International Franchise Association
46th Annual Legal Symposium
May 5-7, 2013
JW Marriott Hotel, Washington, DC
Frequently Arising Issues in
Franchise Litigation
Jess A. Dance
Perkins Coie LLP
Denver, Colorado
Amy Powers
WellBiz Brands, Inc.
Denver, Colorado
Richard L. Rosen
The Richard L. Rosen Law Firm PLLC
New York, New York
I.
INTRODUCTION
Franchise litigation is very similar to other complex commercial litigation in many
respects. The most common causes of action (breach of contract, implied covenant of
good faith and fair dealing, fraud in the inducement) and defenses (statute of limitations,
release, contractual merger and integration clauses) are same in both franchise
litigation and in other commercial litigation. Further, the common procedural issues
(venue, choice of arbitration, enforceability of arbitration agreements, etc.) are often the
same as well. That said, because franchising is a regulated industry, franchise litigation
involves its own unique quirks and challenges. The Federal Trade Commission
regulates franchising and, among other things, requires franchisors to provide prospects
with detailed written pre-sale disclosures. In addition, a patchwork of states have
enacted their own laws governing the registration, disclosure, or termination of
franchises. Further, state “Little FTC Acts” may apply to the sale of franchises in certain
states and circumstances.
This paper attempts to identify in Section II the most frequent claims raised by
franchisees and franchisors throughout the franchise relationship, from complaints
regarding the franchisor’s efforts to sell a franchise to a franchise prospect, through
disputes regarding the operation of a particular unit, to issues that can arise in
connection with the termination of a franchise and the parties’ post-termination conduct.
Section III addresses the primary defenses to such claims, while Section IV discusses
common remedies sought in franchise litigation. Frequently arising procedural issues in
franchise litigation are addressed in Section V and alternative dispute resolution
(arbitration and mediation) is discussed in Section VI. Finally, Sections VII and VIII
conclude with experienced counsel’s reflection on the common concerns of franchisees
and franchisors regarding franchise litigation.
II.
COMMON
CLAIMS
RELATIONSHIP
A.
ARISING
THROUGHOUT
THE
FRANCHISE
OFFER AND SALE
1.
Violations of FTC Franchise Rule
The sale of franchises is regulated by the Federal Trade Commission (“FTC”).
The FTC Franchise Rule, which was amended in 2008 (codified at 16 C.F.R. § 436)
sets forth disclosure requirements applicable to non-exempt franchise sales. The FTC
Franchise Rule was promulgated to prevent deception in the sale of franchises and to
facilitate informed decision making by potential franchisees. It requires franchisors to
provide prospective franchisees with mandated and other material information about the
franchise opportunity prior to the sale and purchase of the franchise. The disclosure
document mandated by the FTC Rule used to be called a Uniform Franchise Offering
Circular (“UFOC”) and is now called a Franchise Disclosure Document (“FDD”). The
FTC Rule sets forth what must and must not be included in the FDD.
The FTC Franchise Rule has the force and effect of law. Violations of the FTC
1
Franchise Rule constitute violations of the U.S. Federal Trade Commission Act. The
FTC can sue franchisors in federal court for violations of the FTC Franchise Rule,
including the making of improper financial performance representations, and may seek
(a) civil penalties of up to $11,000 per violation; (b) injunctions enjoining violations of the
FTC Franchise Rule, including barring franchise sales in the United States; and (c)
2
seeking restitution, rescission, or damages on behalf of affected franchisees. The FTC
can also refer cases for criminal prosecution to the United States Department of Justice.
There is no private right of action under the FTC Franchise Rule. Thus,
franchisees may not sue franchisors for violating the FTC Franchise Rule. In many
states, however, they may a claim under the state’s “Little FTC Act,” which provides that
any violation of the FTC Act and the regulations promulgated thereunder is a violation of
the Little FTC Act. Little FTC Acts often provide remedies of treble damages and the
recovery of attorneys’ fees and costs.
Franchisors must renew their FDD annually and amend upon the occurrence of a
material change in the franchisor’s business.
2.
Violations of State Franchise Registration or Disclosure
3
Statutes
Fifteen states have promulgated franchise registration and/or disclosure
4
statutes. Of these, only 11 require FDD review and registration with the applicable
5
state agency.
State franchise registration or disclosure statutes have been promulgated for the
same purpose as the FTC Franchise Rule—preventing deception in the sale of
franchises and providing prospective franchises with all material information necessary
for the prospect to make an informed investment decision.
Many issues may (and frequently are) litigated under state franchise statutes.
Some of the most common are: (a) the “jurisdictional scope” of the statute (i.e., is the
offer or sale of the franchise “in this state”? 6); and (b) the “substantive scope” of the
1
15 U.S.C. §§ 41-58.
See, e.g., F.T.C. v. Minuteman Press, 53 F.Supp.2d 248, 258 (S.D.N.Y. 1998).
3
Several states have “business opportunity laws” that, depending on the circumstances, may extend to
the sale of franchises. However, claims under such laws are beyond the scope of this paper.
4
California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon,
Rhode Island, South Dakota, Virginia, Washington, and Wisconsin.
5
Indiana, Michigan, and Wisconsin require only a “notice filing,” not actual registration. Oregon requires
disclosure, but not registration or filing.
6
For example, New York’s statute encompasses any franchise sales activity that takes place in New
York, emanates from New York, or is directed to residents of New York.
2
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statute (i.e., does the transaction fall within the definition of a “franchise”? 7). Both of
these issues are discussed more fully below.
State registration/disclosure statutes strictly regulate how, when, and under what
circumstances franchises can be offered and sold. The statutes regulate the timing and
circumstances surrounding disclosure and generally require that the FDD be complete,
truthful and in compliance with the FTC Franchise Rule. In “registration states” the
franchisor and the disclosure document must be registered and approved by the
appropriate state agency before commencing franchise sales activities.
These state statutes also typically prohibit “fraudulent and unlawful practices” by
the franchisor, such as making untrue statements of material fact (or willfully omitting
any such fact) in connection with the registration or disclosure process, employing any
device, scheme, or artifice to defraud, engaging in any act or practice which would
operate as a fraud or deceit, or violating any provision of the registration/disclosure
statute.
Violations of state registration/disclosure laws can have serious consequences.
If the state agency suspects fraud or illegality in the offer and sale process, its
enforcement arm can investigate, bring civil proceedings against the franchisor (seeking
a wide range of remedies such as restitution, damages, injunctions and the imposition
of fines and penalties) and, ultimately, prohibit offers and sales in the state altogether.
State statute violations may also give rise to criminal liability, not only for the franchisor,
but, in certain circumstances, for officers, directors, and/or senior management of the
franchisor if they have participated in the prohibited conduct.
Under state statutes, unlike under the FTC Franchise Rule, franchisees may
assert a private right of action against a franchisor, most commonly an action for
rescission of the franchise agreement and/or an action for actual damages. If
rescinded, the franchise agreement is canceled and deemed to have never existed,
thereby placing the franchisee in the same economic position he or she would have
been in had the franchise agreement not been consummated. The franchisee may also
be entitled to recover his or her reasonable attorneys’ fees and costs.
a.
Sale of an “Unregistered” Franchise
State registration/disclosure statutes are aimed at franchise activity “in this state.”
What that phrase means varies from jurisdiction to jurisdiction. For example, the New
York Franchise Act has, arguably, the broadest interpretation of the phrase, covering
any franchise activity that takes place in New York, emanates from New York, or is
directed to a resident of New York. Therefore, a franchisor must register with the
appropriate New York state agency if: (A) its headquarters are located in the state of
New York; (B) it offers or sells a franchise from the state of New York; (C) it offers or
7
A statute’s definition of a franchise could encompass commercial relationships and transactions that the
parties did not understand or intend to be covered by franchise statutes. This is known as becoming an
“unwitting franchisor”.
-3-
sells a franchise that will be located in the state, or (D) it offers or sells a franchise to a
resident of the state of New York.
Selling (or offering) a franchise to a prospective franchisee without properly
registering could expose a franchisor to suits by franchisees who, depending on the
state, may seek rescission, recovery of their full investment, additional damages, and
attorneys’ fees.
b.
Inadvertently Meeting the Definition of “Franchise”
There is no universal consensus among state statutes as to the definition of a
“franchise.” Therefore, it is important to read, analyze and understand the specific state
statute at issue. Most state statutes define a “franchise” to include three elements: (A)
the right to sell goods or services under a marketing plan or system provided by the
franchisor; (B) in return for a franchise fee (the amount and definition of which varies
from state to state); and (C) where the plan or system is associated with the franchisor’s
trademark. 8 A few states use a “community of interest” test with respect to the
marketing of the goods and services, and do not include in the definition of a “franchise”
the “marketing plan or system” requirement.
Franchise laws may inadvertently encompass other commercial arrangements
that the parties to the arrangement (and perhaps the legislature that enacted the laws)
did not intend. For example, New York’s broad statutory definition of a franchise may
also include licensing or distribution agreements, and certain service agreements. A
finding that an enterprise is an “inadvertent franchisor” can create liability for the offering
party and, under some state statutes (for instance, New York and Illinois), any
9
individuals who have materially aided in the violation.
3.
Violations of State Unfair or Deceptive Trade Practice Statutes
(“Little FTC Acts”)
Twenty-nine (29) states have unfair trade practice acts which allow “consumers”
10
to assert a private right of action for unfair trade practices.
These statutes are
commonly referred to as “Little FTC Acts” because they provide that any violation of the
federal FTC Act or related regulations, including the FTC Franchise Rule, is
automatically a violation of the state Little FTC Act. Therefore, even if a franchisee is
not protected by a state franchise disclosure or registration statute, the franchisee still
8
Again, New York has one of the broadest definitions of a “franchise,” providing that the existence of
either the marketing plan/system component, or the trademark component, coupled with payment of a
franchise fee, automatically triggers the creation of a franchise. See N.Y. Gen. Business Law, Article 33,
§ 681(3).
9
Depending on the state law at issue, an “inadvertent franchisor” may wish to offer its purchasers a right
of rescission. Such an offer could reduce the offeror’s exposure to liability and statutory damages.
10
Alabama, Alaska, Arizona, Connecticut, Florida, Georgia, Hawaii, Idaho, Illinois, Louisiana, Maine,
Maryland, Massachusetts, Mississippi, Montana, New Hampshire, New Mexico, New York, North
Carolina, Ohio, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Utah, Vermont,
Washington, and West Virginia.
-4-
may be able to assert claims against the franchisor under the state’s Little FTC Act.
Approximately half of Little FTC Acts allow for the recovery of treble damages, while
many allow for reasonable attorneys’ fees if a franchisee’s claim is successful.
A primary question under Little FTC Acts is whether or not a franchisee is a
“consumer” for purpose of the Acts. Some states take the position that these statutes
were enacted to protect consumers when they make purchases from businesses; as
business owners who have entered into a complicated business transaction,
franchisees are outside of the intended scope of the statute’s protection in such states.
State franchise investment or relationship laws typically define and prohibit
“fraudulent practices”, enabling franchisees to assert “statutory fraud” claims for material
misrepresentations or omissions of fact in an FDD. New York’s franchise statute
prohibits “fraudulent and unlawful practices” in connection with the offer, sale, or
purchase of a franchise and/or the registration of the required disclosure document.
Fraudulent and unlawful practices under the New York statute include (1) any
intentional untrue statement of a material fact; (2) any intentional omission of a material
fact the absence of which renders another statement misleading; (3) any scheme or
artifice to defraud, (4) any act or practice that would or does operate as a fraud or
deceit, (5) any violation of the franchise statute or regulations, and (6) any attempt to
compel a waiver of the statute’s provisions.” 11
Not all state franchise statutes require proof of intent to establish a violation. For
instance, the Illinois franchise statute requires proof of intent to establish a fraud or
deceit claim, but imposes strict liability for the making of any untrue statement of a
material fact.
Under certain Little FTC Acts, including Illinois’ statute, deception that falls short
of common law fraud may still be actionable. Franchisees are generally not required to
prove actual reliance and their claims are generally not defeated by disclaimers of
reliance in the FDD or other document included with the FDD. The question is whether
or not a reasonable person would likely be misled by the misrepresentations or
omissions. However, in order to recover damages, the franchisee may be required to
prove proximate causation, which effectively requires a showing that the franchisee
actually relied upon the deception in purchasing the franchise.
4.
Misrepresentations or Omissions
a.
Common Law Fraud
Common law fraud is the intentional misrepresentation of a material fact or facts
presented to and relied upon by another party to his or her detriment. The elements of
common law fraud, which in most jurisdiction must be pled with particularity and proved
with clear and convincing evidence are: (1) a material misrepresentation of a presently
11
See Garner (Editor), Franchise Desk Book Second Edition Volume II (Selected State Laws,
Commentary and Annotations) (American Bar Association (2011).
-5-
existing or past fact; (2) knowledge or belief by the other person of its falsity; (3) an
intention that the other person rely on it; (4) reasonable reliance thereon by the other
person; and (5) resulting damages. 12
The Sixth Circuit has explained a party’s duty to disclose material facts as
follows:
[A]n action for fraud or deceit is maintainable not only as a result of
affirmative representations, but also for negative ones, such as a failure of
a party to a transaction to fully disclose facts of a material nature where
there exists a duty to speak… [A] party is under a duty to speak, and
therefore liable for non-disclosure, if the party fails to exercise reasonable
care to disclose a material fact which may justifiably induce another party
to act or refrain from acting, and the non-disclosing party knows that the
failure to disclose such information to the other party will render a prior
statement or representation untrue or misleading. 13
Franchisors often have a fair amount of contact and communication with
prospective franchisees, whether by phone, email, or face to face meetings. These
contacts and communications include franchisor representations about the franchise
system (including those made by representatives of the franchisor), both orally and in
writing.
Following are typical “pre-sale” issues upon which franchisee
misrepresentation/omission claims may be based: (i) the amount of time between
signing the franchise agreement and opening the franchise business, which includes
site selection, lease negotiation, construction and build-out, and related costs; (ii)
franchisor’s failure to communicate its plans to materially change or modify the
franchise system; (iii) the amount of money franchisees in the system earn (either in
terms of revenues/sales or profits/ profit percentages) not contained in Item 19 of the
FDD; 14 (iv) the franchisor’s development plans for the franchise system; (v) the nature
and extent of initial and ongoing training and support provided by the franchisor; and (vi)
any other misrepresentation or omission that a prospective franchisee would deem
material to his or her investment decision.
In most jurisdictions the misrepresentations must be false statements of either a
present or past fact. If the statement is an opinion, or is “mere puffery”, a cause of
action based in fraud will not lie. Similarly, representations that are made as to future
events or future conduct will not ordinarily qualify as actionable fraud or a fraudulent
misrepresentation (e.g., the difference between “you will earn” and “other franchisees
earn” may be meaningful). Further, the “fact” at issue must be “material” which means
12
Gennari v. Weichert Co. Realtors, 148 N.J. 582, 610 (1997).
See Preferred RX, Inc. v. Am. Prescription Plan, Inc., 46 F.2d 535, 546 (6th Cir. 1995).
14
Franchisor financial performance representations are permitted if the representations are included in
Item 19 of the FDD. If they are not included, they are deemed to be improper financial performance
representations (whether or not they are true).
13
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that it must be significant enough to have been a factor in a reasonable person’s
decision to purchase the franchise. 15
The issue of “reasonable reliance” is frequently litigated in connection with fraud
claims. Most franchise agreements contain “merger” and “no oral modification” clauses,
and many agreements contain specific disclaimer language (which may be in a
separate “questionnaire” document signed by the franchisee). These provisions arm
the franchisor with an argument (often a winning argument, depending upon jurisdiction
and the specific facts and circumstances), that the franchisee’s purported reliance was
not “reasonable.” It is very important that franchisee counsel research applicable law
with respect to “reasonable reliance” before drawing conclusions about a franchisee’s
likelihood of success on a fraud claim.
As discussed below, the typical remedy for fraudulent inducement is rescission.
b.
Negligent Misrepresentation
The elements of a cause of action for fraud and a cause of action for negligent
misrepresentation are similar, with differing “state of mind” requirements. Fraud is an
intentional tort; negligent misrepresentation lacks the element of intent to deceive.
Generally, a claim for negligent misrepresentation requires that: (1) the defendant made
a misrepresentation of a past or existing material act; (2) the defendant had no
reasonable ground for believing the statement to be true; (3) the defendant intended to
induce plaintiff’s reliance on the misrepresentation; (4) the plaintiff was ignorant of the
true facts and justifiably relied on the misrepresentation; and (5) the plaintiff was
damaged as a result. 16 As to remedies, franchisees generally elect between rescission
and damages. While non-profitable franchisees often seek rescission (including
compensatory damages in the amount of the investment), profitable franchisees are
more likely to seek lost profits. If a franchisee is seeking to avoid a post-termination
covenant not to compete, he or she is more likely to pursue rescission—the parties’
agreement is deemed to have never existed and, therefore, no non-compete provision
15
In Dunhill Franchisees Trust v. Dunhill Staffing Systems, Inc., 513 F. Supp. 2d 23 (S.D.N.Y. 2007), the
arbitrator found that the franchisor committed fraud. Dunhill, the franchisor of employee placement
(staffing) franchises, commenced an arbitration proceeding against several franchisees for arrearages in
royalty and other payments. Through their franchise association, the franchisees, whose Dunhill
franchises were not profitable, asserted various counterclaims, including common law fraud, alleging that
franchisor had made material misrepresentations and fraudulent omissions in connection with the sale of
the franchises. The arbitrator found that the franchisor knew, or should have known, that the franchises
sold did not have a reasonable chance of success for new entrants to the business who had no prior
experience in the staffing industry. The arbitrator concluded that the franchisor’s disclosure document
and its marketing materials “omitted to state material facts, known to [franchisor], which under the
circumstances in their entirety, operated as a fraud upon [the franchisees].” The arbitrator also found that
the franchisees could not have, in the exercise of reasonable diligence, discovered the omitted material
information prior to acquiring their franchises. The arbitrator awarded rescission, compensatory
damages, and attorneys’ fees. The franchisor’s effort to vacate the arbitrator’s award failed.
16
Maltz v. Union Carbide Chems & Plastics Co., 992 F. Supp. 286 (S.D.N.Y. 1998) (applying California
law).
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ever existed. Of course, “alternative pleading” allows the franchisee to assert both
types of claims.
5.
