This land is my land…

Territory: wars are fought over it, marriages ruined, neighbors divided and political careers forged. No wonder territorial encroachment has become a flash point in the increasingly litigious relationship between franchisors and franchisee.

Foodservice and Hospitality
February 1994

This land is my land…
Territorial disputes have become the litmus test of fair dealing between franchisors and franchisees
Krista Foss

Territory: wars are fought over it, marriages ruined, neighbors divided and political careers forged. No wonder territorial encroachment has become a flash point in the increasingly litigious relationship between franchisors and franchisee.

In an era when franchisees must fight for every customer, the “Service with a Smile” mantra has given way to “Give me space, or I’ll call my lawyer.” Franchisees have always asked that franchise agreements stipulate an area or population base in which the system will sell no other franchises. And franchisors have always registered. But lately many of these disputes are winding up in court, and finding their way onto the agendas of North American legislators.

For David Michael and many others, a franchisor’s approach to territory has become the litmus test of fair dealing with franchisees. Michael is a member of the group of 51 Pizza Pizza franchisees who sued the franchisor last year for dealing with them in bad faith over several issues, including territory. He bought his first Pizza Pizza outlet in west Toronto in 1983. At that time his agreement gave him a protected territory based on a population of about 25,000. When the agreement was renewed several years later, the franchisor cut Michael’s protection by about 10,000 – just enough for it to sell another outlet a mile away. This was about the same time the recession started mellowing the public’s mood for take-out food and other “frills.” Michael’s delivery sales were cut in half. Disagreement over territory wasn’t the only issue to push him into litigation, but he notes, “If you don’t have your market, there really are no other issues.” At press time, the suit had not been resolved.

Such disputes have reached mythic proportions south of the border, notably in Iowa. In 1992, such a dispute resulted in the passing of the Iowa Franchise Investment Act, which legislated a minimum protected area for all foodservice franchises of three miles or a population base of 30,000. It was an unprecedented victory for franchisees. But many saw it as something other than right over might.

“The optimum solution for franchisees is, unfortunately, the opposite of the optimum solution for franchisor,” says franchise consultant Karen Castelane of Toronto

In this David-and-Goliath tale, David was no small-potatoes franchisee being bullied by the system. He was T.K. Schultz, a millionaire soya bean farmer and multi-unit franchisee of Kentucky Fried Chicken. Schultz was an unlikely underdog – a savvy businessman who used his political connections and hired expensive lobbyists to usher the act through the state legislature, to the disbelief of the franchisors caught unprepared.

Besides demonstrating the benefits of having friends in high places, the Iowa experience proves you can’t please everyone when it comes to negotiating territorial issues. “The optimum solution for franchisees is, unfortunately, the opposite of the optimum solution for franchisors,” says franchise consultant Karen Castelane of Toronto.

Clearly, both have a great deal to lose. Without protection from encroachment, franchisees have to worry about cannibalization of sales by their brethren in the franchise system, as well as competition from other concepts. On the flip side, overly protective clauses tie franchisors’ hands. “A franchisor can’t predict all the forces that will come to bear on a protected territory – the traffic changes and growth in population density,” says Castelane. “So the exclusive territory granted today could be ripe for more development tomorrow. But the franchisor has given away the opportunity to develop it, or could be stuck with a lazy franchisee in that area.” An insider at Tim Horton’s Donuts, one of Canada’s most successful franchise systems, says the company has quietly phased out all territorial encroachment clauses over the last 20 years for these reasons.

It was the same worries that spurred the noisy, if tardy, opposition to the Iowa Franchise Investment Act. Franchisors were determined to make legislators understand that the act was bad for business – theirs. Some systems pulled out of Iowa altogether. Others threatened to cease all further development in the state. Organized under the banner of the Iowa Coalition for Responsible Franchising, the franchisors launched a legal challenge to the act. Earlier this year, a federal judge overturned the retroactivity of the act; now only agreements signed after 1992 must comply with the territorial encroachment provisions. But the franchisors aren’t satisfied. Fresh from squelching a bid to have similar legislation passed in Texas, the Washington-based International Franchise Association continues to lobby to have the Iowa law overturned. “There’s some momentum with the franchisors right now,” says the IFA spokesperson Andy Trintia. “We’re very optimistic.”

