Giorgio ZANARONE*

Contract Adaptation under Legal Constraints Revised, March 2011

Abstract

This paper studies how franchise networks adapt to temporal and local conditions in the shadow of the law. I show theoretically that, when the law protects franchisees from unequal treatment, changes to franchisees’ standards tend to be too rigid, both across stores and over time. To increase flexibility, franchisors may modify standards informally when possible while retaining the authority to modify them formally when franchisees are tempted to renege, due to free-riding. I also show that replacing the per se prohibition of unequal treatment with a rule-of-reason approach – whereby courts decide case by case whether unequal treatment harms franchisees – may backfire, as it makes informal agreements comparatively less attractive and hence harder to sustain. Finally, I show that, consistent with the model, car manufacturers in Italy use informal compensation to enforce standards selectively, and retain the authority to modify standards when intra-brand competition is strong, so dealers are tempted to free-ride.

Keywords: Adaptation, Authority, Discrimination, Franchising, Relational Contracts.

JEL codes: D23; L14; L22

* Colegio Universitario de Estudios Financieros; E-mail: gzanarone@cunef.edu. I am grateful to the managers of car manufacturers, Italian dealers and dealer associations for generously providing data and insights and to Andrea Imperiali for guiding me in the legal interpretation of contracts. I thank Benito Arruñada and Robert Gibbons for continuous advice and encouragement, and Lisa Bernstein, Rosa Ferrer, Ricard Gil, Henry Hansmann, Oliver Hart, Desmond Lo, Roberto Pardolesi, Giancarlo Spagnolo, Eric Van Damme, Eric Van den Steen, Birger Wernerfelt, Dean Williamson, Giuseppe Zanarone, seminar audiences at MIT, Pompeu Fabra, Tilburg and Bolzano, and, especially, Bentley MacLeod, for their comments and suggestions. This study received financial support from the European Commission, through the integrated project CIT3-513420, and by the Spanish Ministry of Science and Education, through grant ECO2008-01116.

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1. Introduction

Franchising has emerged in the last decades as one of the most successful forms of

business organization, attracting considerable attention from legal scholars, sociologists and

economists. Most economic theories have studied franchise contracts as static incentive

mechanisms1, and, through that lens, have shed light on the role of revenue sharing

(Mathewson and Winter (1985), Bhattacharyya and Lafontaine (1995)), vertical restraints

(Mathewson and Winter (1984), Klein and Murphy (1988), Klein (1995), Lafontaine and

Raynaud (2002)), and asset ownership (Lutz (1995)) in aligning the incentives of

franchisors and franchisees.2

In this paper I take a complementary view, and model franchise contracts as

mechanisms to promote change and adaptation in the shadow of the law. In doing so, I am

motivated by several observations. First, franchisees’ features such as product lines, outlet

design and advertising policies vary frequently over time, suggesting a need for temporal

adaptation of contract terms.3 Second, franchisees differ from each other in terms of

location, customer pool and demand and cost conditions, suggesting a parallel need for

local adaptation. Third, the structure of franchise contracts suggests that both temporal and

local adaptations are subject to constraints: on one hand, these contracts tend to be uniform

and rigid at any point in time, despite the evident differences among franchisees

(Lafontaine and Slade (1997)); on the other hand, they systematically allocate between

parties the rights to decide changes that are unforeseen ex ante (Hadfield (1990), Arruñada

et al. (2001)), suggesting that temporal adaptation may be driven by authority, rather than

smooth, “coasean” bargaining.

1 An exception is Gallini and Lutz (1992), who study the evolution of dual distribution and royalty rates over time. Unlike this paper, they do not study how franchise contracts adapt to new contingencies. For evidence on the evolution of dual distribution over time, see Lafontaine and Shaw (2005). 2 There is also substantial evidence supporting these theories. For an excellent review of the empirical literature on franchising and retail contracting, see Lafontaine and Slade (1997, 2007). 3 Other contractual provisions, such as royalty rates and entry fees, are relatively stable over time. See Bhattacharyya and Lafontaine (1995) for a possible theoretical explanation, and Lafontaine and Shaw (2005) for empirical evidence on this.

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As possible reasons for why it is difficult to adapt contracts to new contingencies,

previous works have emphasized pre-contractual information asymmetries (Bajari and

Tadelis (2001), Matouschek (2004), Chakravarty and MacLeod (2009)), post-contractual

opportunism (Williamson (1975, 1991), Hart and Moore (2008)), and the cost of describing

performance (Battigalli and Maggi (2002, 2008)) and have it enforced by courts (Baker et

al. (2010)). Here, I focus on legal constraints. Specifically, I model how laws that protect

franchisees from unfair and unequal treatment, both in the EU and in the US, constrain their

ability to contract new performance standards with the franchisor ex post, and how informal

agreements can help circumvent these laws and improve adaptation.4 This emphasis on

legal constraints has several advantages. First, it explains the rigidity of contracts across

franchisees.5 Second, it explains why franchise contracts allocate authority over decisions

that are easy to describe and verify ex post, such as outlet design or the number of

salespeople. Finally, it sheds light on a new topic – how adaptation can be achieved in the

shadow of the law – and, in the process, it yields novel predictions on the effects of legal

reform.

I begin by showing that, under purely formal contracts, adaptation entirely depends on

which party has been assigned, ex ante, the authority to change the contract terms ex post.

When the franchisor has authority, he will impose changes more often and to more

franchisees than efficient. Conversely, when the franchisor does not have authority, he will

offer incentives to franchisees who accept the proposed changes. Because of the law, these

incentives must be either uniform or tied to verifiable features of franchisees, such as sales,

which are imperfectly correlated with their opportunity cost. As a result, changes will be

adopted less often and by fewer franchisees than efficient. The corollary is that assigning

authority to the franchisor is efficient when persuading franchisees to accept changes via

4 There are empirical papers that study the effect of legal constraints on franchisee termination on the extent of dual distribution (Brickley et al. (1991)) and on royalty rates (Brickley (2002)). None of these papers deals with the effect of legal constraints on contract adaptation. 5 Bhattacharyya and Lafontaine (1995) use a double-sided moral hazard model to show that, under specific assumptions on the functional forms, royalty rates and entry fees are uniform across franchisees even in the absence of legal constraints. However, their model does not explain why other provisions, such as standards on outlet design, employees and customer service are also uniform across franchisees.

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formal incentives is costly – for instance, because intra-brand competition is intense, so

franchisees are tempted to free-ride on each other.6

I then ask how informal agreements may improve adaptation, and I obtain three results.

The first is that parties may use informal agreements to circumvent the law. When the

franchisor has authority, he will promise to enforce change selectively whereas, when he

does not have authority, he will promise to compensate franchisees selectively via

disguised, possibly non-monetary payments. Reneging by the franchisor triggers reversion

to inefficient formal contracts in future periods, so if the parties expect their relationship to

last long, informal agreements may achieve first-best adaptation. The second result is that,

when informal agreements do not suffice for the first best, the parties may achieve efficient

adaptation in some states, while resorting to inefficient formal contracts in others. This

implies that, when the franchisor has (does not have) authority, standards will be changed

more (less) often and by more (less) franchisees as the parties’ time horizon shrinks.

Moreover, when the franchisor does not have authority, formal sales-based payments (as

opposed to informal bonuses) will be offered more frequently to franchisees as the time

horizon shrinks. The third result is that replacing a per se prohibition of unfair and unequal

treatment of franchisees with a rule-of-reason approach – whereby courts decide case by

case whether unequal treatment illegally harms franchisees – may actually reduce

adaptation. The reason is that, by softening legal constraints without eliminating them

altogether, a rule-of-reason approach would improve the parties’ fall-back option after

reneging on their informal agreements in the shadow of the law, making these agreements

harder to sustain in the first place.

In the last section, I present some evidence from automobile franchising. First, I

examine the allocation of decision authority in the franchise contracts used in Italy by the

most representative car manufacturers. Consistent with the model, the data show that, after

6 Vertical restraints like exclusive territories and resale price maintenance can mitigate free-riding on pre-sales services by reducing franchisees’ incentives to compete in price (Telser (1960), Mathewson and Winter (1984)). However, Klein and Murphy (1988) and Klein (1995) noted that, because franchisees share a common brand and because customers are to some extent mobile, the quality of service at one store spills over other stores even when these belong to different exclusive territories. Hence, free-riding remains important as a residual phenomenon, even in the presence of vertical restraints that aim to neutralize it.

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the European Commission liberalized intra-brand competition by prohibiting dealer-

exclusive territories in 2002, manufacturers were assigned greater authority over dealers’

operations. I subsequently analyze a cross-section of contractual annexes which

introduced, in 2004, some changes in the dealers’ standards, and the responses from in-

depth interviews with manufacturers and dealers. I find that, when the initial contract

assigns them authority, manufacturers impose certain standards across the board while

exempting low-sales dealers from other standards. When manufacturers do not have

authority, they offer discounts on the list price to dealers who voluntarily accept certain

standards whereas, for other standards, they compensate dealers through hidden bonuses or

through non-monetary tools like tolerance of late payments and technical assistance. These

facts are consistent with the model’s prediction that, when the franchise relation is not

strong enough to achieve first-best adaptation, formal authority is binding in some cases,

whereas it is replaced by informal agreements in others. Moreover, the fact that any

observed differences in formal contracts depend on dealers’ sales, which are objective and

verifiable, suggests that the laws protecting dealers from unequal treatment may be binding.

By studying the case of franchising in detail, this paper illustrates how relational

contracts – that is, contracts deeply rooted in the parties’ long-term relationship – can be

used to escape legislative and judicial overreach, and how their formal and informal

elements are chosen to achieve this goal. This complements the legal and managerial

literature, which has noted the tension between agreements desired by the parties in a

relationship and agreements that courts are willing to enforce, but has mostly focused on

legal reform (Macneil (1978), Klein (1980), Hadfield (1990)) or integration (Williamson

(1991)) as the solutions to such tension.7 Scott (2003) is closer to this paper, as he argues

that parties may deliberately avoid formal contracts on certain verifiable outcomes to

escape distortionary court-enforcement. However, he does not consider the interaction

between formal and informal contracts and the role of authority when self-enforcement

fails. This paper also expands on the economic literature, which mostly focuses on cases

7 Williamson (1991) argues that, while courts enforce contractual disputes between firms relying on classical or neoclassical contract law, they refuse to enforce similar disputes between units of a firm (forbearance doctrine). As a result, integrating transactions within a firm is the only way to “keep courts out”.

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where relational contracts are not designed to circumvent the law but, rather, to economize

on the costs of describing and showing evidence of performance to courts, such as those

due to imperfect monitoring and the vagueness of contractual language (MacLeod and

Malcomson (1989), Baker et al. (1994, 2010), Levin (2003), Battigalli and Maggi (2008)).

