SUPPLY CHAIN ISSUES IN FRANCHISE SYSTEMS
By Joyce Mazero, Suzanne Trigg, and Emma Ricaurte Harker
I. THE FRANCHISE SYSTEM SUPPLY CHAIN: A COMPETITIVE ADVANTAGE
A signature characteristic of franchising is the ability of multiple outlets operating under one brand to provide consistent, high-quality products on an ongoing basis. In addition to maintaining system standards, consistency and high quality are best achieved through the efficient and competitive use of a franchise system’s supply chain. Historically, some franchise systems have been better at achieving and maintaining this internal consistency than others. Today, franchisors are more focused than ever on achieving and maintaining supply chain excellence and franchise systems are increasingly using supply chain management as a way to compete in the global marketplace. 1
An efficient supply chain not only has an impact on quality and consistency, but it can also be an important tool in driving down costs, which directly improves a system’s financial performance.2 A recent study revealed that companies performing in the top 25 percent in their industries spent only 4.2 percent on supply chain costs, versus almost 10 percent spent by merely average performers.3 If more companies were able to manage their supply chains as well as top supply chain performers such as Toyota, Dell, and Home Depot, they would be able to generate hundreds of billions of dollars in value.4
As franchise systems place greater emphasis on ensuring that a franchise system’s supply chain provides a distinct competitive advantage in the marketplace, they must develop more sophisticated supply chain practices, a solid understanding of the supply chain options that are available, and the ability to negotiate effective agreements with suppliers and logistics providers. This chapter is meant to serve as a guide to the variety of unique supply chain strategies that are available to franchise systems, to identify key issues and terms, and to guide franchisors negotiating logistics and supply agreements with logistics providers and other third parties involved in a franchise system supply chain.5This chapter also provides guidance specific to the international nature of many franchise systems and their supply chains. Finally, as restaurants and retail food businesses comprise over two-thirds of business format franchises in the United States,6 this chapter provides a brief overview of supply chain issues affecting such franchise systems.
II. THE BASICS: COMPONENTS OF A FRANCHISE SYSTEM SUPPLY CHAIN AND KEY PARTIES
Efficiently managing a supply chain and effectively negotiating supply chain agreements require an understanding of the components of a supply chain and the parties involved in creating, storing, and transporting products. A supply chain may be defined as “all stages involved, directly or indirectly, in fulfilling a customer request.”7 “All vendors, service providers and customers are links in the supply chain.”8 In a franchise system, a supply chain is the means by which suitable products and services are distributed to franchisees so that they may in turn provide consistent goods and services to their customers.9
Supply chain management is “the planning and management of all activities involved in sourcing and procurement, conversion, and all logistics management activities … [and] also includes coordination and collaboration with … suppliers, intermediaries, third-party service providers, and customers. In essence, supply chain management integrates supply and demand management within and across companies …”10 In short, supply chain management is the active involvement of the organization in the supply chain process, from the purchase of raw materials, to the provision of the goods and services to customers, which necessarily includes working with intermediaries and third-party partners.
At each level of a supply chain, manufacturers, distributors, and logistics providers work to manufacture and distribute products and services so that they may eventually be sold to customers. Depending on the industry of the franchise system and the complexity of its product offerings, the components of a supply chain may vary considerably from one franchise system to another. For example, a restaurant supply chain system might require some of its perishable food items to be delivered chilled or frozen. Such a system would necessarily involve different processes than, and be subject to distinct legal requirements from, for example, a franchise system that sells expensive technological equipment as its core business. Nonetheless, in their simplest form, franchise supply chains involve the purchasing of necessary products or services, the delivery of such products and services, and their distribution, whether to end users or to other distributors.
The supply chain begins with the manufacturers and vendors of products or services.11 At this stage are the companies that either produce the raw materials or develop the finished goods, or both. Service providers are also at this level and may provide services to franchisees and franchisees, such as accounting or maintenance services.12 Finally, producers of intangible goods are also included at the production stage of the supply chain, such as those companies that provide software or other intellectual property-related goods.13
Once the goods and services have been produced, the next stage in a supply chain is storing and moving such goods or services—that is, logistics.14 Logistics involves moving the goods from the manufacturer to either the end user or to a distribution center or warehouse.15 Franchisors and franchisees must determine which modes of transportation are best at addressing the unique needs of their system. Factors to consider include the size of the franchise system, the geographic area it encompasses, and the type of products and services being offered. In general, more expensive products and those with a relatively short shelf life, such as technology products, should use more efficient distribution methods, even though such systems often have higher costs.16 As one would expect, fungible and nonperishable products and commodities may take advantage of the slower, lower-cost modes of transportation, as these products may have a longer shelf life or may not constitute the core of the franchise offering.
