January 6, 2020
By: Thomas M. O’Connell
Citation:
Handel’s Enterprises, Inc. v. Schulenburg, 431 F.Supp.3d 946 (N.D. Ohio 2020).
Executive Summary:
In a reported decision, Judge Barker of the United States District Court for the Northern District of Ohio found that in order to successfully rescind a franchise agreement under the California Franchise Investment Law a franchisee must prove that the violation was willful and the plaintiff relied on the violation in entering into the contract and that the violation caused damages.
Relevant Background:
Plaintiff Handel’s Enterprises, Inc. (“Franchisor”) is an Ohio corporation registered with the California Department of Business Oversight (“DBO”) and authorized to franchise in the State of California. In late March and early April 2015, Franchisor submitted a proposed 2015 franchise disclosure document (“2015 FDD”) to the DBO for registration and approval. On April 13, 2015, the DBO approved the 2015 FDD.
In October 2015, Franchisor met with Defendant Schulenburg (“Franchisee”) to discuss purchasing a franchise in Encinitas, California. On December 17, 2015, Franchisee made a deposit towards the initial franchise fee. On January 11, 2016, Franchisor submitted an application to amend the 2015 FDD. On January 19, 2016, the DBO approved Franchisor’s application (“Amended 2015 FDD”). Also, on January 19, 2016, Franchisee paid the remainder of his initial franchise fee. Two days later–on January 21, 2016–Franchisor provided a copy of the 2015 FDD and not the Amended 2015 FDD. About two months later, Franchisee was apprised of Amended 2015 FDD in response to an inquiry about SBA financing. Franchisor provided a copy of Amended 2015 FDD to Franchisee but Franchisee did not execute it and did nothing further related to SBA financing.
Pursuant to Franchisee’s effective franchise agreement, he opened a location in Encinitas, California and had the first right of refusal in a downtown quarter of San Diego (“Gaslamp District”). For each location, Franchisee had a protected territory radius of __ miles. In addition, the franchise agreement provided a non-compete during the five year term of the agreement and a second non-compete precluded Franchisee from operating an ice cream store within 2 miles of any franchisor location.
About a year and a half after Franchisee entered into the franchise agreement, a dispute between the parties regarding the Gaslamp District store occurred. When they could not resolve that dispute, Franchisee opened an ice cream store in the Gaslamp District. Franchisor and Franchisee filed suit against the other based largely on the California Franchise Investment Law (“CFIL”), and Franchisor was able to obtain a preliminary injunction preventing Franchisee from operating the ice cream store in the Gaslamp District. This matter concerns the Parties cross-motions for summary judgment.
Decision:
The Court’s opinion is quite thorough but the Court’s rulings regarding Franchisee’s request to rescind the franchise agreement is most pertinent. The Court’s reasoning and findings are as follows:
- California Corporations Code s. 31107 provides an exemption from the disclosure requirements for “any offer (but not the sale) by a franchisor of a franchise” made “while an application for renewal or amendment is pending” as long as the prospective franchisee receives all of the following:
- The franchise disclosure document and its exhibits as filed with the commissioner with the application for renewal or amendment.
- A written statement from the franchisor that (1) the filing has been made but is not effective, (2) the information in the franchise disclosure document and exhibits has not been reviewed by the commissioner, and (3) the franchisor will deliver to the prospective franchisee an effective franchise disclosure document and exhibits at least 14 days prior to execution by the prospective franchisee of a binding agreement or payment of any consideration to the franchisor, or any person affiliated with the franchisor, whichever occurs first, showing all material changes from the franchise disclosure document and exhibits received by the prospective franchisee under subdivision (a) of this section.
- The franchise disclosure document and exhibits in accordance with paragraph (3) of subdivision (b) of this section.
Franchisor failed to comply with this section.
- California Corporations Code ss. 31107 and 31119 requires a franchisor to provide a prospective franchisee of the then-effective franchise disclosure and any binding franchise agreement at least 14 days prior to the execution by a prospective franchisee. Franchisor failed to provide Franchisee with its then-effective Amended 2015 FDD when it entered into the franchise agreement.
- California Corporations Code s. 31300 provides that any person who violates certain provisions of the CFIL “shall be liable to the franchisee or subfranchisor, who may sue for damages caused thereby, and if the violation is willful, the franchisee may also sue for rescission.” The Parties dispute whether rescission is allowed where the franchisee did not suffer damages.
- The only case cited by the Parties that is on point is an unpublished opinion, DT Woodard, Inc. v. Mail Boxes Etc., Inc., 2007 wl 3018861 (Cal. Ct. App., Oct. 17, 2007). There, the Court found that in order to obtain rescission, the plaintiff must prove that the violation was willful and the plaintiff relied on the violation in entering into the contract and that the violation caused damages.
- Agreeing with DT Woodard, Inc., the Court provided the following rationale:
“… In addition, the opposing interpretation advocated for by [Franchisee] would give the plaintiff the opportunity to rescind a franchise agreement based on a willful violation without the need to show that the violation ever damaged the plaintiff. This is a perverse result, especially in a situation where a plaintiff seeks to rescind an agreement that has been in place for years based on a statutory violation that did not harm the plaintiff in any way. It is illogical to provide such a drastic remedy without requiring a showing of damages.”
- Franchisee failed to demonstrate how Franchisor’s failures caused him any damages.
As such, the Court granted Franchisor’s Motion for Summary Judgment on this claim for relief.
Looking Forward:
While this is a reported decision in the Northern District of Ohio, California–particularly the California Supreme Court–still has not addressed many questions regarding the operation of California Corporations Code s. 31300. Still, the reasoning of the District Court is sound as both the FTC Rule and its State equivalent enforcement actions largely codify specialized fraud actions against franchisors. Under normal circumstances, to prevail in a fraud action and achieve the remedy of rescission, the common elements that a plaintiff must prove are that it relied on a knowingly (or unknowingly) false representation by the defendant to plaintiff’s detriment. Said differently, even if a defendant knowingly or unknowingly made a false representation to plaintiff that it relied on, so long as the plaintiff did not ultimately suffer any harm, a fraud action will not lie.
So what does this mean going forward?
- For franchisors, this is one more case that they may cite–particularly in District Courts–where an otherwise successful franchisee is seeking to rescind their franchise agreement based on a failure to fully comply with every technical aspect of the CFIL.
- For franchisees, this provides one more example of how important it is to fully plead each and every element of a claim for relief against franchisors that are the equivalent of fraud actions. For instance, had Franchisee plead that there was some material difference between the 2015 FDD and Amended 2015 FDD that actually caused Franchisee harm (i.e., that Franchisee submitted a SBA financing application and could not qualify because it didn’t have the correct documentation), then this matter may have had a different result.
This article was originally published on the California Franchise Network.