Aug 14, 2015 - Franchise Articles by |

Steak n Shake Franchisor Fraud: Franchisor Shakes Down New Franchisee by Fraudulently Hiding Costs

By: Jeffrey M. Goldstein

Goldstein Law Firm, PLLC

goldlawgroup.com

(202) 293 3947

jgoldstein@goldlawgroup.com

 

Cornerstone Investment  Partners, LLC v. Steak N Shake Enterprises, Inc., 2015 WL 4094630, United States District Court, D. New Jersey (July 6, 2015)

            Franchise fraud again. Not surprisingly, another franchisee carcass was spotted lying outside the federal district court in New Jersey last week. The franchisee plaintiff, Cornerstone Investment  Partners I, LLC (“Cornerstone”), sued its franchisor, Steak n Shake Enterprises, Inc., the defendant. The franchisor moved to dismiss the franchisee’s case, and the Court granted the motion. In deciding the motion, the Court, as required, relied exclusively upon the allegations of the franchisee in its Complaint; a summary of these facts is set forth below as part of the analysis.

            Defendant Steak n Shake operates and grants franchises for restaurants offering burgers and milkshakes. Cornerstone initially sought information about one of Steak n Shake’s traditional “Classic” restaurants, which notably operate twenty-four hours a day for seven days a week, feature a full menu, contain typically between 3000 and 4000 square feet of space, and offer dine-in, drive-thru, and carry-out service. Beginning January 2011, defendant began to also offer franchises for “Signature” restaurants, which, in contrast to the Classic restaurant, are smaller and offer a more limited menu.  

Defendant opened its first Signature restaurant in New York City on January 12, 2012, and this unit was the only Signature restaurant in operation during the course of the negotiations between Cornerstone and the franchisor. In a January 22, 2012 meeting, the franchisor’s representatives orally refused to provide information about the Signature model’s costs and told Cornerstone that they should “trust” the franchisor’s research into the financial viability of the Signature restaurant model.

On January 23, 2012, the franchisor withdrew a previous approval for Cornerstone to build a Classic restaurant, and instead told Cornerstone that it could purchase only a Signature restaurant. Cornerstone and Defendant then began negotiations for the franchisee to purchase a Signature restaurant to be located in Paramus Mall, Paramus, New Jersey. Thereafter, as happens in some similar franchise cases, although the franchisor noted some differences between the Signature restaurants and the Classic restaurants, it offered cost estimates using data only from Classic restaurants.

The Court pointed out that, for example, the Franchise Disclosure Document’s (“FDD’s”) Item 19 provided a “historical” range of cost estimates for “Classic” restaurants, and stated: “Our first Steak n Shake Signature Restaurant opened on January 12, 2012, so these figures do not include results from any Steak n Shake Signature Restaurants. Sales at Steak n Shake Signature Restaurants may vary from our Classic Steak n Shake Restaurants due to the limited menu, reduced hours of operation, and lack of drive-thru sales.” The Court also pointed out that a footnote to Item 7 in the FDD, regarding “Estimated Initial Investment,” stated:

We recently developed the Steak n Shake Signature Restaurant model and as of the issuance date of this Disclosure Document, we only operate one Steak n Shake Signature Restaurant in New York City. The [initial investment] figures provided in the above chart for Steak n Shake Signature Restaurants are estimates based on quotes we received to construct a 2,500 [square foot] Steak n Shake Signature in San Antonio, [Texas] … Your individual costs and expenses are likely to vary. You are strongly advised to consult with a business advisor to more accurately determine your particular costs and expenses. The development costs for the New York City Steak n Shake Signature Restaurant were not included since they are not representative of the typical development costs as this location was developed as a flagship location.

On April 5–6, 2012, Cornerstone again repeatedly requested via e-mail cost estimates for the Signature model, and, expectedly, the franchisor refused to provide the estimates. On April 15, 2012, Cornerstone’s insistence on obtaining relevant cost data was finally met, not by the provision of the requested information, but by a promise by a franchisor executive that the franchisor would “work with” Cornerstone to resolve any operational issues. The Steak n Shake executive allegedly stated that Plaintiff could rely on the data associated with Classic restaurants because food and labor costs for the Signature model would be less than those of the Classic model. A few days later, the executive again declined to provide cost estimates for the Signature model.  

