Franchise Litigation: 10 Cases That Changed the Landscape in the Past Decade

Nieman filed suit seeking a refund of the deposit under Florida's Deceptive and Unfair Trade Practices Act (“DUTPA”). The suit claimed that DUSA had failed to make disclosures required under DUTPA and the Federal Trade Commission (FTC) Franchise Rule. DUSA responded by claiming that those regulations did not apply to this transaction executed in Argentina because neither applied extraterritorially.

In response to the suit, a federal district court granted summary judgment to Nieman, explaining that DUTPA applied because Congress maintained the right to prevent unfair trade practices by U.S. citizens engaged in foreign commerce, even if the acts occur outside of the United States. As a result, Nieman was awarded a full refund of the $50,000, and DUSA appealed. The Court of Appeals reversed and determined that DUTPA and the FTC did not intend to apply the Franchise Rule to extraterritorial agreements.

The lesson of Nieman is that a franchisor never knows what sort of legal claims may be made against it. Certainly the franchisor in Nieman was surprised to learn that an Argentina resident might have a claim under the FTC Rule and Florida's Little FTC Act. While the rule of “no extraterritorial application” is being confirmed by the FTC in its currently proposed updated FTC Rule, franchisors and franchisees alike should be aware that creative claims may be made using the laws of the state in which the franchisor resides. While the claims in Nieman were unsuccessful, other states may take a more plaintiff-friendly view of their state laws.

8) Postal Instant Press v. Sealy, Bus. Franchise Guide (CCH) '10,893, 51 Cal. Rptr. 2d 365 (Cal. Ct. App. 1996).

In 1979, Steven and Susan Sealy entered into a 20-year franchise agreement with Postal Instant Press (“PIP”), an internationally known franchisor of printing businesses. The agreement provided PIP's trademark and certain services to the Sealys in exchange for royalty fees of 6% of gross revenues and advertising fees of 1% of gross revenues. These fees were to be paid monthly. The franchise agreement listed numerous possible failures by the franchisee that would constitute a material breach of the agreement. The agreement provided that in the event of a material breach, PIP was entitled to terminate the agreement and bring such action to recover damages. One of the material breaches listed was failure to make payment of a monthly royalty or advertising fee within 10 days after notice that it is unpaid.

After the agreement had been in effect for almost 13 years, the Sealys failed to pay several of their monthly royalty and advertising fee payments. After some attempts to work out a resolution failed, the Sealys again fell delinquent. In Jan. 1992, PIP sent out a termination letter. PIP filed a breach of contract action against the Sealys seeking unpaid past royalties and also sought “future royalties and payments for the remaining unfulfilled term” of the contract in an amount close to $500,000. After a bench trial, the court awarded PIP past royalties and also awarded PIP the future royalties based upon the Sealys' sales history and “estimated future profits,” which came to $301,344. The Sealys appealed to the California Court of Appeals.

The Court of Appeals' ruling in Sealy is the thing of dreams for franchisee advocates and a terrible nightmare for franchisor advocates. The court reversed the future royalty damages awarded to PIP on two different grounds: causation and unconscionability. The court held that under general contract principles, the nonbreaching party is only entitled to recover damages, including lost future profits, which are proximately caused by the specific breach. In other words, “the breaching party is only liable to place the nonbreaching party in the same position as if the specific breach had not occurred.” The court held that in this situation, the franchisee's failure to timely make the past royalty payments was not a direct cause of the franchisor's failure to receive future royalty payments. Instead, it was when PIP elected to terminate its agreement that the Sealys' ability to produce future revenues as a franchisee ended, and PIP's right to collect royalties on those revenues also ended. Therefore, PIP was not entitled to receive future royalty damages since they were not the proximate cause of the Sealys' breach.

