Franchise 101: Getting Away With Tax (Franchisor) Evasion; and Fraud Claim Muzzled by Contractual Limitations Period

Franchisor 101: Getting Away With Tax (Franchisor) Evasion

A Pennsylvania federal court refused to enforce non-competition and non-solicitation covenants in a franchise agreement of a nationwide tax preparation service franchisor. The court dismissed the franchisor’s request for injunctive relief to enforce those covenants.

In 2015, Liberty Tax Service (Liberty) entered into a franchise agreement for the operation of a tax preparation business in Pennsylvania. Liberty terminated the franchise agreement in June 2020, claiming the franchisee breached the franchise agreement by failing to pay monies owed, failing to timely open the franchise for business, and failing to actively operate the Liberty office.

The franchise agreement contained non-compete and confidentiality provisions stating that for two years following termination, the franchisee would not be involved in a competing tax business within her franchise territory or within 25 miles of her territory. The franchise agreement also restricted the franchisee from soliciting Liberty’s customers for the same time period.

Liberty filed a complaint against the former franchisee in January 2023, alleging breach of contract and promissory notes, violations of the Defend Trade Secrets Act (DTSA), conversion, and unjust enrichment. Liberty alleged it “recently discovered” the former franchisee began operating a competing tax service and openly solicited Liberty’s clients while she was still a Liberty franchisee. Liberty also asserted that, post-termination, the former franchisee operated the competing tax service out of the same location as the franchised business, with the same telephone number, advertising on its website that it has serviced customers “for nearly five years” and “offers the same friendly and accurate service” despite its name change. Liberty sought injunctive relief to enforce the non-competition and non-solicitation covenants.

The court denied Liberty’s request for enforcement of the non-competition and non-solicitation covenants because Liberty was trying to enforce the covenants beyond their contractual expiration date of June 9, 2022. The court determined no factor outside of Liberty’s control caused the delay in filing the action, finding Liberty’s “recent discovery” of the covenant violations did not constitute a factor beyond its control.

Franchisors should monitor their former franchisees to determine if they are operating a competing business in violation of the franchise agreement’s non-compete covenants. A franchisor’s delay in discovering such violations may be viewed as a lack of due diligence in monitoring and enforcing its contractual rights and may be used against a franchisor if it later tries to enforce the non-compete or non-solicitation provisions of the franchise agreement. 

JTH Tax LLC v. Foster, 2023 U.S. Dist. LEXIS 161631 (W.D. Pa. Sept 12, 2023)

Franchisee 101: Fraud Claim Muzzled by Contractual Limitations Period

A North Carolina federal court dismissed a complaint brought by a franchisee against its franchisor. The franchisee alleged the franchisor fraudulently induced the franchisee to enter into a franchise agreement, but the court found that the claim was time barred.

After executing a franchise agreement with Hounds Town USA, a pet daycare franchisor, the franchisee contracted with a third-party construction contractor that Hounds Town recommended. The contractor encountered numerous setbacks with the construction of the franchised location. The franchisee did not open their franchised business for two years after signing the franchise agreement. The franchisee entered into a second construction contract with a subcontractor of the original general contractor. The franchisee later terminated that second construction contract and Hounds Town terminated the franchise agreement. The franchisee then filed suit.

Hounds Town moved to dismiss the compliant. The franchisor argued the terms of the franchise agreement barred the franchisee’s claims because the agreement provided for a one-year statute of limitations period. The franchisee alleged the one-year limitation clause was unenforceable because the franchise agreement was induced by fraud and therefore void.

The court found the franchisee failed to allege any essential element of a fraud claim. The court determined that Hounds Town’s recommendation of a contractor prior to the franchise sale was stated as a matter of opinion. The franchisee did not allege Hounds Town made the franchise agreement contingent on the engagement of that contractor. The court found the franchise agreement was not void for fraud-in-the-inducement.

The court also found the one-year limitation clause in the franchise agreement was enforceable. No law prohibited the parties from shortening the usual statutory limitations periods by contractual agreement, and the shortened limitations period was not unreasonable under North Carolina law.

Franchisees considering filing suit against their franchisor should consult with franchise counsel to review the franchise agreement and determine the applicable contractual and statutory limitations periods, including potential law to be applied. Planning in advance will help franchisees avoid time-barred claims.

Bigelow Corp. v. Hounds Town USA, LLC, 2023 U.S. Dist. LEXIS 134352 (W.D.N.C. Aug. 2, 2023)