Aug 17, 2015 - Franchise Articles by |

A Case Analysis Showing the Importance of a Good Franchise Lawyer

Coraud, LLC v. Kidville Franchise Company, LLC, et al., 2015 WL 3651423 United States District Court, S.D. New York (June 12, 2015)

In this franchise fraud case, a childcare center franchisee sued its franchisor and franchisor’s employees, alleging claims for fraud, negligent misrepresentation, violation of the New York State Franchise Sales Act (NYFSA), and violation of the New Jersey Franchise Practices Act (NJFPA). The United States District Court for the Southern District of New York slammed the door on the franchisee’s claim for common law franchise fraud by finding that the contractual disclaimer precluded the franchisee from establishing the necessary reliance element for its fraud and negligent misrepresentation claims. However, the Court did support the franchisee on its contention that NYFSA’s anti-waiver provision prohibited the Court from applying the contractual disclaimer as waiver of franchisee’s fraud claims under the NYFSA. Because the Court was ruling on a motion to dismiss, in its decision, described in part below, it assumed the accuracy of the well-pled facts in the plaintiff’s complaint. 

Kidville operates and franchises facilities used for the “care and development” of young children. In August 2011, husband and wife Paul and Catharine Wilder, the founders of plaintiff Coraud, contacted Kidville about becoming a franchisee, and after a series of conversations and meetings with Kidville, purchased a franchise in April 2012. The Wilders’ primary contact at Kidville was defendant Joe Sexton, Kidville’s Senior Manager of Franchise Development. Significantly, Sexton worked with the Wilders to develop a “business model” before the franchise purchase; the “model” was essentially a profit and loss spreadsheet that included inputs for revenue — such as “payment for classes, income from birthday parties, and income from special events” — and inputs for expenses — such as “contract labor, advertising and promotion, and operating supplies.”

The Wilders, who had no experience with financial statistics similar to those used by the business model, “were completely dependent on Sexton and Kidville” in completing the spreadsheet model. The Wilders thereafter worked with Sexton on the business model over the next few weeks. The final model calculated first-year revenues of $600,000 and a net income of $43,901. Sexton vouched for the accuracy of the expense inputs they used in the business model and told the Wilders that the revenue inputs were “in the ball park” and “on track.” 

Further, Sexton personally provided the Wilders with market and demographic analyses for territories in New Jersey, where the Wilders were considering opening their franchise. The Wilders’ first preference, the suburban town of Westfield, New Jersey, was described by Sexton as one of the “top ten locations.” After receiving this information and assistance from Sexton, the Wilders settled on Westfield to open their franchise.

In February 2012, Kidville provided the Wilders with a revised copy of its Franchise Disclosure Document (the “FDD”), a document that the federal government and many states require franchisors to provide to potential franchisees. With regard to the costs of a franchise, the Kidville FDD stated that the cost of opening an “annex facility,” the type of franchise that the Wilders eventually opened, was $259,405 to $417,750 (exclusive of certain specified costs). In addition, the FDD contained “statistics on the status of the franchise system,” but failed to include any mention of Kidville’s affiliate, J.W. Tumbles, which franchised children’s gyms and had had certain outlets shut down in the previous years.

In turn, the Wilders formed Coraud LLC and, through it, signed a franchise agreement in April 2012.  Shortly after opening, the Wilders allegedly learned that many of Kidville’s representations were inaccurate. One example provided by the Court was that “with respect to expenses, the cost of “building out the franchised premises” was over $680,000, or 63 percent higher than the “top end” estimate of $417,750 in the FDD.” Another similar example given by the Court was with respect to income: “although “Sexton and Kidville approved the Wilders’ projections of revenues in the range of $600,000 for the first year and profits of nearly $44,000,” revenues for the first year were limited to $202,000, leaving the Wilders a loss of $168,000.”

The Court also noted that “Sexton and Kidville had made these various representations without alerting the Wilders to the fact that Kidville “had no experience with suburban locations”—where the Wilders chose to open their franchise, or that J.W. Tumbles had “adverse” results operating in suburban areas.” After continuing to suffer losses in its second year of business, the Coraud’s retained a franchise attorney and filed suit in November 2014.

