Court Watch

As franchise law approaches its 40th birthday, one might imagine that some of the key questions about franchising and distribution generally would have been ironed out by the courts by now. Not true. And nowhere is this better demonstrated than in the continuing quest to define what is, and is not, a franchise or a distributorship. Part of the problem, of course, is that the definitions of these terms vary among the statutes that regulate franchise sales disclosures and franchise relationships, and the FTC's definition of a franchise only further complicates the question ' although not in the franchise relationship context. The bottom line is that what constitutes a franchise for franchise-sales purposes may not be a franchise for franchise-relationship issues, and what might constitute a franchise in California may or may not be a franchise in another jurisdiction in either a franchise-sales situation or a franchise-relationship situation. Moreover, some states try to regulate only what the business world would consider true franchises, while in other jurisdictions, in particular Wisconsin and Rhode Island, relationship laws cover a wider range of distribution systems, including both distributorships and dealerships. In any event, the complex regulatory scheme makes it no surprise that cases trying to define the parameters of a franchise or a distributorship just keep on coming.

Two Recent Cases

Two recent cases, Gabana Gulf Distribution, Ltd. v. Gap International Sales, Inc., Bus. Franchise Guide (CCH) 14,204 (9th Cir. 2009) and F&C Flooring Distributors, Inc. v. Junckers Hardwood, Inc., Bus. Franchise Guide (CCH) 14,280 (E.D. Wis. 2009), illustrate the nature of these recurring definitional problems. Both cases involved claims that termination by a manufacturer violated a relationship statute ' the California Franchise Relations Act (“CFRA”) in Gabana and the Wisconsin Fair Dealership Law (“WFDL”) in F&C Flooring, with the court in each case deciding that the relationship was not covered by the applicable statute.

Under the California statute that was before the court in Gabana, there must be, among other requirements, a substantial association between the distributor or putative franchisee and a supplier or manufacturer for a franchise relationship to exist. In that case, the agreement between the parties expressly prohibited the plaintiff from adopting or using any of the manufacturer's trademarks or related intangible property, including any use on business cards or stationery or in any other way. A dissenting judge looked to cases in other jurisdictions to support his belief that the trial court's decision favoring the manufacturer should be reversed. However, the majority concluded that selling a good or service under a licensor's name in itself did not create the substantial association necessary for a relationship to be characterized as a franchise. Although not expressly stated in the appellate court's opinion, the court tacitly concluded that it was looking for dependence of the franchisee on the licensor before it would consider whether the CFRA's provisions that restrict franchisee terminations had been violated.

In F&C Flooring, the court was faced with the issue of whether the WFDL's provisions restricting a supplier's ability to terminate a relationship with someone lower in the distribution ladder had been violated. Here, the court was not as tacit in noting that the issue involved the question of how dependent a distributor was on its supplier/manufacturer. The WFDL uses the words, “continuity of interest” as the test of whether a relationship is governed by that Act. However, the court vividly cut to the chase by stating three times that the supplier must have the distributor “over a barrel” for the WFDL to be applicable.

In F&C Flooring, the court decided that this was not the case. It looked at two factors from among almost a dozen in reaching this conclusion. First, it found that the percentage of the distributor's revenues and profits that derived from the relationship were quite small ' in the range of 5% or less of the profits during the two preceding years. Thus, termination of the relationship would not have a “significant economic impact” on the distributor. Second, the distributor had not made a significant economic investment in the relationship that would be unrecoverable upon termination, nor had a significant amount of time been invested in developing the relationship.

Profits and Revenues

The profits and revenues argument used by the court to support its decision is worth further examination, particularly in this time of recession, for it illustrates a situation where numbers by themselves do not adequately paint the picture of the situation. In encroachment theory, the same argument is made'for example, that a 5% loss of revenues should not be substantial enough to prohibit the franchisor from opening up a new unit in close proximity to a nearby franchisee whose sales will be reduced by the new store. If the affected unit was working on a very solid profit margin, the analysis leads to the right conclusion: If a franchisee has $1 million in gross sales and $500,000 in net profit, a 5% reduction in sales will make the franchisee less profitable, but still very viable. Contrast that with the situation where the franchisee's sales are $1 million, but he is only breaking even. In this situation, the sales reduction will move him to a loss position.

This same economic approach should be applicable to the termination situation. A court should not stop its analysis after looking only at sales or profits percentages.

A second factor that needs to be considered is whether there can be a replacement supplier for the one that is terminating the relationship. If so, then the potential for economic disaster resulting from the termination will be lessened.

A Sense of Uncertainty

One of the purposes of commercial law is to provide a playbook for the participants. When a court mechanically turns to statistics in determining whether a relationship falls within the purview of a relationship statute, it may be leaving the business world with a sense of uncertainty ' the opposite of what commercial law is supposed to achieve ' although the court may believe that it is creating more definitive guidelines for the business community. In light of decisions such as Gabana and F&C Flooring, one must ask whether the CFRA and the WFDL are counterproductive.

Rupert M. Barkoff is a partner in the Atlanta office of Kilpatrick Stockton LLP. He can be contacted at [email protected].

