Court Watch

When UPS acquired MBE in 2001, UPS presented existing MBE franchisees with the option to join the Gold Shield Program and to convert their Mail Boxes Etc. businesses to “The UPS Store.” Eighty-seven percent of MBE's franchisees accepted the offer and signed amendments to their franchise agreements. The remaining 350 franchisees continued to operate their stores under the Mail Boxes Etc. banner.

The plaintiffs alleged that rather than continuing to support MBE franchisees, MBE and UPS began to abandon and undermine MBE stores and franchisees. The plaintiffs asserted that UPS and MBE attempted to coerce franchisees to convert to “The UPS Store” format and discriminated against franchisees that did not convert.

The MBE franchisees alleged that MBE and UPS interfered with their economic relationships by engaging in deceptive advertising that all MBE stores were becoming The UPS Stores; causing MBE's Web site to direct customer to The UPS Stores, even if a MBE store was closer; diverting national advertising funds for uses that solely benefitted The UPS Stores; and abolishing the national media fund for MBE franchisees while maintaining a national advertising program for The UPS Stores. Because the plaintiffs provided testimony of customers who had been confused by the lack of advertising for MBE stores and advertising for The UPS Stores, lists of customers who stopped using MBE stores, and declarations of customers who switched to The UPS Stores after hearing ads for lower costs for the same services, the court concluded that triable issues of fact remained as to whether MBE and UPS tortiously interfered with the remaining MBE franchisees.

The plaintiffs also claimed that MBE had breached several provisions of the franchise agreement. While the court deemed several of the claims to be meritless, the court found a triable issue of fact as to whether MBE had breached its obligation to develop and provide creative materials for local and regional marketing. The plaintiffs demonstrated that since the inception of the Gold Shield Program, MBE had ceased producing television and radio commercials, eliminated national advertising programs, reduced the number of local print advertising materials that were available, lowered the quality of available in-store signage, reduced the quality of marketing materials so that they were no longer effective, and eliminated in-store promotions. Secondly, the court deemed there to be a triable issue of fact as to whether MBE had used funds collected from the MBE franchisees to purchase advertising for The UPS Stores rather than MBE centers. The plaintiffs were required to contribute to the National Media Fee, a marketing fund that was designed to promote awareness of MBE products and services through national advertising. The plaintiffs alleged that MBE disbanded the National Media Fee and reallocated some funds that had been committed to a national advertising program for the MBE brand to advertise The UPS Store.

The court also held that there was a triable issue of fact as to whether UPS, an affiliate of MBE, violated the franchise agreement by establishing or licensing drop boxes, authorized shipping outlets, and customer counters at locations within the franchisees' exclusive territories. The franchise agreements provided that MBE or its affiliates would “not franchise others or establish company-owned outlets, selling or leasing similar products or services under a different trade name or trademark, within the individual franchise area.” The plaintiffs provided evidence that the drop boxes and authorized shipping outlets directly competed with and took business away from the franchisees and that UPS had established new locations within their territories since its acquisition of MBE.

Finally, the plaintiffs alleged that UPS had tortiously interfered with their franchise agreements by purchasing MBE for the sole purpose of turning MBE businesses into UPS-controlled stores under the UPS brand and “destroying the MBE franchise system, good will, and reputation for UPS's own business gain without compensation to plaintiffs.” The plaintiffs claimed UPS intentionally induced MBE to breach its franchise agreements with the plaintiffs by requiring MBE franchises seeking to renew their franchise agreements to convert their stores to The UPS Store and by eliminating advertising support for MBE franchisees and diverting funds to advertisements for The UPS Store. The plaintiffs also claimed that UPS conducted unlawful price discrimination to attempt to coerce the plaintiffs to modify their franchise agreements with MBE to enable them to compete with lower wholesale prices UPS offered to competitor shipping outlets. The defendants claimed that their conduct was privileged and preempted by the Federal Aviation Administration Authorization Act of 1994. The court decided otherwise, holding that triable issues of fact remained because the defendants failed to meet their burden or production to show that their conduct was privileged and the act did not preempt the cause of action.

