Tag: termination

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.

New California Franchise Law Provides More Rights to Franchisees, Burdens for Franchisors

May 22nd, 2016

by David L. Cahn and Jordan M. Halle

Effective for franchise agreements entered into or renewed this year, new amendments to the California Franchise Relations Act impose significant restrictions on franchisor’s termination or refusal to renew franchise agreements, increase franchisor’s post-termination obligations, and bolster franchisees’ rights to sell their franchised business. These changes make California a somewhat more risky state in which to use franchising as a growth strategy, while arguably bolstering the security of franchisees’ investments in mature brands.

Restrictions on Termination:  a franchisor must have “good cause” to terminate a franchise, and “good cause” for termination is limited to a franchisee’s failure to “substantially” comply with the lawful requirements of the parties’ franchise agreement.  Generally franchisors must provide at least 60 days, but not more than 75 days, to cure a material default.  Franchisors may still terminate for certain “serious” defaults with less than 10 days’ notice, such as failure to pay fees, abandonment, and repeated defaults.  New sanctions available to franchisees terminated or refused renewal without good cause include damages in the amount of the fair market value of the franchised business and assets, and preliminary and injunctive relief for a franchisor’s violation of the statute.  Expect plenty of litigation over whether there was “substantial” noncompliance and a “material” default by a terminated franchisee.

Post-termination repurchase obligation: California always has been a state where franchisors had to approach a decision to terminate with caution, because of a California statute that prohibits enforcement of covenants not to compete as well as case law making it difficult to collect lost future profit damages from terminated franchisees.  Now, absent certain exceptions, a franchisor must buy from the terminated franchisee all inventory, supplies, equipment, fixtures and furnishings that the franchisee had purchased due to a franchise agreement requirement – even if termination is due to the franchisee’s material default.  Any money owed by the franchisee to the franchisor may be offset against the repurchase price for such items.  Notable exceptions to the repurchase requirement are if the franchisee declined the franchisor’s renewal offer, or if the franchisor permits the former franchisee to retain control of the business location after termination.

Right to Transfer:  Franchisors now may not prevent a franchisee from selling the business’s assets or an interest in the business, except if the buyer does not meet the franchisor’s standards for new franchisees or if the franchisee and buyer fail to comply with other reasonable requirements of transfer in the franchise agreement.  The franchisor must provide the franchisee and prospective buyer with written standards by which it determines whether a prospective franchisee is acceptable, and if denying transfer approval on the basis of non-suitability must explain why the proposed buyer does not meet one or more of the standards.  Franchisors may enforce right of first refusal provisions in the franchise agreement, provided that the franchisor pays equal to or greater than the price offered by the prospective buyer.

Conclusion: The new California laws generate issues with the franchise agreement, franchisor operations, and franchisor/franchisee relations that any franchisor selling franchises in California should have reviewed and addressed by an attorney.  Please contact us for further information and advice.

Enforcing Quality Standards in Hotel Franchise Agreements

August 6th, 2014
David Cahn

David Cahn

Take-away. A franchisor’s diligence in conducting and documenting quality assurance inspections is as important as ever, particularly if the franchisor seeks to exercise its ultimate weapon – termination of the franchise agreement. Prudent inspection and documentation practices are particularly crucial in the many U.S. states and territories that have statutes requiring a showing of “good cause” in order for a franchisor to terminate a franchise agreement. In such states, a franchisor must furnish evidence demonstrating that the franchisee failed to substantially comply with the material and reasonable franchise requirements; otherwise, a court may well restore the franchise rights and order money damages to the franchisee.

The Case.  Pooniwala v. Wyndham Worldwide Corp., a May 2014 decision by the U.S. District Court for the District of Minnesota, is an exemplary demonstration of how a franchisor establishes that one of its franchisees repeatedly violated quality assurance standards so that there was “good cause” to terminate the franchise agreement under state law. The franchisor’s in this case diligently conducted and documented regular quality assurance (“QA”) inspections.

