Court Watch

Defendant's spouse, who was the principal in the competing company to which the defendant's business had been transferred, had also signed a separate confidentiality agreement with the plaintiff, but it did not contain an arbitration clause. Therefore, the court found that this agreement, too, did not require plaintiff to arbitrate claims arising under that document.

The moral of Synergistic is that good drafting can cause franchisors to have the benefits of arbitration and simultaneously protect the franchisor's valuable intellectual property rights through judicial proceedings, which have arguably greater benefits and protection than arbitration when it comes to matters involving intellectual property.

Court Finds Tax Preparer's Operations Shady, Puts It Out of Business

In a civil action, one would not expect a federal district court to impose a death sentence on a defendant, but that is, in effect, exactly what happened in U.S. v. ITS Financial LLC, Bus. Franchise Guide (CCH) '15,170 (S.D. Oo. Nov. 6, 2013), where the court found that the conduct by the corporate defendants was so outrageous that the corporate entities should be put out of business ' and they were.

Ever since the Federal Trade Commission Disclosure Rule went into effect in 1979, critics have complained that the Disclosure Rule has no teeth and the FTC has no money to enforce it. ITS is not exactly a franchise case, but it does involve a franchise system that the court said had gone so far in its bad dealings that it must be stopped. Frequently in these types of cases, a franchisor has evolved into one of questionable integrity and sells franchises to the unsuspecting or encourages its franchisees to engage in dubious practices. It is not clear from the lengthy court opinion whether the franchisees were innocent when they signed up for the ITS army, but it is clear that when the system collapsed, the franchisees were part and parcel of many of the offenses committed by the system.

ITS sold franchises that permitted its franchisees to sell tax preparation services, but at some point, maybe even at its infancy, the system became corrupt. The 134-page opinion delineates in great detail numerous practices that were unlawful, and it was not only the franchisor who committed these sins. The franchisees were, literally, trained to engage in illegal activities, and in practice actively did so. A sampling of the unlawful acts committed by the franchisor and/or franchisees included:

• Issuing duplicate checks for instant advances on tax refunds or other loans, such that the banks would receive two demands for payments to the payee, one of the checks being based on forged signatures and resulting in payment refund demands by the bank;
• Failure to pay employment taxes, and submitting false reports to the IRS;
• Charging phony and exorbitant fees to ITS customers;
• Filing tax returns based on pay stubs, rather than W-2s, resulting in the customer failing to report all income on which taxes were due;
• Filing income tax returns without proper customer authorization;
• Encouraging franchisees to lie to government officials during government compliance visits;
• Hiding money in secret bank accounts;
• Violating the terms of a preliminary injunction order that required, among other things, for the franchisor to monitor the conduct of its franchisees;
• In the case of franchisor, conducting seminars on how to file returns based on check stubs, rather than returns based on W-2s, and avoid detection by the Internal Revenue Service; and
• Forging signatures on customers' tax forms.

The court's decision gives a clear impression that these acts were more than inadvertent mistakes. The court found that not only did the defendants actively commit illegal acts, the defendants also acted with “willful blindness to misconduct” on the part of its franchisees, including by failing to conduct background checks because they did not want to know if any employees had criminal records, and failing to monitor franchisees to prevent fraud.

In the end, the court, without hesitation, issued a permanent injunction against the franchisor, the effect of which was to shut down ITS's business in its entirety. In addition, the franchisor's principal was permanently barred from operating, or being involved with in any way, any business relating in any way to preparation of tax returns. The court stated that these sanctions against “the fourth largest tax preparation business in the country” were “necessary to protect the public and the [U.S.] Treasury.”

Over the 35 year history of the FTC Rule, the government has been strongly criticized for not vigorously enforcing the Rule. That may still be a credible argument in the normal case where the franchisees are innocent but the franchisor is corrupt. However, when the two groups join together to conduct unlawful activity, the IRS demonstrates in this case that neither group will escape the wrath of the government. The franchise community has for some time pictured the FTC as a bit of a toothless tiger. ITS projects a different image of the Internal Revenue Service. Perhaps some of its aggressiveness will set an example for the FTC.

Mode-of-Operation Liability Cannot Be Assumed

The defendants appealed from a jury verdict in favor of a plaintiff who fell while patronizing a fast-food restaurant; the primary issue on appeal was the scope of “mode-of-operation” liability. Prioleau v. Kentucky Fried Chicken Inc., 2014 N.J. Super. LEXIS 29 (3/3/14).

The plaintiff and her adult children visited a Cherry Hill, NJ, Kentucky Fried Chicken franchise in December 2009. It was raining heavily that evening, and the plaintiff testified that she and her children were not carrying umbrellas, that they were wet when they entered the restaurant, and that they tracked water in with them. As the plaintiff's children went to the counter to order, the plaintiff headed to the restroom. About five feet from the restroom entrance, she slipped and fell, later testifying on cross-examination: “I felt it was wet first. It was slippery. And ' when we first started sliding is when [sic] I realized that it was grease mixed with water.” The plaintiff at first thought her injuries were minimal and refused the restaurant's assistant manager's offer of medical assistance. Later, however, she experienced more pain and consulted with several medical care providers. The plaintiff declined surgical injections or other intervention, but did attend physical therapy sessions for about two months. She never had to miss work because of her injuries. She brought suit against the restaurant on a premises liability theory. Over defense objection, the trial judge issued an instruction to the jury concerning “mode-of-operation” liability. The jury returned a verdict of $250,000, allocating 51% of the fault to the restaurant.

