Court Watch

COO's Title Insufficient to Create Liability Under State Franchise Act

How much control does it take for an individual to be liable for alleged violations of a franchise act? In the case of Cherrington, et al v. Wild Noodles Franchise Company, LLC, et al, 2006 WL 1704301 (D. Minn., June 15, 2006), the court said that it takes more than a title to create liability.

The Cherringtons entered into an area development agreement in late 2003 that allowed and obligated them to open nine Wild Noodles locations. They signed separate franchise agreements to open two of the locations, but those stores soon failed and the other seven planned stores were never opened.

The Cherringtons sued; two of the defendants were Wild Noodles and Steve Leibsohn. Leibsohn was a part owner of the very first Wild Noodles franchise, and, for approximately 7 months, the chief operating officer of Wild Noodles. Because the Cherring-tons are Minnesota residents, certain claims were made under the Minne-sota Franchise Act ('MFA'). The decision reported on here dealt only with Leibsohn's motion for summary
judgment.

The Cherringtons alleged that Leibsohn was personally liable for Wild Noodles' alleged violations of the MFA because he directly or indirectly controlled the franchisor. Since Leibsohn himself apparently never participated in the allegedly wrongful acts, the Cherringtons argued that his liability arose from him having been a person in control of the franchisor, or as the court deemed it ' from his status as the chief operating officer.

The portion of the MFA in question imposes joint and several liability for a franchisor's violation on 'every person who directly or indirectly controls a person liable [for violating the Act].' The statute explicitly mentions 'every principal executive officer … of a corporation so liable' as well as 'every person occupying a similar status or performing similar functions.'

After the list of categories of persons who may be liable, the statute, without punctuation, continues 'who materially aids in the act or transaction constituting the violation.'

The court first construed the statute and determined that for individual liability to attach, the person must have been in a position of control at the time of the alleged violation. Failing that, individual liability could attach only if the individual materially aided in the alleged violation. The court examined other cases that have construed the same or similar statutory language, noted that a comma or two might have made the meaning clearer, but nonetheless agreed with the holdings in those cases that the words 'materially aids' applies not only to employees, but to everyone named in the statute, including corporate officers.

The court then examined Leibsohn's brief tenure as chief operating officer. The court noted that Leibsohn worked only 10 to 15 hours per week, was not paid, and had very little responsibility, with his role largely ceremonial or related to product development, not to franchise sales. The court determined that Leibsohn was not in control at the time of the alleged violations, and that there was no evidence he actively participated in the alleged violations. Finally, the court determined that there was no evidence Leibsohn materially aided in any of the alleged violations, and that there was no evidence he knew or should have known of the alleged violations. The court dismissed the claims against Leibsohn and dismissed him from the action.

Defining 'Franchise Fee'

The two opinions in the cases of Atchley and Gilroy v. Pepperidge Farm, Inc. ('PFI'), 2005 WL 1213959 (E.D. Wash., May 20, 2005) and 2006 WL 696317 (E.D. Wash., March 20, 2006) required the district court to explore in depth the question: 'What is a franchise fee?'

In early 2003, a PFI distributor in the Spokane area advertised his distributorship for sale. At about the same time, another distributor in the Spokane area abandoned his route. PFI advertised that distributorship for sale, but claimed it did so on behalf of the prior owner.

Atchley and Gilroy met separately with PFI representatives to discuss the possible purchase of those distributorships. Atchley and Gilroy each purchased one of the distributorships. Atchley made his payment to PFI, but PFI contended that payment was for the benefit of the prior distributor. A portion of the sums received by PFI was applied to the former distributor's account with PFI. The balance of the sale proceeds was apparently paid by PFI to the former distributor. Gilroy's financial arrangements were similar, but at least one of his checks was made payable jointly to PFI and the former distributor.

When the relationships between Atchley and Gilroy with PFI soured, they brought suit against PFI. In those lawsuits, the plaintiffs alleged certain violations of the Washington Franchise Investment Protection Act ('FIPA'). To meet FIPA's requirements to establish a franchise relationship, the plaintiffs needed to prove that they paid PFI a franchise fee. Specifically, to be a franchisee, the person must pay, agree to pay, or be required to pay, directly or indirectly, a franchise fee.

The first examination of this requirement came in the plaintiffs' summary judgment motion. Plaintiffs argued that the payments they made related to the acquisition of the distributorships were franchise fees because they were 'paid for the right to enter into business' with PFI. PFI countered that the plaintiffs' payments were not franchise fees, but rather the price for acquiring the distributorships from the previous owners. In May 2005, the court denied the plaintiffs' motion for summary judgment, holding that there were genuine issues of material fact yet to be resolved.

