Court Watch

In the license agreement, Baker agreed to pay Utecht a $30,000 initial license fee and an ongoing monthly royalty for the right to license the U-BAKE mark and system. Utecht agreed to provide assistance related to the setup of the store, inventory ordering process, bookkeeping procedures, and establishment of suppliers. In addition, Utecht agreed to provide two weeks of on-site training. While Utecht agreed to provide the aforementioned assistance, the agreement explicitly stated that Utecht would not exercise any control over the operations of the store or provide any other assistance. Though reviewed and negotiated by Baker's attorney, the agreement included an acknowledgement that the arrangement was not a franchise relationship and that the licensor did not make any claims about actual or potential earnings.

Eighteen months later, after the store's performance failed to meet expectations and after learning of a suit by another dissatisfied licensee, Baker sued Utecht, asserting that Utecht violated the Minnesota Franchise Act (MFA) and Wisconsin Franchise Investment Law (WFIL) by failing to register the franchise, failing to make proper disclosures, and misrepresenting the start-up costs, potential sales, and profits involved with the operation of a store. The suit also included claims of common law fraud and negligent misrepresentation. As a result of these claims, Baker sought to rescind his license agreement and recover $250,000 in damages, plus attorneys' fees.

While it is quite likely that the arrangement would have met the statutory definition of a franchise, the court found it unnecessary to make such a determination. Rather, the court focused on Utecht's defense that Baker was equitably estopped from asserting that state franchise laws were violated. Equitable estoppel prevents the assertion of otherwise valid rights where one party has acted to induce another party to detrimentally rely on those actions. To establish an equitable estoppel defense, Utecht needed to prove that: 1) promises or inducements were made; 2) Utecht reasonably relied on such promises; and 3) Utecht would be harmed if estoppel was not applied.

The court found that the fact that Baker's attorney had reviewed the license agreement prior to execution estopped Baker from later asserting that the license agreement was actually an improper franchise. While Baker's attorney asserted attorney-client privilege when asked if he knew the arrangement was a franchise when he negotiated the license agreement, the court found that nothing contradicted Utecht's assertion that Baker's attorney at least knew at the time of negotiation that the existence of a franchise is determined by examining the characteristics of the parties' business arrangement. This knowledge was imputed to Baker, making Baker responsible for knowing that the license arrangement could potentially constitute a franchise.

The court noted that, during the course of negotiations, Baker never asserted that the arrangement was a franchise or objected to the acknowledgement that it was not a franchise. In addition, Baker prepared a business plan that it used to secure a SBA loan that again acknowledged that the arrangement was a license rather than a franchise. The court concluded that Utecht would be materially harmed if Baker were now allowed to assert claims that were inconsistent with its prior conduct acknowledging that the arrangement was a license rather than a franchise. The court noted that it would be inequitable to allow Baker to “use the franchise laws as an escape hatch to undo a business decision they now regret.”

In granting summary judgment on the claims that Utecht violated the disclosure and registration requirements of the state statute, the court noted its holding did not defeat the purpose of the franchise statutes to protect potential franchisees from abuses, since Baker was not lured into purchasing a franchise and duped into relinquishing unknown rights. Rather, because Baker sought out the arrangement and negotiated the license agreement with the assistance of an attorney, who knew that the business arrangement could constitute a franchise, the agreement was the product of an informed and deliberate process. Moreover, the court dismissed Baker's arguments that the state franchise laws could not be contractually waived, noting that Utecht's defense was one of estoppel rather than contractual waiver.

Turning to Baker's statutory and common law fraud and misrepresentation claims, the court considered Baker's assertions that Utecht misrepresented the store's potential earnings, profit and growth, concluding that Baker failed to prove that it reasonably relied on any misrepresentations. The court reasoned that Baker did not rely on figures provided by Utecht, since Baker developed a business plan that projected higher start-up costs and more robust sales growth than the projections provided by Utecht. As a result, the court granted summary judgment in favor of Utecht with respect to each of Baker's claims.

In Mister Softee, Inc. v. Tsirkos, 2 Bus. Franch. Guide (CCH) '15,296 (S.D.N.Y. Jun. 5, 2014), the franchisor and subfranchisor of MISTER SOFTEE branded ice cream trucks (collectively referred to in this article as Mister Softee), sought a preliminary injunction to enjoin Tsirkos, a former franchisee, from infringing their trademarks and violating a non-compete provision. Despite post-termination covenants prohibiting Tsirkos from operating any ice cream businesses in its former territories or the territories of other MISTER SOFTEE franchisees after the termination of his franchise agreements, Tsirkos continued to operate ice cream trucks in these territories under the name MASTER SOFTEE and SOFT KING. Moreover, Tsirkos retained a similar look and feel on the trucks, including a white color with a blue trim on the bottom, the slogan “the World's Best,” and a waffle cone character with a blue jacket.