As an alternative basis for its holding, the court held that the “lost future profits” award would violate California's statutory and common law prohibitions against damages that are “unreasonable, unconscionable or grossly oppressive.” The court decided that PIP's entitlement to recover its unpaid past royalties and its right to install a new franchise in what had formerly been the Sealys' territory, provided it with full compensation of reasonable damages. A further award of lost future royalties would give PIP a disproportionate compensation which would be unconscionable, unreasonable and grossly oppressive to the Sealys. The court further stated that allowing these types of future damages would give franchisors an unfair advantage in contract disputes with their franchisees.

The court recognized in its holdings the nature of franchise agreements, which it stated, “tend to reflect a gross disparity in bargaining power,” since franchisors are typically, but not always, large corporations and franchisees are typically small businessmen or women. The court went on to state that the agreements typically allow franchisors to terminate the agreements or refuse to renew them for virtually any reason. As a result of the court's view of the typical franchise agreement, it found that allowing future profit awards would leave the franchisee enslaved for years “working primarily for the franchisor's benefit, but without its trademark or services.” The court in its conclusion expressly stated that it was not finding that a court can never appropriately award some lost future profits to a franchisor, since in a future case the breach might be one which directly causes the franchisor to lose future profits independent of the franchisor's own termination of the agreement. The court reiterated that, even in such a case, the award should not be of a size that is “excessive, oppressive or disproportionate to the loss.”

Sealy has survived in California and has actually been followed in various other jurisdictions. The idea that a franchisor cannot terminate a franchise agreement and then claim lost future royalties has an equitable appeal to many courts, particularly when the franchisee was not making any money in the system pre-termination.

9) Queen City Pizza, Inc. v. Domino's Pizza, Inc., Bus. Franchise Guide (CCH) '11,275, 124 F. 3d 430 (3rd Cir. 1997).

This case involved a suit by 11 franchisees of Domino's Pizza, Inc. (“Domino's”) and the International Franchise Advisory Council (“IFAC”), alleging violations of federal antitrust laws, breach of contract, and tortious interference with contract. The standard Domino's franchise agreement required that all pizza ingredients, beverages, and packaging materials used by a franchisee conform to the standards set by Domino's. One section of the agreement further provided that Domino's could, at its discretion, require that ingredients, supplies, and materials used in preparation, packaging, and delivery of pizza be purchased exclusively from Domino's or from approved suppliers and distributors. The agreement retained in Domino's the power to inspect the franchise stores and to test materials and ingredients being used. Under this standard agreement Domino's (at the time) sold approximately 90% of the $500 million in ingredients and supplies used by its franchisees. Domino's did not manufacture its own fresh dough and instead purchased it from approved suppliers and then resold it to franchisees at a markup. Plaintiffs contended that Domino's had a monopoly in the $500-million aftermarket for sales of supplies to Domino's franchisees, and that it had used its monopoly power to restrain trade unreasonably, limit competition, and extract supra-competitive profits.

Plaintiffs pointed to three specific actions to support their claims:

• Plaintiffs alleged that Domino's had restricted their ability to purchase competitively priced dough;
• Plaintiffs objected to efforts by Domino's to block IFAC's attempt to buy less-expensive ingredients and supplies from other sources. IFAC had entered into a purchasing agreement with FoodService Purchasing Cooperative, Inc. (“FPC”), which developed a cooperative purchasing plan under which participating Domino's franchisees could obtain ingredients and supplies at reduced costs; and
• Plaintiffs alleged that Domino's refused to sell fresh dough to franchisees unless the franchisees purchased other ingredients and supplies from Domino's.

As a result of these complaints, plaintiffs alleged that they were forced to pay between $3000 and $10,000 more per year than they would in a competitive market, and that these costs were being passed on to consumers.

The district court ruled for Domino's, and the plaintiffs appealed.

The Court of Appeals quickly and harshly disposed of the franchisees' antitrust “tying” claims, stating that the franchisor had no antitrust “market power” and that its power over its franchisees was as a result of contracts that the franchisees had received and read before entering into the franchise relationship. The shorthand lesson of Queen City Pizza is that, when a franchisor adequately discloses a tying arrangement before the franchisee enters into the franchise system, the franchisor will not be liable to the franchisee who sues for an illegal product “tie” under the antitrust laws.

