Franchising Disputes: Litigation Risks and Practice Tips. Jeffrey J. Jones and J. Todd Kennard. International Franchise Expo April 9, 2010

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1 Franchising Disputes: Litigation Risks and Practice Tips Jeffrey J. Jones and J. Todd Kennard International Franchise Expo April 9, 2010

2 Franchisee Recruiting Oral or written statements made during the sales process (particularly regarding the potential or value of the franchise) can lead to claims of: o Fraud o Misrepresentation o Violation of state deceptive trade practices or consumer sales practices acts 1

3 Franchisee Recruiting Example: Vaughn v. General Foods Corp., 797 F.2d 1403 (7 th Cir. 1986). o Franchisees of the Burger Chef system alleged that General Foods Corporation, which owned the Burger Chef system, had defrauded them by promising to support and build the system when, in fact, General Foods was planning to sell Burger Chef to Hardee s. The jury returned a verdict in the plaintiffs favor. o The court of appeals reversed, finding that the elements of fraud had not been proven. Importantly, the court found there was no misrepresentation because the statements made during sales were statements of opinion and puffing, not statements of fact. The court also found that there was no reasonable reliance because the allegedly fraudulent statements had been made over a fourteen year period, during which the plaintiffs were constantly apprised of the status of their operations. 2

4 Franchisee Recruiting Practice Tip o o Vaughn teaches that the best defense to fraud or misrepresentation claims is that no false or misleading statement of fact was made. Therefore, it is important to provide uniform training to sales staff that addresses what they can state during sales pitches. General opinions are usually okay. Ex: stating that the product is the best or good quality, that it will last a lifetime, be in perfect condition, or make substantial profits have been regarded as statements of opinion by some courts. See, e.g., Royal Business Machines, Inc. v. Lorraine Corp., 633 F.2d 34, 42 (7 th Cir. 1980). Statements of fact and quantitative predictions can lead to trouble. Ex: stating that the franchise will be worth a certain amount at the end of the year, that the market consisted of thousands of prospective customers, that the president of the franchisor was a millionaire, and that the franchisor had enjoyed solid financial success for years are considered statements of fact by some courts. See, e.g., Nationwide Motorist Ass n of Mich., Inc. v. Nationwide Motorist Ass n, Inc., 273 F. Supp. 875, 884 (W.D. Mich. 1967). 3

5 Franchise Disclosure Document Franchisors are required to strictly comply with the Amended FTC Rule. 16 C.F.R. Part 436. Under the Amended FTC Rule, franchisors must, among other things: o Provide the FDD to prospective franchisees at least 14 days before any agreement is signed or before any payment to the franchisor (16 C.F.R (a)) o Make all of the required disclosures that have been outlined in other presentations, including written substantiation for financial performance representations, if any (16 C.F.R ) 4

6 Franchise Disclosure Document There is no private right of action for a violation of the Amended FTC Rule. See, e.g., Mercy Health Sys. of Southeastern Pa. v. Metropolitan Partners Realty LLC, 2002 WL (E.D. Pa. 2002). Franchisees lobbied for such a right when the Rule was amended in 2007, but their request was not honored. ( m). Instead, the FTC is responsible for enforcement. ( o Where the Amended FTC Rule has been violated, the FTC may file an action in federal district court, seeking civil penalties of up to $10,000 per violation of the Rule with actual knowledge or knowledge fairly implied on the basis of objective circumstances that the Rule prohibits the conduct. 15 U.S.C. 45(m). 5

7 Franchise Disclosure Document Example: FTC v. TransNet Wireless Corp., 506 F. Supp.2d 1247 (S.D. Fla 2007). o The franchisor provided a disclosure that was deficient in several ways. First, it did not disclose the names and business experiences of directors and officers for the preceding 5 years. Second, it did not disclose the names, addresses, and phone numbers of other business ventures. Third, it did not state the range of time that had elapsed between the signing of the franchise agreement and site selection. Finally, it did not provide a reasonable basis for earnings claims. Based on these flaws in the FDD, the court granted summary judgment in favor of the FTC. 6