Improper Financial Performance Representations
Prospective franchisees always want to know how much money they can
“expect” to make. Franchisors are not required by any federal or state statute or rule to
provide prospective franchisees with any financial performance information. They may
remain silent or elect to provide information. The law strictly governs the dissemination
of financial performance representations (“FPR”), formerly known as “earnings claims.”
The consequences for violations can be serious, including stiff civil (and even criminal)
penalties. The FTC Franchise Rule defines an FPR as follows:
Any representation, including any oral, written or visual representation, to
a prospective franchisee, including a representation in the general media,
that states, expressly or by implication, a specific level or range of actual
or potential sales, income, gross profits, or net profits. The term includes
a chart, table, or mathematical calculation that shows possible results
based upon a combination of variables.
Neither the franchisor nor its representatives may communicate, either verbally
or in writing, information related to past or projected revenues or sales, gross income,
net income, or profits of franchised units or company owned units, unless the FPR is
disclosed in Item 19 of the franchisor’s FDD. While a franchisor’s communication to
prospects of “cost only” information (i.e., an estimate of likely operating expenses) is,
technically, permitted under the FTC Franchise Rule without being disclosed in Item 19,
a franchisor’s ability to disclose this information is effectively limited to the 35 states
having no franchise registration or disclosure laws. Franchisors are, however, permitted
to communicate to potential purchasers actual financial information relating to a specific
franchised or company-owned location the franchisor is offering for sale (together with
the name and last known address of each owner during the prior three years).
The FTC considers variations of the following to be FPRs:
•
•
•
You should/will earn a $150,000 profit; you should/will earn income of up to
$200,000 per year; or you should/will earn enough money to buy a Mercedes;
You should/will have revenues or sales of $1 million; and
You should/will make back your full investment (or “break even”) within 18
months.
Franchisors are not prohibited, however, from making statements which can be fairly
characterized as sales puffery, such as “this is a great opportunity.”
Depending on the nature of the representations, improper FPRs could led to FTC
action or private lawsuits by franchisees for violations of a state registration or
disclosure statute, violation of a Little FTC Act, or common law fraud.
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B.
OPENING AND OPERATIONS
At some point during a franchise relationship, issues may arise related to the
operation of the franchise business. This section addresses some of the most common
issues raised by franchisors and franchisees. Franchise counsel should examine these
issues in light of the history of the franchise relationship in order to effectively anticipate
both claims and defenses.
1.
Breach of Contract or Breach of Implied Covenant of Good
Faith and Fair Dealing
The majority of franchisor claims against franchisees arise directly out of the
parties’ franchise agreement or other related contracts, such as guaranties or lease
agreements. Franchisees likewise often bring breach of contract or breach of the
implied covenant of good faith and fair dealing claims based on a franchisor’s purported
failure to meet its obligations under the franchise agreement. A “plain vanilla” breach of
contract claim arises from the franchisor’s alleged failure to meet its written obligations
under the franchise agreement or other written obligations, such as those in the
franchisor’s Operations Manual, which is often incorporated by reference into the
franchise agreement.
A failure to meet its obligations under a franchise agreement can not only give
rise to a claim for breach of contract, but can be raised as a defense. Sometimes,
franchisees may not realize that their inability to meet their obligations could be the
result of prior actions by the franchisor. However, a franchisee should think “long and
hard” before withholding royalty payments. Doing so, which puts the franchisee in
default of the franchise agreement, can seriously undermine the franchisee’s position in
litigation. It is critical that counsel for both parties understand whether or not the parties’
have met all of their obligations, and to get “the entire story” from their clients.
Franchisees can also claim that the franchisor has breached the implied
covenant of good faith and fair dealing. The basis for this claim is that, subject to state
law (see below), all contracts contain a “built in” duty of good faith and fair dealing,
regardless of the express language of the contract. The implied covenant of good faith
and fair dealing is a general presumption that the parties to a contract will deal with
each other honestly, fairly, and in good faith, such that neither party destroys the other
17
party’s right to receive the benefits of the contract.
The duty of good faith and fair
dealing, however, “cannot be used to create independent obligations beyond those
18
agreed upon and stated in the express language of the contract[s].”
A franchisee may raise this claim when, despite the general circumstances and
understandings between the parties, the franchisor uses a technical excuse for an
17
See, e.g., Dalton v. Educ. Testing Serv., 663 N.E.2d 289 (N.Y. 1995).
See, e.g., JPMorgan Chase Bank, N.A. v. IDW Group, LLC, No. 08 Civ. 9116 (PGG), 2009 WL 321222,
at *5 (S.D.N.Y. Feb. 9, 2009).
18
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alleged contract breach, or cites specific contractual terms in isolation to refuse
performance under the contract.
Some states do not recognize a breach of the implied covenant claim as an
independent cause of action, either in contract or tort, separate and apart from a claim
19
for breach of contract.
a.
Failure to Provide the Franchisee with Adequate
Training and/or Support
Most franchise agreements provide (and often mandate) that a franchisor provide
operational and other training to its franchisees. If a franchisor fails to provide training
or neglects to memorialize that training occurred, a franchisee can allege that the
franchisor breached the franchise agreement and, if applicable, caused the franchisee’s
business to fail. This can be an effective argument for the franchisee, especially if used
to counter franchisor’s attempt to default the franchisee under the franchise agreement
or, by reference, the Operations Manual.
For example, a fast food franchisor could find it difficult to win an argument that a
franchisee is in default for failing to follow proscribed recipes if the franchisor has failed
to supply the franchisee and/or franchisee’s employees with contractually mandated
training. If a franchisee is able to prove that a franchisor failed to provide training, or
provided insufficient training, he or she may be excused for not paying royalties.
Franchisee can argue that the franchise business failed to generate sufficient revenues
because the franchisee was inadequately trained.
A franchisor’s failure to provide “support” is, perhaps, more nebulous, and is
often raised in breach of implied covenant actions. This claim generally refers to the
failure of a franchisor to provide assistance that a franchisor, in good faith, ought to
extend to its franchisees.
Examples include the franchisor being consistently
unavailable to answer questions, failing to visit the franchisee’s location, failing to
provide guidance regarding its policies and procedures, or failing to use its bargaining
power with suppliers to negotiate advantageous prices for franchisees, especially of a
required product. “Lack of support” can also include franchisor’s failure to intercede
when a franchisee invades another’s protected territory or failure to be reasonable when
non-compliance under the franchise agreement is the result of an occurrence outside of
franchisee’s control, such as a natural disaster.
19
Several states, including Pennsylvania, Texas, Maine, Indiana, and Arkansas, do not acknowledge
implied covenant claims as independent claims apart from ordinary breach of contract claims. See, e.g.,
McHale v. NuEnergy Group, No. 01-4111, 2002 WL 321797 (E.D. Pa. Feb. 27, 2002); Renaissance Yacht
Co. v. Stenbeck, 818 F. Supp. 407, 412 (D. Me. 1993); Arkansas Research Medical Testing, LLC v.
Osborne, 2011 Ark. 158 (Ark. 2011); Allen v. Great Am. Reserve Ins. Co., 766 N.E.2d 1157 (Ind. 2002);
Formosa Plastics Corp. USA v. Presidio Eng’rs & Contractors, Inc., 960 S.W.2d 41 (Tex. 1998).
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b.
Franchisor Failure to Support the System Generally
If a franchisor fails to address a system-wide issue, franchisees may claim a
breach of the franchise agreement or a breach of the implied covenant of good faith and
fair dealing. Issues that affect the franchise system as a whole may include a
franchisor’s failure to adapt to a change in market conditions (including an unforeseen
increase in a key cost, such as the skyrocketing cost of milk for an ice cream franchise)
or a failure to properly advertise the product or franchise with funds available in
systems’ advertising fund. Franchisee associations are often formed to protect
franchisees system-wide and, depending on the specific issues, may prove useful in
working with the franchisor to resolve issues for the good of the system before litigation
ensues.
2.
Encroachment
Encroachment (sometimes referred to as cannibalization) issues typically arise
when franchisees are granted a “protected territory” and that territory is encroached on
by another franchisee (e.g., advertising for customers in the protected territory) or the
franchisor (e.g., if the franchisor allows another franchisee to open a franchised
business or opens a company business in the protected territory). The crucial inquiry in
these cases is whether or not the franchisee truly has a “protected territory” under the
franchise agreement or is merely trying to protect the franchisee’s “market.” Most
courts hold that unambiguous language denying territorial exclusivity precludes any
20
However, some courts have allowed encroachment claims to
encroachment claim.
proceed notwithstanding a specific denial of territorial rights in the franchise
21
agreement.
Moreover, franchise agreements can be nebulous, unclear, or leave
22
major issues, such as regional advertising or internet distribution, unaddressed.
A franchisor’s legal obligation to intercede on an aggrieved franchisee’s behalf to
stop encroachment by another franchisee varies by jurisdiction and is far from settled.
In such cases, the franchisor can attempt to bring the parties together to reach an
amicable resolution, or caution (or default) the encroaching franchisee (especially in
cases where the franchise agreement clearly prohibits solicitation of customers in
another franchisee’s protected territory). If the franchise agreement is not clear on the
issue, the franchisor can nevertheless argue that the encroachment exceeds the license
20
See, e.g., Barnes v. Burger King Corp., 932 F. Supp. 1420 (S.D. Fla. 1996); Payne v. McDonalds
Corp., 957 F. Supp. 749 (D. Md. 1997).
21
See Scheck v. Burger King Corp., 756 F. Supp. 543 (S.D. Fla. 1991) (denied summary judgment and
allowing implied covenant claim challenging encroachment to proceed after holding that franchise
agreement’s denial of exclusive territory did not give Burger King complete discretion in building new
locations that could affect the plaintiff’s existing restaurant). See also, e.g., Foodmaker, Inc. v. Quershi,
Bus. Franchise Guide (CCH) ¶ 11,780 (Cal. Sup. Ct. Dec. 1, 1999).
22
See, e.g., Pro Golf of Fla., Inc. v. Pro Golf of Am., Inc., No. 05-71380, 2006 WL 508631 (E.D. Mich.
Mar. 1, 2006); Emporium Drug Mart, Inc. of Shreveport v. Drug Emporium, Inc., Bus. Franchise Guide
(CCH) ¶ 11,966 (Sept. 2, 2000) (summary).
- 11 -
rights granted in the franchise agreement to the encroaching franchisee to use the
franchisor’s marks and proprietary systems.
A franchisee may also complain of encroachment based on franchisor’s right to
develop the brand through alternative channels of distribution, including the right to
open the branded business in non-traditional locations, such as malls, airports, gas
stations and the like, even if such locations are within the franchisee’s protected
territory. Many franchise agreements reserve these rights to the franchisor, so the
franchisee’s right to bring an encroachment claim will depend on the specific franchise
agreement provisions. Notwithstanding those provisions, if the franchisor’s actions
have a material detrimental effect on the franchisee’s business, the franchisee may
have a claim for breach of the implied covenant of good faith and fair dealing or tortious
interference of the franchisee’s business relationships.
3.
Unreasonably
Assignment
Withholding
Consent
on
Transfer
or
Franchisees often have the right under a franchise agreement to transfer or
assign their franchise rights to third parties, provided the franchisor approves the
transfer (and the transferee). Most franchise agreements state the franchisor cannot
unreasonably withhold its consent to transfer or assign. Disputes arise if the franchisee
alleges economic damage because the franchisor unreasonably withholds consent or
unreasonably delays approving a transfer, which may cause the potential buyer to back
out of the deal. The franchisor may be subject to claims of breach of contract (express
or implied) or tortious interference with business relationships.
4.
Discrimination or Selective Enforcement
Franchisees often assert claims of “discrimination” or selective enforcement of
the terms of the franchise agreement or Operations Manual. For instance, a franchisee
may believe (perhaps erroneously) that the franchisor is treating him or her more
harshly than other franchisees, or that a particular franchise unit is receiving preferential
treatment. A franchisee may decide to ignore a notice of default because the franchisee
believes another franchisee of which he or she is aware has engaged in the same
practice giving rise to the default, and the franchisor has taken no action with respect to
the other franchisee. However, ignoring a default notice is never a good idea.
Perceived or real discriminatory or preferential actions by a franchisor may give
rise to a claim for breach of contract or breach of the implied covenant of good faith and
fair dealing). They can also be evidence that the breach of a particular agreement
provision is not material (i.e., if the provision is being discriminatorily enforced, the
franchisee may claim that his or her default was imposed in bad faith, or that the
agreement provision was not material).
A franchisor’s selective enforcement of franchise agreement provisions does not,
in most cases, excuse the subject franchisee’s contractual obligations under the
- 12 -
franchise agreement. 23 A franchisee is not entitled to stop paying royalties on the basis
that the franchisor has discriminated against the subject franchisee. The franchisee is
unlikely to be aware of all of the facts and circumstances underlying the varying
treatment of franchisees by the franchisor (e.g., the “other” franchisee is, in fact, in
default of his or her agreement, or the “other franchisee has signed a different form of
franchise agreement than the subject franchisee). In most cases, the franchisee should
be careful to stay in compliance, while at the same time working with the franchisor to
resolve the conduct of which the franchisee is complaining.
5.
Advertising Fund Issues
Most franchisors establish a national advertising fund into which franchisees are
required to contribute (generally, up to 1% to 2% of gross revenues) in addition to
payment of royalties and other fees. These advertising funds are to be used for systemwide marketing and advertising of the brand and franchise system. Usually, the
franchisor disclaims any fiduciary duty to the franchisees with respect to the fund, and
discloses the many and varied uses to which the funds will be applied. Franchisors also
generally disclose that they have no duty to spend advertising fund dollars to directly
benefit any particular franchise unit location or market.
A franchisor’s failure to properly utilize advertising fund contributions, or a
franchisee’s perception (right or wrong) that he or she is not benefiting from advertising,
frequently gives rise to disputes between franchisor and franchisees, especially if a
substantial number of other franchisees share the perception. For instance, franchisees
may claim that franchisor is spending the bulk of advertising dollars in those markets
containing mostly company-owned units or is using funds for non-permitted purposes
(e.g., travel and entertainment). At worst, franchisees may have claims that franchisor
is commingling advertising funds with its own operating funds and using the advertising
funds for unsavory purposes, such as a “slush fund.” Such accusations may give rise to
breach of contract, implied covenant, or fiduciary duty claims.
6.
Quality Assurance Visits/Franchisee Operational Capabilities
Successful franchisors are always concerned with how well (or badly) its
franchisees are performing their obligations, and how the brand is being presented to
the public. Healthy, high-performing units not only generate higher revenue (and
correspondingly higher royalty payments), but may also benefit the franchisor in other
23
See, e.g., Original Great Am. Chocolate Chip Cookie Co. v River Valley Cookies Ltd., 970 F.2d 273,
279 (7th Cir. 1992) (“The fact that the [franchisor] may, as the [franchisees] argue, have treated other
franchisees more leniently is no more a defense to a breach of contract than laxity in enforcing the speed
limit is a defense to a speeding ticket.”); I’mnaedaft, Ltd. v. The Intelligent Office Sys., LLC, No. 08-cv01804-LTB-KLM, 2009 WL 1537975, at *6 (D. Colo. May 29, 2009) (“Simply stated, A enters into identical
contracts with B and C. A’s failure to enforce B’s contractual obligations does not result in a breach of A’s
contract with C. A franchisor’s treatment of other franchisees has repeatedly been held to be irrelevant to
a breach of contract claim brought by another franchisee.”); Dunkin’ Donuts, Inc. v. Romanias, No. 001886, 2002 WL 32955492, at *1 (W.D. Pa. May 29, 2002) (granting motion in limine to exclude evidence
about another franchisee alleged to have engaged in the same conduct in case alleging breach of the
duty of good faith and fair dealing).
- 13 -
ways (e.g., successful franchise units can make it easier for franchisor to sell additional
franchises and also enhance the overall reputation of the brand). Franchisors typically
provide for on-site inspections of franchised units at periodic intervals during the year.
These inspections ensure that franchisees are operating their units in accordance with
franchisor’s systems and standards (as set forth in the franchise agreement or
Operations Manual), a legitimate franchisor concern. It is not uncommon for inspections
to be conducted in accordance with specific checklists or “score sheets” created by the
franchisor, the results of which are shared with the franchisee. Franchisor “best
practices” with respect to quality assurance visits is to utilize the information obtained on
the visit as a coaching opportunity, intended to improve the franchisee’s operational
performance. Maintaining the highest degree of operational compliance is especially
critical in the food industry. Failure to maintain standards related to food preparation
and temperatures not only results in defaults under the franchise agreement (or
termination in the case of repeated or serious non-compliance), but can also effectively
ruin a brand if the failure to maintain standards results in a public health crisis (e.g., food
borne illnesses resulting from unsanitary conditions).
A franchisee may view franchisor actions in connection with a failed quality
assurance visit (e.g., default or termination) as abusive or discriminatory. The
franchisee may believe that the franchisor wants the franchisee out of the system for
reasons not related to systems and standards compliance; for instance, because the
franchisee has been vocal and disruptive in its criticisms of the franchisor. If the
franchisee receives a notice of default, however, the franchisee should review the
notice, the terms of his or her franchise agreement, and the Operations Manual to
ascertain what actions are necessary to cure the default and within what amount of time
he or she must do so. Franchisee should then take steps to cure the default and, if the
franchisee believes that the default was unwarranted or invalid, document the actual
state of his or her operations in order to reserve appropriate defenses in the event of a
continuing dispute or litigation.
A franchisor’s abuse of operational defaults (which may result in termination of
the franchise agreement), or discriminatory treatment among franchisees in connection
with issuing defaults, may give rise to a franchisee claim for breach of contract or
breach of the implied covenant of good faith and fair dealing. Before proceeding to
litigation, however, the franchisee should determine whether or not the Operations
Manual contains a procedure allowing the franchisee to contest or extinguish the
default. If the Operations Manual has been incorporated into the franchise agreement
by reference, the franchisee may claim, based on the facts and circumstances, that the
franchisor has, in fact, breached the agreement by issuing the default. The franchisee
can challenge the default under a number of theories, including: (a) contesting the
inspector’s qualifications to inspect; (b) alleging bias on the part of the inspector; and (c)
claiming that the inspector did not follow franchisor’s “checklist” in conducting the
inspection or ignored the checklist altogether. Any litigation involving the actions or
omissions of an individual inspector may result in the individual being named as an
additional defendant. Certain states or jurisdictions may also have statutes or
- 14 -
regulations governing inspector qualifications and acceptable standards of operation. 24
However, in most circumstances, the franchisee will simply have to challenge the
results of the inspection directly.
