Franchise Lawyer Blog

Rights to assignment are crucial to franchisees and have been discussed in this Blog previously. Less discussed, but just as important, is the franchisor's right to assign. Many franchisees buy into a system in reliance on the franchisor's reputation and experience. Franchisees are not aware that franchise agreements frequently give to the franchisors an unfettered right to sell the systems at any time. This right has been tested by the courts and has been upheld.

In a 2009 appeal of a 2007 case, Century Pac., Inc. v. Hilton Hotels Corp., 528 F.Supp.2d 206, 227-228, 230 (S.D.N.Y. 2007); aff'd 354 Fed.Appx. 496, 2009 WL 4072087 (C.A.2 (N.Y.)), Century Pacific, Inc. (“Century”), a Red Lion Hotel franchisee, alleged that the franchisor, Hilton Hotels Corp. (“Hilton”) induced Century into entering into a franchise agreement by representing that Hilton had no intention of selling the Red Lion brand. Subsequent to the franchise purchase, Hilton sold the brand to a third party.

Century asserted claims under New York law for (i) common law fraud; (ii) negligent misrepresentation; and (iii) fraudulent omission in connection with purported misrepresentations made to Century concerning Hilton's intention to keep the Red Lion brand. The District Court ruled against Century and that decision was upheld by the U.S. Court of Appeals. The ruling centered on Century's lack of reasonable reliance upon defendants' representations.

The Court of Appeals found in favor of defendants, stating that Century was a sophisticated party and was aware of the possibility of a sale of the Red Lion brand. Further, the Court of Appeals was swayed by the fact that Century attempted to negotiate a provision preventing a sale of the Red Lion brand, a concession that Century was unable to obtain. Without bargained-for language prohibiting a sale of the Red Lion brand, the Court of Appeals ruled that it was unreasonable for Century, a sophisticated party with knowledge of a risk of sale, to rely on any purported misrepresentations.

This cautionary tale warns franchisors that their franchise agreements must clearly give to them the right to assign their franchise agreements and alerts franchisees to the typical inclusion in most franchise agreements of a franchisor right to convey the system, a right that will result in franchisees dealing with entirely different parties than those from whom it purchased its franchise.

By Richard Bayer

One of the interesting and frustrating things about practicing franchise law is the dizzying manner in which the law is evolving. Because the franchise model extends into virtually every industry, the legal developments come in every conceivable area of practice. It is very difficult for the practitioner to remain current. Here are a couple of recent developments in insurance and antitrust, for example:

Alvord Investments LLC v. The Hartford Financial Services Group, Inc., et.al. 660 F.Supp 2d 850 (W.D. Tenn.2009) stands for the proposition that a franchisor will not be covered under its Directors and Officers policy for a franchisee claim where the policy contains broad language that excludes coverage for claims arising in any way from any franchisee in any capacity. In this case the coverage was denied even though the claimant was no longer a franchisee, the court reading the language to apply the exclusion even to former franchisees. Franchisors should examine their policies and the endorsements contained therein to confirm they are covered for claims by former or current franchisees, or claims arising from their relationships with their franchisees.

Antitrust law is a complex and changing area of the law with respect to franchising. We have previously discussed the impact on franchisors of the re-evaluation of vertical minimum price agreements in the context of the 2007 Leegin case. We read a recent case that sheds some light on the confusing subject of illegal tying arrangements.
An illegal tying arrangment is created when a party agrees to sell one product on the condition that the buyer will also purchase another different product. This is illegal under the Sherman Act where the the seller maintains "market power" in the tied products market.
In the case of Burda v. Wendy's Int'l Inc., Bus Franchise Guide (CCH) #14,240 (S.D. Ohio Sept. 21, 2009), a Wendy's franchisee claimed that the required purchase of food supplies from a Wendy's subsiduary was an illegal tied product, the "tying product" being the sale of the franchise. The court focused on an evaluation of market power based upon a "lock-in" theory; that is, once the purchaser acquired the franchise, did it become locked in to purchase the tied products and was this policy known at the time of the sale. The court found that the claim was valid if Wendy's had not revealed the requirement at the time of the sale of the franchise. If the franchisor puts the franchisee on notice of exclusive purchase requirements prior to the time the franchise is sold, the claimant would be unable to establish a "lock-in" claim.
The decision gives specific language that would serve as appropriate notice. If the franchisor states in its FDD and franchise agreement that it may decide in its sole discretion to require franchisees to purchase exclusively from the franchisor and approved suppliers, then the illegal tying antitrust claim can be avoided. The disclosure of exclusive supply arrangements should be made in the FDD in any event; the avoidance of antitrust claims makes their inclusion even more compelling.

