This article was originally prepared for the Canadian Franchise Association, April 2004
In a franchise context, the term encroachment is generally understood to refer to circumstances where an existing franchisee’s sales and profits decline as a result of the franchisor opening, and licensing one or more other franchisees to open, a new outlet or outlets, in close proximity to the existing franchisee’s outlet. In reality, franchise encroachment may take many forms, as will be described below. All of the various forms of encroachment, however, share a common characteristic: that of an existing franchisee being deprived of sales and, therefore, of profits. Allegations of encroachment will usually begin to be observed within a particular franchise system as the system matures and the franchisor seeks, through increasingly various and novel means, to increase sales of the system’s products and services.
Intrasystem encroachment refers to sources of competition within a franchise system where the same (or, in some instances, broadly similar) channels of distribution are used to offer the same franchise-related products and services for sale to the public in association with the same trade-mark.
Since the raison d’être of any franchisor is to increase profits, and since the main sources of profit for most franchisors are usually royalties and supply markups, volume rebates and allowances (all of which are increased by increasing sales), not surprisingly, expanding the franchise system by increasing the number of franchise outlets within any given market is usually the most logical, and the most common early growth strategy employed by franchisors. Allegations of encroachment by existing franchisees will usually not arise until such “normal” expansion of the franchise system within a particular market leads to declining profits by the “earlier in time” franchisees as they face greater intersystem competition from their franchisor.
Another common growth strategy employed by franchisors of maturing franchise systems is to acquire a rival franchise (or corporate) system that offers similar products and services to the public. The premise underlying this strategy is that if market demand for the similar products and services sold by both systems is finite, and approaching or possibly even at the point of saturation, one way to increase profits is to eliminate an external source of competition by acquiring the rival distribution system. Once the acquisition of the rival system has been completed, further consolidation usually occurs by converting outlets of the once rival system to the acquirer’s brand. From the perspective of both the existing franchisees of the acquiring franchisor and of the once rival franchise system, the end result of such a strategy is the same as the “normal” franchise expansion strategy discussed above, namely, an increase in the number of franchise outlets in close proximity offering the same products and services for sale in association with the same trade-mark.
“Dual distribution” describes a situation where an existing franchisee faces competition not from other franchisees of the same system, but from the franchisor itself, i.e., the outlet or outlets that are competing with the existing franchisee by selling the same products and services in association with the same trade-mark are operated by the franchisor itself (such outlets are commonly referred to as “Company-owned” outlets). In such a situation, the franchisee is apt to feel particularly disadvantaged and aggrieved by having to compete with the franchisor itself, given the typical inequality of size, wealth and know-how as between the two of them and the potential for self preference.
From the franchisor’s perspective, sales that are in some sense unique or specialized, (for example, “house accounts”, airport or stadium sales, and push-cart sales) tend to be viewed as beneficial, even if they are, by definition, something of a departure from the franchise system’s “normal” terms of sale and channels of distribution. Specialized forms of distribution may serve as a means of directly increasing the franchisor’s profits through the usual method of increasing sales of the franchise system’s products and services, or by increasing public recognition, and therefore the value of the goodwill, of the franchisor’s trade-mark.
It is a well-accepted business axiom that the profitability of a business will usually be largely dependent on, and disproportionately affected by, a relatively small core of high volume or repeat customers. In a franchise context, franchisors will often attempt to ensure adherence to this axiom by providing in their franchise agreements for some method by which the franchise-related products and services must be supplied to large or specialized customers (such as large corporate or government customers) with whom the franchisor has entered, or may subsequently enter, into a contract, whether or not such customers are located within an existing franchisee’s market area. This may be accomplished by explicitly reserving to the franchisor the right to supply such preferred customers with franchise-related products and services, or, as noted above, by requiring existing franchisees to service the needs of preferred customers within their market from their own outlets, based on terms negotiated by the franchisor directly with the preferred customer. A “half-way house” between these two approaches would be to reserve to the franchisor a discretionary right to require an existing franchisee to service the needs of preferred customers based on the terms negotiated by the franchisor, while further reserving to the franchisor the right to bypass an existing franchisee altogether if, in the franchisor’s judgement, the franchisee is incapable of servicing the preferred customer in accordance with the franchisor’s quality standards or if the preferred customer insists on dealing only with the franchisor or another franchisee, or to take away the existing franchisee’s right to participate in servicing a preferred customers for similar reasons.
