Court Watch

Franchisor Potentially Liable for Failure to Contribute to Advertising Fund

The U.S. District Court for the District of Massachusetts has denied a franchisor's motion to dismiss a class action complaint brought by a group of franchisees alleging that the franchisor breached its franchise agreements when it failed to put advertising fees collected from franchisees that underreported gross sales into the advertising and sales promotion fund, and instead diverted the fees to its own account. Moghaddam, et. al. v. Dunkin' Donuts, Inc., 2003 WL 22519474 (D. Mass. 2003).

The plaintiff franchisees owned and operated Dunkin' Donuts shops throughout Broward County, FL. Their franchise agreements obligated them to pay monthly franchise fees of 4.9% to 6.99% of gross sales and to make monthly advertising contributions to the Dunkin' Donuts of America, Inc. Franchise Owners' Advertising and Sales Promotion Fund (the “Advertising Fund”) of 5% of gross sales.

According to the plaintiffs, Dunkin' Donuts collected several hundred thousand dollars a year from franchisees who underreported their monthly gross sales. Dunkin' Donuts' own records showed that it collected more than $600,000 from underreporting franchisees. However, it did not allocate any money collected through its loss prevention activities to the Advertising Fund. According to the plaintiffs, Dunkin' Donuts' failure to pay a portion of the proceeds of its collection efforts to the Advertising Fund constituted a breach of the franchise agreements.

Dunkin' Donuts filed a motion to dismiss the class action complaint for failure to state a claim upon which relief could be granted. According to Dunkin' Donuts, the complaint should have been dismissed for four reasons: the franchise agreements provided that all delinquent funds should be paid directly to Dunkin' Donuts and not to the Advertising Fund; Dunkin' Donuts had no obligation to collect royalties and advertising fees from underreporting franchisees; Dunkin' Donuts made no money from its collection efforts because the costs of collection exceeded the return; and the plaintiffs had not been harmed because their franchise agreements specifically disclaim any obligation on the part of Dunkin' Donuts to make expenditures from the Advertising Fund to the benefit of any individual franchisee.

The court was not persuaded by any of Dunkin's arguments. It noted that the franchisees were obligated to make payments to Dunkin' Donuts, and Dunkin' Donuts was then required to contribute a portion of the money to the Advertising Fund. Further, while it was true that Dunkin' had no obligation to bring suit to collect money due to the Advertising Fund, after it did commence litigation which resulted in the collection of past due fees, it had an obligation to place them in the Advertising Fund. Third, said the court, the issue of whether Dunkin' in fact realized no money after paying attorney fees and other costs of collection should be raised on a motion for summary judgment or at trial. Finally, the court held that Dunkin's argument that the individual franchisees were not harmed was relevant to the remedies available to the plaintiffs, and not properly raised in a motion for judgment on the pleadings. The court therefore denied the franchisor's motion for judgment on the pleadings.

While the plaintiffs have a difficult case ahead, this case should serve as a warning to all franchisors: When they collect past due fees from a franchisee, they should keep in mind their obligations to contribute to system advertising funds and other programs that may benefit the franchisees. Franchisors who do not do so may face a class action lawsuit initiated by their franchisees.

Distributorship Agreement Not a Franchise Under Illinois Franchise Disclosure Act

The U.S. District Court for the Northern District of Illinois has granted summary judgment in favor of a wireless phone service provider and against a distributor who alleged, in part, that the provider improperly sold it a franchise without first registering with the state of Illinois or providing an offering circular as required by the Illinois Franchise Disclosure Act (“the IFDA”). Kempner Mobile Electronics, Inc. v. Southwestern Bell Mobile Systems, LLC, d/b/a Cingular Wireless, 2003 WL 22595263 (N.D. Ill. 2003).

Following a dispute between Southwestern Bell Mobile Systems, LLC (“Cingular Wireless”) and Kempner Mobile Electronics, Inc. (“Kempner”), a Cingular Wireless distributor, regarding whether Cingular Wireless could open a location near Kempner's location, Kempner sued Cingular Wireless for breach of contract, fraud, and violation of the IFDA. Cingular Wireless moved for partial summary judgment.

