Decorating Den Hammered In Arbitration With Aussie

By Sand Adler

Leader's Franchising Business & Law Alert, Published by Leader Publications, a division of New York Law Publishing Co., Vol. 4, No. 5, February 1998

The pitfalls of going global became painfully evident to Decorating Den Systems, Inc. and its president, James Bugg, when an arbitrator recently socked the franchisor, a Bethesda, Md.-based mobile interior decorating business, with an award approaching $500,000.

The claimants, Ron and Lynn Scott, alleged that respondents Decorating Den and Mr. Bugg: fraudulently induced them to enter into a Master Franchise Agreement (MFA) for Australia and New Zealand; breached the agreement and their implied covenant of good faith and fair dealing; and violated state and federal laws governing the sale of franchises, resulting in damages to them of $2 million.

The respondents, who are appealing the decision in Maryland federal court, answered that the claim was barred by Maryland's three-year statue of limitations and counter-claimed that the claimants had themselves breached the MFA, resulting in damages of $450,000.

In their findings of fact, the arbitrators, after six days of hearings, found that Decorating Den made material misrepresentations in connection with the sale, including: that the typical franchisee working full time earned between $25,000 and $50,000, and that a formula referred to as "Color Van Potential" was a reasonable basis for assessing the economic viability of individual franchises and the master franchise in Australia and New Zealand, both of which were determined to be false. 

The arbitrators also held, in connection with the sale, that Decorating Den failed to disclose material facts including: that litigation was brought against Decorating Den by several U.S. franchisees; that a significant number of U.S. franchisees were inactive; and that there was a high turnover rate among U.S. franchisees.

The arbitrators held that the Scotts acted reasonably in relying on the information provided them.

Regarding the allegation of breach of contract and implied covenant of good faith and fair dealing, the arbitrators rejected claimants' assertion that they had not received adequate support materials and supervision, noting that respondents not only provided some training, assistance, materials and supervision, but that the MFA provided that the Scotts would receive less support than the typical master franchise because the were in a foreign country requiring that they develop their own trade contracts, adapt U.S. materials, etc.

On the issue of statute of limitations, the arbitrators found that the Scotts only became aware of the mis-representations and omissions less than two years before filing demand for arbitration.

Respondents, the arbitrators found, failed to show that claimants either possessed knowledge of the fraud or had reason to investigate the misrepresentations prior to this time.

The arbitrators concluded that the sustained damages of $264,443 included $148,232 paid to Decorating Den under the MFA; $8,882 for travel expenses in connection with entering into the MFA; and $107,329 claimants had paid to settle litigation brought against them by their Australian franchisees and for attorney fees in connection with that litigation.

In their conclusions of law, the arbitrators found while the Scotts had established fraudulent inducement, they had not proved breach of the MFA or of an implied covenant, or that they had a course of action under federal or state law.

The Scotts' counsel, Robert M. Einhorn, partner with Miami's Zarco & Pardo, said the case is significant because while the arbitrators did not require that Decorating Den provide his clients with a UFOC, they nevertheless imposed similar disclosure obligations upon the franchisor.  "Decorating Den had an obligation to disclose the turnover rate in the franchise system.  If you're selling 100 franchises a year and unloading 90 out of the hundred, it makes one question if the franchise system is legitimate." He said, speaking hypothetically, "So you need to disclose both the sales and the terminations."

In fact, Exhibit 1 in the Scotts' case was an article in the February 1994 issue of McCall's magazine which first alerted the couple-already four years into their master franchise agreement with Decorating Den-of the high turnover rate among U.S. franchisees.  According to the article, in the three-year period ending December 1992, "a whopping 577 out of 1,138 or 51 percent, were terminated."

"What  [Decorating Den] is doing is making money off selling franchises; the people buying the franchises aren't making money," said Mr. Einhorn.

"The only franchisees making any kind of money," he said, "are the few that work 70 or 80 hours a week or set up their own warehouse or go way beyond what's represented to be successful.  If you follow their plan, you have no chance of making any money."

