Corporate
Jul. 23, 2002
Differing Cases Fuel Confusion About Franchise Termination for Violation of Law
Focus Column - By Mitchell S. Shapiro Virtually every well-drafted franchise agreement contains an "obey all laws" clause. A typical clause might read, "Franchisee agrees to comply promptly with all applicable federal, state and local laws, rules, regulations, ordinances and orders of public authorities."
By Mitchell S. Shapiro
Virtually every well-drafted franchise agreement contains an "obey all laws" clause. A typical clause might read, "Franchisee agrees to comply promptly with all applicable federal, state and local laws, rules, regulations, ordinances and orders of public authorities."
It also is common for the agreement to contain a "good will" provision: "Franchisee shall not do or perform directly or indirectly any act injurious or prejudicial to the good will associated with the proprietary marks of the franchisor."
The reason for such provisions is obvious - to provide the franchisor with a clear basis for termination if the franchisee engages in conduct that the franchisor deems deleterious to the system.
Until recently, it was almost universally the case that, if the franchisor learned of lawbreaking conduct and chose to use that conduct as a reason for termination, the courts upheld the termination. A recent 9th U.S. Circuit Court of Appeals case, Chevron USA Inc. v. El-Khoury, 285 F.3d 1159 (9th Cir. 2002), challenges that assumption and creates some doubt as to whether a violation of law is tantamount to termination.
Before looking at Chevron, it is instructive to consider a case decided in the 1st Circuit only 10 months before, Dunkin' Donuts Inc. v. Gav-Stra Donuts, 139 F. Supp.2d 147 (D. Mass. 2001). There, virtually all of the equities were with the franchisee, yet the District Court upheld a termination based on illegal tax avoidance not significantly different than the tax violation in Chevron.
In Gav-Stra, an inexperienced Greek immigrant, George Stratis, formed a partnership to operate a Dunkin' Donuts franchise with Michael Gavriel. Gavriel was caught inflating invoices from a supplier, obtaining kickbacks and not paying taxes.
He pleaded guilty to conspiracy to defraud the United States and was sentenced to two years probation and a $500 fine. Stratis not only was innocent but also, on learning of the crime, paid back both the government and Dunkin' Donuts all money, with interest.
Notwithstanding that Gavriel was no longer affiliated with the franchise and that Stratis was innocent, Dunkin' Donuts terminated the franchise, brought suit to enforce the termination and moved for summary judgment.
Dunkin' Donuts' position was quite simple: The acts of its franchisee constituted a crime and the conduct was a violation of the obey-all-laws provision and constituted a noncurable default. Therefore, the court must enforce the termination.
In defense, Stratis raised the several equities in his favor: He was without fault; he had repaid all of the money at considerable expense to himself; he was an immigrant with limited employment ability; and he was, in essence, a "whistle blower." Thus, it would violate public policy to terminate him.
But the court agreed with Dunkin' Donuts that the violation was a noncurable default or, as the judge put it, "[T]he genie had been let out of the bottle before defendant had a chance to stop it."
Since the parties had agreed in the franchise agreement that no cure period was available if a franchisee falsified financial data, the court said that it was doing no more than enforcing the parties' agreement.
Gav-Stra is consistent with the many cases dealing with obey-all-laws clauses or similar provisions. See, e.g., Dunkin' Donuts Inc. v. Panagakos, Bus. Franchise Guide (CCH) Paragraph 11,174 (D. Mass. May 13, 1997); Dunkin' Donuts Inc. v. Chieng-Eung Thiem, 93-0419 (C.D. Cal. Mar. 9, 1993); and Palombi v. Getty Oil Co., 501 F. Supp. 158 (E.D. Pa. 1980).
With the Gav-Stra court's rejection of the persuasive equitable defenses of Stratis, the law in the area seemed reasonably well-settled. If a semiliterate immigrant who works hard and pays back all of the damages caused by his co-franchisor's law violation cannot avoid termination, then it would be difficult for any franchisee to prevail.
Yet Samir L. El-Khoury was able to persuade the 9th Circuit that summary judgment is inappropriate and that termination is not a forgone conclusion.
El-Khoury had underpaid California sales tax. Chevron discovered the conduct during an audit and terminated El-Khoury. When El-Khoury questioned Chevron's right to terminate, Chevron brought an action for declaratory relief in the District Court, and Judge Audrey Collins granted summary judgment.
On appeal, El-Khoury argued that the termination was pretextual because there was a history of Chevron trying to induce him to combine his unit with a McDonald's and, failing that, attempting without success to purchase his unit. The court did not decide that issue, commenting instead that there was a question of fact as to whether his failure to pay state sales tax was "sufficiently material to the franchise relationship to allow for its termination."
The Chevron franchise agreement was seemingly unambiguous. The dealer agreed to "comply with all applicable federal, state and local laws and regulations relevant to the use and operation of the premises." That provision was not significantly different from the Gav-Stra provision or those found in most franchise agreements.
But the 9th Circuit relied on 15 U.S.C. Section 2802(b)(2)(A) of the Petroleum Marketing Practices Act, which states "failure by the franchisee to comply with any provision of the franchise, which provision is both reasonable and of material significance to the franchise relationship," is cause for termination.
In the 9th Circuit's view, the use of the word "failure" combined with "relevant to the operation of the marketing premises" reflected a legislative intent that an inquiry be made as to whether the violation of law is material to the franchise relationship. Once the court made such a determination necessary, it was manifest that Chevron's motion for summary judgment would be denied because materiality became a question of fact. Or, as the court said, "whether a violation is a 'failure' that is serious enough to warrant termination can be a question of fact for trial."
The problem with this approach, as was recognized by the 9th Circuit ("we emphasize that not every ground for termination under the PMPA require an inquiry into materiality"), is that many cases involve crimes that are inherently valid cause for termination. It is difficult under El-Khoury to determine how to ascertain when a violation of law is cause for termination and when a law violation will require subjective examination by the court.
Despite its recognition of the problem, the court offered no guidance toward its resolution. El-Khoury acknowledged that he intentionally did not pay sales tax because of financial difficulties and intentionally hid that fact from his franchisor. The equities for El-Khoury, even accepting that Chevron's conduct may have been pretextual, certainly were less than those for Stratis.
One could attempt to create a meaningful distinction between the cases. For example, in Gav-Stra, Dunkin' Donuts had been the victim of adverse publicity, whereas Chevron was only able to speculate as to any damages resulting from El-Khoury's conduct. Also, Chevron involved the Petroleum Marketing Practices Act statute, and Gav-Stra did not.
Such distinctions seem artificial, however, and we are left with a great deal of uncertainty as to when violations of law by a franchisee justify termination.
Mitchell S. Shapiro, a partner at Jenkins & Gilchrist, specializes in franchise law.
Columnist
For reprint rights or to order a copy of your photo:
Email
Jeremy_Ellis@dailyjournal.com
for prices.
Direct dial: 213-229-5424
Send a letter to the editor:
Email: letters@dailyjournal.com