Cingular Wireless argued that it could not be liable under the IFDA because its agreement with Kempner did not constitute a franchise as defined by the IFDA. Kempner argued, on the other hand, that its agreement was indeed a franchise, and that it was therefore entitled to relief under the IFDA for Cingular Wireless' failure to register the franchise for sale in the state of Illinois and to give it a Uniform Franchise Offering Circular before entering into the agreement.

In deciding the motion, the court first observed that in order to qualify for the IFDA's protections, a potential franchisee must satisfy the following three-pronged test: that the agreement is a license to use or associate with the franchisor's trademark; that the franchisor is obligated to offer assistance or control, either by way of a marketing plan or some other mechanism; and that the person is required to pay, directly or indirectly, a fee of $500 or more. Cingular Wireless contended that it did not charge Kempner a franchise fee, either directly or indirectly. Kempner argued that two payments that it made to Cingular Wireless constituted indirect franchise fees under the IFDA: First, Kempner made construction improvements to one of its stores; and second, it made payments to Cingular Wireless for inventory purchases of cellular phone equipment.

The court was not persuaded by either of Kempner's arguments. According to the court, the improvements did not constitute a franchise fee because the alleged franchise fee must be an unrecoverable investment in excess of $500, and Kempner failed to prove that the money it spent for the improvement was in excess of $500 and unrecoverable. The court also noted that Kempner failed to dispute Cingular Wireless' contention that the improvements fell under the IFDA's “necessary fixtures exception.” Finally, the court observed that Kempner also failed to offer any evidence that Cingular Wireless required Kempner to “build out” its store, or that any money it paid to Cingular Wireless for the renovations could not have been paid to another source. According to the court, these facts undermined Kempner's claim that the store renovations constituted an indirect franchise fee.

The court also found that Kempner's purchase of inventory did not satisfy the IFDA's franchise-fee requirement. While the court observed that equipment purchases could certainly constitute a franchise fee when the franchisee is required to maintain unreasonably large inventories, it noted that even if Kempner could show that it was required to maintain a large inventory, it would also have to show that such a large inventory was unreasonable because it could not be sold within a reasonable amount of time. The court found that the record was devoid of a single fact showing that Kempner was required to maintain an unreasonably large inventory or that it could not sell its inventory within a reasonable time. Finally, the court noted that Kempner also admitted that it could purchase cellular phone equipment from other vendors and, therefore, the phone equipment inventory fell squarely within the IFDA's exception whereby items available for purchase from other sources cannot qualify as payment of a franchise fee.

The court granted partial summary judgment in favor of Cingular Wireless, and it dismissed Kempner's claims for violation of the Illinois Franchise Disclosure Act.

This opinion is of interest far beyond the borders of Illinois because every (or nearly every) franchise registration/disclosure law excludes the purchase of inventory at a bona fide wholesale price from its definition of a “franchise fee,” but there have been few cases under any of these laws construing this exclusion in general or addressing the specific question of whether the franchisor's inventory purchase requirements are excessive and therefore constitute an indirect franchise fee.

Franchisor Liable for Franchise Fraud, But Damages Limited

The Supreme Court of Rhode Island has affirmed a decision that a commercial janitorial services franchisor breached its franchise agreement with its franchisee and committed fraud. But it reversed the award of lost profit damages as a result of the franchisor's misconduct. Guzman v. Jan-Pro Cleaning Systems, Inc., et. al, 2003 WL 22717827 (R.I. 2003).

In 1995, Guzman entered into a franchise agreement with Jan-Pro Cleaning Systems (“Jan-Pro”), a commercial janitorial services franchisor. Guzman paid $3,285 as a nonrefundable initial franchise fee. Pursuant to the franchise agreement, Jan-Pro promised to furnish Guzman with one or more customer accounts amounting to $8,000 in gross volume per year within the first 120 days of the agreement. After Jan-Pro failed to provide customer accounts, Guzman wrote a letter to Jan-Pro demanding that it refund his franchise fee. As a result of Jan-Pro's efforts to mollify Guzman, the parties amended the franchise agreement to require Jan-Pro to provide two accounts to Guzman grossing $12,000 a year. The amended agreement was personally guaranteed by Jan-Pro's vice president. Jan-Pro failed to provide the accounts to Guzman. Instead, it offered to return Guzman's franchise fee if he signed a mutual release, but Guzman refused to sign the release.

