Question: How Do Franchise Exclusive Territories Work? Answer: They Usually Do Not
By: Jeffrey M. Goldstein
In a recent franchise case before the United States District Court for the District of Colorado, the trial Court granted in part and denied in part the Defendant Franchisor’s motion to dismiss the Franchisee’s encroachment claims. Plaintiff Zubair Kazi was a president of numerous companies that owned and operated franchises across the United States, including a KFC location in Pueblo, Colorado, KFC of Pueblo (Kazi and KFC of Pueblo together the “franchisee”). Defendant, KFC US, LLC (“KFC” or the “franchisor”) was a national franchisor of Kentucky Fried Chicken restaurants. The case arose when KFC licensed another KFC restaurant (“outlet”) near the franchisee’s then-current location.
The parties executed an initial Franchise Agreement (“Franchise Agreement”) allowing the franchisee to prepare fried chicken and other food recipes and to market them with certain trademarks and service marks, and thereafter a renewal Franchise Agreement on June 1, 2017.
The Court identified the following provisions in the Franchise Agreement as “relevant”:
3.6 Except as provided in subsection 3.8, during the License Term KFC shall not use or license others to use any of the trademarks licensed hereunder in connection with the sale of any food products at any location within a radius of one and one-half miles of the Outlet, unless [exceptions not relevant here].
- Right to Apply for New Franchised Outlets. Before permitting the establishment of any new franchised outlet (defined below) at a location closer to the Outlet than to any other franchised outlet (except pursuant to commitments made before the Effective Date of this Agreement), KFC shall be obligated to give Franchisee 30 days prior written notice of such proposed action. During such 30-day period, Franchisee may apply to KFC for a franchise to operate an outlet at such proposed new location and KFC shall negotiate in good faith with Franchisee regarding said application . . . . As used herein “new franchised outlet” means an outlet not previously in existence, whether franchised or owned by KFC or its affiliates, and which will not be owned by KFC and its affiliates.
20.4 Non-Waiver. No failure, forbearance, neglect or delay of any kind or extent on the part of KFC in connection with the enforcement or exercise of any rights under this Agreement shall affect or diminish KFC’s right to strictly enforce and take full benefit of each provision of this Agreement at any time, whether at law for damages, in equity or in injunctive relief of specific performance, or otherwise. No custom, usage, concession or practice with regard to this Agreement, the Franchisee or KFC’s other franchisees shall preclude at any time the strict enforcement of this Agreement (upon due notice) in accordance with its literal terms. No waiver by KFC of performance of any provision of this Agreement shall constitute or be implied as a waiver of KFC’s right to enforce such provisions at any future time.
20.5 Scope of Agreement, Changes, Consents, Etc. This Agreement constitutes the entire understanding and agreement of the parties concerning the Outlet and supersedes all prior and contemporaneous understandings and agreements of the parties, whether oral or written, pertaining to the Outlet, except for any express obligations of the Franchisee under the franchise option agreement for the Outlet and except for any written “master” agreement that may be in force between KFC and the Franchisee. No interpretation, change, termination or waiver of any provision hereof, and no consent or approval hereunder, shall be binding upon the other party or effective unless in writing and signed by Franchisee and KFC’s President, Vice President in charge of franchising or franchise services or General Counsel, except that a waiver need be signed only by the party waiving. Nothing in this section 20.5 is intended to disclaim or require Franchisee to waive reliance on any representation that KFC made in the Franchise Disclosure Document that KFC provided to the Franchisee.
After the renewal agreement had been signed, KFC unilaterally issued a document entitled “KFC Impact Study Guidelines,” which were effective from March 21, 2019 through December 28, 2020. The Guidelines permitted any franchisee who received notice of a new proposed outlet (“option”) under section 19 of the Franchise Agreement or whose location was next-closest to the proposed new outlet and within ten miles to request an impact study, to determine the impact the new proposed outlet on the existing outlet.
The guidelines also included a table that identified specific “KFC Action” based on the results of the impact study. The relevant part of the table indicated that if the potential impact of the new outlet was less than ten percent, KFC would approve the option. If the potential impact was between ten and fifteen percent, KFC’s action was “further review.” If the potential impact was above fifteen percent, the option would be denied. A footnote also stated that “KFC reserved the right to deny option, regardless of the matrix above, based on other situations and circumstances (for example, including but not limited to: impact on low volume restaurant, cumulative owner impact, cumulative same restaurant impact, cross owner impact, etc.).
