Franchise & Distribution Developments

Cases can teach us lessons. We read them and ask ourselves what we can do differently (or sometimes the same) to help manage risk. In this space, we will note significant franchise decisions delivered by the courts in recent weeks. While all decisions matter critically to the parties involved, not all contain meaningful instruction for us, the interested bystanders. Our focus in this space will be that minority of instructive decisions. With each case summary, we will share our thoughts on how the franchisor may use the decision to reduce its risk of a lawsuit and better defend itself when claims are made.

The last several weeks, very typically, yielded a mixed group of decisions reminding us that judicial trend-spotting in franchise law is a dicey business –- one in which the next case unsettles or confirms the prevailing trend-based wisdom with relatively equal frequency.

The Implied Covenant of Good Faith and Fair Dealing. The old saw is that the implied covenant means different things to different judges at different times. In essence, it holds that parties to a contract have a duty to deal with each other honestly and not to deprive one another of the anticipated fruits of the contract. The problem, of course, is defining such vague concepts as lack of "honesty in fact" and denial of the "fruits" of a contract. The fallback becomes: "I can't define it, but I know it when I see it."

The covenant has long been the darling of franchisees who cannot advance a concrete theory of liability. Any kind of generalized "bad acts" become fodder for a lawsuit.

Franchisors and their lawyers have taken some comfort, historically, in one near-universal rule arising from the cases: the implied covenant cannot be used to override or trump an express right of the parties. Relying on this general rule, we sprinkle franchise agreements with reserved rights to minimize liability for an alleged breach of the implied covenant.

A recent decision reminds us that even this approach is not foolproof. Bohne v. Computer Assoc. Int'l, Inc., __ F. Supp.2d __, 2006 WL 2423335 (D. Mass. Aug. 22, 2006). The court, quoting from another case, found that some courts have "implied a covenant of good faith to override express contract terms, ‘mainly . . . in contractual situations which involve a special element of reliance such as that found in partnership, insurance, and franchise agreements . . . [or] where one party has traditionally held vastly superior bargaining power –- the termination of a salesperson's ‘at will' employment contract.'" Id. at *3.

We believe the Computer Associates decision is an aberrational throwback to times when courts were reticent to enforce contracts terminable at will. We continue to believe that the best medicine for avoiding claims of breach of the implied covenant is the franchisor's contractual reservation of specific rights. We also recommend that franchisors set out in their contracts a specific standard for determining good faith. We include within agreements a specific provision that the covenant is satisfied as long as the franchisor is acting consistent with a legitimate business interest.

Franchisor Recovery of Lost Future Royalties. We thought the infamous PIP decision -- (Postal Instant Press, Inc. v. Sealy, 51 Cal. Rptr. 2d 365 (Cal. Ct. App. 1996)) -- was an anomaly when it first came out ten years ago. The California Court of Appeals in PIP decided that a franchisor who terminates a franchise agreement may not recover future lost royalties. The court said that the cause of the franchisor's loss of future royalties in such situations is not the breach of the agreement by the franchisee, but the franchisor's election to terminate the agreement instead of enforcing it. Id. at 370-71. According to the PIP court, a franchisor has the option of suing the franchisee for specific performance and recovering unpaid royalties as they come due. Id. at 370. Thus, the franchisor who wants to recover "future" royalties must wait until they become "past royalties" and then sue the franchisee periodically for the unpaid royalties. Id.

A number of courts since PIP have specifically rejected the decision and found that a franchisor can terminate a franchise agreement for cause and still sue for lost future royalties. Unfortunately, the decisions appear to be trending in favor of the PIP rule. Most recently, the United States District Court in New Jersey applied PIP to deprive Dunkin' Donuts of future royalties where it had terminated the franchise agreement. Dunkin' Donuts, Inc. v. Arkay Donuts, LLC, Civ. No. 05-387-WHW, 2006 WL 2417241 (D.N.J. Aug. 21, 2006). Perhaps the most surprising part of the decision is that the court vacated a default judgment against the franchisee, sua sponte (on its own), because the default judgment included future royalties that were not recoverable under prevailing law.

There are some things franchisors can do to lessen the impact of PIP. First, realize that courts, juries, and arbitrators are reluctant to award future lost royalties. If a franchisee needs to go, the prudent franchisor does not get bogged down in how to reserve a claim for future royalties. Most of the time the terminated franchisee is not able to pay a huge damages claim in any event. Second, the wise franchisor treats the franchisee as the terminating party, where appropriate. For example, if the franchisee abandons the franchise, the franchisor often need not actually terminate the agreement itself, but can simply confirm that the franchisee has terminated the agreement by its abandonment. Third, a franchisor might use liquidated damages as a method to compensate for lost future royalties. Fourth, a contractual stipulation that the franchisor may terminate and still recover future royalties might help avoid PIP problems. Finally, the franchisor can periodically file new claims as fees come due and remain unpaid.

