The author’s recent attendance at the International Franchise Association Annual Legal Symposium in Washington, May 2006, provided an opportunity to compare approaches and solutions relevant to one of the fundamental tensions in the franchise relationship, namely, should the rights to commercialise granted to a franchisee involve exclusivity within a defined territorial area or should, in the interests of flexibility in the franchise system moving forward, those rights be granted on a non-exclusive basis1.
To the franchisor, system expansion is a primary objective. Full system penetration gives enhanced brand recognition and acceptance, better positioning against competitors, greater royalty contributions and enhanced viability for advertising funds. These benefits flow to the franchisor and all of its franchisees.
For the individual franchisee, the primary imperative is that his business be viable to ensure its survival. While he may recognise that the health of the system will also benefit him, the concept of expansion too closely touching on his business, in a negative way, is a matter of concern.
For the parties, a satisfactory resolution is often through the grant of an exclusive territory. Where an exclusive territory is not granted, the relationship may suffer unless the franchisor manages the relationship carefully.
Certain additional rationales for not granting exclusive territories
As stated, well managed expansion will have a positive impact on the system and on its franchisees. Particularly if the strategy includes sufficient flexibility to admit longer-view possibilities such as mergers with competing brands and changes in ownership.
Further, the introduction of new products and associated brands can be more easily managed within the franchise system if exclusive territories are not granted.
Finally, other distribution mechanisms such as internet sales may be easier to implement.
The franchisee whose expectations and understanding have not been properly managed may see fundamental difficulties in only being able to secure a nonexclusive territory.
An example of this was the Australian decision of Far Horizons Pty Ltd v McDonalds Australia Ltd  VSC 310. In this case, the most extreme scenario feared by any premises-based franchisee was realised, namely the establishment by McDonalds of two new McDonalds fast-food restaurants adjacent to two existing McDonalds restaurants owned by the franchisee. The franchisee claimed damages alleging that the decision by McDonalds not to first offer the franchisee a license for one of the new restaurants was in bad faith and that it was aimed at undermining the franchisee’s business. Although the court held that a term of good faith and fair dealing is to be implied into each franchise agreement, the obligation is not so wide that it will operate to deny a party the right to exercise its powers under an agreement or to promote or protect its legitimate commercial interests. The decisions made by McDonalds were viewed as decisions that were aimed at protecting the franchisor’s commercial interests in a manner that was not expressly precluded by the franchise agreement.
Clearly, in the context of systems that promote and distribute products over the internet, the potential for territorial incursion would be even greater. For example, in the case of Dymocks Holdings Pty Ltd v Top Ryde Booksellers Pty Ltd  NSWSC 390 the ‘dymocks.com’ website was acknowledged to be a source of competition for franchisees.
Achieving a balance
In accepting that growth is inherently desirable to the system, and provided that there is not growth for growth’s sake with possible loss of product quality standards and lack of commitment to the health of the system, the franchisor is unlikely to be willing to lose these opportunities. Against this, the franchisee’s fear of encroachment by its own system, with perceived direct negative impacts, also produces an outcome that is undesirable for the franchisor. Namely, a suspicious franchisee who has a guarded and defensive relationship with the system rather than one of positive co-operation in the interests of all parties.
Solutions for the franchisor in meeting its obligations
There are methodologies available to, in some measure, ensure that the grant of exclusivity in a territory can be managed in a way that balances out these competing interests and can allay concerns. These include:
- Focussed analysis by all parties prior to the grant of an exclusive territory
In no case should the grant of an exclusive territory be simply a matter of implementing templated terms such as a fixed circumference drawn from a central point. In addressing the question of a considered approach to determining territory areas, the American view is that the appropriate considerations include:
- Size of the franchise system and extent of market saturation.
- Franchisor’s development goals and the pace required to achieve them.
- Existence of competitors and the likelihood of competitive intrusion.
- The need to take out market share at a fast pace.
- Service of customers of the product being franchised and whether there are alternate means of distribution the franchisor might wish to retain.
