Court Watch

Cooperation with Government Might Not Avoid Equitable Relief Payment ' and Attorneys Beware!

Reported cases brought by the Federal Trade Commission under the FTC Franchise Rule are rare, largely because most targets do not have the resources to go to battle with the federal government. In Federal Trade Commission v. Network Services Depot, Inc. 2010 WL 3211724 (9th Cir. Aug. 16, 2010), the FTC filed suit in Nevada against the promoters of an Internet kiosk business opportunity. The case is worthy of attention because of its interesting facts that deal with the quantum of proof necessary to hold individual owners and executives liable for equitable monetary relief. Further, the case is important for the franchise bar because it imposed a constructive trust on legal fees paid to the attorneys representing the defendants.

The business opportunity ' the sale of Internet kiosks to be located in airports, hotels, etc., with minimum guaranteed returns to the purchasers ' proved to be a Ponzi scheme, with a small fraction of kiosks ever installed and the “guarantees” being paid by new investors. The original promoter, Network Services Depot, Inc. (“NSD”), contracted with a vending company, Bikini Vending Corp., and its related entities (“BVC”), to install the kiosks. BVC managed the enterprise and guaranteed NSD's customers would receive a minimum return each month. BVC falsely reported robust sales, but the scheme unraveled as a result of a TV expos' and employees jumping ship. NSD also claimed to be a victim, paying BVC millions for installation of kiosks that never were installed. When BVC's activities became public, NSD's owner went to the FBI and cooperated in recording incriminating conversations with BVC.

While it may seem that the owner of NSD should not have been targeted by the FTC after having cooperated with another arm of the government, the evidence showed that some time before his cooperation with the FBI, he had received customer complaints about kiosks not being installed, but he did not investigate, and he accepted BVC's explanations at face value. In fact, despite numerous customer complaints, NSD chose not to delve too deeply into BVC's activities, presumably in order to claim a lack of knowledge of BVC's fraudulent claims.

All of this worked to NSD's disadvantage, resulting in affirmation of summary judgment in the FTC's favor on the question of whether NSD's owner and another of its executives had knowledge that NSD or BVC engaged in dishonest or fraudulent conduct. Both defendants also admitted that they were aware that some of the representations were not true, thus weakening the impact of their cooperation with the FBI. The undisputed facts supported a reasonable inference that the owner and one of its executives satisfied the “knowledge” requirement by acting with either: 1) actual knowledge, 2) reckless indifference to truth or falsity, or 3) an awareness of a high probability of fraud and an intentional avoidance of the truth with respect to any of the admitted misrepresentations.

The owner and its executive were not the only losers. The court ruled that attorneys' fees that the owner paid to his lawyer could not be retained by the attorney. In this case, like in the defense of most government actions, the attorney requested a sizeable retainer of $375,000, and his co-counsel (who settled) received a $500,000 retainer. It turns out that this money came from some “custodial” accounts that the owner had told the FTC had been set up years ago for his children. However, the evidence showed that the true source of the funds was the kiosk scheme.

The owner's attorney argued that he should be allowed keep the retainer because he was a “bona fide purchaser” and was entitled to rely on statements from his client that the money came from a legitimate source. The problem was that the attorney was aware of a draft FTC complaint at the time he negotiated his fee. The complaint named all of his client's businesses as participants in the kiosk scheme. A review of the client's financial records would have shown that those businesses were the source of the funds in the custodial accounts. Thus, the attorney could not simply rely on his client's statements, and the court ruled that his failure to investigate defeated his bona fide purchaser claim.

This case should serve as a good lesson to the franchise bar that it is extremely important when undertaking representation in a governmental action to conduct an independent investigation of the source of the payment of legal fees so that they might not later be subjected to a constructive trust and lost.

Wisconsin Cases Tackle 'Community of Interest' Definition

The Wisconsin Fair Dealership Law (“WFDL”), Wisconsin Statutes, Ch. 135, Secs. 135.01 through 135.07 defines a “Dealership” as an arrangement where one party ' the “grantor” ' gives the other party ' the “grantee” ' the right to sell or distribute goods or services, or use a mark or symbol, in which there is a “community of interest” in the sale, lease, etc., of the goods or services. The Wisconsin Franchise Investment Law, Wisconsin Statutes, Ch. 553, Secs. 553.01 through 553.78, uses the “marketing plan or system” element in determining whether a business arrangement is a franchise. However, since a franchise contains both the community of interest and the marketing plan or system elements, it is also a “dealership” under the WFDL.

