Category: Business Law

Signal 88 Security case illustrates the Challenge of Obtaining A Preliminary Injunction to Enforce a Franchise Non-Compete

August 4th, 2017

A covenant not to compete is typically included in a franchise agreement to ensure that customer goodwill, once developed in the name of franchise, is not destroyed by former franchisees. The ultimate weapon for a franchisor to enforce a covenant not to compete is obtaining a preliminary injunction against the former franchisee. However, many courts place a heavy burden on the franchisor to prove that a preliminary injunction is proper.  The recent case of Colorado Security Consultants, LLC v. Signal 88 Franchise Group,  decided in March 2017 by the U.S. District Court for the District of Nebraska, illustrates how difficult that burden can be to meet under unfavorable facts.

Colorado Security Consultants, LLC (CSC), had a three year franchise agreement with franchisor, Signal 88 Franchise Group, Inc., to provide on-site security guard services within a territory in Colorado Springs. CSC also had a right of first refusal over additional franchises to be added within a radius of Colorado Springs. At the end of the initial term, the franchisor and franchisee continued the franchise agreement on a month-to-month basis, subject to 30-day notice of termination.  Signal 88 informed CSC that another person, Rebecca Resendes, wished to enter into a franchise agreement for a territory in the right of first refusal area where CSC had developed contracts with some customers.  Resendes and CSC negotiated for several months over her either purchasing CSC’s franchise or compensating CSC for customers it had developed in her contemplated territory.  When no agreement was reached Resendes signed a direct franchise agreement with Signal 88.  After additional negotiations between CSC and Resendes failed, Signal 88 told CSC that it had to stop serving customers in Resendes’ territory and then terminated CSC’s franchise entirely.  CSC began providing security services under the name “Guardhail”, and then Signal 88 sued CSC for violation of the 2 year post termination non-compete and sought an injunction to stop it from providing any security services.

To obtain an injunction Signal 88 had to demonstrate the following: (a) without an injunction it would suffer irreparable harm greater than the harm the franchisee would suffer from its issuance; (b) it had more than 50% likelihood of demonstrating violation of an enforceable non-compete by CSC, and (c) the injunction would serve the public interest.

Signal 88 alleged that CSC was causing it irreparable harm because it “contacted Signal 88’s customers, undercut Signal 88 on price, and caused a number of customers to cancel contracts with Signal 88.” CSC responded that it did not use “any of the names or trademarks of Signal 88” nor did they use any confidential materials.  All customer contracts in the Signal 88 system are entered into in the name of the franchisor, which also does billing and collection. So if Guardhail sought to continue to serve the customers that CSC recruited for Signal 88 (as seems likely) then CSC would have had to utilize the customer contact information and likely would have made offers that were more attractive than the pricing offered under the franchise.

Nevertheless, in declining to issue a preliminary injunction, the Court determined that Signal 88 failed to show that the “harm is certain and great and of such imminence that there is a clear and present need for equitable relief,” because Signal 88 failed to show that in the harm of CSC’s actions “threatened the very existence” of Signal 88’s business. Accordingly, even if there is a loss of customers and revenue for Signal 88, money damages would still suffice without the “extraordinary” measure of a preliminary injunction.

Signal 88 also argued that failing to enforce the non-compete would cause “irreparable harm to its franchise system”, presumably by encouraging other franchisees to not renew and to flout the non-compete. The court said that Signal 88 had no evidence to back up that general supposition.  Since a preliminary injunction would effectively put CSC out of business and would moot the parties’ claims before addressing the merits of the case, including CSC’s breach of contract counterclaim, the court found that the balance of hardships heavily favored CSC.

Despite the case being heard in Signal 88’s hometown of Omaha and the franchise agreement stating that Nebraska law governed, the Court held that Colorado had a greater material interest in the franchise agreement and therefore its laws regarding non-competes applied. Under Colorado law non-compete provisions are disfavored except to protect trade secrets or if issued when selling one’s business. The Court found that the evidence presented did not demonstrate CSC’s use of Signal 88’s trade secrets with any specificity.  Moreover, CSC argued that, as Signal 88’s selling and servicing agent when dealing with the customers, its principals were Signal 88’s employees – an allegation that, if proven, would cause the non-compete being held to very strict scrutiny under applicable law.  Since that determination is fact-specific the Court would not make such a decision at the preliminary injunction stage.

It is likely that these factors heavily influenced the Court’s denial of the preliminary injunction: (a) CSC recruited and developed the Signal 88 security customers in Colorado Springs, probably through the sales efforts of its owners more than franchisor-provided marketing; (b) accordingly CSC was not provided a customer list and did not inherit a list of long-standing Signal 88 customers, so the Colorado Springs customer list was not trade secret provided by Signal 88; and (c) Signal 88 terminated its relationship with CSC, apparently without cause, and allowed new franchisee Resendes to service all of CSC’s contracts without requiring her to pay for the goodwill that CSC had developed in them.

As this case shows, absent favorable facts it is very difficult for a franchisor to obtain a preliminary injunction enforcing a non-compete. Accordingly, certain franchisors may be well-served by adding a provision requiring a former franchisee that violates a post-expiration covenant not to compete to pay 2 years’ worth of continuing franchise fees.  Such a liquidated damages provision is more easily enforced and represents a fair compromise between franchisor’s interest in retaining customer goodwill and franchisees’ interests in making sure that the franchisor’s brand and business system continue to provide value.

Recent Franchise Non-Compete Cases Show Unpredictability of Enforcement

December 20th, 2013

Summary: Recent cases involving attempted enforcement of covenants not to compete by franchisors show the unpredictability of the results in such cases. However, careful reading of the factual circumstances of the cases also supports the adage that “bad facts make bad law.” So it behooves franchisors to check whether they have a sympathetic case on the facts when trying to enforce their non-competes.

In July 2013, in the case of Golden Crust Patties, Inc. v. Bullock, Case No. 13-CV-2241, the U.S. District Court for the Eastern District of New York “threw the book” at a recently terminated Golden Krust Caribbean Bakery & Grill Restaurant franchisee. The franchise was terminated because the franchisee was “not only selling the competitor’s products (i.e., frozen Caribbean-style patties), but were selling those products using Golden Krust packaging.” Thus, the franchisee was engaging in a classic form of trademark piracy, likely to cause harm to the brand. Despite receiving an immediate termination notice, the franchisee only stopped using the trademarks after Golden Krust filed suit. Even then, rather than adopting a new name it put up a sign reading, “Come in. We are Open. Nothing has Changed Only Our Name”; and another sign that read: “Open. Same Great Food, Same Great Service. Thanks for Your Support!!! Come Again.”

Under those circumstances, the court enjoined the former franchisee and her son, who had managed the restaurant, from continued operation of a Caribbean-style restaurant. In its order the court, acting under New York law, enjoined such operations at the former franchised location and within 4 miles of it (rather than 10 miles, as written in the contract), or within 2.5 miles of any other Golden Krust restaurant (rather than 5 miles, as written in the contract). While giving them a bit of a break on the geographic extent of the non-compete, the court overall had no sympathy for the franchisee’s arguments of harm to their livelihood, including the possibility that their landlord would not allow them to operate a different type of restaurant at the leased premises; rather, the court found that to be a harm of the former franchisee’s own making.

