Court Watch

Rare Franchisee Judicial Victory Sets Dangerous Precedent for Franchisors

Most franchisee practitioners will admit that fraud and similar cases are difficult litigation that much more often than not lead to judgments in favor of the franchisor. An exception to this status quo can be found in Legacy Academy v. Mamilove, LLC, 761 S.E. 2d 880, Bus. Franchise Guide '15,336 (Ga. Ct. App. 2014, cert. granted , Nov. 3, 2014), where the franchisee received a victory against a day care center franchisor based on fraud and other theories that are not often franchisee successful. In particular, claims in this case were made under a Georgia statute that, essentially, gives a franchisee an indirect cause of action under the Federal Trade Commission's Franchise Rule, plus the franchisee also asserted claims under the Georgia RICO statute, for negligent misrepresentation, and for rescission.

The most interesting of these theories are the ones granting the franchisee a claim based on the FTC Franchise Rule violation and the fraud claim.

Fraud claims are difficult for franchisees to prevail on because of the numerous hurdles that must be overcome. To prove fraud, a franchisee must show: 1) a certain statement was made; 2) the statement was false; 3) the franchisor must have known of the falsity; 4) the franchisee relied on the statement and the reliance was reasonable; 5) the reliance caused the damages; and 6) the damages are provable. Usually, the reasonableness of the reliance requirement leads to the franchisee's downfall, especially if the franchise agreement contains reliance disclaimers.

In Legacy Academy, the trial court found that the franchisor's earnings claim was excessively optimistic, not based on actual facts, and therefore fraudulent. Normally, the fact that the franchisee did not read the Franchise Disclosure Document and had failed to consult an attorney before buying the franchisee would have resulted in a victory for the franchisor. However, the franchisee proved at trial that the franchisor pressured the franchisee to buy the franchise by representing that if it did not buy the franchise immediately, it would lose the opportunity to open the franchise in a prime location. But through what must have been skillful lawyering, the franchisee was able to prove all the elements of fraud under the circumstances, including reasonable reliance. Normally, a court frowns upon franchise purchasers who do not read the documents they are given to review. Nevertheless, here, the case resulted in a verdict of $1.1 million in favor of the franchisee, and the verdict was affirmed on appeal. The trial court had also found that the franchisees' right to rescind the franchisee made the disclaimers in the franchise agreement invalid.

While fraud decisions in favor of a franchisee are rare, successful private litigant claims based upon the FTC Franchise Rule are extraordinary absent the existence of a statute that specifically makes violation of the FTC Rule a violation of state law. See, e.g., Tenn. St. Ann. 47-18-101 et seq. However, here, the plaintiff invoked a Georgia statute that provided, “when the law requires a person to perform an act for the benefit of another or to refrain from doing an act which may injure another, although no cause of action is given in express terms, the injured party may recover for the breach of such legal duty if he suffers damage thereby.” O.C.G.A. 51-1-6. The franchisor contended that the FTC Franchise Rule allowed a franchisee to file a complaint with the FTC and the FTC, in turn, could have brought an action against the franchisee; thus the Georgia statute was inapplicable because the franchisee did have a cause of action it could have asserted. The court, however, concluded that the Federal Trade Commission Act did not provide a private cause of action, and, therefore, the franchisor's contention that the FTC could have filed a cause of action on behalf of the franchisee was without merit. If this interpretation of the Georgia law remains in place, it would mean that an FTC Franchise Rule violation derivatively gives a franchisee the right to sue for a breach of the FTC Franchise Rule under this statute. This decision, accordingly, makes better balanced the rights of franchisees in skirmishes against their franchisor.

Franchisors Still Fight To Fend Off Claims Of Vicarious Liability

One of the areas of franchise law that deserves the 2014 award for generating a plethora of litigation is vicarious liability.

In the end, there was little change in vicarious liability law in 2014. Many cases claiming franchisors were liable to third parties under one of the theories that serves as the basis for a claim for vicarious liability were brought, but few were successful for the third-party plaintiff.

In Barrett-O'Neill v. Lalo, LLC, ' 15,342 (D. Ohio Aug. 8, 2014), the disappointment of a franchisee's customer was found not to be actionable against the franchisor because the plaintiff failed to prove that the franchisee acted as the franchisor's agent. Although the franchisor provided training and marketing materials and, as the disappointed customer pointed out, he had received a response to his or her complaint only after contacting the franchisor, the level of control necessary to make a franchisor liable to a third party for the acts of its franchisees was absent. There was little proof that the franchisor had the right to control the franchisee's operations. The acts listed above, plus the franchisor providing networking opportunities, conducting meetings with its franchisees, and the presentation of awards to its franchisees by the franchisor, among other things, were insufficient to prove the level of control necessary to hold a franchisor liable for the acts of its franchisees. The court also noted that the evidence presented did not demonstrate that the franchisor held the franchisee out to the public as having authority to act on its behalf. Thus, judgment was granted in favor of the franchisor.