The question of whether an arrangement contains a marketing plan or system or the parties have a community of interest has led to countless disputes as franchisees and dealers seek to avoid the termination, non-renewal, or other actions prevented by franchise relationship laws such as the WFDL. Two Wisconsin federal cases and one state court case revisited the definition of “community of interest” question in recent months, with slightly different results.

The cases turned to some degree on the list of criteria to be considered when pondering the community of interest question detailed in Ziegler Co., Inc. v. Rexnord, Inc. 433 N.W.2d 8 (Supreme Court of Wisconsin, 1987) and a Seventh Circuit case interpreting the WFDL, Home Protective Services, Inc., v. ADT Securities Services, Inc., 438 F.3d 716 (7th Cir. 2006). Home Protective Services, while acknowledging the Ziegler list, boiled down the community of interest definition to the percentage of revenues and profits the alleged dealer derived from the grantor and the amount of time and money a purported dealer had sunk into the relationship. The bottom line, according to Home Protective Services, is whether the grantor had the alleged dealer “over a barrel.” In that case, even though Home Protective Services derived 95% of its revenue from the sale of ADT products and services, the court held that since it could, and did, find another source, it was not over a barrel and, as such, was not protected by the WFDL ' even though the new business was not as advantageous as the old.

In Stucchi USA, Inc. v. Hyquip, Inc., Bus. Franchise Guide (CCH) '14,437 (USDC E.D. Wisconsin, July 28, 2010), a U.S. District Court struggled with whether a relationship between the U.S. subsidiary of an Italian corporation and a Wisconsin distributor of its hydraulic equipment constituted a “dealership” under the WFDL. The court relied on the two-pronged test of Home Protective Services in finding that the purported dealer's sales of the grantor's products were only a small percentage of the “dealer's” sales and, since the alleged dealer sold similar products for a competing manufacturer, it was not over a barrel. Hence, the dealer did not have WFDL protection against termination.

Another federal district court case, The Dry Dock, LLC, v. The Godfrey Conveyor Company, Inc., Bus. Franchise Guide (CCH) '14,403 (USDC W.D. Wisconsin, June 7, 2010), considered whether the termination of a boat dealer's distribution agreement violated the WFDL. The court found that since the plaintiff sold many other brands of boats and a small percentage of the plaintiff's sales came from the sale of the defendant's products, the manufacturer did not have the plaintiff “over a barrel.” In addition, the court reviewed the parties' relationship against the extensive list of factors detailed in Ziegler, the results of which dictated against finding the existence of a dealership.

What makes the foregoing cases of interest is the rejection of the percentage-of-sales test of the federal cases by a Wisconsin state court within weeks of the two federal cases. In The Water Quality Store, LLC v. Dynasty Spas, Inc., Bus. Franchise Guide (CCH) '14,426 (Court of Appeals of Wisconsin, Dist. IV, July 15, 2010), the court found that Home Protective Services does not provide the proper standard for determining “community of interest,” since it is a variance with the guidance provided by Ziegler. Since Ziegler is a Wisconsin Supreme Court case interpreting Wisconsin law, the court stated that it took precedence over federal cases interpreting that state's law. The court also cited a not-for-publication Wisconsin Supreme Court case, Central Corporation v. Research Products Corporation, 681 N.W.2d 178 (2004), which reversed a summary judgment for the manufacturer against the purported dealer, even though the manufacturer's products comprised only 8%-9% of the dealer's sales.

While it is usually clear whether a franchise fee and a trademark license is present in a business arrangement, the imprecise nature of “marketing plan or system” and “community of interest” will lead to continued confusion and disputes. Since it is unlikely that more exact definitions can be crafted, the continuing ambiguity should keep franchise litigators in business for the foreseeable future.

Darryl A. Hart is an attorney with Bartko, Zankel, Tarrant & Miller in San Francisco. Charles G. Miller is a shareholder and director of the firm. Hart and Miller can be reached by phone at 415-956-1900.

