Contract Adaptation Under Legal Constraints

Abstract

This article studies how franchise contracts adapt to temporal and local conditions in the shadow of the law. I theoretically show that when the law protects franchisees from unequal treatment, the subsequent changes to the franchisees’ standards tend to be too rigid, both across stores and over time. To increase flexibility, franchisors should modify standards informally when possible, while retaining the authority to modify them formally in situations where the franchisees may be tempted to renege, particularly due to free-riding. I also show that when the prohibition of unequal treatment is replaced with a rule-of-reason approach — whereby courts allow unequal contract terms that are economically beneficial — the rule of reason may backfire because it makes any informal agreements less attractive and, hence, harder to sustain. Finally, I provide evidence that, consistent with this model, car manufacturers in Italy use informal compensation to selectively enforce standards and retain the authority to modify the standards when intrabrand competition is strong, so that dealers are tempted to free-ride.

Keywords: Incomplete Contracts, Relational Contracts, Adaptation

JEL Classification: D23, L14, L22