Guzman filed suit against Jan-Pro and its vice president for breach of contract and fraud. After a bench trial, the trial court found in favor of Guzman and against Jan-Pro and its vice president on all claims, including Guzman's claim that the defendants violated the Rhode Island Franchise Investment Act. The court awarded damages to Guzman in the amount of $120,000, plus statutory interest, costs, and attorney's fees. Jan-Pro appealed.

The court affirmed the trial court's finding of liability against Jan-Pro. First, the court agreed with the trial court that Jan-Pro failed to honor its obligations to provide accounts to Guzman totaling $8,000 in gross commissions under the original agreement and $12,000 in gross commissions under the amended agreement.

The court also agreed with the trial court that Jan-Pro's promises to provide accounts to Guzman were fraudulent because at the time that the promises were made, the defendants did not have any ability to furnish the accounts to Guzman. Further, according to the supreme court, the trial court properly found that the defendants' fraudulent promises constituted a violation of the Rhode Island Franchise Investment Act, which prohibits a franchisor, engaged in the offer and sale of a franchise in Rhode Island (or to a Rhode Island resident), from making any untrue statement of material fact, or omitting to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading, or generally, from engaging in any act which operates as a fraud or deceit on a prospective franchisee.

While the court affirmed the trial court's finding of liability against Jan-Pro, it reversed its damage award, which consisted primarily of lost profit damages. The court noted that in order to recover future lost profits, a plaintiff must establish the loss with a reasonable degree of certainty, must establish reasonably precise figures, and cannot rely on speculation. Applying that standard, the court refused to affirm the trial court's damage award on the grounds that Guzman never presented any evidence at trial of his anticipated expenses in performing under the contract; he only presented evidence of its anticipated gross revenues. According to the court, it was therefore impossible for the trial court to calculate the amount of lost profit damages with a reasonable degree of certainty and without speculation. The court therefore remanded the case back to the trial court for additional hearings to determine Guzman's anticipated expenses and to re-calculate his reasonable damages for future lost profits.

Franchisor Potentially Liable for Failure to Contribute to Advertising Fund

The U.S. District Court for the District of Massachusetts has denied a franchisor's motion to dismiss a class action complaint brought by a group of franchisees alleging that the franchisor breached its franchise agreements when it failed to put advertising fees collected from franchisees that underreported gross sales into the advertising and sales promotion fund, and instead diverted the fees to its own account. Moghaddam, et. al. v. Dunkin' Donuts, Inc., 2003 WL 22519474 (D. Mass. 2003).

The plaintiff franchisees owned and operated Dunkin' Donuts shops throughout Broward County, FL. Their franchise agreements obligated them to pay monthly franchise fees of 4.9% to 6.99% of gross sales and to make monthly advertising contributions to the Dunkin' Donuts of America, Inc. Franchise Owners' Advertising and Sales Promotion Fund (the “Advertising Fund”) of 5% of gross sales.

According to the plaintiffs, Dunkin' Donuts collected several hundred thousand dollars a year from franchisees who underreported their monthly gross sales. Dunkin' Donuts' own records showed that it collected more than $600,000 from underreporting franchisees. However, it did not allocate any money collected through its loss prevention activities to the Advertising Fund. According to the plaintiffs, Dunkin' Donuts' failure to pay a portion of the proceeds of its collection efforts to the Advertising Fund constituted a breach of the franchise agreements.

Dunkin' Donuts filed a motion to dismiss the class action complaint for failure to state a claim upon which relief could be granted. According to Dunkin' Donuts, the complaint should have been dismissed for four reasons: the franchise agreements provided that all delinquent funds should be paid directly to Dunkin' Donuts and not to the Advertising Fund; Dunkin' Donuts had no obligation to collect royalties and advertising fees from underreporting franchisees; Dunkin' Donuts made no money from its collection efforts because the costs of collection exceeded the return; and the plaintiffs had not been harmed because their franchise agreements specifically disclaim any obligation on the part of Dunkin' Donuts to make expenditures from the Advertising Fund to the benefit of any individual franchisee.