Cooperation with Government Might Not Avoid Equitable Relief Payment ' and Attorneys Beware!

Reported cases brought by the Federal Trade Commission under the FTC Franchise Rule are rare, largely because most targets do not have the resources to go to battle with the federal government. In Federal Trade Commission v. Network Services Depot, Inc. 2010 WL 3211724 (9th Cir. Aug. 16, 2010), the FTC filed suit in Nevada against the promoters of an Internet kiosk business opportunity. The case is worthy of attention because of its interesting facts that deal with the quantum of proof necessary to hold individual owners and executives liable for equitable monetary relief. Further, the case is important for the franchise bar because it imposed a constructive trust on legal fees paid to the attorneys representing the defendants.

The business opportunity ' the sale of Internet kiosks to be located in airports, hotels, etc., with minimum guaranteed returns to the purchasers ' proved to be a Ponzi scheme, with a small fraction of kiosks ever installed and the “guarantees” being paid by new investors. The original promoter, Network Services Depot, Inc. (“NSD”), contracted with a vending company, Bikini Vending Corp., and its related entities (“BVC”), to install the kiosks. BVC managed the enterprise and guaranteed NSD's customers would receive a minimum return each month. BVC falsely reported robust sales, but the scheme unraveled as a result of a TV expos' and employees jumping ship. NSD also claimed to be a victim, paying BVC millions for installation of kiosks that never were installed. When BVC's activities became public, NSD's owner went to the FBI and cooperated in recording incriminating conversations with BVC.

While it may seem that the owner of NSD should not have been targeted by the FTC after having cooperated with another arm of the government, the evidence showed that some time before his cooperation with the FBI, he had received customer complaints about kiosks not being installed, but he did not investigate, and he accepted BVC's explanations at face value. In fact, despite numerous customer complaints, NSD chose not to delve too deeply into BVC's activities, presumably in order to claim a lack of knowledge of BVC's fraudulent claims.

All of this worked to NSD's disadvantage, resulting in affirmation of summary judgment in the FTC's favor on the question of whether NSD's owner and another of its executives had knowledge that NSD or BVC engaged in dishonest or fraudulent conduct. Both defendants also admitted that they were aware that some of the representations were not true, thus weakening the impact of their cooperation with the FBI. The undisputed facts supported a reasonable inference that the owner and one of its executives satisfied the “knowledge” requirement by acting with either: 1) actual knowledge, 2) reckless indifference to truth or falsity, or 3) an awareness of a high probability of fraud and an intentional avoidance of the truth with respect to any of the admitted misrepresentations.

The owner and its executive were not the only losers. The court ruled that attorneys' fees that the owner paid to his lawyer could not be retained by the attorney. In this case, like in the defense of most government actions, the attorney requested a sizeable retainer of $375,000, and his co-counsel (who settled) received a $500,000 retainer. It turns out that this money came from some “custodial” accounts that the owner had told the FTC had been set up years ago for his children. However, the evidence showed that the true source of the funds was the kiosk scheme.

The owner's attorney argued that he should be allowed keep the retainer because he was a “bona fide purchaser” and was entitled to rely on statements from his client that the money came from a legitimate source. The problem was that the attorney was aware of a draft FTC complaint at the time he negotiated his fee. The complaint named all of his client's businesses as participants in the kiosk scheme. A review of the client's financial records would have shown that those businesses were the source of the funds in the custodial accounts. Thus, the attorney could not simply rely on his client's statements, and the court ruled that his failure to investigate defeated his bona fide purchaser claim.

This case should serve as a good lesson to the franchise bar that it is extremely important when undertaking representation in a governmental action to conduct an independent investigation of the source of the payment of legal fees so that they might not later be subjected to a constructive trust and lost.

Wisconsin Cases Tackle 'Community of Interest' Definition

The Wisconsin Fair Dealership Law (“WFDL”), Wisconsin Statutes, Ch. 135, Secs. 135.01 through 135.07 defines a “Dealership” as an arrangement where one party ' the “grantor” ' gives the other party ' the “grantee” ' the right to sell or distribute goods or services, or use a mark or symbol, in which there is a “community of interest” in the sale, lease, etc., of the goods or services. The Wisconsin Franchise Investment Law, Wisconsin Statutes, Ch. 553, Secs. 553.01 through 553.78, uses the “marketing plan or system” element in determining whether a business arrangement is a franchise. However, since a franchise contains both the community of interest and the marketing plan or system elements, it is also a “dealership” under the WFDL.

