Distribution, Competition, and Antitrust / IP Law

Are Franchise No-Hire Provisions Unlawful?

Two recent suits against McDonald’s and Carl’s Jr. are challenging franchise provisions that limit or prohibit the ability of one franchisee to hire away employees from another franchisee.  These provisions are fairly common, although after the suit McDonald’s decided to repeal its version.

One issue that may be decided is whether these restraints are horizontal or vertical.  From an antitrust perspective, it seems more plausible that they are vertical.

If vertical, then there is likely going to be a balance of anti-competitive effects and pro-competitive efficiencies.  As to the latter, as the linked New York Times article notes, “[t]urnover rates are high in the industry, and maintaining a talented work force requires investing in training and recruitment. Prohibiting franchisees from hiring one another’s workers protects that investment.”  Again, that seems a plausible explanation, though of course it is subject to testing.

Additionally, we might ask whether there is really any anti-competitive harm, given that there isn’t much (if any) real price flexibility between and among franchisees in the same geographic area.  Without meaningful flexibility on downstream prices, franchises may not be able to bid up labor costs, in which case the no-hire restrictions may not have much if any effect on wages.

Given the enforcement agencies’ recent interest in and guidance concerning labor markets, we may see additional challenges to these franchise restrictions.

Can A Franchisor Require Franchisees to Buy Supplies, Ingredients, or Products From It?

Tied in Knots?

The antitrust laws sometimes forbid product “tying.” A tying arrangement is an agreement by a party to sell one product on the condition that the buyer also purchases a different (or tied) product. In the franchise context, franchisors sometimes require franchisees to buy products from them or affiliated companies. Are these arrangements lawful?

Franchisors and franchisees see these arrangements differently. The franchisees – perhaps upset with the pricing of the franchisor-supplied products – may allege an antitrust violation, claiming that the franchise is the “tying” product and the required supplies or ingredients are the “tied” products. (Such ties can hurt competition in the tied product market – for example, if fast food franchises are at issue, ties could deny an important customer base to a competing supplier of food ingredients. That is what makes ties potentially anti-competitive.) The franchisor, of course, will argue that it is entitled on quality, reputation, uniformity, and consistency grounds to require that only certain supplies, ingredients, or products be used in its franchised operations.

The courts’ treatment of these claims has been somewhat complicated and not entirely uniform. It’s probably safe to say that these claims will fail if the franchisor lacks “market power” in the tying product market, or if the plaintiff does not adequately allege product market definitions. In the past, these market power and market definition requirements have stymied plaintiffs. But, as I note below, these claims have not been entirely foreclosed.

In Queen City Pizza, Inc. v. Domino’s Pizza, Inc., 124 F.3d 430, reh’g denied, 129 F.3d 724 (3d Cir. 1997), the Third Circuit took a strict view of how to determine the relevant product markets. The plaintiff franchisees argued that Domino’s had tied the franchise to the purchase of ingredients and supplies, and that the ingredients and supplies used in the operation of a Domino’s pizza shop constituted a relevant market. (The plaintiffs also alleged, among other things, that Domino’s had power in the market for “Domino’s approved” pizza dough and used that power to force plaintiffs to buy unwanted ingredients and supplies in the “aftermarket” for sales of supplies to Domino’s franchisees, and that Domino’s had monopolized the market for ingredients and supplies used in Domino’s stores.)

The court disagreed, holding that the relevant product market could not be limited to Domino’s franchisees. The ingredients and supplies used in a Domino’s franchise were interchangeable with products from other suppliers used in the broader market. The question was not whether a Domino’s franchisee could use both approved and non-approved products, but whether pizza makers generally could use such products interchangeably. They could. The franchise agreement’s contractually-imposed exclusivity restraints could not amount to or create market power; the question was whether the franchisor had pre-contract market power, not whether it had post-contractual “power” under the franchise agreement.

