Court Watch

The Supreme Court reversed and remanded the decision of the lower courts. First, the Court resolved a split of opinion among the federal circuits, holding that when a plaintiff commences a proceeding in a federal forum other than that specified in a forum-selection clause, dismissal under 28 U.S.C. '1406(a) or FRCP 12(b)(3) is inappropriate. With respect to motions to transfer under 28 U.S.C. '1404(a), the Supreme Court held that courts should shift the analysis from weighing the public and private interest factors set forth in 28 U.S.C. '1404(a) and instead give the forum-selection clause “controlling weight in all but the most exceptional cases.” The Supreme Court stated that, when a valid forum-selection clause is present, “[o]nly under extraordinary circumstances ' should a '1404(a) motion be denied.” In so holding, the Supreme Court significantly increased the likelihood of enforcement of forum-selection clauses in contractual agreements, giving franchisors and other business owners wide latitude to litigate contractual disputes in the forum most favorable to them.

One certain result of Atlantic Marine Construction Co. will be to strengthen franchisors' abilities to enforce covenants not to compete, and other in-term and post-term contractual rights, by restricting current or former franchisees from racing to the courthouse of another jurisdiction that may be more favorable to the franchisee. Instead, franchisees will be required to litigate in the forum designated in the franchise or license agreement. In light of this decision, franchisors are encouraged to revisit their contractual agreements to ensure the inclusion of both a forum-selection clause and a choice-of-law clause selecting the venue and applicable law most favorable to any anticipated dispute.

Arbitration Provision Not Enforced Against Franchise Transferee

The federal district court for the District of Connecticut recently refused a franchisor's effort to compel arbitration against one of its franchisees. Doctor's Associates Inc. v. Edison Subs, LLC, Bus. Franchise Guide (CCH) '15,207 (D. Conn. Jan. 3, 2014). Doctor's Associates Inc. (DAI) had entered into a written franchise agreement with Aliya Patel containing an arbitration provision requiring that all disputes be arbitrated in Connecticut. Patel later transferred the Subway franchise to Edison Subs LLC (Edison). In March 2013, Edison commenced a lawsuit in New Jersey state court against DAI, Patel, and Subway Real Estate Corporation, alleging breach of contract, violations of the New Jersey Consumer Fraud Act, negligent misrepresentation, and violations of the covenant of good faith and fair dealing. Despite attaching the written franchise agreement to its complaint, Edison alleged in the New Jersey state court case that it had entered into an “oral franchise agreement” with DAI and Patel, under which it would pay transfer and franchise fees and would receive all of the benefits of owning a Subway franchise.

After commencement of the New Jersey state court action, DAI filed an action in federal court in Connecticut to compel arbitration under the written franchise agreement. It was undisputed that the franchise had been transferred from Patel to Edison; however, the written agreement had been signed only by Patel, and not Edison. It was also undisputed that, since the transfer, Edison had acted as a Subway franchisee and had paid royalties to DAI.

The federal district court considered the five circumstances under which a nonsignatory to an agreement may be compelled to arbitrate under Second Circuit law: 1) incorporation by reference; 2) assumption; 3) agency; 4) veil-piercing/alter ego; and 5) estoppel. The court quickly dismissed the first four and focused its analysis on the application of estoppel theory. Estoppel can be used to compel a nonsignatory to arbitrate only where the nonsignatory has “knowingly accepted the benefits of the unsigned agreement” and “directly benefitted from the agreement.” If either the knowing acceptance of the agreement or the direct benefit is missing, the estoppel theory does not apply, and the nonsignatory cannot be compelled to arbitrate.

In this case, although Edison held itself out as a Subway franchisee, paid royalties to DAI, and received the benefits normally received by franchisees ' including receipt of the operations manual and the right to operate a Subway restaurant using DAI's vendors, trademarks, and business methods ' the court refused to apply the estoppel theory because there was no evidence to show that Edison knowingly exploited the written franchise agreement. DAI did not prove that Edison received a copy of the written franchise agreement prior to receiving the benefits of a franchisee. Instead, the court determined that the benefits received by Edison were pursuant to the alleged oral franchise agreement. Therefore, Edison could not be estopped from pursuing his New Jersey state court litigation, and arbitration could not be compelled.

