Introduction
The first capitalist firms to reach large size in the late nineteenth and early twentieth centuries did so through the mechanism of vertical integration—formal ownership of assets and employment of workers. There are competing explanations for the rise of the large firm, including the superior efficiency of managerial administration over decentralized markets, the historically contingent response by firms with high fixed costs to the deep recession of the 1890s, and demands from capital markets for corporate organization with centralized control.Footnote 1 However, few would disagree that these nineteenth and early to mid-twentieth-century firms combined the ownership of assets and employment of workers to reach large size.
In the 1950s a group of entrepreneurs, concentrated especially in the emerging industry of fast food, pioneered a different route to bigness. This new path deployed highly restrictive franchise contracts rather than formal property ownership and employment relationships to bind subordinate units into coherent, centrally controlled business organizations. Under franchise contracts, a large franchisor like McDonald’s, rather than owning and operating its retail business operations directly, licensed legally independent franchisees to do so. Franchisees typically paid a percentage of their sales to the franchisor and signed long-term contracts that gave franchisors substantial control of unit operations. In 2012, the most recent year for which U.S. Census data are available, franchise establishments employed 7.3 million people in the United States. Franchisors accounted for more than 409,000 establishments and 9.8 percent of all establishments, and sales of franchised chains were about 1.3 trillion dollars, or 7.8 percent of total U.S. GDP.Footnote 2
The economic history and business history literature on franchising is surprisingly thin. Several profiles of successful franchisors have been published.Footnote 3 In addition, Luxenberg’s Roadside Empires is a (highly critical) journalistic account of the history of franchising.Footnote 4 Blair and Lafontaine’s economics textbook provides a good overview of the main legal and economic issues involved in franchising.Footnote 5 Birkeland’s 2002 workplace ethnography of three franchise chains explores the challenges facing franchisees seeking financial success and independence through franchise ownership, as well as their conflicts with franchisors while working under highly restrictive contracts and franchisor surveillance.Footnote 6 Killion’s summary of franchising history for the American Bar Association’s casebook on franchising is an excellent, succinct account of the rise of the business form.Footnote 7 However, Thomas Dicke’s study is to my knowledge the only scholarly history of this business form. Through case studies of five firms from 1840 to 1980, he explores the business form’s history by a comparative analysis of the challenges faced by representative franchisors in five industries.Footnote 8
This paper begins to deepen that history by delving into the concrete struggles franchisors undertook to establish their unique business form. On one hand, franchisors fought against broad antitrust prohibitions on vertical restraints—controls one firm would place on legally separate firms like price, supplier, and customer restrictions. Their eventual victory on this front allowed them to follow an alternate route to giant size different from that pursued by the vertically integrated firms of the nineteenth and early twentieth century. On the other hand, they worked to persuade courts and a wide range of regulators that, despite tight control exercised through vertical restraints, franchised chains should not be considered single organizations under labor, tax, and other laws. Rather, franchised chains should be understood under these laws as loose constellations of dozens, hundreds, or thousands of legally separate organizations, with the central franchisor not ultimately responsible or liable for activity at any of the individual branches.
Franchising thus in a sense redefined the legal boundaries of the firm. There was much to be gained by pulling in the legal boundaries of the firm in this manner. As Nelson Lichtenstein has argued, twentieth-century policy makers created the regulatory law holding firms accountable for the activity they oversaw and controlled with the archetype of the large vertically integrated firm in mind. This meant that they tied legal responsibility and accountability to the formal characteristics of vertical integration: the ownership of assets and employment of workers. While Progressive and New Deal–era regulation worked reasonably well for as long as the relevant economic activity took place within the legal boundaries of such firms, subsequent vertical dis-integration undermined the ability of the public to subject corporations to social control.Footnote 9 For example, vertical dis-integration created what David Weil has called “fissured workplaces,” in which the legal boundaries of the firm acted as barriers excluding workers outside it from gaining access to higher wages paid by large firms, internal career ladders, and legal protections (whose coverage remained largely limited to the firm in which the worker had formal employee status).Footnote 10 Tomaskovic-Devey similarly argued that vertical dis-integration contributes to inequality by excluding workers from “organizational citizenship” and the ability to make claims on the resources of the firm.Footnote 11
In litigating and lobbying to pull in the legal boundaries of the firm, franchisors pursuing vertical dis-integration ironically followed in the footsteps of the nineteenth-century manufacturers that created the first vertically integrated large industrial firms. Most economic studies of vertical integration, dis-integration, and franchising emphasize technological changes or efficiency considerations as driving changes in vertical industrial organization.Footnote 12 However, far from merely responding to technological changes making mass production possible, the first vertically integrated large manufacturing firms actually created, through lobbying and litigation, the very national U.S. market that made it profitable for them to invest in those mass-production technologies in the first place.Footnote 13 Similarly, twentieth-century franchisors, with help from increasingly sympathetic antitrust policy makers, the dynamic law and economics movement, and somnolent labor law, used lobbying and litigation to transform an innovative legal structure of fragile legality into an accepted staple of American business.
