Volume 18, Number 2
March 2001

FRANCHISE LAW

Prospecting the Last Frontier

Legal Considerations for Franchisors Expanding into Inner-City Markets

By Erik F. Dyhrkopp and Andrew H. Kim

Current thinking sees low-income urban neighborhoods as a land of golden opportunity for companies that are willing to compete aggressively for the sizable spending capability of community residents. Because these markets traditionally have been underserved, advocates tout the inner city as "the last frontier of U.S. retailing."

As more franchisors begin to target inner cities aggressively for expansion, it is important that they carefully evaluate the legal risks that may be encountered. Market opportunities in inner cities. The case for businesses to expand into distressed urban areas has been made by the Initiative for a Competitive Inner City (ICIC). Identifying the positive market attributes of those communities, the ICIC has pointed out that inner-city markets are densely populated, resulting in "enormous buying power per square mile in those communities despite the lower household incomes." Stores in the communities also benefit from high foot traffic, and inner-city shoppers are willing to spend their dollars on consumer goods.

Further, inner-city markets typically are underserved. According to the ICIC, more than 25 percent of retail demand is unmet because many merchants are unwilling to locate in inner-city communities. And many of the few businesses that do operate in inner cities offer poor quality and charge high prices. This combination of unmet demand and local high-price stores offers aggressive retailers an opportunity to move into urban areas and quickly stake out their market share. This expansion into inner cities offers a chance for local residents, many of whom are from minority groups, to operate their own businesses using tested, successful business formats. For this reason, the U.S. Small Business Administration has entered into a partnership agreement with the International Franchise Associa-tion (IFA) in which the IFA has agreed to take steps to promote franchising in inner cities.Violent crime. A franchisor must confront the real and perceived impacts of inner-city crime. Many franchise businesses, such as restaurants, are especially susceptible to robbery because of the late hours and the quantities of cash that such businesses often keep. Franchisors contemplating the inner-city market must consider the safety and security of franchise workers and patrons and consider programs to deter crimes on franchise premises. In doing this, franchisors must evaluate the level of involvement in a franchisee’s security that should be taken to minimize the risks of criminal conduct or the threats to human safety.

A franchisor may wish to implement security measures, such as requiring the hiring of security guards or the installation of additional lighting and surveillance cameras. These steps provide some protection to patrons and employees, may improve goodwill by establishing a location where local residents feel secure from harm, and may enhance sales. However, a franchisor’s involvement in a franchise’s security issues may give rise to a duty on the part of the franchisor to protect employees and patrons, thereby exposing the franchisor to liability if an employee or patron is the victim of a crime committed at the franchise location.

Several cases have addressed the liability of a franchisor where a customer or a franchisee employee is killed or injured on the franchise premises. In almost all of these cases, the court determined liability by taking into consideration the conduct of the franchisor and the language of the franchise agreement, focusing on the level of control that the franchisor exercised on the franchise. In particular, the courts looked for the level of control the franchisor had over the day-to-day operations of the franchise, or alternatively, the level of control over security measures at the franchise. Typically, courts declined to find that a franchisor had exercised sufficient control over the operations of a franchisee to impose liability on the franchisor.Graffiti and vandalism. The accelerated wear and tear on urban franchised stores resulting from graffiti and other vandalism presents a difficult choice to a franchisor. How aggressively should the franchisor enforce image standards at these locations? One choice is to require inner-city operators to meet the same image requirements of outlets located in suburban communities that experience less nuisance crime. This approach, however, may impose higher store-maintenance costs on urban franchisors, which must expend greater efforts than their suburban counterparts because of the comparatively greater problem they face. Further, given the rapid reappearance of most graffiti, it may be unrealistic to expect inner-city stores to keep their premises as graffiti-free as stores in other areas. If so, an inner-city franchisee may argue that its failure to achieve unreachable image standards cannot constitute good cause for termination or other adverse action taken by the franchisor. An alternative for the franchisor is to be flexible in applying image standards to locations in blighted urban neighborhoods, tailoring standards to the problems of graffiti and vandalism that confront franchised outlets in such communities. Disappointing results. Des-pite the promise of expansion in inner cities, franchisors also must plan for unsatisfactory outcomes. Although the temptation to finance quick development of the inner cities may be great, particularly where adding franchised outlets in these areas will promote a franchisor’s diversity programs, the practice makes a franchisor vulnerable to potential default by borrowing franchisees. One means of guarding against this risk is for a franchisor to insist that franchisees pioneering the inner city satisfy traditional requirements for working capital and debt-to-equity ratios.

Lending to franchisees to help them overcome financial difficulties can also complicate termination, as demonstrated by Ransom v. A.B.Dick Co. In Ransom, the plaintiff was an exclusive distributor of A.B.Dick products in Mexico. When hard times befell Ransom, A.B.Dick guaranteed loans that Ransom used to pay amounts owed to A.B.Dick, attended company meetings at Ransom, proffered advice on how Ransom could handle its debt problems, encouraged Ransom to restructure its financing rather than to declare bankruptcy, and sent its chief financial officer to help develop a business plan and prospectus for attracting new investors. Ultimately, A.B. Dick announced that it would be appointing a substitute distributor for Mexico. In a lawsuit between the parties, a jury returned a verdict for Ransom after finding that A.B. Dick had violated fiduciary duties owed to the distributor. On appeal, the court held that A.B. Dick’s close involvement with Ransom during its years of financial difficulty, including its guarantees of debt and financial advice to Ransom, was a fact that the jury could have relied on to find a fiduciary relationship between the parties. A.B. Dick breached its fiduciary duties when it "artificially prolonged the existence of Ransom...until it could find a new distributor."

Ransom indicates the risks that may attend a franchisor’s lenient financing of inner-city franchises. Loans to the franchisee may be a first step toward the fiduciary relationship found in Ransom, especially when those loans are used for royalty and other payments to the franchisor and "artificially prolong" the life of the franchisee by encouraging it to continue doing business in the face of mounting losses. Avoiding "redlining." The selection of franchisees to receive new or existing store locations is a subject that has drawn recent fire from minority franchisees claiming that franchisors have discriminated against them on account of race. It is important that franchisors do not steer minority owners to inner-city locations while failing to offer them site opportunities in suburban locations, which could constitute redlining.

Franchisors face potential problems if their minority recruitment efforts are focused exclusively on inner-city locations. Minority operators may assert that they are shunted to hardscrabble urban areas while white operators are offered choice suburban locales. Franchisors should keep an eye on minority recruitment in nonurban areas rather than assume that increasing minority representation in inner cities is sufficient by itself to satisfy diversity objectives for the franchise system.

Erik F. Dyhrkopp is a partner and Andrew H. Kim is an associate with the firm of Bell, Boyd & Lloyd in Chicago.

- This article is an abridged and edited version of one that originally appeared on page 89 of Franchise Law Journal, Spring Winter 2000 (19:3).

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