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Dunkin'' Donuts of America Inc. v. Middletown Donut Corp.

Decided: July 23, 1985.


On certification to the Superior Court, Appellate Division.

For modification -- Justices Clifford, Handler, Pollock, O'Hern and Garibaldi. Opposed -- None. The opinion of the Court was delivered by Clifford, J.


[100 NJ Page 170] We granted certification, 97 N.J. 645 (1984), on the petition of plaintiff-franchisor. Plaintiff obtained relief in the Chancery Division, affirmed by the Appellate Division, based on defendant-franchisee's fraudulent conduct resulting in a breach of the franchise agreements. Despite the fact that the franchisor prevailed below, it claims that the trial court's remedy was inadequate and that the court altered the terms of the franchise contracts, slighted a substantial body of franchise law, and trespassed on the franchisor's valid rights at law. We agree, and therefore modify the judgment below.


Plaintiffs are Dunkin' Donuts of America, Inc. and its wholly-owned subsidiary, Dunkin' Donuts of New Jersey. The former is a national corporation that has franchised hundreds of doughnut shops throughout the country; the latter is a real-estate holding company, used by the parent corporation to hold and to control real estate in New Jersey. This opinion refers to plaintiffs in the singular as Dunkin' Donuts or as franchisor.

Defendant Gerald Smothergill owned all of the stock of defendant corporations, Middletown Donut Corporation and Shawn Donut Corporation. Each corporation had entered into franchise and lease agreements with Dunkin' Donuts, and Smothergill had personally guaranteed these agreements. Defendants are referred to in the singular as Smothergill or as franchisee.

Under the terms of the franchise agreements, Smothergill was licensed to operate two Dunkin' Donuts stores, one in Middletown, and one in West Long Branch. Despite some slight differences between the franchise agreements for the two stores, their basic provisions were the same. Under each franchise agreement, Smothergill was authorized to use the Dunkin' Donuts name and trademarks. He had access to Dunkin' Donuts' baking and marketing methods, and was entitled to the franchisor's technical and management support. Under each franchise agreement, Smothergill was required to keep accurate sales records, to pay a basic franchise fee of 4.9% of gross sales, to pay an advertising fund fee of 2% of gross sales, to meet product quality standards set by Dunkin' Donuts, and to meet the franchisor's service and cleanliness standards.

The lease agreements permitted Smothergill to rent the store premises. Smothergill's right to continue in possession of those premises was expressly conditioned on his remaining as a franchisee in good standing under the related franchise agreements. In August of 1978, Dunkin' Donuts notified Smothergill that his franchise agreements were to be terminated due to

his intentional underreporting of gross sales. The termination notice provided an opportunity for Smothergill to cure his alleged breach by making prompt payment of the amounts claimed to be due. Smothergill made no attempt to cure, taking the position that he was not guilty of underreporting or of any other breach of his franchise obligations.

Having denied any breach, Smothergill refused to abandon his Dunkin' Donuts stores. Thereafter, the franchisor brought suit in the Chancery Division to enforce its claimed right of termination and to collect damages. Smothergill counterclaimed, seeking not only a declaration of his right to continue as a franchisee, but damages as well for unfair treatment by Dunkin' Donuts. The court denied interlocutory relief that would have immediately ousted Smothergill from the stores; hence, Smothergill continued to operate his stores pending the outcome of the trial.

At the conclusion of the trial, the court found as fact that Smothergill had been guilty of substantial, intentional, and long-continued underreporting of gross sales at both of his Dunkin' Donuts stores. The court determined that Smothergill had failed to keep the financial records that were required under the franchise agreements and that the failure to keep records was not the result of carelessness or incompetence. Rather, Smothergill's delinquency in recordkeeping was part of a deliberate effort to underreport sales, which in turn would result in underpayment of franchise fees, underpayment of advertising fund fees, underpayment of rental override charges,*fn1 and evasion of federal and state taxes. The court determined that during the eighteen-month period immediately preceding the filing of this law suit, Smothergill had intentionally

underreported sales at the Middletown store by at least $63,000 and at the West Long Branch store by at least $35,000.

In short, the Chancery Division found as fact that Smothergill was "guilty of unconscionable cheating." So affronted by Smothergill's conduct was the court that it ordered that a copy of its letter opinion be forwarded to the Internal Revenue Service. It also retained all exhibits for examination by the IRS. The court concluded that Smothergill's wrongful acts amounted to substantial non-compliance with his franchising responsibilities so that good cause for termination existed. Finally, the court determined that Smothergill was not entitled to any relief on his counterclaim, as Dunkin' Donuts had acted reasonably in deciding to audit Smothergill and had thereafter conducted the audit "with eminent fairness and courtesy."

As remedy for Smothergill's non-compliance with the franchise agreement, the contract provided that the agreement be terminated and that "the rights of the Licensee [franchisee] hereunder shall cease." The trial court indicated that a literal interpretation of this phrase required that Smothergill lose the right to possess the stores, to operate the franchises, and to transfer them for value. The contract additionally provided that the breaching franchisee was obligated to pay as damages all amounts owed to Dunkin' Donuts as a result of the underreported sales, the full costs of investigating such underreporting, and reasonable attorney's fees incurred as a result of the breach.

Despite the foregoing contract provisions, the trial court fashioned its own remedy on the basis of equitable considerations, to replace the "disproportionately harsh" legal remedies set forth in the franchise agreements. Having determined that the combined value of Smothergill's two Dunkin' Donuts locations was at least $250,000, the court believed that bare surrender of the stores by Smothergill in addition to payment of the other specified damages would result in an "inappropriate windfall" for Dunkin' Donuts. Therefore, the trial court's remedy

provided that although Smothergill would lose all rights to occupy and operate the stores, Dunkin' Donuts was to pay him $115,000 upon his surrender of the franchises.

The basis for the $115,000 figure is not entirely clear. Initially the court adverted in its opinion to the fact that $115,000 was the total price paid by Smothergill to purchase the two stores and that the $115,000 payment would permit Smothergill to "salvage his original economic investment in the shops, and he will be left with a decent sum with which to start afresh in a new enterprise which is non-competitive to Dunkin' Donuts." At a later hearing on a motion to reconsider the judgment, however, the court stressed that its opinion was not to be read as support for the right of a terminated franchisee to recoup his original investment.*fn2 Rather, the court generally explained that the $115,000 payment was part of an equitable remedy "package" that would return to Dunkin' Donuts two franchises worth $250,000, thus netting the franchisor the equivalent of $135,000 in damages due under the terms of the contracts as a result of the breach. See supra at 173. However, the court did not support these amounts by reference to any precise figures or calculations rooted in the evidence. The court's remedy package also restrained Smothergill from having an ownership or employment interest in a New Jersey doughnut shop or bakery for a perior of five years, a restriction subsequently imposed on his widow, Smothergill having died.

Both parties sought review in the Appellate Division, Smothergill claiming there was insufficient credible evidence in the record on which to base the findings of fact made below, and Dunkin' Donuts questioning the authority of the trial court to adopt its "equitable" remedy. In an unreported ...

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