ERIC H. KARP, ESQ., GENERAL COUNSEL TO NCASEF
This one word encapsulates my view of not only the 2019 franchise agreement, but the deeply flawed and contrived process that led to its issuance.
I have been practicing franchise law for more than 40 years. I represent many national franchisee associations. As part of my practice, I have been involved in several circumstances where a franchisor, for one reason or another, offers an early renewal franchise agreement to its franchisees. In every single one of those instances, two things happened.
First, that early renewal franchise agreement was the subject of good faith, as well as prolonged and largely amicable negotiations, between the franchisor and the franchisees, over the form and content of that franchise agreement. The goal in each of those situations to was to create a franchise agreement that reflected a fair balance between the risks and rewards of the franchise relationship. The franchisors in those circumstances realized that unless the franchise agreement was indeed fair and balanced, the likelihood of receiving an endorsement from the independent franchisee organizations was essentially zero. And they realized that the acceptance of the franchisee community, and their willingness to invest in the brand by purchasing additional locations, or by recommending the purchase of the franchise opportunity to family and friends, would be dependent on a signal from their elected representatives that the agreement was acceptable to them.
Second, in order to induce franchisees to renew early, in each of the circumstances there were many carrots held up to franchisees. These included more favorable terms and conditions of the franchise agreement and economic incentives that would add to their bottom lines and the value of their businesses. These more enlightened franchisors realized that making financial and legal concessions to the franchisees in the short run would yield dividends in the long run.
Sadly, but true to form, SEI’s 2019 agreement delivered June 15, 2018, was completely inconsistent with any prior early renewal franchise agreement I have ever worked on or have heard of over the last four decades. This 2019 agreement was presented on a take or leave it basis and constitutes a figurative gun to the head of franchisees, whose arms are being twisted to sign this agreement by December 31, 2018 or at some point be subject to a gross profit split that does serious damage to store level economics.
The 2019 franchise agreement arrived as part of a package that included the franchise disclosure document, which is mandated by federal and state law. Many franchisees justifiably find the document to be impenetrable because it spans some 641 pages and weighs nearly 7 pounds. Here is what it looks like: The 2019 Franchise Agreement weighs nearly 7 pounds.
SEI created a Franchise Agreement Committee (FAC), which was allegedly but misleadingly charged with collaborating with SEI to create an agreement that could eventually be endorsed. The truth is that the process was never intended to be anything more than window dressing. The promise of transparency regarding store level economics generally, and the profitability of fresh and hot foods in particular, never materialized.
This is particularly distressing because according to publicly available documents, the system-wide gross profit margin declined by 0.5 percent in the 12 months ended December 31, 2017 and another 0.3 percent for the three months ended March 31, 2018. In 2017, franchisees purchased $8.3 billion worth of inventory. This reduction in gross profit margin translates into a store level impact of nearly $4,600 per year on average. It is in that context that SEI is threatening to impose what I have called graduated gross profit split on steroids (GGPS-OS). According to our calculations GGPS-OS would reduce a franchisee’s share of gross profit for a $1.7 million store with a 35 percent gross margin by $6,850 per year. For a $2.2 million store the impact would be $13,100 per year. To put it another way, under GGPSOS SEI would take a larger share of the shrinking gross profit pie.
A joint venture of the FAC, the National Coalition and the NBLC created the so-called 27 points document, which included many subparts, and made clear the franchisee community’s consensus on what the new franchise agreement should look like. By our calculation, 95 percent of the points in that document were not only ignored by SEI, but in many cases SEI went in precisely the opposite direction. As just one example, the franchisees requested that SEI increase its indemnification of franchisees to account for inflation and increases in legal costs and settlements. Instead of doing so, SEI eliminated the indemnification altogether and transferred 100 percent of the cost of general liability and related insurance to the franchisees. In addition, we count 44 major changes to the franchise agreement that are unfavorable to the franchisee and just three that are at least partially favorable to the franchisee.
Importantly, the 2019 franchise agreement perpetuates two significant built-in conflicts of interest in the SEI system that are not seen in any other franchise system.
