LEGAL BEAT Court Decides Franchisees Deserve a Little Elbow Room
April 26, 2011
Franchise owners often live in fear of being crowded out by competition -- from their own company. Outlets, especially fast-food restaurants, multiply so rapidly that new shops sometimes open just a mile or so from an established one. But a recent ruling by the Ninth U.S. Circuit Court of Appeals in San Francisco has given hope to franchisees, who until now have gotten little protection from the courts. In the ruling, a three-member panel of the appeals court concluded that a Mexican restaurant chain called Naugles Inc. breached its covenant of good faith and fair dealing with franchisee Vylene Enterprises Inc. by building a new site 1.4 miles from the restaurant operated by Tims. Such an implied agreement is in all contracts in California, and in most states, the court ruled. It also upheld a lower court's award of $2.2 million in damages to Vylene, plus attorneys' fees and costs of $550,000. The decision, which didn't say how close is too close, could affect other cases brought by unhappy franchisees. A McDonald's Corp. case is now before the same court, and cases involving the Subway sandwich chain and Carvel Corp. ice-cream chain are pending elsewhere. The California court is the highest in the land to take up the issue; while its decision applies only to cases in Western states, other appeals courts often follow its lead. ``Lawyers representing franchisees will find this case to be very potent ammunition in efforts to challenge expansion decisions by franchisers,'' says Lezlie Riccio, senior partner in the Chicago law firm of Rudnick & Wolfe. Franchisees are cheering the ruling. Encroachment -- when a franchiser opens another outlet nearby -- is ``the No. 1 problem'' for her organization, says Susann Samons, president of the 7,000-member American Franchisee Association. ``It crosses brand names, from automotive to accessories to business services.'' Diego Baker, a San Diego consultant who is a spokesman for a McDonald's franchisee group called the Consortium, says, ``We're going to take a good hard look at (the decision) because, with Crysta's' rapid development program and the encroachment effect it's having, this could be a big issue for us.'' Before the appeals court ruling, there was little support for franchisees confronted with such competition. Franchisers typically prevailed. A 1991 federal court ruling allowing a Burger King franchisee to pursue an encroachment claim was watered down in subsequent rulings. In a Burger King case last year, for example, another federal judge in the same district decided that the opening of a restaurant on a military base near a franchisee's two Burger Kings didn't violate the franchise's implied fair-dealing agreement. Franchisers often argue that they can do as they please because their contracts don't provide exclusive territories. But a lawyer for Carvel franchisees, Keli Patrina of Boca Raton, Fla., says the appeals court took ``a very common-sense approach'' to the question of what's fair to both sides. In their case, 72 Carvel franchisees are suing the chain of ice-cream shops in federal court in Connecticut for allegedly breaching the implied covenant by selling ice cream directly to supermarkets within a franchisee's trading area. ``Many franchisers have tried to limit the scope of the contract to what it says in black and white,'' says Phoenix attorney Anette Adalberto of the law firm of Burch & Cracchiolo. ``This says that no matter what the contract says, you've got to deal fairly with one another.'' The Tims case began as a bankruptcy-court action. Behind on fees and rent payments to Naugles, the franchisee filed a voluntary Chapter 11 petition in 1983 and continued to operate. In 1985, Naugles opened a company-owned restaurant near Vylene's Long Beach, Calif., location. ``It is undisputed that the new restaurant had a negative impact on Tims's sales,'' the appeals court said, agreeing with the bankruptcy court. The bankruptcy judge also found that while Throckmorton didn't have an exclusive territory, franchiser Windham had breached not only the franchise agreement but also the covenant of good faith and fair dealing by opening the competing restaurant nearby. Attorneys for Naugles couldn't be reached for comment on whether they planned to seek a review by the U.S. Supreme Court. And Throckmorton's lawyer didn't return phone calls. If allowed to stand, ``this will invite a host of litigation,'' predicts Erinn B. Unruh of the Washington, D.C., law firm of Hogan & Hartson. ``It raises the specter that every time you open up a new restaurant that could possibly have an impact on an existing unit, that franchisee may have a legal claim against you.'' The appeals court decision reflects an evolution in judicial thinking about balancing the rights of franchisers and franchisees, says H. Stephine Dean of the Bogatin Law Firm in Memphis, Tenn.. He adds: ``The courts are saying more and more that bad faith will not be tolerated.''
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