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Live by the Franchise, Die by the Franchise

Many small business owners find comfort and success capitalizing on a franchise. Franchisors use Non-Compete (“NCA”) and Non-Disclosure (“NDA”) clauses as well as mandatory arbitration provisions to protect themselves. But should such a provision be effective against a non-signing spouse? That was the question before the Appellate Court in the recent 7th Circuit case of Everett vs. Paul Davis Restoration. The short answer? Yes, it is.

The Family Business

Davis Restoration entered into a Franchise Agreement with Matthew Everett, husband of Plaintiff Renee, as the “principal owner” of Franchisee EA Green Bay. Sometime after signing as the sole owner of EA, Matthew transferred 50% of the company to his wife despite not securing permission from the Franchisor beforehand. Eventually, the Franchise Agreement was terminated and the 2-year non-compete provision took effect. Matthew then transferred the remaining 45% of EA to his wife, who continued to operate it under the name “Building Werks” from the same location with the same customers and employees. Moreover, the Franchisor contended, Building Werks continued to capitalize on its good will and reputation.

Reversal of Fortune

The Franchisor reacted to the breach of its NCA by initiating arbitration with Mrs. Everett, who sought a declaratory judgment in District Court to the effect that she should not be bound by the Arbitration Clause because the Franchise Agreement was signed by her husband. The District Court, however, found “abundant evidence” that she had benefited from the Franchise Agreement and therefore could be compelled to arbitrate according its terms. This was the so-called Direct Benefits Doctrine.

Following arbitration, the Franchisor went back to Court to confirm the unanimous finding in its favor. To its great surprise, this time the District Court denied confirmation and declared that its earlier ruling had been in error. Now, the Court felt, the benefit to Renee from the Franchise Agreement had not been “direct” but “indirect” through her ownership interest in EA and relationship to her husband. As a result, she could not be compelled to accept the arbitration award.

The Doctrine of Direct Benefits Estoppel

The Franchisor appealed to the 7th Circuit, which set about deciding whether the obligation to arbitrate in such a document was limited to those who had personally signed it or could include non-signatories benefited by it. Ultimately the Appellate Court reached same basic conclusion drawn by the District Court the first time around: that the non-signing, benefited party could not escape her obligation to arbitrate because she was estopped from doing so by the Doctrine of Direct Benefits.

As the Court observed, a direct benefit is derived the subject agreement itself. An indirect benefit by contrast would be one derived from exploitation of the contractual relationship of the parties. The 7th Circuit found that Mrs. Everett received the same benefits as her husband, including the ability to trade on the name, goodwill, and reputation of the Franchisor. In fact, Mrs. Everett’s ownership in EA had only arisen because EA had been formed to satisfy the requirements of the Franchisor. In every sense, Renee had benefitted from Matthew’s relationship with the Franchisor.

The Upshot

Perhaps the primary message of this case was that those who live by the Franchise Agreement, die by the Franchise Agreement…. So to speak. If a party directly benefits from a deal, they should be made to comply with its less glorious features as well. After all, any other conclusion would end up handing franchisees a giant loophole.

Questions about your own situation? Business owner looking for answers? Call us in confidence at 630-378-2200 or reach out to us by e-mail at mhedayat[at]mha-law.com.

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