The Court first addressed the franchisee’s fraud and negligent misrepresentation claims, declaring that under New York law, to prevail on a claim of common law fraud or common law negligent misrepresentation, a plaintiff must show, among other things, “reasonable reliance” on the alleged misstatements or omissions. Promptly, without wasting a breath and without any analysis, the Court asserted that “as a general rule, where a contract contains a disclaimer of reliance on certain representations, a “party cannot, in a subsequent action … claim it was fraudulently induced to enter into the contract by the very representation it has disclaimed reliance upon,” … so long as “(1) the disclaimer is made sufficiently specific to the particular type of fact misrepresented or undisclosed; and (2) the alleged misrepresentations or omissions did not concern facts peculiarly within the seller’s knowledge.”

After having identified the legal basis for ripping the guts out of the franchisee’s fraud case, the Court explained “that Coraud cannot prevail on its common law claims because Coraud, when it signed the Franchise Agreement, expressly disclaimed any reliance on statements made outside of the FDD.” In support of its conclusion, the Court cited the following disclaimer in the franchise agreement:

That except as may be provided in our [Kidville’s] Franchise Disclosure Document you [Coraud] have not received from us, and are not relying upon, any representations or guarantees, express or implied, as to the potential volume, sales, income, or profits of a KIDVILLE Facility, that any information you have acquired from other KIDVILLE Facility franchisees regarding their sales, income, profits, or cash flows was not information obtained from us, and that we make no representation about that information’s accuracy.

The Court then very closely connected its reasoning rejecting the fraud claim to the language in the disclaimer in the franchise agreement: “Because this disclaimer covers “the very matter”—potential volume, sales, income, and profits—“as to which [Coraud] now claims it was defrauded,” the disclaimer is “sufficiently specific” to bar Coraud’s claim of reliance.” The Court also rationalized that “Coraud has not alleged that any of the alleged misrepresentations outside of the FDD concerned matters solely within defendants’ knowledge; if the cost of opening a franchise, the expected revenue, and the desirability of the location Coraud chose could not have been discovered with the exercise of due diligence, Coraud has failed to allege it.” Implicitly, the Court indicated that if the franchisee’s attorney had pled that the franchisor had access to nonpublic information regarding the relevant costs of the franchise, the franchisee might have satisfied the “the peculiar knowledge exception to the disclaimer bar.”

Interestingly, the Court in Kidville reached a different decision with regard to Coraud’s fraud claim brought pursuant to the NYSFA. Under Section 687 of the NYFSA it is unlawful for any person, “in connection with the offer, sale or purchase of any franchise,” to “[m]ake any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” After noting that “[R]eliance is an element of a fraud claim under the Franchise Act,” the Court also explained that, not surprisingly, the franchisor was again asserting here the same disclaimer-based argument that it advanced when it moved to dismiss Coraud’s common law fraud claim.

The Court, in refusing to dismiss the franchisee’s statutory fraud claim, pronounced that “The disclaimers … cannot bar a fraud action under Section 687” in light of the anti-waiver provisions contained in the New York statute.  In this regard, the Court confirmed that “Anti-waiver provisions contained within Section 687 provide that “[a]ny condition, stipulation, or provision purporting to bind any person acquiring any franchise to waive compliance with any provision of this law, or rule promulgated hereunder, shall be void” and make it unlawful “to require a franchisee to assent to a release, assignment, novation, waiver or estoppel which would relieve a person from any duty or liability imposed by this article.” The Court also mentioned that a prior franchise case (Emfore Corp. v. Blimpie Associates, Ltd.) had held that these provisions prohibit treating a contractual disclaimer “as a waiver of fraud claims.” Very simply, under Emfore, any disclaimers or acknowledgements signed by a franchisee cannot bar its claims for fraud under the NYSFA.  The Court promptly and mechanically applied the Emfore case to deny the motion to dismiss.

