Court Watch

As a result of the recent decision in Moran Industries, Inc. v. Mr. Transmission of Chattanooga, Inc. (Bus. Franchise Guide (CC) ' 14,428 (E.D. Tenn. Aug. 4, 2010)) from the U.S. District Court for the Eastern District of Tennessee, the law in Tennessee now follows the traditional line of thinking espoused by Georgia. In Moran, after noting the split of authorities that had evolved among the states, the court found the franchise agreement in question to be ambiguous, and thus denied the franchisee's motion to dismiss, ignoring the franchisee's clever but somewhat convoluted argument that the language of the contract limited the possibility of the franchisor's recovering lost future royalties to the initial five years of the contract, a period which had already expired. The court then focused on the damages claimed by the franchisor, noting that, given the 27-year relationship between the parties, a damage claim for lost future royalties would be anything but speculative. The court also noted in passing that even Sealy did not prohibit a franchisor from recovering lost future royalties when the franchisee abandoned the franchise, as was the case in Moran. (The Moran court gives an excellent summary of the development of the law related to collection of lost future royalties; see also Moran, infra, at 6-8.)

Rupert Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he chairs his firm's Franchise Practice Team. He is a past chair of the American Bar Association's Forum on Franchising and co-editor-in-chief of the Forum's Fundamentals of Franchising. He can be reached at 404-815-6366 or [email protected].

Escaping the Long Arms of Government and Individuals

If this were a science fiction novel, the opening line might read, “We are not alone in this world.” The same principle seems to be oozing its way into American jurisprudence, both with respect to how government relates to its constituents and how individuals and businesses cross paths with others.

From the government-constituent perspective, in the franchise arena, there seems to be no area of higher profile than the taxation of out-of-state franchisors where only the ghost of the franchisor crosses into the boundaries of another state's jurisdiction ' i.e., a jurisdiction where the franchisor's presence is almost invisible, but that franchisor's system does affect the economy of the foreign state.

In KFC Corporation v. Iowa Department of Revenue (No. 09-1032, 2010 WL 5393506 (Iowa Dec. 30, 2010)), which is further analyzed on p. 1 of this issue, the Iowa Supreme Court presented a well-stated history of state government attempts to tax out-of-state entities that have minimal financial relationships with those jurisdictions and no physical presence. Historically, these attempts focused on imposing sales and use taxes on entities that shipped products from other jurisdictions into the state that was trying to impose and collect the tax, but where the entity's connections with that state were minimal. As the Iowa Supreme Court eloquently demonstrated in KFC, the courts traditionally looked for some sort of “presence” to justify the long-arm of the state's taxing authority. In recent times, dating back to the decision from the South Carolina Supreme Court in Geoffrey, Inc. v. South Carolina Tax Commission, 313 S.C. 15, 437 S.E.2d 13 (S.C. Jul. 6, 1993), cert. denied , 510 U.S. 992 (1993)), the taxpayers have frequently been losing these battles. In Geoffrey, the court held that income of Toys “R” Us that derived from activities in that state could be subject to that state's income tax. According to the court, the taxpayer's intangible property (i.e., licensing arrangements) acquired a “business situs” in South Carolina, the state whose taxing authority brought the action. KFC is, in essence, a confirmation of the ruling in Geoffrey, demonstrating that the long-arm of state taxation is in fact very long. The concept of physical presence as being a prerequisite for taxation is virtually dead.

The consequences of these decisions is that franchisors should be prepared to file income tax returns in most, if not all, states where they have franchisees, and to pay some taxes to those states. Since income tax credits don't always fully compensate an out-of-state taxpayer, as contrasted to having to pay income taxes only to one jurisdiction, this could mean more cost to a franchisor that expands its franchise systems into numerous jurisdictions.

The long arm of the law, however, has not been reserved to our government. As demonstrated by Bauer v. Douglas Aquatics, Inc., 698 S.E. 2d 757 (N.C. Ct. App. 2010), individuals as well as governments can use intellectual property licensing as the basis for asserting claims against out-of-state franchisors. In Bauer, the franchisor, a Virginia entity whose franchise system was engaged in the construction of swimming pools, licensed various entities to be its franchisees in North Carolina. While the franchisor had no physical presence in that state, the language on its Web site suggested that the franchisees in North Carolina were the franchisor's agents. On a motion by the franchisor to dismiss the proceeding because of lack of jurisdiction, the court first ruled that the franchisee was not the agent of the franchisor. There were insufficient indicia of actual control by the franchisor over the franchisees to make the plaintiff franchisee the franchisor's actual agent, and there was no actual privity of contract between the franchisor and the franchisee's dissatisfied customer. Moreover, the franchise agreement, as is almost always the case, provided that the franchisee was an independent contractor, and not the franchisor's agent.

However, the court found that the franchisee was the apparent agent of the franchisor. The wording on the franchisor's Web site suggested that the North Carolina locations were its locations. In addition, the franchisee's manager, in speaking with the aggrieved customer who brought suit, had represented to the customer that the company had been in business for more than 30 years. Thus, the court concluded that the customer was entitled to rely upon these representations as the basis for thinking that it was dealing with an agent of the Virginia-based franchisor itself, and that the case, as pleaded, was sufficient for the court to assert personal jurisdiction over the franchisor.

The court's decision suggests that in these circumstances, a tweaking of the Web site's language, as well as guidance on the sales presentations made to prospective customers, could have resulted in the opposite conclusion by the court, one favorable to the franchisor. Consequently, Bauer does not stand for the proposition that an out-of-state franchisor can always be successfully dragged into litigation by a franchisee's customers in each jurisdiction where its franchisees are doing business, but it does serve as a clear indication that full caution in the methods of promoting the business is essential in order to avoid this result. Again, we find that the numerous benefits of the Internet often carry baggage with them for a franchisor.

Battle over Enforcement of Collection of Lost Future Royalties Continues

Prior to the California Appellate Court's decision in Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704, 51 Cal. Rptr.2d 365 (1996)), Las Vegas would probably have given favorable odds that a franchisor would be able to recover lost future profits or royalties from any franchisee that failed to keep royalty payments current, if the franchisor decided to terminate the franchise agreement as a result of the franchisee's payment breach. Sealy, however, started a trend in the other direction. In Sealy, the court held that the franchisor could not recover lost future royalties when the franchisor elected to terminate the agreement because the franchisor's decision to terminate was the proximate cause of the franchisor's inability to collect such royalty payments. The court also held that allowing the franchisor to recover those sums would be unconscionable.

Putting aside the unconscionability issue, over the 14 years following the decision, several courts have, in essence, followed the Sealy thinking, Florida and Michigan being two jurisdictions where comparable judicial decisions were rendered. In the last couple of years, Colorado has joined the unenforceability camp, and in North Carolina, the issue is in the midst of battle. In Meineke Car Care Centers, Inc. v. RLB Holdings (No. 3:08cv240-RJC, 2009 WL 2461953 (W.D.N.C. Aug. 10, 2009)), the trial court ruled in favor of the franchisee, but the case is currently on appeal to the Fourth Circuit. As for neighboring Georgia, in Progressive Child Care System, Inc. v. Kids R' Kids International, Inc., (No. 2-07-127-CV, 2008 WL 4831339 (Tex. App. Nov. 6, 2008)), a Texas appellate court, interpreting Georgia law, upheld the franchisor's right to recover lost future profits as damages. Otherwise, the court noted, the franchisor would not obtain the benefit of its bargain from the franchisee.