Franchisor Was Entitled To Terminate Franchises Without Notice Based On Fraudulent Inducement

04/18/2014 / the Franchise & Distribution Practice Group

Franchisees often claim, typically long after the fact, that they were induced to enter into their franchise agreement based on fraudulent representations or omissions by the franchisor.  However, franchisees may also fail to disclose important information to the franchisor, perhaps out of fear that the franchise will not be granted.  A recent case held that a franchisor was within its rights to terminate the franchise agreement (without any liability for reimbursement of fees) upon discovering that important facts had been concealed by a franchisee in the application process.  While franchisors are not in the business of terminating the franchise agreements of its franchisees, the ability to do so can be a powerful negotiating chip with a franchisee who refuses to follow the system or has failed to develop the franchise and is seeking a refund of fees. 

In Dunkin’ Donuts Franchising LLC v. Sai Food Hospitality, LLC, Bus. Franchise Guide (CCH) ¶ 15,205 (E.D. Mo. Dec. 31, 2013), franchisor Dunkin’ Donuts terminated two franchise agreements based on the franchisees’ misrepresentation related to the ownership of the corporate franchisee.  In 2009, husband and wife Jayant and Ulka Patel (“Jayant and Ulka”) signed a Store Development Agreement, giving them the right to develop and open ten Dunkin’ Donuts stores in the St. Louis area by January 2017.  Jayant and Ulka formed a corporation, Sai Food & Hospitality, LLC (“SFH”), to serve as the corporate franchisee for their franchises.  The majority of SFH was owned by Kamlesh Patel and Jigar Patel (“Kamlesh and Jigar”), however, individuals who had not been approved as franchisees and did not sign the Store Development Agreement.  Jayant and Ulka were minority owners in SFH. 

Dunkin’ Donuts required that Kamlesh and Jigar be removed from ownership before Jayant and Ulka would be allowed to enter into a franchise agreement with SFH as the franchisee.  Jayant and Ulka assured Dunkin’ Donuts that they had held a board meeting and changed the corporate structure to remove the other two individuals as owners.  They provided a copy of IRS Form 2553, showing that Jayant and Ulka each owned 50% of SFH.  Based on this material information, Dunkin’ Donuts entered into two franchise agreements with SFH—on November 19, 2010 and August 5, 2011.  In fact, Kamlesh and Jigar were never removed as owners and Jayant and Ulka concealed the true ownership structure information from the franchisor. 

Dunkin’ Donuts conducted an investigation and issued a report on July 14, 2011, concluding that Jayant and Ulka fraudulently induced Dunkin’ Donuts to enter into the first franchise agreement by misrepresenting the ownership of SFH.  The report was forwarded to the legal department for analysis.  By August 24, 2011, the Dunkin’ Donuts legal department decided to terminate the franchise agreements and sent the Patels a notice of termination of the two franchise agreements and the Store Development Agreement, effective immediately upon receipt.

After a bench trial, the court ruled in favor of Dunkin’ Donuts on its claims for breach of contract, trademark infringement, and unfair competition and on the franchisees’ counterclaims for wrongful termination.  The court determined that the original ownership structure—with Kamlesh and Jigar as majority owners—was never changed, and that Jayant and Ulka wrongfully concealed this fact.  The court further determined that misrepresentation of the ownership structure was a material misrepresentation that fraudulently induced Dunkin’ Donuts to enter into the franchise agreements.  Because fraud is grounds for immediate termination under both the franchise agreements and Missouri Franchise Act, the termination by Dunkin’ Donuts was not wrongful.  With respect to the second franchise agreement, the franchisees asserted a promissory estoppel counterclaim based on the fact that the agreement had been signed after the loss prevention department’s report finding fraud.  Despite this timing, the court determined that the franchisor’s legal department was entitled to a reasonable amount of time to analyze the report and make a decision, and that the franchisees had failed to show any damages as a result of their reliance on the franchisor’s decision to enter into the second agreement.

Reprinted with permission from Franchising Business & Law Alert, March 2014.