Beguiling Heresy: Dunkin Donuts Strong Arm Approach of Spying on Franchisees
... the Dunkin' Donuts approach is one of publicly stated mistrust of and surveillance of franchisees. At a meeting of the ABA Forum on Franchising in New Orleans, Stephen Horn, general counsel for Allied Domecq QSR (the parent of Dunkin' Donuts) discussed how Dunkin' spies on franchisees at their homes and work. In his written materials, Horn discusses "franchisee lifestyle ... . Everyone knows which franchisee just built a beach house and which one drives a late model Mercedes." n549 To Horn, every franchisee is suspect: "The franchisee who is happy and wants to expand. Has anyone checked to see how much he claims to earn from the business? ... Of course, poor attitude may also bespeak a problem." n550 How to dig up the dirt? Horn's written materials are circumspect compared to his oral presentation, but instructive:
One of the best ways to gather evidence ... is to conduct surveillance of the franchise ... . Investigators are fairly ingenious at figuring out ways to get the job done. Some are known to use small video cameras that can fit inside a briefcase ... an investigator posing as a customer can shoot footage while eating on line or sitting at a table ... an investigator can pose as a potential buyer if the franchisee has the business on the market. n551
Horn's conclusion:
The best use of surveillance is not necessarily to generate evidence for court, but to confirm that a franchisor's suspicions are correct and provide some ammunition for a confrontation meeting with the franchisee. If the case goes to court, the franchisor can always use subpoenas to gather all the evidence, of which surveillance will provide but a snapshot. n552
At the conclusion of his presentation, Horn turned on a slide projector. He then regaled the assembled attorneys with photographs not of Dunkin' stores, not of Dunkin' franchisee deliveries, not of surveillance inside stores - rather, Horn showed photographs of the personal homes, boats, and cars of Dunkin' franchisees. Horn then made explicit to the attorneys what he meant by "ammunition for a confrontation meeting": the franchisee would be confronted with photos that the private investigator had taken while lurking around the family home. Dunkin' attorneys would point out that there was an "obey all laws" clause; the [*205] family appeared to be living beyond its means, and what would happen if the IRS got these photos? Under such circumstances, Horn stated, the franchisee would normally pay the Dunkin' demand. n553 Franchisees who fight Dunkin' risk exposure of their private lives, as Horn's slide show indicated; one franchisee subsequently said that Dunkin' even makes inquiries into franchisee's "romantic relations" n554 The threat of forfeiting a $ 500,000 investment and having one's "romantic relations" exposed provide a powerful weapon to ensure franchisee submission to franchisor demands.
After the panel finished presenting, several attendees gathered around the two presenters. Several asked Horn about his recent novel, and one for an autograph. None asked about the ethics of Dunkin's strategy. When this author asked if Dunkin's practices did not amount to extortion, Horn hastily said that he had been misunderstood. Some while later, this author had communication with three attorneys about Horn's presentation; two of the attorneys had attended the meeting. One of those who attended noted that his clients had told him about the Dunkin' surveillance, but that he was surprised that Dunkin' was so public about discussing such practices, as well as surprised at the lack of reaction from the attendees. One attorney who had not attended the presentation defended Dunkin' practice and said it was ethically permissible. That is debatable: an attorney who retired after working for a disciplinary committee in a major east coast state told the authors that the issue was clear-cut: threatening criminal prosecution (tax fraud) in order to gain advantage in a civil matter. The issue was not, she explained, how artfully the franchisor attorney skirted the letter of any ethics regulation: "he knows precisely what he is doing, why he is doing it, and he knows what the response of the other party will be. It's not even a close call in my mind. It's shocking to get up and boast; it makes you wonder what else they're up to."
