Continued Trademark Use by Former Franchisee Constitutes “Counterfeiting”

On December 19, 2011, an Indiana federal district court held that a franchisee that continues to use a franchisor’s trademarks after termination of its franchise agreement is liable for counterfeiting – and mandatory treble damages and attorneys fees - under 15 U.S.C. §§ 1116(d)(1)(B) and 1117(b).

In Century 21 Real Estate, LLC v. Destiny Real Estate Properties (2011 WL 6736060 (N.D.Ind.)), franchisee Destiny Real Estate obtained a license, under its franchising agreement with franchisor Century 21, to use Century 21’s federally registered trademarks. In exchange, Destiny agreed to pay an annual commission and advertising fee. When Destiny failed to pay, Century 21 terminated the franchise agreement; however, Destiny continued to use Century 21’s trademarks on signs and websites. Century 21 brought claims against Destiny, including one for counterfeiting under 15 U.S.C. § 1116(d)(1)(B), which, if successful, would entitle Century 21 to mandatory treble damages and attorneys fees under 15 U.S.C. § 1117(b). To make this claim, Century 21 needed to show that: (1) the mark in use by Destiny was “a spurious mark which is identical with, or substantially indistinguishable from” Century 21’s registered mark; (2) Century 21’s mark was registered on the U.S. Patent & Trademark Office’s principal register for use with the same services with which Destiny used the mark; (3) Destiny was not authorized to use the mark at the time the services were provided; and (4) Destiny acted with knowledge and intent. 

The main question for the court was whether the continued use of a mark by a formerly authorized franchisee constituted “use of a counterfeit mark.” The court held that, in fact, it did, stating:

[i]f an unrelated entity had created an identical trademark and provided authorized goods or services (or the kind provided by the owner of the mark) under that mark, there would be no question that there was counterfeiting. The Court can conceive of no reason why an ex-franchisee should escape liability for counterfeiting simply because that person had access to a franchisor's original marks because of the former relationship and therefore did not need to reproduce an identical or substantially similar mark.

Century 21, 2011 WL 6736060, at *5. 

Although franchisors frequently and successfully assert trademark infringement claims against former franchisees, the decision in Century 21 gives franchisors a new weapon in their arsenal for enforcing their trademark rights against ex-franchisees. The threat of additional damages and attorneys’ fees afforded by the counterfeiting claim could encourage ex-franchisees to comply more readily with franchisors’ demands for cessation of use. Franchisees, on the other hand, will have an added incentive to exercise more diligence in promptly ceasing use of franchisor trademarks after termination of a franchise agreement.

Contact:

Suzanne K. Ketler, Ph.D.

330.849.6641

sketler@ralaw.com

Do You Know What Your Employment Practices Liability Insurance Covers?

You might be surprised to find out what your employment practices liability insurance (EPL) covers or, more importantly, what it does not cover. Recently, Cracker Barrel discovered that a lawsuit brought by the Equal Employment Opportunity Commission (EEOC) was not covered by its EPL. As a result, Cracker Barrel is on the hook for the $2 million settlement and $700,000 in legal fees. The case, Cracker Barrel Old Country Store v. Cincinnati Ins. Co., is currently on appeal in front of the United States Court of Appeals for the Sixth Circuit.

The issue boils down to the definition of a claim under the policy. The policy defined a “claim” as “a civil, administrative or arbitration proceeding commenced by the service of a complaint or charge, which is brought by any past, present or prospective ‘employee(s)’ of the ‘insured entity’ against any ‘insured’ for any of the following causes… .” The causes listed in the policy encompassed the usual discrimination, sexual harassment, and wrongful discharge. Between December 1999 and March 2001, 10 Cracker Barrel employees filed charges of discrimination with the EEOC. Cracker Barrel provided notice of these charges to Cincinnati Insurance. On August 11, 2004, the EEOC brought suit against Cracker Barrel. The EEOC’s lawsuit arose from allegations of sexual harassment, racial harassment, race discrimination, and retaliation and included the allegations from the 10 charges of discrimination. Cracker Barrel again provided notice of the lawsuit to Cincinnati.

