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Chapter 30Sole Proprietorships and Private FranchisesIntroductionThe most common forms of business organization are the sole proprietorship and, when two or more persons are involved, the partnership and the corporation, with the limited liability company becoming increasingly popular. In this chapter, the basic features of sole proprietorships are briefed, and some of their advantages and disadvantages are spelled out. There is also a discussion of private franchises.Chapter OutlineI.Sole ProprietorshipsThe simplest form of business is a sole proprietorship. Sole proprietorships constitute over two-thirds of American businesses. They are usually small enterprises—99 percent of those in the United States earn less than $1 million per year.A.Advantages of the Sole Proprietorship?Sole proprietorships are the easiest and least expensive business forms to set up.?Sole proprietorships are more flexible to operate than a partnership or a corporation.?Sole proprietors pay only personal income taxes on business profits.B.Disadvantages of the Sole ProprietorshipThe proprietor bears all of the financial risk of losses and liability.Case Synopsis—Case 30.1: Quality Car & Truck Leasing, Inc. v. SarkMichael Sark Sr. operated a logging business as a sole proprietorship. To acquire equipment for the business, Sark (and his wife Paula) borrowed money from Quality Car & Truck Leasing, Inc. When the business encountered financial difficulties, Sark became unable to pay his creditors, including Quality. The Sarks sold their house (valued at $203,500) to their son Michael Jr. for $1 but continued to live in it. Three months later, Quality obtained a judgment against the Sarks for $150,481.85 and then filed a claim to set aside the transfer of the house to Michael Jr. as a fraudulent conveyance. The court issued a decision in Quality’s favor. The Sarks appealed, arguing that they were not actually Quality’s debtors.A state intermediate appellate court affirmed. The Sarks “are clearly judgment debtors to Quality Leasing and *??*??* the judgment has not been satisfied.”..................................................................................................................................................Notes and QuestionsWhat advantages and disadvantages are associated with the sole proprietorship? A major advantage of the sole proprietorship is that the proprietor receives all of the profits. Also, it is often easier and less costly to start a sole proprietorship than to start any other kind of business. This type of business organization entails more flexibility than does a partnership or a corporation. A sole proprietor pays only personal income taxes on profits. Sole proprietors can establish tax-exempt retirement accounts in the form of Keogh plans.The major disadvantage is that the proprietor bears the burden of any losses or liabilities incurred by the enterprise. The sole proprietorship also lacks continuity on the death of the proprietor. Another disadvantage is that the opportunity to raise capital is limited to personal funds and the funds of those who are willing to make loans.Why did the Sarks take the unethical step of fraudulently conveying their home to their son? What should they have done instead? The Sarks may have taken the steps that led to the dispute in this case to save their home and its value for themselves and their son. They may have been motivated by embarrassment or humiliation for their predicament.Instead of the unethical step of fraudulently conveying their home to their son, the Sarks might have attempted to downsize to a smaller residence. Or they might have attempted to renegotiate the terms of their mortgage, or obtain a second mortgage or initiate a home equity line of credit. Or they might have simply sold the house themselves and applied the proceeds against their debt. If none of these options were possible, they might have tried to renegotiate their debts and the terms with Quality and their other creditors..1.Personal Assets at RiskCreditors can satisfy a sole proprietor’s business debts through his or her personal assets. The liability is unlimited.2.Lack of Continuity and Limitations on FundingA sole proprietorship ends when the owner dies.II.FranchisesA franchise is any arrangement in which the owner of a trademark, a trade name, or a copyright has licensed others to use it in selling goods or services. A franchisee is generally legally independent, but economically dependent on the integrated regional or national business system of the franchisor.A.Types of Franchises1.DistributorshipFranchises can take the form of distributorships, in which a manufacturer licenses a dealer to sell its product, often in an exclusive territory.2.Chain-Style Business OperationA franchise can take the form of a chain-style business operation. Here, the franchise operates under the franchisor’s trade name as part of a select group of dealers. There are normally standardized practices and required levels of performance. Materials and supplies often must be bought from the franchisor.3.Manufacturing or Processing-Plant ArrangementIn this arrangement, the franchisor transmits to the franchisee the ingredients or formula to make a product, which is marketed according to the franchisor’s standards.B.Laws