The court decision deals with Grayson and McKenzie, who are former franchisees of 7-Eleven, Inc. Grayson and McKenzie are also the name plaintiffs in a class action lawsuit they filed against 7-Eleven relating to 7-Eleven's collection of a federal excise tax on pre-paid telephone cards they and other franchisees sold at their respective stores. 

When those cards were sold, 7-Eleven collected excise taxes from the plaintiffs, and paid those taxes to the federal government. 

In 2006, the federal government stopped collecting excise taxes on pre-paid phone cards. The government authorized a one-time refund of the tax for payments made between March 2003 and July 2006. 

The federal government made refund payments to 7-Eleven for millions of dollars, but the franchisees in the lawsuit alleged that 7-Eleven did not return any portion of the payments to them, even though those franchisees believed they were entitled to a 50% share of the refunded money. 

The reason the franchisees believed they were entitled to a portion of the tax refunds was because of the way the 7-Eleven system is structured.  While most franchise systems are designed so that the franchisee will pay the franchisor a royalty fee (as well as other fees) based on the franchisee's gross sales, 7-Eleven's system is built differently. 

In the 7-Eleven system, 7-Eleven and the franchisee will split the store's gross profit as well as the operating expenses. 

Based on the "share and share alike" operating structure, the plaintiffs in the lawsuit alleged that they were entitled to a 50% pro rata share of the excise tax refunds received by 7-Eleven.  The franchisees sued 7-Eleven for: (1) conversion; (2) money had and received; and (3) breach of implied contract.

7-Eleven moved for summary judgment on Grayson and McKenzie's claims, asking the court to dispose of the franchisees' claims.  7-Eleven  based its request on general releases that the franchisees had each signed in 2004 and 2005, respectively, when they terminated their franchise agreements with the company. 

In response, Plaintiffs argued that California Civil Code Sec. 1668 prevents the releases from excusing  7-Eleven from liability. That section states:

All contracts which have for their object, directly or indirectly, to exempt any one from responsibility for his own fraud, or willful injury to the person or property of another, or violation of law, whether willful or negligent, are against the policy of the law. 

In essence, the franchisees argued that their general releases could not be used to dispose of their legal claims because 7-Eleven had engaged in intentional wrongdoing, and that California law does not permit 7-Eleven to obtain a release of those types of claims from the franchisees.

The Court began its analysis by recognizing the rule that "generally, California Civil Code Section 1668 invalidates contracts that purport to exempt an individual or entity from liability for future intentional wrongs, gross negligence, and violations of the law." 

As to the franchisees' conversion claim, the Court stated that "[a]bsent a public interest, section 1668 does not invalidate a release from simple negligence or strict liability claims."  The Court found that conversion is a strict liability tort, and because there is no "public interest" involved in a franchisee-franchisor relationship, the conversion claim was released by the franchisees.

As to the second claim, money had and received, the Court found that the essence of the claim does not require a plaintiff to show that the other party engaged in either gross negligence or intentional wrongdoing.  As a result, the Court found that claim to be released as well. 

Turning to the final claim, breach of implied contract, the Court found that the claim did not involve an intentional tort (which is the type of action that California law protects against), and that it was therefore also released by the franchisees.

Based on the foregoing, the Court held that the releases signed by Grayson and McKenzie released 7-Eleven from each of the claims asserted by them, and entered summary judgment in favor of 7-Eleven.

This case is a good reminder to franchisors of the value of obtaining a general release from a franchisee when it is possible (and legally permissible) to do so. A typical franchise agreement will require a franchisee to provide a general release upon the franchisee's sale of the business, or upon renewal.  A prudent franchisor will be sure to collect a general release upon the occurrence of either event. 

To franchisees, the decision is instructive. General releases, legitimately obtained, are enforceable in most circumstances and will usually result in nullifying any legal claims that may exist against the franchisor. 

As a result, it's important to understand these documents -- and the requirement in most franchise agreements that they be signed under certain circumstances -- before entering into a franchise relationship.

The plaintiff, Prim, LLC entered into a distribution agreement with Pace to become the exclusive distributor for Pace's "amusement devices" in an area that included Hawaii.

