Franchisors Setting Prices – Tinkering with the rules of business?

By Michael Seid, Managing Director, MSA Worldwide

“Law logic – an artificial system of reasoning, exclusively used in courts of justice, but good for nothing anywhere else.” – John Quincy Adams

In a sea of obligations to consistently operate their businesses to their franchisor’s brand standards, there has always been an island of independence that franchisees could point to – the price they charge to customers.

As a result of the Sherman Act in 1890, Congress and then the Supreme Court in Dr. Miles Medical Company v. John D. Park & Sons Co (1911) and United States v. Colgate & Co (1919), the federal government thought it was protecting the general public by controlling businesses and eliminating their ability to establish prices in their downstream distribution channel. These laws against price fixing have been around so long that they have become part of our business DNA.

As businesspeople, we have become comfortable with only being able to establish Manufacturer’s Suggested Retail Prices and including “At Participating Locations” in our advertising. We did not speak about pricing and when we did, only under the strict instructions of our lawyers. After all, based on Sherman, Dr. Miles’ and Colgate’s Retail Price Maintenance plans (RPM) were considered inherently illegal. Then came State Oil Co. v. Khan (1997), followed a short decade later by Leegin Creative Leather Products, Inc. v. PSKS, Inc. (2007), and the Supreme Court pivoted and said maybe setting prices is not bad all the time.

Given this new power, will franchisors begin to set resale prices for their franchisees? Will “At Participating Locations” go the way of Air America and Lehman Bros? Probably not soon, although the 2010 National Franchisee Association v. Burger King Corporation decision has certainly had an impact, as this article explores.

For nearly a century, RPM agreements (agreements between a manufacturer and its resellers on resale pricing) were found to be “per se” (inherently or automatically) illegal. Congress and the courts felt that price controls limited competition and were therefore not in the public’s best interest. Khan and then Leegin changed that by allowing companies to set maximum and minimum prices that could be charged to the public by their downstream participants. Now, however, instead of businesses knowing that establishing pricing was always illegal, the Supreme Court made it possible – so long as the policy met the “rule of reason.”

Through their rulings the Justices finally came to grips with three very basic business principles: (1) Companies should have the right to define their own method of downstream distribution; (2) Retail Price Maintenance can be both anti competitive and pro competitive; and (3) The legality of an RPM strategy should be judged based on each company’s downstream strategy and the particular circumstances of their business.

Moving from “per se” to a “rule of reason” standard has been around since Colgate, but its practical implication is that it substitutes a definitive position with one that is a highly subjective and requires a fact-based review to determine whether doing so is in the public’s interest. Even though there are precedents to look at for guidance, the rule of reason is fraught with the potential for continuing litigation, and is the type of doctrine designed to fatten litigators’ checkbooks. John Quincy Adams apparently had it right.

So why haven’t franchisors exercised this new pricing “power”? There are a host of reasons in addition to the threat of potential litigation. There are the baby Sherman Acts at the state level, modeled after the Sherman Act, that need to be considered. Congress may revisit Sherman, Miles, Colgate, Khan, and Leegin in the near future and try to modify or undo the Court’s decisions. Existing franchise agreements may not give franchisors the right to establish prices. There is a well-founded fear that doing so risks disrupting franchise relations. There is great complexity in establishing pricing in multi-brand segmentation environments where the offerings may overlap or compete (think hospitality brands). And, there are the simplest of questions – is establishing prices for franchisees to charge even a good business strategy? Does the franchisor have the knowledge and capability to do so? And, what is the beneficial impact on the bottom line, short term and long term, for the franchisee and the franchisor if it does?

In 2009, Burger King became embroiled in a “price setting” squabble with its National Franchisee Association over its decision to require franchisees to sell its double cheeseburger for no more than $1.00. Burger King relied upon its franchise agreements and Khan in setting its promotional pricing policy.

Burger King claimed that the issue of maximum pricing had previously been litigated, and that the court found in that case that they had the right to require adherence to a value menu with maximum prices by its franchisees. The NFA, of course, disputed that assertion. According to the facts set out by Burger King in its filings, they had not established a fixed price for the promotion, but instead set the maximum price at $1.00. The NFA claimed that Burger King had set the price at $1.00 and by doing so had caused its members to lose money on the individual transaction.

But, under the “rule of reason,” does maximum pricing need to ensure that an individual transaction needs to be profitable and, if it does, how should that profit measurement be determined? If profits are essential under the rule of reason, do you measure costs at the gross profit level, or do you include all costs associated with operating the business? If the latter, how do you deal with franchisees that have high salaries, high debt, high rents, and which might lose money even if the product was sold at a non-discounted price? There is after all a market ceiling that can be charged on any product, and profitability of a business is never assured.

