By Gary R. Batenhorst
An effective advertising and marketing program is essential to the success of any franchise system. One of the biggest challenges faced by any franchisor is to develop and effectively deliver to consumers a memorable, consistent message promoting the advantages of the franchisor’s goods or services. The projection of a uniform image is a key component as franchise systems seek to expand their reach nationally and internationally. McDonald’s Golden Arches are among the most recognized commercial symbols in the world.1 Wendy’s advertising campaign in the early 1980s became a cultural phenomenon when a series of commercials featuring a little-known actress named Clara Peller criticized competitors’ products with her then-famous question, “Where’s the Beef?”2
Today, as never before, franchised systems face significant obstacles in their efforts to deliver a uniform, consistent message to consumers. The growth of cable and satellite television systems provides consumers with hundreds of channels from which to choose, which vastly complicates local, regional, and national media placement decisions. The decline in newspaper circulation has impaired the effectiveness of print advertising, while the rise of the Internet offers potential advertisers with a wealth of potential sites on which to spend franchise advertising dollars, to varying degrees of effectiveness. Many franchisors expend large sums in developing and implementing marketing plans for their systems. These sums include expenditures in producing television and radio commercials and templates for print advertising programs, developing plans and programs for participation by the system in various forms of social media, marketing research activities to determine the effectiveness of various marketing vehicles, and search engine marketing and optimization activities designed to enhance the effectiveness of Internet advertising.
Franchisees also spend large sums on marketing. These expenditures often take three different forms. First, many franchise agreements require the franchisee to spend a certain percentage of gross sales on various forms of local advertising and marketing approved by the franchisor. Second, the franchise agreement often requires the franchisee to pay a specified percentage of gross sales into a regional or national marketing fund administered by the franchisor. Third, many franchise systems require franchisees to participate in local or regional marketing cooperatives with other franchised and company-operated locations within a specific geographic area.
This chapter will: (1) review myriad legal issues facing franchisors when they establish and administer national or regional marketing funds; (2) explore the legal and practical issues faced by franchisors in forming and providing for the governance of marketing cooperatives; (3) review the provisions related to marketing issues that should be included in the franchise agreement; (4) provide an overview of the consumer advertising laws that have an impact to the marketing programs of franchised systems; (5) discuss agreements—in addition to the franchise agreement—that deal with marketing issues in franchised systems; and (6) provide an overview of marketing issues addressed in franchise operations manuals and related manuals.
II. REQUIRED ADVERTISING EXPENDITURES
Most franchise systems require their franchisees to spend a specified portion of their sales on local marketing activities. Franchise agreements often include provisions that specify the percentage of sales the franchisee is required to spend and the types of activities on which these amounts may be spent, describe the franchisees’ rights and obligations in using the franchisor’s trademarks and other intellectual property, and specify the scope of the franchisees’ rights to use the Internet to promote the franchisees’ business. The franchise agreement normally requires the franchisee to use marketing materials provided by the franchisor or to have materials prepared by or approved in advance by the franchisor. This approval process should be described in the franchise agreement.3 The franchise agreement should also contain provisions that require the franchisee to maintain records of marketing expenditures, and that permit the franchisor to inspect these records to determine compliance with the marketing expenditure requirements in the franchise agreement and study the effectiveness of the advertising by the franchisee. The franchise agreement should provide that a failure to spend the required amount on marketing constitutes a material default.4
Determining the required amount to be spent by the franchisee raises several important issues. First, the franchise agreement should specify the amount to be spent on marketing activities—generally as a percentage of gross or net sales. Then the franchise agreement should identify the type of marketing activities that will satisfy the expenditure requirement, such as television, radio, and print advertising.5 Certain items that are excluded from the required advertising expenditures should also be identified. For example, the franchise agreement may exclude classified telephone directory listings, coupon redemptions, discounts, and the costs of products and services that are given away in calculating compliance with required advertising percentages. The franchise agreement may also exclude or count only a portion of shopping mall lease marketing payments. It is also important for the franchise agreement to identify whether the amounts paid to marketing cooperatives or advertising funds maintained by the franchisor will be credited against the franchisee’s required marketing expenditures, as some systems provide for such credits while others do not.
