The Legal Implications of Reputation Risk Management for Franchisors

• Author: Tom Burns
• Position: Senior Lecturer in Law University of Aberdeen
• Pages: 231-240

Key words:tort, vicarious liability, legal risk, reputation risk management, franchisor, franchisee

Page 231

1. Introduction

The main purpose of this article is to examine a difficult problem faced by franchisors. If the franchisor attempts use the techniques of reputation risk management to protect its corporate brand (which is usually its most valuable asset), the franchisor may inadvertently increase their exposure to third party tort claims. This is because of the unusual structure of the franchised business and the problems of implementing a risk management system within this structure.

Although the franchised business has the appearance of a single business entity because it operates a chain of outlets under the same name and delivers the same, standardised, quality-assured, product and/or service, it is not one. Many of the franchised outlets are, in fact, small to medium-sized independent businesses linked together by contract with the franchisor. These businesses derive their corporate identity and working methods from intellectual property rights that are licensed to them by the franchisor. The franchisor therefore, does not have the normal, "command and control" power over its franchisees, which the management in many conventional organisations have over their employees. Therefore, the implementation and enforcement of a reputation risk management system to protect the franchisor's corporate brand is not as straightforward as it might be for companies with normal management structures. In addition, the franchisees have a degree of autonomy over how the run their businesses and they may resist the imposition of potentially costly risk management procedures by the franchisor. If the franchisor imposes a reputation risk management system on the franchisees, there may be problems over compliance and enforcement. The imposition of such a system may at the same time increase the scope of the franchisor's tortious liability.

Normally, franchisors are in a favourable position in relation to tort claims. In British law, there is a fairly clear legal boundary between the franchisor and the franchisee because they contract at arms-length to operate the franchise. This means that if a third party suffers harm as a result of the franchisee's negligence the injured person would have a claim against the franchisee as an independent contractor. The franchisor would not normally be involved. However, the franchisor's protection from such tort claims could be undermined if the franchisor introduces a reputation risk management system. Reputation risk management would require the franchisor to exercise greater influence and control over the network than has been the case in the past. One important consequence of this could be to strengthen the claims of third parties against the franchisor under the principles of vicarious liability. This could produce a paradoxical result for the franchisor. In its attempts to control the business risk of damage to its reputation, the franchisor may be inadvertently increasing the scope of its legal risk.

This article shall examine this problem. It shall be suggested in the course of the analysis that a form of reputation risk management should be adopted by franchisors, even where the tort risk remains. This is because the franchisor has much to gain from using a modern and efficient method of protecting the corporate brand if appropriate legal and organisational arrangements can be made to further this goal.

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2. The value and the vulnerability of franchised brands

Most franchised businesses are built upon the concept of the brand ¹ and the value of the brand to these businesses can be significant proportion of the total value of the company² .Indeed, in some cases the value of the brand may be the single most valuable company asset. In the case of the very large franchised businesses the brand value can be worth billions of dollars. In a recent survey of the top 100 brands in the world, the brand value of McDonald's was approximately $26 billion, the KFC (Kentucky Fried Chicken) brand and the Pizza Hut brand were worth approximately $5 billion, the Hertz car rental franchise brand was worth approximately $3.5 billion, and the Starbucks coffee shop franchise was worth $2.5 billion³. The world's top brand, as listed by the Interbrand Corporation, the brand consultancy, is a franchised business. It is Coca-Cola, which, like its soft drink rival Pepsi, franchises it bottling operations (Felstead, 1993: 38). According to Interbrand, Coca-Cola's brand value was $67.5 billion, while Pepsi's brand value was worth $12.4 billion.

Although many of the largest franchised brands are immensely valuable, they can also be surprisingly vulnerable. In the twenty-first century it is becoming harder to protect the brands from damaging publicity. For example, if a franchised business were to make a mistake that harmed human health or safety this would be quickly disseminated over the Internet and the 24-hour news channels leaving the business with very little time to investigate the cause of the accident or to respond to its critics. Under these conditions, the corporate reputation may suffer and sales may decline without the full facts of the case being properly investigated. When so much of the value of a franchised business is tied up in an intangible asset that could be affected by bad publicity, franchisors have an incentive to seek new ways to protect their brands. But this is not a straightforward matter because of the peculiar legal structure of the franchised business (examined below).

2. 1 The Coke Products Case

Franchised brands can be damaged by the acts and omissions of the franchisor, but also potentially by the acts or omissions of thousands of local franchisees. It is true that in the case of the franchisees, the franchisors are able to set the standards of performance for the brand, but these standards have to be implemented properly by the franchisees to be effective. Normally most franchisees will run their businesses according to the standards set for the brand (for example, in terms of fast and friendly service, the quality of the product, clean premises, good hygiene, etc). However, because franchisees (as independent business people who have put capital into their enterprises) tend not to be monitored as closely as employee-managers running branch operations in a typical, hierarchical, unified corporate structure, there may be a greater chance for things to go wrong at the local level that could have a negative impact on the brand.⁴ Furthermore, franchisors are reluctant to become too closely associated with the day-to-day operations of the franchisees' businesses because they fear the legal threat of being held vicariously liable for the defaults of their franchisees (Abell, 1989:90): So the risk to the reputation of the franchised brand can be significant.

Indeed, there have been cases where the acts or omissions of a local franchisee in one country have had a wider negative impact on the brand. For example, in 1999, the Coke brand was damaged in an incident involving Page 233 120 people in Belgium and 80 people in France who felt ill after drinking Coke. This temporary illness was attributed to the production operations of the Belgian and French franchisees and was not caused by an act of the brand-owning franchisor, Coca-Cola of Atlanta, Georgia, USA.

On investigation of this incident, it was discovered that the contamination of the Belgian-produced drinks was caused by some defective carbon dioxide being used in a small supply of bottles in the plant of the franchisee in Antwerp. Meanwhile, in France the source of the contamination arose from a fungicide that was used by the franchisee in Dunkirk to spay on wooden pallets. Yet because Coca-Cola management did not intervene either early enough or decisively enough during these crises to allay public concerns, the national media in France and Belgium could justifiably inflame public outrage in these countries. This public outrage led to an unofficial boycott of all Coke-branded drinks and ultimately to a public demand for a total product recall.

The Governments of France and Belgium succumbed to this public pressure (even when it became clear that there was no threat to public health) and they ordered a total product recall. This recall cost Coca-Cola $103 million. Coke's profits subsequently dropped by 31% in these countries and the franchisor had to spend substantial sums in a promotion campaign to restore public confidence in the product (Larkin, 2003). Risk management experts have argued that if a crisis management system (as described below) had been in place in Coca Cola as part of a reputation risk management scheme, the impact on the franchisor's brand could have been much less. However, damaging bad publicity is not only generated by unfortunate incidents like those occurring in Belgium and France; it is sometimes created by campaigning groups as a way of bringing pressure to bear on franchisors to change their business practices and to galvanise the politicians into making laws to curb the alleged bad practices of...