ABA Connection

Troubled Kingdoms


By his own estimate, Minneapolis lawyer Ronald K. Gardner Jr. says, it is probably impossible nowadays to drive 50 miles from any point in the United States and not be able to buy a sandwich from a Subway store.

Gardner’s observation is neither a comment on the collective American palate nor a critique of popular culture. But it does say a lot about the state of franchising in the United States today and its outlook for the future.

By most accounts, that forecast is for continued robust growth. Experts generally expect significant numbers of new franchises to enter the domestic market in the coming years while franchises already established in the United States are exported in growing numbers to other countries.

In 2004, there were more than 767,000 franchised busi­ness­es in 75 different fields in the United States, according to a Pricewater­­house­Coopers study conducted that year. Those franchises contributed some 9.8 million direct jobs and more than 18 million indirect jobs to the U.S. economy.

The franchise industry reaches far beyond fast-food chains and convenience stores. Franchises also are found in a variety of other retail and service businesses such as quick-printing shops, hair salons, tax preparation services, tutoring services, Web hosting services, cleaning services and health clubs. Many distribution systems also are franchises, including automobile parts dealers, boat dealers and gasoline stations.

But there also are concerns that franchising is due to experience some growing pains. How franchise systems respond may create tensions in the relationship between franchisors and franchisees, experts caution.

It’s a relationship that creates a delicate balance between the parties even when a franchise system is humming along.

To some extent, that balance of interests is a product of the hybrid legal nature of franchises.

“A franchisor relationship is an independent contractor relationship, but with a whole layer of controls,” says Dennis E. Wieczorek, who chairs the ABA Forum Com­mittee on Franchising. “The franchisee has to follow what the franchisor says in terms of how to operate the business. So it’s a hybrid between the company-owned store and the hands-off distribution model.”

In franchising, “there is always an inherent conflict,” says Steve Hockett, president of FranChoice, a franchise broker based in Eden Prairie, Minn. “As a franchisee, you are neither subordinate to the franchisor nor do you run the franchise. And the franchisor is not the franchisee’s employer. So you have this mix where neither side is in an employer or employee relationship. Each side has rights and has the ability to protect those rights. It does create some conflict.” In Hockett’s view, “The two key elements are franchisee satisfaction and profitability. If franchise systems focus on that, then they have very little problems. Be­cause—even if the franchisees are restricted—if they are making money and are well-serviced, then they are happy. The litigation you hear about is because the franchisee is not making money and the franchisor is not focused on their satisfaction.”

GROWTH AND CONSEQUENCES

Both those elements of franchisee satisfaction can be undermined if franchise growth isn’t managed properly, experts say.

“Startup franchisors want to give lots of space to pro­spective franchisees to get them into the system,” says Gardner, a member of the governing committee for the ABA Forum Committee on Franchising who practices with Dady & Garner in Minneapolis. “They would rather give them a whole city than one block. So early on, people are given big, exclusive areas. But once a franchisor matures, it runs out of places to continue to expand. Then you get into the ‘what do we do now’ situation when the renewal comes up with the original guy who you’ve given all of a city to, and he only has three stores—and you think that city could support 30 stores.”

Look at cell phone company stores, says Gardner. “Ten years ago, you might have walked by one in the mall. Now there is one in every strip mall you see. “Those are mostly franchises. Had the cell phone companies started out by granting five miles of exclusivity for 15 years, they would have killed themselves. They were smart. They gave out very short agree­ments, typically for two years. So then in two years they could change the agreement to allow for the growth they’ve seen. They got people to buy in because the industry got so wildly successful that everyone wanted a piece of the action.” That, Gardner says, “is a real growing pain. As systems mature, how do you deal with this demographic issue?”

IS EVERYBODY HAPPY?

Expanding a franchise system while keeping the existing franchisees profitable and happy is a challenge at every stage of a franchise business’s growth, according to Wieczorek, who co-chairs the franchise practice group at DLA Piper Rudnick Gray Cary in Chicago.

“There are a number of older, mature systems, and the question is: Can they continue to grow, and how will they continue to grow?” says Wieczorek. “Then there are the smaller, midsize companies that are absolutely going through growing pains and various types of other relationships with their franchisees. And then there are always the startups that are just learning the business, and that creates its own set of problems.”