Franchising allowed firms to escape the legal and regulatory costs and risks that constrained vertically integrated corporations of the earlier era, and many contemporary observers therefore felt that franchisors were unfairly avoiding the law. Donald Conley, the first franchising vice president for McDonald’s, who left that position to become a franchisee, testified before a congressional committee that “the franchise relationship is so sophisticated that it is not presently regulated by any traditional state or federal law, and has basically become a vehicle for getting around traditional law.”Footnote 14 Franchisors had to persuade regulators, legislators, and courts that their business form was new, unique, and valuable, and should not be regulated according to existing conceptions of legal relationships.
Franchisors relied on their trade association, the International Franchise Association (IFA), as their main public voice and lobbying vehicle. The IFA was founded at a trade show by Dunkin’ Donuts CEO William Rosenberg in 1959, and officially incorporated a year later. The IFA initially included forty franchisors.Footnote 15 According to Rosenberg, the founding franchisors were upset about bad press and stingy banks, but were “especially unhappy with the adverse legislation getting passed, mostly by the Federal Trade Commission.”Footnote 16 They therefore endeavored to change their legal environment. As a franchising attorney wrote, the IFA “played a critical role in the development of franchise laws in the 1970s and later … [and] became the voice of franchisors before the courts, the Congress, and state legislatures.”Footnote 17 The IFA has remained the official voice of franchisors from its founding into the present, as franchisors have grown into some of the largest corporations in the United States. In fact, the IFA is the only consistent presence across the two decades of public hearings, litigation, and legislative action over the years 1960–1980. By 2016 the IFA had fourteen hundred franchisor members and forty-two staff.Footnote 18 While opponents of the IFA, in particular the various short-lived franchisee associations, appear in the public record one year and disappear the next, the IFA is still active today. Its activities have included lobbying, filing amicus briefs, lending legal advice to franchisees, engaging in public relations, mobilizing its members to lobby state and federal legislators and agencies and, starting in 1978, becoming one of the early business associations founding a political action committee. As one journalist reported in the 1980s, “The IFA in its own limited area is an unchallenged force.”Footnote 19
Vertical Restraints: An Alternative Route to Bigness
Modern franchising had its roots in the product distribution strategies of nineteenth-century manufacturers McCormick Harvester Machine Company and Singer Sewing Machine Company, which turned to independent dealers to distribute their products under exclusive contracts. Similar distribution strategies would emerge in the ensuing decades. For example, in the 1880s, Coca-Cola began licensing independent bottlers to manufacture its soft drinks, using concentrates purchased exclusively from Coca-Cola. Similarly, petroleum refiners like Sun Oil Company turned to independent dealers in the 1930s, granting dealers the right under exclusive contracts to sell branded gasoline to the public as part of regional and national chains. To protect independent dealers from their more powerful business partners, some states and Congress legislated protections against unjust termination for independent dealers in the auto and petroleum industries.Footnote 20
However, franchising as we know today it did not rise to prominence until the economic boom of the 1950s, when entrepreneurs in service industries, in particular the new industry of fast food, pioneered a new type of business arrangement called “business format” franchising. Business format franchising was not a product distribution strategy like that used by Singer or Coca-Cola, because business format franchisors like McDonald’s and Motel 6 were not in the business of manufacturing products and selling them through independent distributors. Rather, these franchisors contracted with franchisees to manage a service business location as a unit of the franchisor’s uniform chain. The franchisee gained the right to operate a store under the franchisor’s trademark, under the condition that he or she follow the complete business format, including a uniform brand image, signage and fixtures, and detailed operating instructions.Footnote 21 Because business format franchisees managed outlets as part of a uniform chain rather than merely distributing goods under an exclusive contract, business format franchisors enforced much tighter control over their franchisees. This control would soon attract significant legal scrutiny.
According to a study commissioned by the Small Business Administration (SBA) in 1963, “the legal status of franchising is the dominant problem affecting the future of this method of distribution.”Footnote 22 To put it bluntly, franchising as we know it in 2019 was not legal in the 1960s. The history of the creation of franchising is in large part the story of the loosening of antitrust restrictions on what are known as vertical restraints. These contractual controls on independent franchisees, such as price, supplier, and customer restrictions, were the mechanisms franchisors relied on to create the uniform chain store appearance of their far-flung operations in the absence of formal vertical integration. Without vertical restraints, franchisors would have been forced to directly own and operate outlets to achieve similar levels of chain store uniformity.
In important ways, however, franchising represented another method of centralized vertical control rather than true vertical dis-integration. Franchising firms like Burger King sought to tightly control their production networks, setting prices, products, suppliers, menus, recipes, and hours of operation, and dictating everything from the process for making french fries to the manner in which employees greeted customers. They aimed to achieve this, however, without taking title to productive assets or employing workers. As Earl Pollock, a former Antitrust Division attorney and then-chairman of antitrust programs for the American Bar Association, put it in 1973, “Integration by contract is a substitute for integration by ownership.”Footnote 23 From this perspective, franchising was vertical integration by other means.