The United States District Court for the Western District of Pennsylvania has denied a motion by Quizno’s to dismiss certain claims of franchisees of the system that the sandwich shop franchisor fraudulently induced execution of the plaintiffs’ franchise agreements, notwithstanding that the franchisees also executed and delivered to the franchisor written disclaimers of reliance on any statements other than those in the Uniform Franchise Offering Circular given to them.

The plaintiffs in Martrano v. The Quizno’s Franchise Co., L.L.C. compose a putative class of Pennsylvania sandwich shop franchisees who allege, among other things, that their franchisor made specific misrepresentations in its UFOC. The plaintiffs asserted that reliance on those misrepresentations was not waived by the plain language of the franchise agreements and other documents executed by the parties. The franchisees alleged fraud in the inducement of execution of their franchise agreements in the context of claims that Quizno’s violated the federal RICO statute (by charging above-market markups on required services/supplies and over-saturating the market with franchises and by exploiting its economic power over the franchisees to extract exorbitant, unjustifiable payments).

Quizno’s directed the court’s attention to the “Disclosure Acknowledgement Statement” signed by each plaintiff franchisee, which document provided that (1) the franchisee was cognizant of the business risks; (2) the franchisee had reviewed, and had had an opportunity to consult with legal counsel regarding, the franchise investment and the UFOC and other documents; (3) the franchisee’s decision was not predicated upon any oral representations, assurances, warranties, guarantees, or promises made by the franchisor or any of its officers, employees, or agents as to the likelihood of success of the franchise; and (4) except as contained in the UFOC, the franchisee had not received any information from the franchisor concerning actual, average, projected, or forecasted sales, profits, or earnings.

The Disclosure Acknowledgement Statement went on to ask the subscribing franchisee to describe, in space provided, any information concerning actual, average, projected, or forecasted franchise sales, profits, or earnings other than those contained in the UFOC—or to write, “None.”

Notably, the most important basis for the franchisees’ claim of fraud—a statement in the UFOC that the franchisor negotiated with suppliers to obtain discounts for the franchisees’ benefit—was explicitly excepted from the disclaimer.

The court observed that other courts considering the issue have refused to enforce franchise agreement disclaimer provisions on the ground either that public policy forbids contractual preclusion of liability for intentional misconduct, such as fraud, or that a party cannot waive the right to sue for fraud in the inducement by a provision in the contract the validity of which itself is challenged. The court cited to both Westerfield v. Quiznos Franchise Company, LLC (in Wisconsin) and Elhilu v. Quiznos Franchise Co., LLC (in California).

“Because the disclaimer does not purport to nullify an important representation on which Plaintiffs’ fraud claim is based in substantial part,” the court wrote, “Plaintiffs are entitled to go forward with that claim; and it is not necessary at the present stage for the Court to decide whether, in view of the foregoing considerations, the disclaimer provision may be unenforceable with respect to other representations.”

What really got the Martrano court toasty under the robe, however, is the Quizno’s defendants’ invocation of the disclaimer, and in particular the emphasis on the apparent opportunity to identify other statements relied upon. The court found these, in a word, “deceptive.”

