The e-commerce challenge to franchising
30/12/2002

E-commerce's impact on franchising

E-commerce offers significant advantages which may contribute significantly to a franchise business. These include a wider audience, improved logistics, reduced costs, improved efficiency, new sales and global branding. Furthermore, a franchisor's website is an ideal way of attracting new franchisees on-line. However, new threats have also arisen and measures must be put in place to afford both franchisors and franchisees the necessary protection. There are of course also limitations which must first be considered before plunging into e-commerce, and the options which can be applied to overcome them.

Typically, a franchise agreement restricts the ability of a franchisee to offer the franchised products and services outside of that franchisee's specifically defined geographic territory. This meant that the reach of a franchisee was limited to the franchisee's designated territory. E-commerce, however, is conducted in the realm of 'cyberspace' and is not limited to geographic boundaries. The introduction of e-commerce has therefore brought with it the potential entry into new, formerly unreachable markets. Communication means have been improved and new ways of providing goods and services have developed. This has contributed to the erosion of the clearly defined territories so traditionally characteristic of franchise agreements.

In his article, 'Franchising, the Internet and the Emerging Issue of Encroachment' Professor Andrew Terry of the University of New South Wales refers very pertinently to some threats that the introduction of an e-commerce facility within a franchise system pose, and expresses the simultaneous challenge faced as follows:-

The central or driving idea behind traditional franchise agreements is to increase market penetration, attract self-investors and decentralize the franchise's business. On the other hand, the driving idea behind e-commerce is to have a centralized point of sale, storage and distribution to reduce overheads.

These contradictory ideas require imaginative solutions to ensure that both franchisors and their franchisees benefit from the opportunities provided by e-commerce'.

Challenges of e-commerce

As alluded to above, one of the main problems faced by conventional retail franchises regarding e-commerce is the capacity to provide for 'borderless business'. The problem lies in the very real threat of encroachment on the actual or perceived rights of the franchisor and other franchisees as franchisees seek to expand their business using e-commerce.

E-commerce encroachment can occur not only on a geographical basis, but also by the development and exploitation of alternative distribution channels, for example through supermarkets, mail order or direct marketing, or an e-business facility allowing for purchases to be made over the internet.

As franchisors increasingly engage in e-commerce, franchisees are not only challenging geographical restraints placed on them, but are also challenging the right of the franchisors to sell goods and services via the internet to customers located in the territories of franchisees.

Franchisors argue that, although a franchisor's website may absorb sales from the franchisee's designated area, the awareness which it creates amongst existing and potential customers far outweighs the negative impact on sales which the franchisor's involvement in their territory may have. Franchisees, on the other hand, argue that the value of the franchise is not significantly affected by the franchisor's website, but that the value of the franchisee's business is.

A recent Australian decision (Dymocks Holdings vs Top Ryde Booksellers) addressed this very issue. The dispute centered around whether ownership of a domain name and an associated website vested in the franchisor or a franchisee and whether it could be argued that the franchisor's website was competing for customers in the franchisee's territory.

The franchisor in this case wanted exclusive rights to its website, but offered equity shares to its franchisees on condition that they agree in writing to abandon any claim of whatever nature they may have to the site. Three franchisees were, however, not willing to sign away their rights to the website. They based their refusal on the fact that they had paid advertising levies which had contributed to the development of the website, and furthermore that they would suffer damages as the site would compete with them in their territories. The court, whilst granting exclusive rights in the site to the franchisor, also awarded damages to the three franchisees. The judge held that was is a substantial chance that the franchisees's business would be damaged through unrestrained competition from the franchisor's website.

America, on the other hand, has had differing results. In the case of Emporium Drugmart Inc of Shreveport vs Drug Emporium Inc, an arbitration panel ordered that a franchisor may not sell products over the internet to customers located within the territories of franchisees. The arbitration panel held that franchisees were likely to succeed in their claim that the franchisor was breaching the franchise agreements by engaging in these activities. Furthermore, the panel held that the marketing of e-commerce within franchisee territories would result in customer confusion and dilute the value of the franchisee's trade mark licences. It was also held that franchisees did in fact have a reasonable expectation that they would not be forced to compete with direct sales of the franchisor.

In the case of Hale vs. Conroys Inc. a different result occurred where the franchisees claimed that the franchisor had breached the franchise agreement and had violated the covenant of good faith and fair dealing by disregarding the franchise distribution channel in favour of an internet distribution channel. The arbitrator was of the opinion that the franchise agreement was neither breached nor was the obligation of good faith and fair dealing violated even though orders placed via the internet were often filled by non-franchisees.

