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Open-Source Franchising: Laws for the next generation of global business networks.

By Deemant Himmat Lodhia

(Essay contributed towards the degree of LLM at the University of Auckland, New Zealand, November 2010).

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Comments This is wide-ranging discussion of how franchising has developed and a look at how it may develop in future. There is good discussion of economic theory underlying franchising and a tentative attempt to predict the implication of technological developments for its future. Gehan Gunasekara Senior Lecturer The University of Auckland Business School

Table of Contents 1.0

Introduction

2.0

Traditional Franchising

3.0

The Essence of Franchising 3.1 Global Markets, Domestic Institutions

4.0

How the Law affects Franchising 4.1 The Seven Stages of Franchise Development 4.2 System Goodwill and Intellectual Property 4.2.1 Registered Trademarks 4.2.2 Unregistered Trademarks 4.3 The Franchise Agreement 4.4 A Relational-Standard Form Contract 4.4.1 Operational Controls 4.4.2 Control of Key Elements 4.5 Indefinable Terms of the Contract

5.0

The Franchise Paradox 5.1 Economics of Franchising 5.1.1 Transaction Costs of Franchising 5.2 Regulatory Debates 5.3 Other Complications in Building a Global Franchise

6.0

Open-Source Franchising 6.1 Self-Managing Franchise Relationships 6.2 The Collaborative Franchise System 6.3 Becoming, then Remaining Well-Known 6.4 Keeping Pace with Time, Space and Technology

7.0

Conclusion

8.0

Bibliography

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“The only permanent thing is change” Heraclitus

1.0

Introduction

The term open source describes practices that promote access to the end product’s source materials. It may be considered a philosophy or pragmatic methodology and is being applied in the context of franchising to illuminate the next generation of global networks. Franchising is an ideal expansion option for any aspiring business owner ready to flap their wings on a global scale; however commercial and legal practicalities prevent viral distribution of ideas and values across eager consumer networks, ready and waiting for value exchanges in free markets. 1 Adam Smith’s magnum opus, The Wealth of Nations which showed how to create national wealth through production and export of surplus, and also expressed economic philosophers’ desire to make economics a true science, thus modern economic thought embraced goods or objects as having utility properties and relationships are measured in terms of prices and value-in-exchange. 2

Franchising is commonly cited for its business format; management system; product or trade name cloning capabilities in commercially successful applications and most (if not all) of the valuable global brand names present an argumentum a fortiori. The classic relationship between buyers and sellers is co-ordinated and regulated by the market as a commercial transaction. As a result, it has been treated as an arm’s length relationship carrying the common sense view that such dealings should not entail responsibility ‘for each other’s economic and physical security to any greater extent than provided for by their contractual agreement’3 .

Legal scholars have repeatedly distinguished franchising and business format franchising in particular as problematic relationships because of paradoxical issues involving economic arguments of power and control, the relational yet standard form nature of the contracts containing indefinable terms that implement unilaterally determined operational controls while ensuring key elements of the business are retained by the franchisor and is therefore often disadvantageous to the franchisee. In fact, the result is substantial and persistent investor losses, misallocation of capital resources and conflicts from within the franchise 1

Adam Smith (1776). The Wealth of Nations, W Strahan and T Cadell, London. Lusch RF, Vargo SL and O’Brien M, (2007), ‘Competing through service: Insights from service-dominant logic’, Journal of Retailing 83 (1) 5-18 at p.6. 3 Collins H (1990). ‘Independent contractors and the challenge of vertical disintegration to employment protection laws’, Oxford Journal of Legal Studies, vol.10, no.3, 353-380 at 354. 2

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system culminating into significant volumes of civil litigation and calls for public sector enforcement. 4

Many other complications exist in building global brands. The legal barriers impeding expanding empires, that are trying to satisfy global markets through domestic institutions, should be of concern to the policy makers of ill-performing economies. Their regulatory debates hint at a free market answer that gives freedom to the market, hence an opensource franchise infrastructure containing self-managing relationships, which become then remain well-known and are modified for evolution indefinitely through new built-in learning capabilities. Before presenting the future, however, a brief look at the past.

2.0

Traditional Franchising

Franchising is commonly believed to be a recent phenomenon imported from the United States since the 1950s, however, its has also been traced back to the Middle Ages, for example, in Norman England, barons were granted territories by the King in return for the payment of royalties, provided they met other requests by the monarch. 5 Thus a franchise granting rights to maintain order determine and collect taxes in exchange for protection. In Japan, franchise relationships have also existed in private business and commerce, for example the Norenkai system, whereby a former employee opens an independent branch operation in return for a royalty, has operated since the early sixteenth century. 6 The Singer Sewing Machine company during the 1850s turned to commission agents who were given the right (a franchise) to supply consumers within a designated territory, and it proved its worth in terms of accelerating the market penetration of an innovative product. 7 Family businesses can be representative of ‘brand’ franchise that has survived over centuries in many countries as well. 8

4

Andrew Selden (2008). Beyond the Law and the Contracts: Strategies for Effective Franchise Relationship Self-Management, Briggs and Morgan, Minneapolis, USA. 5 Alan Felstead (1993). The corporate paradox; power and control in the business franchise. Routledge, London at 39. 6 Abell M (1989). The Franchise Option: A Legal Guide, Waterlow, London. 7 Jack AB (1957). ‘The channels of distribution for an innovation: the sewing machine industry in America, 1860-1865’, Explorations in Entrepreneurial History, vol.9, no.1, February, 113-141. 8 It is a most basic and traditional ‘brand’ unit that may be well-placed in local communities for enhanced interaction with consumers, for example, observantly Tata and Toyota have used such an approach. Rolex also remains a tightly held family business.

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A simple model 9 reflects the traditional franchise organisation design, allocating decisionmaking authority to the franchisor with a payment for his or her services. 10

Figure 1.

The traditional model of franchising is prevalent and likely to prevail because it protects the franchisor directly and provides maximum monetary benefits almost instantly. This is necessary because there is apparently a need to boost and protect commerce in its present form so as not to cause further distress on global economies. The search is for an appropriate mechanism to mitigate franchise system behaviour that leads to conflict, litigation and eventually policy intervention. 11 Legislative interventions have only increased costs and requirements, whereas private solutions, individually negotiated are proving quite effective in coordinating strategies, allocating costs and benefits, enable adaptation, minimise dissatisfaction and conflict within the franchise system. 12 Franchisors’ recognition of the problems that the traditional models created lead to ameliorization and harmonious working relationships developed. 13 A closer examination of the franchise system in its present form follows.

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Image from Andrew Selden (2008) above n 4 at 14. Ibid at 13-14. 11 Ibid at 3. 12 Andrew Selden (2008) above n 4 at 3. 13 Ibid at 14-18 citing the Midas, Pizza Hut, KFC and several other franchise models. 10

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3.0

The Essence of Franchising

The essence of franchising is in harnessing the power of four key elements; brand; system; infrastructure; networks. 14 These value drivers are documented and packaged ready for replication and the fulfilment of expansion strategies for enterprises of various sorts. These elements provide the incubation environment for growth. Stronger and longer lasting patterns weaved, documented, packaged and delivered in a sustainable manner will survive and their values stored and carried forward by the brand. The contract is charged with governing this process and creates the pathways to carry the brand and its associated system through an infrastructure to the end users in various networks. The commercial lawyer is tasked with the duty to fulfil the purpose of the business enterprise and ‘promise’ its indefinite survival.

Franchising operates on the basis of a contractual agreement between two independent business parties, the franchisor and the franchisee, in which the franchisor grants the franchisee, for the term of the contract, the right to buy and operate the franchisor’s branded and formatted business system for a fee and according to the prescribed rules and procedures developed for the system by the franchisor. 15

Hence the term most commonly used to refer to this type of commercial relationship: “business format franchising”. Most consumers do not realise that they are dealing with a locally run business operating in line with specifications set by the brand owner. The franchisees often own much of the physical apparatus of the business; the franchisor owns the brand name and has the right to determine how it is used. Both do business and market under a common brand name, yet are legally distinct businesses. “This presents a paradox. On the one hand, a franchised business looks and acts like a branch … while on the other hand, it retains a distinct legal persona”. 16 The franchisor’s “business-format franchise” necessarily comprises a slight variance of the above-mentioned elements 17 ;

i. A brand name (registered or unregistered) which serves as the umbrella sign for network, and a rallying sign for the consumer and public; ii. a licence to the use the brand, granted to the franchisee by the franchisor;

14

Andrew Terry (2005), “Network expansion: options, opportunities and challenges”, Franchising Australia/ New Zealand Year Book and Directory. 15 Martin Mendelsohn (2004). Franchising Law, Kluwer. UK. 16 Alan Felstead, The corporate paradox above n 5 at introduction. 17 Martin Mendelsohn above n 15.

