334 | ‘Unsustainable’ Business Model: Hoteliers turn to courts and legislation to reform franchising

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FRANCHISE REFORM: U.S. Sen. Catherine Cortez-Masto of Nevada has sponsored several legislative proposals that would make the Small Business Administration require brands to disclose first-year financial results of franchised outlets to prospective franchisees seeking SBA-guaranteed loans from banks. State and federal lawmakers and regulators, including the Federal Trade Commission, are expected to take on the issues of fair franchising in the months ahead.

Proposals introduced, lawsuits filed while state and federal lawmakers and regulators review current practices with an eye toward revision

Prakash Shah is a hotel financier in Edison, New Jersey, where he leads an organization of hotel owners called Fair Franchising Initiative, which aims to change brand-licensing agreements through legislation.

Shah said although a fair-franchising proposal in the New Jersey legislature has been on hold throughout the pandemic, FFI expects it to eventually pass. From there, the organization will push for reform nationwide.

The New Jersey proposal is a model of the change that hundreds of owners of branded hotels in the U.S. want to see as the lodging industry recovers from the coronavirus crisis.

Although hotel franchisees’ discontent with the brands existed before the pandemic, the crisis has heightened owners’ fear and uncertainty of being able to stay in business and take part in the industry’s recovery unless brand-licensing practices change to meet modern business realities.

“The franchise model as it stands today is unsustainable. It is just not reasonable anymore,” Shah said.

Decades ago, franchisers generated 50 to 80 percent of a hotel’s occupancy. Today, he said, the brand directs 20 to 30 percent. Over the past 20 years, online travel agencies have become a major distribution channel, competing with hotel chains neck and neck for dominance.

Shah said owners of branded hotels pay OTA commissions of up to 15 percent per booking but franchisers double that cost through third-party-booking fees.

“This is clearly, clearly unsustainable and the model has to change,” he said. “If it doesn’t change in a rational way through negotiations or reasoning with each other, then it has to change in a drastic way by simply franchisees deciding to abandon the franchisers.”

‘UNSUSTAINABLE BUSINESS MODEL: Legislative proposals in the U.S. Senate, along with advocacy at the Federal Trade Commission, pending measures at state legislatures and legal challenges in U.S. courts may ultimately reform brand franchising. Episode 334 of Lodging Leaders podcast explores how hotel franchisees’ brewing discontent with franchisers is leading owners to take drastic steps through the courts as well as turn to federal and state lawmakers for solutions.

Meantime, Vimal Patel, founder, president and CEO of Q Hotel Management in LaPlace, Louisiana, is making news headlines since he filed a lawsuit against InterContinental Hotels Group and its subsidiaries.

In the suit filed in U.S. District Court for the Eastern District of Louisiana, Patel claims IHG engages in unlawful business practices, including colluding with vendors in a kickback scheme that franchisees are forced to support when completing brand-mandated property improvement projects.

Patel claims IHG requires owners buy from designated vendors who raise their prices and shorten their warranty periods. In return, the suit says, the vendors financially reward IHG.

Andrew Bleiman, a business lawyer and managing partner at Marks & Klein law firm in Northbrook, Illinois, is representing Patel.

“The franchisees are captive consumers of the franchiser,” Bleiman said.

IHG is “taking advantage of that relationship by mandating vendors, mandating these initiatives and programs that require the franchisees to spend money purchasing services, goods and products from these mandatory vendors. And they’re doing so at an inflated cost.”

The lawsuit was filed in late May against IHG, the IHG Owners Association and IHG subsidiaries, including Holiday Hospitality Franchising, IHG’s licensing arm.

Since then, several more owners have filed similar complaints against IHG in U.S. district courts. The collective suits may result in class-action or multidistrict litigation.

READ: FIRST ONE TO FILE: Vimal Patel of Q Hotel Management in late May filed a lawsuit against InterContinental Hotels Group and its subsidiaries alleging unfair and illegal business practices. Here is a copy of the suit.

Defendants Respond

IHG and the owners association each responded via email to Lodging Leaders’ request for comment about Vimal Patel’s suit.