In October 2010, Pace sent Prim a notice of default, and terminated the exclusivity portion of the agreement between the parties. Prim sued in the U.S. District Court for the District of Hawaii. Among other things, Prim asserted that Pace violated Hawaii's Franchise Investment Law (Haw. Rev. Stat. §480-2 et seq.) by failing to deal with Prim in good faith and by terminating Prim's franchise without good cause.

Pace sought summary judgment on that claim, arguing that there was never a franchise between Prim and Pace, and that Prim never paid Pace a franchise fee.

The Court noted that, under Hawaii law, a franchise consists of an agreement "in which a person grants to another person, a license to use a trade name, service mark, trademark, logotype or related characteristic... and in which the franchisee is required to pay, directly or indirectly, a franchise fee." Haw. Rev. Stat. §482E-2.

Examining the Distribution Agreement, the Court found that the contract did not provide that Prim could use Pace's name, trademarks, or proprietary software, and that instead Prim's role under the contract was to "purchase games" from Pace and "exercise its best efforts to develop markets for the games and distribute" them.

Citing the U.S. Court of Appeals for the Ninth Circuit's decision in Gabana Gulf Distribution, Ltd. v. Gap Int'l Sales, Inc., 343 Fed. App'x 258, 259 (9th Cir. 2009), the Court noted that a distributorship is "not the same thing as a franchise relationship." In this regard, the Court noted that "[t]he very essence of a franchise relationship is that the franchisee represents the franchise to the public; a franchise is not created whenever one company purchases and distributes another company's products."

Considering that the Distribution Agreement only allowed Prim to purchase Pace's products, and did not permit Prim to "substantially associate" with Pace's trademarks, the Court found that the Distribution Agreement did not create a franchise.

The Court also found that Prim did not pay Pace a franchise fee. Under Hawaii law, a franchise fee is "any fee or charge that a franchisee . . . is required to pay or agrees to pay for the right to enter into a business or to continue a business under a franchise agreement," but does not include "the purchase or agreement to purchase goods at a bona fide wholesale price." Haw. Rev. Stat. §482E-2.

The Court cited its previous opinion in JJCO, Inc. v. Isuzu Motors America, Inc., 2009 WL 1444103, at *4 (D. Haw. 2009), aff'd, 2012 WL 2584294 (9th Cir. July 5, 2012) for the "guiding principle is that, unless the expenses result in an unrecoverable investment in the franchisor, they should not normally be considered a fee." The Court found no evidence suggesting that the money paid by Prim to Pace for products was anything other than a bona fide wholesale price, or that it constituted an "unrecoverable investment" in Pace.

Based on its finding that the Distribution Agreement did not create a "franchise" within the meaning of Hawaii law, the Court granted summary judgment for Pace on that claim.

The case is validation for companies that operate through networks of independent distributors.  Where the distributor: (1) is not permitted to "substantially associate" its business with the manufacturer; and/or (2) pays only the bona fide wholesale price for its merchandise (and no other form of compensation) to the manufacturer, the relationship will typically not be considered a franchise under state laws. 

That being said, the "hidden franchise" problem can exist any time a business wishes to structure its model to avoid being considered a franchise. There are many traps for unwary business owners in this area of the law; as a result, it's critically important for a distribution business seeking to avoid being labeled as a franchise to consult with an attorney experienced in franchising before using any particular business model.

Of course, every franchise salesperson claims that his or her franchise offering is going to be the McDonald's of the widget industry, as McDonald's has become the quintessential term for ultimate franchising success.

No. It takes more than that. We think the typical potential franchisor has a profile that goes beyond mere anecdotal celebrity references to the rich and famous.

An irreducible minimum requirement, before anyone is eligible to even think franchising, is a business operator who had at least several years successful experience operating the 'model'. The 'Model' is not the franchise company. The model is the business that the franchisees will operate if the concept is sound. Throughout this article you must constantly distinguish between the model, the business to be franchised, and the franchising company. They are completely different kinds of businesses. The failure to constantly keep this distinction in mind is one of the leading causes of early franchisor failures.

