Goodwill Indemnity: Another Approach to “Competition” between Franchisors and Franchisees

Franchising is a growing business model in the U.S. As franchising grows, however, franchisors can compete with their franchisees over the right to goodwill generated by the franchisee. I have recently completed a dissertation in Temple’s doctoral program that examines legal mechanisms to address expropriation of goodwill generated by franchisees, and proposes an alternative solution.

The franchising model permits the franchisor to impose strict terms and conditions to protect and enhance its brand name. As a result, franchise contracts are often standard form contracts drafted by the franchisor and presented on a “take it or leave it” basis. Although these typically one-sided contracts may be necessary to prevent franchisees from harming the franchisor’s brand name, in practice, the franchisors’ contractual power can lead to franchisor-opportunism, in particular through wrongful terminations, onerous transfer restrictions, and so on.

Currently, U.S. law struggles to provide appropriate solutions to deal with this problem. In most states, courts have developed common law policies that limit particular franchising practices to prevent the franchisor’s appropriation of the franchisee’s investment. Nevertheless, courts are reluctant to override express contract provisions with common law principles. Hence, federal and state legislatures have enacted franchise laws in order to balance potential power imbalances and to protect franchisees from opportunism.

While comprehensive “disclosure requirements” have been the highlights of the regulatory efforts, a number of states have passed “franchise relationship laws” that considerably restrain franchisors’ contractual power. These statutes typically require franchisors to show “good cause” for terminations and non-renewals, in some cases before making any adverse decision. Nevertheless, state relationship laws have been criticized for being harmful to the franchising sector as they restrict franchisors’ termination power, and thus, encourage franchisee-opportunism. Accordingly, the majority of the states have not enacted franchise relationship laws.

As current laws fail to provide a fair solution for both parties, my dissertation offers an alternative theory drawn from the European concept of “goodwill recoupment.”

Under the proposed approach, once a franchise comes to an end, the franchisee would be entitled to a payment for goodwill lost to the franchisor. This solution differs from existing theories in the U.S. legal system mainly because the recovery does not depend on the franchisor’s intentional wrongdoing. If and to the extent that a franchisee has positive local goodwill, the transfer of this value to the franchisor upon cessation justifies the payment. Unlike existing U.S. laws, however, the payment aims to recoup only a limited expected period of time in which the franchisor’s extra earnings might still be traced back to the franchisee’s efforts. Therefore, the recoupment doctrine offers a narrow but relatively precise protection for franchisees’ goodwill. Moreover, because the proposed solution targets the economic effect of franchisor-opportunism, there is no need for strict termination restrictions.

While I do not expect courts or legislatures to enact this proposal immediately, my hope is that it provides a basis for a richer discussion of the balance of power between franchisors and franchisees. The proposed approach is a more tailored solution to franchisor opportunism than those currently used in the U.S. legal system. It would allow the franchisee to receive a fair return for its intangible investment without constraining the franchisor’s monitoring power and flexibility. Ultimately, this approach would reduce both franchisee and franchisor opportunism, and incentivize investment and cooperation.

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