In September of this year, in the case of Steak ‘N Shake Enterprises, Inc. v. Globex Company, LLC, the U.S. District Court for the District of Colorado found that the franchisor had good cause to terminate and force its Denver franchisee to cease use of the trademarks, but did not find cause to enjoin the former franchisee from violating the covenant not to compete. The cause for termination was that the franchisee refused to comply with the franchisor’s demand that it offer a “$4 value menu” and instead insisted on charging higher prices. The court held that Steak ‘N Shake had good cause to terminate the franchise and enjoined continued use of the Steak ‘N Shake trademarks, trade dress and menu item names.

However, the court did not order the former franchisee to refrain from operating a similar restaurant, finding that, because the next closest Steak ‘N Shake restaurant was in Colorado Springs (about 100 miles away) and the franchisor had no prospects to open up any Denver area locations in the near future, it could not prove irreparable harm if the former franchisee continued to operate. This decision does not preclude the franchisor from seeking damages due to violation of the covenant not to compete later in this case. While not expressly stated in the opinion, it is quite possible that the court may have been swayed by the fact that Steak ‘N Shake was requiring that an enormous number of meals be offered for $3.99, which likely would mean little or no profit to the franchisee on those sales. In other words, Steak ‘N Shake had a right to insist that restaurants using its name follow its pricing demands, but if it chose to terminate on those grounds it would have to suffer repercussions.

Finally, on August 6, 2013, in the case of Outdoor Lighting Perspectives Franchising, Inc. v. Patrick Harders, the North Carolina Court of Appeals affirmed a state trial court ruling denying enforcement of a post-expiration covenant not to compete by a North Carolina based franchisor against its former franchisee in northern Virginia. In so doing, the court wrote, “During the time in which Mr. Harders operated as an OLP franchisee, entities holding OLP franchises encountered numerous problems with OLP suppliers. Since [Outdoor Living Brands] purchased [the franchisor] in 2008, numerous franchises have closed and the OLP business model has been devalued. Among other things, [the franchisor] failed to provide its franchisees with adequate support, feedback, and product innovation. Although the information provided to Mr. Harders and OLP-NVA by [the franchisor] was alleged to be proprietary, much of it was publicly available and common knowledge in the industry. Similarly, the training that Mr. Harders had received from [the franchisor] was readily available without charge in many national home improvement stores.

Once the court laid out the facts in this manner, it was obvious that it would rule against the franchisor. It did so in a fairly creative manner, seizing on the fact that the non-compete prohibited the non-renewing franchisee from engaging in a “competitive business” within any “Affiliate’s territory.” At the time of the franchise agreement, the franchisor was only involved in Outdoor Lighting Perspectives, but during the term the franchisor was purchased by OUtdoor Living Brands, which also owned the Mosquito Squad® and Achadeck® franchise systems. While the likely purpose of restricting competition with “affiliates” was to protect Outdoor Lighting Perspective businesses owned by the Franchisor’s corporate siblings, and the franchisor was not seeking to enjoin the former franchisee from competing with later-acquired affiliates in unrelated fields, the literal language of the non-compete supported an argument that it was overbroad in its geographic scope.

The court also found that the definition of a prohibited “Competitive Business” under this non-compete was overly broad. It prohibited involvement in “any business operating in competition with an outdoor lighting business” or “any business similar to the Business.” The provision’s scope could prohibit the former franchisee from operating an indoor lighting business or “obtaining employment at a major home improvement store that sold outdoor lighting supplies, equipment tor services as a small part of its business even if he had no direct involvement” in that part of the operation. The appeals court affirmed the trial court’s decision to read the provision literally and therefore refuse to enforce it in any manner, rather than entering a more limited injunction prohibiting the former franchisee from operating or managing an outdoor lighting business.

Conclusion

These court rulings demonstrate the “bad facts make bad law” truism. The Golden Krust franchisor had a sympathetic case and a franchisee acting badly; in the Steak ‘N Shake case, the parties clearly needed to go their separate ways, but the franchisor’s inflexibility persuaded the court to allow the franchisee to operate independently, at least pending a full trial; and the Outdoor Lighting franchisor, despite litigating in its “home court,” apparently had such an unimpressive franchise system that the court was unwilling to fashion an equitable remedy when confronting an overly broad non-compete. These cases should make franchisors think carefully about the situations in which they seek to enjoin competition by their former franchisees.

Courts Enforce Waivers of Class Actions in Arbitration By Franchisees, Employees and Small Businesses

July 18th, 2013

In 1925, the Federal Arbitration Act (“FAA”) was enacted to strengthen the ability of parties to enforce “purely voluntary” pre-dispute promises to have disputes determined through arbitration. See, e.g., David S. Clancy & Matthew M.K. Stein, An Uninvited Guest: Class Arbitration and the Federal Arbitration Act’s Legislative History, 63 Bus. Law. 55, 60-61 (Nov. 2007). In the decades since, countless federal and state statutes have been passed to protect consumers, employees, franchisees, small businesses and investors, and class and collective lawsuits have developed as an avenue to vindicate those statutory rights. In response, companies have used arbitration clauses to decrease the risks of having to defend against such large potential liabilities. Recent decisions by both the U.S. Court of Appeals for the Fourth Circuit and the U.S. Supreme Court have emphasized that, if the arbitration clause clearly bars class or collective actions, then the FAA precludes parties to the agreement from pursuing a class or group action through court or arbitration. This established trend of statutory interpretation also may be increasing the possibility of that the U.S. Congress will pass the “Arbitration Fairness Act” to limit companies’ ability to use arbitration clauses as a bar to collective legal actions.

Shuttle Express Case – Fourth Circuit

In the case of Muriithi v. Shuttle Express, Inc., issued April 1, 2013, the U.S. Court of Appeals for the Fourth Circuit required individual arbitration of claims due to a franchise agreement’s inclusion of an arbitration clause 1) forbidding any class or group actions, 2) requiring the parties to split the cost of arbitration, and 3) containing a one-year limitations provision.

Plaintiff Samuel Muriithi was a driver for defendant Shuttle Express, who provided transportation for passengers to and from the Baltimore-Washington International Airport. Muriithi filed a class action in federal court against Shuttle Express asserting claims under the federal Fair Labor Standards Act (FLSA) and under Maryland law on behalf of himself and all other Shuttle Express drivers. Muriihi alleged that Shuttle Express misled the drivers about the compensation they would earn, inducing them to sign franchise agreements when they would be employees as a matter of law. Shuttle Express moved to dismiss the complaint, or in the alternative, to compel arbitration under the arbitration provision. The district court refused to compel arbitration on the grounds that the agreement contained three unconscionable provisions, which rendered the arbitration clause unenforceable. On appeal, the Fourth Circuit reversed the district court’s decision, holding that all three provisions at issue were not unconscionable and, therefore, the arbitration clause was enforceable.