III. NATIONAL AND REGIONAL MARKETING FUNDS
The second primary vehicle for requiring a franchisee to fund marketing of the system is a national or regional marketing fund established and administered by the franchisor. Many of these marketing funds are national in scope, and the franchisee typically must pay a percentage of gross sales into these funds. In contrast with marketing cooperatives in which each member typically participates in the governance of the cooperative, marketing funds often are controlled solely by the franchisor. The operative language of the franchise agreement often reserves to the franchisor the right to direct all advertising programs provided by the fund with sole discretion over the creative concepts, materials used, and the media and markets selected. In some systems the franchisor seeks advice and input from its franchisees in the form of an advertising council, marketing roundtable, or other process, but the franchisor retains the ultimate decision-making authority. This broad discretion retained by the franchisor over marketing funds has raised a number of issues generating a considerable body of case law relating to marketing funds.
In one case, a franchisee in a system of hair-styling businesses, which paid 5 percent of sales into an advertising fund administered by the franchisor, claimed that the advertising provided by the franchisor was defective.6 The court rejected this claim, noting that the franchisee’s expert had testified in a deposition that he was unable to establish a causal connection between the alleged defective advertising and ineffective management, and any losses incurred by the franchisees. The court also noted that the franchise agreement provided that the advertising was to be at the franchisor’s discretion and that the franchisor expended more on advertising than the amounts contributed by the franchisees. The franchisee also argued that certain franchisees had failed to make their required payments to the fund and that the franchisor was obligated to enforce this requirement. The court rejected this claim, finding that the agreement did not give the franchisees the right to determine how these funds were to be disbursed.
Courts have differed on the duty of care the franchisor undertakes in managing marketing fund contributions. In one case, the franchisee of an oil change system alleged the franchisor had violated a fiduciary duty by not properly segregating and administering an advertising account to which the franchisees had contributed.7 The court rejected this claim, finding that the pleadings did not allege that the franchisor had substantially greater business experience than the franchisees as required for a fiduciary duty claim under Illinois law, that the franchisor was not entrusted with a significant amount of the franchisee’s business affairs, and that the franchisor’s obligations with respect to the fund were clearly delineated by the franchise agreement.
The court in Brock v. Baskin Robbins, USA, Co.8 permitted a group of more than forty franchisees whose franchise agreements were not renewed to proceed with a claim against the franchisor regarding misuse of advertising funds. The court determined that the franchisor’s commingling of the advertising funds paid by franchisees with certain other funds of the franchisor raised questions of fact regarding whether the franchisor’s actions breached the franchise agreement. The court also noted that there was conflicting evidence as to whether the parties intended to create a trust to which fiduciary duties were attached. While the result in Brock was reversed, the franchise agreement should make clear that even if marketing funds are maintained in a separate account and used solely for certain purposes described in the franchise agreement, the funds are not being held in trust and that the franchisor assumes no fiduciary duties in the administration of the funds. Clarifying this in the agreement may lessen the likelihood a court will determine that a fiduciary relationship exists.
The franchisor should also establish a procedure to provide its franchisees with an accounting of the advertising funds described in the franchise agreement. In Physicians Weight Loss Ctrs. of Am. Inc. v. Creighton,9 the court refused to dismiss a claim by the franchisee that the franchisor breached the franchise agreement by failing to provide the franchisee a statement regarding the operation of the advertising fund requested by the franchisee. The franchise agreement required the franchisor to have a statement of operations prepared annually by an independent certified public accountant and made available to the franchisee upon written request. The franchisor had rejected the franchisee’s request to obtain a copy of this report. This case illustrates the importance of including provisions in the franchise agreement regarding permitted uses of the franchisor’s advertising fund as well as provisions for providing an accounting of these expenditures to franchisees.
IV. MARKETING COOPERATIVES
Many franchise systems use marketing cooperatives as a means of securing the participation of a greater number of franchisees in joint marketing efforts within a specific geographic area. Cooperatives may also provide synergy in marketing expenditures by franchisees by avoiding disparate expenditures, which could be more effective if consolidated. Cooperatives can provide an effective means of localizing the decision-making process for some marketing expenditures. But at the same time, difficult issues often arise in the formation, governance, and operation of these cooperatives.