Certain types of special locations are often viewed by franchisors as desirable “launching pads” from which to expand public recognition of the franchisor’s trade-mark and of the franchise-related products and services. These types of special locations (such as airports, trade shows, sporting facilities, movie theatres, shopping mall concourses etc.) may be located or subsequently developed within an existing franchisee’s market area or exclusive territory, and the franchise agreement will specifically permit this type of encroachment. The rationale for this is that the sale of the franchise-related products and services from the special locations is, outside the “normal” channel of distribution of franchised outlets, and, is therefore, impliedly, not directly competitive with a “normal” outlet. The franchise outlets in such special locations, for example, are often much smaller and do not share the same external or internal configuration or appearance as the “normal” outlets. In a shopping mall concourse, for example, customers of a franchised fast food outlet will usually share seating accommodation in a common area with customers of other eateries located in the same concourse. The patterns of patronage of customers in the special locations may also be “atypical”. For example, passengers in airports, visitors to trade shows, fans at a sporting facility or in a movie theatre may patronize franchise outlets in the special locations as a “one off,” primarily because they are conveniently located and accessible to them, and so are far preferable than visiting the nearby “normal” outlet: in such cases, the customers may view their patronage of the “special” outlet as being entirely incidental to their main reason for being in attendance at the special location (be it to board an airplane, to view the exhibits at a trade show, to attend a sporting event or to watch a movie). So sales from such special locations afford a unique and important opportunity for the franchisor to convert impulse customers by happenstance into regular consumers of the franchisor’s products and services.
Somewhat analogous to the rationale for “reserved locations”, to the franchisor the right to provide, or license others to provide, the franchise system’s products and services within an existing franchisee’s market area through more limited “formats” than the “normal” outlet. The franchisor or licensee will be permitted to sell the same products and services within the existing franchisee’s market area through more limited channels of distribution, such as a kiosk in a shopping mall, or a cart that transacts sales from the common area of a shopping centre. The franchisor usually rationalizes such special formats as being more complementary than competitive in nature in relation to an existing franchisee’s outlet, since the alternative format allows the franchisor’s products and services, together with the system’s trade-mark, to penetrate new markets by reaching out to potential customers who might not otherwise to patronize the system’s “normal” outlets, but who may do so after being pleasantly surprised once having tried the system’s products and services at the kiosk or cart.
Intrabrand encroachment refers to sources of competition within a franchise system where the same franchise-related products and services are offered for sale to the public through different channels of distribution in association with the same trade-mark.
As franchise systems mature, franchisors looking for new ways to sell their products will often begin to experiment with new channels of distribution for their products, other than the franchise system’s normal franchise outlets or the specialized sales described above. Depending on the nature of a franchise system’s products, franchisors may begin to experiment with distributing their products through retailers whose relationship with the franchisor will be that of a “regular” wholesale supplier and retailer (i.e., the franchisor’s products will be made available for sale to the public as a part of the retailer’s regular inventory, rather than serving as the retailer’s exclusive inventory). Franchisors whose food and beverage brands have achieved very broad market penetration, for example, are increasingly attempting to sell their products — which still bear their widely-recognized trade-mark – through non-franchised channels of distribution such as supermarkets. As a result of such arrangements, consumers can often purchase the very same coffee, ice cream, or prepared food products etc. from their local supermarket that they formerly could only purchase by frequenting a “normal” outlet of an existing franchisee of the franchisor. As the above sorts of arrangements between franchisors and non-franchised distributors of their products become more commonplace, allegations by existing franchisees that such arrangements have reduced the need for consumers to frequent their franchise outlets can be expected to be made with greater frequency.