In addressing the enforceability of the class action waiver, the Fourth Circuit rejected the district court’s decision, which identified the class action waiver as a factor in preventing Muriihi from “fully vindicating his statutory rights.” The Fourth Circuit explained that, subsequent to the district court’s decision, the U.S. Supreme Court addressed the issue of class action waivers in AT&T Mobility LLV v. Concepcion, 131 S. Ct. 1740 (2011). According to the court, the FAA, as interpreted in the Concepcion decision and prior Supreme Court rulings, “prohibited courts from altering otherwise valid arbitration agreements by applying the doctrine of unconscionability to eliminate a term barring classwide procedures.” Because the district court reached an opposite conclusion prior to Concepcion, the Fourth Circuit reversed the district court’s decision, finding the class action waiver enforceable.

The Fourth Circuit then addressed the enforceability of the fee-splitting provision. The court found that Muriithi failed to meet his “substantial” burden of showing the likelihood of incurring prohibitive costs as required to invalidate an arbitration agreement. The court explained that a fee-splitting provision has the ability to render an arbitration agreement unenforceable if the arbitration costs are “so prohibitive as to effectively deny the employee access to the arbitral forum.” According to the court, a number of factors are considered when determining prohibitive costs including, “the costs and fees of arbitration, the claimant’s ability to pay, the value of the claim, and the difference between arbitration and litigation.” The court concluded that Muriithi did not meet his substantial burden for proving prohibitive costs because he failed to show the costs of arbitration, “the most basic element” of the challenge. The court further explained that Muriihi could not meet his burden “simply by showing the fees that some arbitrators are charging somewhere.” Muriithi also failed to show the value of his claims, which were necessary to determine the fees under the American Arbitration Association’s rules. Because Murihhi failed to prove these “critical factors”, the Fourth Circuit concluded that he had failed to meet the substantial burden required for a finding of prohibitive costs.

Finally, the Fourth Circuit held that the one-year limitations provision could not be considered in a motion to compel arbitration because it was “not referenced in the Arbitration Clause.” The court referred to Section 2 of the FAA, which states that a party challenging the enforceability of an arbitration clause must rely on grounds that “relate specifically to the arbitration clause and not just to the contract as a whole.” The court stated that the one-year limitations provision related to the general agreement itself rather than the arbitration clause because the language and terms of the provision “did not overlap” with the language of contract’s arbitration clause. Therefore, its enforceability was an issue to be decided by the arbitrator and could not be considered in the motion to compel arbitration.

American Express Antitrust Case – U.S. Supreme Court

In American Express Co. v. Italian Colors Restaurant, No. 12-133 (June 20, 2013), the U.S. Supreme Court, by a 5-4 majority, held that the prohibitively high cost of pursuing an individual claim is not a sufficient reason to invalidate a class action waiver in an arbitration agreement. This decision reinforces Concepcion in demonstrating the Court’s willingness to allow arbitration clauses to be used as class action avoidance mechanisms. This ruling also validates the Fourth Circuit’s interpretation of Concepcion in its Shuttle Express decision.

American Express (“Amex”) requires all of its merchants to enter into a standard form contract. These agreements contain arbitration provisions that require all disputes between the parties to be resolved by arbitration and prohibit all class action claims. In this case, a group of merchants filed individual claims against Amex, claiming that Amex used its “monopoly power” to force them into contractual agreements that violate anti-trust laws. Amex moved to dismiss and to compel arbitration. The district court agreed with Amex, and the merchants appealed. On appeal, the United States Court of Appeals for the Second Circuit reversed, finding the class action waiver unenforceable because the costs that an individual merchant would incur to pursue its claim would substantially exceed the amount of that individual merchant’s damages. The Supreme Court reversed the Second Circuit’s decision.

Justice Scalia, writing for the narrow majority, emphasized that the “overarching principle” of arbitration is a matter of contract, and that courts must “rigorously enforce” arbitration agreements by their expressed terms unless the FAA’s mandate has been “overridden by a contrary congressional command.” The majority failed to find any contrary congressional command that would require a rejection of the class action waiver. According to the Court, antitrust laws do not guarantee that a claim will be resolved affordably, nor do they “evince[e] an intention to preclude a waiver” of class-action procedure.

The Court rejected the merchants’ argument that enforcing the waiver of class arbitration bars effective vindication because merchants have no economic incentive to pursue their antitrust claims individually in arbitration. The Court declined to apply the “effective vindication” exception to the case at hand on the grounds that the exception’s purpose is to prevent “prospective waiver of a party’s right to pursue statutory remedies.” The Court explained that not being worth the costs to prove a statutory remedy is not an elimination of the right to pursue that remedy. In other words, according to the Court, class action waivers merely limit arbitration to the two contracting parties and do not eliminate parties’ rights to pursue statutory remedies.

The majority referred to its decisions in Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20 (1991) and AT&T Mobility LLC v. Concepcion, 130 S. Ct. 1740 (2011) (also decided by a 5-4 vote), to validate that class action waivers in arbitration agreements are, indeed, enforceable and therefore do not preclude the effective vindication of statutory rights. In Gilmer, the Court had “no qualms in enforcing a class waiver in an arbitration agreement even though the federal statute at issue…expressly permitted collective actions.” In Concepcion, the Court stated that class arbitration was not necessary to prosecute claims “that might otherwise slip through the legal system.”

In Justice Kagan’s dissent, she emphasized that the purpose of the FAA is to resolve disputes and facilitate compensation of injuries. According to Justice Kagan, the majority’s decision “admirably flaunt[s]” the fact that monopolists get to use their power to force merchants into contracts that deprive them of all legal recourse. “Too darn bad,” says Justice Kagan, as she describes the majority’s decision in a nutshell. Justice Kagan explains that the majority’s decision offers support to parties who intend to confer immunity from potentially meritorious federal claims through arbitration clauses in standardized form “contracts of adhesion”, which is contrary to the purpose of the FAA as enacted in 1925.

What does this mean?

In light of the body of U.S. Supreme Court precedent in this issue, nearly all parties offering contracts to large groups of similarly situated persons such as employees, franchisees, and consumers of services, should strongly consider including an arbitration provision in the contract that explicitly bars class or collective actions. Under current law, those waivers will almost certainly be enforced and therefore sharply limit the likelihood that the company will have to defend against large-scale litigation brought by disaffected members of such groups. Such arbitration clauses do need to be carefully drafted and implemented to avoid other defenses to their enforcement, and they should be prepared and implemented with the assistance of experienced counsel.

Of course, ubiquitous arbitration clauses and these judicial decisions sharply limit the ability of private practice attorneys to deter violations of protective statutes through civil dispute resolution, leaving an even greater burden of enforcement on overburdened government regulators. This is unlikely to change unless the FAA is amended through legislation. In recent years, the “Arbitration Fairness Act” has been pending in the U.S. Congress. This act would invalidate the enforceability of pre-dispute arbitration clauses with regard to employment, consumer, and civil rights disputes, and antitrust class action proceedings. The bill has been languishing in recent years, and it remains to be seen whether the Supreme Court’s latest decision spurs more aggressive Congressional action on this issue.