Some smaller manufacturers may transport their goods and services directly to the franchise system—as in cases in which the system is making an effort to use local products and services, or if a franchise system elects to deploy a strategy of disintermediation or removing intermediaries in a supply chain and having manufacturers ship directly to retailers,17 which is more commonly known as “cutting out the middleman.” In most instances, however, franchise systems will use distributors. Distributors take products shipped from manufacturers and producers and maintain an inventory in a warehouse or distribution center, which hold the inventory from the manufacturer.18 Distributors typically provide warehousing services for finished goods, but may also be involved in smaller-scale assembly or kitting of goods.19 The purchasing departments of the franchise systems place orders with the distributors for products that are shipped to users at the retail level, which in the case of franchising is the franchisees; or, in many systems, franchisees contact distributors directly. To fulfill such orders while maintaining a profit, distributors typically purchase larger quantities of goods (for instance, the amount necessary to provide products to all franchisees in a particular region), and then ship the products to retailers in smaller quantities, such as shipments to individual franchisees.
A franchise executive or attorney confronting supply chain issues and agreements will encounter a few distinct parties involved in storing and moving goods and services: transportation providers such as freight carriers, warehousemen, third-party logistics providers, and fourth-party logistics providers. The services of a freight carrier or a warehouseman are commonly known. Logistics providers offer unique, bundled services that can control costs and improve the efficiency and quality of a supply chain. Third-party logistics providers (3PLs) offer integrated logistics services to companies.20 They typically provide services such as warehousing, transportation, and inventory management.21 A 3PL, as defined by the Consumer Product Safety Act, is “a person who solely receives, holds, or otherwise transports a consumer product in the ordinary course of business but who does not take title to the product.”22 The act specifically states that 3PLs should not be deemed manufacturers, distributors, or retailers solely because they receive or transport consumer products.23 A fourth-party logistics provider (4PL), otherwise known as a lead logistics provider, is similar to a 3PL, but differs in a few significant ways.24 Namely, the 4PL acts as a single point of contact between the company and multiple logistics service providers.25 4PLs are often joint ventures or other separate legal entities created by a company and one or more of its suppliers. When 4PLs are used effectively, they manage and service all aspects of the company’s supply chain, reducing costs and redundancies, and creating a more efficient supply chain.
III. SUPPLY OPTIONS: APPROVED SUPPLIERS, SOLE-SOURCE SUPPLIERS
As with most business decisions faced by franchisors in shaping their franchise systems, the choice of supply chain structure is largely dependent upon the degree of control the franchisor desires to assert in relation to the cost and ease of administering such a structure. Several structuring options are available for franchise system supply chains, including approved supplier designations and franchisor as supplier (or captive supplier). Other options are issuing product specifications, or even establishing a franchisor/franchisee-owned purchasing cooperative. With each supply chain option for a franchise system, a franchisor will typically find that there is an inverse relationship between the degree of control the franchisor may exercise, and the costs associated with the supply chain model. As with other aspects of the franchise relationship, a franchisor must strike the right balance between its control over the system and the risks associated with such control. In structuring its supply chain, a franchisor must therefore assess the desirability of exerting control to ensure consistent product and service offerings without incurring unnecessary liability or costs. A franchisor’s options in structuring a franchise system’s supply chain are discussed in the following subsections, in the order of the structures that provide the franchisor with the least control, to structures that provide the franchisor with the greatest control.