According to Phillip F Weidman and Steven B Fairman (in their article entitle 'Franchising and Cyberspace') the difference in the two results can be attributed primarily to the different contract languages which governs the two different franchise relationships:

In Drug Emporium, the franchise agreement gave franchisees exclusive territorial rights with no mention of alternate channels of distribution. Moreover, the agreement indicated that Drug Emporium intended to develop its system solely through brick and mortar outlets. In contrast, the Conroys franchise agreement grants the franchisee the exclusive right to operate a retail flower store within a two mile radius of its location, the agreement reserved for the franchisor the right to develop other businesses and to use its trade names with such businesses.

There also were key factorial differences in the two cases. For example, in Drug Emporium, the franchisor was charged with conducting e-commerce at prices well below those found in its franchise outlets, and there was evidence of the continued economic harm this would cause to franchisees. In Conroys, there were no such evidence and the franchisees even benefited to some extend from the franchisor's internet activity'.

The above extracts illustrate how a skillfully drafted franchise agreement can possibly combat limitations and potential pitfalls of establishing and maintaining a website and an e-commerce facility. Franchise agreements should allow for an e-commerce system that will serve the interests of not only the franchisor but also its franchisees and existing and potential customers.

Meeting the challenge

In order to address the above problems posed by e-commerce, a number of approaches have been developed, which can be incorporated in a franchise agreement to provide for the individual needs of the particular franchise relationship.

Firstly, a franchisor may allow its franchisees to develop and maintain individual websites without the franchisor's involvement. In this case the franchisor may want to provide that it receives royalty payments from the franchisee's e-commerce revenues. This is however clearly problematic as the franchisor would lose significant control over the trademark and its marketing strategy.

Numerous websites would, however, lead to confusion (for example as search engines direct enquiries to other franchisees' websites). Variations in website content can cause untold damage to the franchise trade marks and this would also lead to the business at the 'brick and mortar location' being negatively impacted. Furthermore, independent websites may contain information which jeopardizes trade secrets and copyrighted material, and the use, or rather abuse, of customer information can be the cause of much concern.

There is more risk of territorial disputes between franchisees since sales from one location may take place in another franchisee's territory. Research shows that poorly performing internet sales activity has a negative impact on how the brick and mortar locations are viewed by the public and, naturally, this can impact overall systems sales.

Secondly, the franchisor can develop and maintain the website, and conducting e-commerce on its own, without any franchisee participation. In this case the franchisor retains all the revenues generated. However, this may lead to franchisee complaints and, possibly, damages claims from disgruntled franchisees (as happened in Australia). Therefore, a franchisor may want to consider conducting the website and e-commerce on its own, but giving the franchisees a share in the revenue generated from such e-commerce ventures. Clearly this creates certain problems for example, what should such share be, etc.

Finally, an alternative would be for a franchisor to conduct an e-commerce venture with the participation of franchisees. An example would be where the franchisees establish individual websites, but the franchisor provides templates and guidelines to ensure uniformity of websites and e-commerce procedures. This would, however, place demands on the franchisor with regard to time and attention required to monitor the individual sites and maintain consistency. Alternatively the franchisor could conduct e-commerce business, but refer prospective purchasers to franchisees located in the purchaser's geographic area.

There are various factors which weigh heavily in favour of websites being developed by franchisors. These include:

• Trade mark recognition is protected as there is consistency in the 'get-up' of the websites, and uniformity in the e-commerce procedure.
• It is far easier for potential franchisees and customers to access the system as on-site links will be uniform and consistent.
• Trade secrets, copyrighted material and trade marks are more easily protected, and there is a reduced risk of the infringement of consumer privacy.
• Franchisees are protected from the risk of on-line activities of other franchisees. There is therefore a reduced territorial encroachment risk.

There are certain disadvantages, however, which include the fact that a franchisor will have to accept the high costs and time expense that the setting up and maintaining of a website requires. Franchisees may be dissatisfied with this option as they may wish to personalize and localize the content of the webpages to a far greater extent than that allowed for by the franchisor.

Michael H Seid and Kay Mary Ainsley, in their article entitled 'Franchising and the Internet' remind us that the customer must be kept in focus at all times. The backbone of the success of a franchise operation has always been brand consistency and disputes arising from the introduction of e-commerce, reduce brand consistency. Such disputes need to be avoided as the only party which gains from these kinds of disputes are competitors.

Finally, as was seen with the American cases briefly described above, it is imperative that the franchise agreement is carefully drafted to ensure that e-commerce pitfalls are minimized.

In conclusion

E-commerce is an exciting new development in business methodology. Franchising has always been at the cutting edge of business and is itself a relatively new development. As such, franchisors are likely to be aware of the potential benefits of e-commerce to a franchise organization. They must be careful, however, to guard against potential pitfalls that e-commerce places before franchisors and franchisees.

As described above, there are solutions to these potential pitfalls and care must be taken to ensure that e-commerce and the implications thereof are fully taken into account when drafting a franchise agreement. If care is taken when developing an e-commerce strategy and the legal implications are properly catered for, e-commerce is a powerful tool which can be used to benefit both the franchisor and its franchisees