Revitalizing the case for Good Cause Statutes:
the Role of Review Sites
Adi Ayal[*] and Uri Benoliel[**]
Abstract
Good cause statutes (GCSs)require franchisors to show “good cause” (i.e. a material breach of the franchise contract) before terminating contractual relations with a franchisee.These have long been debated in franchise law, with some states adopting them, others rejecting them, and proponents of both sides arguing about accompanying federal regulation.
Proponents of GCSs argue that they protect small and local franchisees from opportunistic termination by large and national chains, invoking ‘big business vs. local entrepreneur’ rhetoric and stressing the asymmetric information and inherent unequal bargaining power plaguing most such relations.The classic law and economics approach, however, opposes the adoption of GCSs. This approach relies on a central argument: GCSs disrupt an indispensable control mechanism against franchisee free riding, namely the ability of the franchisor to terminate any franchise contract at will.
This articlecalls fora rethinking of the classiceconomic analysis of GCSs,in light of the revolution that review sites –namelywebsites which allow customers to post reviews aboutfranchisees – have brought to the marketplace.After reviewing the classic analysis and the case for ‘at will’ termination,we show that online review sitescreate a novel and effective control mechanism against franchisee free-riding. Using hotel franchises as a case-study, we show that even in an industry where most customers are non-repeat travelers, unlikely to return to the same site often enough to constrain free-riding, online reviews serve as a substitute for at-will termination. More specifically, we argue that there arefour interrelated conditions necessary for review sites to serve as effective control mechanisms, and all are met in this case. First,that customers are sufficiently motivated to write reviews(despite not being financially remunerated for doing so).Second, that review sites facilitate analysis of information by including active measures to reduce information overload. Third,that review sites are sufficientlytrustworthy.Fourth, that review sites influence consumer purchasing decisions. With ‘at will’ termination supplanted by online review sites, the case for GCSs as franchisee-protection from franchisor opportunism is thus revitalized.
Article Contents
I. Introduction...... 3
II. The Legal Framework...... 5
III. The Classic Economic Analysis...... 8
A.The Free-Riding Problem...... 8
B. Constraining Free-Riding by Threat of Termination...... 12
IV. The Missing Control Mechanism: Review Sites...... 15
A. Review Sites: A General Description...... 15
B. Customers’ Motivation to Write Reviews...... 17
C. Review Sites as Cognitive Facilitators...... 21
D. Trustworthiness of Online Review Sites...... 25
E. Review Sites Impact Customer Purchasing Decision Making...... 27
V. Conclusion...... 30
- Introduction
Good cause statutes (GCSs), which require franchisors to show “good cause” before terminating contractual relations with a franchisee, have long been debated in franchise law, with some states adopting them, others rejecting them, and proponents of both sides arguing for (and against) accompanying federal regulation.
Proponents of GCSs argue that they protect small and local franchises from opportunistic termination by large and national chains, invoking the inherent unequal access the parties have to relevant information and the asymmetric bargaining power plaguing most such contracts.[1]The classic law and economics approach, however, opposes the adoption of GCSs.[2]Theconventional economic argument is that free-riding is rampant in franchise networks, due to the incentive each individual franchisee has to enjoy the chain’s reputation while skimping on the investment necessary to promote the national brand and ensure quality at the local venue.[3] An ‘at will’ contractis argued by legal economists to be an indispensable control mechanism for managing chains and preventing free riding. It allows franchisors to swiftly terminate the contract without having to prove in court that the franchisees neglected their duties, thus keeping the latter under constant threat of losing their business if quality is neglected.[4] According to this view, since franchisee investment in quality is multi-faceted and relies mostly on effort and care, providing verifiable proof of free riding at a level sufficient to show “good cause”in court is often very costly, if not outright impossible.
This article calls for a rethinking of the classic economic analysis of GSCs in light of the revolution that review sites – namely websites that allow customers to post reviews about franchisees – have brought to the marketplace. We argue that review sites may serve as an effective control mechanism against franchisee free-riding, thereby serving as a substitute for ‘atwill’ termination.Review sites, such as Expedia.com,Booking.com, Hotels.com, andPriceline.com, have become increasingly popular over the past decade.[5]On these sites, millions of customers write reviews on individualfranchisees and rate them on multiple dimensions of quality.[6]. The Internet revolution has thus created a method by which customers punish free-riding directly, by communicating their dismay to other potential customers and negatively affecting the franchisee’s revenues.[7]Online review sites thus provide a direct disincentive to free riding that would reduce customer experience, effectively enlisting reviewers in disciplining wayward franchisees, and making ‘at will’ contracting unnecessary. Insofar as the review mechanism supplants the contractual one, traditional arguments against GCSs lose much of their weight, while the arguments for such laws retain their power. The prevalence of online reviews thus requires a re-assessment of the pros and cons of GCSs, and should help to convince previous detractors that perhaps the time is ripe for change.