In arguing against using Emfore, the franchisor urged the Court to embrace instead Governara v. 7–Eleven, Inc., 2014 WL 4476534 (S.D.N.Y. Aug.20, 2014), a case in which the court considered facts similar to those in Kidville and Emfore. The franchisor criticized Emfore as erroneously relying on a case that held only that anti-waiver provisions void the waiver of explicit statutory rights, not disclaimer provisions in a franchise agreement. The Governara court explained the reason for this position: “Because the [NYSFA] does not give franchisees the statutory right to purchase a franchise while relying on verbal representations outside of a written contract,” … a franchise agreement’s “non-reliance disclaimer is not proscribed per se by the [NYSFA].” In turn, after dismissing the applicability of the anti-waiver provisions in Governara, the court dismissed the franchisee’s Section 687 claim in that case as barred by a contractual disclaimer.

The Kidville Court declined to follow the Governara decision even though the Court recognized that Section 687(4) of the NYSFA does not create a right to “rely[ ] on verbal representations outside of a written contract” (since it does not, on its face, prohibit the waiver of any “rights” created by the NYSFA).  Alternatively, according to the Court, “What Section 687(4) does do, though, is prohibit waivers of “compliance with any provision” of the NYSFA, and Section 687(2), one such provision, makes it “unlawful for a person, in connection with the offer, sale or purchase of any franchise,” to make a fraudulent statement.”  Connecting all of the theoretical dots, the Court concluded “Thus, the disclaimer, if given effect in the manner defendants here request and that Governara allowed, accomplishes what Section 687(4) aims to prevent, namely, freedom from compliance with the NYSFA’s anti-fraud provision.”

Appearing to feel the judicial pressure associated with its having rejected the decision of an identical case, the Kidville Court justified its rejection stating: “[t]he holding of an intermediate appellate state court … is a datum for ascertaining state law which is not to be disregarded by a federal court unless it is convinced by other persuasive data that the highest court of the state would decide otherwise.” … Here, Governara aside, the “data points”—which may “include relevant case law from other jurisdictions on the same or analogous issues, scholarly writings in the field, and any other resources available to the state’s highest court,” convince the Court that Emfore is correct.”

In further support of its apparent rejection of precedent, the Court pointed out that the NYSFA was modeled after the federal securities laws, which also have an anti-waiver provision. “Section 29(a) of the Exchange Act provides, “Any condition, stipulation, or provision binding any person to waive compliance with any provision of this chapter or of any rule or regulation thereunder, or of any rule of a self-regulatory organization, shall be void.”  The Kidville Court  then approvingly cited the analysis of the United States Court of Appeals for the First Circuit, which, in considering the effect of this language on a disclaimer of reliance, stated:

A separate comment should be directed to the contractual acknowledgement of non-reliance…. This is not, in its terms, a ‘condition, stipulation, or provision binding (plaintiff) to waive compliance’ with the Securities Act of 1934, as set forth in Section 29(a) of the Act, (15 U.S.C. § 78cc(a)). But, on analysis, we see no fundamental difference between saying, for example, ‘I waive any rights I might have because of your representations or obligations to make full disclosure’ and ‘I am not relying on your representations or obligations to make full disclosure.’ Were we to hold that the existence of this provision constituted the basis (or a substantial part of the basis) for finding non-reliance as a matter of law, we would have gone far toward eviscerating Section 29(a).

Adopting the First Circuit’s reasoning as directly applicable, the Court reasoned: “Just as Section 29(a) “forecloses anticipatory waivers of compliance with the duties imposed by Rule 10b–5,” … so too Section 687(4) bars anticipatory waivers of compliance with the NYSFA’s anti-fraud provisions.”

Finally, the Kidville Court explained that the policies underlying the NYSFA confirm its interpretation. “The formal legislative findings made part of the NYSFA declare that the statute was enacted in response to “New York residents hav[ing] suffered substantial losses where the franchisor or his representative has not provided full and complete information,” and the “intent” of the statute was therefore “to prohibit the sale of franchises where such sale would lead to fraud.” According to the Court, these findings reflect “the reality that, in the franchise context, written contractual provisions are not as likely to be scrutinized by less sophisticated people, whose judgment may be compromised in the face of aggressive salesmanship.”

As this case shows, there is little certainty in the legal world regarding the viability of franchise fraud claims. Not only does the issue frequently turn on different and complicated state laws, but also on the unique talents and experiences of your franchise lawyer.

By: Jeffrey M. Goldstein

Goldstein Law Firm, PLLC

(202) 293 3947

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