Franchisor-Supplier Relationships

If contractual relationships were always evidenced by a document like our typical franchise agreements, commerce would probably come to a standstill. A certain level of trust is the key in these situations, and most of us believe that if the trust level is established, there is no need to be formalistic. Of course, many law firms operate with no written partnership agreement. Would we advise our commercial clients to conduct their affairs in this manner? Probably not.

Given the way the world works, should franchisors always have written agreements with their suppliers? The answer is not that simple.

Risk Allocation

Stepping back for a moment, we must remember that contracts are in large part about risk allocation. When you buy a house, the law says “caveat emptor.” However, the risk placed on the purchaser can be reallocated to the seller by agreement. Risk can be reduced for the buyer by having the seller make representations as to the current status of certain matters, or by warranties or covenants that speak to liabilities that are discovered later.

Franchisors must recognize that the risks in purchasing goods or services may be extensive. In the case of goods, the franchisor may be buying these for itself, for its franchisees or for both. A franchisor might buy these from a third-party manufacturer and then resell them to the public through points of distribution it owns or controls, or through franchisees who in turn sell them to the public. If the supplier fails to deliver or delivers damaged product, liability to the franchisees and to the public may be created for the franchisor.

In the case of bad product, the customers may get sick. Where there is a no product available to sell, the franchisee might have to shut down. It is because of these and many other risks that arise in any commercial setting that franchisors should document their understandings and relationships with their suppliers. If they do not, and a dispute arises, and the parties are not able to resolve it between themselves, a court would have to look at the common law (or applicable statutes) to determine the winner and loser in the dispute. By contract, the parties can achieve a clearer allocation of who bears the risk in the transaction at hand.

There are two reasons to support the documentation of supplier relationships and one reason not to have documentation. One reason for having a contract is that a written agreement spells out the risks. The common law addresses such issues as: Is there an enforceable contract? Who bears the risk of loss resulting from damaged products? What constitutes acceptance of goods delivered? Who has the responsibility for making sure the goods are shipped in a timely fashion? And who must pay the shipping costs?

Indemnity and Insurance

The second reason for a written contract is based on indemnity and insurance provisions. Indemnity provisions are clear risk shifters. They typically provide that the franchisor will be indemnified by the supplier for any loss resulting from the supplier's breach of the supply contract. In this circumstance, indemnity often does not provide the franchisor with any more relief than a claim for breach of contract. But an indemnity in these circumstances is important because it can, if appropriately drafted, result in the award of attorney's fees to the franchisor, which is not a likely result in the United States absent a contractual provision.

Indemnities are perhaps more helpful to a franchisor when there is a third-party claimant ' the customer who becomes ill, for example. If the supplier has shipped tainted product, and the franchisor and, in all likelihood the franchisee, are sued, the indemnification makes the supplier the ultimate risk-taker, regardless of what the common law would say about the subject. Through an indemnification provision, the direct or indirect beneficiaries of the contract'be they the franchisor or its franchisees, or both ' can more specifically identify the risk, and specify what procedures will be followed in resolving the claim and who should be liable to the third party. The indemnification provision might resolve: Who will defend against the claim? Who chooses counsel? And on what terms can the claim be settled?

Insurance provisions are similar to indemnification provisions because they also are risk shifters, but they provide even further security that ultimately the loss will not fall on the franchisor. The significant point to note here is that insurance provides a deep pocket. A small supplier might not be able to pay damages if a major claim ' such as a claim arising out of a foodborne illness ' is brought against the franchisor. With insurance coverage provided by the supplier, the franchisor's fear that there will not be a pot of money out there to settle with the claimant or cover the litigation costs of defending against any claim is reduced. Note that the franchisor and franchisees may also have insurance to cover these situations.

Why Not Have a Contract?

The one reason not to insist upon a written agreement is leverage. For a big franchisor dealing with a small supplier with numerous competitors, the leverage is all with the franchisor; thus the franchisor is likely to dictate the terms. Conversely, for a small franchisor dealing with a major supplier or distributor, it is not likely that the franchisor will be controlling the negotiations. In fact, the supplier is likely to have its standard terms and conditions.

And where the facts fall in between, it is difficult to predict what the ultimate outcome might be if a written agreement is requested by the franchisor. It is likely that both sides will have experience in these arrangements and thus the negotiations might go smoothly ' but then, again, they may not.

Conclusion

So, what is the best approach? There is no simple answer. However, the certainty a contract provides will tell each party where it stands if things go wrong.

Rupert M. Barkoff is a partner at Kilpatrick Townsend & Stockton, where he chairs the firm's franchise team; he is resident in the Atlanta office. This article also appeared in the New York Law Journal, an ALM sister publication of this newsletter.

It appears that many franchisors have no formal long-term or, for that matter, short-term agreements with their suppliers. Is this an unhealthy move by these franchisors?

The most important relationship a franchisor can have is with its franchisees; the second most important relationship is with its suppliers. Well-drafted franchise agreements typically state that the franchisor has developed a system that includes a network of suppliers whose products or services are one of the key ingredients for making the franchise engine run.