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iii. a business system – a business concept formatted into a duplicable value “package” founded on the franchisor’s tested Know How and his or her continued assistance during the term of the agreement; iv. payment by the franchisee of a financial consideration, either in a direct form, such as an entrance fee and/or continuing fee (“royalty”), and/or an indirect form such as a mark-up on supplied goods; v. Investment in, and ownership of, the franchised business assets.

These are the elements requiring legal influence to enable operations on global markets as domestic institutions.

3.1

Global Markets, Domestic Institutions

Franchise relationships are highly contractual, often encapsulated in lengthy and detailed documents, but their use is more difficult to gauge. Nonetheless, franchisees are bound by a contract, the terms of which have been subject to little or no negotiation, but designed instead to safeguard and privilege the interests of franchisors ahead of theirs. 18 Matters get further complicated when we consider ‘where’ this relationship is to be established as expanding enterprises routinely face transaction counter-parties who operate within quite different legal and political systems, and who rank social priorities quite differently. 19

“Globalisation” and “global markets” are misleading terms, because they mask the local quality of much of the activity within those rubrics, 20 hence ‘Global Markets, Domestic Institutions’ represents franchising’s eventual form if it is to continue being considered as the premier vehicle for international expansion. 21 Understanding global and domestic legal implications provides the wheels and roads for the brand’s vehicle in very different terrains.

18

Alan Felstead, The corporate paradox above n 5 at 128. Milhaupt CJ (2003, ed.). Global Markets, Domestic Institutions: Corporate Law and Governance in a New Era of Cross-Border Deals, Columbia University Press, New York. 20 Ibid at 1-3. 21 Andrew Terry (2009). ‘The Regulation of Franchising in Asia: A Comparative Study’, 6th Asian Law Institute Conference, Hong Kong 29/30 May, at 2. 19

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4.0

How the Law affects Franchising

The essence of franchising is spread in global markets as domestic institutions through the law. The two strands of law in the context of franchising 22 are;

i. Laws affecting business generally and the industry in which [it] operates; and ii. Laws relevant only because the marketing method chosen is franchising.

It is clear that all businesses have to identify and comply with all legal requirements affecting business. 23 The law affects franchising at every stage and in foreseeable and sometimes unforeseeable ways. The brand provides a singular currency for the purposes of exchange and this can be made up of innumerable elements. The present day spread of cultural icons is evidence of successful franchising applications over various legal regimes over decades.

The starting point for development of the business for franchising is through a pilot operation to enable the franchisor to identify these laws. 24 “[T]he franchisee will certainly expect the franchisor’s system to reflect and respect all relevant laws�. 25 Relevant laws may include 26 town and country planning restrictions, by-laws and building regulations, health, hygiene and safety acts, business, employment and tax laws, discrimination, disabilities and other laws applicable to the specific type of business. 27 Once the general business and industry laws are understood, the laws relevant for franchising in particular can be considered in the seven stages of the franchise transaction.

4.1

The Seven Stages of Franchise 28

i. The development of the concept by means of a pilot operation to explore the validity of the concept in practical operations, allow fine-tuning and to establish business, operational and accounting systems in order to prove evidence of marketability to the consumer. At this stage careful environmental analysis and a most suitable and optimum decision needs to be made in light of the given resources in order to develop 22

Martin Mendelsohn (2004). Franchising Law above n 15 at 37. Ibid 24 Ibid. 25 Ibid. 26 This list is by no means exhaustive. 27 Martin Mendelsohn (2004). Franchising Law above n 15 at 38. 28 Ibid at 37-44. 23

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an operational manual, essentially a detailed constitutional document for the business franchise. The franchisor creates many intellectual property rights including trade mark, name, goodwill, trade secrets, confidential information, copyright material, designs, patents, manufacture process, formulae or recipes. 29 First and foremost, these rights must be protected. “Delay can be fatal and names [or other intellectual property] do get stolen”. 30 The common law of passing off may be considered but prevention is always better than the cure.

ii. Structuring the franchise package involves the franchisor deciding on marketability based on the results of the pilot project. Important structural decisions which affect the commercial and legal shape of the transactions are made at this juncture. Considerations include involvement in the property chain, tying products, territorial considerations (exclusivity, size, viability, targets), length of agreement, renewal, initial and continuing fees, methods and procedures for enforcement, the seven P’s of marketing (price, people, promotion, place, process, physical evidence and product) or for a globalising enterprise, a slight variant seven P’s 31 (people, planet, profit, passion, personal (relations), principles, priority). There are many practical decisions including nature and range of services, training, design and layout, fit-out, operational and interaction methods, protection of customer base, franchisee and third party characteristics etcetera. 32 The legal considerations to fulfil may stem from property, competition, tax, employment, privacy, commercial and contractual laws.

iii. Marketing the franchise package to would-be franchisees involves the preparation of marketing materials, determining recruitment method, interview and selection procedures and financial arrangements. Disclosure, misrepresentation, discrimination, contract and the protection of secret and confidential information are the primary legal considerations at this stage. 33 The franchise contract may be signed and binding obligations start to flow both ways. 34

29

Ibid at 38-39. Ibid at 39. 31 As found in many annual statements of multinationals. 32 Ibid at 40-41. 33 Ibid at 41. 34 Ibid at 42. 30

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iv. Opening for business requires transforming the new recruit into a fully trained operator ready to trade. Site decisions, fit out, equipment, stocks and utilities are dealt with in accordance with local practices.

v. The continuing long-term relationship has started and the franchisor wants to ensure that the franchisee performs and that its system is protected in operation and from unfair competition. 35 The contract and its attached operating manual govern this bond. Enforceable commitments are specified according to varying priorities and legal constraints. Sanctity of contract is maintained in many jurisdictions.

vi. The termination of the contract requires a strategy to ensure continued survival under expiring events and by providing for time and opportunity for curing defaults. 36

vii. The consequences of termination calls for protection of the franchisor and the franchise network against unfair post-termination competition especially through use of know-how and other confidential information. This may require de-identifying and providing for return or transfer of any specified items used in the franchise.

Another view that franchise lawyers consider is the centrality of intellectual property issues since the protection of the brand is a key factor in storing accumulated value for any venture, therefore first and foremost, protect the brand and its accumulated goodwill.

4.2

System Goodwill and Intellectual Property (IP) Issues

The most important asset being licensed is the IP and the fundamental principle of IP law is that first in time means first in right, however, the manner in which the law governs the IP and its various commercial recipes in each country is different. The collective system goodwill is another aspect in need of protection to enable the franchisor to indefinitely reap benefits of his or her original idea. IP rights are created through Trade Marks, copyrights, designs and patents granting valuable monopoly rights to owners. 37 Franchising is essentially an IP licence (usually a trade mark) supplemented by a mandated system and business format. A key factor for the franchise system’s success is the strength of the trade 35

Ibid.at 42-43. Ibid at 43. 37 Andrew Terry, ‘Legal Aspects of Brand Management’ School of Business Law and Tax, Australia School of Business, University of NSW. 36

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mark. The value of brands can be many times more than all the physical assets owned by it and the value of leading global brands relies on legal recognition and trade mark protection. 38

4.2.1

Registered Trademarks

Trade Mark protection is the law’s recognition of the psychological function of symbols and is the primary legal expression of the marketing concept of brand, the oldest form of IP. 39 “The brand is an integrated perceptual structure or unity conceived as functionally more than the sum of its parts”. 40 The overall identity of the brand relates to consumers and includes its many image associations that provide meaningful value for the purpose of exchange. 41 The law recognises and protects the brand either as a registered trademark, identified by the symbol ® or as an unregistered trademark (‘TM’) thus maybe protected by the common law tort of passing off or by actions for misleading or deceptive conduct by pirates.

The territorial nature of trademark law and the lack of a single universal registration system present many challenges to franchisors considering expanding to new markets. 42 The extent to which exclusivity over franchise territories is granted has important consequences for both parties, often defined in a way as to privilege franchisor interests over franchisees. For franchisees, it determines insulation from competition within the chain i.e. dilution of any monopoly power they might have. For franchisors, it determines the leeway with which they can expand without being reliant on the franchisee’s plans. 43

Nearly all countries have a system for registration and protection of distinctive trademarks, mostly as a result of a non-negotiable obligation that arose out of the Agreement on Traderelated aspects of Intellectual Property Rights 44 (TRIPS) mandating minimum trademark

38

Andrew Terry and Heather Forrest (2008). ‘Where’s the Beef? Why Burger King is Hungry Jacks in Australia and other complications in building a global franchise brand’, 28 Northwestern Journal of International Law and Business 171, at part III. 39 Andrew Terry ‘Legal Aspects of Brand Management’ above n 37 at 2. 40 Red Bull Australia Pty Ltd v Sydneywide Distributors Pty Ltd [2001] FCA 1228 (Federal Court), upheld on appeal Sydneywide Distributors Pty Ltd v Red Bull Australia Pty Ltd [2002] FCAFC 157 (Full Court). 41 Ibid. 42 Terry A and Forrest H (2008). ‘Where’s the Beef?’ above n 38. 43 Alan Felstead, The corporate paradox above n 5 at 105. 44 Agreement on Trade-Related Aspects of Intellectual Property Rights, Apr 15, 1994, Marrakesh Agreement Establishing the World Trade Organisation, Annex 1C, 1869 UNTS 299 (1994), available at; http://www.wto.org/english/tratop_e/trips_e/t_agm0_e.htm (accessed November 2010).

