Drafting an effective franchise agreement – Part 2


Scope of the Grant

The extent of the franchisee’s interest is defined in large part by the scope of the grant with respect to the territory, the market or channels of distribution, the goods or services, and the extent to which the grant is exclusive.

Exclusive Territory

Frequently, the franchisor will grant an exclusive territory or a radius within which the franchisor will not establish a competing outlet. Exclusivity gives the franchisee an incentive to market in the territory, knowing that this marketing will maximize the franchisee’s earnings and not that of neighboring franchisees. An exclusive territory also implies an obligation on the part of the franchisee to exploit the territory.

Some franchise agreements do not provide for territorial exclusivity, but only for the grant of a franchise at a particular location. This can be a source of tension between the franchisor and franchisee. When the franchise agreement provides no territorial protection or a small territory, the franchisor may be tempted to grant other franchises that may be close enough to compete. The franchisees may object, because the competition may reduce their sales or profits. However, the franchisor may benefit from the total aggregate increase in sales by the competing franchises.

Competition among franchisees within one system may also arise when the franchisor acquires a competing franchise system. The franchisor might anticipate this eventuality by retaining the right to sell competitive goods or services identified by other trademarks in the franchisee’s territory. This might be limited to instances where the franchisor acquires or merges with or is acquired by a competing business, a portion of which is located in the franchisee’s territory. The franchise agreement might provide that in the event of such a merger or acquisition, the franchisor will not change the identity of the competing business to that of the franchisee. The franchisor might also agree that, in the event of such a merger, the franchisor will not give any competitive advantage to a competing franchise in the exclusive territory.

Another approach might be for the franchisor to reserve the right to convert the acquired business to the franchisor’s format and identity either as a company-owned outlet or as a franchised location. The franchisee may object to this. The conversion of the site to the fran-chisor’s identity may pose greater competition than that posed by the same store using a different identity. The franchisor’s brand identity may be stronger and it may difficult for the two franchises to differentiate themselves. In one recent case, for example, a franchisee successfully alleged constructive termination on the basis that the franchisor’s pricing for its products to the acquired dealers in its territory made it impossible to compete.

Reserving Markets to the Franchisor

Usually, exclusivity means that the franchisor will not franchise another location and will not open a company-owned store in the territory. In addition, it may mean that the franchisor will not sell its products directly to other retailers or wholesalers in the territory. Where the franchisee is selling consumer products under the franchisor’s brand, the franchisor may want to reserve the right to sell directly by mail order, or to department stores and other national or regional customers. This type of restriction will be upheld if it is reasonable.

licensee then sought an injunction enjoining Frito Lay from manufacturing, selling and distributing any corn chips within the licensee’s territory. The license agreement specifically prohibited the licensor from selling “Fritos” corn chips in the licensed territory. The licensee argued that there was an implied covenant not to manufacture or sell competitive products. The court held that the products being sold by Frito Lay were not competitive with “Fritos”, and denied the injunction. The Eighth Circuit Court of Appeals affirmed, holding, among other things, that since the license agreement prohibited the sale of “Fritos” corn chips, it was not silent on the subject. The court would not imply a negative covenant where the parties had addressed the issue in the agreement. The lesson of this case is that a clear agreement might have avoided costly litigation.