Robert Zarco, one of the world's foremost franchisee attorneys, n555 takes up the Dunkin' story from this point. In 2002, Zarco says, Dunkin's suit for underreporting by Pittsburgh franchisee Chris Romanias was dismissed because the court did not find Dunkin's accounting methodology to be credible. n556 At the same time, Zarco's [*206] firm was representing Miami franchisee Omar Martinez in a similar suit. n557 After the Pittsburgh case, claims Zarco, the Dunkin' attorneys realized that they could not show any underreporting by Martinez, and indeed on January 3, 2003 Dunkin' dropped its underreporting claim against Martinez. n558 What remained was a claim for violation of the tax and employment laws. n559 The strategy outlined by Horn in New Orleans in 2000 had become the litigation strategy in Miami in 2003. The "violations" were not ones which damaged the franchisor; they were violations of federal law. Dunkin' did not allege that Dunkin' had lost any money, Dunkin' alleged that Martinez had cheated the IRS and had not always filled out the I-9 form of the Immigration & Naturalization service when he hired new employees. n560
Large franchisors can legally avoid taxes on much of their income, and have multimillion-dollar lobbying efforts to ensure, for example, that states do not tax franchisor royalty revenue. n561 There is nothing illegal with franchisors getting the best tax code money can buy, n562 but franchisors have also violated the law when doing so enabled them to take advantage of the most vulnerable. Recall that many of the largest corporations in the country, including major franchisors such as Taco Bell and Wendy's, have been found guilty of violating employment laws and paying less than the legal wage. n563 The franchisor corporations paid fines, but did not forfeit their business as an additional penalty. Employees received back pay awards, but none of them wound up getting the company given to them. It should also be noted that an arbitrator who pleads guilty to a criminal tax charge may still render an award, since tax fraud has no effect on the integrity of the award. n564 One [*207] franchisor even requires that franchisees commingle business and personal tax items, n565 and the dependence of the foodservice industry and the rest of the U.S. economy on the 11 million undocumented workers has been the impetus behind efforts to legalize this essential economic force; n566 just a month before the World Trade Center attack changed views on immigration, the restaurant industry was supporting President Bush's efforts to legalize Mexican immigrants. n567 There is a bit of hypocrisy in the franchisor stance in Martinez.
In the case of Omar Martinez, tax evasion charges were brought not by the government, but by Dunkin' Donuts, after Dunkin' "subpoenaed numerous third-party financial institutions, the Social Security Administration, Defendants' accountant" and conducted various depositions. n568 The court found that Dunkin' had proven that Martinez "failed to comply with applicable tax laws" for 1999, 2000, and 2001. n569 Since this was not a tax fraud case, and since the I.R.S. was not the party [*208] bringing the suit, the court did not assess any penalties to be paid to the I.R.S. or direct the payment of the taxes (presumably Dunkin' will forward the papers to the I.R.S. since Dunkin' conducted the tax audit). n570 The court rewarded Dunkin's assistance to the I.R.S. by forfeiting Omar Martinez' store to the franchisor on the grounds that the false statements Martinez made to the I.R.S. constituted a "material breach" of the franchise contract. n571 In support of its position, the court cited an additional three cases that Dunkin' had brought to terminate franchisees under the "obey all laws" clause. n572 The court gave short shrift to Omar Martinez' argument that he had neither been charged with nor admitted to tax fraud, holding that a franchisor "need only prove Defendants' violation of the law in order to enforce their contractual right to terminate." n573
Dunkin' Donuts and Baskin Robbins are part of the Allied Domecq conglomerate. n574 Omar Martinez was "charged" by Allied Domecq with a handful of violations of federal law during the period 1999-2001, and Allied Domecq argued that Martinez should forfeit his business because of that. Conversely, Allied Domecq violated federal law 20,870 times during 1994-1997, which violations enabled Allied Domecq to add net sales of $ 1,040,905. n575 And unlike Martinez, Allied Domecq's violations were directly related to business activity - indeed, the illegal activity was Domecq's business. Moreover, when the Treasury Department attempted to investigate Allied Domecq's violations of law, the records had disappeared: as one commentator noted, such action "implies evasion to conceal the involvement." n576 Allied Domecq paid the U.S. Government $ 260,000 as a fine for not obeying the law - less than the value of franchises forfeited to it under the "obey all laws" clauses. The publicly available records redact the mitigating circumstances paragraph, so it is not known whether Allied Domecq agreed to assist other Treasury Department investigations, but Allied Domecq subsequently "cooperated fully" with the I.R.S. in getting seven franchisees charged in the Boston area alone. n577 In short: if a franchisee breaks federal law he loses his business, if a franchisor corporation breaks federal law it pays a (relatively) miniscule fine. The distinction here is that Martinez made improper deductions on his tax return, apparently a far more serious offense than Allied Domecq making a million dollars by doing business with a repressive dictatorship in violation of federal law.