Further complicating the “rule of reason” analysis are the very nature of promotions and the basics of marketing. Promotions are generally geared to accomplish one of two things – to increase traffic by introducing, or by re-introducing, your brand to customers. Promotional strategies are also tied to an assumption that when customers buy the discounted item, they may also buy full-priced companion items, and also that the merchant will have the opportunity to sell non-promotional items to others who accompany the promotional buyer to the business. These are basic strategies used in marketing campaigns, and make the simple test of individual product profitability less than a compelling measure.

Equally, through its test in company-owned locations, its marketing studies, and the actual performance of the campaign, if Burger King could show the benefits of its approach to the general public and to its system (after all, the promotional strategy may yet prove to stabilize or increase traffic, sales, and profit performance overall), under a “rule of reason” analysis that measures total impact rather than individual product profits, most lawyers I spoke to expected Burger King to prevail.

And finally, there was an underlying question of whether franchising should be bound by different rules of marketing than vertically integrated companies (company-owned enterprises like Starbucks, Sears and Wall-Mart), who routinely are able to present a consistent promotional message to their customers that has always included the ability to set promotional pricing. The argument against this has always been centered on the franchisees’ ownership and investment in their business, but would that argument be sufficient for the courts to treat franchising differently than its non-franchised competitors?

Would a Burger King win create an opportunity that other franchisors would choose to follow? It could if the case could be made that the benefit of a clear consumer Brand Promise requires consistency regardless of who owns the ultimate end of the distribution chain, and regardless of the profit on the individual item included in the promotion. After all, the four Ps of marketing are Product, Place, Promotion, and also Price. Whether the basic business strategy of consistency includes a franchisor’s ability to control its promotional message, including a maximum price, is the issue that the Burger King litigation decided.

Burger King did win – the court dismissed all counts. Does that mean that franchisors will routinely set prices for non-promotional offers, or will they instead limit themselves to promotional offers only?

As it relates to pricing in general, the likely answer is no. Franchising is a mature business strategy based on the premise that franchisees are individual businesspeople who maximize the potential for success of their business, because they take the beneficial aspects of the franchisor’s system and execute superbly based on their own intelligent management and their understanding of their local markets. If for no other reason than this would be confrontational, I have not seen a wholesale move by franchisors to set everyday pricing for their franchisees.

If, however, franchisors are able to set maximum pricing under Khan, will that result in franchisors taking the next step and requiring their franchisees to adhere to minimum prices a la Leegin? I doubt that will occur either. With maximum pricing, the franchisor can at least easily argue that the maximum price limit is pro-consumer because it keeps prices low. Even if the case could be made under the “rule of reason” that minimum pricing protects a brand because allowing low prices could result in the devaluation of the brand as a whole, franchisors would surely have to explain to a judge why they are trying to raise prices that consumers must pay for their product.

But for promotional offers, my guess is that other franchisors will adopt a similar approach over time. We already have significant promotional consistency, even with “At Participating Locations,” as evidenced by a multitude of promotional campaigns such as Subway’s $5 foot long promotion, value and combination meal offers, and the affinity promotions used in the hospitality industry. But franchisors will first need to understand their rights under the baby Sherman Acts, assess the impact and potential disruption to franchisee relations, and assess the probability of litigation if a prescribed price is included in a marketing campaign. They will also have to go through the costs of determining, in advance, if the business case under the inexact science of an ill-defined legal theory such as the “rule of reason” can be made.

Khan and Leegin did not give franchisors the “per se” right to set pricing; it only cracked open the door a bit. The court’s ruling in Burger King provided additional guidance to clarify the issue for franchisors and franchisees – it found that the plaintiffs had not sufficiently pled that Burger King acted in bad faith, or had breached an implied duty of good faith. The court also asserted that Burger King’s franchise agreements unambiguously permitted Burger King to set promotional prices.

Even with the clarity from the Burger King decisions, franchisors will likely continue to manage their systems and their promotions within the traditional boundaries we have been used to for some time. Maybe other brave souls will test the limits, resulting in other lawsuits. But, with a clear and transferable BK win, as with all new tools, the promotional landscape, as we know it in franchising, is certainly going to change.

To read the National Franchisee Association v. Burger King Corporation court filing, visit https://law.justia.com/cases/federal/district-courts/florida/flsdce/1:2009cv23435/347014/127/.