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Franchising is a method of distribution that capitalizes upon uniformity and brand identification. Franchising has experienced tremendous growth over the past thirty to forty years as franchisors have recognized that they can increase their rate of sales growth by expanding the market for their goods or services through the opening of franchised outlets in areas that would otherwise remain unserved or underserved. On the other hand, entrepreneurs and their lenders have come to appreciate the fact that purchasing a franchise minimizes many of the risks associated with the start-up of a new business. The rationale for this is simple: the franchisee will be operating a proven business concept with pre-existing brand identification or goodwill. Accordingly, prospective entrepreneurs and their lenders often favor a franchise concept over a pure start-up. Stripped to its essentials, a franchise is a continuing commercial arrangement by which a franchisor, in exchange for a fee, grants a license to a third party, or franchisee, either to conduct business under the franchisor’s trademark in compliance with a business format or marketing plan established by the franchisor or to distribute goods that are produced by the franchisor or its designee and which bear the franchisor’s trademark. While this seems simple enough, understanding the rights granted by the franchisor to the franchisee and, correspondingly, the rights reserved by the franchisor is critical to an understanding of the parties’ respective opportunities to maximize gross revenue. The question as to the nature and extent of the franchise rights granted by the franchisor to the franchisee is fraught with potential conflict. In essence, the goal of the franchisor is to maximize system sales in a given trading area, while the goal of the franchisee is to maximize its own gross revenues without fear of its sales being cannibalized by other system outlets or competing distribution channels operating in its trading area. For example, the franchisor may desire the right to open additional locations in the franchisee’s trading area in order to saturate the market. Or the franchisor may wish to distribute its goods or services through alternate channels of distribution in the franchisee’s trading area. The franchiser’s right to open additional locations and its right to operate through alternate channels of distribution in the franchisee’s trading area are, in many cases, the most important issues that should be focused upon by franchisees and their lenders. The issue becomes to what extent the franchisor may conduct competing business in the franchisee’s trading area. In simpler times, franchisors limited the distribution of their goods and/or services to “brick and mortar” retail outlets, either company-owned or franchised. In those years, the analysis was limited to whether the franchisee received territorial protection from the franchisor so that no other retail outlets (company-owned or franchised) were within some agreed-upon radius mileage from the franchisee’s place of business. Times have changed. As franchisors became more sophisticated, they realized that revenues could be dramatically increased by exploiting additional avenues of distribution. Not only could branded ice cream be sold at franchised retail outlets, but it could also be effectively marketed and sold through supermarkets. Branded donuts could be sold at convenience stores. The explosive rise in business conducted on the Internet further complicated the picture. Franchisors could provide services directly to the consumer through an Internet site. Franchisors increasingly “reserve their rights” to provide products or services through the Internet and other avenues of distribution, even though such activities will occur within the franchisee’s trading area and may impact the franchisee’s revenues. ‘ENCROACHMENT’ CASES Not surprisingly, during the past decade, disputes between franchisors and franchisees often concern claims of “encroachment” – placement of a competing unit, whether company-owned or franchised, in close proximity to an existing franchisee’s business. In cases where the franchisee’s business suffers (real or imagined), claims of encroachment follow. Two lines of cases are discernible. The great weight of authority on applying the implied covenant of good faith and fair dealing to cases of encroachment converges around two fairly simple propositions: when the parties include contract language on the issue of competing franchises the implied covenant will not defeat those terms; and when there is no such language the franchisor may not capitalize upon the franchisee’s business in bad faith. See Camp Creek Hospitality Inns, Inc. v. Sheraton Franchise Corporation, ITT. The general rule recognized by a majority of jurisdictions is that every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement. Generally, the implied duty of good faith is intended to protect the reasonable expectations of parties involved in a contractual relationship, absent express contractual provisions to the contrary. Some states, like New Jersey, apply the implied covenant of good faith more broadly and find that the covenant can stand on its own, independent from an express contractual provision. In Sons of Thunder, Inc. v. Borden, Inc., the New Jersey Supreme Court held that a party can breach the implied covenant of good faith and fair dealing by conduct while the contract is in effect, even if that party has not violated the express terms of the contract. The Sons of Thunderstandard is an evaluation of conduct and an assessment of whether a party’s conduct has done anything what conduct will have the effect of destroying or injuring the rights of the other to receive the fruits of the contract. Application of both the general rule and the more expansive doctrine as illustrated by the Sons of Thundercase has resulted in conflicting decisions. The duty of good faith has been applied by some courts as, in effect, an additional contract term where a written agreement is silent regarding the ability of a franchisor to locate proximate competing units. The covenant has also been used as a rationale for tempering the discretion which a contract may permit one party to exercise over decisions involving encroachment. For example, in Scheck v. Burger King Corp., Burger King permitted the conversion of a Howard Johnson’s restaurant located only two miles from the plaintiff’s restaurant; the new unit was situated between the existing franchisee and an interstate highway which was the main source of business. The court distinguished between a franchise contract’s grant of an exclusive territory and an explicit contract right to establish competing units in close proximity. For the Scheckcourt, even the express denial of an exclusive territory to the franchisee did not necessarily imply a wholly different right to the franchisor to open proximate