OUR FRANCHISE CLIENTS AND FRIENDS GRAY PLANT MOOTY S FRANCHISE AND DISTRIBUTION PRACTICE GROUP. Quentin R. Wittrock, Editor of The GPMemorandum

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1 The GPMemorandum TO: OUR FRANCHISE CLIENTS AND FRIENDS FROM: GRAY PLANT MOOTY S FRANCHISE AND DISTRIBUTION PRACTICE GROUP Quentin R. Wittrock, Editor of The GPMemorandum Iris F. Rosario, Assistant Editor DATE: August 7, 2009 No. 122 This section of The GPMemorandum addresses non-judicial developments, trends, and best practices of interest to franchisors. Reports of recent judicial developments begin on page 3. NEW YORK CREATES EXTENSION PROCESS AND CLARIFIES ISSUES RELATING TO NEW FRANCHISOR TAX REPORTING REQUIREMENTS As reported in our last issue of The GPMemorandum, New York recently enacted a new tax law that imposes unprecedented new reporting requirements on franchisors that have at least one franchisee in New York that is required to collect sales tax. To provide further detail as to these reporting requirements, on July 7, 2009, the New York Department of Taxation and Finance issued an informational statement titled, New Requirement for the Filing of Information Returns for Franchisors. This document is available at In reaction to the new law, on July 20, 2009, IFA President Matthew Shay wrote a letter to the Acting Commissioner of the Department of Taxation and Finance requesting an extension of at least 90 days for the first and all subsequent reporting deadlines, pointing out the near impossibility for many franchisors of collecting data regarding third-party supplier sales to franchisees and seeking to clarify the use of the term gross sales in the guidelines. Yesterday the IFA reported that it received a response from New York that contains good news for franchisors. According to the IFA, New York is creating an automatic 90-day extension process for all reporting deadlines and will post on its web site instructions for requesting extensions. Franchisors requesting an automatic extension of their first reporting deadline (September 20, 2009), will have it extended to December 20, 2009, and franchisors requesting an automatic extension of any future March 20 deadline will have it extended to 1

2 June 20. In addition, in what should come as a relief to many franchisors, New York has notified the IFA that while franchisors must still report in their returns the amount of sales they or their affiliated companies make to franchisees, New York is dropping the requirement that franchisors report sales designated or approved suppliers make to franchisees. Finally, according to the IFA, New York has clarified that if a franchisor uses a performance measure other than a percentage of gross sales, an explanation of that performance measure, as well as any quantitative data for the relevant reporting period, still must be reported to the state. UPDATE ON RED FLAGS RULE As we previously discussed in Issue No. 115 of The GPMemorandum (January 21, 2009), the new federal Red Flags Rule requires certain businesses to establish written programs to detect, identify, and respond to signs of possible identity theft. The rule is aimed at reducing identity theft by making it more difficult for identity thieves to use stolen identity information to purchase goods or services. Enforcement by the Federal Trade Commission was set to begin August 1, 2009, but has now been delayed (again) until November 1, Application of the Red Flags Rule. The Red Flags Rule applies to creditors with covered accounts. Businesses are considered creditors under the rule if they regularly extend credit, for example, by deferring payments owed, by allowing purchases of items on credit, or by arranging or providing financing. Under the rule, however, businesses are required to have a written identity theft program only if they have covered accounts. Covered accounts include accounts with individuals for personal or household purposes or any accounts that have risk of identity theft. The FTC has issued guidance to franchisors to assist in evaluating whether a franchisor is subject to the Red Flags Rule: In some franchise systems, the franchisor may not be subject to the Rule but the franchisees are covered (for example, franchised businesses that provide services on Net 30 payment terms). The FTC recently issued an easy do-it-yourself Identity Theft Prevention Program for use by companies that only have a low risk of identity theft, and this online tool may be useful for franchisees that are covered: Compliance with the Red Flags Rule. If a business has covered accounts, the Rule requires it to develop a written program to detect, prevent, and mitigate identity theft by noting Red Flags indicating possible theft. The warning signs may include forged or altered photo identifications or documents, invalid Social Security numbers, the use of an account that has been inactive for a long period, or signals of possible identity theft discovered during a credit check, such as fraud alerts, address discrepancies, and 2