A spokesperson for IHG Hotels & Resorts said, “While we don’t comment on details of pending or ongoing litigation, we are committed to making decisions that are beneficial to our brands and to the fair treatment of all hotel owners who choose to invest in our brands. We are currently reviewing the small number of similar complaints that have been filed by individual owners. We do not believe these claims have merit and will vigorously defend and seek dismissal of these claims through the appropriate legal processes.”

A spokesperson for IHG Owners Association said, “The IHG Owners Association, a not-for-profit member organization, works every day on behalf of owners to maximize the returns on their IHG hotel investments. We believe the claims asserted against the association are baseless and will be dismissed.” (See Editor’s Update at bottom of this article.)

IHG is not the only brand-licensing company to face owner backlash. In June 2020, a group of owners who franchise brands owned by Choice Hotels International filed suit alleging unfair practices in the form of vendor rebates. They also accused the franchiser of racial discrimination against Indian American hoteliers, who comprise about 80 percent of Choice franchisees.

Lodging Leaders reported on the Choice suit last year in Episode 284. According to court documents, the case is in court-ordered arbitration.

READ: OWNERS V. CHOICE: As anyone in franchising knows, legal challenges to existing agreements are not new. Vimal Patel of Q Hotel Management is not the first to file suit against a franchiser amid the pandemic. In June 2020, a group of about 100 Asian American hoteliers who are franchisees of Choice Hotels International sued the franchiser, alleging similar unfair business practices outlined in Patel’s suit. Click here to read a copy of the plaintiffs’ complaint. Click here to read a copy of Choice Hotels International’s response to Lodging Leaders’ request for comment.

Though problems between franchisers and franchisees existed before the pandemic and franchise litigation is far from unusual, Bleiman said the coronavirus crisis has exacerbated the issues his client and other hotel owners face.

“Did COVID play a role? Sure,” he said, noting IHG continued to charge franchisees under the terms of their agreements despite the pandemic’s negative impact on business. “The fact remains that it’s difficult for franchisees to spend money. Also, as a result of COVID, sales were down and financing opportunities aren’t there.” This, he said, has “put a strain on the franchisees’ ability to operate.”

Patel’s company has four IHG-branded hotels in its portfolio. He said he loves the brands but the costs of doing business continue to increase despite the economic downturn caused by the pandemic.

He claims he’s attempted to reason with the franchiser but to no avail. And he said many owners are afraid to speak up at IHG and the IHG Owners Association because they fear retaliation.

“We are held captive by the franchise agreements and a lot of franchisees who know about the challenges, who know about the problem and have raised their objections to the brand have been dealt with differently,” he said. As a result of speaking up, he claims, owners’ “financial ability has been compromised.

“And so everybody has been fearful sort of to take this kind of a stance, to go out there and file a lawsuit in a public forum. It’s not a typical way to fight this cases.”

Patel said his goal is for both the owners and IHG “to fundamentally to make money and profit.”

He said he and other owners take on the bulk of the financial risk when opening a hotel. They sign for the loans, pay the property taxes, meet payroll and satisfy other operating costs. Patel said he has not taken a distribution from his investments in five years.

Six months before the pandemic hit, Patel finished a $1.8 million PIP at his Holiday Inn Express & Suites in LaPlace.

Patel was featured in Lodging Leaders’ Episode 278, released on July 22, 2020, which examined the pandemic’s impact on CMBS lending. Patel financed the hotel’s renovation with a CMBS loan, a debt that offers no recourse when a borrower cannot pay. In that report, Patel had said he attempted to discuss the issue with Wells Fargo Bank, master servicer of the loan, which responded by sending him a letter informing him he had to make debt payments no matter what.

Patel said while he’s struggling with debt, IHG has offered no relief and even reduced its marketing support since the crisis began. “The question comes about, ‘How much we can continue to take?’ And, technically, we have become employees of the brand. We are doing all the investment. We are taking on all the liabilities.”

State Initiative

Patel also joins other franchisees in wondering why they pay marketing fees to the brands when OTAs send the most business to their hotels.