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and IP protection for the members of the World Trade Organisation 45 . TRIPS incorporates and binds members to uphold the Paris Convention for the Protection of Intellectual Property 46 which integrates basic principles of national treatment 47 and most favoured nation status. 48 Significant inroads in harmonising trade mark registerability criteria and the administration of the registration process was made by the Madrid Agreement 49 and the Madrid Protocol 50 . The international procedural mechanism, the Madrid system 51 offers a trademark owner the possibility to have his trademark protected in several countries by simply filing one application directly with his own national or regional trademark office. However, the IP right is granted by a specific territory and is exercisable only within that territory’s borders. 52 En Bloc registration under the Madrid Protocol permits the filing, registration and maintenance of trade mark rights in more than one jurisdiction, provided that the target jurisdiction is a party to the system.

An international mark so registered is equivalent to an application or a registration of the same mark effected directly in each of the countries designated by the applicant. If the trademark office of a designated country does not refuse protection within a specified period, the protection of the mark is the same as if it had been registered by that Office. The Madrid system also simplifies greatly the subsequent management of the mark, since it is possible to record subsequent changes or to renew the registration through a single procedural step. Further countries may be designated subsequently. An example of a registerable mark 53 is; any letter, word, name, signature, numeral, device, brand, heading, label, ticket, aspect of packaging, shape, colour, sound or scent used or intended to be used which can be graphically represented and is capable of distinguishing the applicant’s goods and/ or services relating to the trade mark sought for registration from the product of another, 45

With 150 members and 29 observer governments seeking accession. Paris Convention for the Protection of Industrial Property, March 20, 1883, 21 UST 1583, 828 UNTS 305 as revised and amended in 1967 and 1979, available at; http://www.wipo.int/treaties/en/ip/paris/trtdocs_wo020.html (accessed November 2010). 47 That is, rights from the national system must be available to all member states. 48 Terry A and Forrest H (2008). ‘Where’s the Beef?’ above n 38 at part III. 49 Madrid Agreement Concerning the International Registration of Marks, Apr 14, 1891, 828 UNTS 389, as revised in 1967 and 1979, available at; http://www.wipo.int/madrid/en/legal_texts/trtdocs_wo015.html 50 Protocol Relating to the Madrid Agreement Concerning the International Registration of Marks, June 27, 1989, 28 Indus.Prop.L & Treaties 3-007, 001 (July-Aug. 1989). 51 The Madrid system is administered by the International Bureau of the World Intellectual Property Organisation (WIPO) in Geneva, Switzerland. Current membership of 84 countries. For more information see http://www.wipo.int/madrid/en/ 52 Terry A and Forrest H (2008). ‘Where’s the Beef?’ above n 38 at introduction. 53 Australian Trade Mark Act 1995. 46

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and which is not substantially identical with or deceptively similar to another person’s 54 TM registration or application.

The central concept of registrability is distinctiveness, that is, each mark must be capable of distinguishing goods and or services from that of other traders. Registration is only for that particular class. The Nice Classification is a system of classifying goods and services for the purpose of registering trademarks specified by the World Intellectual Property Organization. It groups products into 45 classes, 34 for goods and 11 classes embrace services. Since the system is recognised in numerous countries, this makes applying for trademarks internationally a more streamlined process.

Foreign trade marks adopted locally, sometimes coincidental but often intentionally and simply a piratical manoeuvre by a shrewd individual or group poses the most serious threat to global expansion of well-known brands. 55 Strong reasons exist to use the same brand for global consistency because goodwill crosses national boundaries and distribution, patterns, packaging, communications etcetera are facilitated and made more efficient.56 The expanding franchisor may have to buy the right to use the trade mark from a pirate or relinquish efficiencies by launching under a new brand. The Burger King and Hungry Jacks cases 57 highlight the need for caution and foresight 58 .

4.2.2

Unregistered Trademark

Under the ancient Assize of Bread and Ale enacted in the mid-thirteenth century, being the first law in British history to regulate the production and sale of food, traders were required to distinguish goods by marks to enable identification of manufacturers. 59 One unintended consequence was the promotion of branding. Unethical traders applied a competitor’s brand to their less attractive product, which in turn demanded the common law to protect a trader’s goodwill in his or her mark through an action now known as ‘passing off’. 60

54

Ibid. Terry A and Forrest H (2008). ‘Where’s the Beef?’ above n 38 at introduction. 56 Ibid. 57 Hungry Jack’s v Burger King [1999] NSWSC 1029; Burger King Corp v Hungry Jack’s Pty Ltd [2001] NSWCA 187. 58 Terry A and Forrest H (2008). ‘Where’s the Beef?’ above n 38 discusses the case in-depth. 59 Andrew Terry, ‘Legal Aspects of Brand Management’ above n 37 at 3. 60 Ibid. 55

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The law of passing off can be summarised in one short general proposition – “no man [or woman] may pass off his [or her] goods as those of another”. 61 In practice, the plaintiff must: 62

i. Establish a goodwill or reputation attached to the goods or services; ii. Demonstrate a misrepresentation by the defendant to the public (whether or not intentional) leading or likely to lead the public to believe that the goods and services offered by him [or her] are the goods or services of the plaintiff; and iii. Demonstrate that the misrepresentation has caused or threatened damage to the plaintiff’s reputation or goodwill.

In the branding space the common law passing off action and domestic statutorial action may overlap providing additional protection. 63 A severe limitation of the passing off action is that “[a] plaintiff with a reputation in a brand in a particular geographic area may succeed in restraining a competitor from carrying on business using that name in that area, but will not succeed in restraining the defendant from using that name in areas where the plaintiff has no prior reputation.” 64 A substantial and long-established American franchised system under the name “Taco Bell” could not restrain a Sydney restaurant from carrying on business under the name because the Sydney restaurant had commenced business four years before the US company commenced operation in Sydney. 65 The more liberal approaches now allow traders a right to protect promotional as well as trading goodwill in a range of circumstances.

[Passing off] is wide enough to encompass other descriptive material, such as slogans or visual images, which radio, television or newspaper advertising campaigns can lead the market to associate with a plaintiff’s product, provided always that such descriptive material has become part of the goodwill of the product. 66

61

Ibid at 4 quoting from Reckitt & Colman Ltd v Borden Inc (1990) 17 IPR 1, 7 per Lord Oliver. Erwen Warnick BV v Townend & Sons (Hull) Ltd [1979] AC 731 (House of Lords); ConAgra Inc v McCain Foods (Aust) Pty Ltd (1992) 33 FLR 302 (Full Federal Court). 63 Andrew Terry, ‘Legal Aspects of Brand Management’ above n 37 at 4. 64 Ibid at 5. See for example, Targetts Pty Ltd v Target Australia Pty [1993] FCA 191, where the litigant had 82 discount stores throughout Australia, but was restrained from using its name in connection with any business of retail sale of clothing, footwear or Manchester products within 30 kilometres of a certain intersection in Launceston Tasmania. In that are, the reputation in the substantially identical name “Targetts” resided with a local department store. 65 Taco Co of Australia Inc v Taco Bell Pty Ltd (1982) 42 ALR 177. Example cited in Andrew Terry, ‘Legal Aspects of Brand Management’ above n 37 at 5. The law has since been replaced by a more liberal approach laid down by the Full Federal Court in ConAgra Inc v McCain Foods (Aust) Pty Ltd (1992) 33 FCR 302 holding that it was not necessary for a trader to have a place of business or even trade in Australia to be successful in maintaining a passing off action. 66 Per Lord Scarman in Cadbury Schweppes Pty Ltd v Pub Squash Co Pty Ltd (1981) 55 ALJR 333 at 336. 62

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Whatever the method of protecting the intellectual property is chosen by the ultimate idea owner, the spread through licensing of this property depends on the relationship formed by the agreement which spells out the laws governing the bonds of franchise that deliver the values to the end-users.

4.3

The Franchise Agreement

For a good agreement, an understanding of basic contract principles, franchise regulations, local and international trade practices, competition legislation, trademark laws and the application of franchise related common law is prerequisite, followed by periodic review and updates. 67 The agreement is part of a set of documents including an initial Franchise Application that is required before releasing the standard franchise agreement, with a conditional deposit or other fees. Upon satisfactory application, the franchise agreement is released that may include assignments, guarantees, user agreements for trade marks, security agreement to protect disbursements owned to the franchisor and leasing arrangements for any real property or arrangements for other assets required for the venture. 68

Each contract needs careful drafting with the franchisor’s intentions in mind, relating to the specific type of franchise business, proven success, allocation of risks and responsibilities amongst the parties. 69 Specific clauses cover every intricate detail of operations and the very fine print is in the operations manual. But, no matter how much drafting is done, ultimately the contract is incomplete. 70 The relational-standard form nature of the contract ‘completes’ the transaction through operational controls and by retention of ownership of the key elements required for the franchise’s indefinite operations.

