Court Watch

The standard that must be met to defeat a motion to dismiss is whether the complaint is legally sufficient to state a cause of action ' it is not a finding on the merits of the matter. Among the arguments put forth by Keller Williams was that it is required by law ' the FTC Rule ' to disclose the terms of the settlement. Despite the terms of the FTC Rule, the court held that certain findings of fact were required before a ruling on that claim could be made. While the opinion in the case is brief, the court seemed to think that the states in which the recipients were located and the franchise laws of those states had a bearing on the ultimate outcome. Of course, the FTC Rule's requirements are applicable in all states, so the court's discussion on that issue is a bit confusing.

Keller Williams argued in support of its motion that the complaint did not allege damages in sufficient detail and that, as a penalty, the liquidated damages provision in the settlement agreement should be found to be invalid. However, the court stated that it had to hear evidence about the circumstances that existed at the time the agreement was executed to determine whether actual damages for a violation of the confidentiality clause were difficult of estimation, and whether the amount recited in the liquidated damages provision was a reasonable forecast of the actual damages. There was evidence that the amount of damages specified in the provision was negotiated between the parties and was not merely dictated by Keller Williams. However, the court stated that the negotiated status of the amount was only some evidence that went to the merits; merits that needed further exploration. As such, the complaint was sufficient to overcome the motion to dismiss.

While the court may be persuaded to find for Keller Williams based on the requirements of the FTC Rule after hearing evidence on the matter, the issue may have been obviated by stating in the settlement agreement that disclosure of the material terms of the settlement was required by Item 3 of the rule and, therefore, the confidentiality provisions would only apply to other disclosure, with any further exceptions to their coverage similarly spelled out.

[Authors' Note: In an earlier edition of this publication (v.19, No.1, Oct. 12, 2012, pp 5-6) we discussed Hamden v. Total Car Franchising Corp., 2012 WL 3255598, Bus. Fran. Guide (CCH) '14,789 (W.D. Va., Aug. 7, 2012), a case where the U.S. District Court denied enforcement of post-expiration noncompetition and non-solicitation provisions in a franchise agreement and a related confidentiality agreement on the basis that the language of the concerned agreements treated expiration differently from termination and, as such, the terms could not be considered coterminous. The ruling in the case was appealed to the Fourth Circuit, which, after a de novo review of the question, issued a not-for-publication opinion (Hamden v. Total Car Franchising Corporation, Bus. Fran. Guide (CCH) '15,190 (U.S. Court of Appeals, 4th Cir., Nov. 22, 2013)) also finding that the terms in the concerned agreements make a distinction between "termination," which requires some affirmative act, and "expiration," which occurs when the contract runs its course and the term expires. Since the noncompetition provision at issue states that it was effective on termination or transfer of the franchise, it did not apply following the expiration of the agreement. In contrast, one provision of the nondisclosure clause stated it was effective during the term of the agreement "and thereafter," indicating that it was effective after the agreement ended for any reason and was, therefore, enforceable; while another section of that clause referred to termination and, therefore, was, not enforceable. In a footnote, the court noted that a violation of the second provision would probably also violate the first, so the different language would not prevent the restrictions on disclosure.

The non-solicitation provision stated that it was effective during the term of the agreement and for two years after its termination. The court, while admitting it made little sense to read the clause as pertaining only to termination, proceeded to do so, reasoning that uniformity of definition controlled, and "termination" means termination, not "expiration."

The basic rule of contract interpretation that an agreement will be construed against the party that drafts it came back to bite the franchisors in the above cases. Care must be taken to cover clearly all eventualities so that one's own language cannot be used against one in the event of a dispute. Those of us who draft franchise and other agreements may know what we mean to say, but the contracts have to be drafted so that others know what we mean as well. Otherwise, in a matter with a sympathetic party on the other side, a court may find against our client if given an opening to do so.]

