The Alvord Decision: Why Periodic Review of Insurance Policies Is a Must for Franchisors

Background

Plaintiff Alvord Investments, LLC (“Alvord”) is the owner of Lenny's Franchisor, LLC (“Lenny's”). When Dynamic Growth Partners (“DGP”) sent a draft complaint and demand for arbitration to Lenny's, Alvord notified its carrier, The Hartford Financial Services Group, Inc. (“Hartford”), the issuer of Alvord's D&O policy. (The parties did not dispute that Lenny's qualifies as an insured under the D&O policy issued to Alvord since Lenny's was a subsidiary of Alvord.) Although Alvord did not dispute that DGP was once a franchisee, Alvord claimed that DGP had ceased to be a franchisee when it made its demand for arbitration.

Hartford informally denied coverage, relying upon the D&O policy's exclusion of coverage for claims “based upon, arising from, or in any way related to any Claim made by or on behalf of any franchisee of the Company in any capacity.” Hartford also rested its denial on the policy's exclusion for claims “based upon, arising from, or in any way related to any liability under any contract or agreement[.]“

DGP filed its complaint with the American Arbitration Association (“AAA”) asserting that Lenny's made “'wildly inaccurate' projections for sales, costs, and profits” and omitted facts and information it had a duty to disclose. Alvord tendered the litigation to Hartford under the D&O policy. After Hartford formally declined coverage, Alvord sued Hartford in federal court, seeking a declaration that Alvord was entitled to coverage for the DGP litigation under the D&O policy and damages for Hartford's breach of the insurance contract.

Hartford moved to dismiss Alvord's lawsuit. Among the documents attached to Hartford's motion to dismiss were: 1) a copy of the insurance policy; 2) the DGP complaint against Lenny's filed with the AAA; 3) a franchise agreement between Lenny's and a franchisee identified as a Florida corporation to be formed as a subsidiary of DGP; and 4) another later franchise agreement. The court sustained Alvord's objection to the court's consideration of the two franchise agreements because Alvord's complaint did not reference them and because the court found that Alvord's claims did not depend on the franchise agreements' terms, among other things.

Based on DGP's AAA complaint and other filings, the court found it “clear” that there was a franchisor-franchisee relationship between Lenny's and DGP, “a fact that is implied, but not stated directly, in Alvord's complaint.” The DGP complaint did not specifically allege whether the franchise agreements had been terminated by the time DGP filed its complaint.

Court's Analysis

Applying Tennessee law, the court explained that the interpretation of an insurance policy “is governed by the same rules as those governing interpretation of other contracts.” (Quotation omitted.) If the language of a policy “is fairly susceptible to more than one meaning,” state law “directs that the ambiguity be construed against the insurer and in favor of the insured.” The court explained that “[t]his is particularly true when the ambiguous language purports to limit coverage.”

In considering the defendants' argument that the D&O policy's franchisee exclusion provides a proper basis for Hartford's denial of coverage for Alvord's dispute with DGP, the court looked to the franchisee exclusion, which provides:

The Insurer shall not pay Loss for any Claim:

'

(M) based upon, arising from, or in any way related to any Claim made by or on behalf of any franchisee of the Company in any capacity.

The court found that the D&O policy failed to define “franchisee” and concluded that the larger policy of which the D&O policy is a part also did not define the term.

While Alvord did not dispute that DGP was at one time a franchisee of Lenny's, Alvord argued that DGP was a former franchisee by the time DGP made its demand and filed the AAA complaint. Alvord argued that because the evidence would show that DGP had already closed its stores and ceased operations by the time of its demand and complaint, DGP was not a “franchisee” under the franchisee exclusion. For its part, Hartford argued that the phrase “in any capacity” in the policy means that the exclusion extends to claims by former franchisees.

The court agreed with Hartford's construction of the policy. Even assuming that DGP was a former franchisee, the court held that the phrase “franchisee ' in any capacity” extends to claims brought by a former franchisee concerning the prior franchisor-franchisee relationship.

The court explained that its reading of the “in any capacity” language is “consistent with the general purpose of a D&O policy, which, broadly stated, is to protect directors and officers from losses resulting from claims made against them in their official capacity as directors and officers.” (Quotation omitted.) While a D&O policy typically provides liability coverage directly to corporate officers and directors for certain claims, a policy also provides “indirect coverage to the corporation for reimbursement of any monies expended to indemnify its officers and directors either by operation of state law or under the corporate bylaws.” (Quotation omitted.) But coverage is not limitless.

The court explained:

A D&O policy, however, is not intended to endow the corporation itself with general liability coverage. Review of the D&O Policy at issue in this case reveals that Alvord's policy is clearly intended to accomplish these same ends and is not meant to grant the insured a blanket policy for any and all claims against the corporate entity itself.