The threshold question is whether the formation of a cooperative will be mandated by the franchisor or proposed by the franchisees within a specified area. Franchisees may be more willing to participate in cooperatives they initiate, but without a franchisor mandate, some franchisees may decline to join the cooperative.
When the franchisor permits marketing cooperatives to be established at the franchisees’ initiative, the franchisor should specify whether a simple majority or a super majority of the eligible franchisees must vote in favor of establishing the cooperative. A super majority requirement is beneficial to secure broader support for the cooperative. However, regardless of the required vote to form a cooperative, once formed, all franchisees within the area should be required to participate. This eliminates the issue of “free-riding” franchisees who receive the benefits of cooperative advertising within an area without paying for this advertising. The franchise agreement should also specify whether company-operated units in the area will be required to participate and the level of their required contribution to the cooperative. A requirement that company stores participate at the same contribution level as franchised locations may be essential in securing the active participation of franchisees in the cooperative.
A second important issue in the formation of marketing cooperatives relates to the geographic area to be covered by the cooperative. Again, the franchise agreement should specify whether this determination will be made by the franchisor or by the franchisees seeking to form the cooperative. Marketing cooperatives are often defined to include all the units within defined counties, metropolitan statistical areas (MSAs), designated market areas, or areas of dominant influence.10 Some cooperatives provide for reduced contribution levels for units located on the fringes of the cooperative area that do not receive all media outlets in which cooperative advertising is placed.11 The franchise agreement should permit the franchisor to retain the flexibility to change the areas that are included in the cooperative.
An important issue in the food-service industry is how to handle nontraditional locations—units placed in convenience stores, airports, and similar venues. The owners of nontraditional locations may be less willing to contribute to marketing cooperatives, as the franchisees’ sales of the products of any one system may be relatively small compared to traditional locations. In addition, nontraditional location owners sometimes argue that their customers are a captive audience, such as college students or travelers, who are not influenced by cooperative advertising efforts or even national advertising conducted by the system.12 Some cooperatives address this issue by providing for a lower contribution requirement for nontraditional units.13 The Franchise Disclosure Document (FDD) should disclose the franchisor’s right to exclude nontraditional locations from the requirement to participate in advertising cooperatives.
Governance issues often present difficult challenges in the operation of marketing cooperatives. Voting rights are key issues. The simplest system is to provide each member location with one vote on all matters. Another approach is to weigh the voting based on the sales volume of each unit to increase the influence of successful units.14 One unit–one vote systems appear to be the most common, but such systems permit the cooperative to be dominated by one owner or a small number of owners within an area who control the majority of units. Such systems also enable the franchisor to control cooperatives in areas where the franchisor has a substantial number of company stores. Super majority requirements, at least on specified major issues, can lessen the influence of large operators. A cap on the number of votes given to one owner will also lessen the influence of these owners, but will likely be met with resistance from large owners. The franchisor may consider a cap on the number of votes it receives in an area where it has a large number of company-operated units.
Another important issue in the administration of marketing cooperatives relates to sanctions against cooperative members who fail to pay amounts owed to the cooperative in a timely manner. The cooperative’s governing documents should include language permitting cooperative funds to be used to pay legal fees and other expenses related to the collection of amounts owed by franchisees to the cooperative. It is important that the cooperative’s governing documents provide for the suspension of the rights of the member who is past due to participate in the cooperative’s meetings and other decision-making processes, but not for the suspension of the member’s obligation to make required payments to the cooperative. The cooperative should have the right to exclude from its advertising the addresses of franchised locations where the franchisee is in default of its obligations to the cooperative. It may be advisable to require the vote of a super majority to suspend a member to attempt to lessen the impact of personalities and politics on the decision to suspend this member. The governance documents should also describe the procedure for reinstating members who have become current in their past-due payments to the cooperative. The franchisor may include a provision in the governance documents requiring franchisor approval of suspension or reinstatement of members in addition to the required vote by other cooperative members. The franchise agreement should also include provisions that make a franchisee’s defaults under marketing cooperative agreements defaults under the franchise agreement and confirm the right and standing of the franchisor to sue the franchisee for violations of marketing cooperative agreements.