“If, as has been alleged,” the court wrote, “Quiznos pursued a policy of requiring all franchisees to write ‘none’ in the blank ostensibly provided for identification of statements relied upon, then the inclusion of a blank to be filled in by the franchisee in lieu of a pre-printed provision amounts to a sham, whose apparent purpose is to mislead a subsequent reviewer, such as this Court, into believing that Quiznos’ unilaterally-prescribed disclaimer language was actually authored without constraint by the franchisees.”

Mmmm… Shady.

by Matthew D. Brozik

The U.S. District Court in Colorado ruled in April in a case involving Quiznos that a provision in a franchise agreement that bars franchisees from banding together in class-action lawsuits is enforceable. The decision is seen as affecting other class-action lawsuits against Quiznos in Wisconsin, Illinois and Pennsylvania and may serve as a precedent discouraging such actions in other systems. Such prohibitions are common in franchise agreements. The extent of the impact of the decision remains to be seen. See Franchise Times June/July isse for further discussion.

The plaintiffs had argued, among other things, that fraudulent practices on the part of Quiznos rendered the entire agreement fraudulent and unenforceable. The Court disagreed. The Court held the class action provision was enforceable based upon a seven part test created by the Colorado Supreme Court in an earlier case, known as the "Davis Factors":

Is the agreement standardized, made by the parties with unequal bargaining power?
Did the parties have an opportunity to read the agreement before signing it?
Did the document bury the provision in fine print?
Is the provision commercially reasonable?
Is the provision substantively unfair?
What is the relationship between the parties?
What are the remaining circumstances surrounding the formation of the contract?

The plaintiffs remain dissatisfied with the result, which their attorneys describe as being fundamentally unfair to individual franchisees. As was reported in BlueMauMau:

Justin Klein of law firm Marks & Klein LLP, attorney for the franchisees, takes exception to the ruling. “The Quiznos franchise agreement says that franchisees have to sue Quiznos one on one,” he explains. “The purpose of our seeking a class action is because it is too expensive to sue Quiznos. It could cost hundreds of thousands of dollars for the individual to sue Quiznos in order to recover their initial franchise fee, which in some cases is $20k - $25k."

However, Judge Arguello found that the fact that the Quiznos franchise agreement is essentially a take-it-or-leave-it contract did not automatically render it unconscionable, because the plaintiffs did not have to enter into an agreement with Quiznos; being new franchisees, they were free to decline and purchase another franchise. More importantly, the plaintiffs had ample opportunity to read and consider the clause and the Court found the clause itself not to be substantively unfair or "unreasonably overreaching."
Bonanno, et.al. v The Quiznos Franchise Company,. LLC, 2009 WL 1068744 (D.Colo.)

We will keep you advised as to how this decision impacts on other judicial holdings across the nation.

Franchisors and franchisees each have a vested interest in determining the prices of the goods or services being sold at franchised locations. These concerns and the manner in which they are addressed frequently bring the franchise world into contact with the labyrinthian world of legal antitrust restrictions.

One basic form of price control is minimum retail prices; that is, the franchisor and/or its suppliers establishing a pricing floor beneath which their products cannot be sold. The motivations behind this device are many: to maximize profits; to prevent dilution of the value of the good and/or services; to encourage competition, etc. For 96 years, vertical minimum price agreements; i.e., agreements running up and down from franchisees/retailers to manufacturers/distributors/franchisors, were considered per se illegal under Section 1 of the Sherman Act as anti-competitive price fixing. Per se illegality means they are automatically illegal regardless of the circumstances.

Then in 2007 came the case now referred to as Leegin. In Leegin, the United States Supreme Court ruled that vertical price restraints should hereafter be judged by "the rule of reason," overruling the 1911 case of Dr. Miles Medical Co. v. John D. Park & Sons Co. Justice Anthony Kennedy's majority opinion held that "Dr. Miles had erred by treating vertical minimum price agreements between manufacturers and retailers as analogous to horizontal price-fixing agreements between sellers."

Since then, commentators have been divided on the impact of Leegin. While the decision has been recognized as affording companies, including franchisors, greater flexibility in imposing minimum retail price maintenance programs, it has been noted that it is not clear how state laws will be affected by the federal decision or even if the states will follow it at all. Many states have laws as restrictive as the Sherman Act but not identical to it.Only time will tell how the individual states continue to enforce their laws intended to prevent anti-competitive behaviour.