Class Action Qualifications in New Jersey

The leverage of threats of class action proceedings by franchisees against their franchisors are vastly overrated. Or are they? As one looks out over the range of class action claims that are often asserted, frequently one will find an individual threatening to bring a class action, when it is patent on its face that there would be significant hurdles in having the class certified. This is particularly true in many franchise system cases. Often, the franchisees have different forms of agreements. In other circumstances, the claims are very individual to particular franchisees ' there is no commonality. Sometimes the damage claims are highly individualized. And we are seeing more and more franchisee agreements that provide for mandatory arbitration and further provide that class arbitrations will not be permitted. When asserting a class action claim, the franchisee often does not realize that these provisions will kill the class action threat.

One of the primary purposes of class actions is to increase judicial efficiency. Why shouldn't individuals be able to collectively assert claims if this will consolidate numerous similar claims, reduce the number of trials, hearings and motions, and simplify discovery?

Of the factors mentioned above, commonality is frequently one requirement that destroys the possibility of a class action. In a recent New Jersey decision, however, McPeak v. S-L Distribution Co, Inc., Bus. Franchise Guide ' 15,351(D. N.J), a federal trial court concluded that class actions should not be quickly dismissed at an early stage of the litigation on grounds of lack of commonality. In McPeak, the case was based on an alleged breach of the New Jersey Franchise Practices Act. The court noted that some of the allegations in the complaint were personal to the named plaintiff, but nevertheless concluded that discovery should be allowed to determine whether there was more evidence of commonality. The court also noted that there were objective standards that could be used in determining commonality.

The McPeak decision makes it easier for class action complaints to survive early motions for dismissal, thus making it more likely that plaintiffs will have their days in court ' although the number of those days may still be sharply limited. The policy issue this decision raises is whether the McPeak court's ruling undermines the concept of judicial efficiency with its emphasis on allowing plaintiffs to go through some early stage of discovery. It will be interesting to see whether other courts will adopt a similarly liberal interpretation of what it will take for a plaintiff to survive an early motion to dismiss a class action complaint, especially in light of recent changes to the Rules of Civil Procedure and Supreme Court decisions that have made class actions more difficult to pursue.

Franchisor Has Wide Discretion in Deciding Who and How Many Franchises

Two frequently asked questions, especially by start-up franchisors, are: who may I choose not to sell my franchise to, or can I limit the number of franchises I must sell to someone who wants to be, or already is, a franchisee? The answers to both questions are the same: Absent an agreement to the contrary, there are few restrictions on a franchisor's rights to decide who may be a franchisee and how many units he will be entitled to own.

The case at issue, LeCompte v. AFC Enterprises, Inc., Bus. Franchise Guide '15,386 (La. Ct.. App. 2014), was brought under the Louisiana Unfair Trade Practices Act, with the trial court granting summary judgment for the franchisor and that decision being affirmed by the Louisiana Court of Appeals. The appellate court agreed with the trial court that a refusal to grant additional franchises was not an unfair or deceptive act under the Louisiana statute. In LeCompte, the franchisee wanted to develop an additional unit, but the franchisor refused to grant him the right to further develop. The franchisee also tried to buy two existing nearby units, but the franchisor again informed the franchisee that it did not want to “grow with him.” In the end, the franchisor's position was accepted by both the trial and appellate court.

Although LeCompte is in accord with the national “folklore” on franchising, practitioners need to recognize the case's limitation. First, it is a Louisiana state decision, and not binding precedent in other jurisdictions. Second, some states have statutes that place certain limitations on a franchisor's ability to discriminate in connection with franchise sales. Third, some states may have other laws that impose restrictions on franchise sales and franchise transfers. Generally, the federal restrictions on discrimination as a result of race, color creed, etc. will not be applicable because franchises generally (although the law may be changing on this point) are not considered employment relationships. Fourth, the franchisor needs to be careful about what it states in its Franchise Disclosure Document or any other written documents, or orally, about future growth opportunities, or it may end up being subject to a fraud claim. And finally, the franchisor must be certain that it has not entered into any oral or written agreements with a prospective or actual franchisee about growth opportunities.

Notwithstanding these caveats, the black letter law still seems to be that a franchisor has the right to select its franchisees and restrict how many units any franchisee may own.

Rupert M. Barkoff is Chairman of the franchise practice at Kilpatrick, Townsend & Stockton LLC. He is a former chair of the American Bar Association's Forum on Franchising, and co-editor-in-chief of Fundamentals of Franchising, a primer on franchise law. He can be reached at [email protected] or 404-815-6366.