Governing FranchisingThere is not a solid body of appellate decisions from federal or state courts relating to franchises. Courts tend to apply general common law principles and appropriate statutory definitions and rules.1.Federal Regulation of Franchisesa.Industry-Specific Standards?The Automobile Dealers’ Franchise Act of 1965 protects auto dealership franchisees from bad faith termination. An auto manufacturer–franchisor cannot make unreasonable demands of dealers-franchises or set unrealistically high sales quotas.?The Petroleum Marketing Practices Act of 1979 protects gasoline station franchisees.?Federal antitrust laws prohibit certain types of anticompetitive agreements.b.The Franchise RuleThe Federal Trade Commission’s Franchise Rule requires—?Material facts. Franchisors must disclose certain material facts for a prospective franchisee to make an informed decision concerning the purchase of a franchise. All materials must be downloadable and savable.?Written or electronic disclosures. Information must include the range of goods and services and the value and estimated profitability of a franchise.?Reasonable basis for representations at the time they are made.?Projected earnings. If these are provided, it must be indicated whether the figures are based on actual or hypothetical examples.?Actual data. If projections are based on actual data for a specific location, the number and percentage of existing franchisees that have achieved the results must be disclosed.?Explanation of terms. This includes termination, cancellation, and renewal.2.State Protection of FranchisingState legislation tends to be similar to federal statutes and regulations (to protect prospective franchisees from dishonest franchisors and prohibit franchisors from bad faith termination).a.State DisclosuresMany states require—?Franchise Disclosure Document (FDD). This must be registered with a state official.?State approval. Advertising aimed at prospective franchisees must be approved.?Disclosures. Costs of operation, recurring expenses, profits earned, and facts substantiating these figures must be disclosed.?State deceptive trade practices acts. These may apply to certain franchisor actions.b.Requirements for TerminationState law may prohibit termination without “good cause” or require that certain procedures.Enhancing Your Lecture—????Franchising in Foreign Nations?????In the last twenty years, many U.S. companies (particularly fast-food chains and coffeehouses) have successfully expanded through franchising in nations around the globe. Franchises offer businesses a way to expand internationally without violating the legal restrictions that many nations impose on foreign ownership of businesses. Although Canada has been the most popular location for franchises in the past, during the last few years, franchisors have expanded their target locations to Asia, South America, Central America, and Mexico.Cultural and Legal Differences Are ImportantBusinesspersons must exercise caution when entering international franchise relationships—perhaps even more so than when entering other types of international contracts. Differences in language, culture, laws, and business practices can seriously complicate the franchising relationship. If a U.S. franchisor has quality control standards that do not mesh with local business practices, for example, how can the franchisor maintain the quality of its product and protect its good reputation? If the law in China, for example, does not provide for the same level of intellectual property protection, how can a U.S. franchisor protect its trademark rights or prevent its “secret recipe or formula” from being copied?The Need to Adequately Assess the MarketBecause of the complexities of international franchising, successful franchisors recommend that a company seeking to franchise overseas conduct thorough research to determine whether its particular type of business will be well received in that location. It is important to know the political and cultural climate of the target country, as well as the economic trends. Marketing surveys to assess the potential success of the franchise location are crucial in international markets. Also, because complying with U.S. disclosure laws may not satisfy the legal requirements of other nations, most successful franchisors retain counsel knowledgeable in the laws of the target location. Competent counsel can draft dispute settlement provisions (such as an arbitration clause) for international franchising contracts and advise the parties about the tax implications of operating a foreign franchise (such as import taxes and customs duties).For Critical AnalysisShould a U.S.