May 7, 2015 - Franchise Articles by |

Franchisor Encroachment: Beware of Your Franchise Agreement

As with most issues in franchise law that end up in litigation, your chances of prevailing in court against your franchisor on a claim that the franchisor has violated your exclusive territory may be wholly dependent on the specific language that you and your lawyer were successful in having included in your franchise agreement. Also, as you will see below, the legal analysis that must be undertaken to negotiate a franchise agreement to fully protect a franchisee from all types of potential encroachment is too complex and esoteric to be performed adequately without expert legal assistance.

I have encountered prolific cases where the franchisee, whose business has been decimated by encroachment, has told me that he “thought” that the language he had personally negotiated and included in the franchise agreement granted him an exclusive territory. In many of these cases, contrary to the beliefs of these franchisees, the franchise agreements contained no language whatsoever regarding an exclusive territory. In other cases, even where the franchise agreement did contain some language relating to an exclusive territory, the language actually gave the franchisor explicit permission to open competing franchises anywhere that the franchisor chose to put them.

Although the specific language in a franchise agreement addressing or relating to an exclusive territory often differs for each franchise brand (and many times even within the same brand), it is possible to categorize “exclusive territory” language into four general types: (1) language that grants a franchisee only an exclusive site but does not expressly permit a franchisor to freely open other franchises; (2) language that grants a franchisee only an exclusive site but grants a franchisor the right to freely open other franchises; (3) language that grants a franchisee an exclusive territory (as opposed to only a single site) and does not expressly permit a franchisor to freely open other franchises; and (4) language that grants a franchisee an exclusive territory (as opposed to only a single site) but grants a franchisor the right to freely open other franchises. Obviously, although a franchisee’s chances of prevailing in court in an encroachment dispute are much greater in situations 3 and 4 (where the language in the franchise agreement expressly grants the franchisee an exclusive territory), his chances of succeeding in situations 1 and 2 above (where the franchisee has been granted “protection” extending only to the hotel’s physical site) are not very high. Moreover, even in situations where the franchisor has granted the franchisee an exclusive territory, if the franchisor has also included language in the franchise agreement that the franchisor is not restricted in where it can open competing stores, some courts may permit the franchisor to open encroaching stores in the exclusive territory.

An encroachment case involving Embassy Suites (“Embassy”) illustrates these observations. In that case, an Embassy Hotel franchisee in Orlando, Florida (“Orlando franchisee”) entered into a franchise agreement with hotel franchisor Embassy. A short time after the Orlando franchisee began operating, Embassy granted additional encroaching Embassy franchises to three other hotel franchisees in the Orlando area, including one located only one-half mile from the Orlando franchisee.

The court quickly rejected disposed of the Orlando franchisee’s complaint, reasoning that, since the Orlando franchisee’s franchise agreement “does not limit the licensor’s right to use or license the System or to engage in or license any business activity at any other location [other than the Orlando franchisee’s specific site]” the franchisor could open anywhere other than the site of the Orlando hotel. The court also rejected the Orlando franchisee’s argument that the term “location” refers to the “area” (not just the site of the hotel) surrounding the Orlando franchisee’s hotel. The Orlando franchisee had argued, unsuccessfully, that since (under his interpretation of the franchise agreement) he had been granted protection from encroachment for an entire “area” and not just his “site,” the franchisor was prohibited from opening a hotel less than one mile from the Orlando franchisee.

In those circumstances where the express language of a franchise agreement is likely to be interpreted to permit a franchisor to engage in encroachment, it is nevertheless possible for a franchisee to argue that the franchisor’s granting of competing franchises violates “the covenant of good faith and fair dealing.” The covenant of good faith and fair dealing is a legal doctrine that forbids a party to a contract from doing anything that will inure the other party’s right to receive the fruits of that contract. As interpreted by the courts, however, it is very difficult for a franchisee to successfully use the covenant to prevent a franchisor’s encroachment.

For instance, an encroachment case involving Sheraton hotels in the Atlanta area was based on a franchise agreement that expressly permitted the franchisor to authorize competing franchises in the same area as the franchisee’s (Camp Creek’s) hotel; however, the agreement was silent with regard to whether the franchisor itself could establish and operate a franchisor-owned hotel in the same area.

At the time that Camp Creek had signed the franchise agreement, another Sheraton franchisee was serving the Atlanta airport market. (Camp Creek was located about three miles from the Atlanta airport.) A few years later, Sheraton corporate purchased a non-affiliated hotel that also served the Atlanta airport market. Sheraton corporate then converted its newly-purchased hotel to a Sheraton and began to compete with Camp Creek and the other Sheraton franchisee in the market.

Although Camp Creek admitted that Sheraton’s operation of the new hotel did not violate the express terms of Camp Creek’s franchise agreement, it argued that Sheraton’s conduct nevertheless violated the covenant of good faith and fair dealing. (It would have been very difficult for Camp Creek to have argued that Sheraton violated an express term of the franchise agreement since the agreement contained neither language granting Camp Creek an exclusive territory nor language prohibiting Sheraton from competing in the market. Camp Creek argued that the covenant of good faith had been breached because Sheraton’s operation of the new hotel right next to Camp Creek denied Camp Creek “the fruits of the agreement.”

The Camp Creek court pointed out that, although the language in the franchise agreement addressed Sheraton’s right to grant additional franchises (by permitting Sheraton to grant franchises anywhere except the same exact site as Camp Creek’s hotel), the agreement did not explicitly permit or prohibit Sheraton itself from operating a hotel in direct competition with Camp Creek. However, the court did point out that Sheraton’s decision to itself operate a competing hotel may have violated the covenant of good faith and fair dealing, which is implied in every contract. (The language in some hotel franchise agreements that sometimes explicitly prohibits a franchisor from directly competing with its franchisees had been deleted from Camp Creek’s franchise agreement.) Accordingly, the Camp Creek court concluded that while Sheraton was permitted to open other franchises competing with Camp Creek, Sheraton could be prohibited from itself opening a competing hotel under the covenant of “good faith and fair dealing.”

As indicated by the above analysis, your chances of prevailing against your franchisor on an encroachment claim may be determined not by the arguments you make in court after the franchisor engages in encroachment, but rather by the explicit language regarding encroachment that you have been able to have included in your franchise agreement. In other words, your best “offense” for preventing your franchisor from encroaching on your business is to either negotiate favorable language in your franchise agreement before you sign it, or refuse to sign the unfair and unreasonable franchise agreement.

Last, although some franchisees believe that a franchisor’s “impact policy” will protect them from potential harm caused by a franchisor’s encroachment, this is a “false hope.” In practice, it is our view that “impact policies” provide little if any protection to franchisees. Our next article will explore and discuss in detail the inherent flaws common to most “impact policies.”

Mr. Goldstein is a franchise lawyer who specializes in a wide range of commercial litigation matters, with an emphasis on franchise and distribution law. Mr. Goldstein’s practice focuses on representing franchisees in litigation and counseling franchisees on how to protect themselves against litigation.

In counseling and litigating on behalf of franchisees, Mr. Goldstein regularly handles issues regarding encroachment, monetary defaults, Quality Assurance defaults, wrongful termination, franchise transfers, sales of franchises, compliance with state and federal laws, franchisor mismanagement of advertising and marketing funds, and misrepresentations by franchisors. Although Mr. Goldstein is a litigator, he frequently reviews and negotiates buy-sell and franchise agreements for franchisees.

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