As franchise law approaches its 40th birthday, one might imagine that some of the key questions about franchising and distribution generally would have been ironed out by the courts by now. Not true. And nowhere is this better demonstrated than in the continuing quest to define what is, and is not, a franchise or a distributorship. Part of the problem, of course, is that the definitions of these terms vary among the statutes that regulate franchise sales disclosures and franchise relationships, and the FTC's definition of a franchise only further complicates the question ' although not in the franchise relationship context. The bottom line is that what constitutes a franchise for franchise-sales purposes may not be a franchise for franchise-relationship issues, and what might constitute a franchise in California may or may not be a franchise in another jurisdiction in either a franchise-sales situation or a franchise-relationship situation. Moreover, some states try to regulate only what the business world would consider true franchises, while in other jurisdictions, in particular Wisconsin and Rhode Island, relationship laws cover a wider range of distribution systems, including both distributorships and dealerships. In any event, the complex regulatory scheme makes it no surprise that cases trying to define the parameters of a franchise or a distributorship just keep on coming.

Two Recent Cases

Two recent cases, Gabana Gulf Distribution, Ltd. v. Gap International Sales, Inc., Bus. Franchise Guide (CCH) 14,204 (9th Cir. 2009) and F&C Flooring Distributors, Inc. v. Junckers Hardwood, Inc., Bus. Franchise Guide (CCH) 14,280 (E.D. Wis. 2009), illustrate the nature of these recurring definitional problems. Both cases involved claims that termination by a manufacturer violated a relationship statute ' the California Franchise Relations Act (“CFRA”) in Gabana and the Wisconsin Fair Dealership Law (“WFDL”) in F&C Flooring, with the court in each case deciding that the relationship was not covered by the applicable statute.

Under the California statute that was before the court in Gabana, there must be, among other requirements, a substantial association between the distributor or putative franchisee and a supplier or manufacturer for a franchise relationship to exist. In that case, the agreement between the parties expressly prohibited the plaintiff from adopting or using any of the manufacturer's trademarks or related intangible property, including any use on business cards or stationery or in any other way. A dissenting judge looked to cases in other jurisdictions to support his belief that the trial court's decision favoring the manufacturer should be reversed. However, the majority concluded that selling a good or service under a licensor's name in itself did not create the substantial association necessary for a relationship to be characterized as a franchise. Although not expressly stated in the appellate court's opinion, the court tacitly concluded that it was looking for dependence of the franchisee on the licensor before it would consider whether the CFRA's provisions that restrict franchisee terminations had been violated.

In F&C Flooring, the court was faced with the issue of whether the WFDL's provisions restricting a supplier's ability to terminate a relationship with someone lower in the distribution ladder had been violated. Here, the court was not as tacit in noting that the issue involved the question of how dependent a distributor was on its supplier/manufacturer. The WFDL uses the words, “continuity of interest” as the test of whether a relationship is governed by that Act. However, the court vividly cut to the chase by stating three times that the supplier must have the distributor “over a barrel” for the WFDL to be applicable.

In F&C Flooring, the court decided that this was not the case. It looked at two factors from among almost a dozen in reaching this conclusion. First, it found that the percentage of the distributor's revenues and profits that derived from the relationship were quite small ' in the range of 5% or less of the profits during the two preceding years. Thus, termination of the relationship would not have a “significant economic impact” on the distributor. Second, the distributor had not made a significant economic investment in the relationship that would be unrecoverable upon termination, nor had a significant amount of time been invested in developing the relationship.

Profits and Revenues

The profits and revenues argument used by the court to support its decision is worth further examination, particularly in this time of recession, for it illustrates a situation where numbers by themselves do not adequately paint the picture of the situation. In encroachment theory, the same argument is made'for example, that a 5% loss of revenues should not be substantial enough to prohibit the franchisor from opening up a new unit in close proximity to a nearby franchisee whose sales will be reduced by the new store. If the affected unit was working on a very solid profit margin, the analysis leads to the right conclusion: If a franchisee has $1 million in gross sales and $500,000 in net profit, a 5% reduction in sales will make the franchisee less profitable, but still very viable. Contrast that with the situation where the franchisee's sales are $1 million, but he is only breaking even. In this situation, the sales reduction will move him to a loss position.

This same economic approach should be applicable to the termination situation. A court should not stop its analysis after looking only at sales or profits percentages.

A second factor that needs to be considered is whether there can be a replacement supplier for the one that is terminating the relationship. If so, then the potential for economic disaster resulting from the termination will be lessened.

A Sense of Uncertainty

One of the purposes of commercial law is to provide a playbook for the participants. When a court mechanically turns to statistics in determining whether a relationship falls within the purview of a relationship statute, it may be leaving the business world with a sense of uncertainty ' the opposite of what commercial law is supposed to achieve ' although the court may believe that it is creating more definitive guidelines for the business community. In light of decisions such as Gabana and F&C Flooring, one must ask whether the CFRA and the WFDL are counterproductive.

Rupert M. Barkoff is a partner in the Atlanta office of Kilpatrick Stockton LLP. He can be contacted at [email protected].