A. FRANCHISEES’ SELECTION OF SUPPLIERS USING PRODUCT SPECIFICATIONS
Often, a franchise system will set itself apart from competition not just with high quality and consistency, but also through the use of one or more key products. In such instances, the franchisor closely guards the secret ingredients or components of the key product (or a proprietary product). It would not release the specifications for such proprietary product to franchisees, or to any suppliers, and even then only with appropriate confidentiality and other restrictions in place. Not all systems use proprietary products, however, and still others use only a few proprietary products and have many generic products. While consistency must still be maintained, the franchisor has a lesser interest in controlling the source of generic products. In such instances, the franchisor may issue product specifications, and instruct its franchisees to purchase only those products and services that meet the franchisor’s specifications. 26
Under such a product specification model, franchisees are free to purchase goods from any number of suppliers, as long as the products meet the minimum qualifications imposed by the franchisor. The franchisor does not take title to goods or negotiate purchasing arrangements on behalf of franchisees. In cases in which franchisees are free to select suppliers using specifications, franchisors may, for obvious reasons, restrict franchisees from purchasing and/or selling products of their competitors. One of the benefits of a product specification supply chain structure is that administration is much easier, and costs to the franchisor and franchise system as a whole are reduced.27 Therefore, a product specification model is most frequently used in smaller or new franchise systems. An entire supply chain based on purchasing according to a franchisor’s product specifications is not preferred, however, as it is one of the least effective ways of maintaining product quality, due to the franchisor’s limited control and influence, and it does not permit franchisors and franchisees to reap the benefits of the collective purchasing power of the entire franchise system.28
B. APPROVED SUPPLIERS
Many franchisors choose to provide franchisees with a list of approved vendors from which franchisees can buy the required products and services directly. An approved supplier model is the most common supply chain method in franchising, with approximately two-thirds of franchise systems using this model.29 Sometimes one of the approved suppliers will be the franchisor itself, as discussed in greater detail below.30 Using the approved supplier method, franchisees can take advantage of the volume discounts negotiated and obtained by the franchisor because the franchise is part of a large system. In cases in which the franchisor operates the franchise system’s supply chain through a list of approved suppliers, the franchisor does not typically take title to the goods or act as guarantor for payment, other than those units owned by the franchisor.31
In determining which vendors to include on their approved list of suppliers, franchisors typically negotiate supply and distribution contracts and may require franchisees to commit to a specific volume of purchases.32 Franchisors that elect an approved supplier system of distribution will almost always carefully screen and approve potential vendors. Commonly, franchisors will limit the number of approved suppliers to take advantage of volume purchasing power, to secure the best price and service for their franchisees, to improve quality, and to provide for ease and efficiency in administration.33 Some franchisors elect to charge a fee to prospective vendors in exchange for considering and evaluating them to be on the list of approved suppliers.34 Other franchisors charge a royalty to suppliers for their use of the franchisor’s trademark and trade name.35
In determining whether to approve a potential supplier, a franchisor must take into consideration a variety of attributes of the supplier. For example, a franchisor may consider whether the supplier operates in a large enough geographic area to accommodate the entire franchise system.36 If not, the franchisor may have to consider a different, larger supplier or multiple suppliers, each with a different regional distribution area. In addition to a supplier’s geographic area, franchisors should consider the potential supplier’s ease of delivery. The supplier must have sufficient frequency of delivery to accommodate the limits of the franchise system’s inventory capabilities.37 Other supplier characteristics include, but are not limited to, customer service and warranties offered for the supplier’s products.38
A franchisor can also use the approved supplier selection process as an opportunity to help it improve the efficiency and effectiveness of its supply chain. In determining which suppliers to approve, a franchisor should consider whether a supplier can help it to develop a contingency plan so that goods will be supplied in the system under various conditions, such as a natural disaster, recall of a product or key ingredients, or the bankruptcy of one of the other channel partners.39 Such a contingency plan should ideally assess both the business of the franchisor and the supplier and the potential risks to both companies to determine if the businesses and risks are managed effectively.40 This will help the franchise system to be able to operate under a variety of circumstances.