This paper will proceed as follows:Part II will review the statutory framework underlyingGCSs, and present their underlying purposes.Part III will providetheoretical context by delving intothe classic law and economic analysis of GCSs.Part IV will detail the novel mechanism, overlooked so far in the debate over the desirability of GCSs: online review sites. Part V concludes.
- The Legal Framework
To date, only seventeen of the fifty states have adopted statutes requiring“good cause”as a condition for the termination of a franchise contractby a franchisor.[8] Under these statutes, good cause is commonly defined as a franchisee’s failure to adequately comply with the requirements of the franchiseagreement.[9]Where a GCS applies, a franchisor terminating the contract without good cause must pay damages to the franchisee.[10]Such damages typically include loss oftangible assets used in the franchise (especially where these are adapted to specifications set by the franchise), but also loss of goodwill and forgone profits.[11]Such terms are usually mandatory, voiding contractual clauses where franchisees waive their rights, as otherwise franchisors will find it easy to restore ‘at will’ termination by specifying as much in the franchise agreement.[12]
Two main purposes have been proposed for GCSs: correction of the perceived inequality in bargaining power between franchisors and franchisees;[13] and protection of franchisees from perceived franchisor opportunism.[14]While the imbalance in bargaining power is an overarching characteristic of most franchise agreements, franchisor opportunism is more direct.Franchisors might threaten to terminate the franchise relationship in order to forcefranchisees to “agree” to modifications of the original contract.[15] Such modifications might include raising the royalty rates directly, or achieving a similar result by forcing the franchisee to purchase additional items from the franchisor (rather than obtaining them from other sources) at higher prices or better terms (for the franchisor). In other cases, franchisors might use their at-will termination power to encroach upon the franchisee’s previously-agreed exclusive territory, raise participation rates in national advertising and marketing campaigns, and more.
Franchisor opportunism might also include more final measures, such as actually terminating the contract in order to transfer the franchise to another franchisee paying higher fees or to their own network of franchisor-owned locations.[16] Such opportunistic termination is more likely when the franchisee in question was actually successful in running the business and building a substantial customer base, as these are seen as transferable assets and the resultant profit looms larger than the previously agreed upon fees and royalty rates.
The vast majority of goodcause statutes were adopted in the 1970s, concurrently with a wave of public outcry against large businesses exploiting the small and the need for the latter’s legal protection.[17]Still, to this day most states haveno GCSs on the books. Since 1992, 30 states have considered enacting franchisee protection laws, including GCSs.[18] In each case, the proposed laws did not pass.[19] At the federal level, several GCSs have also been rejected.[20] For example, in 1998 and 1999, the federal government declined to enact several bills that would have made it unlawful for a franchisor to terminate a franchise agreement prior to its expiration without good cause.[21] To date, no general federal law on franchise termination has been enacted.
- The Classic Economic Analysis
Given the centrality of law and economics in legal scholarship, it is not surprising that legal economists play a dominant role in the debate about the desirability of GCSs. The classic law and economics analysis of GCSs views them as impediments to contractual termination, where such termination is an indispensable mechanism for controlling free-riding franchisees.[22]In the following sub-sections we detail the reasons franchisees might find it in their interest to shirk their duties and free-ride on the reputation of the chain to which they belong, and why ‘at will’ contracting is considered as an essential control mechanism against free-riding. In section IV we then show how online review sites provide an alternative mechanism, supplanting ‘at will’ contracting and providing new support for GCSs.
A.The Free-Riding Problem
For every individual franchisee, her investment in quality benefits the franchise chain as a whole. Expenses necessary to attain customer satisfaction are thus fully borne by the individual franchisee, while the benefits of repeat purchase and brand recognition are dispersed among all franchises on the network.This leads to an obvious incentive to free-ride on other franchisees’ efforts, and skimp on local investment in quality.[23]As a result, the level of quality produced by each individual franchisee is expected to be lower than that they would all agree to, if a binding commitment could be enforced.[24] Common claims are that franchisees conserve funds by neglecting the appearance of their employees, skimping on workplacecleanliness, and overcharging customers.[25]Simply put, the individual franchisee incentive is to "cheat"customersby providing them with low-quality products or services, at the same price charged by otherfranchiseesin the chain, who maintain a higher level of quality.[26] Free riding is thus expected wherever mechanisms to control it are missing, or too weak to counter the monetary incentive created by the accompanying reduction of costs.