By focusing on legal constraints, this paper offers novel and complementary predictions on

the evolution of formal and informal provisions in relational contracts, and on the

interaction between the two. The exercise conducted here is also relevant for empirical

research and policy. Legal constraints on franchise contracts are ubiquitous and subject to

frequent revisions, as testified by the five regulations of vertical agreements passed by the

European Commission between 1995 and 2010, and by the repeated attempts to introduce

Federal franchise legislation in the US (Emerson (1998a, 1998b). This paper offers a

number of testable predictions on the evolution of franchise contracts in the shadow of the

law and on the effects of different legal reforms, which I hope can stimulate future research

on this topic.

The rest of the paper is organized as follows: section 2 reviews the legal provisions that

protect franchisees from discrimination, both in Europe and in the US; section 3 develops a

formal model of adaptation in spot and relational franchise contracts; section 4 presents the

evidence from Italian car dealerships; section 5 concludes.

2. The protection of franchisees from franchisor’s discrimination under European and American law

This section reviews provisions in European and American law that protect franchisees

from unfair and unequal treatment by the franchisor. The main fact that emerges from this

analysis is that, despite the obvious differences between them, the two legal systems seem

to converge towards similar standards.

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2.2. European law

In Europe, franchisees are protected from discrimination both under antitrust law and

under contract law.

Antitrust law

Article 101 (1) of the Treaty on the Functioning of the European Union prohibits “all

agreements between undertakings, decisions by associations of undertakings and concerted

practices […] which apply dissimilar conditions to equivalent transactions with other

trading parties, thereby placing them at a competitive disadvantage”. In addition, article

102 of the Treaty prohibits “any abuse by one or more undertakings of a dominant position

within the internal market or in a substantial part of it” and specifies that “such abuse may,

in particular, consist in […] applying dissimilar conditions to equivalent transactions with

other trading parties, thereby placing them at a competitive disadvantage”. Nearly identical

provisions are contained in the national antitrust laws of France, Germany, Italy, the United

Kingdom, Spain, and other EU countries.

In the landmark Metro case, the European Court of Justice (hereafter ECJ) has applied

article 85 (1) (now article 101 (1)) of the Treaty to selective distribution agreements – that

is, agreements governing distribution systems, such as franchising, where retailers are

selected on the basis of qualitative criteria fixed by the upstream firm. The Court has stated

that “selective distribution systems constitute, together with others, an aspect of

competition which accords with article 85 (1), provided that resellers are chosen on the

basis of objective criteria of a qualitative nature relating to the technical qualifications of

the reseller and his staff and the suitability of his trading premises and that such conditions

are laid down uniformly for all potential resellers and are not applied in a discriminatory

fashion”.8 Since Metro, the requirement that selection criteria must be objective, uniform

for all retailers and non-discriminatory has been reaffirmed in each EU case on selective

8 See Judgement of 25 October 1977, Metro SB-Großmärkte GmbH & co. KG v. Commission, Case C-26/76.

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distribution.9 Moreover, the Metro standard is cited in the guidelines to all the European

Commission’s (hereafter EC) regulations of vertical agreements.10

The EC and ECJ, as well as the national antitrust authorities and courts of EU countries,

have also repeatedly applied article 102 of the Treaty, which prohibits discrimination by

firms in a dominant position, to sanction major upstream firms for offering selective

discounts to distributors.11 Particularly interesting is British Airways, where the European

Court of First Instance followed an approach similar to the US Kodak doctrine, and ruled

that the selective discounts British Airways granted to travel agencies were discriminatory

and anticompetitive because, even though British Airways did not have a dominant position

in the European air transportation market, travel agencies in UK who did not sell British

Airways tickets would be at a competitive disadvantage, and this granted British Airways a

dominant position in the purchase of travel agency services.

9 In AEG v. Commission, the ECJ ruled that AEG could not apply different selection standards to different dealers without an objective and acceptable justification, and that the criteria followed by AEG to deny admission in the network to certain dealers, such as a commitment to a minimum price and the promise to withdraw advertisements in the local press, were neither objective nor acceptable (Judgement of 25 October 1983, Allgemeine AEG-Telefunken AG v. Commission, Case C-107/82). In Binon v. AMP, the ECJ ruled that the refusal of AMP to supply retailer Binon on the ground that it did not satisfy AMP’s standards on the opening of outlets and other geographical criteria was unlawful discrimination, because AMP did not apply the same criteria to various outlets belonging to Lecture General, of which AMP was an important shareholder (Judgement of 3 July 1985, SA Binon & Cie v. SA Agence e messageries de la Presse, Case C-243/83). In the twin Leclerc cases, the European Court of First Instance ruled that the restraints imposed by Givenchy and Yves Saint Laurent to retailers on the shops’ façade, on selling products that devalue the manufacturer’s brand image, and on using a shop name that implies a restriction in decoration or service, cannot be considered discriminatory a priori but “lend themselves to being applied in a subjective and discriminatory fashion”, and urged courts and antitrust authorities in the EU to promptly sanction any discriminatory applications (Judgement of 12 December 1996, Groupement d’achat Édouard Leclerc v. Commission, Case T-88/92). 10 See the Guidelines to the Commission’s regulations on vertical agreements in the automotive sector (1475/1995, 1400/2002 and 461/2010), and on vertical agreements in general (2790/1999 and 330/2010). 11 See Judgement of 13 February 1979, Hoffmann La Roche v. Commission, Case 85/76; Judgement of 9 November 1983, Nederlandsche Banden-Industrie Michelin v. Commission, case C-322/81; Judgement of 7 October 1999, Irish Sugar v. Commission, case T-228/97; Judgement of 30 September 2003, Manufacture Française pneumatiques Michelin v. Commission, case T-203/01; and Judgement of 17 December 2003, British Airways plc v. Commission, case T-219/99. See, also, the judgement of 7 December 1997 of the Italian antitrust authority, which sanctioned Coca Cola for granting discriminatory discounts to exclusive wholesalers. The authority’s decision was upheld in 2002 by Consiglio di Stato – the Italian highest court of appeals in administrative disputes – with Judgement 4001/2002. See, also, Judgement 1271/2006 of Consiglio di Stato, which sanctioned Telecom Italia for granting discriminatory discounts to exclusive business clients.

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Contract law

Since the 1970s, France, Germany, Italy, Spain, Portugal and Greece have passed laws

prohibiting the abuse of a firm’s state of economic dependence. These laws aim to punish

exploitative conducts by firms that do not hold a dominant position in their relevant

markets according to antitrust law, and yet retain substantial economic power over

counterparties who have made specific investments, have short pockets, or are bound by

exclusive dealing agreements and other asymmetric contractual provisions.12 The most

studied and cited cases of firms in a state of economic dependence are franchisees relative

to franchisors on one hand, and small suppliers and contractors relative to large retailers

and manufacturers on the other.

Section 20 of the German Act against Restraints on Competition (Gesetz gegen

Wettbewerbsbeschränkungen, or GWB), after having stated that undertakings with a

dominant position in the market “shall not directly or indirectly hinder in an unfair manner

another undertaking in business activities which are usually open to similar undertakings,

nor directly or indirectly treat it differently from similar undertakings without any objective

justification”, extends the same rule to all undertakings “insofar as small or medium-sized

enterprises as suppliers or purchasers of certain kinds of goods or commercial services

depend on them in such a way that sufficient or reasonable possibilities of resorting to other

undertakings do not exist”. The norm has been applied, among others, to cases of refusal to

deal in the distribution of branded skis, and to franchisee termination in beer and

automobile distribution.13 As in Portugal and Greece, enforcement of the legal provisions

on abuse of economic dependence is exclusively assigned to the German antitrust authority.

In France, article L420-2 of the Commercial Code prohibits “the abusive exploitation

by a firm or a group of firms of the state of economic dependence that a client or supplier

12 The notion of abuse of economic dependence has similarities with the common law doctrines of economic duress and unconscionability, which have been applied, among others, to protect franchisees from arbitrary termination, to excuse suppliers from performing obligations that have turned too onerous, and to void one-sided modifications of long-term contracts. See Schwartz (1992) for a detailed discussion. 13 See, for instance, OLG Stuttgart, in WuW/E OLG, 103; BGH, in WuW/E BGH, 1455 (BMW-Direkthändler); and OLG Düsseldorf, in WuW/E OLG, 3036, 3037 (Peugeot-Vertretung).

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has towards them. Such abuse can consist of […] discriminatory practices as defined by

article L442-6 [of the Commercial Code]”. Enforcement of the provisions on abuse of

economic dependence contained in article L420-2 is assigned to an administrative authority

(Conseil de la Concurrence), and requires to prove that the abuses affect market

competition. The discriminatory practices defined in article L442-6 can also be challenged

in civil courts and, in that case, do not require a proof of anticompetitive effects. In addition

to the victims of abuses, the law recognizes a right to act in court against discriminatory

practices to public prosecutors and to the Treasury Minister.

In Italy, article 9 of Law 192/1998 states that “a firm’s abuse of the state of economic

dependence of clients or suppliers is prohibited. […] The abuse can be represented, among

other things, by […] the imposition of contract terms that are unjustifiably burdensome or

discriminatory”.14 Legal scholars have pointed out that the prohibition of discriminatory

practices must be interpreted as an obligation to offer equal contract terms unless there is a

reasonable business reason for doing otherwise, and that evidence of unequal treatment is

sufficient to prove an abuse even if a deliberate discriminatory intent cannot be

demonstrated, because the law simply protects the ability of firms in a state of economic

dependence to compete in the market (Maffeis (2006)). The law has been applied to cases

of franchisee termination and to sanction a franchisor of electric equipment whose prices to

final consumers were lower than the maximum prices permitted to one of his franchisees.15

Enforcement of the Law is assigned to civil courts. In addition, and similarly to France and

Spain, article 9.3-bis of the Law assigns enforcement powers to the antitrust authority

(AGCM) whenever the abuses affect competition in the market.

14 While the Italian law 192/1998 regulates subcontracting, both legal scholars (Ceridonio (2000), Maugeri (2001), Colangelo (2006) and Agrifoglio (2008)) and the dominant jurisprudence (Trib. Roma, 17 March 2009; Trib. Torre Annunziata, 30 March 2007; Trib. Isernia, 12 April 2006; Trib. Trieste, 21 September 2006; Trib. Bari, 22 October 2004; Trib. Catania, 5 January 2004) have concluded, based on the letter of the norm and on the parliamentary debates preceding its enactment, that article 9, which prohibits the abuse of economic dependence, applies to all kinds of inter-firm relations, including franchising. Indeed, most of the recent applications of the norm regard franchising. 15 Trib. Isernia, 12 April 2006.

