'Kodak' Hits the Franchises #1

Recent cases warn franchisors to be wary of 'Kodak' liability.

The National Law Journal (p. C01)
Monday, March 31, 1997

WHEN THE Supreme Court decided Eastman Kodak Co. v. Image Technical Services Inc. five years ago, Justice Antonin Scalia's dissent stated that the majority's decision "threatens to release a torrent of litigation and a flood of commercial intimidation."¹ If recent trends in franchise litigation continue, it may be time for many franchisors to start building an ark.

Kodak did not change the elements an antitrust plaintiff must prove to establish that a tying arrangement is per se unlawful under Sec. 1 of the Sherman Act. The Supreme Court's prior decision in Jefferson Parish² had confirmed the four prerequisites for a tying arrangement to be per se unlawful. First is conditioning the sale or lease of one product--the tying product--on the purchase of another--the tied product.³ Second, the tying product and the tied product must be separate and distinct.⁴ The third element, market power over the tying product, requires a showing that the seller had the ability to "force" buyers to purchase the tied product.⁵ The fourth element is merely an effect on a "not insubstantial" amount of interstate commerce.⁶

Before Kodak, antitrust challenges to requirements that franchisees purchase certain components of the franchise system from the franchisor or its affiliates were becoming increasingly rare. But there had been some early victories for plaintiffs. For example, in the 1971 decision in Siegel v. Chicken Delight Inc.,⁷ the 9th U.S. Circuit Court of Appeals held that the franchisor's trademark was, for tying purposes, a separate product from the various items that franchisees were required to purchase from the franchisor.

Most subsequent decisions rejected that view. For example, in a 1980 decision, the 4th Circuit, in Principe v. McDonald's Corp., "agree[d] with McDonald's that the lease, note and license are not separate products but component parts of the overall franchise package."⁸ Indeed, by 1981, the 9th Circuit itself seemed to disavow Chicken Delight. In Krehl v. Baskin-Robbins Ice Cream Co., the 9th Circuit held that the franchisor's trademark and ice cream products were "inextricably related" and therefore not separate products.⁹

After years of decisions such as Principe and Krehl, Kodak seemed like a franchisee plaintiff's dream come true. The Kodak majority found that, under certain circumstances, the relevant product market can be defined in terms of the manufacturer's own products.¹⁰ In a relevant product market limited to the manufacturer's own products, most manufacturers have the market power necessary to find a per se unlawful tying arrangement.

In Kodak, the Supreme Court found that the relevant market was properly defined as replacement parts for Kodak brand photocopiers rather than for photocopiers generally. The Kodak majority thus found that purchasers of Kodak brand photocopiers, having made a substantial up-front investment in the equipment, were "locked in" and vulnerable to exploitation in the aftermarket for service.¹¹

New Life for 'Chicken Delight'

The implications of Kodak for franchising were not lost on franchisee plaintiffs' lawyers. The Kodak majority's market definition promised to breathe new life into decisions, such as Chicken Delight, that had defined the relevant product market in terms of the franchisor's own trademark and franchise system. If purchasers of Kodak brand photocopiers were locked into their investments, it would seem that franchisees, who had paid hefty up-front franchise fees, invested heavily in a franchised location and paid royalties for years, were similarly situated.

Yet Kodak was not all bad for franchisors' defense counsel. For one thing, Justice Harry A. Blackmun had modestly characterized Kodak as "just 'another case that concerns the standard for summary judgment in an antitrust controversy.'"¹² Arguably, Kodak had not changed the substantive law of tying. More important, Justice Scalia's dissent suggested a way to limit the holding in Kodak to a fairly unique fact pattern. Had Kodak imposed the tie up front when purchasers bought the photocopiers--rather than after the fact--the relevant product market would have been all brands of photocopiers, "a market in which (we assume) Kodak has no power to influence price or quantity."¹³

By analogy, the requirement that franchisees purchase certain goods and services from the franchisor is often imposed up front in the franchise agreement. If so, and if these requirements are adequately disclosed in accordance with federal and state franchise law, then arguably, the relevant market should be defined in terms of all competing franchises. Few if any franchisors would ever have market power in a relevant product market defined to include all competing franchises.

Within the past year, at least three district courts have applied Kodak in the context of franchising. So far, at least, the results have been as disparate as the majority opinion by Justice Blackmun and the dissent by Justice Scalia in Kodak.

