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The huge surge in the number of franchise systems, as well as chains in general, during the last quarter of the 20th century has created a dilemma for many retailers and wholesalers. In order to sustain increased profitability, they must continue to grow. At some point, however, growth will cause saturation in the marketplace. How can these systems continue to expand and deal with the saturation problem? For fully integrated distribution systems, the problem becomes one of internal management. That is, the company must decide whether its next units will have an impact on existing ones, and, if so, how they will deal with the consequences among the various store managers, divisions and other layers of management within the company. In a franchise system, the problem is considerably more complex because each franchised unit is a profit center unto itself. In a vertically integrated system, one hopes that a reduction in sales at one unit would mean higher profits for the company overall. However, in a franchise system, the profits of the existing franchise unit owner, an independent businessman, will take the full hit when sales from his existing unit are transferred to a new unit in which he has no ownership interest. At the same time, the company, or possibly another franchisee, will reap the benefits of the new unit. Absent some sort of compensation-for-loss arrangement, the existing franchisee becomes the sacrificial lamb. This phenomenon of transferring sales from one part of a distribution system to another part of the system goes by several names. In franchise settings, franchisors like to use monikers that are positive, or at least not negative, in their tone: Expansion is the most commonly used term for this phenomenon; frequently, sales transfers will be identified as “impact.” In contrast, franchisees look at the dark side. They use colorful and sinister, descriptive phrases such as “encroachment,” “penetration” and “cannibalization” to describe situations in which the franchisor allows a new unit to eat away at an existing market or trade area. The image these labels invoke is of a little Pacman running around frenetically, nibbling away at the franchisee’s sales until his business is destroyed and no longer viable. Historically, encroachment most often has been discussed in the context of physical territory. Can the new unit be placed, for example, two miles from an existing unit, or must it be placed even farther away in order for the existing unit to maintain its viability? With the rise of the Internet, as well as franchisors’ desires to expand into new markets, the problems surrounding growth have correspondingly increased. For example, delivery is now the hot concept in the restaurant industry. Each delivered pizza, however, may mean one fewer store customer. In retailing, catalog sales and orders over the Internet also may take sales away from retail outlets. The services field also presents notable examples of encroachment. Reading and other correspondence and education programs, for example, may be offered over the Internet rather than in physical facilities designed to provide tutorial or remedial learning services. Contracts govern exclusivity Ever since franchising became a common means of distribution, the franchisee’s rights, if any, to be free from franchisor encroachment were spelled out in the franchise agreement, as franchising has always been predominantly a relationship created by contract. The franchisor might designate a particular geographical area in which it would not set up a competing outlet, or it might even go so far as to say that it would not compete in the relevant market at all-for example, by sales of trademarked products in supermarkets, convenience stores or other limited-function distribution points. On the other hand, the franchisor may have decided that it did not want to be restrained at all in its future growth activities and thus refuses to grant any exclusivity at all in its franchise agreements. While this decision might seem monstrous at first, it is certainly not without business justification. One can easily think of many circumstances in which two hotels could be placed in close proximity, especially when the existing hotel is constantly sold out and demand consistently far exceeds supply. By not granting any exclusivity, the franchisor leaves open the opportunity to strategically place a new unit near an existing one as the marketplace in question develops over time. In this situation, where the franchisee receives no territorial protection, the franchisee must trust that its franchisor will make location decisions that are designed to enhance the overall strength of the franchise system, rather than the franchisor’s current bottom line. But even then, the franchisee usually remains insecure because it may make sense from a business perspective for the franchisor or another franchisee to open a unit nearby, but this rational business decision may nevertheless put the existing franchisee out of business. The overall good of the distribution system will be of little comfort to a franchisee who watches his unit go into a negative cash flow position. From the legal perspective, the courts have traditionally upheld the bargain struck between the franchisor and its franchisee. There are numerous cases in which, if the court found a clear intent for there to be no exclusivity, it so ruled. See, e.g., Rado-Mat Holdings v. Holiday Inns (1990-1992 Transfer Binder) Bus. Franchise Guide (CCH) � 9975 at 22,968 (Dec. 17, 1991); Payne v. McDonald’s Corp., 957 F. Supp. 749 (D. Md. 1997); and Linquist & Craig Hotels & Resorts Inc. v. Holiday Inns Franchising Inc., (1997-1998 Transfer Binder) (CCH) Bus. Franchise Guide � 11,514 at 31,240 (Sept. 24, 1998). In the early 1990s, however, encroachment became a significant problem in the quick-service restaurant sector, and litigation began to increase as franchisors expanded, thus threatening the lifeblood of many franchisees. The ‘Scheck’ ruling The decision in Scheck v. Burger King Corp., 756 F. Supp. 543 (S.D. Fla. 1991), motion for reconsideration denied, 798 F. Supp. 692 (1992), was the high mark for franchisees in their battle for turf protection. In Scheck, the court stated that even though the Burger King franchise agreement gave the franchisee no exclusive territory, this did not by itself give the franchisor the right to destroy a franchisee’s business by putting a new unit too close to the franchisee’s operation. The court went on to say that if a franchisor wanted this right, it had to say so expressly in the franchise agreement. Thus, Steve Scheck survived a motion for summary judgment filed by his franchisor. On rehearing, predicated upon a motion by Burger King Corp. for reconsideration, the court stood by its earlier decision. The Scheck decisions were viewed among attorneys representing franchisors as Armageddon. In fact, while there have been one or two cases that have followed similar lines (e.g., In re Vylene Enterprises, Inc., 90 F.3d 1472 (9th Cir. 1996); Carvel Corp. v. Baker, 79 F. Supp. 2d 53 (D. Conn. 