LOUISVILLE – Papa John’s International is defending itself against a lawsuit brought by the purchaser of 84 underperforming franchises, Essential Pizza, Inc. The franchises are a multi-million dollar acquisition between Blackstreet Capital Management and Essential Pizza.

Essential Pizza claims the franchisor failed to disclose significant tax expense and liability in the amount of $1.2 million when preparing financial documentation for the sale.  The multi-unit franchisee alleges there was also additional liabilities that should have been disclosed including “the crippling burden of fighting extensive class action litigation” by Papa John’s delivery drivers. He states, “Papa John’s negligently opened itself and its franchisees up to liability for wage violations related to complying with minimum wage laws” with its policy of charging a set “delivery fee” to customers for every delivery.

In the amended complaint filed July 7, 2011 in Minnesota District Court, Hennepin County, Essential Pizza also made separate claims against seller Blackstreet Capital, a private equity firm that focuses on controlled buyouts of underperforming “corporate orphans” between $25 and $150 million in revenues. Blue MauMau has since learned that Essential Pizza, through its lead attorneys Zarco Einhorn Salkowski & Brito, filed a joint stipulation for dismissal without prejudice to voluntarily remove the equity firm and two named individuals from its lawsuit.

Papa John’s takes a different view on the litigation.

Vice president and senior counsel Caroline Oyler said the action stems from a dispute between the two franchisees related to the purchase and sale of Papa John’s restaurants in Minnesota and Colorado. “Papa John's was not involved in that transaction.  While Papa John's introduced the buyer and seller, as is common in the restaurant franchising industry, we did not negotiate the terms of the sale, and we were not parties to the agreement,” Oyler adamantly declared. She explained that the current franchisee, Essential Pizza, has not been able to achieve the success it had hoped for when it made its purchase, and is now far behind on royalties and amounts owed to Papa John’s and others.  “In our view, they are looking for others to blame, including Papa John's, for their own inability to operate the business,” she asserted.

Oyler said she knew nothing about Blackstreet Capital being dismissed from the litigation.

History of the lawsuit

Blackstreet Capital Management formed PJCOMN Acquisition Corporation in 2005 to purchase the restaurants in Minnesota and Colorado directly from Papa John’s International. The equity firm’s intention was to revive the underperforming stores through improved operations. But as it operated the pizza shops in those markets, Blackstreet continued to lose money, and in 2007 it began looking at ways to rid itself of all 84 stores.

The complaint states that the litigation evolved after Papa John’s president Bill Van Epps approached Brian Mills, principal of Essential Pizza, Inc., in 2007 about forming a venture to purchase the Papa John’s stores in Minnesota and Colorado. Epps sold the acquisition as “an excellent deal and opportunity,” repeatedly telling Mills that the Minnesota market was a “diamond in the rough.” He said the stores would perform well with an experienced operator like Mill’s company at the helm.

When Mills showed an interest, Papa John’s moved forward with the deal, acting as the de facto broker and liaison between Essential Pizza and Blackstreet Capital Management. Because Mills was not in a financial position to purchase restaurants, Papa John’s became involved in the deal, offering Mill’s company supplementary financing through a “franchise assistance agreement.”  When the acquisition was finalized by means of a stock sale, Essential Pizza became the owners of the 84 Papa John’s units, and became indebted to Papa John’s, Blackstreet Capital and lender GE Capital Franchise Finance for millions.

Documents prepared by the franchisor on behalf of Blackstreet Capital allegedly failed to disclose a significant tax expense and liability in the amount of $1.2 million, as well as additional unrecorded liabilities in the amount of $700,000-plus. In the stock purchase agreement, Blackstreet warranted that its disclosures fairly and accurately presented the assets and liabilities of the company it sold.

In 2008 and 2009, Essential Pizza principals became aware of previously undisclosed liabilities as they received unpaid invoices attributable to Blackstreet prior to the sale closing. At a meeting in 2010, Papa John’s executives informed Mills and partner Cliff Harris that the company would write off $1 million in deferred royalties that they allegedly owed to the franchisor. In return, Essential Pizza owners, in a show of being a team player and a good corporate citizen, paid out of their own pocket to settle outstanding liabilities to Blackstreet. But according to the lawsuit, Papa John’s then changed its position and refused to forgive the royalty payments originally promised.

