Franchisees' Lawsuits

Chains' nontraditional growth paths lead to new encroachment battles
By Milford Prewitt

Nation's Retuarant News, The Newsweekly of the Foodservice Industry, Vol. 29, No. 39, October 9, 1995

First there was non-traditional expansion.

Now chain operators must prepare for lawsuits from franchisees charging non-traditional encroachment.

Mature restaurant systems including those whose owners are among the most tenacious developers of alternative sales formats, are discovering that non-traditional expansion can be a powder keg in their sometimes volatile franchise relations.

Burger King, Blimpie, Carvel, KFC, Taco Bell and Little Caesars are only several who believe their sales have been diminished by competing non-traditional outlets, such as licensed kiosks and carts in such unconventional venues as schools and supermarkets.

Not too long ago an encroachment allegation typically ensued when a franchisor or a franchisee opened a stand-alone unit within another franchisee's established trading area.

But today---with kiosks, tandem units, dual branding, product placement in supermarkets and even home delivery---encroachment has become as tentacled as a hydra head and equally ugly to franchisees.

Contract lawyers who specialize in restaurant franchise litigation say the irony inherent in the friction over non-traditional expansion is that many mature chains need to embrace these new ways of brand penetration if their systems are to evolve.

"I think we are seeing more and more litigation today over encroachment than ever before," Philip Zeidman, co-founder of Brownstein, Zeidman and Lore, a 25-year-old Washington-based law firm that defends franchisors in contract battles.  "There are these intense concerns by franchisees over reduced margins, greater competition and this suspicion that the franchisor is seeking to take advantage of the consumer awareness that the franchisees created themselves."

"The franchisor's perspective is that there is more market penetration that we can obtain, and if we don't, someone else will.  So you can see how it can create an impass."

Robert Zarco, on the other hand, said non-traditional sites are putting many franchisees on the brink.  A prominent Miami attorney who claims to receive five to 10 calls each day from restaurant franchisees, Zarco recently won a $4 million settlement for a Burger King operator in Massachusetts in a precedent-setting encroachment case even though the franchisee's contract conferred no territorial exclusivity.

"In marginal markets where you might have an existing franchisee, these alternative points of distribution can put a franchisee out of business," Zarco said.  "It's happening all over the country in practically every chain."

Perhaps the best-known case of friction over non-traditional encroachment concerns the 4-year-old brand alliance between Little Caesars and Kmart.  The 2,350 unit Kmart has put more than 560 Little Caesars Pizza stations in its discount stores.

The Association for the Little Caesars Franchisees argues that many of its members are being hurt by the franchisor's alliance with Kmart, especially in small towns where old-line franchisees reportedly are experiencing steep declines in volume.

But Little Caesars counters that the in-store units have not been cannibalizing franchises, pointing out that the Kmart-based branches are outlets of convenience geared to selling pizza slices and prepackaged items like muffins and cookies rather than whole pizzas.

Moreover, Little Caesars argues that more outlets bearing the chains brand name only increase consumer awareness and benefits every operator in the chain by heightening demand.

In a more recent case, a group of Carvel franchisees sued the franchisor over its 3-year-old merchandising agreement with several supermarket chains.

Carvel franchisees claim they've lost business since the company started selling the chain's premium ice-cream sales in large supermarket chains like Winn Dixie, often at $3 less than is normally charged in a Carvel store.

Taco Bell also is battling several lawsuits from individual operators who charge that their sales have been cannibalized by non-traditional outlets on college campuses.  What's adding fuel to the fire, the franchisees claim is that non-traditional outlets in the Taco Bell system are not obligated to contribute funds to advertising co-ops.

In Minneapolis, a 36-year franchisee of KFC tried mediation at first, but has since filed a breach of contract suit against his franchisor over encroachment by two non-traditional locations in his market.  In that case the franchisee claimed his eight-unit company was damaged when KFC allowed the University of Minnesota to open a kiosk on its campus and allowed an EZ Stop convenience store operator to install a kiosk in his store.  Both units were within the franchisee's market territory.

Blimpie, the fast-growing submarine sandwich chain that is hardly near saturation point in any city, had a fracas involving non-traditional units.  A Tampa, Fla. Franchisee settled with the chain out of court after complaining that a Blimpie unit inside a Pick 'N Pay convenience store 1,000 feet away threatened to ruin his business.

Even chains that are trying home delivery for the first time have been challenged legally by franchisees for non-traditional encroachment.  Zarco said he represented a franchisee of a chicken chain who sued the franchisor upon discovering that a company-owned unit was delivering chicken to customers in the franchisee's market area.

"I think it's a sad commentary on the state of franchise relations in foodservice today that in many cases the franchisor is a franchisee's biggest competitor," said attorney Gary Austerman of Klenda, Mitchell, Austerman and Zuercher in Wichita, Kan., a law firm that represents franchisees in high-profile cases and class-action litigation.