Contractual Notice Period as a Damages Limitation. On the flip side of the damages question -- the franchisee's entitlement to damages in a wrongful termination scenario -- franchisors who fail to observe a statutory or contractual notice period before otherwise lawfully terminating typically assume that damages exposure will be limited to the franchisee's lost profits for the would-be notice period. While that may hold true under certain contracts and statutes, a recent decision involving a terminated independent sales representative challenges, with a vengeance, any expectation that this will always be the case. Wingert & Assoc., Inc. v. Paramount Apparel Int'l, Inc., 458 F.3d 740 (8th Cir. 2006).

Wingert had an oral contract of indefinite duration that was covered by a state statute, which permitted termination on 180 days advance written notice. Id. at 742. Defendant terminated on three days' written notice, and argued that damages could not exceed the commissions Wingert would have earned in the 180-day notice period. Id. at 742. The jury awarded Wingert those damages, plus another four and a half years of lost profits beyond the notice period -– apparently crediting Wingert's contention that the sudden termination permanently prevented it from replacing departing employees (hired away by the defendant) and securing a substitute product line. Id. at 743-44. The Eighth Circuit panel affirmed the jury's damages award in full (splitting 2-1 on the issue of a 180-day damages limitation).

Wingert reminds us of at least two things: first, early case assessment should look creatively and exhaustively at the franchisee's potential damages theories (as you can bet that the franchisee will be doing exactly that); and second, once a damages limitation argument fails with the judge, the franchisor had better buckle up, particularly if confronted with challenges on the equities (such as the "employee raiding" theme available to Wingert.)

Choice of Law. Choice of law provisions continue to trap the unwary -– with the courts landing nowhere very reliable as they interpret such provisions. Most recently, a Texas Court of Appeals found that Ohio law did not necessarily govern statutory and tort claims where the parties' choice of that jurisdiction was limited to the interpretation, construction, and enforcement of the franchise agreement. Red Roof Inns, Inc. v. Murat Holdings, LLC, __ S.W.2d __, 2006 WL 2458563 (Tex. Ct. App.-Dallas Aug. 25, 2006).

We recommend that franchisors specifically state whether their choice-of-law provision applies simply to contract claims or to statutory and tort claims as well. In addition, franchisors residing in states with franchise relationship acts would do well to choose a law other than their own. We generally favor choosing the law of the jurisdiction where the franchisee resides as the applicable law. Courts will often, as a matter of public policy, apply protectionist legislation of a franchisee's home state even where the parties chose a different law. So why risk a court applying franchisee-friendly laws from two states (the franchisor's, through a choice of law provision, and the franchisee's)?

Tying Claims. The courts continue to pound the proverbial nails in the coffin of Sherman § 1 tying claims against franchisors. The most recent decision is FF Orthotics, Inc. v. Paul, No. DO44226, 2006 WL 1980270 (Cal. Ct. App. July 17, 2006) (unpublished decision). The antitrust theory is that the franchisor who, as a condition to obtaining franchise rights, requires its franchisees to buy products from it violates the Sherman Antitrust Act. Under the theory, the franchisor commits a per se breach of Sherman § 1 by conditioning the sale of one product (the franchise) on the sale of others (goods and services).

The Orthotics court summarily rejected the claim, finding that "the requirement that a franchisee carry the franchisor's full line of products as a condition to obtaining a franchise does not violate antitrust laws." Id. at *6. The court also specifically rejected the now-disfavored theory that the Supreme Court's Kodak decision gave franchisees who are "locked in" to their franchise arrangement a right to assert tying claims that arise after the creation of the franchise relationship. Id. at *5.

The bottom line is that franchisors generally may lawfully require that franchisees purchase products and services from them. Franchisors should, however, specifically reserve in the franchise agreement (and put the franchisee on notice in the UFOC) that it may require the franchisee to purchase product from it. Proof of franchisee awareness, upfront, of the obligation to purchase product from the franchisor will hamper any later claim to a Kodak lock-in tying arrangement.

Product Pricing and the UCC. Speaking of selling products to franchisees, the price charged by the franchisor may become a sticky issue. Franchise agreements usually do not specify the price to be charged for a product, or, for that matter, say anything whatsoever about pricing. Here is where the Uniform Commercial Code (UCC) may step in.

Courts typically find that the UCC governs the sale of products by franchisors to franchisees. Section 2-305 of the UCC addresses open price terms for the sale of goods. It states that where a seller has the right to fix a price, the seller is duty-bound to do so in good faith. Good faith is defined, in turn, as "honesty in fact in the observance of reasonable commercial standards of fair dealing in the trade." And who gets to decide ultimately whether the price charged by the franchisor meets the test? A jury.

We believe juries are a wonderful thing, but we do not see a lot of margin to juries (or judges for that matter) deciding the fate of a franchise system. In order to minimize the risk of judicial interference in a franchisor's setting of prices, franchisors who sell product to their franchisees may want to consider including special language in the franchise agreement. In particular, Comment 3 to Section 2-305 contains a "safe harbor" for sellers setting prices for their products. Comment 3 says that in a "normal case" a "posted price," a "price in effect," or other similar language "satisfies the good faith requirement."