Assuming that an individual or corporation violates federal law, that is a matter for the government. If Allied Domecq was auditing its franchisees out of some perceived civic duty to enforce the Internal Revenue Code, that would be odd but not illegal or unethical. And given Domecq's inability to uncover one of their own executive's theft and transfer of $ 15 million to tax-free offshore bank accounts, n578 their concern for a few off-the-books jelly doughnuts is arguably misplaced and Pittsburgh court was correct in questioning Domecq's auditing acumen. However, given the written and oral representations of Dunkin's counsel at an ABA seminar coupled with the circumstances of Martinez, serious questions are raised about the legality of Dunkin' tactics and the legal ethics of Dunkin' counsel. Even if Dunkin' now institutes a policy of mandating reporting to the I.R.S. of all Dunkin' compliance audits, Dunkin' can still accomplish its goals at the "confrontation meeting" by threatening to exercise Dunkin's contractual rights to have Dunkin's phalanx of tax auditors pore over the franchisee tax returns. Unless the franchisee is prepared to take the risk that there is nothing in all of the franchisee's business and personal tax returns that is open to question, and no embarrassing "romantic relations," it is not worth the risk of a spurned Dunkin' "cooperating fully" with the I.R.S. (not to mention a wrathful spouse). The issues raised by Dunkin's tactics go beyond the scope of this paper, but do illustrate the ability of franchisors to bring the resources of a multibillion-dollar conglomerate to bear in an ethically questionable manner in order to seize without payment the business of a franchisee.
pgs. 203 - 209. Beguiling Heresy, Regulating the Franchise Relationship. Reprinted with permission of the author and by permission of The Dickinson School of Law at PennState.
--
Notes
n549. Stephen Horn and Jeffery S. Haff, Franchisee Nonpayment of Fees: Underreporting, "Royalty Strikes" and Related Issues, in Franchising Without Borders at Tab W9 at 3(2000 ABA Forum on Franchising).
n550. Id.
n551. Id. at 4. One Massachusetts attorney told this author that his client suspected that one of Dunkin's undercover spies was even dressed in military uniform.
n552. Id. Footnote noted attorney Jeff Haff's comment that such behavior adversely affects franchisee morale and trust in their franchisor.
n553. Horn regarded the slide show as the pinnacle of his presentation, repeatedly noting how effective such photos were. When the projector initially did not work, a hotel employee was dispatched to fix the equipment and Horn noted how glad he was that the attendees had been able to see his slides.
n554. Martin, supra note 148, at 111 (citing fall 2002 interview in Bloomberg Markets magazine).
n555. Zarco won the Scheck case (U.S.) and Hungry Jack's (Australia). See www.zarcolaw.com.
n556. Martin, supra note 148, at 111.
n557. Dunkin' Donuts Inc. v. Omar Martinez, 2003 WL 685875 (S.D. Fla. 2003).
n558. Id. at n.2.
n559. Id.
n560. Id. at 2.
n561. Jerry Wilkerson, Franchising Likely To Grow as Recently Jobless Seek To Mind Their Businesses, Nation's Restaurant News, May 26, 2003, at 27 (efforts by states to tax royalties deemed "a government obsession for dollars"). Companies can also do avoidance strategies such as placing their trademarks in a tax-free or low-tax jurisdiction and "charging" the parent company royalties, thus making income tax-free.
