The FTC Staff issued FAQ 37 on October 16, 2012. This is the latest of the FTC’s “frequently asked questions” that clarify various aspects of its trade regulation rule on franchising (the “FTC Rule”).
FAQ 37 further defines the term “exclusive territory”. This FAQ will change the way that many franchisors describe the franchisee’s territory in Item 12 of their franchise disclosure document (FDD). Unfortunately, the required change may be more confusing than illuminating.
Many franchisors grant exclusive territories to franchisees but reserve the right to open franchised or company outlets in “non-traditional venues” like airports, arenas, hospitals, hotels, malls, military installations, national parks, schools, stadiums and theme parks.
In FAQ 37, the FTC staff states that sales in non-traditional venues can no longer be characterized as exceptions to the a grant of territorial exclusivity. Instead, the reservation of rights in non-traditional venues means that the entire territorial grant is non-exclusive.
Disclosing competition from the franchisor
As such, the FTC Rule now requires that franchisors who reserve rights in non-traditional venues to state in Item 12 that the franchisee may face competition from the franchisor or other franchisees. In many cases, this statement may be untrue. For this reason, it seems likely that FAQ 37 will make many FDDs less clear to prospective franchisees.
Franchisors must disclose in Item 12, among other things, whether the franchisor grants an exclusive territory. The FTC Rule states that if the franchisor does not grant an exclusive territory, then Item 12 must contain this statement:
You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control.
But what does “exclusive territory” mean?
FAQ 25 indicates that “exclusive territory” means a geographic area within which “the franchisor 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 or service marks.”
Alternative channels vs. non-traditional venues
Many franchisors reserve the right to sell in the franchisee’s “exclusive territory” through alternative channels of distribution, such as the Internet or catalog sales. FAQ 25 indicates that such a reservation of right does not change the fact that the grant is exclusive. The reason is that the FTC Rule specifically requires franchisors to disclose in Item 12 the reservation of rights to sell through alternative channels of distribution.
The FTC Rule specifically states that whether the territory is exclusive or nonexclusive, the franchisor must disclose in Item 12
whether the franchisor or an affiliate has used or reserves the right to use other channels of distribution, such as the Internet, catalog sales, telemarketing, or other direct marketing, to make sales within the franchisee’s territory using the franchisor’s principal trademarks.
FAQ 37 deals with a related question. It addresses franchise offerings in which the franchisor reserves the right to open franchised or company outlets in “non-traditional venues” like airports, arenas, hospitals, hotels, malls, military installations, national parks, schools, stadiums and theme parks. In FAQ 37, the FTC staff states that sales in non-traditional venues are not just exceptions to the a grant of territorial exclusivity. They make the territory nonexclusive.
The FTC staff views non-traditional venues as something different than “alternative channels of distribution”. They base the distinction on the fact that these venues are physically located in the franchisee’s territory. They distinguish the physical location from sales via the Internet or mail order that may originate from a location outside the territory. Accordingly, a franchisor that reserves the right to sell through “non-traditional venues” must state in Item 12 that it does not provide an exclusive territory and that the franchisee may face competition from the franchisor and other franchisees.
But non-traditional venues do not compete
This interpretation of non-traditional venues can be problematic.
Sales via the Internet or mail order can compete with a store in any physical location. Yet franchisors who reserve the right to make Internet or mail order sales are not required to say explicitly that franchisees may face competition from the franchisor.
By contrast, many sales in non-traditional venues do not compete with stores outside of those locations, even those in close geographic proximity. These venues typically constitute a separate market.
An airport, hospital, hotel, military installation, park, school, stadium or theme park is distinct from the surrounding geographic area. The people in those venues are there for a reason. They are a captive market for the outlets in those venues.
People located in the venue do not commonly leave the venue to shop or eat elsewhere while they are awaiting their scheduled flight or attending classes, or in the middle of a sports event or a visit to a theme park. They are in the venue for a specific reason. They are a captive market.
Similarly, a person who lives outside of an airport, hospital, school stadium or a theme park does not enter that venue in order to shop or eat at a particular franchised store or restaurant.
Non-traditional venues are often distinct islands within a larger geographic territory that otherwise can be exclusive to the franchisee within the meaning described in FAQ 25. Outside of these non-traditional venues but within the boundaries of the franchisee’s territory, the franchisor can indeed promise that it will not “establish either a company-owned or franchised outlet selling the same or similar goods or services under the same or similar trademarks or service marks.” The franchised and company outlets in the non-traditional venues may not pose competition in any way to the franchisee. On the contrary, they may enhance the brand for the benefit of all franchisees.
Non-traditional venues are usually defined as such for the very reason that they do not compete with locations in the rest of the territory.
In some cases, the statement that the franchisee may face competition from the company and other franchisees will be true. A restaurant or store in a mall, for example, can indeed compete with locations outside the mall. It is not uncommon for people to go to a mall specifically to buy from a particular outlet or eat at a particular restaurant. Accordingly, one can argue that a mall should not be considered “non-traditional”.
But even a franchisor that only reserves the right to sell in airports and sports stadiums within the boundaries of the franchisee’s territory must now state that the territory is nonexclusive, even if this is not true.
Because of the FTC staff’s position in FAQ 37, a franchisor that grants an exclusive territory with specific exceptions for non-traditional venues must now say that the grant is non-exclusive and that, therefore, the franchisee may face competition from other franchisees, from outlets that the franchisor owns, or from competitive brands that the franchisor controls.
The FTC does allow the franchisor to include an explanation of the specific rights the franchisor is reserving. But a franchisor who reserves rights in non-traditional locations within the territory can no longer describe the territory as “exclusive”. And the mandatory warning regarding competition from the franchisor and other franchisees may be misleading, confusing or simply wrong.
FAQ 37 is clear guidance for lawyers and does promote uniform disclosure across different franchise systems. It will result in many amended FDDs in the coming months.
Unfortunately, the Item 12 changes that FAQ 37 will require many franchisors to make are not likely to further the plain language goal of franchise disclosure regulation generally. These changes are not likely to benefit franchisors or prospective franchisees.