The minute control franchisors sought to impose on franchisees could be intense. As Ray Kroc, the founder of franchisor par excellence McDonald’s, put it, “The only way we can positively know that these units are doing what they are supposed to do … is to give them no alternative whatsoever. You can’t give them an inch.”Footnote 24 To enforce this control, franchisors required franchisees to follow detailed operations manuals incorporated into the franchise contract. These manuals often left little to franchisee discretion. As one bemused regulator complained to an IFA audience in 1976, a certain Mexican food chain’s operations manual opened with the three lines: “Put the key in the door,” “Open the door,” and “Turn on the light.”Footnote 25
Franchisors, however, soon faced a problem in replacing property and employment with contract as a means of vertical integration. While antitrust laws traditionally allowed centralized control and coordination within firms, they prohibited many types of control and coordination between firms, including vertical price fixing and other vertical restraints.Footnote 26 In particular, many antitrust policy makers believed antitrust laws should protect the independence of small business from domination and control by larger firms through vertical restraints. For example, when Monte Pendleton, then-president of the IFA, argued in 1965 before the Senate Subcommittee on Antitrust and Monopoly that franchisors should have the same ability to impose constraints through contract that vertically integrated corporations could impose through administrative fiat, Jerry Cohen, chief counsel to the subcommittee, was incredulous:
Then what would be the difference between a franchise operation and an integrated corporation? The argument we get here for franchising is that it allows an independent businessman to be independent. But if he is told what product he has to buy, what prices he has to charge, what operation he has to operate in, then he is no longer independent is he? He is part of an integrated franchisor’s operation.Footnote 27
Cohen, articulating a widely held antitrust principle of the time, felt that franchisors violated the antitrust laws when they constrained the independence of smaller firms through vertical restraints.
After the 1960s, antitrust policy moved away from the goal of preserving the independence of small business and toward a consumer welfare standard focused narrowly on maintaining low consumer prices. Economists replaced lawyers as top staffers in the Antitrust Division of the Department of Justice and the Federal Trade Commission (FTC) in the 1960s, bringing with them a focus on prices rising above marginal cost as the chief evil of monopoly.Footnote 28 Meanwhile, the law and economics movement, which applied anti-regulation University of Chicago economic theories to law, grew increasingly influential within the judiciary from the mid-1970s. According to law and economics doctrines, the proper role of law, especially antitrust law, was to promote economic efficiency rather than social goals like restraining corporate power.Footnote 29 Law and economics antitrust theory was especially helpful to franchisors by providing scholarly ammunition for their arguments about vertical contracts, which law and economics scholars like Robert Bork argued should be presumed efficient, because firms would not adopt them if they were not.Footnote 30 In particular, franchisors and law and economics scholars both argued that vertical restraints, including price-fixing contracts, promoted efficiency by enhancing competition between brands (interbrand competition), even if they hampered competition between franchisees within brands (intrabrand competition).Footnote 31
However, franchisees, many of whom had been lured to franchising by the promise of independent business ownership, often rebelled against vertical restraints. Franchisee frustration with franchisor controls ultimately fueled litigation, in which the courts judged the various vertical restraints in terms of their compliance with antitrust laws. The courts struggled to come to terms with franchising in its initial two decades. In the White Motor case in 1963, the Supreme Court said it did not have enough information about franchising to issue a blanket rule on the legality of non-price vertical restraints. This ruling initiated a period of confusing and sometimes conflicting judicial rulings.Footnote 32
Judicial rulings over vertical restraints reflected a deep divide in legal thinking about antitrust that ran all the way back to the debates over the passage of the Sherman Act itself. Was its goal keeping consumer prices low (the “consumer welfare standard”), as staff economists at the Antitrust Division and FTC, as well as University of Chicago law and economics scholars, argued? Or was it meant to restrain the power of big business, including protecting the independence of small business from control by larger corporations, as the antitrust tradition associated with Louis Brandeis held? In the early years of franchising this divide had not yet been resolved in favor of the consumer welfare standard. At the beginning of the first congressional hearings addressing the new business form, Senator Philip Hart declared, “About the only area of agreement is that there is disagreement about how the antitrust laws should be applied in this area.”Footnote 33 It would take two decades for regulators and courts to bless the legality of franchising under antitrust law.
The courts initially applied antitrust law to franchising in a confused manner, exemplified by the bombshell U.S. Supreme Court decision in United States v. Arnold, Schwinn, & Co in 1967.Footnote 34 Schwinn struck down vertical restraints in bicycle manufacturer Schwinn’s contracts with its franchisees that barred franchisees from selling Schwinn bicycles outside their assigned territories. The court ruled that such vertical restraints were per se violations of Section 1 of the Sherman Act, meaning that such contract terms were always illegal no matter the circumstances, and courts would not even listen to evidence justifying them on a case-by-case basis. Nothing dominated the International Franchise Association’s annual legal meeting agendas from that date through the 1970s as much as the fallout from Schwinn and the IFA’s strategy to overturn it. Schwinn struck at the heart of franchising by refusing to grant broad antitrust approval to franchisor vertical restraints on franchisees.Footnote 35
The ruling put franchising on uncertain legal ground. Over the course of ten years following the Schwinn decision, franchisors agonized over whether and how Schwinn might apply to them. The Supreme Court created confusion by grounding its decision in the fact that Schwinn franchisees took title to the bicycles, and thereby as the owner had the right to dispose of them free from franchisor vertical interference. According to a narrow interpretation of the majority opinion, the per se rule in Schwinn only applied to product distribution franchising, in which franchisees took title to the franchisor’s goods, and did not apply to business format franchisors like Burger King or Jiffy Lube that provided services under a licensed trademark.
