Beware of Claims Based on Misuse of Advertising Contributions

January 01, 2004

The advertising fund is an important component of the franchisor-franchisee relationship. However, with it comes important rights and obligations for both the franchisor and the franchisee.

Typically, franchise agreements require franchisees to pay into a marketing and advertising fund. The payments are usually calculated based on a percentage of the franchisee’s revenues. The failure to make these required advertising fund payments is a common basis for a declaration of default and, indeed, termination. On the other hand, it is not uncommon for franchisees to assert claims against franchisors — either defensively, in response to a default or termination notice, or otherwise — for misuse or misapplication of advertising funds.

Certain of these claims are transparently meritless, and are dealt with accordingly. For example, in a relatively recent California state court case brought against a sandwich shop franchisor, the court held that a franchisee failed to allege sufficient predicate acts under the racketeering statute, where it was claimed that the franchisor “extorted” the payment of advertising fund fees. The court found that the payments were required by contract and, further, that the threat of termination if such contributions were not made did not constitute extortion. Likewise, in a federal case brought by a donut shop franchisor in Illinois, the court found that the franchisee’s counterclaims for negligence, unjust enrichment, conversion, and breach of fiduciary duty — all based on alleged misuse of advertising funds — could not possibly have been asserted in good faith and, indeed, were sanctionable.

Not all claims alleging misuse of advertising contributions fail, however, which a donut shop franchisor recently found out the hard way. The case involved the franchisor’s ongoing efforts to collect revenue from underreporting franchisees — for its “loss prevention activities.” The franchisees, in turn, claimed that the franchisor wrongfully diverted the fees collected to its own account, rather than placing a percentage in the advertising fund. The court denied the franchisor’s motion for judgment in its favor. The court noted that the franchisor’s failure to make contributions to its advertising fund from money collected through its loss prevention activities appeared to run afoul of the provisions of the franchise agreement. The agreement required the franchisor to remit a percentage of revenue collected for advertising expenses, and did not distinguish between fees collected in the ordinary course of business and fees collected as a result of loss prevention activities. Thus, the court permitted the action to continue.

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