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2.3. US law

In the US, franchisees can sue for discrimination under antitrust law, under common

law and under state statutes.16

Antitrust law

To sue a franchisor for discrimination under US antitrust law, franchisees must prove

that the franchisor has market power and that discrimination is part of an attempt to

monopolize the market. While most franchisors do not have market power according to

traditional antitrust definitions, US courts have often accepted – implicitly and, after the

Kodak case, explicitly – the argument that, due to their sunk specific investments,

franchisees are locked into a relationship with the franchisor, who can force them to accept

conditions they would refuse if they could promptly switch to other chains. Two antitrust

cases involving franchisee discrimination are Blanton v. Mobil Oil Corp. and Milsen Co. v.

Southland Corp. In Blanton, the court ruled against Mobil for selectively enforcing

contractual provisions against service station dealers who refused to purchase Mobil tires.

In Milsen, the court ruled against Open Pantry for selectively collecting unpaid fees from

convenience-store franchisees that bought different brands of dairy products or raised the

resale price above the franchisor’s maximum. Overall, the lock-in doctrine has been

haphazardly applied by US courts (Grimes (1999, 2006), McDavid and Steuer (1999)) and,

as a result, antitrust suits represent a feasible but uncertain venue for franchisees alleging

discrimination and other franchisor’s abuses.

Common law

Discrimination claims under common law have been mostly unsuccessful. In the

representative Original Great American Chocolate Chip Cookie Co. v. River Valley

16 See Grimes (1999, 2006) on antitrust law, and Burzych and Matthews (2003) on common law and state statutes. See, also, Emerson (1998a, 1998b) on discrimination suits by franchisees from minority groups.

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Cookies case, judge Posner stated that “The fact that Cookie Company may […] have

treated other franchisees more leniently [than River Valley Cookies] is no more a defense

to a breach of contract than laxity in enforcing the speed limit is a defense to a speeding

ticket”.17

State statutes

Several US statutory laws prohibit franchisee discrimination. Specifically, statutes in

Delaware, Vermont and Wyoming prohibit car manufacturers to discriminate unfairly

among dealers with respect to warranty periods. In Georgia and Nevada, it is illegal for any

car manufacturer to discriminate unfavorably among its dealers. New Mexico prohibits car

manufacturers to price discriminate. Ohio prohibits dealer termination when it is based on a

failure to achieve discriminatory performance criteria. Washington prohibits manufacturers

to discriminate among dealers in prices of cars and accessories, promotion plans, marketing

plans, and any other pricing provisions. Moreover, statutes in six states (Arkansas, Hawaii,

Illinois, Indiana, Washington and Wisconsin) have anti-discrimination provisions that apply

to all types of franchise agreements. Specifically, the Arkansas and Wisconsin statutes

prohibit franchisors to terminate franchisees without good cause, defined as a failure to

comply with franchisor’s standards that are non-discriminatory as compared with the

requirements imposed on other similarly situated dealers. The statutes in Hawaii, Illinois,

Indiana and Washington prohibit franchisors to discriminate between franchisees in charges

offered or made for royalties, goods, equipment, rentals, advertising, or in any other

business dealing, unless they can prove that discrimination is reasonable. The non-

discrimination principle has also been applied in several judicial decisions under these

statutes.18

17 For similar rulings, see MacDonald’s Corp. v. Robertson, Bonanza International Inc. v. Restaurant Management Consultants, and Kilday v. Econo-Travel Motor Hotel Corp. 18 In Morley-Murphy Co. v. Zenith Electronics Corp., the court declared that, under the Wisconsin statute, a franchisor’s economic circumstances may constitute good cause to alter its method of doing business with its dealers if the franchisor can prove that the changes are essential, reasonable and nondiscriminatory. In Open Pantry Food Marts of Wisconsin v. Howell, a Wisconsin court ruled against a franchisor that terminated franchisees with negative net worth despite the fact that they were in better financial conditions than other franchisees with negative net worth who were not terminated. Some successful discrimination claims have also been brought under statutes that do not explicitly address discrimination. For instance, in Tractor and

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2.4. Discussion

The legislation, jurisprudence and legal scholarship discussed above indicate that,

absent an objective and verifiable justification, applying unequal contract terms to

franchisees within a network is illegal in the European Union and in numerous US states.

This generates two types of risk for franchisors who apply unequal contract terms. First,

they may be sued for damages by disgruntled franchisees; while lawsuits may not be

numerous, they are likely to cause large reputational losses to the franchisor, especially

when promoted by franchisees from minority groups (Emerson (1998a, 1998b)). Second,

franchisors may be prosecuted by antitrust authorities, which can act unilaterally or upon

demand of a third party, are allowed to inflict both damages and administrative fines and,

unlike judges, have career-driven incentives to act.

As a result of anti-discrimination laws, franchisors may want to offer equal contract

terms to franchisees, base any unequal terms on objective business reasons and, more

generally, avoid contract terms that may be interpreted by courts as discriminatory or

abusive. Here, I study how this may prevent franchisors from adapting their distribution

networks to different local conditions of franchisees and to new strategies of competitors,

and how informal contractual arrangements may help them achieve these goals in the

shadow of the law. In doing so, I do not deny that, by protecting franchisees from the risk

of holdup, anti-discrimination provisions may also serve efficiency or other socially

desirable goals. Rather, I take the benefits of these provisions as granted and I focus on

their negative effects on contractual flexibility and adaptation, which have received less

attention in the legal and economic literature.

Farm Supply Inc. v. Ford New Holland Inc., the court stated that the Michigan statute requires a legitimate, nondiscriminatory reason for nonrenewal of a franchise agreement and that all similarly situated franchisees must be treated similarly. In General Aviation v. Cessna Aircraft Co., the court stated that, under the Michigan statute, whenever a franchisor renews some franchisees but not others, the disparate treatment must meet a good cause standard, and that Cessna could have treated General Aviation differently from other franchisees with expired contracts only if it had provided legitimate reasons.

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3. The model

Consider a network composed by a franchisor and N franchisees, all of them risk-

neutral. Franchisees are selected at the outset on the basis of certain standards, such as pre-

specified showroom design and furniture, number and qualification of employees, operating

capital, and the like. As the environment changes, the initial standards may become

obsolete and need to be changed. To keep the analysis simple, and without loss of

generality, I assume that, in any given state of the world s, there is only one meaningful

way of changing standards, so franchisee i must choose whether to change his standards

(decision isd 1= ) or keep them as they are (decision isd 0= ). In each period, the timing of

the franchise relation is as follows:

1. The franchisor offers to franchisees a long-term contract { }g F, f∈ , where g F=

implies that the franchisor has authority to impose isd 1= to every i in the future, and

g f= implies that the franchisor does not have such authority;

2. A state { }s s ss , ,= v ω c is drawn with probability sp from the finite set S and observed

by both the franchisor and the franchisees. A typical element isv of vector sv denotes

the total sales generated by franchisee i in state s when isd 1= . A typical element isω of

sω denotes the total sales generated by franchisee i in state s when isd 0= . Finally, a

typical element isc of sc denotes franchisee i’s direct cost of implementing isd 1= in

state s;

3. The party who has been assigned authority at stage 1 chooses { }isd 0,1∈ ;19

19 In reality, when g = F and the franchisor orders franchisee i to set dis = 1, franchisee i has an opportunity to breach the contract and set dis = 0. I assume that remedies against breach, such as damages and termination from the network, are strong enough to prevent franchisee i from disobeying in every state. If that was not the case, the franchisor’s authority might be non-binding in some states.

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4. The franchisor receives gross profit s s isi NF q

∈= α∑ and franchisee i receives gross

profit ( )is s is is isf 1 q d c= −α − , where:

( ) ( )jis i is is is is js js js jsj i

1q d v 1 d d v 1 d

N 1≠

− γ⎡ ⎤= γ + − ω + + − ω⎡ ⎤⎣ ⎦ ⎣ ⎦−∑ denotes the sales of

franchisee i in state s; [ ]i 0,1γ ∈ denotes the portion of sales generated by franchisee i

that is captured by that franchisee;20 [ ]s 0,1α ∈ is a share parameter that splits revenues

between the franchisor and his franchisees; and retail prices are all normalized to 1 for

simplicity.

The model formalizes two well-known features of franchising. First, because

franchisees share the same brand, their decisions affect the sales of other franchisees in the

network. This horizontal externality is captured by iγ , which can be interpreted as an

inverse measure of intra-brand competition in i’s location, or the extent to which franchisee

i serves repeat customers. Second, franchisees only capture a fraction of the revenues

generated at their own location, so their decisions affect the franchisor’s revenues. This

vertical externality is captured by the share parameter sα .21 The agency literature has

shown that sα should be between 0 and 1, so that both the franchisor and the franchisees

have incentives to perform certain non-contractible tasks, such as brand-building and sales

effort, respectively.22 Because this point is well appreciated, and because the focus of this

model is on the contractible decisions d1s,…, dns, I take sα as exogenous.

The model also captures two features of franchising that are not emphasized in previous

works. First, franchisees operate in a dynamic environment, so their features must be

frequently adapted to new contingencies (temporal adaptation). For instance, it may be

20 It is easy to check that the results would be unchanged if the portion of sales generated by i but captured by other franchisees in the network were allowed to vary across franchisees. I assume it constant to simplify notation. 21 The share parameter αs could be a royalty rate, as in business-format franchising, or a wholesale price, as in traditional franchising. In the latter case, if retail prices were not normalized to 1 each franchisee would have a different share parameter αis = pus / pis, where pis is i’s retail price and pus is the upstream price. The model’s qualitative results would be unchanged under this more general formulation. 22 See, for instance, Lutz (1995) and Batthacharyya and Lafontaine (1995).

16

optimal to renew the outlets’ design to reflect innovations in the brand’s image and the

introduction of new products, or to hire new salespeople in order to face a sudden increase

in demand. This is captured by assuming that optimal decisions, as well as their benefits

and costs, depend on the realized state of the world s. Second, franchisees differ from each

other, so decisions should also differ across franchisees (local adaptation). For instance,

offering premium coffee, “latte” and sofa-areas in fast foods like McDonald’s may add

value to restaurants that mainly serve tourists and students (a high value of isv ), but not to

restaurant that serve factory workers or employees hurrying up to the office. Also, car

dealers with greater managerial skills and motivation (a high value of isω ) may sell high

volumes while offering less promotions, employing less salespeople and having simpler

showrooms than other dealers. Finally, implementing certain changes – for instance,

increasing the hours of training per employee or monitoring whether salespeople are

dressed as required – is more costly for large franchisees than for small ones (a high value

of isc ).

