Court Watch

By Susan H. Morton and David W. Oppenheim
October 01, 2003

Failure to Disclose Under FTC Rule May Make Agreement Unenforceable

The U.S. District Court for the Eastern District of Pennsylvania has ruled that a letter agreement may have been unenforceable if the franchisor failed to comply with the FTC Franchise Rule by making required disclosure before the agreement was signed. Checkers Drive-In Restaurants, Inc. v. Benjamin Laster, et al., __ F.Supp.2d __, 2003 WL 22133836 (E.D.Pa. 2003).

Checkers, the franchisor, moved for summary judgment on its claims for breach of contract, alleging that the franchisee failed to make payments required under a letter agreement between the parties that authorized the franchisee to operate 17 Checkers restaurants. The franchisee cross-moved for summary judgment, arguing that the franchisor's failure to provide disclosures required by the FTC Franchise Rule rendered any agreement void and unenforceable. The franchisor disputed the applicability of the FTC Franchise Rule, and also contended that it had given the required disclosure.

The court refused to grant summary judgment for either party, stating that whether and under what terms the letter agreement was enforceable could turn on “the disputed issue of whether disclosure had been made pursuant to the FTC franchise rules.”

Because this is a very unusual ruling with far-reaching implications, it is important to consider whether any other courts have reached the same conclusion. There is no private right of action under the FTC Franchise Rule, and the authors are unaware of any other case in which a claim was made that failure to disclose under the FTC Franchise Rule directly rendered a franchise agreement unenforceable or otherwise created a private cause of action. In Mario Nieman v. Dryclean U.S.A. Franchise Co., Inc., however, the U.S., District Court for the Southern District of Florida ruled that an aggrieved Argentinean franchisee could bring suit under Florida's “little FTC Act” for the franchisor's failure to disclose in violation of the FTC Franchise Rule. CCH Bus. Fran. Guide Par. 11,166, not reported in F.Supp.2d, (S.D. Fla. 1997). On appeal, the U.S. Court of Appeals for the 11th Circuit reversed the ruling, but the grounds for the reversal were that the FTC Franchise Rule did not apply extraterritorially. There was no reversal of the principle that the Florida “little FTC Act” made the FTC Franchise Rule applicable to a private suit and that it entitled a franchisee who received no FTC Franchise Rule disclosure to the return of a $50,000 deposit. Mario Nieman v. Dryclean U.S.A. Franchise Co., Inc., 178 F.3d 1126 (11th Cir. 2000).

The issue of whether failure to disclose renders an agreement unenforceable has been litigated under the New York Franchise Sales Act, where there is, of course, a private right of action. In King Computer v. Beeper Plus, the U.S. District Court for the Southern District of New York ruled that a franchise contract offered by a franchisor who failed to register a prospectus as required by the New York Franchise Sales Act was not enforceable. 92 Civ 5494; 1993 US Dist LEXIS 27070, (S.D.N.Y. 1993). This ruling was soundly and expressly rejected by a New York appellate court, which affirmed a New York lower court ruling holding that a franchisor's alleged failure to register an offering prospectus in violation of the New York Franchise Sales Act did not nullify its franchise agreements or bar its causes of action based on the franchisees' alleged breach of contract. TKO Fleet Enterprises, Inc. v. Elite Limousine Plus, Inc., 286 A.D.2d 436, 729 N.Y.S.2d 193 (2d Dept. 2001), affirming 708 N.Y.S.2d 593 (N.Y.Sup. 2000).

A similar claim that failure to make pre-sale disclosure voided a franchise agreement was equally unsuccessful in a case brought under the Illinois Franchise Disclosure Act, Moseley's & Co. et al. v. The Maxim Group, Inc., et al., not reported in F.Supp.2d, CCH Bus. Fran. Guide Par. 11,664, (S.D.Iowa 1999).

Franchisor Awarded Lost Future Profits from Terminated Franchisee

The U.S. Court of Appeals for the Sixth Circuit affirmed an award of lost future profits to a printing shop franchisor that had terminated a franchisee for nonpayment of royalties. American Speedy Printing Centers, Inc. v. AM Marketing, Inc. et al., not reported in F.3d., 69 Fed.Appx. 692, 2003 WL 21580384, CCH Bus. Fran. Guide Par. 12,616 (6th Cir. 2003).

The franchisee admitted that it breached the franchise agreement by failing to pay royalties. However, it appealed a federal district court's award to the franchisor of the royalties that it would have received for the remainder of the 20-year term of the franchise agreement if it had not terminated the franchisee for nonpayment. The court held that the franchisor was entitled to all damages necessary to put it in a position equivalent to that in which it would find itself if the agreement continued for the full 20 years.

