By Peter Dilon for AdvocateDaily.com
A recent study conducted by Franchisegrade.com of the scope and extent of territorial protection granted by U.S. franchisors is of interest to anyone practicing in this area, whether for franchisors or franchisees.
The study used as its source 654 franchise disclosure documents registered in 2015 with various state authorities, to which the public has open access. There is no such repository of disclosure documents available in Canada. Given the number of U.S. franchisors operating in Canada, and the similarity of principles that apply with respect to the granting of territories north and south of the border, this study is, I suggest, equally informative on the subject of territorial protection in Canada as it is in the U.S.
It’s worth noting that franchise regulation in the United States is far more scientific and advanced than in Canada. At the federal level, the Federal Trade Commission (FTC) devotes considerable resources to the study, analysis and regulation of franchising. Several years ago it promulgated its most recent update to its Franchise Rule, which was the result of several years of in-depth study, including a more than 400-page analysis written by the FTC staff and hundreds of hours of public hearings and written submissions. At the state level, 15 or so states regulate franchising through their respective securities commissions and the states have banded together through the conduit of the North American Securities Administrators Association to develop uniform rules for disclosure.
Both at the federal and state level, franchisors enjoy the benefit of extensive written guidelines and interpretive opinions to help them through the administrative process of preparing and updating their disclosure documentation. In addition, a federal or state regulator is only a phone call or email away to provide assistance. In states where registration of a disclosure document is required, the state examiner thoroughly reviews the disclosure document, providing commentary and necessary revisions. The result is a much higher standard of disclosure, both in terms of content and consistency.
The FTC Franchise Rule relating to franchise territories states that a claim of “territorial exclusivity” may only be made if the franchisor “contractually promises not to establish either a company-owned or franchised outlet selling the same or similar goods or services under the same or similar trademarks” within the geographic area or territory granted to a franchisee. If the franchisor reserves the right to open outlets selling the same goods or services under the same trademarks in their franchisee’s territory, then such a claim of territorial exclusivity may not be made and a disclaimer to the effect that “this territory is not exclusive due to certain reserved rights and the franchisee may have competition from other franchisees or company outlets” must be included.
A franchisee may still be contractually bound to operate within a defined territory, even if he or she does not receive exclusivity or any other form of territorial protection. Still, other systems will expressly state that the franchisee receives no territorial protection whatsoever.
Methodologies for defining franchise territories vary. They include:
- political boundaries such as postal codes, municipal boundaries or provincial borders;
- a radius containing a certain defined population, sometimes specific to a particular age group or other demographic; and
- a simple radius based on kilometres, the number of city blocks, average delivery time, number of shopping malls, number of businesses, owner occupied households etc.
All Canadian provincial jurisdictions require that a description of territorial rights be set out in the disclosure document. The Ontario Court of Appeal decision in 6792341 Canada Inc. v. Dollar It Limited, 2009 ONCA 385, at para. 62, specified that negative disclosure may be required (i.e., the fact that a protected territory is not provided must also be specifically disclosed).
All provincial legislation requires that any means by which territorial rights may be varied or exclusivity may be lost must also be disclosed. Means by which protected territories can be lost typically include:
- a failure to obtain minimum specified sales quotas or other performance metrics;
- a failure to meet minimum royalty thresholds;
- a carve out in favour of the franchisor for Internet sales;
- a special event carve out (trade shows, stadiums, concerts etc.);
- a special location-based carve out (hospitals, airports, military bases etc.); and,
- national accounts.
The Franchisegrade.com study suggested that 49 per cent of all franchise systems in its study provided some form of territorial protection to franchisees. The real estate, retail products and services and commercial and residential services sectors provided the highest percentage of territorial exclusivity (33 per cent of systems provide an exclusive territory, 20 per cent of systems provided some form of limited protection, and 40 per cent of systems provided some form of geographical definition of the franchisee’s territory), with lodging, QSR and table/full-service restaurant sectors provided the lowest percentage of territorial exclusivity (five per cent exclusive territory, 44 per cent protected and 44 per cent had a defined territory.)
It is generally assumed that a protected territory translates into greater sales for franchisees, although there is a certain amount of at least anecdotal evidence that this may not be true. Although I’m not aware of any scientific study, a consideration of the Tim Hortons experience is worth considering. When I arrived in London, Ont. in 1989, the city was chockablock with independent and chain coffee and doughnut brands. Aside from its excellent managerial and operational attributes, Tim Hortons pioneered the drive-through concept, and more recently, the central commissary features that have provided a considerable competitive advantage to their franchisees. What else is noteworthy about Tim Hortons franchises? The franchisor does not provide any form of territorial exclusivity. That’s why you’re never very far from the next Tim Hortons — sometimes it’s just a kitty corner from the one you’re currently at.
The considerable competitive advantage this has provided to Tim Hortons is the ability to saturate a market with the consideration of the consumer foremost — as opposed to some artificial protection of the franchisee’s territorial rights.
Fast forward to 2015 and one is hard-pressed to attend any gathering in London where the coffee cups are not exclusively from Tim Hortons. All other independent and franchised brands have been — if not eradicated — at least largely eliminated. The one exception to this is Starbucks, which arguably serves a different market sector, but is also free, as a result of its corporate ownership, from any notion of territorial exclusivity or protection.
Now, there is a distinction to be drawn between market saturation and cannibalization. Saturation means that whatever the given market for coffee and doughnuts is in London, all or most of that market is available to the Tim Hortons brand. That is, any given Tim Hortons franchisee is no worse off with a Tim Hortons across the street from it, than it would be with a competitor from a different brand. And, of course, the reality is that each of the Tim Hortons franchisees will be better off being across the street from one another, since both of them are building brand recognition, eliminating competition, and contributing to a common pool of resources including, in the case of Tim Hortons, an enormous advertising fund.
Cannibalization, on the other hand, occurs when either avarice or bad judgment results in the placement of an additional unit in such proximity as to materially adversely affect the sales of the existing unit. Because a franchisor typically collects royalties based on a franchisee’s gross sales, it has been argued (and is no doubt true in many cases) that greedy franchisors will open units only with a view to increasing the combined topline sales of all locations, without regard to maintaining bottom-line healthy profitability for each franchised location. Savvy and fair franchisors will develop radius protection policies to ensure that this does not occur.
Make no mistake, franchisees have every right to insist on protections against cannibalization, and to be outraged if and when it occurs. By any assessment, cannibalization is a bad and unsustainable business practice.