While Tsirkos acknowledged that he was operating in violation of the non-compete provisions, he claimed that he was entitled to rescission of his franchise agreements, because the plaintiffs violated the New York Franchise Sales Act by failing to provide him with a Franchise Disclosure Document. Under the Act, a franchisor that fails to provide a prospectus to a franchisee can be liable for damages, and, in the case of willful and material violations of the Act, the agreements are subject to rescission. In this case, it was true that Tsirkos technically never possessed an FDD. However, Mister Softee testified that they attempted to deliver a FDD to the defendant, but he refused to accept it, arguing that since he had been a franchisee in the system for thirty years, he knew everything about the system already.

The court noted that there were no precedents considering whether merely making a FDD available to a prospect would be sufficient to satisfy the Act's requirement to provide a prospectus. Rather than reaching a conclusion on that point, the court noted that it was clear that the plaintiffs, by offering the opportunity to review the FDD, did not willfully intend to violate the statute, and the agreements could therefore not be rescinded.

As a fallback position, Tsirkos challenged the validity of the non-compete, claiming that it was unreasonable in scope and duration. The court recognized that the non-compete would prevent Tsirkos from operating any sort of ice cream business, including mobile and fixed locations and wholesale and retail businesses, for two years within an area over 100 miles long that encompassed most of metropolitan New York City. However, the court found that these restrictions were justifiable with respect to fixed or mobile retail operations, because Mister Softee would have greater difficulty finding a replacement franchisee in the territory and had an interest in protecting its goodwill. With respect to wholesale ice cream businesses, the court concluded that the plaintiffs had failed to show why the restriction was necessary. As a result, the court opted to partially enforce the restrictive covenant, restricting Tsirkos from engaging in retail sales in its former territories and other Mister Softee territories for two years.

In addition to its successful non-compete claims, Mister Softee also asserted trademark infringement claims. In short order, the court concluded that Tsirkos' use of the MASTER SOFTEE and SOFT KING truck designs were confusingly similar to the MISTER SOFTEE trademarks and design. Besides the obvious similarities between the names and the trade dress of the trucks, the court noted that the franchisor had shown that some customers had actually been confused and that Tsirkos has adopted the similar trade dress in bad faith. As a result, the court concluded that Mister Softee was likely to succeed on its trademark infringement claims against Tsirkos.

Having established a likelihood of success on the merits of Mister Softee's claims, the court evaluated whether Mister Softee would be irreparably harmed absent injunctive relief and whether the public's interest weighed in favor of granting an injunction. The court concluded that the plaintiffs had shown irreparable harm in the form of customer confusion, loss of goodwill, and potential reputation damage if Tsirkos was allowed to continue to use marks and trade dress confusingly similar to those of Mister Softee. Moreover, the plaintiffs had shown that they could suffer a loss of goodwill of its customers and difficulty in establishing replacement franchisees if Tsirkos was allowed to operate an ice cream retail business in Mister Softee territories. Given the public's interest in preventing public confusion, the court issued the requested preliminary injunction.

Taken together, these cases are particularly instructive for prospective franchises and their legal counsel, since even though franchise disclosure laws may have been violated, the impacted franchisees were ultimately unable to successfully use those violations as a means to escape their contractual obligations. In these cases, the decision to refuse to receive or to decline to demand a Franchise Disclosure Document effectively estopped the franchisees from later asserting they were damaged by failing to receive the disclosures. In the case of U-Bake, a different result may have been reached had the franchisee not sought and received the advice of counsel. These cases suggest that once a franchisee has, or should have, received knowledge of the disclosure requirement, it is ultimately the franchisee's responsibility to obtain and review the disclosure in order to make an educated investment decision.

Alexander G. Tuneski is a Counsel in the Washington, DC, office of Kilpatrick Townsend & Stockton LLP.

No Disclosure Document? Not Always a Problem.

In two recent cases, franchisees attempted to assert that their failure to receive a Franchise Disclosure Document entitled them to rescind their franchise agreements. In both cases, the franchisee's arguments were ultimately rejected, because the franchisees purchased their franchises despite knowing that they should have or could have received the appropriate disclosures.