67

Frank Zeid (editor), Legal Analysis of Typical Franchise Agreement, from Canadian Franchise Guide, Carswell. 68 Ibid. 69 Ibid. 70 Gillian Hadfield (1990). “Problematic Relations: Franchising and the Law of Incomplete Contracts”, 42 Stanford Law Review 927 at 947. See paragraph below on indefinable terms for an ‘incomplete contract argument’.

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4.4

Indefinable Terms of Franchise Contract

Franchise contracts are by necessity incomplete “because mutual desires for flexible, but bounded, responses to uncertain future conditions limit the scope and precision of verifiable terms”. 71 Contractual incompleteness and relational complexity amongst parties, who are not strangers, allow them to interact and balance various elements while ensuring accumulated reputation capital of franchisor’s brand is forever maintained. 72 The incomplete nature of the franchise contract 73 provides the opportunity for successful, yet flexible coercion of resources to fulfil consumer demands. Disputes tend to centre on formal and actual exercise of unfettered powers, yet despite relational constraints and some business rationale for the franchise parties’ actions, courts will not interfere to address the true nature of the exchange. 74 Hadfield concludes that commitments stem not just from the written document but also from the common understanding of the relationship, therefore its content must be understood in order to enable proper enforcement of the true franchise exchange. 75 Andrew Terry examines 76 the underlying relational considerations that influenced the judgement in Dymocks Franchise Systems (NSW) Pty Ltd v Todd 77 which supports a wider look at franchising relationships than just the contract provisions. The relational vibe is the dominant quality likely to be more influential in franchising litigation. 78

4.5

Relational-Standard Form Contract

The contract governing the relationship is commercially grounded. The franchise agreement is the primary franchise document placing legally binding obligations and duties on both parties. The document is often a standard form contract and any departures from the printed form are rare with little or no room for variation, that is, the contract is nonnegotiable and offered on a take-it-or-leave-it basis. 79 Dr Elizabeth Spencer outlines the essential attributes of both standard form and relational contracts, and discusses how

71

Ibid at 927-928. Ibid at 928. 73 Ibid at 947. 74 Ibid at 992. 75 Ibid at 992. 76 Andrew Terry (2005). ‘Franchising, Relational Contracts and the Vibe’, 33 ABLR 287. 77 Dymocks Franchise Systems (NSW) Pty Ltd v Todd [2002] 2 All ER (Comm) 849. 78 Andrew Terry (2005) above n 76. 79 Alan Felstead, The corporate paradox above n 5 at 95. 72

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unequal bargaining power, lack of negotiation of standard form, reliance on relational flexibility, implicit trust to reinforce imbalance of power in relationship and the higher risks and uncertainty to the franchisee create problems that only compound when statutory regulation focuses on contract formation while neglecting relational qualities.80 Her article concludes with a call for revision to account for the combined effects of standard form and relational nature at all levels in the relationship. 81

Franchisees have little bargaining power because they are seeking to use the accumulated experience; know-how and trade mark of the franchisor, and are economically inferior to the franchisor whilst suffering from unequal access to relevant information. The clauses in the agreement impose far more requirements on the franchisees than the franchisor and differences exist in detail, level of specification and the degree of flexibility applied in practice. 82 Franchisors retain control over key strategic decisions and take some of what is produced as a result. Hadfield examined this interplay underlying the relational structure including factors such as superiority, experience (or lack of it), intimacy and interdependence that gives rise to potential for conflict. 83 The relational structure, norms and practice is important to identify the incomplete content of the relationship. 84 This is also revealed in the contract in three ways 85 ; the controls placed on the operation of the business; the payments made by the franchisee to the franchisor 86 ; and the retention of key elements of the business apparatus by the franchisor.

80

Dr Elizabeth Spencer (2008). ‘Unintended (or are they?) Consequences: the interaction of standard form and relational contracting in franchising’, Franchise Law Symposium, Bond University, November. 81 Ibid. 82 Alan Felstead, The corporate paradox above n 5 at 96. 83 Gillian Hadfield (1990). “Problematic Relations” above n 70 at 955-969. 84 Ibid at 991-992. 85 Alan Felstead, The corporate paradox above n 5 at 97. 86 Note that reciprocity is identified as a key motivational factor.

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4.5.1

Operational Controls

As Lucchesi puts it to Michael Corleone "[We gladly put you at the helm of our little fleet,] but our ships must all sail in the same direction. Otherwise, who can say how long your stay with us will last. It's not personal, it's only business. You should know." 87

Despite the absence of a boss, the franchisees are required to operate within procedures laid down and subject to unilateral change by the franchisor and maybe committed to adhere to franchisor-set performance targets and give primacy to franchisors’ turnover maximisation goals. Franchisees appropriate profits and losses only after they have made turnover related payments to the franchisor. Although the franchisees buy or lease much of the physical business apparatus, some parts remain with franchisor and restrictions may exist on their use during and after the currency of the agreement. 88 The business idea, name and format is simply ‘borrowed’.

“Since the provisions of the operating manual can be changed at the prerogative of the franchisor, the franchisees find themselves in the tenuous position of being bound to a contract that can be modified unilaterally by the franchisor.” 89 However, changes can only be made if they do not contradict other clauses in the contract.

Operational controls are designed to regulate day-to-day business so as to convey a common, uniform image to the consumers and to shape the longer-term development of the franchisee’s business. 90 The franchisee is buying the right to operate on a pre-determined basis and the detailed minimum standards are laid down in the operations manual. These standards may relate to a number of issues such as, size, layout, décor of premises, organisation and staffing, technical training, service facilities and equipment, to receiving and handling customers, accounting and stocking systems, and to advertising and sales promotion. The franchisor is usually allowed to unilaterally ‘make amendments, alterations and improvements to the operations manual from time to time’. “In effect, this commits the franchisee to an open-ended agreement. 91

87

Mario Puzo and Francis Ford Coppola (1990). The Godfather; Part III. Paramount Pictures. Alan Felstead, The corporate paradox above n 5 at 191. 89 Hunt SD (1972). ‘The socioeconomic consequences of the franchise system of distribution’, Journal of Marketing, vol.36, July, 32-38 at 36-37. 90 Alan Felstead, The corporate paradox above n 5 at 98. 91 Ibid at 100. 88

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The importance placed on uniformity has a determining influence on the degree of outlet monitoring required, and this may be stipulated in the contract to be with or without warning. 92 In sectors where uniformity is less important, monitoring is less stringent especially where the scope for customers to compare products or services across the chain is limited. 93 Minimum quality standards and keeping track of complaints may suffice but the most important standardisation device is the initial training instead of ongoing monitoring. 94 The potency of these factors is determined by the franchisor through the contract and the nature of the product market that franchisees face.

Operational control of the franchisee’s business is through certain inter-related factors contained in the operations manual which is incorporated with the franchise contract. More complete and in-depth detail in the manual increases the potential for uniformity and details may be updated regularly through bulletins announcing new regulations. 95 “The provisions applying to the franchisee tend to say that ‘the franchisee will do such and such at a given place, in a specific amount of time, and in a particular manner’. On the other hand, franchisor provisions are inclined to be more vague and are hedged in limiting phrases, such as ‘the franchisor at its sole discretion’, ‘at a time and place chosen by the franchisor’ and ‘the franchisor reserves the right to vary its policy with regard to X, Y and Z from time to time in the light of experience’.” 96

Another factor that gives franchisors operational control over franchisees, concerns the specificity of the product or service supplied at the outlet, but this varies significantly for different industries, for example, fast food products are highly specified whereas car servicing is determined by the franchisees expertise, so the manual may only provide a guide to bespoke production. 97 A third factor is the need for uniformity which seeks to address an externality problem, that is, if any one franchisee allows quality to deteriorate and benefits from savings of the reduced quality while customers perceive the quality to be the same as other outlets bearing the same trade mark thus benefiting at the expense of other franchisees. 98 “The credibility, viability and enforceability of the [franchise] system

92

Ibid at 119. Ibid at 121. 94 Ibid at 121. 95 Luxenberg S (1985). Roadside Empires: How the chains franchised America, Viking Penguin: New York, at 78-79. 96 Alan Felstead, The corporate paradox above n 5 at 96. 97 Felstead A (1988). ‘Technological change, industrial relations and the small firm: a study of small printing firms’, unpublished PhD, University of London. 98 Alan Felstead, The corporate paradox above n 5 at 119. 93

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is at stake, if [the franchisee] can thumb his nose at the system and its standards then so too can operators everywhere.” 99

[F]ranchisors are armed with a whole battery of control mechanisms designed to induce franchisees into their service. The contract gives franchisors powers to curb individual flair for the sake of uniformity and to ensure that their economic interests are given primacy in the running of the outlet, despite a substantial sum of investment by the franchisee. 100

Different circumstances may lead either to rigid imposition of the terms of contract or the franchisors may choose to turn a blind eye. Contracts may be ‘used’ in two ways; regulate the ongoing relationship with certain clauses enforced or through contractual remedies in the event of something going wrong. 101 The use of such powers varies from franchise to franchise.