On the other hand, some business commentators have noted a willingness on the part of manufacturers, and presumably franchisors and their suppliers, to "embrace their newfound pricing power." Some of have expressed concern that this will feed inflation.

The effect of the case will bear close scrutiny for some time. Congress continues to look at the effect of the Leegin decision on consumer prices. Many legal commentators warn that determining that vertical minimum price maintenance is not per se illegal is not the same thing as saying that it is per se legal; in other words, the rule of reason analysis can still find that the conduct violates the Sherman Act. For that reason, franchisors and their manufacturers and suppliers are urged to implement any such pricing structures with a carefully thought out plan that takes into account the specifics of the Supreme Court's decision.

Not all franchises succeed and some industries are inherently riskier than others. Perhaps none is more risky than start-up restaurants. Although the risks and obstacles to success in these types of ventures are well known, it is human nature to look for someone (other than yourself) to blame when failure occurs. In the franchising universe, sometimes the franchisor is to blame. But not always.

A United States District Court in Georgia has ruled in favor of a franchisor, Raving Brands, in a lawsuit filed against it last year by a group of franchisees. The franchisees had each claimed fraud and misrepresentations against the former franchisor in the purchase of a Mama Fu franchise. Mama Fu's is a restaurant serving pan-Asian cuisine.

The federal judge ruled that there are natural risks associated with the acquisition of a franchise, particularly a restaurant, and that it was these economic conditions that caused the failure of the franchisees' locations, not any misrepresentations by the franchisor. The court found that the franchisor had clear intentions of building a chain as successful as their hugely popular Moe's Southwest Grill. But various conditions prevented that from happening. Franchisee lawyers take issue with the decision, noting that clear evidence was presented demonstrating some misrepresentations in the sale of the concept.

Raving Brands has since sold the system to Murphy Adams Restaurant Group. That franchisor continues to push the sale of updated models of its franchise.

A recent news item reported that the Burger King franchisor entered into a multi-million dollar settlement for a personal injury suit. Why was the Burger King franchisor ultimately liable for an accident that took place on the premises of one of its franchisees? The legal principles affecting that question should be of great concern to any franchisor.

The basis for this claim and others like it rest in a variety of legal concepts founded on the notion of vicarious liability; that is, liability imposed upon a party because of the actions of another. The claims are usually based on the doctrine of respondeat superior, which provides that the franchisor, as master, is liable for the acts of its servants and agents, in this case the franchisee. Other cases present the argument as one of "ostensible agency," the franchisee effectively acts as agent on behalf of the franchisor and so any liability created by the franchisee becomes the franchisor's.

The key element to determine is the degree of control; whether the franchisor had the right to control the conduct of the franchisee that caused the injury. Ironically, retaining control over the business environment is typically viewed as being of vital importance to a franchisor's business success. In this context, control becomes a double-edged sword.

It has been recommended that this exposure can be reduced by including disclaimers and waivers of control within the franchise agreement. Too often, the issue of franchisor liability for franchisee actions are covered in standardized clauses covering liability and indemnification that are inserted into franchise agreements without much thought. However, a carefully written agreement will seek to retain control in certain vital areas (financial reporting, for instance), while disclaiming or waiving any degree of control over certain day to day operations of a franchisee that might give rise to liability.

When a franchisor sues a franchisee to obtain judicial blessing of a notice of default and termination—on the franchisor’s own initiative, or because the franchisee challenges the validity of the termination—typically the franchisor will include a cause of action for trademark infringement and move early, perhaps immediately, for a preliminary injunction enjoining the franchisee from continuing to use the franchisor’s intellectual property. Such an injunction, if granted, effectively shuts down the franchisee, inasmuch as it is the use of the franchisor’s intellectual property that the franchisee is paying for, principally.

