Pre-litigation mediation is being employed successfully more and more in franchise disputes. Both the franchisor and franchisee have significant interests in resolving disputes early before incurring large litigation costs and completely jeopardizing the existing franchise relationship or the entire franchise system. Such benefits include (a) finding a collaborative win-win resolution quickly, (b) giving each party an opportunity to air issues in person, (c) better understanding the other’s issues in efforts to bridge the gap, (d) repairing and salvaging the relationship and (e) strengthening the overall franchised system. As a mediator, I call upon my years of experience to evaluate objectively the strengths and weaknesses of the parties’ arguments helping them to find a resolution without resort to protracted litigation. Facilitating caucuses, evaluating proposals and counterproposals, it is my role to bridge the gaps bringing the parties closer and closer to reach that win-win resolution. Sometimes the resolution in franchise disputes results in repairing and preserve the long-standing relationship. But if not, pre-litigation mediation can be the means to an expedient, respectable, and cost-effective end to the franchise relationship.
COMPLEX ISSUES RESOLVED IN PRE-LITIGATION MEDIATION
In my mediation and long-career experience, most franchise disputes involve a myriad of legal issues including breach of system standards, non-payment of royalty fees, fraud in the inducement, enforceability of a post-term noncompete, recovering lost future royalties and profits, and grounds for rescission. And these are exactly the types of claims that are ripe for pre-litigation mediation. In a recent mediation, all of these issues were at the heart of the dispute.
POST-TERM NONCOMPETE CLAUSES
In many mediations, the franchisee has failed to cure non-payment defaults or meet the operational standards in the system. Franchisee in turn asserts that the franchisor failed to maintain the trademarks, systems, failed to market and promote the business, or provide the training or ongoing assistance promised at the outset. In one of my mediations, following receipt of a default letter from the franchisor, the franchisee believed he could now simply exit the agreement, deidentify, change its signage to a new name, and remain in the same location breaching the noncompete covenant.
The post-term noncompete clause is challenged often. The enforceability in any particular state will depend on the duration of the restriction, the geographical restraint, and whether “blue-penciling” is permitted in the state. In my particular mediation last year, enforceability was challenged because the geographical area was over 30 miles from the “Territory” of the franchisee’s location or any other location in the franchised network. Whether 30 miles was too broad for the type of business was hotly debated. The real dilemma was that the word “Territory” had not been clearly defined in the franchise agreement. The summary terms page of the agreement had only stated “TBD”. What constituted the “Territory” was vague at best. Was it meant to be 30 miles around the actual physical location of the business? Possibly, but it left the door open for the franchisee to contend it was too broad, ambiguous and therefore unenforceable.
FRAUDULENT INDUCEMENT AND RESCISSION
In the above dispute, the franchisee claimed she was fraudulently induced into signing the agreement. Franchisee submitted the franchisor had misrepresented its financial condition by failing to disclose it had received written notice from a former franchisee of an impending lawsuit about to be filed against franchisor. It was further complicated since the threat of litigation related to a prior franchisee’s lawsuit previously disclosed in Item 3 of the franchise Disclosure Document (“FDD”). It begged this question: does Item 3 require a franchisor to disclose its knowledge of an impending lawsuit not yet filed. The simple answer is no. Yet the franchisee argued that it was a significant material change which could affect the financial strength of the franchisor and its ability to meet obligations under the franchise Agreement. As such, it constituted a “material change” and should have been disclosed irrespective of Item 3 requirements.
Based on claims of fraudulent inducement and ambiguity in the contract, the franchisee sought rescission. Claims of rescission, while frequently asserted, are subject to state law, but typically are unsuccessful. For rescission to be successful, it must be sought early, demonstrate often a mutual mistake of fact or claims that but for the fraud in the inducement, the franchisee would have never signed the agreement.
RECOVERY OF LOST FUTURE ROYALTIES AND PROFITS
Almost every franchise dispute will involve claims by the franchisor to recover lost future royalties and profits upon termination for default and failure to cure, or other breach. In my recent mediation, the agreement simply provided that the franchisor was entitled to recover lost future royalties for the remainder of the term without any further detail. Often courts will limit the recovery to a reasonable period for the franchisor to market the territory, resell the area, and mitigate any damage to the brand caused by the franchisee’s breach. Three or maybe four years. Pre-litigation mediation gives the parties the chance to fully evaluate the viability of the franchisor’s recovery. How many years could the franchisee be required to pay? How is the estimated loss calculated? Will the amount need to be reduced to present day value? And the mediator’s role is to help the parties bridge the gap on these issues to resolve it amicably before litigation is the only means left for the parties. In my experience, reaching a mutual agreement on this very issue will drive the parties to settlement on the other issues. And it did in the recent matter I handled.
WHAT HAPPENS IF FRANCHISOR FILES FOR CHAPTER 11 BANKRUPTCY
In this particular mediation, facts were further complicated by a franchisor bankruptcy. The original franchisor had filed for Chapter 11 Bankruptcy before the franchisee was in default and prior to any termination action undertaken.
If a franchisor files for Chapter 11, the bankruptcy laws give a franchisee a limited time to elect to terminate its executory franchise contract before the confirmation of the Plan of Reorganization. Franchisees should engage a bankruptcy lawyer to ensure its rights and options are exercised. In this case, the franchisee missed the window. Claims that might have held legitimacy against the original franchisor, lost merit against the successor franchisor. In most confirmation plans, the successor franchisor will acquire the assets of the franchised business, but not assume any prior debts or claims that might otherwise be made against the original franchisor. The successor franchisor begins with a completely new slate. If the successor takes over, attempts to address the concerns of its remaining and often disgruntled franchisees or undertakes significant contributions of time and effort to improve the system, then the franchisee’s position is weakened.
In the final analysis, I view my role as Mediator as the vehicle to drive the parties to a settlement where both parties feel they have won. Avoiding deep discovery, lengthy litigation preparation, hours of time away from their business at exorbitant expense is a win for both sides. Sometimes giving the franchisee a chance to stay in the system with both parties’ concerns addressed with compromises and renewed vigor is a win for both. But if not, finding the bridge to enable the franchisor and franchisee to part ways expediently, with concessions on both sides, reasonable compensation for damages, and resolving the noncompete to allow the franchisee to operate a business on some level, is certainly a win-win for both. And this is exactly what happened after many long hours of this pre-litigation mediation.
Adele Vespa, Esq.
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