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Reasonable Franchise Growth or Unreasonable Encroachment?

New franchise openings are a lightning rod in the franchise world; while franchisor advocates see new location openings as a legitimate mode of franchise growth, franchisee advocates view such openings as unreasonable franchise encroachment.

On a semantic level, one of the most exasperating problems hindering meaningful discussion of the franchise growth issue is the unsystematic and undisciplined use of the term encroachment. Very simply, encroachment is an outcome-determinative term; as used in the franchise context it includes both reasonable and unreasonable growth. Accordingly, because it includes any growth that could or does cause any negative impact on an existing franchisee, the term is descriptively, conceptually and analytically useless at best, and destructive at worst. Further, the term encroachment similarly fails to account for the crucial distinction between non-opportunistic and opportunistic growth. In this regard, opportunistic behavior may be found in both the reasonable and unreasonable growth scenarios.

Making matters worse from a semantic perspective is that the term opportunism itself is uncertain, ambiguous and anecdotal. Although opportunism in the relevant law and economics literature possesses elements of selfishness and self-interest, there is no consensus on whether all forms of opportunism harm efficiency. Again, the literature has failed to provide a uniformly-accepted definition of opportunism in the world of contracts, economics and franchising. Whereas many types of conduct have been identified as opportunistic (e.g., shirking, free-riding, stealing), no uniform theoretical definition has been formulated or accepted. One common element of many of these myriad definitions, however, is that opportunism occurs when one contracting party acts unreasonably or in conflict with how the other party reasonably envisioned that the first party would reasonably behave under the agreement. Unfortunately, franchisee advocates, to the extent they examine the concept of opportunism at all, simply characterize every instance of franchise growth as an example of opportunistic encroachment. This circular theoretical reasoning is futile, unconvincing and threadbare. It also leaves notably unexplored the boundary between encroachment that arises from opportunism, and encroachment that arises from discordant static market incentives between franchisors and franchisees (e.g., the conflict between sales and profits maximization).

Further, and related to the above failures, is that the existing discussion of franchise system growth and encroachment fails to accurately, concisely, and mechanically identify, evaluate and distinguish the myriad motivations (many non-opportunistic) for expansion that exist in the free market, notably in a two-tier distribution market. In this regard, there are inherent conflicts, in goals and results, between maximization models associated with monopoly chains (owned by one entity to maximize profits from all locations as a group); monopoly franchise chains (if decisions are made by individual franchisees to maximize profits at single locations); free market independent locations (comprised of different individual entities with their own brands making their own independent decisions); and monopoly franchise chains (where decisions are made by the franchisor to maximize overall sales instead of locational profits). The unique policy choices suggested by these individual models are glossed over by most advocates on both sides of the growth issue.

However, at the end of the day, franchisor advocates are far more adept than franchisee advocates at slicing, dicing, and spinning together general economic principles underlying encroachment and system growth. Pro-franchisor advocates in their writings have learned to effortlessly mimic the sounds, smells and shapes associated with conventional economic principles, making their arguments comparatively appealing to consumers, legislators, and courts.

Franchisor advocates in lock-step successfully chant free-market jargon in the face of every challenge to system growth, regardless of how unreasonable or opportunistic the system growth might be. Stock phrases are used indiscriminately. These include: “we needed to open a location ‘there’ before our competitor did”, or “the demand in that market was outstripping our ability to serve customers”, or “the existing franchisee wasn’t capable of serving its existing market”, or ‘we need more competition between branded locations to bring lower prices and better service to customers.”

In poignant contrast, most pro-franchisee backers, to the extent they use any economics, apply outdated and facially-defective theoretical models, many times including obsolete populist tenets that long ago were thrown on the trash heap of debunked economic hypotheses. Many who embrace these antiquated pro-franchisee models appear oblivious to, or uninformed about, the detailed theoretical armor that has been amassed by pro-franchisor advocates on the opposing side of this issue. And, the few pro-franchisee advocates who are best-positioned to grapple with the intricacies of neoclassical models of encroachment (and these can be counted on one hand) have failed to undertake the laborious, time-consuming, and tricky analyses necessary to show that, even in the free market, franchisor growth may cause a direct diminution in market efficiency, not just inconsequential injury to a limited number of impacted franchisees who were the victims of isolated poorly conceived growth. Franchisees cannot win – or even hold their own — in this debate by repetitively declaring that encroachment thrusts many franchisees into bankruptcy. Emotional anecdotes recounting financial meltdowns of franchisees cannot substitute for rigorous theoretical confrontation.

Moreover, courts, apparently recognizing this theoretical muddle, have avoided the need to choose as correct one of the two nebulous substantive schools of thought regarding encroachment; instead, courts appear to have resorted to applying objective ‘default’ rules of contractual interpretation to resolve encroachment disputes. In this way, courts have rebuffed both the stultified encroachment theories asserted by franchisor supporters, as well as the wooly-headed encroachment models proposed by franchisee advocates. Unfortunately, the use by courts of the traditional rules of contract interpretation has resulted indirectly in the wholesale adoption of jumbled and bastardized free-market models of encroachment asserted by franchisors. However, all is not yet lost for franchisees in the legal realm. Myriad statutes, as well as the covenant of good faith and fair dealing, provide a life-line to franchisees litigating encroachment claims.

Although the application of neoclassical economics to the franchise growth issue ensures far more system growth than franchisees would ever want to accept, this does not mean that conventional economics can never be used to prove that unreasonable encroachment can cause a diminution in market efficiency. Franchisees, however, must be more proficient in finding the theoretical ‘sweet spot’ regarding encroachment, as well as in producing empirical evidence showing that some encroachment decisions, as conceived and carried out by franchisors and manufacturers, undermine allocative efficiency. Franchisee advocates’ efforts to do so thus far have been notably ineffective, fragile, and unresponsive.

Theoretical dominance, however, does not always ensure theoretical invulnerability. Indeed, upon closer scrutiny, new extensions to existing economic theory show that franchise growth theory has some chinks in its armor. Although I am a passionate franchisee-advocate, I also am a great believer in the free market. As I have always argued, these positions are not necessarily in doctrinal conflict. Unfortunately, as a group, franchisee advocates have failed, or been unable, to appreciate, identify and synthesize this convergence.

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