|August 12, 2014|
Previously published on August 6, 2014
Take-away. A franchisor’s diligence in conducting and documenting quality assurance inspections is as important as ever, particularly if the franchisor seeks to exercise its ultimate weapon - termination of the franchise agreement. Prudent inspection and documentation practices are particularly crucial in the many U.S. states and territories that have statutes requiring a showing of “good cause” in order for a franchisor to terminate a franchise agreement. In such states, a franchisor must furnish evidence demonstrating that the franchisee failed to substantially comply with the material and reasonable franchise requirements; otherwise, a court may well restore the franchise rights and order money damages to the franchisee.
The Case. Pooniwala v. Wyndham Worldwide Corp., a May 2014 decision by the U.S. District Court for the District of Minnesota, is an exemplary demonstration of how a franchisor establishes that one of its franchisees repeatedly violated quality assurance standards so that there was “good cause” to terminate the franchise agreement under state law. The franchisor’s in this case diligently conducted and documented regular quality assurance (“QA”) inspections.
The Facts. Minn. Stat. Section 80C.14, part of the Minnesota Franchise Act, allows a franchisor to terminate an agreement if the franchisor can show “good cause” for termination. Good cause means failure by the franchisee to substantially comply with the material and reasonable franchise requirements imposed by the franchisor, including “any act by or conduct of the franchisee which materially impairs the goodwill associated with the franchisor's trademark, trade name, service mark, logotype or other commercial symbol.”
Pooniwala involved franchise agreements for two hotels, one a “Super 8,” and the other a “Travelodge.” The franchisee alleged that the franchisors, both of which are affiliated companies within the Wyndham Hotel Group, took retaliatory action against the franchisee because of a lawsuit between the franchisee and Ramada Worldwide Inc., its fellow Wyndham Group affiliate. The franchisors, for their side, argued that their attempts to terminate the franchise agreements were not retaliatory actions, but rather that the franchisee had repeatedly violated QA standards found in the respective franchise agreements, giving each franchisor good cause for termination.
The first attempted termination involved a Super 8 hotel facility in Roseville Minnesota. The franchise agreement for the Roseville Super 8 included quality assurance requirements, as well as provisions allowing Super 8 to inspect the facility to ensure that it was operating in compliance with Super 8’s system standards and QA requirements. The franchisee had failed six consecutive QA inspections at the Roseville Super 8. Each inspection was followed by a letter indicating that the franchisee had received a failing score on the QA inspections. The letters also gave the franchisee notice that it had sixty days to cure the QA deficiencies, the failure of which could result in termination of the franchise agreement. Finally in September 2013 Super 8 notified the franchisee that the franchise would terminate on December 29, 2013, unless the hotel passed a final QA inspection. The franchisee failed that final inspection, and shortly thereafter Super 8 informed the franchisee that termination would take effect on the originally scheduled termination date.
The second termination was for a Travelodge hotel facility in Burnsville, Minnesota. The Burnsville Travelodge agreement contained similar QA requirements, and the franchisee failed eight consecutive QA inspections, receiving letters documenting the failures following each inspection. Finally the franchisee received notice of termination for the Travelodge franchise. The notice described QA deficiencies, and stated that termination would take effect in ninety days, but that another inspection would be scheduled to determine whether the QA violations had been cured. The franchisee failed that inspection, and as a result Travelodge informed the franchisee that termination would take effect on the originally scheduled date.
Preliminary Injunction. It is not a wonder that motions for preliminary injunction are commonplace in hotel franchise termination cases. With the great potential for loss of good will among customers, employees and suppliers, franchisees will not want to give up their rights to franchise logos or their presence on a franchisor’s reservation system. In Pooniwala, the franchisee sought an order for preliminary injunction to stop the franchisors from terminating the franchise agreements before the court heard the case on its merits.
In deciding whether to grant a preliminary injunction, courts have to balance the harm to the two sides. They also consider the requesting party’s likelihood of success on the merits in the underlying claim--here, violation of the good cause requirement of the Minnesota Franchise Act.
In Pooniwala, the court denied the franchisee’s motion for preliminary injunction and ordered it to go ahead with its post-termination obligations, such as removing the franchised brands’ signage. The court found that, given the many QA inspection failures at the two hotels, and the fact that the franchisees had continuing franchise relationships with Wyndham Hotel Group affiliates at other hotel properties, the franchisee did not demonstrate an adequate likelihood of success of proving that the termination was without good cause. Further, the court held that, while the franchisee would suffer obvious harm through loss of the franchise rights, the franchisors were also suffering continuing, irreparable harm as long as the franchisee’s hotels continued to operate under their trademarks while not maintaining brand quality standards.
Conclusion. Hotel franchise agreements typically provide for substantial liquidated damages if the franchisor terminates for cause, meaning that the Pooniwala franchisees are likely to owe hundreds of thousands of dollars. In other franchise cases, the terminated franchisee may be forced to cease operating a similar business due to a covenant not to compete.
The stakes are high, and franchisors can expect a fight. So if they decide to take the drastic step of terminating for cause, they had better have their “ducks in a row.” In Pooniwala, the Wyndham Hotel Group franchisors showed how this is done.