Ill. Appellate Court Holds FDD Earnings Claim Disclaimers Defeat Fraud Claim

Disclaimers that earnings claims represented only a small percentage of stores and should not be considered to represent actual or potential results to be realized by the franchisee worked to prevent a fraud suit from continuing in Avon Hardware Company v. Ace Hardware Corporation, Bus. Fran. Guide (CCH) '15,174 (Ill. App., October 28, 2013).

Most earnings claims that are contained in Franchise Disclosure Documents (FDDs) have cautionary language that they should not be relied upon as representative of actual or potential earnings. In the Avon Hardware case, that language (plus more) worked to stop the suit. The franchisees sued for common law fraud, violations of the Illinois Consumer Fraud and Deceptive Business Practices Act and the Indiana Franchise Disclosure Act, claiming that the financial information in the FDD as to the results of other franchised stores was inflated and false. The franchisor had given the franchisees pro-formas and an FDD, which stated that the projections contained therein were “merely estimates and should not be considered as the actual or potential sales, profits or earnings that will be realized by any specific store operator.” The FDD also spelled out in footnotes to Item 19 that the information was from stores that reported, which amounted to approximately 40% of the member stores. These types of disclaimers are often found in Item 19. In addition, the signed receipt contained language that the franchisee has not relied on the information in Item 19.

The appellate court first held that the projections were not representations of fact necessary to establish a fraud claim but that the false information in the historical data presented could be considered a misstatement of fact. Nonetheless, the “cautionary” language (referenced above) “render[ed] any reliance ' unreasonable.”

In the Ace Hardware case, the manipulation of the numbers was alleged to be a result of “cherry picking,” and ignoring failed stores. The court held that the cautionary language covered these situations.

While carefully drafted cautionary language may work to result in a dismissal of fraud suits, such “disclaimers” are increasingly attacked by franchisee attorneys. They may not work if the franchisee is able to establish that the franchisor deliberately falsified the numbers. In such a case, a court may well hold that the franchisor cannot so easily exculpate itself from claims of fraud.

Noting New York City's Density, Court Enforces, But Limits, Restrictive Covenant

In Golden Krust Patties Inc. v. Marilyn Bullock, No, 13-cv-2241 (RLM), 2013 WL 3766551 (S.D.N.Y. July 16, 2013), the U.S. District Court for the Eastern District of New York recently issued a preliminary injunction, enforcing the non-compete provision in franchisor Golden Krust's franchise agreement with former franchisees, thereby enjoining the defendants from operating a Caribbean-style restaurant within four miles of the franchise location and two-and-a-half miles from other Golden Krust franchises.

Following the franchisor's discovery that the then-franchisees were selling competing products in Golden Krust packaging in violation of the parties' franchise agreement, the franchisor sent a termination letter. The franchisor then filed suit, asserting claims for breach of contract and misappropriation of trade secrets and sought a preliminary injunction enjoining the defendants from: 1) using or displaying the franchisor's trademarks or otherwise engaging in actions that would cause confusion as to the franchisee's goods and services; and 2) operating a business within the geographical scope of the non-compete provision.

The court first endeavored to set forth the relevant test for a preliminary injunction, noting the confusion within the Circuit. The court next concluded that it must consider the balance of hardships even where a plaintiff demonstrates a likelihood of success on the merits. However, even if the plaintiff does not demonstrate a likelihood of success on the merits, he still may meet his burden for showing that an injunction is warranted by establishing “sufficiently serious questions going to the merits to make them a fair ground for litigation” and that the balance of hardships “tips decidedly” in his favor.

Regarding the franchisor's contention that it would suffer irreparable injury due to its loss of good will or business relationships, the court found significant photographic evidence showing that even though the former franchisees removed the Golden Krust trade dress, they brazenly sought to exploit the franchisor's goodwill by failing to adopt a new store name. In addition, the store also displayed signs declaring “Come in. We are Open. Nothing has Changed Only Our Name,” and “Open. Same Great Food. Same Great Service. Thanks for Your Support!!! Come Again.” The court did not find, however, that the franchisor would suffer irreparable harm based on the franchisee's misappropriation of trade secrets, reasoning that the franchisor failed to provide any specific details as to what trade secrets or confidential information was misappropriated, and presented no evidence establishing the harm it would suffer absent an injunction.

