Overview
Reprinted with permission from Law360. A link to the original publication can be found here.
On May 1, 2018, a California jury awarded an El Pollo Loco Inc. franchisee over $8 million in an encroachment dispute.[1] Encroachment disputes arise when a franchisor sets up a new store in some degree of proximity to an existing franchisee. I say “some degree of proximity” rather than “in the territory of” because lawsuits arise even when the franchisee does not have rights to exclusive territory.
That is what happened in Bryman v. El Pollo Loco Inc., pending in the Superior Court of the State of California, County of Los Angeles. The franchisee had no exclusive territory rights, yet it obtained a substantial judgment because a jury found that El Pollo Loco, in setting up a company-owned restaurant approximately 2.25 miles from the franchisee, had breached the covenant of good faith and fair dealing.[2]
Critically, the case proceeded to a jury trial even though the franchise agreement provided El Pollo Loco with an express right to establish new restaurants, including new company-owned restaurants, “in the immediate vicinity of or adjacent to the [franchisee’s] Restaurant.”[3] The court found this “adjacent location clause” to be unconscionable with respect to the opening of company stores and, accordingly, invalidated it.[4] Had the court enforced that provision, it presumably would have dismissed the good faith and fair dealing claim.
The court’s unconscionability ruling and the jury verdict, including the damages award, are interesting news, but the question for franchisors and franchisees, and lawyers representing them, is how much of a game changer Bryman really is.
The Facts
The decision that paved the way for the case to go to a jury was the court’s March 30, 2017, summary judgment decision.
According to the court, the franchisees, Michael Bryman and Janice Handlers-Bryman, bought their El Pollo Loco franchise in 1999. They entered into a new franchise agreement in 2009. Neither their original agreement nor their 2009 agreement granted the Brymans exclusive territorial rights. Moreover, both contracts ostensibly permitted El Pollo Loco to establish restaurants at any location, including in the immediate vicinity of the Brymans’ restaurant.[5]
After signing the 2009 agreement, the Brymans proposed establishing new locations for El Pollo Loco restaurants. The Brymans were allegedly unable to open these proposed restaurants within a certain timeframe, at which point El Pollo Loco proceeded to open a franchisor-owned store approximately 2.25 miles away from the Brymans’ store. According to the Brymans, El Pollo Loco had “set impossible deadlines and used Plaintiffs’ proposed sites as planned sites for stores owned directly by [El Pollo Loco].”[6]
The Court’s Unconscionability Ruling
The court found the adjacent location clause to be unconscionable and accordingly declined to enforce it. The court started by finding that certain boilerplate or standard terms of the El Pollo Loco franchise agreement, including the adjacent location clause, were adhesion contracts.
The court then explained that whether the adjacent location clause was unconscionable depended on the degree to which it was procedurally unconscionable and substantively unconscionable, though as the court explained, the provision could be found unconscionable under California law based on there being a high degree of substantive unconscionability. The court then explained that “A provision is substantively unconscionable if it involves contract terms that are so one-sided as to shock the conscience, or impose harsh or oppressive terms.”[7]
Applying these principles, the court found the adjacent location clause unconscionable. Critically, the court distinguished between a clause that would have permitted the opening of franchised restaurants only, as opposed to allowing the opening of company-owned restaurants. As the court explained, granting a nearby franchise on similar terms and conditions as the Brymans’ franchise “would not compel a conclusion that the new franchise was granted for the purpose of unlawful, unfair competition.”[8]
By contrast, the court found that a provision allowing a new company-owned restaurant to be opened nearby would present unfair competition concerns, because the company-owned restaurant has certain advantages in the marketplace, including a lower cost structure that results from not having to pay franchise and royalty fees. In addition, the court noted that El Pollo Loco had access to the Brymans’ confidential financial and business data, including real-time access to sales data, which gave it another advantage as a competitor. In view of these advantages, the court found that the adjacent location clause, as applied to company-owned stores, was unconscionable and declined to enforce it.[9]
El Pollo Loco Had a Clear Right to Open the Company Store — Until It Didn’t
The result in Bryman is a reminder that otherwise express contractual rights can be fleeting. The El Pollo Loco franchise agreement expressly authorized El Pollo Loco to establish company restaurants adjacent to its franchisee’s restaurant. El Pollo Loco was perhaps relying on that provision when it decided to open its company-owned restaurant.