The requirements for the formation, governance, and operation of marketing cooperatives are often found in three sources: the franchise agreement, the bylaws of the cooperative, and the cooperative membership agreement. The franchise agreement should describe the general requirements for the formation of cooperatives, required participation by company and franchised units within a defined geographic area, and required contributions. The franchise agreement should not contain excessive detail regarding governance or operating issues, as such issues may change from time to time as the system evolves during the term of the franchise agreement. Most of the details regarding the governance and operation of the cooperative will be contained in the bylaws.15 Each cooperative member should be required to sign a membership agreement. This agreement varies in its detail but at a minimum should include an acknowledgement that the cooperative will be governed by its bylaws, and that the member will participate as a member in good standing throughout the duration of the cooperative.
Marketing cooperatives will often hire a local or regional advertising agency to assist in the operation of the cooperative. Franchisors sometimes require their cooperatives to use the franchisor’s advertising agencies. Franchisors may also require their cooperatives to coordinate their advertising campaigns with those of the franchisor or to keep the franchisor informed regarding the advertising planned by the cooperative, particularly when the cooperative plans a large advertising campaign. The agency may assist in developing plans and programs to support the cooperative’s strategies and objectives, purchase media to carry out these plans and programs, and in some cases, provide administrative support in the operation of the cooperative. The cooperative’s bylaws should address the selection of advertising agencies, the responsibilities to be assumed by the agencies, and the obligations of the agencies to coordinate their efforts with those of the franchisor and its advertising agencies. In many cases the cooperative—if it is established as a separate entity—or the franchisor will enter into a services agreement with the advertising agency to identify the scope of the work to be performed by the agency.16
Antitrust issues are an inherent risk for marketing cooperatives, given the collaborative nature of the activities among businesses that compete for the same customers within a geographic area. The primary issues of concern to cooperatives are the discussion of pricing by cooperative members, the potential for territorial allocation among cooperative members, and efforts by the franchisor to specify minimum or maximum resale prices for its franchisees within the cooperative.
Antitrust restraints can either take the form of vertical restraints, imposed by the franchisor on its franchisees, or horizontal restraints, agreed upon by businesses at the same level of a distribution system, such as franchisees.17 Antitrust issues may be subject to either a per se analysis or a rule of reason analysis. Under a per se analysis, certain practices, such as horizontal price fixing, are deemed to be anticompetitive without an analysis of the reasonableness of the restraint. Certain practices, including vertical territorial restraints, are subject to a rule of reason analysis, which considers the economic impact of the restraint.18 Two Supreme Court decisions in recent years have provided for a rule of reason analysis of such vertical restraints as minimum or maximum resale price maintenance.19 However, horizontal price fixing and horizontal territorial allocations remain subject to per se analysis, which substantially increases the liability risk to franchisees who engage in such activities with other members of marketing cooperatives.20
The Supreme Court’s decision in Leegin21 opened the door for franchisors to attempt to prescribe minimum prices to be charged by their franchisees.22 However, franchisors who seek to implement minimum price maintenance programs face challenges that include the need to prove the program passes scrutiny under a rule of reason analysis, state law statutory provisions or case law mandating that such programs continue to be reviewed under a per se analysis, and the possible application of a stricter rule of reason analysis if the program is reviewed by the Federal Trade Commission (FTC).23
V. DRAFTING MARKETING PROVISIONS FOR FRANCHISE AGREEMENTS
Start-up franchisors and franchisors preparing a new form of franchise agreement for their system should consider including language on a variety of marketing issues to lessen the likelihood of disputes with franchisees related to these issues. As a threshold matter, franchise agreements should always include language permitting the establishment of marketing cooperatives and national or regional advertising and marketing funds. Including this language, even in cases in which the franchisor does not initially intend to use marketing cooperatives or funds, saves the franchisor from the difficult task of convincing existing franchisees at a later date to agree to amend the franchise agreement to provide for the establishment of cooperatives and marketing funds. The franchise agreement should address issues related to the commencement, operation, amendment, and termination of marketing funds and cooperatives. The franchise agreement may provide for the franchisor to give notice to franchisees that may range from ninety days to one year before commencing to collect revenues for the marketing funds or forming cooperatives. The franchise agreement should provide for the segregation of marketing funds into separate accounts by the franchisor, and the franchisor may want to include language that the franchisor does not intend to create a trust or fiduciary relationship.24 Some franchise agreements provide that the amount franchisees are required to contribute to a marketing fund may be increased by the affirmative vote of a specified percentage of franchisees.