4.5.2

Retention of Ownership of Key Elements

Franchisors retain ownership of the intangible business assets and may also exercise a ‘hold’ over many tangible assets as well, for example, franchisee’s right to assign only to approved buyer or a ‘stake’ in site or equipment. Production requires upfront capital to buy the tangible assets, use of tangible and intangible assets combined with labour efforts into a working format. The franchisor secures an on-going source of revenue on basis of supplying the franchisees with a format that ‘works’ but to sustain revenues, access to the business format must be limited, otherwise it would be available to all at no cost. 102 For example, early franchisors failed to appreciate this point; McDonald’s generously shared information about their production procedures, equipment and suppliers, so no one needed a franchise to learn the ‘secret’ and many imitators set up competition. “By restricting the transfer of relevant ‘know-how’ and accumulated business experience to its franchisees alone, a franchisor is able to engender a dependent relationship from which a return can then be drawn”. 103

Control of intangible assets is retained by the franchisor through non-competition and nonsolicitation clauses prevalent in franchise agreements. Both types of clauses prevent 99

Dayan v McDonald’s Corporation [1982], unpublished, at 83 per Judge Curry’s opinion. Alan Felstead, The corporate paradox above n 5 at 107. 101 Beale H and Dugdale T (1975). ‘Contracts between businessmen: planning and the use of contractual remedies’, British Journal of Law and Society, vol.2, no.1, Summer 45-60. 102 Alan Felstead, The corporate paradox above n 5 at 110. 103 Alan Felstead, The corporate paradox above n 5 at 111. 100

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former franchisees from competing with the franchisor’s business through use of contacts, acquaintances and other knowledge acquired through the franchise but must be of limited duration and geographical scope to be enforceable. 104 “[A] good deal of legal ‘know-how’ is required for the successful drafting of a restrictive covenant.” 105 Much turns on the court’s interpretation of the wording used.

Another common way to gain enhanced control over franchisees is through stake in the property on which the branch is built. The franchisor owns the head-lease and sublets to the franchisee. The best known examples are McDonald’s and Dunkin’ Donuts. “[F]ranchisees have virtually no ownership rights in the intangible business assets and only restricted rights in the more tangible ones”. 106

5.0

The Franchise Paradox

Franchisees operate businesses that are neither independent nor subsidiaries of another company. They can be more aptly considered to be ‘betwixt and between’ these two extremes. 107 This is reflected in the ambiguous nature of the franchisee’s status; sometimes acting and responding like employees, while at other times resembling independent businesses. Prima facie, franchisees are legally independent from franchisor and others in chain, yet they trade in much the same way and under a common brand name as those from whom they are supposed to be autonomous. 108 This paradox is examined in light of the forces of autonomy versus control, and determining who has the upper hand. The mechanisms of control remain in the hands of franchisors, which allow them to shape and reshape how franchisees do business in spite of the fact that franchisees remain legally independent of the franchisor, invest their own money and take on greater risks implying that one party has the ability to wield power over another despite appearances to the contrary. 109

104

Aikin O (1991). ‘Creating workable restraint clauses’, Personnel Management, vol.20, no.10, 89-90. Person LJ in Commercial Plastics Ltd v Vincent [1964] 3 All ER 546 at 555. 106 Alan Felstead, The corporate paradox above n 5 at 114. 107 Office Overload Ltd v Gunn [1977] FSR 39 CA. 108 Alan Felstead, The corporate paradox above n 5 at 37. 109 Ibid at 202. 105

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5.1

Economics of Franchising

The difficulties in franchising arise from its basic structure, that is, the franchisor needs to control the franchisees delivery of the output from the franchisor’s system, and this creates the franchisee’s problem of opportunistic use of that control power that leads to potential conflicts of interest. 110 The franchisor’s quality control problem is a result of the system’s differentiated output that consumers expect and are willing to pay for, and to fulfil this expectation, the system needs to be implemented correctly at the retail level. 111

The trademark is a storage medium of value, and a better store of values means enhanced financial gains. 112 Values are vulnerable to franchisee free-riding, a principle-agent problem in economic literature that pervades almost all organisational forms. 113 The greater control problem, however, is the divergence between franchisee and franchisor. 114

A franchisee wants to maximise her profits from the operation of the outlet; she does not wish to undertake any efforts or expenditures that will not compensate the undertaking. On the other hand, once a franchisor establishes a particular franchise, it aspires to sell more franchises and increase royalty revenues. 115

Unrestricted control by the franchisor will favour franchisor’s interest and create risks of opportunism. 116 The franchisee’s investments are usually a sunk cost, which cannot be easily recovered in case of business failure thus creating an important incentive for an established relationship. 117 The conundrum is that the franchisee cannot abandon the investment and the franchisor can create situation where loses induced, for example, raise costs at franchisee’s expense. 118 Deciding whether the exercise of control was legitimate or opportunistic is difficult and this is why franchise contracts are incomplete because the task is too enormous to write in every detail of a long-term relationship. 119 The consequence of these unsolved problems is constant re-interpretation and enforcement in light of given resources and abilities.

110

Gillian Hadfield (1990). “Problematic Relations” above n 70 at 949. Ibid at 950. 112 Ibid. 113 Ibid. 114 Ibid. 115 Ibid. 116 Ibid at 951. 117 Ibid at 951. 118 Ibid at 951-952. 119 Ibid at 953. 111

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Commitments to take or refrain from taking certain actions are indispensable elements in interaction and exchange transactions. 120 As the transaction spreads out over time and becomes more complex, more solid grounding is required, and is therefore provided by the contract. 121 “The philosophy underlying the nineteenth century ideal of ‘sanctity of contract’ is that both parties to the contract are approximately equal and enter into it without coercion. However, the franchisee does not bargain with the franchisor as an equal.” 122 Franchisees are economically inferior to franchisors, and without access to the franchisor’s accumulated knowledge, experience and trade mark as well as contractual ties, the franchisees business aspirations will remain difficult if not impossible. “The most obvious consequence of this situation is to make the franchisee dependent on their franchisor”, thus a key source of power in the organisation. 123 “Power is having something that somebody else wants”. 124

The franchisor relies on the franchisees’ money capital to expand their network and substantially reduce risks to the franchisor should an outlet fail. The franchisee bears the greater financial risk should the business make a loss, yet shares the profits with the franchisor when trading profitably. 125 “[T]he legal ‘independence’ of franchisees belies the economic fact that, despite bearing most of the risk of setting up a branch, they are not able to reap the full rewards of their own efforts.” 126

5.1.1

Transaction Costs of Franchising

The existence of transaction costs rests on the combination of certain human attributes and presence of certain environmental factors. The behavioural factors are bounded rationality and opportunism; and the environmental factors are uncertainty, complexity and small business exchange. 127 Bounded rationality specifies a state in which players have limited analytical and data processing capabilities therefore limits to formulating and solving complex problems. If not for bounded rationality, all economic exchange could be organised through contracts written for each and every contingency. 128 Costs could be

120

Ibid at 927. Ibid at 927. 122 Alan Felstead, The corporate paradox above n 5 at 77-78. 123 Pfeffer J (1981). Power in Organizations, Pitman: Boston, Massachusetts. 124 Farney quoted in Pfeffer (1981) ibid at 100. 125 Alan Felstead, The corporate paradox above n 5 at 107. 126 Ibid at 109. 127 Ibid at 62-63. 128 Debreu G (1959). Theory of Value. Yale University Press, New Haven, Conn., London. 121

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reduced in a more certain and uncomplicated world. But for the simultaneous existence of both bounded rationality and opportunism; contracting problems are trivial, that is, the presence of bounded rationality precludes complete ex ante contracting, thereby rendering all contracts incomplete.

The interplay of relational and standard form nature of the franchise contract may help reduce transaction costs. 129

Tying the franchisor’s income to the fortunes of the franchise network (either by levying a royalty on franchisee turnover, marking-up supplies or simply providing a distribution outlet for finished goods) ensures that franchisors bear some of the costs of the opportunistic behaviour of their franchisees. Franchisors therefore stand to lose out, both in terms of the falling value of the franchise chain and more immediately in falling revenue from the network, should franchisees ‘skimp’ on quality. The immediacy of falling revenue heightens franchisor incentives to maintain quality levels; franchisors therefore have a particular interest in closely monitoring the quality of the goods produced or services supplied. 130

If a minimalist approach is taken we can lower transactions costs and create economic growth prospects by removing legal shackles hindering the spread of what could otherwise be very successful franchises. A pre-determined set of high values;

Franchisees’ customers value the trade mark as providing information about the price and reassurance of a minimum level of quality of goods and services sold by establishments bearing a given trade mark. Those who buy from the franchisees have this information precisely because the franchisor polices the system and maintains quality according to a pre-determined set of standards. 131

Franchisors possess a brand, idea or format (i.e. ‘know-how’), and the business is shaped according to the franchisor’s accumulated experience. Many franchise businesses would not exist without the franchisor’s scarce knowledge, thus they properly seek rewards from a competitive market place. 132 In franchising, the economic power is exercised by controlling the use of intangible assets such as the trade mark, idea and format.

