Fifth Circuit Affirms Lanham Act and Antitrust Judgment for Franchisor

In Schlotzsky's Ltd. v. Sterling Purchasing and National Dist-ribution Co., Inc. (“Sterling“), 502 F.3d 393 (5th Cir. 2008), the Fifth Circuit reinforced the tough standard for proving an antitrust tying claim against a franchisor and clarified the broad scope of the Lanham Act's unfair competition provision. The decision is important for franchisors defending claims of market power.

A Brief History

The Schlotzsky's' franchise system, now thriving, was once on the brink of disappearing. In August 2004, Schlotzsky's, Inc. ('SI') and its affiliates, including the former franchisor, filed for Chapter 11 bankruptcy protection. By that time, the company was insolvent, and it was struggling to ensure the distribution of Schlotzsky's' proprietary and branded products to its franchisees. During the bankruptcy, interim management approved Sterling Purchasing and National Distribution (“Sterling”) as a non-exclusive supply chain manager for the franchise system. The approval letter made clear that the franchisor owned the trademarks and system and had the right to approve all products, suppliers, and distributors. The letter also expressly stated that the authorization was “effective unless and until revoked by Schlotzsky's in writing to Sterling, the Suppliers and the Franchisees.”

Three months later, in December 2004, a predecessor to Schlotzsky's, Ltd. (“SL”) purchased the bankrupt franchisor's assets at a bankruptcy court auction. When the sale closed in January 2005, the franchise system'and, in particular, product distribution'was in complete disarray. The new owners quickly investigated different options for improving the distribution of products to franchisees. In March 2005, SL contracted with two new primary distributors for branded, proprietary and logoed products.

Around the same time, SL was also learning that Sterling had misrepresented its non-exclusive status to suppliers, franchisees, and distributors. In contracts and correspondence, Sterling claimed that it was the “exclusive representative” and “purchasing agent” for the franchisor and the entire Schlotzsky's' system. In the spring of 2005, SL sued Sterling in federal court in the Western District of Texas and also revoked Sterling's non-exclusive supply chain manager status. Sterling counterclaimed with various antitrust and tort claims.

At trial, District Court Judge Sam Sparks directed judgment for SL on Sterling's antitrust and state law counterclaims. The jury then returned a verdict for SL on its Lanham Act claim, finding that Sterling had committed a false designation of affiliation, sponsorship or approval with respect to its commercial activities. The district court issued a broad injunction, including the requirement that Sterling send an affirmative corrective notice to suppliers, distributors and franchisees in the system. The court also awarded SL $96,304.50 in attorneys' fees for its Lanham Act claim.

Fifth Circuit Affirms

The Fifth Circuit affirmed the district court's judgment in its entirety. Discussing Sterling's appeal of the Lanham Act judgment first, the court easily rejected Sterling's claim that the Lanham Act did not prohibit Sterling's conduct, noting that Section 43(a) “goes beyond trademark protection” and “should be broadly construed.” Id., 399 (citations omitted). The court held that Sterling had violated Section 43(a) because “[a]s middleman between suppliers and franchisees, Sterling deceptively used the Schlotzsky's brand name in an effort to further Sterling's position in the marketplace.” Id.

Moreover, SL's inability to prove a precise amount of damages was not fatal to its claim, especially where it was “beyond question” that SL had suffered “significant damage” as a result of Sterling's actions. Id., 400 (citing from district court order). The Fifth Circuit noted that Sterling's misrepresentations “were occurring during a period of intense financial distress for the company and the franchisees,” which made it difficult to establish damages precisely. Id. The appellate court affirmed the award of attorneys' fees and the broad, permanent injunction to remedy SL's harm. Id., 401-03. The court pointed to evidence that Sterling's owner “operates a new franchise supply chain business,” and noted that the “injunction prohibits Sterling's affiliates from engaging in the kind of misrepresentations that Sterling repeatedly used to advance its business position.” Id., 402-03.

