COURT WATCH

New Jersey Consumer Fraud Act Applies to the Acquisition of a Franchise

The Appellate Division of the Superior Court of New Jersey has recently held that the New Jersey Consumer Fraud Act (the 'Act') applied to the acquisition of a franchise from a franchisor that acquired its franchisees from general advertising over the Internet. Kavky v. Herbal Life International of America, _____ N.J. Super _____, 2003 WL 1918411 (A.D. 2003).

Steven Kavky became an Herbal Life distributor in January 2000 after he responded to Herbal Life's Internet advertisement. Herbal Life used general advertising over the Internet to solicit distributors for a variety of products that it sells in the United States. Its offer was to make anyone a distributor in return for $85 and to provide 'pre-paid retail internet customers' at $8.50 per customer.

After reading the advertisement, Kavky agreed to become a distributor and to purchase 10 customers for a total cost of $170. According to Kavky, although Herbal Life sent him materials relating to his distributorship, it never intended to send him any Internet customers, and it refused to do so. Kavky alleged that he spent significant time and money to establish a network of Herbal Life distributors, and that his efforts were fruitless because of Herbal Life's failure to provide the promised customers. Kavky then filed a complaint against Herbal Life for a violation of the Act and for common law fraud.

Herbal Life moved to dismiss the complaint for failure to state a claim upon which relief could be granted. The trial court granted the motion for two reasons. First, it found that the facts were alleged without sufficient particularization, and second, the Act did not apply to investments in franchises. Kavky appealed the trial court's decision.

The appellate court framed the novel issue as follows: whether a purchaser of a franchise distributorship is protected by the Act, or stated differently, whether franchises and distributorships fall within the Act's definition of 'merchandise.' The appellate court observed that the U.S. Court of Appeals for the 3rd Circuit, applying New Jersey law, considered the issue in J&R Ice Cream Corp. v. California Smoothie Licensing Corp., 31 F.3d 1259, 1270-74 (3d Cir. 1994) and predicted that the New Jersey State Supreme Court would hold that the Act is inapplicable to any distributor or franchise relationship, including those made available to the public at large, because those transactions involve the purchase of a business.

But the appellate court disagreed with the 3rd Circuit's broad conclusion. It did not disagree with the result reached in J&R because J&R appeared to involve a substantial and complex commercial transaction, which likely fell within the New Jersey Franchise Practices Act. But the court explained that it could not endorse the 3rd Circuit's broad holding that the Act did not apply to the offer and sale of franchises because the holding would deprive the citizens of New Jersey of protection against pyramid sales schemes, and similar mass-public frauds, a consequence which the Appellate Court believed the state Supreme Court would reject if it considered the issue. The Appellate Court further explained that despite what J&R held, investments in a franchise are not really the acquisition of a business even though the franchise is purchased, because it really involves the acquisition of both goods and services.

In the last issue of this publication, we reported on a case in the U.S. District Court for the District of New Jersey, Christy v. We The People Forms and Service Centers, USA, Inc., in which the court, applying New Jersey law, followed J&R and held that the Act does not apply to the acquisition of a franchise because it constitutes the purchase of a business rather than the purchase of a consumer good or service. In light of Kavky, it will be interesting to see if the District Court's decision is upheld on appeal.

Franchisor Could Be Vicariously Liable For Acts of the Franchisee's Employee

The California Court of Appeal, Second District, recently reversed the decision of a trial court which had granted summary judgment in favor of a franchisor against a third party who was injured by one of its franchisee's employees. Jazmin v. El Centro Foods, Inc., et al., 2003 WL 1950478 (Cal. App. 2nd Dist. 2003).

Librada Jazmin, an elderly pedestrian, was struck by an automobile driven by a 'Pizza Man' franchisee's employee. According to the employee, he was returning to the store from a pizza delivery when the elderly pedestrian ran in front of his car, and he hit her. Jazmin brought suit against the driver, the driver's employer, who was also a Pizza Man franchisee, and El Centro Foods, Inc., the Pizza Man franchisor.

The franchisor moved for summary judgment on the grounds that it could not be vicariously liable for the acts of its franchisee's employee because it did not have substantial control over the franchisee. The trial court agreed with the franchisor, and it entered summary judgment in its favor. Jazmin appealed.

The Appellate Court disagreed with the trial court. It observed that the general rule is that where a franchise agreement gives the franchisor the right of complete or substantial control over the franchisee, an agency relationship exists. According to the court, in the field of franchise agreements, the question of whether the franchisee is an independent contractor or an agent is ordinarily one of fact, depending on whether the franchisor exercises complete or substantial control over the franchisee. Stated differently, the court observed that an actual agency relationship exists when the franchisor retains controls extending beyond those necessary to protect and maintain its trademark, trade name, and good will, and into the day-to-day details of the franchisee's operation by giving the franchisor virtually absolute control of the enterprise. Moreover, according to the court, the fact that the franchise agreement includes provisions consistent with the non-existence of an agency relationship is not dispositive, especially when the franchise documents include other provisions giving the franchisor the right to control the day-to-day management decision and to cancel the contract in the event the franchisee does not meet the franchisor's prescribed standards.

