Encroachment and Franchisee Claims of Constructive Termination

Sustained impact can be measured by sales drops compared to the sales trends in other locations. The impact measurement must also be evaluated pursuant to several other criteria, such as other competitors, market penetration, customer traffic and purchase patterns, physical barriers, population density, retail, employment, recreational and educational trends.

For litigation purposes, an expert can measure impact by polling customers from locations, determining why they shop at a particular location and plotting a map of their destination and return routes. These results can be measured and produce a fairly good study whether the two locations actually encroach.

Avoiding Impact Claims

Intelligent brand development requires that geography and trading markets be mapped and assessed, demographics and psychographics be determined, and that a plan be adopted to support new franchisees in that area. When the franchise agreement contains a protected territory where the franchisor is prohibited from encroaching, the franchisor is generally safe from encroachment claims where the alleged encroacher is located outside of the protective territory. Where, as in most systems, no protected territory is granted, brand development may require locations be located near each other in order to ensure market penetration.

Franchisors can develop protest policies to allow franchisees to protest future locations and allow deeper study of the impact, with a decision for the opening of the new location decided by a panel. Another method is to have a franchisee compensation policy for when the impact is sustained and permanent, which compensates the franchisee for the impact and provides proactive steps to minimize future impact. Those proactive steps may be for royalty or advertising forgiveness or deferral. In the alternative, the franchisor may agree to enhanced support and/or advertising. The impacted franchisees may also agree to a revenue sharing or override arrangement. The goal is to expand the brand and take care of the affected franchisee.

Impact Claims and Constructive Termination

In some jurisdictions, impact claims are not cognizable unless the franchisee goes out of business. New Jersey law holds that a constructive termination claim cannot lie “where the franchise is still in operation,” according to Naik v. 7-Eleven, No. 13-4578, 2014 U.S. Dist. LEXIS 107139 at *41-42 (D.N.J. Aug. 5, 2014), citing Pai v. DRX Urgent Care LLC, No. 13-4333, 2014 U.S. Dist. LEXIS 27071 (D.N.J. Mar. 4, 2014). In Pai, the franchisee argued that the franchisors “have constructively terminated its franchise without good cause in violation of the New Jersey Franchise Practices Act.” However, this court rejected its argument because “the Supreme Court recently has made clear that a claim for constructive termination by a franchisee requires that a franchisee no longer be in operation,” citing Mac's Shell Service v. Shell Oil Products, 559 U.S. 175, 178, 130 S. Ct. 1251, 176 L. Ed. 2d 36 (2010).

The franchisee specifically argued that “a New Jersey appellate court decision that issued before the Mac's Shell decision, Maintainco v. Mitsubishi Caterpillar Forklift America, 408 N.J. Super. 461, 975 A.2d 510 (App. Div. 2009), stands for the proposition that a franchisee can state a claim for constructive termination under the NJFPA even if it is an operating franchise.” The court called the argument “unpersuasive” and found Maintainco to be “unpersuasive authority for the proposition that a franchisee that is currently operating, accepting the benefits of the franchise, and making a profit can bring a claim for constructive termination.” The court concluded by holding that “based upon the Supreme Court's holding in Mac's Shell, a claim for constructive termination requires that a franchisee no longer be operating.”

Franchisor's Best Practices

Establishing a protected territory effectively gives the franchisor a license to impact outside of the geographic protection. Although claims could still survive even if the location is located outside of the territory, the impact and strength of the claim is weaker. Franchisors should have an impact policy that allows franchisees to establish protest boards to identify, measure, evaluate, and sometimes even compensate for encroachment. Experts should be consulted in the measurement to ensure scientific methodology is being applied to this quite emotional issue.

Craig R. Tractenberg is a partner on the franchise team at Nixon Peabody and an adjunct professor of franchise law at Temple University's Beasley School of Law. This article also appeared in The Legal Intelligencer, an ALM sister publication of this newsletter.

“Encroachment” is a term used in the franchise industry to describe sales and revenues being transferred from one location to another because of their proximity. If a new location is established near an existing franchise location, then it is possible that existing sales will be transferred from the old location to the new. Litigants sometimes claim the encroachment is so extensive so as to threaten the viability of the existing location. In these instances, claims have been asserted for constructive termination because the existing location is alleged to no longer be viable. More likely, the claim for constructive termination is not viable.