Distribution of a franchisor’s products through non-franchised “bricks and mortar” stores are not, however, the only alternative channels of distribution that are available to franchisors, and that may constitute troublesome sources of competition to existing franchisees. Once again, depending on the nature of their products, franchisors may also be able to sell their products to consumers directly – thereby bypassing the need for those same consumers to frequent the outlets of existing franchisees – through such alternative channels of distribution as catalogue sales, telemarketing and, increasingly, through internet websites created by franchisors.
Interbrand encroachment refers to sources of competition that are ostensibly outside of the franchise system to which the franchisees belong. In some instances, however, the source of such competition is a franchise system or a non-franchised business that is owned by the franchisor or a related company. On the face of it, such competition may not be “direct” in the sense that the related system or business may market different products and services under different brand names, but the related franchise system or non-franchised business is competitive in the more general sense that it will offer similar (if not exactly identical) products and services as the outlets of existing franchisees, and will market those products and services to the same target consumers.
Interbrand encroachment may take the form of competition from a related but different franchise system or non-franchised business. In Canada, for example, Cara Operations Limited operates both company-owned and franchised full service restaurants in association with different trade-mark including SWISS CHALET, HARVEY’S, KELSEY’S, MONTANA’S and OUTBACK. It is arguable that Cara’s restaurants are sufficiently differentiated that they are not directly competitive with one another, since the restaurants offer different menus, the external and internal appearance and configuration of the restaurants are different, and the trade-mark associated with the systems are also different. At a more general level, however, many of Cara’s restaurants are competitive, at least indirectly, consumers who are looking for relaxed, family-oriented dining, with an emphasis on menus that focus on comfort foods that are available at low to modest prices. Accordingly, while one can argue that Cara’s “Swiss Chalet” and “Harvey’s” restaurants, for example, are not competitive, there is clearly at the very least some overlap in the consumers that are targeted by both operations, and in the similarity of “chicken ‘n fries” versus “burger ‘n fries” core menu items.
Another form of cross-brand encroachment occurs when a non-franchised business entity acquires a franchise system that sells similar products and services or, conversely, when a franchisor acquires a non-franchised business that sells similar products and services as the franchisor’s existing franchise system. The acquisition of the Apple Auto Glass franchise system by TCGI International Inc. provides a “real world” example of the above sort of cross-brand encroachment. When TCGI acquired the Apple Auto Glass system in 1993, TCGI was already operating an extensive network of auto glass repair and replacements businesses corporately under the trade-mark Speedy Glass, Speedy Auto Glass and Speedy Auto & Window Glass. The core business of both the Apple franchise outlets and the Speedy corporate stores is virtually identical and consists of glass repair and replacement services that are primarily motor vehicle-related. In short, there is very little substantive difference between the products and services of the APPLE AUTO GLASS franchise system owned by TCGI and TCGI’s corporately-operated SPEEDY AUTO GLASS business. As a result of TCGI’s common control of the two glass repair and replacement businesses, the APPLE AUTO GLASS franchise agreement contains explicit reservations in favour of the franchisor that permit numerous forms of competition from the franchisor, including: the franchisor’s right to operate, or to permit others to operate, SPEEDY AUTO GLASS stores in the APPLE AUTO GLASS franchisee’s territory; the franchisor’s right to sell competitive products in the APPLE AUTO GLASS franchisee’s territory using other trade-mark, and the franchisor’s right to continue acquiring competing businesses. In addition, the prior rights of franchisees to source the ancillary products associated with their businesses (windshields, mirrors, sunroofs etc.) from alternative suppliers has been replaced by the requirement that all product purchases must be made from exclusive suppliers that are related to TCGI.
Part of the difficulty in resolving encroachment disputes between franchisors and franchisees flows from the fact that their business interests are inherently in conflict.