The FTC’s Ad Hoc Committee on Franchising concluded that the reasoning of Schwinn probably did not apply to service or business format franchisors.Footnote 36 However, others warned that Schwinn was the first step in a movement by the courts to protect small business franchisees from large franchisors. Robert Grossman, chief of evaluation for the Antitrust Division, warned that the court “left little doubt as to its desire to preserve the business prerogatives of independent distributors” and was likely to rule against franchisors in future business format franchising cases.Footnote 37 During this era of antitrust jurisprudence, before the consumer welfare standard and the law and economics movement attained ascendancy, the idea of a large corporation controlling and dominating a smaller company still evoked the whiff of antitrust violations. As IFA chairman Jerrold Van Cise lamented, “Easier for a camel to go through the eye of a needle than for a fat franchisor to comply with the antitrust laws when he seeks to control the franchisee.”Footnote 38
Some types of vertical restraints attracted virtually no legal scrutiny. Minimum hours requirements were rarely challenged, and when they were, franchisors won soundly.Footnote 39 Vertical restraints upholding quality standards such as sales quotas and controls over service standards, layout and design, and advertising also attracted little antitrust scrutiny.Footnote 40 For other types of vertical restraints, franchisors used workarounds to adverse antitrust rulings, such as partial vertical integration (operating company-owned shops in competition with franchisee-owned locations), franchisor advertising of prices, or using the threat of termination or nonrenewal against franchisees who did not comply with “suggested” prices, products, and so on.Footnote 41 Some of these techniques were borrowed from older product distribution franchisees. Coca-Cola famously managed to keep the price of a bottle of its soda at five cents for over seventy years without vertical price restraints by blanketing the country with five-cent ads, making it virtually impossible for bottlers to charge a different price.Footnote 42 Others were more innovative. For example, when Siegel v. Chicken Delight in 1970 prohibited forcing franchisees to buy certain inputs from the franchisor as a condition of using the franchise trademark, franchisors largely stopped requiring mandatory purchases. Instead, they adopted lists of “approved suppliers” and quality standards and earned income from franchisees by charging them royalties rather than selling them inputs.Footnote 43
In other instances, franchising firms went ahead and engaged in vertical conduct of uncertain legality. When franchisees challenged these practices in court, the IFA helped individual franchisors litigate to change the courts’ interpretation of the laws. In key cases, the IFA’s lawyers represented franchisors, and the IFA itself filed amici briefs in support of franchisors, beginning with Susser v. Carvel, a supplier restriction case decided in 1965.Footnote 44 Franchisors benefited from the lack of an organized opposition: in most cases, only the IFA and industry-specific franchisor trade associations filed briefs, leaving only individual franchisee plaintiffs representing the franchisees’ side.
Supplier restrictions, in particular, faced difficult challenges under antitrust law. For franchisors, maintaining uniform appearance and quality equivalent to that found in an integrated chain was essential. However, a major obstacle was antitrust law’s prohibition against tying—requiring a buyer to buy a second, undesired item as a condition of buying a first, desired item. Early court decisions found that the trademark license was a separate product from the other inputs to a franchise, and could therefore be considered a tying item under antitrust law. This opened up franchisors to challenges from franchisees who did not want to lease real estate from franchisors or buy other inputs from franchisors or suppliers designated by franchisors.Footnote 45 In Susser v. Carvel in 1965, the IFA’s first intervention through an amicus brief, franchisees of the Carvel ice cream chain alleged that Carvel had violated the antitrust laws by requiring franchisees to purchase ice cream through Carvel itself. The court ruled for the franchisor on the tying issue, finding that Carvel’s need to protect its trademark justified its requiring franchisees to buy ice cream only through the company.
