'Kodak' Hits the Franchises #2

Circuits' decisions may make franchisee victory short-lived.

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

TWO RECENT cases have revived a long-dormant antitrust theory attacking franchisor-imposed exclusive supply agreements. In Wilson v. Mobil Oil Corp.¹ and Collins v. International Dairy Queen Inc.,² the U.S. district courts for the Eastern District of Louisiana and the Middle District of Georgia, respectively, held that requiring franchisees to purchase supplies only from a franchisor-approved source could create an unlawful tying arrangement by the franchisor.

Relying on the U.S. Supreme Court's rationale in Eastman Kodak Co. v. Image Technical Services Inc.,³ both courts held that a franchisor's trademark may constitute a separate product market, which enabled it to exercise market power over its franchisees. Nonetheless, recent circuit court decisions suggest the impact of Wilson and Collins will be short-lived if franchisors disclose any purchase restrictions before the franchise agreement is signed.

In the 1980s and early 1990s, courts largely rejected claims that a franchisor's distribution system amounted to a separate product market or enabled the franchisor to dictate contract terms to potential franchisees.⁴ Because the Supreme Court requires proof of market power in the tying market⁵ and the franchise industry appeared highly competitive, most franchisors had little reason to be concerned with tying claims from franchisees.⁶

Kodak's analysis of secondary aftermarkets significantly changed the legal landscape. Kodak sold copiers that were incompatible with competitive equipment and required custom-ordered parts.

Kodak initially sold replacement parts to independent service organizations, or ISOs, that repaired Kodak equipment. Later, Kodak refused to sell parts to ISOs, a practice that allegedly drove ISOs out of the market and allowed Kodak to charge supra-competitive prices for repair work.

Kodak moved for summary judgment on the ISOs' tying claims for two reasons: Parts and repair services were not separate markets, and Kodak could not exercise market power because of competition from other copier manufacturers.

Kodak lost on both counts. The Supreme Court found that consumer demand for ISO services indicated that a repair service market existed separate from the parts market. The court also found that competition in the copier market would not necessarily have prevented Kodak from exercising market power in the parts market.

Barriers to Switching

First, high information costs in determining "accurate lifecycle pricing" would have prevented some consumers from switching to other copier manufacturers.⁷ Second, the "heavy initial outlay for Kodak equipment" would have raised switching costs, rebutting Kodak's assumption "that the equipment and service markets act as pure complements to one another."⁸

The Kodak court's emphasis on information and switching costs has not escaped the notice of disgruntled franchisees looking to reduce their product costs. In Wilson, for example, a class of fast-lube franchisees alleged that their franchisor had created an unlawful tie by requiring them to purchase high-priced motor oil exclusively from Mobil Oil Corp.

The defendants argued that no tie could exist because the franchisor lacked market power in the national fast-lube market. The court, however, found that the franchisees were "subject to the same economic dislocation" as the equipment owners in Kodak "because the size of the capital investment in a business format franchise may well outstrip the cost of investing in a Kodak copier, and 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."⁹

The Wilson court also rejected the contention that "if the tie-in is disclosed at the outset of the franchise relationship there can be no exercise of market power in the aftermarket if the franchisor does not have a sizable market share in the primary market."¹⁰ Relying on Kodak, the court reasoned that a franchisee may not be able to discern the "lifecycle pricing" of a long-term franchise agreement and the franchisor's exclusive supply requirements.¹¹

Ice Cream Wars

In Collins, the Middle District of Georgia also found that an approved-source-of-supply clause could amount to a Kodak lock-in.

In that case, International Dairy Queen moved for summary judgment on plaintiff-franchisees' tying claim because its share of the fast-food franchise market was only 2.5 percent and a franchise could not constitute a tying arrangement as a matter of law.

The district court rejected the first argument because the franchisees presented evidence indicating the market was limited to "soft-serve ice cream franchises," and prospective franchisees did not consider other fast food franchises interchangeable.¹² Citing Kodak, the court also held that a tying arrangement could exist since franchisees were effectively locked into their relationship because of the "excessive cost and potential losses associated with purchasing another franchise."¹³

Wilson and Collins significantly increase franchisors' antitrust exposure. Approved-source-of-supply clauses are "widely, if not universally, embodied in franchise agreements and [are] central to the existence and maintenance of the franchise relationship."¹⁴

The 1st, 6th and 7th U.S. circuit courts of appeals, however, have held that Kodak applies only when the defendant has either changed its policy after it locked in its customers or failed to disclose its pricing structure.