Perhaps one of the most important things that a franchisee can do if he or she
intends to contest an operational default is to timely document his or her arguments in a
letter or other written communication to the franchisor (including photos or other
evidence that the default was unwarranted). At a minimum, this will create a “record”
should the dispute result in litigation.
While “selective enforcement” is not usually a good defense to contractual
obligations, it can be persuasive if a franchisee can show that, for instance, the
franchisor has consistently failed to default or terminate operations at company-owned
units that conduct operations substantially in the same way as the defaulted or
terminated franchisee.
If the franchisee believes that the franchisor is abusing its discretion by issuing
unwarranted or inaccurate default notices (or default notices based on patently false
grounds) as a pretext for termination of the franchise agreement, the franchisee should
seriously consider seeking injunctive relief to avoid immediate termination of the
franchise agreement, at least during the pendency of any litigation or arbitration action.
7.
Franchisor Rebates/Required Supplies and Suppliers
Franchisees may defend operational defaults by claiming that identified issues
were caused due to exorbitant expenses, including above-market prices charged by
mandated suppliers. The argument continues that prices are above market because
the franchisor is receiving rebates (or “kickbacks”) from the supplier, which would
otherwise be passed on to the franchisees in the form of lower prices. Franchisees
frequently explore whether a particular supplier relationship has been properly disclosed
to them in franchisor’s FDD. Item 8 of the FDD requires disclosure of any revenues
received by franchisor on account of franchisee purchases (either directly from the
franchisor, or as the result of supplier rebates to franchisor).
Before suing, franchisees who believe they may have a claim related to
undisclosed or improper franchisor/supplier relationships should (a) complain to the
franchisor; (b) identify alternative sources of supply; and (c) submit the alternative
suppliers to franchisor approval. While the franchisor may refuse, the franchisee will
have established a solid evidentiary basis for bringing such a claim or defense.
While there is no private right of action for disclosure violations under the FTC
Franchise Rule, the franchisee may file an action under a state’s Little FTC Act, if
available. The franchisee may also have the right to assert certain common law claims,
such as tortious interference (the argument being that franchisor’s acceptance and
24
For example, see the Texas Department of State Health Services’ Mold Assessment and Remediation
Rules. See www.dshs.state.tx.us/mold.
- 15 -
retention of rebates received from suppliers the franchisor requires its franchisees to
use interferes with the franchisee’s right to contract with suppliers who can supply the
same products or services at lower prices).
8.
Tortious Interference with Business Relationship
Tortious interference with business relationship (either “actual” or “prospective”)
generally takes the form, depending on the jurisdiction, of tortious interference with an
existing contract. However, some states also allow claims for tortious interference with
prospective economic advantage. Each jurisdiction is different. As an example, “to
state a claim of tortious interference with prospective business relations under New
York law, a plaintiff must establish the following elements: (i) the plaintiff had business
relations with a third party; (ii) the defendant interfered with those business relations; (iii)
the defendant acted for a wrongful purpose or used dishonest, unfair, or improper
25
means; and (iv) the defendant’s acts injured the relationship.”
Therefore, depending
on the jurisdiction, a plaintiff may need only a business relationship, and not an actual
contract, in order to pursue a tortious interference claim.
9.
Promissory Estoppel
Promissory estoppel is a cause of action based in equity, not contract, and may
be available as an independent cause of action in certain jurisdictions. According to
Black’s Law Dictionary (8th ed. 2004), “promissory estoppel is the principle that a
promise made without consideration may nonetheless be enforced to prevent “injustice”
if the promisor should have reasonably expected that the promisee would rely on the
26
promise and if the promisee did actually rely on the promise to his or her detriment.”
Though included here under the “Opening and Operations” section, it may also apply to
27
claims arising prior to the parties’ execution of the franchise agreement.
If permitted in the jurisdiction, a franchisee may have a claim for promissory
estoppel under certain circumstances, but it is the exception rather than the rule.
Promissory estoppel is a claim in equity that operates independently of the franchise
agreement. Because of its equitable nature, typical contractual rules of construction,
such as the statute of frauds, and customary contractual provisions in franchise
agreements meant to prohibit claims arising outside the “four corners” of the contract,
such as merger and integration clauses, do not automatically preclude a promissory
estoppel claim. However, these contractual rules of construction and customary
25
Berman v. Sugo LLC, 580 F.Supp.2d 191, 208 (S.D.N.Y. 2008) (citing Scutti Enters., LLC v. Park Place
Entm’t Corp., 322 F.3d 211, 215 (2d Cir. 2003)).
26
In New York, which allows claims for promissory estoppel in the franchise context, the elements of a
claim for promissory estoppel are: (i) a clear and unambiguous promise; (ii) a reasonable and foreseeable
reliance by the party to whom the promise is made; and (iii) injury sustained by the party asserting the
promissory estoppel claim by virtue of that reliance. See NGR, LLC v. Gen. Elec. Co., 807 N.Y.S.2d 105
(N.Y. App. Div. 2005).
27
Promissory estoppel is generally considered a cause of action, not a defense. On the other hand,
equitable estoppel, which is a different doctrine, is generally considered a defense.
- 16 -
contractual provisions should be raised because most jurisdictions strictly construe
promissory estoppel claims (including the reasonable reliance element); absent
exceptional circumstances, most courts and arbitrators find it is not “reasonable” for a
franchisee to rely on, for example, an oral representation when the franchise agreement
contains a “no oral representations” clause and merger clause. Nonetheless, it is a
28
claim that can be effective if available in the relevant jurisdiction.
10.
Unlawful Material Changes to the Franchise Business
Franchise agreements typically reserve to franchisors the right to make changes
to the franchise business model, operational systems and other requirements under the
franchise agreement. It is important that the franchisor have the flexibility to make
changes to the franchise system for the benefit of all franchisees. The vehicle most
commonly used by franchisors to make these modifications is the Franchisor’s
Operations Manual, which provides for detailed information and requirements to which
the franchisees are subject. The franchise agreement will generally provide that
franchisor has the right to make such modifications through the Operations Manual,
which the franchisee acknowledges is incorporated into, and forms a part of the
franchise agreement. Such changes may impact the franchise business operations,
submissions of reports to the franchisor, changes to fees required to be paid to
franchisor, and the like.
A franchisor must, however, use its discretion with respect to such changes. In
some cases, the franchise agreement may provide that modifications cannot materially
burden the franchisee, economically or otherwise. If the franchisor’s changes to the
franchise system are material enough that they may be deemed to have materially
changed the terms of the franchise agreement, the franchisor becomes vulnerable to
claims that it has materially modified the franchise agreement without due
consideration, a claim that, depending on the circumstances, may be difficult to defend.
The franchisee will, however, have to overcome the likely provision in the franchise
agreement providing the franchisor with this right.
28
As an example, in Triology Variety Stores, Ltd. v. City Products Corp., the court, applying New York law
in the context of a franchise agreement, denied the franchisor’s motion to dismiss franchisee’s promissory
estoppel claim. Triology Variety Stores, Ltd. v. City Products Corp., 523 F. Supp. 691, 696 (S.D.N.Y.
1981). The franchisor had made oral promises that “as long as the franchise was in good standing, the
[franchisee’s] sublease [from the franchisor] would be renewed.” Id. at 696. In reliance on this statement,
the franchisee expended $93,000.00 to purchase the business and make capital improvements to the
premises. After 26 months, the franchisor decided not to renew its lease with its landlord (and, in turn,
not renew the franchisee’s sublease), thus terminating the franchisee’s business. The court found that
plaintiffs would not have made their significant investment unless they had reason to believe the
investment was for a longer term than 26 months. Under these circumstances, promissory estoppel could
be alleged.
- 17 -
11.
Franchisee Claim that Franchisor Failed to Provide a Viable
Business Opportunity
The Dunhill case 29, which was referred to above in the context of common law
fraud, is also significant as a “unique case” in which the arbitrator made a determination
against the franchisor that, in connection with a franchisor’s sale of the franchise, the
franchisor’s failure to provide the franchisee with a “viable business opportunity” was
actionable. The arbitrator ultimately concluded, among other things, that a successful
fraud claim could be based upon a finding that the franchisor failed to provide
franchisees with a “viable business opportunity.” The arbitrator found against franchisor
on franchisee’s claim of fraud in the inducement (resulting from franchisor’s omission of
material facts from its disclosure document and marketing materials) and defined the
term “viable business opportunity” as “a proven business model which a new entrant to
the business can employ with the expectation of a reasonable chance at starting and
establishing a successful business, though without any guarantee of success.”
12.
Franchisor Claims for Monetary Default
The most common claim asserted by franchisors is for monetary defaults,
typically the franchisee’s failure to pay royalties, advertising fees, or compensation for
products or services. Claims for nonpayment are generally straightforward breach of
contract claims. The contractual obligation usually is clear and relevant proof and is
readily ascertainable. Further, a franchisee may not withhold royalties or other
30
payments based upon asserted grievances against the franchisor. While a franchisor
could file suit each time a franchisee fails or refuses to pay royalties when due, this is
generally not an efficient or cost-effective strategy. Instead, the process usually
involves a default and, if the default is not cured on a timely basis, the termination of the
franchise agreement.
13.
Franchisor Claims for Non-Compliance
Another common claim by franchisors is that the franchisee failed to comply with
system standards. “Noncompliance” and “operational default” are broad terms ranging
from extraordinarily serious health and safety issues that can put the franchisor’s brand
at risk, to more routine issues ordinarily addressed at the field level. The obligation
relied upon may be contained in the franchise agreement itself, or in an Operations
Manual with which the franchise agreement mandates compliance. The greatest
challenge in supporting an operational termination or obtaining judicial relief based on
noncompliance with standards is creating a clear record of contemporaneous visual or
documented evidence of the obligation, violation, and failure to cure after notice. This
evidence is essential if the matter proceeds to litigation.
29
30
Dunhill Franchisees Trust v. Dunhill Staffing Sys., Inc., 513 F.Supp.2d 23 (S.D.N.Y. 2007).
See, e.g., S & R Corp. v. Jiffy Lube Int’l, Inc., 968 F.2d 371 (3d Cir. 1992).
- 18 -
In handling a particular compliance issue, a consistent and regular process can
31
be critical. While some courts will permit selective enforcement, a franchisee may be
able to successfully argue that termination is pre-textual if similar violations have
previously been ignored or addressed through less drastic measures. The franchisee
may alternatively argue that the violation is not sufficiently “material” to justify
termination if similar violations by other franchisees (or in company-operated locations)
have been permitted to persist. Thus, while situations are unique and perfect
consistency is impossible, a regular process with objective criteria and clear
documentation is usually the best approach.
C.
TERMINATION AND RENEWAL
1.
Renewal
A franchisee’s renewal rights are often critical to a franchisee’s long term
success. Franchisees should be cautious before entering into a franchise agreement
when renewal terms allow franchisors too much latitude to refuse to renew a franchise.
Most franchise agreements provide that, upon renewal, the franchisee will enter
into the franchisor’s then-current form of franchise agreement. When the terms of the
new franchise agreement differ substantially from the original franchise agreement, a
franchisee may have a claim for constructive non-renewal. Essentially, a constructive
non-renewal claim exists if the franchisor has made such significant modifications to the
terms of the existing franchise agreement, without sufficient disclosure of the possibility
of that fact at the time of execution of the original franchise agreement, that the
franchisee has a viable claim for breach of renewal rights. Whether such a cause of
action exists will clearly depend on the provisions involved and the fact pattern.
However, franchisee counsel should closely examine the renewal provisions, the FDD
at the time of a franchisee’s execution, any amendments to the franchise agreement,
and how different the new contract is in its key terms.
2.
Franchisor’s Violation of State Relationship Statutes
While a franchise agreement may allow for termination under certain
circumstances, 16 states have “relationship” laws that alter the franchise relationship by,
inter alia, imposing certain minimum requirements for the proper termination or non32
33
renewal of a franchise. For example, New Jersey’s relationship statute provides that
franchisors must comply with certain notice requirements, and can only terminate, or
choose not to renew, a franchise for “good cause,” regardless of what the franchise
31
See supra note 23.
The states with relationship laws are Arkansas, California, Connecticut, Delaware, Hawaii, Illinois,
Indiana, Iowa, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Washington and
Wisconsin. (The District of Columbia, Puerto Rico, and the Virgin Islands also have statutes that govern
termination of franchises). South Dakota and Virginia's statutes do not directly address termination but
they arguably restrict a franchisor’s discretion to refuse renewal of a franchise.
33
N.J.S.A. 56-10-1, et. seq.
32
- 19 -
agreement provides. Delaware’s relationship statute requires at least 90-days’ notice
34
prior to terminating a franchise, and no termination or non-renewal may be “unjust.”
When faced with a termination or non-renewal dispute, both franchisor and franchisee
counsel should ascertain if a state relationship statute supersedes the provisions of the
franchise agreement and provides additional rights to franchisees.
3.
Termination of Franchise Agreement
Franchise agreements typically spell out what constitutes a default under the
agreement, the applicable cure periods, and, if the default is not cured and the
agreement is terminated, the franchisee’s obligations post-termination. Certain defaults
are not curable; however, Franchisor has the discretion in such cases to provide for a
cure period. In all cases of default, Franchisor has the discretion to waive defaults,
depending on the circumstances. State relationship laws may dictate the specific
acceptable grounds for termination as well as the required cure periods.
a.
Curable Defaults
Many defaults can be cured within a period of time specified in the agreement.
Typically, the franchise agreement will provide for a 10-day (or shorter) cure period for
payment defaults and a 30-day cure period for other curable defaults.
Common curable defaults include:
•
Franchisee’s failure to pay Franchisor (royalties, fees, or other payments to
Franchisor) or failure to pay third parties;
•
Franchisee’s underreporting of royalties, which is more likely to occur in
franchise systems where the franchisees have a duty to “self report” revenues
and royalties;
•
Franchisee’s misuse of Franchisor’s proprietary marks;
•
Operational non-compliance;
•
Unauthorized transfer of the franchise;
•
Franchisee’s default under loans from third parties; and
•
Franchisee’s default of any other provision of the franchise agreement.
b.
Non-Curable Defaults
Certain defaults under the agreement are, by their nature, non-curable; however,
the Franchisor may use its discretion to provide for a cure period or waive the default.
34
See 6 Del. Code §§ 2254, 2552.
- 20 -
Common non-curable defaults include:
•
Franchisee commits fraud in connection with the purchase or operation of the
franchise business or otherwise engages in conduct that impairs (or could
impair) the goodwill associated with franchisor’s marks;
•
Franchisee ceases to operate the franchise business or otherwise abandons
the franchise business for a specified period of time;
•
Franchisee intentionally or negligently discloses to any unauthorized person
franchisor’s proprietary information;
•
Franchisee files bankruptcy (although once filed, franchisor cannot terminate
the franchise agreement because it becomes an asset of the franchisee’s
bankruptcy estate to be discharged in the same manner as other franchisee
assets;
•
Franchisee fails to open his or her franchise business within the time period
specified in the franchise agreement; and
•
Franchisee is convicted of, or pleads no contest or guilty to, a felony, a crime
involving moral turpitude, or any crime or offense that is reasonably likely to
harm or unfavorably affect franchisor’s marks, goodwill, or reputation.
c.
Termination Under Cross-Default Provision
The franchise agreement may also allow termination of the franchise agreement
in the event any other agreement between franchisor and franchisee is terminated,
(e.g., other franchise agreements to which franchisor and franchisee are parties, and
agreements for the payment of money by franchisee to franchisor). Franchisees
typically argue that the failure of one underperforming unit should have no effect on their
other units.
D.
POST-TERMINATION
Common issues that arise once the franchise agreement has been terminated
relate to: (1) franchisees who continue to operate their franchise business
notwithstanding the termination; and (2) franchisees who fail to abide by the posttermination non-compete provisions of their agreements.
1.
Trademark Infringement
In the event a franchisee continues to operate the franchise business after the
franchise agreement is terminated, a franchisor has a claim for trademark infringement
35
under the federal Lanham Act.
The franchise agreement grants the franchisee a
35
15 U.S.C. § 1051, et seq.
- 21 -
license to use the franchisor’s marks and other proprietary systems and assets. This
license terminates upon termination of the franchise agreement. Franchise agreements
containing dispute resolution provisions requiring that the parties arbitrate their claims
against each other will generally also contain an exception to the arbitration requirement
for Lanham Act claims, which a franchisor can pursue in federal court. Perhaps the
most difficult aspect of such claims is obtaining proof sufficient to succeed on the
claims. It is not uncommon for franchisors to enlist the aid of investigatory agencies to
obtain photographs and other proof of continued operation.
That the franchisee is challenging the termination, or has pending claims against
the franchisor, does not give the franchisee the right to use the franchisor’s name and
36
marks without authorization.
In fact, under certain circumstances (including “holding
over” or continuing to use the franchisor’s trademarks after termination), continued use
37
can be deemed counterfeiting.
2.
Post-Termination Covenants Not To Compete
It is not uncommon for former franchisees to continue to operate the same type
of business as the franchise business post termination—a violation of the franchise
agreement’s post-termination non-compete provisions. Competition restrictions are
typically limited as to length of time following termination (or the end of the contractual
term) and geographic scope. These limitations must be reasonable. Alternatively,
some competition restrictions prohibit the solicitation of business from the franchisor or
other franchisees for a specified period. Whether and how a court will enforce a posttermination non-compete provision varies.
In some jurisdictions, non-compete
38
provisions may be rarely enforced (such as California ); in others, “reasonable” noncompete provisions will be enforced. Several states allow courts to modify (or “blue
39
pencil”) an overbroad non-compete provision to make it enforceable.
III.
COMMON DEFENSES
The same affirmative defenses that are available in generic business disputes
are generally available in franchisor-franchisee disputes. In addition to the common
36
See S & R Corp., 968 F.2d at 375 (“a franchisor’s right to terminate a franchisee exists independently
of any claims the franchisee might have against the franchisor... . Once a franchise is terminated, the
franchisor has the right to enjoin unauthorized use of its trademark under the Lanham Act.”); Gorenstein
Enters., Inc. v. Quality Care USA, Inc., 874 F.2d 431, 435 (7th Cir. 1989) (affirming judgment for
franchisor on infringement claim because “once a franchisee has been terminated, the franchisee cannot
be allowed to [continue] using the trademark.”).