10) State Oil Co. v. Khan, Bus. Franchise Guide (CCH) '11,274, 522 U.S. 3 (1997).

Respondent Khan agreed to lease and operate a gas station and convenience store franchise from State Oil. The leasing agreement permitted State Oil to set a suggested retail price for Khan's resale of gasoline that State Oil supplied. Additionally, the agreement provided that State Oil would sell gasoline to Khan at the suggested retail price minus 3.25 cents per gallon, which would constitute Khan's profit margin. The contract did not prohibit Khan from selling above or below the suggested retail price, but required Kahn to rebate to State Oil the difference between the suggested retail price and any amount charged in excess of the suggested retail price. State Oil permitted Khan to sell gasoline below the suggested retail price without penalty. After operating the franchise for approximately 1 year, Khan failed to make several lease payments. As a result, State Oil declared its intent to terminate the contract and initiated eviction proceedings. At State Oil's request, a receiver was appointed to operate the station, although that receiver was not subject to price restraints imposed on Khan. Because of this pricing flexibility, the receiver obtained a profit in excess of 3.5 cents per gallon by charging above the suggested retail price for premium gasoline and below suggested retail price for regular grade. Khan then filed an action in U.S. District Court for the Northern District of Illinois that alleged, among other claims, that State Oil's lease agreement violated Section 1 of the Sherman Act through the practice of “vertical maximum price fixing.”

Ultimately the matter reached the U.S. Supreme Court. Prior to the Kahn case the Supreme Court had found that any sort of resale price maintenance agreement was a per se violation of the Sherman Antitrust Act. Albrecht v Herald Co., 390 U.S. 145, 152-154 (1968). This was the rule even if the price maintenance agreement resulted in lower prices to the public through “maximum resale price maintenance” (where the retailer is not allowed to sell the product at a price above a certain level).

The Supreme Court overruled Albrecht. The Court found that while minimum resale price maintenance seemed almost certain to hurt competition and the consumer (because outlets wanted to charge less and could not), the same could not be said about maximum resale price maintenance (where outlets want to charge consumers more for a product than they are allowed to). As a result of Khan, the law now permits maximum resale price maintenance to be evaluated under the “rule of reason,” making it far more likely that the resale price maintenance will be upheld as a proper agreement. Franchisors now have a much bigger hammer against franchisees that refuse to sell hamburgers for 99 cents, or shoes for $19.99, or tacos for 39 cents. Surprisingly, franchisors do not seem to have utilized this power to the extent feared by franchisee advocates in the wake of Khan.

Conclusion

Cases come along every once in a while that change how franchisors and franchisees see the world. At times these cases rapidly alter the landscape, causing a great deal of joy on one side and a great deal of consternation on the other. At other times the case brings clarity to a situation in which clarity was badly needed. Still other times, the case is like a large snowstorm, changing things significantly for a period of time, but then slowly melting away.

We hope that this summary of 10 important cases has given you some understanding and appreciation for a few of the significant judicial events over the past several years. We cannot hope to cover everything that has occurred, but we are confident that we have addressed many of the high points (or low points, depending on your point of view).

The authors developed this article from a presentation that they made at the 2004 American Bar Association's Forum on Franchising Legal Symposium. To obtain the full presentation, contact ABA.

Part Two of a Two-Part Series

The authors conclude their analysis of 10 highly significant decisions in the past decade that affected the franchising industry.