The lesson for all commercial actors, including franchisors, is that you cannot assume that when a case gets to court, you will enjoy the contractual benefits that you believe you have bargained for. There are many contract law principles and rules for construing contracts that can be used to upset your understanding of your rights. That might not change the ultimate business decision, but cases like this are a reminder that even when rights may seem clear, there is risk that a contract term will be invalidated, or will be interpreted by the court in a manner that is different than you understood.
So Is the El Pollo Loco Case a Game Changer?
When looked at in context, it appears that the El Pollo Loco case, even if it is affirmed, will not be a significant game changer. To be sure, all franchisors could take some lessons from the case, but the facts of the case will likely limit its persuasive value to situations in which a franchisor is seeking to open a company-owned store as opposed to a franchisee-owned store. Even then, the persuasive value of the case could be rather limited based on the jurisdiction or the language of the contractual clause at issue.
Moreover, for franchisors that sell primarily through franchisees, Bryman should not have much, if any, persuasive value, at least with respect to the unconscionability ruling on the adjacent location clause. The court in Bryman itself distinguished between franchised locations and company-owned locations, albeit with a note about a new franchised location operating under similar terms as the incumbent franchisee. Thus, franchisors that operate principally through franchisees, which include motor vehicle manufacturers who in many states are prohibited from selling directly to consumers, may not be impacted by Bryman in any meaningful way.
The limited impact Bryman presents to companies that principally sell to the public through franchisees is underscored by the cases that have found that a franchisee cannot maintain a good faith and fair dealing claim when its contract expressly provides that the franchisee does not enjoy territorial exclusivity.[10] Under this authority, so long as the franchisee does not have territorial exclusivity, it would not matter whether a franchise agreement reserves to the franchisee the discretion to open additional franchises wherever it chooses, though some contracts expressly provide as much.[11]
Franchisors should be aware, however, that an express reservation of the right to place new franchises may be necessary in some jurisdictions.[12] And of course, to the extent that the express reservation allows a franchisor to place a company store wherever it chooses, franchisors may face the risk of an unconscionability finding, such as in Bryman.
Ultimately, regardless of circumstances, franchisors would be wise to take this lesson from the Bryman case: When looking to take some initiative with your franchise/dealer/distributor network, including establishing new stores, it is advisable to think about how a neutral third party, be it a judge, jury or arbitrator, will view your conduct. As many experienced commercial trial attorneys will tell you, the fairer your conduct appears, the stronger your case is, regardless of what the terms of a contract say.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] https://www.law360.com/articles/1039858/el-pollo-loco-franchisees-win-8-8m-in-territory-dispute.
[2] See March 30, 2017, Statement of Decision, at 2.
[3] Id. at 6, fn1.
[4] Id. at 6-11.
[5] Id. at 2.
[6] Id. at 2.
[7] Id. at 8 (citation and internal quotes omitted).
[8] Id. at 8.
[9] Id. at 8.
[10] Burger King Corp. v. Weaver, 169 F.3d 1310, 1317 (11th Cir. 1999); Nibeel v. McDonald's Corp., No. 97 C 7203, 1998 WL 547286, at *7 (N.D. Ill. Aug. 27, 1998); RHC, LLC v. Quizno's Franchising LLC, No. 04CV985, 2005 WL 1799536, at *6 (Colo. Dist. Ct. July 19, 2005); But see Camp Creek Hosp. Inns Inc. v. Sheraton Franchise Corp., 139 F.3d 1396, 1404 (11th Cir. 1998) (holding that express right to establish franchise store in vicinity of hotel franchisee did not extend to company owned stores).
[11] Cook v. Little Caesar Enterprises Inc., 972 F. Supp. 400, 409 (E.D. Mich. 1997), aff'd, 210 F.3d 653 (6th Cir. 2000).
[12] In re Vylene Enterprises Inc., 90 F.3d 1472, 1477 (9th Cir. 1996). But see Clark v. Am.'s Favorite Chicken Co., 110 F.3d 295, 297 fn2 (5th Cir. 1997) (distinguishing Vylene because it did not involve an express reservation of the franchisor’s right to establish competing restaurants). Note that Vylene may be another example of the facts influencing outcome, as the competing restaurant was franchisor-owned and was opened approximately a mile and a half from the franchisee. See id.