The first is the fact that SEI owns the equipment in each of the stores, but the franchisees are responsible for the maintenance of that equipment. SEI has consistently refused to make any commitment regarding expenditures for the replacement of worn out equipment or the renovation or refurbishment of tired and worn out looking stores. However, based on disclosures made by its publicly held parent, we see that actual capital expenditures on existing stores is on a downward trend year over- year. For example, for the three months ended March 31, 2018, capital expenditures on existing stores fell by nearly 29 percent from the same three-month period in 2017.
Thus, franchisees are stuck with the expense of maintaining older and older equipment, which gets more and more expensive over time, and SEI gets to devote its capital to buying more stores. Over the last several years, SEI has spent more than $4 billion on acquisitions and by comparison, pennies on improving existing stores.
The second built-in conflict of interest is based upon the fact that SEI sets the retail price for consigned gasoline. Thus SEI has a built in incentive to maximize its revenue and profit from gasoline because the franchisees do not share in that profit. In 2017 SEI earned gross profits on gasoline of just under $1.2 billion. Tellingly its gross margin on gasoline in 2011 was 5.8 percent; in 2017 it had risen to 9.45 percent. When gasoline is priced to maximize gross profit, it reduces the number of gallons sold thus decreasing the commission payable to franchisees. It also reduces the number of customer trips to the franchised location and thus negatively impacts revenue in the store.
Neither of these built-in conflicts of interest are in any way addressed in the new franchise agreement.
The 2019 agreement has a whole array of actual and potential increases in costs, expenses and liabilities to franchisees. These arise in the areas of grand openings, manager training, Internet sales fulfillment, employment law auditors, E-Verify, re-audits, loyalty programs, delivery service labor and equipment, computer equipment, liability insurance, advertising fees for lower volume stores, higher renewal fees for many stores, payroll costs, management fees, legal fees and mediation fees.
For this reason, Chris Tanco’s email to all franchisees of August 15, 2018 should cause all discerning franchisees to laugh out loud. He incorrectly claims that the new franchise agreement is “fair and balanced” and that it was based upon “extensive input and feedback from many Franchisees.” As this article demonstrates in great detail, the facts are otherwise.
We prepared a complete summary of the 47 most important changes in the 2019 franchise agreement, which has been posted on the National Coalition website. This document was summarized in a PowerPoint presentation at the most recent NCASEF Tradeshow and Convention and has been made available to all FOA presidents. Time and space do not permit a complete explanation of those changes here.
Let me close by focusing on a number of changes that have not received the attention they deserve. These changes relate to dispute resolution and related matters. Here are some of the very disturbing ways that SEI has radically changed these provisions:
- Mediation is no longer required, and SEI will now pay only 50 percent of the cost, not 2/3.
- Texas law governs the contract, which is designed to deprive franchisees of the franchise specific protections that may be available to them under their home state laws.
- All disputes must be heard in SEI’s hometown.
- SEI can recover legal fees from the franchisee even if no legal proceeding is actually filed and even if it does not prevail.
- Jury trials have been waived.
- Franchisees must assert claims within two years after the cause of action accrues, whether or not the franchisee even knows there is a claim.
I point out these provisions not because the typical franchisee will be affected by them, but because they illustrate how SEI has taken a franchise agreement— which was already unfair and inequitable in many respects, and already steeply one-sided on a whole array of issues—and made it materially worse for the franchisee.
I have said many times in this space that the most important challenge in the system is not anything specific to the franchise agreement, but rather the culture of this franchisor. SEI remains the most opaque, top-down, take-it-or-leave-it, myway-or-the-highway franchisor that I have ever encountered. Every attempt to negotiate and collaborate on a fair and balanced franchise agreement in the context of a mutually respectfully and transparent relationship, has been rebuffed. Until that culture changes, the relationship between this franchisor and its franchisees has little hope of improvement.
I wish it were not so. But when I was privileged to be appointed your General Counsel, I promised to “call them as I see them.” That’s exactly what I’m doing now.