Respondents' attorney Charles Traylor, a partner with Dann Pecar Newman & Kleiman in Indianapolis, criticized the McCall's article.  "Only a handful of people of those interviewed felt they were wronged.  In fact, an independent media watch group trashed the article, saying the conclusions were disproved by the contents of the article."

Mr. Einhorn also noted that, in discovery prior to the arbitration, Mr. Bugg admitted that information he provided to the Wall Street Journal as to the average earnings in the Decorating Den system was incorrect, and that he subsequently did not use the article in connection with franchise sales in the U.S. (also because the FTC prohibits franchisors from making earnings representations to franchisee), "yet he provided a copy of the article to our clients."

Mr. Traylor said the franchisor provided the Scotts with the information they claim they never received, but, absent a UFOC, it was unable to prove that it did so.

Next time Decorating Den "goes overseas," he said, "they should have a very thorough written record on what they provide so there is no question as to what they received.  And they should get acknowledgement in writing from the master licensee that it's their responsibility to implement the system in that country to hold off claims that the [master franchisee] didn't get enough direction, even though in our arbitration, the award didn’t say that was the case."

Mr. Traylor noted that while the award said Decorating Den was under no requirement to provide a UFOC, "we weren't liable to satisfy the arbitrators that we'd sent [the Scots] the necessary info, so we would've been better off sending the UFOC with a cover letter."

Mr. Traylor also believes the arbitrators incorrectly characterized the relationship between the claimants and the respondents as a traditional franchisor-franchisee relationship rather that that of "two equal business entities.  The Scotts have substantial business interests.  We feel they were more savvy.  Mr. Scott has a master's degree in business."

Mr. Einhorn took aim at the arbitration clause in the franchisee agreement.  "We argued that part of their strategy is to separate the franchisees, prevent them from bringing a class action by forcing them to arbitration.  That makes it more expensive for the franchisees.  And by requiring that all arbitrations be held in Bethesda, its expensive if, say, you're a California franchisee."

Mr. Traylor disagreed. "I don't think a forum designation is unusual for an arbitration clause.  Maryland is where the documents are and where the company's executives are.  The arbitration clause is not burdensome to franchisees.  To the contrary.  It's more burdensome to pay for litigation. Plus you save time, 120 days verses a couple years."

He dismissed the notion that the clause is an attempt at preventing class-action suits.  "There are fewer and fewer class actions because courts have held fraud claims depend on facts of each individual case."

Because courts are loath to second-guess arbitrators' findings of fact, the basis of Decorating Den's appeal is that the arbitrators misinterpreted Maryland law by requiring Decorating Den to prove that the Scotts should have discovered the alleged fraud within the statutory period.   "My reading of the law is just the opposite," Mr. Traylor said.  "The claimant has to show that there's a reason they couldn't have discovered the turnover rate and earnings of U.S. franchisees within the statutory period."

Mr. Einhorn finds it ironic that the respondents are refusing to pay the award. "The arbitration clause is the result of their own agreement, yet now they're disputing the result, even though those clauses have been successful for them for years.  Now when a franchisee hits it big against them, they fail to honor it."

The total award, including attorney fees, approached $500,000, he said.  "This includes the money paid for the franchise and expended to settle litigation with Australian franchisees.  What they didn't get was the negative effect on some of their other businesses.  But the arbitrators gave them $215,000 attorney fees.  We put in about 700 hours on the case."

The case stands for the proposition, said Mr. Einhorn, "that if you're going to sell franchises out of this country, that doesn't mean you don't have to follow the laws of this country.  Decorating Den didn't gave then a UFOC, and arguably did not have to, but it did give them the Wall Street Journal article despite the fact that it contained [earnings] information Decorating Den knew to be false."

Moreover, he pointed out, Decorating Den's agreement specifies that the law of Maryland applies.  "To the extent Decorating Den tried to argue some lesser responsibility on its part because it was acting internationally, its own, agreement defeated."

Mr. Traylor blamed the Scotts' poor results on "their approach to marketing - The Australian franchisees put more emphasis on media than direct marketing.  The media-targeted shopper is looking for curtains at the best price, and not for a product that's little higher end.  That's why their franchisees did a great deal better in terms of gross income.  Decorating Den even sent someone there to get them to focus on lower sales and greater profitability."