Sometimes franchisors choose to separate their various approved suppliers into different categories, including an “approved,” “preferred,” or “exclusive” provider for certain products.41 For example, some franchise systems use the designation of “preferred supplier” for those suppliers that have completed the franchisor’s training program.42 Suppliers will in turn use these designations to advertise their products to the franchisees and may try to get a larger percentage of the franchisee purchasing market than their competitors.43
A franchisor must make its list of approved suppliers readily available to existing franchisees, but the franchisor should not list approved suppliers and distributors in the franchise agreement.44 Doing so could create problems farther down the road if the franchisor needs to change suppliers when, for example, a supplier becomes insolvent, is acquired by another entity, suffers a lack of quality and consistency, or is unable to obtain the necessary raw materials. It could also create liability if the franchisor failed to include one or more suppliers in the franchise agreement.45 Further, a franchise agreement should include language that expressly reserves the right of the franchisor to change suppliers and distributors at any point in the future, and as such, specifying suppliers in the agreement is unnecessary.46 Instead, the franchise agreement should specify that the franchisee must only purchase from approved suppliers, which will be determined by the franchisor.
In drafting franchise agreements, franchisors may want to retain certain rights regarding approved suppliers, including the right to require that certain products be purchased from only one supplier when necessary or advisable.47 Additionally, franchisors usually include a provision in the franchise agreement outlining procedures for franchisees to request to purchase products from unapproved suppliers. Such provisions often provide that the franchisor reserves the right to evaluate any potential supplier, which may include testing the supplier’s products. A franchisor may approve a request by a franchisee to add an additional supplier if the quality standards imposed by the franchisor are met. If a franchisor does approve additional suppliers, it may choose to make such approval revocable as needed. Reasons for a franchisor to revoke its approval of an additional supplier include the supplier not meeting the franchisor’s product quality standards and the availability of better product from another source. As will be discussed below, a franchisor must disclose certain information regarding the franchise system’s sources of supply, including the methods it uses in approving alternative suppliers, in Item 8 of the Franchise Disclosure Document (FDD).
Using approved suppliers, rather than making simple product specifications, is advantageous for a number of reasons. One of the benefits of using approved suppliers is that the franchisees are able to take advantage of economies of scale. The franchisor is also able to maintain control over the quality of products and any intellectual property associated with the products.48 However, this method does have drawbacks, including potential liability to the franchisor in the event of disruption to the supply chain.49 There is also the potential for the franchisor to get caught in disputes between the franchisees and the suppliers.50 Finally, franchisees often complain when franchisors fail to approve their requested alternative supplier.51 They may also contend that is too costly for them.
C. FRANCHISOR AS SUPPLIER OR CAPTIVE SUPPLIERS
In some franchise systems, including most notably product franchise systems, the franchisor or its affiliate (a captive supplier) is the sole source of the goods offered and sold throughout the system.52 However, for business format franchises, the franchisor has more flexibility to determine the degree to which it wants to be involved in the franchise system’s supply chain.53 Rarely will the franchisor of a business format franchise system be the supplier of all products for a system, but occasionally, such as in the case of proprietary products, the franchisor may choose to be the supplier of one or more key products.
To the extent that a franchise system relies on certain proprietary products or products from a single source, the franchisor and franchisees will face increased risk of supply chain disruption. A major disruption to the system can be caused if proprietary products that are considered core to the franchise concept suddenly become unavailable. Therefore, it is necessary for franchisors to monitor the supplier(s) of such proprietary products closely, which often leads a franchisor to determine that the system would be best served if the franchisor or its affiliate supplies the proprietary product to franchisees themselves.
When the franchisor acts as a supplier of products to its franchisees, it must take several factors into consideration. First, when a franchisor is supplying products to the system, particularly if the franchisor is the only approved supplier for a product, it often creates strife with franchisees that do not believe the franchisor or any of its affiliates should make any margin, or profit, from the sales of products to franchisees. In addition, the franchisor’s relationship with its franchisees may change, as the franchisor may become a creditor and then must analyze how it will handle past-due accounts and other collateral issues related to this type of relationship. A franchisor considering being the supplier of some or all of the products to the franchise system must also consider its capability to deliver products in a timely manner, and potential ramifications if it cannot. Even as to key proprietary products, it may be beneficial for the franchisor to spread the risk associated with its supply chain by engaging multiple suppliers or larger suppliers that are less likely to suffer supply chain disruptions. By engaging other suppliers, a franchisor may limit its liability for temporary or permanent delays. Also, a franchisor’s involvement in the supply chain process to this degree may put a strain on an otherwise good relationship between the franchisor and franchisee.54 Nevertheless, in large, product-dependent franchise systems, the strict quality control and control over intellectual property provided by the franchisor or its affiliates acting as the approved supplier for a product can outweigh potential disadvantages, particularly when the franchisor makes its supply chain methods known to prospective franchisees from the outset.