8 Franchise Disclosure Document Practice Tips o Have a compliance program in place to assist the management and sales teams o Ask legal counsel to provide training or instruction on franchise disclosure rules o Use checklists when preparing the FDD 7

9 Site Selection Various legal issues may arise, including: o Fraud or misrepresentation allegations based upon oral statements o Breach of contract based upon express language in the franchise agreement o Bad faith claims where express contractual language is absent 8

10 Site Selection Example: JRT, Inc. v. TCBY Systems, Inc., 52 F.3d 734 (8 th Cir. 1995). o A frozen yogurt store franchisee brought suit against the franchisor, alleging breach of the duty of good faith and fair dealing, fraud, and misrepresentation based upon an allegation that the franchisor failed to adequately assist with site selection. Summary judgment was granted in favor of the franchisor and the court of appeals affirmed, finding no intentional bad faith and a lack of any factual statements to support a claim of fraud or misrepresentation. 9

11 Site Selection Practice Tips o Instruct sales staff not to make oral promises regarding site selection o Make sure contractual language clearly establishes the franchisor s rights and responsibilities with respect to site selection o Include an integration clause ( this is everything that we have agreed to ; no other agreements ; changes have to be in writing ) o Make sure site selection staff fulfill their contractual obligations 10

12 Territorial Rights As with site selection, franchisees may raise various claims regarding territorial rights, including: o Fraud or misrepresentation based upon oral statements o Breach of contract based upon express language in the franchise agreement o Bad faith where express contractual language is absent o Possible statutory claims 11

13 Territorial Rights Example: John Keenan Co. v. Norrell Corp., 2001 WL (E.D. La. July 18, 2001). o The franchise agreement prohibited the franchisor from operating a competing business under the same name as that licensed under the contract. The court held that operating a competing business with a different name did not violate the franchise agreement. 12

14 Territorial Rights Example: Photovest Corp. v. Fotomat, 606 F.2d 704 (7th Cir. 1979). o The franchise agreement did not include any exclusivity language. The court found a breach of the covenant of good faith and fair dealing because the company had determined that corporate stores were more profitable than franchise units and then took action to drive down franchisee sales in an effort to get them to sell out to the franchisor. 13

15 Territorial Rights Practice Tips o Instruct sales staff not to make promises regarding territorial rights during sales pitches beyond proposed contractual language o If there is no specific territory reserved to the franchisee, include express language in the franchise agreement that permits the franchisor to establish competing businesses, regardless of their proximity to the franchisee s location. o If a specific territory is reserved to the franchisee, then be specific about what rights are reserved to the franchisor, including the right to operate other (potentially competing) distribution channels in the territory and the franchisor's ability to limit exclusivity if the franchisee does not perform (e.g., meet sales targets). 14

16 Trademark and Trade Name Actually, my name is Bobby. Jimmy's Lemonade is an international franchise. 15

17 Trademark and Trade Name Franchisors may have to pursue trademark or trade name infringement actions in situations such as: o Where franchisees are selling unauthorized goods or services in connection with the trademark or trade name o Where franchisees have been terminated or not renewed but continue to use the mark or name 16

18 Trademarks and Trade Names Example: T.G.I. Friday s Inc. v. Great Northwest Restaurants, Inc., 652 F. Supp.2d 763 (N.D. Tex. 2009). o This past summer, T.G.I. Friday s filed a trademark infringement action against franchisees who continued to use its trademarks and service marks in connection with restaurants owned and operated in California, Oregon, and Washington. The court granted a preliminary injunction in favor of the franchisor. 17

19 Trademarks and Trade Names Practice Tips o Include language that the franchisor owns the marks or has rights that are superior to the franchisee s rights. o Include language in every franchise agreement that addresses proper use of the franchisor s trademarks and trade name during the relationship. o Also include language that expressly ends the franchisee s right to use trademarks and trade names after termination. o Be aware of franchisees activities both during the relationship and afterward to protect trademarks and trade names. 18