The model rests on the following additional assumptions: 1) g is contractible before the

state is realized, but not after; 2) s, isv , isω , isc , Fs, fis and iγ are all non-contractible, for

any i and s; 3) isd is contractible after the state is realized but not before, for any i and s; 4)

isq is contractible, for any i and s; 5) is isv ≥ ω for any i and s; 6) the opportunity cost of

change of franchisee i in state s is ( ) ( )is is s i is isOC c 1 v 0= − −α γ −ω > ; 7) is jsq q≥ for any i

> j and s; 8) is is js jsv v−ω ≥ −ω for any i j> and s; 9) is jsc c≥ for any i j> and s; 10)

( ) ( )is js is is js jsc c v v− ≤ −ω − −ω for any i j> and s; 11) is jsOC OC> and hs ksOC OC≤ , for

some i j> , h k> and s; 12) it is illegal for the franchisor to threaten to impose isd 1= if

franchisee i does not pay him, in money or in kind; 13) it is illegal for the franchisor to set

is jsd d≠ or to offer payments is jst t≠ to any franchisees i and j, unless is jsq q≠ and the

decision and payment schedules isd and ist are monotonic in sales.

17

Discussion

Assumption 1) implies that, in any given period, the allocation of authority can be

negotiated before the state is realized, but it cannot be changed after the state is realized and

before the decisions d1s,…, dns are made. This could be because reallocating authority takes

some time, whereas decisions must be made quickly after the state is realized (Baker et al.

(2002, 2010)). Assumptions 2) and 3) imply that contracts are incomplete, in the sense of

Grossman, Hart and Moore: it is not possible to describe decisions before observing the

state of the world, or to make them contingent on state variables, but it is possible to

describe and contract decisions once the state is realized. Assumption 4) implies that,

although the individual components of realized sales are non-contractible, sales are

themselves contractible, so payments and other contracts based on them can be enforced in

court. Assumption 5) implies that implementing change in any given state does not reduce

sales, and assumption 6) implies that the franchisees’ opportunity cost of changing

standards is positive. This is consistent with many press articles describing conflicts on the

implementation of standards as one of the main issues in franchise relations.23 Assumptions

5) and 6) are useful to simplify the analysis, but the results would be qualitatively

unaffected if they were violated for some (but not all) franchisees and states. Assumption 7)

implies that the ranking of franchisees by sales is constant across states. This captures the

idea that the relative size and sales of franchisees depend to a great extent on their location.

Assumption 8) implies that, by updating their standards, high-sales franchisees generate

(weakly) more value than low-sales ones. The idea is that high-sales franchisees serve more

customers, so they have greater impact on the franchisor’s brand. Assumption 9) implies

that, as argued before, the direct cost of updating standards is (weakly) greater for high-

sales franchisees. Assumption 10) implies that the difference in value dominates the

difference in direct costs, so it is more efficient for high-sales franchisees than for low-sales

ones to implement change. Assumption 11) implies that franchisees’ opportunity cost of

updating standards – that is, the direct cost minus the benefit in terms of increased sales – is

imperfectly correlated with sales. Finally, assumptions 12) and 13) draw from section 2 and 23 See, for instance, the Wall Street Journal (2008a, 2008b, 2008c) and Profit (2010).

18

establish that it is illegal for the franchisor to apply unequal conditions to franchisees unless

these are objectively different and the unequal treatment is justified. On one hand, using

contractual authority to impose new obligations on franchisees that refuse to pay would be

illegal discrimination and an abuse of bargaining power by the standards of Milsen and

Blanton and according to European contract law.24 On the other hand, imposing different

standards or offering different incentives to franchisees of similar size would constitute

illegal discrimination under US statutes and under EU antitrust and contract law.25

3.2. Contracts in the absence of legal constraints

In this section I briefly consider the case where the law does not constrain franchise

contracts. The first best implies that, for any state s, franchisees in the set

{ }s is is isK i : v c= −ω ≥ (1)

implement change. We can then prove the following

Proposition 1: absent legal constraints, the parties achieve the first best under any

allocation of authority { }g F, f∈ .

Proof: in appendix.

Given Proposition 1, the expected total surplus from the franchise relation absent legal

constraints is

( )s s

FBs is is isi K i K

TS E v c∈ ∉

⎡ ⎤= − + ω⎣ ⎦∑ ∑ ,

(2)

where [ ] [ ]s ss SE p

∈⋅ = ⋅∑ is the expectation operator over states.

24 Recently, the Italian highest court of appeals (Corte di Cassazione) stated that there is an abuse of economic dependence whenever a party exerts a formally legitimate contractual power in order to obtain different and additional benefits from those for which the power had been granted, and in such a way that it causes a disproportionate and unnecessary harm to the other party (Cass. 2010/2009). 25 This depends on the assumption that sales are the only court-verifiable difference between franchisees. If other differences were verifiable and acceptable for courts, discrimination based on such differences would be permitted by the law. See section 4 for more on this.

19

Proposition 1 is an application of the Coase theorem, which states that, absent

transaction costs, the parties will bargain to the efficient ex post allocation of resources

independent of the ex ante allocation of rights. Here, the ex post allocation of resources is

given by the decisions d1s,…, dns, the ex ante allocation of rights is { }g F,f∈ , and

transaction costs are represented by the legal constraints.

3.3. Spot contracts in the presence of legal constraints

In the rest of this paper I will focus on the case where assumptions 12) and 13) hold

and, therefore, franchise contracts are constrained by the law. In this section, I assume that

the parties meet only once, so they can only rely on court-enforceable contracts. In the next

section, I will allow for relational contracts sustained by repeated interactions between the

franchisor and franchisees.

Case 1: The franchisor has authority

The first best contracts described in section 3.2 require that the franchisor threatens to

impose isd 1= by authority to any franchisee who does not pay him, which is illegal

(assumption 12). We can then state the following

Proposition 2: when the franchisor has authority, he will set isd 1= for every i N∈ and

s S∈ .

Proof: Because of the law, the franchisor cannot threaten to impose isd 1= if franchisee i

does not pay him. Since is isv > ω for any i and s, the franchisor will then set isd 1= . This is

inefficient in any state s such that sK N⊂ . QED.

Proposition 2 suggests that, when the franchisor has authority to update franchisees’

standards unilaterally, standards will be changed too frequently ( isd 1= for every s) and, in

any given state, franchisees’ outlets and operations will be too standardized ( isd 1= for

20

every i). Given proposition 2, the expected profit of franchisee i from signing contract

g F= at stage 1 is

( ) jFi s s i is js isj i

1f E 1 v v c .

N 1≠

⎡ − γ ⎤⎛ ⎞= −α γ + −⎢ ⎥⎜ ⎟−⎝ ⎠⎣ ⎦

∑

In what follows, I assume that Fif 0≥ for every i (which is possible, due to the positive

horizontal externalities from other franchisees), so all the N franchisees accept to be in the

network at stage 1.26 Under this assumption, the expected total surplus when the franchisor

has authority is

( )SPF s is isi N

TS E v c∈

⎡ ⎤= −⎣ ⎦∑ . (3)

Case 2: The franchisor does not have authority

Even in this case, the first best contracts described in section 3.2 are illegal. To see why,

recall that, by assumption 11, the opportunity cost of change increases in sales for some

franchisees but not for others, so under a first-best contract it must be that is jst t> for some

i j> and hs kst t≤ for some h k> . In words, first best contracts require that high-sales

franchisees are paid more than low-sales ones in some cases but not in others. However,

because all variables other than sales are non-verifiable, courts would see these contracts as

discriminatory.

In order to elicit change from franchisees without violating the law, the franchisor must

offer non-discriminatory payments. Denote the set of franchisees who accept to implement

26 Suppose, instead, that F

if 0< for i M N∈ ⊆ and that the franchisor wants all the N franchisees to be in

the network. Then, he must offer { }Fii M

max f∈

to all of them, due to the non-discrimination constraint. If doing

so is unprofitable for the franchisor, he will let some franchisees in the set M leave the network at stage 1. The franchisor may then give up on having outlets in those franchisees’ locations, or open vertically integrated outlets, which would not be constrained by franchise laws. I leave for future work an exploration of the case where the size of the network and the choice between vertical integration and franchising are endogenously determined.

21

isd 1= in exchange for a payment offered by the franchisor as SPsH . We can then state the

following

Proposition 3: when g = f, it must be that SPs sH K⊆ .

Proof: in appendix.

Intuitively, when the law prevents him from offering personalized payments, the

franchisor must compensate some franchisees above their opportunity cost, and this may

push him towards offering payments that induce fewer franchisees than efficient to

implement change. Given Proposition 3, the expected total surplus under a spot contract

when the franchisor does not have authority is

( )SP SPs s

SPf s is is isi H i H

TS E v c∈ ∉

⎡ ⎤= − + ω⎣ ⎦∑ ∑ . (4)

Optimal allocation of authority

In the presence of legal constraints, the optimal allocation of authority in spot contracts

is defined by the following

Proposition 4: in a spot contract, assigning authority to the franchisor is efficient when 1)

iγ is small for some i, and 2) there are many i and s such that is is isv c−ω ≥ .

Proof: in appendix.

The intuition behind Proposition 4 is simple. When the franchisor has authority, change

is implemented by too many franchisees in each state, whereas change is implemented by

too few franchisees when the franchisor does not have authority. Hence, assigning authority

to the franchisor is efficient when too much change is preferable to too little change. This

will occur, all else equal, when changing standards is valuable (that is, the set Ks of

franchisees such that is is isv c−ω ≥ is on average close to N), and when intra-brand

competition is intense (that is, iγ is small for some franchisees), so persuading franchisees

to cooperate via monetary incentives is costly for the franchisor.

22

Proposition 4 implies that, in the presence of legal constraints, assigning authority ex

ante matters for efficiency. Theoretically, anti-discrimination constraints are not the only

reason for allocating authority. On one hand, even if manufacturers and dealers could

negotiate efficient standards ex post, they might want to allocate authority ex ante to protect

each other’s non-contractible specific investments (Grossman and Hart (1986), Aghion and

Tirole (1994), hereafter the GHM models)). On the other hand, manufacturers and dealers

may fail to contract standards ex post for reasons other than the non-discrimination

constraints discussed here, such as asymmetric information (Matouschek’s (2004),

Chakravarty and MacLeod (2009)) and the costs of describing standards (Battigalli and

Maggi (2002, 2008)) and making them verifiable to courts (Baker et al. (2010)). However,

these alternative theories yield comparative static predictions that seem either unrelated to

those in proposition 4 or inconsistent with basic features of franchising, which are captured

by the model presented here.

First, the GHM models predict that, since authority protects the parties’ non-

contractible specific investments, it should be reallocated when the marginal productivities

of such investments change (Whinston (2003)). In contrast, proposition 4 predicts that

authority be reallocated to franchisors in response to increases in intra-brand competition,

which seems unrelated to the productivity of both franchisors’ and franchisees’ ex ante

investments. Second, field interviews discussed in section 4 of this paper indicate that,

even when franchisors do not have authority, they tend to initiate contractual modifications

ex post, presenting them as take-it-or-leave-it offers. This suggests that shifting bargaining

power to prevent negotiation breakdowns due to asymmetric information may not be the

main reason for allocating authority in franchising. Finally, describing and monitoring

franchisees’ standards such as a new outlet façade or an increase in the number of

salespeople seems relatively simple. Indeed, we will see in section 4 that these types of

standards are often formalized ex post in annexes to franchise contracts. Yet, franchise

contracts systematically allocate authority over these standards, suggesting that there must

be reasons for allocating authority other than the costs of describing and verifying

performance ex post.