37
See, e.g., Century 21 Real Estate, LLC v. Destiny Real Estate Props., No. 4:11-CV-38 JD, 2011 WL
6736060 (N.D. Ind. Dec. 19, 2011) (holding that franchisee’s continued unlicensed use of franchisor’s
trademarks after termination constitutes use of counterfeit marks).
38
See Cal. Bus. & Prof. Code § 16600 (voiding noncompetition agreements in most circumstances).
39
See, e.g., Armstrong v. Taco Time Int’l, Inc., Bus. Franchise Guide (CCH) ¶ 7755 (Wash. Ct. App.
1981) (covenant prohibiting competition for five years post-term throughout the continental United States
was modified to prohibit competition for two-and-a-half years within the franchise territory or any other
franchisee’s territory).
- 22 -
defenses typically raised against default and breach of contract claims, affirmative
causes of action can sometimes be used to excuse performance under the franchise
agreement. Therefore, counsel should consider raising some of his or her client’s
affirmative causes of action (e.g., fraud) as additional defenses, as they may excuse
non-performance or breach.
A.
RELEASE
It is not unusual for a franchisee to sign one or more releases during the course
of the franchise relationship.
Franchisors often request (or require) full and
unconditional releases of all claims the franchisee may then have against franchisor in
exchange for forgiving monetary or operational defaults, for extending a franchisee’s
deadline to open, or for agreeing to allow the franchisee to sell its unit and transfer the
franchise agreement, among other things.
Releases are contracts and, as such, are governed by applicable state law.
40
Generally, a clear and unambiguous release is binding and will be enforced as written.
The scope of the release is governed by its precise language. A release can be
narrowly limited by its terms to claims regarding a specific transaction or can broadly
extend to any and all disputes between the parties arising out of their contracts or
relationship. Further, like any contract, a release must be supported by consideration.
B.
STATUTE OF LIMITATIONS AND CONTRACTUAL LIMITATIONS
PERIODS
Parties can be in a franchise relationship for years before litigation arises. In
these circumstances it is not uncommon for him or her to sue the franchisor for
purported misrepresentations or omissions that occurred before the franchise
agreement was signed. The applicable statute of limitations varies from claim to claim
and state to state. In addition to knowing the length of the statute of limitations, counsel
must determine if it is triggered by the occurrence of purported wrongful conduct or runs
from the date the franchisee knew, or should have known, of the facts giving rise to the
claim (the discovery rule).
A party’s deadline for filing a claim may also be limited by the franchise
agreement. Franchise agreements often contain contractual limitations clauses in
which the parties agree that any suit must be filed within a specified time after the claim
arises, which may be significantly shorter than the otherwise applicable statute of
limitations (e.g., one year). If deemed reasonable, contractual limitations periods are
41
enforceable in many states. One-year contractual limitations periods have been held
42
to be reasonable.
40
See, e.g., Anderson v. Eby, 998 F.2d 858, 862 (10th Cir. 1993); Artery v. Allstate Ins. Co., 984 P.2d
1187, 1191 (Colo. App. 1999); Buttermore v. Aliquippa Hosp., 561 A.2d 733, 735 (Pa. 1989).
41
See, e.g., 42 Pa. Con. Stat. § 5501(a) (authorizing contracting parties to agree in writing to “a shorter
time which is not manifestly unreasonable”); McElhiney v. Allstate Ins. Co., 33 F.Supp.2d 405, 406 (E.D.
- 23 -
C.
CONTRACTUAL MERGER AND INTEGRATION CLAUSES
Like many contracts, franchise agreements frequently contain merger and
integration clauses in which the parties agree that the franchise agreement contains the
entire agreement between the parties and the franchisor is not liable for any oral
representations or commitments made prior to the execution of the franchise
agreement. Franchisors frequently rely on such clauses to successfully bar fraudulent
and negligent misrepresentation claims, though some courts hold that such clauses
43
cannot preclude fraud claims.
D.
UNREASONABLE RELIANCE
Under the laws of most states, a key element of fraud claims is that the plaintiff
reasonably relied to his or her detriment on a purported misrepresentation or omission.
If franchisee bases a fraud claim on purported pre-signing oral misrepresentations,
franchisors frequently argue that the franchisee’s purported reliance was unreasonable.
In addition to merger and integration clauses, franchise agreements may contain a “no
reliance clause” in which the franchisee disclaims any reliance on statements other than
those expressly set forth in the franchise agreement or FDD. In light of such provisions,
franchisors argue it is unreasonable as a matter of law for franchisees to later claim to
have relied on oral statements they had previously explicitly acknowledged and agreed
44
they had not relied on. Reliance on an oral statement is even more unreasonable if it
is directly contradicted by the unambiguous terms of the written franchise agreement or
45
FDD.
Pa. 1999); Grant Family Farms, Inc. v. Colo. Farm Bur. Mut. Ins., 155 P.3d 537, 539 (Colo. App. 2006).
42
See, e.g., Han v. Mobil Oil Corp., 73 F.3d 872, 877 (9th Cir. 1995) (affirming holding that franchise
agreement’s one-year limitations period was reasonable under California law and franchisee’s claims
were time barred); Tri-State Generation & Transmission Ass’n, Inc. v. Union Pac. R.R. Co., No. 08-cv00902-BNB-KLM, 2009 WL 1099013, at *3-4 (D. Colo. April 23, 2009); Lardas v. Underwriters Ins. Co.,
426 Pa. 47, 50, 231 A.2d 740, 741 (Pa. 1967).
43
See, e.g., Cutrone v. Daimler-Chrysler Motors Co., LLC, 160 Fed. Appx. 215, 218 (3d Cir. 2005)
(plaintiffs’ “fraud claim is similarly doomed, as the integration clause in the parties’ 2000 franchise
agreement prevents its assertion”); Student Marketing Group, Inc. v. College P’ship, Inc., 247 Fed. Appx.
90, 99 (10th Cir. 2007) (holding integration clause precluded negligent misrepresentation claim under
Colorado law); C.K.H., LLC v. The Quizno’s Master, L.L.C., No. 04-RB-1164 (BNB), 2005 U.S. Dist.
LEXIS 42347, at *13 n.3 (D. Colo. Mar. 24, 2005) (rejecting a fraudulent inducement claim against
franchisor because “the plain language of the merger clause specifically disclaim[s] any liability for the
very claims plaintiffs seek to pursue.”).
44
See, e.g., Hardee’s of Maumelle, Ark, Inc. v. Hardee’s Food, 31 F.3d 573, 576 (7th Cir. 1994) (holding
that claimed reliance was unreasonable where “plaintiffs signed a release acknowledging that Hardees
‘has not made any statements regarding the profitability of a restaurant to be operated by franchisee.’”);
JM Vidal, Inc. v. Texdis USA, Inc., No. 08 Civ. 6398(CM)(KNF), 2011 WL 347608, at *12-13 (S.D.N.Y.
Feb. 2, 2011) (granting franchisor summary judgment on franchisee’s fraudulent misrepresentation claim
where franchisee warranted in franchise agreement that he did not rely on any representation about
potential success or income of the franchise).
45
See, e.g., Cousins Subs Sys., Inc. v. McKinney, 59 F. Supp. 2d 816, 819 (E.D. Wis. 1999) (holding that
franchisee’s claims based on oral representations of expected annual profits between $250,000 and
- 24 -
E.
ECONOMIC DURESS
Economic duress, a defense rooted in contract which varies by jurisdiction, can
occasionally be used to excuse performance under a franchise agreement. For
example, where the non-breaching party has exerted such a high degree of economic
pressure upon the aggrieved party (usually rising to the level of wrongful or criminal
misconduct) that a reasonable person would succumb to the economic pressure, the
aggrieved party may be excused from performance.
The elements may vary by jurisdiction. Some states (e.g., California) do not
require actual wrongful misconduct, but merely take it into consideration as a factor in
analyzing whether the defense is sufficient to excuse a breach. Other states (e.g.,
46
Connecticut) require that the claim be predicated on unlawful or wrongful acts.
47
Establishing a duress defense is generally a heavy burden. As a practical matter, it is
generally a disfavored defense that applies only when there is significant, and arguably
criminal, wrongdoing by the franchisor, and the franchisee literally has no other option
48
than to accede to the franchisor’s demands.
F.
UNCONSCIONABILITY
Unconscionability
encompasses
two
separate
elements—procedural
unconscionability and substantive unconscionability. Some jurisdictions require that
both be shown in order to establish the defense, while other jurisdictions allow either
49
procedural or substantive unconscionability to function as a defense.
Broadly speaking, procedural unconscionability (the focus of which is the manner
in which the contract was entered into) alleges that the circumstances surrounding the
$500,000 were not actionable where they were “directly contradicted by the written terms of the
agreements … signed”).
46
See, e.g., Perez v. Uline, Inc., 157 Cal. App. 4th 953, 68 Cal. Rptr. 3d 872 (Cal. Ct. App. 2007);
Twachtman v. Hastings, No. CV 9557307S, 1997 WL 433878, at *9 (Conn. Super. Ct. July 23, 1997),
aff'd by 52 Conn. App. 661, 727 A.2d 791 (Conn. App. Ct. 1999) (“The mere fact that a person enters into
an agreement as a result of the pressure of business circumstances, financial embarrassment, or
economic necessity, cannot be the sole basis for a claim of business compulsion or economic duress, nor
can such a claim be predicated on a demand which is lawful or upon the assertion of a legal right, in the
absence of a wrongful act by the party against whom the claim is made that takes undue or unfair
advantage of the situation to coerce him into making the agreement.”).
47
See, e.g., N.Y. State Thruway Auth. v. Level 3 Commc’ns, Inc., No. 1:10-cv-0154 (LEK/RFT), 2012 WL
1085772, at *3-5 (N.D.N.Y. Mar. 30, 2012) (franchisee failed to establish economic duress); Pizzeria Uno
Corp. v. Pizza By Pubs, Inc., No. 09-12015-DC, 2011 WL 4020845, at *6 (D. Mass. Sept. 9, 2011).
48
See, e.g., Rich & Whillock, Inc. v. Ashton Development Inc., 157 Cal. App. 3d 1154, 1159 (Cal. Ct. App.
1984) (courts apply the doctrine of economic duress reluctantly and “only as a last resort to correct
exploitation of business circumstances when conventional alternatives and remedies are unavailing.”)
49
Compare Crippen v. Cent. Valley RV Outlet, Inc., 22 Cal. Rptr. 3d 189, 192 (Cal. Ct. App. 2004)
(California law requires proof of both procedural and substantive unconscionability) with Maxwell v.
Fidelity Fin. Servs., 907 P.2d 51, 59 (Ariz. 1995) (under Arizona law, “a claim of unconscionability can be
established with a showing of substantive unconscionability alone]”).
- 25 -
process of execution or consent were so unfair that consent is vitiated. It is often
characterized as “unfair surprise.”
In such cases courts examine factors influencing: the real and voluntary
meeting of the minds of the contracting party: age; education; intelligence;
business acumen and experience; relative bargaining power; who drafted
the contract; whether the terms were explained to the weaker party;
whether alterations in the printed terms were possible; [and] whether there
50
were alternative sources of supply of the goods in question.
Substantive unconscionability, in contrast, deals with the contractual provision
itself. It examines whether the term would be unconscionable if enforced, and,
51
therefore, examines the relative fairness of the obligations. The purpose and context
of the provision, as well as the effect on the aggrieved party, are examined to determine
whether the provision itself is unconscionable. Essentially, if the term is so lopsided that
a reasonable party would not agree to it, then substantive unconscionability may be
established. Notably, because this claim must be made with respect to one or more
specific contractual provisions, the filing party is not able to escape all of his or her
obligations under the contract.
A typical unconscionability claim can arise with respect to the arbitration or
dispute resolution provisions in a franchise agreement. Arbitration is a “creature of
contract,” and arbitration provisions are generally enforced. There are circumstances,
however, where even an arbitration provision (or elements of it) can be deemed
unconscionable and stricken by the court. For example, a federal District of Arizona
decision found an arbitration “appeal” provision, subjecting the franchisee to a second,
costly, three arbitrator “appeals” process, even if the franchisee won the arbitration, to
be both substantively and procedurally unconscionable.
Any provision in a franchise agreement can be challenged on the grounds of
unconscionability. Franchisee counsel should examine the provision and the context in
which the franchise agreement was executed. The defense may be raised if a
franchisee is relatively unsophisticated, at the time of agreement execution there was
some significant degree of duress or the parties had unequal bargaining positions, and
the provision being enforced will result in unconscionable damage to the franchisee.
Franchise agreements are often presented to franchisees on a “take it or leave it”
basis, and courts sometimes consider them to be contracts of adhesion. Further,
unscrupulous franchisors can exert undue pressure to obtain franchisee’s signature,
and may sometimes tell an aggrieved franchisee that he or she “[doesn’t] really need a
50
Maxwell, 907 P.2d at 58.
See, e.g., Harrington v. Pulte Home Corp., 119 P.3d 1044, 1055 (Ariz. Ct. App. 2005) (noting factors
showing substantive unconscionability include “contractual terms so one-sided as to oppress or unfairly
surprise an innocent party, an overall imbalance in the obligations and rights imposed by the bargain, and
significant cost-price disparity”).
51
- 26 -
52
lawyer” or “must execute today or lose the territory”. Alternatively, an unconscionability
argument is less persuasive if the franchisee is sophisticated and was represented by
counsel, and the subject provision, if enforced, would not be unconscionable.
G.
ACQUIESCENCE, WAIVER, AND LACHES
Acquiescence, waiver, and laches are contractual defenses arising from the
failure of a party to enforce a particular provision of, or rights under, a contract for a
lengthy period of time. The defenses of acquiescence, waiver and laches can,
therefore, be raised by franchisees in certain circumstances to prevent a franchisor from
belatedly raising claims that it could have raised, but chose not to, for a significant
period of time. There are differences to the defenses, and counsel should examine the
law of the particular jurisdiction for exact elements. To paraphrase Black’s, (1)
“acquiescence” is a party’s tacit or passive acceptance, granting an implied consent, (2)
“waiver” is the voluntary relinquishment or abandonment, express or implied, of a legal
right or advantage, and (3) “laches” is an unreasonable delay in asserting a claim that
results in prejudice against the party against whom an obligation is now being
53
These definitions will vary by jurisdiction, although as a practical matter,
enforced.
they are often different sides of the same coin, and practitioners usually raise them
simultaneously, often as one enumerated defense.
The defenses of acquiescence, waiver, and laches may be valid defenses in the
context of a franchisee’s ownership of a domain name that contains the franchisor’s
name or trademark. If terminated from the franchise system, the franchisee may face a
situation where the domain name containing franchisor’s mark is, nevertheless,
essential to business operations. For example, if the franchisor is the fictional
“McBurger,” the franchisee may have, at the time he or she signed the franchise
agreement 10 years previously, purchased the domain name “McBurgerBoston.com.”
Over the years, the franchisee has become identified with the domain name by clients,
vendors, and others, and the domain name is included on franchisee’s emails, and
websites and all of franchisee’s business stationery, marketing materials, and other
documents related to franchisee’s business. Ten years later, upon termination of the
franchise agreement, “McBurger” attempts to enforce the franchise agreement provision
prohibiting franchisee’s continued use of franchisor’s marks. Because franchisor failed
to enforce the prohibition for years, the franchisee may well prevail in an action
regarding the domain name due the defenses of acquiescence, waiver, and laches. (As
discussed above, whether the franchisee could compete against the franchisor in this
scenario—with or without the domain name—will be governed by the terms of any posttermination covenant not to compete.)
In a recent National Arbitration Forum (NAF) Uniform Domain-Name DisputeResolution Policy Proceeding (“UDRP” proceeding), American Express Travel Related
Services, Inc. found itself in just such a quandary. It attempted to enforce contractual
52
See, e.g., Cold Stone Creamery Inc. v. Cindy Kilman et al., D. Ariz. Case No. 2:11-cv-01192-MEA (filed
2011) (franchisor told the franchisee that counsel’s review of the franchise agreement was not needed).
53
See, e.g., Black’s Law Dictionary (8th ed. 2004).
- 27 -
rights to its registered trademark “AMEX,” by commencing a UDRP action against its
former franchisee, Planetarium Travels Inc., to seize the domain name
“planetamex.com,” arguing that its registered trademark “AMEX” was, inter alia, being
used for an improper purpose (i.e., to confuse and misdirect clients of American
54
Express). However, the franchisee had properly registered planetamex.com,” in good
faith and had openly used the domain name for well over a decade. The NAF panelists
found, among other things, that the franchisor had “acquiesced to the use of its AMEX
mark in the [franchisee’s] domain name for at least a period of several years
subsequent to the domain name’s registration.”
Franchisors that fail to enforce their rights for substantial periods of time do so at
their own peril. If a franchisee is sued under a provision the franchisor has failed to
enforce for a long period of time should assess whether he or she has a potential
defense to enforcement based upon acquiescence, waiver and/or laches.
H.
EQUITABLE TOLLING OR EQUITABLE ESTOPPEL
Equitable tolling, which varies by jurisdiction, is a defense to statute of limitations
arguments. The doctrine of equitable tolling “permits a plaintiff to avoid the bar of the
statute of limitations if despite all due diligence he is unable to obtain vital information
55
bearing on the existence of his claim.”
“As a general matter, a litigant seeking
equitable tolling must establish two elements: ‘(1) that he has been pursuing his rights
diligently, and (2) that some extraordinary circumstance stood in his way and prevented
56
57
timely filing.’” Equitable tolling applies only in “rare and exceptional circumstances.”
58
The burden is on the petitioner to demonstrate that equitable tolling is appropriate. A
franchisee can raise an equitable tolling argument if fraud or concealment may have
prevented the franchisee from discovering that he or she possessed a claim. “A district
court can evaluate specific claims of fraudulent concealment and equitable tolling to
determine if the general rule would be unjust or frustrate [a statute’s] purposes and
59
adjust the limitations period accordingly.”
Equitable estoppel is a typical defense to a party’s attempt to enforce a right or
obligation for which the party has previously taken a contrary position. In such case, the
aggrieved party has relied to his detriment on that contrary position and, as a result, will
be damaged should the original right now be enforced. For example, under Washington
law, equitable estoppel requires (1) a statement or act inconsistent with the claim
afterwards asserted; (2) an action by the other party on the faith of that statement or act;
54
See Am. Express Mktg. & Dev. Corp. v. Planet Amex & Blake Fleetwood, NAF Decision, Claim
Number: FA1106001395159 (1/6/2012).
55
Shropshear v. Corp. Counsel of the City of Chi., 275 F.3d 593, 595 (7th Cir. 2001).