Franchisor Entitled to Terminate Franchises Without Notice Based on Fraudulent Inducement

In Dunkin' Donuts Franchisng LLC v. Sai Food Hospitality, LLC, Bus. Franchise Guide (CCH) '15,205 (E.D. Mo. Dec. 31, 2013), franchisor Dunkin' Donuts terminated two franchise agreements based on the franchisees' misrepresentation related to the ownership of the corporate franchisee. In 2009, husband and wife Jayant and Ulka Patel (Jayant and Ulka) signed a Store Development Agreement, giving them the right to develop and open ten Dunkin' Donuts stores in the St. Louis area by January 2017. Jayant and Ulka formed a corporation, Sai Food & Hospitality, LLC (SFH), to serve as the corporate franchisee for their franchises. However, the majority of SFH was owned by Kamlesh Patel and Jigar Patel (Kamlesh and Jigar), individuals who had not been approved as franchisees and did not sign the Store Development Agreement. Jayant and Ulka were minority owners in SFH.

Dunkin' Donuts required that Kamlesh and Jigar be removed from ownership before Jayant and Ulka would be allowed to enter into a franchise agreement with SFH as the franchisee. Kamlesh and Jigar could become owners of the corporate franchisee only after they were approved as franchisees in their individual capacities.

Jayant and Ulka assured Dunkin' Donuts that they had held a board meeting and changed the corporate structure to remove the other two individuals as owners. They did not provide minutes of the purported board meeting, but did provide a copy of IRS Form 2553, showing that Jayant and Ulka each owned 50% of SFH. Based on this material information, Dunkin' Donuts entered into two franchise agreements with SFH ' on Nov. 19, 2010 and Aug. 5, 2011. In fact, the evidence at trial showed that Kamlesh and Jigar were never removed as owners and that Jayant and Ulka knowingly concealed the true ownership structure information from the franchisor.

In the meantime, Dunkin' Donuts' loss prevention department conducted an investigation and issued a report on July 14, 2011, concluding that Jayant and Ulka fraudulently induced Dunkin' Donuts to enter into the first franchise agreement by misrepresenting the ownership of FSH. The report was forwarded to the legal department for analysis. By Aug. 24, 2011, the Dunkin' Donuts legal department decided to terminate the franchise agreements and sent the Patels a notice of termination of the two franchise agreements and the Store Development Agreement, effective immediately upon receipt.

After a bench trial, the court ruled in favor of Dunkin' Donuts on its claims for breach of contract, trademark infringement, and unfair competition and on the franchisees' counterclaims for wrongful termination. The court determined that the original ownership structure ' with Kamlesh and Jigar as majority owners ' was never changed, and that Jayant and Ulka wrongfully concealed this fact. The court further determined that misrepresentation of the ownership structure was a material misrepresentation that fraudulently induced Dunkin' Donuts to enter into the franchise agreements. Because fraud is grounds for immediate termination under both the franchise agreements and Missouri Franchise Act, the termination by Dunkin' Donuts was not wrongful. With respect to the second franchise agreement, the franchisees asserted a promissory estoppel counterclaim based on the fact that the agreement had been signed after the loss prevention department's report finding fraud. Despite this timing, the court determined that the franchisor's legal department was entitled to a reasonable amount of time to analyze the report and make a decision, and that the franchisees had failed to show any damages as a result of their reliance on the franchisor's decision to enter into the second agreement.

Cynthia M. Klaus is a shareholder and Susan E. Tegt is an associate with Larkin Hoffman. Ms. Klaus can be contacted at [email protected], and Ms. Tegt can be contacted at [email protected].

U.S. Supreme Court Strengthens Franchisors' Ability to Litigate In Chosen Forum

On Dec. 3, 2013, the U.S. Supreme Court issued a unanimous opinion clarifying the procedural mechanism for dismissing or transferring a lawsuit in which the parties to the lawsuit are also parties to a contract with a valid forum-selection provision. Atlantic Marine Construction Co. v. United States District Court for the Western District of Texas, 134 S. Ct. 568, 571 U.S. ___ (2013). Perhaps more important, particularly for franchisors and other business owners, the Supreme Court held that such contractual forum-selection clauses will be enforced in “all but the most unusual cases.” This ruling gives franchisors strengthened ability to litigate contractual disputes in the forum of their choosing.