Wrongful Termination Battle over Underperforming Franchise

While in MBE, the franchisor was accused of trying to eliminate one franchise system in favor of a new franchise system, in In Re: Magna Cum Latte, Inc., Chapter 11, Debtor v. Diedrich Coffee, Inc., Bus. Franch. Guide (CCH) 13894 (Bankr. S.D. Tex. 2007), a franchisor was accused of wrongfully terminating a franchise that was one of the last holdouts of a failed franchising plan that the franchisor was abandoning. In that case, the franchisor's sole remaining franchisee, Magna Cum Latte, filed suit against the franchisor, Diedrich Coffee, alleging that Diedrich breached the implied covenant of good faith and fair dealing by declining to exercise a lease renewal option for the franchisee's store and violated the California Franchise Relations Act (“CFRA”) by terminating its franchise without good cause.

In 2001, Magna purchased three company-owned stores from Diedrich and entered into franchise, sublease, and purchase agreements with respect to each of the stores. The franchise agreements included a term equal to 10 years, unless the franchisee executed its own lease for the premises for a period of less than 10 years, in which event the franchise would be for a term identical to the term of the franchisee's lease.

Under Diedrich's Master Leases, the stores' initial lease terms expired in 2001, 2002, and 2004. Diedrich, however, held one or two five-year options on each store. The sublease agreements did not explicitly require Diedrich to exercise the options, nor did it specify under what circumstances Diedrich could decline to exercise the options.

In the sublease agreements, the parties agreed that Magna's rent obligation would be based, in part, on a percentage of gross sales. However, sales at Magna's stores failed to meet expectations. As a result, Magna's rent payment to Diedrich failed to cover Diedrich's rent obligations under the master leases. Diedrich repeatedly attempted to renegotiate the sublease, threatening to let the store's renewal options expire if Magna did not agree to more favorable rent terms. Magna refused, contending that the parties' agreements obligated Diedrich to exercise the options.

In May 2006, Diedrich followed through on its threat and declined to exercise a renewal option for Magna's best-performing store. Magna was unsuccessful in its attempts to negotiate a new lease directly with the landlord, causing Magna to close the store, default on its obligations to Diedrich, and file a Chapter 11 bankruptcy petition. Magna then filed suit against Diedrich, seeking over $12 million in damages and lost profits related to its terminated franchise agreement.

Because the franchise and sublease agreements did not explicitly require Diedrich to exercise the lease options, the court determined that Diedrich had not breached its agreements with Magna. However, under California law (the law chosen in the franchise agreements), the covenant of good faith and fair dealing is implied within all contracts. The court considered whether Diedrich had exercised its discretion to not renew the lease option in good faith. The court noted that a “party may exercise discretionary power only in a manner that would have been within the parties' reasonable contemplation at the time of contract formation.”

The court concluded that, at the time of formation, the parties contemplated that Diedrich would exercise its lease options if Magna had not obtained its own lease directly with the landlord, because the parties intended to have a long-term relationship. By its terms, the franchise agreement was intended to have a term of 10 years or the length of the store's lease, which included the options. The court noted that Diedrich had exercised the option for another one of the stores in 2004, indicating that the parties had intended for the options to be renewed. In addition, the court reasoned that Magna would not have paid $1,025,000 for the franchise and development rights to the stores if it was contemplated that the terms could expire within three years after signing the agreements. The court asserted that Diedrich could not have reasonably believed that it was receiving such sums for such a short term. Because the parties initially intended for the relationship to continue past the initial terms of the leases, Diedrich's decision to decline the option breached the implied covenant of good faith and fair dealing.