As to the franchisor's likelihood of success on the merits, the court found the non-compete covenant was enforceable, but blue-penciled the agreement's restriction of barring the defendants from operating a competing business within 10 miles of the franchise for a two-year period and within five miles of another Golden Krust location. Taking judicial notice of the dense population of New York City, the court concluded that restricting the defendants from operating a Caribbean-style restaurant within a four-mile radius of the franchise location and a two-and-a-half-mile radius of other Golden Krust locations was reasonable.

Upon concluding that the balance of harms and public interest favored the issuance of an injunction, the court granted the franchisor's motion.

Charles G. Miller is a shareholder and director, and Darryl A. Hart is an attorney with Bartko, Zankel, Bunzel & Miller in San Francisco. They can be reached at 415-956-1900 or at [email protected] and [email protected], respectively.

Recent Cases Raise Red Flags for Franchise Agreement Drafters

In connection with concluded litigation, Item 3 of the 2007 Federal Trade Commission Franchise Rule (16 CFR Part 436) requires that a Franchise Disclosure Document (FDD) disclose all material terms of any settlements, whether or not the settlement agreement is confidential, as long as the settlement was entered into after the franchisor began selling franchises. (16 CFR '436.5(c)(3)(ii)). In Caudill et al v. Keller Williams Realty Inc., Bus. Fran. Guide (CCH) '15,162 (USDC N.D. Illinois, Oct. 31, 2013), the parties had entered into a Settlement Agreement and Mutual Release resolving a prior lawsuit between them. The settlement agreement stated that “[t]he terms, covenants, conditions of this settlement, specifically including the amount to be paid in settlement ' will be held strictly in confidence and will not be disseminated or disclosed by the parties ' except to ' governmental agencies or regulatory authorities as required by law.” The settlement agreement provided for liquidated damages in the amount of $10,000 for each breach of the confidentiality provision.

In March of 2013, following the effective date of the settlement agreement, Keller Williams, an international franchisor of real estate brokerage offices that began selling franchises in 1995, sent its updated FDD to existing franchisees, regional owners, regional directors and prospective franchisees. The updated FDD described the terms of the settlement with the plaintiffs, including the amount of the settlement, as required by Item 3 of the FTC Rule. Several months later, the plaintiffs filed the instant suit seeking damages, including the liquidated damages specified in the settlement agreement, for what they maintained were unauthorized disclosures under the terms of the settlement agreement. They also sought an injunction against Keller Williams seeking to prevent future disclosure of the settlement agreement's terms, alleging that such disclosure would damage their reputation and business relations. Keller Williams moved to dismiss the complaint.

The standard that must be met to defeat a motion to dismiss is whether the complaint is legally sufficient to state a cause of action ' it is not a finding on the merits of the matter. Among the arguments put forth by Keller Williams was that it is required by law ' the FTC Rule ' to disclose the terms of the settlement. Despite the terms of the FTC Rule, the court held that certain findings of fact were required before a ruling on that claim could be made. While the opinion in the case is brief, the court seemed to think that the states in which the recipients were located and the franchise laws of those states had a bearing on the ultimate outcome. Of course, the FTC Rule's requirements are applicable in all states, so the court's discussion on that issue is a bit confusing.

Keller Williams argued in support of its motion that the complaint did not allege damages in sufficient detail and that, as a penalty, the liquidated damages provision in the settlement agreement should be found to be invalid. However, the court stated that it had to hear evidence about the circumstances that existed at the time the agreement was executed to determine whether actual damages for a violation of the confidentiality clause were difficult of estimation, and whether the amount recited in the liquidated damages provision was a reasonable forecast of the actual damages. There was evidence that the amount of damages specified in the provision was negotiated between the parties and was not merely dictated by Keller Williams. However, the court stated that the negotiated status of the amount was only some evidence that went to the merits; merits that needed further exploration. As such, the complaint was sufficient to overcome the motion to dismiss.