By way of background, Atlantic Marine Construction Co. (Atlantic Marine) and J-Crew Management Inc. (J-Crew Management) entered into a contract requiring all contractual disputes to be litigated in Virginia. J-Crew Management, however, filed suit in federal court in Texas when a dispute arose. Seeking to enforce the forum-selection clause, Atlantic Marine moved to dismiss the case for wrong or improper venue under Federal Rule of Civil Procedure (FRCP) 12(b)(3), or for the wrong venue under 28 U.S.C. '1406(a). Atlantic Marine alternatively moved to transfer the action to Virginia under 28 U.S.C. '1404(a). The district court denied Atlantic Marine's motion to dismiss and concluded that a motion to transfer venue under 28 U.S.C. '1404(a) is the sole mechanism to enforce a forum-selection clause, reasoning that dismissal is appropriate only when the contractual forum-selection clause identifies a foreign or state court forum, or an arbitral forum. Weighing several public and private interest factors relating to the request for a transfer, only one of which was the forum-selection clause, the district court concluded Atlantic Marine had not met its burden to transfer venue. The Fifth Circuit Court of Appeals agreed with the district court's analysis and denied Atlantic Marine's application for a writ of mandamus.

The Supreme Court reversed and remanded the decision of the lower courts. First, the Court resolved a split of opinion among the federal circuits, holding that when a plaintiff commences a proceeding in a federal forum other than that specified in a forum-selection clause, dismissal under 28 U.S.C. '1406(a) or FRCP 12(b)(3) is inappropriate. With respect to motions to transfer under 28 U.S.C. '1404(a), the Supreme Court held that courts should shift the analysis from weighing the public and private interest factors set forth in 28 U.S.C. '1404(a) and instead give the forum-selection clause “controlling weight in all but the most exceptional cases.” The Supreme Court stated that, when a valid forum-selection clause is present, “[o]nly under extraordinary circumstances ' should a '1404(a) motion be denied.” In so holding, the Supreme Court significantly increased the likelihood of enforcement of forum-selection clauses in contractual agreements, giving franchisors and other business owners wide latitude to litigate contractual disputes in the forum most favorable to them.

One certain result of Atlantic Marine Construction Co. will be to strengthen franchisors' abilities to enforce covenants not to compete, and other in-term and post-term contractual rights, by restricting current or former franchisees from racing to the courthouse of another jurisdiction that may be more favorable to the franchisee. Instead, franchisees will be required to litigate in the forum designated in the franchise or license agreement. In light of this decision, franchisors are encouraged to revisit their contractual agreements to ensure the inclusion of both a forum-selection clause and a choice-of-law clause selecting the venue and applicable law most favorable to any anticipated dispute.

Arbitration Provision Not Enforced Against Franchise Transferee

The federal district court for the District of Connecticut recently refused a franchisor's effort to compel arbitration against one of its franchisees. Doctor's Associates Inc. v. Edison Subs, LLC, Bus. Franchise Guide (CCH) '15,207 (D. Conn. Jan. 3, 2014). Doctor's Associates Inc. (DAI) had entered into a written franchise agreement with Aliya Patel containing an arbitration provision requiring that all disputes be arbitrated in Connecticut. Patel later transferred the Subway franchise to Edison Subs LLC (Edison). In March 2013, Edison commenced a lawsuit in New Jersey state court against DAI, Patel, and Subway Real Estate Corporation, alleging breach of contract, violations of the New Jersey Consumer Fraud Act, negligent misrepresentation, and violations of the covenant of good faith and fair dealing. Despite attaching the written franchise agreement to its complaint, Edison alleged in the New Jersey state court case that it had entered into an “oral franchise agreement” with DAI and Patel, under which it would pay transfer and franchise fees and would receive all of the benefits of owning a Subway franchise.

After commencement of the New Jersey state court action, DAI filed an action in federal court in Connecticut to compel arbitration under the written franchise agreement. It was undisputed that the franchise had been transferred from Patel to Edison; however, the written agreement had been signed only by Patel, and not Edison. It was also undisputed that, since the transfer, Edison had acted as a Subway franchisee and had paid royalties to DAI.

The federal district court considered the five circumstances under which a nonsignatory to an agreement may be compelled to arbitrate under Second Circuit law: 1) incorporation by reference; 2) assumption; 3) agency; 4) veil-piercing/alter ego; and 5) estoppel. The court quickly dismissed the first four and focused its analysis on the application of estoppel theory. Estoppel can be used to compel a nonsignatory to arbitrate only where the nonsignatory has “knowingly accepted the benefits of the unsigned agreement” and “directly benefitted from the agreement.” If either the knowing acceptance of the agreement or the direct benefit is missing, the estoppel theory does not apply, and the nonsignatory cannot be compelled to arbitrate.