-based franchisor be allowed to impose different contract terms and quality control standards on franchisees in foreign nations that are different than those imposed on domestic franchisees? Why or why not?Enhancing Your Lecture—????Independent Contractor or Franchisee??????When Janet Isbell, a sales representative for Mary Kay cosmetics, lost her job, she sued Mary Kay, Inc., claiming that she was a franchisee and, as such, was entitled to the protections of the state franchising law. Among other things, this law provided that a franchisor could terminate a franchising relationship only for cause and required that the franchisee be given ninety days’ notice. Mary Kay responded that Isbell was not a franchisee but an independent contractor. The case eventually reached the Arkansas Supreme Court, and in deciding the issue, the court looked to the Arkansas Franchise Practices Act. At first, the letter of the law, as spelled out in that act, was not very helpful. The act’s definition of a franchise, for example, did not shed any light on the case at hand. The court did find one provision in the act, though, that could guide its decision. According to that provision, the act applied only to a franchise that contemplated or required the franchisee “to establish or maintain a place of business in the state.” Although Isbell had rented storefront space in a Little Rock mall to use as a training center for Mary Kay representatives and to hold meetings, Isbell’s contract with Mary Kay did not require her to do so. Therefore, under Arkansas law, she was an independent contractor, not a franchisee.aThe Bottom LineBusinesspersons should realize that the law, and not an agreement between private parties, ultimately determines whether a franchising relationship exists. In some cases, courts have held that even though parties have signed a franchising agreement, the franchisees are in fact employees because of the degree of control exercised over them by the franchisors. In other cases, courts have held that a franchising relationship exists even in the absence of a franchising contract.a. Mary Kay, Inc. v. Isbell, 338 Ark. 556, 999 S.W.2d 669 (1999).Additional Background—Law and the FranchiseeA franchise arrangement appeals to many prospective businesspersons who want to be financially independent and yet feel more comfortable working with an established product or service and a management network that is regional or national in scope and that has been in place for some time. Although franchises have a relatively high survival rate (90 percent) as compared to small businesses (20 percent), franchise agreements and operations may cause some franchisees to suffer considerable financial losses.Nearly all franchise contracts require a franchise fee payable up front or in installments. Some franchise arrangements hide franchise-fee payments in long-term supply purchase requirements that typically continue for the duration of the franchise agreement. These purchase requirements will usually require the franchisee to purchase supplies (including generic products such as napkins and plastic flatware) at a premium price from the franchisor. The franchisee may also be required to contribute monies for advertising expenses which are actually in excess of the franchisee’s bona fide pro rata share. This excess is also an implicit franchise fee.The franchisee will often suffer significant negative consequences if the franchise is terminated by the franchisor. Unfortunately, the courts have not yet made a clear statement as to what a franchisee’s rights are upon termination. Some courts have held, for example, that if a franchise investment is substantial and the relationship between the parties is an established one, then the franchise cannot be terminated until a reasonable period of time has elapsed. How the term “reasonable” is defined, of course, will depend on the particular circumstances of each case. In any event, a potential franchisee should always be sure to obtain all the relevant details of the business and of the franchise agreement before paying for the franchise in order to avoid many unnecessary financial and legal problems. III.The Franchise ContractFirst, prospective franchisees must decide on the type of business they wish to undertake and get information about the business from the franchisor. This information should include details about the franchise contract.A.Payment for the FranchiseThe franchisee ordinarily pays an initial fee for the franchise license, fees for products purchased from or through the franchisor, a percentage of sales, a percentage of advertising costs, and some administrative expenses.B.Business PremisesThe franchise agreement may specify whether the premises must be purchased or may be leased, and which party will supply equipment and furnishings.C.Location of the FranchiseThe franchisor determines the franchisee’s territory. Territorial rights are often disputed, and the implied covenant of good faith and fair dealing may apply.D.Quality Control by the FranchisorA franchise agreement may give a franchisor a degree of supervision and control over the franchisee’s operation to protect the franchise’s name and reputation.1.Means of ControlThe contract may provide that the franchisor can make periodic inspections to ensure that standards are maintained.2.Degree of ControlA franchisor may set quality standards, but the tighter the control, the more likely the franchisor may be responsible for the acts of the franchisee and his or her employees.E.Pricing ArrangementsFranchisors may require the purchase of certain supplies at a set price and may set the price at which a franchisee resells goods. This could violate antitrust laws, however.Enhancing Your Lecture—????What Problems Can a Franchisee Anticipate? ?????A franchise arrangement appeals to many prospective businesspersons for several reasons. Entrepreneurs who purchase franchises can operate independently and without the risks associated