June 16th, 2010
Even in the best of franchise relationships, franchisors must be wary of litigation and potential liability arising out of their franchisees’ business operations. Where a franchisor imposes and exercises substantial controls over its franchisees’ operational and administrative methods and procedures, the franchisor may well find itself a defendant in lawsuits brought by customers and employees of its franchised outlets, claiming that the franchisor’s exercise of control makes it liable for its franchisees’ negligence or misconduct.
Two recent cases involving employee and customer claims against Jackson Hewitt shed light on this issue. In one case, a customer of a Jackson Hewitt franchised tax center in Louisiana filed suit against the franchisor based upon a privacy breach committed by the franchisee. In the other, an employee of a Jackson Hewitt franchise in Pennsylvania sued the franchisor for sexual harassment based upon the alleged actions of certain owners and managers of the franchise. In asserting their claims against the franchisor, both plaintiffs relied heavily upon language in Jackson Hewitt’s franchise operations manual and other documentation, and also the direct involvement of Jackson Hewitt representatives in the operations of its franchisees. The courts in both cases were willing to consider the plaintiffs’ claims against Jackson Hewitt despite clear admonitions in the Franchise Agreement and Operations Manual that the franchisee and its employees “shall not be considered or represented [by the franchisee] as [Jackson Hewitt’s] employees or agents” and that franchisee has exclusive responsibility over hiring and matters relating to personnel.
The conclusion to be drawn from the Jackson Hewitt litigation is that franchisors are essentially presented with two options when drafting their franchise agreements and operations manuals. The first option is to impose significant operational controls over their franchisees’ operations, similar to those described above, and assume the attendant risk of facing liability for third-party claims arising from actions taken in accordance with the operational mandates. The other option is to limit the franchise operations manual to providing examples, general guidance and non-mandatory recommendations for operating procedures and specifications.
The first approach allows franchisors to impose greater control over, and have more say in, their franchisees’ operations—which is an attractive proposition for many franchisors. In addition, franchisees may perceive greater value in a franchise system that provides strict operating standards and procedures, which may help to distinguish the franchisor from competing brands. If the franchisor chooses this approach, it should consider increasing the minimum policy limits required for franchisees’ insurance policies and the types of required policies. It may also want to explore direct insurance coverage for the franchisor for all claims arising from franchised operations.
The advantages of the second option are demonstrated by a recent court decision from Illinois, Braucher v. Swagat Group, LLC, Bus. Franchise Guide (CCH) ¶ 14,355 (Mar. 19, 2010), in which Choice Hotels International, Inc. avoided liability in a wrongful death claim for the alleged negligence of one of its franchisees in maintaining its indoor swimming pool and whirlpool. Choice provided very limited operational guidance and controls with regard to swimming areas, and this approach allows a franchisor to avoid potential liability associated with imposing mandatory operational controls over franchises. However, it also carries the potentially negative business implications of allowing franchisees a measured level of discretion in running their businesses under the franchised brand. The term “measured” is important, because the franchise agreement should still include rights of termination or other remedies for acts or omissions that have the potential to cause material detriment to the franchise system’s goodwill. In addition, franchisees may view a franchisor that employs this approach as providing very little in terms of affirmative guidance and support, not acknowledging that the information and non-binding recommendations of a franchisor can provide value in and of themselves, irrespective of whether compliance is deemed mandatory.
A prospective franchisee can also glean guidance from the information provided above. When evaluating a franchise opportunity, a prospective franchisee should seek to review the franchisor’s operations manual, even if its table of contents is provided in the Franchise Disclosure Document (“FDD”). It is acceptable for a franchisor to require the prospect to sign a non-disclosure agreement with regard to the Manual. If the operations manual provides detailed mandatory specifications and procedures, the prospective franchisee should be wary of the likelihood that the franchisor will pursue rigorous enforcement, to account for the assumption of the significant liability risks described above. While the “deep pocket” franchisor’s potential “joint and several” liability for third-party claims may seem like a benefit to the franchisee, the prospect should be aware that indemnification and contribution provisions in the franchise agreement is likely to shift the ultimate financial burden back to the franchisee, unless it can prove that the franchisor’s actions caused the third party’s claim.