franchises at will, regardless of their effect on the franchisee’s right to enjoy the fruits of the contract. According to the court, in order to assure that it had the right to open proximate units at will, the franchisor should have included a specific contract term to that effect, rather than leave the contract silent on the issue. This same reasoning was followed by an 11th Circuit panel in 1998 in Camp Creek Hospital Inns, Inc. v. Sheraton Franchise Corporation, ITT. In that case, the franchisor established a company-owned hotel in close proximity to an existing franchised Sheraton Inn. Under the express terms of the franchise agreement, Sheraton could have authorized a competing franchise directly across the street from the inn, and Camp Creek would have had little recourse. However, the franchise agreement was silent on the issue of whether or where Sheraton and its affiliates could establish company-owned properties that competed against the plaintiff’s business. The appellate court decided that the franchisor’s failure to include an explicit provision in the franchise agreement carving out a right to compete anywhere with the franchisee rendered the contract ambiguous on this issue, and a jury would have to decide whether the franchisor’s action had breached the implied duty of good faith and fair dealing. Encroachment also may occur when the franchisor begins to distribute its product through alternative methods. The case of Baker v. Carvel Corp.involved a dispute over the franchisor’s supermarket sales program in which Carvel began to distribute its ice cream in supermarkets within the franchisee’s exclusive territory. Two types of agreement were involved: one which did not expressly reserve the right to establish the new supermarket distribution system, and one which granted Carvel the right, in its sole discretion, to sell its products through alternative channels. Relying on a section of the agreement which discussed the unique system of distribution Carvel used, the franchisee argued that the parties had a common understanding that the franchisor would not implement any distribution system other than the sale of products through franchised stores. The franchisee also argued that Carvel had a duty to exercise its discretion to sell through other distribution channels reasonably and in good faith. At the conclusion of a jury trial in the case, the court denied Carvel’s motion for judgment as a matter of law on the implied covenant claim. The court stated that, under New York law, there is a covenant of good faith and fair dealing implied in every contract, which is breached when one party impairs the other’s rights to obtain the benefits of the contract. The court found that Carvel’s supermarket program could impair the plaintiff’s right to obtain the benefits of the franchise agreement. On the other hand, courts have frequently recognized a rule that the implied covenant cannot override express contract terms. Some jurisdictions go farther and also refuse to permit a claim for breach of the implied covenant in the absence of a viable claim for breach of an express contract term. In 1999, a different panel of the 11th Circuit repudiated the Scheckdecision in Burger King Corp. v. Weaverand, while avoiding any reference to the earlier Camp Creekcase, held that a cause of action for breach of the implied covenant of good faith cannot be maintained in derogation of the express terms of the contract or in the absence of a breach of an express contract term. In analyzing the encroachment issue, the Weavercourt emphasized that right and duty are different sides of the same coin: if one party to a contract has no right to any exclusive territory, then the other party has no duty to limit the licensing of new restaurants. These courts emphasize that the parties’ rights are created by the agreement itself. If a contract grants one party absolute discretion over the location of other units or the establishment of alternative distribution channels, then a court should not tamper with that agreement by imposing its own conception of reasonableness to override the agreement’s express term. Counsel for the franchisor must carefully consider the franchisor’s goals and stage of development in order that all rights that are important to the franchisor’s future development of the system are reserved. For example, a franchisor should, in its franchise agreement, expressly reserve the right to satisfy all segments of its potential market whether that market is the Internet, non-traditional locations, such as airports, stadiums, college campuses or highway rest stops, or auxiliary retail locations such as kiosks or display cases in other retail environments. Counsel for the franchisor must also recognize that a franchise system is not static, that it evolves over time. The franchise agreement must be crafted in a way to permit the system to adapt to changing customer tastes, habits, demographics and market conditions. For example, a franchisor of coffee shops may sell freshly brewed coffee, beans and accessories in its retail stores. Given that the goal of a franchisor is to maximize gross revenues, it would be a logical extension of the franchisor’s system to offer certain of its non-perishable goods through alternate channels of distribution such as the Internet. Accordingly, counsel should reserve for the franchisor and its affiliates the right to sell its wares through alternate channels of distribution. Conversely, counsel for a franchisee or its lender needs to focus on the nature and extent of the franchise grant to determine whether the franchisee will have sufficient protections to develop and grow its business. Most franchise agreements contain express prohibitions against a franchisee offering its products or services, except at specific retail locations. In addition, franchisors typically reserve a whole host of rights to maximize the distribution of their goods or services. As the cases described above indicate, the more express the language, the better. Counsel should advise the franchisee to consider the economic impact upon its operations that would likely result if the franchisor exercised any one or more of its rights. Counsel for a franchisee must consider whether the grant is one that will provide the type of protection necessary for the franchisee to enjoy the fruits of the franchise agreement. Benjamin A. Levin is the partner in charge of the franchise and distribution law group at Ballard Spahr Andrews & Ingersoll. He is the founding chair of the franchise law committee of the New Jersey State Bar Association and an editor of the American Bar Association’s Franchise Law Journal. Edward J. Demarco is a partner in the business & finance department and chair of the franchise law committee of the business law section of the Philadelphia Bar Association. Richard S. Morrison is an associate in the firm’s franchise & distribution law group.

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