Rare Franchisee Judicial Victory Sets Dangerous Precedent for Franchisors

Most franchisee practitioners will admit that fraud and similar cases are difficult litigation that much more often than not lead to judgments in favor of the franchisor. An exception to this status quo can be found in Legacy Academy v. Mamilove, LLC, 761 S.E. 2d 880, Bus. Franchise Guide '15,336 (Ga. Ct. App. 2014, cert. granted , Nov. 3, 2014), where the franchisee received a victory against a day care center franchisor based on fraud and other theories that are not often franchisee successful. In particular, claims in this case were made under a Georgia statute that, essentially, gives a franchisee an indirect cause of action under the Federal Trade Commission's Franchise Rule, plus the franchisee also asserted claims under the Georgia RICO statute, for negligent misrepresentation, and for rescission.

The most interesting of these theories are the ones granting the franchisee a claim based on the FTC Franchise Rule violation and the fraud claim.

Fraud claims are difficult for franchisees to prevail on because of the numerous hurdles that must be overcome. To prove fraud, a franchisee must show: 1) a certain statement was made; 2) the statement was false; 3) the franchisor must have known of the falsity; 4) the franchisee relied on the statement and the reliance was reasonable; 5) the reliance caused the damages; and 6) the damages are provable. Usually, the reasonableness of the reliance requirement leads to the franchisee's downfall, especially if the franchise agreement contains reliance disclaimers.

In Legacy Academy, the trial court found that the franchisor's earnings claim was excessively optimistic, not based on actual facts, and therefore fraudulent. Normally, the fact that the franchisee did not read the Franchise Disclosure Document and had failed to consult an attorney before buying the franchisee would have resulted in a victory for the franchisor. However, the franchisee proved at trial that the franchisor pressured the franchisee to buy the franchise by representing that if it did not buy the franchise immediately, it would lose the opportunity to open the franchise in a prime location. But through what must have been skillful lawyering, the franchisee was able to prove all the elements of fraud under the circumstances, including reasonable reliance. Normally, a court frowns upon franchise purchasers who do not read the documents they are given to review. Nevertheless, here, the case resulted in a verdict of $1.1 million in favor of the franchisee, and the verdict was affirmed on appeal. The trial court had also found that the franchisees' right to rescind the franchisee made the disclaimers in the franchise agreement invalid.

While fraud decisions in favor of a franchisee are rare, successful private litigant claims based upon the FTC Franchise Rule are extraordinary absent the existence of a statute that specifically makes violation of the FTC Rule a violation of state law. See, e.g., Tenn. St. Ann. 47-18-101 et seq. However, here, the plaintiff invoked a Georgia statute that provided, “when the law requires a person to perform an act for the benefit of another or to refrain from doing an act which may injure another, although no cause of action is given in express terms, the injured party may recover for the breach of such legal duty if he suffers damage thereby.” O.C.G.A. 51-1-6. The franchisor contended that the FTC Franchise Rule allowed a franchisee to file a complaint with the FTC and the FTC, in turn, could have brought an action against the franchisee; thus the Georgia statute was inapplicable because the franchisee did have a cause of action it could have asserted. The court, however, concluded that the Federal Trade Commission Act did not provide a private cause of action, and, therefore, the franchisor's contention that the FTC could have filed a cause of action on behalf of the franchisee was without merit. If this interpretation of the Georgia law remains in place, it would mean that an FTC Franchise Rule violation derivatively gives a franchisee the right to sue for a breach of the FTC Franchise Rule under this statute. This decision, accordingly, makes better balanced the rights of franchisees in skirmishes against their franchisor.

Franchisors Still Fight To Fend Off Claims Of Vicarious Liability

One of the areas of franchise law that deserves the 2014 award for generating a plethora of litigation is vicarious liability.

In the end, there was little change in vicarious liability law in 2014. Many cases claiming franchisors were liable to third parties under one of the theories that serves as the basis for a claim for vicarious liability were brought, but few were successful for the third-party plaintiff.

In Barrett-O'Neill v. Lalo, LLC, ' 15,342 (D. Ohio Aug. 8, 2014), the disappointment of a franchisee's customer was found not to be actionable against the franchisor because the plaintiff failed to prove that the franchisee acted as the franchisor's agent. Although the franchisor provided training and marketing materials and, as the disappointed customer pointed out, he had received a response to his or her complaint only after contacting the franchisor, the level of control necessary to make a franchisor liable to a third party for the acts of its franchisees was absent. There was little proof that the franchisor had the right to control the franchisee's operations. The acts listed above, plus the franchisor providing networking opportunities, conducting meetings with its franchisees, and the presentation of awards to its franchisees by the franchisor, among other things, were insufficient to prove the level of control necessary to hold a franchisor liable for the acts of its franchisees. The court also noted that the evidence presented did not demonstrate that the franchisor held the franchisee out to the public as having authority to act on its behalf. Thus, judgment was granted in favor of the franchisor.

