DLA Piper’s Top 10 Franchise Cases for 2017

Earlier this month, DLA Piper presented the firm's selection of the top 10 franchise legal cases decided in 2017, those that provided guidance as to business considerations for franchisors. At the end of the presentation, the attorneys discussed a trend they see developing. In Part One, the first five cases, in no order of priority, are listed below:

• Cajun Global LLC d/b/a Church's Chicken and Cajun Funding Corp. v. Swati Enterprises, Inc. (N.D. Georgia. Dec. 13, 2017)

Attorney Barry Heller presented the first case by asking "Can a franchisor enforce a post-termination non-compete against a non-signatory to the franchise agreement?"

The facts of the case are that Church's entered into a franchise agreement with franchisee Swati Enterprises in 2007. Swati could not sell or transfer the franchise agreement without consent of Church's. Without Church's consent, Swati sold the franchise agreement to Rahman (two months after Swati signed the franchise agreement. Rahman never signed the franchise agreement.

Rahman operated the restaurant as a Church's as if he were the franchisee, remitting royalties and ad fees to Church's. Swati used Church's trademarks, and obtained training from Church's, receiving the company's confidential operations manual. This went on for 10 years with Church's thinking Rahman was the manager while Swati was still the franchisee. Upon expiration of the franchise agreement in 2017, Rahman re-branded the restaurant as "Orange Fried Chicken" and used logos and marks similar to that of Church's. Church's then sued Rahman and Swati to enforce the post-term non-compete.

Swati, the franchisee, did not oppose the injunction sought but said it could not comply because it no longer controlled the restaurant. Rahman claimed he was not bound by the non-compete because he never signed the franchise agreement. Rahman also claimed the forum/personal jurisdiction clauses did not apply to him.

Court's analysis states the legal issue is whether Rahman, a non-signatory, is bound by the obligations in the franchise agreement, non-compete and forum/personal jurisdiction clauses. The court said "yes," reasoning that it applied all the terms of the franchise agreement to Rahman as neither he nor Swati disclosed sale to Church's and he performed for 10 years under the agreement. Rule 65 of FRCP applies to parties to an action and "persons in active concert or participation with them." The court found that Rahman was "in active concert or participation" with Swati. The court also found that Rahman was bound by the forum/personal jurisdiction clauses "so closely related to this dispute that it was foreseeable" that he would be bound by those restrictions.

The takeaways from the court ruling are that franchisors should not walk away from enforcing a non-compete against a non-signatory: Develop a strong factual case for why the non-signatory should be estopped from evading the non-compete; received the benefits of the Franchise Agreement; post-expiration assistance from the franchisee; relative of franchisee/is it a sham? Franchisor may be better off proceeding against a non-signatory in federal court, Rule 65, but look for similar language in state injunctive rules. Court did not address enforceability of non-compete under Georgia law.

• Sun Aviation, Inc. v. L-3 Commc'ns Avionics Sys., Inc. (Missouri, Oct. 31, 2017)

Attorney John Hughes presented the second case, asking "What lost profits can a franchise recover when a franchisor fails to provide the required 90-days' notice of termination?"

The facts of the case tell that L-3 is a manufacturer of aircraft instruments, and Sun Aviation was an L-3 distributor. L-3 terminated Sun's distributorship without providing Sun with the 90 days' written notice of termination, in violation of the Missouri Franchise Act. The Act states that a franchisee suffering damage as a result of the failure to give notice as required . . . may institute legal proceedings, and when the franchisee prevails in any such action in the circuit court, he may be awarded a recovery of damages sustained to include loss of goodwill, costs of the suit, and any equitable relief that the court deems proper.

The circuit court granted Sun's motion for partial summary judgment as to liability, followed by a trial on damages. It awarded 18 years of lost profits and L-3 appealed the award of damages. The appellate court transferred the case to Missouri Supreme Court and the issue was whether damages sustained as a result of L-3's failure to give Sun the required 90-days' notice was limited to damages sustained during that 90-day period. The issue was whether "damages sustained" as a result of L-3's failure to give the 90-day notice was limited to "damages sustained" during that period. In summary, the Supreme Court allowed for damages "as a result of the failure to give notice." It stated, "Franchise may be lawfully terminated so long as required notice given – regardless of lost profits after the notice period." And, "No "good cause" requirement under the Missouri Franchise Act.

The takeaways from the ruling are that franchisors should not always panic if they fail to provide the statutorily required notice of termination; franchisee's recovery might be limited to damages incurred during the notice period. The "result might be different under another franchise statute, and the court's reasoning could extend to contractual provisions that require notice periods prior to termination."

• JDS Group v. Metal Supermarkets Franchising Am., Inc . (WD New York June 20, 2017)

The third case, also presented by attorney Hughes, asked, "Can a franchisor require a franchisee to install new operating software? Facts stated that the franchisor provided franchisees with computer software program "Metal Magic", and when the software was determined to be outdated, the franchisor developed new version, "MetalTech", over three-year period, at a cost in excess of $1 million. Franchisee JDS Group contended MetalTech did not perform as required and submitted declarations from six other franchisees that reported serious problems.