The court also affirmed the directed judgment on Sterling's tort and antitrust claims, relying largely on the nature of the franchise relationship. The court squarely rejected Sterling's claim of an illegal tying arrangement, focusing heavily on the franchisor's lack of market power. According to the court, “the Schlotzsky's universe was created by contract, and not by dominance of a market. A franchisor usually exercises control not through market power but by voluntary agreement.” Id., 407 (emphasis added). The court also cautioned that the tying analysis must consider the “symbiotic” nature of a franchise relationship, in which “[t]he success of franchisor and franchisee are interrelated.” Id. That symbiotic relationship was demonstrated here, where “[t]he evidence support[ed] that Schlotzsky's actions were a good faith effort to see each franchisee prosper.” Id., 408. In fact, “[f]ar from being anti-competitive, Schlotzsky's efforts to return its troubled franchisees to profitability benefited competition by avoiding the disappearance of the Schlotzsky's brand stores.” Id.

Conclusion

The Fifth Circuit's decision is the latest in a long line of cases distinguishing market power from contract power, and rejecting tying claims against franchisors. See also Siemer v. The Quizno's Franchise Company LLC, 2008 WL 904874, at *11 (Mar. 31, 2008) (granting motion to dismiss where franchisor exercised only contract power). The case may be unique, however, in its understanding that the challenged conduct was actually instrumental in saving an entire franchise system.

After the trial of this case, affiliates of Focus Brands purchased SL's assets.

Edward Wood Dunham and Erika L. Amarante represented Schlotzsky's' in Schlotzsky's Ltd. v. Sterling Purchasing and National Distribution Co., Inc. Chair of the American Bar Association Forum on Franchising and a past Editor-in-Chief of the ABA Franchise Law Journal, Dunham is a partner in the New Haven, CT, office of Wiggin & Dana; he can be contacted at 203-498-4327, or [email protected]. Amarante is a partner in the New Haven office, and she can be contacted at 203-498-4493 or [email protected].

In Schlotzsky's Ltd. v. Sterling Purchasing and National Dist-ribution Co., Inc. (“Sterling“), 502 F.3d 393 (5th Cir. 2008), the Fifth Circuit reinforced the tough standard for proving an antitrust tying claim against a franchisor and clarified the broad scope of the Lanham Act's unfair competition provision. The decision is important for franchisors defending claims of market power.

A Brief History

The Schlotzsky's' franchise system, now thriving, was once on the brink of disappearing. In August 2004, Schlotzsky's, Inc. ('SI') and its affiliates, including the former franchisor, filed for Chapter 11 bankruptcy protection. By that time, the company was insolvent, and it was struggling to ensure the distribution of Schlotzsky's' proprietary and branded products to its franchisees. During the bankruptcy, interim management approved Sterling Purchasing and National Distribution (“Sterling”) as a non-exclusive supply chain manager for the franchise system. The approval letter made clear that the franchisor owned the trademarks and system and had the right to approve all products, suppliers, and distributors. The letter also expressly stated that the authorization was “effective unless and until revoked by Schlotzsky's in writing to Sterling, the Suppliers and the Franchisees.”

Three months later, in December 2004, a predecessor to Schlotzsky's, Ltd. (“SL”) purchased the bankrupt franchisor's assets at a bankruptcy court auction. When the sale closed in January 2005, the franchise system'and, in particular, product distribution'was in complete disarray. The new owners quickly investigated different options for improving the distribution of products to franchisees. In March 2005, SL contracted with two new primary distributors for branded, proprietary and logoed products.

Around the same time, SL was also learning that Sterling had misrepresented its non-exclusive status to suppliers, franchisees, and distributors. In contracts and correspondence, Sterling claimed that it was the “exclusive representative” and “purchasing agent” for the franchisor and the entire Schlotzsky's' system. In the spring of 2005, SL sued Sterling in federal court in the Western District of Texas and also revoked Sterling's non-exclusive supply chain manager status. Sterling counterclaimed with various antitrust and tort claims.

