The End of 'Exclusive' Territories?

Through the Looking Glass.

In franchising, the answer to Humpty Dumpty's question is that the Federal Trade Commission is the master of the meaning of words and, with its FAQ 37, the FTC has now provided more definition to the term “exclusive.” Prospective franchisees tend to like “exclusive” territories. To meet that demand, franchisors often seek to use the word “exclusive” and, while doing so, disclaim later in an FDD or franchise agreement much of what the word “exclusive” is thought to mean. One of the key drivers of a franchisee's interest in a particular franchisor's product or service is the idea of having the “exclusive” right to sell what it views as a hot brand or service in an area. No prospective franchisee wants two of the same restaurants to go up next to each other. If a brand or service has a unique appeal, franchisees want to capitalize on it by being the sole provider of that product or service in their area. In order to get that right, franchises are willing to pay royalties and abide by the franchisor's rules. The word “exclusive” has value when trying to sell franchises.

On the other hand, franchisors often want to be able to maximize the sale of their service or products. To do so, they also want to be able to distribute their products in nontraditional venues, like airports, arenas, hospitals, and the like. These nontraditional venues typically serve captive audiences, with little chance of cannibalizing a standard venue's sales. (Indeed, one very rarely goes to an airport or a hospital to eat at a particular restaurant or to acquire a particular service.) To account for this, franchisors often include reservation of rights language in their FDDs and franchise agreements. Often, this language will reserve the right to a franchisor to open a franchise company outlet in nontraditional venues. Yet, at the same time, many franchisors use the attractive adjective “exclusive” to describe the protection afforded to it franchisees.

But what does “exclusive” really mean? The use of the term “exclusive” may be coming to an end in light of a recent FAQ 37 promulgated by the FTC on Oct. 16, 2012. FAQ 37 provided:

May a franchisor state in Item 12 that it grants an “exclusive territory” if it reserves the right to open franchised or company outlets in so-called “non-traditional venues” like airports, arenas, hospitals, hotels, malls, military installations, national parks, schools, stadiums and theme parks?

Answer: No. Pursuant to FAQ 25, a franchisor may state in Item 12 that it grants an “exclusive territory” only if the franchisor contractually “promises not to establish either a company-owned or a franchise outlet selling the same or similar goods or services under the same or similar trademarks or service marks” within the geographic area or territory granted to a franchisee. A reservation of rights to open outlets selling the same goods or services under the same trademarks or service marks within a franchisee's territory negates any such commitment and triggers the Item 12 requirement to include a disclaimer stating that the franchisees will not receive an exclusive territory. FAQ 25 [Dealing with Item 12 and what is meant by an "exclusive territory"] notes that it is consistent with the disclosure scheme in Item 12 for a franchisor to grant an exclusive territory yet reserve the right to make sales in a territory through other channels of distribution or competitive brands because Item 12 elsewhere specifically requires detailed disclosures about such potential competition. The required disclosures about “other channels of distribution such as internet, catalog sales, telemarketing, or other direct marketing” are limited by the examples provided, however, to sales not requiring a franchised or company outlet physically located in a franchisee's exclusive territory.

Because “non-traditional venues” entail an outlet physically located in a franchisee's territory, we can find no principal basis for interpreting “other channels of distribution” to include them. Accordingly, it is Staff's view that a franchisor that reserves the right to sell through such “non-traditional venues” must make the disclosure that it does not provide an exclusive territory.

Staff recognizes that where a reservation of rights to make sales through “non-traditional venues” prevents a franchisor from offering an exclusive territory, Item 12 could be interpreted as prohibiting disclosure of the rights the franchisor is reserving. As a matter of enforcement policy, Staff will not object to the inclusion in this instance of the specific rights the franchisor is reserving because it would not conflict with the mandatory disclosure that the franchisor does not grant an exclusive territory and the additional information would provide respective franchisees with useful information about competition from “non-traditional venues.”