Metal Supermarkets Franchising argued that 78 or 86 franchisees using new software "had not been forced to close their stores" as a result of the new software. And stores that converted saw a 7.4 percent increase in sales. The franchise agreement provided that the franchisor had the right to develop or designate computer software programs and accounting systems and require the franchisees to use them.

Franchisee asserted claims of violation of the Washington Franchise Investment Protection Act, and breach of the implied covenant of good faith and fair dealing, and sought preliminary injunction preventing the franchisor from installing MetalTech in its stores. Washington statute states "parties shall deal with each other in good faith." The franchisor cannot require the purchase of new software unless it can prove the purchase is reasonably necessary "for a lawful purpose justified on business grounds, and do not substantially affect competition."

Court proceedings said it was unlikely the franchisee could succeed on the merits of its case, that there was no evidence the franchisor acted in bad faith. Federal courts have held that it is permissible for a franchisor to require use of its proprietary software. The franchise statute would not be interpreted to undercut a franchisor's business judgment in establishing system standards.

Takeaways from the case are that franchisors should include language in franchise agreements that allow them to require their franchisees to use proprietary computer programs, even if it is not perfect. And they should consider documenting the reliability of the software before requiring it.

• Lenexa Hotel, LP v. Holiday Hospitality Franchising, Inc. (Kansas May 24, 2017)

Attorney Karen Marchiano presented the fourth case, asking, "Can a franchisor ever owe a fiduciary duty to its franchisee? Facts state that plaintiff Lenexa Hotel was one of two Crowne Plaza hotels in Kansas City, Missouri market area. Lenexa was in Lenexa, Kansas and the other hotel was in downtown Kansas City, Missouri, 14 miles from plaintiff. Crowne Plaza is under the parent company of Holiday Hospitality Franchising, based in Georgia.

The complaint states that guests looking for a Kansas City market hotel, the Crowne Plaza reservation system never appropriately identified Lenexa Hotel as an option. The franchisor had exclusive control over the reservations system, and franchisee Lenexa was completely dependent on the franchisor as its reservations agent. The franchise agreement contained a disclaimer saying that no fiduciary relationship was created.

In general, a franchisor does not owe a fiduciary duty to a franchisee. Georgia law imposes a fiduciary relationship, "whether arising from nature, created by law, or resulting from contracts, where one party is so situated as to exercise a controlling influence over the will, conduct, and interest of another or where, from a similar relationship of mutual confidence, the law requires the utmost good faith, such as the relationship between partners, principal and agent, etc." There is no fiduciary duty exists when parties act to further their own individual business objectives, rather than a common business interest.

Plaintiff Lenexa Hotel asserted that defendant Holiday Hospitality exercised a controlling influence over plaintiff's business because it required plaintiff to use a reservations system over which defendant exercised exclusive control, plaintiff's business was entirely dependent on defendant for use of the system, and the plaintiff and defendant sought to further a common business interest, i.e. to drive business to the hotel. At motion to dismiss stage, this was enough to allow the fiduciary duty claim to move forward.

The takeaway states, "On unusual facts, a fiduciary duty claim might survive a motion to dismiss."

• Raheel Foods, LLC v. Yum! Brands, Inc., (WD of Kentucky. Jan. 18, 2017)

Attorney Karen Marchiano presented the fifth case by asking the question, "Can a franchisor ever tortiously interfere by denying approval of the sale of a franchise?" The facts of the case alleged in the complaint are that Raheel Foods, plaintiffs (and related parties), owned Long John Silver's, A&W, and KFC franchises and underlying real estate in multiple states. Plaintiffs sought approval from KFC of at least ten prospective buyers, including buyers who were already approved franchisees (package deals). The franchisors denied the deals and diverted buyers by either selling them corporate-owned stores at a discount or later approving them for purchase of their own stores.

The result was that plaintiff Raheel Foods pled cause for intentional interference with prospective economic advantage. It stated, "The exercise of legitimate contract rights cannot give rise to an intentional interference claim." However, "Plaintiffs do not allege that Defendants' mere denial of Non-Party Raheel Foods proposed sales was improper interference. The problem, as alleged by plaintiffs, is that defendants used their disapproval rights for an improper purpose—to take plaintiffs' buyers for themselves."

Case settled before any findings on the merits of the tortious interference claim.

The takeaways were that transfer approval process remains a flashpoint for litigation. Franchisors should be cautious about disapproving potential transferee and then later approving that applicant in separate transaction with the franchisor. Particularly with package deals involving multiple entities, plaintiffs may try to seek tort remedies in addition to a more traditional breach of contract and a breach of implied covenant remedies.

Note: Part Two will conclude with the remaining five cases, Tim Hortons USA, Inc. v. Singh; Andy Mohr Truck Center, Inc. v. Volvo Trucks N. Am.; Hy-Brand Industrial Contractors, Ltd and Brandt Constr. Co., et al.; Roman v. Jan-Pro Franchising International, Inc. and DiFederico v. Marriott International, Inc.