However, antitrust concerns about tying remained, especially in cases, unlike Carvel, in which franchisors required franchisees to buy items outside the franchisors’ core brand identity. At the extreme, an FTC Bureau of Competition staffer warned IFA members against exclusive deals with name-brand catsup and soft drink providers, asking, “[Is there] a substantial difference in quality catsups between Heinz, Hunts, and Ritters?”Footnote 46 Today we take our inability to get a Pepsi at McDonald’s or a Coke at Taco Bell for granted, but at least some in the FTC questioned the legality of such vertical restraints in the early years of franchising. Franchisor attorney Harvey Applebaum noted four years later, “Virtually every major national, and sometimes even local, fast food or ‘business package’ franchisor is presently or recently has been under some form of antitrust treble damage attack with respect to required purchases of products.”Footnote 47 In 1975 the FTC required seventy-five fast food franchisors to answer a questionnaire pertaining to whether they required franchisees to purchase products or services from designated suppliers and to justify any such requirements.Footnote 48
Thus, in the mid-1970s franchisors were not certain whether the logic of Schwinn would be pushed further into business format franchising. Would they be able to impose sufficient control on franchisees to project a chain store image and achieve vertical integration by contract, or would the regulators and courts block their efforts in order to preserve the independence of franchisees? Until the mid-1970s, franchisors felt the momentum of judicial reasoning was against them and moving in the direction of “expanding the applicability of the Schwinn doctrine.”Footnote 49
The fortunes of franchisors took a decisively positive turn, however, with the outcome of the Sylvania case at the Supreme Court in 1977. GTE Sylvania, a product distribution franchisor, restricted the geographic areas in which its franchised distributors could sell its products. Its distributors sued, and the case made its way to the Supreme Court. The distributors had good reason to be optimistic: this is the same type of vertical restraint that Schwinn had imposed, which the Supreme Court had found to be a per se violation of the Sherman Act. While considered a watershed in antitrust jurisprudence today, only the IFA and two industry-specific franchisor groups filed amici briefs. The court, in language very similar to that in the IFA’s amicus brief, overturned Schwinn. Moreover, rather than ruling on narrow technical grounds, the court used the opportunity to strike down all per se prohibitions on nonprice vertical restraints, as the IFA had urged in its brief.Footnote 50 The decision terminated uncertainty surrounding non-price vertical restraints, ending a decade of confusion as to the legality of a key pillar of the franchising business form. IFA Washington counsel Philip F. Zeidman celebrated the importance of the case for business format franchisors:
For those operating service franchises or business format franchises, the haunting question of the applicability of Schwinn in the absence of a sale and resale context … has now presumably been rendered academic.Footnote 51
Zeidman was not exaggerating when he beamed of the Sylvania decision, “With that holding, one era of franchise litigation comes to an end.”Footnote 52
While it is difficult to assess how large a role franchisors played in pushing the courts to look more benignly on vertical restraints, franchisors and the IFA likely had some influence in the timing and direction of the shift. For one thing, franchisors were the interest group most motivated to loosen antitrust rules against vertical restraints, because the viability of their business model depended on it. Indeed, as recorded earlier, franchisor organizations were the only groups who bothered to file amici briefs regarding Sylvania. More fundamentally, for the Sylvania ruling to happen, a franchisor (albeit a product distribution franchisor) had to impose a plainly illegal vertical restraint on franchisees and then see the litigation through all the way to the Supreme Court. While new economic ideas on vertical restraints from the law and economics movement surely also played a key role in the outcome of Sylvania, Robert Bork’s seminal The Antitrust Paradox, the text widely credited with changing legal thinking on vertical restraints, was not published until 1978, one year after Sylvania. Moreover, it was franchisors who pioneered, slightly earlier and apparently independently from Bork, the legal arguments prioritizing interbrand over intrabrand competition that now underpin the current permissive antitrust orthodoxy regarding vertical restraints.Footnote 53
While the time period of the analysis in this paper ends in 1980, it is worth noting that the permissive logic of Sylvania with respect to vertical restraints did not end with that case. Eventually, the courts extended their blessing even to vertical price restraints. With State Oil Co. v. Khan in 1997, the Supreme Court found that maximum vertical price restraints could be pro-competitive, because they kept consumer prices low.Footnote 54 Finally, in 2007 the Supreme Court in Leegin Creative Leather Products, Inc. v. PSKS, Inc. overturned the 96-year-old per se prohibition on minimum vertical price restraints.Footnote 55 There is no more fundamental business decision than what price to charge. Post-Leegin, franchisors were free to control even this aspect of their “independent” franchisees’ operations.
The Benefits of Vertical Separation
At the same time that franchisors sought to achieve centralized economic control through vertical restraints, they also lobbied and litigated to escape the consequences of that economic control. They sought to convince government agencies and courts that economic control through contracts should not entail the same kinds of legal responsibilities that control through ownership traditionally entailed, especially responsibilities to workers under employment law. In seeking economic control without legal responsibilities, franchisors sought to pull in the legal boundaries of the firm, taking advantage of the differential legal and regulatory treatment of activities occurring inside versus outside the legal boundaries of the firm.
