Franchise Law

September 2002

COURT DEALS FRANCHISEE A DIAMOND FLUSH

by James D. Henderson, Jr., Esq.

Nature’s 10 held itself out as a franchisor offering potential franchisees an opportunity to participate in retail sales of various articles of jewelry at discounted prices. Nature’s 10 stores were advertised as marketing diamonds obtained from Nature’s 10's own mines, cut in its own facilities and offered at lower prices to franchisees. Nature’s 10 was registered to sell franchises with the South Dakota Division of Securities.

On August 27, 1997, the South Dakota Division of Securities notified Nature’s 10 and its officers that Nature’s 10 franchise registration had expired. Then, on October 1, 1997, the Division withdrew the company’s registration number effective July 29, 1997. Nature’s 10 was warned that the company “will no longer be engaged in the offer or sale of franchises in South Dakota.”

Sam Savage (Savage), a Florida resident, had previously been in the jewelry business and was interested in operating a jewelry franchise store. Savage negotiated with Nature’s 10 and signed a franchise agreement with the company on December 19, 1997—more than four months after Nature’s 10 was no longer authorized to sell franchises.

After signing the franchise agreement, Savage made additional, substantial investments and opened his Nature’s 10 franchise store in Naples, Florida in April of 1998. On May 14, 1998, Nature’s 10 was formally dissolved as a corporation by the South Dakota Secretary of State. Savage closed his store in January of 1999 after losing several hundred thousand dollars.

Nature’s 10 claimed to be a wonderful and unique business opportunity for prospective franchisees.

Nature’s 10 offered “manufacturer-direct purchasing” with “a continuous supply of discounted wholesale diamonds from the company’s own mines” cut in their own facilities. Nature’s 10 promised the following to Savage:

Nature’s 10 would allow Savage to provide diamonds to insurance companies that were replacing jewelry lost by or stolen from their insureds.

Nature’s 10 would provide Savage initial training in the operation of a franchise.

Nature’s 10 would develop and administer a corporate awards program.

Savage would receive company-administered updates and maintenance for computerized inventory catalog of jewelry designs.

Nature’s 10 would establish a toll free telephone service number to provide information and assistance.

Nature’s 10 would provide training for bookkeeping, accounting, inventory control and other procedures for the operation of a franchise.

As it turned out, Nature’s 10 was the “cubic zirconium” of jewelry franchises. Nature’s 10 had no diamond mines, no cutting facilities, and no diamonds. There was no insurance jewelry replacement program, no coordinated advertising and strategies, no franchise training, no corporate awards program, no computerized inventory catalog of jewelry designs, no toll free service number, no training and support for bookkeeping, accounting, inventory control and other procedures. Nature’s 10 provided none of the guaranteed franchise products and services.

In short, the things that Nature’s 10 promoted did not exist, and the things that Nature’s 10 promised were not provided. Savage was forced to close his business at a substantial loss.

In his lawsuit, Savage alleged breach of contract, failure of consideration, breach of implied duty of good faith and fair dealing, fraud, misrepresentation in the sale of a franchise, piercing the corporate veil to impose personal liability on the directors and officers, and additional counts alleging specific franchise statute violations. Nature’s 10 moved for compulsory arbitration in accordance with a clause in the franchise agreement. Although Savage opposed the motion, the trial court entered an order requiring arbitration. Savage filed an appeal.

The Appellate Court reviewed the franchise agreement between Nature’s 10 and Savage and found that it contained the following arbitration clause: “Any monetary claim arising out of or relating to this Agreement, or any breach thereof ... shall be submitted to arbitration in [Union] County, South Dakota, in accordance with the rules of the American Arbitration Association and judgment upon the award may be entered in any court having jurisdiction thereof and shall be final, binding and unappealable.....”

The Court of Appeals noted that Courts consistently favor the resolution of disputes by arbitration. Since the purpose of arbitrating disputes is to provide a relatively quick and inexpensive resolution with the cost and delay that may come with legal proceedings, there is an overriding policy favoring arbitration when a contract provides for it. In addition, South Dakota has adopted the Uniform Arbitration Act. SDCL 21-25A-1 provides: A written agreement to submit any existing controversy to arbitration or a provision in a written contract to submit to arbitration any controversy thereafter arising between the parties is valid, enforceable, and irrevocable, save upon such grounds as exist at law or in equity for the revocation of any contract.

If there is doubt whether a case should be resolved by traditional judicial means or by arbitration, arbitration will prevail.

In this case, the Court found that there was no valid contract. The agreement was entered into between Savage and Nature’s 10 several months after the registration expired, and was void, not voidable. A void contract is invalid or unlawful from its inception. It is a “mere nullity, and incapable of confirming or ratification.” A voidable contract, on the other hand, is a valid contract that can be “legally voided at the option of one of the parties.” Here, the franchise agreement between Savage and Nature’s 10 was signed in violation of SDCL 27-5A-6. This statute provides that “no person may offer or sell any franchise . . . unless there is an effective registration statement on file....” Because there was no effective registration statement on file, the agreement was unlawful from its inception and thus void

While there may be policy favoring arbitration when a contract provides for it, one cannot arbitrate a felony. In Party Yards, Inc., v. Templeton, the Fifth District Florida Court of Appeals said: “A claim that a contract is illegal and, as in this case, criminal in nature, is not a matter which can be determined by an arbitrator. An arbitrator cannot order a party to perform an illegal act.” In this case, Nature’s 10 contracted with Savage in violation of state law. None of the promises was fulfilled. The corporation was evaporated.

The Court of Appeals refused to permit the individuals who committed the illegal acts on behalf of the corporation to benefit from the arbitration clause in the illegal act, and allowed Mr. Savage to pursue his claims in court rather than arbitration.