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LOS ANGELES – At the October American Bar Association Forum on Franchising, aptly themed Franchising: Your Backstage Pass, Peter Silverman and Jim Goniea presented the behind-the-scenes legal cases affecting franchising and distribution in 2012.
Although there were no blockbuster cases this year, attorney Silverman of Shumaker, Loop & Kendrick gave Blue MauMau a summary of key legal developments for franchisees. The ABA period extends from September 2011 through August 2012, and the cases are Silverman’s view alone.
The trend in antitrust could best be summarized as FAIL. While antitrust law once gave franchisees and distributors strong litigation rights, the industry and the law have evolved to the point that antitrust claims rarely succeed now in litigation. This year continued that trend.
For example, in Johnson Brothers Liquor v. Bacardi, two major liquor manufacturers, Bacardi and Brown Forman, formed a marketing partnership to align national distribution. Part of their plan resulted in both manufacturers terminating their long-time distributor, Johnson Brothers, and jointly selecting a new distributor to distribute all their brands in Johnson’s territories. The new distributor ended up controlling nearly 100% of the market in the affected territories for rum and whisky, which were Bacardi’s and Brown-Forman’s signature products, as the new distributor was already carrying rum and whisky made by Bacardi and Brown-Forman’s competitors.
Johnson filed suit, claiming that the manufacturers’ conduct constituted a concerted refusal to deal in violation of Section 1 of the Sherman Act. The Court disagreed, finding that consumers wouldn’t be hurt by the alignment. Bacardi and Brown-Forman couldn’t raise prices as a monopolist would because the new distributor could turn to its other brands for price competition. Since consumers weren’t hurt, the terminated distributor didn’t have a claim under the antitrust laws.
One area of law that showed promise for franchisees was RICO, the Racketeer Influenced and Corrupt Organizations Act. Initially aimed at organized crime, RICO’s application has been broadened to a legal claim against any group that, over an extended period of time, has committed a pattern of fraud that violates federal laws. The courts don’t like turning garden-variety fraud claims into RICO violations, and so place a number of hurdles to stating a claim under RICO.
A distributor jumped those hurdles in Jay Automotive Group v. American Suzuki Motor. There the dealer claimed that over a four-year period, its manufacturer, Suzuki, conspired with favored dealerships to defraud him into renewing his dealership and spending $1.5 million to build a new facility.
Jay brought suit, alleging, among other things, that Suzuki and cooperating dealers violated RICO. Suzuki moved to dismiss the case for failure to state a claim. The Court denied the motion. Assuming that the facts in the complaint were true (the test for a motion to dismiss at the start of a case), the Court found that the Complaint properly pleaded that Suzuki and its dealers were a functioning enterprise that defrauded the dealer over a four-year period in violation of the federal mail and wire fraud statutes (meaning they carried out the fraud using telephones, mail, and e-mail).
In another case, Massey v. Moe’s Southwest Grill, franchisees presented evidence that from 2001-2004, Moe’s president had an interest in an affiliate company receiving rebates on purchases by Moe’s franchisees, but Moe’s failed to disclose that in its UFOC (now called an FDD, or a franchise disclosure document). Applying Georgia law (most states have their own RICO statutes), the Court found that the franchisees presented enough evidence to allow their case to proceed to trial. The Court held that a genuine issue of material fact existed on Moe’s, its affiliate, and its President, acting together as an enterprise, violated the Georgia statute of theft by deception, which requires intentional fraud.
There have been other favorable RICO cases as well, but I question how practical the theory is for franchisees. Bringing a RICO claim requires extensive investigation and pleading, and almost guarantees expensive motion practice to dismiss and for summary judgment. Also, RICO has far more elements to prove at trial than common law fraud. Any win will likely face appeal on a number of difficult issues. The question is how many franchisees and distributors will have the resources to fight that battle, especially since common law fraud is cheaper to plead and prove, and far less likely to be challenged on appeal.
Another area where franchisees scored some wins was in bankruptcy because bankruptcy courts are equity courts that aim to protect creditors, even if it requires overriding provisions in a franchise agreement.
For example, in In re Chicago Investments, the bankruptcy court allowed the franchisee to transfer units to a new franchisee over the franchisor’s objections. That was the only way to fund the franchisee’s reorganization plan and satisfy all the creditors. And in In re Stone Resources, the franchisor failed to get the automatic stay in bankruptcy lifted to force the terminated franchisee from competing against the franchisor in violation of the franchise agreement.
While Chapter 11 bankruptcy (reorganization) does offer franchisees some protections, franchisees shouldn’t look at filing bankruptcy as a trump card. A bankruptcy is very expensive to file and litigate. And unless the franchisee has strong resources and a viable plan to reorganize, all bankruptcy does is buy a bit of time before the franchisee’s demise.
