Franchisee Bill of Rights Doesn’t Ensure Franchisor Competency
By: Jeffrey M. Goldstein
A recent suit in the United States District Court for the Western District of New York resulted in the denial of a franchisee’s motion for a preliminary injunction to prevent the franchisor from requiring the franchisee to install a new computer system. JDS Grp. Ltd. v. Metal Supermarkets Franchising Am., Inc., No. 17-CV-6293 (MAT), 2017 U.S. Dist. LEXIS 94779 (W.D.N.Y. 2017). In JDS, the franchisee JDS brought a suit against its franchisor Metal Supermarkets Franchising America (MSFA) for violation of the Washington State Franchise Investment Protection Act (FIPA), which includes a Franchisee Bill of Rights, as well as for breach of the implied covenant of good faith and fair dealing.
The facts as found by the Court include the following. JDS owned two retail stores that sold metal components used in various industries. The stores were in Kent, Washington, and Portland, Oregon. JDS had been a franchisee of MSFA for approximately ten years. JDS used a software system called “Metal Magic,” that was provided by MSFA. In 2012, MSFA determined that Metal Magic was outdated, inefficient, and unable to accommodate anticipated growth and functionality changes. As a result, MSFA undertook development of a new, modern software system, called “MetalTech,” which cost over $1,000,000 and took three years to develop.
In 2015, MSFA began installing MetalTech at its franchisee locations. JDS did not want to use MetalTech in its stores, but instead wanted to keep using Metal Magic. Plaintiff maintained that MetalTech was unreliable and did not perform as required. Specifically, Plaintiff contended that “MetalTech was unable to generate accurate and reliable financial statements, readily calculate sales tax, “run more than a few checks at a time, ‘reliably generate invoices, or effectively transfer materials between co-owned stores, and that MetalTech makes it more time-consuming to perform simple tasks than Metal Magic did.’” Plaintiff also submitted declarations from six other MSFA franchisees, all of whom reported that using MetalTech negatively impacted their ability to do business.
Defendant denied the Franchisee’s contentions, and produced evidence that 78 of 86 Metal Supermarket stores were currently using MetalTech, and that none of the stores had been forced to close as a result of the new software. The Franchisor also argued that, contrary to Plaintiff’s accusations, those franchise stores that had converted to MetalTech had, on average, seen a 7.4% increase in sales following the conversion.
Further, shortly before filing the lawsuit, the Franchisee had signed a new franchise agreement that expressly provided that MSFA had the right to develop or designate computer software programs and require that Plaintiff use them. Even though JDS admitted that it understood the essence and scope of the planned computer software changes before it signed the renewal agreement, it nevertheless argued that it had been ‘forced’ to sign it. This argument apparently held little sway with the Court given that the Franchisee’s lawyer had negotiated the franchise agreement before JDS signed it.
The Court began its analysis by laying out what a plaintiff must show in order to obtain a preliminary injunction: “1) that it is subject to irreparable harm; and 2) either a) that it will likely succeed on the merits or b) that there are sufficiently serious questions going to the merits of the case to make them a fair ground for litigation, and that a balancing of the hardships tips ‘decidedly’ in favor of the moving party.”
JDS Could Not Show That It Was Likely to Succeed on the Merits
The Court looked at the second prong (likelihood of success on the merits) first. JDS contended that it would likely succeed on the merits because MSFA’s actions violated FIPA §1, §2(b), and §2(h) of FIPA. The Court found that MSFA’s actions violated none of these provisions.
FIPA §1 requires that “parties to a franchise agreement shall ‘deal with each other in good faith.’” The Court pointed out that lack of good faith requires the presence of bad faith, and that proving bad faith is a heavy burden to carry, as bad faith “embraces more than bad judgment or negligence and imports dishonest purpose, moral obliquity, conscious wrongdoing, breach of known duty through some ulterior motive or ill will partaking of the nature of fraud, and embraces actual intent to mislead or deceive another.”
JDS argued that MSFA acted in bad faith by requiring JDS to adopt MetalTech. The Court found no such evidence of bad faith. Here, the Court found, the contract explicitly allowed for the exact actions that JDS alleged were performed in bad faith. First, the Court noted that “the express terms of the franchise agreements permit MSFA to develop or designate computer software programs and accounting system software and require that JDS use them.” The Court also found that under Washington case law, the duty of good faith cannot alter the express terms of a contract. “The duty of good faith set forth in FIPA does not operate to create rights not contracted for, nor does it override the express terms of a contract.” In sum, regarding bad faith, the Court found that “the evidence (including the declarations submitted by plaintiff) shows that MSFA has devoted significant time and resources to MetalTech, including efforts to resolve the flaws identified by its franchisees. Indeed, it would make little sense for MSFA to deliberately sabotage its franchisees’ business operations, thereby injuring its own revenue stream.”
As there was no bad faith, (as required to find a violation of FIPA), the Court found that it was unlikely that JDS would prevail on the merits of a claim that MSFA had violated FIPA §1. The Court further explained that if there was no bad faith under FIPA, there could also be no breach of the implied covenant of good faith and fair dealing under the common law, as the standard was the same for both claims.