Franchisors view their chief sources of competition as being other businesses, both franchised and non-franchised alike, that offer similar products or services to the same target consumers, but under different brands. Because the franchisor’s primary focus is on competing successfully for consumer loyalty against such interbrand competition, understandably a franchisor’s main goal will be to increase the sales of its franchised goods or services, and to broaden public recognition of its trade-mark, including (as discussed above) opening more franchise outlets, acquiring and converting outlets of the rival system to its own system, selling to special customers on a preferred basis, selling from special locations that offer unique promotional opportunities, selling through novel business formats, or selling through entirely different channels of distribution than the “normal” franchise outlets. Franchisors will argue that if they are prevented from engaging in these sorts of activities (which, to their franchisees, amount to encroachment) they will not be able to preserve and grow their franchise systems and their trade-mark, and in the long term, that result is not in the best interests of either the franchisor or it’s franchisees.
Franchisees, on the other hand, operate businesses that sell through only one channel of distribution (their franchise outlets) which, under the terms of their franchise agreements, are restricted to selling only the goods or services associated with the franchise system to which they belong, and (usually) only through the franchised outlet. As a result, franchisees are more concerned with the negative impact on their profitability of the numerous, above-described forms of franchisor than with true “outside” competitors who sell similar goods or services under different brands.
An economic analysis of the businesses of the franchisor and franchisee tends to confirm that a major source of competition-related conflict between the franchisor and its franchisees resides in the fundamentally different ways in which their businesses earn a profit. The franchisor is ordinarily paid royalties based on the gross sales of its franchisees. The franchisee, on the other hand, earns profits only after all expenses (including royalties) have been paid. In other words, the franchisor earns its profit from the franchisee’s Atop line@ sales, while the franchisee earns its profit only at the Abottom line.@ In addition, the franchisor will also retain some or all of the rebates and allowances paid by the system’s approved suppliers based on the volume of the franchise system’s purchases from those suppliers, and a higher volume of purchases by the franchise system (which leads to greater rebates and allowances for the franchisor) is driven by greater total sales system-wide, regardless of whether those sales translate into profits for the franchisees. As a result, there is a clear economic incentive for a franchisor to try to increase the total sales of its franchised goods and services not only by increasing the number of franchise outlets, but also by selling through alternate channels of distribution and engaging in the other forms of sales-enhancing behaviors described above. However, since a franchisee’s profitability derives only form its own revenue stream, a franchisee who loses sales as a result of any form of encroachment will experience reduced profits.
Competition between a franchisor and its franchisees, whether internal or external to the franchise system, direct or indirect, will inevitably occur within any maturing franchise system because of the conflicting interests inherent in the franchise relationship. In addition, increased marketplace competition, changing demographics and evolving consumer tastes represent genuine challenges that a franchisor must confront by constantly striving to increase the market penetration of its brand and thereby increase the value of its franchise system. Therefore, the fundamental challenge is not to avoid competition between franchisor and franchisees, but rather to recognize encroachment-related conflicts as and when they begin to emerge, and to develop effective methods of resolving them, on a business basis, rather than through litigation.
From a functional perspective, then, the concerns of the franchisor who is contemplating encroachment would include, at a minimum, the following:
- How should the decision to expand the number of franchise outlets in a particular market be made in the first place?
- Once the decision to expand has been made, who should bear the costs of the expansion?
- Should the franchisees be allowed to share in the benefits of expansion of the franchise system, and, if so, how?
- How should the potential impact of a proposed new outlet on existing franchisees be determined?
- If the proposed new outlet will likely result in reduced sales for an existing franchisee, how should the affected franchisee be compensated?
Intrasystem encroachment creates conflicts that are internal to a particular franchise system, i.e., the source of the franchisee’s discontent is that the franchisee is facing competition from sales of the same brand of products and services by the franchisor and other franchisees through the same channel of trade. Possible ways to manage or resolve the conflicts caused by intrasystem encroachment include the following approaches:
The franchise agreement provides the franchisor with the first opportunity to “head off” encroachment-related conflicts, by specifically spelling out the franchisor’s encroachment rights in the contract. Carefully-drafted contractual provisions that deal explicitly and in detail with encroachment rights will eliminate future uncertainty over what protection the franchisee has been granted against “internal” sources of competition. If the franchisee, after reasonable disclosure, voluntarily signs a franchisee agreement that clearly spells out encroachment rights, thereby knowingly assuming the risks of the potential competition disclosed in the franchise agreement, prior he ought not complain, and will not have any actionable rights if any of those sources of competition do, in fact, materialize.