Applying the above standard, the appellate court reversed the decision of the trial court. It found that there was a triable issue of fact as to whether the franchise documents (namely the franchise agreement and operations manual) were sufficient to create a triable issue of material fact regarding whether El Centro Foods maintained the right of complete and substantial control over the franchisee and whether there was an agency relationship between the parties. For example, the court observed that the franchise agreement obligated the franchisee to operate his Pizza Man store in continuous and full compliance with the Pizza Man system and manuals, as modified by El Centro Foods from time to time in its sole discretion. The court observed that the manual covered everything from food and sanitation to insurance and advertising. The manual further set forth strict procedures for the delivery of pizza by requiring a 30-minute delivery schedule.

According to the court, the above factors created a triable issue of fact, and the entry of summary judgment was improper.

Texas Statute Preempted by the Federal Arbitration Act

The U.S. District Court of Appeals for the 5th Circuit has held that a franchisee's claim that the franchisor breached its statutory duty of good faith and fair dealing was arbitrable pursuant to the agreement between the parties, and not exclusively with the jurisdiction of the Texas Motor Vehicle Board as provided in a Texas statute. Saturn Distribution Corporation v. Paramount Saturn, Ltd., _____ F.3d _____, 2003 WL 1561908 (5th Cir. 2003).

Paramount became a Saturn franchisee in Houston in 1997. Subsequently, it sought to purchase three additional dealerships from Saturn. But Saturn refused to sell the additional dealerships to Paramount. As a result, Paramount brought a claim against Saturn before the Texas Motor Vehicle Board, alleging that Saturn breached its statutory duty of good faith and fair dealing. Saturn moved to compel arbitration pursuant to the franchise agreement. The district court granted Saturn's motion to compel arbitration, and Paramount appealed.

The appellate court affirmed the district court's ruling. It found that the claim was arbitrable because the statutory duty on which Paramount based its claim (ie, good faith and fair dealing) arose out of the parties' franchise agreement, which contained a broad arbitration provision. Further, according to the court, there were no legal restraints external to the parties' arbitration agreement that foreclosed the arbitration of their dispute because the Texas Motor Vehicle Board did not have exclusive jurisdiction of contractual disputes between franchisors and franchisees in the motor vehicle industry. And even if it did, according to the court, the strong federal policy favoring arbitration preempts state laws that act to limit the availability of arbitration. Accordingly, the court affirmed the district court's decision.

Forty-Five-Mile Restrictive Covenant Reasonable Under Wisconsin Law

The U.S. District Court for the Eastern District of Wisconsin has recently held that a one-year, 45-mile covenant not to compete in a tax service franchise agreement was a reasonable, enforceable covenant not to compete under Wisconsin common law. H&R Block Eastern Tax Services, Inc. v. Vorpahl, _____ F. Supp.2d _____ 2003 WL 1787032 (E.D.Wis. 2003).

H&R Block, a tax service franchisor, filed an action against a former franchisee seeking a declaratory judgment that the post-termination restrictive covenant contained in a franchise agreement was enforceable under Wisconsin law. The post-termination covenant not to compete prohibited the former franchisee from owning or operating a tax preparation business within 45 miles of the franchisee's territory of Oconto Falls, WI, for a period of one year.

After filing the complaint, H&R Block moved for partial summary judgment on the restrictive covenant issue. The former franchisee argued, among other things, that the covenant not to compete was unreasonable and in violation of a Wisconsin statute (Wis. Stat. '103.465), which prohibits unreasonable restraint in employment contracts. H&R Block argued that '103.465 did not apply because the franchisor/franchisee relationship was not an employment relationship, and the covenant not to compete was reasonable under Wisconsin common law.

The court rejected the franchisee's argument. It held that '103.465 of the Wisconsin statute was inapplicable to the franchise relationship because it applied only to employment contracts, and the franchise agreement clearly was not a contract of employment. The court, therefore, applied Wisconsin common law, which requires the court to consider the following factors in determining whether a covenant not to compete is reasonable: (i) whether the restriction was reasonably necessary to protect the beneficiary; (ii) whether the time, space, purpose, and scope were reasonable; and, (iii) whether the public would be injured by the restriction's enforcement. Applying those factors, the court held that the covenant was reasonable, and it granted summary judgment in favor of the franchisor.

Susan H. Morton is a partner and David W. Oppenheim is an associate of New York City's Kaufmann, Feiner, Yamin, Gildin & Robbins LLP.

