In a recent win for franchisor 7-Eleven, Inc., the U.S. Court of Appeals for the Third Circuit upheld a New Jersey district court’s ruling that 7-Eleven properly terminated its franchise agreements for cause based on the franchisee’s failure to pay taxes. 2017 U.S. App. LEXIS 16177, *7-8 (3d Cir. Aug. 24, 2017). The opinions of both the New Jersey district court and the Third Circuit are instructive in the area of franchise law, albeit for different reasons. The New Jersey district court provided an in-depth analysis of the claims brought under the New Jersey Franchise Practices Act (NJFPA) and held that a franchisor may terminate an agreement for good cause regardless of the franchisor’s motive. The Third Circuit’s opinion is more limited because the franchisee did not explicitly appeal whether “good cause” existed for termination under the NJFPA. However, the Third Circuit reinforced the principle that the implied covenant of good faith and fair dealing cannot override an express term in a contract.

Background

Defendant Karamjeet Sodhi, one of three defendants in the case, became a 7-Eleven franchise operator in 2001 and eventually owned six 7-Eleven convenience stores. Each store was subject to a franchise agreement that contained several requirements for the franchisee, including paying all sales, payroll and income taxes related to the operation of the stores.

In 2011, 7-Eleven performed an audit of Sodhi’s financial and employment practices at the stores and identified several accounting and employment issues. In 2013 and 2014, 7-Eleven sent two separate notices of material breach. Among other things, the 2013 notice stated that Sodhi “intentionally failed to report multiple hundreds of thousands of dollars of merchandise sales, including taxable sales, at the Stores . . . used the cash illicitly, and secretly, siphoned from the Stores to pay the Stores’ workers, some of whom were undocumented, in cash (in violation of Federal and State law).” 7-Eleven, Inc. v. Sodhi, 2016 U.S. Dist. LEXIS 70794, *10 (D.N.J. May 31, 2016).

The District Court Finds in Favor of 7-Eleven

7-Eleven sued the defendants and sought declaratory relief finding that it properly terminated the franchise agreements based on the defendants’ breaches. In response, the defendants asserted counterclaims for violation of the NJFPA, breach of the implied covenant of good faith and fair dealing, violation of the Fair Labor Standards Act, and violation of the New Jersey Law Against Discrimination.

The district court granted 7-Eleven’s motion for summary judgment on the defendants’ counterclaims and 7-Eleven’s claim for declaratory judgment that the franchise agreements were properly terminated. The court cited to the NJFPA, which states, “[i]t shall be a violation of this act for a franchisor to terminate, cancel or fail to renew a franchise without good cause. For the purposes of this act, good cause for terminating, canceling, or failing to renew a franchise shall be limited to failure by the franchisee to substantially comply with those requirements imposed upon him by the franchise.” N.J. Stat. § 56:10-5.

The court observed that “Mr. Sodhi has admitted that he failed to pay payroll taxes, provide workers’ compensation insurance, or withhold and pay Social Security taxes for employees of his Stores.” 7-Eleven, Inc. v. Sodhi, 2016 U.S. Dist. LEXIS 70794, *13. Importantly, the court found that the defendants did not dispute that these failures were a material breach of the franchise agreements. Id. at *14. The court held that these material breaches constituted good cause for 7-Eleven’s termination of the agreements. The court went a step further and opined that “any purported ulterior motive of 7-Eleven, even if shown, is irrelevant to finding that 7-Eleven had good cause to terminate the Franchise Agreements.” Id. at *15.

In its analysis of the defendants’ claim for breach of the implied duty of good faith and fair dealing, the court rejected several statements allegedly made by 7-Eleven as inadmissible hearsay. Id. at *17. The court did, however, consider documents listing Sodhi and other franchise owners who appeared to be of Indian descent as “Second Wave Target[s].” Though the court acknowledged that this evidence “suggest[ed] that 7-Eleven may have had an ulterior motive in terminating the Franchise Agreements,” the implied duty of good faith and fair dealing does not preclude a party from exercising its express rights under such an agreement. Because “an ulterior motive does not preclude termination for good cause” under the NJFPA, the court found that 7-Eleven was entitled to judgment as a matter of law on the implied duty claim. Id. at *17-18.

