Conflicts Of Interest
Many of us are familiar generally with the concept of a conflict of interest, but seldom is that term defined in a formal sense. Essentially, a conflict of interest exists where the impartiality of a party is undermined by simultaneous duties to other parties that have differing interests. Many franchise systems give franchisors the power to make a broad range of decisions that can have a material impact on the bottom line of both the franchisor and the franchisee. The age-old question in franchising is: what duties does the franchisor have to the franchisee in making these kinds of decisions, which can have an enormous impact on the franchisee’s bottom line?
In all contracts, and in all franchise agreements, in particular, there is an implied covenant of good faith and fair dealing. This covenant requires a party to exercise their discretion reasonably and with proper motive, and not arbitrarily, capriciously or in a manner inconsistent with the reasonable expectations of the parties. It is this covenant that addresses the inherent conflict of interest that exists in the typical franchise agreement. Moreover, conflicts of interest can frequently be resolved or at least reduced by full disclosure of information regarding the transactions or events that give rise to the conflict.
The 7-Eleven franchise system is particularly fraught with potential conflict of interest issues because of its unique nature among franchise systems generally. These issues arise in three major areas.
- Cost of Goods Sold
The franchise agreement requires SEI to make a “commercially reasonable effort” to obtain the lowest cost for products and services available from vendors to stores on a “Market Basket Basis.” At the same time, franchisees can purchase up to 15 percent of their products other than from Recommended Vendors. While many franchisees are concerned that they are not getting the lowest possible cost of goods sold, SEI points out that its self-interest is at least partially aligned with that of its franchisees, given that the parties share the gross profit earned at the store level. That is to say, the higher the cost of goods sold, the lower the gross profit, and thus the lower SEI’s split on that gross profit. While this fact surely does not eliminate franchisee concerns, and it suggests that franchisees should be vigilant in their efforts to ensure that they are getting the lowest possible cost of goods sold, SEI’s argument on this issue has marginally more validity than it does with two other major components of the business.
In my most recent column in Avanti, I posed the rhetorical question, “What Business Is Your Franchisor In?” The answer appears to be 7-Eleven is increasingly a gasoline company, having spent billions of dollars to acquire gasoline stores and wholesale retail operations over the last four years. SEI’s gross margin from the sale of gasoline has grown at literally twice the rate of the increase in gross margin in franchised stores. Gross margin from gasoline sales now exceeds the total gross margin for in-store merchandise sales at company stores.
The conflict arises from the commission structure in the gasoline component of the business. Franchisees are paid a fixed commission of $0.015 per gallon sold. In any gasoline operation, pricing at the pump can be designed to increase the number of gallons pumped through lower prices and thus lower gross margins (increasing commissions payable to franchisees) or to increase the gross margin achieved at the pump through higher prices and thus lower gallonage (decreasing the commissions payable to franchisees). Unlike its position with respect to the cost of goods sold, SEI keeps 100 percent of the gross margin from gasoline sales, and thus has no incentive to strike a fair and reasonable balance between the irreconcilable goals of more gallons or higher gross margin.
What choice has SEI made?
From 2013 to 2016, SEI’s fuel revenues dropped by $3.8 billion or 27 percent, chiefly because of reductions in oil prices generally, and wholesale gasoline prices in particular. All of us experienced this phenomenon at the pump. In the face of declining revenue, one would expect that the gross margin dollars achieved would fall proportionately, but that is not what happened. From 2013 to 2016, SEI’s gross margin from fuel revenue rose by almost $165 million, or by 20 percent. More importantly, from 2012 to 2016, SEI’s gross margin percentage from fuel revenue rose from 5.53 percent to 9.61 percent. Clearly, SEI has made an unannounced decision to focus on gross margin, and not on gallonage, to the detriment of franchised gasoline locations in the United States.
Just as higher prices for gasoline reduce the number of gallons sold, they also reduce the number of customers at the pump and thus the number of customers that enter the store to purchase merchandise. SEI has apparently been willing to suffer this trade-off. During the period 2012 through 2016, SEI’s gross margin percentage on merchandise sales in company-owned stores fell from 31.48 percent to 28.87 percent. And during the same period of time, SEI reduced its footprint of company-owned stores by 538 units or 34 percent, transferring some of the effect of high gasoline gross margin and thus lower merchandise sales from the company-owned side of the ledger to the franchise side of the ledger.
This phenomenon is likely to continue in the future, given that more than 41 percent of SEI sales in 2016 came from gasoline. We estimate that following the $3.3 billion acquisition of 1,100 Sunoco gasoline stations, more than 44 percent of all 7-Eleven stores will have gasoline.
SEI: what is your gasoline pricing strategy? Are you intent on sacrificing in-store sales and profit in favor of gasoline gross margin? To what extent are your pricing policies dictated by the fixed commission paid to franchisees?
- Equipment Maintenance
7-Eleven is an outlier franchise system in the sense that the system requires franchisees to pay the cost of maintaining equipment they did not choose and do not own. The franchise agreement then gives SEI the right to retain contractors to perform maintenance on its equipment, but at the expense of the franchisee. The franchise agreement purports to give SEI the right to decide when it’s necessary to replace equipment, without regard to any industry or other standards that might govern that decision.
Just as no one can deny the relationship between the price of gasoline at the pump and the customer traffic generated by that pricing, no one can deny the correlation between the age of equipment and the cost of repairing and maintaining it. This gives SEI an economic incentive to continue to use fully depreciated equipment that it would surely choose to replace if it was required to shoulder the cost of maintaining that existing equipment.
According to figures furnished to us by Vixxo, formerly known as FM Facility Maintenance, SEI was budgeted to spend only $38 million on proactive equipment upgrades in 2016 and another $69 million on reactive equipment upgrades. We have asked Vixxo for a report of actual equipment expenditures in 2016 and budgeted expenditures in later years, but it is apparent that they are not in a position to provide this data without the consent of SEI. Thus, the data has not been provided. We implore SEI to be more transparent with information about the age of its equipment inventory, its historic expenditures on equipment replacement and its budget for those expenditures over the next three years. What does SEI have to hide?
Compare the equipment replacement numbers to our estimate SEI has spent more than $6 billion on acquisitions since 2013. These mammoth capital investments in acquisitions are generated by SEI’s parent entity, whose financial performance and stock price have been lagging for an extended period of time. We believe that the parent company of SEI is looking to your franchisor to be the primary vehicle for its recovery, giving it a heavy financial incentive to allocate capital to acquiring more gasoline assets and to keep transferring as much of the ongoing maintenance costs to franchisees.
The 7-Eleven franchise agreement and system gives rise to an unusually broad range of issues on which SEI claims to have discretion, thus putting itself in the position of choosing to act in its own self-interest, or in a manner that reasonably and in good faith balances the economic interests of both franchisor and franchisee. This especially includes those relating to gasoline pricing and equipment maintenance. SEI’s choices have not been fair or reasonable. And SEI has resisted attempts by the franchisee community to get real data that would inform how and why they make these decisions.
Supreme Court Justice Louis Brandeis famously stated that “sunlight is said to be the best of disinfectants” in a 1913 Harper’s Weekly article, entitled “What Publicity Can Do.” Why not follow his shining example and be more forthcoming with franchisees with information that vitally affects their businesses?
This is why the ongoing discussions regarding the 2019 franchise agreement are far and away the most important issue confronting the owners of the almost 7,000 7-Eleven franchised stores in the United States. No other issue comes close. This is why all franchisees must support their FOA and their FOA leaders, who in turn must stand united in demanding more transparency and a fair and balanced renewal franchise agreement, free of the conflict of interests that have plagued franchisees for far too long.