For years (though it seems like forever) encroachment has reigned as franchisees' single most important concern. And yet a recent court ruling may have finally prompted the industry to come up with a definitive solution and at last put an end to the scuffles.
The ruling by the 9th U.S. Circuit Court of Appeals found that Mexican-restaurant chain Naugles Inc. breached the good faith and fair dealing clause in its franchise agreement when it opened a restaurant 1.4 miles away from a Long Beach, California, location owned by franchisee Vylene Enterprises Inc., which eventually went out of business.
Besides awarding Vylene damages of $2.2 million, the court handed franchisees considerable ammunition for future encroachment suits against franchisors. The Vylene case is "probably one of the most significant cases in franchising in the past 25 years," says Erik Wulff, a partner with Washington, DC, law firm Hogan & Hartson, who points out the case will likely set a persuasive precedent even for states outside the 9th Circuit's Western region jurisdiction.
Franchisees and their advocates, unaccustomed to the taste of legal victory, are thrilled. "It's obviously a very exciting case for franchisees," says Robert Purvin, chairman of the board of trustees of the American Association of Franchisees & Dealers. "In terms of encroachment, Vylene is a good-news case--the franchisee won. But the real significance of Vylene is that good faith and fair dealing in a franchise agreement have been acknowledged as the law in the 9th Circuit."
In fact, the Vylene case is significant in that it found Naugles had encroached on its franchisee even though the system's franchise contract did not guarantee a protected territory. Moreover, the court did not venture to define just how close is too close. So while franchisees rejoice, franchisors are biting their nails.
"The limits set in one court won't be the limits in another," says Lewis G. Rudnick, partner of Chicago-based law firm Rudnick & Wolfe. "It will be impossible for franchisors to figure out where to put additional units if they have to worry about being second-guessed [by the courts]."
This ambiguity is what's going to spawn litigation, Wulff adds. "Whenever franchisees think there's some impact on their unit and want to make a legal issue out of it," he says, "they've got a case that permits them to pursue that [allegation] to trial."
Meanwhile, Purvin believes the court was right to leave out a specific radial definition of encroachment. "The [issue of] substantive fairness is even more important than focusing strictly on encroachment," he says.
Fairness is ideal. Still, in the real world, most anticipate the case will result in a spate of franchisee-instigated litigation. "Franchisees and their lawyers are going to seize on this decision as giving new life to [their cause]," Rudnick predicts. "It will certainly be widely cited in their claims."
"Will franchisees be emboldened by the fact that over the last six months, they've had [several] significant decisions that went their way? You'd better believe it," says Purvin. "But I think that's going to cause more franchisors to wake up and take a reality check, and get together and negotiate with franchisees so they don't have problems."
Basically, franchisors have a few black-and-white options to offset lawsuits spurred by the Vylene case. "The first is to have a sensible expansion policy and to make decisions that [consider] the interests of franchisees," says Wulff. "The second thing they can do is start giving some radius protection to franchisees--it would be very unusual for a court to question a franchise agreement that contains radius protection, even though it may be relatively small. Or they could take a hard-nosed attitude and articulate in the franchise agreement that a franchisee has no territorial rights, is buying a franchise for a specific location, and that the franchisor has a right to put a location anywhere it wants."
Whatever the franchisor chooses, it's clear some action is necessary. "That way, you have some predictability in these situations," says Wulff. "It's better than leaving it to the vagaries of some court down the road."
Though the ruling requires harsh measures, "it may result in the issue of encroachment being addressed in a more positive way through [franchise] contracts," says Wulff. "Otherwise, as a franchisor, you're just going to end up spending all your time, effort and money on litigation. No one wants to do that."
Adds Purvin, "Franchisors will be crying foul, saying they can't predict what they can or can't open. But from the franchisees' perspective, we're pushing for mechanisms to set these definitions within [individual] systems. If people use their brains and are compassionate upfront, they can set up processes to ensure this whole [problem is solved]."