The language referenced in FAQ 37 that must be included on the FDD is laid out in 16 C.F.R. 436.5(1)(5)(i), which requires a statement that “You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control.” These words are not encouraging to someone interested in acquiring a franchise. Franchisors would like to avoid including that type of language in an FDD if at all possible, because it could dissuade potential purchasers of the franchises.

The confusion has created some practical problems in drafting an FDD. The average franchisee understands the term “exclusive” to mean no exceptions. The FTC has previously come out to say that franchisors may make a claim of exclusivity even if they take catalog orders for products or service from customers within the territory, or contract with another company to complete Internet sales within the territory, or telemarket to customers within the territory. The FTC finds these activities to be “other channels of distribution.” Other channels of distribution, in the FTC Rule are not considered an infringement of a franchisee's territory exclusivity rights. Through FAQ 37, the FTC is saying that not everything can be declared other channels of distribution. There must be a line where other channels of the distribution end and exclusivity begins.

The term “exclusive” now seems to be a loaded term inviting scrutiny. Many wrestle with the strict and somewhat inconsistent language of these Item 12 requirements. Typically, a franchisor will define a franchisee's protective territory with special location carved out, such as an “exclusive territory” in the franchise agreement. In order to avoid confusion, many franchisors will now need to avoid the grant of an “exclusive territory” in Item 12. To alleviate any concerns, it might be best to avoid the phrase “exclusive territory” in an FDD. A better practice may be to use the term “protected territory” or “restricted territory” or “franchisee territory” as an alternative when special location carve outs are used. Some may even go so far as to include the additional language “not an exclusive territory” to satisfy this requirement.

Suffice it to say, the use of the term “exclusive territory” in FDDs and franchise agreements may be coming to an end. The FTC is the master of the meaning of “exclusive.”

Mark Wagoner is a partner in the franchise and litigation practice groups in the Toledo and Columbus offices of Shumaker, Loop & Kendrick LLP. He can be contacted at [email protected] or 419-241-9000.

“When I use a word,” Humpty Dumpty said, in a rather scornful tone, “it means just what I choose it to mean ' neither more nor less.”

“The question is,” said Alice, “whether you can make words mean so many different things.”

“The question is,” said Humpty Dumpty, “which is to be master ' that's all.”

Through the Looking Glass.

In franchising, the answer to Humpty Dumpty's question is that the Federal Trade Commission is the master of the meaning of words and, with its FAQ 37, the FTC has now provided more definition to the term “exclusive.” Prospective franchisees tend to like “exclusive” territories. To meet that demand, franchisors often seek to use the word “exclusive” and, while doing so, disclaim later in an FDD or franchise agreement much of what the word “exclusive” is thought to mean. One of the key drivers of a franchisee's interest in a particular franchisor's product or service is the idea of having the “exclusive” right to sell what it views as a hot brand or service in an area. No prospective franchisee wants two of the same restaurants to go up next to each other. If a brand or service has a unique appeal, franchisees want to capitalize on it by being the sole provider of that product or service in their area. In order to get that right, franchises are willing to pay royalties and abide by the franchisor's rules. The word “exclusive” has value when trying to sell franchises.

On the other hand, franchisors often want to be able to maximize the sale of their service or products. To do so, they also want to be able to distribute their products in nontraditional venues, like airports, arenas, hospitals, and the like. These nontraditional venues typically serve captive audiences, with little chance of cannibalizing a standard venue's sales. (Indeed, one very rarely goes to an airport or a hospital to eat at a particular restaurant or to acquire a particular service.) To account for this, franchisors often include reservation of rights language in their FDDs and franchise agreements. Often, this language will reserve the right to a franchisor to open a franchise company outlet in nontraditional venues. Yet, at the same time, many franchisors use the attractive adjective “exclusive” to describe the protection afforded to it franchisees.

But what does “exclusive” really mean? The use of the term “exclusive” may be coming to an end in light of a recent FAQ 37 promulgated by the FTC on Oct. 16, 2012. FAQ 37 provided:

May a franchisor state in Item 12 that it grants an “exclusive territory” if it reserves the right to open franchised or company outlets in so-called “non-traditional venues” like airports, arenas, hospitals, hotels, malls, military installations, national parks, schools, stadiums and theme parks?