In all likelihood, a reasonably franchisable concept will be operated by its owner in multiple locations, all running successfully. This evidences that the concept is replicable and that it can be run by managers who can be trained. If the owner has to be everywhere all the time to keep the multiple units afloat, that is a strong sign of replication difficulty.

Either the system is too complicated to teach to a lot of people, or it is idiosyncratic, the extension of the owner's unique personality, unlikely to be successfully replicated with others at the helms of the various units.

In such a scenario, it is to be expected that customers have helped plant the seed of franchisability in the owner's mind. People come in, have the customer experience for that business, and exclaim their pleasure, their having been impressed with the idea and the manner of its execution, and their belief that it would be very nice to have such a business in their home town. 'Have you ever thought of franchising this?' will have been asked many times.

Eventually, the owner's thought processes turn into the franchise thinking neighborhood, and he starts talking to people who are in franchising, no matter at what level they may happen to live.

The model owner starts hearing money talk - initial fees of $30,000, royalties of 6% - 8% of gross sales, an advertising fund swollen with franchisee contributions of another 2% of gross sales, area development agreements through which entire states are sold off with large initial fees and a contractual requirement to build out and open a substantial number of stores within a very short time.

The model owner goes to the library and reads up on success stories of multi-millionaires who made it big from franchising.

There are no stories of franchisor failures - wrong spin control. In the world of franchise literature, everything is wonderful all the time, prospects are always bright, franchisor organizations constantly bestow awards upon their membership at conventions held in exotic places.

Soon, the model owner is slavering over a virtual feast of franchising good fortune and is ready to write checks to get the structure established, to get to the first sale. The entire focus becomes sales fixed, there is a great hurry to get to that first closing, and carts get put in front of horses.

The franchise sale is the last step in establishing a potentially successful franchise system, not the first. To be sure, even after the sale there are details like franchisee training, site selection and store opening assistance, but even these post sale responsibilities have to be prepared and tested well before the first sale closes.

Where does one start, then, in deciding to franchise. One starts with trying to find the answers to the feasibility issue.

Albeit I have a very good business that I have operated successfully in several locations for several years, how can I find out whether this concept, configured as I have configured my own businesses, has very good potential as a vehicle for franchising? If more people began here, at the real beginning, fewer franchisors would be in failure and fewer franchisees would have wasted their investments in an incompetently evaluated franchise opportunity.

Unfortunately, so many new franchisors start with lawyers drawing up contracts and disclosure documents, a fantasy trip with zero value and enormous potential for harm.

What the lawyers have never learned is that the legal work has to match the business concept, not vice versa.

The legal work is done last. Then it can, if done by attorneys who understand the franchising business as well as simply being able to draft contracts, become a charter that has rational positive value to the franchise relationship rather than merely being some set of rules cut and pasted out of somebody else's franchise documents, that most surely won't fit the situation to which it is being applied in many very difficult areas, and that become litigation breeding machines.

The business comes first, not the legal work.  (Part 1 of a four-part series on Why New Franchises Fail.)

So it's always interesting to hear a story about someone who failed to grasp this fairly simple concept -- and how they got caught doing it.  This time it was the Husains, longtime McDonald's franchisees, who lied to a court in Northern California in litigation against their franchisor.

The decision in Husain v. McDonald's Corp. was handed down by the California Court of Appeals on March 28, 2013.  The story goes something like this:

The Husains are longtime McDonald's franchisees, having owned up to five different McDonald's franchises located in northern California since the early 1980s.  In June 2005, the Husains entered into an agreement with a third party to purchase an additional 7 restaurants.  Of those, 3 of the franchise agreements were nearing the end of their 20-year franchise terms.  

As part of the purchase, the Husains asked McDonald's whether it would agree to provide them with new 20-year franchise agreements when the 3 expiring agreements came to the end of their respective terms. 

McDonald's offered to extend the Husains' expiring terms by letter, which offer had to be countersigned and agreed to by the Husains to become effective.  McDonald's claimed the offer was never accepted and expired on its own terms, leaving the Husains without renewal franchise agreements for the 3 expiring restaurants.  The Husains sued to enforce McDonald's alleged promise to them. McDonald's filed a cross-complaint to compel the Husains to relinquish the 3 restaurants to the company.

