Franchise and Trade Regulation Update - July 2013

Date: July 25, 2013

Is California's "Good Faith" Franchise Legislation Necessary or Meaningful?
By: David L. Cahn, Esq.

Originally published in the July 2013 LJN’s Franchising Business & Law Alert®, by ALM Media, LLC, and republished with permission of that copyright owner.

On May 28, the California Senate passed S.B. 610, which is an amendment to California’s Franchise Relations Act (the “CFRA”). The bill has been introduced in California’s General Assembly and was referred to that body’s Judiciary Committee on June 10.

This legislation could provide some increased leverage and protections to existing franchisees, but it may come at a cost to franchising as a method of expanding brands and providing opportunities. This bill, if approved by the state’s General Assembly and signed by Gov. Jerry Brown, would add the following relevant provisions to the CFRA:

Without limiting the other provisions of this chapter, the following specific rights and prohibitions shall govern the relations between a franchisor, subfranchisor, and franchisee:

Section 20016;
(a) (1) These parties shall deal with each other in good faith in the performance and enforcement of the franchise agreement.
(2) “Good faith” for purposes of this subdivision means honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.
(b) A franchisor or subfranchisor shall not restrict the right of a franchisee to join or participate in an association of franchisees to the extent the restriction is prohibited by Section 31220 of the Corporations Code.

Section 20017:
(a) A franchisee may bring an action against a franchisor or subfranchisor who offers to sell, sells, fails to renew or transfer, or terminates a franchise in violation of Section 20016 for damages caused thereby, or for rescission or other relief deemed appropriate by the court. In addition, the court may in its discretion award reasonable costs and attorney’s fees to a prevailing plaintiff.

The CFRA already prohibits a franchisor from terminating a franchise relationship without good cause and restricts a franchisor’s ability to refuse to renew a franchise at the end of its term or to restrict transfer of ownership to the franchisee’s heirs following death. Moreover, the implied covenant of good faith and fair dealing applies to all contracts governed by California law and the law of many other states, and the language in Section 20016 is essentially the same as such an implied covenant as contained in the Uniform Commercial Code and under American “common law” as interpreted in the courts. Finally, Section 31220 of the Corporations Code makes it unlawful for a franchisor “to restrict or inhibit the right of franchisees to join a trade association or to prohibit the right of free association among franchisees for any lawful purpose”, and Section 31302.5 of that statute provides a vigorous private right of action for a franchisee who proves violation of this provision.

So is this legislation really significant, and, if so, how?

Legislation’s Possible Impact

From a franchisor’s perspective, the legislation increases the risks of seeking to enforce their contract rights, principally because of liability for a franchisee’s attorneys’ fees if a franchisee wins a case under this statute. This may discourage franchisors from seeking to terminate franchises that are not upholding brand standards, which may result in a lower quality of goods and services being provided to consumers. For these reasons, the IFA has opposed the legislation, even as S.B. 610 represents a much less encompassing set of changes than did a bill introduced in the California legislature last year.

Franchisees, generally speaking, seem to favor the legislation. But an observer has to wonder if the impact would be more mixed for franchisees than they expect.

Its potential significance to existing franchisees is at least twofold. First, many franchise agreements are governed by the laws where the franchisor is located, and some large states (such as Texas) generally do not recognize an implied covenant of good faith and fair dealing that is applicable to franchise agreements. See, e.g., Miller v. KFC Corporation, 2001 U.S. Dist. LEXIS 8537 (N.D. Tex. 2001). For such franchisees, if a franchisor acts in a manner that technically is permitted by the contract, then the franchisee has no legal right oppose it, even if the franchisor’s action is opportunistic, unfair and/or overreaching in the commercial context.

Second, the CFRA does not specify damages that can be awarded to a franchisee that proves a violation of the statute, nor does it allow such a prevailing party to obtain reimbursement for its attorneys’ fees and other costs in pursuing the claim. Moreover, many franchise agreements only give the franchisor the ability to obtain judgments for its attorneys’ fees and costs if it enforces the contract (a “one way” clause), but this legislation would in essentially convert those clauses to mutual “loser pays” provisions for most contract disputes. From a franchisee’s perspective, particularly those in large, established franchise systems who may be more easily susceptible to franchisor oppression, these are helpful provisions. For example, certain hotel franchise systems have been notoriously aggressive in seeking to terminate franchises due to alleged service quality or facility maintenance deficiencies, and then seek substantial liquidated damages judgments against the former franchisee. Even where the implied covenant of good faith is a part of the law of the contract, many of the largest chains have “one way” attorneys’ fees clauses that make the franchisee’s risk of attempting to defeat the termination and damages claims extremely risky. S.B. 610 might encourage franchisees to fight against such franchisor efforts.