Answer: No. Pursuant to FAQ 25, a franchisor may state in Item 12 that it grants an “exclusive territory” only if the franchisor contractually “promises not to establish either a company-owned or a franchise outlet selling the same or similar goods or services under the same or similar trademarks or service marks” within the geographic area or territory granted to a franchisee. A reservation of rights to open outlets selling the same goods or services under the same trademarks or service marks within a franchisee's territory negates any such commitment and triggers the Item 12 requirement to include a disclaimer stating that the franchisees will not receive an exclusive territory. FAQ 25 [Dealing with Item 12 and what is meant by an "exclusive territory"] notes that it is consistent with the disclosure scheme in Item 12 for a franchisor to grant an exclusive territory yet reserve the right to make sales in a territory through other channels of distribution or competitive brands because Item 12 elsewhere specifically requires detailed disclosures about such potential competition. The required disclosures about “other channels of distribution such as internet, catalog sales, telemarketing, or other direct marketing” are limited by the examples provided, however, to sales not requiring a franchised or company outlet physically located in a franchisee's exclusive territory.

Because “non-traditional venues” entail an outlet physically located in a franchisee's territory, we can find no principal basis for interpreting “other channels of distribution” to include them. Accordingly, it is Staff's view that a franchisor that reserves the right to sell through such “non-traditional venues” must make the disclosure that it does not provide an exclusive territory.

Staff recognizes that where a reservation of rights to make sales through “non-traditional venues” prevents a franchisor from offering an exclusive territory, Item 12 could be interpreted as prohibiting disclosure of the rights the franchisor is reserving. As a matter of enforcement policy, Staff will not object to the inclusion in this instance of the specific rights the franchisor is reserving because it would not conflict with the mandatory disclosure that the franchisor does not grant an exclusive territory and the additional information would provide respective franchisees with useful information about competition from “non-traditional venues.”

The language referenced in FAQ 37 that must be included on the FDD is laid out in 16 C.F.R. 436.5(1)(5)(i), which requires a statement that “You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control.” These words are not encouraging to someone interested in acquiring a franchise. Franchisors would like to avoid including that type of language in an FDD if at all possible, because it could dissuade potential purchasers of the franchises.

The confusion has created some practical problems in drafting an FDD. The average franchisee understands the term “exclusive” to mean no exceptions. The FTC has previously come out to say that franchisors may make a claim of exclusivity even if they take catalog orders for products or service from customers within the territory, or contract with another company to complete Internet sales within the territory, or telemarket to customers within the territory. The FTC finds these activities to be “other channels of distribution.” Other channels of distribution, in the FTC Rule are not considered an infringement of a franchisee's territory exclusivity rights. Through FAQ 37, the FTC is saying that not everything can be declared other channels of distribution. There must be a line where other channels of the distribution end and exclusivity begins.

The term “exclusive” now seems to be a loaded term inviting scrutiny. Many wrestle with the strict and somewhat inconsistent language of these Item 12 requirements. Typically, a franchisor will define a franchisee's protective territory with special location carved out, such as an “exclusive territory” in the franchise agreement. In order to avoid confusion, many franchisors will now need to avoid the grant of an “exclusive territory” in Item 12. To alleviate any concerns, it might be best to avoid the phrase “exclusive territory” in an FDD. A better practice may be to use the term “protected territory” or “restricted territory” or “franchisee territory” as an alternative when special location carve outs are used. Some may even go so far as to include the additional language “not an exclusive territory” to satisfy this requirement.

Suffice it to say, the use of the term “exclusive territory” in FDDs and franchise agreements may be coming to an end. The FTC is the master of the meaning of “exclusive.”

Mark Wagoner is a partner in the franchise and litigation practice groups in the Toledo and Columbus offices of Shumaker, Loop & Kendrick LLP. He can be contacted at [email protected] or 419-241-9000.