Franchise Encroachment, Part 1

Two legal experts take up both sides of this increasingly hot topic

It's something we've all seen before: A few blocks away from our neighborhood's big-name fast-food restaurant, another one exactly like it opens. The occurrence is so common that passersby probably never guess that, behind the scenes, a long-term dispute about encroachment is brewing between franchisors and franchisees.

What is encroachment? The definition is simple: Encroachment is "trespassing" on the property of another. The issue of encroachment in franchising, though, is another story. Over the past few years, the debate between franchisors and franchisees has become more complicated, focusing on franchisees' explicit or implicit rights to protected markets to sell their goods and services in.

Should franchisees always have protected areas around their locations where no intrabrand competition is allowed? Are franchisees allowed every imaginable-or unimagined as of yet-method of distribution or just the methods of distribution licensed to them? Do franchisors have a duty to compensate franchisees for any real or potential reduction in sales when they allow additional locations to open or establish different methods of selling goods or services that may compete with existing franchisees? What happens if the new location is owned by the same franchisee who opened the original location? Is that encroachment also?

For some answers-or maybe to raise some additional questions-I turned to 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.

Most Significant Encroachment Issues

Franchise Zone: What are the most significant issues concerning encroachment in franchising?

David Kaufmann:

  • The Internet and e-commerce, and the extent to which these channels constitute "virtual encroachment."
  • Franchisees' contention that they're entitled to protected market areas despite the contrary explicit terms of their franchise agreements (especially those that afford "site only" or limited territorial protection).
  • Franchisor dual-distribution programs, under which franchisors' products are sold in such secondary venues as supermarkets, convenience stores, on the premises of independent retailers and so on.
  • Franchisors' placement of units in nontraditional or seasonal locations (such as universities, military bases, workplaces and expositions).

These "issues" aren't true disputes as to what the agreement says or does not say but are based instead on a franchisee's unhappiness with previously agreed-to terms.

Robert Zarco:

  • Placing a competing unit operated by the franchisor or another franchisee in close proximity to an existing unit.
  • Taking away sales of an existing unit by mailing products or providing services from outside the franchisee's area into his or her market through the use of the Internet or other means.
  • The development of alternative distribution channels such as supermarkets, kiosks, convenience stores and so on.
  • Sister-brand encroachment, in which a franchisor acquires a competing brand and the franchisor's marketing and trade secrets are shared with franchisees from the other brand.

Encroachment Solution

What's the solution?

Kaufmann: As always, the solution to franchisee unhappiness over claimed franchisor "encroachment" is for the franchisee to truly understand-with the assistance of competent franchise counsel-the nature and extent of the territorial protections, if [there are] any. These provisions should be reviewed three times by every prospective franchisee-first in the UFOC, second in the specimen franchise agreement appended to the UFOC and third in the actual franchise agreement executed by the parties. All too often, franchisees later complain of encroachment and suggest they really didn't pay attention to the franchise agreement's territorial provisions before signing the contract. This is truly unfortunate, as realistic expectations-framed by fully and thoroughly understanding the franchise agreement before it's signed-will almost always militate against subsequent franchisee unhappiness over contractual terms.

Zarco: The franchisor that will benefit from additional locations should share in the existing franchisee's decrease of profits. It can do this by making a direct financial contribution, reducing the royalty rates or requiring the new franchisee to pay a portion of its royalties to the affected franchisee. The franchisee nearest the new unit should have the right of first refusal to obtain the new unit based on objective criteria established by the franchisor.

Competition Issues

Kaufmann: That's frequently the case. Contrary to popular franchisee conception, franchisor executives don't come to work each morning looking to do battle with their franchisees. They come to work looking to do battle with the competition. And the competition all too often is able to respond to changes in technology, demographics and consumer demand far more quickly than franchisors weighed down by antiquated franchisee-agreement territorial provisions and/or franchisees whose "location concerns" are rooted in desire rather than contractual rights. Is it a coincidence that Starbucks avoided franchising while achieving dominance through nationwide-and rapid-market saturation?

Zarco: Unlike nonfranchised companies, which use their own money to expand and thus can spend and allocate it as they choose, there are different equitable considerations to take into account in a franchise environment. Franchisors must always consider franchisees' rights and interests in their investments. If a particular franchisor wishes to grow without regard to the impact that growth has on its franchisees, it should purchase all the units back and become a complete corporate operation.

Contractural Concerns

Do franchisees have an unrestricted right for claims of encroachment regardless of the language of the contracts?

Kaufmann: If franchise-agreement territorial provisions are clear, well-drafted, explicit and adhered to by the franchisor, then technically franchisees have no claim of encroachment whatsoever against their franchisors. It's unfortunately the case, however, that some members of the judiciary-using as cover the "implied covenant of good faith and fair dealing"-substitute their notions of what is "fair" for franchisees separate and apart from what the contracts actually say. This destructive tendency of some jurists contravenes the basic principle that what was "fair" when the contract was signed is "fair" today.

Zarco: Franchisees absolutely do not have an unrestricted right. The contractual language is crucial in determining whether franchisees can assert and monitor claims against franchisors for Breach of Contract, Breach of Implied Covenant of Good Faith and Fair Dealing and so on. If a particular franchise agreement contains language that clearly and specifically states the franchisor has reserved for itself the right to place a competing unit in close proximity to an existing franchisee's location, regardless of impact, then there's a substantial legal precedent to uphold the franchisor's right to encroach. If, however, the franchise agreement fails to specifically set forth the respective rights of the parties as to the location or expansion of future stores, then the franchisee is free to allege and maintain express and implied contract claims.

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