In U-Bake Rochester, LLC v. Utecht, 2 Bus. Franch. Guide (CCH) '15,228, (D. Minn. Jan. 21, 2014), a licensee was equitably estopped from asserting that state franchise statutes were violated when it agreed to purchase the right to operate a U-BAKE frozen dough and bulk food store. The plaintiff, Baker, expressed an interest in licensing the rights to operate a U-BAKE store to Utecht, the founder and operator of U-BAKE stores. The parties negotiated the terms of a license agreement, which culminated with Baker opening and operating his own U-BAKE store.

In the license agreement, Baker agreed to pay Utecht a $30,000 initial license fee and an ongoing monthly royalty for the right to license the U-BAKE mark and system. Utecht agreed to provide assistance related to the setup of the store, inventory ordering process, bookkeeping procedures, and establishment of suppliers. In addition, Utecht agreed to provide two weeks of on-site training. While Utecht agreed to provide the aforementioned assistance, the agreement explicitly stated that Utecht would not exercise any control over the operations of the store or provide any other assistance. Though reviewed and negotiated by Baker's attorney, the agreement included an acknowledgement that the arrangement was not a franchise relationship and that the licensor did not make any claims about actual or potential earnings.

Eighteen months later, after the store's performance failed to meet expectations and after learning of a suit by another dissatisfied licensee, Baker sued Utecht, asserting that Utecht violated the Minnesota Franchise Act (MFA) and Wisconsin Franchise Investment Law (WFIL) by failing to register the franchise, failing to make proper disclosures, and misrepresenting the start-up costs, potential sales, and profits involved with the operation of a store. The suit also included claims of common law fraud and negligent misrepresentation. As a result of these claims, Baker sought to rescind his license agreement and recover $250,000 in damages, plus attorneys' fees.

While it is quite likely that the arrangement would have met the statutory definition of a franchise, the court found it unnecessary to make such a determination. Rather, the court focused on Utecht's defense that Baker was equitably estopped from asserting that state franchise laws were violated. Equitable estoppel prevents the assertion of otherwise valid rights where one party has acted to induce another party to detrimentally rely on those actions. To establish an equitable estoppel defense, Utecht needed to prove that: 1) promises or inducements were made; 2) Utecht reasonably relied on such promises; and 3) Utecht would be harmed if estoppel was not applied.

The court found that the fact that Baker's attorney had reviewed the license agreement prior to execution estopped Baker from later asserting that the license agreement was actually an improper franchise. While Baker's attorney asserted attorney-client privilege when asked if he knew the arrangement was a franchise when he negotiated the license agreement, the court found that nothing contradicted Utecht's assertion that Baker's attorney at least knew at the time of negotiation that the existence of a franchise is determined by examining the characteristics of the parties' business arrangement. This knowledge was imputed to Baker, making Baker responsible for knowing that the license arrangement could potentially constitute a franchise.

The court noted that, during the course of negotiations, Baker never asserted that the arrangement was a franchise or objected to the acknowledgement that it was not a franchise. In addition, Baker prepared a business plan that it used to secure a SBA loan that again acknowledged that the arrangement was a license rather than a franchise. The court concluded that Utecht would be materially harmed if Baker were now allowed to assert claims that were inconsistent with its prior conduct acknowledging that the arrangement was a license rather than a franchise. The court noted that it would be inequitable to allow Baker to “use the franchise laws as an escape hatch to undo a business decision they now regret.”

In granting summary judgment on the claims that Utecht violated the disclosure and registration requirements of the state statute, the court noted its holding did not defeat the purpose of the franchise statutes to protect potential franchisees from abuses, since Baker was not lured into purchasing a franchise and duped into relinquishing unknown rights. Rather, because Baker sought out the arrangement and negotiated the license agreement with the assistance of an attorney, who knew that the business arrangement could constitute a franchise, the agreement was the product of an informed and deliberate process. Moreover, the court dismissed Baker's arguments that the state franchise laws could not be contractually waived, noting that Utecht's defense was one of estoppel rather than contractual waiver.

Turning to Baker's statutory and common law fraud and misrepresentation claims, the court considered Baker's assertions that Utecht misrepresented the store's potential earnings, profit and growth, concluding that Baker failed to prove that it reasonably relied on any misrepresentations. The court reasoned that Baker did not rely on figures provided by Utecht, since Baker developed a business plan that projected higher start-up costs and more robust sales growth than the projections provided by Utecht. As a result, the court granted summary judgment in favor of Utecht with respect to each of Baker's claims.