While franchisors fought to expand the economic control of franchised organizations through legalization of vertical restraints, they also worked to establish franchisees’ legal status as independent contractors outside the firm. Franchisors’ first success in this arena came when the SBA changed its definition of “small businesses” eligible for SBA assistance to include franchisees. Before the 1966 rule change, the SBA considered franchisees, due to vertical controls, to be part of franchisor organizations and not independent businesses at all.Footnote 56 As SBA administrator Eugene P. Foley testified in 1965, any requirement that a small businessperson “conduct his business in strict conformity with an operating manual issued by the franchisor” or establishment by the franchisor of “standards of quality, service, protection and advertising” rendered the franchisee ineligible.Footnote 57 According to Foley, “the major decision for the SBA is this: Are we financing the distribution outlets of large businesses or are we financing independent small businesses as the Congress intended us to?”Footnote 58
Shortly after Foley’s testimony, the SBA decided to revisit the issue of franchising. In early 1966, the SBA invited academics and businesspeople to present information and opinions on whether the SBA should change its definition of small business to include franchisees. It is difficult to determine exactly why the SBA chose to do so. The SBA’s involvement in franchising and the revisions to the size standards for small business are missing from the only book-length study of the agency during this period.Footnote 59 Chin Jou’s recent history of federal subsidies for fast food shows that the SBA became keenly interested in using franchising to expand opportunities for minority entrepreneurs during the 1960s, but does not discuss whether this influenced the 1966 rule change.Footnote 60 Unfortunately for historians looking to surmise the IFA’s precise role, while the IFA would begin proudly documenting its lobbying and litigating activities in 1967 by publishing transcripts of annual legal symposia and a trade journal, they were not publishing such documents in 1965 and 1966. Nonetheless, it seems likely that franchisor lobbying was an important influence. The IFA was heavily involved in the consultation process, and it seems unlikely that the new organization would have won that role without actively seeking it. The IFA advised the SBA on whom to invite, and the IFA’s general counsel, president, and chairman all received invitations to attend.Footnote 61 Meanwhile, very few, if any, franchisees participated. As then-SBA general counsel Philip F. Zeidman confessed to the SBA administrator, “It must be conceded that the hearing was inadequate in that most of those participating were either franchisors or associations representing franchisors.”Footnote 62
Zeidman recommended that the agency completely abandon any consideration of franchisor control in approving SBA loans. The SBA followed his advice. The new standard for independence under the Small Business Act would be that the franchisee had the “right to profit” from effort and bore the “risk of loss or failure,” regardless of the level of control of its business by a larger firm. The rule change opened up an important new source of financing to franchisors that remains important to this day: In 2014, 43 percent of first-time franchisees obtained financing from SBA loans.Footnote 63 The SBA rule change was also the first federal response to the uncertainty released by White Motor and an early ruling in favor of a more permissive approach to franchising. Henceforth, for purposes of receiving SBA financing, franchisees would be considered legally separate businesses, despite the control exerted by franchisors. The SBA went from skepticism of big business controlling small business through franchise agreements to being the advocate for franchising it remains to this day, as foreshadowed by Zeidman’s note to SBA administrator Bernard L. Boutin that “SBA will endeavor to influence the shaping of antitrust enforcement policy with respect to franchising as well as otherwise into directions legitimately and appropriately beneficial to small business concerns.”Footnote 64 Zeidman went on to serve as Washington counsel to the IFA from 1970 to 2016.
Throughout this period, franchisors also expressed intense anxiety that their control over franchisee operations might create a legal employment relationship between themselves and their franchisees or between themselves and their franchisees’ employees. While franchisors sought to create a path to bigness different from traditional vertical integration by imposing vertical restrictions on franchisees, they desperately wanted to keep franchisees and franchised employees outside the legal boundaries of the firm under employment law. At the 1971 IFA Legal and Government Affairs Symposium, for example, IFA attorney Jerome Fels chastised McDonald’s for accepting the legal standard of employer–employee relationships in litigation of a post-termination covenant not to compete,Footnote 65 warning that “accepting any theory that the franchisor/franchisee relationship is an employment relationship or similar to it might have some unfortunate consequences.”Footnote 66 Those “unfortunate consequences” were that workers at franchise establishments would have legal rights against franchisors. Of particular concern was the possibility that workers could unionize and gain the right to bargain directly with the franchisor, not just the franchisee that formally employed them, under the “joint employer” doctrine. As a law professor invited to the IFA’s 1972 legal symposium explained,
If the [National Labor Relations] Board does not assert jurisdiction, those employees do not have the protection of the National Labor Relations Act. They can be fired for union activity, and … the employees have few legal rights with respect to union organizing. So it is in the immediate interest of the McDonald [sic] Corporation to assert that the franchisee is the sole employer of those employees.Footnote 67
IFA general counsel Harry L. Rudnick sounded the alarm in 1967 after the National Labor Relations Board (NLRB) ruled that a Mister Softee franchisee’s truck drivers were employees rather than independent contractors under the definition of the National Labor Relations Act (NLRA). The board ruled that while formally the drivers’ contracts were those of independent contractors and not wage workers, the substance of the controls enforced by the franchisor and franchisee removed them from independent contractor status and put them under the jurisdiction of the NLRA as employees. The relevant test, according to the board, was a “right of control” test: Who controlled the means and manner by which the output was generated?Footnote 68 While the ruling did not challenge the franchise relationship itself, focusing only on the relationship of ice cream truck drivers to a franchisee, Rudnick warned that “it is not difficult to project the application of this line of analysis and reasoning to a great many franchise systems.”Footnote 69
Franchisors must have breathed a sigh of relief, then, when two years later the NLRB refused to use franchisor control over franchisees as a reason to expand its jurisdiction to franchising relationships. In 1968’s Southland Corporation v. Retail Store Employees Union, the board ruled that Southland, the franchisor of 7-11 stores, was not the joint employer of a franchisee’s employees, because the franchisor did not directly control the labor relations of the franchised store. According to the board, “We have long held that the critical factor in determining whether a joint employer relationship exists is the control which one party exercises over the labor relations policy of the other.”Footnote 70 If franchisors avoided interfering directly in the labor relations of franchisees, such as by telling them whom to hire and fire or setting shift schedules, they would avoid triggering NLRB jurisdiction, even if they indirectly controlled labor conditions by controlling the work process, equipment used, hours of operation, franchisee prices, and countless other aspects of the business through contractual restraints.