The Facts. Minn. Stat. Section 80C.14, part of the Minnesota Franchise Act, allows a franchisor to terminate an agreement if the franchisor can show “good cause” for termination. Good cause means failure by the franchisee to substantially comply with the material and reasonable franchise requirements imposed by the franchisor, including “any act by or conduct of the franchisee which materially impairs the goodwill associated with the franchisor’s trademark, trade name, service mark, logotype or other commercial symbol.”

Pooniwala involved franchise agreements for two hotels, one a “Super 8,” and the other a “Travelodge.” The franchisee alleged that the franchisors, both of which are affiliated companies within the Wyndham Hotel Group, took retaliatory action against the franchisee because of a lawsuit between the franchisee and Ramada Worldwide Inc., its fellow Wyndham Group affiliate. The franchisors, for their side, argued that their attempts to terminate the franchise agreements were not retaliatory actions, but rather that the franchisee had repeatedly violated QA standards found in the respective franchise agreements, giving each franchisor good cause for termination.

The first attempted termination involved a Super 8 hotel facility in Roseville Minnesota. The franchise agreement for the Roseville Super 8 included quality assurance requirements, as well as provisions allowing Super 8 to inspect the facility to ensure that it was operating in compliance with Super 8’s system standards and QA requirements.  The franchisee had failed six consecutive QA inspections at the Roseville Super 8.  Each inspection was followed by a letter indicating that the franchisee had received a failing score on the QA inspections. The letters also gave the franchisee notice that it had sixty days to cure the QA deficiencies, the failure of which could result in termination of the franchise agreement. Finally in September 2013 Super 8 notified the franchisee that the franchise would terminate on December 29, 2013, unless the hotel passed a final QA inspection. The franchisee failed that final inspection, and shortly thereafter Super 8 informed the franchisee that termination would take effect on the originally scheduled termination date.

The second termination was for a Travelodge hotel facility in Burnsville, Minnesota. The Burnsville Travelodge agreement contained similar QA requirements, and the franchisee failed eight consecutive QA inspections, receiving letters documenting the failures following each inspection. Finally the franchisee received notice of termination for the Travelodge franchise. The notice described QA deficiencies, and stated that termination would take effect in ninety days, but that another inspection would be scheduled to determine whether the QA violations had been cured. The franchisee failed that inspection, and as a result Travelodge informed the franchisee that termination would take effect on the originally scheduled date.

Preliminary Injunction. It is not a wonder that motions for preliminary injunction are commonplace in hotel franchise termination cases. With the great potential for loss of good will among customers, employees and suppliers, franchisees will not want to give up their rights to franchise logos or their presence on a franchisor’s reservation system. In Pooniwala, the franchisee sought an order for preliminary injunction to stop the franchisors from terminating the franchise agreements before the court heard the case on its merits.

In deciding whether to grant a preliminary injunction, courts have to balance the harm to the two sides. They also consider the requesting party’s likelihood of success on the merits in the underlying claim–here, violation of the good cause requirement of the Minnesota Franchise Act.

In Pooniwala, the court denied the franchisee’s motion for preliminary injunction and ordered it to go ahead with its post-termination obligations, such as removing the franchised brands’ signage. The court found that, given the many QA inspection failures at the two hotels, and the fact that the franchisees had continuing franchise relationships with Wyndham Hotel Group affiliates at other hotel properties, the franchisee did not demonstrate an adequate likelihood of success of proving that the termination was without good cause. Further, the court held that, while the franchisee would suffer obvious harm through loss of the franchise rights, the franchisors were also suffering continuing, irreparable harm as long as the franchisee’s hotels continued to operate under their trademarks while not maintaining brand quality standards.

Conclusion. Hotel franchise agreements typically provide for substantial liquidated damages if the franchisor terminates for cause, meaning that the Pooniwala franchisees are likely to owe hundreds of thousands of dollars. In other franchise cases, the terminated franchisee may be forced to cease operating a similar business due to a covenant not to compete.

