Franchisees Get Feisty

They're suing franchisers to gain power--and winning

When Meineke Discount Muffler Shops Inc. used to hit up franchisee Mark J. Zuckerman for 10% of his sales to help pay for marketing, he expected to see top-notch ads. But in 1990, the Trumbull (Conn.) resident started noticing that newspaper advertising was waning and TV spots were appearing after midnight. Zuckerman and 19 other franchisees began asking questions. To their shock, they eventually discovered that the Charlotte (N.C.) franchiser (a division of British-based GKN PLC) had been pocketing 15% of the communal ad funds--while Zuckerman's group thought it was taking only 2%. From 1986 to 1996, Meineke's take totaled $17 million.

In 1993, the franchisees sued for this and other acts of alleged bad faith. And on Dec. 18, a jury in federal district court in North Carolina awarded all of the chain's franchisees $347 million--the biggest verdict in the history of franchising. The penalty could ultimately hit $741 million, if the company is also found guilty of violating North Carolina trade practices law. Meineke says that its actions were authorized by the company's franchising contracts and that it will appeal.

The suit has thrown a scare into the massive franchising industry, which accounts for nearly $1 trillion in annual sales. Applying a groundbreaking legal standard to Meineke, Judge Robert D. Potter said that the company had a fiduciary duty to ensure that franchisees' funds were properly managed. If more judges were to rule along the same lines, franchisers warn they would be reduced to little more than babysitters for their franchisees. "You wouldn't be in business for yourself. You would essentially be in business for the franchisee," grumbles Joyce G. Mazero, a Dallas attorney representing franchisers.

The Meineke case is just the latest in a string of important franchisee legal triumphs over the past year. After decades of griping about mistreatment, franchisees are enjoying unprecedented success persuading judges to rewrite the rules concerning such critical issues as when a franchiser may build an outlet near an existing one and how a franchisee can be terminated. Courtroom victims include Sun Microsystems, printing chain Postal Instant Press, and fast-food outlet Naugles. Additionally, KFC Corp. (the soon-to-be spun off PepsiCo Inc. unit that runs Kentucky Fried Chicken) and Mail Boxes Etc. Inc. both recently offered large out-of-court settlements to unhappy franchisees.

LOADED RESUMES. The main reason for this litigation success: a new generation of sophisticated franchisees. A decade ago, most franchisees were inexperienced would-be entrepreneurs. Today's franchisees are increasingly likely to come from the ranks of downsized corporate managers. Equipped with MBAs and loaded resumes, they're banding together like never before. Membership in the American Franchisee Assn. has risen from 4,000 in 1993 to 7,500. The American Association of Franchisees & Dealers (AAFD), founded in 1992 with only 20 members, today has 6,000.

More important, franchisees of a single company are forming independent groups, such as the Jiffy Lube Dealers Assn., to represent them against franchisers. While such associations have existed for years at mature chains such as Midas-International Corp. and Burger King, where some powerful franchisees have accumulated dozens of outlets, they have traditionally been rare elsewhere. But over the past three years, the number of independent franchisee associations has doubled to nearly 250, says Robert L. Purvin Jr., AAFD chairman. And the recent triumph of the Meineke franchisees will probably accelerate the trend: Zuckerman says that a big reason his group could afford to take on the company was because it formed an independent association in 1990.

Franchisers, meanwhile, warn that the new wave of litigation threatens to stifle growth of the booming industry. They fear that by handing over more power to franchisees, judges will limit companies' ability to ensure the quality and consistency of far-flung outlets.

TREACHEROUS. A backlash is building. Some chains are trying to erase the franchisees' courtroom gains by rewriting their contracts with even more onerous financial terms. Others are trying a different tack, sharing more power with franchisees in an attempt to win loyalty and attract quality partners. "Franchisers need their franchisees to be successful," says Don J. DeBolt, president of the International Franchise Assn.

The Meineke case illustrates that this can still be a treacherous business. It revolved around a frequent franchisee complaint: the management of communal ad funds. Meineke franchisees claim, among other things, that the parent company channeled their ad funds to an in-house shop called New Horizons Advertising Inc., run out of the company's Charlotte offices. While the franchisees knew about this arrangement, they weren't aware that New Horizons was negotiating volume discounts for print and TV ads and pocketing the leftover money itself--millions the franchisees say should have been spent for their benefit.

Franchisees then convinced the jury that the money would have triggered a bonanza of new business had it been invested in advertising--hence the huge verdict. Meineke contends that the disputed funds received by New Horizons were "commissions" that it was contractually entitled to receive, and that the court erred in finding that it had fiduciary responsibilities to franchisees.

As they did in the Meineke case, franchisees are convincing courts that there's an inherent inequality in the overall franchising relationship. Last July, Fullerton (Calif.) Mexican fast-food chain Naugles Inc. was ordered to pay $2.2 million to a franchisee after opening a company-owned restaurant nearby. The California federal court decision shocked the industry because it essentially granted rights to the franchisee that the contract didn't provide, in this case protection against neighborhood competition. The industry now fears that other judges may also start rewriting contracts to punish franchisers for perceived abuses. Naugles, now owned by Del Taco Inc., says that the new restaurant did not hurt the plaintiff and that it's appealing the ruling.

Other bastions of franchiser control are also falling. In July, the New Jersey Supreme Court invalidated a legal tool of Sun Microsystems Inc.--a contract provision requiring disputes with franchisees to be tried in Sun's home state of California. This requirement makes it much more expensive for franchisees to sue, often forcing them to travel to distant courtrooms and hire out-of-state attorneys. The court charged that this legal requirement failed to protect franchisees from "exploitation by franchisers with superior bargaining power" and should be disregarded unless the franchisee explicitly consented to it. Sun is now attempting to prove that the franchisee did agree to the provision.

It's no coincidence that much of the new wave of litigation is occurring in saturated markets such as fast food and auto parts. Franchisers are themselves under so much pressure to pump up revenues that they end up competing against their franchisees in new locations or with new products. After Carvel Corp. suffered declining store traffic in its ice cream shops, it started marketing some of its products in supermarkets in 1993. Franchisees hit the roof, and the two sides are now duking it out in a Connecticut federal court. Other franchiser attempts to distribute outside of the franchisee system--for example, through mail order sales or partnerships with other chains--have also led to litigation.

But while some franchisers are busy fighting with their franchisees, others are trying to draw them closer, in hopes of building loyalty and attracting the best talent. In mid-January, Mobil Corp. announced that it had hired Merrill Lynch & Co. to help provide franchisees with financial planning advice. Burger King recently agreed to notify franchisees whenever it planned to develop a new restaurant nearby. Franchisees can then request that Burger King study the impact of the new outlet. If the new store will siphon off an unreasonable amount of sales, the company promises to reimburse the franchisee for some of the lost profit. Similarly, Jani-King International Inc., a Dallas cleaning company, increased training after franchisees complained that they weren't equipped to handle new hotel and university clients.

These developments are good news for franchisees in a few chains. But in this savagely competitive business, their brethren in other systems may find that the path to more power still leads through the courts.

Before it's here, it's on the Bloomberg Terminal.