Drawing a distinction based on whether or not the relationship with the franchisee has terminated thus makes little sense in terms of what objectives a D&O policy is to serve. The court finds this to be particularly true when the franchisee alleges that it has been misled into becoming a franchisee in the first place and seeks to formally sever its ties with the franchisor. In such a situation, whether asserted by a current or a former franchisee, the essence of the allegations against each franchisor would be the same ' namely, that the franchisor's officers and/or agents provided false and misleading information in the process of inducing the franchisee to enter into a relationship with the franchisor. The court sees no reason why in the case of an action by a current franchisee the D&O policy would exclude coverage, but in the case of virtually the same action by a former franchisee it would not. Instead, in the case of an action brought by “any” franchisee, current or former, the insurer's interest is the same, and thus whether or not coverage is available would naturally be governed by the same considerations.

(Internal citations omitted; emphasis added.)

Finally, the court rejected Alvord's argument that because the common definitions section specifically defines “manager” and “employee” to include any “past, present, or future” manager or employee but not using “past, present, or future” in describing franchisee in the D&O policy, the “franchisee” definition should be limited to current franchisees and, thus, only claims by current franchisees should be excluded. The court was “not persuaded” by this argument because there is no definition of “franchisee” anywhere in the policy, let alone a definition with the same structure and form as “manager” and “employee” in the common definitions section. The court also noted that Alvord did not claim that evidence would show that Alvord attached any special meaning to the franchisee exclusion such that only current franchisees were intended to be excluded. A subsequent appeal to the U.S. Court of Appeals for the Sixth Circuit was dismissed.

Conclusion

The Alvord decision should remind franchisors to periodically review their policies to ensure that they have appropriate insurance coverage related to potential disputes with franchisees. Although having coverage for franchisee disputes will cost more than a policy that excludes such claims, the coverage is often warranted. If a franchisor seeks coverage for claims by former franchisees, the franchisor should make sure that appropriate coverage language is contained in the policy. An appropriate endorsement or other language in the policy can potentially address issues related to claims asserted by franchisees.

J. Kevin Cogan and J. Todd Kennard are partners at Jones Day, in the Columbus, OH, office. They can be reached at 614-469-3939, [email protected], or [email protected]. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the law firm with which they are associated.

Franchisors, like other businesses, should periodically review their insurance policies to make certain that they understand the scope of their existing coverage and to identify (and remedy) any significant gaps in that coverage. Given that franchisors are more frequently finding themselves in the cross-hairs of their franchisees, franchisors should pay particular attention to whether they have coverage for franchisee claims and, if so, the extent of that coverage. Franchisors should not wait until they have become a target to determine whether they have insurance protection.

A federal judge recently held that a franchisor did not have coverage for claims by a former franchisee under a Directors and Officers policy that excluded claims “based upon, arising from, or in any way related to any Claim made by or on behalf of any franchisee of the Company in any capacity.” (Emphasis added.) The court determined that an endorsement to the D&O policy excluded coverage regardless of whether the claim was made by a current or former franchisee. Alvord Investments, LLC v. The Hartford Financial Services Group, Inc. et al., 660 F. Supp. 2d 850 (W.D. Tenn. 2009).

Given the language of the endorsement, the outcome of the case is not surprising. What is surprising about the case is that the franchisor's policy contained an endorsement specifically excluding coverage for “franchisee” claims. See Id., Doc. 23-2 (p. 37), Case No. 2:09-cv-02072. The decision should lead franchisors to re-examine their D&O policies to determine the scope of coverage related to claims by disgruntled current or former franchisees so that there are no surprises if, or more likely when, a dispute between a franchisor and franchisee arises.

Background

Plaintiff Alvord Investments, LLC (“Alvord”) is the owner of Lenny's Franchisor, LLC (“Lenny's”). When Dynamic Growth Partners (“DGP”) sent a draft complaint and demand for arbitration to Lenny's, Alvord notified its carrier, The Hartford Financial Services Group, Inc. (“Hartford”), the issuer of Alvord's D&O policy. (The parties did not dispute that Lenny's qualifies as an insured under the D&O policy issued to Alvord since Lenny's was a subsidiary of Alvord.) Although Alvord did not dispute that DGP was once a franchisee, Alvord claimed that DGP had ceased to be a franchisee when it made its demand for arbitration.

Hartford informally denied coverage, relying upon the D&O policy's exclusion of coverage for claims “based upon, arising from, or in any way related to any Claim made by or on behalf of any franchisee of the Company in any capacity.” Hartford also rested its denial on the policy's exclusion for claims “based upon, arising from, or in any way related to any liability under any contract or agreement[.]“

DGP filed its complaint with the American Arbitration Association (“AAA”) asserting that Lenny's made “'wildly inaccurate' projections for sales, costs, and profits” and omitted facts and information it had a duty to disclose. Alvord tendered the litigation to Hartford under the D&O policy. After Hartford formally declined coverage, Alvord sued Hartford in federal court, seeking a declaration that Alvord was entitled to coverage for the DGP litigation under the D&O policy and damages for Hartford's breach of the insurance contract.

Hartford moved to dismiss Alvord's lawsuit. Among the documents attached to Hartford's motion to dismiss were: 1) a copy of the insurance policy; 2) the DGP complaint against Lenny's filed with the AAA; 3) a franchise agreement between Lenny's and a franchisee identified as a Florida corporation to be formed as a subsidiary of DGP; and 4) another later franchise agreement. The court sustained Alvord's objection to the court's consideration of the two franchise agreements because Alvord's complaint did not reference them and because the court found that Alvord's claims did not depend on the franchise agreements' terms, among other things.