n562. Like everyone else, franchisors don't like to pay taxes and have fought against paying taxes on income from franchisee royalties, AAMCO Transmissions, Inc. v. Taxation & Revenue Dep't, 600 P.2d 841 (N.M. 1979) (IFA amicus brief for franchisor), and lobbied against the estate tax, Fisher Schumacher & Zucker, Franchise Alert, February 2001 (We have ... lobbied ... in support of repealing federal estate taxes). On IFA position, see, Paul Frumkin, Industry Supports Federal Tax Cut Plans, Nation's Restaurant News, May 26, 2003, at 1, 96 (quoting Don DeBolt on corporate dividends tax cut).
n563. Supra note 329.
n564. United Transportation Union v. Gateway Western Railway Co., 284 F.3d 710, 712 (7th Cir. 2002).
n565. For example, Subway sandwich franchisees are required to purchase supplies through the Independent Purchasing Cooperative (IPC), an organization ostensibly independent of the franchisor. For liability reasons, franchisees often assign their operating rights to a corporate entity. Expenses and revenues are netted out and taxes paid (commonly but not always as an S corporation). The IPC sends an annual check for each store representing vendor rebates on business purchases. Disregarding the corporate form, the check is payable not to the corporate entity which purchased the items, but to a natural person. Hence, the franchise is making purchases which are deductible as business expenses on the business tax return and a portion of the expenditure is sent back (as income) to a natural person, the franchisee. This practice also places the franchisee at risk of those seeking to pierce the corporate veil. Subway franchisees are also required to keep available on-site 3 years of tax returns (business & personal) for perusal by franchisor representatives. Doctor's Associates, Inc. Franchise Agreement, available in Subway Franchise Offering Circular at Exhibit "A," p. 5 (1st ed. 2002).
n566. Milford Prewitt, Many Borders To Cross: Immigration Reform on Rocky Road, Nation's Restaurant News, July 7, 2003 at 1, 49 (food industry workers overwhelmingly Latino), at 50 (Pakistani deli owners in Brooklyn), at 52 (rule rather than exception that undocumented workers staff high-end restaurants), also, John Moreno Gonzales, Turning Blind Eyes: Illegals essential to work force, employers say, Newsday (Queens Edition), July 23, 2003 at A18, A36 (Government "fully aware" of illegals and that "the only way to retain this work force is to allow the new immigrants to work without papers"). The role of undocumented workers is widespread in the U.S., and in Freeport, N.Y. the village paid to set up a job hiring site to match workers with employers. Elissa Gootman, Battling on 2 Fronts on L.I. Over Immigrant Job Centers, N.Y. Times, Sept. 19, 2002, at B5.
n567. Milford Prewitt, Operators, Lobbyists Laud "Alien' Amnesty, Nation's Restaurant News, Aug. 13, 2001, at 1.
n568. Dunkin' Donuts Inc. v. Omar Martinez, 2003 WL 685875 (S.D.Fla.), Feb. 21, 2003 at 1-2. The result may have been different if the subject franchise had been a gas station; the PMPA permits termination for "fraud or criminal misconduct by the franchisee relevant to the operation of the marketing premises." 15 U.S.C. 2802(c)(1). Martinez' activities related to personal expenses deducted on a tax return, not to operation of the Dunkin' franchise itself.
n569. Martinez at 5.
n570. Id. at 12-13.
n571. Id. at 9.
n572. Id.
n573. Id. at 10.
n574. James Peters, Dunkin'-Baskin-Togo's Parent Allied Domecq Lists Shares on NYSE, Nation's Restaurant News, Aug. 19, 2002, at 4 (noting that only 10% of 2001 revenues of $ 4.2 billion came from restaurant division).
n575. Memorandum of Betsy Sue Scott (Chief, Civil Penalties, U.S. Department of the Treasury) dated Oct. 3, 2001, available at www.ustreas.gov/foia/reading-room/docs/ofac-index.html (June 25, 2002 production, Image 2) (multiple violations of Cuban trade embargo, travel to Cuba, failure to retain records).
n576. Christopher H. Johnson, U.S. Foreign Trade Sanctions and the Multinational Corporation, Intl. L. News, Spring 2003 at 15, 16. The article refers to Allied "Comecq" [sic].
n577. Martin, supra note 148.