The question of whether an arrangement contains a marketing plan or system or the parties have a community of interest has led to countless disputes as franchisees and dealers seek to avoid the termination, non-renewal, or other actions prevented by franchise relationship laws such as the WFDL. Two Wisconsin federal cases and one state court case revisited the definition of “community of interest” question in recent months, with slightly different results.

The cases turned to some degree on the list of criteria to be considered when pondering the community of interest question detailed in Ziegler Co., Inc. v. Rexnord, Inc. 433 N.W.2d 8 (Supreme Court of Wisconsin, 1987) and a Seventh Circuit case interpreting the WFDL, Home Protective Services, Inc., v. ADT Securities Services, Inc. , 438 F.3d 716 (7th Cir. 2006). Home Protective Services, while acknowledging the Ziegler list, boiled down the community of interest definition to the percentage of revenues and profits the alleged dealer derived from the grantor and the amount of time and money a purported dealer had sunk into the relationship. The bottom line, according to Home Protective Services, is whether the grantor had the alleged dealer “over a barrel.” In that case, even though Home Protective Services derived 95% of its revenue from the sale of ADT products and services, the court held that since it could, and did, find another source, it was not over a barrel and, as such, was not protected by the WFDL ' even though the new business was not as advantageous as the old.

In Stucchi USA, Inc. v. Hyquip, Inc., Bus. Franchise Guide (CCH) '14,437 (USDC E.D. Wisconsin, July 28, 2010), a U.S. District Court struggled with whether a relationship between the U.S. subsidiary of an Italian corporation and a Wisconsin distributor of its hydraulic equipment constituted a “dealership” under the WFDL. The court relied on the two-pronged test of Home Protective Services in finding that the purported dealer's sales of the grantor's products were only a small percentage of the “dealer's” sales and, since the alleged dealer sold similar products for a competing manufacturer, it was not over a barrel. Hence, the dealer did not have WFDL protection against termination.

Another federal district court case, The Dry Dock, LLC, v. The Godfrey Conveyor Company, Inc., Bus. Franchise Guide (CCH) '14,403 (USDC W.D. Wisconsin, June 7, 2010), considered whether the termination of a boat dealer's distribution agreement violated the WFDL. The court found that since the plaintiff sold many other brands of boats and a small percentage of the plaintiff's sales came from the sale of the defendant's products, the manufacturer did not have the plaintiff “over a barrel.” In addition, the court reviewed the parties' relationship against the extensive list of factors detailed in Ziegler, the results of which dictated against finding the existence of a dealership.

What makes the foregoing cases of interest is the rejection of the percentage-of-sales test of the federal cases by a Wisconsin state court within weeks of the two federal cases. In The Water Quality Store, LLC v. Dynasty Spas, Inc., Bus. Franchise Guide (CCH) '14,426 (Court of Appeals of Wisconsin, Dist. IV, July 15, 2010), the court found that Home Protective Services does not provide the proper standard for determining “community of interest,” since it is a variance with the guidance provided by Ziegler. Since Ziegler is a Wisconsin Supreme Court case interpreting Wisconsin law, the court stated that it took precedence over federal cases interpreting that state's law. The court also cited a not-for-publication Wisconsin Supreme Court case, Central Corporation v. Research Products Corporation, 681 N.W.2d 178 (2004), which reversed a summary judgment for the manufacturer against the purported dealer, even though the manufacturer's products comprised only 8%-9% of the dealer's sales.

While it is usually clear whether a franchise fee and a trademark license is present in a business arrangement, the imprecise nature of “marketing plan or system” and “community of interest” will lead to continued confusion and disputes. Since it is unlikely that more exact definitions can be crafted, the continuing ambiguity should keep franchise litigators in business for the foreseeable future.

Darryl A. Hart is an attorney with Bartko, Zankel, Tarrant & Miller in San Francisco. Charles G. Miller is a shareholder and director of the firm. Hart and Miller can be reached by phone at 415-956-1900.