The relationship between franchisor and franchisee still is essentially a matter of contract law. The Federal Trade Commission and 19 states have regulations covering franchises, but those focus primarily on disclosure and registration requirements.

While franchise agreements can vary greatly in the details, a typical agreement imposes extensive restrictions on franchisees. As long as the relationship results in satisfaction and profitability for the franchisees, they tend to be happy with the agreement, Hockett says. But when satisfaction and profitability drop off, the terms of the agreement can become the focus of franchisee disenchantment—and legal challenges.

Over the years, franchisees have tried to attack franchise agreements under different legal theories with varying degrees of success. Early on, their arguments were based primarily on antitrust law, but then they turned to the arguments of implied covenant of good faith and fair dealing to attack franchise agreements. But those arguments ultimately backfired on franchi­sees because they only encouraged franchisors to develop agreements that were even more one-sided, Gardner says.

“At the end of the day, the thing about winning a covenant-of-good-faith case is that the courts say that the contract is not so clear, and that is why they end up ruling for the franchisee,” says Gardner.

“But then the franchisors can just change the contract, and the struggle continues. Franchisors are now very express about what they can do. In some contracts the franchisors have even disclaimed the covenant of good faith. That is stunning for a franchisor to say, that ‘We have no obligation to be fair with you.’ ”

But franchisees have started to make legal inroads by claiming that some franchise agreements, or at least certain provisions, are so one-sided that they are unconscionable.

Last year, the California Supreme Court struck down as unconscionable a prohibition against class action arbitration in consumer contracts. Discover Bank v. Superior Court, 113 P.3d 1100 (June 27). Later, a California court of appeal extended the holding to franchise agreements in Inde­pen­dent Association of Mailbox Center Owners Inc. v. Superior Court, 133 Cal. App. 4th 396 (Sept. 16).

That decision could pave the way to widespread class action arbitrations if franchisees can get other jurisdictions to adopt it, says Charles G. Miller, a lawyer at Bartko, Zankel, Tarrant & Miller in San Francisco who litigates franchise matters. “I don’t know if we will see more franchisee class actions as a result, but people will not feel as constrained as they used to,” he says.

Another 2005 California Supreme Court decision, this one dealing with jury trial waivers, also has the potential to create major changes in franchise agreements, according to Miller.

The court ruled in Grafton Partners v. Superior Court, 116 P.3d 479 (Aug. 4), that contract provisions providing for jury trial waivers are unenforceable because waivers only may be allowed by statute.

Jury trial waivers often are contained in franchise agreements, and Miller says he would not be surprised to see franchisees using Grafton Partners in efforts to level the playing field in litigation against franchisors.

Franchisees and their counsel also have been looking for other ways to skirt the prohibitions against class actions that are contained in many franchise agreements.

Some suggest that franchisee associations may provide one possible means for accomplishing that. Generally, these associations are formed in efforts to give franchisees more leverage in dealing with franchisors on systemwide issues. But now, some franchisees want to use their associations as vehicles for litigating more effectively with their franchisors.

So far, no court has agreed to grant a franchisee asso­ciation standing to sue a franchisor, but several cases are percolating around the country that will test those precedents, says John Baer, a lawyer at Sonnenschein Nath & Rosenthal in Chicago.

For now, though, most franchise lawsuits tend to be one-on-one affairs pitting a single franchisee against the franchisor.

And increasingly, that litigation is testing the balance of power between franchisors and their franchisees.

TERRITORIAL IMPERATIVES

A key concern for franchisees in today’s increasingly competitive environment is encroachment, says Richard Rosen, a solo practitioner in New York City. Encroachment typically occurs when a franchisor wants to maximize its profits by adding additional franchise units into a territory.

“The franchisor wants its franchisee to be profitable, but the franchisor might feel that an area could handle two or three locations, while the franchisee says it can only handle one location—‘And that is mine,’ ” Rosen says.

Adding more franchise locations may increase the franchisor’s profits from the royalty fees that additional units generate, but it also may dilute the sales that occur at each individual franchise.

Many franchise agreements do not give franchisees exclusive territories, and encroachment has spawned numerous court cases.