Franchisors must exercise care in drafting provisions that give franchisees the opportunity to provide input into national marketing programs. In some systems the franchisor may establish a franchise marketing council or similar group of franchisees whose specific function is to provide input on marketing issues. Some systems hold meetings in which the franchisor solicits input from a selected group of franchisees regarding marketing strategies and tactics. Still other systems rely on their established franchise advisory councils to provide input on a wide range of issues concerning the franchise relationship, including marketing issues.
These mechanisms enable franchisors to maintain significant controls over the development and execution of marketing strategies, while seeking input from franchisees to obtain a broader range of opinions and to obtain greater acceptance of the franchisor’s marketing strategy. Franchisors are well advised to provide franchisees the rights to participate in the governance and administration, or at least offer input on the use of marketing funds provided for by the franchise agreement or other governing documents of the marketing funds. However, if a franchisor intends to exclude franchisees from such involvement, the franchise agreement and FDD should make that clear. In D & K Foods, Inc. v. Bruegger’s Corp.,25 the franchise agreement obligated franchisees to contribute 2 percent of gross sales to support the Bruegger’s national network. A group of franchisees sued the franchisor claiming that the franchisor failed to permit franchisee representatives to participate in the administration of this advertising fund. The court agreed with the franchisees that the plain language of the franchise agreement obligated the franchisor to establish a national advertising council comprising both franchisor and franchisee members. The court noted that the franchise agreement permitted the franchisor to modify the powers of the national advertising council only pursuant to governance documents prepared by the franchisor. The court permitted the franchisees to pursue discovery to determine whether the franchisor had properly prepared documents relieving the franchisor of certain contractual obligations to the franchisees regarding the administration of this fund.
The supreme court of Connecticut upheld an arbitration award of punitive damages of $150,000 each made to two Subway franchisees in a dispute related to the election of directors to the Subway franchise advertising fund trust.26 One of the defendants, Frederick DeLuca, was the founder of Subway and a 50 percent owner of the franchisor. He had concerns about the plaintiffs’ candidacies for election to the trust board and their campaigns. DeLuca prepared a video expressing his concerns in which he encouraged the incumbent board members to make certain changes in the election rules and threatened to end the franchisor’s voluntary contribution to the trust if the board did not make his recommended changes. After viewing the video, the board cancelled the election and adopted new rules that prevented the two plaintiffs from seeking elections to the board. An arbitration panel determined that the defendants’ actions improperly interfered with the election and violated the Connecticut Unfair Trade Practices Act.27 The supreme court of Connecticut upheld this award.28
Franchisors often reserve to themselves considerable discretion in the management of marketing and advertising funds. Courts have provided mixed results in cases in which franchisors are challenged on their use of this discretion. In a case involving an IHOP subfranchisor and its franchisee,29 the subfranchisor established a cooperative advertising program as permitted by the franchise agreement to which the franchisee was required to contribute 1.5 percent of sales. The franchisee alleged that the subfranchisor used the funds solicited for the cooperative advertising campaign to promote the subfranchisor’s locations while excluding the franchisee’s locations. The subfranchisor argued that even if the franchisee’s claim was true, another section of the franchise agreement granted the subfranchisor sole discretion over the use of the funds. The court agreed that the discretion granted to the subfranchisor was undoubtedly broad, but said an argument could be made that such a broad interpretation by the subfranchisor of its discretion was inconsistent with the franchise agreement provision permitting the establishment of cooperative advertising funds and inconsistent with the intent of the parties as expressed in the franchise agreement. The court refused to dismiss the franchisee’s claim for breach of contract.