If a pure contractual approach to dealing with encroachment rights is to succeed, the case law suggests that the franchise agreement should clearly describe not only what specific distribution rights are being conferred on the franchisee, but also what distribution rights are being specifically retained by the franchisor. General terms such as “exclusive” and “non-exclusive” dealing with the grant of franchise rights, are very dangerous, and the franchise agreement should always go further than that by specifying exactly what the term “exclusive” or “non-exclusive” means, and what the franchisor will, and will not, be able to do by way of competing activity.
Drafting contractual provisions for intrasystem encroachment is theoretically limited only by the franchisor’s creative imagination, and can run from granting the franchisee a fixed exclusive territory around the outlet through a larger territory that is initially exclusive but whose area diminishes over time (perhaps based on increases in population, or the franchisee’s sales), through granting the franchisee a right of first refusal to acquire any proposed new outlet that might impact sales through to no exclusive territory at all.
An obvious problem of the contractual approach to resolving encroachment-related conflicts is that the approach presumes that the franchisor can foresee all of the competitive behaviors that it will reserve to itself. In reality, the franchisor’s future need to encroach may be driven by external factors such as the emergence of unforeseeable competitors, changing demographics and consumer preferences, and new technology (recall the recent emergence of the internet as an effective channel of distribution) — that are not predictable at the time the franchise agreement is being drafted. Because of this problem, a franchisor will be more successful in resolving encroachment-issues by combining the contractual approach with other methods of conflict resolution that recognize the dynamic nature of the problem.
Even if the franchise agreement clearly permits the franchisor to encroach, as a practical matter, the franchisor should do everything reasonably possible to preserve good relations with its franchisees and to avoid the destructive impact of low franchisee moral. One way to accomplish this to implement a formal encroachment (or “impact”) policy, which provides definitive guidelines for the franchisor and affected franchisees to follow if additional company-owned or franchise outlets are proposed in close proximity to existing outlets. By publishing clear guidelines for opening new outlets, the franchisor will communicate the message to its franchisees that it wants to keep “lines of communication” open, and that it welcomes reasonable input from franchisees who may be affected by the expansion
Any impact policy should provide specific written guidelines on the procedures to be followed by both franchisor and the affected franchisees. For example, the guidelines might:
- Require franchisor to provide lengthy advance notice to all affected franchisees regarding the proposed opening of a new outlet in their market (unless circumstances justify abridging the notice period);
- Clearly state who will qualify as an “affected franchisee”;
- Allow for reasonable input from the affected franchisees, including resort to independently-generated impact studies (and state who must pay for such studies);
- Provide clear objective standards for determining the possible impact of the proposed new outlet;
- Clearly state how the final decision will be made regarding the proposed new outlet should franchisor and affected franchisees be unable to settle their differences (e.g., the policy may call for the disagreement to be arbitrated); and
- Specify what rights, if any, will be afforded to affected franchisees if a decision to proceed with the new outlet is made (as noted above, one possibility would be the grant the affected franchisees , in order of decreasing impact, a right of first refusal to acquire the new outlet, before the franchisor attempts to open it or franchise it to a new franchisee).
Another approach to dealing with intrasystem encroachment conflict is to defuse the potential for conflict by permitting franchisees who will be affected by the opening of new outlets to share in the financial “take” of the new outlets. A practical example of this approach might be the inclusion of a “profit passover” clause in the franchise agreement: where the new outlet is to be a corporate outlet, this might require the franchisor to reduce the affected franchisee’s royalty rate, or to contribute towards the affected franchisee’s local and regional advertising costs, or to some other form of financial concession; perhaps even a share of the new outlet’s profits. Where the new outlet is to be a franchise outlet (which the affected franchisee has perhaps refused to acquire pursuant to a right of first refusal), a profit passover clause might require the new franchisee to pay a percentage of gross sales to the affected franchisee (coupled, perhaps. with a reduction in the royalty rate payable by the new franchisee to the franchisor). As an alternative, the new franchisee might be required to make a contribution towards the affected franchisee’s local and regional advertising costs. In any case, the nature and quantum of the financial compensation to be paid to the affected franchisee by the franchisor or the new franchisee, ought to be based on the results of a formal impact study for that would inject a measure of objectivity into the determination of proper compensation.
