Federal Judge: Franchising Sounds Like Ponzi Scheme

Is franchising "a modified Ponzi scheme?" Last week, a federal judge said it might be…The Judge went on to say that he believed that in fact Coverall was in the business of janitorial services and that under Massachusetts law the "franchisees" were really employees of Coverall. But the use of the term..

http://www.bluemaumau.org
April 1, 2010

Federal Judge: Franchising Sounds Like Ponzi Scheme
Corbin Williston

Is franchising "a modified Ponzi scheme?" Last week, a federal judge said it might be.

Janitorial franchises have long been a source of embarrassment for the franchise industry, and frequently attract purchasers with few assets and poor command of English.

* A 2001 report by the GAO on FTC enforcement of the Franchise Rule found that from 1993-2000, Coverall violations had affected 2591 investors, and JaniKing violations affected 900 investors.
* A 2005 news article in the NY Times noted complaints by Brazilian immigrant franchisees of Coverall in Boston, and a settlement of Coverall litigation in Los Angeles in which franchisees alleged fraud.
* An August 2009 interview with Franchise Times quoted Coverall making this claim:

Jacqueline Vlaming, Coverall’s general counsel, said, “Every franchise owner who runs it like a business can make money.”

In the most recent lawsuit, Pius Awuah and 10 other franchisees relate similar stories:

1. They paid Coverall North America a "franchise fee" in exchange for which
2. They were promised a minimum dollar amount of client accounts to service each month.
3. Coverall entered into the contract with the clients and billed the clients.
4. Coverall assigned the franchisees to clean the client premises, and
5. Coverall would remit money to the franchisees after deducting various charges.

The franchisees alleged in their Complaint that they were never given the amount of business they had been promised, and that the degree of control which Coverall exercised over them meant that as a matter of Massachusetts law that they were really employees of Coverall.

After filing suit, the franchisee attorneys uncovered damaging information and Coverall moved to seal court documents. In an interlocutory appeal, a 3 judge panel of the 1st Circuit Court of Appeals said in October 2009:

Coverall has been charged — it has not been found liable in this case — with activities that could be viewed as highly unattractive. [cite omitted]

It is not necessarily the disclosure to competitors that makes the district court's order a matter of concern. Others, including enforcement agencies and potential plaintiffs, may find the disclosures of interest in ways that would not serve Coverall's interests. [emphasis underlined in original]

The lawsuit continued and on March 23, 2010 the District Court ruled in favor of the "franchisee" plaintiffs, holding that they are in fact employees.

What has attracted attention within the franchise community is the Judge's comments about Coverall's assertion that its business was actually the sale of franchises. Traditionally industry trade groups such as the IFA have maintained that franchising is not an industry but rather a business model (although the IFA has on other occasions defined franchising as an industry).

Judge Young stated:

Describing franchising as a business in itself, as Coverall seeks to do, sounds vaguely like a description for a modified Ponzi scheme – a company that does not earn money from the sale of goods and services, but from taking in more money from unwitting franchisees to make payments to previous franchisees.

The Judge went on to say that he believed that in fact Coverall was in the business of janitorial services and that under Massachusetts law the "franchisees" were really employees of Coverall. But the use of the term "Ponzi scheme" and the interlocutory ruling have caused this case to gain wide attention.

An interesting issue raised by franchise law firm Nixon Peabody is the impact of the Massachusetts statute and case law on post-term non-compete clauses.

The IFA issued a press release criticizing the ruling as a threat to franchising in Massachusetts. As far back as 1998, the IFA took the (then) unheard-of step and filed an amicus brief opposing a janitor who filed for unemployment after being fired from his job at West Sanitation Services. (Matter of Francis, 688 N.Y.S.2d 55)

A bigger threat to Coverall might be the bad publicity which has caused it to lose contracts with Boston-area clients such as Legal Sea Foods and Cheescake Factory (NASDAQ: CAKE). Both restaurants paid Coverall, but the mostly Hispanic cleaning staff did not get paid.

Coverall said it had properly sent money to the Boston "franchisee" and that it bore no responsibility for seeing that the workers were paid. After media reports, Coverall paid the wages. Legal Sea Foods terminated Coverall due to concerns about worker mistreatment, Cheescake Factory terminated Coverall due to a number of concerns, and the Massachusetts Attorney General is investigating the janitorial industry, according to the Boston Globe.

Awuah et al v. Coverall, D. Mass. 1:07-cv-10287, March 23 2010

For Plaintiffs: Lichten & Liss-Riordan P.C. (Boston)

For Defendant: DLA Piper USA LLP (Boston, Chicago, & Washington offices)


Attachments:
Awuah_v_Coverall_North_America_Memorandum _Order.pdf
Awuah Court of Appeals interlocutory ORDER.pdf
Awuah v. Coverall COMPLAINT.pdf
Awuah v. Coverall Defendant Answr.pdf
Awuah v. Coverall Ans to CntrClaim.pdf
IFA Statement on Coverall decision.pdf
GAO report- FTC Enforcement of Franchise Rule.pdf

Comments

1. By Don Sniegowski 2010-04-03 16:21
Franchisees as employees

The big issue coming out of the Coverall case is that franchisors are reminded that too much control over the day-to-day sales and operations of franchisees, as if they were company-owned, may define the franchisees as employees and enact employment laws.