The stakes are high, and franchisors can expect a fight. So if they decide to take the drastic step of terminating for cause, they had better have their “ducks in a row.” In Pooniwala, the Wyndham Hotel Group franchisors showed how this is done.

 Nicholas Cintron, a law clerk at the firm and a 2016 J.D. candidate at Wake Forest University Law School, contributed to the preparation of this article.

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.

Could Your Association’s Chapter Program Be Considered a Franchise System?

March 20th, 2012

David Cahn

In Girl Scouts of Manitou Council, Inc. v. Girl Scouts of the United States of America, Inc., 646 F.3d 983 (7th Cir. 2011), the U.S. Court of Appeals for Illinois, Indiana and Wisconsin held that the national Girl Scouts organization, a nonprofit incorporated by an Act of Congress, violated the Wisconsin Fair Dealership Law by dissolving a local Wisconsin chapter of the national organization “without good cause.” The 2011 decision is notable both because of its author, the extremely well-known, respected and conservative Judge Richard Posner, and because of the language used by the Court in rejecting the Girl Scouts of the United States’ arguments for immunity based on its nonprofit mission. This article is designed to help the leaders of nonprofit organizations and associations identify ways to mitigate risks posed by this decision.

Under the Wisconsin law, a “dealer” is one who is granted the right by contract to “use [the grantor’s] trade name, trademark, service mark, logotype, advertising or other commercial symbol” and has “a community of interest” with the other party to the contract “in the business of offering, selling or distributing goods or services at wholesale, retail, by lease, agreement, or otherwise.” The Girl Scouts of the United States argued that its contract with the affiliate was not “commercial” and that the affiliate was not “in business.” To that, the Court said:

. . . one doesn’t usually think of nonprofit enterprises as being “commercial” and engaged in “business.” Or didn’t use to–for outweighing these hints is the fact that nonprofit enterprises frequently do engage in “commercial” or “business” activities, and certainly the Girl Scouts do. Proceeds of the sale of Girl Scout cookies are the major source of Manitou’s income. The local councils sell other merchandise as well. Sales of merchandise account for almost a fifth of the national organization’s income, and most of the rest comes from membership fees and thus depends on the success of the local councils in recruiting members; that in turn depends on the councils’ revenues and thus gives the national organization an indirect stake in the cookie sales.

646 F.3d at 987. The Court went on to emphasize that, when competing with for-profit entities in commercial enterprises and endeavors, nonprofits may be held to the same legal standards of conduct.

Laws that prohibit termination or cancellation of a dealer or franchisee, except for “good cause,” are called “franchise relationship” laws. Wisconsin’s definition of a “dealer” is similar to the definition of a “franchise” under the franchise relationship laws of Arkansas, Connecticut, Delaware and New Jersey. Another 11 states have franchise relationship laws, but require the “franchisee” to prove that it was required to pay some sort of “fee” as a condition of selling goods or services under the “grantor’s” trademark. Such “fees” have been deemed charged if the “franchisee” was required to pay the “franchisor” for a policies and procedures manual, for its director to attend a training conference, or even for marketing materials to distribute to prospective customers of the good or service.

The 15 states that have laws regulating the granting of a franchise, typically known as “franchise sales laws,” mandate certain disclosures be provided to prospective franchisees and that the franchisor refrain from certain actions in recruiting franchisees. All of those laws also contain a requirement that the “grantee” directly or indirectly pay some sort of “fee” to the grantor as a condition of operating under the grantor’s trademark. Most of those laws do not require that the fee be paid up front, and thus the fee could be a percentage of the grantee’s cash received in operating the business. However, payments from the grantee to the grantor for products at their “bona fide wholesale price” cannot be franchise fees, and the payment of commissions to the grantee when it has acted as a bona fide sales agent of the grantor are excluded. However, if the fee element is satisfied and there is substantial association with a common name, then Judge Posner’s reasoning on what is a “commercial endeavor” and operation of a “business” could be meaningful in proving the existence of a franchise.