This narrow reading stems from Justice Antonin Scalia's dissenting opinion in Kodak. Justice Scalia argued that no per se tying arrangement would have existed "had Kodak--from the date of its market entry--consistently pursued an announced policy of limiting parts sales...so that consumers bought with the knowledge that aftermarket support could be obtained only from Kodak."¹⁵ Writing for the majority, Justice Harry A. Blackmun accepted the legal premise of Justice Scalia's hypothetical but found there was no "concrete evidence that the restrictive parts policy was...generally known."¹⁶

Bundling Spare Parts

Based on this analysis, the 7th Circuit rejected an antitrust claim that Digital Equipment Corp. had tied the sale of operating systems with computers.¹⁷ According to Judge Frank H. Easterbrook, Kodak turned on evidence that some consumers did not anticipate a change in the manufacturer's parts policy: "[I]f spare parts had been bundled with Kodak's copiers from the outset, or Kodak had informed customers about its policies before they bought its machines, purchasers could have shopped around for competitive life-cycle prices."¹⁸

In Lee v. Life Insurance Co. of North America,¹⁹ the 1st Circuit applied the same limitation to Kodak: "Had previous customers known, at the time they bought their Kodak copiers, that Kodak would implement its restrictive parts-service policy, Kodak's 'market power,' i.e., its leverage to induce customers to purchase Kodak servicing, could only have been as significant as its [market power] in the copier market, which was stipulated to be inconsequential or nonexistent."²⁰

In January, the 6th Circuit likewise restricted Kodak to cases in which a seller's post-contract conduct allowed it to exploit locked-in customers.

In PSI Repair Services Inc. v. Honeywell Inc.,²¹ an ISO alleged that Honeywell had created an unlawful tie by prohibiting manufacturers from selling components for Honeywell circuit boards to repair companies.

Both sides rehashed arguments from Kodak. Honeywell claimed that competition from other circuit board manufacturers prevented it from exerting market power in the components market. The ISO claimed that high information costs enabled Honeywell to exploit existing customers.²² After reviewing Kodak's majority and dissent, the 6th Circuit agreed "the change in policy in Kodak was the crucial factor in the Court's decision."²³

The circuit court found that information costs alone would not create a Kodak lock-in.

According to the court, the "evil condemned" by Kodak was the increase in information costs caused by the manufacturer.

Thus, "an antitrust plaintiff cannot succeed on a Kodak-type theory when the defendant has not changed its policy after locking-in some customers, and the defendant has been otherwise forthcoming about its pricing structure and service policies."²⁴ Because Honeywell had not changed its parts policy and customers freely negotiated the sale of Honeywell equipment, Kodak did not apply.

Post-Contract Policy Shift

Leading antitrust commentators agree that Kodak requires an unexpected change in policy enabling a seller to exploit a captured customer base. For example, Profs. Carl Shapiro and David J. Teece, of the University of California at Berkeley School of Law (Boalt Hall), argue that "any harm to end users that might have been caused by Kodak's policy must flow from the policy change being a 'surprise.'"²⁵ Profs. Phillip E. Areeda, of Harvard Law School, and Herbert Turner, of the University of Iowa College of Law, likewise contend that, when the policy is generally known at the pre-contract stage, the tying analysis should properly focus on the defendant's market power at the time the contract is executed.²⁶

Applying this rationale to franchise agreements, two recent cases have rejected tying claims in which franchisors disclosed their purchasing policy during contract negotiations. In Queen City Pizza Inc. v. Domino's Pizza Inc.,²⁷ the franchise agreement required franchisees to buy supplies from a defendant-approved source. The Eastern District of Pennsylvania dismissed a Kodak-based tying claim because plaintiffs that knowingly entered into the franchise agreements.²⁸

The court explained that a franchise agreement does not create a separate product market unless the franchisor has the power to coerce franchisees at the pre-contract stage: "'Precontract competition among franchisors (such as McDonald's or Kentucky Fried Chicken) to sign up franchisees prevents [a single franchisor] from exercising any economic power in setting contract terms with potential franchisees.' "²⁹