23

3.4. Relational contracts in the shadow of the law

Suppose, now, that the parties repeat the spot game forever. Then, provided that they

value future transactions highly, they may be able to circumvent the law and efficiently

adapt standards to states of the world and local conditions.

Case 1: The franchisor has authority

The franchisor may promise that, in state s, he will allow every franchisee

{ }RFs si H N K∈ ⊆ − to set isd 0= , in exchange for an upfront payment wi. To implement

this contract without violating the law, the franchisor can announce that isd 1= only applies

when { }RFs

is jsj H

q min q∉

≥ . Also, he may informally agree that wi take the form of publicity

investments, promotions, long working hours, and the like, so that it would be difficult to

prove in court that wi has been collected. The upshot is that, because wi cannot be formally

contracted due to the legal constraints, the franchisor is not obliged to set isd 0= for

franchisees in RFsH , so his promise to do so must be self-enforcing. As standard in the

literature, I define self-enforcing relational contracts as trigger-strategy equilibria of the

infinitely repeated game, as follows:27

• At stage 1 of any period t, franchisee i pays wi to the franchisor;

• At stage 2, the franchisor orders isd 0= to every RFsi H∈ and isd 1= to every

RFsi H∉ .

If everyone honors, the game is repeated identically at time t+1. If any franchisee

reneges on wi, the parties revert to the optimal spot contract { }

{ }SP SP SPF f

g F,fg arg max TS ,TS

∈=

27 See MacLeod and Malcomson (1989) and Levin (2003) for models of relational contracts where the allocation of authority is exogenous, and Baker et al. (2002, 2010) for models where authority is endogenous, as in this paper.

24

from the current period t and thereafter. Finally, if the franchisor reneges on RFsH , the

parties revert to the optimal spot contract SPg from period t+1 and thereafter.

To simplify the self-enforcement constraints, let the franchisor’s and ith franchisee’s

gross expected payoffs under the relational contract be, respectively:

RF RFs s

RFs s is s isi H i H

F E v∈ ∉

⎡ ⎤= α ω + α⎣ ⎦∑ ∑ and

( ) ( ) ( )( ) ( ) RF RFs s

j jRF RF RFi s is i s is is i s is is s js jsj H j H

1 1f E h 1 1 h 1 v c 1 v

N 1 N 1∈ ∉

⎡ −γ −γ ⎤⎛ ⎞= γ −α ω + − γ −α − + −α ω +⎢ ⎥⎜ ⎟− −⎝ ⎠⎣ ⎦

∑ ∑ ,

where { }RFish 0,1∈ and RF

ish 1= if RFsi H∈ . Also, denote the franchisor’s and ith franchisee’s

expected payoffs under the optimal spot contract as SPF and SPif , respectively.

Given this notation, the relational contract is self-enforcing if, and only if:

RF SPii N

1 r 1 rF w Fr r∈

+ +⎡ ⎤+ ≥⎣ ⎦∑ , (5)

RF SPi i i

1 r 1 rf w fr r+ +⎡ ⎤− ≥⎣ ⎦ for every i N∈ , and (6)

RF RFs s

RF SPs is i s isi H i N i H

1 1F w v Fr r∈ ∈ ∈⎡ ⎤α ω + + ≥ α +⎣ ⎦∑ ∑ ∑ for every s S∈ , (7)

where r is the parties’ common interest rate. Conditions (5) and (6) are the franchisor’s and

the ith franchisee’s participation constraints, respectively, while condition (7) is the

franchisor’s inter-temporal incentive constraint. By setting wi so that (6) binds for every i,

the franchisor’s participation and incentive constraints boil down, respectively, to

RF RF RF SP SP SPi ii N i N

TS F f F f TS∈ ∈

= + ≥ + =∑ ∑ , and (8)

( ) ( )RFs

RF SPs is isi H

1v TS TSr∈

α −ω ≤ −∑ for every s S∈ . (9)

Because (9) is more restrictive than (8), (9) is necessary and sufficient for the relational

contract to be self-enforcing. In turn, the S conditions in (9) boil down to

25

( ){ } ( )RFs

RF SPs is isi Hs S

1max v TS TSr∈∈

α −ω ≤ −∑ . (10)

Hence, the franchisor will choose RFsH , for every s, to maximize TSRF subject to (10).

For low values of r, the first best relational contract RFs sH N K= − will be feasible in every

s. For intermediate values of r, the best feasible relational contract will be RFs sH N K⊂ − in

some s. Finally, for high values of r, no relational contract that improves on the optimal

spot contract will be feasible. We can summarize these results in the following

Proposition 5: when g = F in a relational contract, 1) the number of franchisees for

whom isd 1= is non-decreasing in r for any s, and 2) is jsd d≥ for any i > j and s, with the

inequality holding strictly for some i > j and s.

Proof: by inspection of (10).

It is clear from proposition 5 that, when the franchisor has authority, relational contracts

are adapted in a different way from spot contracts. First, in relational contracts the

franchisor will be more self-restrained in using his authority to unilaterally update standards

and, as a result, franchisees’ outlets, service and policies will be less standardized and

uniform across both locations and states. Because relational contracts are sustained by the

prospect of future transactions, the degree of standardization will be greater when such

prospect is grim. Second, and consistent with the fact that high-sales franchisees add more

value to the network by updating their standards (assumption 10), the franchisor’s self-

restraint in using his authority will take the form of exemptions for low-sales franchisees.

Case 2: The franchisor does not have authority

In this case, the franchisor may ask every franchisee i to pay her wi upfront at the

beginning of each period, offer an informal bonus bis to every franchisee Rfs si H K∈ ⊆ who

implements isd 1= when Rf SPs sH H> , and offer the optimal spot formal payment SP

st when

Rf SPs sH H< . Denote the franchisor’s decision on what payment to offer ex post by

26

{ }s 0,1β ∈ , where s 1β = when the franchisor offers an informal bonus.28 Like before, the

payments wi and bis should be interpreted as tacitly agreed and possibly non-monetary, so

that they cannot be verified by courts. Example of informal, non-monetary bonuses could

be tolerance of late payments, extra-training, and technical assistance.29 The game is as

follows:

• At stage 1 of any period t, franchisee i pays wi to the franchisor;

• At stage 3, the franchisor chooses sβ . If s 1β = , every franchisee Rfsi H∈ sets isd 1=

and the franchisor pays her the informal bonus bis; if s 0β = , every franchisee

SPsi H∈ sets isd 1= , and the franchisor pays her the formal bonus SP

st .

Let the franchisor’s and ith franchisee’s gross expected payoffs under the relational

contract be, respectively:

( ) ( )( )Rf Rf SP SPs s s s

Rfs s s is s is s s is s isi H i H i H i H

F E v 1 v∈ ∉ ∈ ∉

⎡ ⎤= β α + α ω + −β α + α ω⎢ ⎥⎣ ⎦∑ ∑ ∑ ∑ , and

( )( ) ( ) ( ) ( )

( ) ( )( ) ( )( ) ( )

Rf Rfs s

SP SPs s

j jRf Rfs is i s is is s is i is s js jsj H j H

Rfi s

j jSP SPs is i s is is s is i is s js jsj H i H

1 1h 1 v c 1 1 h 1 v

N 1 N 1f E

1 11 h 1 v c 1 1 h 1 v

N 1 N 1

∈ ∉

∈ −∉

⎧ ⎫⎡ −γ −γ ⎤⎛ ⎞β γ −α − + −α − γω + −α + ω +⎪ ⎪⎢ ⎥⎜ ⎟− −⎝ ⎠⎪ ⎣ ⎦= ⎨ ⎬

⎡ −γ −γ ⎤⎛ ⎞⎪+ −β γ −α − + −α − γω + −α + ω⎢ ⎥⎜ ⎟⎪ − −⎝ ⎠⎣ ⎦⎩

∑ ∑

∑ ∑

⎪

⎪⎪⎭

,

where Rfish 1= when Rf

si H∈ , and SPish 1= when SP

si H∈ .

Given this notation, the relational contract is self-enforcing if, and only if:

28 In addition to the informal bonus bis, the franchisor may want to offer to franchisee i a formal payment compatible with the non-discrimination legal constraint, in order to reduce his own temptation to renege on compensation, as in Baker et al. (1994). Note however that administering both formal and informal payments may be more costly than administering informal payments alone (for instance, because franchisor’s employees must communicate to each franchisee that the payment will be divided into formal and informal, issue receipts, and the like). In order to save on administrative costs, the franchisor would then use informal payments alone in states where his reneging temptation is not too large, and add formal payments only when his reneging temptation grows larger. To keep the model simple, I assume there are no states where formal and informal payments coexist. 29 Iossa and Spagnolo (2010) formally show that tolerating non-compliance with formal contractual provisions can help enforce informal ones.

27

( )Rf SPs s

Rf SP SPs s is s is ii H i H i N

1 r 1 rF E b 1 t w Fr r∈ ∈ ∈

+ +⎡ ⎤⎡ ⎤− β + −β + ≥⎢ ⎥⎣ ⎦⎣ ⎦∑ ∑ ∑ , (11)

( )RF Rf SP SP SPi s s is is s is is i i

1 r 1 rf E h b 1 h t w fr r+ +⎡ ⎤⎡ ⎤+ β + −β − ≥⎣ ⎦⎣ ⎦ for every i N∈ , (12)

( )Rf Rf SPs s s

Rf SP SPs is s s is s is ii H i H i H i N

1 1b F E b 1 t w Fr r∈ ∈ ∈ ∈⎡ ⎤⎡ ⎤−β + − β + −β + ≥⎢ ⎥⎣ ⎦⎣ ⎦∑ ∑ ∑ ∑

for every s S∈ , and (13)

( ){ } ( )

( )

Rf RF Rf SP SPs is s i is is is i s s is is s is is i

Rf SPs is s i is i

1h 1 v c b f E h b 1 h t wr

1h 1 fr

⎡ ⎤⎡ ⎤β −α γ − + + + β + −β − ≥⎡ ⎤⎣ ⎦ ⎣ ⎦⎣ ⎦

≥ β −α γ ω +

for every i N∈ and s S∈ . (14)

By setting bis and wi so that (12) and (14) bind, the franchisor’s participation and

incentive constraints boil down, respectively, to

Rf Rf Rf SP SP SPi ii N i N

TS F f F f TS∈ ∈

= + ≥ + =∑ ∑ , and (15)

( ) ( ) ( )Rfs

Rf SPs is s i is isi H

1c 1 v TS TSr∈

β − −α γ −ω ≤ −⎡ ⎤⎣ ⎦∑ for every s S∈ . (16)

Because (16) is more restrictive than (15), (16) is necessary and sufficient for the relational

contract to be self-enforcing. The S conditions in (16) can be rewritten, in turn, as

( ) ( ){ } ( )Rfs

Rf SPs is s i is isi Hs S

1max c 1 v TS TSr∈∈

β − −α γ −ω ≤ −⎡ ⎤⎣ ⎦∑ . (17)

Hence, the franchisor will choose sβ and RfsH to maximize RfTS , subject to (17). For

low values of r, the optimal relational contract implies that s isd 1β = = for every si K∈ and

every s S∈ , as in the first best. For intermediate values of r, the optimal relational contract

is second best, that is, it implies that s isd 0β = = for some si K∈ and s S∈ . Finally, for

high values of r, no relational contract that improves on the optimal spot contract is

feasible. We can summarize these results in the following

28

Proposition 6: when g = f in a relational contract, 1) the number of states where the

franchisor offers a formal payment SPst is non-decreasing in r, and 2) the number of

franchisees for whom isd 1= is non-increasing in r.