with products that have never been marketed before. Additionally, the franchisee can usually rely on the assistance and guidance of a management network that is regional or national in scope and has been in place for some time. Franchisees do face potential problems, however. Generally, to avoid possibly significant economic and legal problems, it is imperative that you obtain all relevant details about the business and that you have an attorney evaluate the franchise contract for possible pitfalls.The Franchise FeeVirtually all franchise contracts require a franchise fee payable up front or in installments. This fee often ranges between $10,000 and $50,000. For nationally known franchises, such as McDonald’s, the fee may be $500,000 or more. To calculate the true cost of the franchise, however, you must also include the fees that are paid once the franchisee opens for business. For example, as a franchisee, you would probably pay 2 to 8 percent of your gross sales as royalties to the franchisor (for the use of the franchisor’s trademark, for example). Another 1 to 2 percent of gross sales might go to the franchisor to cover advertising costs. Although your business would benefit from the advertising, the cost of that advertising might exceed the benefits you would realize.Electronic Encroachment and Termination ProvisionsAnother problem that many franchisees do not anticipate is the adverse effects on their businesses of so-called electronic encroachment. For example, suppose that a franchise contract gives the franchisee exclusive rights to operate a franchise in a certain territory. Nothing in the contract, though, indicates what will happen if the franchisor sells its products to customers located within the franchisee’s territory via telemarketing, mail-order catalogues, or online services over the Internet. As a prospective franchisee, you should make sure that your franchise contract covers such contingencies and protects you against any losses you might incur if you face these types of competition in your area.A major economic consequence, usually of a negative nature, will occur if the franchisor terminates your franchise agreement. Before you sign a franchise contract, make sure that the contract provisions regarding termination are reasonable and clearly specified.Checklist for the Franchisee1.Find out all you can about the franchisor: How long has the franchisor been in business? How profitable is the business? Is there a healthy market for the product?2.Obtain the most recent financial statement from the franchisor and a complete description of the business.3.Obtain a clear and complete statement of all fees that you will be required to pay.4.Will the franchisor help you in training management and employees? With promotion and advertising? By supplying capital or credit? In finding a good location for your business?5.Visit other franchisees in the same business. Ask them about their experiences with the product, the market, and the franchisor.6.Evaluate your training and experience in the business on which you are about to embark. Are they sufficient to ensure success as a franchisee?7.Carefully examine the franchise contract provisions relating to termination of the franchise agreement. Are they specific enough to allow you to sue for breach of contract in the event the franchisor wrongfully terminates the contract? Find out how many franchises have been terminated in the past several years.8.Will you have an exclusive geographic territory and, if so, for how many years? What plans does the franchisor have in regard to telemarketing, electronic marketing, and mail-order sales to customers within the territory?9.Finally, the most important way to protect yourself is to have an attorney familiar with franchise law examine the contract before you sign it.IV.Franchise TerminationA franchise usually begins with a short term, such as a year, which is extended or increased if everything works out.A.Grounds for TerminationTermination must be for cause, such as the franchisee’s death, disability, insolvency, breach of the agreement, or failure to meet quotas.Case Synopsis—Case 30.2: Century 21 Real Estate LLC v. All Professional Realty, Inc..All Professional Realty, Inc., signed four franchise agreements with Century 21 Real Estate LLC, to operate offices in Sacramento and Folsom, California, and Honolulu, Hawaii, under the name “Century 21 All Professional.” The agreements required All Professional to pay royalty and advertising fees, and permitted Century 21 to terminate the agreements for good cause, including the franchisee's failure to operate at an approved location. All Professional signed a note for $75,000 payable to Century 21 and agreed to make annual payments on the note. Four years later, All Professional stopped paying the franchise fees, made no payments on the note, and closed the Folsom office. Century 21 terminated All Professional’s franchise agreements. All Professional filed a suit against Century 21, alleging breach of contract. A federal district court issued a summary judgment in the franchisor’s favor. All Professional appealed.The U.S. Court of Appeals for the Sixth Circuit affirmed. All Professional breached the franchise agreements—Century 21 did