3 credit freezes. The Rule is flexible in that the compliance program should be tailored to the nature and risk of the business. RECENT CASES Here are summaries of recent cases of interest to franchisors: SYSTEM STANDARDS/CHANGE ELEVENTH CIRCUIT UPHOLDS BURGER KING S RIGHT TO ENFORCE MENU CHANGE AND ITS PROCEDURE FOR DOING SO The United States Court of Appeals for the Eleventh Circuit recently affirmed summary judgment in favor of Burger King Corporation in a case arising out of its termination of multiple franchise agreements based on a franchisee s refusal to implement the Burger King Value Menu. In Burger King Corporation v. E-Z Eating, 41 Corporation, 2009 WL (11th Cir. June 30, 2009), a franchisee with four financially distressed Burger King locations in New York City refused to implement Burger King s required menu or to submit a written application to be excused from the requirement. Instead, in response to a demand for compliance from Burger King s legal department, the franchisee s attorney sent letters to Burger King s in-house counsel stating his belief that his client qualified for an exception and asking the lawyer to call to discuss the matter. Ultimately, Burger King terminated all of the franchise agreements as a result of the franchisee s failure to adopt the Value Menu. In affirming the summary judgment enforcing the termination, the Eleventh Circuit found Burger King squarely within its rights to require its franchisees to implement the Value Menu, stating the Franchise Agreements provided that the franchisee agrees that changes in the standards, specifications and procedures may become necessary and desirable from time to time and agrees to accept and comply with such modifications... There is simply no question that [Burger King] had the power and authority under the Franchise Agreements to impose the Value Menu on its franchisees. The court also found that the letters from the attorney did not meet Burger King s requirements for a request for an exception, noting both that they were addressed to in-house counsel rather than the appropriate division vice president (as required) and that neither letter actually asked for a specific exception... specified which of the three exceptions [the franchisee] sought, or why they qualified under a particular exception. In sum, the decision upheld Burger King s right to enforce implementation of the Value Menu policy and to establish and require strict compliance with internal procedures for 3

4 complying with the policy, such as the requirement that applications for exception be submitted in writing to a particular officer. NON-COMPETE COVENANTS GEORGIA COURT RESTRICTS IN-TERM COVENANTS AGAINST COMPETITION In Atlanta Bread Company Int l, Inc. v. Lupton-Smith, 2009 WL (Ga. June 29, 2009), the Georgia Supreme Court held that in-term and post-term covenants against competition in franchise agreements are subject to a strict scrutiny standard of review, rendering them more difficult to enforce in Georgia. In this case, the franchise agreements between Atlanta Bread Company International, Inc. ( ABCI ) and the franchisee prohibited the franchisee from owning or engaging in any bakery/deli business whose method of operation is similar to that employed by store units within the System. The post-term covenant prohibited the franchisee from engaging in a competing business within 20 miles of any Atlanta Bread Company store for one year. During the term of the franchise agreements, the franchisee opened a PJ s Coffee & Lounge in the same city as four of his ABCI franchises. Soon after, ABCI terminated the franchise agreements, alleging that the operation of PJ s Coffee & Lounge was a breach of the in-term non-compete covenant. The Georgia Supreme Court affirmed the court of appeals ruling that the in-term covenant was not enforceable because it was not limited to a specific territory. The high court disagreed with ABCI s argument that the covenant was a loyalty covenant rather than a covenant against competition, stating that [a] plain reading of the clause shows that it prohibits the franchisee from engaging in a certain type of business during the term of the parties agreement and, thus, it is a partial restraint of trade designed to lessen competition. The court held that restrictive covenants in franchise or distributorship agreements are subject to the same level of strict scrutiny applied to restrictive non-competition covenants found in employment agreements. This level of strict scrutiny is to be applied to restrictive covenants in franchise agreements, the court held, regardless of when they are in effect. The court further held that because in-term covenants against competition are subject to strict scrutiny, they cannot be bluepenciled under Georgia law, meaning that the court could not insert a territorial restriction to render the covenant enforceable. In light of this case, franchisors who have franchises governed by Georgia law will need to make sure they carefully set a territory covered by any non-competition covenants. 4

