Incurable Defaults

Get your facts straight before you terminate. “Don't terminate a franchise and run to court because you think the franchisee is stealing from you,” Rubenstein said. “Take the time and commit the resources to really investigate. What has made courts willing to disregard the language in the contract is that there was no ability for the franchisee to say it didn't do it. The franchisor had the goods on them. The facts were not in dispute ' what was in dispute was the consequences of the facts.”

Kevin Adler is associate editor of FBLA.

Franchising relationships are defined by contracts, but they are sustained when franchisors and franchisees trust each other and believe that the other is acting in the best interests of the brand and the system. Even when significant disagreements arise, franchise contracts provide for ways in which violations can be cured so that the relationship can continue. Unfortunately, on occasion, a franchisee's actions are so egregious that a franchisor decides that it needs to immediately terminate the franchise and declare that the relationship is irrevocably harmed: an incurable default.

These instances of incurable defaults are rare, said Gregg Rubenstein, partner with Nixon Peabody (Boston) in a recent webinar sponsored by his firm. But they have been upheld in circumstances when franchisors have been able to demonstrate franchisee theft, deception, self-dealing, and other severe misconduct.

“The terms of a franchise contract are usually held as sacrosanct. They are the starting point for a court's analysis. Where the terms are clear and unambiguous they will be enforced as written, and there will be no opportunity to interpret the terms,” Rubenstein said. “But there are times when, despite that clear language, we get a result that arguably is at odds with it. That is because, although franchising is inherently a contractual relationship, there is something more: the relationship of trust between the parties. The franchisor trusts that a franchisee will fairly report its revenues and protect the brand. The franchisee trusts that the franchisor will enhance and grow the brand. While we see language in franchise agreements stating this generally, its import goes beyond the language.”

In a case of incurable default, franchisors have argued that certain breaches cannot be cured, even with payment of damages. “Some violations are going to forever affect the would-be relationship of the parties on a going-forward basis,” said Rubenstein. “Because the acts have destroyed the trust necessary for the relationship, the incurable default allows for termination despite a contractual right to cure. This is at the heart of the concept.”

The intent of the franchisee is crucial, he added. “Courts do not want to get caught up in deciding whether the franchisee made an honest mistake or misunderstood the contract,” said Rubenstein, so a franchisor needs to clearly show that the franchisee's conduct was not caused by misunderstanding or carelessness. “Incurable default cases are all about intentional conduct, where a franchisee has an intent to deceive.”

When Claims of Incurable Default Have Been Upheld

One case that illustrates the type of conduct that can lead to an incurable default can be found in Olin v. Central Industries, Inc. , 576 F.2d 642 (5th Cir. 1978). Olin manufactured fertilizer, which Central Industries contracted to buy in bulk and repackage for customers into 50-lb. bags. Olin discovered that Central Industries was filling the bags with 49 lbs. of fertilizer and reselling the remainder.

“If this was only an oral contract, clearly Olin would have the right to terminate,” said Rubenstein. “But here, the contract specifically addressed termination and said that Olin could only terminate after 'written notice and failure to cure after 90 days.'”

Olin terminated the contract anyway, and Central Industries sued. The court allowed the termination to stand, despite the language in the contract. The court said that the termination provision in the contract was not the exclusive way or only basis on which Olin could terminate. “The court said that the contract 'does not bar the ordinary remedy of termination for a breach which is material or which goes to the root of the matter or essence of the contract,'” said Rubenstein. “That's the magic language.”

In Larken v. Larken City Partnership, Ltd. , 589 N.W. 2d 700 (Iowa 1998), a company was contracted to manage a hotel for the hotel's owner. (Technically, the two parties were not in a franchise relationship, but the terms of the agreement were similar to terms found in lodging franchise contracts.) The owner learned that the management company was taking rebates due to the owner and engaging in other forms of self-dealing.

“Arguably, this contract was more favorable to the management company than the contract in Olin because it listed actions that were incurable, but said that the manager would have 30 days to cure all other breaches,” said Rubenstein. “The theft of the rebates and other actions [committed by the hotel manager] were not among the specifically enumerated incurable breaches.”

Nonetheless, the owner terminated the contract immediately, and the court upheld the termination. The court stated: “The acts of self-dealing ' were so serious that they frustrated one of the principal purposes of the management agreement, which was to manage the hotel in the best interests of the owner and to be honest and forthright in its dealing. Self-dealing is the antithesis of that purpose ' .”

More recently, in LJL Transportation Inc. v. Pilot Air Freight Corp. , 99 Pa. 546 (2009), the Pennsylvania Supreme Court upheld the termination of a franchise contract in a freight-forwarding system. The franchisee, LJL Transportation, deliberately and systematically diverted shipments from Pilot Air to a separate company that the franchisee owned. Pilot Air terminated the contract, and it was upheld, even though the franchise agreement provided the franchisee with an unqualified 90-day right to cure. “Arguably, there was an explicit contractual provision in the contract that gave the franchisee the right to cure,” said Rubenstein. “But the court found that intentional theft would allow for immediate termination.”

Other courts have upheld franchisors' immediate termination for incurable breach when a franchisee underreported revenue ( Southland Corp. v. Froelich , 41 F. Supp. 2d 227 (E.D.N.Y. 1999)); engaged in theft, even of a small amount of money due to the franchisor ( Southland Corp. v. Joeng C.A., No. 93-3168 (D.N.J. Dec. 7, 1993)); or lied to the Internal Revenue Service (Dunkin' Donuts v. Martinez, 2003 WL 685875 (S.D. Fla. Feb. 21, 2003)). The Dunkin' case is notable, said Rubenstein, because the franchisee's actions had no direct adverse consequence for Dunkin', but it violated the concept of fundamental trust in the franchisee, as well as the obey-all-laws clause that's common in franchise contracts.

Lessons for Franchisors

Rubenstein concluded his presentation with five practical suggestions for franchisors.

Take a look at your current franchise agreement and the specific language addressing default. Franchisors might wish to make sure that where their contracts state the reasons for which a franchise can be terminated, they also include the phrase “including but not limited to,” or similar language. This type of language has been cited by courts to extend to franchisors a wider range of reasons for termination than those that are specifically detailed in the contract. In contrast, a contract lacking that language might suggest limitations on a franchisor's reasons for termination.

Affirmatively, put in your contract language that says you are “reserving rights under common law or otherwise available.” Again, this is language that broadens the scope of what the courts will support.

Remember that not every default is an incurable default. Rubenstein observed that the cases he cited in his presentation “are the exceptions, not the rules. If there is a right to cure that seems to address the alleged default, it will be difficult, though not impossible, to get an incurable default.”

Treat franchisees consistently. A franchisor that lets a strong franchisee violate the contract, even in a small way, will have a much more difficult time terminating another franchisee for a similar violation. “There may be good reasons why you have treated different franchisees differently,
but when you have to get into the nitty-gritty of explaining it, you have lost half the battle,” he said.

Get your facts straight before you terminate. “Don't terminate a franchise and run to court because you think the franchisee is stealing from you,” Rubenstein said. “Take the time and commit the resources to really investigate. What has made courts willing to disregard the language in the contract is that there was no ability for the franchisee to say it didn't do it. The franchisor had the goods on them. The facts were not in dispute ' what was in dispute was the consequences of the facts.”

Kevin Adler is associate editor of FBLA.