JDS also brought a claim under FIPA §2(b), which states that it shall be unlawful for a franchisor to require a franchisee “to purchase or lease goods or services of the franchisor or from approved sources of supply unless and to the extent that the franchisor satisfies the burden of proving that such restrictive purchasing agreements are reasonably necessary for a lawful purpose.” The Court found that there was no case law interpreting this provision. However, the Court pointed out that FIPA notes that the Court should look at “decisions of the courts of the United States interpreting and applying the anti-trust laws of the United States” when applying FIPA §2(b). Because JDS made no showing that the requirement to adopt MetalTech violated the U.S. antitrust laws, the Court found that this requirement did not violate FIPA §2(b). The Court further stated that “federal courts have repeatedly held that it is permissible for a franchisor to require use of its proprietary computer systems.”
Finally, JDS brought a claim under FIPA §2(h). The language here is similar to the language in §2(b), and states that “’it shall be an unfair or deceptive act or practice or an unfair method of competition and therefore unlawful’ for a franchisor to ‘impose on a franchisee by contract, rule, or regulation, whether written or oral, any standard of conduct unless the person so doing can sustain the burden of proving such to be reasonable and necessary.’” While there was no case law directly interpreting this provision, the Court found that Washington law was submissive to franchisors’ decisions generally. The Court explained that “courts generally give considerable deference to franchisors’ efforts to restructure, retrench, or wind down their franchise systems.” The Court also stated that §2(h) should not be interpreted “to undercut a franchisor’s business judgment in establishing standards for its franchise system.” As such, the Court refused to find a violation of §2(h).
JDS Could Not Show That It Would Suffer Irreparable Harm Absent a Preliminary Injunction
JDS argued that it would suffer irreparable harm if it was forced to adopt MetalTech because “MetalTech is so flawed that it will substantially impair plaintiff’s ability to do business, thereby damaging its reputation and goodwill, driving away customers, causing employee morale issues, and resulting in lost sales.” The Court found that JDS simply had not shown enough evidence that this would be the case. JDS was able to collect some anecdotes from other franchisees about the weaknesses of MetalTech, but the Court found that the great weight of the evidence actually cut against JDS’s position, stating that: “78 out of 86 Metal Supermarket stores are now using MetalTech. Contrary to the dire predictions set forth in plaintiff’s papers, stores that have converted to MetalTech have, on average, seen their sales increase in the months after the conversion.”
Because JDS was unable to show that it was likely to prevail on the merits or that it would suffer irreparable harm if it did not obtain the preliminary injunction, its motion for a preliminary injunction was denied. Indeed, from the Court’s perspective, it would make little sense for MSFA to deliberately sabotage its franchisees’ business operations, thereby injuring its own revenue stream.
Unfortunately for the franchisee, this case began and ended with the specific anti-franchisee language in the franchise agreement. The franchisee’s counsel implicitly admitted this by refusing to bring a traditional and straight-forward breach of contract claim against the franchisor. Very simply, the language of the franchise agreement left no room to maneuver – it stated that “MSFA has the right to develop or have developed for us or to designate (a) computer software programs and accounting system software that you must use in connection with the Computer System which you must install.” The franchise agreement further hammered home the point when it said: “If we [MFSA] require you [JDS] to use any or all of the above items, then you agree that you will do so.” Language in the associated Hosting Support and Software License Agreement also explicitly supported the Franchisor’s unilateral action: “because of the complex nature of computer software, [MSFA] cannot and does not warrant that the operation of [MetalTech] will be without interruption, completely secure or error-free. [JDS] understands that it assumes all risks as to the use, quality, and performance of the hosted solution.”
Although an applicable state franchise statute can sometimes provide a viable claim for an injured franchisee, the FIPA in this case clearly failed to do so, despite its Franchisee Bill of Rights. In essence, the franchisee attempted to thrust round pegs in square holes.
Making matters worse for JDS was that it chose to fight the battle in an emergency litigation context; a plaintiff seeking a preliminary injunction is required to make a very strong showing that absent the preliminary injunction it will suffer an immediate ‘irreparable harm.’ The Franchisee’s showing on this point was woefully inadequate legally and factually. Unable to marshal facts to show that it would be driven out of business as a result of being forced to use the computer system, the franchisee attempted to rely instead upon a litany of ‘problems’ with the software, few of which were articulated with sufficient particularity. The Franchisee’s lackluster showing on these points was topped off by an informal survey of a small number of franchisees showing only that the new computer system generally ‘made it more difficult’ to operate the business.
This case shows that while bad facts can make bad law, very bad facts can make very bad law. From a franchisee point of view, the decision in this case seriously, harmfully and unfittingly limits the reach of FIPA. More appropriate facts could have better developed the permanent boundaries of FIPA. Most important, this case also exposes the cruel underbelly of franchising, that franchisees have no legal right to competent franchisor decisions even though the free market cannot by itself effortlessly, consistently and readily ensure such expertise.