On April 4, 2019 KFC informed franchisee that it was considering establishing a new KFC location in north Pueblo and advised franchisee of its rights under section 19 of the Franchise Agreement to apply to operate the new outlet, to request an impact study, or both. On April 12, 2019 franchisee opted not to apply for the right to operate the new outlet but to request an impact study, because he was “confident” that a “reasonably and prudently prepared Impact Study” would show that the potential impact of the new outlet on his own outlet would be more than fifteen percent. In this regard, the Franchisee, per the guidelines, submitted a timely request for an impact study along with the required fee.
KFC commissioned the James Andrews Group (“JAG”) consulting firm to conduct the impact study. On June 12, 2019 JAG produced a report that said the proposed north Pueblo KFC location would impact franchisee’s south Pueblo KFC location by 13.4 percent. The franchisee alleged that the JAG study and corresponding survey were “not reasonably and prudently performed” and were “fundamentally flawed.” In response franchisee commissioned his own impact study, completed by FTI consulting, which concluded that the proposed north Pueblo KFC would adversely impact franchisee’s south Pueblo location by 33 percent to 36 percent.
The franchisee asked KFC not to allow the proposed north Pueblo franchise and licensure to proceed. KFC refused. Franchisee alleges that by the time he filed his amended complaint on February 20, 2020 the new franchisee for that location had obtained a building permit and begun construction.
According to the franchisee, the parties “came to know and understand” that the Pueblo market could likely not sustain more than one KFC location because other KFC locations in the area had become unprofitable and unsustainable in the past. The franchisee alleged also that its contract with KFC “came to include” these guidelines and that “the Parties came to understand and agree that they be part of the Agreement.” The franchisee further alleged that while KFC had discretion regarding new outlet locations in the Pueblo area, KFC represented to the franchisee that it would license new outlets according to the guidelines and their course of dealing. Finally, the franchisee argued that it relied on the contract, the guidelines, and the parties’ course of dealing, in investing substantial time and money into develop the franchise location in Pueblo.
Court’s Legal Analysis
The Court began its analysis by setting out the elements of proof for a breach of contract under Kentucky law, including: 1) existence of a contract; 2) breach of that contract; and 3) damages flowing from the breach of contract.
In turn, the Court identified the relevant contract or agreement, stating that “the contract between the parties here is captured in the Franchise Agreement that they renewed in June 2017.” According to the Court, the franchisee failed to point to any explicit term or provision in that document that KFC allegedly breached. Instead, according to the Court, the franchisee’s express breach claim relied on the argument that the “KFC Impact Study Guidelines” were incorporated into the Franchise Agreement and that KFC breached those guidelines. As the franchisee argued, “although the Guidelines are not specifically referenced or incorporated in the Renewal and Addendum … the parties came to understand and agree that they be part of the Agreement.” As the Court explained the franchisee’s argument: “franchisee argues, in essence, that the parties mutually agreed to modify the contract with regards to KFC’s discretion to open additional outlets more than one and one-half miles from franchisee’s location.”
From the Court’s point of view, KFC’s argument relied upon contractual language that prohibited any modifications to the Franchise Agreement: KFC contends that any contract modification franchisee alleges is precluded by the Franchise Agreement provisions on waivers, integration, and modification. KFC notes that the integration and anti-waiver clauses ensure that the contract “constitutes the entire understanding and agreement of the parties” and that no alleged “custom, usage, concession or practice” shall “preclude at any time the strict enforcement of this Agreement (upon due notice) in accordance with its literal terms. KFC also argues that the contract can only be amended by a writing signed by a KFC executive. Finally, KFC asserts that the complaint contains no non-conclusory allegations of mutual assent as required for contract modification.
The Court then examined KFC’s broad-sweeping arguments that the Franchise Agreement could not lawfully be modified, under the contract’s non-waiver, integration, and modification clauses. The Court stated: “it is true, as KFC notes, that in Kentucky “’non-waiver clauses are routinely upheld as enforceable”, and that “in the absence of ambiguity a written instrument will be enforced strictly according to its terms, and a Court will interpret the contract’s terms by assigning language its ordinary meaning and without resort to extrinsic evidence.” The Court quickly noted, however, that “a merger and integration clause does not prohibit the parties from future agreements to modify or even to rescind the contract.”
As the Court explained, the Supreme Court of Kentucky has long recognized “that parties who have the right to make a contract have the power to unmake or modify, regardless of self-imposed limitations; that by subsequent agreement based upon a sufficient consideration parties may modify their contract in any manner they choose; and that generally a new consideration is required in order for an attempted modification for a contract to be valid.” Thus, according to the Court “for the guidelines to be part of the contract the franchisee must allege either that the parties amended the Franchise Agreement in accordance with its modification clause, or that the parties mutually assented to modification and provided new consideration.”