D. CHOOSING THE BEST SUPPLY CHAIN FOR A FRANCHISE SYSTEM
It is important to note that the supply chain structures discussed above are not mutually exclusive, and most franchise systems use a combination of approved suppliers and product specifications, with possibly the franchisor as the sole supplier for certain proprietary products.55 A franchisor’s choice of supply chain structure will depend on a variety of factors, including the characteristics of the franchise system, the type of product, and the availability of rebates. As will be discussed below, once a distribution system is chosen, the franchisor must then disclose relevant information regarding the distribution model.56
The characteristics of a franchise system naturally influence the choice of appropriate supply chain methods for the system. Perishable products, commodities, and expensive technological products will all dictate different supply chain needs. After the type of products and services offered by the franchise system, the size of the system and the location of its franchised units will drive the type of supply chain needed. For example, if the system is offering a relatively new concept and is in a rapid growth phase, there may not be a high concentration of units in a given geographic area that would support the use of approved suppliers, as there may not be distributors efficiently linking such suppliers to franchisees.
The need to supply different products to the franchise system in the future should also guide a franchisor’s choice of a supply chain structure, and should persuade franchisors to draft their franchise agreements broadly so that supply chain arrangements may change in the future as the system grows. To ensure the continued success of the franchise system, a franchisor must occasionally develop and test new products and must maintain control over matters related to product selection and development. A franchisor must necessarily consider the limits of its current supply chain in the event that it wishes to expand its future product offering. With the potential need to change products in mind, franchise systems will need to maintain a certain degree of flexibility in their supply chain regarding the products they plan to offer. The franchisor must therefore negotiate contracts with suppliers to provide for the development of new products. The franchisor will need to work with suppliers to ensure the system’s ability to add more products or change the specifications of existing products if necessary, whether due to changing consumer demand, new laws and regulations, or increased costs.
IV. AN ADDITIONAL OPTION: PURCHASING COOPERATIVES
Recent years have seen renewed attention on franchise system purchasing cooperatives, with large franchise systems establishing such cooperatives.57 Franchise system purchasing cooperatives have traditionally been founded, funded, and operated largely by franchisees, often because franchisees felt the need to ensure that the franchisor would not profit from the supply chain.58 But recently, as economic troubles have mounted and commodity costs have soared, franchisors have actively pursued and funded new purchasing cooperatives, thus ushering in a new era of purchasing cooperatives in which franchisors and franchisees work together to provide the best supply chain solution for the franchise system.
The goal of a purchasing cooperative is to provide products and services to members of the purchasing cooperative, and not to the general public.59 It is a member-owned and member-controlled business entity which can either be for profit or non-profit.60 A purchasing cooperative distributes benefits to its members, typically in the form of patronage dividends, which are essentially refunds based on a member’s purchases, or patronage of the cooperative.61 The benefits can also be in the form of reduced costs for products and services. In the franchising context, the members can be just the franchisees, or also the franchisor, which may use the cooperative to serve company-owned outlets.62
A. CONTROLLING THE PURCHASING COOPERATIVE
A franchisor contemplating using a purchasing cooperative to supply its system must decide which rights and obligations it wants to delegate to the new purchasing cooperative and which it desires to retain for itself. To the extent that the franchisor is able to delegate certain functions to the purchasing cooperative, it will significantly lower its overhead costs and increase the efficiency of the purchasing system. Increased delegation does, of course, mean that the franchisor must give up a degree of control. This may not be ideal in order for the franchisor to protect the brand sufficiently. Further, if the franchisor delegates too much responsibility to the purchasing cooperative, it could potentially open itself up to liability.
To maintain an acceptable level of control and to ensure that it is adequately informed of decisions made by the cooperative, a franchisor may pursue seats on the cooperative’s board. Further, a franchisor might insist on the right to veto or override decisions of the purchasing cooperative as they relate to critical brand matters, such as selling products to nonmembers, acquiring or being acquired by another entity, or changing requirements for membership. Such measures permit a franchisor to ensure that it can maintain brand standards.