Nieman v. Dryclean U.S.A. Franchise Co., Inc., Bus. Franchise Guide (CCH) '11,644, 178 F.3d 1126 (11th Cir. 1999). Dryclean U.S.A. Franchise Co. (“DUSA”) was a Florida-based dry cleaning franchise that entered negotiations with Mario Nieman, a citizen of Argentina. Nieman sought to purchase a master franchise that would give him the right to sell DUSA franchises in Argentina. The parties entered into an agreement in Feb. 1994 through a letter signed by Nieman in Argentina and then countersigned by a DUSA representative in Florida. As a result of the contract, Nieman provided a $50,000 nonrefundable deposit, which effectively purchased a 60-day option on a master franchise in Argentina. However, Nieman failed to raise the financial capital and did not purchase the master franchise agreement.

Nieman filed suit seeking a refund of the deposit under Florida's Deceptive and Unfair Trade Practices Act (“DUTPA”). The suit claimed that DUSA had failed to make disclosures required under DUTPA and the Federal Trade Commission (FTC) Franchise Rule. DUSA responded by claiming that those regulations did not apply to this transaction executed in Argentina because neither applied extraterritorially.

In response to the suit, a federal district court granted summary judgment to Nieman, explaining that DUTPA applied because Congress maintained the right to prevent unfair trade practices by U.S. citizens engaged in foreign commerce, even if the acts occur outside of the United States. As a result, Nieman was awarded a full refund of the $50,000, and DUSA appealed. The Court of Appeals reversed and determined that DUTPA and the FTC did not intend to apply the Franchise Rule to extraterritorial agreements.

The lesson of Nieman is that a franchisor never knows what sort of legal claims may be made against it. Certainly the franchisor in Nieman was surprised to learn that an Argentina resident might have a claim under the FTC Rule and Florida's Little FTC Act. While the rule of “no extraterritorial application” is being confirmed by the FTC in its currently proposed updated FTC Rule, franchisors and franchisees alike should be aware that creative claims may be made using the laws of the state in which the franchisor resides. While the claims in Nieman were unsuccessful, other states may take a more plaintiff-friendly view of their state laws.

8) Postal Instant Press v. Sealy, Bus. Franchise Guide (CCH) '10,893, 51 Cal. Rptr. 2d 365 (Cal. Ct. App. 1996).

In 1979, Steven and Susan Sealy entered into a 20-year franchise agreement with Postal Instant Press (“PIP”), an internationally known franchisor of printing businesses. The agreement provided PIP's trademark and certain services to the Sealys in exchange for royalty fees of 6% of gross revenues and advertising fees of 1% of gross revenues. These fees were to be paid monthly. The franchise agreement listed numerous possible failures by the franchisee that would constitute a material breach of the agreement. The agreement provided that in the event of a material breach, PIP was entitled to terminate the agreement and bring such action to recover damages. One of the material breaches listed was failure to make payment of a monthly royalty or advertising fee within 10 days after notice that it is unpaid.

After the agreement had been in effect for almost 13 years, the Sealys failed to pay several of their monthly royalty and advertising fee payments. After some attempts to work out a resolution failed, the Sealys again fell delinquent. In Jan. 1992, PIP sent out a termination letter. PIP filed a breach of contract action against the Sealys seeking unpaid past royalties and also sought “future royalties and payments for the remaining unfulfilled term” of the contract in an amount close to $500,000. After a bench trial, the court awarded PIP past royalties and also awarded PIP the future royalties based upon the Sealys' sales history and “estimated future profits,” which came to $301,344. The Sealys appealed to the California Court of Appeals.

The Court of Appeals' ruling in Sealy is the thing of dreams for franchisee advocates and a terrible nightmare for franchisor advocates. The court reversed the future royalty damages awarded to PIP on two different grounds: causation and unconscionability. The court held that under general contract principles, the nonbreaching party is only entitled to recover damages, including lost future profits, which are proximately caused by the specific breach. In other words, “the breaching party is only liable to place the nonbreaching party in the same position as if the specific breach had not occurred.” The court held that in this situation, the franchisee's failure to timely make the past royalty payments was not a direct cause of the franchisor's failure to receive future royalty payments. Instead, it was when PIP elected to terminate its agreement that the Sealys' ability to produce future revenues as a franchisee ended, and PIP's right to collect royalties on those revenues also ended. Therefore, PIP was not entitled to receive future royalty damages since they were not the proximate cause of the Sealys' breach.