The Sixth Circuit rejected the franchisee's assertion that the franchisor was requesting inconsistent remedies. The franchisor was not attempting to dissolve the franchise agreement through the action and, at the same time, receive damages for lost profits/royalties following that dissolution, the court held. The franchisor had already terminated the agreement in response to the franchisee's breach and then sought injunctive relief to stop the franchisee from using its marks and monetary compensation in the form of lost profits/royalties for the franchisee's actual breach of the agreement that already occurred. These, the court ruled, were entirely consistent remedies for separate and distinct injuries.

Compare this ruling to the well-known holding in Postal Instant Press, Inc. v. Sealy, in which a California appellate court refused to allow an award of lost profits to a franchisor. 51 Cal. Rptr. 2d 365 (Cal. Ct. App. 1996). The Sealy court reasoned that the franchisee's failure to make royalty and advertising payments in the past did not prevent the franchisor from receiving royalties in the future, so that it was the franchisor's own decision to terminate the franchise agreement rather than the franchisee's failure to pay that prevented the franchisor from receiving future revenues.

Franchisee Association Complaint Dismissed for Lack of Diversity Jurisdiction On Grounds Franchisee Members Should Have Been Parties

The U.S. District Court for the Northern District of Illinois has dismissed a complaint brought by a franchisee association on the grounds that the association's member franchisees were the real parties in interest, and joining them as plaintiffs would destroy federal diversity jurisdiction. Gingiss Owners Association, Inc. v. The Gingiss Group, Inc., et al., __ F.Supp.2d __, 2003 WL 22118929 (N.D.Ill. 2003).

The defendants, franchisors and related companies, moved to dismiss a complaint brought in federal court by an association of Gingiss Formalwear franchise owners. The complaint alleged that the franchisor violated the territorial commitments in its franchise agreements by opening units in franchisees' territories owned by entities related to the franchisor.

The court granted the defendants' motion to dismiss the complaint. The real parties in interest, it ruled, were the franchise owners themselves rather than their association, since the contractual rights of the franchisees were at issue, rather than any rights of the franchise association.

The franchisee association argued that it had negotiated directly with the defendants with respect to modification of the terms of the franchisor's standard franchise agreement as well as with respect to the issues that gave rise to this case. The association also pointed out that it consulted with the defendants regarding advertising programs and interceded with the defendants on behalf of franchisees. The court ruled that even if these facts were true, they were not relevant as to the issue of whether the association was seeking to enforce a right that it possessed. The association was not a party to the contracts it sought to enforce. The fact that it contracted directly with defendants in other agreements was irrelevant, the court held, because the association was not seeking to enforce the terms of those agreements.

The association's members – the franchisees – were the real parties in interest to the controversy, and the citizenship of the real party in interest determined whether diversity jurisdiction was present, according to the court. Since some of the franchisees were citizens of Illinois and California, and each defendant was a citizen of Illinois or California, the necessary complete diversity was destroyed. The court dismissed the complaint.

Franchisee Owner not Personally Liable for Post-Termination Trademark Infringement

The U.S. District Court for the Northern District of New York has ruled that the post-termination use of a hotel franchisor's marks constituted trademark infringement, but the court also held that an owner of the franchisee corporation was not personally liable for the infringement. Ramada Franchise Systems, Inc. v. Gene Boychuk, et al., __ F.Supp.2d __, 2003 WL 22170670 (N.D.N.Y. 2003).

In 1973, Gene Boychuk and his brother George formed a corporation to serve as the franchisee under a Ramada franchise agreement. Only George Boychuk provided a financial statement, and only he was named on and signed the original and renewal franchise agreements. In 1998, George Boychuk passed away, and Gene Boychuk appointed a general manager to run the hotel. In 2000, due to the nonpayment of a mortgage that had been personally guaranteed by both Boychuks, the hotel went into receivership, but the general manager appointed by Gene Boychuk continued to control the day-to-day operations. Ramada terminated the hotel franchise agreement in 2001 for failure to meet quality assurance standards, but the hotel continued to use the Ramada marks.

Ramada brought suit against Boychuk and the franchisee corporation for trademark infringement. The defendants did not dispute the trademark infringement, but Boychuk and the franchisee corporation each claimed that they should not be held liable for the infringement.

According to the court, a corporate officer can be held personally liable for a Lanham Act violation, but only if he has been proven to be “a moving, active conscious force” behind the corporation's infringement. The court found that Boychuk was a mere investor in the hotel corporation who was not involved in the day-to-day decision-making or operations of the hotel and did not directly participate in the trademark law violations. Therefore, Boychuk was not personally liable for the violations.

The court ruled, however, that the franchisee corporation was liable for the violations. Through the general manager, the franchisee corporation directly participated in the Lanham Act violations, the court found. The corporation's general manager ran the day-to-day operations of the hotel, participated and made decisions as to marketing and promotional activities, and specifically decided which bills to pay. He had complete authority over any removal of Ramada's marks and trade dress from hotel property and signs, and, despite being fully aware of Ramada's termination letter, he continued to permit the infringing activities to occur.