Through their membership interests in the purchasing cooperative, franchisees are afforded a certain degree of control regarding the selection and quality of goods and services the cooperative offers. In their dual roles as both franchisees of the system and members of the cooperative that services the system, franchisees will be concerned with the quality of the purchasing cooperative’s management, their ability to control the costs and quality of goods and services, and their ability to have direct control of the future of the purchasing cooperative, in addition to the benefits of membership to their individual franchised businesses.
B. FORMING A NEW PURCHASING COOPERATIVE
A franchise system can choose either to join an existing purchasing cooperative, in which case some members would be outside the franchise system, or it can form a system-specific purchasing cooperative. Most franchise systems that have gone the purchasing cooperative route have decided to form a purchasing cooperative that is specific to the franchise system, or systems, such as in cases of multiple brands under common ownership. A franchise system must decide whether both the franchisor and the franchisee will have membership interests, or whether only the franchisees will be members of the cooperative.
A franchise system must determine the source of funds for up-front costs of establishing the cooperative. Having capital is often one of the greatest challenges to purchasing cooperatives.63 At the outset, a franchise purchasing cooperative must have sufficient capital to cover the purchasing requirements of the franchise system’s current supply chain, and must give adequate consideration to the potential expansion of the system, the products offered, or the supply chain operations. At a minimum, purchasing cooperatives must have sufficient capital to cover: (1) legal and administrative expenses; (2) salaries and compensation packages of experienced executives to operate the cooperative; (3) infrastructure, such as office space, computers, and supply chain software; and (4) feasibility studies and other data analysis to ensure efficiency. Factors that affect the amount of capital needed include: (1) the projected volume of the cooperative’s business, (2) the types of services it will provide, (3) the degree of risk it will assume, and (4) its competition in the marketplace. To raise capital, the organizers of the cooperative can choose to borrow money from its founding franchisee members, or receive a loan or contributions from the franchisor. If the franchisor provides start-up costs to the cooperative, such funding may help the franchisor to retain more control and have more input on the operation of the cooperative.
A franchisor must also consider whether the purchasing cooperative will be the sole purchasing agent for the system, or whether the franchisor or franchisees may work directly with vendors for certain goods and services. An advantage of having the cooperative serve as the sole purchasing agent for the system is that the cooperative will be better able to take advantage of economies of scale and will wield significantly more bargaining power. This in turn can lead to greater benefits to the cooperative members in the form of better prices and larger dividends.
C. DISTINCT LEGAL CONSIDERATIONS IN ESTABLISHING PURCHASING COOPERATIVES
Like other business entities, a cooperative is a legal entity, has perpetual existence, offers its owners limited liability, is formed through the filing of articles of incorporation, adopts bylaws, is governed by a board of directors, elects officers, and is owed a standard of care by its officers and directors.64
A cooperative may be formed under the law of the state in which it is headquartered. However, like traditional corporations, many cooperatives are organized under the laws of a state other than the one where its headquarters are located, such as the state of Delaware. The selection of a state of formation often depends on whether the state where the cooperative will be based has a cooperative formation law.65 Many states have specific statutes that govern the organization and operation of a cooperative, which are designed to address the unique nature of a cooperative as a form of business.66
Most cooperatives qualify for non-profit entity treatment under one or more of the following state statutes: non-profit corporations, cooperative associations, and for-profit corporations. If the latter is chosen as the organizing statute, the cooperative’s charter and bylaws should state that the purpose of the cooperative is a non-profit one.67 Although cooperatives may be formed as non-profit corporations under the corporate or cooperative statutes in some states, many are formed as limited liability companies that operate on a cooperative basis due to tax and governance considerations.