AUTHOR’S NOTE: THIS ARTICLE WAS CO-WRITTEN BY DAVID L. CAHN, CHAIR OF THE FRANCHISE BUSINESS LAW GROUP AT WHITEFORD TAYLOR & PRESTON, AND KATELYN P. VU, WHO IS A SUMMER ASSOCIATE AT THE FIRM AND A 2015 J.D. CANDIDATE AT UNIVERSITY OF BALTIMORE LAW SCHOOL.

PLEASE ALSO NOTE THAT THIS ARTICLE REPRESENTS THE VIEWS OF THE AUTHORS AND NOT THE VIEWS OF WHITEFORD TAYLOR & PRESTON L.L.P.

Hashim and Walker Provide Valuable Insight on Franchise Agreement and Relationship Priorities

May 20th, 2013

David Cahn

David Cahn

In the opening General Session of the International Franchise Association (“IFA”) Legal Symposium on May 6, 2013, Aziz Hashim, President & CEO of NRD Holdings, LLC (Multi-Unit Franchisee of Popeye’s, Checkers, and Domino’s Pizza) & the IFA’s current Secretary, and Kenneth L. Walker, formerly IFA Chairman and the Chairman of the Board of Driven Brands, Inc. (franchisor of Meineke Car Care businesses), commented on franchise agreements and franchise relationship management in an interview-style program moderated by Joel Buckberg. Their comments, which are summarized below, demonstrate both the promise and the challenges inherent in franchising.

Franchise Agreement “Turn-offs”: Hashim’s “bad marks” when evaluating franchise agreements all relate to the security of the franchisee’s equity investment in the business, and are:
1. Franchisor’s right to a liquidated damages award following termination for any reason;
2. Unlimited personal guarantees required by the franchisee’s owners, particularly after an approved sale of the owner’s interest in the franchisee;
3. Franchisor’s right to require the buyer of a location to sign the franchisor’s then-current form of franchise agreement, which might have higher fees or weakened territorial rights;
4. Franchisor’s right to require “periodic” remodeling, without limitations on the frequency, timing or cost of the facility changes.

Walker did not list any concerns with franchise agreements, which is not surprising given his background as a franchisor executive. However, he did emphasize that one of his biggest “turnoffs” when he was CEO (from 1996 until 2012) was having the first contact in a negotiation coming from a franchisee’s lawyer rather than the franchisee executive himself. He was much more likely to negotiate an issue with a franchisee who first approached him directly, even if the final agreement might be worked through by each party’s counsel.

Use of Marketing Funds: Walker expressed a preference for wide franchisor discretion in deciding how to use franchisee contributions, as long as the uses were devoted to growing franchisees’ businesses. Hashim agreed, but with the caveat that franchisees had to be actively engaged and consulted as to the franchisor’s proposed uses of the monies. Hashim objected to use of such funds to cover part of franchisor’s executive salaries (such as for a Chief Marketing Officer) or to conduct product development analysis. He supported flexible uses such as contributing towards the remodeling and rebranding of franchisee restaurants. Walker agreed that franchisee engagement and “buy-in” is critical, on the basis that it is better to have a somewhat flawed marketing plan that is widely executed than an outstanding plan that the franchisees refuse to implement.

Territorial Rights: With regard to franchisees’ territory protections, Walker argued that if the brand as a whole is losing market share to competitors with its existing network of locations, then it should be able to “backfill” with additional franchises. Hashim seemed to agree, as long as the plan protected franchisees who were properly executing the system and meeting expected revenue targets.
Supply Chain Controls: Hashim argued that franchisors should not require purchases of commonly available supplies or ingredients from more expensive sources, if the franchisees can obtain the same items less expensively through other means. He said that at a minimum, there should be clear disclosure to prospective franchisees of how the franchisor makes money from the supply chain.

Facility Remodeling and “Upgrades”: The panelists agreed that it is critical for franchisors to efficiently monitor the quality of goods and services being provided and to discipline franchisees who are not meeting such standards. However, Hashim argued that franchisors need to “make the business case” as to how facility updates or remodeling are going to benefit the profitability and value of the franchisees’ businesses rather than just drive revenue growth. He also believes that “smart franchisors” help fund the costs of facility updates to obtain rapid adoption by most franchisees.
Transfer: Walker emphasized the need to make sure that approval of a transfer is unlikely to harm the viability of a location. Hashim said that it is critical that the franchisor’s rules for obtaining approval are clear, objective and disclosed to active franchisees, and if the criteria are changed the franchisor should be able to explain why change is necessary. Hashim recommends this simple test: “If you would sell this person a new franchise, then you should approve a transfer to that same person.”

Training and Operations Support: Walker believes that in-person, live training and conventions continue to have value in fostering a team spirit among franchisees and an exchange of best practices information, as compared to Internet “webinars” or recorded trainings. Hashim expressed frustration that the ratio of franchisor field staff or “business consultants” to franchisees has been decreasing over time, and the experience level of those consultants has been decreasing. He said that periodic visits by qualified field representatives play in important role in franchisee satisfaction and success.
Termination and Damages: Despite his broad disapproval of personal guarantees and liquidated damages, Hashim agreed with Walker that, if a franchisee is not in financial distress but simply wants to quit the franchise to stop paying royalties, then it is appropriate to require that franchisee to pay termination compensation to the franchisor.

Concluding Comments: Hashim made the following noteworthy comments to franchisors:
1. Recognize that you are not bestowing franchise rights, but rather recruiting important business partners;
2. Don’t make your franchise agreement so harsh that it scares of good prospective franchisees, since quality franchisees drive a brand’s success;
3. Poll your best franchisees to find out their thoughts about the brand and franchisor staff;
4. Mystery shop your franchise salespeople, to find out what they are saying (and failing to say) to prospects; and
5. Employ a true ombudsman to address franchisee complaints and concerns before they mushroom into disputes.

In many ways this program showed the best that the IFA has to offer, since it brought together franchisor and franchisee perspectives for the purpose of furthering industry best practices. It also highlighted Aziz Hashim as a rising leader in franchising who bears watching in the future.

Another Court Ruling Shows Franchisors the Value of Providing an Item 19 FPR

May 10th, 2013
David Cahn

David Cahn

Takeaway: 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, decided February 12, 2013, 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 it 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 the franchisee the data in the FDD and made it easy for him to investigate further, so it is ridiculous to believe he relied on something are franchise salesperson said.” In that situation it may be more likely than not that the jury would agree with the franchisor. By contrast, 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 believe that the franchise seller “went over the line.”

“Gangland” Judicial Opinion is a Reminder of Liability for Franchisees and Their Franchisors

November 26th, 2012

David Cahn


In Ford v. Palmden Restaurants, LLC, the Court of Appeals of California issued a strong reminder to both restaurant franchisees and their franchisors of their potential liability for criminal conduct that takes place on a restaurant’s premises. While the legal principles at issue differ for franchisees and franchisors, this potential liability is one that neither can ignore.

