David J. Kaufmann

The U.S. District Court for the Southern District of New York had the opportunity once again to review the subject matter jurisdictional scope of the New York Franchise Act in Safe Step Walk In Tub Co. v. CKH Industries, 2017 WL 1050126 (S.D.N.Y. 2017), in which plaintiff—the manufacturer of walk-in bathtubs—commenced an action for unpaid fees from a dealer of those tubs. The dealer-defendant counterclaimed that plaintiff was in fact a “franchisor,” as that term is defined in the Act, and plaintiff sought to dismiss inter alia that assertion for failure to state a cause of action.

After noting that the defendant plausibly alleged a substantial association with plaintiff’s trademark and service mark, that a marketing plan prescribed in substantial part by plaintiff was imposed upon defendant, and that the agreement called for the payment of a $10,000 “licensing” fee, the court held that defendant’s operation qualified as a “franchise” under the New York Franchise Act, entitling it to pursue the Act’s protections and causes of action “at this stage.”

However, the court observed that, as this Commentary frequently addresses, the New York Franchise Act has a three-year statute of limitations which begins to run upon the “act or transaction constituting the violation,” universally held to be the date on which the subject franchise agreement is executed. Thus, observed the court, since more than three years had passed before defendant’s New York Franchise Act claim was asserted, no claim could be advanced based on failure to provide disclosure as required by the Act, but claims based on failure to renew the relationship or constructive termination of the agreements would not be barred since those events accrued within three years of defendant filing its counterclaims.

In Safe Step, we once again encounter the principle that regardless of how a relationship is denominated (in this case, the agreement was referred to as a “dealership/license agreement”), if the New York Franchise Act’s definitional elements are present in the relationship, then at law that relationship is actually a “franchise” and subject to the requirements, protections and prohibitions of the New York Franchise Act.

Damages for Post-Termination Violation of Covenant Not to Compete

In what the author views as a dangerous and ill-advised decision, the U.S. District Court for the District of New Jersey (interpreting and applying the New York Franchise Act), in Mister Softee, Inc. et al. v. Amanollahi, 2016 WL 5745105 (D.N.J. 2016), considered a motion by plaintiff Mister Softee for summary judgment permanently enjoining a terminated franchisee from using Mister Softee’s name and marks and seeking lost future profits from that franchisee.

Mister Softee was granted summary judgment on its request for a permanent injunction against defendant’s use of its name and mark, for monies due under promissory notes, and its entitlement to attorney fees.

Most troubling, however, was the court’s denial of summary judgment with respect to Mister Softee’s entitlement to lost future royalties in the amount of $462,400. The court entirely denied this branch of Mister Softee’s motion for summary judgment, citing to the infamous California case of Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 428, 1704 (1996), holding:

Here, Mister Softee decided to terminate (the defendant’s) Franchise Agreements because (defendant) moved his trucks out of (an agreed upon depot) and stopped making payments under the Truck Notes. Mister Softee faced a choice: terminate the Agreements, or remain with the Agreements and sue for the ongoing unpaid royalties. It chose the former. On the record currently before me, (Mister Softee) is not as a matter of law entitled to future royalties under the Franchise Agreements. (Mister Softee’s) motion for summary judgment must be denied on this count.

This decision in Mister Softee follows the same flawed logic of its original progenitor, Postal Instant Press. This purported logic would require a franchisor whose franchisee has stopped paying royalties or any other fees but nevertheless continues to operate its franchised business either to permit that franchisee to do so and continually sue for unpaid sums due or terminate the franchise but as a consequence forfeit any right to lost future royalties. This makes little legal or practical sense.

First, it would have been one thing to observe that Mister Softee was not entitled to the full $462,400 (for defendant’s 22 franchises) in lost future royalties it was seeking (the minimum $3,400 per year royalty fee multiplied by the number of years remaining in the terms of the franchise agreements), since a franchisor such as Mister Softee—like all other parties seeking damages—has a duty to mitigate its damages. Under mitigation theory, Mister Softee would ordinarily be awarded all lost future royalties for the period of time it reasonably would have taken it to put in place successor franchisees (or to capture the total amount of lost future royalties if it could conclusively demonstrate that it had no ability to secure and put in place successor franchisees).

But to cut off altogether a franchisor’s right to secure lost future royalties from a terminated franchisee due to the fact that the franchisor technically terminated the franchise agreement is quixotic. After all, it was Mister Softee’s franchisee who triggered termination of the subject franchise agreements by persistently, repeatedly and materially breaching same. That is, it was the franchisee’s conduct which gave rise to its franchise termination, not some arbitrary and capricious termination forthcoming from Mister Softee. We thus must question why it is that Mister Softee was held not to be entitled to those damages which any other party to a contract terminated due to the other party’s material breach is routinely awarded—lost future profits (in this case, royalties) subject to the non-breaching party’s duty to mitigate such a damage award if at all possible.

(Interestingly, the court adverted to this contradiction in footnote 17 of its opinion: “It also does not seem equitable that Mister Softee may, without any effort to mitigate, simply collect up to ten years’ worth of royalties on an agreement terminated. In connection with the preliminary injunction, I found that two years was a reasonable duration for the non-compete, because that was an adequate time for Mister Softee to obtain substitute franchisees.”)

So it is that the Mister Softee decision adverts to the standard law of damages (lost future profits minus diminution thereof following mitigation of damages analysis) but then entirely disregards same in its opinion.

