For many Franchisors the use of required vendors is justified by the assurance of quality control, maintaining confidentiality, preserving trade secret information and increasing profitability for the Franchisor. But when Franchisors adopt a restrictive approach by designating an exclusive supplier, Franchisees sometimes question prices charged as compared to other non-designated suppliers.
While Franchisees may recognize the advantages of some degree of control over sources of supply, they become very disgruntled when there is only one source of supply. But, when a Franchisor is receiving consideration from the vendor based upon the volume of purchases from Franchisees or when the Franchisor receives a discounted price for itself or an affiliate owned operation and the discount is based upon the volume of Franchisee purchases, questions will be raised.
Even when a Franchisor requires Franchisees to use one designated supplier and/or collects volume rebates, lawsuits usually don’t spring up until a Franchisee fails to make the money it thought would be made, or worse, when the Franchisee is losing money. Don’t wait for that dissatisfaction to fester. Franchisors must plan in advance. Before initiating a required supplier/vendor and/or rebate program, develop a plan to prevent potential legal claims from your Franchisees, which usually comes in three forms:
- Antitrust Violations – illegally tying the purchase of goods and services to the sale of the Franchise, in violation of the Sherman Act or claims that the rebates equal a sort of commercial bribery violating the Robinson-Patman Act.
- Misrepresentation or Fraud – This is often framed as i) negligent misrepresentation, ii) a deceptive or deficient disclosure (usually Item 8 of the Franchise Disclosure Document and not complying with the Amended FTC Rule), iii) violating state “Little FTC Acts” (which prohibit unfair and deceptive trade practices), and iv) breach of a fiduciary duty.
- Breach of Contract – Franchisees usually contend the Franchisor’s use or disposition of the rebate violates a contract (normally the Franchise Agreement or some ancillary agreement) between the Franchisee and Franchisor.
“An Ounce of Prevention is Worth a Pound of Cure”
All of the legal claims set out above are fact specific, but in most cases could have been prevented with an advance legal plan in place. Start by building a solid foundation and disclose supplier requirements and any rebate programs in Item 8 of the FDD.
The Amended FTC Franchise Rule requires disclosure of not only the existence of rebate programs but the amount received, officers or owners interest in required suppliers, how Franchisees get approval of alternate suppliers and the list of required information continues until full disclosure is before a Franchisee considering the purchase of a franchise.
When full disclosure is made by the Franchisor, courts are much more receptive to holding that the Franchisee entered into the Franchise Agreement with full knowledge of Franchisor’s standards and requirements, prior to executing the agreement. Comprehensive disclosure documents and proper verbiage in Franchise Agreements will go a long way in preventing or mitigating legal actions by Franchisees.
Planning in advance is the key and may be that “ounce of prevention” that saves a Franchisor thousands or even hundreds of thousands in damages and legal fees. Start with your Franchise counsel to avoid the pitfalls of using required vendors and mandatory rebates.