District Court of New Hampshire Finds Contract Exclusion In D&O Policy Does Not Apply to Claim for Violation of California Franchise Investment Law

On November 1, 2024, the United States District Court of New Hampshire, applying California law, decided in MRFranchise, Inc. v. Stratford Insurance Company, 2024 WL 4651195 (D. N.H. Nov. 1, 2024) that the contract exclusion in a director and officers insurance policy did not preclude coverage for a claim for violation of the California Franchise Investment Law (“CFIL”) where a franchisor failed to disclose prior fraud suits.

In MRFranchise, MRFranchise, Inc. (“MRFranchise”) was the franchisor of a restaurant chain called Panini Kabob Grill (“PKG”). In 2016, several franchisees inquired about opening a PKG location in California. On May 25, 2017, in compliance with state and federal law, MRFranchise provided the franchisees with required disclosures contained within a Franchise Disclosure Document (the “Disclosure”). The Disclosure required, in relevant part, a disclosure of whether MRFranchise or its officers had been held liable in a civil case involving allegations of “fraud, unfair or deceptive practices, or comparable allegations.” Any willful violation of this Disclosure was deemed unlawful under the CFIL. MRFranchise answered the Disclosure as follows: “No litigation is required to be disclosed…”

On June 15, 2017, MRFranchise executed a franchise agreement which referenced the Disclosure (the “Agreement”). On May 3, 2019, the franchisees opened the PKG location but received a notice of default under the Agreement on August 27, 2019 for their delay in obtaining the necessary training. In December 2019, the franchisees attempted to sell back the PKG franchise to MRFranchise, but the parties failed to agree to the terms of a buy-back arrangement.

On May 26, 2020, MRFranchise filed an arbitration action which alleged breach of the Agreement against the franchisees. In July 2020, the franchisees filed a counter-complaint, alleging that MRFranchise and Rafipoor – its founder, President and Chief Executive Officer – violated the CFIL by failing to disclose prior fraud cases against Rafipoor. In October 2021, the arbitrator ruled that MRFranchise’s failure to disclose the prior fraud cases was a willful violation of the CFIL for which MRFranchise and Rafipoor (collectively, “Plaintiffs”) were jointly and severally liable. The arbitrator rescinded the Agreement and awarded consequential damages to the franchisees.

Prior to the arbitration action, MRFranchise applied for a directors and officers liability insurance policy from Stratford Insurance Company (“Stratford”). In the application, MRFranchise denied knowledge of “any act, error or omission” which could give rise to a claim under the policy. Plaintiffs later sought coverage for the counter-complaint and Stratford denied coverage pursuant to the contract exclusion, among others. Plaintiffs sued Stratford for breach of contract and Stratford moved for summary judgment under the contract exclusion. Plaintiffs cross-moved for summary judgment alleging that no exclusions applied to bar coverage. Applying California law, the court denied Stratford’s motion and granted Plaintiffs’ motion, in part, as to the contract exclusion.

The contract exclusion precludes, in relevant part, coverage for “[l]oss arising from any claim…based upon or attributable to liability under any oral or written contract or agreement …” Relying on dictionary definitions, the court determined that the CFIL claim was not “based upon or attributable to liability under” the Agreement.

The court evaluated the scope of the contract exclusion, stating that more than a minimal connection was required than other exclusions which used language such as “arising out of, based upon or in consequence of, resulting from or in any way involving. . .” Acknowledging that the contract exclusion is the only policy exclusion which used the phrase “based upon or attributable to” to describe the factual nexus, the court maintained that a closer relationship was required between the insured’s liability and the circumstances barring coverage.

The court acknowledged that some California cases interpret the phrase “based upon” broadly to require only a minimal or incidental connection between liability and a contract; however, these cases involved broader contract exclusions that were not materially similar to the contract exclusion at issue. The court maintained that the CFIL violation did not have a causal connection to a breach of contract because it involved entirely distinct conduct from the breach of contract claim. The court treated the Disclosure and Agreement as separate and independent documents and determined that the Disclosure involved conduct predating the Agreement.

The court reiterated that the CFIL claim was premised on misrepresentations in the Disclosure, not “based upon or attributable to liability under” the Agreement. As such, the court held that the contract exclusion did not bar coverage of the CFIL claim.