If the operations manual provides only examples and recommendations for franchisee policies and operational procedures, as opposed to detailed mandates, the franchisor may be attempting to avoid any direct performance obligations to its franchisees, or it may simply be attempting to limit its exposure. In performing its due diligence, a prospective franchisee should attempt to gain as much information as possible from the franchisor and its active franchisees to discern the quality and operational support the franchisor actually offers.
The operations manual and other forms and operational materials can be valuable tools for franchisors and franchisees alike. But, depending on how they are written, they can expose the franchisor to liability and raise serious questions in the minds of franchisees as to the benefit to be derived from subscribing to a particular franchise. Parties on both sides of the table should be sure to carefully evaluate these documents to ensure that they serve and meet their needs and expectations.
June 15th, 2010
A recent decision by the Maryland Court of Special Appeals illustrates the fundamental importance of seeking affirmative legal protection for your intellectual property rights. While Brass Metal Products, Inc. v. E-J Enterprises, Inc., 984 A.2d 361, 189 Md. App. 310 (Md. App. 2009) involves an inventor’s loss of rights as a result of his failure to obtain a patent for his invention, the principles applied by the Court are equally applicable to other forms of intangible property.
In Brass Metal Products, Brass Metal, a distributor of aluminum construction railing products, entered into a wholesale supply agreement with E-J Enterprises (“E-J”), under which E-J would purchase unique aluminum railings from extrusion mills for resale to Brass Metal on an as-needed basis. The railings were designed by Brass Metal’s owner, James Burger, but Burger never obtained patents on his designs. Several years later Brass Metal authorized E-J to sell its excess inventory of railings extruded from Burger’s designs.
Eventually, E-J began selling railings it had purchased for Brass Metal to Parthenon, a new company owned by Brass Metal’s top salesman. When E-J refused Brass Metal’s request to stop these sales, Brass Metal filed suit against Parthenon and E-J. However, since neither Brass Metal nor its owner had obtained patents for the designs, Brass Metal was limited to basing its claim concerning use of designs on the tort theory of conversion rather than a statutory patent infringement. Brass Metal settled with Parthenon before trial, but lost its case against E-J and then appealed.
Conversion is essentially theft (“any distinct act of ownership or dominion exerted by one person over the personal property of another in denial of its right or inconsistent with it”). Darcars Motors of Silver Spring, Inc. v. Borzym, 379 Md. 249, 261 (2004). Fundamental to any claim for conversion is that the claimant must have a property interest in the thing that it claims was converted. This requirement imposes unique hurdles to protect intangible property rights. To succeed on a claim for conversion of intangible property, the Maryland courts have held that the owner’s rights must be “merged or incorporated into a transferable document.” Allied Inv. Corp. v. Jasen, 354 Md. 547 (1999). Burger and Brass Metal failed to meet this requirement in this case, at least as to E-J.
Brass Metal also asserted that custom and usage in the industry demonstrated that E-J understood that Brass Metal’s rights in the railings’ design were protected. The court denied this claim, citing Brass Metal’s failure to meet the “clear and convincing evidence” standard for establishing the custom and usage of the aluminum extrusion industry.
Absent the prerequisites for a claim for conversion of intangible property, since Brass Metal failed to obtain a patent for Burger’s design, it did not have the right to prohibit E-J from selling to Parthenon (or anyone else) aluminum railings extruded from Burger’s designs or extremely similar ones provided by to E-J by Parthenon. As a result, the trial court ruled in favor of E-J Enterprises on all claims.
The Maryland courts have held that, subject to the limitation discussed above, claims for conversion may succeed for forms of intangible property other than patents, such as partnership interests and copyrights, although conversion claims for copyrightable materials may be subject to preemption by the federal Copyright Act. See U.S. ex rel. Berge v. Bd. of Trustees of the Univ. of Alamaba, 104 F.3d 1453 (4th Cir. 1997). Before entering into any transaction involving any type of creative work, including technical designs or specifications, business people should be sure to take all steps necessary to fully protect their intangible rights and write contracts properly safeguarding these rights.