Third Circuit Rejects Sodhi’s Implied Covenant Argument

On appeal to the Third Circuit, Sodhi argued, among other things, that 7-Eleven breached the franchise agreements’ implied covenant of good faith and fair dealing by targeting his store for closure. Sodhi did not dispute that he breached the franchise agreement by not paying taxes or that he breached a material term of the franchise agreement.¹ The Third Circuit rejected Sodhi’s arguments. Though the Third Circuit acknowledged that an implied covenant of good faith and fair dealing is present in every contract in the state of New Jersey, the Third Circuit reiterated the longstanding principle that “the implied covenant of good faith and fair dealing cannot override an express term in a contract.” 7-Eleven, 2017 U.S. App. LEXIS 16177 at *8.

The court then noted that Sodhi admitted his failure to pay taxes in violation of the franchise agreements and that there was no evidence in the record that Sodhi cured the breach. Therefore, 7-Eleven had good cause to terminate the franchise agreements despite its motivation for doing so. The Third Circuit did not review the district court’s decision on the NJFPA claim except to affirm the district court’s reliance on 7-Eleven’s supplemental notice of termination as a basis for its compliance with the NJFPA.

Notwithstanding the Third Circuit’s lack of review of the wrongful termination claim under the NJFPA, its decision in Sodhi suggests that a franchisee’s violation of the franchise agreement (in Sodhi’s case, failing to pay taxes) without curing the breach constitutes “good cause” for termination under the NJFPA. Courts interpreting the statute have observed that “[s]ubstantial compliance is surely something less than absolute adherence to every nuanced term of an agreement, but substantial compliance — at a minimum — requires that the franchisee refrain from acting in direct defiance of a term of the Agreement.” Maple Shade Motor Corp. v. Kia Motors of Am., Inc., 384 F. Supp. 2d 770, 775 (D.N.J. 2005) (internal citations omitted).

New Jersey state and federal courts have found that a franchisee failed to substantially comply with the terms of a franchise agreement where, among other things, the franchisee:

• overcharged its customers and violated federal gas pricing regulations (Amerada Hess Corp. v. Quinn, 362 A.2d 1258, 1267-68 (N.J. Super. 1976))

• added a competitor’s franchise to the location and premises without the franchisor’s authorization (GMC v. New A.C. Chevrolet, Inc., 91 F. Supp. 733, 740 (D.N.J. 2000))

• transferred the franchise to a purchaser who was unacceptable to the franchisor and without prior notice to the franchisor (Simmons v. Gen. Motors Corp., Oldsmobile Div., 435 A.2d 1167, 1178 (N.J. Super. 1981))

• was convicted of a crime and sentenced to prison (Int’l House of Pancakes, LLC v. Parsippany Pancake House Inc., 900 F. Supp. 2d 403, 407 (D.N.J. 2012)).

Neither opinion in the Sodhi case discussed whether the NJFPA should recognize a requirement that the franchisor act in good faith when terminating a franchise for cause under the NJFPA. The Third Circuit has previously acknowledged this issue in passing without answering it.

In 2001, former Third Circuit Chief Judge Becker addressed an appellant’s argument that, under New Jersey law, an examination of whether a franchisor’s termination was supported by good cause required an inquiry into whether the franchisor also acted in good faith. GMC, 263 F.3d 296, 320 (3d Cir. 2001). Judge Becker observed “[a]lthough this argument is an interesting one, and, as we explain briefly in the margin, New Jersey law offers no clear answer on this point, resolution of this issue is not necessary to our disposition.” Id.; see also Maple Shade Motor Corp., 384 F. Supp. 2d. at 774, n. 4 (“No court has resolved the issue of whether good faith by the franchisor is also required.”).

The GMC court found that it did not need to address the issue because the appellant failed to produce evidence to create a genuine issue regarding whether the appellee acted in good faith or without pretextual motive when it terminated the franchise. Id. In a footnote, the court also noted that, although the plain language of the NJFPA does not include a good faith requirement, New Jersey courts have imposed good faith requirements in certain circumstances when construing other franchise-related statutes that similarly omit an explicit good faith requirement. Id. at n.11 Whether intended or not, in Sodhi, the district court and the Third Circuit missed an opportunity to clarify whether a franchisor’s termination decision must be analyzed through the prism of good faith. But based on their express rejection of the franchisee’s “motivation” defense in spite of allegations of the franchisor’s bad faith, the New Jersey district court and the Third Circuit do not seem inclined to recognize such a good faith requirement.

Takeaways

• The implied covenant of good faith and fair dealing cannot override an express term in a contract.

• A franchisor with “good cause” may terminate a franchise agreement regardless of its motivation.

• The New Jersey district court and the Third Circuit are not inclined to find that the NJFPA imposes a good faith requirement on franchisors when they seek to terminate a franchisee for cause. But this issue has not been finally resolved.

Endnote