New Jersey Consumer Fraud Act Applies to the Acquisition of a Franchise

The Appellate Division of the Superior Court of New Jersey has recently held that the New Jersey Consumer Fraud Act (the 'Act') applied to the acquisition of a franchise from a franchisor that acquired its franchisees from general advertising over the Internet. Kavky v. Herbal Life International of America, _____ N.J. Super _____, 2003 WL 1918411 (A.D. 2003).

Steven Kavky became an Herbal Life distributor in January 2000 after he responded to Herbal Life's Internet advertisement. Herbal Life used general advertising over the Internet to solicit distributors for a variety of products that it sells in the United States. Its offer was to make anyone a distributor in return for $85 and to provide 'pre-paid retail internet customers' at $8.50 per customer.

After reading the advertisement, Kavky agreed to become a distributor and to purchase 10 customers for a total cost of $170. According to Kavky, although Herbal Life sent him materials relating to his distributorship, it never intended to send him any Internet customers, and it refused to do so. Kavky alleged that he spent significant time and money to establish a network of Herbal Life distributors, and that his efforts were fruitless because of Herbal Life's failure to provide the promised customers. Kavky then filed a complaint against Herbal Life for a violation of the Act and for common law fraud.

Herbal Life moved to dismiss the complaint for failure to state a claim upon which relief could be granted. The trial court granted the motion for two reasons. First, it found that the facts were alleged without sufficient particularization, and second, the Act did not apply to investments in franchises. Kavky appealed the trial court's decision.

The appellate court framed the novel issue as follows: whether a purchaser of a franchise distributorship is protected by the Act, or stated differently, whether franchises and distributorships fall within the Act's definition of 'merchandise.' The appellate court observed that the U.S. Court of Appeals for the 3rd Circuit, applying New Jersey law, considered the issue in J&R Ice Cream Corp. v. California Smoothie Licensing Corp., 31 F.3d 1259, 1270-74 (3d Cir. 1994) and predicted that the New Jersey State Supreme Court would hold that the Act is inapplicable to any distributor or franchise relationship, including those made available to the public at large, because those transactions involve the purchase of a business.

But the appellate court disagreed with the 3rd Circuit's broad conclusion. It did not disagree with the result reached in J&R because J&R appeared to involve a substantial and complex commercial transaction, which likely fell within the New Jersey Franchise Practices Act. But the court explained that it could not endorse the 3rd Circuit's broad holding that the Act did not apply to the offer and sale of franchises because the holding would deprive the citizens of New Jersey of protection against pyramid sales schemes, and similar mass-public frauds, a consequence which the Appellate Court believed the state Supreme Court would reject if it considered the issue. The Appellate Court further explained that despite what J&R held, investments in a franchise are not really the acquisition of a business even though the franchise is purchased, because it really involves the acquisition of both goods and services.

In the last issue of this publication, we reported on a case in the U.S. District Court for the District of New Jersey, Christy v. We The People Forms and Service Centers, USA, Inc., in which the court, applying New Jersey law, followed J&R and held that the Act does not apply to the acquisition of a franchise because it constitutes the purchase of a business rather than the purchase of a consumer good or service. In light of Kavky, it will be interesting to see if the District Court's decision is upheld on appeal.

Franchisor Could Be Vicariously Liable For Acts of the Franchisee's Employee

The California Court of Appeal, Second District, recently reversed the decision of a trial court which had granted summary judgment in favor of a franchisor against a third party who was injured by one of its franchisee's employees. Jazmin v. El Centro Foods, Inc., et al., 2003 WL 1950478 (Cal. App. 2nd Dist. 2003).

Librada Jazmin, an elderly pedestrian, was struck by an automobile driven by a 'Pizza Man' franchisee's employee. According to the employee, he was returning to the store from a pizza delivery when the elderly pedestrian ran in front of his car, and he hit her. Jazmin brought suit against the driver, the driver's employer, who was also a Pizza Man franchisee, and El Centro Foods, Inc., the Pizza Man franchisor.

The franchisor moved for summary judgment on the grounds that it could not be vicariously liable for the acts of its franchisee's employee because it did not have substantial control over the franchisee. The trial court agreed with the franchisor, and it entered summary judgment in its favor. Jazmin appealed.

The Appellate Court disagreed with the trial court. It observed that the general rule is that where a franchise agreement gives the franchisor the right of complete or substantial control over the franchisee, an agency relationship exists. According to the court, in the field of franchise agreements, the question of whether the franchisee is an independent contractor or an agent is ordinarily one of fact, depending on whether the franchisor exercises complete or substantial control over the franchisee. Stated differently, the court observed that an actual agency relationship exists when the franchisor retains controls extending beyond those necessary to protect and maintain its trademark, trade name, and good will, and into the day-to-day details of the franchisee's operation by giving the franchisor virtually absolute control of the enterprise. Moreover, according to the court, the fact that the franchise agreement includes provisions consistent with the non-existence of an agency relationship is not dispositive, especially when the franchise documents include other provisions giving the franchisor the right to control the day-to-day management decision and to cancel the contract in the event the franchisee does not meet the franchisor's prescribed standards.