In this case, although Edison held itself out as a Subway franchisee, paid royalties to DAI, and received the benefits normally received by franchisees ' including receipt of the operations manual and the right to operate a Subway restaurant using DAI's vendors, trademarks, and business methods ' the court refused to apply the estoppel theory because there was no evidence to show that Edison knowingly exploited the written franchise agreement. DAI did not prove that Edison received a copy of the written franchise agreement prior to receiving the benefits of a franchisee. Instead, the court determined that the benefits received by Edison were pursuant to the alleged oral franchise agreement. Therefore, Edison could not be estopped from pursuing his New Jersey state court litigation, and arbitration could not be compelled.

Franchisor Entitled to Terminate Franchises Without Notice Based on Fraudulent Inducement

In Dunkin' Donuts Franchisng LLC v. Sai Food Hospitality, LLC, Bus. Franchise Guide (CCH) '15,205 (E.D. Mo. Dec. 31, 2013), franchisor Dunkin' Donuts terminated two franchise agreements based on the franchisees' misrepresentation related to the ownership of the corporate franchisee. In 2009, husband and wife Jayant and Ulka Patel (Jayant and Ulka) signed a Store Development Agreement, giving them the right to develop and open ten Dunkin' Donuts stores in the St. Louis area by January 2017. Jayant and Ulka formed a corporation, Sai Food & Hospitality, LLC (SFH), to serve as the corporate franchisee for their franchises. However, the majority of SFH was owned by Kamlesh Patel and Jigar Patel (Kamlesh and Jigar), individuals who had not been approved as franchisees and did not sign the Store Development Agreement. Jayant and Ulka were minority owners in SFH.

Dunkin' Donuts required that Kamlesh and Jigar be removed from ownership before Jayant and Ulka would be allowed to enter into a franchise agreement with SFH as the franchisee. Kamlesh and Jigar could become owners of the corporate franchisee only after they were approved as franchisees in their individual capacities.

Jayant and Ulka assured Dunkin' Donuts that they had held a board meeting and changed the corporate structure to remove the other two individuals as owners. They did not provide minutes of the purported board meeting, but did provide a copy of IRS Form 2553, showing that Jayant and Ulka each owned 50% of SFH. Based on this material information, Dunkin' Donuts entered into two franchise agreements with SFH ' on Nov. 19, 2010 and Aug. 5, 2011. In fact, the evidence at trial showed that Kamlesh and Jigar were never removed as owners and that Jayant and Ulka knowingly concealed the true ownership structure information from the franchisor.

In the meantime, Dunkin' Donuts' loss prevention department conducted an investigation and issued a report on July 14, 2011, concluding that Jayant and Ulka fraudulently induced Dunkin' Donuts to enter into the first franchise agreement by misrepresenting the ownership of FSH. The report was forwarded to the legal department for analysis. By Aug. 24, 2011, the Dunkin' Donuts legal department decided to terminate the franchise agreements and sent the Patels a notice of termination of the two franchise agreements and the Store Development Agreement, effective immediately upon receipt.

After a bench trial, the court ruled in favor of Dunkin' Donuts on its claims for breach of contract, trademark infringement, and unfair competition and on the franchisees' counterclaims for wrongful termination. The court determined that the original ownership structure ' with Kamlesh and Jigar as majority owners ' was never changed, and that Jayant and Ulka wrongfully concealed this fact. The court further determined that misrepresentation of the ownership structure was a material misrepresentation that fraudulently induced Dunkin' Donuts to enter into the franchise agreements. Because fraud is grounds for immediate termination under both the franchise agreements and Missouri Franchise Act, the termination by Dunkin' Donuts was not wrongful. With respect to the second franchise agreement, the franchisees asserted a promissory estoppel counterclaim based on the fact that the agreement had been signed after the loss prevention department's report finding fraud. Despite this timing, the court determined that the franchisor's legal department was entitled to a reasonable amount of time to analyze the report and make a decision, and that the franchisees had failed to show any damages as a result of their reliance on the franchisor's decision to enter into the second agreement.

Cynthia M. Klaus is a shareholder and Susan E. Tegt is an associate with Larkin Hoffman. Ms. Klaus can be contacted at [email protected], and Ms. Tegt can be contacted at [email protected].