not...................................................................................................................................................Notes and QuestionsWhy might a franchisor want to terminate a franchise? Why might a franchisee want to continue its association with a franchisor? A franchisor might want terminate a franchise for any of a number of reasons. A franchisee may not be as profitable for the franchisor as might have been anticipated or as might be necessary to continue the business relationship. A franchisee might prove incapable of maintaining certain standards of goodwill, which could affect the public’s perception of all of the franchisor’s operations. A franchisee might not be protective of a franchisor’s trademarks or other intellectual property.Despite disagreements, a franchisee might want to continue its relationship with a franchisor to increase profits. Franchisee, who normally invests a substantial amount of time and financial resources in making a franchise operation successful, may receive little or nothing for the business on termination. The same reasons that attracted the franchisee to the franchise in the first place might support its continuanceassociation with a national organization, a well-known or familiar brand, national marketing and advertising, and other factors.Does a franchisee have any recourse when a franchisor changes the terms of their franchise agreement? Yes, there could be grounds for a breach-of-contract suit, if the changes are imposed without consent, and they are one-sided and unconscionable, or otherwise arguably in violation of the law. If the contract had been induced by fraud, there is a basis for a claim. But if the franchisor acted in good faith and dealt fairly, if the franchisee entered into the contract with full knowledge of its terms, and if the contract included a notice provision with respect to the franchisor’s changes, there might be little ground on which the franchisee could obtain relief.Additional Cases Addressing this Issue —Franchise TerminationCases focusing on the termination of franchises include the following.?Zeidler v. A & W Restaurants, Inc., 301 F.3d 572 (7th Cir. 2002) (a franchisee's closing of its restaurant barred it from establishing that the franchisor wrongfully terminated the franchise, even though the franchisee asserted that the franchisor acted in bad faith by threatening termination, because the franchisee could not show a link between the termination threats and the restaurant's closure and the voluntary abandonment of the franchise constituted good cause for the franchisor to terminate the agreement).?Hale Trucks of Maryland, LLC v. Volvo Trucks North America, Inc., 224 F.Supp.2d 1010 (D.Md. 2002) (a truck manufacturer was entitled to terminate a dealership agreement on fifteen days' notice after the dealer’s lender repossessed all of the dealer’s vehicles).?Duarte & Witting, Inc. v. New Motor Vehicle Board, 104 Cal.App.4th 626, 128 Cal.Rptr.2d 501 (3 Dist. 2002) (in a Chrysler-Plymouth dealer’s suit against termination of its Plymouth franchise by Daimler Chrysler Motors Corp., it was undisputed that the franchisor was discontinuing the manufacture of the product and the franchise agreement allowed for the termination of the franchise on the discontinuation, and thus good cause for termination of the franchise existed as a matter of law).?Midwest Automotive III, LLC v. Iowa Department of Transportation, 646 N.W.2d 417 (Iowa 2002) (a change in the ownership of a franchisee's auto dealership constituted good cause for the termination of the franchise when the majority of the dealership's new owner's customer satisfaction index scores were below average).1.Notice RequirementsThere must be notice and reasonable time to wind up the business.2.Opportunity to Cure a BreachA franchisee may have the contractual opportunity to cure a breach and avoid termination. But this is not likely on a breach of the duty of honesty and fidelity.B.Wrongful TerminationMuch of the franchise case law that exists concerns termination—bad faith, unconscionability of the contract termination provisions, and so onC.The Importance of Good Faith and Fair DealingFranchise statutes often cover termination, requiring good faith and fair dealing. Courts generally try to balance the rights of both parties and provide a remedy if the franchisor acted unfairly. If termination occurred in the normal course of business and reasonable notice was given, however, termination was not likely wrongful.Case Synopsis—Case 30.3: Holiday Inn Franchising, Inc. v. Hotel Associates, Inc.Buddy House was in construction. For decades, he collaborated on projects with Holiday Inns Franchising, Inc. At Holiday Inn’s request, House inspected a certain hotel and estimated that the cost to get it into shape would take more than ten years to recover. Holiday Inn refused to grant a longer franchise term, but said that if the hotel were run “appropriately,” the term would be extended at the end of ten years. House bought the hotel, and renovated and operated it, as Hotel Associates, Inc. (HAI). Greg Aden, a Holiday Inn executive, planned to license a different local hotel so that he could obtain a commission. No one informed House of Aden’s plan. When HAI applied for an extension of its franchise, Holiday Inn asked for major renovations. HAI complied, but Holiday Inn did not renew the term. HAI sold its hotel and filed a suit in an Arkansas state court against Holiday Inn, asserting fraud. The court awarded HAI compensatory and punitive damages. Holiday Inn appealed.A state intermediate appellate court affirmed. House’s relationship with Holiday Inn was characterized by “honesty, trust, and the free flow of pertinent information.” House was justified in assuming that an extension of his franchise was not in jeopardy if he ran his hotel “appropriately.” Holiday Inn knew, however, and did not inform House, of Aden’s plan to license a different facility. This was fraud. The appellate court increased the amount of punitive damages, citing Holiday Inn’s “degree of reprehensibility.”