The organization of relational contracts: The allocation of rights in franchising

Abstract Franchising contracts are designed to bring together two kinds of entrepreneurs, the franchiser and the franchisee, and to maintain their relationship in the long run. In contrast to standard exchange contracts in law, which are specifically designed to bring about the completion of an exchange efficiently, franchise contracts are designed to make it possible for the entrepreneurs to initiate, to maintain, and to eventually terminate their relationship without dispute. The research reported in this article is an attempt to see how the dual purpose of franchising contracts are achieved. The article first describes the internal organization of franchise contracts (what we called the micro-contractual aspects) and how different kinds of rights and obligations are allocated to accomplish these multiple ends. The second part of the article provides an empirical examination of 30 franchise contracts to see if the internal organization of the contracts influence both the expansion of the franchise operations through new franchises and the amount of dispute between the two sides of franchise contracts. Every franchise contract includes a set of provisions that define the commencement, termination, and ongoing operations of franchise relations. The internal organization of franchise contracts specifies what kinds of rights and obligations are distributed to the parties and the nature of this allocation within each domain of provisions. We argue that the commencement and termination aspects of franchise contracts are usually written in order to make the relationship between the parties clear, and the contingencies specific. In these provisions, the contract is written in discrete terms in which each party's rights and duties are specifically delineated. The contractual provisions dealing with the ongoing operations and the conduct of the parties, on the other hand, cannot be made specific because it is impossible to define all the future contingencies and possible business opportunities. Under these conditions, the contract is usually written in relational terms in which each party's rights and obligations are defined in terms of powers and liabilities towards each other rather than in terms of specific duties and rights. One critical consequence of writing contracts that include powers and liabilities, however, is that it may lead to disputes and undesirable conflict that are detrimental to the success of the franchise. In order to deal with these conflicts among the parties, the contract needs to specify conflict resolution mechanisms that are an integral part of franchise contracts. These general arguments are tested with the use of 30 randomly selected franchise contracts from a diverse set of businesses. Our results show that, indeed, different parts of franchise contracts allocate rights and obligations differently and the more relational a contract becomes the more likely that it would include various dispute resolution mechanisms. We also found that the success of a franchise contract, which is measured by the number of legal disputes it generates and the growth of franchised units, is influenced by the existence of relational provisions and the explicit dispute resolution mechanisms included in the contract. We recommend that franchise contracts should be written to make the commencement and termination aspect of the relationship as discrete as possible. The operations and conduct provisions of the contract, on the other hand, should be written in relational terms to give the parties the ability to respond to changes in business conditions without renegotiating the contract. It is usually the tendency on the part of franchise lawyers to write discrete contracts that attempt to specify every conceivable contingency to avoid future disputes. We argue here that a better strategy is to limit the discrete aspects of the contract to the commencement and termination clauses and to concentrate more on the dispute resolution mechanisms that can become an integral part of the contract. Thus, we also recommend that various dispute resolution mechanisms, such as franchisee associations, franchisee councils, and third party arbitration should be set up within the contract to address the possible disputes early on rather than to wait for potentially very costly court proceedings for both parties.