''Circular' reasoning dogs defendant in Shakey's Pizza lawsuit

Feb. 1, 2004

Troubling details about the financial condition of Shakey's Inc. have emerged in a class-action lawsuit filed December 2002 by 39 of its franchisees.

Franchisees accuse the franchisor of the 61-store Garden Grove, Calif.-based chain, and its chairman, Chin-Yong Wong, of fraud and negligent misrepresentation for their attempts to negotiate franchise contract renewals with an outdated and incomplete uniform franchise offering circular (UFOC) in the fall of 2002.

According to documents obtained by PizzaMarketplace, Shakey's applied for renewal of its UFOC to the State of California's Department of Corporations on Sept. 13, 2002. The state declined to renew it, however, because of concerns over Shakey's financial condition and its potential inability to honor future franchise agreements.

In an Oct. 3, 2002, letter to Shakey's counsel David Kagel, California Senior Corporations Counsel W. Anthony Colbert said that due to Shakey's questionable financial condition, the company must enter into impound procedures in order to have its UFOC renewed. The mandate required Shakey's to place in an impound account (escrow) funds equal to its $25,000 initial franchise fee; those funds would guarantee that any new franchisee could recover his investment should the company not fulfill its obligations to help him start his business.

On Oct. 11, 2002, Shakey's attorney Kagel asked Colbert to reconsider the impound mandate, but Colbert did not.

Despite not entering into impound procedures or pursuing the renewal further, franchisees claim Shakey's attempted to negotiate renewal contracts well into 2002--without informing its franchisees that the UFOC's renewal was unlikely.

On May 15, 2003, the Department of Corporations declared the pizza chain's request for renewal officially "abandoned." Franchisees, however, did not discover the abandonment until late 2003.

"During the time that the parties (in the current lawsuit) were in negotiation for renewal, Shakey's told them that they had submitted a UFOC application, and that it had been or shortly would be approved," said Mike Grace, attorney for the plaintiffs in the class action. "The Department of Corporations said they would not approve Shakey's application unless they opened an impound account because of Shakey's precarious financial condition. Shakey's concealed that document from the dealers, and we have only learned about it during the discovery process in this case."

Need for impound

Colbert's Oct. 3, 2002, letter to Shakey's counsel Kagel illustrates why he insisted the company meet the impound conditions. Among his concerns were "the deterioration of the franchisor's financial condition and its involvement in potentially costly litigation."

In an Oct. 11 letter to Colbert, Kagel pointed out that the litigation had been settled without "any payments being made by Shakey's," and added that the company's perceived financial deterioration was caused only by the cost of the litigation.

In an interview with PizzaMarketplace, Colbert said he did not recall the particulars of Shakey's application ("You can imagine how many of these applications we get," he said), but it's likely Shakey's financial statement, submitted with its current UFOC, sparked his concern.

According to its most recent financials, dated July 30, 2002, the company claims total equity of approximately $2.1 million. Yet, its total current liabilities of nearly $950,000 clearly illustrate a cash flow struggle.

Its franchisees are troubled by other issues. Among the $1.5 million listed as total current assets is a line item dubbed "Intercompany," totaling more than $1 million. It also claims fixed assets, listed as fixtures, signs, equipment and computers, totaling more than $562,000.

John McNulty, a one-store Shakey's franchisee and president of the Shakey's Franchised Dealers Association, said he and other franchisees couldn't determine the meaning of "Intercompany" or understand how the company could claim more than a half-million dollars in fixed assets. Shortly after, McNulty sent formal requests to Shakey's Inc. for a more detailed explanation, as well as audited financials from previous years. All appeals, he said, were ignored.

"There are sections in there that are completely missing," McNulty said of Shakey's financials. "That is in no way the consolidated financials we requested."

Not only was Shakey's in violation of its covenant of good faith and fair dealing, McNulty said, its officers failed to reveal that California's Department of Corporations had not yet approved its UFOC renewal. That alone, he said, would have raised grave concerns among dealers whose contracts were nearing expiration and up for re-negotiation.

"They concealed material information about the UFOC from the dealers during the time that negotiations for (franchise contract) renewal were apparently going on," said McNulty, who is not a litigant in the class action suit. "This game of hiding the ball is par for the course with Shakey's."

Onward to trial

Mitchell Shapiro, the attorney representing Shakey's in the class-action suit, denied the chain's officials committed any wrongdoing by attempting to negotiate contract renewals with the current UFOC. Sales of new franchises with an outdated UFOC, he said, would be illegal, but renewing previously signed contracts is legal.

"Not only is Shakey's not selling franchises at the moment, Shakey's hasn't sold any franchises in the past several years," said Shapiro.

Chuck Wilburn, a one-store Shakey's franchisee and a spokesman for the current litigants, said Shapiro's point is irrelevant because Shakey's continual misrepresentation of the company is the central issue of the franchisees' complaint.

"We had the right for full disclosure and understanding of what financial condition the company was in," Wilburn said. "By them hiding it and not giving it to us, they were trying to misrepresent the strength of the company. It didn't give us a fair opportunity to say we'll take our buildings and businesses and go somewhere else with them instead of signing up another 20 years with this company."

Despite a failed attempt by Shakey's to dismiss the franchisees' fraud claim against Chin-Yong and the dismissal of a motion by Shakey's to have Grace relieved as the franchisees' counsel, Shapiro is confident that as the March 24 trial draws nearer, Shakey's and Chin-Yong will prevail.

"I don't think they have a prayer of being successful," he said of the franchisees. A hearing for Shakey's motion for summary judgment is set for Feb. 19. "I'm confident we'll either win that, or the court will throw out a great deal of the case at that time. ... The case, as presently postured, won't go to trial."

Over the 13 months since the lawsuit was filed, Wilburn has insisted that the franchisees will settle for nothing less than a jury trial. The complaints in the suit, he said, deserve to be heard by a jury that he expects will decide against Shakey's.

"We are suing Shakey's because we want them to honor the contract: something they've not done," he said. "We will see this through to the end, and that will be a jury trial."

To read related Shakey's stories, click here.

Topics: Shakey's

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