..................................................................................................................................................Notes and QuestionsA jury awarded HAI compensatory damages of $13 million, but the trial court reduced this amount to $10 million. What most likely served as the jury’s basis for its award? Why did the court reduce it? The jury based its award on $3 million for the cost of the renovations undertaken at Holiday Inn’s request before the franchise extension was denied, and $10 million as the cost of the lost opportunity to sell the hotel. The court reduced this amount by about $3 million, however, in consideration of the amount that HAI earned from the hotel before it was sold for $5 million.A jury awarded HAI $12 million in punitive damages. The state court reduced this to $1 million, but the appellate court reinstated the original award. Did Holiday Inn’s conduct warrant the $12 million punitive damages award? The purpose of punitive damages is to punish a defendant and deter similar future conduct. Yes, Holiday Inn’s conduct supported the increased amount of punitive damages. The harm to HAI was substantial. Holiday Inn—which is a wealthy, a multi-national corporation—failed to disclose significant information to House with whom it had worked for decades on a basis of good faith and trust. Holiday Inn caused House to spend $3 million on a hotel that he believed would be granted an extended franchise when a denial of the extension was already planned. The failure to disclose the plan, which Holiday Inn knew that House and HAI were entitled to, suggests a deliberate attempt to keep them unapprised. This supports the appellate court’s conclusion that “Holiday Inn’s degree of reprehensibility” justified the original punitive damages award.Teaching Suggestions1.Explain that creditors are often reluctant to permit the owner of a sole proprietorship to contract out of personal liability because the business assets may not satisfy all of the creditors’ claims if the debts are not paid. Many lenders insist that a sole proprietor sign a personal guaranty so that the lender will have recourse to his or her personal assets.2.Sometimes, a franchisor appears to attempt to drive its franchisee out of business by establishing a competing business within the geographic market area. Why would a franchisor attempt to drive its own franchisee out of business? There are several possible reasons. Perhaps the franchisor was not using good business judgment but only asserting its power. Maybe the franchisor hoped to drive the higher priced restaurant out of business to make ultimately more profit in the lower priced restaurant. Maybe the franchisor did not necessarily intend to drive the franchisee out of business, but only wanted to attract patrons with different incomes.3.Why do we tend to sympathize with a franchisee when a franchise arrangement is terminated unilaterally by the franchisor? We tend to assume that the cancellation of a franchise agreement for “good cause” can only occur if the franchisee has violated the agreement in some way. Sometimes, however, it is a case of the franchisor facing declining profits and taking action, in a commercially reasonable manner, to reduce the adverse effects of a nonprofitable undertaking. Economic realities face all of us.4.Remind students of the importance of agency law principles in business organizations. Even a franchise may be deemed a principal-agent relationship if there is a close relationship between a franchisor and its franchisee.Cyberlaw LinkWhich form of business organization would be best for a business that transacts deals only online? What are the legal and policy issues for the design, development, and operation of a sole proprietorship’s Web site?Discussion Questions1.What is an entrepreneur? An entrepreneur is one who initiates and assumes the financial risks of a new enterprise and undertakes to provide or control its management. Before going into business, however, the entrepreneur must consider whether it would be most advantageous to do business as a sole proprietorship, a partnership (general or limited) or as a corporation.2.Because the Internet has made it possible for sole proprietorships to do business worldwide without greatly increasing their costs, should they be considered, for some purposes, the equivalent of other business forms? Why or why not? Probably not. Most sole proprietorships remain small: what may constitute large sales for a small one-owner enterprise would be dwarfed by the sales of most associational business forms. Global distribution capabilities cannot convert