We recently represented the franchisor in a multi-franchisee arbitration challenging the product pricing set by our client. Because the franchisor set out in writing that the franchisee would be required to pay the price then in effect for products, there was a presumption that its prices were reasonable, a presumption the claimant franchisees failed to overcome. Wilcox et al. v. Pirtek USA, LLC, Bus. Franchise Guide (CCH) ¶ 13,404 (A.A.A. 2006). The obvious lesson is that the franchisor should specifically spell out in relevant franchise documents that the franchisee will be required to pay the price then in effect at a given time for a particular product, or other such similar language.

Vicarious Liability. The prospect of franchisor liability for franchisee acts, based on nothing more than the existence of the franchise relationship, continues to haunt franchisors. The courts have traditionally followed the Restatement of Agency's liability test, under which a franchisor may be "vicariously liable" for the acts of its franchisee if the franchisor controls its day-to-day operations. Because a jury typically decides whether a franchisor exercises such controls, franchisors are often at the mercy of six to twelve folks to decide their fate. This is not a comforting notion in a personal injury case, given juries' probable view of franchisors as having the "deep pockets."

Here's the rub. Try as you will, it is tough to convince a jury that all of those controls given to the franchisor in the franchise agreement are not really about day-to-day operations.

Because franchising is all about controls, we argue in court that the traditional Restatement test does not make sense in a franchise context. Instead, we say the focus should be on whether the franchisor controlled the instrumentality that caused the harm to the plaintiff. For example, if the claim is that the franchisor should be liable for its franchisee's failure to follow proper security measures, the court should look at only the franchisor's control of security. Thankfully, enlightened courts are moving in this direction, although some courts continue to follow the traditional Restatement test first established in 1958, when franchising as we know it today was almost nonexistent. Two decisions from the last few weeks illustrate the conflict in views.

In the most recent decision rejecting the historical Restatement test, a state supreme court refused to concentrate on McDonald's generalized controls over its franchisee, and found instead that vicarious liability "turns narrowly upon the defendant's level of control over the alleged ‘instrumentality' which caused the harm." Vandemark v. McDonald's Corp., __ A.2d __, 2006 WL 2034071 (N.H. July 21, 2006). Affirming summary judgment in favor of the franchisor, the court said that "although the defendant maintained authority to ensure the uniformity and standardization of products and services offered by the . . . restaurant, such authority did not extend to the control of security operations." Id. at *8.

Toppel v. Marriott Int'l, Inc., No. 03-Civ. 3042 (DAB), 2006 WL 2466247, *6 (S.D.N.Y. Aug. 24, 2006), also suggested that the franchisor may have exercised control over the safety of the hotel premises because "it appears that the franchisor had imposed a requirement specifically regarding the amount of lighting in and around the restaurant where Ms. Toppel's injury allegedly took place."

The moral of the story is that franchisors, looking to minimize their risk of vicarious liability for the acts of the franchisee, must focus on both their control of day-to-day operations and their control of any instrumentality that might harm a third party, at least until there is uniformity among the courts in applying a causation test. This means that franchisor controls generally should be limited to those necessary to assure quality and uniformity in the product or service delivered to the end-user. Similarly, franchisors should not control (or keep the right to control) things that may cause injuries or damages –- safety, security, and the like. Franchisors certainly should help their franchisees avoid liability to third parties, but advice in this area should be just that -– advice and not requirements. Franchise agreements, manuals, site-inspection forms, and the like should phrase security and safety measures as "recommendations" and not "requirements." A franchisor that controls a franchisee's practices will be found liable for the franchisee's shortcomings. And another thing: Franchisors should make sure that their franchisees have followed through on their promise to purchase satisfactory insurance for the franchised business.

The Incurable Default. Franchisors often ask us whether they must give notice and an opportunity to cure a default that is "incurable." The courts generally hold that a franchisor has no such duty when it comes to a truly "incurable" default. The Superior Court of Pennsylvania so held in LJL Transp., Inc. v. Pilot Air Freight Corp., __A.2d __, 2006 WL 1977508 (Pa. Super. Ct. July 17, 2006). Specifically, the court said that the franchisor had a right to terminate the franchise relationship immediately despite a cure provision where the default destroyed the trust relationship between the franchisor and franchisee. Id. at *1-*2.

Franchisors must be aware, however, that the courts are not unanimous in their view of this subject. A few courts have held that a franchisor may have a duty to fashion some sort of cure, even for defaults that are seemingly incurable. Similarly, the line between a default that is curable and one that is incurable can be thin indeed. It is often best for the franchisor to err on the side of developing and articulating a cure for what may seem at first blush incurable if it wants to avoid a lawsuit or demand for arbitration.