- The market at the point of the grant versus the market towards the end of the term.
Appropriate considerations of these matters in defining exclusive territories could anticipate questions of shifting territory (eg expansion of city or suburban limits).
- Reservation of right
Notwithstanding a grant of an exclusive territory the franchisor can reserve rights to alternative means of distribution in the area such as internet sales. However, as previously stated, the use of the internet can in itself give rise to issues of territorial encroachment.
- Territory reduction
Drafting that permits the reduction of exclusive territory where the franchisee fails to meet its obligations or achieve full territory coverage.
- Rights of first refusal
In compliance with applicable agreements, the franchisor might indicate its wish to develop additional franchise services within a protected market place and provide the franchisee with the first option to take up the additional expansion opportunities these new products offer. Should the franchisee not take up the opportunity, then the franchisor might develop an additional franchise site thus diminishing the exclusivity restraints inherent within the original grant.
What protections might the franchisor offer to a franchisee in circumstances where no exclusive territory is granted?
The best franchise systems will not ignore the potential impact on franchisees from system expansion close to the franchisee’s area of trading or indeed within it. This is a commercial approach that looks beyond the strict rights to establish unit sites within an area to the broader issue of managing franchisee relations. There are a number of methodologies recognised as appropriate in achieving a commercially appropriate outcome which include:
- Granting exclusivity for a limited period
Certain systems combine concepts of exclusivity and non-exclusivity by providing the franchisee with critical exclusivity rights for a limited period (such as two years from commencement) to enable the franchisee to firmly establish its business within its chosen geographic area. Upon expiry of that period the franchisee should be firmly embedded in the market place so that the franchisor’s conduct in seeking to expand its system’s penetration within that geographic area should not be inhibited.
- Relationship management
The notion of limited exclusivity is a contractual solution. There are, however, subtle methodologies relating to the management of the relationship between the franchisor and the franchisee that can be used to achieve similar outcomes and which will assist in preserving a positive relationship between the parties.
- Appropriate notification and communication
Where it is intended to set up a new franchise location near to an existing franchisee business, then communication with the franchisee, well in advance, together with appropriate steps to determine the impact on the franchisee’s business through discussion, and if need be, independent studies, should commence. The relevant market and the potential impact of the new site on an existing franchisee should be established to enable calculations of an appropriate buffer zone to be made for separation between the existing and new site, or may result in the franchisor offering financial consideration to the franchisee as compensation for the establishment of the new site. Financial compensation could include reduction in royalties for a temporary period, or the provision of product purchase discounts. Although this solution might cause the franchisor to experience short-term financial loss, the alternative option, buying back the franchise territory, would be more detrimental if the franchisee was otherwise performing adequately.
There is also much to be said for establishing a liaison body between the franchisor and the franchisee where the interests of the system and the interests of its franchisees can be canvassed and balanced, if need be, by persons offering objective analysis.
- Collapsing areas
A contractual solution advocated by American attorneys is the grant of a negotiated exclusive territory of a larger nature in year one, reducing in a controlled manner in future years for part or all of the balance of the term. The feeder market would be greater in the establishment phase and as the franchisee business matures, its entitlements would reduce proportionately.
The question of whether to grant exclusive territory or not is an important consideration in the franchise model. The tensions of expansion versus franchisee business survival concerns are capable of being overcome through careful analysis and proper drafting, and the implementation of methodologies where the franchisee is considered in a fashion that achieves the best outcomes for all parties. The approach should always be relationship driven and assisted by meaningful pre-analysis.
1 A number of the views expressed in this paper are derived from a paper entitled: Protected Territories – Effective Development Tool or Legal Liability Speakers: Randall S Hammer, InterContinental Hotels Group, Atlanta GA Roy Flora, US Franchise Systems Inc (Microtel Hotels) Atlanta GA International Franchise Association Annual Legal Symposium, Washington, May 2006 and the author acknowledges the guidance provided by that presentation.
This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.