Regarding these two potential legal theories, the Court held that “neither is the case here.” First, the Court noted that the franchisee had failed to provide any facts supporting his argument for modification by amendment per the Franchise Agreement’s provisions:
The guidelines are in writing, but they are not signed by either franchisee or a KFC executive as required by § 20.4. They are distinctly less formal than the contract addendum the parties did properly execute when they renewed the Franchise Agreement in June 2017 (amending the contract in a document with signatures from franchisee and KFC’s Vice President and General Counsel). There is no question that the guidelines did not become part of the contract by amendment in compliance with the contract’s own provisions.
The Court rejected the Franchisee’s contention that the parties had come “to an understanding” that the Guidelines were part of the contract, characterizing this statement as “merely conclusory.” As the Court reasoned:
[The Franchisee] has not alleged that the parties negotiated over the guidelines. Nor has he alleged any facts suggesting that KFC intended to be legally bound by them as by a contract. It is unclear from the complaint who exactly drafted the Guidelines, at what level of the organization they were authorized, or how widely or consistently they were used. At most, the Court could infer that KFC intended to follow the guidelines because it presumably drafted them (they are titled “KFC Impact Study Guidelines”) and in fact did follow them—at least technically—in this case. But this is insufficient to establish mutual assent.
The Court continued its explanation of why the Franchisee had not proven that the Franchise Agreement had been modified by pointing out that the Franchisee’s argument failed to demonstrate that the required legal “consideration” had been exchanged between the parties. As the Court reasoned, the contractual benefit (or consideration) ran only one way between the parties:
As written the guidelines say that KFC will undertake an impact study when considering new locations within ten miles of the existing location. This appears to benefit the franchisee but not the franchisor. It effectively operates as a possible extension of the exclusive franchise area for the franchisee, while the franchisor commits to pay for the impact study (in most cases) and ultimately reject the new location if it will impact the existing location by over fifteen percent. Under the Court’s view, “the guidelines cannot be evidence of consideration by franchisee when they suggest no apparent benefit to KFC.”
Based on the above, the Court concluded that “the franchisee does not have a cognizable claim for breach of contract based on the express terms of the parties’ agreement … since he alleges no breach of an explicit provision of the Franchise Agreement, and he has not alleged sufficient facts to suggest that the parties modified the contract to incorporate the guidelines.” Thus, the Court denied the franchisee’s first claim for an explicit breach of the Franchise Agreement.
The Court interpreted the Franchisee’s second claim for “bad faith” as a claim for breach of the covenant of good faith and fair dealing. As the Court explained, “this too is technically a breach of contract claim but for breach of an implied covenant instead of an express term.” The Court explained that “every contract in Kentucky implies a covenant of good faith and fair dealing,”, and that under Kentucky law this covenant “imposes on the parties thereto a duty to do everything necessary to carry out the contract.” The Court continued noting that the covenant of good faith “also “requires a party vested with contractual discretion to ‘exercise that discretion reasonably and with proper motive, and [not] arbitrarily, capriciously, or in a manner inconsistent with the reasonable expectations of the parties.'” In completing its explanation of the legal bones of the claim, the Court explained that breach of a covenant of good faith is available to both parties in a contractual relationship, and that such breach is an independent cause of action, relying upon Sixth Circuit precedent holding that “in order to show a violation of the implied covenant of good faith and fair dealing, a showing of breach of contract is ordinarily not required; rather, the party asserting the violation must ‘provide evidence sufficient to support a conclusion that the party alleged to have acted in bad faith has engaged in some conduct that denied the benefit of the bargain originally intended by the parties.’”
The Franchisee argued that KFC breached the covenant of good faith and fair dealing by exercising its discretion unreasonably with respect to opening the new location. As the Franchisee framed its argument, KFC (1) had discretion under the contract regarding outlets beyond the one and one-half mile radius from franchisee’s outlets; and (2) “set its own bar” for reasonable non-encroachment by creating and following location impact guidelines.