The Federal Trade Commission also has a trade regulation rule that contains disclosure requirements and recruitment prohibitions that are similar to the state franchise sales laws. Fortunately for nonprofit organizations, the FTC has issued several advisory opinions finding that a nonprofit engaging in transactions that would otherwise be considered franchising were exempt from the Franchise Rule provided that (a) the licensor is not engaged in the relationship “for its own profit or the profit of its members,” and (b) the licensees are also bona fide non-profits. The first requirement is driven by the limit of the FTC’s jurisdiction, since it may only regulate a company “which is organized to carry on business for its own profit or that of its members.” 15 U.S.C. § 44. However, when the nonprofit associations of glass makers and insurance agents collaborated to form “The Glass Network” to enable the insurers to obtain lower cost auto glass replacement services and the glass makers access to that market, the FTC staff found that “network” to be covered by the Franchise Rule, notwithstanding its ownership by nonprofits. The Glass Network, LLC, FTC Informal Staff Advisory Opinion 04-4 (2004).

What follows are some key questions to ask in determining whether your chapter or affiliate program could be deemed a franchise system, or should otherwise focus on franchise law matters:

1. Are your members for-profit companies or professionals?

2. Is there an upfront affiliation fee or annual dues to maintain affiliate status, or a requirement that the affiliate purchase certain quantities of goods or services, regardless of customer demand?

3. Do your affiliates pay you a share of membership dues they receive, or does the affiliate receive membership commissions from you?

4. Is your association’s name or logo a prominent or significant part of the affiliate’s name or identity, from the perspective of its members?

5. Do your affiliates provide direct business development opportunities for their members (as opposed to general promotional benefit)?

6. Does a substantial portion of each of your affiliates’ revenues come from the sale of the same type of products or services, and are those products or services also sold by for-profit companies? Examples besides cookies are travel tours, function facility space, summer camps, or sports leagues.

7. Do your affiliates have exclusive territorial rights?

8. Is there a minimum quota of memberships that the affiliate must maintain?

9. Is good cause required to terminate the affiliate’s charter?

10. Is there a covenant not to compete after revocation of the charter, and if so who does it bind (i.e., just the affiliate as a nonprofit entity, or also its officers and directors)?

If a nonprofit organization or association answers “yes” to many of these questions, it may be advisable to review the chapter or affiliate structure – and applicable affiliation agreement – to mitigate the risk of inadvertently being considered to fall within the franchise laws.

Can They Really Do That? Franchisees’ Liability for Lost Future Royalties after Store Failure

September 27th, 2011

In its recent decision of Meineke Car Care Centers, Inc. v. RBL Holdings, LLC, et al., Case No. 09-2030, Case No. 09-2030, Bus. Franchise Guide (CCH) ¶ 14,586 (decided April 14, 2011), the United States Court of Appeals for the Fourth Circuit provided valuable guidance on one of the most important legal issues for franchisors and franchisees. Specifically, if a franchisee closes franchised businesses that it can no longer afford to operate, can its franchisor obtain a judgment for “lost future royalties” that it would have earned had the businesses continued to operate?

In this Meineke case, the trial court had granted summary judgment dismissing the franchisor’s claim, on the bases that: (1) the franchise agreement did not state that the franchisee would be liable for royalties even if the business closed, and (2) even if Meineke had the right to seek lost future profits due to the franchisee’s closure of the stores, the claim failed because Meineke could not prove that it was “reasonably certain” that such profits would have been realized if the stores had not been closed. The U.S. Court of Appeals disagreed on both points and remanded the case for trial on Meineke’s claim.