56
Bolarinwa v. Williams, 593 F.3d 226, 231 (2d Cir. 2010) (quoting Lawrence v. Florida, 549 U.S. 327,
336 (2007)).
57
Harper v. Ercole, 648 F.3d 132, at *3 (2d Cir. July 26, 2011) (quotations omitted).
58
Boos v. Runyon, 201 F.3d 178, 184-185 (2d Cir. 2000).
59
Katz v. Bank of California, 640 F.2d 1024, 1025 (9th Cir. 1981).
- 28 -
and (3) an injury to the other party if the claimant is allowed to contradict or repudiate
his earlier statement or act. A party claiming equitable estoppel must “be free from fault
in the transaction at issue,” and “must have proceeded in good faith and with clean
60
hands.” Other jurisdictions require an element of fraud or deceit for equitable estoppel
defenses. “Under Florida law, equitable estoppel arises when one party lulls another
party into a disadvantageous legal position. Equitable estoppel presupposes a legal
shortcoming in a party’s case that is directly attributable to the opposing party’s
misconduct. The doctrine bars the wrongdoer from asserting that shortcoming and
profiting from his or her own misconduct. Equitable estoppel thus functions as a shield,
61
not a sword, and operates against the wrongdoer, not the victim.”
I.
ORAL AGREEMENT WITH RELIANCE AND PARTIAL PERFORMANCE
Similar to an equitable estoppel defense, a franchisee may be able to enforce an
oral agreement with a franchisor despite provisions to the contrary in the franchise
agreement. Although jurisdictional requirements vary, generally, the franchisee must
evince partial performance based on the oral promise that is “unequivocally referable to
the agreement.” For example, in an attempt to resolve an ongoing dispute, a franchisor
might agree not to enforce a specific agreement provision or otherwise modify the
franchise agreement (e.g., providing franchisee a rebate on rent, or agreeing to defer or
reduce royalties) and the parties take certain actions in furtherance of that agreement.
In New York, partial performance of an oral agreement to modify a written contract, if
unequivocally referable to the modification, avoids the statutory requirement of a writing.
However, “for performance to be unequivocally referable to the agreement, there must
be no explanation for the parties’ conduct other than performance of the alleged [oral]
agreement.” Therefore, the actions must factually arise solely from the promise that
the franchisee seeks to enforce.
J.
FRUSTRATION OF PURPOSE/IMPOSSIBILITY OF PERFORMANCE
Frustration of purpose or impossibility of performance is a defense that can be
raised by either party if the entire mutual purpose of the contract has been frustrated for
reasons outside the parties’ control. The defense may be available, for example, if a
franchisee is unable to timely open his business because the area surrounding his
intended location has been deemed unfit for construction as the result of hurricane
damage. Or, if a franchisor franchises home health care businesses, a change to state
health care law could make it illegal for franchisees (i.e., anyone other than state
licensed professionals) to perform the services constituting the core business of the
60
Red Lion Hotels Franchising, Inc. v. MAK, LLC, 663 F.3d 1080, 1091-92 (9th Cir. 2011) (franchisee’s
own unchallenged acts of misrepresentation precluded his defense of equitable estoppel because he was
not “free from fault”).
61
See id. (equitable estoppel could not be used by a franchisor to overcome a 4 year statute of limitations
so it could sue for damages because a sign using its mark had been up for years, and franchisor should
have acted sooner to have it removed, despite a verbal assurance that the sign would be removed by
franchisee).
- 29 -
franchise. Such circumstances are clearly outside of either party’s control, and might
allow a party to assert impossibility or frustration as a defense.
It is important to note that the defense is utilized rarely and is not available if the
circumstances are within one of the parties’ control. For instance, a franchisee’s failure
to obtain adequate financing to secure funds to build a location would not give rise to an
62
impossibility or frustration defense. The key to determining whether it can be asserted
is whether or not the entire purpose of the contract has been undermined, such that
neither party can perform.
IV.
REMEDIES
Remedies and damages are the ultimate purpose of litigation. Remedies
available for a given cause of action vary from jurisdiction to jurisdiction and require
research to ascertain which ones are available for specific causes of action.
Prior to moving on to specific areas of damages, however, it is important for a
litigant in the franchise context to consider retaining an expert (early in the case if
possible) in most cases where monetary damages are sought. Oftentimes in franchise
disputes, the damages attributable to a lost franchise require a complex calculation
arising from the loss of the business, or the lost future value/earnings of the franchise.
For franchisors, a common issue that arises is how to valuate a future profit stream, or
quantify lost future royalties, where a franchisee has ceased paying royalties. In order
to satisfy evidentiary requirements concerning whether damage calculations are
sufficiently reliable and quantifiable, it is usually advisable to retain the services of an
expert. Indeed, in many jurisdictions, it is impossible to establish certain categories of
damages (such as lost future profits) without an expert. Damages are usually a
required element of a claim, and cases can be won or lost based on the failure to
properly establish damages.
A.
CONTRACT DAMAGES
Contract damages can be as varied as the nature of the breach for which the
damages are being sought, and the type of damages that result. This is further
complicated by jurisdictional differences in what kinds of damages are available, and
the type of proof necessary to establish them.
62
See e.g. Howard Johnson Int'l, Inc. v. M.D.1, LLC, No. 11 C 2593, 2012 U.S. Dist. LEXIS 151223
(D.N.J., 2012) (To sustain a defense under the doctrine of frustration under New Jersey law it is not
“sufficient to disclose that the ‘purpose’ or ‘desired object’ of but one of the contracting parties has been
frustrated.” It is their common object that has to be frustrated, not merely the individual advantage which
one party or other might have achieved from the contract.). See also, e.g., Pizzeria Uno, 2011 WL
4020845, at *5 (“Defendants’ impossibility defense rests entirely on its assertion that, in 2005, ‘Uno
changed from a franchise whose signature item was the Chicago-style Deep Dish Pizza, to a franchise
selling lobster sandwiches.’ Again, whatever the merits of this assertion ... the doctrine of impossibility
does not excuse Defendants from performing under the note.”)
- 30 -
In a typical franchise agreement, there are usually provisions further limiting the
types of damages available. For example, many franchise agreements contain
provisions limiting damages to “actual” damages, or waiving punitive or exemplary
damages. Counsel should examine the franchise agreement to see whether one or
both of the parties may have modified their right to sue for certain categories of
damages. However, the existence of such a provision is not necessarily preempt a
parties’ ability to sue for those damages. Defenses can be raised, depending upon the
circumstances, to the damages limitation provision. Further, certain jurisdictions may
have statutory limitations on what the parties may agree to in the franchise context, and
therefore, the provision may be unenforceable.
1.
Recovery of Unpaid Amounts
One of the most common causes of action that a franchisor asserts against a
franchisee, or former franchisee, is for the recovery of unpaid amounts due under the
franchise agreement. Typically, this is a claim for unpaid royalties (including recovery of
royalty underpayments resulting from franchisee’s underreporting of sales or revenues),
and advertising or other fees. Normally, this is a “plain vanilla” breach of contract claim,
where the franchise agreement sets forth the obligation and often contains clauses
regarding interest rates, liquidated damages, or additional penalties and fees associated
with non-payment or late payment. In the most simple fact pattern, a franchisor can
make a straight-forward calculation based upon what was not paid, apply any additional
contractual amounts (such as interest), and sue for recovery.
There may be instances, however, where the franchise agreement was poorly (or
too aggressively) drafted, and/or was not drafted in accordance with the specific
jurisdiction’s applicable laws. For instance, a franchisee who is facing exorbitantly high
interest rates, or punitive liquidated damages or penalty provisions, can raise defenses
based upon unconscionability, unfair or prohibited “penalty provisions,” or state usury
statutes (which govern the maximum amount of interest that may be charged on any
particular amount).
Counsel should be aware that some states have powerful usury statutes which
courts may use to invalidate a franchise agreement’s interest provisions. Michigan has
63
a usury statute which prohibits “interest on past due amounts” in excess of 10%. New
64
York has an even more draconian usury statute, which caps interest rates on unpaid
amount at less than 25%; if violated, the entire principal, not just interest, is forfeited.
To avoid the problem, many franchise agreement interest provision provide for the lower
of X% or the “highest legal rate of interest permitted.”
2.
Lost Future Profits
Lost future profits as a category of damages typically arises in a situation where
a franchise has been terminated. A franchisee who was improperly terminated may be
63
64
MCLS § 438.101.
N.Y. Gen Obg. Law § 5-501, et seq.; N.Y. Penal Law § 190.4.
- 31 -
suing for the value of the franchisee’s lost future profits. Alternatively, where a
franchisee prematurely abandons its unit, a franchisor may be able to sue for its lost
future royalties. Lost future profits may be available even if not mentioned in the
65
franchise agreement.
Lost future profits by their very nature are approximations
based upon what a likely outcome would have been. Most jurisdictions recognize that
claims for future damages can be approximations. As stated in a recent New York
case:
[A] degree of uncertainty is to be expected in assessing lost profits. When
the existence of damage is certain, and the only uncertainty is as to its
amount, the plaintiff will not be denied recovery of substantial damages,
although, of course, the plaintiff must show a stable foundation for a
reasonable estimate of damages. An estimate of lost profits incurred
through a breach of contract necessarily requires some improvisation, and
the party who has caused the loss may not insist on theoretical perfection.
It is always the breaching party … who must shoulder the burden of the
66
uncertainty regarding the amount of damages.
It is important to remember that each jurisdiction has its own substantive law on
damages, and the proofs necessary to establish them. Counsel faced with either
proving lost future profits, or defending against such a claim, is likely going to need an
expert to testify.
3.
Liquidated Damages
Liquidated damage provisions are often used in contracts, and occasionally are
used in franchise agreements. These provisions function is to designate a specific
damage amount that the parties mutually agree properly approximates the damage that
will occur if a specified event or breach occurs. (Black’s defines it as “an amount
contractually stipulated as a reasonable estimation of actual damages to be recovered
by one party if the other party breaches”). Sometimes liquidated damages provisions
can be incorporated into ancillary agreements, such as non-compete provisions or
failure to de-identify following the termination of a franchise. One of the overriding
concerns related to liquidated damages is whether the specified amount properly
approximates the potential harm for which they are intended to compensate a party. If
67
excessive, the provision may be voided as a disguised, or functional, penalty.
In
68
Michigan, for example, liquidated damages must be “just and reasonable.”
The
65
Meineke Car Ctrs., Inc. v. RLB Holdings, LLC, 423 Fed. Appx. 274 (4th Cir. 2011) (holding that
franchisor could recover its future profits lost due to franchisee’s abandonment, even though lost future
profits were not mentioned in the franchise agreement).
66
Wathne Imports, Ltd. v. PRL USA, Inc. et al., 953 N.Y.S.2d 7, 11 (N.Y. App. Div. Oct. 18, 2012)
(citations omitted).
67
See Nichols v. Seaks, 296 Mich. 154, 162, 295 N.W. 596, 599 (1941).
68
Id.
- 32 -
overriding applicable principle is whether the suspect provision operates as just
69
compensation.
Another potential liquidated damages issue arises if the provision functions to
provide contractual “monetary relief” as a remedy for breach, making it impossible for a
party to obtain injunctive relief for that same breach. For example, a franchise
agreement may state that after termination the franchisee will be subject to a $1,000 per
day assessment for each day the former franchisee fails to “de-identify” (cease using
the franchisor’s marks), as compensation for improper use of the mark. In these
circumstances, the franchisee may argue that the provision was intended to be just
compensation (for improper use of the marks) and that no injunction need be issued
because the franchisor will suffer no irreparable harm, as evidenced by the parties’
agreement that monetary relief alone fully compensates the aggrieved franchisor. While
this is, in the first instance, a drafting issue in the franchise agreement (and/or a
strategic choice), a liquidated damages provision in this context may have the
unintended consequence of making it difficult to obtain injunctive relief to protect a
trademark or enforce a non-compete provision.
B.
PUNITIVE DAMAGES
Punitive damages (sometimes called exemplary damages) are designed to
punish a party for especially egregious misconduct and deter both the subject party and
future wrongdoers from engaging in similar misconduct. These damages are awarded
in addition to actual damages when a defendant has acted with recklessness, malice, or
deceit. Where available, punitive damages may be limited—they must bear some
relation to the reprehensibility of the conduct being punished and there must be a
reasonable relationship between the harm and the award, and between the award and
70
the civil penalties authorized in comparable cases.
Many franchise agreements contain waivers of punitive damages, and counsel
should determine if one exists, and, if it does, ascertain its enforceability.
There are some jurisdictions and forums where punitive damages are
unavailable or allowed only in certain circumstances. For example, New York law
provides that “there may be a recovery of exemplary damages in fraud and deceit
actions where the fraud, aimed at the public generally, is gross and involves high moral
71
culpability.”
However, New York prohibits an arbitrator from awarding any punitive
damages, and most jurisdictions do not allow recovery of punitive damages for breach
of franchise agreement claims (at least absent some serious misconduct); punitive
69
See Exemplar Manufacturing Co. v. Lear Corp., 331 B.R. 704, 711 (Bankr. E.D. Mich. 2005)
(“liquidated damages are enforceable if they are ‘reasonable’ when viewed in light of several factors; an
‘unreasonably large’ liquidated damages amount is ‘void as a penalty.’”).
70
See BMW of NA, Inc. v. Gore, 517 U.S. 559 (1996).
71
Koufakis v. Carvel, 425 F.2d 892, 907 (2d Cir. 1970) (quoting Walker v. Sheldon, 10 N.Y.2d 401, 405,
179 N.E.2d 497, 223 N.Y.S.2d 488 (1961)).
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damages are generally not recoverable on breach of contract claims and are more
typically assessed in tort actions, such as an action claiming fraud.
C.
SPECIFIC PERFORMANCE
When suing for specific performance, a party essentially asks a court or
arbitration panel to force the breaching party to perform an obligation under the
contract. Specific performance claims generally arise in the franchise context when a
franchisor wishes to compel compliance with a non-monetary component of the
franchise agreement. A franchisor might sue for specific performance to enforce a
franchisee’s post-termination obligation to de-identify, or to force a franchisee to
continue operating a location and pay royalties. Franchisees can likewise use specific
performance to force a franchisor to perform a non-monetary obligation, such as
providing a particular support service to, or enforcing a franchisee’s right under, the
franchise agreement. 72
D.
FRANCHISOR’S RECAPTURE OF THE PREMISES
Franchise agreements often provide the franchisor a right to “recapture” or
“seize” a franchisee’s premises under certain circumstances, including as the result of a
“for cause” termination of the franchise. Some franchise agreements provide the
franchisor with so called “step-in-rights”, allowing the franchisor to “step-in” and operate
the franchisee’s business under certain circumstances. In these cases, franchisor and
franchisee should closely examine their respective rights and obligations under the
franchise agreement.
A recapture remedy can create significant liability for the franchisor if not carefully
exercised. A franchisor should utilize this remedy only after ensuring that it is complying
with the letter of the agreement and is not violating any jurisdictional statutes. Seizing a
franchisee’s premises exposes the franchisor to substantial risks, including liability for
the going concern value of the franchise business if the “recapture” is deemed improper.
Common disputes arising under a recapture scenario relate to the lease for the
premises and the relative rights under the lease of the landlord, franchisee and
franchisor. In addition, disputes can arise over the treatment of equipment, furniture,
fixtures, books, records, and the like located at the premises. For instance, if the
franchisee maintains an office on the premises, including franchisee’s books and
records, franchisor, if not entitled to possession of the books and records, may be
subject to claims for trespass to chattel or conversion of the records. Because litigation
is likely in these cases, the franchisor also has a duty to preserve evidence and will be
subject to spoliation claims if books and records are damaged or destroyed.
72
See, e.g., Schwartz v. Rent A Wreck of Am., Inc., 468 Fed. Appx. 238 (4th Cir. 2012) (franchisee sued
franchisor for specific performance to enforce implied franchise rights to exclusive territory).
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E.
RESCISSION AND RESTITUTION
Rescission or restitution damages are designed to place an aggrieved party in
the position that he or she would have been in prior to contracting with another party; in
essence, to “un-do” the contract and return the parties to the status quo.
If violated, certain franchise statutes provide for rescission and/or damages as
73
remedies. For example, New York’s franchise law governing offers and sales of
franchises and franchisor’s duties with respect to disclosure and registration, entitles a
franchisee to either or both remedies if franchisor’s violations are “material” and “willful”.
In other jurisdictions, the parties are forced to elect between rescission and damages.
Still others may combine rescission into one remedy or define “returning the party to the
status quo” to include an award of damages sufficient to return the party to the status
quo.
A recent case, 3801 Beach Channel, Inc. et al v. Shvartzman et al., awarded
(and explained) rescission and damages as follows:
Rescission is an equitable remedy “to be invoked only when there is
lacking [a] complete and adequate remedy at law and where the status
quo may be substantially restored[.]” Rudman v. Cowles Commc’ns, 30
N.Y.2d 1, 280 N.E.2d 867, 874, 330 N.Y.S.2d 33 (N.Y. 1972). When a
contract is rescinded, its “effect is to declare the contract void from its
inception and to ... restore the parties to status quo.” Symphony Space v.
Pergola Props., 214 A.D.2d 66, 631 N.Y.S.2d 136, 144 (App. Div. 1995)
(internal quotation marks omitted).
New York law now provides that, “[i]n an action for rescission[,] or based upon
rescission[,] the aggrieved party shall be allowed to obtain complete relief in one action,
74
including rescission ... and damages to which he is entitled because of such fraud.”
F.
INJUNCTIVE RELIEF
Injunctive relief is typically “emergency relief” requesting a court to preserve the
status quo while the parties’ respective rights are being determined. “The purpose of a
preliminary injunction is to preserve the relative positions of the parties until a trial on
75
the merits can be held.”
The standard for obtaining an injunction varies depending on the jurisdiction.
However, most have very similar requirements. For example, the Sixth Circuit has
described its standard as follows:
73
N.Y. Gen. Bus. Law § 680, et seq.
N.Y. C.P.L.R. § 3002(e). See 3801 Beach Channel, Inc. et al v. Shvartzman et al, 05-CV-0207
(CBA)(JO), 2010 WL 6471990 (E.D.N.Y. Sept. 30, 2010) (franchisee awarded rescission and damages).
75
Univ. of Texas v. Camenisch, 451 U.S. 390, 395 (1981). Civil preliminary injunction in federal court are
governed by Fed. R. Civ. P. 65.