Finally, on April 23, 2012, Cornerstone signed the franchisor’s standard-term franchise agreement (“Agreement”). This was three months after the opening of the Defendant’s first Signature restaurant. On October 1, 2012, Cornerstone opened its Signature restaurant and immediately began experiencing significant operating losses associated with unexpectedly high costs. Cornerstone promptly requested that the franchisor modify certain standards of performance required by the franchisor to accommodate for these high costs. Defendant refused to permit the modifications to its franchise system standards. On October 23, 2014, the franchisee sued the franchisor; the complaint alleged eight counts including: a violation of the New Jersey Franchise Practices Act (Count I), fraud (Count II), misrepresentation (Count III), a violation of the New York Franchise Sales Act (Count IV), a violation of the Racketeer Influenced and Corrupt Organizations Act (“RICO”) (Count V), breach of contract due to a violation of the covenant of good faith and fair dealing (Count VI), a violation of the New Jersey Consumer Fraud Act (“NJCF Act”) (Count VII), and punitive damages (Count VIII).

The Court initially focused on the fraud claim, noting that under the common law of New Jersey the following elements are required: (1) a material misrepresentation of a presently existing or past fact; (2) knowledge or belief by the defendant of its falsity; (3) an intention that the other person rely on it; (4) reasonable reliance thereon by the other person; and (5) resulting damages. As pled, according to the Court “Plaintiffs have not set forth facts to support claims for fraud and misrepresentation.” Looking first at the alleged fraud associated with the FDD, the Court stated: “Plaintiffs entered into the franchise agreement, knowing the Signature business and flagship had operated for a relatively short period of time.” Further, the Court reasoned that “although Plaintiffs state that Defendant withheld material information regarding food and labor costs, Plaintiffs have not clearly alleged how they were misled.” Similarly, the Court attacked the franchisee’s reliance: “The Agreement did not indicate that Defendant was required to provide the information identified by Plaintiffs, specifically to support the contention that the new model Signature restaurants had significantly higher food and labor costs than the historical figures.”

The continued its attack on the franchisee’s pleading by asserting that “Plaintiffs include vague statements in their Complaint regarding the alleged material information Defendant failed to disclose. Claiming generally that Defendant made misleading statements and material omissions without support is insufficient.” The bottom line for the Court was that the franchisee had failed to “allege that Defendant failed to disclose anything that it was required to disclose under the FDD. Item 19 clearly states that FDD includes the ‘historical financial performance representations … for company operated and franchised Classic Steak n Shake Restaurants.’”        

The Court proceeded to turn the franchisee’s own pleading against them concluding that “Plaintiffs’ own statements and pleadings make it clear that they knew the “Signature” restaurant was a new product. As pled, the issues regarding alleged oral statements, food and labor costs and menu items are insufficient to maintain claims for fraud and misrepresentation.”

Next the Court turned to the count under the New Jersey Franchise Practices Act. The franchisee’s main contention here was that due to the franchisor’s uniform pricing strategy and unproven business format the franchisor had unlawfully “imposed unreasonable standards in violation of the New Jersey Franchise Practices Act.” Although recognizing that, pursuant to the NJFPA, a franchisor may not impose “unreasonable standards of performance,” the Court concluded that “Here, Plaintiffs have not set forth facts to support claims that Defendant imposed “unreasonable” standards in violation of the Act, but rather, that they had difficulty meeting these standards given their higher occupancy costs.”

            With regard to the New York Franchise Sales Act (“NYFSA”) claim, Section 687(2) requires the disclosure of necessary information for a franchise agreement. In this case, the franchisor argued that it was not required to register in New York pursuant to an exemption based on its net worth. The exemption applies “if the department finds that such action is not inconsistent with the public interest or the protection of prospective franchisees.” Equating the facts alleged in support of the NYFSA claim with those of the franchisee’s common law fraud claim, the Court dismissed this claim as being vaguely pled within the Complaint and contradicted by the language of the Agreement.

            Plaintiff’s breach of contract due to a violation of the covenant of good faith and fair dealing was also dismissed, although the Court’s reasoning is questionable, as it seemed to assume that the franchisee’s covenant of good faith and fair dealing were based upon its fraud claims. In this regard the Court again attacked plaintiff’s pleading stating that the franchisee had failed to plead that a specific provision of the FDD was breached. (And, here, as well, it is difficult to understand how the FDD – a disclosure document and not a contract — could be ‘breached’ as assumed by the Court).  Dismissing the claim, the Court reasoned that “Plaintiffs claim that oral misrepresentations by Defendant’s representatives (including James Valentino) were made regarding the food and labor data, upon which information Plaintiffs reasonably relied. However, Item 19 of the FDD states that no representative for the Defendant may make any historical cost information representations outside of those provided in Item 19.”

            With regard to the last count, the punitive damages claim, the franchisor argued that it should be dismissed for the following reasons: (1) no independent claim exists for punitive damages; and (2) Plaintiffs waived such damages in the franchise agreement. The Court did not appear to accept or reject these arguments, instead dismissing the Court because it was based on only the fraud counts that the Court had itself dismissed earlier in the decision.

By: Jeffrey M. Goldstein

Goldstein Law Firm, PLLC

goldlawgroup.com

(202) 293 3947

jgoldstein@goldlawgroup.com

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