Based on DGP's AAA complaint and other filings, the court found it “clear” that there was a franchisor-franchisee relationship between Lenny's and DGP, “a fact that is implied, but not stated directly, in Alvord's complaint.” The DGP complaint did not specifically allege whether the franchise agreements had been terminated by the time DGP filed its complaint.

Court's Analysis

Applying Tennessee law, the court explained that the interpretation of an insurance policy “is governed by the same rules as those governing interpretation of other contracts.” (Quotation omitted.) If the language of a policy “is fairly susceptible to more than one meaning,” state law “directs that the ambiguity be construed against the insurer and in favor of the insured.” The court explained that “[t]his is particularly true when the ambiguous language purports to limit coverage.”

In considering the defendants' argument that the D&O policy's franchisee exclusion provides a proper basis for Hartford's denial of coverage for Alvord's dispute with DGP, the court looked to the franchisee exclusion, which provides:

The Insurer shall not pay Loss for any Claim:

'

(M) based upon, arising from, or in any way related to any Claim made by or on behalf of any franchisee of the Company in any capacity.

The court found that the D&O policy failed to define “franchisee” and concluded that the larger policy of which the D&O policy is a part also did not define the term.

While Alvord did not dispute that DGP was at one time a franchisee of Lenny's, Alvord argued that DGP was a former franchisee by the time DGP made its demand and filed the AAA complaint. Alvord argued that because the evidence would show that DGP had already closed its stores and ceased operations by the time of its demand and complaint, DGP was not a “franchisee” under the franchisee exclusion. For its part, Hartford argued that the phrase “in any capacity” in the policy means that the exclusion extends to claims by former franchisees.

The court agreed with Hartford's construction of the policy. Even assuming that DGP was a former franchisee, the court held that the phrase “franchisee ' in any capacity” extends to claims brought by a former franchisee concerning the prior franchisor-franchisee relationship.

The court explained that its reading of the “in any capacity” language is “consistent with the general purpose of a D&O policy, which, broadly stated, is to protect directors and officers from losses resulting from claims made against them in their official capacity as directors and officers.” (Quotation omitted.) While a D&O policy typically provides liability coverage directly to corporate officers and directors for certain claims, a policy also provides “indirect coverage to the corporation for reimbursement of any monies expended to indemnify its officers and directors either by operation of state law or under the corporate bylaws.” (Quotation omitted.) But coverage is not limitless.

The court explained:

A D&O policy, however, is not intended to endow the corporation itself with general liability coverage. Review of the D&O Policy at issue in this case reveals that Alvord's policy is clearly intended to accomplish these same ends and is not meant to grant the insured a blanket policy for any and all claims against the corporate entity itself.

Drawing a distinction based on whether or not the relationship with the franchisee has terminated thus makes little sense in terms of what objectives a D&O policy is to serve. The court finds this to be particularly true when the franchisee alleges that it has been misled into becoming a franchisee in the first place and seeks to formally sever its ties with the franchisor. In such a situation, whether asserted by a current or a former franchisee, the essence of the allegations against each franchisor would be the same ' namely, that the franchisor's officers and/or agents provided false and misleading information in the process of inducing the franchisee to enter into a relationship with the franchisor. The court sees no reason why in the case of an action by a current franchisee the D&O policy would exclude coverage, but in the case of virtually the same action by a former franchisee it would not. Instead, in the case of an action brought by “any” franchisee, current or former, the insurer's interest is the same, and thus whether or not coverage is available would naturally be governed by the same considerations.

(Internal citations omitted; emphasis added.)

Finally, the court rejected Alvord's argument that because the common definitions section specifically defines “manager” and “employee” to include any “past, present, or future” manager or employee but not using “past, present, or future” in describing franchisee in the D&O policy, the “franchisee” definition should be limited to current franchisees and, thus, only claims by current franchisees should be excluded. The court was “not persuaded” by this argument because there is no definition of “franchisee” anywhere in the policy, let alone a definition with the same structure and form as “manager” and “employee” in the common definitions section. The court also noted that Alvord did not claim that evidence would show that Alvord attached any special meaning to the franchisee exclusion such that only current franchisees were intended to be excluded. A subsequent appeal to the U.S. Court of Appeals for the Sixth Circuit was dismissed.

Conclusion

The Alvord decision should remind franchisors to periodically review their policies to ensure that they have appropriate insurance coverage related to potential disputes with franchisees. Although having coverage for franchisee disputes will cost more than a policy that excludes such claims, the coverage is often warranted. If a franchisor seeks coverage for claims by former franchisees, the franchisor should make sure that appropriate coverage language is contained in the policy. An appropriate endorsement or other language in the policy can potentially address issues related to claims asserted by franchisees.

J. Kevin Cogan and J. Todd Kennard are partners at Jones Day, in the Columbus, OH, office. They can be reached at 614-469-3939, [email protected], or [email protected]. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the law firm with which they are associated.