May 6, 2015 - Franchise Articles by |

David Abbo, Colorado Toyz, Inc., and Wireless Phones, L.L.C.v. Wireless Toyz Franchise, L.L.C., Joe Barbat, Richard Simtob, Jsb Enterprizes, Inc., and Jack Barbat, 2014 Wl 1978185, Court Of Appeals Of Michigan (May 13, 2014)

Wireless Toyz Franchise, L.L.C. (WTF), a franchisor, and David Abbo, its franchisee, initially entered into a franchise agreement for a retail store in Colorado and subsequently signed a development agent agreement under which Abbo was required to open additional Wireless Toyz franchise stores. Wireless Toyz franchises are retail stores that sell electronic communication devices and initiate cellular telephone services with various providers. Franchisees earn commissions by selling third-party service contracts and additionally profit by marketing cell phones and related merchandise.  Abbo paid a $20,000 franchise fee, in addition to $180,600 for the exclusive right to market and sell Wireless Toyz franchises throughout Colorado.

Although initially Abbo’s store ranked in the top third of WTF’s stores nationwide, he deemed his profit insufficient. His store experienced an average chargeback rate of 40 percent each month and absorbed hits of $75 to $100 on almost every phone sold. Abbo also discovered that Verizon refused to participate directly with Wireless Toyz franchises; instead, cellular service activations for that company were brokered through a middleman who received a cut of the profit. And Wireless Toyz had no relationship with Cingular. Despite WTF’s agent’s (Simtob’s) claim that Wireless Toyz enjoyed low inventory costs, Abbo determined that it was actually cheaper for him to purchase items at a big box store. Further, Abbo claimed that WTF never trained him regarding how to manage a chargeback dispute, how to conduct commission audits, or how to control inventory.

Abbo decided that being a WTF franchisee was a losing proposition, and attempted, unsuccessfully, to sell the franchise back to WTF. WTF refused the offer. By 2009, Abbo’s Wireless Toyz store had closed. Abbo then filed suit against the franchisor resulting in a 12–day trial with more than two dozen witnesses and hundreds of exhibits. The jury found in Abbo’s favor on only one claim, rejecting eight others. The trial judge retired and a different judge, on a post- trial motion by the franchisor, reversed the jury’s initial verdict for the franchisee. The Court of Appeals (“the Court”) in turn, in the opinion described in this article, reversed the second judge’s ruling and reinstated the jury’s verdict in favor of the franchisee.

The fraudulent scheme, as shown by the franchisee, began when the franchisee attended a Discovery Day presentation by the franchisor that provided a basic overview of certain profit calculations or reductions unique to the cellular telephone industry: hits and chargebacks. Hits are discounts awarded to customers as incentives to purchase a telephone. Chargebacks are revocations of a franchise store-owner’s commission that take effect when a customer prematurely cancels a service contract. Abbo specifically inquired about the extent of hits and chargebacks experienced by Wireless Toyz stores. Simtob represented that chargebacks annulled only five to seven percent of commissions and that out-of-state stores were subject to only “very minor” hits. The average hit, according to Simtob, did not exceed $50.

After hearing Simtob’s Discovery Day sales pitch, Abbo reviewed WTF’s Uniform Franchise Offering Circular (UFOC), a franchise disclosure statement mandated by the Federal Trade Commission (FTC). The document set forth estimated costs and profits based on historical data from 2003, and included various disclaimers informing prospective franchisees that WTF could not guarantee financial success. The UFOC presented a chart detailing average monthly gross revenues for WTF stores. The chart also showed that there were 181 “average post paid activations per location” each month, and $222.31 in “average commissions per postpaid activation.” Notably, however, the UFOC made no mention of hits. Although the UFOC advised readers that a franchisee’s commissions could be subject to chargebacks, it did not include any data illustrating the manner in which chargebacks operated to decrease the gross profit number represented by the “average commissions” figure.