a sole proprietorship into a corporation with its limited liability and other attributes. And to expand the definition of “corporation” to include sole proprietorships would unrealistically burden the owners in terms of court appearances and in other situations.3.What is a franchise? A franchise is any arrangement in which the owner of a trademark, a trade name, or a copyright has licensed others to use it in selling goods and services. A franchisee (a purchaser of a franchise) is generally legally independent but economically dependent on the integrated business system of the franchisor (the seller of the franchise). A franchising agreement permits the franchisee to operate an independent business but still obtain the advantages of a regional or national organization.4.Discuss the principal types of franchises. A franchise may take the form of (1) a distributorship, (2) a chain-style business operation or (3) a manufacturing arrangement. (1) A distributorship is established when a manufacturing concern (franchisor) licenses a dealer (franchisee) to sell its product in a specified territory. (2) A chain-style business franchise operates under a franchisor’s trade name and is identified as a member of a select group of dealers that engages in the franchisor’s business and complies with the standardized or prescribed methods of operation including exclusive supply purchase requirements. (3) A manufacturing arrangement is created when the franchisor transmits to the franchisee the essential ingredients or formula to make a particular product, thus enabling the franchisee to market it in accordance with the franchisor’s standards.5.How is a franchise paid for? The franchisee ordinarily pays an initial fee or lump-sum price for the franchise license. This fee is separate from the fee for the various products that the franchisee purchases from the franchisor. In most cases, the franchisor will receive a stated percentage of the annual sales or annual volume of business done by the franchisee. The franchise agreement may also require the franchisee to pay a percentage of the advertising costs as well as certain administrative expenses incurred under the franchise agreement.6.What is the duration of a franchise? The parties determine the duration of a franchise. Most franchises begin with a “trial period” in which the franchisee and franchisor can determine whether they want to stay in business with one another. Most franchise agreements typically require that termination be “for cause,” such as the death or disability of the franchisee, the insolvency of the franchisee, a breach of the franchise agreement or a failure to meet specified sales quotas. Not surprisingly, much litigation has arisen over termination provisions.7.What do franchise agreements generally provide with respect to a franchisee’s location and form of doing business? Most standard franchise agreements contain detailed provisions for such areas of coverage as the following: Business Form of the Franchise. A franchisor may specify certain requirements for the form and capital structure of the business. A franchise agreement may also set out standards of operation for the franchisee’s conduct of the business, including quotas, quality, and record keeping requirements. A franchisor may also insist on training the franchisee’s personnel and retain control over the administrative aspects of the business. Location of the Franchise. The franchise agreement usually specifies the territory in which the franchise is permitted to operate as well as whether the franchise is exclusive or nonexclusive.8.How do franchise agreements generally delegate price and quality controls over the franchisee’s business? Price Controls. Because the franchisee provides the franchisor with an outlet for the franchisor’s goods and services, the franchise agreement may require the franchisee to purchase certain supplies from the franchisor at an established price. Federal antitrust statutes may prevent the franchisor from setting the prices at which the franchisee may sell its goods but the franchisor is free to suggest retail prices. Quality Control. The franchise agreement can provide that standards of operation relating to such aspects of the business as sales quotas, quality, or record keeping be met by the franchisee. It can also impose specific requirements relating to such things as the training of employees. Because the franchisor has a legitimate interest in maintaining the quality of the product or service in order to protect its name and reputation, it can exercise greater control in this area than would otherwise be tolerated.9.Should a franchisor be allowed to control the operation of its franchisee—with a goal of maintaining a certain standard of quality—without liability for the franchisee’s conduct? No, because there should be some responsibility (liability) assumed for the exercise of control over the franchise’s activities. Yes, because the franchisee should be responsible for its own conduct. What would constitute a “right to control” under a franchise contract? A franchisor would have a “right to control” if it retained a right to intervene in employee management. “Helpful hints,” “guidelines,” “words of advice,” and similar suggestions or recommendations for addressing problems and disciplining employees