Antitrust Law Daily Wrap Up, FRANCHISING & DISTRIBUTION—BankrWDNC: Sellers of Unregistered New York Franchises Personally Liable for Franchisee’s Fees, Could Not Discharge Debt in Bankruptcy, (Dec 11, 2012)

By Tobias J. Gillett, J.D., LLM.

Former operators of a public relations franchise company were personally liable for a New York franchisee’s fees paid during a period when the franchisor did not have authorization to sell franchises in New York, the federal bankruptcy court in Charlotte, North Carolina has ruled (In Re: Butler and Butler, December 10, 2012, Whitley, J.). Moreover, the operators could not discharge this debt in bankruptcy,

The operators, Michael L. Butler and Kathy H. Butler, managed a network of franchises, called PR Stores, that offered public relations services to small businesses. Under the network’s model, the franchises would sell services to customers, while the work would be performed by professionals in the headquarters office.

In 2007, John Mangione purchased the franchise rights to 20 PR Stores in New York from the operators’ franchise company, PRS Franchise Systems, LLC. In the process, Mangione engaged in meetings with the Butlers and their broker concerning the business.

By 2008, however, Mangione’s business was struggling, principally due to PRS’s failure to provide product to the customers. PRS itself had difficulties and soon failed, primarily as a result of the franchise fees being dissipated to the Butlers, the broker, and the Butlers’ other corporations. PRS and PR Stores were dissolved in 2009.

Under New York Franchises Law, parties selling franchises in the state must register with the state prior to soliciting franchise purchases and must provide the state with a variety of financial information, including financial statements and a proposed prospectus. Although PRS initially had authorization from the state to sell franchises in New York, it had intentionally permitted that authorization to lapse by failing to provide the required documentation.

Although PRS made a purported effort to renew its authorization due to Mangione’s interest in opening franchises in New York, and filed a partial application, it did not actually obtain that authorization, nor did it ever provide Mangione with a prospectus as New York law also requires. PRS further failed to escrow Mangione’s franchise fees while its application and prospectus were pending.

Under New York law, these failures entitled Mangione to rescind his contract and receive a refund of his franchise fees, with interest. When Mangione sued in New York to recover the fees, the Butlers filed for bankruptcy in North Carolina.

Personal Liability of Franchise Operators

Magione contended that the Butlers had personal liability for the franchise fees owed to him and that the Butlers could not discharge the debt through the bankruptcy process. He alleged that the Butlers and PRS had misrepresented the financial strength of the franchise and that they had authorization to sell franchises in New York.

Personal Liability

With regard to personal liability, the Butlers maintained that PRS had applied for re-registration under New York law, and therefore had authorization to solicit franchise purchases at the time Mangione bought his franchises. In any case, the Butlers argued, the CEO of PRS and its franchise broker had performed the actual solicitation, not the Butlers, whose involvement was limited to operating the creative branch of the enterprise. Therefore, the Butlers claimed, PRS had liability for any fraud or misrepresentation.

The court found the Butlers personally liable to Mangione. It noted that PRS had not provided Mangione a prospectus, that PRS had not escrowed his fees, and that PRS’s application for reauthorization was defective and was filed after negotiations with Mangione had begun. The court found that PRS’s management, including the Butlers, was aware it did not have authorization to operate in New York at the time. Therefore, the court found that Mangione was entitled to the remedy provided under New York law—rescission of the contract, refund of the franchise fees, and recovery of attorney fees and costs.

Moreover, the court found that the Butlers could not shift liability to either PRS or PRS’s broker. The court noted that the broker only served as an agent for the company, and thus through the principle of respondeat superior PRS had responsibility for his actions undertaken on its behalf.

Furthermore, the court held, the corporate shield did not protect the Butlers, both because “[o]fficers are personally liable for their participation in tortious acts that cause harm to a third party” and because the New York franchise law provides that individuals who directly participate in an unlawful sale have civil liability for the resulting damages. The broker had acted under the supervision of the Butlers, the promotional materials advertised that the Butlers were the “key members” of the franchise, and the Butlers had personally met with Mangione to discuss the business. Moreover, the various corporate entities functioned as one business, with money shared between them, the principals, and the broker. Since the Butlers controlled the company, directly participated in the sale to Mangione, and profited from his payments, the court held them personally liable.

Discharge of Franchise Fees

The court also held that the Butlers could not discharge their debt to Mangione through the bankruptcy process. Under the Bankruptcy Code, an individual cannot discharge any debt for assets obtained by “false pretenses, a false representation, or actual fraud,” or for any debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” The court found that each of these provisions rendered Mangione’s claims non-dischargeable.

Under the first provision, the court found that Mangione’s debt “arose from the Butlers’ fraudulent conduct.” The court found that the Butlers’ conduct met each of the elements of fraud, including “(1) a fraudulent misrepresentation; (2) that induces another to act or refrain from acting; (3) causing harm to the plaintiff; and (4) the plaintiff’s justifiable reliance on the misrepresentation.”

The court observed that the Butlers had knowingly misrepresented that they had the capacity to sell franchises in New York, and intended Mangione to rely on that misrepresentation. Moreover, that representation induced Mangione to purchases the franchises, and led to his injury from their failure. Mangione had also conducted due diligence before purchasing the franchises, without discovering the lack of authorization, satisfying the reasonable reliance element. Therefore, the Butlers’ conduct constituted fraud barring discharge of the debt.

The court also found that the debt “arose from the Butlers’ defalcation.” To prove defalcation, a creditor must show “(1) that the debt in issue arose while the debtor was acting in a fiduciary capacity; and (2) that the debt arose from the debtor’s fraud or defalcation.” The court noted that “negligence or even an innocent mistake” could satisfy this standard, but that here the Butlers had “effectively stole[n] money from Mangione” by converting his franchise fees for their own use rather than escrowing them. Therefore, the Butlers’ conduct also constituted defalcation barring discharge.

Finally, the court found that, even if the fraudulent conduct and defalcation had not barred discharge, the Butlers’ misconduct in discovery would also have denied them discharge. The Butlers had claimed “they were not member-managers of PRS, when in fact they were” and “that they did not sign checks, were not involved in sales, and did not control the money of the business, when in fact the evidence showed that they did.” Moreover, the Butlers did not provide all documents requested by Mangione, and delivered some the night before trial. The court found that the Butlers had “attempted to further mislead Mangione as well as to mislead this bankruptcy court,” conduct that in itself would have prevented them from obtaining discharge.

The case is No. 10-32030, Adversary Proceeding No. 10-3314.

Jeffrey G. Dalrymple (Jeffrey G. Dalrymple, P.A.) for Michael L. Butler. Stacey Cordes (Burt and Cordes PLLC) for John Mangione.

Cases: FranchisingDistribution NorthCarolinaNews