Simtob also told Abbo that a store needed to sell 75 telephones each month to break even. According to Abbo, Simtob implied that selling 200 phones each month would garner a good profit. Specifically, Simtob informed Abbo that his brother owned a Wireless Toyz franchise store in Phoenix situated in a similar commercial location and was excited to open a second store upon reaching the 200–phones–a–month sales mark.

Although the jury refused to find that the franchisor made any actionable affirmative fraudulent statements, it found defendants liable of silent fraud. The jury awarded Abbo $20,000, representing the franchise fee, and $180,600, representing the development agent fee.  After the trial, the case was reassigned to a different judge (“the second judge”), who set aside the initial verdict for the franchisee. Specifically, the second judge agreed with the defendants that: (1) the merger clauses in the franchise and development agent agreements precluded, as a matter of law, defendants’ liability for silent fraud; (2) the trial evidence did not support a claim for silent fraud; and (3) “Plaintiffs failed to establish the reasonable reliance element of the Silent Fraud claim as a matter of law.” The Court of Appeals, however, reversed the decision of the second judge regarding the silent fraud issue.

The Court began its discussion by describing the tort of ‘silent fraud’ in the applicable jurisdiction, Michigan. “Silent fraud, also known as fraudulent concealment, arises from suppression of the truth. Long ago, our Supreme Court declared that ‘[a] fraud arising from the suppression of the truth is as prejudicial as that which springs from the assertion of a falsehood, and courts have not hesitated to sustain recoveries where the truth has been suppressed with the intent to defraud.’” The Court further noted that even though “the term ‘suppression’ implies deliberate action”, it may also “result from inaction – silence – when there is a duty to speak.” The Court viewed silent fraud as “equivalent to a false representation.”

The Court stated that the franchisor “had a statutory duty to disclose those material facts “necessary” to make the UFOC’s statements “not misleading” under the circumstances in which they were presented. Abbo’s silent fraud claim, according to the Court, also arose secondarily from a breach of defendant’s common-law responsibility to truthfully respond to direct inquiries regarding hits and chargebacks, and to avoid creating false impressions when allaying Abbo’s financial concerns. Providing additional legal guidance, the Court stated that “a legal duty to make a disclosure will arise most commonly in a situation where inquiries are made by the plaintiff, to which the defendant makes incomplete replies that are truthful in themselves but omit material information.”

The Court of Appeals also explicitly disagreed with the second judge’s ruling where the judge had determined that the merger clauses of the franchise and development agent agreements barred Abbo’s silent fraud claim regarding the extra-contractual and oral misrepresentations or omissions. According to the second judge, “Merger clauses prohibit the introduction of parol evidence introduced to revise or contradict the terms of a written contract.”

The Court, in working its way analytically to the issue of the merger clause, provided additional insight for its distinction between affirmative fraud and silent fraud stating that “Silent fraud … involves information that has been deliberately and deceptively withheld by one of the contracting parties. Undisclosed material facts that were never the subjects of pre-contractual negotiations are not absorbed by a contract.”

In concluding that a merger clause conceptually by itself could not bar ‘silent fraud’ claims, the Court reasoned that “A contrary ruling would immunize from liability a contracting party who suppressed information that it was duty-bound to include in the parties’ discussions. Contrary to the post trial court’s opinion, the trial court correctly allowed Abbo to introduce parol evidence substantiating that defendants deliberately suppressed such pertinent information.”

In turn, the Court identified the merger clauses that specifically were contained in the franchise and development agent agreements. The franchise contract provided: “ENTIRE AGREEMENT — This agreement and the Manuals contain all of the covenants and agreements of the parties with respect to this subject matter, and supersede any and all prior or contemporaneous agreements, whether oral, written, express or implied, between the parties with respect to the subject matter.” The development agent agreement’s corresponding merger clause states: “Entire Agreement; Modifications. This Agreement and all appendices and other documents attached to this Agreement are incorporated in this Agreement and will constitute the entire agreement between the parties. This Agreement supersedes all previous written and oral agreements or understandings between the parties. This Agreement may not be amended or modified except in writing executed by both parties.”

