Criticizing the economic analysis of franchise encroachment law.

AuthorBenoliel, Uri

ABSTRACT

One of the most vital legal debates in the field of franchise law has focused on one central question: whether encroachment--that is, the phenomenon in which the franchisor establishes a new franchise unit in unreasonable proximity to its existing franchisee--should be restricted by law. Given the centrality of the law and economics school of thought, it is not surprising that legal economists play a dominant role in the legal debate over encroachment legislation. Law and economics' conventional analysis contends that franchise encroachment legislation, restricting the franchisor from establishing a new unit in unreasonable proximity to its existing franchisee, is inefficient. Opposition to such legislation is based upon the belief that franchise encroachment increases consumer welfare, mainly by increasing price and service competition among neighboring franchisees.

Focusing on consumer welfare, this article argues that traditional law and economics analysis is incomplete; the conventional analysis ignores the broader and long-term negative implications that encroachment practices may have on consumer welfare. While, as legal economists suggest, encroachment may enhance consumer welfare in the short-term by increasing price and service competition, encroachment will bear a high cost for consumers in the long run.

The argument presented in this article is the following: encroachment practices are often used by franchisors in order to cause their respective franchisees' businesses to fail, thereby allowing franchisors to evade a contractual or statutory obligation to pay damages to a franchisee upon direct contract termination. Such manipulative practices therefore increase the rate of franchisee business failure in the franchise industry as a whole. The increase in the rate of franchisee business failure, as caused by encroachment practices, is likely to deter individuals considering becoming franchisees from joining the franchise industry. Deterring such individuals ultimately will reduce consumer welfare by decreasing the inherent pro-consumer efficiencies achieved by franchisees, including lower prices and product standardization.

Since an encroaching franchisor typically does not bear the entirety of the long-term social costs of her destructive strategy, yet directly benefits from such a strategy, this article ultimately calls on federal and state policy makers who are currently considering the adoption of encroachment laws to adopt such laws. Under these laws, adopted so far by a minority of states, should a franchisor encroach on a franchisee's market area, the franchisee has a cause of action for monetary damages against the franchisor. A damages regime forces the franchisor to internalize the social harm that her destructive encroachment strategy may cause in the long run.

ARTICLE CONTENTS I. INTRODUCTION II. FRANCHISE ENCROACHMENT--LEGAL FRAMEWORK A. State Legislation B. Federal Legislation III. THE LAW AND ECONOMICS OF ENCROACHMENT: CONSUMER PERSPECTIVE IV. ENCROACHMENT AND CONSUMER WELFARE--A SECOND LOOK A. Encroachment Increases Franchisee Failure Rates 1. Encroachment Reduces the Revenues of Existing Franchisees 2. Reduced Revenues Lead to Franchisee Failure B. Increased Franchisee Risk of Failure is Likely to Deter Individuals from Becoming Franchisees C. Deterring Individuals from Becoming Franchisees Decreases Consumer Welfare V. CONCLUSION I. INTRODUCTION

Franchise encroachment--the phenomenon in which the franchisor establishes a new franchise unit in unreasonable proximity to its existing franchisee--is widespread. (1) To illustrate, a nationwide survey of 179 sandwich shop franchisees indicated that twenty-seven percent of the franchisees had suffered from encroachment by their franchisor. (2) Likewise, most large restaurant franchisors had been dragged into a court battle with frustrated franchisees over encroachment. (3) For example, McDonald's, Burger King, Subway, Taco Bell, Dunkin' Donuts, and KFC "found themselves roiled in [legal] disputes over outlets opening in close proximity to those of an existing" franchisee. (4) In light of the frequency of encroachment disputes, it is not surprising that "[t]he topic of encroachment has ... received more attention in the trade press over the last several years than any other issue related to franchising." (5) Naturally, one of the most vital legal debates in the field of franchise law has focused on one central question: should encroachment be restricted by law? (6)