Moreover, not only does the opinion in Mister Softee clash with the traditional law of damages (and, with the very few exceptions noted in the court’s opinion, virtually every other decision nationwide regarding a franchisor’s entitlement to recover lost future royalties from terminated franchisees), it also invites a course of conduct which is time consuming, expensive and extraordinarily wasteful of judicial resources. If, as the court in Mister Softee suggests, a franchisor cannot terminate the franchise agreement of a franchisee who persistently and repeatedly fails to make royalty and other payments due to the franchisor, but must instead serially sue the franchisee for such amounts owed, then the time devoted to legal actions with this one defaulting franchisee; the burdensome and significant legal fees associated with such activity; and, perhaps most significantly, the judicial time and resources which will have to be allocated to such serial litigation will prove entirely inordinate, unnecessary and diseconomic.

We know from decades of decisions that the predilection of New Jersey’s judiciary is extraordinarily “pro franchisee.” However, we do not believe that this predilection and desire to protect franchisees should negate a franchisor’s ability to recover those damages which every other party is entitled to as a matter of law.

Vicarious Liability

Rejecting once again an effort by a consumer injured in a franchised unit to have the franchisor held liable under “vicarious liability” theories, the Appellate Division, First Department, held in quite clear terms that: “(D)efendant 7-Eleven, Inc. is not liable by virtue of its franchise agreement with defendant (franchisee), pursuant to which it relinquished control of the day-to-day operations of the store, including maintenance, to (the franchisee)” in O’Sullivan v. 7-Eleven, Inc. et al., 151 A.D.3d 658 (1st Dept. 2017). Accordingly, the court held that the Supreme Court’s grant of summary of judgment to 7-Eleven was proper.

In a similar (but more unusual) vein, the court in Louis v. Jerome, 2016 WL 4532115 (E.D.N.Y. 2016), rejected the claim of a Liberty Tax Service customer that the franchisor of Liberty Tax Service (JTH Tax Inc. d/b/a Liberty Tax Services) was vicariously liable for its franchisee’s purported violations of federal mail fraud, wire fraud and RICO statutes as well as allegations that the franchisee violated state laws pertaining to fraud, conversion, unjust enrichment and intentional infliction of emotional distress. Rejecting plaintiff’s contention, the court observed:

Plaintiff alleges that JTH is responsible for the acts of its franchisees … She claims that since JTH “exercises strict control over the manner and means by which franchisees operate their businesses,” those franchisees are agents of JTH (citation to Complaint omitted).

… (T)he complaint alleges no facts indicating that JTH derives any substantial benefit from the fraud. As the complaint does not allege activity by JTH sufficient to hold it vicariously liable for the RICO claims, JTH’s motion to dismiss those claims is granted…

… A franchisor may be held accountable for the acts of its franchisee if the franchisor exercised such complete control over the day-to-day operations of the franchisee’s business that its purported independence may be fairly dismissed as a fiction (internal quotation marks and citation omitted) … There is not a single specific allegation (in the Complaint) as to JTH’s daily activities or involvement in (the subject) franchise. Considering plaintiff’s allegations in the light most favorable to her, she has not alleged that JTH exercise control over the daily operations of these franchises sufficient to impose liability upon the franchisor…

Accordingly, JTH’s motion to dismiss was granted and it was terminated as a defendant in this action (with the case remaining open as to plaintiff’s claims against the franchisee-defendants).

A warning that a franchisor should not move too soon for summary judgment in a vicarious liability action was imparted in Stern v. Starwood Hotels and Resorts Worldwide, 54 Misc. 3d 203, 38 N.Y.S.3d 789 (Sup. Ct., N.Y. Cty. 2016) aff’d. 149 A.D.3d 496, 52 N.Y.S.3d 58 (1st Dept. 2017). In this action, a guest at a franchised Sheraton hotel—a brand owned by defendant Starwood Hotels and franchised by one of its subsidiaries—filed a “slip and fall” personal injury action against Starwood and Starwood moved for summary judgment dismissing that branch of plaintiff’s complaint. After observing the well-established law that “… franchisor Sheraton exercised insufficient control of the day-to-day operations of the franchisee to give rise to a duty in negligence,” the court nevertheless denied Starwood’s motion for summary judgment as premature because “… the precise interrelationship among the various entities involved here and their responsibilities to the hotel had not yet been the subject of defendant’s deposition, and knowledge about the relationship and responsibilities between the various corporate entities is solely within the control of defendant, not of plaintiff … Where essential facts to justify opposition to a motion for summary judgment might exist, but cannot be stated because they are in the moving party’s exclusive knowledge or control, summary judgment must be denied (citations and internal quotation marks omitted).”

Affirming the Supreme Court’s decision, the Appellate Division, First Department, observed that plaintiff “… submitted evidence that Starwood’s reservations website holds the hotel out to the public as a Starwood property, and that plaintiff relied on the representations on Starwood’s website in choosing to book a room at the hotel. This evidence of public representations and reliance may support a finding of apparent or ostensible agency, which may serve as a basis for imposing vicarious liability against Starwood (citations omitted). Although the license agreement required (the franchisee) to disclose that it was an “independent legal entity operating under license” from Sheraton and to place “notices of independent ownership” on the premises, Starwood did not provide any evidence that (the franchisee) complied with those requirements.

David J. Kaufmann is senior partner of Kaufmann Gildin & Robbins and authored the New York Franchise Act while serving as Special Deputy Attorney General of New York.