Applying the above standard, the appellate court reversed the decision of the trial court. It found that there was a triable issue of fact as to whether the franchise documents (namely the franchise agreement and operations manual) were sufficient to create a triable issue of material fact regarding whether El Centro Foods maintained the right of complete and substantial control over the franchisee and whether there was an agency relationship between the parties. For example, the court observed that the franchise agreement obligated the franchisee to operate his Pizza Man store in continuous and full compliance with the Pizza Man system and manuals, as modified by El Centro Foods from time to time in its sole discretion. The court observed that the manual covered everything from food and sanitation to insurance and advertising. The manual further set forth strict procedures for the delivery of pizza by requiring a 30-minute delivery schedule.

According to the court, the above factors created a triable issue of fact, and the entry of summary judgment was improper.

Texas Statute Preempted by the Federal Arbitration Act

The U.S. District Court of Appeals for the 5th Circuit has held that a franchisee's claim that the franchisor breached its statutory duty of good faith and fair dealing was arbitrable pursuant to the agreement between the parties, and not exclusively with the jurisdiction of the Texas Motor Vehicle Board as provided in a Texas statute. Saturn Distribution Corporation v. Paramount Saturn, Ltd., _____ F.3d _____, 2003 WL 1561908 (5th Cir. 2003).

Paramount became a Saturn franchisee in Houston in 1997. Subsequently, it sought to purchase three additional dealerships from Saturn. But Saturn refused to sell the additional dealerships to Paramount. As a result, Paramount brought a claim against Saturn before the Texas Motor Vehicle Board, alleging that Saturn breached its statutory duty of good faith and fair dealing. Saturn moved to compel arbitration pursuant to the franchise agreement. The district court granted Saturn's motion to compel arbitration, and Paramount appealed.

The appellate court affirmed the district court's ruling. It found that the claim was arbitrable because the statutory duty on which Paramount based its claim (ie, good faith and fair dealing) arose out of the parties' franchise agreement, which contained a broad arbitration provision. Further, according to the court, there were no legal restraints external to the parties' arbitration agreement that foreclosed the arbitration of their dispute because the Texas Motor Vehicle Board did not have exclusive jurisdiction of contractual disputes between franchisors and franchisees in the motor vehicle industry. And even if it did, according to the court, the strong federal policy favoring arbitration preempts state laws that act to limit the availability of arbitration. Accordingly, the court affirmed the district court's decision.

Forty-Five-Mile Restrictive Covenant Reasonable Under Wisconsin Law

The U.S. District Court for the Eastern District of Wisconsin has recently held that a one-year, 45-mile covenant not to compete in a tax service franchise agreement was a reasonable, enforceable covenant not to compete under Wisconsin common law. H&R Block Eastern Tax Services, Inc. v. Vorpahl, _____ F. Supp.2d _____ 2003 WL 1787032 (E.D.Wis. 2003).

H&R Block, a tax service franchisor, filed an action against a former franchisee seeking a declaratory judgment that the post-termination restrictive covenant contained in a franchise agreement was enforceable under Wisconsin law. The post-termination covenant not to compete prohibited the former franchisee from owning or operating a tax preparation business within 45 miles of the franchisee's territory of Oconto Falls, WI, for a period of one year.

After filing the complaint, H&R Block moved for partial summary judgment on the restrictive covenant issue. The former franchisee argued, among other things, that the covenant not to compete was unreasonable and in violation of a Wisconsin statute (Wis. Stat. '103.465), which prohibits unreasonable restraint in employment contracts. H&R Block argued that '103.465 did not apply because the franchisor/franchisee relationship was not an employment relationship, and the covenant not to compete was reasonable under Wisconsin common law.

The court rejected the franchisee's argument. It held that '103.465 of the Wisconsin statute was inapplicable to the franchise relationship because it applied only to employment contracts, and the franchise agreement clearly was not a contract of employment. The court, therefore, applied Wisconsin common law, which requires the court to consider the following factors in determining whether a covenant not to compete is reasonable: (i) whether the restriction was reasonably necessary to protect the beneficiary; (ii) whether the time, space, purpose, and scope were reasonable; and, (iii) whether the public would be injured by the restriction's enforcement. Applying those factors, the court held that the covenant was reasonable, and it granted summary judgment in favor of the franchisor.

Susan H. Morton is a partner and David W. Oppenheim is an associate of New York City's Kaufmann, Feiner, Yamin, Gildin & Robbins LLP.