Franchisors plug into POS systems, monitor orders, connect with customers, attempt to control business entrepreneurs — is that actually an employee relationship?

2. By Guest 2010-04-06 07:52
3 prong test under Mass law

It is true that franchisors exercise a large amount of control over their franchisees. In some cases, a franchisor may exercise even more control—for example, a franchisee is often required to show the franchisor his personal tax return including sensitive information about the franchisee and spouse.

In this case, the judge ruled against Coverall because it found a violation of the 2nd prong of the statute. Specifically the judge found that Coverall was not in the "business" of franchising but rather in the business of providing cleaning services. Therefore as a matter of law in Massachusetts, the "franchisees" were actually employees. This is why some observers have noted the implications for the post-term non-compete clause.

The Mass law MGL 149 reads:

Section 148B. (a) For the purpose of this chapter and chapter 151, an individual performing any service, except as authorized under this chapter, shall be considered to be an employee under those chapters unless:—

(1) the individual is free from control and direction in connection with the performance of the service, both under his contract for the performance of service and in fact; and

(2) the service is performed outside the usual course of the business of the employer; and,

(3) the individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.

3. By Ray Borradale 2010-04-03 17:49
Employees to the contract?

The customer base belongs to the franchisor and with non-compete clauses that goes beyond even the contract term. Franchisees do not control the supply chain and many would argue effectively that they don’t benefit from the franchisor’s supply chain. Franchisees get to hire and fire in a role somewhat similar to that of a manager.

Many would argue that there are systems where the profit performance is mostly, if not totally controlled by the franchisor. Many more would argue that the difference is that employees get paid and some might mention employees get paid without having to risk everything.

Under Australia’s work place legislation employers are held accountable for the termination of a staff while franchisors are not held accountable when terminating franchisees who [mostly] cannot fund a defence.

In Australia we have seen many cases being pushed toward the Industrial Relations Courts with confidence held by some astute lawyers that franchisees were employees to the contract. But they seem to either settle or the franchisor’s lawyers delay for a few years until franchisees run out of money. This is quite probably because the franchising industry suspects a ruling somewhat similar to Judge Young’s.

Such a ruling here would bring into play legislation that would very much flatten the playing field.


*http://ausfranchising.wordpress.com/ *Australian Franchise Opportunities]**, a common sense approach to franchising

4. By Polly Glot 2010-04-03 10:14
What Judge Young says

Here is the essence of Judge Young's pronouncements in other languages for the benefit of our immigrant friends. It is translated from Babylon online translation service:

SPANISH: U. S. Juez William Young dice LAS servicio de limpieza Coverall suena como una pirámide de engañar inmigrantes a comprar una franquicia. Gobernó la tienda propietarios son en realidad los empleados de la Coverall LAS y tienen derecho a salario mínimo y beneficios.

RUSSIAN: американский судья Уильям молодых говорит Coverall уборке помещени компании звучит, как финансовой пирамиды хитрость иммигрантов на покупку франшизы. Он постановил, что владельцы магазинов, фактически работников Coverall компании и имеют право на минимальную заработную плату и пособия.

URDU: امریکی جج کا کہنا ہے کہ Coverall ولیم نوجوان صفائی سروس کمپنی اوازیں جیسے پايئرامڈ بتولا تارکین وطن کو خریدنے کے لئے ادھکار. انہوں نے لاہور کے مالکان کی دکان کے ملازمین ہیں ان پر واقعی طور پر Coverall کمپنی اور مستحق ہوں. کم سے کم تنخواہ اور مراعات

KOREAN: 미국의 젊은 판사는 윌리엄 Coverall 소리 환경미화원 회사 피라미드처럼 체계를 장난을 사는 이주민들에게 8372만원. 판결했습니다. 그리고 상점 주인들은 실제로는 직원들이 회사 Coverall 자격이 있고 최소 연봉과 이익을 가져다 줄 것입니다.

CHINESE: 美國法官William Young說Coverall清潔服務公司好像一個金字塔計劃,故弄玄虛移民,買一個專營權公司。 他裁定有關商戶其實是雇員的Coverall公司,有權得到最低工資和福利。

5. By Kusunoki Masashige 2010-04-02 01:31
Not possible to be a bad franchisor and a member of the IFA

Is the federal court picking on Coverall Cleaning, a paying member of the International Franchise Association? Other franchisors would not let their names be tarnished by allowing such riff-raff to receive the blessings and honor of their fellowship.

Think about it. How could what a judge deems as a Ponzi franchise system possibly win the 2008 Stevie American Business Award for Best Support Organization? Business brokers Franchoice has selected Coverall Cleaning to sell.

Nah. Those organizations just wouldn't let convicted tricksters taint their good name.

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