As an alternative basis for its holding, the court held that the “lost future profits” award would violate California's statutory and common law prohibitions against damages that are “unreasonable, unconscionable or grossly oppressive.” The court decided that PIP's entitlement to recover its unpaid past royalties and its right to install a new franchise in what had formerly been the Sealys' territory, provided it with full compensation of reasonable damages. A further award of lost future royalties would give PIP a disproportionate compensation which would be unconscionable, unreasonable and grossly oppressive to the Sealys. The court further stated that allowing these types of future damages would give franchisors an unfair advantage in contract disputes with their franchisees.

The court recognized in its holdings the nature of franchise agreements, which it stated, “tend to reflect a gross disparity in bargaining power,” since franchisors are typically, but not always, large corporations and franchisees are typically small businessmen or women. The court went on to state that the agreements typically allow franchisors to terminate the agreements or refuse to renew them for virtually any reason. As a result of the court's view of the typical franchise agreement, it found that allowing future profit awards would leave the franchisee enslaved for years “working primarily for the franchisor's benefit, but without its trademark or services.” The court in its conclusion expressly stated that it was not finding that a court can never appropriately award some lost future profits to a franchisor, since in a future case the breach might be one which directly causes the franchisor to lose future profits independent of the franchisor's own termination of the agreement. The court reiterated that, even in such a case, the award should not be of a size that is “excessive, oppressive or disproportionate to the loss.”

Sealy has survived in California and has actually been followed in various other jurisdictions. The idea that a franchisor cannot terminate a franchise agreement and then claim lost future royalties has an equitable appeal to many courts, particularly when the franchisee was not making any money in the system pre-termination.

9) Queen City Pizza, Inc. v. Domino's Pizza, Inc., Bus. Franchise Guide (CCH) '11,275, 124 F. 3d 430 (3rd Cir. 1997).

This case involved a suit by 11 franchisees of Domino's Pizza, Inc. (“Domino's”) and the International Franchise Advisory Council (“IFAC”), alleging violations of federal antitrust laws, breach of contract, and tortious interference with contract. The standard Domino's franchise agreement required that all pizza ingredients, beverages, and packaging materials used by a franchisee conform to the standards set by Domino's. One section of the agreement further provided that Domino's could, at its discretion, require that ingredients, supplies, and materials used in preparation, packaging, and delivery of pizza be purchased exclusively from Domino's or from approved suppliers and distributors. The agreement retained in Domino's the power to inspect the franchise stores and to test materials and ingredients being used. Under this standard agreement Domino's (at the time) sold approximately 90% of the $500 million in ingredients and supplies used by its franchisees. Domino's did not manufacture its own fresh dough and instead purchased it from approved suppliers and then resold it to franchisees at a markup. Plaintiffs contended that Domino's had a monopoly in the $500-million aftermarket for sales of supplies to Domino's franchisees, and that it had used its monopoly power to restrain trade unreasonably, limit competition, and extract supra-competitive profits.

Plaintiffs pointed to three specific actions to support their claims:

• Plaintiffs alleged that Domino's had restricted their ability to purchase competitively priced dough;
• Plaintiffs objected to efforts by Domino's to block IFAC's attempt to buy less-expensive ingredients and supplies from other sources. IFAC had entered into a purchasing agreement with FoodService Purchasing Cooperative, Inc. (“FPC”), which developed a cooperative purchasing plan under which participating Domino's franchisees could obtain ingredients and supplies at reduced costs; and
• Plaintiffs alleged that Domino's refused to sell fresh dough to franchisees unless the franchisees purchased other ingredients and supplies from Domino's.