To "prove" that they had, indeed, accepted McDonald's offer to extend the expiring franchise terms, the Husains produced a certificate of mailing with a United States Postal Service postmark dated before the offer expired, alleging that the agreement had been properly accepted.  McDonald's countered by producing evidence that the post office that had supposedly provided the certificate of mailing was closed on the date bearing the postmark, and that the postmark stamp on the certificate was not in use until 2008.

Based on this evidence, McDonald's claimed that the Husains had committed perjury and fabricated evidence, and sought terminating sanctions -- in other words, McDonald's asked the Court to sanction the Husains by not permitting them to continue litigating their case. 

The trial court denied the motion, finding that at most McDonald's would be entitled only to dismissal of a cause of action the Husains had already dismissed, and that there was a factual dispute regarding the fabrication charges that could not be determined at the motion stage.

Renewed Motion for Terminating Sanctions

Four weeks into the trial and after the Husains had presented their case-in-chief, McDonald's filed a renewed motion for terminating sanctions. The motion was based on McDonald's contentions that Mr. Husain:

(1) presented falsified invoice information to overstate his investment in the franchise;

(2) falsified the certificate of mailing; and

(3) repeatedly mentioned his wife's recurring breast cancer in violation of a court order on a motion in limine on that subject. 

McDonald's argued that the sanctions were required under California Code of Civil Procedure Sec. 2023.030 and pursuant to the inherent power of the court.

The trial court found the Husains committed perjury, provided false evidence in discovery, and willfully and repeatedly violated its order on McDonald's motion in limine regarding the mention of Mrs. Husain's breast cancer. 

The court ordered terminating sanctions, finding that "[n]o lesser sanction would be appropriate or would ensure compliance and a fair trial." 

The court dismissed the Husains' complaint with prejudice, and struck their answer to McDonald's cross-complaint.  The court also dissolved the preliminary injunction in the Husains' favor and granted McDonald's an injunction preventing the Husains from continuing to occupy the restaurants and use its trademarks. 

The Husains appealed.

Appeal

The appellate court began by observing that "[b]ecause a terminating sanction is a drastic measure that denies a party the right to a trial on the merits, our courts have limited its use to only the rarest and most extreme cases of litigation misconduct when no lesser sanction can preserve the fairness of the trial and restore balance to the adversary system." 

The Court found the Husain's conduct reprehensible, but that it did not necessarily justify terminating sanctions.  

Examining the Husains' conduct, the appellate court reasoned that the discovery statutes relating to document production, depositions, and interrogatories do not authorize terminating sanctions unless a party refuses to obey a court order relating to that discovery. 

The court found that the Husains had not in fact disobeyed any discovery order by doctoring evidence, and that the end result of their tampering was "of little or no consequence to the litigation." Based on this, the court found that the discovery statutes did not authorize terminating sanctions.

The appellate court also found that the trial court's inherent powers did not justify terminating sanctions because McDonald's failed to show that "the Husains' misconduct deprived it of a fair adversary trial in any sense."  McDonald's, the appellate court reasoned, had the opportunity to effectively cross-examine Mr. Husain and place his credibility at doubt. 

In other words, McDonald's had the opportunity at trial to use Mr. Husain's actions against him. The court also found that Mr. Husain's violations of the trial court's orders on McDonald's motions in limine "could not have so impaired McDonald's ability to defend itself as to throw the fairness of the trial into question."  The court reasoned that some lesser sanctions would have fully protected McDonald's right to a fair trial.  

Because it found that terminating sanctions were not justified, the court of appeals set aside the terminating sanctions and ordered the trial court to schedule a new trial date -- in effect, permitting the Husains to continue litigating their case against McDonalds. 

Presumably, the serious issues of the franchisees' credibility, along with any lesser sanctions the trial court enters due to their perjury, will be a significant enough consequence to them to ensure that they are not able to benefit from their fraud on the court.

Part of this is that the quality of the concept being sold has been marginal and worse almost all the time. Whole business segments are now populated junk offerings.