On appeal, the defendants challenged, inter alia, that the judge's instruction to the jury telling them that proof that the restaurant was on actual or constructive notice of a hazardous condition need not be shown if the defendant's mode of operation created the hazardous condition. Mode-of-operation liability may attach when the business allows customers to handle the merchandise in a way that is inherently likely to cause a hazardous condition, such as when customers are permitted to dispense their own ice and drinks. When mode-of-operation danger is shown, the plaintiff is relieved of responsibility for showing the defendant had actual or constructive notice of a dangerous condition, and the burden immediately shifts to the defendant to show that it did all that a reasonably prudent person could be expected to do to avoid a risk of injury. However, the trial judge here issued the instruction simply on the basis of the fact that the defendant operated a fast-food restaurant. The appeals court held this was error because “[c]ontrary to the trial judge's conclusion, defendants' business as a 'fast-food operation' has no relationship to plaintiff's fall. There is no link between the manner in which the business was conducted and the alleged hazard plaintiff slipped on or its source. No testimony showed the alleged wet/greasy floor was the result of a patron's spilled drink or dropped food. Further, there was no evidence the restaurant's floor was ill-kept, strewn with debris or laden with overflowing trash.”

Because the jury charge had the capacity to mislead the jury, the judgment was reversed and the case remanded for a new trial.

' Janice G. Inman, Associate Editor

Arbitration of Trademark Dispute Not Required

Twenty years ago, arbitration clauses were rarely found in franchise agreements, but they have become considerably more popular over the last two decades. However, while there are many franchisors that prefer arbitration over court, there are some issues that franchisors prefer not to have decided by arbitration ' in particular, those relating to trademarks. Thus, it is common for broad arbitration provisions to have broad exceptions for disputes relating to trademarks. This was the case in Synergistic International LLC v. Monaghan, Bus. Franchise Guide (CCH) '15,146 (C.D. Ill., Oct. 10, 2013).

After the franchise agreement at issue in Synergistic expired, the franchisee committed numerous violations of the post-term covenants, including the non-compete and the cessation of trademark use provisions. Rather than instituting an arbitration proceeding, the franchisor immediately brought suit asking the court for, among other things, injunctive, declaratory and monetary relief. Arbitration was generally required under the franchise agreement, but each party had the right to opt out of arbitration under certain circumstances, including where disputes related to trademarks. Defendant franchisee argued, unsuccessfully, that all the issues should be decided by arbitration. The plaintiff franchisor successfully demonstrated, among other things, that all of the issues were “related to the marks” ' including claims that: defendant failed to cease using plaintiff's methods of operations, telephone numbers and plaintiff's mark; failed to transfer the business to the franchisor as required by the franchise agreement; defendant established a competing business to which defendant's assets were transferred; and defendant failed to comply with the non-compete and other post-term obligations. Therefore, the court allowed the lawsuit to proceed in court, foregoing arbitration entirely.

Defendant's spouse, who was the principal in the competing company to which the defendant's business had been transferred, had also signed a separate confidentiality agreement with the plaintiff, but it did not contain an arbitration clause. Therefore, the court found that this agreement, too, did not require plaintiff to arbitrate claims arising under that document.

The moral of Synergistic is that good drafting can cause franchisors to have the benefits of arbitration and simultaneously protect the franchisor's valuable intellectual property rights through judicial proceedings, which have arguably greater benefits and protection than arbitration when it comes to matters involving intellectual property.

Court Finds Tax Preparer's Operations Shady, Puts It Out of Business

In a civil action, one would not expect a federal district court to impose a death sentence on a defendant, but that is, in effect, exactly what happened in U.S. v. ITS Financial LLC, Bus. Franchise Guide (CCH) '15,170 (S.D. Oo. Nov. 6, 2013), where the court found that the conduct by the corporate defendants was so outrageous that the corporate entities should be put out of business ' and they were.

Ever since the Federal Trade Commission Disclosure Rule went into effect in 1979, critics have complained that the Disclosure Rule has no teeth and the FTC has no money to enforce it. ITS is not exactly a franchise case, but it does involve a franchise system that the court said had gone so far in its bad dealings that it must be stopped. Frequently in these types of cases, a franchisor has evolved into one of questionable integrity and sells franchises to the unsuspecting or encourages its franchisees to engage in dubious practices. It is not clear from the lengthy court opinion whether the franchisees were innocent when they signed up for the ITS army, but it is clear that when the system collapsed, the franchisees were part and parcel of many of the offenses committed by the system.