74
- 35 -
In exercising its discretion to grant a preliminary injunction, … the district
court must consider four factors:
1)
Whether the plaintiff has shown a strong or substantial
likelihood or probability of success on the merits;
2)
Whether the plaintiff has shown irreparable injury;
3)
Whether the issuance of a preliminary injunction would
cause substantial harm to others;
4)
Whether the public interest would be served by issuing a
preliminary injunction.
Although these four factors guide the discretion of the district court, they
do not establish a rigid and comprehensive test for determining the
appropriateness of preliminary injunctive relief. A fixed legal standard is
76
not the essence of equity jurisprudence....
In cases where an injunction cannot be issued quickly enough to protect a party’s
rights, the party may apply for a temporary restraining order (“TRO”). In federal civil
actions, a TRO issues pursuant to Federal Rule of Civil Procedure 65(b), which states in
relevant part:
Temporary Restraining Order; Notice; Hearing; Duration. A temporary
restraining order may be granted without written or oral notice to the
adverse party or that party’s attorney only if (1) it clearly appears from
specific facts shown by affidavit or by the verified complaint that
immediate and irreparable injury, loss, or damage will result to the
applicant before the adverse party or that party’s attorney can be heard in
opposition, and (2) the applicant’s attorney certifies to the court in writing
the efforts, if any, which have been made to give the notice and the
reasons supporting the claim that notice should not be required.
An injunction can be a powerful means of obtaining relief or preventing great
harm. Franchisors commonly use federal injunctive relief in order to protect their marks.
If the violation is sufficient and is coupled with a Lanham Act claim, an injunction can,
and is often, the first and best weapon in a franchisor’s arsenal.
77
Although less common, franchisees may seek injunctive relief in order to
prevent non-renewal of a franchise agreement or prevent the franchisor from imposing
upon franchisee performance standards he or she believes are unreasonable. Most
frequently, however, franchisees seek injunctive relief to prevent the franchisor from
76
See, e.g., Friendship Materials, Inc. v. Michigan Brick, Inc., 679 F.2d 100 (6th Cir. 1982).
Typically, franchisees are permitted to bring such motions in court despite the fact that the franchise
agreement has a broadly stated arbitration provision in its dispute resolution clause.
77
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terminating the parties’ franchise agreement. For example, the franchisee may contend
that: (i) the franchisor does not have the requisite “good cause” in order to effectuate a
termination (which rights are sometimes afforded to franchisees under franchise
statutes); (ii) the franchisor has not complied with proper contractual and/or statutory
notice provisions in trying to effectuate a termination; or (iii) the alleged default(s)
referenced in a notice from the franchisor are wrong, inappropriate or otherwise
78
unjust.
If a franchisee desires to prevent termination by the franchisor (at least through
the period during which any dispute will be litigated or arbitrated), it may have no choice
but to file for injunctive relief. The franchisee should act quickly; the “status quo” (i.e.,
continuing to operate the franchise business in the franchise system) becomes moot
once the franchise agreement is terminated. Upon termination, the franchisee’s sole
remedy is to file a claim for damages.
G.
ATTORNEYS’ FEES
The default “American Rule” regarding (attorneys’) fees is that each party must
bear its own attorneys’ fees and costs. However, in the franchise context, the parties
often contractually agree to fee shifting within the franchise agreement. Sometimes, the
agreement can be “one-sided,” e.g. the franchisor, if successful in bringing an action
may recover its fees and costs, but the franchisee may not. The enforceability of such a
provision may be subject to challenge, but counsel should review the franchise
agreement at the outset of litigation, as the potential for fee shifting may guide a party’s
strategy, and determine whether a matter is worth pursuing or fighting.
There are also many franchise relationship statutes and franchise disclosure
statutes that provide for fee shifting (the award of attorneys’ fees and costs), so counsel
should also be aware that when such a statute is involved, an award of attorneys’ fees
and costs may also be assessed. Fee shifting provisions, as a practical matter, may be
determinative of whether it makes “good sense” to attempt to negotiate a settlement, or
pursue a party’s rights through a full-blown litigation.
78
Franchisors are usually required under their franchise agreement to provide the franchisee with written
notice of default when the franchisor believes that the franchisee is in breach of the agreement. This
“cure notice” is typically sent by certified mail or by overnight delivery and is a predicate for a second,
later notice of termination to the franchisee. Alternatively, the franchisor sometimes sends the franchisee
written notice that it is terminating the franchise agreement effective “x” days later based upon some
“incurable” alleged default of the franchise agreement (such as intentionally submitting false reports,
transferring or attempting to transfer its interest in the franchise or the franchise agreement without the
written consent of the franchisor, or being convicted of, or pleading guilty to, a felony or other crime which
reflects poorly upon the goodwill or trademarks of the franchisor or its system.
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V.
PROCEDURAL ISSUES
A.
VENUE OR FORUM
Where to file suit is one of the critical decisions a franchisor or franchisee faces
before filing suit. A plaintiff must decide which state to file suit in, and whether to sue in
state or federal court. In many situations, the franchisor and franchisee are not located
in the same state. Normally, each party will prefer to litigate in its home state. On the
other hand, upon being sued, a defendant must promptly decide whether to remove a
case to federal court (if it was filed in state court) or whether to seek a transfer to the
defendant’s home state. Often these decisions are guided by a forum selection clause
in the franchise agreement. Because where a case is heard can greatly impact all
subsequent proceedings, forum issues can lead to significant motions practice, can
result in races to the courthouse, and can prompt or affect a party’s settlement position
based on their view of the court’s venue decision.
1.
State or Federal Court
When filing suit, a franchisee or franchisor must decide whether to sue in state or
federal court. State courts are courts of general jurisdiction; that is, subject to some
specific exceptions, they have jurisdiction over almost all types of claims and cases.
Federal courts, on the other hand, are courts of limited jurisdiction. A case can only be
brought in federal court if it involves a federal cause of action or there is diversity of
79
citizenship.
Federal question jurisdiction under 28 U.S.C. § 1331 requires that the action
“aris[e] under the Constitution, laws, or treaties of the United States.” A claim “arises
under” federal law only if “a right or immunity created by the constitution or laws of the
80
United States is an essential element of the plaintiff’s cause of action.”
The federal
claim must appear on the face of the plaintiff’s well-pleaded complaint; the fact that a
defendant bases a counterclaim or affirmative defense on federal law is not sufficient.
The most common federal question in franchise disputes involves claims of trademark
infringement under the federal Lanham Act, though franchisees sometimes bring federal
antitrust or RICO claims against franchisors.
Parties also can have their case heard in federal court if the case meets the
requirements for diversity jurisdiction under 28 U.S.C. § 1332. Section 1332(a) provides
for federal jurisdiction when the amount in controversy exceeds the sum or value of
$75,000, exclusive of interest and costs, and the dispute is between “citizens of different
81
States.”
In order to satisfy the diversity requirements, there must be “complete
diversity” between the parties: all plaintiffs must be from states that are different from all
79
U.S. Const. art. III, § 2, cl. 1.
Gully v. First Nat’l Bank, 299 U.S. 109, 112 (1936).
81
28 U.S.C. § 1332(a).
80
- 38 -
82
defendants.
The anticipated value to the plaintiff or cost to the defendant of an
injunction or declaratory judgment can be considered in determining the amount in
83
controversy. The complaint must clearly set forth the grounds for federal jurisdiction.
Presuming federal jurisdiction is available, several strategic concerns influence
whether a litigant prefers state or federal court. Considerations include the perception
of local bias, the pace of the litigation docket, judicial competence, jury pool differences,
more appealing procedural rules, standards for admissibility of expert testimony, and
the extent of judicial pretrial involvement. Franchisees often perceive state court judges
as more favorable to their claims and as less likely to grant dispositive motions, and the
standard for admissibility of expert testimony is more lenient in several states than in
federal court. Also, discovery and other pretrial procedures are generally less costly in
state court. On the other hand, franchisors often believe federal courts are more likely
to scrutinize a case and dismiss weak claims. Before filing suit, the franchisor or
franchisee, as the case may be, should consult with local counsel to gather information
about the contemplated forum.
2.
Removal to Federal Court
If a case is filed in state court, it may be removed to federal court by the
defendant as long as the federal court would have had original jurisdiction over the
84
case. That is, a defendant can remove a case to federal court if one or more of the
plaintiff’s claims arise under federal law, or if there is complete diversity of citizenship
and the amount in controversy exceeds $75,000. However, even if there is complete
diversity of citizenship, a case may not be removed if any of the defendants is citizen of
85
the state in which the lawsuit was filed.
There are a number of technical requirements for removing a case to federal
court. The notice of removal must be filed within 30 days after the defendant is served,
or otherwise receives a copy of, the complaint, all defendants must join in or consent to
removal, and the notice of removal must state the grounds for the federal court’s
86
jurisdiction.
Because the removing defendant bears the burden of proving all
necessary jurisdictional facts, the defendant should be very diligent where federal
jurisdiction is not clear from the face of the plaintiff’s state court complaint. For
example, if the complaint does not request specific damages, the removing defendant
must show that the $75,000 jurisdictional threshold is met. A forum selection clause
82
See Strawbridge v. Curtiss, 7 U.S. 267 (1806). The Class Action Fairness Act relaxed the complete
diversity requirement for some class actions. Federal courts have diversity jurisdiction over multi-state
actions involving aggregate claims of over $5 million where there is minimal diversity. 28 U.S.C. §
1332(d).
83
The importance of properly alleging jurisdiction is illustrated by Dunkin’ Donuts Franchising LLC v.
Komal Int’l, Inc., No. 08-61483-CIV, 2008 WL 4809860 (S.D. Fla. Oct. 28, 2008).
84
28 U.S.C. § 1441.
85
28 U.S.C. § 1441(b)(2).
86
28 U.S.C. § 1446.
- 39 -
87
requiring suit in state court can prevent removal of an otherwise removable case. If a
case is improperly removed, the plaintiff may seek to remand the case to the state court
in which it was originally filed, and the court may award costs and attorneys’ fees to the
88
plaintiff if there was no basis for removal.
3.
Forum Selection Clauses
Many franchise agreements contain forum selection clauses that specify where
disputes may or must be litigated. Such provisions generally designate the state or
federal court (or either) in the franchisor’s home state as the exclusive forum. However,
some franchise agreements authorize certain types of claims, such as trademark
infringement or post-termination non-compete claims, to be filed in the franchisee’s
home state. The reason for this exception to the general forum selection clause is the
belief that it will be easier and faster for a franchisor to enforce an injunction issued by a
court in the franchisee’s home state. Though not uniform, most courts will enforce
forum selection clauses. Forum selection clauses in franchise agreements frequently
give rise to a variety of disputes, including (1) whether the clause is mandatory or
permissive, (2) whether the clause covers the claims at issue, and (3) whether the
clause is enforceable. Parties should review any forum selection clause in the franchise
agreement before filing suit.
a.
Mandatory or Permissive Forum Selection Clauses
Forum selection clauses come in two basic types: permissive and mandatory. A
permissive clause authorizes the parties to file suit in a designated forum and
preemptively waives both parties’ objections to personal jurisdiction and venue in the
preferred court, but does not prohibit them from filing suit elsewhere. On the other
hand, a mandatory forum selection clause dictates the exclusive forum for litigation. As
discussed below, most courts will enforce mandatory forum selection clauses.
b.
Scope of Forum Selection Clauses
Forum selection clauses can be drafted narrowly, applying only to specific types
of claims, or can encompass all claims arising under or relating to the franchise
agreement or the parties’ franchise relationship. Courts typically will interpret a broad
forum selection clause to cover both contract and tort claims that arise out of or
implicate the parties’ relationship or the franchise agreement in any way. Since most
franchisors draft their forum-selection clauses as broadly as possible to cover all
conceivable types of claims, litigation over the scope of forum selection clauses is
relatively rare. One scope issue that does rise with some frequency, however, is
whether the franchise agreement’s forum selection clause applies to claims arising
under a guarantee, lease, or other ancillary agreement between the parties, that does
not contain its own forum selection clause. Resolution of this issue turns on the intent
of the parties.
87
88
See Milk ‘N’ More, Inc. v. Beavert, 963 F.2d 1342, 1346 (10th Cir. 1992).
28 U.S.C. § 1447(c).
- 40 -
c.
Enforceability of Forum Selection Clauses
Forum selection clauses “are prima facie valid and should be enforced unless
enforcement is shown by the resisting party to be ‘unreasonable’ under the
89
circumstances.”
Federal law recognizes only three exceptions to enforceability: (1)
the inclusion of the forum selection clause in the agreement was the result of fraud or
overreaching; (2) the party challenging enforcement will, for all practical purposes, be
deprived of its day in court because of the inconvenience or unfairness of the selected
forum; or (3) enforcement of the forum selection clause would contravene a strong
90
public policy of the forum state.
It is rare for a franchisee to successfully invalidate a forum selection clause on
the basis of fraud. First, the purported fraud must be directed to the provision itself and
91
not merely to the underlying franchise agreement.
Second, the language of an
unambiguous forum selection clause will usually defeat a franchisee’s claim that the
franchisor misrepresented the clause.
It is also difficult for franchisees to show they would lose their day in court if
forced to litigate in the designated forum. The franchisee must essentially show that it
cannot afford to litigate its claims in the contractually chosen forum, but that it can afford
to litigate its claims if the case proceeds in the forum where the case was filed.
Depending on where the case was filed, franchisees have had success
challenging forum selection clauses on the ground that they contravene a strong public
policy of the franchisee’s home state. Approximately 15 states, including California,
Illinois, Michigan, Minnesota, and Rhode Island, have franchise statutes or regulations
that render void a provision in a franchise agreement requiring the franchisee to litigate
92
certain claims in an out-of-state forum. Franchisees have successfully relied on these
types of statues and regulations to nullify forum selection clauses requiring them to
93
Such statutes and regulations do
litigate in an out-of-state franchisor’s home state.
not necessarily guarantee a franchisee an in-state forum, but, depending on where the
case is filed, they may make it more difficult for the franchisor to enforce the forum
selection clause. For example, if a California franchisee files suit in California,
California law will likely preclude the franchisor’s attempt to enforce a non-California
89
M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 10 (1972).
Id. at 18.
91
Marano Enters. of Kansas v. Z-Teca Restaurants, L.P., 254 F.3d 753, 757 (8th Cir. 2001); Moses v.
Bus. Card Express, 929 F.2d 1131 (6th Cir. 1991).
92
Many such state statutes either explicitly do not apply to forum selection clauses contained in
arbitration agreements or are preempted by the Federal Arbitration Act. The Supreme Court has made
clear that state attempts to restrict enforcement of arbitration agreements according to their express terms
violates the FAA and the Constitution’s Supremacy Clause. Southland v. Keating, 465 U.S. 1 (1984).
93
See, e.g., Jones v. GNC Franchising, Inc., 211 F.3d 495, 498 (9th Cir. 2000) (finding strong public
policy through California statute which voided “any clause in a franchise agreement limiting venue to a
non-California forum for claims arising under or relating to a franchise located in the state”).
90
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94
venue clause. On the other hand, if the franchisor files first in the designated forum,
then the forum court is less likely to defer to the public policy of a different state.
4.
Transfer of Venue
For the convenience of the parties or witnesses, and in the interest of justice, a
federal court may transfer a case under 28 U.S.C. § 1404(a) to another federal court
where the case could have been brought or to where all parties consent. The propriety
of a transfer frequently arises in franchise litigation when a party files suit in a court
other than the court specified in the franchise agreement’s forum-selection clause.
Though not dispositive, the presence of a mandatory forum selection is “a significant
factor that figures centrally in the district court’s calculus.” Generally, it is the movant’s
burden to show there should be a change of venue under § 1404(a); however, once a
mandatory forum selection clause is deemed valid, the burden shifts to the plaintiff to
demonstrate exceptional facts that justify disregarding the contract. Some courts,
particularly those in California, have found that state franchise laws that protect a
franchisee’s right to an in-state forum exhibit a public policy that outweighs the parties’
contractual venue choice. Since § 1404(a) governs transfers, state franchise laws
guaranteeing franchisees an in-state forum are not determinative, but are a factor to be
considered. Other factors that impact the § 1404(a) analysis are whether the movant is
attempting to enforce or escape the designated venue, whether the franchisee is relying
on the law and public policy of the forum court or the requested destination court, and
where witnesses, particularly third party witnesses, are located.
B.
CHOICE OF LAW
Franchise agreements frequently contain choice-of-law provisions selecting the
franchisor’s home state law as the governing law. Franchisors do this for several
reasons, including the desire for national uniformity and predictability, familiarity with
their home state’s law, and the desire to avoid some states’ pro-franchisee laws. Most
choice-of-law disputes in the franchise context involve either the scope of the clause or
its enforceability in the face of a contrary public policy of the franchisee’s home state.
1.
Enforceability of Choice-of-Law Clauses
Choice-of-law clauses will generally be enforced in most jurisdictions unless (1)
there is no reasonable basis for the parties’ chosen law, or (2) application of the chosen
law would violate a fundamental public policy of the state with the greater interest in the
determination of the issue. Restatement (Second) of Conflicts of Laws § 187.
Because most choice-of-law clauses in franchise agreements designate the law
of the franchisor’s home state, it is relatively rare for a choice-of-law clause to be
challenged on the ground that it does not bear a reasonable relationship to the parties’
agreement. Even where a franchisor subsequently relocates its headquarters to a
different state, courts will generally still enforce the choice-of law clauses, either
94
Id.
- 42 -
because a reasonable relationship to the parties’ agreement existed at the time of
contracting or because there is a reasonable basis (i.e. uniformity) for the parties to
choose one state’s law to govern their relationship. 95
Most challenges to choice-of-law clauses in franchise agreements argue that the
clause violates a strong public policy of the franchisee’s home state, most often
embodied in a state franchise disclosure or relationship statute. Many of these statutes
address the enforceability of choice-of-law clauses. Some do so directly, by declaring
void and unenforceable choice-of-law clauses that specify the application of another
96
state’s law.
Others do so indirectly, by invalidating any provision in a franchise
agreement that purports to require a franchisee to waive any of the protections of the
97
statute. Such anti-waiver laws may void a franchise agreement’s choice-of-law clause
if the franchisee would otherwise lose the protections of its home state’s franchise
98
relationship or disclosure law. On the other hand, some courts have observed that an
anti-waiver provision in a state franchise or dealership statute does not necessarily
99
evidence a strong public policy sufficient to override a choice-of-law clause. Further, a
franchisor may be able to enforce the choice-of-law as to most issues by conceding that
100
certain non-waivable state relationship or disclosure law claims remain.