1997)), there are numerous post- Scheck decisions that have followed the more traditional approach toward encroachment and have not been as protective of franchisee territorial rights as was the Scheck court. See Payne and Linquist, supra. The Scheck decision itself came into disfavor one year later when the same federal district court, in another case involving Burger King, cut away at the underpinnings of the decision. Burger King Corp. v. Weaver, 798 F. Supp. 684 (S.D. Fla. 1992). The Weaver decision was shortly thereafter affirmed by the 11th U.S. Circuit Court of Appeals, signaling a return to what franchisor advocates might characterize as “normalcy.” Burger King Corp. v. C.R. Weaver, 182 F.3d 938 (11th Cir. 1999). However, the Scheck decision has had a lasting influence on franchising. Today, perhaps as a consequence of Scheck, many franchisors have become more sensitive to the needs to protect the existing businesses of their franchisees. These franchisors still view growth as attractive, but not if it means that existing businesses will fail or become only marginally profitable. Poorly performing units will make sales of new franchises more difficult, and even the existence of a threat of encroachment may kill certain projects. Lenders, for example, may be skittish about making loans on new franchised hotels if they know that their borrowers’ successes can be eroded by the franchisor’s right to place new competing units in the same trade areas. Many franchisors are still reluctant to grant franchisees exclusivity, but, to assuage the franchisees’ concerns, several have adopted impact, expansion or encroachment policies. These policies generally do not rise to the level of contractual commitments. Nibeel v. McDonald’s Corp., No. 97 C7203, 1998 WL 547286 (N.D. Ill. Aug. 27, 1998). However, they establish guidelines as to how growth decisions will be made and do provide franchisees with some level of comfort. In the hotel industry, these policies became prevalent several years before Scheck. The quick-service restaurant sector has been slower to move in this direction. Although encroachment/impact policies vary considerably among franchise systems, they generally require a franchisor to give advance notice to affected franchisees of new development in, or nearby, their trade area. The affected franchisees are afforded the opportunity to present their opposition to the growth decision, and, in some systems, the affected franchisees are permitted to request an impact study, which will estimate how much damage to sales can be expected once the new location is opened. At this point, the policies usually require the franchisor to make a go or no-go decision. If the decision is to build, in some instances the right to the new unit will be granted to the affected franchisee. In other cases, the affected franchisee might receive compensation from the franchisor, such as temporarily reduced royalties, or short-term financing to help the franchisee weather the storm caused by contemplated reduced sales for a period of time. In a couple of chains, if the predicted impact exceeds a certain level, the franchisor has committed to abandon the project. It is important, from a legal perspective, that the decision be made by the franchisor and not by any adversely affected franchisee. Serious antitrust violations may result if the franchisee has a true veto right over the expansion decision. American Motor Inns v. Holiday Inns, 521 F.2d 1230 (3d Cir. 1975). While many chains still do not have systematized encroachment/impact policies, the policies, where adopted, will certainly enhance the franchisees’ comfort level with the franchisor’s attempts to expand the system. Internet encroachment As noted earlier, territorial encroachment is only one facet of the encroachment problem today. Growth through alternative means of distribution, such as grocery store or Internet sales, has added a new dimension to encroachment, with the related judicial decisions showing, again, mixed signs to the franchise community. Interestingly, the three leading decisions in this arena have come from arbitration decisions, rather than judicial pronouncements. Emporium Drug Mart Inc. of Shreveport v. Drug Emporium Inc., (2000-2001 Transfer Binder) Bus. Franchise Guide (CCH) � 11,966, at 33,665 (Sept. 2, 2000); In the Matter of Hales v. Conroy’s Inc., (2001-2002 Transfer Binder) Bus. Franchise Guide (CCH) � 12,177 at 34,875 (June 14, 2001); and In the Matter of the Arbitration Between Franklin 1989 Revocable Family Trust v. H&R Block Inc., Bus. Franchise Guide (CCH) � 12,473 at 36,250 (Dec. 31, 2002). In Drug Emporium, the franchisor began to offer drugstore items over the Internet. The franchise agreement prohibited the operation of a drugstore within the franchisee’s prescribed territory. An arbitration panel ruled that the franchisor’s decision to offer competitive drugstore products through its Web site constituted the operation of a drugstore within each franchisee’s territory, even though this drugstore was “virtual” and not real. In contrast, looking at substantially similar contract language and facts similar to Drug Emporium, the Conroy’s arbitrator concluded that the franchisor’s sales activities over the Internet did not constitute a breach of the relevant franchise agreement. The arbitration panel in H&R Block reached the same conclusion, but went into an extensive analysis of the facts before doing so. To comfort the franchisees in these situations, some franchisors have implemented what might be described as “reverse royalties programs.” Under these plans, the franchisor pays its franchisees a percentage of the revenues generated from sales made via alternative means of distribution to customers located within the franchisees’ territories. As technology increasingly penetrates the U.S. business community and the global economy becomes the rule, there certainly will be more feuds between franchisor and franchisees on the issue of which of them is entitled to new market opportunities. In advising franchisor clients, experienced franchise lawyers consistently counsel their clients not to get locked into static situations in a changing environment, for the needs of today may be distinctly different from the marketplace of the future. Those franchisors that follow this advice should nevertheless heed the concerns of their franchisees, even though there might be no legal obligation to do so. Franchise systems are more likely to succeed when both parties work in harmony to develop the distribution system and forgo, to some extent, their personal stakes. A franchise system will not succeed unless both the franchisor and its franchisees are profitable. As one fast-food chicken chain currently advertises, using cows to encourage people to eat more chicken, “United We Stand, Divided We’re Steak!” Rupert M. Barkoff is a partner at Atlanta’s Kilpatrick Stockton, where he chairs the firm’s franchise team. He is a former chair of the American Bar Association’s Forum on Franchising and author of more than 100 articles and columns on franchising.

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