On the first point, the court held that the parties are not required to specify in the Franchise Agreement all categories of potential damages each could seek as a result of the other’s breach. Rather, the standard is whether, at the time of entering into the agreement, “lost profits may reasonably be supposed to have been within [the parties’] contemplation as a probable result of [the franchisee’s] premature closure of the Shops.” A specific statement in the Franchise Agreement that the franchisee would be liable for all royalties throughout the term of the agreement would have been powerful evidence of the parties’ understanding when they signed the contracts. However, it was not the only admissible evidence of the parties’ “contemplation” on that issue, and therefore a factual dispute on that point existed – making it an issue for the jury to decide.

On the second point, the court emphasized that the royalties payable to Meineke were calculated from a percentage of the Stores’ gross revenue, not net profits. The court found that Meineke had demonstrated “with reasonable certainty” that, except for the franchisee’s breach of the agreements by closing the Shops, some revenue and therefore some lost royalties would have been realized. Thus, a trial was necessary to determine the amount of those lost “profits” with reasonable certainty.

However, at the trial, it would be relevant in making that determination how long it would have been “commercially feasible” to continue to operate each of the Shops, based on its historical net profits to the owner. In other words, the fact finder’s decision of how long it was “commercially feasible” to expect the franchisee to keep the doors open would determine the amount of the lost future royalties damages.

The takeaways:
(1) the only way that a franchisee and its personal guarantors can be sure that they will not be liable for lost future royalties if the franchise fails is to insist upon language in the franchise agreement eliminating (or limiting) the franchisor’s right to those damages.

(2) if a franchised store ceases operations and truly “goes dark” due to ongoing net operating losses, at trial on a claim for lost future royalties the franchisor will need to be able to demonstrate that it was “commercially feasible” for the franchisee to remain open and, if so, provide some reasonable basis for the fact finder to determine how long the store should have remained open.

Given the uncertainty and fact intensive nature of such a case, it is probably in the best interests of both the franchisor and the franchisee to directly address the issue in the written agreement the franchisor’s right to “lost future royalties” and an agreed upon method to calculate those “damages.”

The full opinion can be viewed at http://pacer.ca4.uscourts.gov/opinion.pdf/092030.U.pdf

Holiday Inn case shows danger of deception

May 13th, 2011

A recent case with compelling facts shows that, despite attempts through written agreements and disclosure documents to shield franchisors from liability, deceptive conduct within the franchise relationship can still result in substantial liability for franchisors.

In Holiday Inn Franchising, Inc. v. Hotel Associates, Inc., 2011 Ark.App. 147 (Ark. Ct. Apps. 2011), the franchisee Hotel Associates, Inc. (“HAI”), is owned by J.O. “Buddy” House, one of the early Holiday Inn franchisees who was close friends with the chain’s founder.  The court found that, over the course of decades, House had developed a relationship with the executives of Holiday Inn Franchising, Inc. (“Holiday Inn”) founded in “honesty, trust and the free flow of pertinent information”, thereby creating a “special relationship” imposing a duty on Holiday Inn to disclose facts material to the ongoing relationship. 

In 1994, HAI, at the suggestion of a Holiday Inn executive, considered purchase of a rundown hotel in Wichita Falls, Texas to convert to a Holiday Inn.  House realized that the property would need expensive renovations and requested a 15 or 20 year term in the Holiday Inn franchise agreement.  Holiday Inn declined, but its Vice President of Franchising  “stated that, if House operated the hotel appropriately, there was no reason to think that he would not receive a license extension at the end of the ten years.” 

HAI signed a ten year franchise agreement in early 1995 and made extensive renovations before opening.  The hotel was successful and HAI received offers to sell for up to $15 million, but declined based on its belief that the franchise would be extended.  Meanwhile, Holiday Inn’s commission franchise salesperson was pursuing conversion of a nearby Radisson hotel at the end of HAI’s term and  prepared a business plan for that conversion in 1999.

In 2001, an employee of HAI spoke to a Holiday Inn representative about early relicensure, and was convinced to send Holiday Inn a $2,500 fee to obtain a Property Improvement Plan (“PIP”) for changes needed for relicensure.  The PIP required changes costing  $2 million dollars, and after going through 2 rounds of Holiday Inn PIPs, HAI spent about $3,000,000 — without ever being informed of  the business plan for the Radisson, which continued to be pursued.

