BUSINESS FORMATION & SALES BLOG

In Zavodnick, Perlmutter & Boccia L.L.C., v. Zavodnick, No. A-1242-11T1 (App. Div. August 2, 2012), the Superior Court of New Jersey, Appellate Division, upheld an arbitrator’s decision to allow a law firm to buyout a disabled member. Id. at 8.  In so doing, the Court refused to limit the scope of the arbitrator’s authority to determine issues relating to the disability.

In that case, the members of the law firm, Zavodnick, Perlmutter & Boccia L.L.C (“law firm”), had signed an operating agreement that provided of resolution of any disputes concerning the withdrawal of a disabled member.  That resolution was to be handled by the parties themselves, if possible.  If not, the exclusive remedy would be arbitration under the rules of the American Arbitration Association (“AAA”).  An AAA arbitration was instituted in regard to the members’ decision to require one of the attorneys, Allen Zavodnick, Esq. withdraw due to his disability.

Zavodnick challenged the arbitrator’s ruling upholding the decision to have him removed.  In that
regard, Zavodnick filed a lawsuit in the Superior Court of New Jersey, Chancery Division, Hudson County.  The Court upheld the arbitrator’s decision. Zavodnick appealed to the Appellate Division. 

The Appellate Division also upheld the decision.  In its opinion, it stated in part “[b]ecause the request for arbitration  . . . clearly encompassed the issue of whether defendant’s disability or his
cessation of professional service constituted a withdrawal event, and because the operating agreements plain terms required arbitration of that issue, we find defendant’s arguments to be of insufficient merit to warrant discussion in a written opinion.” Id. at 8.

This case highlights the importance of paying particular attention to the disability provision of an operating agreement before entering into one.  Very few of us ever expect to become disabled; however, it is best to account for the unlikely event that such a provision might need to be invoked.

Comments/Questions: gdn@gdnlaw.com

© 2012 Nissenbaum Law Group, LLC

American Franchisors should be aware of the special laws relating to establishing franchises in Canada. For example, the Quebec Civil Code attaches a contractual obligation to the franchisor of a franchise agreement to protect and enhance the franchise brand.  In Bertico Inc, et al. v. Dunkin’ Brands Canada LTD., No. 500-17-015511-036; 500-17-019989-048; 500-17-028727-058 (Quebec Super. Ct. June 21, 2012), the Quebec Superior Court addressed this issue and held that an American franchisor could be liable for failing to sufficiently maintain the strength of its brand for Canadian franchisees.

In that case, a class action was filed against the Dunkin’ Donuts franchisor in Quebec for failing to address the franchisees’ concerns about rejuvenating the Dunkin’ brand and business strategy to compete with a new franchise competitor.  The franchisees argued that the Dunkin’ Donuts franchisor was unresponsive to their request in violation of their franchise agreements.  In the agreements the franchisor promised to protect and enhance Dunkin’ Donuts’ reputation and “the demand for the products of the Dunkin’ Donuts system.” Id at 6.

The Court sided with the franchisees, finding the franchisor’s failure to sufficiently protect the brand had fundamentally breached its franchise agreements. As a result of the franchisor’s inaction, the competitor’s franchise achieved considerable market share in Quebec at the cost of Dunkin’ Donuts and its franchisees. The Judge stated that the franchisor’s failure to respond in a way that was competitive with others in the industry prevented the franchisees from benefiting from their investments in the Dunkin’ Donuts franchise.  See id. at 19, 37.

In coming to its decision, the Court did make mention of the franchisees’ level of fault or lack therefore.  Ultimately, the Court did not find that the franchisees were poor operators.  See id.  In fact, the Judge stated that ‘[t]hey were amongst the best and most successful in the Quebec …”  Id.

It should be noted that while the franchisor was found at fault, this decision is particular to Quebec Civil Code, and only binding on Quebec courts. As previously stated, the Quebec Civil Code attaches a contractual obligation to the franchisor of a franchise agreement to protect and enhance the brand.  In Bertico, the Court relied on the specific terms of the franchise agreements and made the franchisor accountable for its written promise to protect and enhance the Dunkin’ Donuts brand.

Franchisors should be cautious of the kinds of promises and representations made when drafting or signing a franchise agreement in Canada.  As shown here, a Court may look to the terms of the franchise agreement when determining the franchisor’s responsibilities, and ultimately, the franchisor’s liability.

Comments/Questions: gdn@gdnlaw.com

© 2012 Nissenbaum Law Group, LLC

In December 2011, Texas Attorney General Greg Abbott (“Abbott”) sued the Texas Highway Patrol Association (“THPA”), the Texas Highway Patrol Museum, THPA Services, Inc. and several senior THPA officials (collectively “THPA and Affiliates,” separately “Affiliates”).  The suit claimed that THPA and Affiliates defrauded charitable donors by illegally soliciting donations under the false pretense that the contributions would be used to benefit the families of slain state troopers.  Instead, state investigators found that few survivors actually received financial assistance from THPA and Affiliates, and the money went toward personal use such as meals, movie theater and amusement park tickets and unauthorized association credit card charges for travel for officials and their family and friends.