That echoes one of the reasons why in early 2020 a group of hoteliers formed Fair Franchising Initiative, a non-profit organization pushing for legislation they believe will create equitable licensing agreements.

The New Jersey-based group held its inaugural conference in March 2020, one week before the coronavirus outbreak was declared a global pandemic.

Though the organization has not held in-person meetings in the past 18 months, Shah said it continues to promote legislative proposals that would strengthen brand-licensing agreements on behalf of franchisees.

In consideration is Assembly Bill 2682, which would prohibit franchisers from several practices, including:

  • Requiring an owner to spend more than $25,000 more than once every five years on property improvements unless the franchiser can demonstrate the franchisee would recover the value of investment during the contract term;
  • Receiving rebates or bonuses from brand-certified vendors that sell goods or services to the franchisee unless the deal is transparent in the franchise agreement;
  • Requiring franchisees to buy from specific vendors or service providers; and
  • Making any unilateral changes to the original franchise agreement during the term of the licensing contract.

Shah said New Jersey lawmakers are focused on the current election season, but once November has passed, FFI will advocate for the passage of the proposal in both chambers.

From there, FFI hopes to expand its effort to other states.

Federal Territory

While a “state-by-state” approach is part of FFI’s strategy, Shah said, the organizing is advocating for proposals before the Federal Trade Commission that could alter government regulation of franchising.

The FTC activity, he said, is “picking up momentum. And we are really very hopeful that the new setup at the FTC with the new commissioners, the new chairperson, will be very much interested in a sustained interest in fair franchising, which certainly it appears right now. And we really hope to capitalize on that.”

The commission oversees brand licensing of all kinds of businesses under its franchise rule. But many franchisees are not aware that the FTC regulates franchising.

That’s because the commission has little impact on actual licensing agreements and has rarely exercised its authority over the franchising industry, said Keith Miller, owner of Franchisee Advocacy Consulting who advises FFI and other franchisee groups.

The FTC adopted its franchise rule about 30 years ago, Miller said. It only covers the franchise disclosure document.

“It basically is a pre-sale-disclosure rule and it basically ends at the point that you signed your franchise agreement,” he said. “As soon as the ink dries, the FTC theoretically has no involvement from the franchise rule.”

The FTC’s franchise rule has no teeth to enforce fair-franchising practices. Worse, Miller said, is the FTC rarely reviews FDDs. “They don’t even collect those documents. So I don’t know how you can call it oversight of the industry when the oversight agency doesn’t even collect the document.”

Miller spends a lot of time lobbying members of Congress as well as heads of federal departments that regulate business, including the FTC.

The commission is under the new leadership of Lina Khan, who was appointed by President Biden and sworn in in June.

Miller and other fair-franchising advocates expect the FTC to strengthen its oversight of brand-licensing agreements. For good reason.

Another Biden appointment that gives the franchisee community hope is that of Rohit Chopra as head of the Consumer Financial Protection Bureau, an organization he helped launch in 2011.

Chopra in 2018 became a commissioner at the FTC, where he has since voiced concern about its franchising rule.

Chopra has “put the word ‘franchising’ back in the vocabulary at the FTC,” Miller said. “It had probably been two decades since the commission uttered the word ‘franchise’ much less started trying to publicize it and work on it.”

Meantime, Khan has discussed franchising with her staff, Miller said.

The subject caught Khan’s attention while she was investigating the alleged imbalance of power between big tech and big pharma in contracts, he said. “Khan kind of looks at franchising as falling under that same model. If there’s a power imbalance in the contracts then the FTC should be providing some fairness to it.”

Lawmakers on the move

Miller is a member of American Association of Franchisees and Dealers and is its director of public affairs and advocacy.

He is seeing several congresspeople becoming more aware of the need for stronger franchisee rights in brand licensing and begin to push for reform.

During a virtual meeting in July with the AAFD, Representative Jan Schakowsky of the 9th District of Illinois, said she asked the General Accounting Office to study the inadequacies of the FTC Franchising Rule.