Proof: by inspection of (17).

Like proposition 5, proposition 6 also points at differences between how relational

contracts and spot contracts are adapted ex post, given the ex ante allocation of authority.

First, we should expect that, in relational contracts where the franchisor does not have the

authority to update standards unilaterally, formal payments to franchisees are sometimes

replaced by informal ones, which can be better tailored to the franchisees’ opportunity

costs. Second, and related, standards should be updated at more locations and in more states

than in spot contracts, because relational contracts circumvent, at least in part, the non-

discrimination law that constrains formal payments. In particular, since relational contracts

are sustained by the prospect of future transactions, we should expect more formal

incentives and fewer changes when such prospect is grim.

Optimal allocation of authority in relational contracts

Conditions (10) and (17) suggest that the predictions of proposition 4 on the optimal

allocation of authority under spot contracts are still valid under relational contracts. A

decrease in the i 'sγ makes (17) tighter without affecting (10), and it also reduces SPsH in

states where s 0β = , thus making it more desirable to assign authority to the franchisor.

Similarly, a greater size of Ks weakly reduces SPsH in states where s 0β = , again making it

more desirable to assign authority to the franchisor.

3.5. Changes in the law

We have seen that the per se prohibition of franchisee discrimination may inefficiently

reduce flexibility and adaptation by limiting the franchisor’s ability to contract decisions ex

29

post with individual franchisees. In the light of this, it is natural to ask whether reforms

aimed at softening the law can reduce ex post inefficiencies and improve adaptation.

I distinguish between two types of legal change: a full liberalization of franchisee

discrimination and a rule-of-reason approach, whereby courts may or may not prohibit

discrimination, depending on the circumstances. I assume that, under the rule of reason,

parties expect the courts to enforce contracts that were previously illegal with probability

π , where π may reflect an average court’s balance between the expected social benefits

and costs of discrimination. Hence, the expected total surplus from writing a previously

illegal contract when the rule-of-reason standard applies is FBTSπ , irrespective of who has

authority. To make the analysis interesting, I also assume that { }FB SP SPF fTS max TS ,TSπ > ,

implying that, if a rule-of-reason approach is introduced, it is binding. Given these

assumptions, the efficiency effects of legal changes are defined by the following

Proposition 7: switching from a per se prohibition to a full liberalization of franchisee

discrimination achieves the first best. When relational contracts can be used to circumvent

the law, switching from a per se prohibition to a rule-of-reason approach improves

adaptation if, and only if r is high enough.

Proof: in appendix.

Intuitively, under a rule-of-reason approach, the franchisor may offer different formal

contracts to franchisees (irrespective of their sales) or collect payments from franchisees in

exchange for a “merciful” use of his authority, as in the first-best contracts from section

3.2, and yet hold some chance to walk away with it. The franchisor will still prefer to use

informal agreements in order to fully escape the risk of judicial interference. However, by

increasing total surplus under formal contracts, the rule-of-reason approach reduces the

franchisor’s future loss from reneging on informal ones, thus making it harder to sustain

them.30 This problem is more serious when informal agreements matter – that is, when the

interest rate is low.

30 Baker et al. (1994) apply the idea that an improvement in the parties’ post-reneging payoffs may weaken informal contracts to the interaction between objective and subjective incentive pay in firms. See, also, MacLeod (2007) for a recent review of the literature on the interaction between formal and informal contracts.

30

Besides the specific case of franchising, proposition 7 has a general implication for

contract-law reform. The rationale for replacing the per se prohibition of certain contractual

provisions with a rule-of-reason approach is to mitigate the prohibition’s inefficient effects

while allowing courts to selectively intervene in order to protect competition, weak firms

and other public interests. According to proposition 8, such “soft” liberalization may be

unsuccessful, and may even backfire, by making it difficult to enforce informal agreements

that circumvent the law. When this effect is substantial, legislators may be unable to

implement gradual contract-law reforms, and may have to choose, instead, between

maintaining the per se prohibition of contractual clauses or fully repealing it, depending on

their balance of the economic and social interests at stake.

3.6. Testability

For empirical purposes, the model can be summarized as follows. Propositions 2, 3, 5

and 6 predict how the ex ante allocation of authority in franchise contracts ( { }g F, f∈ ) and

the prospect of future interactions between franchisor and franchisees (r) affect the choice

to update standards ( { }isd 0,1∈ ) and the use of formal incentives (respectively, { }s 0,1β ∈

and SPst ), both across franchisees and over realized states. Proposition 4 predicts how the

importance of updating standards in the future (the size of sK ) and the degree of intra-

brand competition between franchisees ( iγ ) affect the ex ante allocation of authority.

Finally, proposition 7 predicts how the prospect of future interactions between the

franchisor and franchisees affects the performance – and, consequently, the choice – of

different legal rules on franchisee discrimination. Hence, testing the model requires data on

g , isd , sβ , iγ , SPst , sK , r and the applicable law, or at least on some of these variables.

Data on g can be obtained by looking at provisions in boilerplate franchise contracts

allocating the authority to introduce new standards in the future (see section 4 for more on

this). Data on isd , sβ and SPst can be obtained by looking at the annexes to franchise

contracts for one or more brands over multiple years. Annexes contain information on what

31

standards franchisees are currently required to respect, whether standards apply to all

franchisees or only to those with high sales, and whether the franchisor offers formal

monetary incentives to franchisees who comply with the standards. Data on iγ can be

obtained by looking at the number and density of franchisees across networks or locations

within a network. As we shall see in section 4, legislative liberalizations of intra-brand

competition can also provide system-wide measures of iγ .

While identifying Ks in a given state is problematic, certain characteristics of franchise

networks are likely to be associated to the size of Ks. For instance, when the franchisor’s

brand is known for sophistication and quality, it may be efficient to subject all franchisees

to strict standards, and also to regularly upgrade standards in order to maintain an aura of

exclusivity. There are a number of possible measures for the franchisor’s sophistication and

quality, such as menu prices and in-house food preparation in chain restaurants (Yeap

(2006)) or the average list price of cars in automobile distribution (Arruñada et al. (2001)).

While previous empirical studies on relational contracts have proxied r with the

frequency of past interactions between parties (Corts and Singh (2004)), r measures in fact

the prospect of future interactions, so an appropriate proxy for r should capture exogenous

factors related to how long and how frequently the franchisor and franchisees will do

business together.31 Franchisees’ proximity to retirement age may be a good, exogenous

proxy for the prospect of future transactions with the franchisor. This type of information

could be obtained by asking franchisors to provide data on the age of their franchisees or by

directly surveying a sample of franchisees. A network-level proxy for r may also be an

announced restructuring of the franchise network due to poor market conditions, which

typically involves termination of several franchises.32

31 In this vein, Gil and Marion (2010) measure the r parameter in contracts between contractors and subcontractors of highway construction projects as the number of future projects scheduled by the government. They argue that this is an exogenous proxy for r because the government’s calendar for construction projects is unrelated to the likelihood that specific pairs of contractors and subcontractors will work together in the future. 32 Restructuring decisions are usually announced in advance because the law protects franchisees from holdup by requesting an advance notice for termination at will. For instance, in the EU, the 1400/2002 Commission regulation of automobile distribution requires a two-year advance notice, and the Italian law on franchising

32

The US constitute a good setting for testing the effect of different legal treatments of

franchisee discrimination on contracts (proposition 7) because, as discussed in section 2,

some states have explicit anti-discrimination laws (akin to the per se prohibition scenario),

others have laws that protect franchisees from unfair and abusive treatment but do not

explicitly mention discrimination (akin to the rule-of-reason scenario), and some other

states do not have franchise laws at all, so common law, which permits discrimination,

regulates franchise disputes (akin to the full liberalization scenario). In the EU this type of

test would be more problematic because, while not all member countries have national anti-

discrimination laws, the EU antitrust law, which applies to all members, explicitly prohibits

discrimination.

One last point pertains to informal payments. The relational contracts analyzed in

section 3.4 rely on individual, informal payments between the franchisor and the

franchisees ( iw for proposition 5 and iw and isb for proposition 6). While some anecdotes

on informal payments can be obtained through interviews – examples from automobile

franchising are discussed in section 4 – observing them systematically is problematic.

Indeed, if informal payments aim to circumvent the law, as the model assumes, they should

be carefully disguised to third parties – for instance, taking the form of voluntary publicity

investments or long working hours. Fortunately, the comparative-static predictions in

propositions 5 and 6 – such as the relation between standardization, frequency of formal

payments and r – do not require direct observation of the informal payments.

4. Evidence from automobile franchising

In this section I present a survey of automobile franchising in Italy, which helps

illustrate several assumptions and predictions of the model. The data come from three

sources. First, I collected boilerplate franchise contracts used in Italy by 19 representative

requires a three-year notice. In the US, several states have laws requiring that franchisees be not terminated before they can recover their initial investments (see Brickley et al. (1991) for a comprehensive survey).

33

brands.33 These contracts allocate the authority to define dealers’ standard features and

other commercial practices. For each brand, I had access to the contract negotiated under

the 1475/1995 EU regulation of car distribution (hereafter the “1995 contract”) and to the

one negotiated under the 1400/2002 EU regulation (hereafter the “2002 contract”), resulting

in a sample of 38 contracts. As discussed in a companion paper (Zanarone (2009)), an

important difference between the 1995 and 2002 contracts is that, due to the new regulatory

provisions, the latter do not contain “location clauses”, that is, clauses assigning dealers to

exclusive territories.34 As a result, the change in regulation provides a quasi-natural

experiment to test proposition 4, which predicts that an expected increase in intra-brand

competition should lead to an increase in the contractual authority of franchisors.