THPA and Affiliates received up to $10,000.00 a day and they could not produce receipts for their expenditures that evidenced business related transactions.  While the organization had raised approximately $12,000,000.00 in donations within five (5) years, only a reported $63,500.00 was given to the families of fallen state police officers.

Some THPA officials gave employees excessive compensation and used donations to pay for personal vehicles.  Although THPA officials told investigators that the cars were for business, the insurance policy listed the purpose of the vehicles as being for pleasure.

The lawsuit also charged THPA and Affiliates with falsely claiming that they were a tax-exempt, charitable organization registered with the Internal Revenue Service (“IRS”).  THPA was a nonprofit business league, not a charity.

THPA and Affiliates also face civil penalties under the Texas Deceptive Trade Practices Act for falsely claiming that they are associated with the Texas Department of Public Safety (“DPS”) and its highway patrol division.  Neither the THPA nor its Affiliates are associated with the DPS.

The Travis County Probate Judge Guy Herman appointed a temporary receiver and froze THPA’s assets at $490,000.00.  The total amount of money improperly used was not acknowledged in the suit because Abbott plans to make that a part of the ongoing investigation.  The suit has not yet been adjudicated.

Comments/Questions: gdn@gdnlaw.com

© 2012 Nissenbaum Law Group, LLC

In Fabrau, L.L.C. v. Prashant Shah, et. al., No. A-4464-10T3 (N.J. Super. Ct. App. Div. July 11, 2012), the Appellate Division of the Superior Court of New Jersey was presented with the following question: Should parties be bound by an executed operating agreement that was not intended by all the parties to be final when there is evidence that a subsequent operating agreement was created but was not signed?

In that case, Fabrau, L.L.C. (“Fabrau”) filed a complaint against two of its alleged members, Prashant Shah (“Shah”) and Srinivisa Nallamotu (“Nallamotu”) (collectively “Parties”) for breach of the confidentiality and non-competition provisions of an operating agreement. Id. at 2.

Fabrau sought to develop low-cost, transparent software to assist in setting prices for pharmaceuticals sold by smaller pharmaceutical companies to government entities.  Chester Schwartz (“Schwartz”) was approached to help with sales and marketing, Nallamotu was approached because he was also interested in a more affordable alternative to a government pricing system and Shah was approached to help develop the product.  A draft amended operating agreement was created naming the members as Fabriczi (one of the creators of Fabrau), Rau (the other creator of Fabrau) (collectively “The Creators”), Nallamotu, Schwartz and Shah.  However, Shah sent an email explaining that there was changes he wished to discuss as per his lawyer’s suggestion.  At some point either before or after this e-mail, an undated draft operating agreement was executed by everyone except Nallamotu in a parking lot.

Fabrau argued that the signed agreement was final and binding on both Shah and Nallamotu because, although Nallamotu did not sign it Nallamotu had written an e-mail to a customer announcing that he had formed a company with a few people from the industry.  See Id. at 5.  Fabrau contended that this evidenced Nallamotu’s intention to be bound by the operating agreement. See Id. 

In contrast, Shah asserted that he was induced to sign the agreement by The Creators’ representation that Schwartz would not do his part of the work unless an agreement were signed; Shah also claimed that all who signed in the parking lot acknowledged that the agreement was not binding. See Id.  Nallamotu asserted that the fact that he never executed the agreement at issue should have been enough to show that he was not bound by its terms. 

The Appellate Division pointed to evidence that showed that sometime after the execution of the initial agreement, another member was recruited to the company.  The operating agreement was amended to reflect Christopher Biddle’s (“Biddle”) name, however, it was never executed.  A subsequent email was sent to all of the members asking that the document be executed and a few days after that another email listed the execution of the agreement as one of the “Company Action Items.” Id. at 7.  The Parties contended that the unexecuted document further evidenced that no agreement was ever reached.

After months of struggling to make sales of the pricing system, and after months of no communication between the members, The Creators decided to contact an outside vendor to see about converting the Shah-designed government pricing system to a web-based application.  Then they contacted a venture capital company (“Company”) to promote the product. Unbeknownst to The Creators, Shah and Nallamotu had also contacted the Company for help with the same product.  As a result of intellectual property concerns, the Company made inquiries that led to The Creators and Shah and Nallamotu finding out that each group was trying to promote the product. The Creators consequently filed a lawsuit against Shah and Nallamotu.

At trial, the Superior Court of New Jersey, Law Division, found that because Shah was admittedly the sole creator of the product, he had an ownership interest in the software.  Further, they found that no certificate of formation of Fabrau named Shah and Nallamotu as members of the company.  The Law Division concluded that a viable partnership agreement had never been reached by the parties.