On Jan. 14, the California Court of Appeal relied on Queen City Pizza in dismissing a claim that Exxon Corp. had violated California's antitrust statute by requiring franchisees to buy Exxon gasoline.³⁰

The court first rejected plaintiffs' contention that the Exxon franchise and Exxon gas are separate product markets. Unlike Kodak copiers, Exxon gas is not unique and does not lock in consumers: "From the perspective of retail gasoline consumers, the relevant market is all gas, not just Exxon gas."³¹

Next, the court held that a franchisee cannot claim to be locked into a contract it voluntarily signed: "[T]here was no 'lock-in' until plaintiffs voluntarily assumed their roles as franchisees; they had the entire spectrum of gasoline sellers from whom to chose in deciding how to structure their service station businesses."³²

Unlike the sale of copiers in Kodak, the sale of franchises is heavily regulated. Federal and state franchise disclosure laws generally require franchisors to reveal the terms of any ancillary purchase requirements.³³ Accordingly, claims that franchisees incur high information costs likely will not survive judicial scrutiny.

Most courts also have rejected the notion that information costs alone create an aftermarket lock-in. Absent a material change in a franchisor's purchasing policy, courts in the 1st, 6th and 7th circuits likely will not apply Kodak to franchise relationships. The Digital, Lee and Honeywell decisions suggest that courts in other circuits would reject Wilson and Collins as well.

(1) 940 F. Supp. 944 (E.D. La. 1996).

(2) 939 F. Supp. 875 (M.D. Ga. 1996).

(3) 504 U.S. 451 (1993).

(4) See, e.g., Tominaga v. Shepherd, 682 F. Supp. 1489, 1494 (C.D. Calif. 1988).

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

(6) See Janet L. McDavid, "Kodak Decision Revitalizes Tying Claims," Franchise L.J., Summer 1992 at 3.

(7) 504 U.S. at 473.

(8) Id. at 477.

(9) 940 F. Supp. at 952.

(10) Id. at 953.

(11) Id.

(12) 939 F. Supp. at 880.

(13) Id. at 883.

(14) Fast Food Fabricators v. McDonald's Corp., 1980-2 Trade Cas. (CCH) para. 63,552, at 76,947 (N.D. Calif. Aug. 16, 1980).

(15) 504 U.S. at 491.

(16) 504 U.S. at 477, n.24 (internal citation omitted).

(17) Digital Equip. v. Uniq Digital Tech., 73 F.3d 756 (7th Cir. 1996).

(18) Id. at 763.

(19) 23 F.3d 14 (1st Cir.), cert. denied, 115 S. Ct. 427 (1994).

(20) Id. at 20.

(21) 1997-1 Trade Cas. (CCH) ¶ 71,674 (6th Cir. Jan. 13, 1997).

(22) Id. at 78,768.

(23) Id. at 78,769.

(24) Id. at 78,769-70.

(25) Carl Shapiro and David J. Teece, "Systems Competition and Aftermarkets: An Economic Analysis of Kodak," The Antitrust Bulletin, Spring 1994, at 135-62.

(26) See 10 Phillip E. Areeda and Herbert Hovenkamp, Antitrust Law, para. 1740c3 (1996).

(27) 922 F. Supp. 1055 (E.D. Pa. 1996).

(28) Id. at 1061-62.

(29) Id. at 1061 (quoting Benjamin Klein and Lester F. Saft, "The Law & Economics of Franchise Tying Contracts," 28 J. Law & Econ. 345, 356 (1985)).

(30) Exxon Corp. v. Superior Court of Santa Clara Co., 60 Cal. Rptr. 2d 195 (6th Dist. 1997).

(31) Id at 204.

(32) Id.

(33) See, e.g., FTC Franchise Rule, 16 C.F.R. 436; Uniform Franchise Offering Circular, Business Franchise Guide (CCH) para. 5700; Illinois Franchise Disclosure Act, 815 Ill. Comp. Stat. 705/1-44 (West 1993); N.Y. Gen. Bus. Law Secs. 680-695 (McKinney 1996).