Most franchisor trade associations publish codes of ethics and rules of conduct, and require compliance with them, (to a greater or lesser extent), by member franchisors, as a prerequisite to continued membership in the association. The International Franchise Association Code of Conduct contains the following statement dealing with “System Expansion”:
ASound franchising practice requires a franchisor to consider those factors relevant to its business that will determine the impact of an additional outlet on the business of an existing franchisee and to balance the projected impact with the needs of the franchisor=s network to expand, gain market share and meet competition.@
The “relevant factors” described in the IFA Code of Conduct are:
- Territorial rights of existing franchisees contained in their franchise agreements.
- The similarity of the new outlet and the existing outlet in terms if products and services to be offered and the trade-mark to be used.
- Whether the new outlet and the existing outlet will sell products or services to the same customers for the same occasion.
- The competitive activities in the market.
- The characteristics of the market.
- The ability of the existing outlet to adequately supply anticipated demand.
- The positive or negative effect of the new outlet on the existing outlet.
- The quality of operations and physical condition of the existing outlet.
- Compliance by the franchisee of the existing outlet with the franchise agreement.
- The experience of the franchisor in similar circumstances.
While the IFA and other trade associations can attempt to enforce compliance with their codes of conduct against their own members, these codes of conduct often have limited utility in resolving encroachment-related conflicts simply because trade associations have no power or authority to enforce compliance with code by non-member franchisors.
Where intrabrand encroachment through intangible channels of distribution (such as telemarketing or internet sales), the objections of affected franchisees are often assuaged by the franchisor adopting a profit passover approach. For example, the franchisor could refer sales to be effected through such channels of distribution back to the franchise outlets in closest proximity to the customers.
Resolving conflicts that have their source in inter-brand encroachment poses a significantly greater challenge, since the source of competition in such cases is external to the franchise system (the source of the competition is either another franchise system or a non-franchised business that is owned by the franchisor, or a related company). A practical solution to conflicts that arise as a result of inter-brand encroachment where the source of the competition is a franchisor-related franchise system “combination franchising (sometimes called “twinning”). Where circumstances suggest that this as a viable growth strategy, the franchisor ignores the reality that the two franchise systems are legally distinct, and looks for creative ways tooperate both franchise systems in conjunction or cooperatively. Where a franchisor has pursued expansion through the acquisition of a rival franchise system, the viability of “twinning” as a solution to inter-brand encroachment is somewhat more problematic, because the franchisees of the acquired system have contractual rights that they may be unwilling to relinquish in favour of entering into a cooperative “twinning” venture with the franchisees of the other franchise system. Where a franchisor has acquired a rival franchise system, where the owner of a non-franchised business has acquired a franchise system that competes with its company-owned outlets, the cross-brand encroachment faced by the franchisees of the acquired system can also be addressed by the offering a buy-out the solution to affected franchisees on equitable terms, with a view to closing them down. The same buy-out option is available where some franchisees of an acquired system simply cannot bring themselves to accept the conversion of their franchise outlets to the acquiror’s franchise system.
As the Canadian marketplace becomes ever more saturated and competitive, and legislative initiatives attempting to redress perceived imbalances of power between franchisor and franchisee become prevalent, we are likely to witness a large increase in reported encroachment cases in Canada. While many mature franchisors will continue to develop their own “ad hoc” mechanisms for dealing with the encroachment problem within their own franchise systems, a more industry -wide approach to resolving encroachment conflicts is unlikely, given the absence of sophisticated franchisee associations a leadership role in any such process. In both the near and long term, lawyers will, as always, have a vital role to play in avoiding encroachment disputes between franchisors and franchisees, by crafting franchise agreements which clearly describe what protections the franchisor offers against the different forms of encroachment.