However, the legislation comes with several long-term policy costs:

  1. It may make franchisors less willing to aggressively enforce their standards, particularly when deciding whether or not to consent to a franchisee’s request to assign its agreement or to allow a franchisee to renew the franchise at the end of a contract term. These decisions can have critical impacts on the health of franchise systems and also on the welfare of consumers who patronize franchises. The prospect of having its decisions “second guessed” by a jury or even an arbitrator may make franchisors more tentative in taking steps necessary to protect its brand, which would harm the ability of franchise systems to provide a consistent level of goods and services to consumers.
  2. It provides another reason for companies to shy away from franchising as a growth method. The number of companies expanding through licensing continues to grow, and more companies than ever will seek to avoid being a “franchise” as a matter of law because of the burdens of complying with disclosure and relationship provisions. This matters because the putative licensee, sales representative or product dealer will not receive important information provided in the disclosure process, or be as fully protected from misrepresentations made by the putative licensor or supplier. While avoiding the franchise definition is easier said than done, legislation of this nature will encourage even more entrepreneurs to make the effort to do so.

Another Court Ruling Shows Franchisors the Value of Providing an Item 19 FPR
By: David L. Cahn, Esq.

Take-away: Franchisors cannot rely on disclaimers in the contracts and FDD to protect against claims of providing false financial information.

The Case: In a recent decision, Long John Silver’s Inc. v. Nickleson, the U.S. District Court for the Western District of Kentucky once again showed the danger of a franchisor relying on disclaimers in its contracts and the Franchise Disclosure Document (“FDD”) to defeat claims that it provided false financial performance information in selling a franchise. The court denied summary judgment for the franchisor of A&W Restaurants, Inc. (“A&W”) and will allow the franchisee’s claims of fraud and violation of franchise sales laws to be decided at trial. The case is particularly noteworthy because the franchise purchased was the claimant’s fourth from the same franchisor.

A&W’s FDD had what is known a “negative disclosure” in Item 19 concerning the provision of information about the sales or profits at existing franchises, specifically saying “[w]e do not make any representations about a franchisee’s future financial performance or past financial performance of company-owned or franchised outlets.” The Minnesota-based franchisee alleged that, in connection with considering purchase of a franchise to open a new “drive in” model A&W restaurant, the franchisor provided “information, including financial projections, which was laden with false data.” These allegations, if true, would mean that A&W provided a financial performance representation (“FPR”) outside of its FDD, in violation of federal and state franchise sales laws.

A&W followed the usual route of trying to get the franchisee’s claims thrown out before trial on the argument that, in light of the disclaimers in Item 19 of the FDD and in various parts of the franchise agreement, as a matter of law the franchisee could not “reasonably rely” on the information provided. The court rejected the argument that the disclaimers could be used to flatly bar the franchisee’s claim that A&W provided misleading information in violation of the Minnesota Franchise Act, because that law (like the Maryland Franchise Registration & Disclosure Law) contains a provision making “void” any waivers of conduct contrary to the franchise sales law. Instead, the franchisor will be permitted to use the disclaimers at trial as evidence to persuade the jury that the franchisee could not have reasonably relied on the "projections."

The court also ruled that the disclaimers could not be used to deny the franchisee a trial on its claim of common law fraud (under Kentucky law) with regard to its allegation that the projections were based on false data about other locations’ sales or earnings. In the words of the court, “A broadly-worded, strategically placed disclaimer should not negate reliance as a matter of law where A&W allegedly shared objectively false data to induce Defendant to enter into the Franchise Agreement.” Therefore summary judgment was denied and the franchisee’s fraud claim will proceed to trial, with A&W potentially liable for punitive damages if the franchisee prevails on that claim.

Further thoughts: Given that the franchisee in this case already owned three other A&W restaurants at the time it purchased the franchise at issue, it would hardly be surprising if it demanded and received specific financial performance information about the other “drive-in” models. A logical question is, if A&W had included sales and earnings data in Item 19 of the FDD that it provided to this franchisee, would it have been less likely to have faced the allegations made in this case? In this author’s opinion, based on more than 15 years of representing franchisors and franchisees, A&W would have been in a better position to defend itself if had included such data in Item 19. The reason is that the data would have been reviewed by A&W’s attorneys and probably by upper management, who would have been more likely to make sure that the presentation was accurate and not misleading. Once the presentation is in the FDD, most franchise salespeople will be less likely to “go off script” and provide information that is more optimistic than Item 19.