However, two relatively recent cases illustrate that the law in this area may not be entirely settled, or at least that tying claims in the franchise context are not completely dead. For example, in Burda v. Wendy’s International, Inc., 659 F. Supp. 2d 928 (S.D. Ohio 2009), the court refused to dismiss a franchise tying claim. Wendy’s had allegedly insisted that franchisees purchase foods or ingredients from it (or its affiliates) after franchisees entered into a franchise agreement that, at least according to the pleadings, did not contemplate such exclusivity. The lack-of-disclosure-at-time-of-franchising allegation was significant. Because the Wendy’s franchisees allegedly did not know that the “market power” was contractually established by the franchise agreements, the court concluded that Queen City Pizza was not controlling. (In Queen City Pizza, the standard form franchise agreement expressly provided that Domino’s reserved the right to require ingredients and supplies to be purchased exclusively from it.)

Compare Burda with Martrano v. The Quizno’s Franchise Co., L.L.C. (W.D. Pa. 2009). There, the court rather quickly dismissed a tying claim, reasoning that the alleged market for “Quick Service Toasted Sandwich Restaurant Franchises” was improper as a matter of law. Before plaintiffs signed their franchise agreements, they could have chosen among other fast food franchises, or, more narrowly, among other fast-food sandwich franchises. In such markets, Quizno’s did not have market power. Therefore, plaintiffs had no tying claim.

So what’s the upshot? First, franchisors still have broad abilities to impose supply and ingredient restrictions. But they are much safer if they do so as part of the franchise disclosures and the franchise agreement, rather than imposing them later. Such surprise restrictions may stimulate arguments that franchisees are suddenly “locked in” to exclusive sources of supply in connection with a market where the franchisor has market power, and ultimately prompt the filing of antitrust claims.

Second, in rejecting an aftermarket claim, the Queen City Pizza court stressed that the ingredients and supplies at issue were interchangeable with other ingredients and supplies on the broader market. The only factor that differentiated them was that they were approved by Domino’s. There may be cases, however, where products are not interchangeable. If the franchisor supplies truly unique products, and requires franchisees to purchase the products exclusively from it, some caution and further analysis is warranted.

A Way To Avoid Arbitration?

In EA Independent Franchisee Ass’n, LLC v. Edible Arrangements International, Inc. (D. Conn. No. 3:10-cv-1489-WWE, July 19, 2011) (no link yet), the court denied the franchisor’s motion to dismiss for lack of standing, allowing an association of franchisees to assert a declaratory judgment claim.  (The association alleges various failures to disclose affiliate relationships and undisclosed fees associated with franchisees’ mandatory use of an online ordering system, among other things.)

The court allowed the suit to proceed even though the EA franchise agreement requires arbitration of disputes.  The association has no right or obligation to arbitrate on behalf of its members, the court concluded.

Lesson: even if a franchisor has arbitration clauses in all its franchise agreements, its franchisees may neverthless find (or invent) a novel vehicle that takes them directly to federal court.

Even the Girl Scouts Can Violate Fair Dealership Laws

In a very interesting opinion, Judge Posner of the Seventh Circuit last week ruled that the Girl Scouts could violate Wisconsin’s Fair Dealership Law, and that they were not immune to that law’s reach by virtue of the First Amendment.  See Girl Scouts of Manitou Council, Inc. v. Girl Scouts of the United States of America, Inc., No. 10-1986 (7th Cir. May 31, 2011).

The national Girl Scouts organization granted exclusive territories to some 300 local “councils.”  Each council was authorized to sell Girl Scouts cookies and other merchandise under the Girl Scout trademark.  The councils earned income from the sales of cookies and merchandise, as well as from charitable donations, and paid membership fees to the national organization.  The national organization concluded that there were too many councils, and so decided to dissolve the Manitou Council and reallocate its entire territory to other councils.  This plan would not have put the Manitou Council out of business per se, but it would have precluded it from using the Girl Scout trademark or representing itself as a Girl Scout organization.