ITS sold franchises that permitted its franchisees to sell tax preparation services, but at some point, maybe even at its infancy, the system became corrupt. The 134-page opinion delineates in great detail numerous practices that were unlawful, and it was not only the franchisor who committed these sins. The franchisees were, literally, trained to engage in illegal activities, and in practice actively did so. A sampling of the unlawful acts committed by the franchisor and/or franchisees included:

• Issuing duplicate checks for instant advances on tax refunds or other loans, such that the banks would receive two demands for payments to the payee, one of the checks being based on forged signatures and resulting in payment refund demands by the bank;
• Failure to pay employment taxes, and submitting false reports to the IRS;
• Charging phony and exorbitant fees to ITS customers;
• Filing tax returns based on pay stubs, rather than W-2s, resulting in the customer failing to report all income on which taxes were due;
• Filing income tax returns without proper customer authorization;
• Encouraging franchisees to lie to government officials during government compliance visits;
• Hiding money in secret bank accounts;
• Violating the terms of a preliminary injunction order that required, among other things, for the franchisor to monitor the conduct of its franchisees;
• In the case of franchisor, conducting seminars on how to file returns based on check stubs, rather than returns based on W-2s, and avoid detection by the Internal Revenue Service; and
• Forging signatures on customers' tax forms.

The court's decision gives a clear impression that these acts were more than inadvertent mistakes. The court found that not only did the defendants actively commit illegal acts, the defendants also acted with “willful blindness to misconduct” on the part of its franchisees, including by failing to conduct background checks because they did not want to know if any employees had criminal records, and failing to monitor franchisees to prevent fraud.

In the end, the court, without hesitation, issued a permanent injunction against the franchisor, the effect of which was to shut down ITS's business in its entirety. In addition, the franchisor's principal was permanently barred from operating, or being involved with in any way, any business relating in any way to preparation of tax returns. The court stated that these sanctions against “the fourth largest tax preparation business in the country” were “necessary to protect the public and the [U.S.] Treasury.”

Over the 35 year history of the FTC Rule, the government has been strongly criticized for not vigorously enforcing the Rule. That may still be a credible argument in the normal case where the franchisees are innocent but the franchisor is corrupt. However, when the two groups join together to conduct unlawful activity, the IRS demonstrates in this case that neither group will escape the wrath of the government. The franchise community has for some time pictured the FTC as a bit of a toothless tiger. ITS projects a different image of the Internal Revenue Service. Perhaps some of its aggressiveness will set an example for the FTC.

Mode-of-Operation Liability Cannot Be Assumed

The defendants appealed from a jury verdict in favor of a plaintiff who fell while patronizing a fast-food restaurant; the primary issue on appeal was the scope of “mode-of-operation” liability. Prioleau v. Kentucky Fried Chicken Inc., 2014 N.J. Super. LEXIS 29 (3/3/14).

The plaintiff and her adult children visited a Cherry Hill, NJ, Kentucky Fried Chicken franchise in December 2009. It was raining heavily that evening, and the plaintiff testified that she and her children were not carrying umbrellas, that they were wet when they entered the restaurant, and that they tracked water in with them. As the plaintiff's children went to the counter to order, the plaintiff headed to the restroom. About five feet from the restroom entrance, she slipped and fell, later testifying on cross-examination: “I felt it was wet first. It was slippery. And ' when we first started sliding is when [sic] I realized that it was grease mixed with water.” The plaintiff at first thought her injuries were minimal and refused the restaurant's assistant manager's offer of medical assistance. Later, however, she experienced more pain and consulted with several medical care providers. The plaintiff declined surgical injections or other intervention, but did attend physical therapy sessions for about two months. She never had to miss work because of her injuries. She brought suit against the restaurant on a premises liability theory. Over defense objection, the trial judge issued an instruction to the jury concerning “mode-of-operation” liability. The jury returned a verdict of $250,000, allocating 51% of the fault to the restaurant.

On appeal, the defendants challenged, inter alia, that the judge's instruction to the jury telling them that proof that the restaurant was on actual or constructive notice of a hazardous condition need not be shown if the defendant's mode of operation created the hazardous condition. Mode-of-operation liability may attach when the business allows customers to handle the merchandise in a way that is inherently likely to cause a hazardous condition, such as when customers are permitted to dispense their own ice and drinks. When mode-of-operation danger is shown, the plaintiff is relieved of responsibility for showing the defendant had actual or constructive notice of a dangerous condition, and the burden immediately shifts to the defendant to show that it did all that a reasonably prudent person could be expected to do to avoid a risk of injury. However, the trial judge here issued the instruction simply on the basis of the fact that the defendant operated a fast-food restaurant. The appeals court held this was error because “[c]ontrary to the trial judge's conclusion, defendants' business as a 'fast-food operation' has no relationship to plaintiff's fall. There is no link between the manner in which the business was conducted and the alleged hazard plaintiff slipped on or its source. No testimony showed the alleged wet/greasy floor was the result of a patron's spilled drink or dropped food. Further, there was no evidence the restaurant's floor was ill-kept, strewn with debris or laden with overflowing trash.”

Because the jury charge had the capacity to mislead the jury, the judgment was reversed and the case remanded for a new trial.

' Janice G. Inman, Associate Editor