The Franchise Memorandum

The United States Court of Appeals for the Fifth Circuit recently affirmed the dismissal of a distributor’s antitrust counterclaim against a franchisor in a lawsuit brought by the franchisor against the distributor. Schlotzsky’s, Ltd. v. Sterling Purchasing & National Distrib. Co., 2008 WL 588640 (5th Cir. March 5, 2008). The most important aspect of the case for franchisors is the analysis of relevant market issues in the franchise context.

Plaintiff Schlotzky’s is the franchisor for a quick-serve restaurant system and owner of the related trademarks and associated rights. Sterling was a non-exclusive supply chain manager for the Schlotzky’s system. After Sterling began to hold itself out to manufacturers and other distributors as the exclusive representative for purchasing and distribution of all goods and services within the Schlotzky’s system, Schlotzky’s filed suit alleging false designation under the Lanham Act. Sterling counterclaimed that the Schlotzky’s mandate to its franchisees to purchase at least 95 percent of their products from two new distributors was an illegal tying arrangement under Section 1 of the Sherman Act, and that it constituted tortious interference with Sterling’s relationship with Schlotzky’s franchisees. The district court awarded Schlotzky’s extensive injunctive relief and attorneys’ fees on its Lanham Act claim and dismissed Sterling’s antitrust and tortious interference counterclaims.

On appeal, the Fifth Circuit affirmed the dismissal of Sterling’s antitrust counterclaim and drew the distinction between market power, which is required to support a tying claim under the Sherman Act, and contractual power. It noted that each of the Schlotzky’s franchise agreements gave Schlotzky’s the right to establish system-wide quality standards, specify approved products, and designate manufacturers and distributors for products in which Schlotzky’s had a proprietary interest. Citing the Third Circuit’s 1997 decision in Queen City and the Fifth Circuit’s own United Farmers decision from 1996, the court held that economic power derived from such contractual agreements “has nothing to do with market power, ultimate consumer welfare, or antitrust,” and that Sterling’s exclusion from future business with Schlotzky’s franchisees was a termination that was consistent with Sterling’s status as a non-exclusive supply chain manager. The court held that, even if Schlotzky’s required franchisees to turn from Sterling to the other two distributors as part of the franchisees’ continuation of doing business under that name, such a requirement was not an antitrust “tying arrangement” because it was not an exercise of market power but of contractual power.