2.
Scope of Choice-of-Law Clauses
Presuming a choice-of-law clause is enforceable, the issue will be whether it
extends to all claims and issues in the litigation. A choice-of-law clause can be narrow,
providing, for example, only that the franchise agreement will be “interpreted” under the
chosen state’s laws or that the designated law will apply to disputes “based on” or
“arising under” the franchise agreement. On the other hand, a choice-of-law clause can
be broad, requiring the franchise agreement to be “interpreted, governed by, and
construed in accordance with” the designated law” or designating the chosen law to
95
In 1-800 Got Junk?LLC v. Superior Court of Los Angeles County, 116 Cal.Rptr.3d 923 (Cal. Ct. App.
2010), a California state appellate court enforced a Washington choice-of-law clause in an agreement
between a Canadian franchisor and a California franchisee, even though neither of the parties nor their
agreement had any contact with Washington, finding a reasonable basis for selection of the law of the
closest to the franchisor’s Canadian headquarters. Interestingly, it was the franchisor who was seeking to
avoid the choice-of-law clause in order to take advantage of more favorable California law.
96
See, e.g., R.I. Gen. Laws § 19-28.1-14.
97
See, e.g., Cal. Bus. & Prof. Code § 20010; Ill. Comp. Stat. § 705/41.
98
See, e.g., Volvo Constr. Equip. N. Am., Inc. v. CLM Equip. Co., Inc., 386 F.3d 581 (4th Cir. 2004).
99
Id.
100
See, e.g., Smith v. Paul Green Sch. of Rock Music Franchising, LLC, No. CV 08-00888 DDP (MANx),
2008 WL 2037721, at *5 (C.D. Cal. May 5, 2008) (“Given [franchisor’s] concession that the Pennsylvania
forum is required to apply the CFIL under conflict of law principles, the Court finds that [the franchise
agreement’s] forum selection and choice of law provisions are enforceable because [franchisee’s] nonwaivable substantive rights under the CFIL will not be undermined.”); Cottman Transmission Sys., LLC v.
Kershner, 492 F.Supp.2d 461, 467-71 (E.D. Pa. 2007) (allowing franchisee’s claims under California
Franchise Investment Law to proceed despite Pennsylvania choice of law provisions, but applying
Pennsylvania law as to all other claims).
- 43 -
govern all disputes between the parties, including any disputes arising under, related to,
or concerning the franchise agreement or the parties’ relationship.
C.
ASSOCIATIONAL
ACTIONS)
STANDING
(FRANCHISEE
ASSOCIATION
Sometimes franchisee counsel desires to bring claims against the franchisor in
the name of a franchisee association whose members have pooled their resources,
rather than bringing individual actions by separate franchisees. However, counsel for
franchisees have often been frustrated by court decisions in this area.
An association, such as a franchisee association, has standing to sue on behalf
of its members only if it satisfies the three-prong test articulated by the U.S. Supreme
Court in Hunt v. Washington State Apple Advertising Commission: (i) its members
would otherwise have standing to sue in their own right; (ii) the interests it seeks to
protect are germane to the organization’s purpose; and (iii) neither the claim asserted
nor the relief requested requires the participation of individual members in the
101
lawsuit.
In order to satisfy the first prong of the Hunt case, the association must
prove that at least one of its members satisfies each of the three prongs. A failure to
identify any specific member of the association that has already suffered or will
imminently suffer “injury in fact” is fatal to a claim of associational standing. A
franchisee association will not have standing when only a handful of association
102
members would benefit from the lawsuit. Since Warth v. Seldin, courts have routinely
rejected associational standing where the association advances claims based on
alleged breaches of their members’ franchise agreements.
Some courts, however, have allowed franchise associations to pursue claims
against the franchisor. For example, in National Franchisee Association v. Burger King
103
Corp.,
a federal district court held that the franchisee association had association
standing to seek a declaratory judgment that Burger King did not have the right to set
the maximum price franchisees could charge for hamburgers. Though ultimately
holding that Burger King had the right to do so, the court found that the association had
standing because the complaint alleged that at least one member would suffer injury
from the setting of the maximum price and because the court could interpret the
“unambiguous” provision of the franchise agreement as a matter of law without
participation of each individual franchisee.
Even if associational standing is otherwise present, a lawsuit by a franchisee
association will generally be precluded where its members agreed in their franchise
agreements to arbitrate their disputes against the franchisor. Courts have been
unwilling to permit franchisee associations to do “an end run” around its members’ duty
101
432 U.S. 333, 342 (1977).
See Warth v. Seldin, 422 U.S. 490, 515 (1975) (dismissing suit by association because “whatever
injury may have been suffered is peculiar to the individual member concerned, and both the fact and
extent of injury would require individualized proof).
103
715 F.Supp.2d 1232 (S.D. Fla. 2010).
102
- 44 -
104
to arbitrate.
Whether or not a franchisee association may arbitrate on behalf of its
members may be an issue for the arbitrator to decide based on the language of the
105
franchise agreement and arbitration provision.
D.
CLASS ACTIONS
A class action is a form of lawsuit in which a group of individuals (or entities)
collectively bring a claim to court or arbitration, and/or in which a class of defendants is
being sued. The class is typically represented by a single or a few individuals for the
benefit of the class. Federal Rule of Civil Procedure 23 sets forth the rules and
procedures for class litigation. There are several prerequisites that a collective group
106
must meet in order to successfully bring a class action lawsuit in court.
Franchise agreements sometimes prohibit franchisees from joining together to
sue the franchisor in a class or collective action. The enforceability of such class action
bars or waivers remains an open question. Two of the leading decisions, which
reached opposite results, came out of the Quiznos system. The Quiznos franchise
agreement explicitly bars class actions or consolidation. In Bonanno v. Quizno’s
107
Franchise Co.,
the federal court in Colorado denied franchisees’ motion for class
certification based on the franchise agreement’s class action bar. The court concluded
that class certification is a procedural tool and not a substantive right, it was plaintiffs’
burden to prove the class action bar was not enforceable, and the class action bar was
not unconscionable. A few months later, another federal court, analyzing the identical
contractual provision in the Quiznos franchise agreement, reached the opposite
conclusion. Reasoning that private parties cannot constrain a federal court’s application
of its own rules, the Western District of Pennsylvania held in Martrano v. Quizno’s
108
that the franchise agreement’s class action and consolidation bars
Franchise Co.
104
See Doctor’s Assocs., Inc. v. Downey, No. 3:06-cv-1170 (D. Conn. Feb. 28, 2007); and NIACCF v.
Cold Stone Creamery, Inc., No. 12-20756-Civ., 2012 1852941 (S.D. Fla. May 21, 2012).
105
In Fantastic Sams Franchise Corp. v. FSRO Ass’n Ltd., 683 F.3d 18 (1st Cir. 2012), the First Circuit
affirmed a decision denying a franchisor’s petition to compel individual arbitrations where a franchisee
association initiated arbitration on behalf of its members. Noting differences regarding arbitration in
different franchise agreements, the court held that whether the franchise agreements allowed for an
associational claim was left to the arbitrator.
106
To obtain class certification, a plaintiff must establish both all four elements of Rule 23(a)—numerosity,
commonality, typicality, and adequacy of representation—and that the case falls within one of the three
categories of suits set forth in Rule 23(b). Under Rule 23(b), a class action may be maintained if (1)
prosecuting separate actions would create a risk of inconsistent or varying adjudications leading to
incompatible standards of conduct for the party opposing certification, or individual adjudications would
substantially impair or impede the ability of non-parties to protect their interests; (2) the party opposing
certification has acted or refused to act on grounds that apply generally to the class, so that injunctive or
declaratory relief is appropriate for the class as a whole; or (3) common questions of law or fact
predominate over any questions affecting only individual members and a class action is superior to other
available methods for fairly and efficiently adjudicating the controversy.
107
No. 06-cv-02358-CMA-KLM, 2009 WL 1068744 (D. Colo. Apr. 20, 2009).
108
No. 08-0932, 2009 WL 1704469 (W.D. Pa. June 15, 2009).
- 45 -
could not override the court’s discretion to certify a class under Rule 23 or consolidate
proceedings under Rule 42.
A franchisee should seriously weigh the pros and cons of class litigation before
filing a class action. (Franchisors rarely, if ever, file class actions against their
franchisees.) There are benefits and downsides to class litigation. As a benefit, class
proceedings (whether in court or arbitration) may allow aggrieved franchisees who
otherwise could not afford to pursue claims against the franchisor to share the costs and
expenses of litigation, including attorneys’ fees. Another significant benefit for
franchisees is that the mere risk of losing a class action could compel a franchisor to
settle a dispute it would have otherwise taken to trial. On the other hand, obtaining
class certification can be difficult and expensive for franchisees and, in fact, the use of
them appears to be on the decline. As an additional consideration, many franchisors
now include provisions in their franchise agreements specifically prohibiting class
109
arbitrations. In AT&T Mobility LLC v. Concepcion, the U.S. Supreme Court held that
such waiver clauses are enforceable in the arbitration context.
VI.
ALTERNATIVE DISPUTE RESOLUTION
A.
ARBITRATION
Many franchise agreements require the parties to arbitrate their disputes. The
110
Federal Arbitration Act (“FAA”)
applies whenever interstate commerce is implicated
or the parties expressly agree the FAA will apply. This is frequently the case in the
franchise context as the parties’ franchise relationship involves interstate commerce or
the franchise agreement explicitly states that arbitration shall be governed by the FAA.
111
The FAA expresses a strong federal policy in favor of arbitration.
Several states
likewise favor arbitration under their state counterparts to the FAA.
Broadly speaking, franchisors are more likely to prefer arbitration than
franchisees.
Traditionally, that is because arbitration is considered by most
practitioners to be a quicker, more efficient, and less expensive way to resolve disputes
than litigation. Over time, however, arbitration has taken on many of the characteristics
traditionally associated only with litigation as arbitrators have discretion to allow
dispositive motions, broad discovery, and pre-hearing and post-hearing briefing. These
characteristics often diminish or eliminate altogether the perceived benefits of economy
and efficiency in arbitration. Further, while several arbitrators are willing to entertain
dispositive motions, increasingly few are willing to grant them, preferring instead to “take
it to the hearing.” In addition, the lack of an appeal is making many franchisors
reconsider the merits of arbitration. Still, many franchisors continue to include
arbitration clauses in their franchise agreements to eliminate the possibility of a
109
AT&T Mobility LLC v. Concepcion, 131 S. Ct. 1740 (2011).
9 U.S.C. § 1, et seq.
111
See 9 U.S.C. § 2; Allied-Bruce Terminix Cos. v. Dobson, 513 U.S. 265, 270-273 (1995); Moses H.
Cone Mem’l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24 (1983).
110
- 46 -
catastrophic and precedential result in a jury trial or a class action lawsuit, as well as to
minimize the risk that an adverse result in litigation will be taken advantage of by
franchisees system-wide.
Many franchisees, on the other hand, typically disfavor arbitration and prefer to
be in court. This dislike stems from high up-front costs of arbitration, a belief that juries
will be more favorable to franchisees than arbitrators, a better chance to choose a
convenient forum, and the fact that arbitration agreements often prohibit class or group
proceedings. In addition, forum selection clauses contained in an arbitration agreement
are much more difficult to overcome than litigation forum selection clauses. Further,
arbitration frequently (but not always) can lead to a quicker result than litigation.
1.
Compelling Arbitration
When either the franchisor or franchisee initiates litigation in violation of an
arbitration agreement, the other party can move to compel arbitration and/or move to
stay the litigation pending arbitration. Section 4 of the FAA authorizes courts to order
“the parties to proceed to arbitration in accordance with the terms of the [arbitration]
agreement.” Several states likewise have arbitration acts under which a party may
move to compel arbitration. In addressing a motion to compel arbitration, the most
common issues are the enforceability and scope of the arbitration provision.
a.
Enforceability of Arbitration Clause
Under the FAA, arbitration agreements are “valid, irrevocable and enforceable,
112
save upon such grounds as exist at law or in equity for revocation of any contract.”
This means that while common law defenses to any type of contract, such as fraud,
unconscionability, or lack of mutuality, can render an arbitration clause unenforceable,
the FAA preempts state laws that specifically target arbitration agreements for
113
unfavorable treatment.
Franchisees often claim arbitration provisions were fraudulently induced.
However, to avoid arbitration, the defense of fraud must be directed at the arbitration
114
clause specifically as opposed to the franchise agreement as a whole.
As a result,
franchisees have had very little success in challenging the validity of arbitration clauses
based on fraud because the plain language of the arbitration agreement usually will
112
9 U.S.C. § 2.
AT&T Mobility LLC v. Concepcion, 131 S. Ct. 1740, 1748 & 1753 (2011) (holding FAA preempted
California’s judicial rule that held unconscionable class arbitration waivers in consumer contracts of
adhesion involving small amounts of damages); Bradley v. Harris Research, Inc., 275 F.3d 884, 890 (9th
Cir. 2001) (holding the FAA preempts § 20040.5 of the California Franchise Relations Act, which voids
provisions in a franchise agreement restricting venue to a forum outside California).
114
Faulkenberg v. CB Tax Franchise Sys., LP, 637 F.3d 801, 811 (7th Cir. 2011) (“The only relevant
inquiry at this stage is whether the arbitration clause itself was fraudulently induced – that is, whether
there was fraud that “goes to the ‘making’ of the agreement to arbitrate”).
113
- 47 -
defeat any argument that the franchisee did not understand the agreement or was
misled regarding its legal effect.
Franchisees have had some success challenging arbitration agreements on the
115
basis of unconscionability, particularly in California and the Ninth Circuit.
Franchisees frequently attack arbitration provisions as being unconscionable where
they require an out-of-state venue, impose high costs on the franchisee, or are not
mutual (e.g., allowing the franchisor to litigate certain claims while forcing the franchisee
only to arbitrate). Whether an arbitration provision will be invalidated as unconscionable
frequently turns on which state’s law governs and the specific terms of the particular
arbitration provision at issue.
b.
Scope of Arbitration Provision
“The ‘principal purpose’ of the FAA is to ‘ensure that private arbitration
agreements are enforced according to their terms.’” Thus, the specific language of the
arbitration provision will determine whether it covers only claims arising under the
franchise agreement or whether it extends to claims involving related agreements (such
as guarantees, leases, or supply agreements) or tort claims. Because “any doubts
regarding the scope of arbitrable issues should be resolved in favor of arbitration,”
courts broadly construe arbitration clauses and narrowly construe any carve outs or
exceptions thereto. Arbitration should not be denied “unless it may be said with positive
assurance that the arbitration clause is not susceptible of an interpretation that covers
the asserted dispute.” As a result, courts and arbitrators often conclude that tort claims
between the parties are arbitrable, as are claims under related contracts between the
parties that do not contain their own arbitration clauses. In addition, depending on the
circumstances, an arbitration provision in a franchise agreement may apply to claims
made by or against nonsignatories, such as guarantors.
c.
Procedural Issues in Initiating or Compelling Arbitration
Frequently disputed is whether the court or an arbitrator should decide certain
threshold issues, such as whether an arbitration agreement is unconscionable or
whether it applies to a particular claim. As a general rule, courts decide scope issues
and challenges to the enforceability of an arbitration agreement specifically, while
arbitrators address challenges to the enforceability of the underlying agreement as a
whole. 116 However, if the parties “clearly and unmistakably” indicate in their arbitration
agreement that the arbitrator shall decide such issues, courts will honor that
agreement. 117 In such cases, the arbitrator essentially determines his or her own
115
See, e.g., Nagrampa v. MailCoups, Inc., 469 F.3d 1257, 1280 (9th Cir. 2006) (holding arbitration
clause in franchise agreement was unconscionable under California law where it required arbitration in
franchisor’s home state, lacked mutuality, and was offered to plaintiff on a “take it or leave it” basis);
Independent Assn. of Mailbox Center Owners, Inc. v. Superior Court, 133 Cal. App. 4th 396, 407 (2005)
(stating that franchise agreements can be examined to determine if they show the characteristics of
unconscionability).
116
Prima Paint v. Flood & Conklin Mfg., 388 U.S. 395, 403-04 (1967).
117
See Green v. Supershuttle Int’l, Inc., No. 09-2129 (ADM/JJG) 2010 WL 3702592, at *2 (D. Minn. Sept.
- 48 -
jurisdiction to decide the dispute. Finally, “[p]rocedural questions, which grow out of the
dispute and bear on its final disposition are presumptively not for the judge, but for an
arbitrator to decide.”118
Even if arbitration should be compelled, there is a further issue of which court
can compel arbitration. The “majority view” is that “where the parties agreed to arbitrate
in a particular forum only a district court in that forum has authority to compel arbitration
under § 4 [of the FAA].” 119 Thus, if the franchise agreement designates Colorado as the
site for any arbitration, then only a court in Colorado can compel arbitration. This
creates a procedural headache where the franchisee files suit in a different jurisdiction,
most often the franchisee’s home state. In such a situation, the franchisor can initiate
its own action to compel arbitration in federal or state court in the state in which
120
arbitration is to be held.
Issuing a stay is generally mandatory under Section 3 of the FAA if any of the
issues in the proceeding are within the scope of the arbitration clause. 121 Once a court
determines that the dispute falls within the scope of a valid arbitration agreement, it
“shall” stay the court proceedings pending arbitration. 122 Several states likewise require
a stay of litigation if the court compel arbitration, with some states even mandating a
stay of all litigation pending resolution of a motion to compel. 123
2.
Enforcement of Arbitration Award
Appeals of arbitration awards are generally very limited. Under the FAA and its
state counterparts, an arbitration decision may be vacated or modified only in limited
circumstances: (1) where the award was procured by corruption, fraud, or undue
means; (2) where there was evident partiality or corruption by the arbitrator; (3) where
the arbitrators are guilty of misconduct in refusing to postpone the hearing, upon
13, 2010). Parties can agree in their arbitration agreements that the arbitrator will decide issues of
arbitrability, either by explicitly saying so or by stipulating to rules that say so, such as the American
Arbitration Association’s Commercial Arbitration Rules. Terminix Int’l Co., LP v. Palmer Ranch Ltd.
P’ship, 432 F.3d 1327 (11th Cir. 2005).
118
Howsam v. Dean Witter Reynolds, Inc., 537 U.S. 79, 84 (2002).
