Individual Liability of Directors and Officers Under the California Franchise Investment Law

By Mulcahy LLP on July 22, 2013

It is widely understood that the owner or operator of a corporation acting in her “corporate capacity” can hide behind the protective veil of the corporation to avoid liability of the corporation. However, this fundamental protection afforded the principals of most business models may not be available to franchisors. California is one of just a handful of states that has stripped the protections of the corporate veil from those selling franchises with-in its borders. Irrespective of corporate status, the franchisor’s principal executive officers, directors and others may be jointly and severally liable for those acts of the franchisor corporation.

Under common law, the plaintiff suing a corporation has a heavy burden of proof to prevail against officers and directors of the corporation for the corporation’s misconduct. To succeed, the plaintiff must prove that the individual defendants personally participated in the unlawful conduct (called direct liability), or that the corporate separateness between the entity and the individual was essentially a fraud – that the individual exercised sufficient control over the corporation such that the corporation was essentially the individual’s “alter-ego” (called piercing the corporate veil). If direct liability can be proved, or the corporate veil pierced, then the individual defendant may be held personally liable for the corporation’s misconduct. Because both of these forms of personal liability require the plaintiff to carry a heavy burden of proof, the officers, directors and employees of franchisors typically enjoy unfettered protection against any misconduct of the corporation. The California Franchise Investment Law (“CFIL”), however, provides franchisee plaintiffs with an easier route to the pocketbook of the franchisor’s offi¬cers and dir-ectors. In Califor¬nia, every person who controls the corporate franchisor or materially aids in the unlawful act may be jointly and severally liable with the corporation for violations of the CFIL. This rule was codified at California Corporations Code Section 31302, which provides that “[e]very person who directly or indirectly controls” a franchisor is subject to civil liability for unlawfully selling or offering to sell a franchise in violation of the CFIL, including “every principal executive officer or director[...,] every person occupying a similar status or performing similar functions, [and] every employee [...] who materially aids in the act or transaction constituting the violation...” is “liable jointly and severally with and to the same extent as the [franchisor].”[1] The plain language of the statute both imposes liability on “control persons,” and independently imposes presumptive liability on certain specifically enumerated classes of individuals, including principal executive officers and directors.[2] Moreover, the controlling person can be jointly and severally liable with the franchisor even though she was not directly involved in the unlawful conduct.

Section 31302 was modeled after two federal statutes – the Securities Act of 1933 and the Securities Exchange Act of 1934.

Unfortunately for franchisors, the class of persons liable under Section 31302 was expanded beyond the limited concept of a controlling person under the federal statues to include a variety of persons with relationships or other connections to the franchisor.[3] This has allowed courts to impose joint and several liability on non-controlling directors and executive officers, regardless of whether they may independently be held liable as a control person.[4]

Even though Section 31302 was enacted back in 1970 – and has gone unchanged since that time – surprisingly there is very little case law interpreting it. The cases that have interpreted it have resulted in mixed results for the franchisor. For example, one court found that the secondary liability provided by Section 31302 does not require the plaintiff to successfully sue the franchisor to secure personal liability over the individual defendants.[5] Instead, the plaintiff need only show that liability could have been imposed on the franchisor.[6] In light of this broad interpretation of Section 31302, any executive of a franchisor considering bankrupting the franchisor should seriously consider the consequences to her own potential liability. Bankruptcy may leave the executive alone holding the liability for the franchisor’s misconduct.

Notwithstanding the above, there is one bright spot for franchisor officers and director in all of this. California courts have uniformly shut down franchisee attorneys’ attempts to use Section 31302 to bootstrap personal jurisdiction in California over an out-of-state executive or other employee of the franchisor.[7] Thus, Section 31302 only extends joint and several liability over controlling persons already subject to personal jurisdiction in California. In addition, the prospect of personal liability under the CFIL has most certainly had a chilling effect on those small and mid-sized out-of-state franchisors interested in making their system-wide business opportunities available to the 38-plus million people in California, the personal liability imposed by Section 31302 is not absolute. An individual may avoid personal liability under the CFIL for acts of the franchisor by showing that she had no knowledge or reasonable grounds to believe in the existence of the facts underlying the alleged wrong.[8] However, the individual seeking to avoid personal liability under this “no knowledge exception” to the CFIL has the burden of proving it.[9]

While executives working for franchisors with “deep pockets” face little risk of personal exposure, franchisee attorneys nevertheless have notoriously used Section 31302 as a tool to extort quick and favorable settlements from franchisors. To avoid this outcome, franchisors and their executives should take careful note and use caution when implementing the sale and disclosure requirements imposed by the CFIL.

Disclaimer: While every effort has been made to ensure the accuracy of this article, it is not intended to provide legal advice as individual situations will differ and should be discussed with an experienced franchise lawyer. For specific technical or legal advice on the information provided and related topics, please contact Mulcahy LLP.

[1] Cal. Corp. Code § 31302.
[2] See Openwave Sys. v. Fuld, 2009 U.S. Dist. LEXIS 48206, 19-21 (N.D. Cal. June 6, 2009) (citing to Courtney v. Waring, 191 Cal.App.3d 1434 (Cal. Ct. App. 1987).
[3] See Courtney v. Waring, supra, 191 Cal.App.3d at 1441 n.8 (citing to Pharo v. Smith, 621 F.2d 656, 673 (5th Cir. 1980)).
[4] Courtney v. Waring, supra, 191 Cal.App.3d at 1441 n.8.
[5] Id. at 1442.
[6] Id.
[7] See Thompson v. Anderson, 113 Cal.App.4th 258, 267-70 (Cal. Ct. App. 2003) (“Section 31302 extends liability to nonresident controlling persons subject to personal jurisdiction in California. Personal jurisdiction over a nonresident is a constitutional requirement applicable in every case.”); see also Burgo v. Lady of Am. Franchise Corp., 2006 U.S. Dist. LEXIS 98755, 18-20 (C.D. Cal. May 4, 2006) (the CFIL creates an independent basis for personal jurisdiction over the individual defendants).
[8] Cal. Corp. Code § 31302.
[9] See Neptune Society Corp. v. Longanecker 194 Cal. App. 3d 1233, 1247–1248 (Cal. Ct. App. 1987) (because the evidence showed that the officer was present at time offer was made, imposition of personal liability was proper); see also Spahn v. Guild Industries Corp., 94 Cal. App. 3d 143, 158 (Cal. Ct. App. 1979) (Burden of proof is on individual officers of franchisor to prove their exemption from liability through proof of their lack of knowledge of acts giving rise to liability.); and Eastwood v. Froehlich, 60 Cal. App. 3d 523, 531, 131 (Cal. Ct. App. 1976) (Same).






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