Cincinnati denied coverage and Cracker Barrel brought suit requesting the court declare that Cincinnati had both a duty to defend and a duty to indemnify Cracker Barrel for any loss. Cracker Barrel also asserted a claim for bad faith against Cincinnati. A duty to defend is broader than the duty to indemnify. Typically an insurance company has a duty to defend if the policy arguably covers any of the claims. Cracker Barrel argued that at the very least it was entitled to reimbursement of the $700,000 in attorney fees it incurred because Cincinnati had a duty to defend. Cincinnati argued it had no duty to defend or indemnify.

The court determined that in order for claims to be covered under the policy they must be brought by an employee. In this case, the claims were brought by the EEOC. As such, the court determined that Cincinnati did not have a duty to defend or indemnify Cracker Barrel.

EPL policies differ in their definitions of claim. As noted, the definition of claim in this policy included language that it must be brought by an employee. Many policies do not include this limiting language. It is in the employer’s best interests to review EPL policies and understand what claims are covered before incurring liability or spending significant attorneys’ fees defending a claim that the insurance company does not cover. This is especially applicable now as the EEOC recently reported that in 2011 it filed 300 lawsuits against employers compared to 271 lawsuits in 2010. Additionally, for the third year in a row the total monetary relief the EEOC obtained from filing lawsuits increased.  

Contact: Jon Secrest

614.723.2029

jsecrest@ralaw.com

Does It Matter How You Own Your Franchise?

Richard S. Mulligan, a partner in the Columbus, Ohio office of Roetzel & Andress, recently wrote an article for Franchise Law News, “Does It Matter How You Own Your Franchise?" in which he examines the ownership structure of franchisees and the importance of understanding that this structure is subject to the rules and procedures set forth by the franchisor. If a franchise is not owned in the proper manner, the franchisor has the right to object and may terminate the franchise.

The article discusses a State of Washington Appellate Court ruling (Marte v. Hernandez, May 16, 2011). The case involved the purchase of two McDonald's franchises by a pair of brothers, and demonstrates that deception can cause even blood relationships to disintegrate. Click to read the entire article. 

Contact: Richard S. Mulligan
614.723.2035
rmulligan@ralaw.com

It Doesn’t Always Pay to Be Royalty, Especially if You’re a Dairy Queen

While the general public is star struck by the glamour and glitz of royalty, in the franchise world, royalty is not always desirable, especially if the franchisor is a closely held corporation.

If a franchisor is deemed to be a closely held regular corporation for federal tax purposes, negative tax consequences can result from the franchisor’s receipt of certain royalty payments. Such royalty payments can be construed to be personal holding company income and thereby subject the corporation to a penalty tax on its undistributed earnings, known as the personal holding company (PHC) tax.

Under Section 541 of the Internal Revenue Code (Code), in addition to other taxes, there is a tax imposed on the undistributed PHC income of every personal holding company equal to 15% of the distributed income of the PHC.

What, then, is this mysterious PHC income? PHC income is income derived from any one of eight specific categories, but for our purposes, the category of focus is dividends, comprised of dividends, interest, royalties (other than mineral, oil or gas royalties or copyright royalties), and annuities.

The bottom line is that if you are a franchisor operating through a closely held corporation and you receive royalty payments, you could be subject to PHC tax. The Tax Court has had tremendous difficulty wrestling with the issue of PHC income.

The most notable line of cases with respect to characterization of royalty income to a franchisor involves Dairy Queen. In each of the Dairy Queen cases, the franchise agreements governing payment to the franchisor contained varying language regarding the characterization of certain rights transferred to the franchisees and the consideration paid to the franchisor for such rights. The courts in multiple jurisdictions produced wildly varying results with respect to the characterization of income earned, partly because of the differing language in each of the franchise agreements. Finally, Congress enacted Code Section 1253, effectively characterizing payments received by franchisors as ordinary income.  

Even after the enactment of Code Section 1253, known in tax circles as the “Dairy Queen section,” courts continue to grapple with the question of whether “royalties” should be characterized as PHC income or ordinary income because, while Code Section 1253 characterized royalty income as ordinary income, Congress left open whether the ordinary income should be characterized as PHC income. PHC income is subject to PHC tax while income that is not PHC income is not subject to PHC tax.