20 Transfers by Franchisees If a franchisee wants to sell the franchised business and the franchisor does not agree with the transfer, the franchisee may take legal action. Possible causes of action include: o Breach of contract (actual or implied duty to withhold approval only where reasonable) o Tortious interference o Statutory provisions 19

21 Transfers by Franchisees Example: Brock v. Baskin-Robbins, USA, Co., 2003 WL (E.D. Tex. Jan. 17, 2003). o Ice cream store franchisees sued the franchisor after it declined to approve the franchisee s request to transfer the franchise. The court found that a provision in the franchise agreement that allowed the franchisor to withhold consent for any reason precluded a claim for tortious interference with the potential transfer agreement. 20

22 Transfers by Franchisees Practice Tips o Include language in the franchise agreement that allows the franchisor complete discretion to withhold approval of a transfer. o Be sure the agreement includes an integration clause. o Consider approving the transfer where the proposed transferee is acceptable from a business perspective and the risk of litigation warrants such approval. o Where the franchisee s suggested transferee is unacceptable, consider steering potential buyers to the franchisee or even purchasing the location and re-selling it or operating it as a company-owned store, if permissible, until a suitable purchaser can be found. 21

23 Injuries to Customers of the Franchisee and Vicarious Liability Individuals injured by franchisees products, facilities, or employees may sue the franchisor, seeking a deep pocket. In some cases, a court may find a franchisor vicariously liable where it is demonstrated that the franchisee was the franchisor s agent as to the product, facility, or employee at issue. 22

24 Injuries to Customers of the Franchisee and Vicarious Liability When determining whether a franchisor is the agent of a franchisee, courts focus on whether the franchisor had control or the right of control over the product, facility, or employee at issue. Kerl v. Dennis Rasmussen, Inc., 682 N.W.2d 328 (Wisc. 2004). In other words, a franchisor may be vicariously liable for the tortious conduct of its franchisee when it, in fact, has control or right of control over the daily operation of the specific aspect of the franchisee's business that is alleged to have caused the harm. Papa John s Int l v. McCoy, 244 S.W.3d 44 (Ky. 2008). 23

25 Injuries to Customers of the Franchisee and Vicarious Liability Example: Papa John s Int l v. McCoy, 244 S.W.3d 44 (Ky. 2008). o A customer brought suit against a pizza franchisor for injuries incurred in connection with an encounter with a delivery driver. The court found that vicarious liability is possible only where the franchisor has control over the daily operations of the portion of the franchisee s business that is alleged to have caused the harm. The court then held that the franchisor did not have control over the conduct of delivery drivers, so there was no vicarious liability. 24

26 Injuries to Customers of the Franchisee and Vicarious Liability Example: Butler v. McDonald s Corp., 110 F. Supp.2d 62 (D. R.I. 2000). o The parents of a child who was injured by a glass door at a McDonald s franchise sued McDonald s. McDonald s argued there was no vicarious liability because it did not control the franchisee as a principal would in an agency relationship. The court declined to grant McDonald s summary judgment based upon evidence that McDonald s exercised a right of control through its requirement that the franchisee conform to the McDonald s comprehensive system, the frequent and detailed inspection of the premises and its operations, the taking of profits, and the right of the defendant to terminate the agreement for material breach. Id. at 67. Importantly, the court s decision has been criticized. For example, the New Hampshire Supreme Court has declined to follow it, stating that vicarious liability turns on the defendant s level of control over the alleged instrumentality that caused the harm, not general control. Vandemark v. McDonald s Corp, 904 A.2d 627 (D. N.H. 2006). 25

27 Injuries to Customers of the Franchisee and Vicarious Liability Practice Tip o Some control over franchisees is necessary to maintain uniformity and acceptable standards. However, franchisors should also make clear that the franchisee is responsible for his or her facilities and employees. 26

28 Conditions Placed Upon Franchisee Franchisors desire uniformity and achieve their goal by imposing conditions on franchisees. However, franchisees may allege that conditions are an improper vertical restraint on trade (imposed by one level of distribution on a lower level) in violation of: o federal antitrust laws (the Sherman Act, the Clayton Act, and the Robinson-Patman Act) o state anti-trust laws 27