The case involved a Denny’s restaurant in Palm Springs, California, that was operated by Palmden Restaurants, LLC (“Palmden”). Starting during 2002 members of a gang known as the Gateway Posse Crips (“Gateway”) would “take over” the restaurant around 2 a.m. each Sunday, after closing of the club that they “hung out at” on Saturday night. “Taking over” meant:

“Members of the Gateway group refused to wait in line; they would just seat themselves. They were loud; they would use “foul language.” They would “table-hop.” Only a few of them would order food, and the ones who did would leave without paying. Other customers responded by canceling their orders or asking for their food to go and then leaving. Some Gateway members would stay outside in the parking lot, drinking and smoking marijuana. They had had “many fights,” both outside and inside the restaurant.”

In March 2003, there was a significant brawl around 2 a.m. at the restaurant, instigated by members of Gateway. The fight involved injuries to “innocent” female patrons, overturned furniture and a broken window. Police officers recommended to the owner of Palmden that she take several security measures, including installing video cameras and hiring off-duty uniformed police officers. Palmden closed the restaurant for the early a.m. hours only during the first weekend after the brawl, and thereafter Gateway resumed its “take overs.” Palmden did not install security cameras, hire off-duty police officers or take other new substantive security measures.

In April 2004, Terrelle Ford, who was a loan officer, had the misfortune of being at the restaurant with friends on a Sunday at 2 a.m. when the Gateway members arrived. A large group of men began beating one man standing outside the restaurant, and some of Ford’s friends went outside to break up the fight. When Ford saw his cousin being attacked he came outside to protect him and was severely beaten by Gateway members, suffering permanent brain injury. Shortly thereafter Palmden began closing the restaurant on Sundays in the early a.m., and the Gateway gang found a new “after-hours hangout.”

Could the Franchisee Be Liable for the Patron’s Injuries?

The trial court had granted summary judgment in favor of Palmden, finding that it could not be liable for the harms caused by the criminal acts of the Gateway gang members. The appeals court disagreed and reversed, sending the case back for trial.

The court, following well-established precedent, held that all restaurants and other public establishments have an obligation to undertake reasonable steps to secure common areas against the foreseeable criminal acts of third parties that are likely to occur without such precautionary measures: “The more certain the likelihood of harm, the higher the burden a court will impose on a [proprietor] to prevent it; the less foreseeable the harm, the lower the burden a court will place on a [proprietor].” The central question was the extent of Palmden’s duty to take action to prevent gang violence, and the essence of the decision was that Palmden was liable because it adopted no meaningful new security measures after the 2003 gang fight and before Ford’s severe beating. As the court said:

“We emphasize that we are not saying that a business that is plagued by gang members necessarily has to shut down (even for a few hours). It would be perfectly reasonable for it to experiment first with lesser measures, such as surveillance cameras, security guards, or a protective order. [Palmden argues that] it is speculative [whether] these would have been successful. What we can say with certainty is that either these measures would have worked, or else closing down the restaurant would have worked.”

Therefore, Palmden’s failure to act may have been a substantial cause of Ford’s injuries and Ford had a right to have a jury decide Palmden’s liability.

What About the Franchisor?

Ford advanced several arguments as to why DFO, LLC, the Denny’s franchisor; Denny’s, Inc., which leased the restaurant to Palmden; and the parent company of both of those entities, Denny’s Corporation, should be held jointly liable for his damages. The court found that summary judgment could be overturned on the grounds that Palmden was those entities’ “ostensible agent” in operating the restaurant, because Ford was not aware that the Denny’s restaurant was a franchise and his belief that it was a “corporate location” must be reasonable under the circumstances. The court found the following facts important in making that conclusion:

“While some Denny’s restaurants are franchisee-operated, others are corporate-operated; hence, we cannot say it is common knowledge that all Denny’s are necessarily franchises. There was no signage or other indication that the particular Denny’s was actually operated by a franchisee. Finally, Ford testified that he had seen advertisements identifying Denny’s as “a family style restaurant . . . in which a patron could enjoy a good meal in a friendly, safe, and secure environment” and that this led him to conclude that “[h]e and [his] friends could enjoy a meal at the subject Denny’s . . . .” ”

The court also reversed summary judgment in favor of the landlord, Denny’s, Inc., the parent company Denny’s Corporation and other affiliates, on the basis that they might be “alter egos” of the franchisor DFO, LLC. The trial court had granted summary judgment for those entities without analysis and they had not provided the appeals court with support in favor of keeping them out of the case.

Takeaways

If you own a restaurant you have a duty to your patrons and employees to establish security that is reasonable under the circumstances. If the circumstances are as dire as described in this case, your best course of action is to close the restaurant during the dangerous hours, and if you need permission build the case for doing so in writing directed to your franchisor and/or landlord.

If you are a restaurant franchisor, at a minimum make sure that each restaurant has a conspicuous sign identifying who owns the restaurant, as an independent licensee of your company. If the restaurant is run by your affiliate company, then that affiliate should be identified just like a franchisee. Seek to include the words “independently owned” in any local advertising. For casual dining establishments, consider including a place in the menu template to identify the owner, perhaps underneath the logo.

Contingency Planning For The Business Owner – Are You Covered?

November 8th, 2012

David Cahn

Most of the work that I do for franchise owners (or “franchisees”) falls into two categories: (1) helping to evaluate a potential franchise opportunity and negotiating the franchise agreement and real estate lease, and (2) representing franchisees seeking to exit the franchise, including evaluating claims against the franchisor. While grateful to serve in those capacities, I worry whether franchisees and other small business owners are adequately planning for and protecting against their own death or disability.

While life and disability income insurance are very important, there are several legal and practical issues that business owners (or indeed all reasonably solvent adults) should address while they are healthy and of sound mind. Some of those issues are:

1. Will: Why do you need a will? Without one, after you die the laws of the state where you live and held property will determine what happens to that property. Your spouse, children or other heirs could end up with less than you planned, the assets could be mismanaged, your minor children might not have the guardian you wished, or your estate could end up paying more in taxes and legal fees than necessary. Writing a will allows you to control who gets what, and also could enable you to leave some of your assets to charities or other causes. Clarity is particularly important if you own a business since succession planning is critical to the wellbeing of the business’s employees and other stakeholders.

2. Titling of Assets: How you hold title to certain assets can have a significant effect on the ability of your creditors to take away those assets. If you are married, holding an asset in the names of yourself and your spouse may prevent a creditor of only one of you from taking that asset. However, this is often more appropriate for personal assets (such as homes and cars) than ownership interests in a business. If you are not married then there are other legal devices that, under appropriate circumstances, could enable you to shield assets from seizure if your financial fortunes decline.

3. Durable Power of Attorney: A power of attorney (“POA”) designates a representative to perform certain actions on your behalf. A durable POA can be particularly important if you are a small business owner, to make sure that the business is able to function on your behalf if you become ill, incapacitated or otherwise unable to manage your affairs, since otherwise your chosen representative (usually a spouse, parent or sibling) will have to receive court approval to perform needed financial transactions. However, the durable POA also needs to be crafted with some care to avoid any abuse by the appointed representative.