Given that the franchisor does not want its income characterized as PHC income, the first step is to fight the characterization of payments received as “royalties” as PHC income. In order to avoid this characterization, special care must be given to the franchise agreement. In most franchise agreements, royalty payments to franchisors are not solely for the use of a trademark or license, but include other services rendered. The payments for other services rendered should not be royalty income for PHC income, but ordinary income that is not subject to PHC tax.

The Tax Court has examined the language in franchise agreements to determine whether royalty payments should be characterized as PHC income. If a franchise agreement does not contain provisions with respect to other services rendered as part of the royalties paid to a franchisor, the Tax Court has held that the franchisor has not met the burden of proof required to classify royalty payments to a franchisor as non-PHC income for services rendered.

Contact Tae Shin and the franchise attorneys at Roetzel & Andress to discuss drafting your franchise agreements to properly characterize royalty payments.

Contact: Tae Shin

407.245.2452

tshin@ralaw.com

Department of Labor Takes Aim at the Restaurant Industry

The restaurant industry has traditionally been closely scrutinized by the Department of Labor (DOL). Recently, the DOL has focused even more attention on the industry. In New York, the DOL has an ongoing enforcement initiative targeted at full-service restaurants to investigate whether these restaurants are complying with the Fair Labor Standards Act’s (FLSA) overtime and minimum wage provisions. Under this initiative, the DOL has investigated 46 establishments. These investigations resulted in the awarding of $2,341,507 in back wages to 578 employees. Additionally, the DOL assessed $202,315 in civil penalties against restaurants that violated the FLSA.

In Florida, the DOL has an ongoing enforcement initiative targeting full-service buffet restaurants. In 2011, the DOL completed 34 investigations of these restaurants, which resulted in awards of $667,704 in back wages to 271 employees. The DOL also assessed $14,520 in civil penalties against the restaurants.

The DOL determined that common violations occurred at the restaurants in both New York and Florida. These violations included paying cash wages “off the books,” requiring employees to work exclusively for tips, paying a fixed salary for all hours worked, allowing managers to participate in tip pools, and failing to maintain required records for employees.

The DOL’s investigative practices include reviewing payroll records, interviewing employees, and conducting surveillance of employers. Increasingly, the DOL is utilizing unannounced inspections, which means an investigator appears at an employer’s place of business requesting to review payroll records and speak to employees with no prior warning. Accordingly, it is imperative for employers to have a plan in place for dealing with the DOL and a point person to interact with the investigator.

The DOL indicated it will utilize any and all enforcement tools available to it to ensure the restaurant industry is complying with the FLSA. These enforcement tools include litigation, administrative subpoenas, civil monetary penalties, and liquidated damages. Also, the DOL is coordinating with local agencies and criminal enforcement authorities when it uncovers violations such as falsification of records and tax filings.

The amount of violations uncovered by the DOL strongly suggests it will continue to target restaurants across the country. DOL Secretary Hilda Solis stated, “The Wage and Hour Division will continue to monitor full-service restaurants and other industries in which unlawful pay practices are widespread in order to level the playing field for the many employers who abide by the law and properly pay their employees.” 

Contact: Jon Secrest

614.723.2029

jsecrest@ralaw.com

Franchisor’s Expectation of Continued Operation

Franchise Agreements commonly contain a requirement that a franchisee continuously operate its business and that the business operate for the entire term of the Franchise Agreement. If the franchisee ceases operation before the Franchise Agreement terminates, can the franchisor recover for its loss of revenues, i.e., loss of royalties or advertising fees? Cessation of operation is customarily an event of default, which can give rise to damages.

Franchisors rely on a stream of income from royalties and advertising fees for their financial viability. When these sources are prematurely affected, the franchisor’s future can be impaired. A recent Missouri, United States District Court Case, Hardee’s v. Hallbeck, 2011 WL 4407435, September 21, 2011, found that a franchisee could not prevail on a motion for summary judgment, and, therefore, the franchisor’s claim for lost profits--because of the franchisee’s closing of a Hardee’s franchise a year and a half before the end of a Franchise Agreement--would proceed, and the amount, if any, of the damages remained a question of fact to be determined at trial.