119
Ansari v. Qwest Communications Corp., 414 F.3d 1214, 1218-21 (10th Cir. 2005). Under a minority
view, the Ninth Circuit has interpreted § 4 as allowing federal courts to order arbitration within the district
in which the suit was filed; thus, as an example, the Northern District of California can compel arbitration
in San Francisco even if the parties’ arbitration agreement requires arbitration in Chicago. See
Continental Grain Co. v. Dant & Russell, 118 F.2d 967, 968-69 (9th Cir. 1941); Larson v. Speetjens, 2006
WL 3365589, at *2 (N.D. Cal. Nov. 17, 2006). The Ninth Circuit’s interpretation has been criticized as
disagreeing with the FAA’s command to enforce arbitration agreements as written. Nearly all courts
agree that a court can compel arbitration to occur in a different district.
120
Because the FAA does not confer subject matter jurisdiction upon federal courts, a party seeking to
initiate a federal action to compel arbitration must independently satisfy the requirements for federal
jurisdiction.
121
9 U.S.C. § 3; In re Complaint of Hornbeck Offshore Corp., 981 F.2d 752, 754 (9th Cir. 1993).
122
See 9 U.S.C. § 3; Daugherty v. Encana Oil & Gas (USA), Inc., No. 10-cv-02272-WJM-KLM, 2011 WL
2791338, at *3 (D. Colo. July 15, 2011).
123
See, e.g., Cal. Code Civ. Proc. § 1281.4; Colo. Rev. Stat. § 13-22-207(6) – (7).
- 49 -
sufficient cause shown, or in refusing to hear evidence pertinent and material to the
controversy, or guilty of any other misbehavior prejudicing a party’s rights; or (4) where
the arbitrators exceeded their powers, or so imperfectly executed them that a mutual,
final, and definite award upon the subject matter submitted was not made. Significantly,
even egregious mistakes by an arbitrator in weighing the evidence or applying the law
to the evidence are not sufficient to overturn an arbitration award. There is currently
considerable uncertainty over whether the non-statutory ground for appeal known as
“manifest disregard of the law” remains a viable ground for vacating an arbitration
award. While there have been prominent franchise decisions arising out of the
enforcement of arbitration awards, there is nothing unique in the franchise relationship
that gives rise to recurring issues in the enforcement context.
3.
Class Action Arbitrations
The U.S. Supreme Court has addressed class arbitrations several times in the
past few terms. In 2010, the Court held that an arbitrator could not impose class
procedures where the arbitration agreement was silent on class arbitration. 124 In 2011,
the Supreme Court held in Concepcion that the FAA preempted a California judicial
doctrine that invalidated some class action waivers as unconscionable. 125 The Court
found that “[r]equiring the availability of classwide arbitration interferes with fundamental
attributes of arbitration and thus creates a scheme inconsistent with the FAA.” 126 In
light of Stolt-Neilsen and Concepcion, it appears that class arbitrations may not be
allowed absent a clear agreement by the parties. 127
B.
MEDIATION
Another alternate dispute resolution mechanism is mediation. Mediation is
frequently an effective non-binding way to resolve disputes between parties. Generally,
parties must agree to mediate either by a written provision in the Franchise Agreement
or by voluntarily agreeing to mediate a dispute. Alternatively, mediation can be courtordered. If a resolution without litigation appears possible, the parties may wish to enter
into a tolling agreement (tolling of the statute of limitations for a period of time) to allow
124
Stolt-Neilsen, S.A. v. AnimalFeeds Int’l Corp., 559 U.S. 662 (2010).
Concepcion, 131 S. Ct. at 1753 (overruling Discover Bank v. Superior Court, 113 P.3d 1100 (Cal.
2005), which held class arbitration waivers in consumer contracts of adhesion were unconscionable
where disputes predictably involve small amounts of damages).
126
Id. at 1748.
127
Whether bars on class arbitration renders arbitration provisions unconscionable remains a hot topic.
On April 1, 2013, the Fourth Circuit, citing Concepcion, held that the presence of class action waiver and
fee splitting clauses did not render a franchise agreement’s arbitration provision unconscionable, nor did
a contractual one-year limitations provision found elsewhere in the franchise agreement. See Muriithi v.
Shuttle Express, Inc., Case No. 11-1445 (4th Cir. April 1, 2013). According to the Fourth Circuit,
Concepcion “plainly prohibited application of the general contract defense of unconscionability to
invalidated an otherwise valid arbitration agreement under these circumstances.” Id. In addition, the U.S.
Supreme Court will address this term whether the FAA permits courts, under the “federal substantive law
of arbitrability,” to invalidate arbitration agreements as unconscionable on the grounds that they do not
permit class arbitration of federal law claims. American Express Co. v. Italian Colors Restaurant, Case
No. 12-133. This case is currently pending.
125
- 50 -
the parties to mediate without fear that the statute of limitations will run out. Mediation
frequently precedes arbitration or litigation, though it may also be used during litigation
or arbitration to help the parties come to a quicker resolution or narrow the issues.
Although mediation can be helpful, it is not always looked upon favorably by parties.
Some disfavor mediation because they fear giving the opposition a “look at their case.”
Nevertheless, mediation can be a useful tool when resolving disputes because face-toface interaction often facilitates settlement.
VII.
COMMON CONCERNS OF FRANCHISEES
A.
HIGH COST OF LITIGATION OR ARBITRATION
Franchisees should be aware that filing claims against the franchisor can result
significant expenditures of not only dollars, but time, attention and effort. Litigation is
generally more expensive than arbitration, although franchisees should keep in mind
that arbitration is also an expensive proposition. Although arbitration is likely to reach
final resolution in a shorter period of time than litigation, arbitration is still costly. (e.g.,
filing and administrative fees and the arbitrator’s hourly fee (per arbitrator if there is
128
Regardless of which dispute resolution mechanism a franchisee
more than one)
either chooses or is obligated to use, neither litigation nor arbitration is inexpensive.
In addition to the financial and other resource costs, a franchisee may incur
additional costs related to the choice of venue/forum provisions in most franchise
agreements. A franchisor generally requires that any arbitration or litigation take place
in the jurisdiction where it has its principal place of business. This requirement typically
requires franchisees to shoulder the burden of additional costs related to travel,
accommodations and engagement of local counsel (the last is more likely in litigation
than arbitration.
B.
TIME INVOLVEMENT
Litigation or arbitration with a franchisor is not only a significant financial
undertaking, but one that will involve a significant amount of time and effort (for both
parties). Litigation and arbitration do not mean a “speedy” resolution of the dispute.
The period from filing through trial can take upwards of at least a year. During the
pendency of the trial, much time and effort will be focused on motion practice, discovery
and other preparations for trial.
C.
NEED TO RETAIN SPECIAL FRANCHISE COUNSEL
A franchisee should also consider whether or not to retain special franchise
counsel. As our readers are likely aware, franchise law is a specialized legal field
containing issues and nuances on both the state and federal levels that may be
unknown to the general practitioner. Franchisors are almost always represented by
128
For example, the American Arbitration Association’s initial filing fees start at $775.00 and can be as
high as $65,000.00, depending on the amount of the claimant’s claim.
- 51 -
sophisticated and knowledgeable counsel, who frequently practice franchise law
exclusively. Therefore, franchisee’s engagement of franchise counsel is almost a
necessity to ensure that all issues are properly identified and analyzed, all necessary
claims and defenses are raised, and that the franchisee’s case is appropriately
prosecuted or defended.
VIII.
COMMON CONCERNS OF FRANCHISORS
A.
“BET THE COMPANY” CASE – FRANCHISOR RISK THAT LOSS
COULD JEOPARDIZE ENTIRE FRANCHISE SYSTEM
If the franchisor structures the franchise system in a way, or engages in systemwide conduct, that franchisees view as detrimental to their individual and/or collective
interests, the Franchisor becomes susceptible to lawsuits filed on behalf of multiple
franchisee plaintiffs or franchisee class action claims. A significant judgment in such a
case can have a material adverse effect on the franchisor business, up to and including
bankruptcy.
Many franchise agreements prohibit franchisees from filing multi-plaintiff lawsuits
and from filing class actions. Whether or not a court will enforce these provisions
depends on the jurisdiction in which the case is filed. It is generally agreed that these
types of provisions are more likely to be enforced in an arbitration, rather than court,
setting.
B.
NEGATIVE PUBLICITY FOR FRANCHISOR
Negative publicity for a franchisor can arise from a number of sources. Extensive
litigation with its franchisees can lead to negative perceptions about the franchisor.
Incidents at individual franchise businesses can also affect the reputation and goodwill
of franchisor’s brand. For instance, an outbreak of food borne illness, or litigation
resulting from a single location incident of any kind, can have a detrimental effect on
other franchise locations, franchisor’s brand and the franchise system as a whole.
Negative publicity can also affect franchisor’s ability to grow the franchise system,
crippling its ability to sell additional franchise agreements.
It is imperative, therefore, that franchisor consistently enforce compliance with its
standards and systems to minimize the risk of negative publicity resulting from individual
franchisee’s actions or inactions. However, if the manner or type of enforcement is
seen by the franchisees to be onerous, unfair or otherwise detrimental to their interests,
the franchisees themselves can institute litigation that will negatively affect franchisor’s
reputation and the good will of the brand. The successful franchisor will maintain a
balance between these two conflicting potential outcomes; failure to do so significantly
increases franchisor’s exposure to liability and negative publicity.
- 52 -
C.
FRANCHISOR LOSS IN LITIGATION
PRECEDENT FOR THE SYSTEM
OR
ARBITRATION
AS
A franchisor is required to disclose in its FDD certain types of litigation to which it
is a party, and the outcome of those cases. The impact of this disclosure has a
significant impact on how franchisor conducts litigation, whether as plaintiff or as
defendant. If the franchisor is sued by a franchisee, franchisor should, after reviewing
all of the facts and circumstances, determine whether or not to attempt to settle the
case. Franchisor should carefully consider this decision, as consistently settling cases
with its franchisees (and disclosing the settlements in the FDD) could prompt additional
litigation from other franchisees who may be emboldened to file a lawsuit in the hope
that the “settlement precedent” will be applied to their disputes. On the other hand, the
franchisor may find that a positive precedent is set if it consistently, through litigation or
otherwise, pursues its remedies against, for instance, franchisees who fail to abide by
their post-termination obligations (e.g., post-termination non-compete obligations).
Other franchisees in the system are usually encouraged when they see that the
franchisor is willing to pursue its rights against franchisees whose actions harm the
brand, other franchisees (collectively or individually) and franchise system.
D.
FRANCHISOR
VICARIOUS
LIABILITY
FRANCHISEE ACTIONS OR INACTIONS
WITH
REGARD
TO
Generally, franchisors are not vicariously liable for the actions or failures to act of
its franchisees, or for incidents occurring in franchise locations. The franchise business
is owned by the franchisee and the franchisee determines how his or her business is
operated. The test of whether or not a franchisor can be held liable in connection with,
for instance, a customer slip and fall at a franchise location is the amount of “control”
franchisor exerts over its franchisees. Traditionally, the control test has been framed as
control over the day to day to operations of the franchise location. Because franchisor
employees and representatives are generally not present at individual franchise
businesses, it is difficult to hold franchisor accountable for incidents at the location.
However, every franchisor dictates, to a certain extent, how franchisees are required to
run their businesses—in accordance with franchisor’s systems and standards. This
requirement, which maintains the franchisor’s brand integrity and consistent consumer
experience, is essential to the successful operation of the franchise system as whole.
Historically, franchisors have been successful in arguing that their lack of control
over the day to day operations of the franchise business protects them from liability in
cases where the franchisee and franchisor are named as defendants in lawsuits by
customers and employees of the franchisee and other third parties who may file actions
against franchisee and franchisor (e.g., vendors, landlords, banks and the like).
However, there has been a relatively recent shift in the courts, with more decisions
finding franchisors liable in these instances. The courts are scrutinizing franchisors’
required systems and standards requirements as a means to find that enforcement of
such systems and standards rises to the level of “control” of the franchise business. For
franchisors, this is a negative trend to be closely watched. Franchisors would be well
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warned to keep these decisions in mind when crafting their systems and standards
requirements.
E.
COST OF LITIGATION OR ARBITRATION,
DISCOVERY AND TIME INVOLVEMENT
INCLUDING
ESI
The proliferation of ways in which a franchisor communicates with its franchisees
and others, including email, text, Facebook, Twitter and other social media has
significantly increased the costs of litigation for franchisor, particularly with respect to
discovery of electronically stored information (“ESI”). The cost to locate and produce
ESI from such varied sources can be prohibitive. The emergence of ESI has added a
significant burden and increased the costs of all litigation. In addition, franchisor must
make certain that its employees and representatives understand the importance of
retaining, unchanged, any relevant documents, electronic or otherwise, and further have
the burden of “reminding” employees periodically during the course of litigation of their
responsibility to do so. Of course, even if ESI did not exist, litigation always creates a
distraction for the franchisor and its officers, directors and employees. A significant
amount of executive and employee time is diverted from day-to-day tasks whenever the
franchisor is engaged in litigation, whether these individuals are involved in retrieving
information, or are witnesses in the case.
F.
WHEN AREA DIRECTOR IS ALSO A FRANCHISEE
Many franchise systems utilize area directors to assist franchisor in developing
markets, especially in the early years of a franchise system. Typical area director
agreements provide that an area director pay a fee to franchisor for the right to develop
a specific geographic area, including the right to sell franchises and assist franchisees
during the pre-opening and post-opening periods (essentially the assignment by
franchisor of its obligations under the franchise agreement, although, typically, the
Franchisor remains liable for such obligations). Unlike international master franchise
agreements, pursuant to which the master franchisee develops markets and (rather
than franchisor) enters into franchise agreements with the franchisees, under typical
area director arrangements, the franchise agreement is executed by the franchisor and
franchisee, not the area director and the franchisee. In exchange for these area director
development rights, area director is entitled to receive a portion of franchise fees and
royalties collected by franchisor. In some franchise systems, the area directors may
also be franchise owners.
Area directors are representatives of the franchisor, charged with stepping into
franchisor’s shoes with respect to the franchisees in the area director’s designated
territory. The roles and responsibilities of an area director, versus the roles and
responsibilities of a franchisee, create fertile ground for conflicts of interest. The
vigilance required to wear the “appropriate hat” at all times is difficult, if not impossible,
to maintain.
In the event franchisor permits franchisees to also be area directors, it is
common for the area director agreement to provide not only a general cross-default
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provision (if an area director/franchisee’s franchise agreement is terminated, franchisor
may also terminate the area director agreement), but a specific franchisor right to
terminate the area director agreement if the area director abandons a franchise
business he or she owns.
G.
POTENTIAL CLAIMS AGAINST PRINCIPALS OR ATTORNEYS OF
FRANCHISOR
It is not unusual for principals or in-house counsel of the franchisor to be named
with the franchisor as defendants in a lawsuit. 129 Unless there is a conflict of interest, all
those defendants generally will be represented by common counsel. In such cases,
counsel will request that the franchisor and the principals enter into a joint
representation letter. If a conflict between franchisor and its principals arises during the
term of the representation, the principals will have agreed, by signing the joint
representation letter, that counsel for franchisor will continue to represent franchisor,
and the principals will obtain their own separate representation in the case. Whether or
not the principals are covered by franchisor insurance policies and whether or not the
principals’ legal fees will be paid by the company, is dependent on the terms of
franchisor’s insurance policies and corporate governance documents, as well the laws
of the state in which franchisor is incorporated.
H.
INSURANCE COVERAGE
In addition to issuing a litigation hold upon the commencement or threat of
litigation, it is vitally important that the franchisor timely notify its insurance carriers of
potential or actual litigation. Timely notification can be tricky in the case of potential
litigation; a franchisor must determine at what point potential litigation becomes likely
enough to merit carrier notification. If a franchisor fails to notify the carrier of potential
litigation, and only notifies upon the actual filing of suit, it risks denial of coverage by the
carrier on the grounds that notification was not timely.
A franchisor’s Errors and Omissions policy should cover typical franchise
litigation, including claims implicating the franchisor’s rendering of services to its
franchisees. Depending on the nature of the claims, a franchisor may have coverage
under its D&O insurance policy as well. It is important when obtaining coverage that the
franchisor understand the terms of its policies and, more importantly, any exclusions.
For example, because a typical E&O policy will contain exclusions for “refunds,” a
carrier is likely to disclaim coverage where the franchisee’s requested remedy is return
of initial franchise fees. In addition, a carrier may also deny coverage of litigation arising
from the termination of an area director on the grounds that, even if the franchisor may
had to pay damages, the franchisor really benefitted from the termination by receiving a
valuable asset (i.e., the right to receive that portion of royalties from stores in the area
director’s territory that would have otherwise been paid to area director).
129
See, e.g., NYSFA § 691(3) (providing that principals, officers, or directors of a franchisor who
“materially aid” in an act or transaction constituting a violation are jointly and severally liable).
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The relationship between a franchisor and its carriers (along with the types and
terms of coverage available) is extremely important. If a franchisor can establish a real
working relationship with its carrier, then the carrier may be willing to contribute to
judgments or settlements that, at least technically, it could otherwise deny.
CONCLUDING STATEMENT
In the interest of full disclosure, your presenters (Jess Dance, Amy Powers, and
Richard L. Rosen) disclose that they, their firms, or their current or former companies
were involved in several of the cases mentioned in this paper, including: Cold Stone
Creamery Inc. v. Cindy Kilman et al., D. Ariz. Case No. 2:11-cv-01192-MEA (filed 2011);
Martrano v. Quizno’s Franchise Co., No. 08-0932, 2009 WL 1704469 (W.D. Pa. June
15, 2009); Bonanno v. Quizno’s Franchise Co., No. 06-cv-02358-CMA-KLM, 2009 WL
1068744 (D. Colo. Apr. 20, 2009); Dunhill Franchisees Trust v. Dunhill Staffing
Systems, Inc., 513 F. Supp. 2d 23 (S.D.N.Y. 2007); C.K.H., LLC v. The Quizno’s
Master, L.L.C., No. 04-RB-1164 (BNB), 2005 U.S. Dist. LEXIS 42347, at * 13 n.3 (D.
Colo. Mar. 24, 2005); and American Express Marketing & Development Corp. v. Planet
Amex and Blake Fleetwood, NAF Decision, Claim Number: FA1106001395159
(1/6/2012). In addition, Richard L. Rosen would like to thank and acknowledge Leonard
S. Salis, John A. Karol, and Lauren A. LaGrua for their contributions to this paper.
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