Conflict of interest is also evident in determination of pricing as long as the franchisor receives royalty from revenues. 133 The franchisor aims to maximise outlet turnover whereas the franchisee seeks profit maximisation. Revenue or other performance targets 129

Dr Elizabeth Spencer (2008) above n 80. Alan Felstead, The corporate paradox above n 5 at 67-68. 131 Ibid. 132 Marglin SA (1984). ‘Knowledge and power’, in Stephen FH (ed.) Firms, Organization and Labour: Approaches to the Economics of Work Organization, Macmillan: London. 133 Alan Felstead, The corporate paradox above n 5 at 102. 130

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are set unilaterally by the franchisor and should the franchisee fail to meet targets, the franchisor may invoke remedies such as the right to appoint a manager or the ultimate sanction of revoking the agreement. 134 On the other hand, if targets are being met easily then it may be necessary to invoke expansion triggers in the contract (if any) so as not to let sales go begging.

An economic perspective highlights how a franchise exchange may achieve balance as risks to the franchisee are reduced through the experienced and sophisticated business practices of the franchisor. 135 The franchisee relies on the superior knowledge and follows directives. 136 In practice, a significant balancing act is played by the relational norms that deliver on the commitments. 137 Opportunism necessitates various institutional devices to deter malpractice resulting from this economic conundrum during the life of the contract and is the subject of much regulatory debate. 138

5.2

Regulatory Debates

Many forces and actors contribute to the regulatory process (meta-regulation) as they try to move away from command and control structures to delegated regulation to networks of stakeholders, policy makers, consumers and international organisations. 139

A recent contribution of normative economics to the search for a rational division of powers and the unification of law explains the advantages in any unified substantive economic (framework) policy (in contrast to process oriented policy); unification contributes to securing the freedom of the individual, it increases the certainty and the knowledge of laws, and it improves the efficiency of economic organisation. 140 However, being too perfectionist at harmonisation entails too many controversies beyond the scope of this essay. The real dilemma well known in business and antitrust law is that;

134

Ibid at 104-105. Gillian Hadfield (1990). “Problematic Relations” above n 70 at 991-992. 136 Ibid. 137 Ibid at 930. See for example, Stewart Macaulay’s demonstration of how disputes in automobile franchises are often resolved on the basis of relational norms instead of contractual terms. Stewart Macaulay (1966). Law and the Balance of Power. 138 Alan Felstead, The corporate paradox above n 5 at 63. 139 Dr Elizabeth Spencer (2008) above n 80. 140 Bernholz & Faber (1986), “Uberlegungen zu einer normativen okonomuschen Theorie der Rechtsvereinheitlichung,” 50 RabelsZ 35-60 at 41. 135

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too much law impairs the development and innovativeness of markets, too little law leads to abuses and ultimately to the perversion of the free markets themselves. The answer may lie in the elaboration of market law (framework policy) and key rule harmonization (which is not the same as minimum harmonisation). 141

An antipodean analysis may give support to this proposition, for example, in June 2009 New Zealand’s Minister of Commerce announced, following a full assessment of the industry, that no franchise specific regulation was required. 142 The decision was influenced by a change of power to a Conservative Government with election pledges of limited interference with business and regulatory requirements, an observation that extensive disclosure requirements in overseas markets fail to remedy the imbalance of knowledge and negotiating power because they are so long and detailed that the very people who are intended to benefit from them would be unlikely to read them and a well structured voluntary scheme may prove suffice. 143 It is no surprise that New Zealand ranks third in overall ease of doing business indicators. 144 Nonetheless, a large number of trade, consumer, competition (anti-trust) and other commercial legal and practice protections or requirements provide a more reliable business environment without the unnecessary baggage. Isolated examples of misrepresentation at the criminal end of the scale and concerns about the potential for an overeager franchisor to misrepresent business opportunities is not evidence of endemic fraud or misleading conduct. Clear cases of fraud can be addressed through criminal prosecution, whilst allegations of misrepresentations may be resolved through dispute resolution processes or through the Courts. 145

Australia, despite its vast reservoir of untapped resources, territorial superiority and many other advantages, ranks tenth in ease of doing business perhaps indicating anomalies in policy regulating business activity, of which franchising is a significant portion. The Franchising Code of Conduct is Australia’s mandatory franchising code and was the Government’s response to the 1997 Fair Trading Report that cited issues of high economic costs, such as no returns on sunk costs, market inefficiencies out of exploitative conduct 141

Buxbaum RM and Hopt KJ (1988). Legal harmonization and the Business Enterprise: Corporate and capital market law harmonization policy in Europe and the USA. Integration through Law; Europe and the American Federal Experience Vol.4, Walter de Gruyter, Berlin, at 263. 142 Ministry of Economic Development, Review of Franchising Regulation in New Zealand, Discussion Document August 2008. 143 Cotterill D (2009). ‘Franchising in New Zealand’, available at http://www.taglaw.com/index.php?option=com_content&view=article&id=1404:franchising-in-newzealand&catid=150&Itemid=100082 (accessed 8th November 2010). 144 http://www.doingbusiness.org/rankings 145 David v TFAC Limited CA26/2008 involving a home services master franchisee which sued the New Zealand master franchisor for return of their purchase price based on misrepresentation is a classic example of ‘buyers remorse’ and the Court of Appeal leaned on the black letter contract law and did not consider franchisees to be in need of consumer-like protection.

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and implications for employment and growth; and social costs of business failure, such as stress, marriage breakdowns and poor health. 146 Accompanying the Code was a prohibition on misleading, deceptive and unconscionable conduct. 147 Although Australia has comprehensive regulation, inquiries in 2008 suggest concern at a lack of an overarching standard of conduct for the conduct of parties in a franchise contract. 148

Most countries continue to rely on underlying commercial laws to regulate franchising supplemented by voluntary self-regulatory codes of practice, however; there has been a clear move towards dedicated regulation over the past decade, 149 for example China introduced a regulation on the Administration of Commercial franchises in 2007, Vietnam has a modern and well-drafted law since 2005, Korea introduced the Fair Franchise Transaction Act 2002 (amended 2007). However, the top three countries for doing business are Singapore, Hong Kong and New Zealand, and all three have comprehensive voluntary self-regulation administered by a national franchise association. 150

Business are shaped by regulation and administration by government, the challenge is for unregulated sectors to either adapt to ‘proper conduct’ voluntarily and build sufficient protections under general commercial law or provide official recognition with specific regulation. “The most successful systems are innovative, dynamic and responsive”. 151 The regulatory environment must be designed to be supportive of innovative, dynamic and responsive structures to allow commerce to freely occur in the marketplace hence contribute to developing economies.

Another threat is that despite efforts, harmonization may remain merely a formality without true behavioural change. 152 It has been suggested that significant legal integration, at least on the legislative scene will take place ‘from below’ or at least not only ‘from above’. 153

146

Andrew Terry, “Franchise Regulation in Asia: A Comparative Study”, 6th Asian Law Institute Conference, Hong Kong 29/30 May 2009. 147 Trade Practices Act 1974(Cth) ss 51AC and 52. 148 Andrew Terry, “Franchise Regulation in Asia” above n 146. 149 Ibid. 150 Ibid. 151 Andrew Terry (2005) above n 37 at 25. 152 Buxbaum & Hopt above n 141 at 266. 153 Ibid at 271. For Legal Harmonization in general, see the study by Kotz, “Rechtsvereinheitlichung – Nutzen, Kosten, Methoden, Ziele,” 50 RabelsZ 1-18, esp. at 12 (1986) (with English Summary).

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5.3

Other Complications in Building a Global Brand

There is no formal strategic guide for even the most successful cultural brands. 154 Building a global iconic brand requires a build up of customer experiences and marketing to create meaningful associations for repeat patronage. 155 Brands become powerful because the collective nature of individual perceptions continually reinforces stories that are treated as truth in everyday interactions. 156 Customers value brands for their identity values, that is, stories that consumers find valuable in constructing their identities. The myth eventually resides in the markers.

Developments over the last century influenced by mass marketing of consumer goods and more recently services combined with increase in legal protection has enabled brand owners to build set of values, both tangible and intangible, which are appropriate and attractive to consumers and conducive to development of customer loyalty. 157 There is no reason to alter this commercially beneficial idea-spreading virus; in fact, there is more reason to ensure removal of barriers and harmonisation of key rule principles that may boost viral branding. 158 The next chapter, on open source franchising looks at a franchise law beyond contractual boundaries and provides hints at establishing self-managing, wellknown and individually-tailored global brands that benefits all the parties linked in the chain that eventually provides the experience satisfying the desire that gave rise to an idea.