The Manitou Council sought a preliminary injunction to prevent its exclusive territory from being dissolved.  It lost in the district court, but that decision was reversed in the Seventh Circuit in 2007.  Later, the district court granted the national organization summary judgment, reasoning that to apply the Fair Dealership Law to the national organization would violate the organization’s freedom of expression guaranteed by the First Amendment to the United States Constitution.

The Seventh Circuit disagreed.  The Wisconsin Fair Dealership Law is a state law of general applicability with only a remote, hypothetical impact on the organization’s message.  Originally, the national organization justified its reorganization plan on the basis that it would improve marketing of cookies, exploit economies of scale, and promote effective fundraising.  These justifications did not directly implicate First Amendment concerns.  On appeal, the national organization emphasized a goal of increasing the racial and ethnic diversity of the Girl Scouts (picking up on the district court’s First Amendment reasoning).  However, the Seventh Circuit found no evidence of a connection between realignment of the councils and the promotion of diversity.  “How changing the territorial boundaries would increase the recruitment of girls from minority groups is nowhere shown.”  The possibility that a law of general application might indirectly and unintentionally impede an organization’s efforts to communicate its message effectively cannot be enough to condemn the law.

The Seventh Circuit also addressed several arguments relating to the Fair Dealership Law itself.  First, the court rejected the argument that the statute is inapplicable to nonprofit entities.  “No gulf separates the profit from the nonprofit sectors of the American economy.”  The principal objective of dealer protection laws is to prevent franchisors from appropriating good will created by their dealers.  That concern is applicable to nonprofit enterprises that enter dealership agreements.

Second, the Seventh Circuit rejected the national organization’s argument that its alteration of the Manitou Council’s territory did not change the competitive circumstances of the dealership agreement.  “Altering a franchisee’s territorial boundaries can have the same effect as opening new stores in his territory; the narrower those boundaries, the less protection the franchisee has against competition from other franchisees.  But when as in this case the franchisor, though authorized to alter boundaries, attempts to use that authority to terminate the franchise altogether, he runs up against the provision of the Wisconsin act that requires ‘good cause’ to cancel a dealership.  Wis. Stat. § 135.03.”  Although the franchisor’s goal of increasing sales constitutes “good cause” under various franchise laws, the national organization rested its good-cause argument on the proposition that realignment was necessary to its expressive activity – an argument that the Court had already rejected.  “The purpose of the realignment remains an enigma; like many corporate and governmental reorganizations, it may reflect internal bureaucratic pressures unrelated to the organization’s professed legitimate concerns.”

* * *

So what is the take-away from the Seventh Circuit’s decision? I think there are four fundamental points.

First, state franchise statutes and fair dealership laws can have wide application – sometimes much wider than you might think.  They can even apply, for example, to the distribution of Girl Scout cookies.

Second, courts are not very receptive to the argument that nonprofits are exempt from the reach of these statutes.

Third, creative arguments – such as application of one of these statutes would interfere with First Amendment rights – must be backed up by actual (and probably compelling) evidence, otherwise they will be easily dismissed.

And fourth, franchisors’ significant decisions that may effectively amount to a de facto termination should be supported by solid, and adequately documented, business reasons.

Special Franchise Statutes

Franchise relationships can be subject to various special statutes. One such statute is the Petroleum Marketing Practices Act (PMPA), 15 U.S.C. §§ 2801, et seq.  Unsurprisingly, the PMPA applies to gasoline stations.  Among other things, it prohibits gasoline refiners and distributors from terminating, or failing to renew, franchises absent the fulfillment of certain conditions, and unless one or more enumerated grounds for termination or non-renewal is met.

Of course, if a franchisee is offered and signs a renewed franchise agreement, the franchisee probably cannot maintain a claim for unlawful renewal under the PMPA.  See Poquez v. Suncor Holdings-CPOII, LLC, N.D. Cal., No. 3:11-cv-328-SC (5/26/11) (no public link available yet).