June 9th, 2010
During the summer two parties agree to a transfer of a mobile festival concessions business for a total sales price of $150,000. The assets of the business to be transferred include a truck, a trailer, kitchen equipment, signs and lighting apparatus. The purchasers (a mother and daughter) pay $10,000 cash up front, with the balance due once the purchaser secures bank financing. The purchasers take possession of the assets and operate the business for several months, paying the sellers (a husband and his wife) a modest consulting fee to assist with the business transition. Insurance and title to the assets remains in the sellers’ name, pending payment of the $140,000 balance owed. The purchasers buy replacement equipment, pay the business’s taxes and pay the business’s employees.
By the end of the festival season, the profits do not meet the purchasers’ expectations. The purchasers’ loan has been approved, but the funds have not been transferred. The purchasers attempt to return the truck and equipment to the sellers’ storage facility and avoid the parties’ oral agreement. Who wins and why?
This law school-worthy fact pattern presented itself in a 2008 case from Illinois, Jannusch v. Naffziger, 883 N.E.2d 711 (Ill. App. 2008), and the entertaining scenario provides a well-suited platform for analyzing contract issues relevant to commercial transactions and business acquisitions of all shapes and sizes.
The purchasers argued that the parties had never entered into a valid agreement for the sale of the concessions business named “Fesitival Foods”. Specifically, the purchasers asserted that the parties’ discussions did not address numerous essential terms that were necessary for a binding agreement, including allocation of the purchase price among equipment and goodwill, whether there would be a covenant not to compete binding the sellers, how lien releases would be obtained, and what would occur if the financing never came through. The court disagreed, finding that the parties had agreed to all the necessary “essential terms” which were the purchase price and the items to be transferred. Thus, the purchasers’ argument that the parties course of conduct was merely preliminary to a potential future purchase agreement was found unpersuasive:
“The conduct in this case is clear. Parties discussing the sale of goods do not transfer those goods and allow them to be retained for a substantial period before reaching agreement. [The purchasers] replaced equipment, reported income, paid taxes, and paid [the sellers] for [their] time and expenses, all of which is inconsistent with the idea that [the purchasers were] only ‘pursuing buying the business.’ An agreement to make an agreement is not an agreement, but there was clearly more than that here.”
Contracts for the sale of goods are governed by Article 2 of the Uniform Commercial Code (“UCC”). However, whether a business acquisition constitutes a “sale of goods” is not always cut and dry. Where a transaction, such as a typical business acquisition, involves sales of both goods and services, courts apply the “predominant purpose” test to determine whether Article 2 applies. In Jannusch, the court held that the fact that, “significant tangible assets were involved” was sufficient to place the parties’ transaction within the scope of Article 2.
As noted by the purchasers, the general rule under Article 2 is that contracts for the sale of goods over $500 must be in writing to be enforceable. However, even oral contracts in excess of $500 will be enforced if one side has either acknowledged the agreement in court or partially performed its obligations under the agreement. Thus, in Jannusch, even though the parties’ contract was oral, it still was governed by Article 2 because both sides had partially performed. Specifically, the sellers had delivered the equipment, the purchasers had made the $10,000 down payment and, most importantly, the purchasers had applied for and obtained a bank loan to pay the $140,000 balance of the purchase price. In addition, one of the purchasers acknowledged in her testimony that the purchasers had agreed to pay $150,000 for the business, she just couldn’t recall exactly when.
As a result, despite the lack of formality and the limited terms upon which the parties had actually agreed, the trial court found—and the appellate court affirmed—that the parties had entered into a valid, binding and enforceable contract for the sale of the business. The defendants’ attempt to “get out of the deal” because of disappointing profits during two months of operations failed, and the defendants were liable for a $140,000 judgment.
Court decisions like Jannusch are important for businesspeople because they demonstrate that a party’s subjective understanding of a transaction—or even a communication not intended to form a transaction—can be irrelevant to the legal results that arise. While the purchasers’ claims in this case may have been an after-the-fact attempt to avoid the effects of their knowing conduct, the implications extend to cases of legitimate misunderstanding and lack of intent to form a contract. Parties considering any substantial sale or purchase need to be careful to take steps to ensure that their oral or informal (e.g., email) interactions with potential buyers or sellers are limited so that they do not reach a binding agreement without intending to. Carefully drafted documentation is the best way to avoid disputes based upon conflicting intents and understandings.