WATCH: ‘INADEQUACIES’ IN FTC RULE: U.S. Rep. Jan Schakowsky, D-Ill., spoke to the American Association of Franchisees and Dealers during a virtual conference in July about her efforts to expand and strengthen the Federal Trade Commission’s oversight of franchising. Click here to watch Schakowsky’s presentation.

Schakowsky chairs the House Consumer Protection and Commerce Subcommittee. Schakowsky in December joined Sen. Catherine Cortez-Masto of Nevada in publicly calling for the FTC to reform its franchise rule.

They want to see increased financial disclosure, a ban on unfair contract terms and protections for franchisees with limited proficiency in the English language.

During her meeting with the AAFD, Schakowsky noted she also plans to introduce a legislative proposal that will create a private right of action for franchisees who believe they’ve been harmed by their franchiser.

As it stands now, Miller said, franchisees and prospective franchisees can sue only for violation of what’s outlined in the FDD. The lawmakers want the FTC to enable owners to sue for violations of what’s in the actual licensing agreements.

“The franchise rule doesn’t say you don’t have a private right of action,” Miller said, “but all the courts, and it’s been footnoted inside the franchise rule, that said since it didn’t explicitly give you the right to sue for a private right of action, you can’t assume it. And only Congress can actually provide that. And so that’s the intent of this legislation.”

SBA targeted

Another legislative movement on Capitol Hill is focused on what franchisers disclose to the Small Business Administration about the financial viability of their brands.

In July 2019, Miller, who also is a Subway franchisee, testified before the Senate Committee on Banking, Housing and Urban Affairs’ Subcommittee on Economic Policy in favor of changes to the FTC’s franchise rule. You can read his testimony here.

He also talked about the SBA practice of guaranteeing 7(a) business loans to prospective franchisees unaware of loan defaults of previous license holders.

Many franchise developers mislead prospective owners on how much revenue a hotel or outlet can generate in a year. The owner soon finds the business does half that amount – not enough to pay back the loans.

Miller proposed the FTC expand its franchise disclosure of brands that qualify for SBA 7(a) loans.

The SBA has a Franchise Directory meant to help lenders determine the eligibility of a business that plans to operate under a brand flag.

Miller asked that any prospective franchisee that seeks an SBA loan should receive the average first-year revenue generated by the franchised outlets and how many owners ceased doing business within the first year of opening.

As a result of that hearing, Cortez-Masto introduced the SBA Franchise Loan Transparency Act, which would require brands disclose specific financial information.

Because of the pandemic, the bill did not get to the Senate floor for a vote.

Cortez-Masto re-introduced the measure in April as Senate Bill 1120.

“This bill would require if that a brand is going to receive SBA loans that it have very specific financial representation disclosure in that document,” Miller said. “That would include average unit volume; first-year revenue numbers; and average unit for first year of operation. And that’s important because when you provide your data for an SBA loan, you have to come up with a first-year projection of how much money you’re going to make.

“It would also require disclosure of how many units failed in the first year. Because if the unit opens and closes within six months, it never hits a first-year average.”

Miller said the best part of the proposal is if it’s proven that the franchiser’s deception caused a licensee’s business to fail, the franchiser is liable for the SBA loan debt.

Franchise Study

Throughout the pandemic, Cortez-Masto continued to research the franchising industry.

In April, she released a report on the franchising industry, citing practices that can bankrupt franchisees.

In June, Cortez-Masto and Sen. Elizabeth Warren of Massachusetts co-sponsored the SBA Loan Default Disclosure Act or Senate Bill 2162, which would require the SBA to publish loan-default rates of franchised brands.

 

*Editor’s Update: On Aug. 27, Marks & Klein law firm filed a motion in U.S. District Court for the Eastern District of Louisiana to dismiss IHG Owners Association as a defendant in the lawsuit filed by Vimal Patel of Q Hotel Management. An IHG spokesperson on Sept. 2 emailed this statement: “The IHG Owners Association has been dismissed from all cases and is no longer a part of this dispute.” Lodging Leaders updated this article on Sept. 15.

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