Should all contract breach litigation be decided on who breached first? Perhaps that should be the rule on deciding complex commercial cases. It seems to work well to simplify complex fact patterns and responsibilities. Do all breaches have the same weight?

This rule was applied well in the case of Jack in the Box v. Deepak Mehta, (N.D. CA. June 21, 2016), aff’d, ____ Fed.Appx. —–(2018) (9th Cir., June 12, 2018). The opinion is currently unpublished but instructive.

Facts Regarding the Defaults

Defendants signed 19 franchise agreements that authorized use of the franchisor’s commercial marks, format and restaurant operating system in exchange for monthly payment of royalty and marketing fees. The franchise agreements also required that the defendants maintain and submit all state and federal taxes associated with the operation of the restaurants, and to comply with all obligations contained in any other agreement with the franchisor.

The franchise agreement would be deemed in default and would automatically terminate upon insolvency without notice. In addition, upon failure to pay any amount default, termination could be effected upon a 10-day notice with opportunity to cure any amounts owed to the franchisor, within five days for amounts due for taxes and within 30 days for all other defaults. The defendants also signed percentage rent leases for each location, which leases require timely payment of taxes, as well as any other amounts due the franchisor/landlord.

The franchisee failed to pay obligations to the franchisor for one year and ran up a total receivable in August 2012 of $567,002.45. Through mediation, the parties agreed that the franchisee would sign a term note to satisfy the receivable, and the franchisee would release the franchisor. The note provided that any rebates from vendors would be remitted to the franchisor to accelerate payment of the note.

All was well until the taxing authorities filed liens against the franchisee’s assets for failure to pay real estate property and personal property taxes, followed by a sales tax assessment of $648,400. Then to add insult to injury, Coca Cola paid a rebate to the franchisee that was not remitted to the franchisor. By the time the notices of default were issued, the franchisee owed $1.9 million. The franchisor extended the time for cure to allow refinance of all of the debt.

Failed Refinancing Sets Up Counterclaims

The franchisee applied for a loan from Bank of America for $7.8 million. The bank issued a loan commitment, conditioned on good standing from the franchisor and sale of five units to pay outstanding debt. The franchisor issued a letter stating that franchisee was in default, but that the refinance would be used to cure the default, and issued a payoff letter for $2.3 million. The bank notified the franchisee that it did not want to move forward because it did not know of the default, and that the amount owed was much larger than the amount previously disclosed in the loan application. Once the refinance was terminated by the bank, the franchisor granted reasonable time to cure and then terminated the franchise upon the expiration of the extension.

Dismissal of the Counterclaims

The franchisee asserted counterclaims for breach of contract, breach of good faith and fair dealing, promissory estoppel and negligent interference, all based on the franchisor’s communications with the bank. The facts are clear that the franchisee breached first, and the court therefore held no recovery was available on a subsequent breach of the same contract. On promissory estoppel, the “cure deal” did not contain an unambiguous promise never to terminate the franchise agreement. On the negligent interference, the court found that the $2.3 million payoff demand was not negligently prepared, and on that basis, denied the counterclaim and granted judgment in favor of the franchisor.

Trademark Infringement and Unfair Competition

After termination, the franchisee continued to operate Jack in the Box restaurants, using the registered trademarks and business system of the franchisor. Until a few years ago, such conduct would support a motion for a preliminary injunction against the franchisee for unfair competition and trademark infringement, especially from a former franchisee. A holdover franchisee using the marks satisfies most of the showing for customer confusion necessary for an injunction. However, the eBay case eliminated the presumption of irreparable harm in injunction matters; accordingly, injunctions are rarely granted because absent strong evidence of current injury. On summary judgment, however, the burden for showing harm is demonstrated by the holdover franchisee using the identical marks. The granted summary judgment in favor of the franchisor, and then set a conference to schedule a trial on damages.

What About the Who Breached First Rule?

The franchisee resolved its issue with the franchisor by settling its debt with a promissory note, but breached another obligation of the franchise agreement by not paying tax debt. The franchisor’s reputation is harmed by adverse publicity when a franchisee is publicly notified as a tax debtor. Moreover, it impairs the credit of the franchisee and erodes confidence in the franchised system. The amount of the tax debt was significant and the reputational damage is not minimal. This is a serious default under the franchise agreement, which is incurable.

However, suppose the franchisor were to be found to have torpedoed the refinance with an inflated payment demand. Would not that have been sufficiently separate so that the franchisor could be liable for failure to allow a cure by negligently interfering with the refinance Alternatively, would that have been a set-off claim? If the franchisor had acted with malice to interfere with the refinance through a false demand for payment, the franchisor eliminated the last chance for rehabilitation. Would a wrongful act by the franchisor directed toward the banker have defeated the “who breached first” argument?

I would answer that who breached first is important, but if the franchisor actually interfered with the ability to cure by killing the refinance, then the franchisor should still be liable. So maybe there should be a last clear chance rule for contract breach.

Reprinted with permission from the July 19 issue of The Legal Intelligencer. (c) 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.