The court was not persuaded by any of Dunkin's arguments. It noted that the franchisees were obligated to make payments to Dunkin' Donuts, and Dunkin' Donuts was then required to contribute a portion of the money to the Advertising Fund. Further, while it was true that Dunkin' had no obligation to bring suit to collect money due to the Advertising Fund, after it did commence litigation which resulted in the collection of past due fees, it had an obligation to place them in the Advertising Fund. Third, said the court, the issue of whether Dunkin' in fact realized no money after paying attorney fees and other costs of collection should be raised on a motion for summary judgment or at trial. Finally, the court held that Dunkin's argument that the individual franchisees were not harmed was relevant to the remedies available to the plaintiffs, and not properly raised in a motion for judgment on the pleadings. The court therefore denied the franchisor's motion for judgment on the pleadings.

While the plaintiffs have a difficult case ahead, this case should serve as a warning to all franchisors: When they collect past due fees from a franchisee, they should keep in mind their obligations to contribute to system advertising funds and other programs that may benefit the franchisees. Franchisors who do not do so may face a class action lawsuit initiated by their franchisees.

Distributorship Agreement Not a Franchise Under Illinois Franchise Disclosure Act

The U.S. District Court for the Northern District of Illinois has granted summary judgment in favor of a wireless phone service provider and against a distributor who alleged, in part, that the provider improperly sold it a franchise without first registering with the state of Illinois or providing an offering circular as required by the Illinois Franchise Disclosure Act (“the IFDA”). Kempner Mobile Electronics, Inc. v. Southwestern Bell Mobile Systems, LLC, d/b/a Cingular Wireless, 2003 WL 22595263 (N.D. Ill. 2003).

Following a dispute between Southwestern Bell Mobile Systems, LLC (“Cingular Wireless”) and Kempner Mobile Electronics, Inc. (“Kempner”), a Cingular Wireless distributor, regarding whether Cingular Wireless could open a location near Kempner's location, Kempner sued Cingular Wireless for breach of contract, fraud, and violation of the IFDA. Cingular Wireless moved for partial summary judgment.

Cingular Wireless argued that it could not be liable under the IFDA because its agreement with Kempner did not constitute a franchise as defined by the IFDA. Kempner argued, on the other hand, that its agreement was indeed a franchise, and that it was therefore entitled to relief under the IFDA for Cingular Wireless' failure to register the franchise for sale in the state of Illinois and to give it a Uniform Franchise Offering Circular before entering into the agreement.

In deciding the motion, the court first observed that in order to qualify for the IFDA's protections, a potential franchisee must satisfy the following three-pronged test: that the agreement is a license to use or associate with the franchisor's trademark; that the franchisor is obligated to offer assistance or control, either by way of a marketing plan or some other mechanism; and that the person is required to pay, directly or indirectly, a fee of $500 or more. Cingular Wireless contended that it did not charge Kempner a franchise fee, either directly or indirectly. Kempner argued that two payments that it made to Cingular Wireless constituted indirect franchise fees under the IFDA: First, Kempner made construction improvements to one of its stores; and second, it made payments to Cingular Wireless for inventory purchases of cellular phone equipment.

The court was not persuaded by either of Kempner's arguments. According to the court, the improvements did not constitute a franchise fee because the alleged franchise fee must be an unrecoverable investment in excess of $500, and Kempner failed to prove that the money it spent for the improvement was in excess of $500 and unrecoverable. The court also noted that Kempner failed to dispute Cingular Wireless' contention that the improvements fell under the IFDA's “necessary fixtures exception.” Finally, the court observed that Kempner also failed to offer any evidence that Cingular Wireless required Kempner to “build out” its store, or that any money it paid to Cingular Wireless for the renovations could not have been paid to another source. According to the court, these facts undermined Kempner's claim that the store renovations constituted an indirect franchise fee.

The court also found that Kempner's purchase of inventory did not satisfy the IFDA's franchise-fee requirement. While the court observed that equipment purchases could certainly constitute a franchise fee when the franchisee is required to maintain unreasonably large inventories, it noted that even if Kempner could show that it was required to maintain a large inventory, it would also have to show that such a large inventory was unreasonable because it could not be sold within a reasonable amount of time. The court found that the record was devoid of a single fact showing that Kempner was required to maintain an unreasonably large inventory or that it could not sell its inventory within a reasonable time. Finally, the court noted that Kempner also admitted that it could purchase cellular phone equipment from other vendors and, therefore, the phone equipment inventory fell squarely within the IFDA's exception whereby items available for purchase from other sources cannot qualify as payment of a franchise fee.