After reaching this conclusion, the court dismissed Diedrich's assertions that it had acted in good faith by giving Magna advance notice of its intent not to renew the agreement and by offering to exercise the option if Magna agreed to renegotiate the terms of the sublease and pay 100% of Diedrich's rent obligation to the landlord. The court asserted that Diedrich's offer to renegotiate was made in bad faith, as it would have required Magna to pay higher rent in exchange for Diedrich following through on an obligation required by the implied covenant. The court, however, rejected additional claims asserted by Magna that Diedrich breached the implied covenant with respect to other agreements between the parties and alleged omissions and misrepresentations made during the parties' relationship.

Having concluded that Diedrich was obligated to exercise the lease option when it was apparent that Magna would not be able to enter into a lease directly with the landlord, the court went on to conclude that the termination of Magna's franchise agreement violated the CFRA, which prohibits franchisors from terminating franchises without good cause. Because the agreement was terminated due to the expiration of the store lease, the court ruled that the termination was the result of Diedrich's wrongful decision to not renew the lease. The franchisor's decision to not renew the lease did not constitute good cause to terminate the franchise relationship.

In both of these cases, the franchisors were accused of acting in bad faith to undermine franchised businesses for the franchisor's own pecuniary interest. While the MBE case has not yet been resolved, the two cases highlight the need for franchisors seeking to eliminate or substantially modify franchise programs to use caution when taking actions that may interfere with or undermine existing franchisee's businesses.

Alexander G. Tuneski is an attorney with Kilpatrick Stockton in Washington, DC. He can be reached at 202-508-5814 or [email protected].

Franchisees Sue Franchisors Seeking to Terminate Franchise Programs

In two recent cases, franchisors were accused of improperly undermining or terminating franchises that continued to operate under franchise systems that the franchisors intended to phase out for financial reasons. While in one case the franchisor allegedly intended to coerce its existing franchisees to convert to a new franchise program that would be more profitable for the franchisor, in the other case, the franchisor was accused of terminating a franchisee after concluding that its fledgling franchising system was not as profitable as expected.

In McDougal, Inc. v. Mail Boxes Etc., 2 Bus. Franch. Guide (CCH) 13,908 (Cal. Ct. App. 2008), three franchisees of Mail Boxes Etc. (“MBE”) sued their franchisor and its acquirer, United Parcel Service (“UPS”), for breach of contract, tortious interference with prospective economic advantage, and tortious interference with contract, amongst 33 total causes of action. The California Court of Appeals reversed a lower court decision granting summary judgment to the defendants, finding triable issues of fact on three of the asserted causes of action.

When UPS acquired MBE in 2001, UPS presented existing MBE franchisees with the option to join the Gold Shield Program and to convert their Mail Boxes Etc. businesses to “The UPS Store.” Eighty-seven percent of MBE's franchisees accepted the offer and signed amendments to their franchise agreements. The remaining 350 franchisees continued to operate their stores under the Mail Boxes Etc. banner.

The plaintiffs alleged that rather than continuing to support MBE franchisees, MBE and UPS began to abandon and undermine MBE stores and franchisees. The plaintiffs asserted that UPS and MBE attempted to coerce franchisees to convert to “The UPS Store” format and discriminated against franchisees that did not convert.

The MBE franchisees alleged that MBE and UPS interfered with their economic relationships by engaging in deceptive advertising that all MBE stores were becoming The UPS Stores; causing MBE's Web site to direct customer to The UPS Stores, even if a MBE store was closer; diverting national advertising funds for uses that solely benefitted The UPS Stores; and abolishing the national media fund for MBE franchisees while maintaining a national advertising program for The UPS Stores. Because the plaintiffs provided testimony of customers who had been confused by the lack of advertising for MBE stores and advertising for The UPS Stores, lists of customers who stopped using MBE stores, and declarations of customers who switched to The UPS Stores after hearing ads for lower costs for the same services, the court concluded that triable issues of fact remained as to whether MBE and UPS tortiously interfered with the remaining MBE franchisees.

