Court Not Interested in Terminated Franchisee’s Excuse for Failing to Pay Franchise Fees
By: Jeffrey M. Goldstein, Esquire
Franchisees and dealers facing a termination grounded on a failure to pay franchise fees frequently make one of three arguments: (1) the franchisor waived the right to insist on the prompt payment; (2) the amount of the arrears was not material; or (3) the franchisor’s wrongful conduct caused the franchisee’s inability to pay. Courts, however, have little patience for such attempts by franchisees to justify the non-payment of fees. Indeed, from a legal standpoint, there is no worse position for a franchisee than to have been terminated for a failure to pay. A recent case in the United States District Court for the District of Puerto Rico clearly demonstrates how most courts deal with a franchisee terminated for failure to pay. Kemco Food Distributors, Inc. v. R.L. Schreiber, Inc., 2016 U.S. Dist. LEXIS 27349 (D.P.R. February 29, 2016). Kemco is notable as it shows that the franchisee was treated harshly despite the existence of an applicable general state franchise statute providing some protection to franchisees from the economic power of franchisors.
In the Kemco case, Schreiber, a family-owned and operated food manufacturing company in South Florida, designated Kemco as its exclusive distributor in Puerto Rico, contingent upon Kemco's remaining current on its payments to Schreiber. The evidence showed that Kemco made untimely payments for every invoice that was issued from January 1, 2014 through the termination of the relationship. The untimely payments spanned over 35 invoice periods. In response to these failures to timely pay, Schreiber sent ongoing statements to Kemco, via e-mail, identifying outstanding invoices, amounts that needed to be paid, and requesting payment. Finally, after other unsuccessful attempts to obtain payment, Schreiber placed Kemco's account on hold and refused to ship new orders until Kemco reduced its outstanding debt. On June 10, 2015, Schreiber terminated its relationship with Kemco explaining that the relationship was terminated for Kemco’s failure to pay; at the time of the termination, Kemco's account was delinquent and on hold due to the lack of payment.
The Franchisee then sued the franchisor based upon Puerto Rico’s Franchise Law called Law 75, which was enacted to “remedy the abusive practices of suppliers who arbitrarily eliminated distributors after they had invested in the business and had successfully established a market in Puerto Rico for the supplier's product or service.” Toward this end, Law 75 prohibits unilateral terminations except those for “just cause”, and imposes significant economic consequences on franchisors for unjustifiable terminations. In turn, Law 75 defines "just cause" to include a dealer's failure to perform any of the essential conditions of the agreement as well as any action or omission that adversely and substantially affects the interests of the marketing or distribution of the merchandise or service. Schreiber argued that under the Franchise Law its termination of Kemco was justified because of Kemco's repeated failure to remain in good standing with its payments. To resolve the issue, the Court relied upon prior decisions dealing with the payment of goods under Law 75. As the Court stated: “Normally, paying for goods on time is one of the essential obligations of the dealer's contract, the non-fulfillment of which has been recognized as just cause for termination under Law 75.”
In support of its case, Kemco maintained that late payments cannot be deemed an essential condition of the agreement under the agreement. The Court abruptly rejected this argument, stating that the contract expressly states that "Kemco Food, Inc. is designated as the exclusive distributor for Schreiber's products in Puerto Rico provided that it remains in good standing with its accounts receivable and shows continued commitment to the growth of sales for the R.L. Schreiber, Inc. product line." In addition, the Court construed Schreiber’s repeated emails and calls to Kemco to pay its outstanding invoices, as well as its putting Kemco numerous times on hold, as evidence that “timely payments were a matter of serious concern in this distribution relationship.”
Kemco also made the related argument that Schreiber failed to raise the back payment issue in a timely fashion. Again, the Court promptly rejected this argument as in conflict with the facts and law. As the Court noted, “Law 75 does not impose upon suppliers the obligation to immediately terminate the infringing dealer, to issue an ultimatum, or to permit the dealer to exhaust cure periods not set forth in a contract before validly terminating the relationship when the dealer has breached an essential condition of the distribution agreement.” The Court was also persuaded by prior cases that rejected the tenet that a franchisor had no just cause to terminate a distribution agreement if it had never threatened the dealer before for late payments. Similarly the Court pointed out that relevant case law held that even though the Franchisor tolerated past due balances and attempted to address the issue through payment plans, this by itself did not imply a tacit alteration of the terms of payment or an endorsement of untimely payments.