5 TERMINATIONS SIXTH CIRCUIT AFFIRMS SUMMARY JUDGMENT IN FAVOR OF WENDY S The Sixth Circuit recently affirmed a summary judgment ruling by an Ohio federal district court in favor of plaintiff Wendy s International, Inc. on all claims brought against it by a franchisee. Wendy s International, Inc. v. Saverin, 2009 WL (6th Cir. July 9, 2009). The franchisee operated 42 stores in Missouri and Illinois. In 2006, the franchisee began defaulting on its financial obligations, leading Wendy s to terminate three of its franchise agreements. The parties subsequently reinstated the franchises through a reinstatement agreement that required the defendant to cure certain financial defaults. The defendant, however, continued to experience financial difficulties, which led the parties to enter into a forbearance agreement to facilitate the winding down of their relationship. But the defendant defaulted on a payment to Wendy s shortly after the forbearance agreement was signed. Despite notice and the opportunity to cure, the defendant failed to cure its financial defaults. A state court ultimately appointed a receiver for the franchises. Accordingly, Wendy s terminated the franchise agreements. Wendy s filed a complaint for breach of contract in federal court, claiming that the defendant was individually liable under his personal guaranty for obligations incurred under the franchise, reinstatement, and forbearance agreements. The defendant denied liability and brought counterclaims based on Wendy s alleged breach of the forbearance agreement and of the implied covenant of good faith and fair dealing contained in the forbearance agreement. The defendant s theory was that Wendy s breached a good faith obligation to oppose the appointment of the receiver, which then triggered Wendy s right to terminate the franchise agreements. The district court granted Wendy s motion for summary judgment and dismissed the defendant s counterclaims. In affirming the lower court s summary judgment ruling, the Sixth Circuit found that, pursuant to the forbearance agreement, Wendy s properly terminated the defendant s franchise agreements based on the financial defaults. The court rejected the defendant s counterclaim that Wendy s violated the implied covenant of good faith by taking action that allegedly hastened the appointment of a receiver over the franchises. First, the court held that where a contract contains an integration clause, as did the forbearance agreement, extrinsic evidence could not be used to prove an additional promise in this case, an alleged promise to oppose a receivership that was not included in the express terms of the agreement. Second, the court held that under Ohio law, the implied covenant is only implicated by acts or omissions that could not have been contemplated at the time of drafting and therefore were not explicitly addressed by the contract. The court found that the possible appointment of a receiver 5

6 was of the utmost concern when the forbearance agreement was drafted, so the implied covenant did not apply. Finally, the Sixth Circuit also affirmed summary judgment in favor of Wendy s on its claims under the personal guaranty. The court found that all of the financial obligations under the forbearance agreement were within the scope of the guaranty. It rejected the defendant s claim that he was entitled to a setoff based on the profits Wendy s would earn by refranchising his restaurants or opening company-owned restaurants in his market. The court found this to be based on the speculative assumptions that Wendy would reopen each restaurant and that it would earn more in profits from company-owned locations than it would have earned from the defendant s restaurants if they had continued operating. FRANCHISOR DID NOT WAIVE ITS RIGHT TO TERMINATE FOR NONPAYMENT A Florida federal court recently granted an injunction to franchisor Dunkin Donuts for the franchisee s failure to pay franchise and advertising fees and to comply with the post-termination provisions of the franchise agreements. The case is Dunkin Donuts Franchised Rest. LLC v. KEV Enter., Inc., 2009 WL (M.D. Fla. June 5, 2009). At issue was whether the franchisor had waived the right to terminate based on nonpayment. The franchisee contended that Dunkin Donuts tolerated late payment and therefore waived the right to terminate it on those grounds. The court disagreed and sided with Dunkin Donuts that the letters exchanged between the parties concerning nonpayment specifically stated that the franchisor was not waiving any of its rights and claims. This was further bolstered by the franchise agreements, which also contained this anti-waiver language. The court held that the parties course of dealing was not sufficient to modify the terms of the franchise agreements and was, in any event, not supported by any consideration. The court held that, under Massachusetts law, which requires a showing of clear, decisive and unequivocal conduct of waiver, the franchisee had failed to meet its burden. Gray Plant Mooty represented Dunkin Donuts in this case. NEW JERSEY FEDERAL COURT HOLDS THAT HOTEL FRANCHISOR PROPERLY TERMINATED FRANCHISE AGREEMENT In Ramada Worldwide, Inc. v. RIP Management Group Corp., 2009 WL (D.N.J. June 25, 2009), Ramada terminated the franchise agreement after the franchisees failed to cure certain quality assurance defaults. The franchisees argued that the termination was wrongful and that Ramada unfairly and inconsistently conducted the quality assurance inspections with the intention of defaulting them in breach of the covenant of good faith and fair dealing under New Jersey law. 6