One of the seminal cases in this area is Scheck v. Burger King Corp., 756 F. Supp. 543 (S.D. Fla. 1991).

In Scheck, a Burger King franchisee claimed the franchisor encroached upon his territory by allowing another Burger King to open two miles away from his restaurant. While the franchise agreement did not grant franchisees any type of exclusive territory, the plaintiff argued that the opening of the second restaurant violated an implied contractual covenant of good faith and fair dealing.

In dismissing the franchisor’s motion for summary judg­ment, a U.S. district judge held that, “while Scheck is not entitled to an exclusive territory, he is entitled to expect that Burger King will not act to destroy the right of the franchisee to enjoy the fruits of the contract.”

The Scheck decision made many franchisors take no­tice, says Miller, because, up until then, most thought that their standard language in franchise agreements was a sufficient defense to encroachment.

But in subsequent rulings, several courts declined to follow Scheck. See Burger King Corp. v. Weaver, 169 F.3d 1310 (11th Cir. 1999); Barnes v. Burger King, 932 F. Supp. 1420 (S.D. Fla. 1996).

“The simple explanation is because it didn’t really make sense,” says Miller. “If I say you have no exclu­sivity, that means I can build or franchise nearby.” Michael Joblove of Miami’s Genovese Joblove & Battista says Scheck left many more questions than answers. One of those is whether a franchisor’s Internet sales can constitute encroachment on the geographical territories of franchisees.

“There are so many different ways that franchise systems grant territories,” he says. “What kinds of protections do they offer franchisees? If I have a location in a strip mall, can a franchisor have a Web site? Does that violate a franchisee’s territory? As new methods of retail occur, there is a continuing struggle in how to define territories. Cases have gone both ways. Some agreements only protect against stand-alone sites coming in. Other language has been held to be sufficient to protect against [online] competition.”

E-VOLVING ISSUES

Many franchise agreements don’t account for e-commerce. The Internet had not even been contemplated when some franchise systems came into existence, and many original agreements still govern the relationships between franchisors and their long-term franchisees.

Some franchisors have seized upon the absence of any provisions on e-commerce to delve into Internet-based sales and distribution channels. Franchisees, however, say these sales are encroaching on their bricks-and-mortar territories.

In 2000, a group of Drug Emporium franchisees claimed that their franchisor’s online subsidiary—which engaged in direct sales of the system’s products over the Internet—encroached on their territories. A panel of arbitrators ruled in favor of the franchisees, concluding that Internet sales violated the exclusivity provisions of the franchise agreements. The panel also rejected claims by the franchisor that attempted to distinguish between bricks-and-mortar stores and virtual stores. Emporium Drug Mart Inc. v. Drug Emporium Inc., Bus. Franchise Guide (CCH), para. 11,966 (AAA Sept. 2, 2000).

Since the Drug Emporium ruling, there has been a rush by franchisors to revise their franchise agreements to explicitly reserve e-commerce rights, Gardner says.

Recent cases have led to some innovative legal solutions to the encroachment issue. Rosen says some franchises have adopted buffer zones around protected territories where franchisees are granted a right of first refusal over any new units. Other systems are conducting impact studies of alleged territorial encroachments, and if a study shows a negative impact on an existing franchise, certain rights are triggered on the part of the franchisee, including damage awards. Still other systems are establishing ombudsman positions to give franchisees an avenue to discuss complaints against the franchisor.

At the same time, however, franchise systems are expanding their power in other ways that may test the franchisor-franchisee relationship, according to fran­chise law practitioners.

Edward Dunham of Wiggin and Dana in New Haven, Conn., says there has been an uptick in the number of franchise systems that are unleashing direct competitors into the markets of their existing franchisees. The motivation is continued growth, but it also can be an invitation for litigation, says Dunham, who serves on the governing committee of the ABA Forum Committee on Franchising.

In 1998, the 11th U.S. Circuit Court of Appeals at Atlanta effectively greenlighted an encroachment claim based on this fact pattern in Camp Creek Hospitality Inns Inc. v. Sheraton Franchise Corp., 139 F.3d 1396.

