Ownership of competitive franchise systems: risks and rewards

FranCast Series

Franchise systems have been, and continue to be, sought-after investment and acquisition targets.  As a result of this, the demand for ownership of franchise systems often exceeds supply.  In fact, there has been almost a frenzy of recent franchise system purchases across various industries from food, to retail, to hospitality, and more.1  As the number of these purchases increases, so does the likelihood of multiple brands in the same industry being operated by the same (or an affiliated) entity.  For example, in the hospitality industry:

 

  • Marriott operates at least 17 brands: (Ritz Carlton, BVLGARI Hotel & Resorts, JW Marriott, EDITION, Autograph Collection Hotels, Renaissance Hotels, AC Hotels by Marriott, Marriott Hotels, Courtyard by Marriott, SpringHill Suites by Marriott, Fairfield Inn & Suites by Marriott, Residence Inn by Marriott, TownePlace Suites by Marriott, Marriott Executive Apartments, Gaylord Hotels, Protea and Marriott Vacation Club). 
  • Starwood Hotels & Resorts operates at least 9 brands: (Four Points by Sheraton, Sheraton Hotels & Resorts, Aloft, W Hotels, Le Méridien, The Luxury Collection, element, Westin Hotels & Resorts and St. Regis Hotels & Resorts).
  • Hilton Worldwide operates at least 10 brands: (Waldorf Astoria Hotels & Resorts, Conrad Hotels & Resorts, Hilton Hotels & Resorts, Doubletree by Hilton, Embassy Suites Hotels, Hilton Garden Inn, Hampton Inn, Homewood Suites by Hilton, Home2 Suites by Hilton and Hilton Grand Vacations).

And these are only examples from the hospitality sector.  These days, there seems to be no slowdown in the purchases of franchise systems by both private equity and strategic buyers that already own other, competing franchisors.

When an acquirer purchases franchise systems in unrelated industries, legal issues associated with competition are nil.  But when competing (or even partially competing) franchise systems are acquired, the desire to extract synergies can bring competitive legal issues to the forefront.

I.          Benefits of owning competitive franchise systems

Purchasers of franchise systems attempt to combine franchise systems to offer a broader array of products and services offerings, but also to realize the efficiencies and benefits of owning multiple franchise systems.  For example, in the case of two competing brands and systems ("Brand A" and "Brand B"), such synergies might include:

                  i.        targeting each system’s customer bases through, for example, cross-marketing and cross-promotion (perhaps using Brand A for certain market segments and Brand B for others), which in turn could lower the cost of obtaining new customers

                 ii.        targeting each system’s franchisees as prospective franchisees for the other system – which will increase franchise development

                iii.        having executives and employees in Brand A also serve as executives and employees in Brand B – thereby saving on labor costs

               iv.        having suppliers to Brand A also become suppliers to Brand B in order to achieve better buying power and volume discounts

                v.        combining technologies, such as software, website platform and mobile applications

               vi.        combining back-office functions, such as IT support, executive support, operations, franchise sales, customer service, advertising, accounting, purchasing, and warehousing and

              vii.        combining customer-facing functions (such as advertising, websites, social media, reservation systems, frequent use programs and gift card programs), sometimes using concepts from Brand A in connection with Brand B and/or combining the trade names for added benefit (e.g., “Brand B, powered by Brand A”).

II.         Issues with owning competitive franchise systems

While there are potential benefits to operating competing franchise systems, certain legal restrictions affect the decisions that can be made.  In order to derive synergies from the ownership of two competing systems, it is common to consider a number of business possibilities. In doing so, however, care must be taken in order to not violate the contractual, statutory and other legal rights of any franchisees.

Consideration of these legal issues typically arises in two contexts: (1) pre-acquisition, when buying a franchise system, and (2) post-acquisition, when making business changes to either of the now-owned competing franchise systems.

Regarding pre-acquisition, a prospective purchaser of a franchise system that will end up owning competing franchise systems must analyze and examine legal restrictions as part of its due diligence. Some of the legal concerns may be inherent in the combination regardless of business plans (e.g., if franchise agreements promise no competing operations in a territory, regardless of brand). Other restrictions may arise only if the purchaser has certain post-acquisition business plans that would violate legal rights (e.g., to combine the brands under a single mark without a contractual right to change the name of one of the existing brands). 

