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Franchisor Alter-Ego Liability

A new case recently came out of the United States District Court, D. Arizona, discussing corporate alter-ego liability, a relatively “hot-button” issue for franchisors. While the court did not make a dispositive ruling on alter-ego liability, the decision offers a useful checklist of the issues that need to be examined.

In the case, Cornelis v. B&J Smith Associates, LLC, franchisees who entered into a franchise agreement with Eatza Pizza, Inc., alleged that upon the sale of the franchise, Eatza Pizza promptly sold all of its assets to a second ‘undercapitalized shell company” which subsequently filed bankruptcy and failed to fulfill any of Eatza Pizza’s contractual obligations.

Plaintiffs brought causes of action for breach of contract, violations of Arizona’s Uniform Fraudulent Transfer Act, and declaratory judgment, against B&J Smith Associates and B&J Associates, (the “Business Entity Defendants”) and against three individuals, who were corporate officers of the Business Entity Defendants.

The plaintiffs alleged that the Business Entity Defendants and individual defendants wholly owned Eatza Pizza, and exercised complete and daily control over the direction and operation of Eatza Pizza.

The court analyzed the claims against the Business Entity Defendants and the individual defendants separately.

Franchisees’ claims against the Business Entity Defendants:

Applying Arizona state law, the court held that it would disregard the corporate form only if the subsidiary was the parent’s alter ego or the parent’s agent.

To show that the Business Entity Defendants were alter egos of Eatza Pizza, the court held that plaintiffs must establish:

  1. That there is such unity of interest and ownership that the separate personalities of the two entities no longer exist; and
  2. That failure to disregard their separate identities would result in fraud or injustice.

The court outlined several factors it would consider to determine whether a parent company and subsidiary share a unity of control, including the following:

  • Stock ownership by the parent
  • Common officers or directors
  • Financing of subsidiary by the parent
  • Payment of salaries and other expenses of subsidiary by parent
  • Failure of subsidiary to maintain formalities of separate corporate existence
  • Similarity of logo
  • Plaintiff’s lack of knowledge of subsidiary’s separate corporate existence.

The court stated that isolated instances of some of the above-referenced factors would not be enough to justify an alter-ego theory, and that the corporate parent must exert “substantially total control” over the subsidiary so that the subsidiary becomes a “mere instrumentality” of the parent.

Franchisees’ claims against the individual defendants:

Applying Arizona state law, the court held that alter-ego status exists “when there is such a unity of interest and ownership that the separate personalities of the corporation and owners cease to exist.”

The court again outlined several factors to consider whether individual corporate officers would be considered alter-egos of a corporation, including the following:

  • Payment of salaries and expenses of the corporation by shareholders
  • Failure to maintain corporate formalities
  • Undercapitalization
  • Commingling of corporate and personal finances
  • Plaintiff’s lack of knowledge about a separate corporate existence
  • Owners making interest-free loans to the corporation
  • Diversion of corporate property for individual use.

 

The court held that plaintiffs in this action had not sufficiently plead their claims based on alter ego liability, but allowed plaintiffs, who were proceeding pro se, to amend their complaint to comply with the court’s ruling.

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