To date, there has been no spillover effect from Iowa into Canada. While several U.S. states have laws governing franchising, in Canada only Alberta has undertaken to regulate this business format, though British Columbia has considered it. Neither province has attempted to define territorial rights.

Canadian franchise lawyers like Ned Levitt of the Toronto-based firm Fogler Rubinoff are monitoring the abundance of territorial dispute cases in U.S. courts. One of the most controversial rulings, as reported recently in the American Bar Association’s Franchise Law Journal, involves a Burger King franchisee in Florida known as Scheck. He won compensation from Burger King after it opened another unit close to his own, even though there was no exclusive territory clause in his franchise agreement or any state law protecting his territory. Scheck’s lawyer argued that in opening a second unit close to his client, Burger King was adversely affecting sales of Scheck’s restaurant, breaching the implied covenant of good faith and fair dealing between Scheck and the franchisor. The judge, curiously enough, agreed. The cautionary judgement reads, “The express denial of an exclusive territorial interest to Scheck does not necessarily imply a wholly different right to Burger King – the right to open other proximate franchises at will, regardless of their effect on the plaintiff’s operations.” (italics added)

Legally, U.S. rulings do not set precedents in Canadian courts, but they can be used to support an argument. “In franchising it’s particularly appropriate to look to the American experience,” says Levitt, “because of the sheer volume of litigation.” And yes, he has trotted out the “good faith and fair dealing” argument to defend a franchisee in a territorial dispute with his system. But he’s mum on the details.

As more territorial disputes find their way into the courts, negotiating the terms of franchise agreements has become a tightrope walk for today’s intrepid franchisor and franchisee. Colin Simon, president, Simon & Associates, a Toronto-based franchise consultancy, advises that both sides do their homework. His advice to franchisors: “A lot of problems would be solved by doing market research to make sure the population count and the area are realistic for the unit density being sold, and for the concept.” He advises franchisees to avoid performance-based territory agreements (in which the franchisee must operate at a certain sales volume or risk losing the protected area). “If there are no records for a company operating in the area, then there is nothing for the franchisee to base a decision on but the franchisor’ projection,” says Simon. “And unscrupulous franchisors could easily make those projections unrealistic in the hope of overriding the exclusivity when the targets aren’t met.”

Conscientious franchisors have been able to avoid territorial encroachment clauses. Jan Findlay is director of franchising for the two-year-old gourmet cookie concept Monsieur Felix & Mr. Norton. Based in Montreal and currently expanding into southern Ontario, the cookie vendor already has 25 locations and plans 10 more in Toronto in the next year and a half. According to Findlay, none of the franchisees has territorial rights guaranteed in franchise agreements, nor have they requested them. “We know our credibility is at stake in respecting the territory of franchisees,” says Findlay. “So it hasn’t been a problem.”

And similarly, it hasn’t been a problem for Joey’s Only Seafood restaurants, a dinnerhouse concept that originated in Calgary in 1985 and has grown to 34 units in the western provinces. (Joey’s Only is now expanding in Ontario, with plans for 50 restaurants, the first of which opened in December.) But the reason it’s not a problem is that every Joey’s Only agreement grants the franchisee an exclusive protected area. “It’s the only fair thing to do,” says Joey’s founder, Joe Klassen. That attitude may be system’s undoing, but it will keep it out of the courts. And these days, that is to everybody’s benefit.

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Risks: Investments in franchising will stop & be lost if law passed, Fear mongering, David and Goliath story, Encroachment (too many outlets in area), International Franchise Association, Bad faith and unfair dealings, Canada, 19940201 This land

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