Patronage dividends can be a distinct advantage of purchasing cooperatives. Many purchasing cooperatives are structured to be able to operate under Subchapter T of the Internal Revenue Code (IRC).68 Subchapter T treatment means that the earnings of the purchasing cooperative are passed through to the members as patronage dividends, as long as certain requirements are met, such as democratic governance with one vote per member, although a certain degree of flexibility is permitted.69 Potential drawbacks of Subchapter T status include compliance with complex rules pertaining to restrictions on the deductibility of patronage dividends, such as the timing and form of distributions, the method of allocation among members, and limitations on sources of income.70
To qualify for Subchapter T status, the purchasing cooperative must be “operating on a cooperative basis.”71 The IRC and the tax regulations do not define the phrase “operating on a cooperative basis.”72 The decision by the tax court in Puget Sound Plywood, Inc. v. Commissioner of Internal Revenue illuminated this subject by outlining three guiding principles: (1) subordination of capital, (2) democratic control by members of the cooperative, and (3) allocation among members of the fruits and increases arising from the cooperative endeavor in proportion to the member’s participation.73
A franchise system deliberating the establishment of a purchasing cooperative must also consider certain securities laws and their implications. Provided that cooperatives meet certain parameters, they are not subject to the U.S. Securities and Exchange Commission’s (SEC) reporting or registration requirements for securities.74 There are no bright-line rules that determine when a membership interest in a cooperative is considered a security subject to federal and state securities laws.75 Therefore, purchasing cooperatives must assess the potential applicability of federal and state securities law regulations.76 This is significant because cooperatives can incur harsh penalties for securities law violations.77 Moreover, an enforcement action could harm the goodwill of the purchasing cooperative and the brand(s) it services.78
D. ONGOING ROLE OF A FRANCHISOR IN A PURCHASING COOPERATIVE
A purchasing cooperative must be able to manage its day-to-day relationship with suppliers and distributors and enter into agreements with suppliers and distributors on behalf of the cooperative.79 These functions are necessary for the operation of the cooperative, and therefore, the franchisor must relinquish such responsibilities. Additionally, the franchisor must retain certain of its functions with suppliers and distributors to preserve its rights to manage the system and ensure that its proprietary information remains confidential. For instance, the franchisor should have the right to review the purchasing cooperative’s supplier and distributor agreements to ensure that its rights are adequately protected with provisions concerning adequate insurance, recall and other safety procedures, the free flow of information from the supplier or distributor to the franchisor, and indemnification of the purchasing cooperative. Additionally, the franchisor should continue to contract directly with the suppliers to ensure that its proprietary information remains confidential.
The franchisor will also need to take steps to retain its control over the approval and disapproval of suppliers when a purchasing cooperative is to provide its services to the franchise system’s supply chain. It is important for the franchisor to retain this right, as the distribution of a defective product to the system can present liability issues for the franchisor.80 The franchisor’s contract with a supplier should address issues the franchisor will continue to confront with the supplier, including confidentiality of specifications, formulations and business information, quality control, and warranties. A franchisor also needs to retain its ability to prevent a supplier from taking wrongful actions, such as continuing to promote its products to franchisees after it has been notified of the franchisor’s disapproval.81
While the franchisor must retain a separate contractual relationship with suppliers, a purchasing cooperative can make valuable contributions to the system by undertaking some of the monitoring of suppliers via the cooperative’s contract with a supplier and day-to-day interaction with the supplier. For example, the purchasing cooperative can ensure that vendors have adequate insurance in place and are meeting production and delivery expectations. The purchasing cooperative representatives who interact with vendors often may be better able to predict when a vendor is not financially stable or is having difficulties that may contribute to low-quality goods or delivery problems. The franchisor and purchasing cooperative should clearly establish which retains control over each aspect of the selection, approval, disapproval, and monitoring of vendors as well as reporting requirements and provide a means for sharing of information about suppliers and distributors. Furthermore, the franchisor and purchasing cooperative should agree on the types of statements and representations that the purchasing cooperative may make to potential suppliers so the purchasing cooperative arrangement does not create confusion among suppliers as to whether the franchisor or the purchasing cooperative is in control of the approval, monitoring, and potential disapproval of suppliers.
E. RELATIONSHIP OF PURCHASING COOPERATIVE WITH FRANCHISOR
Often, franchise system purchasing cooperatives are governed, in part, by an agreement between the cooperative and the franchisor that spells out the terms of their relationship and their respective duties. This so-called relationship agreement is perhaps a franchisor’s best opportunity to influence decisions of the cooperative. If crafted carefully and creatively, the relationship agreement can serve as an important cornerstone of the relationship between the franchisor and the purchasing cooperative.