“We must become the change we wish to see”. Mahatma Gandhi.

6.0

Open-Source Franchising

Modern organisational responses call for a move towards systems that coordinate crossunit networks and elicit cooperation of branches rather than ordering it as in a hub-andspoke mode. 159 The idea of a ‘flexible firm’ that reins in its frontiers and includes only a narrow ‘core’ of workers that can still exercise various degrees of control over those

154

Douglas B Holt (2004). How brands become icons: the principles of cultural branding. Harvard Business School Publishing, Boston, Massachusetts at xi. 155 Douglas B Holt (2004). How brands become icons at 3. 156 Ibid at 3. 157 Andrew Terry ‘Legal aspects of Brand Management’, above n 37. 158 Douglas B Holt (2004). How brands become icons. 159 Bartlett CA and Ghoshal S, Managing across borders: new organizational responses’, in Gupta AK and Westney DE (2003, eds.). Smart Globalization: Designing global strategies, creating global networks. MIT Sloan Management Review Series, Jossey-Bass, San Francisco.

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operating on the ‘periphery’ 160 ; the underlying relationship is commercial rather than employment. 161 Apparently there is a movement towards more market-based business relationships. 162 Andrew Selden examined the evolution of the American franchise system organisation and design of their internal governance structures in reconciling the divergent interests of the franchisor and franchisee communities. 163 He concludes with suggestions for a baseline public sector support necessary for an environment in which parties can establish effective private sector solutions to the franchise relationship management challenges. 164

6.1

Self-Managing Franchise Relationships

The problems plaguing franchise relationships are not irreconcilable. 165 In fact a large, diverse and growing body of non-legal academic research on networked businesses, including franchise systems, already explores in great depth the underlying structure and operations of such systems. 166 Franchising provides a strategic alliance between autonomous partners bound by contract and when practiced successfully, it leverages parties’ very different resources and skills to generate mutual benefits in the form of a shared business enterprise. 167

The law has struggled to grasp this unique character and efforts by franchisees to import countervailing principles from other two-party and semi-adversarial legal relationships, for example fiduciary duties as in partnerships, have mostly been rejected by the courts of law. 168 The fundamental business of the franchisor is very different to the franchisee in goals, perspectives and necessary resources. 169 The franchisor is a licensor of intellectual property and is primarily concerned with maximum commercial exploitation of it through whatever means available, whereas the franchisee is engaged in a retail operation, selling the goods and or services represented by the system’s brand identity in order to maximise

160

Alan Felstead, The corporate paradox above n 5 at 11 A good retail example is H & M; see www.hm.com 162 Child J (1987), ‘Information technology, organisation and the response to strategic challenges’, paper presented at the 8th EGOS Colloquium, Antwerp. 163 Andrew Selden (2008). Beyond the Law and the Contracts above n 4. 164 Ibid. 165 Ibid at 3-4. 166 Ibid. 167 Ibid. 168 Ibid. 169 Ibid at 3-7. 161

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the bottom-line. 170 With differing goals and expectations, the potential for conflict is only exasperated by information imbalance that breeds unequal bargaining power in coordinating strategies and allocating gains. 171

Command and control hierarchies, inherited from the traditional forms of franchising, have proven counter-productive as problems increase with the system’s growth, age and experience. 172 The key correlates for a franchise system’s commercial success should now include factors such as role integrity, loyalty, trust, commitment, solidarity, equity, mutuality, flexibility and restraint in the use of power within the relationship. 173 These form the key drivers behind the Franchisee Perceived Relationship Value (FPRV), the result of a study that analysed exchanges in franchise relationships as functions of combinations of self-interest, cooperation, reciprocity and increasing mutual benefit. 174 Reciprocity being the key driver for satisfaction is therefore of critical importance to developing open-source business systems as motivational satisfaction is built-in with the new structure. Traditional structures must be replaced by formalised active collaborative ones that formally coordinate inter-organisational strategies under prevailing conditions. 175

6.2

The Collaborative Franchise System

A structure for system of governance through joint, collaborative interaction of the franchisor and a franchisee association allows for differences of opinion and heated debate but it produces an outcome that both parties feel they can ‘live with’ precisely because the process represents and respects the goals and interests of both sides. 176 Figure 2 represents an idealized depiction of a collaborative franchise system governance structure, illustrating how all organs of the business can participate and relate to a collaborative decision-making apparatus. 177

170

Ibid. Ibid. 172 Ibid. 173 Ibid at 4-5. 174 Tracey R Harmon & Merlyn A Griffiths (2008), ‘Franchisee Perceived Relationship Value’, 23 J. Bus & Indus. Marketing 256. 175 Andrew Selden (2008). Beyond the Law and the Contracts above n 4 at 4-5. 176 Ibid at 18. 177 Ibid. 171

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Figure 2.

Because of the central role of the original ‘creator’; the franchisor or owner, in organising the various entities to become self-managing; their fortunes must be assured; as the entire group grows, the most fair and equitable reward as per their wish should be provided; investors will withdraw the most financial rewards whilst others in the chain will also get their ‘fair share’. These are normative ideals and the age old questions of what is ‘fair and just’ can potentially be answered by market dynamics for the specific outlet(s), perhaps eliminating business privacy in the transition because the brand vehicle is being driven by the informed consumer, some may say it is already happening, for example with Google have spread the myth of ‘don’t be evil’ backed up by a most powerful system onto the world wide web infrastructure, they removed the greed and let the pure idea flow freely; it became well-known and then benefits reverted back to its owners in insurmountable ways. Google found novel ways of generating revenue 178 whilst continuously re-inventing its image and using its information base for global benefits. A lot of win-win-win results but now they also have to deal with privacy issues.

Other concepts that may lend support to such structures, may be imported from other legal disciplines, for example, resource sharing concepts developed by environmental lawyers,

178

For example through AdWords that charge businesses for delivering their image across to anyone with internet access modified to their locality and nature of the website.

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such as equitable benefit-sharing schemes, sustainability etcetera may provide additional sustenance.

6.3

Becoming, then Remaining Well-Known

Sir Edward Bernay’s believed that “[t]he engineering of consent is the very essence of the democratic process, the freedom to persuade and suggest”. 179 “The conscious and intelligent manipulation of the organised habits and opinions of the masses is an important element in democratic society. We are governed, our minds are molded, our tastes formed, our ideas suggested, largely by [people] we have never heard of. This is a logical result of the way in which our democratic [societies are] organised.” 180

Iconic brands have extraordinary value because they address collective anxieties and desires of nation(s). 181 Similarities result because identity is constructed in response to the same or similar historical changes that influenced the nation built through mass media perhaps by use of identity myths such as imaginary stories or other aspirations of identity. 182 The myth eventually resides in the markers and consumers experience the myth when using or interacting with the end-good or service therefore forming a tight emotional connection to the brand. 183 Becoming well-known and famous (in order to benefit in some way) is the purpose of a business’s expansion plans, it is not being suggested that every brand will achieve this purpose, however unfettered expansion is possible for many, as yet, unknown brands.

Having formed an idea that engenders the consent of the masses, all it takes for an idea owner to begin franchising… “is the desire to [enter] and the ability to convince at least one other person (a potential franchisee) that he or she should buy the right to operate a business under the franchisor’s trade mark and to abide by certain contractual conditions.” 184 The key advantage with franchising is that it has few natural barriers to entry for potential franchisors. To enter franchising, huge capital outlays for manufacturing facilities are not required; a ready-made national dealer network does not have to be in place; massive national advertising campaigns are not necessary; the 179

Edward L Bernays (1947) “The Engineering of Consent”. See also his magnum opus, Propaganda (1928). 180 Ibid. 181 Douglas B Holt (2004). How brands become icons at 6. 182 Ibid. 183 Ibid. 184 Alan Felstead, The corporate paradox above n 5 at 80.

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ownership of, or access to, unique sources of supply is not essential; and the ownership of unique patent rights is not required. 185 Ample capital, national advertising, a well-known trade mark and patented processes are all desirable, but not necessary, for a potential franchisor to enter the industry.

