Scrutinizing Franchise Legal Claims

For the Legal Intelligencer

by Craig R. Tractenberg

Franchisees need to carefully consider their actions when faced with a franchisor that is seeking claims and recourse for violations under the terms of the  franchise agreement.

Judges are charged with performing justice among the litigants.  Members of the bar benefit when the judiciary writes not only for the litigants, but to explain its reasoning for others. The decision in the Eastern District of Pennsylvania in AAMCO Transmission v. Wirth expounds on what franchisees need to allege in order to succeed in overcoming a motion to dismiss for failure to state a claim under Pennsylvania law.

The case was brought by AAMCO to enforce a settlement agreement with its franchisee Wirth. The settlement agreement provided for catch up payments by Wirth for economic defaults and upon default, the franchise agreement could be terminated.  Upon termination, Wirth was to stop operating, observe a post-termination non-compete agreement and pay the back money. AAMCO terminated the franchise and filed a complaint to enforce the settlement agreement. AAMCO claimed that Wirth continued to operate after effective termination under the settlement agreement. AAMCO moved for a preliminary injunction, which was resolved by stipulation and Wirth filed a counterclaim.

The counterclaim alleged that AAMCO represented it had a proven formula and system for success for its franchisees and that its business model contained cost containment provisions for labor and parts that would allow Wirth to make a profit. Wirth further alleged that the model was profitable only for rebuilding transmissions and not for other services offered, such as general automobile repairs, installing remanufactured or used transmissions, which are facts AAMCO should have known and disclosed. Wirth further alleged that AAMCO should not have removed Wirth from its internal website and external Center Locator merely because it could not pay for its adverting costs. Wirth claimed that it could not pay the advertising contributions because the model failed, and Wirth could not make catch up payments under the settlement agreement because of the flawed model. The counterclaim asserted breaches of the franchise agreement, breach of good faith and fair dealing and for fraudulent misrepresentation.

AAMCO filed a motion to dismiss, which requires the court to review the allegations with every factual inference interpreted in favor of Wirth. In addition, the Court noted that the claims will be dismissed unless a plausible claim for relief is asserted, reviewed as a context-specific task that requires to the court to draw on its judicial experience and common sense. The Court reviewed each of the claims against this standard.

With respect to the fraud counterclaim, the Court found the claim alleged two components, fraud in the inducement and fraud in the performance. Fraud in the inducement requires a false statement which induced the signing of the franchise agreement. The parol evidence rule, however, could bar admission of the false statement if the contract contains terms which directly deal with the subject matter of the representations and the contract contains an integration clause. In this case, the franchise agreement was found to explicitly disclaim any prior representation as to the potential profitability of operating an AAMCO and nothing in the remainder of the franchise agreement implied that adherence to the business model would guarantee any level of profitability.  The Court further found the integration clause unequivocally represented that the entire agreement of the parties was contained in the franchise agreement. The Court rejected Wirth’s argument that the narrow exception to the parol evidence rule under Pennsylvania law for “real estate inspection cases” could relieve the harsh result of the parol evidence rule. The rationale of the exception is that like a real estate buyer, a franchisee cannot assess the true condition of what is being bought. The Court refused to extend the narrow exception.

The Court also dismissed the fraud in performance claim based on the gist of the action doctrine. The gravamen of the claim is that AAMCO told Wirth that his profits would improve the business model were followed.  The gist of the action doctrine allows a tort claim only if the contract is collateral to conduct that is primarily tortuous. Here the Court found that the tort claim was barred because it was grounded on a duty to perform under a contract.

The Court then turned to the two breaches of contract claims. The first claim is the removal of Wirth from the website and Center locator. The second is the licensing of two other franchisees within ten miles.  On the website and Center locator claim, the Court found that Wirth failed to identify a duty within the franchise agreement that required such a performance. To the extent such a performance did exist, it was an obligation only to assist in advertising.  Assuming arguendo that an actual duty did exist to advertise, and then Wirth concedes that he failed to pay the pooled advertising contribution. The Court refused to grant Wirth a free ride for advertising.

The Court similarly could not find a provision in the contract that prevented the licensing of two franchisees within a ten mile radius. The contract contained a population density metric, but not a ten mile radius prohibition, and the complaint failed to explain how one related to the other. Moreover, the contract states “Franchisee agrees that he does not have and is not being granted a protected trading area, specifically without limitation, in regard to placement of other AAMCO Centers. “

Finally, the Court addressed the good faith and fair dealing claim and explained that not every contract applying Pennsylvania law imposes the duty of good faith and fair dealing, and that the doctrine is limited in franchise settings to issues of termination.  To the extent that the doctrine of good faith and fair dealing did apply to this setting, the doctrine could not override an express contractual term which disclaimed a protected trading area. 

Although Wirth had creative arguments with some basis in the contract, the Court explained the limits of Pennsylvania law and its obligation not to extend those limits. The case is a very good summary of the current law regarding the pleading of claims of fraud and breach of contract by franchisees.

Craig Tractenberg is the leader of the franchise and distribution group, and a partner in the business litigation and bankruptcy teams in the New York and Philadelphia offices of Nixon Peabody LLP. His practice focuses on complex litigation and counseling requiring expertise with franchise and distribution, insolvency or intellectual property issues.

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