While the court may be persuaded to find for Keller Williams based on the requirements of the FTC Rule after hearing evidence on the matter, the issue may have been obviated by stating in the settlement agreement that disclosure of the material terms of the settlement was required by Item 3 of the rule and, therefore, the confidentiality provisions would only apply to other disclosure, with any further exceptions to their coverage similarly spelled out.

[Authors' Note: In an earlier edition of this publication (v.19, No.1, Oct. 12, 2012, pp 5-6) we discussed Hamden v. Total Car Franchising Corp., 2012 WL 3255598, Bus. Fran. Guide (CCH) '14,789 (W.D. Va., Aug. 7, 2012), a case where the U.S. District Court denied enforcement of post-expiration noncompetition and non-solicitation provisions in a franchise agreement and a related confidentiality agreement on the basis that the language of the concerned agreements treated expiration differently from termination and, as such, the terms could not be considered coterminous. The ruling in the case was appealed to the Fourth Circuit, which, after a de novo review of the question, issued a not-for-publication opinion (Hamden v. Total Car Franchising Corporation, Bus. Fran. Guide (CCH) '15,190 (U.S. Court of Appeals, 4th Cir., Nov. 22, 2013)) also finding that the terms in the concerned agreements make a distinction between "termination," which requires some affirmative act, and "expiration," which occurs when the contract runs its course and the term expires. Since the noncompetition provision at issue states that it was effective on termination or transfer of the franchise, it did not apply following the expiration of the agreement. In contrast, one provision of the nondisclosure clause stated it was effective during the term of the agreement "and thereafter," indicating that it was effective after the agreement ended for any reason and was, therefore, enforceable; while another section of that clause referred to termination and, therefore, was, not enforceable. In a footnote, the court noted that a violation of the second provision would probably also violate the first, so the different language would not prevent the restrictions on disclosure.

The non-solicitation provision stated that it was effective during the term of the agreement and for two years after its termination. The court, while admitting it made little sense to read the clause as pertaining only to termination, proceeded to do so, reasoning that uniformity of definition controlled, and "termination" means termination, not "expiration."

The basic rule of contract interpretation that an agreement will be construed against the party that drafts it came back to bite the franchisors in the above cases. Care must be taken to cover clearly all eventualities so that one's own language cannot be used against one in the event of a dispute. Those of us who draft franchise and other agreements may know what we mean to say, but the contracts have to be drafted so that others know what we mean as well. Otherwise, in a matter with a sympathetic party on the other side, a court may find against our client if given an opening to do so.]

Ill. Appellate Court Holds FDD Earnings Claim Disclaimers Defeat Fraud Claim

Disclaimers that earnings claims represented only a small percentage of stores and should not be considered to represent actual or potential results to be realized by the franchisee worked to prevent a fraud suit from continuing in Avon Hardware Company v. Ace Hardware Corporation, Bus. Fran. Guide (CCH) '15,174 (Ill. App., October 28, 2013).

Most earnings claims that are contained in Franchise Disclosure Documents (FDDs) have cautionary language that they should not be relied upon as representative of actual or potential earnings. In the Avon Hardware case, that language (plus more) worked to stop the suit. The franchisees sued for common law fraud, violations of the Illinois Consumer Fraud and Deceptive Business Practices Act and the Indiana Franchise Disclosure Act, claiming that the financial information in the FDD as to the results of other franchised stores was inflated and false. The franchisor had given the franchisees pro-formas and an FDD, which stated that the projections contained therein were “merely estimates and should not be considered as the actual or potential sales, profits or earnings that will be realized by any specific store operator.” The FDD also spelled out in footnotes to Item 19 that the information was from stores that reported, which amounted to approximately 40% of the member stores. These types of disclaimers are often found in Item 19. In addition, the signed receipt contained language that the franchisee has not relied on the information in Item 19.