At trial, District Court Judge Sam Sparks directed judgment for SL on Sterling's antitrust and state law counterclaims. The jury then returned a verdict for SL on its Lanham Act claim, finding that Sterling had committed a false designation of affiliation, sponsorship or approval with respect to its commercial activities. The district court issued a broad injunction, including the requirement that Sterling send an affirmative corrective notice to suppliers, distributors and franchisees in the system. The court also awarded SL $96,304.50 in attorneys' fees for its Lanham Act claim.

Fifth Circuit Affirms

The Fifth Circuit affirmed the district court's judgment in its entirety. Discussing Sterling's appeal of the Lanham Act judgment first, the court easily rejected Sterling's claim that the Lanham Act did not prohibit Sterling's conduct, noting that Section 43(a) “goes beyond trademark protection” and “should be broadly construed.” Id., 399 (citations omitted). The court held that Sterling had violated Section 43(a) because “[a]s middleman between suppliers and franchisees, Sterling deceptively used the Schlotzsky's brand name in an effort to further Sterling's position in the marketplace.” Id.

Moreover, SL's inability to prove a precise amount of damages was not fatal to its claim, especially where it was “beyond question” that SL had suffered “significant damage” as a result of Sterling's actions. Id., 400 (citing from district court order). The Fifth Circuit noted that Sterling's misrepresentations “were occurring during a period of intense financial distress for the company and the franchisees,” which made it difficult to establish damages precisely. Id. The appellate court affirmed the award of attorneys' fees and the broad, permanent injunction to remedy SL's harm. Id., 401-03. The court pointed to evidence that Sterling's owner “operates a new franchise supply chain business,” and noted that the “injunction prohibits Sterling's affiliates from engaging in the kind of misrepresentations that Sterling repeatedly used to advance its business position.” Id., 402-03.

The court also affirmed the directed judgment on Sterling's tort and antitrust claims, relying largely on the nature of the franchise relationship. The court squarely rejected Sterling's claim of an illegal tying arrangement, focusing heavily on the franchisor's lack of market power. According to the court, “the Schlotzsky's universe was created by contract, and not by dominance of a market. A franchisor usually exercises control not through market power but by voluntary agreement.” Id., 407 (emphasis added). The court also cautioned that the tying analysis must consider the “symbiotic” nature of a franchise relationship, in which “[t]he success of franchisor and franchisee are interrelated.” Id. That symbiotic relationship was demonstrated here, where “[t]he evidence support[ed] that Schlotzsky's actions were a good faith effort to see each franchisee prosper.” Id., 408. In fact, “[f]ar from being anti-competitive, Schlotzsky's efforts to return its troubled franchisees to profitability benefited competition by avoiding the disappearance of the Schlotzsky's brand stores.” Id.

Conclusion

The Fifth Circuit's decision is the latest in a long line of cases distinguishing market power from contract power, and rejecting tying claims against franchisors. See also Siemer v. The Quizno's Franchise Company LLC, 2008 WL 904874, at *11 (Mar. 31, 2008) (granting motion to dismiss where franchisor exercised only contract power). The case may be unique, however, in its understanding that the challenged conduct was actually instrumental in saving an entire franchise system.

After the trial of this case, affiliates of Focus Brands purchased SL's assets.

Edward Wood Dunham and Erika L. Amarante represented Schlotzsky's' in Schlotzsky's Ltd. v. Sterling Purchasing and National Distribution Co., Inc. Chair of the American Bar Association Forum on Franchising and a past Editor-in-Chief of the ABA Franchise Law Journal, Dunham is a partner in the New Haven, CT, office of Wiggin & Dana; he can be contacted at 203-498-4327, or [email protected]. Amarante is a partner in the New Haven office, and she can be contacted at 203-498-4493 or [email protected].