February 22, 2019
By: Thomas M. O’Connell
United Studios of Self Defense, Inc. v. Rinehart, 2019 WL 1109682 (C.D.Cal. Feb. 22, 2019).
In an unreported decision, Judge Carter of the United States District Court for the Central District of California denied Plaintiff’s Motion to Strike and granted in part Plaintiff’s Motion to Dismiss certain counterclaims against it. While not entirely novel, the critical lessons from the case include just how long a State enforcement action against a franchisor can be used by litigants against it, how claims for relief that are not titled as franchise claims can be deemed as such if the gravamen of the claim for relief relates to franchise law, and what restrictions a franchisor can place on a franchisee’s communications with and association with other franchisees.
In 1992, United Studios of Self Defense, Inc. (“USSD” or “Plaintiff”) began licensing and franchising its system for operating martial arts studios under the USSD brand name. In 1996, the California Commissioner for Corporations (the “State”) revoked USSD’s franchise registration. In 1996, the State filed a complaint against USSD for further violations of California franchise law. Less than a month after filing that complaint, the State and USSD entered into a stipulated final judgment that permanently enjoined USSD and its related parties from, among other things, offering to sell franchises (the “Injunction”). Following the Injunction, USSD began entering into license agreements that (i) prescribed a system for which the licensee would operate its unit; (ii) the system used USSD’s trademarks; and (iii) the licensee was required to pay a fee for using the system and trademarks.
On June 13, 2018, USSD filed a complaint against a licensee personally and his respective studios. USSD amended the complaint on September 14, 2018, adding defendants and alleging twelve claims for relief including various breach of franchise agreements claims and declaratory relief actions voiding certain license agreements. Defendants filed a counterclaim against USSD seeking declaratory relief that would rescind the franchise agreements and license agreements among other claims for relief. USSD filed a motion to dismiss seven of eight of those claims as well as a motion to strike portions of Defendants’ counterclaim that referenced a prior lawsuit against USSD and the State’s enforcement action.
Motions to strike are “generally not granted unless it is clear that the matter to be stricken could have no possible bearing on the subject matter of the litigation.” LeDuc v. Ky. Cent. Life Ins. Co., 814 F. Supp. 820, 830 (N.D.Cal. 1992). With this in mind, the court found that:
- The reference to the State’s enforcement action would not be stricken because they have a possible bearing on the subject matter of the complaint and USSD did not demonstrate “they are redundant, immaterial, impertinent, or scandalous”; and
- The reference to a prior lawsuit that resulted in a finding of an illegal sale of an unregistered franchise by USSD because it may also be relevant to the counterclaims.
Regarding the Motion to Dismiss, the Court first analyzed the “nature of the cause of action, i.e., the ‘gravamen’ of the cause of action” to determine what statute of limitations should apply because “[t]he nature of the right sued upon and not the form of action nor the relief demanded determines the applicability of the statute of limitations under our code.” Marin Healthcare Dist. v. Sutter Health, 103 Cal.App.4th, 874-75 (2002). Based thereon, the Court made the following conclusions:
- Defendants’ allegations that USSD offered and sold an unregistered franchise was the gravamen of Defendants’ first three claims for relief. Thus, even though they were not titled as violations of the California Franchise Investment Law, the Court was bound to follow the statute of limitations period provided for in Cal. Corp. Code s. 31303.
- Corp. Code s. 31303 bars liability created under Section 31300 unless they are brought before the earlier of (i) four years after the act or transaction constituting the violation or (ii) one year after the discovery of the fact constituting the violation.
- The Court dismissed all actions against USSD arising from entering into franchise/license agreements that were more than four years before Defendants filed their counterclaim against USSD.
- The Court applied one year after discovery statute of limitations to Defendants’ allegations that a franchise/license agreement had materially different terms in them than were discussed because Defendants were or should have been aware of these facts when they executed the agreement.
- The Court denied USSD’s motion to dismiss related to a request to rescind a license agreement that was entered into less than a year before the initiation of the lawsuit because the Court found that it satisfies each of the elements of a franchise under Cal. Corp. Code s. 31005 (i.e., (i) prescribed a system for which the licensee would operate its unit; (ii) the system used USSD’s trademarks; and (iii) the licensee was required to pay a fee for using the system and trademarks).
Relevant here, the Court turned to allegations that USSD had prevented Defendants from participating in USSD events. The Court found:
- Even though Defendants did not specifically identify precisely what provision of the agreements USSD conduct breached, the Court found it sufficient that attaching the agreement to the counterclaim and pleading the “legal effect” of the contract was sufficient to enable USSD to understand and respond to a breach of contract counterclaim.
- Preventing Defendants from attending USSD events did not violate Cal. Copr. Code s. 31220 prohibition against a franchisor restricting or inhibiting “the right of franchisees to join a trade association or to prohibit the right of free association among franchisees for any lawful purpose” because USSD did not forbid Defendants from otherwise with communicating with another franchisee outside of USSD meetings.
There are four critical lessons from this matter for franchisors and franchisees to keep in mind moving forward:
- Businesses should always be mindful of the difference between a license agreement and franchise agreement. The Court has and will continue to liberally analyze the three elements of a franchisor under Cal. Corp. Code s. 31005 so (i) businesses need to ensure they do not satisfy all three of these elements if they want to be a licensor and (ii) businesses that satisfy all three of these elements need to ensure they are properly registered with the State of California.
- Even though the State’s enforcement action was almost 15 years before the earliest agreement at issue in this case and more than 20 years before the lawsuit was filed, the District Court still found it may be relevant to the lawsuit.
- While Courts will liberally analyze the three elements of a franchise under Cal. Corp. Code s. 31005, they will also liberally analyze the gravamen of claims for relief against franchisors–regardless of their title–to determine whether the statute of limitations that should apply is pursuant to Cal. Corp. Code s. 31303. This becomes particularly important given the “discovery” period of limitations is one year for franchise related claims while Cal. Code Civ. Proc. s. 338(d) provides a three year statute of limitations from discovery of the facts constituting the fraud or mistake by the aggrieved party.
- Speech and association rights by franchisees are still a novel question of law. The Court stated that it was only aware of a single, unreported case–Overturf v. Rocky Mountain Chocolate Factory, Inc., 2009 WL 10675269 (C.D.Cal. Feb. 13, 2009)–that had dealt with this issue at the pleading stage and this matter is also unreported. While the general principle that a franchisor can place restrictions on a franchisee so long as it does not prohibit said franchisee from otherwise communicating with other franchisees is sound, unless and until it is cited in a reported decision–particularly by a California Court of Appeal or the California Supreme Court–franchisors should exercise caution related to restricting franchisees ability to participate in franchise events or communicate with other franchisees.
This article was originally published on the California Franchise Network.