4. Living Will and Medical Proxy: A living will is a written declaration of what life-sustaining medical treatments you will allow or not allow if you are incapacitated; for example, life-sustaining nourishment when terminally ill. The medical proxy or medical POA authorizes a specific individual to make medical decisions for you if you are unable to do so.

5. Letters of Instruction: In this digital age a lot of our personal and digital information is saved electronically in password-protected accounts. After your death the person you chose to manage your estate (your “personal representative”) will benefit greatly from written instructions on how to access those accounts. Since the will itself is meant to cover the disposition of categories of property, the letters of instruction can aid your personal representative in disposing of specific pieces of property (such as family heirlooms) in the manner that you wish.

6. Life Insurance Trust. One common trust for people of even relatively modest means is a trust to hold life insurance policies. Estates with net assets of over $1,000,000 are subject to the estate taxes in Maryland and several other states, and the federal (U.S.) estate tax threshold has been moved several times in recent years but may move down to $1,000,000 effective January 1, 2013. Utilizing an irrevocable trust to hold your life insurance policy excludes their death benefits from your estate, which may allow your estate to be completely exempt from taxation.

Estate planning is not just for people like Bill Gates, Oprah Winfrey or Mark Zuckerberg – it is necessary for all reasonably successful adults and particularly for franchise owners. At Whiteford Taylor & Preston we have a talented team of estates and trust attorneys licensed in Maryland, New York, Pennsylvania, Virginia and the District of Columbia who can assist you on the types of issues described above at either fixed fees or reasonable hourly rates. Contact us so we can help you make sure that your bases are covered.

NLRB “Pushing the Envelope” to Protect Employees’ Rights to Communicate Online

July 11th, 2012

David Cahn

Section 7 of the U.S. National Labor Relations Act (“NLRA”) states,

Employees shall have the right to self-organization, to form, join, or assist labor organizations, to bargain collectively through representatives of their own choosing, and to engage in other concerted activities for the purpose of collective bargaining or other mutual aid or protection . . .

U.S. Code, Title 29, Section 157.

This provision and the balance of the NLRA, which was enacted during the Great Depression of the 1930’s, are primarily focused on the right to join a union and collectively bargain. As the percentage of U.S. private sector employees represented by unions has dropped substantially over recent decades, the NLRA has become a much less prominent part of the discussion of employment-related legal matters. However, through its recent activities the current National Labor Relations Board (“NLRB”) has indicated its determination to make the NLRA relevant to all U.S. employees (and employers), by focusing on the last part of the quoted portion of Section 7, “Employees shall have the right . . . to engage in other concerted activities for the purpose of . . . mutual aid or protection.”

Among the areas where this emphasis is being shown is the ability of employers to limit employees’ use of social media networks such as Facebook. The “social media policies” area is particularly interesting because many (if not most) of employees’ online posts relating to their employers cannot be construed as “concerted activities for the purpose of mutual aid or protection.” Nevertheless, the NLRB has authority to stop an employer from maintaining a “work rule” that if that rule “would reasonably tend to” discourage employees from communicating with other employees “for the purpose of mutual aid or protection.” If the “social media policy” does not clearly restrict protected activities, such as by forbidding employees to “friend” each other on Facebook or to write posts about wages, hours or working conditions, then the policy only violates the NLRA if: “(1) employees would reasonably construe the language to prohibit Section 7 activity; (2) the rule was promulgated in response to union activity; or (3) the rule has been applied to restrict the exercise of Section 7 rights.”

In several cases, the NLRB has found that an employer’s social media policy has in fact been applied to restrict the exercise of Section 7 rights, and required the employer to reinstate employees terminated due to their Facebook postings and subsequent responses by Facebook friends. For example, after an employee of a collections agency was transferred to a different position that would substantially limit her earning capacity, she posted on her Facebook page that her employer had “messed up” (using expletives) and that she was “done with being a good employee.” The employee was Facebook friends with approximately 10 current and former coworkers, including her direct supervisor. An extensive exchange ensued among the coworkers regarding the employer’s management methods and preference for cheap labor, culminating with one of the former employees calling for a class action among the disaffected workers.

The employee who had prompted the exchange was fired the next work day explicitly because of her Facebook posts and the responses they triggered. The NLRB found the discharge to be a violation of the NLRA because (a) the employer had an unlawfully broad “non-disparagement policy,” the violation of which was the basis for the termination, and (b) the employee had been fired for “engaging in conduct that implicates the concerns underlying Section 7 of the Act.”

In other recent cases brought before it, the NLRB has concluded that, while the complaining former employee was not unlawfully discharged due to his or her online postings, the employer’s policy itself violated the NLRA and needed to be modified. In response to this, the NLRB recently issued a report summarizing its decisions specifically on acceptable social media policies, and perhaps most importantly, has in essence provided a sample policy that it has deemed to be lawful. The policy, as amended by Wal-Mart after the initiation of an NLRB complaint regarding its prior policy, focuses fairly narrowly on refraining from posts that “include discriminatory remarks, harassment and threats of violence” or are “meant to intentionally harm someone’s reputation.” While the policy forbids dissemination of the company’s confidential information, it provides a sufficient specific definition of “trade secrets” to put employees on notice that the policy (probably) does not include internal reports or procedures specifically touching on conditions of employment. Perhaps most importantly, the policy expressly acknowledges that employees may post work-related complaints and criticism, even while discounting the possibility that such posts are likely to result in changes that the employee seeks.

If your company has a social media policy, we can review it for purposes of conforming it to the NLRB’s latest guidance on acceptable policies and help you avoid future problems that could result from overly broad restrictions on employee’s online conduct. Of course, as specific situations arise we are available to counsel you as to legally appropriate measures to take in response to employee’s online conduct.

Can I Stop “Bargain Basement Pricing” of My Branded Products?

May 7th, 2012

David Cahn

While the continuous growth of Internet-based commerce has to lower prices for many consumer shopping for goods, it has been a major problem for many “bricks and mortar” retailers and also has caused concerns for product manufacturers who want to insure quality experiences for customers purchasing their goods. The question is the extent to which manufacturers may, under applicable U.S. anti-trust and competition law, take steps to protect the image of their brand as well as stopping the “e-tailers” from “free-riding” on the promotion efforts of traditional retailers.

U.S. law applicable to manufacturer’s application of retail pricing requirements has been in flux since the Supreme Court’s decision in Leegin Creative Leather Products, Inc v. PSKS, Inc., 127 S. Ct. 2705 (2007). In that decision, the Court overruled the holding in Dr. Miles Medical Co. v. John D. Park & Sons Co., 31 S. Ct. 376 (1911), that any agreement not to sell a product at below a specific minimum price was per se illegal under Section 1 of the Sherman Act, the U.S.’s primary antitrust statute.