Approximately a year later, plaintiffs made a new motion for partial summary judgment on the FIPA claims. This time, PFI made its own cross-motion for summary judgment on those claims. The plaintiffs' new motion was based on other fees and costs that they claimed were hidden or indirect franchise fees. The court noted that Washington courts have construed FIPA as suggesting that a franchise fee includes 'fees hidden in the franchisor's charges for goods or services.' See Corp v. ARCO, 726 P.2nd 66 (Wash. App. 1986). The plaintiffs cited five charges that they believed constituted hidden franchise fees.

The first was a change in their consignment agreement with respect to 'stale products.' Although PFI distributors could only sell such products to stores dealing exclusively in stale products, there had previously been no limit on the amount of stale products that could be sold. In August 2003, PFI limited such sales to 1% of the distributor's total sales during the same fiscal period. Because the distributor was not required to purchase a set quantity of product, the court determined the change in the stale product policy was simply a method of risk sharing if a distributor were to purchase too much product.

Plaintiffs next contended that a pallet charge was an indirect franchise fee. PFI was occasionally requested to deliver products directly to a distributor's customers, on pallets. Although that delivery came directly from PFI, the distributors still received a sales commission. PFI charged a palletization fee, which apparently covered the cost of shrink wrapping the product and delivering it on pallets. The court determined the palletization fee was not a hidden franchise fee because the plaintiffs received something of equal value in exchange for the payment, namely the delivery of goods to its customers, for which it earned a sales commission, without incurring the expense of delivering the product on pallets.

The court also evaluated and rejected claims regarding a maintenance program for the hand-held inventory computer equipment used by the distributors, help-line charges that arose when PFI was required to make manual invoice adjustments, and Atchley's purchase of trucks directly from the prior distributor. The court granted PFI's motion for summary judgment on the FIPA claims, deciding at last the question of fees. Other claims in the case, however, did survive summary judgment.

Jon Swierzewski is an attorney with Larkin Hoffman Daly & Lindgren Ltd. in Minneapolis. He can be reached by phone at 952-835-3800 or by e-mail at [email protected].

COO's Title Insufficient to Create Liability Under State Franchise Act

How much control does it take for an individual to be liable for alleged violations of a franchise act? In the case of Cherrington, et al v. Wild Noodles Franchise Company, LLC, et al, 2006 WL 1704301 (D. Minn., June 15, 2006), the court said that it takes more than a title to create liability.

The Cherringtons entered into an area development agreement in late 2003 that allowed and obligated them to open nine Wild Noodles locations. They signed separate franchise agreements to open two of the locations, but those stores soon failed and the other seven planned stores were never opened.

The Cherringtons sued; two of the defendants were Wild Noodles and Steve Leibsohn. Leibsohn was a part owner of the very first Wild Noodles franchise, and, for approximately 7 months, the chief operating officer of Wild Noodles. Because the Cherring-tons are Minnesota residents, certain claims were made under the Minne-sota Franchise Act ('MFA'). The decision reported on here dealt only with Leibsohn's motion for summary
judgment.

The Cherringtons alleged that Leibsohn was personally liable for Wild Noodles' alleged violations of the MFA because he directly or indirectly controlled the franchisor. Since Leibsohn himself apparently never participated in the allegedly wrongful acts, the Cherringtons argued that his liability arose from him having been a person in control of the franchisor, or as the court deemed it ' from his status as the chief operating officer.

The portion of the MFA in question imposes joint and several liability for a franchisor's violation on 'every person who directly or indirectly controls a person liable [for violating the Act].' The statute explicitly mentions 'every principal executive officer … of a corporation so liable' as well as 'every person occupying a similar status or performing similar functions.'

After the list of categories of persons who may be liable, the statute, without punctuation, continues 'who materially aids in the act or transaction constituting the violation.'

The court first construed the statute and determined that for individual liability to attach, the person must have been in a position of control at the time of the alleged violation. Failing that, individual liability could attach only if the individual materially aided in the alleged violation. The court examined other cases that have construed the same or similar statutory language, noted that a comma or two might have made the meaning clearer, but nonetheless agreed with the holdings in those cases that the words 'materially aids' applies not only to employees, but to everyone named in the statute, including corporate officers.

