New Jersey Law Journal      VOL. 202 - NO 12        DECEMBER 20, 2010       

Internet-Based Franchise Encroachment Runs Rampant

By Jonathan Bick Jonathan Bick is of counsel to Brach Eichler of Roseland and is an adjunct professor of Internet law at Pace Law School and Rutgers Law School-Newark. He is also the author of 101 Things You Need To Know About Internet Law (Random House 2000).

Internet communications have blurred franchise location boundaries through novel, low-cost marketing opportunities for commercial enterprises, creating causes of action for violation of contractual and statutory rights.

Some Internet communications, such as e-mails sent by a franchisee to existing customers, do not result in franchise encroachment, but untargeted Internet commercial communication such as Web sites, “Google Ad Word,” marketing and spam can and do.

Customarily, a franchise agreement authorizes a commercial entity to use trademarks and other proprietary information in exchange for royalties owned by another, and it delineates an owner’s exclusive use in a particular locality. In the past, the difficulties associated with franchise encroachment were, as a rule, based upon a contractual finding that one franchisee had a claim to some exclusive territory into which the franchisor has made use.

Today, the problem most commonly related to encroachment is associated with use of the Internet by franchisors that results in marketing to customers within and outside their franchise area.

Most franchisees sell goods that are protected from competition by trademarks and proprietary information. Thus, a franchise owner’s threat of competition comes not from substitute products, but from fellow franchisees. Franchisees seek to make their individual units as profitable as possible. Their franchise agreements do not require concern for the welfare of fellow franchise owners.

A franchise agreement usually grants territorial exclusivity. To do so, it may detail a territorial confinement policy that limits where a franchisee may solicit or make sales, both by restricting the franchisee’s fixed business location, as well as perhaps prohibiting its marketing via other methods (e.g., Internet sales) to customers outside the franchisee’s territory.

If a franchisee’s exclusive territorial rights are violated, it not only has contractual remedies, but also, in some states, statutory rights against the of-fending franchisor. These statutes prohibit the encroachment on exclusive territories by a franchisee, but there is little case law on these statutes. Generally, a franchisee can obtain an in junction against any party that violates an exclusivity clause. Most recently, these franchise laws are used to outlaw a fellow franchisee from competing unfairly with the franchisee within a reasonable area.

Franchise agreements use geographical boundaries for the demarcation of territorial rights, but the protocols which allow the Internet to work are not capable of recognizing geographical boundaries. With use of credit cards, and both electronic and third-party delivery systems, many goods and services need not be geographically specific. Thus, even if a franchise agreement grants exclusive territories, the franchisor or another franchisee may be able to sell products and services without violating the terms of the franchise agreement to limit its operations to a particular location.

The lack of disclosure of the possibility of Internet market competitor alone has been used as a cause of action related to encroachment. Several lawsuits against chain franchises claim that there is an engagement in deceptive trade practices by showing the company’s circular stated that it would not open a store within two to three miles of a franchisee and showing the impact of Internet marketing on existing stores. Other franchisees claimed tortious interference with prospective economic relations merely because of Internet market competition.

Internet use is a recognized marketing element and is normally considered by franchise agreements. Courts are loath to interfere with business practices that result from contractual agreements, other than contracts of adhesion.

Carvel Corp. v. Noonan, 818 N.E.2d 1100 (N.Y. 2004), is illustrative. Several franchisees had successfully sued Carvel Corporation in federal court after asserting claims arising from Carvel selling its ice cream directly to supermarkets. On appeal, the Second U.S. Circuit Court of Appeals certified to the New York Court of Appeals the question of whether the franchisees had a valid claim for tortious interference with prospective economic relations. The state court found that the relation-ship between franchisors and franchisees is a complex one. While cooperative, the relationship does not preclude all competition and the extent to which competition is allowed should be deter-mined by the contracts between the par-ties, not by courts.

The New York Court of Appeals thus concluded that only contract law should govern whether competition be-tween a franchisor and a franchisee is wrongful, including the implied cove¬nant of good faith and fair dealing. The court found that the intervention of tort law to regulate when a franchisor may or may not compete with its franchisees is neither necessary nor useful.

Initially, courts sidestepped the Internet marketing issue. In Armstrong Business Services, Inc. v. H&R Block, 96 S.W.3d 867, 874-79 (Mo. Ct. App. 2002), the Missouri Court of Appeals refused to address the franchisees’ challenge to H&R Block’s Internet ser¬ vice programs while it upheld the fran¬chisor’s right to let expire a franchise agreement.

In Franklin 1989 Revocable Family Trust v. H&R Block, Inc., a three-member American Arbitration Association panel upheld H&R Block’s right to sell its Internet service in a franchisee’s territory without compensating the franchisee. The panel found this Internet service did not unreasonably intrude on Franklin’s brick-and-mortar operations. Thus, the franchisor’s Internet sales to customers residing in Franklin’s territory did not contravene the exclusivity granted in Franklin’s agreements.

In Pro Golf of Florida, Inc. v. Pro Golf of America, Inc., 2006 WL 508631 (E.D. Mich. Mar. 1, 2006), a federal court found that unless a franchise agreement specifically addressed Internet transactions, Internet encroachment claims should be precluded under the territorial exclusivity provisions contained in most franchise agreements. Although the actual agreement’s language was silent as to the specific issue of Internet sales, the court applied black-letter commercial law rather than an attempt to rewrite the parties’ bargain to govern an unanticipated development.

To prevent Internet encroachment, franchisees should contractually bind the franchisor to bar, reduce or financially account for Internet encroachment. Franchisees might also have a cause of action if they are not warned about the possibility of Internet encroachment.

It may also be argued that Federal Trade Commission disclosure requirements, 72 Fed. Reg. 15,444 (Mar. 30, 2007) (codified at 16 C.F.R. pts. 436-37 (2009)) require franchisors to disclose the possibility of Internet encroachment in order to help prospective franchisees “avoid harm” while choosing in which franchise to invest. If Internet encroachment is not prohibited by the franchise agreement, then franchisors are well advised to state that the franchisee has not been given an exclusive territory. This disclosure allows the potential franchisee to understand better the nature of the franchise relationship. Such disclosure will reduce or eliminate several causes of action.

Appropriate and timely disclosure of Internet marketing competition by a franchisor is advised to minimize to eliminate encroachment-related litigation. Franchisors must state that the franchisee may face competition from the franchisor, other franchisees, or other channels of Internet distribution that the franchisor does not control.

Franchisors are not responsible for and need not prevent Internet marketing competition. Court decisions have upheld the franchisor position that — absent an express contractual provision — franchisees cannot expect protection from every means of competition, including Internet-based encroachment. However, franchisors must fully dis-close the nature of Internet marketing competition or be prepared to resolve the legal difficulties for their failure to do so.