7 On Ramada s motion for summary judgment, the court held that the express terms of the franchise agreement allowed Ramada to make unlimited and unannounced inspections to determine whether the franchisees hotel was in compliance with Ramada s quality requirements. The court also determined that the franchise agreement unequivocally granted Ramada the authority to terminate the agreement if any quality assurance defaults were not cured. Finally, the court found that there was no evidence of bad faith or improper motive on behalf of Ramada. Specifically, there was no evidence that Ramada intentionally assigned failing scores to the inspections in an effort to deprive the franchisees of the benefits of the franchise agreement. Accordingly, the court dismissed the franchisees good faith and fair dealing claim and granted judgment, as a matter of law, in favor of Ramada on its breach of contract claims, including the franchisees failure to pay liquidated damages. FRANCHISEE ASSOCIATIONS COURT REFUSES TO ORDER FRANCHISOR TO PAY FOR NONPARTY FRANCHISEE ASSOCIATION S DISCOVERY COSTS In Sound Security, Inc. v. Sonitrol Corp., 2009 WL (W.D. Wash. June 26, 2009), franchisor Sonitrol served nonparty discovery requests on the Sonitrol National Dealers Association ( SNDA ), an association of Sonitrol franchisees. SNDA moved the court for an order shifting the costs of complying with those discovery requests to Sonitrol, arguing that as a nonparty to the litigation, it should not be required to bear the cost of responding. The court denied that motion and ordered SNDA to bear its own costs and attorneys fees. The court found that Sonitrol s discovery requests were reasonable and not excessive, and noted Sonitrol s efforts to reduce the cost of complying with them. The court also found that SNDA had its own interest in the outcome of the litigation as the association for Sonitrol franchisees, and held that a nonparty to litigation cannot shift its discovery costs if it has a substantial interest in the outcome of the case. SNDA s interest was shown by its willingness to expend tens of thousands of dollars in attorneys fees in responding to discovery requests directed to the franchisee, not to SNDA itself. This case illustrates the high degree of federal district courts discretionary control over the allocation of discovery costs. Under Federal Rule of Civil Procedure 45(c)(2)(B)(ii), a court order compelling production or inspection must protect a person who is neither a party nor a party s officer from significant expense resulting from compliance. Although the court acknowledged that the expenses for which SNDA sought reimbursement, including fees, were significant (more than $86,000), it applied equitable factors and left SNDA to bear those expenses itself, requiring Sonitrol to reimburse only SNDA s copying and mailing costs, as it had volunteered to do. 7

8 ARBITRATION SUPPLIER CANNOT COMPEL ARBITRATION BECAUSE IT WAS A NONSIGNATORY TO THE DEALERSHIP AGREEMENT The Eighth Circuit last month held that a supplier could not compel arbitration of a dealer s cross-claim against it under the arbitration clause of the dealer agreement because the supplier was not a party to that agreement. In so ruling, the Eighth Circuit reversed the district court, which had found that arbitration could be compelled. The appellate decision is Donaldson Co., Inc. v. Burroughs Diesel, Inc., No (8th Cir. July 20, 2009). The supplier argued that although it was not a party to the dealer agreement, arbitration was required because the dealer s claim was premised on the existence of the agreement and because the dealer had previously alleged that the supplier acted in concert with the manufacturer, which was able to compel arbitration. The Eighth Circuit held that while in certain instances nonsignatories may be able to compel arbitration pursuant to an underlying agreement, such was not the case here because the supplier could not establish a sufficiently close relationship to the dealer. In addition, the supplier had failed to demonstrate that the cross-claim arose out of or related to the agreement. Finally, the court held that even though the cross-claim did have allegations in common with the claim against the manufacturer, there were no allegations that the two acted in concert or were sufficiently intertwined such that arbitration could be compelled on the claim against the supplier. FRANCHISE SALES/FRAUD DISCLAIMERS IN FRANCHISE DOCUMENTS HELP DEFEAT FRANCHISEE S SALES FRAUD CLAIMS AGAINST COLD STONE In Cold Stone Creamery, Inc. v. Lenora Foods I, LLC, 2009 WL (11th Cir. June 3, 2009), the Eleventh Circuit Court of Appeals affirmed a decision dismissing franchisee Lenora s counterclaims against Cold Stone Creamery, Inc. under the Florida Franchise Act and the Florida Deceptive and Unfair Trade Practices Act. The court dismissed these claims due, in part, to specific statements in Cold Stone s franchise documents encouraging franchisees to conduct independent investigations before purchasing a franchise and notifying franchisees of the risks in purchasing a franchise. In its first counterclaim, Lenora alleged that Cold Stone violated the Florida Franchise Act by misrepresenting Lenora s ability to succeed if it purchased a Cold Stone franchise. The district court granted Cold Stone s summary judgment motion on the 8

