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McDonald's Loses to Franchisees on Appeal

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SAN FRANCISCO – An appeals court has affirmed a lower court decision that two 30-year multi-unit franchisee veterans may continue operating their three McDonald’s restaurants, pending completion of their trial. The jury trial will begin on May 29, challenging McDonald’s on its decision not to grant 20-year “rewrites” of their existing franchise terms, after promising to do so.

Lead counsel Peter Lagarias of Lagarias & Boulter, representing Syed Husain and his wife Khursheed, said this case is significant to franchisees, especially regarding their rights to renew their franchise agreements. "When franchisees are told they will not be renewed, or given a rewrite, they face a catastrophe,” he declared. He explained that franchise owners invest substantial amounts of money in their businesses and most often look to the businesses for their livelihoods. “Franchisors denying renewal often threaten to seek immediate court relief, and franchisees usually must seek preliminary injunctions to maintain their businesses pending trial on renewal issues," he added.

Lagarias said this decision addresses and rejects virtually all of the issues franchisors raise to defeat preliminary injunctive relief. “The Court of Appeals holds that renewal relief of specific performance is not barred by McDonald's contentions that their franchise contracts are personal services agreements," he stressed. 

Lagarias recently testified at California’s Business Committee hearing addressing the need for new legislation (Level Playing Field for Small Businesses Act (AB2305). The bill failed to get through. The ability to renew franchise agreements is a key issue for franchisees. Some franchisee associations push for this right.

Lawsuit focuses on "rewrites”

The Husains have owned McDonald’s restaurants since the early1980s. By 2005 they owned five in the San Francisco area. At that time they decided to expand their operations and purchased seven restaurants from the previous owners. Three of the franchised stores that would soon expire qualified for McDonald’s “Plan to Win” program, allowing them to obtain “rewrites”, giving them an additional 20-year term.

In purchasing the new locations, the franchise owners assumed considerable financial obligations. In 2007 they suffered setbacks involving financial losses due to an employee embezzlement problem. Although they became delinquent with their payments to McDonald’s they were able to quickly recover, and once again become current. But as a result, the franchisor notified them that they were no longer qualified “for growth or rewrite.” Syed Husain then offered his franchise agreements as collateral for the loan and new loan extension, and McDonald’s approved the first “rewrite.”

When McDonald’s issued mandates on improvements on their restaurants, Husain completed those modifications, although not in the precise manner or the time allotted. Those major alterations included an inside bathroom and a second drive-thru window. But the committee that determines whether rewrites will be approved issued a denial in December 2008 on a 20-year term extension on their next expiring store.

The Husains had no intention to sell those units and filed their lawsuit in 2009. They asserted that McDonald’s is contractually obligated to offer rewrites of the existing contracts of the stores they purchased. Court documents state that McDonald’s did offer the Husains new 20-year franchise terms on the three franchise agreements at issue. The hamburger giant only disputes that Husain did not respond to the offer they made him.  As a result, McDonald’s is urging him to sell the restaurants prior to their expiration dates.

After Husain applied for preliminary injunction, the Marin Superior Court judge found there was sufficient evidence to support their stores staying open through trial. He stated that the “balance of harms” tips strongly in the franchise owners’ favor.

Judge rules “franchise agreement not personal service contract”

McDonald’s claimed in its appeal that the trial court erred in granting the Husains injunctive relief because of the personal nature of the relationship between franchisor and franchisee. It argued that its franchise agreements are contracts for “personal services of franchisees” not subject to enforcement by either party in the event of a breach of contract. Further, the franchisor claimed that the contract language was the “maintenance of a “close personal working relationship,” the essence of the franchise.

The appeals court disagreed. “A close personal working relationship does not automatically equate to ‘personal services’ as defined by law.” The ruling states that although the Husains may be providing services to McDonald’s customers, they do so in a manner McDonald’s strictly controls.

While McDonald’s claimed the preliminary injunction it sought would cause it irreparable harm due to “loss of control” of its trademarks, the appeals court did not agree. “. . . franchisors are not automatically entitled to enjoin the continued use of their trademarks when disputes arise over the termination of a franchise,” the judge asserted. He stated that McDonald’s must prove it is likely to prevail on the question of whether the termination was proper before such relief could be given.