In the case, a Sheraton franchisee sued the hotel chain after it opened a competing brand nearby. A district court granted Sheraton summary judgment on all of the franchisee’s claims, but the 11th Circuit reversed the sum­mary judgment with respect to the encroachment claims. The appellate court noted that a license agreement allowing the franchisor to reserve the right to compete was never signed by the parties, which the court said constituted evidence that the franchisee had never consented to the franchisor’s use of competing brands, says Gardner.

As a result of this case, many new franchise agreements or renewal agreements now expressly allow franchisors to have competing brands, Rosen says, and the issue continues to be a thorn in the side of franchisees. “A lot of franchisees say, ‘I know I am going to have competition, but I don’t want it coming from my franchisor,’ ” he notes.

Another potentially troublesome trend for franchisees concerned about encroachment is co-branding. Fran­chisors may require their franchisees to carry another brand of products that was not part of the original franchise system. One example of co-branding is the placement of Dunkin’ Donuts and Baskin-Robbins franchises together as part of an effort to increase revenues, says Rosen. So a franchisee that started out selling doughnuts may now also be required to sell ice cream from the same location.

While franchise agreements usually contemplate co-branding, the arrangement still often makes for an unhappy franchisee because of the cash expenditures typically associated with adding new signage, finding space for the new products and making renovations to stores, Rosen says.

Some franchises, in an effort to boost sales, have taken their re-branding efforts a step further by reinventing their concepts and even changing their names. Gardner represented one group of franchisees of a restaurant chain that changed both its name and its operating pro­cedures. Franchisees had little choice but to comply—or terminate the agreements and risk losing their investments.

While franchisors enter a potential legal minefield when they pursue aggressive sales and growth strategies, sometimes they also can get into trouble with franchisees for not being aggressive enough, Joblove says.

Other potential points of contention between franchisors and franchisees include franchise advertising and marketing funds.

Franchisees typically are required to pay a percentage of their revenues into an advertising or marketing fund. But these funds can be rife with trouble, particularly when franchisees feel that the franchise is not properly supporting them, says Miller of San Francisco.

“You are talking about big money and who makes the decisions,” he says. “It’s an issue that is coming up more and more.”

Franchisees also often claim wrongdoing by franchisors when it comes to rebates the franchisors receive from suppliers. The situation is especially troubling if franchisees are required to buy from suppliers giving the rebates, says Mary Beth Brody, a lawyer at Faegre & Benson in Minneapolis.

Rebate disputes have triggered some claims by franchisees against franchisors under the federal Robinson-Patman Act, which prohibits price discrimination aimed at preventing competition. Such claims have failed in the courts so far, says Brody, but she does not think the issue is settled. In the meantime, she says, “generally, what we try to do when representing franchisors is to make sure that all the rebates are fully disclosed. It’s a big problem if it is not because it sparks litigation.”

OUTWARD BOUND

At some point, a franchisee may want out. Franchise lawyers caution that the time to think about this is when the franchisee is getting into the system. Franchisee agreements often restrict the sale or assignment of a franchise. Some require the franchisee to seek franchisor approval before a sale or transfer, while others reserve a right of first refusal for the franchisor. And even when franchisees negotiate a favorable exit from a franchise system, it often involves them signing noncompete agreements, says Louis C. Spelios, a lawyer at Powell Goldstein in Atlanta.

Spelios says that courts have characterized sales of fran­chises as sales of businesses and not employment contracts. As such, the more restrictive noncompete clauses that are typically contained in sale-of-business contracts tend to be enforced in cases involving franchises, he says.

A saturated U.S. franchise market is leading an in­creasing number of franchise systems to look overseas for growth opportunities. But international expansion also is rife with legal issues, says Wieczorek of the ABA’s franchising committee.

At least 20 countries have disclosure laws, and more countries are expected to adopt similar regulatory schemes as franchising grows overseas. These laws present compliance issues for franchise systems expanding into foreign markets, Wieczorek says.

U.S. franchises also need to be prepared to deal with anti-American sentiment, cultural laws and anti-globalization sentiment in some foreign markets, according to Wieczorek.

But despite these potential obstacles, Wieczorek sees more U.S. franchise systems drawn into foreign markets by the growth opportunities. “U.S. brands usually are viewed with a lot of positive feelings,” he says, “and in most foreign countries, U.S. franchises usually get a good reception.”

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