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Senator: Weak regulations leave franchisees out in the cold

U.S. Sen. Catherine Cortez Masto calls for tougher oversight of franchises, citing problems at numerous companies including Burgerim, Subway and Quiznos.
Franchise problems
Photo by Jon Springer

Unfair and deceptive franchise offerings push countless franchisees into bankruptcy and cost taxpayers tens of millions of dollars every year in failed loans, according to a report on Tuesday from a U.S. senator calling for greater Congressional and regulatory oversight of franchise businesses.

The extensive report from U.S. Sen. Catherine Cortez Masto, D-Nev., highlights problems at several franchised restaurant brands, including Burgerim, Subway, Dickey’s and Quiznos, and cites several pieces first published by Restaurant Business highlighting some of these problems.

It’s not just franchisees that are left holding the bag when the restaurants fail. Taxpayers do, too. The report faults the U.S. Small Business Administration for frequently approving loans to “at-risk” franchises. By doing so, the report says, the government “inadvertently condones” franchises’ practices.

“When franchise corporations engage in deceptive practices or enforce unfair rules, such as demanding payments for inadequate training or requiring unfair contracts, while also using government resources and requirements to appear as a regulated investment or aid in financing, the government inadvertently condones franchises’ misrepresentation,” the report says.

Franchise failure is more common than it appears. Between 2010 and 2018, franchise owners opened 353,685 locations, yet the total number of franchises only grew by 78,878—meaning 274,807 franchised outlets closed during that timeframe. 

The report cites data from the International Franchise Association estimating that 8.67 million people work for some 785,316 franchises in 2020.

“Franchises are sold as a proven and profitable business model,” the report said. “But when the actual numbers are revealed, what looks like growth may just be a lot of openings without consideration of store closures.”

The report is the latest sign that franchises could be in for heavier regulation under a Biden Administration and with a Democrat-controlled Congress.

Franchising is a decades-old business model in which franchisors sell the right to operate a brand to investors, or franchisees, who agree to take on the financial risk to open and operate new locations. Many franchises prove to be good investments and the report cites Dunkin’ and Popeyes among the franchises that worked for their franchisees.

Yet the business model is poorly regulated, and there have been a number of examples of serious problems that led to hundreds of even thousands of franchisees to lose their investment or more.

That includes Burgerim, whose problems were first revealed in an extensive Restaurant Business investigation last year. The company allegedly took $57 million in franchise fees from 1,500 investors, according to investigators in California, before its founder left the country. The vast majority of those were never able to get a restaurant open and lost $50,000 in franchise fees—though many of those who did get open closed.

Quiznos, meanwhile, largely collapsed over the past decade, as more than 4,000 franchisees shut their doors and walked away from a business that was losing money. In that system, high food costs from the company’s franchisor-owned supply chain left many of its franchisees unable to make a profit.

The report cites several other brands, including Subway and Dickey’s BBQ, in addition to a number of non-restaurant franchises such as 7-Eleven.

“Franchise businesses sound ideal for an eager entrepreneur—you can benefit from an experienced and successful brand and build your own thriving business,” Cortez Masto said in a statement. “However, hardworking Americans have poured their life savings into franchise businesses only to lose everything at the hands of deceptive and misleading corporations and lenders.”

The report cites four areas where franchise complaints are most problematic: Unfair and deceptive contracts that give nearly all control to the franchise corporation; false information and lack of transparency in financial disclosure documents; kickbacks from vendors that drive up operators’ food prices and “excessive fees with no actual benefit.”

When franchisees of such brands struggle, they often end up failing to pay back loans backed by the U.S. Small Business Administration. Such loans come with personal guarantees—meaning the operator could lose their homes—while costing taxpayers millions. In 2019, the SBA guaranteed $3.7 billion in loans to franchises through its 7(a) program and another $851 million through its 504 program. That percentage has been growing in recent years.

When a lot of franchisees fail, the government ends up paying. The report notes that 20% of 269 loans to Dickey’s operators were charged off between 2000 and 2020, while 30% of 2,133 loans made to Quiznos franchisees ended up failing. Yet the SBA has received “decades of warnings” of approvals of loans made to struggling franchise brands. “SBA continued to guarantee loans to high-risk franchises and industries without monitoring risks and, where necessary, implementing controls to mitigate those risks,” the SBA’s Office of Inspector General wrote last year.

The SBA guaranteed $38 million in loans to 119 Burgerim franchisees. The report says that more than a quarter of Dickey’s loans are “not current.”

Cortez Masto’s report calls on both Congress and regulators to change these practices. She is calling for increased oversight from the U.S. Federal Trade Commission—which regulates franchises—as well as the SBA. She is asking the FTC to change the franchise rule to require franchises provide financial information to franchisees.

She is also calling on Congress to increase funding for the FTC to step up enforcement of franchise rules and also let franchisees sue franchisors for violations of franchise regulations.

“The COVID-19 pandemic has also increased the appeal of franchising for people looking for new opportunities after losing their job or business,” Cortez Masto said. “I’m concerned that some entrepreneurs may decide to purchase a franchise at a discount without being aware of the risks they are taking.”

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