As a result of these complaints, plaintiffs alleged that they were forced to pay between $3000 and $10,000 more per year than they would in a competitive market, and that these costs were being passed on to consumers.

The district court ruled for Domino's, and the plaintiffs appealed.

The Court of Appeals quickly and harshly disposed of the franchisees' antitrust “tying” claims, stating that the franchisor had no antitrust “market power” and that its power over its franchisees was as a result of contracts that the franchisees had received and read before entering into the franchise relationship. The shorthand lesson of Queen City Pizza is that, when a franchisor adequately discloses a tying arrangement before the franchisee enters into the franchise system, the franchisor will not be liable to the franchisee who sues for an illegal product “tie” under the antitrust laws.

10) State Oil Co. v. Khan, Bus. Franchise Guide (CCH) '11,274, 522 U.S. 3 (1997).

Respondent Khan agreed to lease and operate a gas station and convenience store franchise from State Oil. The leasing agreement permitted State Oil to set a suggested retail price for Khan's resale of gasoline that State Oil supplied. Additionally, the agreement provided that State Oil would sell gasoline to Khan at the suggested retail price minus 3.25 cents per gallon, which would constitute Khan's profit margin. The contract did not prohibit Khan from selling above or below the suggested retail price, but required Kahn to rebate to State Oil the difference between the suggested retail price and any amount charged in excess of the suggested retail price. State Oil permitted Khan to sell gasoline below the suggested retail price without penalty. After operating the franchise for approximately 1 year, Khan failed to make several lease payments. As a result, State Oil declared its intent to terminate the contract and initiated eviction proceedings. At State Oil's request, a receiver was appointed to operate the station, although that receiver was not subject to price restraints imposed on Khan. Because of this pricing flexibility, the receiver obtained a profit in excess of 3.5 cents per gallon by charging above the suggested retail price for premium gasoline and below suggested retail price for regular grade. Khan then filed an action in U.S. District Court for the Northern District of Illinois that alleged, among other claims, that State Oil's lease agreement violated Section 1 of the Sherman Act through the practice of “vertical maximum price fixing.”

Ultimately the matter reached the U.S. Supreme Court. Prior to the Kahn case the Supreme Court had found that any sort of resale price maintenance agreement was a per se violation of the Sherman Antitrust Act. Albrecht v Herald Co., 390 U.S. 145, 152-154 (1968). This was the rule even if the price maintenance agreement resulted in lower prices to the public through “maximum resale price maintenance” (where the retailer is not allowed to sell the product at a price above a certain level).

The Supreme Court overruled Albrecht. The Court found that while minimum resale price maintenance seemed almost certain to hurt competition and the consumer (because outlets wanted to charge less and could not), the same could not be said about maximum resale price maintenance (where outlets want to charge consumers more for a product than they are allowed to). As a result of Khan, the law now permits maximum resale price maintenance to be evaluated under the “rule of reason,” making it far more likely that the resale price maintenance will be upheld as a proper agreement. Franchisors now have a much bigger hammer against franchisees that refuse to sell hamburgers for 99 cents, or shoes for $19.99, or tacos for 39 cents. Surprisingly, franchisors do not seem to have utilized this power to the extent feared by franchisee advocates in the wake of Khan.

Conclusion

Cases come along every once in a while that change how franchisors and franchisees see the world. At times these cases rapidly alter the landscape, causing a great deal of joy on one side and a great deal of consternation on the other. At other times the case brings clarity to a situation in which clarity was badly needed. Still other times, the case is like a large snowstorm, changing things significantly for a period of time, but then slowly melting away.

We hope that this summary of 10 important cases has given you some understanding and appreciation for a few of the significant judicial events over the past several years. We cannot hope to cover everything that has occurred, but we are confident that we have addressed many of the high points (or low points, depending on your point of view).

The authors developed this article from a presentation that they made at the 2004 American Bar Association's Forum on Franchising Legal Symposium. To obtain the full presentation, contact ABA.