The Court then drew a fine, but rigid distinction, between prior agreements and prior statements and representations. As this Court has emphasized, “the raison d’etre of an integration clause is to prohibit consideration of parol evidence by nullifying agreements not included in the written agreement. But merger clauses do not mechanically eliminate from consideration all precontractual statements or representations.”

Accordingly, as the Court explained, the law in Michigan is that “parol evidence is admissible to show that the execution of a written instrument was procured by fraud, for the purpose of invalidating the instrument.” Indeed, the Court cited to one of the major historical legal scholars in contracts law in stating that “The exception to the parol evidence rule applies even if the testimony contradicts the terms of a completely integrated writing.” To hold otherwise, reasoned the Court “would be to provide an impenetrable shield to ‘disreputable parties who knowingly submit false accountings … to unknowing parties as long as they were savvy enough to include a merger clause in their contracts.’”

The Court next went the extra step of disentangling the specific words of the particular merger clauses in question, ruling that “Neither merger clause makes reference to prior ‘representations’ or ‘inducements.’” Rather, these clauses provide that the signed contracts embody the parties’ bargained-for “agreements.” Specifically, the Court held that “While the merger clauses disclaimed ‘any and all prior agreements or understandings,’ they did not preclude the admission of factual representations regarding matters unaddressed by the contract.”

In applying these parameters, the Court concluded that “Parol evidence substantiating that WTF fraudulently concealed the true effects of hits and chargebacks, WTF’s poor relationships with cellular carriers, high inventory costs, and ineffective training program neither contradicted nor varied any contractual terms. Because defendants’ factual representations regarding the operational mechanics of a Wireless Toyz store did not constitute ‘agreements’ contradicting contract terms, they were not merged into the contracts.”

With regard to specific record evidence supporting the franchisor’s case, the Court identified evidence showing that defendants misrepresented the frequency and extent of hits and chargebacks, “creating a false impression of a store’s profit potential.” The Court also identified evidence that “While the UFOC recommended that interested parties consult several identified Wireless Toyz stores for information about the franchise, it neglected to mention that the listed stores paid no franchise fees or royalties.” And, also, the Court drew comfort from the record evidence that, “Contrary to Simtob’s representation that WTF enjoyed strong relationships with cellular carriers, Abbo learned that WTF had no relationship at all with Cingular, and that he had to work through a ‘master agent’ middleman to sell Verizon products.”

The Court then focused in on the specific issue of franchise expenses, disagreeing with the second judge’s determination that the franchisee failed to establish that it was defrauded regarding franchise expenses because the UFOC warned prospective franchisees that it contained only estimates of store revenues and disclaimed any financial guarantees.  As the Court noted, “The post-trial court highlighted the UFOC’s statement that ‘[t]here is a charge back for customer contracts that are cancelled by the customer within a period specified by the Carrier’s and Abbo’s admitted awareness of the potential financial impact of hits and chargebacks.’” Regardless of the latter, according to the Court, when viewed in the light most favorable to Abbo, “the evidence established that the UFOC omitted material facts, that defendants falsely answered Abbo’s questions regarding hits and chargebacks, and that defendants failed to disclose material aspects of Wireless Toyz’s business structure.”

The Court also found error with the second judge’s ruling that Abbo failed to establish the reliance element of silent fraud. Specifically, according to the appellate court, the second judge erred in “concluding that even if the jury had been properly instructed on the element of reliance in a Silent Fraud claim, the Court finds that based upon the evidence, any reliance on extra contractual statements was inherently unreasonable.”

Arguably one of the most interesting pedagogical aspects of the decision was the Court’s outright rejection of the franchisor’s contention that “Abbo could not have reasonably relied on any statements made by Simtob regarding chargebacks and hits because they failed to investigate the impact of these items when questioning current franchisees about their businesses.” According to the Court, ‘silent fraud” does “not require the party asserting fraud to have performed an investigation of all assertions and representations made by its contracting partner.”

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