Franchisor’s Liability Under CFIL Not Barred From Insurance Coverage

Franchise insurance is a critical tool designed to protect both franchisors and their principals from numerous risks and liabilities. A recent federal court decision provides confirmation that franchise-specific claims are not barred from coverage just because they include terms such as fraud or contract. The decision in MRFranchise, Inc. v. Stratford Insurance Co., No. 1:22-cv-00572-LM (D.N.H. Nov. 1, 2024), which applied California law, demonstrates the importance for franchisors to be prepared to fight back against denials of insurance coverage. 

After the plaintiff MRFranchise, a restaurant franchisor, alleged that its insurance company breached its duty to defend and indemnify the franchisor in an arbitration with a franchisee, the franchisor brought suit seeking an order requiring its insurance company to provide coverage. The federal district court in New Hampshire partially granted the franchisor’s motion for summary judgment, and denied the insurance company’s summary judgment motions, saving the franchisor’s principal from a judgment for about $1 million. 

The court found that two of the three policy exclusions relied upon by the insurance company did not apply, but did find that a prior notice exclusion could apply.  The court also denied the insurance company’s summary judgment motion because liability for the franchisees’ claims was attributable to MRFranchise’s failure to disclose a prior litigation did not flow from the franchise agreement. 

Background to the Claims

In 2016, three prospective franchisees inquired about opening a Panini Kabob Grill in California. Discussions between the prospective franchisees and MRFranchise progressed and a deal closed. Shortly thereafter, the relationship broke down and the parties began negotiating a buy-back deal.  When that fell through, the franchisees sued the principal at MRFranchise, MRFranchise and its affiliate.

In May 2020, MRFranchise sent the franchisees a termination notice. Thereafter, MRFranchise filed arbitration and the franchisees counterclaimed for violation of the CFIL[1] for failure to disclose prior fraud cases.

The arbitrator found in favor of MRFranchise on all counterclaims, except for the CFIL claim, granted rescission of the agreement and awarded the franchisees approximately $1 million in damages.

MRFranchise claimed coverage under an executive liability insurance that Stratford Insurance Company (Stratford) had sold to it. The policy provided coverage similar to directors and officers liability (commonly called D&O) coverage, including for “Wrongful Acts.”  The Stratford denied coverage, citing a contractual liability exclusion, prior notice exclusion, intentional acts exclusion, and a professional services exclusion. Stratford denied its obligation to defend MRFranchise and, after the $1 million arbitration award, denied coverage to indemnify for the award, prompting MRFranchise to sue for coverage. 

The court framed Stratford’s denial as denying coverage for the defense or indemnity of the franchisees’ claims against MRFranchise based on:

(1) the Prior Notice Exclusion because [MRFranchise] knew of a likely claim prior to the Policy’s start date but failed to disclose it; (2) the Prof. Services Exclusion because the claims arose out of [MRFranchise] providing “professional services”; and (3) the Contract Exclusion because the claims are premised on liability under the Franchise Agreement.

Contractual Liability Exclusion

On cross motions for summary judgment, Stratford argued that the policy’s contractual liability exclusion barred coverage for the entire counter-complaint in the arbitration because the claims arose from the franchise agreement. MRFranchise argued no exclusion barred coverage for the defense costs or the ruling in the arbitration finding liability.  The arbitrator had dismissed all but four breach of contract claims, two tort claims, and a statutory claim under the CFIL. After hearing, the arbitrator denied all counterclaims except for the statutory claim, finding MRFranchise willfully failed to disclose prior litigation.

The court more specifically, in examining the contractual liability exclusion, the court found that it requires a closer relationship between the insured’s liability and the circumstance barring coverage than alleged failure to disclose prior claims. The finding that MRFranchise violated the CFIL did not flow from the franchise agreement.  Therefore, the court found that the contract exclusion too narrow to encompass statutory liability that has only an incidental nexus to a contract.  The court rejected Stratford’s argument that “the Contract Exclusion applie[d] because all of the Franchisees’ counterclaims are related to the conduct that formed the basis for the franchisees’ breach of contract counterclaim.” 

The court further noted that even if insurance company could show that the contract exclusion applied, it could not show that one of its exceptions did not apply because the contract exclusion stated that “this exclusion shall not be applicable to the Insured’s alleged liability that exists in the absence of such contract or agreement…” Additionally, the court stated that “The CFIL violation bears no causal connection to a breach of contract.”  Because the exclusion did not apply to liability that existed independent of a contract, the CFIL claim fell “squarely within the exception to the Contract Exclusion, even if the exclusion did apply. 

Professional Services Exclusion

The court similarly concluded that the professional services exclusion did not apply. The court concluded that the exclusion did not encompass MRFranchise’s role as franchisor because franchising is effectively entering into a business relationship.  Unlike professional services, which, under California law, typically involve specialized skill or labor, Stratford countered that MRFranchise agreed to provide training, but the court held that MRFranchise’s liability under the CFIL was unrelated to its alleged failure to provide training to the franchisees.  Accordingly, the exclusion did not apply.

Prior Notice Exclusion 

Stratford also argued that the Prior Notice exclusion barred coverage because MRFranchise had notice of the franchisees’ claims prior to issuance of the policy.  Six days after the policy went into effect, the franchisees asserted their claims that led to the arbitration. The court concluded a reasonable jury could find that MRFranchise had “actual knowledge” of a potential claim before they purchased the policy, that a lawsuit could ensue. The court therefore denied summary judgment because the prior notice exclusion could bar coverage.

Intentional Acts Exclusion

Last, the court turned to the Intentional Acts Exclusion, which Stratford claimed applied despite that the principal of MRFranchise was “found to have committed an intentional criminal or deliberate fraudulent act, or to otherwise have acted willfully, and MRFranchise’s intentional acts may not be imputed to the franchisor’s principal by the plain terms of the exclusion.”  Stratford argued that the exclusion nonetheless applied because the principal “aided and abetted” willful conduct. The court found that aiding and abetting is not conduct subject to the Intentional Acts Exclusion, in a holding that is a boon for all policyholders, not just franchisors.

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The case is set for trial on the limited question of whether the policyholder had actual knowledge of certain information.  The decision is a well-reasoned rejection of overbroad application of exclusions to deny franchisors the insurance coverage they purchase.

[1] The California Franchise Investment Law is the analogous state law to the FTC Amended Rule, which does not grant a private right of action for disclosure violations.