discourage this behavior, it has implemented a set of proscribed “fines” (I call them fines, but they are really liquidated damages) for a list of common violations from system standards. This list of fines, reviewed and endorsed by a franchise advisory council, seems to have worked to encourage compliance with system standards, and as a tool to spotlight to the importance of compliance within the franchisee community.
I also know another franchisor that uses rebates as an incentive for compliance. In this system, franchisees are encouraged, but not required, to participate in monthly promotional programs offered to their customers. All franchisees are charged a marketing fee based on a specified percentage of gross sales, but a franchisee who has fully complied with all aspects of that month’s programs receives a 2% rebate of the fee. True, some franchisees still elect not to participate, but the percentage of participating franchises has increased, albeit grudgingly so by some franchisees.
And there may be other things a franchisor could do through its agreement to incentivize compliance. These contractual provisions will never eliminate the problem of noncompliance with system standards by all franchisees, but they are apt to discourage a franchisee who would otherwise consciously decide to ride off the efforts of complying franchisees. The typical franchise agreement can be tweaked to encourage good behavior. And that is a lot better result than issuing piles of notices of default.