In Mister Softee, Inc. v. Tsirkos, 2 Bus. Franch. Guide (CCH) '15,296 (S.D.N.Y. Jun. 5, 2014), the franchisor and subfranchisor of MISTER SOFTEE branded ice cream trucks (collectively referred to in this article as Mister Softee), sought a preliminary injunction to enjoin Tsirkos, a former franchisee, from infringing their trademarks and violating a non-compete provision. Despite post-termination covenants prohibiting Tsirkos from operating any ice cream businesses in its former territories or the territories of other MISTER SOFTEE franchisees after the termination of his franchise agreements, Tsirkos continued to operate ice cream trucks in these territories under the name MASTER SOFTEE and SOFT KING. Moreover, Tsirkos retained a similar look and feel on the trucks, including a white color with a blue trim on the bottom, the slogan “the World's Best,” and a waffle cone character with a blue jacket.

While Tsirkos acknowledged that he was operating in violation of the non-compete provisions, he claimed that he was entitled to rescission of his franchise agreements, because the plaintiffs violated the New York Franchise Sales Act by failing to provide him with a Franchise Disclosure Document. Under the Act, a franchisor that fails to provide a prospectus to a franchisee can be liable for damages, and, in the case of willful and material violations of the Act, the agreements are subject to rescission. In this case, it was true that Tsirkos technically never possessed an FDD. However, Mister Softee testified that they attempted to deliver a FDD to the defendant, but he refused to accept it, arguing that since he had been a franchisee in the system for thirty years, he knew everything about the system already.

The court noted that there were no precedents considering whether merely making a FDD available to a prospect would be sufficient to satisfy the Act's requirement to provide a prospectus. Rather than reaching a conclusion on that point, the court noted that it was clear that the plaintiffs, by offering the opportunity to review the FDD, did not willfully intend to violate the statute, and the agreements could therefore not be rescinded.

As a fallback position, Tsirkos challenged the validity of the non-compete, claiming that it was unreasonable in scope and duration. The court recognized that the non-compete would prevent Tsirkos from operating any sort of ice cream business, including mobile and fixed locations and wholesale and retail businesses, for two years within an area over 100 miles long that encompassed most of metropolitan New York City. However, the court found that these restrictions were justifiable with respect to fixed or mobile retail operations, because Mister Softee would have greater difficulty finding a replacement franchisee in the territory and had an interest in protecting its goodwill. With respect to wholesale ice cream businesses, the court concluded that the plaintiffs had failed to show why the restriction was necessary. As a result, the court opted to partially enforce the restrictive covenant, restricting Tsirkos from engaging in retail sales in its former territories and other Mister Softee territories for two years.

In addition to its successful non-compete claims, Mister Softee also asserted trademark infringement claims. In short order, the court concluded that Tsirkos' use of the MASTER SOFTEE and SOFT KING truck designs were confusingly similar to the MISTER SOFTEE trademarks and design. Besides the obvious similarities between the names and the trade dress of the trucks, the court noted that the franchisor had shown that some customers had actually been confused and that Tsirkos has adopted the similar trade dress in bad faith. As a result, the court concluded that Mister Softee was likely to succeed on its trademark infringement claims against Tsirkos.

Having established a likelihood of success on the merits of Mister Softee's claims, the court evaluated whether Mister Softee would be irreparably harmed absent injunctive relief and whether the public's interest weighed in favor of granting an injunction. The court concluded that the plaintiffs had shown irreparable harm in the form of customer confusion, loss of goodwill, and potential reputation damage if Tsirkos was allowed to continue to use marks and trade dress confusingly similar to those of Mister Softee. Moreover, the plaintiffs had shown that they could suffer a loss of goodwill of its customers and difficulty in establishing replacement franchisees if Tsirkos was allowed to operate an ice cream retail business in Mister Softee territories. Given the public's interest in preventing public confusion, the court issued the requested preliminary injunction.

Taken together, these cases are particularly instructive for prospective franchises and their legal counsel, since even though franchise disclosure laws may have been violated, the impacted franchisees were ultimately unable to successfully use those violations as a means to escape their contractual obligations. In these cases, the decision to refuse to receive or to decline to demand a Franchise Disclosure Document effectively estopped the franchisees from later asserting they were damaged by failing to receive the disclosures. In the case of U-Bake, a different result may have been reached had the franchisee not sought and received the advice of counsel. These cases suggest that once a franchisee has, or should have, received knowledge of the disclosure requirement, it is ultimately the franchisee's responsibility to obtain and review the disclosure in order to make an educated investment decision.

Alexander G. Tuneski is a Counsel in the Washington, DC, office of Kilpatrick Townsend & Stockton LLP.