In Burger King Corp. v. Kellogg,30 a terminated franchisee asserted counter-claims based on Burger King’s use of certain advertising funds. The franchise agreement required the franchisee to pay 4 percent of its monthly gross sales to Burger King Corporation for use in advertising, sales promotion, and public relations activities—both in the franchisee’s market and on a national basis. The franchise agreement provided that all expenditures were to be at Burger King’s sole discretion. The franchisee claimed that Burger King breached this provision by failing to use the advertising funds in franchisee’s market for seven months and for not engaging local advertising concerns. The court rejected the franchisee’s argument, finding that the franchise agreement allowed Burger King to use the advertising funds as Burger King determined to be beneficial, which could include advertising in local markets through the use of national media.
Another case involving a Burger King franchisee reached a different result than Kellogg. In Burger King Corp. v. Austin,31 another terminated franchisee made claims similar to those in Kellogg regarding the expenditure of advertising funds. The court rejected claims based on breach of contract and conversion theories, but said that the franchisee may have stated a claim based on the covenant of good faith and fair dealing, which required Burger King to exercise its discretion in a manner consistent with the parties’ reasonable expectations.
In Clark v. Am.’s Favorite Chicken Co.,32 the franchisor operated both the Popeye’s Famous Fried Chicken and Church’s Fried Chicken concepts. Clark, a Popeye’s franchisee, sued the franchisor alleging it breached the covenant of good faith and fair dealing by carrying out a dual marketing strategy of positioning Popeye’s on the high end and Church’s on the low end of the bone-in chicken market. The franchisee alleged this strategy required the franchisee to carry certain products that did not sell well in its low-income areas and prohibited the franchisee from advertising certain specials that Church’s locations offered. In rejecting the franchisee’s argument, the U.S. Court of Appeals for the Fifth Circuit noted that the franchise agreement provided that the franchisor, as administrator of the advertising fund to which the franchisee had to contribute 3 percent of its gross sales, had sole discretion over the selection of media and the locations where the media was placed. The franchise agreement also made it clear that the advertising was designed to benefit the system as a whole and not any individual franchisee.
In another case involving a Popeye’s franchisee, the Fifth Circuit affirmed a decision in favor of the franchisor, in which the franchisee alleged that the franchisor failed to allocate sufficient advertising funds to the franchisee’s local market.33 The district court had relied on language in the franchise agreement giving the franchisor complete discretion in allocating advertising funds. The court also rejected the contention that language in the franchise agreement conflicted with the Uniform Franchise Offering Circular provided to the franchisee or with language in the system operations manual. The court stated that these documents underscored the fact that the franchisor had sole discretion in allocating advertising funds.
VI. MARKETING COOPERATIVE PROVISIONS IN FRANCHISE AGREEMENTS
As described in this chapter, many franchise systems use local or regional marketing cooperatives to pool the funds of franchised and company-operated units within a specified geographic area to expend these funds more efficiently. Many of the provisions related to the governance and operation of cooperatives are found in the bylaws or membership agreements of these cooperatives. However, it is important to include in the franchise agreement general provisions related to the formation of these cooperatives. These provisions should be included in the initial versions of the franchise agreement even if the franchisor does not intend to use cooperatives in the initial development of the franchised system.
The franchise agreement should state that the franchisor has the right to establish marketing cooperatives. In some systems, cooperatives may be formed at the franchisor’s initiative while in other systems, the majority of the company-operated units and franchisees in a geographic area can elect to form a cooperative.
The franchisor may consider including in the franchise agreement language that the franchisor may require all franchisees in the geographic area of the cooperative to participate. This language puts every franchisee on notice before entering into the franchise agreement that the franchisee may be required to join a cooperative. This will help the franchisor avoid claims that the franchisee was coerced to join the cooperative. In Larry James Oldsmobile-Pontiac-GMC Truck Co. v. Gen. Motors Corp.,34