29 Conditions Placed Upon Franchisee Vertical restraints, whether they involve price or some other factor, are judged under the rule of reason, which requires the fact finder to weigh all of the circumstances including specific information about the relevant business and the restraint s history, nature, and effect. The rule distinguishes between restraints with an anticompetitive effect, which are illegal, and restraints with a procompetitive effect, which are in the consumer s best interest. Leegin Creative Leather Prods., Inc. v. PSKS, Inc., 127 S.Ct (2007). 28

30 Conditions Placed Upon Franchisee Example: Ezzo's Investments, Inc. v. Royal Beauty Supply, Inc., 243 F.3d 980 (6th Cir. 2001). o A manufacturer of hair care products required retailers to be beauty salons that obtained more than 50% of their revenues from hair care services in order to carry their products. A terminated salon argued this was an improper vertical restraint on trade. Applying the rule of reason, the court held the restriction was proper. 29

31 Conditions Placed Upon Franchisee Example: o In November 2009, The National Franchise Association, a group that represents more than 80 percent of Burger King's U.S. franchisees, sued Burger King in federal district court, arguing that Burger King cannot force franchisees to sell double cheeseburgers for only $1 because the burgers cost $1.10 or more to produce. In short, it has asserted that, through the promotion, Burger King is improperly setting a maximum price. 30

32 Conditions Placed Upon Franchisee Practice Tip o If restraints are reasonable in light of the nature of your business, they can be upheld under the antitrust laws. Carefully research the restraint and use your best judgment. 31

33 Termination/Non-Renewal Termination/non-renewal is undeniably a hotbutton issue. There are many possible legal theories franchisees can use when challenging termination or non-renewal. o Some state statutes provide that termination can only be for good cause (e.g., some state dealer statutes) o Breach of express contractual provisions o Breach of the duty of good faith and fair dealing in the absence of express contractual terms 32

34 Termination/Non-Renewal Every state for-cause statute is different, but the following issues are sometimes deemed sufficient for termination: o Failure to comply with the terms of the franchise agreement o Abandonment of the franchise o Criminal conviction o Acts that impair the franchisor s trademarks or trade name o Insolvency/bankruptcy o Loss of the right to occupy the premises o Failure to pay franchisor moneys due o Fraud or conduct that reflects badly on the franchise system o Failure to follow applicable laws o Imminent danger to the public health or safety 33

35 Termination/Non-Renewal When a franchise agreement expressly provides the grounds upon which a franchise may be terminated, courts will often enforce such provisions, except to the extent that statutory provisions require otherwise. Similarly, provisions for termination on notice without cause are often enforced unless subject to statutory regulations. In Highway Equip. Co. v. Caterpillar, Inc., 707 F. Supp. 954, 958 (S.D. Ohio 1989), the court held that a provision for termination without cause on 90- days notice gave either party the unbridled discretion to terminate the contract for any reason or no reason. 34

36 Termination/Non-Renewal Practice Tips for Termination o Make sure the franchise agreement has clear contractual provisions that govern termination. Where possible, include a term that permits termination on notice without cause. o Communicate with the franchisee throughout the process o Document the termination process o Deliver a timely, written notice of termination o Maintain objective procedures treat franchisees similarly o Consider an in-house appeal procedure o Make sure your compliance department is aware of any state statutes that govern termination Alternatives o Facilitate the transfer of the franchise to another party, if appropriate 35

37 Spotlight on Discovery In franchising cases, discovery can sometimes be expansive and can delve into your everyday operations, including potentially how important decisions are made. Moreover, discovery can be sought from a joint venture, not just from manufacturers or franchisors who transfer their brands. o For example, this past summer, a federal district court held that a group of beer distributors were entitled to discovery on the issue of how important operational decisions were made and who made them at MillerCoors, a new joint venture created when Miller and Coors transferred their brands. In other words, the court permitted the distributors to reach beyond the original manufacturers to seek discovery from the new joint venture. Beverage Distributors, Inc, et al. v. Miller Brewing Co., et al., 2009 WL (S.D. Ohio June 2, 2009). 36

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