Working Paper No. 07-03:
The Effect of Contract Regulation: The Case of Franchising

Author(s):

Jonathan Klick, Bruce Kobayashi, Larry Ribstein

Date Posted: 2007

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Abstract:

States and the federal government have enacted laws intended to police franchisors' use of termination provisions in franchise contracts to opportunistically take over profitable establishments. This regulation may, however, reduce the total number of chain outlets because franchising is a valuable form of contracting and termination rights allow franchisors to police franchisee free-riding on the franchised trademark. On the other hand, no such effect is implied if the regulation reduces franchisors' extra gains from skimming profitable franchises. We exploit two new sources of data to provide new empirical evidence on the effects of franchise regulation. Panel data on fast food establishments extracted from uniform franchise offering circulars show that laws restricting franchisor termination rights lead to a reduction in franchising, and this reduction is not offset by the concomitant increase in franchisor-operated establishments. This article also examines how Coasian bargaining between the franchisor and franchisee can mitigate the effect of regulation. In particular, regulation may be apparently important but actually inconsequential because affected parties can easily waive the regulation or avoid it through contractual choice-of-law and choice-of-forum clauses. To examine this, we use state employment data to more broadly examine the effects of franchise regulation. We find that employment in franchise industries is significantly reduced when states enact restrictions on franchisor termination rights and the effect is larger when states limit the ability to contract around these restrictions.