The appellate court first held that the projections were not representations of fact necessary to establish a fraud claim but that the false information in the historical data presented could be considered a misstatement of fact. Nonetheless, the “cautionary” language (referenced above) “render[ed] any reliance ' unreasonable.”

In the Ace Hardware case, the manipulation of the numbers was alleged to be a result of “cherry picking,” and ignoring failed stores. The court held that the cautionary language covered these situations.

While carefully drafted cautionary language may work to result in a dismissal of fraud suits, such “disclaimers” are increasingly attacked by franchisee attorneys. They may not work if the franchisee is able to establish that the franchisor deliberately falsified the numbers. In such a case, a court may well hold that the franchisor cannot so easily exculpate itself from claims of fraud.

Noting New York City's Density, Court Enforces, But Limits, Restrictive Covenant

In Golden Krust Patties Inc. v. Marilyn Bullock, No, 13-cv-2241 (RLM), 2013 WL 3766551 (S.D.N.Y. July 16, 2013), the U.S. District Court for the Eastern District of New York recently issued a preliminary injunction, enforcing the non-compete provision in franchisor Golden Krust's franchise agreement with former franchisees, thereby enjoining the defendants from operating a Caribbean-style restaurant within four miles of the franchise location and two-and-a-half miles from other Golden Krust franchises.

Following the franchisor's discovery that the then-franchisees were selling competing products in Golden Krust packaging in violation of the parties' franchise agreement, the franchisor sent a termination letter. The franchisor then filed suit, asserting claims for breach of contract and misappropriation of trade secrets and sought a preliminary injunction enjoining the defendants from: 1) using or displaying the franchisor's trademarks or otherwise engaging in actions that would cause confusion as to the franchisee's goods and services; and 2) operating a business within the geographical scope of the non-compete provision.

The court first endeavored to set forth the relevant test for a preliminary injunction, noting the confusion within the Circuit. The court next concluded that it must consider the balance of hardships even where a plaintiff demonstrates a likelihood of success on the merits. However, even if the plaintiff does not demonstrate a likelihood of success on the merits, he still may meet his burden for showing that an injunction is warranted by establishing “sufficiently serious questions going to the merits to make them a fair ground for litigation” and that the balance of hardships “tips decidedly” in his favor.

Regarding the franchisor's contention that it would suffer irreparable injury due to its loss of good will or business relationships, the court found significant photographic evidence showing that even though the former franchisees removed the Golden Krust trade dress, they brazenly sought to exploit the franchisor's goodwill by failing to adopt a new store name. In addition, the store also displayed signs declaring “Come in. We are Open. Nothing has Changed Only Our Name,” and “Open. Same Great Food. Same Great Service. Thanks for Your Support!!! Come Again.” The court did not find, however, that the franchisor would suffer irreparable harm based on the franchisee's misappropriation of trade secrets, reasoning that the franchisor failed to provide any specific details as to what trade secrets or confidential information was misappropriated, and presented no evidence establishing the harm it would suffer absent an injunction.

As to the franchisor's likelihood of success on the merits, the court found the non-compete covenant was enforceable, but blue-penciled the agreement's restriction of barring the defendants from operating a competing business within 10 miles of the franchise for a two-year period and within five miles of another Golden Krust location. Taking judicial notice of the dense population of New York City, the court concluded that restricting the defendants from operating a Caribbean-style restaurant within a four-mile radius of the franchise location and a two-and-a-half-mile radius of other Golden Krust locations was reasonable.

Upon concluding that the balance of harms and public interest favored the issuance of an injunction, the court granted the franchisor's motion.

Charles G. Miller is a shareholder and director, and Darryl A. Hart is an attorney with Bartko, Zankel, Bunzel & Miller in San Francisco. They can be reached at 415-956-1900 or at [email protected] and [email protected], respectively.