6.4

Keeping Pace with Time, Space and Technology

Just as Jimi Hendrix’s Experience can be played through the technical storage system delivered over established global networks via a free market based institutional infrastructure design, in order to trigger the iconic image almost seamlessly amongst listeners, so to must the new self-sustaining experience(s) be recreate-able at any given time, space and available technology. 186

Human evolution through better educational foundations has placed the present generation at a crux in this point in time where a leap into the future is within grasp because of continuously improved technical superiority and a better understanding of the complexities of life, time and space. Weaved patterns created by entrepreneurs using such threads provide clues as to what consequences we can expect. Current think-tanks are pondering topics including for example, robotics 187 , artificial intelligence 188 , terra-forming 189 on Mars (for the time being) to create a sustainable 185

Ibid. A franchise networks past performance may not necessarily be repeated in the future by following the same methods of doing business. The commercial environment may have changed significantly challenging fundamentals of the business set-up. The franchisor may therefore seek to reshape the franchise to meet the changing environment. For example, Kentucky Fried Chicken renamed its entire franchise network brand to KFC because of changing consumer perception towards fried foods, more specifically the label ‘fried’ deterred customers from patronising their outlets as health issues became more prominent in recent years. Another example, discussed at length in Alan Felstead’s The corporate paradox above n 5 at 157-186 is Coca-Cola’s franchise restructure throughout the 1980s as a result of changes in the business environment. The old structure had outlived its usefulness as small territories prevented low-cost production and distribution systems being established and the demands of large retailers for better terms and conditions of supply became more difficult to accommodate as a direct result of the franchise structure which gave franchisees monopoly rights within a small geographically defined area. The franchisor flexed its hierarchical muscles by demanding changes during contract renewals thus creating a new generation of franchisees with fewer members but with larger territories able to support up-to-date, high capacity plants and distribution networks. 187 With the advent of robotics we no longer need employees and managers or Training Manuals as they are replaced by programmers and software engineers who can understand and apply quantum mechanics in order to drive the machines (i.e. robots) to perform mundane physical tasks. MacDonalds – the world’s first and still largest franchise has been working on such fully-automated systems for a long time. 188 Not only will robots replace physical tasks; mental-bots will take over decision-making once the artificial intelligence barrier is overcome. Ray Kurzweil has used Moore's law (which describes the relentless exponential improvement in digital technology) to calculate that desktop computers will have the same processing power as human brains by the year 2029. He also predicts that by 2045 artificial intelligence will 186

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environment for human settlements, new energy sources 190 , implications of graphene 191 , quantum and nano-mechanics, stem cells, enhancement of the human deoxyribonucleic acid or modifications of the natural instructions of other biological and chemical matter, mining for resources beyond Earth’s environment and perhaps most importantly the dealing with associated resultant implications in daily human life. These are but a few of the nearly seven billion ideas floating in various market places across the globe today. Many of these recipes and especially those that require interaction with end-users can be rapidly replicated and deployed using franchising. The paramount need for uniformity or standardisation 192 may perhaps be altered to accept the need for sensible flexibility in order to allow adaptation of best local practices into the global networks know-how matrix. It can be further enhanced by seeking to vary per individual consumer clientele by design, for example, Prada’s latest retail outlet on Corso Venezia, Milan introduced ‘the personal touch’ Made to Order service which takes personalisation of clothing and fashion apparels to a whole new level. 193 The flexibility to cater to individual consumers’ tastes and preferences can be built into the system so that customisation always occurs at point of interaction. By ensuring a cyclic flow of information, best practices built in one location can be transferred and applied in another part of the world thus retaining some degree of globalisation while remaining a domestic institution. Human technological advancements means systems, networks and infrastructure are in a continuing state of flux, and will provide ever-changing methods of brand or idea distribution in the exchange process for (hopefully) some equitable remuneration.

reach a point where it is able to improve itself at a rate that far exceeds anything conceivable in the past, a scenario that science fiction writer Vernor Vinge named the "technological singularity". Edward Fredkin argues that "artificial intelligence is the next stage in evolution, an idea first proposed by Samuel Butler's "Darwin among the Machines" (1863), and expanded upon by George Dyson in his book of the same name in 1998. 189 … is the process of deliberately modifying a planet’s atmosphere, temperature, surface topography or ecology to be similar to those of Earth to make it habitable by terran organisms. NASA has held several debates on the planetary engineering of Mars using large greenhouse gas emitting industries to create a selfregulating Martian biosphere. See for example, planetologist Christopher McKay, (1982). "Terraforming Mars". Journal of the British Interplanetary Society. 190 Hydrogen, wind and solar are just the beginning of the end for fossil fuels. 191 On October 5, 2010, the Nobel Prize in Physics for the year was awarded to Andre Geim and Konstantin Novoselov from the University of Manchester for their work on graphene often described as a "wonder material" with many possible technological applications from ultra-fast transistors to DNA sequencing. 192 Chapter 26 LBO 5th Edition pp.692-698. 193 Tsang C http://theglassmagazine.com/forum/feature.asp?tid=614#title (accessed 8th November 2010). Also referred to as ‘Metailing’ in business circles.

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7.0

Conclusion

If some of the concepts hinted at in the preceding arguments are embedded into the fabric of the franchise agreement, then we can witness superfast brand deployments. Development of franchising is still in its infancy as far as law and commerce is concerned. The key issue for the lawyer is how to harmonise the law and the business enterprise so as to unleash economic booms. The entrepreneurial spirit will consistently reinvent customer experiences thus franchising contracts that suits the given purposes and prevailing circumstances will evolve. Effects of technological revolutions such as the internet and mobile phones are re-shaping the way business is done and many more technologies will change how things are being done tomorrow. It is acknowledged globally that humans are engaging in unsustainable ways of doing business and the global commune requires restructuring human behaviour towards sustainable mannerisms.

The essence of franchising captures and steadily maintains the end manifestation of all that is the brand, for benefits to all those involved in the value chain. The key balancing act being played by the market is in evaluating the need to standardise diverse tastes and preferences, while at the same time trying to diversify standardised goods and services to suit local conditions. For the budding entrepreneur, it is essential to bring together the various elements and begin to weave stronger and longer lasting super-legal bonds. As the myth of the Adidas brand suggests, “Impossible is nothing�. In order to give franchising law a dynamic boundary, it may be essential to include the consumer, or whoever the enduser is intended to be, for more meaningful definition of the business model. Businessformat franchising encapsulates the essential elements for the successful spread of a brand and its associated values.

Observing global and mega-trends, innovation and global connectivity, barriers that have existed in the past are being further reduced. The next generation of franchises will incorporate the consumer and community; the franchisee will on behalf of franchisor form a symbiotic relationship and get attached to the brand. Local knowledge is particularly crucial in emerging markets where such knowledge can help the expanding business not only in penetrating these markets but also in capitalising on opportunities for innovation

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and reverse learning. 194 It is not so problematic with newer technologies to link the brand to the consumer directly. Open-Source franchising is a free market idea that will give ‘proof of our collective potential to change the world’. Reiterating Jimmy Wales suggestion; 195

We can keep it open – you can use the information in [an open source franchise in] any way you want. We can keep it growing – spreading knowledge everywhere and inviting participation from everyone.

Benefit-sharing is another integral part of the scheme; the more equitable the scheme the greater the uptake of franchise as local conditions of ‘what is fair’ are prioritised over a foreigner’s imposition of ‘what I think is fair’, thus encouraging deeper growth for the brand. The beneficiaries of the scheme are the franchisor – the one with the packaged franchise, the franchisee – the suitable candidate(s) to engage with the consumer and deliver the good or service produced by the franchise, and the consumer (or community) derives multiple benefits from end-use. Free markets determine and accent to the franchise. An equitable and sustainable benefit in return from the various markets is then justified and can be rightfully demanded and maintained at law and supported by whatever governing body in control of their respective territories. The final echo that rings is ‘easier said then done’ but in giving freedom to the markets, entrepreneurs will get it done then say it, or as Mae West so eloquently articulates; “an ounce of performance is worth pounds of promises.”

194

Arnold DJ and Quelch JA, ‘New strategies in emerging markets’, in Gupta AK and Westney DE (2003, eds.). Smart Globalization: Designing global strategies, creating global networks. MIT Sloan Management Review Series, Jossey-Bass, San Francisco. 195 Founder of Wikipedia.

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Cases

Red Bull Australia Pty Ltd v Sydneywide Distributors Pty Ltd [2001] FCA 1228 (Federal Court).

Sydneywide Distributors Pty Ltd v Red Bull Australia Pty Ltd [2002] FCAFC 157 (Full Court).

Hungry Jack’s v Burger King [1999] NSWSC 1029;

Burger King Corp v Hungry Jack’s Pty Ltd [2001] NSWCA 187.

Reckitt & Colman Ltd v Borden Inc (1990) 17 IPR 1, 7 per Lord Oliver.

Erwen Warnick BV v Townend & Sons (Hull) Ltd [1979] AC 731 (House of Lords);

ConAgra Inc v McCain Foods (Aust) Pty Ltd (1992) 33 FLR 302 (Full Federal Court).

Targetts Pty Ltd v Target Australia Pty [1993] FCA 191

Taco Co of Australia Inc v Taco Bell Pty Ltd (1982) 42 ALR 177.

Cadbury Schweppes Pty Ltd v Pub Squash Co Pty Ltd (1981) 55 ALJR 333 at 336.

Dymocks Franchise Systems (NSW) Pty Ltd v Todd [2002] 2 All ER (Comm) 849.

Dayan v McDonald’s Corporation [1982], unpublished.

Office Overload Ltd v Gunn [1977] FSR 39 CA.

Commercial Plastics Ltd v Vincent [1964] 3 All ER 546 at 555.

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For comments and publication inquiries, please contact the author by email; deemantlodhia@gmail.com

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Open Source Franchising; Laws for the next generation of global business networks