Along these lines one might mention sandwiches, ice cream yogurt and gelato shops, pizza, printing, car repair and maintenance and dozens more. For various reasons - a long list - these are not real business investment opportunities and only fools buy them. Since the market does not provide protection for fools, I am not going to waste any more time talking about what they are and how they are sold. Rather, I would prefer to discuss how one should sell a real, investment worthy franchise opportunity.

In a real investment opportunity you have demonstrable revenue credibility.

The franchisor, before embarking upon a franchising program, had a real business that made decent profits and showed substantial growth and could be operated by trained and monitored managers in several replications of the franchise model. This kind of franchisor paid attention to what was happening in his market and made adjustments and improvements as soon as the opportunities presented themselves, keeping the operating manual current and paying attention to detail. It is a fine tuned, well managed business at the moment that the decision is made to franchise it.

In other words, it is a real business with an identifiable attainable breakeven point that will occur within a year in the right market.

The franchise's financial performance is sufficiently monitored both in company store mode and in the franchised mode, and differences in financial performance are accounted for in terms of what causes the differences. The franchisor knows his franchise and is not just some circus clown with a glib sales pitch chock a block with slogans and meaningless pseudo information.

A real franchise is not sold to every bozo with a temperature and a room temperature IQ who can write a check for the initial fee. A real franchise is not sold in any market where its anticipated performance is not responsibly projectable.

A real franchise skims the best markets first. In that manner the franchise itself, as a system, achieves early revenue credibility that enables the franchisor to begin writing a more aggressive FDD.

A real franchise is sold to carefully vetted franchisee prospects with more than enough money than will be needed and a proven business track record that includes actually having to make serious business risk decisions, not some marginal mid level "executive" who had to remortgage his house to meet the anticipated total initial investment.

Total initial investment, as presented in almost every FDD is an inadequate range of numbers intended to speak to the first 90 days after store opening and omits far too much to be remotely reasonable. In our real franchise, the Item 7 information will be a much higher number because the caliber of investor sought will not be scared off by it.

The number will also change frequently because its underlying information is being monitored carefully. The franchisor will have a good grasp on where breakeven can be expected to occur and how long it takes to get there. This enables more aggressive FDD information that is not misleading. This is the kind of information a real investor wants to know about. This is what sells franchises to intelligent investors.

If area development deals are sold, they are sold to people who have a track record demonstrating the capability to meet a development schedule. That schedule will describe the art of the possible in an area with defined top level geographic areas and good demographics specifically measured for this franchise.

With this approach the FDD can and will become more aggressively informative each year. There will be few surprises and those easily manageable. The franchisor will be willing to make adjustments for these surprises so that they do not result in serious economic disruption and the rise of disputes. The franchisor's willingness and ability to make adjustments and accommodations where appropriate, no matter what the franchise agreement may say, will mark that franchisor as the affiliation of choice for the best operators. Good reputations grow almost as fast as bad ones, and one does not become known as a chump for using good sense.

In this kind of franchise there is no danger in demanding compliance with the agreement terms, because the business is not financially impaired by the range of possible additional charges that could be made by the piggish franchisor. Good business partners know that everyone in the deal has to make money and that only a pig tries to squeeze every last nickel and dime out of it.

However, the extraneous revenue stream temptation will always be there, and an enlightened franchisor is all too often succeeded by more opportunistic types. For this reason it is critically important that franchisees establish an effective independent franchisee association long before abuses occur. It is far easier and less expensive to prevent abuse than it is to stop abuse.

Usually franchisees assume the best and leave themselves open to abuse until it is too late. That is a terrible mistake.

Franchisor established franchisee advisory boards are no substitute for the franchisees having their own independent organization. The franchisees of Quiznos and Marble Slab Creamery and many others learned this lesson the hard way. They are now dropping like flies.

For several years the franchise world has been populated mainly by mediocrities and worse, all sold to moron FranWads who were usually corporate middle management types - glorified clerks. They accumulated close to a million dollars in many instances through hard work and frugality, only to lose it all and end up in bankruptcy.