A classic truism oft-repeated in the law and economics literature, is that firms provide differential levels of service to different customers, based on their probability of repeat purchase.[27] Where facing repeat players, sellers maximize long-term returns, investing in current quality and customer satisfaction in order to attract future business.[28] Where one-shot customers are prevalent, sellers maximize current returns by skimping on quality or service, with common examples being “tourist traps” and the like.[29] In the case of franchise chains, the relationship is similar.Where franchises serve mostly local repeat customers the risk of franchisee free-riding is relatively low, since one expects reputation to travel by word-of-mouth and most customers to be repeat, rather than one-shot players.[30]In contrast, where non-repeat customers, such as hotel travelers,are served, the risk of franchisee free-riding is relatively high.[31] This is becausemost unsatisfied customers are anyway unlikely to return to the same location with similar needs in the foreseeable future, and therefore no significant harm has occurred from the perspective of the free-riding franchisee.[32]The risk of losing customers in these situations is borne by the entirety of the franchise chain, affecting the free-riding franchise only marginally.[33]
B.Constraining Free-Riding by Threat of Termination
‘At will’ termination – allowing a swift termination of a free-riding franchisee’s contract – is generally thought to be the premier (if not only) method of controlling franchisees’ incentive to free-ride. As the late Professor Larry Ribstein proffered: “Termination at will can be an important right for franchisers, since it may be the only way they can effectively monitor their franchisees to prevent franchisees from free-riding on and decreasing the value of the franchiser’s brand name.” (emphasis added).[34] Similarly, Professor Erin Ann O'Hara states: "The only way to ensure that [the franchisee] complies with her obligations is to enable the franchisor to threaten immediate termination" (emphasis added).[35]In this, scholars are mirroring what franchisors themselves say when arguing for their right to terminate contracts at will as a control mechanism.[36]
The conventional argument that at-will termination is an indispensable control mechanism against franchisee free riding is based on the assumption that when a franchisor has the ability to terminate a contract at will, the franchisee will know that detection of free riding results in swift termination and loss of lucrative business opportunities within the chain.[37] Any franchisee lured by the quick profits of skimping on investment in quality would be forewarned that if the franchisor deems performance sub-par, swift termination would result, with the accompanying economic loss borne by the offending franchisee. Beyond loss of future business stemming from the brand name, franchisees would then lose all relationship-specific investments sunk into the site and adaptation to chain procedures. These could be substantial, and impossible to use outside of the specific franchise chain, including physical fixtures such as floor plans, signs, light fixtures, floor coverings, and the like – but also process-related, such as business methods, employee training, expertise in specific types of food preparation, and more. Beyond the obvious, one should take into account the lost franchise and legal fees paid at the outset of the relationship, loss of inventory, supplies and contracts committed to but deemed irrelevant, and more. Such sunk costs could easily run into hundreds of thousands of dollars, and are irredeemably lost for the franchisee once his contract is terminated, thus creating a considerable threat-point for franchisors able to commit to terminating an offending franchise.[38]
In contrast, under a ‘good cause’ regime courts (or arbitrators) must determine what constitutes ‘good cause’ based on the facts as proven before them.Franchisors, in order to prove ‘good cause’,must rely on verifiable information, which is often lacking. For example, the franchisor can be certain that cleanliness is not fully maintained in the franchised unit, yet still find it prohibitively costlyto prove this in third-party proceedings. Franchisees are thus able to reduce costs by shirking their duties while relying on protection from courts and arbitrators if the franchisor attempts to terminate his contract with them.The difficulties in disentangling a ‘good cause’ contract are attested to in oft-repeated claims by frustrated franchisors: “you need a dead rat in the kitchen, and preferably three or four, if you want a chance of winning”.[39] Examining actual franchise litigation might mislead the casual observer, as it mostly revolves around royalties rather than operational details, but this attests not to where the central problem of franchising lies, but to what courts are best at determining. As Adam Badawi shows, franchises are governed by a combination of formal and informal mechanisms, where reliance on contract enforcement to facilitate investment in quality by franchisees is difficult at best.[40] Using courts to enforce quality-control is problematic due to unverifiable information, thus ‘at will’ contract termination is an effective threat looming over franchisees’ heads.
In short, the classic law and economics analysis claimsGCSs disrupt the irreplaceable at-will control mechanism against franchisee free riding.[41]These statutes require increased payments to the franchisee in the case of termination unless “good cause” can be proved in court, which is costly.[42]GCSs are thought to harm not only the franchisor unable to terminate contractual relations with an offending franchisee, but also the other franchisees in the network whom he is unable to protect from rampant free riding. Ultimately, according to this view, GCSs forbid the main contractual mechanism which protects the network as a whole from a multi-participant Prisoner’s Dilemma, as each franchisee sees free riding as bestowing immediate and internalized benefits while creating delayed and externalized harms.Ex ante, the argument goes, all franchisees would choose ‘at will’ contracting in order to ensure competent management of brand reputation and quick removal of offending parties from the network.