Class Action Qualifications in New Jersey

The leverage of threats of class action proceedings by franchisees against their franchisors are vastly overrated. Or are they? As one looks out over the range of class action claims that are often asserted, frequently one will find an individual threatening to bring a class action, when it is patent on its face that there would be significant hurdles in having the class certified. This is particularly true in many franchise system cases. Often, the franchisees have different forms of agreements. In other circumstances, the claims are very individual to particular franchisees ' there is no commonality. Sometimes the damage claims are highly individualized. And we are seeing more and more franchisee agreements that provide for mandatory arbitration and further provide that class arbitrations will not be permitted. When asserting a class action claim, the franchisee often does not realize that these provisions will kill the class action threat.

One of the primary purposes of class actions is to increase judicial efficiency. Why shouldn't individuals be able to collectively assert claims if this will consolidate numerous similar claims, reduce the number of trials, hearings and motions, and simplify discovery?

Of the factors mentioned above, commonality is frequently one requirement that destroys the possibility of a class action. In a recent New Jersey decision, however, McPeak v. S-L Distribution Co, Inc., Bus. Franchise Guide ' 15,351(D. N.J), a federal trial court concluded that class actions should not be quickly dismissed at an early stage of the litigation on grounds of lack of commonality. In McPeak, the case was based on an alleged breach of the New Jersey Franchise Practices Act. The court noted that some of the allegations in the complaint were personal to the named plaintiff, but nevertheless concluded that discovery should be allowed to determine whether there was more evidence of commonality. The court also noted that there were objective standards that could be used in determining commonality.

The McPeak decision makes it easier for class action complaints to survive early motions for dismissal, thus making it more likely that plaintiffs will have their days in court ' although the number of those days may still be sharply limited. The policy issue this decision raises is whether the McPeak court's ruling undermines the concept of judicial efficiency with its emphasis on allowing plaintiffs to go through some early stage of discovery. It will be interesting to see whether other courts will adopt a similarly liberal interpretation of what it will take for a plaintiff to survive an early motion to dismiss a class action complaint, especially in light of recent changes to the Rules of Civil Procedure and Supreme Court decisions that have made class actions more difficult to pursue.

Franchisor Has Wide Discretion in Deciding Who and How Many Franchises

Two frequently asked questions, especially by start-up franchisors, are: who may I choose not to sell my franchise to, or can I limit the number of franchises I must sell to someone who wants to be, or already is, a franchisee? The answers to both questions are the same: Absent an agreement to the contrary, there are few restrictions on a franchisor's rights to decide who may be a franchisee and how many units he will be entitled to own.

The case at issue, LeCompte v. AFC Enterprises, Inc., Bus. Franchise Guide '15,386 (La. Ct.. App. 2014), was brought under the Louisiana Unfair Trade Practices Act, with the trial court granting summary judgment for the franchisor and that decision being affirmed by the Louisiana Court of Appeals. The appellate court agreed with the trial court that a refusal to grant additional franchises was not an unfair or deceptive act under the Louisiana statute. In LeCompte, the franchisee wanted to develop an additional unit, but the franchisor refused to grant him the right to further develop. The franchisee also tried to buy two existing nearby units, but the franchisor again informed the franchisee that it did not want to “grow with him.” In the end, the franchisor's position was accepted by both the trial and appellate court.

Although LeCompte is in accord with the national “folklore” on franchising, practitioners need to recognize the case's limitation. First, it is a Louisiana state decision, and not binding precedent in other jurisdictions. Second, some states have statutes that place certain limitations on a franchisor's ability to discriminate in connection with franchise sales. Third, some states may have other laws that impose restrictions on franchise sales and franchise transfers. Generally, the federal restrictions on discrimination as a result of race, color creed, etc. will not be applicable because franchises generally (although the law may be changing on this point) are not considered employment relationships. Fourth, the franchisor needs to be careful about what it states in its Franchise Disclosure Document or any other written documents, or orally, about future growth opportunities, or it may end up being subject to a fraud claim. And finally, the franchisor must be certain that it has not entered into any oral or written agreements with a prospective or actual franchisee about growth opportunities.

Notwithstanding these caveats, the black letter law still seems to be that a franchisor has the right to select its franchisees and restrict how many units any franchisee may own.

Rupert M. Barkoff is Chairman of the franchise practice at Kilpatrick, Townsend & Stockton LLC. He is a former chair of the American Bar Association's Forum on Franchising, and co-editor-in-chief of Fundamentals of Franchising, a primer on franchise law. He can be reached at [email protected] or 404-815-6366.