KFC, in opposition, made four arguments for why the Franchisee’s good faith claim was not actionable. First, KFC argued that Kentucky does not recognize a “standalone claim” for breach of the covenant separate from a legitimate breach of contract claim. The Court rejected this argument stating that although Kentucky law typically specifies that breach of the implied covenant does not create an independent tort claim, “breach of the implied covenant can give rise, however, to a contract claim if the breach denies a party a benefit of their bargain under the contract.” Interestingly, the Court then acknowledged the arguable lack of uniformity among cases on this issue: “To the extent some decisions suggest there can be no breach of the covenant without breach of an express contract term, KFC itself acknowledges a case that suggests the opposite.” Second, KFC argued that existing case law foreclosed reading the implied covenant to prevent franchise encroachment relying on various cases that found the opening of additional franchises did not violate the covenant when a franchisee’s territory was expressly delineated in the contract. However, the Court noted that these decisions were not precedent under Kentucky law and were also distinguishable from the case here.
KFC’s third argument was that “the implied covenant of good faith and fair dealing cannot prevent a party from exercising its contractual rights or change how rights are contractually allocated.” KFC argued that because the Franchise Agreement was unambiguous, its “plain terms” allowed KFC to license new outlets anywhere it wanted beyond the one and one-half mile zone. The Court quickly rejected this argument pointing out that the language of section 3.6 states only that “KFC shall not use or license others to use any of the trademarks licensed hereunder . . . at any location within a radius of one and one-half miles of [franchisee’s] Outlet.” The Court further distinguished this contractual language from that in Barnes, a case cited by KFC:
Unlike in Barnes, there is no provision in the Franchise Agreement explicitly reserving to KFC the unfettered right to do whatever it wishes regarding other outlets beyond this radius. Instead the contract is silent with respect to any activity outside that one and one-half mile zone. KFC implicitly urges the Court to read that silence in its favor instead of franchisee’s.
The Court concluded that “KFC undoubtedly has discretion to license additional restaurants — to find otherwise would lead to an absurd result that extended franchisee’s exclusive territory indefinitely.” However, the Court quickly pointed out that “the covenant of good faith and fair dealing requires that KFC exercise that discretion reasonably and not inconsistently with the parties’ reasonable expectations”. As the Court explained:
Here, KFC unilaterally issued guidelines that outlined what would happen when KFC was considering a new outlet within ten miles of an existing one. In doing so KFC communicated what a reasonable exercise of its discretion looked like. It also generated reasonable expectations among its franchisees that KFC would follow the guidelines. Had KFC not issued these guidelines the situation might be different. But it did. The Court will not, as franchisee fears, interpret the guidelines as meaningless. It was reasonable for franchisee to expect KFC to abide by the guidelines in good faith when proposing new outlets within ten miles of franchisee’s existing outlet.
KFC’s fourth and final argument was that franchisee cannot establish a breach of the implied covenant because KFC did in fact follow the guidelines. KFC asserts that franchisee’s disagreement with the methodology behind the impact study cannot support the franchisee’s claim, and that franchisee’s allegations of “bad faith” are purely conclusory. The Court responded that “the franchisee does not dispute that KFC undertook an impact study … instead, what franchisee alleges is that the study was, in effect, bogus—that its approach was so fundamentally flawed and inaccurate that its results could not reasonably be used to justify a new outlet in the area.” The Court continued that “the franchisee supports these allegations with reference to his own study reporting an impact nearly three times as large as the result KFC’s study predicted.”
Based on the franchisee’s study, the Court concluded that “the franchisee has alleged sufficient facts to suggest that KFC treated its guidelines as a perfunctory box-checking process instead of truly assessing the impact a new outlet would have on franchisee.” The Court continued:
The issue is not whether KFC nominally followed its own guidelines. It is whether KFC acted reasonably in exercising its discretion to locate a new outlet near the existing one. Franchisee has sufficiently pled a breach of the covenant of good faith and fair dealing implied in its contract with KFC. I therefore DENY defendant’s motion to dismiss this claim (“Second Claim for Relief”).
Although this case was decided in favor of the franchisee, it is not a decision that I believe will have significant impact on other franchisee disputes involving predatory territorial cannibalization. Most important, the overwhelming number of franchise agreements today have what is called a ‘reservation of rights’ clause that simply and explicitly grants to the franchisor the legal right to directly compete with the franchisee at any time, at any place and for any reason. Further, although we all live and work in the USA, every state has different contract laws, most of which do not recognize an expansive reach of the covenant of good faith and fair dealing, as did Kentucky law in this case. So, the bottom line here is that although the legal stars and planets aligned for the franchisee in this case, it is not likely such an alignment will be visible again for another century or more. Accordingly, before signing a franchise agreement, you should retain the services of a national commercial litigator who specializes in distribution, franchising and antitrust to provide you with an analysis of the proposed franchise or distribution documents.