Franchisors’ concerns with the Fair Labor Standards Act (FLSA), which regulates minimum wages and overtime, echoed their anxieties about the NLRA. In a 1978 article in the IFA Current Legal Digest, Lewis Rudnick and John Dickens, citing a recent Department of Labor interpretive bulletin, highlighted the risk that the Wage and Hour Division of the Department of Labor would find franchisors to be joint employers under the FLSA, making them liable for wage and hour and overtime violations at franchised establishments.Footnote 71 As it happened, the courts ultimately defined the meaning of “employer” narrowly in interpreting the FLSA, relying on a physical control test similar to that of the NRLB.Footnote 72
In retrospect, franchisor fears seem misplaced, because the NLRB and Department of Labor would stick to the “right to control” test and refuse to consider the indirect ways in which one firm could control the labor relations of another firm by controlling production processes and other aspects of the firm’s operations that determine labor relations. But for franchisors in the 1960s and 1970s fighting to establish their organizational form as a relationship of vertical integration for antitrust purposes and independent contracting under employment, tax, and other law, franchising’s legal status did not feel secure just yet.
Franchisors were also apprehensive about courts and regulators finding franchisees to be inside the boundaries of the firm under other legal regimes. A major concern was that courts would find franchisors liable for the actions of franchisees under principal-agent law, under which courts could rule that the franchisor’s control over the franchisee meant that the franchisee was legally acting on behalf of the franchisor. In that case the franchisor would be responsible for the franchisee’s actions undertaken on its behalf. As Lewis Rudnick cautioned in 1967, “The courts will not unlikely say that the franchisor has guided and controlled its franchisee to the extent necessary to make him the franchisor’s agent.”Footnote 73
Throughout the 1970s, the IFA fought back attempts by state legislatures to tie franchisors to franchisees under a variety of laws. After intense lobbying from the IFA, in 1976 New Jersey restricted an indemnification and warranty bill holding franchisors responsible for actions taking place within their chains to the automobile industry, excluding business format franchisees from its jurisdiction.Footnote 74 In 1978 the IFA lobbied against attempts in two states to include franchised chains under chain store tax regimes.Footnote 75 That year also saw Arizona and Massachusetts consider laws to impose joint tort liability on franchisors by statute. IFA persuaded the Arizona senator who introduced the law to withdraw it, and the Massachusetts legislature rejected a similar bill.Footnote 76
Fighting Off Alternative Regulations
Robert Pitofsky, then-director of the FTC’s Bureau of Consumer Protection, grappled with the danger of franchising falling into an unregulated gap between antitrust and labor law in 1972:
If the relationship is viewed as one between “independent” businessmen or businesses … then it makes sense to apply the public policies of the antitrust laws, with the prime objective of preserving the franchise as an independent competitive unit…. On the other hand, one may view the relationship as essentially characterized by vastly unequal bargaining power and access, in which the franchise is … virtually indistinguishable from the position of employees or agents. Given this view, it makes sense to apply the public policies of the National Labor laws.Footnote 77
Pitofsky was uneasy with franchisors’ attempt to create a new kind of status, franchisee, that was neither a truly independent competitor protected by antitrust laws nor an employee protected by labor laws.
As franchisors succeeded in avoiding regulation of franchising under either antitrust or employment law doctrines, federal and state lawmakers stepped into the breach to propose regulations to control this new business form, which had escaped the grasp of traditional doctrines. Their main concern was the gross power imbalance between the parties. Franchisees were small businesses that signed restrictive, one-sided contracts offered on a take-it-or-leave-it basis from franchisors that were often large corporations. Indentured servitude and feudal metaphors abounded: franchising, for example, was “feudal in concept—the lord and the serf” according to a Senate Antitrust Subcommittee lawyer.Footnote 78 As Timothy H. Fine, general counsel of the short-lived franchisee organization the National Franchisee Association Coalition put it, “If franchisees are to be more than branch managers taking orders from a parent corporation, such power must be curbed.”Footnote 79
Laws that equalized bargaining power by prohibiting certain onerous contract terms soon emerged as an alternative to both labor law and the regulation of vertical restraints as a means of regulating franchising. Franchisees advocated laws that regulated the substance of the franchise relationship itself, in particular termination and nonrenewal clauses. The IFA strongly opposed these efforts and sought to channel franchise regulatory efforts into laws regulating the sale of franchises, particularly favoring precontract disclosure laws.Footnote 80 The first skirmish was fought over the Franchise Competitive Practices Act, introduced in 1967 by Senator Philip Hart, chair of the Subcommittee on Antitrust and Monopoly, to regulate termination and nonrenewal of franchises. A revised version of Hart’s bill introduced in 1969 prohibited terminations and failures to renew without cause. The bill did not pass, and the IFA took credit for killing it.Footnote 81 Franchising bills continued to be introduced in subsequent years, with Representative Abner Mikva’s Franchising Practices Reform Act in 1976 garnering an “an almost unheard of” 109 cosponsors, according to Zeidman.Footnote 82 Ultimately, however, like the Hart bill, Mikva’s legislation came to nothing.