However, even if the franchise seller did provide information beyond the written FPR, at trial the franchisor would have been able to point to the data provided in Item 19 and say, “Look, we gave you the data right here, we made it easy for you to investigate further, and you chose to believe overly optimistic statements by our franchises salesperson.” Most people would believe that course of conduct by the franchisee to be unreasonable, even it true. By denying its franchise seller use of an Item 19 FPR, A&W made it difficult to both comply with the law and convince qualified candidates to purchase the franchise -- setting up a scenario where a jury may likely believe that the franchise seller “went over the line.”

Severe Consequences for Franchisor Executives: Personal Liability and Non-dischargeable Debt
By: David L. Cahn, Esq.

“Do not pass Go, do not collect $200” is a phrase we all remember from the childhood game Monopoly. Like Monopoly, state franchise sales laws have rules and regulations that must be followed. A franchisor’s failure to follow these basic procedural rules for selling franchises can result in self-destruction.

On December 10, 2012, a decision in the case of In Re Butler demonstrated a strict approach on the policy and procedures that a franchisor must follow for selling a franchise. The U.S. Bankruptcy Court sitting in North Carolina ruled that the owners of a franchise were personally liable to a franchisee for $714,000 plus interest in damages for violating the New York Franchise Law. The court further ruled that the franchise owners’ liability was non-dischargeable in bankruptcy.

Michael and Kathy Butler opened a small retail store to serve the marketing needs of small businesses. After much success, the Butlers formed PRS Franchise Systems LLC (“PRS”). Based in North Carolina, PRS Franchise handled all of the franchising for the PR Stores. PRS had obtained a one year license from New York to sell franchises to its residents, but subsequently PRS did not renew its New York registration on an annual basis.

In 2007, John Mangione, a New York resident, expressed interest in purchasing 20 PR Store franchises in the New York area. Because of Mangione’s interest, PRS submitted an application to renew its registration to sell franchises in New York. Before receiving approval of its renewal application, PRS sold 20 PR Store franchises to Mangione and received $716,000 in initial franchise fees between April and July 2007.

The franchise relationship was not to Mangione’s satisfaction, most of his PR Store locations were unsuccessful, and he ceased operating them by 2009. The Butlers also had a reversal of fortune and by 2009 they had dissolved PRS and filed for bankruptcy.

The Butlers argued that they were permitted to engage in franchise sale transactions while the application of renewal for registration was pending under New York law. The court rejected this argument on the grounds that, while New York law does permit franchisors to sell franchises while renewal applications are pending, the law also requires the franchisor to give the buyer its last registered offering prospectus (also commonly known as the franchise disclosure document, or “FDD”), escrow the franchise fees paid in a separate trust account and then, once the renewal application is approved, provide the franchisee with the approved new prospectus and an opportunity to rescind the franchise agreement and have the fees returned.

The court stated that even if PRS’ application was timely, PRS failed to escrow the initial franchise fees, provide Mangione with the registered prospectus after its approval in August 2007 and offer rescission as required by New York law. Instead, shortly after receiving initial franchise fee payments, PRS distributed the funds as sales commissions to its broker and as salaries for the principals of the company -- the Butlers.

Because the Butlers directly engaged in the unlawful sale of the franchises to Mangione, and profited personally from his payments, the court found that the Butlers were personally liable to Mangione. The court stated that the remedies for an unlawful offer or sale of a franchise are: 1) rescission of the Franchise Agreement, 2) damages with 6% interest from the date of the transaction, and 3) reasonable attorney fees and costs. Therefore, the court found that Mangione was entitled to rescission of the franchise agreements and return of the $714,000 paid by him, plus 6% interest from May 7, 2007.

The next issue that the court addressed was whether the Butlers’ debt was dischargeable in bankruptcy. According to the court, a debtor’s debt is non-dischargeable if the money is obtained by “false pretenses, a false representation, or actual fraud.” The court found that the Butlers committed fraud by misrepresenting to Mangione that PRS had the legal right to sell franchises in New York, even though its registration was only pending, not approved. The court further stated that a debtor’s debt is non-dischargeable “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” The court stated that a debtor must prove: 1) the debt arose while the debtor was acting in a fiduciary capacity, and 2) the debt arose from the debtor’s fraud or defalcation. In this case, the court found that the Butlers’ failure to escrow the franchise fees, and their failure to return the funds to Mangione, each amounted to defalcation.

This case demonstrates the danger to the franchisor’s executives if their company fails to follow franchise sales rules. A violation of such rules can, without additional evidence of factual fraud or misrepresentation, result in those executives being held personally liable to the franchisee and being unable to obtain a discharge of that judgment in their personal bankruptcy proceedings.

Author's Note: This article was co-written by Katelyn P. Vu, who is a summer associate at Whiteford, Taylor & Preston and a 2015 J.D. candidate at the University of Baltimore Law School.