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In August, as General Nutrition Companies, franchisor of General Nutrition Centers, was presenting its franchisees with a settlement to a class action lawsuit, The New York Times ran an article describing the facts of the case and why some franchisees were not pleased with the proposal.
Brought up in the suit were charges of territory violations and unfair competition by GNC against its franchisees. GNC, its franchisees allege, opened company-owned stores near franchised locations and charged less for products, causing some franchisees to lose customers or go out of business.
Cases like this that make a push for the protection of franchisee territories seem like a good cause, but are they? Are there times when having an exclusive territory doesn't benefit the franchisee or franchisor? Franchise Zone spoke with Robert Nye, franchise attorney and professor of law at The John Marshall Law School in Chicago, about this controversial issue and found that there are no easy answers to these questions.
Franchise Zone: What are the benefits of exclusive territories for franchisees?
Robert Nye: The benefit to a franchisee is to assure the franchisee there will be no encroachment on its customers or its customer base or its geographical territory by the franchisor or by another franchisee in that system. A franchisee would want that assurance against encroachment because if there are sales increases resulting from the franchisee's efforts in that territory, the franchisee wants to get the benefit of those sales increases, and that's natural, normal and to be expected and desired.
Are there any benefits for the franchisor?
There are a couple of legal benefits as well as practical ones. States sometimes, in certain industries, require that there be exclusive territories; for example, a winery or brewery franchise would be in violation of some state statutes by not giving exclusive territories to its wholesalers and distributors.
Secondly, as far as the law is concerned, even when a franchisor is not required by law to give an exclusive territory to a franchisee, there are states that have by statute made it unlawful for a franchisor to "compete unfairly" with the franchisee within a "reasonable area." If there is going to be a problem for a franchisor, even if a franchisor doesn't typically give an exclusive territory, it might be reasonable for the franchisor to consider granting an exclusive territory so that the franchisor and franchisee both know what that "reasonable area" is that's mentioned in some of those statutes.
Some of the practical reasons for granting an exclusive territory, from the point of view of the franchisor, have to do with the very nature of the franchise relationship. When a franchisor grants an exclusive territory to a franchisee, the franchisor knows that that franchisee has the incentive to build sales, to build a customer base and increase it in that particular territory, and that helps not only the franchisee but also the franchisor and the entire franchise system. The franchise relationship is an interesting one-the franchisor has a lot of control over what the franchisee does but is also dependent upon the progress and the sales and the activity of the franchisee in order to expand and prosper.
What are the drawbacks to exclusive territories?
So far as a franchisee is concerned, the drawbacks might be if the exclusive territory is too small and then the franchisee is making sales in that particular area but wants to expand and can't. That doesn't mean the franchisee and franchisor can't negotiate for an expansion of the territory, but you start running into the problems of the franchisees in the next exclusive territory. A franchisee in a particular territory might also find the territory is too large and, under the franchise agreement, [have] obligated itself to certain minimum sales it can't make in that particular size territory.
Meanwhile, franchisors are going to be reluctant to grant an exclusive territory to a franchisee when the size or something about the territory demonstrates it ought to be served by more than one franchisee.
Today, there's a big concern in franchising about franchisors selling online. What do we do if a franchisor has granted an exclusive territory to a franchisee and then, through the franchisor's own Web site, sells the same product or services to persons who normally would have been serviced by the franchisee in that franchisee's exclusive territory? There have been claims already made that a franchisor is violating the franchise agreement and is encroaching on the franchisee's exclusive territory in that way. Lawyers are currently discussing and developing reasonable ways to accommodate both the needs and desires of the franchisee and the franchisor with respect to those kinds of online sales.
There's also the question of whether the franchisor would want to permit a franchisee to sell online [to customers who] otherwise would have been served within other franchisees' exclusive territories, and so there might be a violation of the exclusive territory provision in that way. These sorts of things need to be dealt with in light of current technology developments.
Does it make a difference if the franchise is a retail or service business?
The same issues are going to be present whether you're talking about a product or a service.
Let's assume the franchise is for maid service in a home. Franchisees have to put together groups of people to provide the service, and I don't see why franchisors would interfere with a particular franchisee's exclusive territory in the providing of that kind of service. But if it's the kind of service that can be provided online, for example, or by telephone, information service or something like that, claims of encroachment are possible.
When franchisors establish an express location in a gas station or sell in grocery stores, does that violate a territory?
Again, we have to look at what territory, if any, has been given. One of the interesting things about [encroachment] law is that some states are now saying it's unlawful for a franchisor to "compete unfairly with a franchisee within a reasonable area." The terms "reasonable area" and "compete unfairly" are going to be subject to the type of franchise, the location, how many people pass by and what has happened since the opening of this alleged unfairly competing franchise store or company store.
Is this an issue that will divide franchisees and franchisors? Is it something they would take sides over?
Usually exclusive territory isn't an issue franchisors and franchisees who are already in a relationship get involved in. And if a prospective franchisee doesn't like the franchise agreement because it doesn't provide for an exclusive territory, he doesn't become a franchisee. However, a franchisee may decide, based upon the franchise agreement and advice of counsel, even without an exclusive territory, "I'm going to with it anyway. It's a good franchise, and this franchisor has treated its franchisees well, and I'm willing to rely on the statutes that exist, and that may hereafter exist in my state, to protect me in the event that a franchisor does compete unfairly with me in my reasonable area, even if I don't have any exclusive territory. And I'm willing to take the chance that the franchisor won't sell a franchise to another franchisee in my reasonable area, even though I don't have an exclusive territory, because of my knowledge of the franchisor."
In the process of settling a class-action lawsuit, GNC brought up the issue of violating exclusive territories, not only because they were building company-owned stores near franchise locations but also because the company-owned stores got their products for a lot less and were able to charge lower prices than franchisees. Does pricing come into an exclusive territories deal?
I don't know that that's an exclusive territory issue, although, depending on the case, the unfair treatment concept with respect to obtaining goods at lowered costs might be involved with an exclusive territory or an encroachment matter.
Does having or not having an exclusive territory affect a franchise's success?
Some franchisees who don't have an exclusive territory might feel the pressure of other franchisees in their area; some would be impacted negatively. Other franchisees might treat it as a challenge and rise to the occasion, becoming the preeminent franchisee in their particular area. So it all depends on the basic personality and drive-and the resources-of a particular franchisee.