From the standpoint of defendants, the most encouraging application of Kodak was a 1996 decision of the federal district court in Philadelphia, which is now on appeal to the 3d Circuit. In Queen City Pizza v. Domino's Pizza,¹⁴ a number of franchisees and an association to which they belonged challenged a provision of Domino's' franchise agreement that authorized Domino's to designate approved suppliers and distributors. The plaintiffs alleged that this provision of the franchise agreement "effectively precluded [franchisees] from purchasing ingredients and supplies in a competitive market."¹⁵

The district court rejected the franchisees' contention that they were locked into the franchise investment and that the relevant market should be defined in terms of the Domino's franchise. Instead, the court found a "key distinction" between "a franchisor's pre-contractual market power versus the post-contractual economic power it possesses under the contract."¹⁶

Critical to the court's decision was the fact that franchisees were aware of the challenged provision of the franchise agreement at the time they signed the contract. The court therefore granted summary judgment in favor of the defendant, holding that the plaintiffs' relevant market definition was insufficient as a matter of law "because the 'market' was created by virtue of the franchise agreements Plaintiffs freely entered."¹⁷

Soft-Serve Market

The ink was barely dry on the Domino's decision, however, when at least two district courts rejected its rationale by denying franchisors' summary judgment motions. In Collins v. International Dairy Queen Inc., the federal court in Macon, Ga., denied defendants' motion for summary judgment on franchisee claims that required purchases from the franchisor constituted an illegal tying arrangement.¹⁸

The court found sufficient evidence from which a trier of fact could conclude that the relevant market was "limited to soft-serve ice cream franchises," a market in which Dairy Queen allegedly enjoyed a 91.3 percent market share.¹⁹

The federal court in New Orleans similarly declined to adopt the rationale of Domino's, denying defendants' motion for summary judgment in the case of Wilson v. Mobil Oil Corp.²⁰ In Wilson, the franchisees of Speedee Oil Change Systems challenged the requirement that they purchase lubricants, equipment and financial services from Mobil.

The court found too many parallels between the rationale of the Kodak majority and the franchisees' allegations to grant the defendants' motion for summary judgment. In Wilson, the court found that the franchisees might be as locked in as were the plaintiffs in Kodak in view of "the size of the capital investment in a business format franchise" and because "the franchise agreement can involve a long-term arrangement in which the franchisee invests in brand development, which may make switching to another franchise costly."²¹

The court in Wilson was also concerned about the possibility that "imperfect information" might have precluded prospective franchisees from making meaningful comparisons among competing franchise systems: "This is particularly true if both the franchise and the supply arrangements are long-term, without full disclosure about current and future prices and requirements for the tied items, and the franchisee is unable to predict or assess his total product, equipment and financing needs over the life of the franchise at the point of purchase."²²

Franchisors and their counsel will have to attempt to reconcile Domino's and Wilson long before the federal courts of appeals do--if they ever do. As much as these two courts disagreed, the one thing about which they did agree was the importance of adequate disclosure before the parties enter into a franchise relationship.

In Domino's, the court found that the franchisor's approved supplier program had been adequately disclosed so that the franchisees could not complain after the fact of being locked in, and the relevant market was properly defined in terms of all competing franchises. In Wilson, the court found that the adequacy of pre-contractual disclosure was a disputed issue of fact that precluded summary judgment.

No franchisor can design an approved supplier program that is litigation-proof--except not to have one at all. And there are often good reasons for franchisors to impose such a requirement.

To minimize the risk of a successful tying claim, however, the soundest advice is to disclose such requirements so prominently up front that no franchisee can legitimately claim to have been surprised.

(1) 504 U.S. 451, 489 (1992).

(2) Jefferson Parish Hospital Dist. No. 2 v. Hyde, 466 U.S. 2 (1984).

(3) Id. at 6.

(4) Id. at 19.

(5) Id. at 12.

(6) See U.S. v. Loew's Inc., 371 U.S. 38, 49 (1962) ($60,800 not insubstantial); Fortner Enterprises Inc. v. U.S. Steel Corp., 394 U.S. 495, 502 (1969) (Fortner I) (dollar volume measured by all sales subject to tying arrangement).

(7) 448 F.2d 43 (9th Cir. 1971), cert. denied, 405 U.S. 955 (1972).

(8) 631 F.2d 303 (4th Cir. 1980), cert. denied, 451 U.S. 970 (1981).

(9) 664 F.2d 1348, 1354 (9th Cir. 1982).

(10) 504 U.S. at 486.

(11) Id. at 476-77.

(12) Id. at 486.

(13) Id. at 491.

(14) 922 F. Supp. 1055 (E.D. Pa. 1996).

(15) Id. at 1058.

(16) Id. at 1061.

(17) Id. at 1063.

(18) 939 F. Supp. 875 (M.D. Ga. 1996).

(19) Id. at 880.

(20) 940 F. Supp. 944 (E.D. La. 1996).

(21) Id. at 952.

(22) Id. at 952.