In Leegin, the Court ruled that, in determining whether Section 1 of the Sherman Act is violated by a series of express agreements in which dealers promise not to sell a manufacturer’s product at below a specific retail price, courts would apply the so-called “Rule of Reason” to determine whether such an agreement actually causes harm to competition. To boil this down, such an agreement will not violate U.S. antitrust law if (a) the manufacturer does not have more than 25% market share for the sale of that type of product, and (b) the minimum pricing program is not the result of the demands of a single dominant retailer or an agreement among retailers purchasing a substantial percentage of the goods to demand that the manufacturer adopt such policies (as opposed to individual retailers’ complaints).

An example of the “dealer cartel” scenario was a 2008 ruling in Toledo Mack Sales & Service, Inc. v. Mack Trucks, Inc., in which Mack Trucks terminated a dealer who repeatedly sought sales of products in other dealer’s primary service areas by undercutting the local dealers on price. After numerous dealers complained about that specific discounter, and after Mack demanded that the discounter comply with pricing guidelines, Mack Trucks finally ceases supplying the discounter. Because Mack Trucks does have appreciable market power nationally in heavy construction equipment, the U.S. District Court refused to grant Mack summary judgment and the Third Circuit Court of Appeals upheld that decision.

A fact pattern in which a dominant retailer allegedly coercing several manufacturers into minimum pricing requirements is a 2008 ruling in Babyage.com, Inc. v. Toys “R” Us, Inc., which a court refused to dismiss a claim by an Internet retailer involving alleged actions by “Babies ‘R’ Us“ with regard to the sale of strollers and other baby products. Specifically, Babies ‘R’ Us allegedly threatened to cease buying the manufacturers’ items or to give them extremely unfavorable shelf space and promotion unless the manufacturer enforced a minimum RPM program with regard to Internet retailers. Because Babies ‘R’ Us has sufficient market power to coerce the manufacturers with such threats, its actions may have harmed competition at the consumer level and therefore violated the Sherman Act.

If a manufacturer has appreciable market power in a product market, then the risk of a series of minimum RPM agreements increases, particularly if manufacturers that also have substantial market share implement similar minimum RPM agreements and this “parallel conduct” causes an overall increase in pricing for “high-quality” apparel of this type. Such contracts may still be permissible under U.S. antitrust law if the manufacturer can demonstrate that it is driven by the desire to maintain the brand’s profile in high end (and high volume) traditional retail outlets, which would not be possible without such a program. If it can make the business case that such a move actually will result in higher total volume sales on a wholesale basis, then such contract clauses may be “pro-competitive” as envisioned by the Supreme Court in Leegin.

Yes, but What About State Antitrust Laws?

As the Supreme Court emphasized in a 1989 opinion, “Congress intended the federal antitrust laws to supplement, not displace, state antitrust remedies”, and states are free to enact laws that further the purposes embodied by U.S. anti-trust law of “deterring anticompetitive conduct and ensuring the compensation of victims of that conduct.” California v. ARC America Corp., 490 U.S. 93 (1989). In somewhere between 11 and 14 different U.S. states, including California, Illinois, Maryland, Michigan, New York, New Jersey and Ohio, it is illegal to enter into any contract requiring another party to agree to not to sell a product or service below a specific price. The manufacturer cannot enforce an express minimum RPM agreement with any retailer that is headquartered in any of those states, and it is possible that such retailers could prevail in a state law civil antitrust claim if the manufacturer refuses to sell and the retailer can prove damages from not being able to obtain the manufacturer’s products.

Moreover, in eight states (including California, Illinois, Michigan, New Jersey and New York), consumers have standing as “indirect purchasers” to pursue claims for damages in the amount of inflated prices caused by resale price maintenance programs. The decision of the Supreme Court of Kansas in O’Brien v. Leegin Creative Leather Products, Inc., Case No. 101,100 (decided May 4, 2012), Kansas’ highest court reversed summary judgment against the plaintiffs in a class action case brought under Kansas’ anti-trust statute against the same manufacturer of Brighton leather goods that had won the U.S. Supreme Court victory in 2007. Under the Kansas law, the practice of implementing and enforcing a retail pricing policy to be a per se violation of Kansas anti-trust statute, which that court summarized as follows:

There are alternate theories under which a Kansas restraint of trade plaintiff may proceed [under the state’s statute]: A plaintiff may prove the existence of an arrangement, contract, agreement, trust, or combination between persons designed to advance, reduce, or control price, or one that tends to advance, reduce, or control price. Mere arrangements between persons are within the scope of the statute; a plaintiff does not have to show a relationship rising to the level of an agreement. In addition, it is enough to show that the arrangement is designed to or tends to control prices; a plaintiff does not have to show that the arrangement actually succeeds in increasing prices.

It remains to be seen whether other states with statutes that more specifically address resale price maintenance follow this opinion and find that a practice intended to maintain a brand’s retail pricing is a violation, even if it is not embodied in a formal agreement between the manufacturer and its retailers.

Manufacturer’s Unilateral Use of a Pricing Policy

If a manufacturer sells at wholesale through purchase orders or other less formal means than written dealer agreements, there is little need for any reciprocal written agreement with retailers. Instead, in accepting purchase orders a manufacturer might unilaterally state, “Our products will be delivered to you with minimum suggested retail pricing (“MSRP”) for each item. If you sell any of our products at below the MSRP, we reserve the right to refuse to supply you with our products at wholesale in the future.” Such a policy is not a considered a “contract, combination or conspiracy” in restraint of trade, but rather the unilateral act of the seller. United States v. Colgate, 250 U.S. 300 (1919). See also, Australian Gold, Inc. v. Hatfield, 436 F.3d 1228, 1236 (10th Cir. 2006) (holding that similar “rights reserved” language in a standard written, bilateral distributor agreement constituted unilateral action permissible under Colgate).

California and New York courts have confirmed that proper implementation of a Colgate policy is not a violation of their state antitrust laws. State of New York v. Tempur-pedic International, Inc., 916 N.Y.S.2d 900 (N.Y. County Sup. Ct. 2011) and Chavez v. Whirlpool Corporation 93 Cal. App. 4th 363 (Cal. Ct. App. 2001). However, the New York Attorney General’s office appeal of the adverse trial court ruling in Temper-pedic is currently pending.

Another method of mitigating risks is to use a Minimum Advertised Price (“MAP”) policy, rather than MSRP. Such a policy would merely restrict the advertising of the product for sale below a specific price. It does not restrict retailers from discounting at checkout, whether at a physical location or the “shopping cart” of a website, if the discounting is evenly applied to all goods sold by the retailer and is not specific to the manufacturer’s products.

There are disadvantages to using a Colgate policy. First, the manufacturer cannot offer more favorable pricing or terms for retailers who explicitly agree to adhere to the MSRP, since that would turn the policy into a bilateral agreement. Second, the manufacturer’s sole remedy is to cease selling to the retailer without issuing any additional warning. Confronting the retailer and demanding that it comply with policy risks waiving the Colgate defense to a claim of unlawful conspiracy, particularly if (as is usually the case) the confrontation is prompted by complaining dealers. Under Colgate, the manufacturer is free to “cut off” the discounter after receiving complaints from other retailers (subject to the “dealer cartel” issue explained above), but it cannot try to coerce the “violator” into complying.