Given the centrality of the law and economics school of thought, legal economists play a dominant role in the legal debate over encroachment legislation. The traditional law and economics analysis concludes that laws restricting encroachment are inefficient. (7) In brief, the economic opposition to encroachment laws is primarily based on the argument that encroachment improves consumer welfare by increasing price and service competition among neighboring franchisees. (8) Such opposition to encroachment laws has been of significant influence in the development of franchise encroachment law in general, as witnessed by state and federal policy-making. To date, most states have refused to adopt general laws restricting encroachment. (9) Similarly, at the federal level, there have been frequent federal proposals to restrict encroachment; however, all of them have been rejected. (10)

This article argues that traditional law and economics analysis is incomplete. It ignores the broader and long-term implications that encroachment practices may have on consumer welfare. While encroachment may enhance consumer welfare in the short-term by increasing price and service competition, the situation will bear a high cost to consumers in the long-term. I will present my argument in three stages. First, encroachment practices, which are often used by franchisors in order to cause their franchisees' businesses to fail, increase the rate of franchisee business failure in the franchise industry as a whole. Second, an increase in the franchisee business failure rate, caused by encroachment strategies, is likely to deter individuals considering becoming franchisees from joining the franchise industry. Finally, deterring individuals from becoming franchisees will reduce consumer welfare, as it will decrease the intrinsic pro-consumer efficiencies achieved by franchisees, including lower prices and product standardization.

Part II of this article will provide context by briefly reviewing the legal framework which forms the backdrop of the debate over franchise encroachment legislation. Both state and federal encroachment legislative initiatives will be presented. Part III will review the central argument underlying the traditional law and economics opposition to encroachment laws, namely that encroachment increases consumer welfare. Part IV will propose an addition to the conventional economic model. Particularly, it will reveal the broader and long-term negative implications that encroachment practices may have on consumer welfare. Part V provides a brief conclusion.

  1. FRANCHISE ENCROACHMENT--LEGAL FRAMEWORK

    1. State Legislation

      To date, most states have refused to adopt general laws restricting encroachment. A few states, however, have enacted general franchise laws with direct or indirect anti-encroachment provisions. (11) The most rigorous encroachment law is found in Iowa. Iowa code prohibits the franchisor from establishing a new unit in unreasonable proximity to an established franchisee unit if the new unit has an adverse effect on the gross sales of the established franchisee unit. (12) If the franchisor encroaches on the franchisee's market area, the franchisee, under Iowa Code, has a cause of action for monetary damages against the franchisor. (13) Damages include the lost profits attributed to the opening of the new outlet. (14) The Indiana Code also includes anti-encroachment provisions. (15) It prohibits a franchisor from establishing an outlet that competes unfairly with the franchisee within an unreasonable area. (16)

      Washington, Hawaii, and Minnesota also have laws with anti-encroachment provisions. (17) These provisions, however, are much less stringent than those in Iowa and Indiana. They simply reaffirm the territorial exclusivity agreed upon in the franchise contract. For example, under Washington law, if the franchise contract provides that the franchisee has an exclusive territory, the franchisor is prohibited from competing with the franchisee in said exclusive territory or from establishing competitive franchises in the exclusive territory area. (18) Similarly, the Hawaiian law prohibits the franchisor from establishing a new outlet within the geographical area specifically designated as an exclusive territory in the franchise contract. (19) Likewise, Minnesota law prohibits the franchisor from competing with an existing franchisee or establishing competing franchises in the exclusive territory granted to the existing franchisee in the franchise contract. (20) A handful of other states have laws that indirectly address the issue of encroachment. To illustrate, Wisconsin prohibits a franchisor from changing the competitive circumstances of a franchisee absent good cause. (21)

      In addition to the general franchise state laws that regulate encroachment, some states have industry-specific statutes that address the issue. These statutes, passed in 1963, mainly cover the automobile industry. (22) They are referred to as "relevant market area (RMA) laws." (23) The purpose of RMA laws is twofold: first, to protect franchisees from the unequal bargaining power of franchisors; (24) and second, to protect existing franchisees from injury due to the establishment of encroaching franchisees. (25) Accordingly, these laws usually stipulate that an automobile franchisor may not appoint a new franchisee within the relevant market area of an existing franchisee without...

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