Franchise Encroachment, Part 2

Two legal experts take up both sides of this increasingly hot topic
6 min read
Opinions expressed by Entrepreneur contributors are their own.

In Part 1 of this in-depth look at one of the hottest topics in franchising, our author spoke with two of the most recognized names on the legal side of this debate: David Kaufmann, senior partner of New York City-based law firm Kaufmann, Feiner, Yamin, Gildin & Robbins LLP, who works primarily with franchisors; and Robert Zarco, founding partner of Miami-based law firm Zarco & Pardo, who works with franchisees. Read on to see what else these two attorneys have to say on the issue:

Do you think some franchisors' e-commerce activities can be considered encroachment?

Kaufmann: Franchisor e-commerce activities are just another subset of contractual market-exploitation divisions created by the franchise agreement. If the franchise agreement permits the franchisor to engage in e-commerce to the exclusion of franchisees-or with limited participation by, or recompense to, franchisees-then franchisees shouldn't complain when such activity transpires. The adage remains the same: Read and understand your franchise agreement before signing it!

Franchisees acquire only the limited rights to sell and furnish their franchisors' goods or services through one or more defined distribution modes (such as retail units or assigned accounts)-and not through every other conceivable distribution mode developed now or hereafter. The Internet-which traverses all boundaries-is the best example of why this must be. If franchisees felt free, under some implied but nowhere memorialized "right," to establish Web sites and offer their products/services worldwide, the franchise's ability to devise a coherent e-commerce strategy would disappear. The system would quickly disintegrate thanks to a plethora of conflicting Web pages; franchisees' "virtual" encroachment on other franchisees would grow; pricing, fulfillment and return policies would be disparate; and, in general, e-chaos [would ensue].

If franchisees desire distribution rights beyond those explicitly granted by their franchise agreements, they should negotiate for them before the relationship ensues.

Zarco: Overall, I'm for franchisors' e-commerce activities, with one caveat: In e-commerce, it's difficult to limit use to one market area only. Since it's generally global in nature, it seems patently unfair to completely prevent a franchisor from carrying on its business in a manner that could be detrimental to a particular franchisee, but could benefit it and its system as a whole on a global basis.

In such a situation, the franchisor should work out a fair and reasonable compensation package to reduce the impact such expansion would have on the franchisee especially considering the potentially large reward and benefit the franchisor could receive.

Michael H. Seid is managing director of Michael H. Seid & Associates, a management consulting firm specializing in the franchise industry. Seid recently co-wrote Franchising for Dummies (IDG Books) with Wendy's founder Dave Thomas.

Minimum-Distance Legislation

Is Iowa-type legislation, which stipulates a minimum distance between units or impact formula, a reasonable solution to franchisee concerns?

Kaufmann: Iowa-type franchise-relationship legislation may at first blush appear to be an attractive way to resolve franchisee "encroachment" concerns. But, in reality, they prove a bane to both franchisors and franchisees. Government dictating just where retail units should or should not be situated didn't work in the former Soviet Union and won't work here. If such legislation is enacted on a widespread basis, the end result would be many franchisors withdrawing from franchising altogether and substituting, with relatively great ease, joint venture protocols. Many franchise opportunities would disappear-all to the detriment of many people who want to obtain franchises.

Zarco: Minimum distance restrictions are easier to apply and measure because they're objective. Impact measurements, on the other hand, raise the question: What factors do you take into account to measure impact? You can't just rely on gross sales comparisons between different years. What if, in addition to the impact of the new store, the existing franchisee's sales suffer from external factors, such as new and different competition, taste differences, road constructions, economic fluctuations and a gain or loss in traffic generations? This method of calculating impact is much more complex and subjective although ultimately more accurate.

Encroachment Formulas

Would building encroachment formulas into relationship laws improve the lot of franchisees?

Kaufmann: In the short term, encroachment formulas built into franchise relationship laws could marginally improve the lot of existing franchisees by keeping intrabrand competitors away. If I owned the first McDonald's franchise in Manhattan, it might appear logical that I, too, would want to limit McDonald's ability to franchise others on the island. But this would be a grave error on my part.

The secret to franchising's success is, and has always been, marketplace saturation sufficient to outstrip and preempt the competition, foster broad brand-name recognition, yield significant collective purchasing power and, most critically, garner optimal advertising penetration within any given market. If a market is underserved by too few franchisees as a result of encroachment formulas built into franchise relationship laws, franchisees in that market will quickly find themselves at a significant competitive disadvantage with little potential for brand growth.

Zarco: Encroachment formulas built into relationship laws will improve the lot of franchisees, because the profile of the franchisee today is very different from in the past. Today's franchisees are much more sophisticated and aware of their legal rights. As such, any assurance that they'll be fairly compensated in the event of encroachment will raise the franchisor's credibility within the system and naturally attract a greater number of applicants. Once the word gets out that a franchisee who has suffered will receive fair compensation, then more franchisees of a higher caliber will flock to that system.

Wrapping Up

The dispute over the issue of encroachment isn't going to be settled any time soon. House Resolution 3308 introduced by Rep. Howard Coble (R-NC) and Rep. John Conyers (D-MI)-which would micromanage the nation's franchise relationships, including encroachment-has been introduced in Congress and has nearly 50 co-sponsors, although a few who previously were sponsors have distanced themselves from the proposed legislation.

While it's not likely to pass this year, some form of H.R. 3308 will probably re-emerge next year. It's supported by the American Franchisee Association, a national trade association of franchisees and dealers with more than 16,000 members, which will push hard for its passage. Those opposed, including the U.S. Chamber of Commerce, the National Association of Manufacturers, the Small Business Survival Committee, the National Franchise Council and the International Franchise Association, will battle just as hard for its defeat.

What's most interesting in the debate over H.R. 3308 and government-established encroachment criteria is that franchisee support for protective legislation is not universal. Recently, the Franchisee Advisory Council of the International Franchise Association (an association representing more than 30,000 franchisees operating in more than 70 different industries) came out in opposition to the proposed legislation.

Stay tuned to see how this debate turns out.

Franchisee Encroachment: Do you think franchisors should be restricted from building additional locations within a certain proximity to existing franchisees?

Because franchises compete with nonfranchises (The Coffee Beanery vs. Starbucks, Alphagraphics vs. Kinkos), if the government dictates the distance between franchised locations, should it also dictate distance between nonfranchised locations so the two types are affected equally?

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