would likely not be enough. Whichever party has the discretion to set the terms and conditions of employment would most likely be considered to have a “right to control.” In the absence of a “right to control,” could a franchisor be found vicariously liable for the actions of a franchisee’s employees? Yes, if the franchisor exercised actual control.Activity and Research Assignments1.Ask students to discuss any of their own experiences as sole proprietors. They might especially be asked to discuss to advantages and disadvantages of this form of business as those factors were made apparent by their experiences.2.Ask students about running businesses on the Internet. Is it easier to start a business in “virtual” space than in “real” space? Is it less (or more) expensive? What are the applicable laws? Perhaps most important from a business person’s perspective, is it possible to turn a profit? How? Are there different considerations for choosing an organizational form for doing business on the Net than there are for doing business elsewhere? If so, what are they?Explanation of a Selected Footnote in the TextFootnote 9: Pilot Air Freight Corp. franchisees included LJL Transportation Inc., which Louis Pektor and Leo Decker own. The franchise agreement required LJL to route all shipments through Pilot. The agreement also provided, “Pilot shall allow Franchisee an opportunity to cure a default within ninety (90) days of receipt of written notice.” When LJL diverted shipments to Northeast Transportation, a competitive service owned by Pektor and Decker, Pilot terminated the franchise agreement. LJL filed a suit in a Pennsylvania state court against Pilot, alleging breach of contract and asserting a right to cure. The court issued a judgment in Pilot’s favor and a state intermediate appellate court affirmed. LJL appealed. In LJL Transportation, Inc. v. Pilot Air Freight Corp., the Pennsylvania Supreme Court affirmed. A franchise agreement may be terminated immediately “when there is a material breach of the contract so serious it goes directly to the heart and essence of the contract, rendering the breach incurable.” Good faith and honesty are requirements for the performance and enforcement of a contract. Self-dealing contravenes those requirements, violating the trust on which an agreement is based. A franchisee’s breach of these duties goes to the contract’s “heart.” In that situation, a franchisor could terminate the franchise agreement without notice despite any right-to-cure provision.Suppose that Pilot had terminated its franchise agreement simply because it no longer wished to be bound. Would refusing to allow LJL to invoke the right-to-cure provision in this circumstance have been valid? No. A party’s attempt to terminate an agreement not because of any egregious or fraudulent conduct of the other party—which would constitute a vital and essential breach of the contract—but simply because the party no longer wished to be bound would not excuse a refusal to follow the procedure for termination set out in the agreement. The attempted termination would be invalid for noncompliance with the terms.The Pilot franchise agreement required LJL to file reports with the franchisor detailing daily shipments and other business. To divert shipments, LJL had filed false reports. What covenant might be implied in this requirement? Did LJL breach it? This requirement might be construed to create an implied covenant in which the franchisee agreed not to engage in schemes that would deprive the franchisor of its revenue. LJL would have breached this covenant by filing false reports. This conduct too could have been held to be sufficiently fraudulent to render obsolete the right-to-cure provision of the agreement: the only way that Pilot had of knowing the business that transpired would have been based on the reports.Did LJL act unethically? Yes. The dishonest and untrustworthy nature of its actions is nothing if not unethical. LJL’s acts of self-dealing were so serious they frustrated the principal purposes of the franchise agreement. From an ethical perspective, as well as the legal view, no remedy for the breach existed because no amount of repayment of the lost funds could restore the franchisor’s lost trust.What if Pilot could not show a monetary loss due to the breach? This seems unlikely unless Pilot discovered the diversions early in LJL’s breach. Even if this were true, however, the breach would have been no less serious and might still have been sufficient to support the franchise agreement’s immediate termination.From an ethical perspective, if LJL had been allowed to invoke the right-to-cure provision, could it have undone its wrongdoing so that the franchise relationship could have continued? Why or why not? Probably not. No amount of payment for LJL’s theft could restore Pilot’s business trust and confidence in its franchisee. More than revenue or profit, that is what was lost by the breach. LJL’s lack of ethics in its acts of self-dealing, and its legal breach of the agreement, undermined the parties’ relationship to the extent that their deal could probably not be restored. Pilot might have been justified in rescinding the contract even if it had been for a fixed term with no right of termination. ................
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