Franchisees regularly underestimate the franchisor’s power to recover lost future profits after terminating the franchise agreement. But the general rule is emerging that if the franchisee caused the termination by closing down or refusing to pay royalties (or similar default), the franchisee may need to pay lost future profits as damages to franchisors
One example is Hardee’s Food Systems v. Hallbeck, where the franchisees began to lose money and closed their restaurant with approximately fifteen months left on the term of its agreement. Hardee’s then terminated the agreement, and filed suit to collect the expected future royalty payments it would have collected for the remaining fifteen months of the agreement. The franchisees contended that Hardee’s had actually terminated the franchise agreement, and that Hardee’s was at fault for the termination because its racy advertising had led to the franchisee’s losing money.
In a pretrial ruling, the court found, as a general matter, that franchisors are entitled to future profits as would any commercial party to a contract that promises future action. Thus Hardees could bring to trial its claim for lost future profits.
Another area that franchisees regularly underestimate is the power of the clause in almost every franchise agreement saying that the franchisee is relying only on the written agreement, and not on anything the franchisee learned before signing the contract other than what is in the FDD. In litigation, franchisors raise this clause, known as an integration clause, when franchisees claim that that the franchisor misled them into signing the agreement. As a general rule, courts enforce integration clauses and prevent the franchisee from raising pre-contract misrepresentations.
Some states have narrow exceptions. Franchisees need to key in to these if they want to bring misrepresentation claims. For example, in Next Generation Group v. Sylvan Learning Centers, the franchisees claimed that the franchisor induced them to enter into the franchise agreement by promising to transfer them two other profitable existing units. When the franchisor failed to transfer the other two units to them, the franchisees sued for fraud and misrepresentation. The franchise agreement contained an integration clause that negated what was outside the agreement, and the franchisor moved to dismiss.
In a pretrial ruling applying an exception in Maryland law, the Court found that the integration clause bars fraud claims as a matter of law only if the integration clause specifically refers to the representation on which the franchisee allegedly relied. Here the clause did not specifically refer to that representation, and the Court allowed the claim to proceed.
In another case, franchisor Cousin Subs System v. Better Subs Development, the franchisee claimed the franchisor induced it to sign franchise and development agreements by providing it with false financial forecasts. The franchise and development agreements had integration clauses, and the franchisee had also responded to disclosure questionnaires that it wasn’t relying on financial performance representations to make its decision for a franchise. Based on the integration clause and disclosure representations, the franchisor moved for summary judgment.
Applying an exception under Wisconsin law, the Court granted summary judgment on the negligent misrepresentation claim because an integration clause bar such claims as a matter of law. For intentional fraud, though, integration clauses are not enforceable in Wisconsin. Thus the case could proceed to trial on the intentional fraud claim.
Franchisor as employer
Another area showing a trend was cases where individuals or governments sued franchisors for being liable as implied-at-law employers of the franchisee’s employees. These claims may seem like quite a reach, but franchisors have some vulnerability because they do impose restrictions on how franchisees should operate. Last year, though, courts showed a strong trend of rejecting these claims.
In Aleksick v. 7-Eleven, the Court found that, for purposes of California’s Unfair Compensation Law, 7-Eleven didn’t become the employer of its franchisees’ employees simply because the franchisees used 7-Eleven’s payroll system. Likewise, in Doctors’ Associates. v. Uninsured Employers’ Fund, the Court found that, for purposes of Kentucky’s workers compensation law, Doctor’s Associates (Subway) was not the employer of its franchisees employees as it did not control them.
And on a similar issue, Juarez v. Jani-King of California, found that, for purposes of California’s Labor Code, franchisees in a janitorial franchise could not be deemed the franchisor’s employees because Jani-King didn’t exercise “control [of the manner and means of service] beyond that necessary to protect and maintain its interest in its trademark, trade name, and good will.”
In arbitration, two issues stood out. The first is whether franchisee associations can bring lawsuits in court against the franchisor if the association’s members have arbitration clauses in their franchise agreements. Last year, two courts came out differently on the issue. In NIACCF v. Cold Stone Creamery, a Florida federal court stayed a case brought by an association related to rebate disclosure so that the issue could be addressed in individual arbitrations. But in EA Independent Franchise Association v. Edible Arrangements, a Connecticut federal court allowed the association’s multi-pronged court claims proceed though the Court also allowed Edible Arrangements to proceed on individual arbitrations at the same time.
The second issue is whether franchisees or distributors can bring class actions in arbitration if the arbitration clause in the franchise agreement is silent on the issue. The Supreme Court addressed this issue in Stolt-Nielsen v. AnimalFeeds, finding that the silent arbitration clause in that case did not authorize class arbitration. The Federal Courts of Appeals, though, have differed in their reading of Stolt. Presumably to remedy this confusion, the Supreme Court accepted an appeal in Oxford Health Plans LLC v. John Ivan Sutter MD, where the Third Circuit upheld an arbitrator’s decision to allow a class action arbitration to proceed even though the arbitration clause was silent on the issue.
Closing words to the wise
Attorney Silverman stated in his concluding remarks that the summary presented is a short discussion of some of the key trends in franchise and distribution law. “It’s hard to muster any general conclusion other than to encourage all franchisors and franchisees to hire lawyers knowledgeable and skilled in this area as it is complex and ever-changing,” the Ohio attorney asserted.