Court Watch

Cure Rights for Franchisees Under Franchise Agreements: Are They Worth the Paper They Are Written On?

Last month's Court Watch column reviewed the decision in LJL Transp., Inc. v. Pilot Air Freight Corp., [New Developments] Bus. Franchise Guide (CCH) 14,058 (Pa. Sup. Ct. Jan. 22, 2009). Additional reflection on that decision brings to mind numerous questions that will give franchise lawyers much to chew on in the future.

First, a quick review. In LJL Transportation, the franchisee intentionally and flagrantly diverted sales to an affiliated entity, thereby depriving the franchisor of revenues that it was entitled to receive under the terms of the franchise agreement. The diversion appeared to be a clear breach of several of the provisions of the franchise agreement, giving the franchisor a right to terminate. However, as drafted, even for egregious conduct, the franchise agreement gave the franchisee a cure right and cure period after receiving notice of default. In this case, the franchisor immediately terminated the franchise agreement without giving the opportunity to cure. The Pennsylvania Court of Common Pleas, the Pennsylvania Superior Court, and the Pennsylvania Supreme Court all concluded that the franchisor had acted within its rights. The Pennsylvania Supreme Court, citing the Superior Court's opinion with approval, noted that “there are circumstances where the nature of the breach permits the aggrieved party to immediately terminate the contract despite a 'cure' provision.”

LJL Transportation raises several intriguing questions:

• Why did the court feel compelled to stretch contract law principles when a fraud claim may have brought the court to the same conclusion?
• Was there any ambiguity about what the parties had agreed to with respect to cure rights?
• What constitutes “cure”? Arguably, the acts of misconduct could not be corrected as such, but, as the court acknowledged, there could have been monetary compensation for the business diversions. The court was apparently worried about the nature of the breach, as distinguished from the monetary loss caused by the franchisee's conduct.
• How does “cure” in this case differ from the situation where a restaurant franchisee only cooks its hamburgers to 140-degree temperatures, when the franchisor's regulations, and possibly health codes, require them to be cooked to 160 degrees?
• Given the express language of the contract, was it appropriate for the court to even mention the implied covenant of good faith and fair dealing, when so many courts have noted that this implied covenant cannot override the express terms of a contract?
• Contract law generally requires that any ambiguity in a contract be construed against the drafter. Although we cannot tell from the published opinion, presumably the contract was prepared by the franchisor or its counsel. Did the franchise agreement expressly provide, as is sometimes the case, that the contract should not be construed automatically against the drafter?
• Was it necessary to invoke the principle that every provision of a contract have meaning? Weren't there other situations where the “non-exclusive” remedies could have had applicability?
• How does the element of “trust” enter into the picture? Broussard v. Meineke Discount Muffler Shops, Inc. (155 F.3d 331 (4th Cir. 1998)) suggests that in most circumstances, a franchise relationship does not impose a fiduciary duty on a franchisor; it is a commercial relationship. Is there a fiduciary duty imposed upon a franchisee? If not, is trust really a valid basis for the court's conclusion?
• Was the court essentially adopting an unconscionability rationale to this kind of conduct? Is there some point, as in consumer cases, where conduct shocks the conscience? If so, at what point is the line drawn?
• Absent language to the contrary, can a franchisee argue that a contractual provision giving a franchisor cure rights be similarly nullified in the appropriate situation?

To set the record straight, the author is not taking a stand, either way, on the merits of the LJL Transportation decision, and especially the ultimate outcome. Intellectually, the case is problematical, and may well find its way into case books covering franchise law. Professors beware!

Franchisees' Duty to Timely Investigate Possible Fraud

In an unpublished opinion from the Washington Court of Appeals (which means that citations to the case may be limited), the court addresses the interesting issue of what due diligence a franchisee must perform before buying a franchise. Rand v. CM Franchise Sys, Inc., No. 61828-8, 2009 WL 667227 (Wash. Ct. App. Mar. 16, 2009).