In addition to the franchise contracts, I obtained annexes to 10 of the contracts for the

year 2004. While contracts allocate the right to make decisions in the future and are

relatively stable over time – those in the sample have been changed only once since 1995,

after the new EU regulation was passed – the annexes specify and describe in detail these

decisions at a specific point in time, and are subject to yearly revisions. Hence, they provide

information on how contract terms are adapted ex post, given the initial allocation of

authority.

To complement the contractual data, I conducted in-depth interviews with managers of

Italian branches of manufacturers, dealers and dealer associations, and with an authoritative

Italian lawyer specialized in the automobile industry.35 The interviews provide anecdotes

33 The contracts represent the following brands: Ford, Opel, Toyota, Mitsubishi, Mazda, Mercedes, BMW, Volkswagen, Audi, Peugeot, Citroen, Renault, Volvo, Jaguar, Land Rover, Seat, Fiat, Alfa Romeo and Lancia. These brands accounted, in 2004, for 85% of new car sales in Italy (source: the European Car Distribution Handbook, 2005 edition). 34 The prohibition of location clauses has been withdrawn by the latest EU regulations of automobile distribution (Commission regulation 461/2010) and vertical agreements (Commission regulation 330/2010). However, the new legislation will only apply from June 2013. 35 The interviews were conducted in 2007, nine in person and the rest on the phone. In addition to the lawyer, I interviewed a dealer for Citroen, Volkswagen, Audi, Skoda, the presidents of the Italian associations of Fiat, Alfa, Lancia and Peugeot dealers, the general secretary of the Italian federal association of dealers (FEDERAICPA), and managers responsible for the distribution networks in Fiat, Alfa, Lancia, Jaguar, Nissan, Honda, Volvo and Porsche. The interviews lasted on average two hours and were semi-structured. All respondents were asked to briefly answer some questions, and then left free to complement their answers with anecdotes and examples.

34

and insights on practices that are not formalized either in contracts or in annexes, thus

shedding some light on the interaction between formal and informal contracts.

4.2. Ex ante allocation of authority

The data on authority were obtained by listing 13 decision rights that are explicitly

mentioned in at least one of the 38 boilerplate contracts in the sample, and then defining a

dummy variable that takes value one whenever a decision right is assigned to the

manufacturer. This results in a total of 492 observations – that is, 13 × 38 = 494, minus 2

missing observations. Descriptive statistics are displayed in table 1.

<TABLE 1 HERE>

To test the effect of free intra-brand competition on authority, I estimate dprobit

regressions for the probability that a contractual provision assigns authority to the

manufacturer. As explanatory variable I use a dummy for whether provisions are extracted

from 2002 contracts. To control for unobserved heterogeneity, I include fixed effects for

the 19 manufacturers and the 13 decision rights in the sample. The results are displayed in

table 2.

<TABLE 2 HERE>

The regressions indicate that, after the European Commission prohibited manufacturers

to restrict intra-brand competition through dealer-exclusive territories, franchise contracts

substantially increased the manufacturers’ discretion to impose new standards and other

obligations on dealers. The coefficients on the legal change dummy are positive and

statistically significant even after including the fixed effects and clustering standard errors

by manufacturer. The coefficients are also economically significant: after the change in

European regulation, the probability to observe a contractual clause assigning authority to

the manufacturer increases by 20 percentage points. These results are consistent with the

model, which predicts that, in the presence of legal constraints that limit the franchisor’s

ability to efficiently contract standards with franchisees ex post, authority should be

35

allocated to the franchisor when intra-brand competition is tougher and, therefore,

franchisees have weaker incentives to implement the standards he requires.36

4.3. Ex post adaptation through formal contracts

Table 3 displays information from the contractual annexes. Specifically, table 3 reports,

for each type of standard, how many manufacturers impose it by authority (mandatory) or

not (non-mandatory), how many apply the standard uniformly to all dealers (uniform), and

how many allow low-sales dealers to adopt a softer standard (stricter for high-sales

dealers). Sales-based standards are defined by broad sales categories, although the number

of categories varies across brands. For instance, three manufacturers divide dealers into 3

sales categories, whereas one manufacturer divides them into 9 categories.

<TABLE 3 HERE>

Standards

It is clear from table 3 that financial standards, standards on the honorability and

qualification of employees, those on accounting and information systems, those on the

dealers’ marketing strategy and those that relate to customer satisfaction tend to be uniform.

Conversely, standards on the size of dealers’ premises, on the number of employees and

their training, on the number of display and demonstration cars, and on the dealers’

minimum advertising budget tend to be stricter for high-sales dealers. There are significant

exceptions, however, in both directions. On one hand, five manufacturers require a delivery

area of uniform size regardless of sales, and one manufacturer requires all dealers to keep

the same number of cars in stock and for demonstration. On the other hand, one

manufacturer requires high-sales dealers to implement tougher marketing policies (defined

as the number of promotional activities per year), four manufacturers require them to adopt

36 Arruñada et al. (2001) find that automobile franchise contracts in Spain assign more decision rights to manufacturers in networks with greater intra-brand competition, as measured by the number of dealers. The data presented here validate their results by showing that the link between intra-brand competition and authority holds even after measuring intra-brand competition through the exogenous change in European law and controlling for unobserved heterogeneity at the manufacturer and decision-right level.

36

stricter interior design standards, and three manufacturers require them to employ a full-

time customer-relationship manger.

The fact that certain standards are stricter for high-sales dealers is consistent with the

model’s assumption that standards have a greater impact on the brand’s image when

implemented by large franchisees. Moreover, the fact that sales are nearly the only criterion

by which formal contract terms differ across dealers suggests that, consistent with the

model’s legal assumptions, sales-based differences are more acceptable for courts. Indeed,

only one manufacturer out of the ten for which contractual annexes were available uses

criteria other than sales to differentiate between dealers – namely, he allows dealers in areas

with high rental costs to display less cars in the showroom.37 Finally, the fact that

manufacturers allow softer standards to low-sales dealers even when they could impose

tight standards on all indicates that, in contrast with the analysis of spot contracts in the

model (proposition 2), manufacturers use their authority with self-restraint. This could be

because authority is sometimes non-binding – for instance, because low-sales dealers would

prefer to breach the contract to complying (see footnote 23), or because imposing a tough

standard to low-sales dealers does not benefit the manufacturer (formally, is isv = ω ).

However, the fact that very similar standards are uniform in some contracts and

differentiated by sales in other contracts does not seem consistent with these hypotheses.

An alternative explanation, consistent with proposition 5, is that, even though

manufacturers have a private interest in imposing tough standards on all dealers, they use

authority with self-restraint to honor an informal promise to small dealers, who have a more

limited impact on the brand’s image. A way of fully separating the two hypotheses would

be to check whether standards are more uniform across dealers when the likelihood of

future interactions with the manufacturer is smaller, as discussed in section 3.6. I leave this

for future research.

37 When asked to motivate the lack of exceptions for dealers in high-rent areas, the manager of a leading Asian manufacturer declared that he prefers to issue looser but uniform standards on the dimensions of dealerships in order to avoid discrimination claims.

37

Formal payments

According to the data displayed in table 3, some manufacturers offer fixed, uniform

subsidies to all dealers who upgrade certain exterior features in their showroom. For all the

other incentivized standards, dealers do not receive a fixed subsidy but, rather, a discount

on the list price of cars, implying that large dealers are compensated more than small ones.

Interestingly, this occurs not only when large dealers face tougher standards – which is

natural, given the increase in implementation costs – but also when they face the same

standards as small ones. For instance, one manufacturer offers a discount to dealers who

constitute themselves as limited-liability companies; nine manufacturers offer a discount to

dealers who achieve a critical level of customer satisfaction, as measured by yearly surveys;

and one manufacturer offers a discount to dealers who install a tower with glass ceiling at

the centre of the showroom, whose dimensions are independent of showroom size. A

possible reason for the prevalence of discounts, not modeled here, is that large dealers have

greater bargaining power and, therefore, they are able to persuade manufacturers to adopt a

discount scheme that favors them. Another possibility is that there are many dealers whose

sales are positively correlated with the opportunity cost of implementing standards. This

may be plausible, since large franchisees tend to be located in urban areas (Lafontaine and

Slade (1997)), where occasional car buyers are more likely (in the model, this would imply

that they are characterized by greater values of iγ ).

Another interesting fact from table 3 is that the dealers’ incentives are linearly

increasing in sales. A possible explanation is that linear payments are easier to administer

(an aspect that is not considered in the model), and the savings in administration costs may

offset the losses from overpaying infra-marginal dealers. This, however, seems inconsistent

with the fact, to be discussed momentarily, that manufacturers tailor some standards and

incentives to individual dealers via informal agreements. An alternative explanation, which

is fully consistent with the legal constraints analyzed in this paper, is that courts may

consider payments that increase with sales in a non-linear fashion as discriminatory,

because they cannot verify the reasons for non-linearity. To prevent this, manufacturers

38

may want to commit to a uniform discount rate, so that differences in payments between

dealers with different sales obey to an objective rule.

4.4. Ex post adaptation through informal contracts

All of the managers who participated to the survey reported that, in addition to applying

different standards to high-sales and low-sales dealers, manufacturers enforce some

standards selectively, and that this informal flexibility is important to adapt standards to

differences between dealers without violating the law. This is mainly achieved by

alternating formal audits and informal inspections of dealerships. Formal audits are

predictable and relatively infrequent, they are mostly outsourced to specialized contractors,

and their results are disclosed to dealers’ associations. In contrast, informal inspections are

conducted by manufacturers on a discretionary basis, and their results are neither

formalized in official documents nor disclosed to dealers’ associations. Manufacturers can

safeguard against allegations of discriminatory treatment by having formal audits on few,

minimum standards that all dealers satisfy, while using informal audits to collect more

comprehensive information. This allows manufacturers to tolerate a dealer’s non-

compliance with certain contractual standards, if he wants so, without producing verifiable

evidence that this has occurred.

Consistent with the model (proposition 6), the interviews also suggest that

manufacturers take steps to informally implement standards that they have no authority to

impose. The managers of two car manufacturers and the president of a dealer association

reported that manufacturers use discretionary bonuses to incentivize dealers, and that these

bonuses are handled informally in order to avoid formal discrimination. The other

respondents said no discretionary bonuses are used, and one of them added that using such

bonuses “would constitute corruption”. However, one dealer of a large European make

revealed that the manufacturer often sends dealers e-mails and letters asking them to

implement standards on which he lacks formal authority and that are clearly costly for

dealers, such as increasing the amount of fuel injected in cars prior to delivery, committing

to deliver cars to customers within 5 days from the announced date, and owning, rather than

39

renting, the machinery and tools used in repair workshops. The letters specify no formal

compensation for adopting these standards. When asked to explain why dealers comply

with these requests even though they are neither obliged nor incentivized, the dealer

pointed out that manufacturers have many avenues to motivate dealers besides monetary

incentives, such as tolerating late payments and extending the deadline to comply with

mandatory standards. This suggests that, even though most managers prefer not to use

discretionary bonuses – or not to talk about them – payments “in kind” are used to facilitate

informal adaptation of contracts when the manufacturer does not have authority.