Despite the fact that the Franchise Agreement did not have a provision as to future damages or a liquidation damages clause, the court held that a franchisee that breaches a Franchise Agreement by abandoning the franchise mid term did not warrant summary judgment being granted to the franchisee. Under Missouri law, which the court held governed the case, lost profits relating to a breach preventing performance are recoverable provided the loss: is the natural and proximate result of the breach; is ascertainable with reasonable certainty; is not speculative or conjectural; and was within the contemplation of the parties when the contract was made. The court believed that the franchisee’s closure of its Hardee’s could serve as the proximate cause of any lost profits, and that a genuine fact issue existed as to whether the franchisee would have realized future profits. The court felt a fact finder could find that, except for the store closure, some revenue could have been realized from continued operation, and the length of operations and the amount of revenue that may have been derived were fact issues.

The franchisee’s attempts to argue that the franchisor’s acts and conduct relieved them of their contractual obligations fell on the court’s deaf ears.

The franchisor produced expert testimony that provided an adequate basis for estimating lost profits with reasonable certainty. The court stated that the amount, if any, of said lost profits constituting the franchisor’s damages, remained a question of fact to be determined at trial.

So if the franchisor is able to convince the trier of fact as to the amount of lost profits, which their expert concluded amounted to approximately $50,000, then the franchisee could be liable for closing its restaurant and going dark before the end of the Franchise Agreement. Also, the Franchise Agreement provided that the prevailing party in any judicial proceeding would be entitled to expenses and attorney’s fees. It remains to be seen what will happen when the case gets to trial, but suffice it to say that early termination of a Franchise Agreement without provocation should cause franchisees to think twice before they shut their doors.

Contact: Richard S. Mulligan

614.723.2035

rmulligan@ralaw.com

Tax Nexus Update: Supreme Court Declines to Review the Colonel’s Case

Earlier this year, we reported that in KFC Corporation vs. Iowa Department of Revenue, the Iowa Supreme Court upheld the state’s ability to assess income tax on KFC Corporation and other out-of-state franchisors who, despite not having a physical presence in Iowa, nonetheless derive revenue through its franchisees. The Iowa Supreme Court held that a franchisor’s physical presence in Iowa is not a required element in determining whether a sufficient tax nexus exists to justify the imposition and collection of state income tax.

Recently, the United States Supreme Court declined to review the Iowa Supreme Court’s ruling with respect to physical presence and substantial tax nexus. The implications of the Supreme Court’s declining to review the KFC nexus case are potentially far reaching in that other states, including Iowa, will now begin to aggressively pursue the collection of income tax from out-of-state franchisors who have no physical presence in a state. The tax nexus ruling could also affect other areas of interstate commerce where there is no physical presence.

We expect that states will begin adopting their own tax nexus analysis based loosely on the Iowa Supreme Court’s analysis and will soon require out-of-state franchisors to begin filing income tax returns if they are not already doing so.

Franchisors with significant presence in multiple states should begin preparing for what seems to be an inevitable outcome with respect to reporting and paying state income tax in each state they will be deemed to have a sufficient tax nexus.

Franchisors may consider spreading the cost of additional tax among their franchisees through higher fees or higher cost of goods. This could result in the consumer’s paying a higher price for the franchisor’s good or service.

If required to file and pay state income taxes, franchisors who previously were not subject to state income tax need to begin analyzing their taxable income with respect to those states in which they derive franchise income not only to determine their potential state income tax liability, but also to begin planning with respect to reporting and accounting procedures.

Franchisors should conduct tax planning and analysis at the state level where they will now be required to report and pay income tax, but the analysis should start at the federal level with respect to income, expense, deduction and planning opportunities to minimize tax exposure at the state level. As part of the analysis, franchisors may want to examine their current franchise structures to determine whether income and deduction items are properly characterized.

For help in tax planning for out-of-state franchisors, please contact attorney Tae Shin in Roetzel’s Franchise Law group.

Contact: Tae Shin

407.245.2452

tshin@ralaw.com