Kansas Supreme Court’s decision in O’Brien v. Leegin Creative Leather Products, Inc. demonstrates the difficulty of proving that a pricing program’s implementation was truly “unilateral” by the manufacturer. While acknowledging that truly unilateral conduct by “Brighton” by issuing a pricing policy and then cutting off violating retailers would not prove a “combination” that is necessary to violate Kansas’ antitrust law. However, the Court found that two emails from Brighton’s chief operating officer to retailers, one denying a retailer’s request to offer discounted pricing and another explaining why compliance with the policy was important for all retailers of Brighton products, was sufficient evidence to show a knowing “arrangement” between Brighton and independent retailers to maintain the prices paid by consumers to Brighton’s suggested retail price. That court was clearly influenced by the facts that Brighton has a substantial direct to consumer retail sales division, including its own retail stores in Kansas, and also that Brighton “cut off” at least one Kansas retailer after receiving complaints about its discount pricing from another independent Kansas retailer.

Promotional Allowances

The one “inducement” that a manufacturer may be able to provide and remain within the Colgate exemption is promotional assistance to retailers who comply with MSRP or the MAP policy. If the manufacturer catches one of the retailers violating the policy, it can inform that retailer that it is no longer eligible for the allowance. The manufacturer should not “bargain” with the retailer after sending such a notice, i.e., agreeing to resume the assistance if the retailer agrees to comply with the policy. It can continue to supply the retailer and monitor its retail pricing and sales practices, and if that retailer starts complying then the manufacturer can resume providing promotional assistance. However, this type of program may be risky to use in the states identified above in which RPM programs are or may be per se unlawful.

Implementation

Even if individual retailers’ complaints (or threats) have led the manufacturer to decide to implement an MSRP or MAP policy, when implementing the policy the manufacturer should make clear to all of its wholesale customers that they are not to discuss retail pricing among themselves and that the manufacturer has the exclusive right to determine what steps to take if a customer does not comply with the policy. The manufacturer should then put in place a program to monitor compliance with the policy, either through internal staff or through a third party monitor. These steps are important to avoid converting a vertical manufacturer to retailer restraint into a horizontal conspiracy with complaining retailers that could be a per se violation of U.S. antitrust law. This is especially true if the manufacturer also sells direct to consumers on a retail basis.

International Law

As an attorney licensed in Maryland and the District of Columbia, I am qualified to provide a summary on U.S. anti-trust law as it concerns this subject, whereas I do not provide legal advice on other countries’ competition laws. However, as a general matter most other countries have yet to follow Leegin and continue to treat any manufacturer practices designed to set minimum retail price levels as per se illegal, and given that disposition are unlikely to look favorably on Colgate-like arguments regarding unilateral conduct in “cutting off” a seller who sells below the desired minimum price. In addition, European courts have issued decisions indicating that restrictions on the re-sale of products through the Internet will generally be considered violations of European competition law. See Pierre Fabre Dermo-Cosmétique SAS (European Court of Justice, March 3, 2011).

There is some basis for a position that the competition laws of other countries will not be applicable to vertical pricing restraints in which both the manufacturer and their wholesale customers are small enterprises that do not have substantial market share in the relevant product types. However, an analysis of the applicable law of the foreign jurisdictions must be made through qualified counsel before a manufacturer pursues any programs to restrict minimum retail price.

Sylvan Learning, Inc. Fighting Franchise Act Claim

April 24th, 2012

David Cahn

During 2012 Sylvan Learning, Inc. and its corporate affiliates are fighting a claim of violating of the Maryland Franchise Registration & Disclosure Law and fraudulent conduct in its sale of tutoring center franchise rights, after having its motions to dismiss the fraud claims denied by the U.S. District Court in Baltimore.

In Next Generation Group, LLC v. Sylvan Learning Centers, LLC, Case CCB-11-0986 (decided Jan. 5, 2012), the plaintiff franchisee alleged that he agreed to develop and operate a new Sylvan Learning Center in Irving, Texas, in reliance upon representations from Sylvan that it would sell the plaintiff two existing Centers in nearby Arlington and Allen, Texas. According to the Amended Complaint, those representations were made orally by Sylvan’s agent to plaintiff’s principal both before and after the plaintiff signed the franchise agreement for Irving, but several weeks before the Irving location opened, Sylvan’s agent advised plaintiff’s principal “in writing that Sylvan had approved his acquisition of the Arlington and Allen Learning centers, respectively.” The parties executed letters of intent for the sale of both sites about two weeks before the Irving Center opened. However, about three weeks after the Irving Center opened, Sylvan’s same agent “informed [plaintiff] that Sylvan would not sell him the license and assets for any more franchises.” According to the Amended Complaint, Sylvan provided no explanation of its reversal of course. The franchisee claimed that Sylvan fraudulently induced it to develop and open the Irving location.

Sylvan argued for dismissal of the claims on the basis that the Irving franchise agreement contained an “integration clause” that prevented the plaintiff from relying on promises made outside that written agreement. The court rejected this, by quoting a prior court decision stating, “[T]he law in Maryland … is that a plaintiff can successfully bring a tort action for fraud that is based on false pre-contract promises by the defendant even if (1) the written contract contains an integration clause and even if (2) the pre-contractual promises that constitute the fraud are not mentioned in the written contract. Most of our sister states apply a similar rule. Greenfield v. Heckenbach, 144 Md. App. 108, 130, 797 A.2d 63, 76 (2002).” Sylvan’s problem is that the contractual “integration clause” did not disclaim any specific oral representations, and certainly not any concerning Sylvan’s willingness to sell the plaintiff additional existing franchised businesses. Without specific disclaimers as to representations made on that specific topic, the integration clause did not prevent pursuit of the claim.

While Sylvan could use the presence of the integration clause at trial to challenge whether the plaintiff reasonably relied on promises made outside of the Irving franchise agreement, based on the facts alleged the court stated, “there is reason to believe [plaintiff] could reasonably have relied on Sylvan’s representations” concerning the sale of the existing locations. Therefore, the court held that permitting the plaintiff to file a second amended complaint would not be “futile” and granted the plaintiff’s motion to do so.

After the plaintiff filed its Second Amended Complaint, Sylvan immediately moved to dismiss it on essentially the same grounds as asserted previously, and the court once again refused to dismiss the claims for fraud and violation of the Maryland Franchise Registration & Disclosure Law. Accordingly, the parties are now conducting discovery that may take most of 2012 to complete.

It is important to recognize that the proceedings in this case to date solely concern the sufficiency of the plaintiff’s factual allegations as a matter of law, and in later proceedings Sylvan’s representatives will provide information on what occurred with regard to this franchise sale. Nevertheless, the decision reiterates an important point for all Maryland business people – even if promises and statements are excluded from a particular written agreement, they may have legal consequences if the subsequent business relationship fails to meet the other party’s expectations.