Control Person and Vicarious Liabilities
The U.S. Bankruptcy Court for the Western District of North Carolina recently construed and applied Section 691(3) of the New York Franchise Act, which imposes "control person" liability upon individuals serving a franchisor who participate in conduct proscribed by the act.
Specifically, Section 691(3) of the act provides:
A person who directly or indirectly controls a person liable under this article, a partner in a firm so liable, a principal executive officer or director of a corporation so liable, a person occupying a similar status or performing similar functions, and an employee of a person so liable, who materially aids in the act [or] transaction constituting the violation, is also liable jointly and severally with and to the same extent as the controlled person, partnership, corporation or employer.
In In re Michael L. Butler and Kathy H. Butler Debtors, John Mangione v. Michael L. Butler and Kathy H. Butler, Defendants, 2012 WL 6106586 (U.S. Bankruptcy Ct., W.D.N.C. Dec. 10, 2012), plaintiff-franchisee John Mangione sought to impose personal liability upon the two individual principals and owners of franchisor PRS Franchise Systems, LLC—and to have that liability declared non-dischargeable in said individuals' bankruptcy proceeding.
Plaintiff Mangione paid the franchisor $714,000 for the exclusive right to open up to 20 PR Stores throughout the metropolitan New York City area. According to the court, within months of opening, Mangione's franchises began to experience difficulties primarily due to an inability to provide public relations and marketing product to its customers, notwithstanding the fact that this was the central obligation of the franchisor under Mangione's franchise agreement. According to the court, the franchisor was foundering and soon failed "…because the bulk of the franchise sales proceeds were immediately dissipated by [franchisor] PRS to the principals."
In addition, observed the court, franchisor PRS Franchise Systems, LLC was not registered to sell franchises in New York, the central requirement of the New York Franchise Act. Instead, the court noted, PRS permitted its franchise registration to lapse months before plaintiff Mangione's purchase. The court noted that because of Mangione's interest in acquiring franchises, "PRS made a half-hearted effort to reinstate its registration. It submitted an application to renew its authority on April 6, 2007, or approximately two weeks before it inked the first sales agreement with Mangione. However, that application was fatally defective…." Ultimately, PRS did obtain its franchise registration from the New York Attorney General—but only four months after it had sold the aforementioned 20 franchises to Mangione and collected $714,000 from him.
At trial, the franchisor's principals—Michael and Kathy Butler—contended that they believed their renewal application permitted them to offer and sell franchises while that application was pending pursuant to Section 200.3[i] of the New York Franchise Regulations; however, noted the court, that regulation provides that any franchise fees received before registration is granted must be held in escrow by the subject franchisor and that, following registration, franchisees who purchased during the lapsed period must be furnished with a copy of the franchisor's amended disclosure document and offered rescission. Nothing of the sort transpired in this case, stated the court.
Shortly after Mangione commenced an action in New York attempting to recover his monies, the Butlers dissolved PRS and filed personal bankruptcy in North Carolina, hoping to discharge any personal liabilities they might owe to Mangione.
Their effort was unavailing.
Following trial, the court held that the Butlers were personally liable to Mangione under New York law. First, the court noted that the Butlers' debt to Mangione was a debt incurred by fraud and thus non-dischargeable under Section 523(a) of the U.S. Bankruptcy Code. As well, the court held that the Butlers' debt was further nondischargeable under Section 523(a) of the code because, instead of escrowing Mangione's payments pending approval of their PRS renewal franchise registration application, the Butlers merely spent it and converted Mangione's franchise fees to their own use, which amounts to defalcation and consequential nondischargeability.