After the Court concluded that Kemco failed to comply with an essential condition of its agreement with Schreiber, Kemco took one last shot at persuading the Court not to grant a preliminary injunction by arguing that Schreieber’s purported reason for terminating the relationship (payment issue) was merely a pretext, and that the real reason for the termination was Kemco’s refusal to implement a sales model proposed by Schreiber. In so arguing, Kemco asked the Court to allow it to carry out further discovery to find evidence to support the pretext. In support of its argument that it needed additional time, Kemco argued that: (1) Schreiber's representative/ liaison for Puerto Rico came to Puerto Rico to meet with Kemco's management and to participate in a BBQ competition and trade show; (2) during the visit, the representative/liaison approached Kemco to inquire as to the possibility of Kempo's employing a fleet of vehicles in order to sell Scheriber's products "door to door" at restaurants and hotels, as those products are being distributed in other markets throughout the United States; and (3) after some discussion, Kemco declined to consider selling Schreiber's products in that manner.
Based on the pretext argument, Kemco identified the types of discovery it needed to conduct that would allegedly support its claims, including: (1) how Schreiber treated other distributors throughout the United States and internationally with regards to payment histories; (2) how Schreiber changed its sales model in the United States, and if there was a timeline for the implementation of a new sales model in Puerto Rico; (3) what are Schreiber's new sales projections for its Puerto Rico market in order to gauge the extent of the economic incentive behind Kemco's termination; and (4) any other topic relevant to this litigation, to include information pertaining to the decision making process behind the termination of Kemco. Kemco’s discovery requests were rejected by the Court stating that “Kemco's proffer does not support what it seeks,” reasoning, in part, that the question “How Schreiber does business in other markets or how it has opted to do business in Puerto Rico after terminating the relationship it had with Kemco do not change those facts” — that the payments were deemed essential by the Franchisor.
Kemco’s defense, both its contours and magnitude, was enabled by an esoteric sliver of case law regarding Law 75 that traces back to a 1986 decision by the United States Circuit Court for the First Circuit — Biomedical Instrument v. Cordis, 797 F.2d 16, 18 (1st Cir. 1986). The Biomedical holds that in circumstances in which a supplier does not care about late payments, a termination based on such payments cannot be consistent with Law 75. Specifically, although the Biomedical court did recognize that a failure to pay fees consistently would in most circumstances be viewed to be a failure to perform an essential obligation of the dealer’s agreement, it also created an exception, stating that there are cases that present “special circumstances.”
In Biomedical, the Franchisee argued that its duty to pay on time, while an obligation, was not an “essential” obligation of its distribution contract. The Court, in refusing to grant summary judgment to the Franchisor, Cordis, suggested that the Franchisee had presented sufficient facts to get its case to a jury. First, there was evidence in Biomedical suggesting that Cordis' decision to terminate had little to do with overdue balances, and instead, rested upon Cordis' view that Biomedical had not done enough to promote Cordis' products. In this regard, Cordis' termination letter to Biomedical focused almost exclusively upon Biomedical's performance. Second, Biomedical contended that the parties understood that overdue balances would not constitute grounds for terminating their relationship. Biomedical submitted affidavits from its own president, and Cordis' former regional sales manager, who jointly confirmed that as a matter of fact, every time there were outstanding invoices not paid, the Franchisor would accommodate Biomedical through some type of payment arrangement or extension of its credit line.
After examining the complicated payment history, the Court stated: “This history, of course, shows that Biomedical's payments were late. But it also helps to substantiate Biomedical's claim that overdue balances in these amounts were not a matter of serious concern to the parties, that Cordis understood that Biomedical's financial position might prevent timely payments, and, that Biomedical's obligation to pay these sums on time was not ‘essential’ to the manufacturer-distributor relationship.”
At the end of the day, unfortunately, a franchisee’s failure to pay its franchise fees in a timely manner will almost always be found by a court to be a breach of a material or essential term in a distribution agreement. Accordingly, franchisees and dealers are well advised to retain an experienced franchise attorney at the first sign of financial distress. The franchisees in Kemco and Biomedical might still be operating had they followed this advice.