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28 JAN 2010

Responding to bankrupt franchisee's cheating
FRANCAST

David A. Beyer Philip V. Martino

With the downturn in the economy, an increasing number of distressed franchisees are turning to bankruptcy court to escape both monies-owed obligations and their competitive obligations to their franchisors. Sometimes, the franchisee “prepares” for the bankruptcy by setting up a competing business that is ready to hit the ground running when the bankruptcy is filed. Even though this conduct breaches the parties’ franchise agreement, many franchisors do not pursue their claims in the belief that the franchisee’s debts and obligations will be discharged during the bankruptcy process. But bankruptcy courts are increasingly willing to refuse to discharge franchisees’ debts and obligations after scrutinizing their conduct leading up to the bankruptcy. Just recently, Rescuecom successfully challenged a bankrupt franchisee’s attempt to discharge monetary obligations in In re Khafaga.1 Less than one year after signing his second franchise agreement with Rescuecom, Khafaga embarked on a deliberate plan to violate the competitive restrictions of his franchise agreements and divert business to a competing business called Computer Medics, organized under his wife’s name. Computer Medics began providing the very same computer repair services as the Rescuecom businesses. Rescuecom alleged that the franchisee had diverted business and customers from his franchises to Computer Medics before termination of his franchises. After the termination of his franchises, he continued to solicit and divert Rescuecom customers to his Computer Medics business, in violation of the covenant not to compete and covenant not to solicit or divert customers contained in the franchise agreements. The franchise agreements contained in-term and post-term competitive restrictions, both of which were enforceable under state law. The franchise agreements also required Khafaga to report all sales and services rendered, whether or not formally provided through his franchised corporate entity. He was required to make annual financial disclosures to Rescuecom of all business and personal bank accounts, tax returns and sales and income. But the sales, services and revenue reported by Khafaga to Rescuecom never included the sales, services and revenue generated from the competing Computer Medics business. Thus, the reports were all false and underreported his true sales. He also did not provide the annual reports, because doing so would have revealed his secret competing operations. When Rescuecom discovered Khafaga’s competing business, it notified him of the breach and his failure to provide financial disclosures and information. Khafaga did not cure the defaults and Rescuecom terminated the franchise agreements. Rescuecom then sued Khafaga in state court for monies owed and damages. Faced with Rescuecom’s lawsuit, Khafaga filed for bankruptcy under Chapter 7 of the Bankruptcy Code, thereby staying the litigation. Rescuecom then sued Khafaga in bankruptcy court, seeking to declare Khafaga’s debt as nondischargeable on various grounds. First, Rescuecom argued that Khafaga’s debt should not be discharged because he obtained the debt by false pretenses under Code § 523(a)(2)(A). But the court concluded that the franchise agreement was not induced by Khafaga’s fraudulent conduct. Rather, the debts were created after the franchise agreements were entered into. Thus, that section of the Code did not apply. Second, Rescuecom argued under Code § 523(a)(2)(B) that the debt owed to it was nondischargeable

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because Khafaga knowingly submitted false financial reports, with the specific intent of deceiving Rescuecom as to his true sales. Again, the court found that the debts were dischargeable because the allegedly false written statements and the corresponding damages did not arise when the franchise agreements were executed. Thus, because Rescuecom did not rely on any false statements from Khafaga when entering into the franchise agreements, the debtor’s actions did not violate this Code Section. Third, Rescuecom argued that the debts were nondischargeable under Code § 523(a)(6) because they were incurred by causing willful and malicious injury to the franchisor. The court found that Rescuecom sufficiently alleged willfulness. The complaint adequately alleged that Khafaga “secretly diverted customers and business away from his Rescuecom franchises with the express purpose of depriving Rescuecom of royalties due under the franchise agreements . . . and failed to make required annual financial disclosures in order to perpetuate the scheme. . . .”2 The court also found that Rescuecom successfully alleged maliciousness. The court stated that a debtor’s knowing breach of contract generally does not satisfy the malicious element of Code § 523(a) (6). To establish malice, the court required some aggravating circumstance evidencing conduct so reprehensible as to warrant denial of the fresh start to which an honest but unfortunate debtor would normally be entitled. Courts examine on a case-by-case basis whether the circumstances are sufficiently aggravating to support a finding of malice. The court recognized that Rescuecom’s complaint did not merely allege that Khafaga violated the noncompetition clause and failed to pay royalties. “Rather, it goes further, alleging that [Khafaga] secretly opened a competing business under his wife’s name in order to avoid detection, actively diverted customers and business away from his own Rescuecom franchises, and submitted false reports to Rescuecom to conceal his actions. . . .”3 Accordingly, the court found that the circumstances alleged were sufficient for Rescuecom’s complaint to go forward to enforce the monetary debt owed by Khafaga. Similar circumstances enabled a franchisor to pursue competitive restrictions against a franchisee seeking to discharge them in bankruptcy. In In re Fein4, the court was initially inclined not to grant the franchisor relief from the stay to enforce noncompetition covenants. But it was compelled to do so by the franchisee’s egregious conduct, reasoning that bankruptcy debtors are entitled to a “fresh start,” but not a “head start.” After a dispute with Liberty Tax over royalties, Fein decided not to renew and let his contract for one unit expire. But he continued operations, and Liberty sued to enforce all post-term obligations, including the noncompetition covenant. Fein then filed Chapter 13. The franchise agreement specified money damages for violating the noncompetition covenant; most monetary obligations are discharged in bankruptcy. Furthermore, the franchise agreement did not explicitly allow injunctive relief to the franchisor and did not state that monetary damages would be an insufficient remedy. According to the court, “without more,” it was inclined to discharge the noncompetition obligation; but the court admonished, “There is more.” The court examined Fein’s behavior after he decided not to renew. Fein continued to attend franchisee meetings to learn proprietary marketing programs. Fein opened his American Tax Service in the same location as his Liberty Tax franchise, while keeping both the Liberty Tax signs and his own American Tax trade name at the location. Fein solicited both former Liberty Tax customers and former Liberty Tax employees. He ignored his obligation to assign phone numbers and manipulated the phone services to divert customers from his other Liberty Tax locations to the American Tax location. According to the court, Fein converted customer goodwill to himself, and Liberty’s loss was not a dischargeable claim. The court also took into account Fein’s elusive and deceptive answers in court. Thus, the court decided that Fein’s noncompetition obligations were not dischargeable under the Bankruptcy Code and granted Liberty Tax relief from the stay to enforce them. When granted relief from the automatic stay, franchisors have often successfully enforced noncompetition covenants.5 Franchisors facing bankrupt franchisees that are trying to discharge their debts and obligations should scrutinize the actions of the franchisee in the period leading up to the bankruptcy. Willful and deceptive acts by the franchisee may prevent a discharge and enable the franchisor to enforce both monies owed and competition restrictions. These actions may not result in a monetary recovery for the franchisors after all, the franchisee is in bankruptcy and if the non-compete is enforced the debtor likely has no livelihood – but occasional aggressive actions by franchisors may deter similar misconduct by other franchisees.

1 2009 WL 426 9441 (Bankr. E.D. N.Y., Nov. 30, 2009). 2 Id.

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3 Id. 4 Bus. Franchise Guide (CCH) ¶13,951 (Bankr. D. Mass., May 5, 2008). 5 See, e.g., In re Kennedy, 267 F.3d 493 (6th Cir. 2001); In re Udell, 18 F.3d 403 (7th Cir. 1994); In re Printronics, Inc., 189 B.R. 995 (Bankr. N.D. Fla. 1995).

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