In October 2002, when the hotel was fully renovated pursuant to the PIP and received a quality score of 96.05 (out of 100),  Holiday Inn informed HAI that the Radisson had applied for a license and was being considered as a possible “partial replacement” for HAI’s facility “if it left the system.”  After HAI protested, Holiday Inn stated that the Radisson application had been denied.  However, after several more twists and turns, the new franchise development team “prevailed” over the relationship managers, the Radisson was licensed and HAI’s facility was denied relicensure.  HAI sold it in 2007 for $5 million, before the real estate crash.

After a jury trial, HAI prevailed on claims against Holiday Inn of fraud and promissory estoppel, which means detrimental reliance on promises.  After appeal, HAI’s judgment was for over $10 million in compensatory damages and $12 million in punitive damages.  The case is notable because (a) HAI had no right to relicensure under the parties’ written agreement, but (b) the court found a “special relationship” that imposed a duty to disclose to the franchisee material information about the future of the business relationship, and (c) the court found that Holiday Inn’s course of conduct supported a punitive damages award.

Non-Competition Covenants May Apply to Individual Franchise Owners, Even if They Never Agree to be Bound

October 27th, 2009

In a recent case out of the Federal District for the Eastern District of Virginia, it was held that a franchise agreement’s non-competition covenant could be applied to an owner of a corporate franchisee who had not signed the franchise agreement or a personal guarantee of the franchisee’s obligations. The facts of the case make the outcome unsurprising, and highlight a rule of federal law that can serve as an important tool for franchisors facing similar situations.

 The case involved a short-lived Little Caesar’s pizza restaurant in Portsmouth, Virginia. Apparently in ongoing discussions with Little Caesar’s, an individual prospective franchisee, Ms. Ross, worked with her partner, Mr. Krever, to acquire a lease and begin building out the leased space to suit a Little Caesar’s franchise. Ms. Ross approached Little Caesar’s about Mr. Krever also becoming a party to the anticipated franchise agreement, but Little Caesar’s refused.

 Despite this refusal, Ms. Ross and Mr. Krever jointly formed Little Caesar’s VA, Inc., and Ms. Ross entered into a franchise agreement with Little Caesar’s on the corporation’s behalf. While the agreement contained provisions requiring all owners to be approved and to sign a personal guarantee, Little Caesar’s was never made aware of Mr. Krever’s ownership interest.

 The franchisee’s restaurant quickly failed and Mr. Krever took over operations, rebranding the restaurant as “Family Pizza Plus”, but continuing to use Little Caesar’s advertising and ingredients. Little Caesar’s sent a notice of default and termination to Ms. Ross, and sent multiple cease and desist notices to Mr. Krever, the unauthorized partner.

 Following Mr. Krever’s refusal to cease operations of Family Pizza Plus, Little Caesar’s sued the franchisee-entity and both owners in federal court. Among other things, the complaint sought injunctive relief to enforce the franchise agreement’s non-competition provisions against both Ms. Ross and Mr. Krever.

 The court awarded Little Caesar’s the relief sought. Despite never signing the franchise agreement or a personal guaranty, Mr. Krever was found to be subject to the franchise agreement’s non-competition provisions. The court cited two reasons for this result. First, Rule 65(d) of the Federal Rules of Civil Procedure grants federal courts the authority to issue injunctions against parties and their “officers, agents, servants, employees, and attorneys.” Second, the court held that the unauthorized partner should not be permitted to benefit from his own fraud and deception. According to the court, had Mr. Krever’s involvement been made known to Little Caesar’s, he would have been required to agree the franchise agreement’s non-competition provisions. The equities clearly favored Little Caesar’s in this case, and accordingly the court issued an order enjoining Mr. Krever from operating the Family Pizza Plus business at the former Little Caesar’s franchise location.

By: Jeffrey S. Fabian