The lower court also found that the Husains were likely to succeed on the merits of their case, that the assignment agreement promised them the rewrites. Despite McDonald’s arguments, the appellate court agreed. The trial court found that the franchisees would suffer financial hardship if the stores were closed, and the appellate court again agreed.

McDonald’s motive a mystery

Richard Adams, founder of Franchise Equity Group, and former McDonald’s executive and former franchisee, said this is a significant ruling that never would have happened if McDonald’s hadn’t appealed the lower court’s decision.  “They got a decision they really don’t want,” Adams surmised. He said McDonald’s rarely goes before a jury.

Adams said he couldn’t figure out why the company would take this route. If McDonald’s starts knocking holes in its rewrite program, Adams feels that is rather shortsighted of them. “The rewrite program is very important right now, because the company is only building between 100 to 150 new restaurants in the U.S. each year. That’s not enough to control all of the franchisees with expandability. So now they do it with rewrites” with existing franchisees,” he explained. 

Adams also feels the Husains did McDonald’s a great favor by buying the seven stores from the Magruders, because the franchisees had gotten into huge trouble over wage and hour issues. “When restaurant workers filed a class action against the former owner, Husain was the only person in the area who had the money and people to take over those stores instantaneously.” Adams said it was the Husains who bailed Magruder out of the mess.

McDonald’s response

McDonald’s declined to give comment regarding the appellate court ruling, saying it is ongoing litigation. A spokesperson referred to her previous comments made in 2011.

In that statement, McDonald’s said it plans to vigorously defend its rights to protect its trademarks and brand. When asked if McDonald’s addresses renewal, rewrites and extensions in its franchise disclosure documents, the company replied, “A McDonald’s franchise is granted for a specific period of time, and the franchisee acknowledges in the franchise agreement that McDonald’s makes no promise or representation as to the renewal of the agreement.”

When asked if the outcome of the litigation will affect Husain’s other franchises, the company answered: “This lawsuit involves three of the 10 McDonald’s franchises operated by Mr. Husain. The franchise term for each of those three restaurants has expired and, although Mr. Husain was given the opportunity to sell those franchises to a qualified McDonald’s franchisee, he elected not to do so.” The franchisor also stated that should McDonald’s succeed in the litigation, the three restaurants will not be owned by McDonald’s, but be re-franchised to a qualified McDonald’s franchisee.

Husain’s disappointed in McDonald’s efforts

The franchise owner had previously testified he would never have made the purchase of the Marin county stores if he was buying them for a five- year, or less, term. “I believed - I trusted McDonald’s to do the right thing,” he declared.

Husain said although the California Court of Appeals has rendered a favorable opinion in their case he still remains very disappointing that his franchisor has insisted on trying to take the stores for which they paid millions of dollars.

“My legal team has done a great job in advancing my case against the tremendous resources McDonald's has devoted to this matter.  As a result of our efforts it saddens me that McDonald's would simply not grant me and my wife what we paid for particularly since we have been successful operators in good standing since 1981,” he stated.

Husain added, “I remain committed to the McDonald's brand and I am hopeful of a favorable resolution at the trial in this matter.”

Looking back at Darling case

Going into trial on May 29, the Husains have hired George Knopfler of Hamrick & Evan as counsel. In 2003, Knopfler represented Sandra Darling and husband James in a lawsuit against the hamburger giant, under similar circumstances.

Darling was a daughter of a long-time McDonald’s operator. After she was encouraged to expand by the company she got into financial difficulty, and McDonald’s tried to take over her restaurants. When she was forced into bankruptcy, she brought claims of fraud against the hamburger chain, stating McDonald’s had planned the fraudulent scheme against her from the beginning.

As a result, a Los Angeles County Superior Court jury found McDonald's guilty of fraud in its dealings with Darling, and they awarded her $6.5 million in compensatory damages. Following a separate hearing on the issue of punitive damages, the jury awarded her and additional $10 million.

McDonald's appealed the verdict and judgment of the court, posting a bond of $24,750,000 on November 10, 2003 to carry the case forward. But in 2006, at age 60, Sandra Darling passed away. The lawsuit was later settled out of court with undisclosed terms.

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