Regarding post-acquisition, once the competing systems are under the same tent, the owners will likely consider a number of business changes to extract from the combination the synergies and benefits described above. Careful analysis will be necessary as to each business change proposed. In some instances, the change will be acceptable because the modifying franchisor will be operating within its legal rights. In other instances, depending on the circumstances, the proposed change may violate obligations to franchisees. In these instances, a risk assessment must be made.

The following sections describe (A) the general scenarios in which post-acquisition legal restrictions on business changes emanating from the ownership of competing systems typically arise, (B) the nature of the legal restrictions that typically are used to challenge these business changes, and (C) some examples of the business changes that could be thwarted, or lead to legal claims, due to these legal restrictions:

A.        When may legal restrictions on business changes arise?

Legal limitations of the type addressed by this article do not arise when a company owns competitive systems that are not franchised. In such company-owned situations, the owner is free to combine any or all of the aspects of one company-owned system with the other company-owned system (C2C) – without infringing on rights. 

If either of the systems are franchised, however – and especially if both of the systems are franchised by the same (or an affiliated) franchisor – the rights of the franchisees need to be taken into account. The changes as a result of the ownership of competitive franchise systems may entail movement of certain system aspects from a company-owned system to a franchised system (C2F), from a franchised system to a company-owned system (F2C), or from one franchised system to another franchised system (F2F).

In each of these scenarios involving franchised systems, great care needs to be taken as to the rights of the franchisees when, for example:

                  i.        in a C2F scenario, company-owned units in one system are added into franchised territories

                 ii.        in another C2F scenario, aspects of the company-owned system (e.g., software requirements) are added to the operations of the franchised system

                iii.        in an F2C scenario, franchised units in one system are added into the markets in which company-owned units operate

               iv.        in another F2C scenario, aspects of the franchised system (e.g., marketing techniques) are added into the operations of the company-owned system

                v.        in an F2F scenario, units in a franchised system are added into the franchised territories of the other system and

               vi.        in another F2F scenario, aspects of one franchised system (e.g., call centers or reservations systems) are added to the operations of the other franchised system.

B.        What are the legal restrictions? 

As a franchisor makes post-acquisition changes – whether of a C2F, F2C or F2F nature – franchisees that are adversely affected by these changes or otherwise fearful of the effect of these changes on their future business may explore and bring legal claims. These may include, for example, claims for:  

                  i.        breach of contract (for instance, for encroachment in violation of their contractual territorial rights; for efforts to impose system changes that are not permitted under the contract; and for breach of the franchise agreement transfer provisions)

                 ii.        breach of the implied covenant of good faith and fair dealing2

                iii.        violation of franchise relationship laws (for instance, if the franchisor of one of the brands terminates non-compliant franchisees, such as those who fail to adopt system changes occasioned by the combination)

               iv.        unfair competition (such as for transference of franchise system advantages to competing company-owned units)

                v.        fraud (such as concealing, suppressing or omitting material facts from franchisees)

               vi.        violation of antitrust laws (such as pricing issues) and

              vii.        other legal violations (e.g., tortious interference, corporate espionage, theft of trade secrets, and inducement of employees to breach their contracts).

C.        Business changes that may lead to legal claims 

Some of the specific business changes that are commonly considered in the context of the proposed ownership of competing franchise systems – and that can sometimes (e.g., depending upon the contractual terms, the identity of the franchisor, representations made and the manner of implementation) lead to legal claims – include:

                  i.        establishing new franchise units of Brand A in territories in which there are Brand B franchises – or selling Brand A products and services (under the Brand A marks or some other mark) into the territories in which there are Brand B franchisees – in violation of contractual3 and/or good faith and fair dealing rights4 of Brand B franchisees

                 ii.        sharing confidential and proprietary information across brands – sharing Brand A information (such as procedures and protocols, pricing lists, customer lists, sales numbers, product plans, financial performance data, marketing strategies, development plans, forecasts or other non-publically available information) with Brand B franchisees

                iii.        shifting – unfairly – existing business advantages from one system to the other system (for example, with regard to national accounts, customer reservations, product access or purchasing arrangements)   

               iv.        creating new pricing structures and combined marketing materials for both Brand A and Brand B, in a manner that disadvantages one brand over the other (without corresponding benefits)

                v.        having salespersons favor one brand over the other, in order to create an image for Brand A that is different from the image for Brand B and that causes harm and

               vi.        ultimately, separating the Brand A and Brand B systems (following their original combination) in a manner that shortchanges either or both systems, in order to allow for a sale of one brand or the sale of both brands to different buyers.  