The court granted partial summary judgment in favor of Cingular Wireless, and it dismissed Kempner's claims for violation of the Illinois Franchise Disclosure Act.

This opinion is of interest far beyond the borders of Illinois because every (or nearly every) franchise registration/disclosure law excludes the purchase of inventory at a bona fide wholesale price from its definition of a “franchise fee,” but there have been few cases under any of these laws construing this exclusion in general or addressing the specific question of whether the franchisor's inventory purchase requirements are excessive and therefore constitute an indirect franchise fee.

Franchisor Liable for Franchise Fraud, But Damages Limited

The Supreme Court of Rhode Island has affirmed a decision that a commercial janitorial services franchisor breached its franchise agreement with its franchisee and committed fraud. But it reversed the award of lost profit damages as a result of the franchisor's misconduct. Guzman v. Jan-Pro Cleaning Systems, Inc., et. al, 2003 WL 22717827 (R.I. 2003).

In 1995, Guzman entered into a franchise agreement with Jan-Pro Cleaning Systems (“Jan-Pro”), a commercial janitorial services franchisor. Guzman paid $3,285 as a nonrefundable initial franchise fee. Pursuant to the franchise agreement, Jan-Pro promised to furnish Guzman with one or more customer accounts amounting to $8,000 in gross volume per year within the first 120 days of the agreement. After Jan-Pro failed to provide customer accounts, Guzman wrote a letter to Jan-Pro demanding that it refund his franchise fee. As a result of Jan-Pro's efforts to mollify Guzman, the parties amended the franchise agreement to require Jan-Pro to provide two accounts to Guzman grossing $12,000 a year. The amended agreement was personally guaranteed by Jan-Pro's vice president. Jan-Pro failed to provide the accounts to Guzman. Instead, it offered to return Guzman's franchise fee if he signed a mutual release, but Guzman refused to sign the release.

Guzman filed suit against Jan-Pro and its vice president for breach of contract and fraud. After a bench trial, the trial court found in favor of Guzman and against Jan-Pro and its vice president on all claims, including Guzman's claim that the defendants violated the Rhode Island Franchise Investment Act. The court awarded damages to Guzman in the amount of $120,000, plus statutory interest, costs, and attorney's fees. Jan-Pro appealed.

The court affirmed the trial court's finding of liability against Jan-Pro. First, the court agreed with the trial court that Jan-Pro failed to honor its obligations to provide accounts to Guzman totaling $8,000 in gross commissions under the original agreement and $12,000 in gross commissions under the amended agreement.

The court also agreed with the trial court that Jan-Pro's promises to provide accounts to Guzman were fraudulent because at the time that the promises were made, the defendants did not have any ability to furnish the accounts to Guzman. Further, according to the supreme court, the trial court properly found that the defendants' fraudulent promises constituted a violation of the Rhode Island Franchise Investment Act, which prohibits a franchisor, engaged in the offer and sale of a franchise in Rhode Island (or to a Rhode Island resident), from making any untrue statement of material fact, or omitting to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading, or generally, from engaging in any act which operates as a fraud or deceit on a prospective franchisee.

While the court affirmed the trial court's finding of liability against Jan-Pro, it reversed its damage award, which consisted primarily of lost profit damages. The court noted that in order to recover future lost profits, a plaintiff must establish the loss with a reasonable degree of certainty, must establish reasonably precise figures, and cannot rely on speculation. Applying that standard, the court refused to affirm the trial court's damage award on the grounds that Guzman never presented any evidence at trial of his anticipated expenses in performing under the contract; he only presented evidence of its anticipated gross revenues. According to the court, it was therefore impossible for the trial court to calculate the amount of lost profit damages with a reasonable degree of certainty and without speculation. The court therefore remanded the case back to the trial court for additional hearings to determine Guzman's anticipated expenses and to re-calculate his reasonable damages for future lost profits.