Franchise relationship laws were also introduced in a number of state legislatures in the early 1970s, and the IFA played an extremely active role in lobbying and shaping state legislation, with considerable success. As of 2004, only eighteen states had relationship laws. Of these, most did not regulate the franchisor’s right to terminate contracts, requiring only advance notice of termination. Only eight states (Arkansas, Hawaii, Illinois, Iowa, Michigan, Minnesota, Washington, and Wisconsin) required that franchisors give franchisees an opportunity to address defaults before terminating a franchisee.Footnote 83
From the franchisor’s perspective, all this talk of unequal bargaining power was completely beside the point. Philip Zeidman declared during one hearing, “In fact, all men are not equal, nor does anything in our law or our history require that they be so.”Footnote 84 The IFA sought to keep franchising firmly within the domain of contract law, where “buyer beware” governed agreements between consenting parties, no matter the balance of power between them. The IFA accordingly pushed precontract disclosure rather than postcontract regulation as the remedy for the alleged abuses in franchising. It argued that as long as franchisees were warned beforehand about the contents of the contract they signed, there could be no complaint afterward about the unfairness of any contract term. The IFA drafted model disclosure legislation and worked closely with lawmakers to introduce and pass it around the country. The IFA also urged the FTC to adopt a disclosure approach when the agency announced its intention to regulate franchising in 1971. In 1970, Lewis Rudnick declared the IFA-developed California Franchise Investment Law to be the IFA’s “model act,” and optimistically predicted that in ten years federal legislation along the lines of that law would be enacted.Footnote 85 He was almost right—but it would be a FTC regulation, not a federal statute, that applied the principles of the California law to the whole country.
While the FTC discussed, but never aggressively pursued, taking action against dominant franchisors under its Section 5 authority to prohibit unfair methods of competition, it ultimately took the path favored by the IFA and implemented a disclosure rule. The IFA’s allies in advocating for this approach included the Nixon White House.Footnote 86 When the FTC announced its intention to promulgate a trade rule regulating franchising in 1971, the IFA was there from the beginning, lobbying the FTC to attack fraud and misrepresentation in franchise sales, but to leave the franchise relationship alone.Footnote 87 Disclosure regulation was favored by franchisors, because it attacked the “fast buck artists” and frauds who gave franchising a bad name, while leaving the basic power imbalance at the heart of franchising unchallenged. Disclosure, moreover, actually protected franchisors in litigation with franchisees: after mandatory full disclosure, franchisees could no longer claim franchise contracts were adhesion contracts that they were pressured to sign.Footnote 88 A disclosure rule would thus sanctify franchise contracts as purely private, bilateral, arms-length transactions between equal parties in the marketplace, cementing franchisees’ status as outside the firm.
The FTC rule was finally enacted in 1979. With Sylvania and the FTC rule, franchisors ended the 1970s with their regulatory agenda largely achieved. Franchisees, for their part, never supported and were dismayed by the FTC’s embrace of disclosure rather than regulation. Robert Purvin, franchisee lawyer and head of the American Association of Franchised Dealers, argued during the FTC’s 1995 review that the rule “has achieved a situation of legitimizing what I call systematic fraud.”Footnote 89 As franchisee attorney Harold Brown remarked, “With the adoption of this rule in 1979, the FTC has, for almost all practical purposes, withdrawn from the conduct regulation activity in which it previously was occupied.”Footnote 90
Unfortunately for franchisees, they have never been as well organized as their franchisor opponents.Footnote 91 While the IFA was a consistent presence across virtually the entire history of business format franchising, from its founding in the early 1960s through the present, franchisee organizations have appeared in the historical record during the 1960–1980 period of this study only sporadically, ad hoc, and in response to emerging threats and concerns. They have tended to disappear just as quickly, without leaving much of a trace. It is difficult to say why franchisees were so ineffective in organizing for their interests during this period. However, a likely contributor was that franchisees did not have much time outside work for forming organizations and lobbying their representatives, as one Pearl Vision franchisee explained to a congressional committee in 1999.Footnote 92 The two main franchisee organizations existing today, the American Association of Franchised Dealers and the Coalition of Franchisee Associations, were founded in 1990 and 2007, respectively, after much of the regulatory damage, from the franchisees’ perspective, had been done.
Conclusion
By 1980, franchisors had succeeded in establishing their organizational innovation under the law, giving them rights to coordination and control consistent with vertical integration without triggering the responsibilities, under employment and other laws, that traditionally accompanied integration. The Supreme Court gave franchisors the right to vertically integrate by contract, rather than direct ownership, through non-price vertical restraints. The FTC, meanwhile, abandoned any attempt to reduce the power imbalance between franchisees and franchisors, adopting the IFA’s preferred policy of precontract disclosure rather than postcontract regulation. The IFA simultaneously beat back most attempts at the federal and state level to regulate the franchise relationship beyond disclosure requirements. Finally, employment and other laws that New Deal–era policy had used to socially control corporations did not adapt to changing legal forms and remained fixated on narrow, formalistic definitions of the boundaries of the firm.
This paper has shown how the creation of franchising entailed a political and legal struggle to shrink the legal boundaries of the firm relative to its economic boundaries. Franchisors persuaded regulators, courts, and legislatures to allow them to pursue de facto vertical integration by contract (imposing vertical restraints such as customer and price restrictions on their franchisees), while simultaneously claiming benefits of vertical separation, such as eligibility for SBA assistance and avoidance of tax, labor, and other laws that would apply if franchisees were not legally separate entities. Franchisors transformed business practices that rested on shaky legal ground in the 1960s into legal components of a new business form.