It is time for a higher level of investment quality. There are plenty of investors for those opportunities who are financially and experientially qualified. Following the plan suggested here and elsewhere on www.FranchiseRemedies.com a solid and credible franchise investment environment can again be established. I will be very happy to help guide them through their early years into their growth phase to maturity.

The department's lawsuit seeks to recover unpaid overtime compensation and liquidated damages for more than 800 current and former laborers. It also requests the court to permanently enjoin the defendants from committing future violations of the FLSA.

Employment agencies Universal Contracting and CSG Workforce Partners provided laborers to contractors--Decorative Enterprises and Mountain Builders--and charged the laborers and contractors a fee for their employment placement services. Wage and Hour Division investigators found that the companies misclassified workers as something other than employees, claiming there was no employee-employer relationship, and denied the employees overtime compensation, as required by the FLSA.

"Universal Contracting, CSG Workforce Partners and their clients are intentionally skirting the law by willfully and wrongfully claiming that their workers are not employees because they are members or owners in a limited liability company," said Cynthia Watson, Wage and Hour Division southwest regional administrator. "As demonstrated by this lawsuit, the department is vigorously pursuing corrective action in those situations where misclassified workers are actually employees, to ensure that they are paid required wages and to level the playing field for employers who play by the rules."

The department's suit was filed in the Central District of Utah, Salt Lake City, following investigations by the Wage and Hour Division's Salt Lake City Office that found the defendants violated the FLSA by failing to maintain a record of hours worked by employees and failed to pay the employees the federally mandated overtime compensation, as required by the FLSA.

The violations committed by Universal Contracting and CSG Workforce Partners are considered willful because the companies had been notified previously by the Wage Hour Division that the workers are employees. As such, they are entitled to the wages and employment protections guaranteed by the FLSA. Universal Contracting and CSG Workforce Partners willfully and purposefully pursued an operational method that makes it difficult to determine the hours its laborers worked and the corresponding compensation received for those hours.

The department's lawsuit seeks to hold Universal Contracting and CSG Workforce Partner's clients, Mountain Builders and Decorative Enterprises, severally liable for the violations. Mountain Builders and Decorative Enterprises are in a joint employment relationship with Universal Contracting and CSG Workforce Partners. The department has also filed a motion for preliminary injunction seeking an order directing Universal Contracting and CSG Workforce Partners to immediately comply with the FLSA's overtime and recordkeeping provisions.

The misclassification of employees as something other than employees, such as independent contractors, presents a serious problem for affected employees, employers and to the economy. Misclassified employees are often denied access to critical benefits and protections, such as family and medical leave, overtime, minimum wage and unemployment insurance, to which they are entitled. Employee misclassification also generates substantial losses to the Treasury and the Social Security and Medicare funds, as well as to state unemployment insurance and workers' compensation funds.

The Wage and Hour Division's Salt Lake City Office and the Denver branch of the Office of the Solicitor, through an agency memorandum of understanding with the Utah Labor Commission, have been working on employee misclassification issues, including issues regarding this case, with the Commission, the Utah Division of Occupational and Professional Licensing and the Utah Industrial Accidents Division. Under the terms of a similar information-sharing memorandum of understanding, this is the type of case that the Labor Department may refer to the Internal Revenue Service.

Memorandums of understanding with state government agencies arose as part of the department's Misclassification Initiative, with the goal of preventing, detecting and remedying employee misclassification. More information is available on the department's misclassification Web page at http://www.dol.gov/misclassification.

The FLSA requires that covered, nonexempt employees be paid at least the federal minimum wage of $7.25 for all hours worked, plus time and one-half their regular rates, including commissions, bonuses and incentive pay, for hours worked beyond 40 per week. Additionally, employers must maintain accurate time and payroll records. Employers who violate the law are, as a general rule, liable to employees for their back wages and an equal amount in liquidated damages. Back wages and liquidated damages are paid directly to the affected employees.

For more information about federal wage laws, call the Wage and Hour Division's toll-free helpline at 866-4US-WAGE (487-9243) or its Salt Lake City office at 801-524-5706. Information also is available at http://www.dol.gov/whd.