To preclude competition, use the word ‘exclusive’

Just as every love affair does not necessarily have a happy ending, not every franchisee will be successful.

Franchisers do not usually guarantee the returns of franchise stores, and often do not comply with their non-compete obligations. Even if a franchiser does comply with its non-compete obligations, it will, in its own economic interest, seek to increase the number of its franchisees, which may result in fierce and damaging competition. When franchisees’ revenues and profits fall or they face operational difficulties, disputes over the franchise will quickly follow.

A feature of franchising is that franchisees join a franchise system as independent owners and there is no lateral connection between them. They are independent from the franchiser and other franchisees, practise independent accounting, and enjoy and bear their profits and losses themselves. When there is intense competition between franchisees, the head office of the franchiser may often lack effective policies to address the situation.

In practice, franchisers demand that franchisees select business locations in accordance with a set of standard requirements, prohibit them from changing location without authorization, and restrict their franchise territory. A franchisee also wishes to have the exclusive right to operate within a specific territory so as to ensure levels of sales and profits, and does not want franchise rights to be granted to a third party in the same area or to be subjected to competitive pressure from the franchiser itself. However, not every franchise operation relationship is characterized by such exclusivity.

Two cases

In one case, party A issued a retail franchise certificate to party B. In the course of its operations, B discovered that party C, after being supplied by A, was also selling the same merchandise in B’s territory.

Following this, B entered into an agreement with A reaffirming its exclusive franchise rights. The main provision of the agreement stated that “in order to ensure B’s profits … A shall cease supplying goods to C. In the event of a breach, A shall pay B compensation for loss in the amount of RMB200,000 [US$30,000]”. Subsequently, after discovering that C was still selling A’s products, B took A to court, requesting that the court order A to compensate for its losses in the amount of RMB200,000. Ultimately the court upheld its claim.

In a second case, party A and party B executed a product end sale contract under which party B became party A’s end seller. A licensed B to sell a line of goods provided by A in B’s own store. At the end of the contract, the parties wrote in by hand: “Note: Party B shall enjoy a preemptive agency right in the territory of XX”. On the same day, A issued B a letter of authorization, granting B operating and sales rights in the territory in question.

On the following day, B discovered two stores on the same street in which its place of business was located that were dealing in identical products. Believing that it enjoyed exclusive agency rights in the territory in question, B took A to court after unsuccessfully attempting to contact A on several occasions, requesting rescission of the contract.

The court held that neither the contract nor the letter of authorization specified that B was the exclusive agent in the territory in question, and that it was not possible to construe the handwritten codicil to the contract as granting B exclusive rights. It rejected B’s claims.

‘Exclusive agent’ is key term

Both of the above cases touch on the issue of competition encountered by franchisees in their territories, either from the franchiser or other franchisees.

In the first case, the competition experienced by the franchisee came from the franchiser, and the franchisee’s claims were ultimately upheld by the court. In contrast, in the second case, the competition experienced by the franchisee came from other franchisees, but the results do not offer much room for optimism. In addition to its claims being rejected by the court, the franchisee’s future business prospects were adversely affected. Why was this? In the first case, the franchisee’s magic bullet can be found in the last agreement that it signed. That agreement clarified the non-compete obligations of the franchiser.

In the second case, although the product end sale contract had the codicil providing for “preemptive agency rights”, from a literal interpretation of that term, B did not secure exclusive rights from A, and therefore lost the case.

Achieving a win-win situation

Ensuring a win-win result for both the franchiser and the franchisee requires some effort from both parties. For the franchiser, unrestrictedly growing the number of franchisees with the sole purpose of collecting initial franchise fees should be avoided at all costs. Leaving aside the fact that poor performance by franchisees is likely to trigger disputes, this will also have a strong adverse effect on the franchis- er’s commercial reputation and brand, and may even result in the paralysis of its franchise system.

Accordingly, before entering into a franchise contract, a franchiser needs to carefully select its franchisees and grant them exclusive rights. It should conduct a location survey and a market survey in the selected locations, and prepare sales and profit forecasts for the stores that will operate in that territory.

In addition to familiarizing itself with the information disclosed by the franchiser, a franchisee should, before executing a franchise contract, closely inspect the proposed franchise territory and carefully select its location. In order to ensure its future operating profit, it should specify in the franchise contract that the franchiser is under a non-compete obligation and that the franchisee has exclusive franchise operation rights so as to preclude unwanted competition and allow it “exclusively” to enjoy the commercial benefits in the territory specified in the franchise contract.