Antitrust Law Daily Wrap Up, FRANCHISING & DISTRIBUTION—NDTex: Bankruptcy Court Did Not Err in Awarding Nondischargeable Actual and Punitive Damages for Franchisor’s Failure to Refund Franchise Fee, (Feb 20, 2013)

By Tobias J. Gillett, J.D., LLM.

A bankruptcy court did not err in awarding actual and punitive damages under Texas fraud, fraudulent inducement, and Deceptive Trade Practices Act (DTPA) law to a former prospective franchisee for a franchisor’s failure to refund a franchise fee, and in declaring those damages nondischargeable, the federal district court in Dallas has ruled (Carroll v. Farooqi, February 19, 2013, Lindsay, S.). The bankruptcy court’s adjudication was a constitutional exercise of its judicial power, the franchisee’s complaint satisfied Federal Rule of Civil Procedure 9(b), the bankruptcy court did not err in treating the franchisee’s complaint as an informal proof of claim, the consumer had standing as a “consumer” under the DTPA, and the bankruptcy court did not err in rejecting the argument that the franchisee’s claims were not timely filed.

In 2009, Anjum A. Farooqi attempted to purchase a franchise from Michael Carroll, principal officer of the Salad Bowl Franchise Corporation and owner and officer of its parent company, The Salad Bowl, Inc. As part of this process, Farooqi paid a $25,000 fee and signed an option-to-purchase agreement. Later, Farooqi was unable to obtain financing for his franchise, and demanded a refund of his fee.

After failing to receive a refund for almost a year, Farooqi filed suit in state court, and later brought an adversary proceeding in bankruptcy court when Carroll filed for bankruptcy protection asserting claims for fraudulent inducement, fraud, and violations of the DTPA. The bankruptcy court found in Farooqi’s favor, and awarded him $88,500 in actual and exemplary damages, later determined to be nondischargeable. Carroll appealed.

Unconstitutional exercise of judicial power. Carroll first contended that the bankruptcy court, as an Article I court, should not have entered a judgment on Farooqi’s fraudulent inducement and DTPA claims because the claims were not so closely connected to bankruptcy matters that the dispute was transformed “from a typical private rights dispute to a public rights dispute. In its 2011 decision in Stern v. Marshall, 131 S. Ct. 2594, the Supreme Court concluded that “Article I bankruptcy courts lacked constitutional authority to enter final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim.” As Farooqi never filed a proof of claim, Carroll argued, his claims could not be resolved through ruling on a proof of claim.

The court disagreed. Although Farooqi did not file a formal proof of claim, his adversary proceeding could constitute an informal proof of claim. Treating the proceeding as an informal proof of claim was not inequitable merely because Farooqi failed to file a timely formal proof of claim, and the court was unwilling to find that the failure of Farooqi’s student attorneys to file a formal proof of claim weighed against allowing Farooqi’s claim.

Moreover, Stern was distinguishable from the present case in that the bankruptcy court in Stern had entered judgment on a state law counterclaim asserted by the debtor, while the present case involved “a final determination as to the dischargeability of a creditor’s claim against a debtor.” As the court retained authority under Fifth Circuit precedent following Stern to decide whether claims were dischargeable and to liquidate a state law claim, “the bankruptcy court did not unconstitutionally exercise the judicial power of the United States by finally adjudicating Farooqi’s state law claims.”

Rule 9(b). Carroll next argued that Farooqi’s complaint failed to satisfy Federal Rule of Civil Procedure 9(b)’s heightened pleading standard for fraud claims. The court again disagreed, concluding that Farooqi’s complaint had specified that he “was seeking damages from Carroll personally,” that it asserted a claim for fraudulent inducement, and that it “describe[d] the representations that Farooqi believed were fraudulent.” The court concluded that Farooqi’s complaint had met Rule 9(b)’s standard.

Informal Proof of Claim. Carroll further contended that the bankruptcy court should not have awarded Farooqi an informal proof of claim in the bankruptcy without Farooqi requesting a proof of claim, and without Farooqi complying with the full procedures for seeking a proof of claim. In response, Farooqi argued that informal proofs of claim are intended to cure procedural defects.

The court concluded that “it was not unreasonable for the bankruptcy judge to treat Farooqi’s complaint as an informal proof of claim,” and that equity required flexibility regarding form “when justice requires.” Therefore, the court found “that the bankruptcy court did not err in holding that Farooqi’s filing of the adversary proceeding constitutes the filing of an informal proof of claim.”

DTPA Standing. Carroll next argued that Farooqi lacked standing to bring his claims under the DTPA. Under the DTPA, only “consumers,” those who seek to acquire “goods” or “services,” may have standing to sue for treble damages and attorneys’ fees. According to Carroll, Farooqi had sought to purchase an option contract, which did not constitute a “good” or “service” under the DTPA, and thus he did not represent a “consumer” for DTPA purposes.

The court concluded that Farooqi was a “consumer” under the DTPA. The court observed that, under Texas law, a “a court must look at the plaintiff’s relationship to a transaction and the plaintiff’s central objective, from the plaintiff’s perspective, in the transaction in determining whether a plaintiff qualifies as a consumer.” Farooqi’s purpose was to acquire a franchise, not an option contract, in the court’s view, and a franchise may be a “good” or “service” under Texas law. Therefore, Farooqi was a consumer for DTPA purposes.

Untimely Filed Claims. The court also rejected Carroll’s argument that Farooqi’s Second Amended Complaint was not timely filed, and that its claims “should have been denied on the basis of limitations.” The complaint asserted the same causes of action as the original complaint, and generally requested punitive damages. To extent the request for punitive damages added a new substantive claim, it related back to the original claims, in the court’s view. Therefore, the bankruptcy court did not err in overruling Carroll’s objection to the complaint.

The case is Civil Action No. 3:12-CV-804-L.

Attorneys: Joyce W. Lindauer for Michael Carroll. Eliot D. Shavin (Southern Methodist University Legal Clinic) for Anjum A. Farooqi.

Companies: Salad Bowl Franchise Corp.; The Salad Bowl, Inc.

Cases: FranchisingDistribution StateUnfairTradePractices TexasNews