5. Conclusion

Franchisors must adapt their contracts with franchisees to diverse temporal and local

conditions. This paper has shown theoretically that, when the law protects franchisees from

unfair and unequal treatment, contract adaptation may be too rigid, both across franchisees

and over time. To achieve flexible adaptation in the shadow of the law, franchisors may

rely on informal agreements with individual franchisees, while retaining the formal

authority to change the contract terms for all when these are tempted to renege, due to free-

riding. Contractual data from automobile franchising in Italy provide robust econometric

evidence on the model’s prediction on authority, as well as descriptive and anecdotal

evidence that franchisors use formal and informal contractual tools to achieve adaptation in

the shadow of the law.

This paper offers at least three contributions. First, it provides a theory of how non-

discrimination laws affect the design and evolution of franchise contracts, which is largely

consistent with real-world practices. Second, it offers an example of relational contracts as

“judge-free” areas protecting the parties from legislative and judicial overreach, rather than

substitutes or complements of insufficient judicial enforcement. Finally, the paper provides

a new rationale for allocating authority in incomplete contracts besides those emphasized in

the literature – namely, asymmetric information, the costs of specifying and enforcing

contracts, and the need to protect specific investments.

40

The model may be extended to settings where equal and fair contract terms are desired

by the parties, as in Hart and Moore (2008), rather than imposed by the law. I conjecture

that, even if franchisees were averse to unequal terms irrespective of whether these are

formal or informal, the franchisor might still use informal contracts to better hide

inequalities. A similar argument may also apply to the employment relationship. While

these extensions are beyond the scope of the present paper, I hope to pursue them in future

research.

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45

Appendix: mathematical proofs

Proof of proposition 1: Suppose that g = F, and consider the following three franchisor’s

strategies: (1) set isd 1= for franchisee i in state s, (2) offer to set isd 1= if every franchisee

other than i pays ( ) ( )is s is is

11 vN 1− γ

τ = −α −ω−

to the franchisor and (3) offer to set isd 0= if

franchisee i pays ( ) ( )is is s i is ist c 1 v= − −α γ −ω to the franchisor. Plugging tis and sτ into the

franchisor’s payoffs, we obtain that the best credible strategy for the franchisor is (1) when

( ) ( ){ }s is s s i is is si K i : c 1 v K−∈ = < α + −α γ −ω ⊆⎡ ⎤⎣ ⎦ , (2) when ( )s si K K−∈ − , and (3) when

si K∉ , which is efficient. Suppose now that g = f, and consider the following franchisor’s

strategies: (1) pay ( ) ( )is is s i is ist c 1 v= − −α γ −ω to franchisee i if i sets isd 1= , (2) pay

( ) ( )is is s i is ist c 1 v= − −α γ −ω to franchisee i if i sets isd 1= and every j i≠ pays

( ) ( )is is is

11 vN 1− γ

−α −ω−

to the franchisor, or (3) pay nothing and get isd 0= . By the same

argument as before, the best credible strategy for the franchisor is (1) when si K−∈ , (2)

when ( )s si K K−∈ − , and (3) when si K∉ , which is efficient. QED.

Proof of proposition 3: To achieve the first best without violating the law, the franchisor

must offer to every franchisee s

is isi Ki : q min q

∈≥ who sets isd 1= a payment schedule s ist + τ ,

such that is jsτ ≥ τ for any i j> . The cheapest such schedule is: st 0= , is isOCτ = when

sis isi K

q min q∈

≥ and is i 1,sOC OC −≥ , and is i 1,sOC −τ = when s

is isi Kq min q

∈≥ and is i 1,sOC OC −< . The

franchisor will offer this schedule if, and only if

( ) ( ) ( )s is is is s i is isv c 1 vα −ω ≥ − −α γ −ω for every s is i 1,si : i K OC OC −∈ ∧ ≥ , and (A1)

( ) ( ) ( )s is is i 1,s s i 1 i 1,s i 1,sv c 1 v− − − −α −ω ≥ − −α γ −ω for every s is i 1,si : i K OC OC −∈ ∧ < . (A2)

46

Both conditions are more restrictive than the efficient condition (1), so they need not hold

for every si K∈ . If both (A1) and (A2) hold, it will be SPs sH K= If either (A1) or (A2) fails

to hold, it will be SPs sH K⊂ . QED.

Proof of proposition 4: It follows from (3) and (4) that g = F is efficient if, and only if

( )SP SPs s

s is is s isi H i HE v E c

∉ ∉⎡ ⎤ ⎡ ⎤−ω >⎣ ⎦ ⎣ ⎦∑ ∑ . (A3)

Suppose a new franchisee i enters the set Ks in state s. This loosens (A3) if SPsi H∉ and

leaves (A3) unaffected if SPsi H∈ , thus making g = F weakly more efficient. Moreover, (A1)

and (A2) imply that a decrease in iγ , for any i, weakly reduces the size of SPsH , which,

given (A3), makes g = F weakly more efficient. QED.

Proof of proposition 7: the fact that first best adaptation is feasible when franchisee

discrimination is fully liberalized follows directly from proposition 1. To evaluate the

impact of a rule-of-reason approach, assume, without loss of generality, that the allocation

of authority is g = f. Then, the optimal relational contract under a rule of reason chooses the

schedules sβ and RfsH to maximize

( )( ) ( )( ) ( ) ( )( )Rf Rfs s s s

RFs s is is is s is is isi H i H i K i K

TS E v c 1 v c∈ ∉ ∈ ∉

⎡ ⎤= β − + ω + −β π − + ω⎢ ⎥⎣ ⎦∑ ∑ ∑ ∑

subject to

( ) ( )( ){ } ( )Rfs

Rf FBs is s i is isi Hs S

1max c 1 v TS TSr∈∈

β − −α γ −ω ≤ − π⎡ ⎤⎣ ⎦∑ . (A4)

Comparing (A4) with (17), we can see that the legal reform has two opposite effects.

First, it increases RFTS for given values of sβ ; second, it tightens the franchisor’s reneging

temptation. Denote the optimal relational contracts before and after the reform as Rfs s,Hβ

and ( )'' Rfs s, Hβ , respectively. Then, the reform increases surplus in states where 1)

's s 0β = β = and in states where 2) s 1β = , '

s 0β = and

( )( ) ( )Rf Rfs s s s

is is is is is isi K i K i H i Hv c v c

∈ ∉ ∈ ∉π − + ω > − + ω∑ ∑ ∑ ∑ . On the other hand, the

47

reform reduces surplus in states where 3) 's s 1β = β = and in states where 4) s 1β = , '

s 0β =

and ( )( ) ( )Rf Rfs s s s

is is is is is isi K i K i H i Hv c v c

∈ ∉ ∈ ∉π − + ω < − + ω∑ ∑ ∑ ∑ . When r is low, more

states fall into categories 3) and 4), so the negative effect of the reform dominates. QED.

48

Table 1: Descriptive statistics

Decisions over which authority is allocated Showroom design

Advertising contribution

Advertising quality

Advertising budget

Size of personnel

Qualification of personnel

Mandatory training

Operating capital

Customer satisfaction programs

Customer satisfaction targets

Dealers’ working hours

General duty to respect standards

Maximum retail price

Authority mean 0.39

Authority standard deviation 0.48

Number of contracts 38

Number of decisions 13

Missing observations 2

Total number of observations 492

Notes: Authority is a dummy variable that takes value 1 when any of the 38 contracts in the sample assigns to the manufacturer the right to make any of the 13 decisions listed in the table.

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Table 2: The effect of free intra-brand competition on the authority of car manufacturers (dprobit regressions)

Independent variables:

Dependent variable: 1 for clauses assigning authority over a decision to the manufacturer, 0 otherwise

(1) (2) (3) (4)

Free intra-brand competition (1 for 2002 regulation, 0 for 1995 regulation)

0.17***

(0.04) 0.17***

(0.04) 0.19***

(0.05) 0.20***

(0.54)

Manufacturer fixed effects No Yes No Yes Decision-right fixed effects No No Yes Yes Observations 492 492 492 492

Pseudo R2 0.02 0.05 0.14 0.18

Notes: *** Significant at the 1% level. Robust standard errors clustered by manufacturer in parentheses. The intra-brand-competition coefficients measure how much the probability to observe a contractual clause assigning authority to the manufacturer changes after the change in European regulation.

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Table 3: Contractual standards used by 10 manufacturers in 2004

Type of standard Number of manufacturers that define standards of given type as: Incentive for non-mandatory standards

Mandatory Non-mandatory

Uniform Stricter for higher-sales dealers

Size of premises 8 1 1 8 Discount Size of display area 10 0 0 10 Size of delivery area 4 4 5 3 Discount Parking lots 10 0 0 10 # cars in display* 9 1 0 10 Discount # demo cars 10 1 1 9 Discount # cars in stock 5 0 1 4 No # employees 10 0 0 10 No Juridical form 7 1 8 0 Discount Qualification of personnel 10 5 10 0 Discount Training 10 2 10 0 Discount Standardized accounting 10 0 10 0 No Information systems 10 5 10 0 Discount Marketing materials & brochures

7 3 10 0 Discount

Marketing strategy 7 2 6 1 Discount Publicity budget 6 0 0 6 No Trade-in 5 0 5 0 No Interior design 6 5 6 4 Discount and

fixed subsidy Exterior design 10 4 10 0 Discount and

fixed subsidy Financial standards 9 0 9 0 No Customer Relationship Management

3 6 3 3 Discount

Certification of dealership 5 0 5 0 No Customer Satisfaction Index

0 9 9 0 Discount

Hours 7 0 7 0 No

Notes:

• The same manufacturer may use several standards of a given type (for instance, many interior design standards), some mandatory, some non-mandatory, some uniform and some stricter for high-sales dealers.

• Mandatory = standards imposed when the manufacturer has authority. Dealers who do not comply can be terminated. • Non-mandatory = standards that the manufacturer has no authority to impose. Dealers who do not comply cannot be

terminated. • Uniform = standards that are equal for all dealers of the same brand. • Stricter for high-sales dealers = standards that are more demanding for dealers in higher sales categories. Example:

“dealers with sales target < 200 must do 1 promotion per year; dealers with target > 200 must do 3 promotions”. • Sales are the only criterion by which formal standards differ across dealers, except for one manufacturer who allows

dealers in areas with high rental costs to keep fewer cars in display. • Discount = share of the list price of cars. In all annexes, the discount rate is uniform across dealers. • Fixed subsidy = upfront payment from manufacturer to dealers who comply with a standard. When used, it is

uniform across dealers.