On appeal, the Appellate Division agreed with the Law Division and also found that there was no meeting of the minds with respect to the operating agreement. It remained unexecuted in the Parties’ eyes at the time it was presented to Biddle and thereafter (as evidenced by the e-mail asserting that execution of the agreement was on the “Company Action Items” list). See Id. at 15. Ultimately, the Appellate Division found that the agreement that was executed in the parking lot was a sham designed to mislead Schwartz into believing that his expectations would be protected if he proceeded.  The parties’ conduct failed to manifest intent to be bound by their initial agreement.  See Id. at 17.  The Appellate Division affirmed the Law Division’s holding that no contract existed, and Shah and Nallamotu could not be bound.  See Id.

Proof of execution of an agreement is not the only thing that courts use to determine the rights and obligations of parties.  As shown in Fabrau, a court might consider the intent of the parties in conjunction with electronic communication that evince a contrary intention than what is displayed in the agreement.  The parties should have a common understanding of their expectations and responsibilities under the agreement.  Most importantly, it is vital that any correspondence or documentation between the parties reflect what they intend. This will serve to increase the agreements enforceability in court.

Comments/Questions: gdn@gdnlaw.com

© 2012 Nissenbaum Law Group, LLC

When is a franchise agreement unconscionable and, therefore, unenforceable as a matter of law? Legal precedent from the United States Court of Appeals for the Seventh Circuit is illustrative on this point. We Care Hair Development, Inc. v. Engen, et. al., 180 F.3d 838 (7^th Cir, 1999).

In that case, a group of franchisees filed a class action lawsuit in the circuit court of Madison County, Illinois (“state circuit court”) against We Care Hair Development, Inc. (“We Care Hair’) and others, claiming among other things, breach of fiduciary duty, fraud and violations of the Illinois Franchise Disclosure Act.  The state circuit court held that the arbitration clauses in the franchise agreements (“Agreement(s)”) were void and unenforceable.  However, the lower court (the Federal District Court for the Northern District of Illinois) upheld the Agreements and ordered the franchisees to arbitrate their claims, enjoining them from further action in the state court lawsuits.  The Franchisees appealed.

All the franchisees entered into Agreements that contained arbitration clauses as a “condition precedent to the commencement of legal action for all disputes arising out of or relating to the franchise agreement.” Id. at 2.  The franchise agreements provided that the laws of the State of Illinois would govern the Agreements.  The franchisees were required to sublease their premises from a leasing company, We Care Hair Realty (“Hair Realty”), an alter ego of We Care Hair.  Under the subleases, arbitration was not required, but the subleases allowed the leasing company to file eviction lawsuits against a franchisee for any breach of the sublease. See id.  There was a cross-default provision in every sublease. That meant that every breach of the Agreement would also be a “cross-default” precipitating a breach of the sublease.  The uniform offering circular for We Care Hair salons advised the prospective franchisees that the leasing company, Hair Realty, could terminate a sublease without We Care Hair also terminating the Agreement. See id.

On appeal, the franchisees contended that the District Court erred in failing to give full faith and credit to the Illinois State Circuit Court’s decision holding the arbitration clauses unenforceable.  They based this on the legal concept of  res judicata (claim preclusion) which states that if one court issues a ruling, a second court will be bound to apply that ruling if:

1) a final judgment or order on the merits has been entered by a court of competent jurisdiction;

2) the same causes of action were involved in both; and

3) the identical parties or their privies were litigants in both lawsuits.

Id. at 4.

The Appellate Court found that since the Illinois Circuit Court’s order was not a final order, res judicata did not apply. Therefore, the District Court did not err in independently finding that the arbitration clauses were enforceable.  See id. at 4.

Next, the franchisees claimed that the District Court ruling was in error because the arbitration clauses and the cross-default provisions in the subleases were unconscionable.  See id.   The franchisees stated that the clauses were unconscionable because they “required[d] the franchises to arbitrate their claims while permitting the franchisor to litigate its claims through eviction actions filed in the name of the alter ego leasing company.” See id.

However, as the Seventh Circuit noted, Illinois courts examine the circumstances existing at the time of the contract’s formation when assessing the enforceability of a contractual provision. See id.  This means that the bargaining positions of the parties were examined and a determination was made as to whether the provisions operation would result in unfair surprise. See id.  The Seventh Circuit found that the arbitration clauses did not create unfair surprise in that case.

The Seventh Circuit acknowledged that each franchisee was provided with a copy of the uniform offering circular before signing the Agreement and it clearly disclosed all of the terms and rights of the parties. See id. at 5. Furthermore, the Seventh Circuit felt that the franchisees were not unsophisticated or helpless consumers and were not forced into the Agreements.  See id. Ultimately, the Seventh Circuit affirmed the District Court’s holding, and held that the arbitration clauses, even when coupled with the cross-default provisions of the subleases, were not unconscionable.

Before invalidating an arbitration clause in a Franchise Agreement, a Court may consider the circumstances existing at the time of the parties’ transaction along with any other evidence displaying an unequal bargaining power between the parties.

Comments/Questions: gdn@gdnlaw.com

© 2012 Nissenbaum Law Group, LLC