III.    Assess the risks

Before deciding to acquire and then combine competing franchise systems, the potential synergistic benefits and possibility for legal claims must be considered.

A similar risk assessment must then be made again – post-acquisition – each time a business change is proposed that would potentially lead to a legal claim of the types described above. And, even beyond legal claims, the franchisor proposing the system modification must consider how franchisor-franchisee relations will be affected as a result of the proposed modification.  This analysis is likely to lead to some proposals that should indeed move forward, whereas others would likely create too much potential liability and, thus, should remain as separate functions.

We have represented many franchisors in competing multi-brand pre-acquisition and post-acquisition situations. Whenever the purchase of a franchise system that will operate among other competitive brands is contemplated, legal guidance should be sought – not only to address the specific questions that arise in the course of the specific deal, but also with regard to the rights of franchisees in relation to the other franchise system.  Similarly, post-acquisition proposals to combine or co-mingle aspects of competing systems need a thorough legal analysis and assessment of the risk.  And, of course, the same pre- and post-acquisition issues often manifest themselves in litigation and arbitrations that we handle for multi-brand franchisors.  Combining of franchise systems can be complex, and appropriate guidance is essential to avoid liability and franchisor-franchisee relationship concerns.

Please contact us to find out more about purchasing franchise systems, implementing system changes, and handling disputes that result from the combining of competing franchise systems.


1 Some franchise system sales that took place in the recent past include: (i) Marriott International, Inc.'s acquisition of South Africa’s Protea Hospitality Holdings' three brands and management company; (ii) private equity firm Apollo Global Management, LLC's acquisition of CEC Entertainment, which operates 577 Chuck E. Cheese’s restaurants; (iii) the sale by Nestle SA, the world’s largest food company, of its Jenny Craig diet business to private equity firm North Castle Partners (the owner of the Curves weight loss and fitness business); and (iv) Centre Partners' acquisition of the Captain D’s Seafood Restaurant chain (as an addition to its restaurant portfolio).  For a more complete and up-to-date listing of recent franchise system sales, see "Franchisor Equity News" at www.franchisorpipeline.com.

2 In most states, the implied covenant of good faith and fair dealing does not override an express contract provision authorizing specific conduct.  For example, this was the finding in one of the most significant cases involving operation of two competing systems –  Clark v. America’s Favorite Chicken Co., 916 F. Supp. 586 (E.D. La. 1996), aff’d, 110 F.3d 295 (5th Cir. 1997).  The case involved the acquisition of the Church’s restaurant system and the Popeye’s restaurant system by America’s Favorite Chicken (AFC).  After the acquisition, a Popeye’s franchisee sued AFC, claiming, among other things, breach of contract and breach of the implied covenant of good faith and fair dealing, due to the post-acquisition dual marketing strategy designed to market Popeye’s as a higher-end chicken restaurant and Church’s as a lower-end chicken restaurant.  The franchisee claimed that the dual marketing strategy harmed its existing Popeye’s restaurants located near Church's restaurants.  The court ruled for AFC because the franchise agreement explicitly reserved to the franchisor the right to compete with its franchisees under different marks.  Further, the court found no breach of the implied covenant of good faith and fair dealing because there was no showing of the bad intent or ill will necessary to establish the claim.

3 For example, whether or not the selling franchisor of the Brand B franchise system reserved the right to sell other products in territories in which there are Brand B franchisees.

4 Where a franchisor has expressly reserved in the contract the right to distribute its product through alternative channels, the provision is generally enforceable.  For example, in Carlock v. Pillsbury Co., 719 F. Supp. 791, (D. Minn. 1989) and Rosenberg v. Pillsbury Co., 718 F. Supp. 1146 (S.D.N.Y. 1989), franchisees sued after Pillsbury decided to start mass distribution of its ice cream via supermarkets.  The court found enforceable the provision in the franchise agreement that “the Haagen-Dazs trademark owner [i.e. Pillsbury] has the right and may distribute products identified by the Haagen-Dazs trademarks through not only Haagen-Dazs shops but through any other distribution method which may from time to time be established.”