"Encroachment is out of hand today," Austerman added.  "In the 70s and 80s, a franchisee banked on the fact that they were developing a relationship with a franchisor in a protected area that would give them a leg up on the competition.

"What has happened is that these large chains, often owned by larger, more competitive companies, are under pressure to show growth. To do that, they are setting up businesses within one mile of an old-line franchisee."

Matthew Shay, vice president and chief counsel of the International Franchise Association, a group of large franchisors, called Austerman's observation ignorant.

Shay said franchisors are pursuing well-intentioned strategies to expand the brand, but those efforts can rile franchisees in older systems that are nearing the saturation point.

"I think the [Austerman] comment demonstrates an ignorance of the changes in the marketplace that require, for the benefit of franchisee and franchisor, an aggressive approach to market penetration and market saturation," Shay said.  "A franchisee whose franchisor permits competitors to gain a decisive share of a particular market will not be a successful franchisee for long."

But Shay acknowledged that with older systems, conflict over new ways of pursuing growth might be unavoidable.

"As franchising has matured, a level of discomfort settles in certain segments of the franchise community as companies react to changes in the marketplace and as competitive circumstances force them to find new ways of distribution." He said.

Mark Siebert, president of Olympia Fields, Ill-based Francorp, said many chains are growing more sensitive to the issue of encroachment.

"There may be franchisors with very little regard toward encroachment and for whom the goal of selling franchises takes priority over common sense," said Siebert, whose firm consults on and researches franchise development issues.  "But I think there are very good franchisors who are cognizant of territoriality and are doing what they can to the extent that they can, to make sure that their franchisees are successful, too."

But Susan Kezios, president of the American Franchise Association, a franchisee-rights advocacy group, said encroachment resulting from expansion innovations is one of the most divisive issues affecting chain relations.

"Franchisors are always looking for new ways to do business," Kezios said. "Unfortunately, these new ways of doing business are often executed at the franchisees' peril."

Zeidman, the franchisor attorney, called it flawed reasoning to suggest that franchisors are plotting the demise of their franchisee though non-traditional expansion.

"No franchisor is seeking to weaken its franchisees by distributing goods and services through other means when it is self-evident that it is in the franchisor's best interest that their franchisees succeed," Zeidman said. "But if there is a new way to reach customers whose needs are not being met or to reach customers in some other venue who would otherwise not be buying from the franchisor or even perhaps buying from the competition, what you are really doing is reaching an underserved marketplace."

However, many franchisees respond that net gains from royalties and revenues accrue to franchisors even when franchisees' sales decline following their chains' increased market penetration.

Still, many industry observers believe that non-traditional expansion is only one manifestation of an industry that is evolving and whose players must accept change in technology, management and marketing if they are to survive.

But Kezios argues that some companies are using change to take advantage of operators when it comes time to renew their agreements.

"People are finding radically different franchise agreements upon renewal," she said.  "They are not necessarily renewing but entering into whole new agreements with materially different financial operational and marketing terms.

"The problem with radically different contracts is that you may find yourself in a business that you did not buy into originally, and worst of all, it's unilaterally modified as the franchisor's dictates.  So the franchisor ends up having his cake and eating it too."

But Neil Simon, a franchisor attorney with Reed Smith Shaw & McClay in Washington, counters that contracts have to be updated if restaurant chains are to remain competitive, even to include the advent of non-traditional outlets.  He said many mature restaurant chains have hit or are beginning to hit plateaus in their growth cycles and must 'redefine their relationship's with franchisees if the chain is to remain viable.

"Personally, I think the term contract renewal is a misnomer and misleading," Simon said. "A well-advised franchisor will use the expiration of an agreement as a chance to upgrade its systems and to redefine their relationship with the franchisee.  Just think, 10, 15, maybe 20 years have gone by since the last contract, and in that time the chain has evolved and so has the market."

"If the chain is to remain competitive, change in the marketplace and in business practices have to be reflected in the new contract.  Any company that is renewing 20-year-old agreements is a company that will not be around for long."

Zeidman argues that behind most franchisee lawsuits over non-traditional encroachment and other issues is the fear of change.

"You might go to court to fight over section 19-G, paragraph 4 of the franchise agreement, but once you step back after all the counseling and mediation, you realize that change, new ways of doing business, is what precipitates so many of these actions." Zeidman said.  "Franchisees tend to get insecure and uncertain in a period of rapid change."

"What franchisors and franchisees need to do is to accommodate change in a way that is mutually beneficial."

Shay of the IFA said companies could mitigate the number of lawsuits through better communication.

"The key to a successful relationship is effective communication," Say said.  "To the extent that there is effective communication, there will not be this fear of the unknown."

"The largest and most mature systems are beginning to deal with this effectively, and they are finding ways to deal with these problems before they become acute and lead to litigation."