Essentially, the facts showed that the franchisor disclosed to the franchisee, prior to the execution of a franchise agreement, certain financial information about the system's top-performing unit, located in Century City, Los Angeles, and also furnished to the prospect a list of existing franchisees. The testimony also showed that the franchisee at that point in time knew that this unit was the top performer. This disclosure was made before the franchise sale was consummated and at least three years prior to the date the franchisee filed suit.

Subsequent to the franchise sale, but within three years after the date suit was filed, the franchisor disclosed more information about system franchise sales, and the franchisee learned, presumably for the first time, how much better the Century City unit did as compared with the system generally. The franchisee, Rand, sued the franchisor for failure to register its franchises under the Washington Franchise Investment Law (“WFIL”), claiming a violation of the WFIL for failure to register, as well as for making unlawful, fraudulent earnings claims outside the scope of a disclosure statement.

On the failure-to-register issue, the court found that the applicable statute of limitations was two years, and the suit was brought after the statute of limitations had run. Thus, the “technical” (failure to register) claim was dismissed.

On the “fraud” claim, the court also ruled in favor of the franchisor, concluding that Washington law relating to statutes of limitation ' generally three years from the date the franchisee knew or should have known of the fraud ' had also run. The court concluded that because the franchisee knew that the Century City store did better than other units and had been provided a list of existing franchisees, the franchisee had a duty to investigate how other units had performed when he received the Century City figures and the names of the franchisees. This was well before three years from the date the franchise filed suit. Hence, the statute of limitations here, too, also had expired.

It has often been said that a franchise disclosure document is only the beginning of the due diligence that a franchisee must perform. Rand further suggests that, as a matter of law, a franchisee must actively investigate a franchise opportunity, and cannot indefinitely sit on its rights to claim a violation of a franchise registration statute.

Rupert Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta office of Kilpatrick Stockton LLP. He can be contacted at [email protected].

Cure Rights for Franchisees Under Franchise Agreements: Are They Worth the Paper They Are Written On?

Last month's Court Watch column reviewed the decision in LJL Transp., Inc. v. Pilot Air Freight Corp., [New Developments] Bus. Franchise Guide (CCH) 14,058 (Pa. Sup. Ct. Jan. 22, 2009). Additional reflection on that decision brings to mind numerous questions that will give franchise lawyers much to chew on in the future.

First, a quick review. In LJL Transportation, the franchisee intentionally and flagrantly diverted sales to an affiliated entity, thereby depriving the franchisor of revenues that it was entitled to receive under the terms of the franchise agreement. The diversion appeared to be a clear breach of several of the provisions of the franchise agreement, giving the franchisor a right to terminate. However, as drafted, even for egregious conduct, the franchise agreement gave the franchisee a cure right and cure period after receiving notice of default. In this case, the franchisor immediately terminated the franchise agreement without giving the opportunity to cure. The Pennsylvania Court of Common Pleas, the Pennsylvania Superior Court, and the Pennsylvania Supreme Court all concluded that the franchisor had acted within its rights. The Pennsylvania Supreme Court, citing the Superior Court's opinion with approval, noted that “there are circumstances where the nature of the breach permits the aggrieved party to immediately terminate the contract despite a 'cure' provision.”

LJL Transportation raises several intriguing questions:

• Why did the court feel compelled to stretch contract law principles when a fraud claim may have brought the court to the same conclusion?
• Was there any ambiguity about what the parties had agreed to with respect to cure rights?
• What constitutes “cure”? Arguably, the acts of misconduct could not be corrected as such, but, as the court acknowledged, there could have been monetary compensation for the business diversions. The court was apparently worried about the nature of the breach, as distinguished from the monetary loss caused by the franchisee's conduct.
• How does “cure” in this case differ from the situation where a restaurant franchisee only cooks its hamburgers to 140-degree temperatures, when the franchisor's regulations, and possibly health codes, require them to be cooked to 160 degrees?
• Given the express language of the contract, was it appropriate for the court to even mention the implied covenant of good faith and fair dealing, when so many courts have noted that this implied covenant cannot override the express terms of a contract?
• Contract law generally requires that any ambiguity in a contract be construed against the drafter. Although we cannot tell from the published opinion, presumably the contract was prepared by the franchisor or its counsel. Did the franchise agreement expressly provide, as is sometimes the case, that the contract should not be construed automatically against the drafter?
• Was it necessary to invoke the principle that every provision of a contract have meaning? Weren't there other situations where the “non-exclusive” remedies could have had applicability?
• How does the element of “trust” enter into the picture? Broussard v. Meineke Discount Muffler Shops, Inc. (155 F.3d 331 (4th Cir. 1998)) suggests that in most circumstances, a franchise relationship does not impose a fiduciary duty on a franchisor; it is a commercial relationship. Is there a fiduciary duty imposed upon a franchisee? If not, is trust really a valid basis for the court's conclusion?
• Was the court essentially adopting an unconscionability rationale to this kind of conduct? Is there some point, as in consumer cases, where conduct shocks the conscience? If so, at what point is the line drawn?
• Absent language to the contrary, can a franchisee argue that a contractual provision giving a franchisor cure rights be similarly nullified in the appropriate situation?

To set the record straight, the author is not taking a stand, either way, on the merits of the LJL Transportation decision, and especially the ultimate outcome. Intellectually, the case is problematical, and may well find its way into case books covering franchise law. Professors beware!

Franchisees' Duty to Timely Investigate Possible Fraud

In an unpublished opinion from the Washington Court of Appeals (which means that citations to the case may be limited), the court addresses the interesting issue of what due diligence a franchisee must perform before buying a franchise. Rand v. CM Franchise Sys, Inc., No. 61828-8, 2009 WL 667227 (Wash. Ct. App. Mar. 16, 2009).

Essentially, the facts showed that the franchisor disclosed to the franchisee, prior to the execution of a franchise agreement, certain financial information about the system's top-performing unit, located in Century City, Los Angeles, and also furnished to the prospect a list of existing franchisees. The testimony also showed that the franchisee at that point in time knew that this unit was the top performer. This disclosure was made before the franchise sale was consummated and at least three years prior to the date the franchisee filed suit.

Subsequent to the franchise sale, but within three years after the date suit was filed, the franchisor disclosed more information about system franchise sales, and the franchisee learned, presumably for the first time, how much better the Century City unit did as compared with the system generally. The franchisee, Rand, sued the franchisor for failure to register its franchises under the Washington Franchise Investment Law (“WFIL”), claiming a violation of the WFIL for failure to register, as well as for making unlawful, fraudulent earnings claims outside the scope of a disclosure statement.

On the failure-to-register issue, the court found that the applicable statute of limitations was two years, and the suit was brought after the statute of limitations had run. Thus, the “technical” (failure to register) claim was dismissed.

On the “fraud” claim, the court also ruled in favor of the franchisor, concluding that Washington law relating to statutes of limitation ' generally three years from the date the franchisee knew or should have known of the fraud ' had also run. The court concluded that because the franchisee knew that the Century City store did better than other units and had been provided a list of existing franchisees, the franchisee had a duty to investigate how other units had performed when he received the Century City figures and the names of the franchisees. This was well before three years from the date the franchise filed suit. Hence, the statute of limitations here, too, also had expired.

It has often been said that a franchise disclosure document is only the beginning of the due diligence that a franchisee must perform. Rand further suggests that, as a matter of law, a franchisee must actively investigate a franchise opportunity, and cannot indefinitely sit on its rights to claim a violation of a franchise registration statute.

Rupert Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta office of Kilpatrick Stockton LLP. He can be contacted at [email protected].