Nash & Associates, Inc. v. Lum's of Ohio, Inc.

• Decision Date: 05 September 1973
• Docket Number: No. 73-1049.,73-1049.
• Citation: 484 F.2d 392
• Parties: NASH & ASSOCIATES, INC., et al., Plaintiffs-Appellants, v. LUM'S OF OHIO, INC., et al., Defendants-Appellees.
• Court: U.S. Court of Appeals — Sixth Circuit

484 F.2d 392 (1973)

NASH & ASSOCIATES, INC., et al., Plaintiffs-Appellants, v. LUM'S OF OHIO, INC., et al., Defendants-Appellees.

No. 73-1049.

United States Court of Appeals, Sixth Circuit.

Argued June 8, 1973.

Decided September 5, 1973.

Charles E. Pierson and Daniel G. LaPorte, Akron, Ohio, on brief, for plaintiffs-appellants.

James B. Koplow, Cleveland, Ohio, on brief, for defendants-appellees.

Before PHILLIPS, Chief Judge, LIVELY, Circuit Judge, and O'SULLIVAN, Senior Circuit Judge.

PHILLIPS, Chief Judge.

Appellant Nash and Associates, Incorporated (Nash) brought suit on September 21, 1971, against Lum's of Ohio 283 Corporation, Lum's Incorporated (Lum's) and Full Disclosure Sales, Incorporated (Full Disclosure)¹ alleging fraudulent statements and omissions in connection with the offer and sale of a fast food restaurant franchise. Suit was brought under §§ 12(2) and 17(a) of the Securities Act of 1933, 15 U.S.C. §§ 77l(2) and 77q(a) and § 10(b) of the Securities Exchange Act of 1934, 15 U. S.C. § 78j(b); also under Rule 10b-5 promulgated under the latter statute. Additionally pendent jurisdiction was asserted for common law fraud and for violations of the Ohio blue sky laws.

On December 3, 1971, Lum's moved for dismissal on the ground that the complaint failed to state a claim upon which relief could be granted or in the alternative for summary judgment. Rules 12(b) (6) and 56, Fed.R.Civ.P. Both parties filed affidavits. On August 23, 1972, District Judge Thomas D. Lambros held that the franchise package did not constitute a security under either federal act. Pendent jurisdiction over the state issues was declined and the suit dismissed.

Full Disclosure never filed an answer to the complaint and a default was entered by the Clerk. The District Court denied Nash's application for the entry of a default judgment on the ground that Lum's defense of lack of federal subject matter jurisdiction inured to the benefit of the defaulting party. On this appeal Nash asserts that the District Court erred in holding that neither the initial offer nor the actual franchise agreement constituted securities under the federal statutes. It is further urged that the District Court erred in declining pendent jurisdiction over the state law claims and in not entering a default judgment against Full Disclosure.

We affirm.

Viewing the affidavits submitted by the parties in the light most favorable to the appellant, we agree with the District Court that there are no genuine issues of material fact. Rule 56, Fed.R.Civ.P. We find that the initial offer and the actual agreement envision nothing more than a traditional franchise agreement. As such the arrangement is beyond the scope of the federal securities legislation. Chapman v. Rudd Paint & Varnish Co., 409 F.2d 635 (9th Cir. 1969); Wieboldt v. Metz, 355 F. Supp. 255 (S.D.N.Y.1973); See, Note, 33 Ohio St.L.J. 718 (1972).

In 1968, the Nash promoters became interested in obtaining a Lum's restaurant franchise in the Akron, Ohio area. The promoters were encouraged by Lum's Ohio sales agent, Full Disclosure, to visit the franchisor's corporate headquarters in Miami, Florida. At that time they were exposed to a new restaurant franchise being promoted known as Abner's Beef House. After speaking to various sales agents and reading the company's literature, Nash decided to purchase an Abner's franchise.

Nash selected a manager, who was trained by Lum's, and the restaurant opened in February of 1970. Within three months thereafter, Lum's decided to discontinue its Abner's operations. Thus the anticipated national advertising campaign did not materialize and Nash failed to prosper.

Nash brought this suit to rescind the franchise agreement and to recover its expenses. The central issue is whether either the offer or the agreement constitutes an investment contract and therefore a security under the federal statutes. An examination of the affidavits and the agreement convinces us that it is not.

At the time the parties began their negotiations, Lum's was a solvent and well established owner, operator, and franchisor of fast food restaurants. The corporation had over 200 restaurants open and had gross sales of over $27,000,000. It is clear that the franchisor was to provide a great deal of assistance to the franchisee and this fact is stressed in Lum's promotions. However, although the assistance was to be extensive, it also is clear that nothing more than assistance was contemplated and that the ultimate responsibility for local success rested with the franchisee.

The franchisee was to select a site and this location was subject to the approval of Lum's. Had the franchisee desired assistance in locating a site, the franchisor agreed to provide it. After a site was agreed upon, the franchisor agreed to provide architectural plans, including adaptations to meet local requirements. The plan also called for Lum's originally to lease the building and then sublease it to Nash.

Lum's further agreed to train the franchisee and his employees and to provide a special crew to operate the restaurant for the first two weeks. Extensive bookkeeping and advertising services were also promised.

In return for these services and the use of the Abner's name, the franchisee agreed to pay $15,000 in franchise and development fees. The franchisee was also bound to purchase an equipment package from the franchisor for $34,000 or to purchase an equivalent. Monthly rental was $1,641.67 plus 5% of gross sales. An additional 2% of gross sales was to be paid into an advertising account. Further an Abner's franchisee was required to meet certain quality standards in products, accessories, and building maintenance. A prescribed amount of insurance had to be carried and financial reports filed. In addition Nash was required to send at least three employees to the franchisor's training school.

While neither the Securities Act nor the Exchange Act specifically include franchise agreements within their definition of a security, both include investment contracts. § 2(1) of the Securities Act, 15 U.S.C. § 77b(1) and § 3(a) (10) of the Exchange Act, 15 U.S.C. § 78c(a) (10). It is the contention of Nash that its agreement constitutes an investment contract.

In determining whether a particular transaction qualifies as an investment contract the treatment afforded a transaction will not turn on the title employed by the parties. The courts will look through form to economic reality in light of the entire transaction. S.E.C. v. C. M. Joiner Leasing Corp., 320 U.S. 344, 64 S.Ct. 120, 88 L.Ed. 88 (1943); See, Tcherepnin v. Knight, 389 U.S. 332, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967). The term investment contract was defined by the Supreme Court in S.E.C. v. W. J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946) as:

"an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. . . ." 328 U.S. at 298-299, 66 S. Ct. at 1103.

While Howey dealt with an investment contract under the Securities Act, the definition is equally applicable to the Exchange Act. Tcherepnin v. Knight, supra.

Howey emphasized the need for flexibility in examining a potential investment contract in order to, "meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits." 328 U.S. at 299, 66 S.Ct. at 1103.

The major stumbling block for franchisees attempting to employ the protection of the securities statutes has been the Howey requirement that profits are to come solely from the efforts of others. In the traditional franchise arrangement the franchisee manages...