Franchisors, Dirty Hands and Equity

Owners of trademarks understandably sue licensees when licensees continue to use the owners’ trademarks after owners have retracted their authorization to use them. The form of relief sought by a trademark owner in this circumstance is a preliminary injunction enjoining the defendant from continuing to operate its business using the trademarks. In the franchise context, this frequently occurs following a franchisor’s termination of a franchisee, when the franchisee continues to hold itself out to the public as a franchisee using the franchisor’s trademarks believing that it is justified in doing so because it was wrongfully terminated.

When franchisees defend a post-termination preliminary injunction request, they many times assert a defense of “unclean hands.” This defense arises out of the old equitable legal maxim that “he who seeks equity must do equity.”  In these cases the franchisee argues that the franchisor is not entitled to preliminary injunctive relief because the franchisor itself has unclean hands in its having acted inequitably during the tenure of the franchise relationship. Courts, however, have been unreceptive, and more accurately hostile, to franchisees’ attempts to use the defense.

In making an unclean hands argument, the franchisee has a very significant, if not insurmountable, burden. First, the franchisee has to convince the court that existing law in that particular jurisdiction requires the franchisor to demonstrate a proper termination before it will be entitled to obtain equitable relief. Incredibly, this is not a settled legal principle, since some courts have come down in favor of the proposition and others have not. Second, assuming that the franchisee fortuitously finds itself in front of a court that requires the franchisor to demonstrate a proper termination, the franchisee must also show that the franchisor’s particular breaches or other wrongful conduct caused direct injury to the franchisee.

In a recent case, Petro (pdf), the court considered but rejected the franchisee’s unclean hands defense to the franchisor’s request for preliminary injunction. The franchisee argued that the franchisor had acted inequitably when it merged two different but competing brands thereby violating the franchisee’s exclusivity provisions in its franchise agreement. The franchisee further argued that the unlawful merger had damaged it financially to the point that it was unable to pay its franchise fees, which was the basis of the termination.

In refusing to recognize the unclean hands defense, the court appeared to have ruled that the franchisee’s argument could not be recognized as a matter of law. At a minimum, the court pointed out, the plaintiff’s inequitable conduct must have directly injured the defendant. In Petro, the franchisee argued that the plaintiff’s conduct substantially reduced its sales, which, according to the franchisee, established the necessary direct link between the inequitable conduct and its claimed injury. The court immediately stated: “This is not enough.”

In rejecting the franchisee’s unclean hands defense, the court appeared to have applied a purely legal rule regarding the relationship or causation issue: “Plaintiffs' alleged misconduct [the merger of the brands] relates to Plaintiffs' trademark infringement claim only insofar as they both stem from the Franchise Agreement. The relationship is not immediate, necessary, or direct; nor does it relate to the controversy in question. Plaintiffs' trademark infringement claim is based on their termination of the Franchise Agreements; that termination is in turn based on Franchisees' default for failure to pay any franchise fees”

After setting out this legal conclusion, which arguably resolved the issue, the Petro court then surprisingly proceeded to examine the factual basis for the franchisee’s assertion that the merger caused its financial difficulties.  After looking at the franchisee’s affidavit showing that after the merger its sales had been “substantially reduced”, the court rejected its evidentiary significance stating: “This [merger of the two brands] likely affected franchisee’s desire to pay; it does not show that it affected its ability to pay.”

Anticipating that the court might take this position, the franchisee in Petro also argued in its papers (pdf) that the franchisor’s merger directly placed the franchisee in the position of being unable to pay its franchise fees. Unfortunately for the franchisee, at least according to the court, the franchisee had failed to present any evidence of such causation other than the naked affidavit of diminished sales. “Allegations in pleadings are not evidence.” Thus, according to the court, the franchisee had failed to prove the franchisor’s unclean hands.

As bad as this decision was for franchisees, it is important to understand that the franchisee did have an opportunity to try to preserve its franchise while at the same time challenging the franchisor’s merger in court by filing a motion for preliminary injunction when the merger occurred. Such an injunction would have sought to prevent the franchisor from merging the brands, or, if it did so, preventing the franchisor from terminating the franchisee pending a resolution of the franchisee’s case on the merits. Even this path, however, is fraught with legal difficulties and uncertainties.

At the end of the day, a franchisee that has been terminated for failure to make royalty payments has very little chance of sustaining an unclean hands defense to a franchisor’s request for preliminary injunction, even though the franchisee would be able to prove a case for damages later in the case. As the court in Petro pointed out, “This Court is not aware of a single case where, as here, a franchisee was terminated for non-payment of fees as plainly set forth in a franchise agreement, did not contest its non-payment, and nevertheless established improper termination [for purposes of showing unclean hands].” 

Goldstein Law Group, PC

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