The franchisor’s argument to the court, as it must be, is that the continued use of its trade marks, et cetera, by the franchisee allegedly in default is a violation of both contract and law that will cause the franchisor irreparable harm. This is probably true if the default at issue concerns a system violation concerning heath, safety, or the quality of goods or services provided by the franchisee.

But what if the default is simply an alleged failure to pay money, or the like? The franchisor might be likely to prevail on this cause of action, and in the end would be entitled to terminate the franchise agreement (and the included license to use its marks), but there is no harm to the public during the pendency of the action. If the doughnuts are the same as they ever were, for example, then there is no risk of consumer confusion, the sine qua non of trademark protection. Accordingly there is, arguably, no reason to enjoin the franchisee’s use of the marks pending trial of the action.

To the contrary, injunction would require the franchisee to go dark, almost always ruining its business. Therefore, even if trial reveals that the franchisor is not entitled to judgment, potentially irremediable damage to the franchisee will have been done—damage that an injunction bond might not adequately protect against.

The law is, for better or worse (that is, better for franchisors, worse for franchisees), that a franchisor is entitled to stop a franchisee from using the franchisor’s marks even while it remains to be decided by a court whether the franchisee has defaulted in its obligations under its franchise agreements. But should it be so?

Continue reading "Dollars to Donuts: The Dark Side of Trademark Injunctions in Franchise Actions" »

We noted in our first blog that both the business and the law of franchising are rapidly developing. One of our aims in this blog is to assist interested parties in staying abreast of those developments, whether they be attorneys, franchisors, franchisees or others working with them.

Our August 12 blog discussed a significant case for franchisees. Franchisor rights have also been evolving. In a significant victory for franchisors, a federal appeals court has ruled that a franchisor may require the purchase and use of specific equipment by its franchisees. The United States Court of Appeals for the Eighth Circuit, in a case involving Domino’s Pizza (Bores v. Domino’s Pizza, LLC, 530 F.3d 671 [2008]), overruled the trial court and held that a provision in the Domino’s franchise agreement permitted the franchisor to require its franchisees to purchase and install custom-designed integrated computer systems created specially for Domino’s units. The lower court ruling had caused significant concern in the franchise industry, where many franchise agreements require the purchase of specific computer equipment for point-of-sale systems.

The reversal turned on interpretation of the words “any” and “specification.” The franchisee plaintiffs argued that the provision at issue—“We will provide you with specifications for… computer hardware and software…. You may purchase items meeting our specifications from any source.”—had meaning only if the equipment at issue were available for sale from more than one source. The court disagreed. The court held as well that in fact a franchisee could purchase the point-of-sale equipment mandated either new from Domino’s or used from another franchisee.

Franchise practioners continue to assemble these fresh readings of contract language and statutory references to make certain that their own documents present their clients with the most advantageous interpretation.

Periodically we will examine recent decisions and statutory developments that relate to the relationships of franchisors and franchisees. The following is a developing case of significance.

Unless the Court of Appeals rules otherwise—and whether the high court of New York State will even hear the issue remains to be seen—a franchisor may not employ a pre-sale questionnaire subscribed by a prospective franchisee to summarily defeat the franchisee’s claims of fraud brought under the New York Franchise Act.

In Emfore Corp. v. Blimpie Associates, Ltd, et al., the Appellate Division, First Department reversed the trial court’s dismissal of a franchisee plaintiff’s claims of fraud in the inducement under section 687 of the NY Franchise Act, holding that subsections (4) and (5), the “anti-waiver” provisions of the Act, preclude such dismissal.

Blimpie, supported by the International Franchise Association as amicus curiae, moved the First Department to reconsider, maintaining that questionnaires are used to root out fraud, not to foster it; the appellate court in May modified its decision and order, but did not alter its general holding. Again with the IFA in its corner, Blimpie most recently moved the First Department for a clarification of its ruling or, in the alternative, leave to appeal to the Court of Appeals. The First Department last week denied the motion in its entirety.

Einbinder & Dunn represents Emfore Corp.
Submitted by Matthew D. Brozik, Esq.