The plaintiffs also claimed that MBE had breached several provisions of the franchise agreement. While the court deemed several of the claims to be meritless, the court found a triable issue of fact as to whether MBE had breached its obligation to develop and provide creative materials for local and regional marketing. The plaintiffs demonstrated that since the inception of the Gold Shield Program, MBE had ceased producing television and radio commercials, eliminated national advertising programs, reduced the number of local print advertising materials that were available, lowered the quality of available in-store signage, reduced the quality of marketing materials so that they were no longer effective, and eliminated in-store promotions. Secondly, the court deemed there to be a triable issue of fact as to whether MBE had used funds collected from the MBE franchisees to purchase advertising for The UPS Stores rather than MBE centers. The plaintiffs were required to contribute to the National Media Fee, a marketing fund that was designed to promote awareness of MBE products and services through national advertising. The plaintiffs alleged that MBE disbanded the National Media Fee and reallocated some funds that had been committed to a national advertising program for the MBE brand to advertise The UPS Store.

The court also held that there was a triable issue of fact as to whether UPS, an affiliate of MBE, violated the franchise agreement by establishing or licensing drop boxes, authorized shipping outlets, and customer counters at locations within the franchisees' exclusive territories. The franchise agreements provided that MBE or its affiliates would “not franchise others or establish company-owned outlets, selling or leasing similar products or services under a different trade name or trademark, within the individual franchise area.” The plaintiffs provided evidence that the drop boxes and authorized shipping outlets directly competed with and took business away from the franchisees and that UPS had established new locations within their territories since its acquisition of MBE.

Finally, the plaintiffs alleged that UPS had tortiously interfered with their franchise agreements by purchasing MBE for the sole purpose of turning MBE businesses into UPS-controlled stores under the UPS brand and “destroying the MBE franchise system, good will, and reputation for UPS's own business gain without compensation to plaintiffs.” The plaintiffs claimed UPS intentionally induced MBE to breach its franchise agreements with the plaintiffs by requiring MBE franchises seeking to renew their franchise agreements to convert their stores to The UPS Store and by eliminating advertising support for MBE franchisees and diverting funds to advertisements for The UPS Store. The plaintiffs also claimed that UPS conducted unlawful price discrimination to attempt to coerce the plaintiffs to modify their franchise agreements with MBE to enable them to compete with lower wholesale prices UPS offered to competitor shipping outlets. The defendants claimed that their conduct was privileged and preempted by the Federal Aviation Administration Authorization Act of 1994. The court decided otherwise, holding that triable issues of fact remained because the defendants failed to meet their burden or production to show that their conduct was privileged and the act did not preempt the cause of action.

Wrongful Termination Battle over Underperforming Franchise

While in MBE, the franchisor was accused of trying to eliminate one franchise system in favor of a new franchise system, in In Re: Magna Cum Latte, Inc., Chapter 11, Debtor v. Diedrich Coffee, Inc., Bus. Franch. Guide (CCH) 13894 (Bankr. S.D. Tex. 2007), a franchisor was accused of wrongfully terminating a franchise that was one of the last holdouts of a failed franchising plan that the franchisor was abandoning. In that case, the franchisor's sole remaining franchisee, Magna Cum Latte, filed suit against the franchisor, Diedrich Coffee, alleging that Diedrich breached the implied covenant of good faith and fair dealing by declining to exercise a lease renewal option for the franchisee's store and violated the California Franchise Relations Act (“CFRA”) by terminating its franchise without good cause.

In 2001, Magna purchased three company-owned stores from Diedrich and entered into franchise, sublease, and purchase agreements with respect to each of the stores. The franchise agreements included a term equal to 10 years, unless the franchisee executed its own lease for the premises for a period of less than 10 years, in which event the franchise would be for a term identical to the term of the franchisee's lease.