Essential Pizza asserts that Papa John’s misrepresentations and lack of disclosure caused the business to be overvalued and the price over-inflated. Additionally, it states that it is likely GE Capital Franchise Finance would not have granted its company a loan if accurate financial expense and liability disclosures had been made.

Burden of delivery driver class action lawsuits

Essential Pizza asserts that one of the biggest disclosure blunders Papa John’s made was not informing them of potential liability posed by pizza delivery drivers because of violations of federal and state wage laws. They state that Papa John’s kept close watch on litigation against Pizza Hut, alleging it was not complying with minimum wage labor laws when it failed to reimburse drivers for costs incurred on the job. 

After purchasing the 84 stores in 2007, Essential continued Papa John’s practice of charging a set “delivery fee” to customers. Their lawsuit states that typical industry practice is that delivery charges should be retained by the pizza restaurant. The charges should not be used for employee compensation. Papa John’s franchise agreements required that royalties be paid to Papa John’s on all delivery fees collected by franchisees, and  Essential Pizza was no exception.

The complaint explains that Minnesota law has ruled for over twenty years that “gratuities” are the property of employees. Employers may not credit employee gratuities toward the payment of employee minimum wage. Because the law clearly states that the nature of delivery charges must be disclosed on websites or pizza boxes, Papa John’s knew or should have known it was not in compliance with state law. Papa John’s system requires that owners retain delivery fees and pay royalties on them, knowing that Essential Pizza was at risk for liability.

The sale was conditioned on Essential Pizza obtaining insurance policies for all of the stores only through Risk Services Corporation, an insurance broker that is a wholly owned affiliate of Papa John’s, from which it derives substantial revenue. The pizza franchisor represented that this arrangement was advantageous to Essential because Risk Services had a specialized protection program for franchisees that would protect against the “relevant risks incurred in operating a Papa John’s store.”

In July 2009, Shane Bass and other delivery drivers filed a class action complaint in Colorado district court against Essential Pizza seeking damages on a wage violation identical to that alleged in the Pizza Hut case. The franchisee then submitted a claim to Risk Services.

The insurer refused to pay that claim.

Another delivery driver filed a class action lawsuit against Essential Pizza Hut in Minnesota federal court in September 2010, alleging federal and state wage violations. In particular, he claims that the delivery fee charged by the Minnesota Papa John’s stores was legally a driver’s gratuity, according to state law.

Essential notified Risk Services of the litigation and requested that the insurer indemnify and defend Essential in the lawsuit under its employment practices liability policy. Three months later, Risk Services notified the franchisee that the “specialized” insurance package that Papa John’s required it to purchase would not cover the claims. Specifically, those related to the franchisor’s failure to have conspicuous disclosures on its web site and pizza boxes regarding the nature of the delivery fee.

Essential Pizza asserts in its lawsuit that in addition to having to pay for substantial undisclosed liabilities and having paid an inflated price for the 84 Papa John’s stores, their company is also now faced with the burden of fighting extensive class action litigation. Essential finds itself having to reimburse delivery fees that were expressly authorized by Papa John’s, which Papa John’s collected and received royalty on.

Papa John’s responds to class actions

Concerning the delivery drivers class action lawsuits, Oyler agreed that it was a big issue in the pizza delivery industry today. She said Papa John’s had its own lawsuit that is similar to ones brought against PJCOMN and Essential. She added, “I have a hard time making any connection between the lawsuit they have and us. That is a real stretch. Franchisees make their own decisions and choices on how they compensate their drivers.”

As a result of the franchisee’s latest actions, Olyer said Papa John’s filed a federal lawsuit in Kentucky against Essential Pizza for defaulting on payment of more than $1 million they owe Papa John’s. The franchisor has also filed a motion to stay and motion to dismiss the action in Minnesota, which they will put before the district judge at the October 7 hearing. In support of its motion, Papa John’s argues that in all of its franchise agreements the parties agree to arbitrate any disputes in Louisville, Kentucky.

Oyler expressed that Papa John’s never desires to be in litigation with its franchisees. “We have worked with this franchisee throughout the relationship and have gone above and beyond in treating its owners fairly.” She said they have given support in many ways including deferring royalties and trying to find a buyer for their markets. She added, “Now that the franchisee has chosen this course, we will aggressively defend our rights and pursue what is owed to us. We have been erroneously and inappropriately named, and we are confident we will prevail.”

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