All of us who have taken Contracts in law school know that you do not need a signed document to have an enforceable agreement, except in limited circumstances. When a neighborhood youth stops by and asks if he can cut your grass, you usually ask, “How much?” and perhaps, “When can you do it?” or “How often?” Once these terms are agreed to, a contract exists. You do not whip out a five-page document setting forth detailed provisions talking about what law governs, what will be the standard of care the kid will use, confirm that he has insurance, or ask him to make various representations about his legal status. At most, you might have a one-page document saying what he will do, when he will do it, and how much he will charge.

If contractual relationships were always evidenced by a document like our typical franchise agreements, commerce would probably come to a standstill. A certain level of trust is the key in these situations, and most of us believe that if the trust level is established, there is no need to be formalistic. Of course, many law firms operate with no written partnership agreement. Would we advise our commercial clients to conduct their affairs in this manner? Probably not.

Given the way the world works, should franchisors always have written agreements with their suppliers? The answer is not that simple.

Risk Allocation

Stepping back for a moment, we must remember that contracts are in large part about risk allocation. When you buy a house, the law says “caveat emptor.” However, the risk placed on the purchaser can be reallocated to the seller by agreement. Risk can be reduced for the buyer by having the seller make representations as to the current status of certain matters, or by warranties or covenants that speak to liabilities that are discovered later.

Franchisors must recognize that the risks in purchasing goods or services may be extensive. In the case of goods, the franchisor may be buying these for itself, for its franchisees or for both. A franchisor might buy these from a third-party manufacturer and then resell them to the public through points of distribution it owns or controls, or through franchisees who in turn sell them to the public. If the supplier fails to deliver or delivers damaged product, liability to the franchisees and to the public may be created for the franchisor.

In the case of bad product, the customers may get sick. Where there is a no product available to sell, the franchisee might have to shut down. It is because of these and many other risks that arise in any commercial setting that franchisors should document their understandings and relationships with their suppliers. If they do not, and a dispute arises, and the parties are not able to resolve it between themselves, a court would have to look at the common law (or applicable statutes) to determine the winner and loser in the dispute. By contract, the parties can achieve a clearer allocation of who bears the risk in the transaction at hand.

There are two reasons to support the documentation of supplier relationships and one reason not to have documentation. One reason for having a contract is that a written agreement spells out the risks. The common law addresses such issues as: Is there an enforceable contract? Who bears the risk of loss resulting from damaged products? What constitutes acceptance of goods delivered? Who has the responsibility for making sure the goods are shipped in a timely fashion? And who must pay the shipping costs?

Indemnity and Insurance

The second reason for a written contract is based on indemnity and insurance provisions. Indemnity provisions are clear risk shifters. They typically provide that the franchisor will be indemnified by the supplier for any loss resulting from the supplier's breach of the supply contract. In this circumstance, indemnity often does not provide the franchisor with any more relief than a claim for breach of contract. But an indemnity in these circumstances is important because it can, if appropriately drafted, result in the award of attorney's fees to the franchisor, which is not a likely result in the United States absent a contractual provision.

Indemnities are perhaps more helpful to a franchisor when there is a third-party claimant ' the customer who becomes ill, for example. If the supplier has shipped tainted product, and the franchisor and, in all likelihood the franchisee, are sued, the indemnification makes the supplier the ultimate risk-taker, regardless of what the common law would say about the subject. Through an indemnification provision, the direct or indirect beneficiaries of the contract'be they the franchisor or its franchisees, or both ' can more specifically identify the risk, and specify what procedures will be followed in resolving the claim and who should be liable to the third party. The indemnification provision might resolve: Who will defend against the claim? Who chooses counsel? And on what terms can the claim be settled?

Insurance provisions are similar to indemnification provisions because they also are risk shifters, but they provide even further security that ultimately the loss will not fall on the franchisor. The significant point to note here is that insurance provides a deep pocket. A small supplier might not be able to pay damages if a major claim ' such as a claim arising out of a foodborne illness ' is brought against the franchisor. With insurance coverage provided by the supplier, the franchisor's fear that there will not be a pot of money out there to settle with the claimant or cover the litigation costs of defending against any claim is reduced. Note that the franchisor and franchisees may also have insurance to cover these situations.

Why Not Have a Contract?

The one reason not to insist upon a written agreement is leverage. For a big franchisor dealing with a small supplier with numerous competitors, the leverage is all with the franchisor; thus the franchisor is likely to dictate the terms. Conversely, for a small franchisor dealing with a major supplier or distributor, it is not likely that the franchisor will be controlling the negotiations. In fact, the supplier is likely to have its standard terms and conditions.

And where the facts fall in between, it is difficult to predict what the ultimate outcome might be if a written agreement is requested by the franchisor. It is likely that both sides will have experience in these arrangements and thus the negotiations might go smoothly ' but then, again, they may not.

Conclusion

So, what is the best approach? There is no simple answer. However, the certainty a contract provides will tell each party where it stands if things go wrong.

Rupert M. Barkoff is a partner at Kilpatrick Townsend & Stockton, where he chairs the firm's franchise team; he is resident in the Atlanta office. This article also appeared in the New York Law Journal, an ALM sister publication of this newsletter.