Bottom line, make certain you understand what statutes apply to your business relationship, and whether actions you have taken allow you to establish, or preclude you from establishing, elements of statutory claims.

If you’re going to defend a manufactuer’s charge that you’ve materially breached a dealership agreement . . . .

Make sure you haven’t seriously underperformed your peers and your prior distributors, according to the express terms of your dealership agreement.

34th Annual Forum on Franchising

34th Annual Forum on Franchising
October 19-21, 2011
Baltimore Marriott Waterfront
Baltimore, MD

Here’s the link.

If you want to rely upon a forum selection clause in a franchise agreement . . .

It’s a good idea to make sure that it’s exclusive.  Otherwise, this can happen.  (Van Buren Lodging, LLC v. Wingate Inns, Int’l, Inc., D.S.D. Mar. 11, 2011.)

BMW Has To Face Tying Charges

BMW of North America last week failed to dismiss a complaint alleging that it tied certification of body shops as “certified collision repair centers” (CCRCs) to the sale of BMW-branded paint.  The Northern District of California (Judge Illston) analogized the claim brought by a competing paint distributor to a claim brought against a franchisor, and found that the plaintiff had adequately alleged (i) two separate products (the BMW paint might not be an “essential ingredient” of the CCRC branding and thus part and parcel of a single product) and (ii) an unlawful tie.

The tying of products to a franchise always requires careful analysis.  This case again demonstrates the very real possibility that an outsider to the distribution system (an aggrieved, competing supplier of product precluded from selling to franchisees) may complain about a tie.

Nicolosi Distributing, Inc. v. BMW of North America, LLC, No. 3:10-cv-03256SI (N.D. Cal. Apr. 19, 2011).

Don’t Get Tied in a Knot

Franchisors always need to be a bit careful when imposing upon franchisees a requirement to buy products from them. On March 11, in Shamrock Marketing, Inc. v. Bridgestone Bandag, LLC (W.D. Ky. No. 3:10-cv-00074-H), a federal district court refused to dismiss tying claims brought by a competing product supplier against a franchisor. (A “tie” typically exists when a supplier requires someone to purchase product B if she wants product A. Product A is the tying product, and Product B is the tied product.) Bandag, a franchisor with about 300 tire dealerships, did not impose an express tie, but instead allegedly provides strong incentives to purchase certain products from Bandag. Under this program, franchisees receive a credit good towards the purchase of certain products (“curing envelopes”) (the tied product) for every pound of rubber purchased from Bandag (the tying product). All franchisees are required to participate in the incentive program. This program allegedly totally or nearly totally offsets the price for Bandag curing envelopes. Allegedly as a result, the plaintiff saw a 90% decrease in sales of curing envelopes to Bandag franchisees.

The case illustrates a few principles. First, franchisors can be sued by third-party suppliers (as if worrying about franchisees is not enough). Second, a tying claim can be based on something other than a categorical requirement to buy two products together; a tying arrangement can be found where a deal induces all rational buyers of the tying product to accept the tied product (though the court noted the difficulties of actually proving and prevailing on such a claim). And third, franchisors may have to impose less burdensome restrictions to ensure quality. Although Bandag did not expressly assert a quality defense, the court found that it could have defended quality through a less burdensome alternative to tying, i.e., quality specifications.

On the plus side for franchisors, the court refused to allow the plaintiff to proceed on allegations that the relevant market consisted of Bandag rubber (which would, of course, have raised Bandag’s market share considerably – tying is usually not actionable unless the defendant has sufficient economic power in the tying product market). There was no change in policy following the “lock in” of franchisees, because Bandag always had a contractual right to impose its requirements. A policy change is a prerequisite, in the court’s view, to a restricted market definition. However, because Bandag allegedly has a 50% share of the overall market, and the remaining 50% is fragmented, the court found there were sufficient allegations that Bandag has enough market power to commit actionable tying.

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