Under Diedrich's Master Leases, the stores' initial lease terms expired in 2001, 2002, and 2004. Diedrich, however, held one or two five-year options on each store. The sublease agreements did not explicitly require Diedrich to exercise the options, nor did it specify under what circumstances Diedrich could decline to exercise the options.

In the sublease agreements, the parties agreed that Magna's rent obligation would be based, in part, on a percentage of gross sales. However, sales at Magna's stores failed to meet expectations. As a result, Magna's rent payment to Diedrich failed to cover Diedrich's rent obligations under the master leases. Diedrich repeatedly attempted to renegotiate the sublease, threatening to let the store's renewal options expire if Magna did not agree to more favorable rent terms. Magna refused, contending that the parties' agreements obligated Diedrich to exercise the options.

In May 2006, Diedrich followed through on its threat and declined to exercise a renewal option for Magna's best-performing store. Magna was unsuccessful in its attempts to negotiate a new lease directly with the landlord, causing Magna to close the store, default on its obligations to Diedrich, and file a Chapter 11 bankruptcy petition. Magna then filed suit against Diedrich, seeking over $12 million in damages and lost profits related to its terminated franchise agreement.

Because the franchise and sublease agreements did not explicitly require Diedrich to exercise the lease options, the court determined that Diedrich had not breached its agreements with Magna. However, under California law (the law chosen in the franchise agreements), the covenant of good faith and fair dealing is implied within all contracts. The court considered whether Diedrich had exercised its discretion to not renew the lease option in good faith. The court noted that a “party may exercise discretionary power only in a manner that would have been within the parties' reasonable contemplation at the time of contract formation.”

The court concluded that, at the time of formation, the parties contemplated that Diedrich would exercise its lease options if Magna had not obtained its own lease directly with the landlord, because the parties intended to have a long-term relationship. By its terms, the franchise agreement was intended to have a term of 10 years or the length of the store's lease, which included the options. The court noted that Diedrich had exercised the option for another one of the stores in 2004, indicating that the parties had intended for the options to be renewed. In addition, the court reasoned that Magna would not have paid $1,025,000 for the franchise and development rights to the stores if it was contemplated that the terms could expire within three years after signing the agreements. The court asserted that Diedrich could not have reasonably believed that it was receiving such sums for such a short term. Because the parties initially intended for the relationship to continue past the initial terms of the leases, Diedrich's decision to decline the option breached the implied covenant of good faith and fair dealing.

After reaching this conclusion, the court dismissed Diedrich's assertions that it had acted in good faith by giving Magna advance notice of its intent not to renew the agreement and by offering to exercise the option if Magna agreed to renegotiate the terms of the sublease and pay 100% of Diedrich's rent obligation to the landlord. The court asserted that Diedrich's offer to renegotiate was made in bad faith, as it would have required Magna to pay higher rent in exchange for Diedrich following through on an obligation required by the implied covenant. The court, however, rejected additional claims asserted by Magna that Diedrich breached the implied covenant with respect to other agreements between the parties and alleged omissions and misrepresentations made during the parties' relationship.

Having concluded that Diedrich was obligated to exercise the lease option when it was apparent that Magna would not be able to enter into a lease directly with the landlord, the court went on to conclude that the termination of Magna's franchise agreement violated the CFRA, which prohibits franchisors from terminating franchises without good cause. Because the agreement was terminated due to the expiration of the store lease, the court ruled that the termination was the result of Diedrich's wrongful decision to not renew the lease. The franchisor's decision to not renew the lease did not constitute good cause to terminate the franchise relationship.

In both of these cases, the franchisors were accused of acting in bad faith to undermine franchised businesses for the franchisor's own pecuniary interest. While the MBE case has not yet been resolved, the two cases highlight the need for franchisors seeking to eliminate or substantially modify franchise programs to use caution when taking actions that may interfere with or undermine existing franchisee's businesses.

Alexander G. Tuneski is an attorney with Kilpatrick Stockton in Washington, DC. He can be reached at 202-508-5814 or [email protected].