9 counterclaim, and the Eleventh Circuit affirmed, finding that Lenora failed to provide the court with evidence that it relied on any misrepresentation. In particular, the court noted that Cold Stone provided Lenora with a detailed disclaimer about the risks of purchasing a franchise and encouraged it to conduct its own independent investigation. Further, the court found that the parties franchise agreement did not guarantee Lenora s success. Finally, the record demonstrated that Lenora had conducted an independent investigation and understood the franchise agreement it signed. In its second counterclaim, Lenora alleged that Cold Stone violated the Florida Deceptive and Unfair Trade Practices Act. In particular, Lenora alleged that before the sale of the franchise, two franchisees who appeared to be acting as agents of Cold Stone made statements to Lenora about the chances of success if it purchased a franchise. The district court granted Cold Stone s summary judgment motion, and the Eleventh Circuit affirmed, finding that Lenora failed to prove that the alleged actions were likely to deceive a consumer acting reasonably in the same circumstances. The court noted that the franchise agreement stated that franchisees cannot make financial representations on Cold Stone s behalf. In addition, Cold Stone provided Lenora with a financial performance representation that contained specific disclaimers notifying prospective franchisees that they may not achieve the same results. As a result, the court concluded that no reasonable consumer would have been deceived by the two franchisees statements. PENNSYLVANIA COURT ALLOWS SOME CLAIMS TO PROCEED AGAINST QUIZNO S After three years of difficult litigation across the country, a United States Magistrate Judge in Pennsylvania once again has dissected Quiznos ongoing franchise battle in Martrano v. Quiznos Franchise Co., 2009 WL (W.D. Pa. June 15, 2009). In analyzing Quiznos motion to dismiss, the Pennsylvania court issued a decision with heavy citation to a Wisconsin court s treatment of a similar Quiznos motion to dismiss in Westerfield v. Quizno s Franchise Co., LLC (see Issue 101 of The GPMemorandum). The Pennsylvania court then dismissed only the franchisees claims of criminal theft (finding no private cause of action), and antitrust violations under the Sherman Act (finding franchisee s Quick Service Toasted Sandwich Restaurant Franchise a bit too narrow to constitute the relevant market). The court found the rest of the franchisees claims, which included several RICO claims, fraud in the inducement, breach of contract, and breach of covenant of good faith and fair dealing, to be much too factually disputed to be dismissed as a matter of law. Similar cases are pending in Wisconsin and Colorado. 9

10 Minneapolis, MN Office John W. Fitzgerald, cochair ( ) Megan L. Anderson ( ) Wade T. Anderson ( ) Phillip W. Bohl ( ) Jennifer C. Debrow ( ) Elizabeth S. Dillon ( ) Collin B. Foulds ( ) Michael R. Gray ( ) Laura J. Hein ( ) Kelly W. Hoversten ( ) Franklin C. Jesse, Jr. ( ) Cheryl L. Johnson ( ) Jeremy L. Johnson ( ) Gaylen L. Knack ( ) Kirk W. Reilly, cochair ( ) Kate G. Nilan ( ) Craig P. Miller ( ) Bruce W. Mooty ( ) John W. Mooty ( ) Kevin J. Moran ( ) Max J. Schott II ( ) Daniel R. Shulman ( ) Jason J. Stover ( ) Michael P. Sullivan, Sr. ( ) Michael P. Sullivan, Jr. ( ) Henry Wang ( ) Lori L. Wiese-Parks ( ) Quentin R. Wittrock ( ) Washington, DC Office Robert Zisk, cochair ( ) Arthur I. Cantor ( ) Jimmy Chatsuthiphan ( ) Ashley M. Ewald ( ) Jeffrey L. Karlin ( ) Peter J. Klarfeld ( ) Iris F. Rosario ( ) Stephen J. Vaughan ( ) Katherine L. Wallman ( ) David E. Worthen ( ) Eric L. Yaffe ( ) Carl Zwisler ( ) Wrote or edited articles for this issue. For more information on our Franchise and Distribution practice and for recent back issues of this publication, visit the Franchise and Distribution practice group at GRAY PLANT MOOTY 500 IDS Center Suite 1111 The Watergate 80 South Eighth Street 2600 Virginia Avenue, N.W. Minneapolis, MN Washington, DC Phone: Phone: Fax: Fax: The GPMemorandum is a periodic publication of Gray, Plant, Mooty, Mooty & Bennett, P.A., and should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and you are urged to consult your own franchise lawyer concerning your own situation and any specific legal questions you may have. 10