Measuring Impact

Impact attributed to a neighboring location triggers high emotions. The distance between the locations is one factor, but not the only one, and may ultimately be insignificant. The first rule is that initial impact is not actionable, because it is normal for a new location to attract attention and curiosity. Sustained impacts over months may be actionable, but legal theories to support such claims are thin. Absent a direct breach of a protected area, the franchisor has discretion to locate another location proximate to the complaining location in good faith.

Sustained impact can be measured by sales drops compared to the sales trends in other locations. The impact measurement must also be evaluated pursuant to several other criteria, such as other competitors, market penetration, customer traffic and purchase patterns, physical barriers, population density, retail, employment, recreational and educational trends.

For litigation purposes, an expert can measure impact by polling customers from locations, determining why they shop at a particular location and plotting a map of their destination and return routes. These results can be measured and produce a fairly good study whether the two locations actually encroach.

Avoiding Impact Claims

Intelligent brand development requires that geography and trading markets be mapped and assessed, demographics and psychographics be determined, and that a plan be adopted to support new franchisees in that area. When the franchise agreement contains a protected territory where the franchisor is prohibited from encroaching, the franchisor is generally safe from encroachment claims where the alleged encroacher is located outside of the protective territory. Where, as in most systems, no protected territory is granted, brand development may require locations be located near each other in order to ensure market penetration.

Franchisors can develop protest policies to allow franchisees to protest future locations and allow deeper study of the impact, with a decision for the opening of the new location decided by a panel. Another method is to have a franchisee compensation policy for when the impact is sustained and permanent, which compensates the franchisee for the impact and provides proactive steps to minimize future impact. Those proactive steps may be for royalty or advertising forgiveness or deferral. In the alternative, the franchisor may agree to enhanced support and/or advertising. The impacted franchisees may also agree to a revenue sharing or override arrangement. The goal is to expand the brand and take care of the affected franchisee.

Impact Claims and Constructive Termination

In some jurisdictions, impact claims are not cognizable unless the franchisee goes out of business. New Jersey law holds that a constructive termination claim cannot lie “where the franchise is still in operation,” according to Naik v. 7-Eleven, No. 13-4578, 2014 U.S. Dist. LEXIS 107139 at *41-42 (D.N.J. Aug. 5, 2014), citing Pai v. DRX Urgent Care LLC, No. 13-4333, 2014 U.S. Dist. LEXIS 27071 (D.N.J. Mar. 4, 2014). In Pai , the franchisee argued that the franchisors “have constructively terminated its franchise without good cause in violation of the New Jersey Franchise Practices Act.” However, this court rejected its argument because “the Supreme Court recently has made clear that a claim for constructive termination by a franchisee requires that a franchisee no longer be in operation,” citing Mac's Shell Service v. Shell Oil Products , 559 U.S. 175, 178, 130 S. Ct. 1251, 176 L. Ed. 2d 36 (2010).

The franchisee specifically argued that “a New Jersey appellate court decision that issued before the Mac's Shell decision, Maintainco v. Mitsubishi Caterpillar Forklift America , 408 N.J. Super. 461, 975 A.2d 510 (App. Div. 2009), stands for the proposition that a franchisee can state a claim for constructive termination under the NJFPA even if it is an operating franchise.” The court called the argument “unpersuasive” and found Maintainco to be “unpersuasive authority for the proposition that a franchisee that is currently operating, accepting the benefits of the franchise, and making a profit can bring a claim for constructive termination.” The court concluded by holding that “based upon the Supreme Court's holding in Mac's Shell , a claim for constructive termination requires that a franchisee no longer be operating.”

Franchisor's Best Practices

Establishing a protected territory effectively gives the franchisor a license to impact outside of the geographic protection. Although claims could still survive even if the location is located outside of the territory, the impact and strength of the claim is weaker. Franchisors should have an impact policy that allows franchisees to establish protest boards to identify, measure, evaluate, and sometimes even compensate for encroachment. Experts should be consulted in the measurement to ensure scientific methodology is being applied to this quite emotional issue.

Craig R. Tractenberg is a partner on the franchise team at Nixon Peabody and an adjunct professor of franchise law at Temple University's Beasley School of Law. This article also appeared in The Legal Intelligencer, an ALM sister publication of this newsletter.