The franchisee corporation argued that it should escape responsibility for violations occurring during the period of receivership. The court rejected this argument. While the receiver was ultimately responsible for making financial decisions, including whether to pay Ramada for the use of its marks, these decisions were largely influenced by the general manager, the court found. The general manager would recommend which bills to pay, and the receiver by and large followed those recommendations.

The court ruled that the fact that the receiver was handling certain financial aspects of the hotel was irrelevant to whether the franchisee corporation was liable for the Lanham Act violations. The issue was not whether the franchisee corporation could have paid for the use of the Ramada marks and trade dress, the court noted. Because the franchise agreement was already terminated, any use of Ramada's marks and trade dress was unauthorized, whether paid for or not, the court held. The court found no evidence that the appointment of the receiver resulted in the general manager losing control over the day-to-day operations of the hotel, but rather found that the receiver specifically left such operations to the general manager's discretion. The general manager was aware that Ramada had terminated the license agreement, yet he decided, as the ultimate authority of the hotel, to continue to use its marks and trade dress without permission or consent, the court held.

Therefore, the court concluded that while Boychuk was a corporate officer involved almost exclusively in investing in the hotel and therefore not responsible for the hotel's infringing activities, the franchisee corporation was liable for the entire time period in which the Lanham Act was violated.

Susan H. Morton David W. Oppenheim

Failure to Disclose Under FTC Rule May Make Agreement Unenforceable

The U.S. District Court for the Eastern District of Pennsylvania has ruled that a letter agreement may have been unenforceable if the franchisor failed to comply with the FTC Franchise Rule by making required disclosure before the agreement was signed. Checkers Drive-In Restaurants, Inc. v. Benjamin Laster, et al., __ F.Supp.2d __, 2003 WL 22133836 (E.D.Pa. 2003).

Checkers, the franchisor, moved for summary judgment on its claims for breach of contract, alleging that the franchisee failed to make payments required under a letter agreement between the parties that authorized the franchisee to operate 17 Checkers restaurants. The franchisee cross-moved for summary judgment, arguing that the franchisor's failure to provide disclosures required by the FTC Franchise Rule rendered any agreement void and unenforceable. The franchisor disputed the applicability of the FTC Franchise Rule, and also contended that it had given the required disclosure.

The court refused to grant summary judgment for either party, stating that whether and under what terms the letter agreement was enforceable could turn on “the disputed issue of whether disclosure had been made pursuant to the FTC franchise rules.”

Because this is a very unusual ruling with far-reaching implications, it is important to consider whether any other courts have reached the same conclusion. There is no private right of action under the FTC Franchise Rule, and the authors are unaware of any other case in which a claim was made that failure to disclose under the FTC Franchise Rule directly rendered a franchise agreement unenforceable or otherwise created a private cause of action. In Mario Nieman v. Dryclean U.S.A. Franchise Co., Inc., however, the U.S., District Court for the Southern District of Florida ruled that an aggrieved Argentinean franchisee could bring suit under Florida's “little FTC Act” for the franchisor's failure to disclose in violation of the FTC Franchise Rule. CCH Bus. Fran. Guide Par. 11,166, not reported in F.Supp.2d, (S.D. Fla. 1997). On appeal, the U.S. Court of Appeals for the 11th Circuit reversed the ruling, but the grounds for the reversal were that the FTC Franchise Rule did not apply extraterritorially. There was no reversal of the principle that the Florida “little FTC Act” made the FTC Franchise Rule applicable to a private suit and that it entitled a franchisee who received no FTC Franchise Rule disclosure to the return of a $50,000 deposit. Mario Nieman v. Dryclean U.S.A. Franchise Co., Inc ., 178 F.3d 1126 (11th Cir. 2000).

The issue of whether failure to disclose renders an agreement unenforceable has been litigated under the New York Franchise Sales Act, where there is, of course, a private right of action. In King Computer v. Beeper Plus, the U.S. District Court for the Southern District of New York ruled that a franchise contract offered by a franchisor who failed to register a prospectus as required by the New York Franchise Sales Act was not enforceable. 92 Civ 5494; 1993 US Dist LEXIS 27070, (S.D.N.Y. 1993). This ruling was soundly and expressly rejected by a New York appellate court, which affirmed a New York lower court ruling holding that a franchisor's alleged failure to register an offering prospectus in violation of the New York Franchise Sales Act did not nullify its franchise agreements or bar its causes of action based on the franchisees' alleged breach of contract. TKO Fleet Enterprises, Inc. v. Elite Limousine Plus, Inc., 286 A.D.2d 436, 729 N.Y.S.2d 193 (2d Dept. 2001), affirming 708 N.Y.S.2d 593 (N.Y.Sup. 2000).