March/ April/ May 2014 Big Whopper Economics

Want fast-food workers to get a raise? Let local restaurant owners form a union to fight their corporate masters.

By Josh Freedman

In August, Larry and Kathryn Baerns and their son, Christopher, filed court papers charging that the two new Steak ’n Shake restaurants they had just opened in the Denver area were under siege. Suppliers refused to make deliveries. Their computer system went dark. Desperate, they bought old-school cash registers and took orders by hand while seeking a restraining order against the forces trying to shut them down.

The Baernses were up against Steak ’n Shake’s own national corporate offices, from whom they had bought their two Steak ’n Shake franchises. The franchisor was taking actions designed to “cut them off at the knees,” the Baernses alleged, over a dispute about whether their two restaurants had to offer a $4 value menu.

The Baernses claimed that they been misled about the profitability of Steak ’n Shake franchises, and that their business would fail if they sold items at the promotional price. In the middle of the legal battle, the two sides even turned to espionage: the chain sent an undercover operative into the franchisee’s stores to try to prove that they were not selling at approved prices. In response, the Baernses sent their own undercover agents to St. Louis to investigate prices at other Steak ’n Shake outlets.

Two weeks later, the Baernses lost their restaurants—and, with them, their investment. A court found them in breach of their contract with Steak ’n Shake. The restaurants closed in the first week of September, leaving behind only handwritten notes that read “Sorry closed.”

The Baernses’ story might seem distinct from the mounting strikes and protests over low wages in the fast-food industry that have received so much national attention in recent months. But there is a strong and revealing connection. As the Baernses’ experience shows, the owners of fast-food franchises often have very little power over how their businesses are run. They must pay the prices franchisors demand for supplies and equipment, and usually have no control over the prices they charge customers in turn.

This means that they also have little control over how much they can afford to pay their workers. While being a franchisor is often highly lucrative, being a franchisee often means living on very small, or no, margins. Biglari Holdings Inc., for example, which owns the Steak ’n Shake company, last year paid its chairman and CEO, Sardar Biglari, just shy of $11 million in total compensation. But due to adverse court decisions, changing patterns of corporate ownership, and other factors, many franchisees, like the Bearnses, lose money or barely get by. Until the growing imbalance of power between franchisors and franchisees is corrected, there is little chance that wages for fast-food workers can be substantially improved. For workers to get a raise, we need to reform the franchised fast-food industry from top to bottom.

Most fast-food restaurants are not owned by the company with its logo on display. The signs might say McDonald’s or Burger King or Steak ’n Shake, but the restaurant itself is typically owned by local businesspeople under a franchise arrangement. These franchisees pay for the use of the franchisor’s brand, starting with an upfront fee per location, which can range from $15,000 for a Subway sandwich shop to $50,000 if you want to put Burger King’s name on your restaurant. Franchisees also pay for the entire cost of constructing and equipping the restaurant, which in the case of a new McDonald’s requires an investment of $1 million to $2 million. Franchisees then pay a fixed percentage of their revenues every month in royalty and advertising fees, while also often having to buy most of their supplies through the franchisor.

Done correctly, franchising can work well for everyone. Franchisees, many of whom are first-time entrepreneurs, benefit from the tested products and strategies of a large chain. They can also realize some economies of scale by purchasing supplies in bulk and spreading the costs of shared expenses, such as advertising. At the same time, as small business owners, individual franchisees are more responsive to their local communities than are large, distant corporations. Thomas Dicke, author of Franchising in America: The Development of a Business Method, 1840-1960, explains this confluence. Franchising in the mid-twentieth century, he writes, created “a system that combined the economic efficiency and security of big business with the independence of small business.”

Some franchise relationships today still reflect this ideal. Popeyes Louisiana Kitchen—formerly Popeyes Chicken & Biscuits—has been praised for working closely with individual owners to improve profitability, for example. Yet increasingly this relationship is fraught with inequity and even outright abuse. Franchisors often write very imbalanced contracts that squeeze individual franchisees at every turn, including charging high prices for supplies. Today, many franchisors earn high profits even as many of their franchisees are struggling or going out of business.

One of the major reasons such practices have spread is a big shift in how the courts interpret antitrust and contract law. For franchisees, 1997 marked a turning point on two fronts. In Queen City Pizza v. Domino’s Pizza, the owners of Queen City Pizza argued that they shouldn’t be bound by the language in their franchise agreement that required them to buy their pizza supplies exclusively from Domino’s. They argued that this language constituted a “tying arrangement,” and that the courts had long prevented franchisors from exercising such power over franchisees under antitrust laws. The 3rd Circuit Court of Appeals rejected this claim, however. Writing in the Franchise Law Journal, lawyer Andrew Selden notes that the Queen City Pizza decision “for all practical purposes sounded the death knell for tying claims in business-format franchises.” The decision left franchisors free to coerce franchisees into buying just about anything at any price so long as it was specified in their contract.

The same year, another ruling further limited the power of franchisees. The U.S. Supreme Court’s decision in State Oil Company v. Khan broke precedence by allowing franchisors to put ceilings on what franchisees could charge for specified items. This decision was affirmed in 2009 when Burger King franchisees sued the company for forcing them to be part of an unprofitable promotion. The franchisees argued that it was unfair to require them to sell double cheeseburgers, which cost more than $1 to make, for just $1. The courts ruled in favor of Burger King’s right to set maximum prices. Other court decisions have also limited the ability of franchisees to make their own decisions about cutting prices, giving franchisors near-total control over menu prices.

One might suppose that market forces would automatically correct any imbalance of power in franchising. It seems logical that franchisors would have an interest in seeing their franchisees do as well as possible. But that’s not necessarily true. The problem is that in a relationship of unequal power, reliance on contracts and the market has only made the imbalance of power between franchisors and franchisees worse. Bad franchisors have not gone out of business.

Josh Freedman is a policy analyst in the Economic Growth Program at the New America Foundation, where he writes and researches about economic and social policy in the United States.


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