The court then examined Leibsohn's brief tenure as chief operating officer. The court noted that Leibsohn worked only 10 to 15 hours per week, was not paid, and had very little responsibility, with his role largely ceremonial or related to product development, not to franchise sales. The court determined that Leibsohn was not in control at the time of the alleged violations, and that there was no evidence he actively participated in the alleged violations. Finally, the court determined that there was no evidence Leibsohn materially aided in any of the alleged violations, and that there was no evidence he knew or should have known of the alleged violations. The court dismissed the claims against Leibsohn and dismissed him from the action.

Defining 'Franchise Fee'

The two opinions in the cases of Atchley and Gilroy v. Pepperidge Farm, Inc . ('PFI'), 2005 WL 1213959 (E.D. Wash., May 20, 2005) and 2006 WL 696317 (E.D. Wash., March 20, 2006) required the district court to explore in depth the question: 'What is a franchise fee?'

In early 2003, a PFI distributor in the Spokane area advertised his distributorship for sale. At about the same time, another distributor in the Spokane area abandoned his route. PFI advertised that distributorship for sale, but claimed it did so on behalf of the prior owner.

Atchley and Gilroy met separately with PFI representatives to discuss the possible purchase of those distributorships. Atchley and Gilroy each purchased one of the distributorships. Atchley made his payment to PFI, but PFI contended that payment was for the benefit of the prior distributor. A portion of the sums received by PFI was applied to the former distributor's account with PFI. The balance of the sale proceeds was apparently paid by PFI to the former distributor. Gilroy's financial arrangements were similar, but at least one of his checks was made payable jointly to PFI and the former distributor.

When the relationships between Atchley and Gilroy with PFI soured, they brought suit against PFI. In those lawsuits, the plaintiffs alleged certain violations of the Washington Franchise Investment Protection Act ('FIPA'). To meet FIPA's requirements to establish a franchise relationship, the plaintiffs needed to prove that they paid PFI a franchise fee. Specifically, to be a franchisee, the person must pay, agree to pay, or be required to pay, directly or indirectly, a franchise fee.

The first examination of this requirement came in the plaintiffs' summary judgment motion. Plaintiffs argued that the payments they made related to the acquisition of the distributorships were franchise fees because they were 'paid for the right to enter into business' with PFI. PFI countered that the plaintiffs' payments were not franchise fees, but rather the price for acquiring the distributorships from the previous owners. In May 2005, the court denied the plaintiffs' motion for summary judgment, holding that there were genuine issues of material fact yet to be resolved.

Approximately a year later, plaintiffs made a new motion for partial summary judgment on the FIPA claims. This time, PFI made its own cross-motion for summary judgment on those claims. The plaintiffs' new motion was based on other fees and costs that they claimed were hidden or indirect franchise fees. The court noted that Washington courts have construed FIPA as suggesting that a franchise fee includes 'fees hidden in the franchisor's charges for goods or services.' See Corp v. ARCO , 726 P.2nd 66 (Wash. App. 1986). The plaintiffs cited five charges that they believed constituted hidden franchise fees.

The first was a change in their consignment agreement with respect to 'stale products.' Although PFI distributors could only sell such products to stores dealing exclusively in stale products, there had previously been no limit on the amount of stale products that could be sold. In August 2003, PFI limited such sales to 1% of the distributor's total sales during the same fiscal period. Because the distributor was not required to purchase a set quantity of product, the court determined the change in the stale product policy was simply a method of risk sharing if a distributor were to purchase too much product.

Plaintiffs next contended that a pallet charge was an indirect franchise fee. PFI was occasionally requested to deliver products directly to a distributor's customers, on pallets. Although that delivery came directly from PFI, the distributors still received a sales commission. PFI charged a palletization fee, which apparently covered the cost of shrink wrapping the product and delivering it on pallets. The court determined the palletization fee was not a hidden franchise fee because the plaintiffs received something of equal value in exchange for the payment, namely the delivery of goods to its customers, for which it earned a sales commission, without incurring the expense of delivering the product on pallets.

The court also evaluated and rejected claims regarding a maintenance program for the hand-held inventory computer equipment used by the distributors, help-line charges that arose when PFI was required to make manual invoice adjustments, and Atchley's purchase of trucks directly from the prior distributor. The court granted PFI's motion for summary judgment on the FIPA claims, deciding at last the question of fees. Other claims in the case, however, did survive summary judgment.

Jon Swierzewski is an attorney with Larkin Hoffman Daly & Lindgren Ltd. in Minneapolis. He can be reached by phone at 952-835-3800 or by e-mail at [email protected].