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SOUTHLAND CORP. v. FROELICH

March 19, 1999

THE SOUTHLAND CORPORATION, PLAINTIFF,
v.
RICHARD FROELICH, DEFENDANT.



The opinion of the court was delivered by: Seybert, District Judge.

  MEMORANDUM AND ORDER

Pending before the Court are the objections of Plaintiff, The Southland Corporation ("Southland"), to the February 26, 1998 Report and Recommendation of Magistrate Judge Viktor V. Pohorelsky. The Report recommended that this Court deny both Southland's motion for a preliminary injunction, and Defendant Richard Froelich's ("Froelich") motion for injunctive relief. Upon de novo review of the report and recommendation, pursuant to 28 U.S.C. § 636(b)(1)(C) and Fed.R.Civ.P. 72(b), the Court adopts the recommendation to deny Froelich's motion, but declines to adopt the recommendation to deny Southland's motion.

PROCEDURAL BACKGROUND

Southland initiated this action on March 27, 1997 against defendant Richard Froelich,*fn1 the operator of one of Southland's well-known 7-Eleven franchises. The complaint contains twelve causes of action, ten of which pertain to Froelich.*fn2

On April 9, 1997, Southland moved by Order to Show Cause ("OSC") for a preliminary injunction, pursuant to Fed. R.Civ.P. 65. Through the OSC, Southland sought to enjoin Froelich from using Southland's 7-Eleven service marks, trade dress, trade name, and trademarks during the pendency of the action. The OSC also sought to compel Froelich to vacate and surrender the premises of his franchise 7-Eleven store, located at Peconic Street and First Avenue in Lakeland, New York. Southland further sought, pursuant to Fed.R.Civ.P. 64, to seize from Froelich and deliver to Southland the inventory and other goods held for sale, and also the equipment that had been leased to the store.

On June 24 and 25, 1997, Magistrate Judge Pohorelsky conducted an evidentiary hearing on Southland's motion for a preliminary injunction.*fn3 Prior to a decision being rendered, Southland brought a supplemental order to show cause asserting additional grounds for the issuance of the injunction. Magistrate Judge Pohorelsky conducted additional hearings on December 2 and 3, 1997. Approximately three weeks later, Froelich cross-moved by order to show cause for an injunction compelling Southland to permit him to sell his interest in the Peconic Street 7-Eleven store. That application also was referred to Magistrate Judge Pohorelsky, but no further evidentiary hearings were held.

The magistrate judge issued his Report and Recommendation on February 26, 1998, recommending that both motions for injunctive relief be denied. On March 16, 1998, Southland filed its objections to the Report and Recommendation. Froelich did not object to the Report and Recommendation, and did not reply to Southland's objections. Therefore, the recommendation to deny Froelich's motion for injunctive relief is ADOPTED in its entirety, and the magistrate judge's recommendation to deny Southland's application for a preliminary injunction is considered solely on the basis of Southland's submissions to the Court.

LEGAL STANDARDS

A. Standard of Review of Magistrate Judge Pohorelsky's Report
  and Recommendation

Pursuant to Fed.R.Civ.P. 72(c), a party objecting to the recommended disposition of a matter may file specific, written objections to the magistrate judge's report and recommendation. "The district judge to whom the case is assigned shall make a de novo determination upon the record . . . [and] may accept, reject, or modify the recommended decision, receive further evidence, or recommit the matter to the magistrate judge with instructions." Fed. R.Civ.P. 72(c).

B. Standard for Issuance of a Preliminary Injunction

The issuance of a preliminary injunction in the Second Circuit is dependent upon the movant's demonstration of (1) irreparable harm and (2) either a likelihood of success on the merits, or a sufficiently serious question as to the merits of the case to make them a fair ground for litigation and a balance of hardships tipping decidedly in its favor. Tom Doherty Assoc., Inc. v. Saban Entertainment, Inc., 60 F.3d 27, 33 (2d Cir. 1995). Such relief is extraordinary and should not be granted indiscriminately. Patton v. Dole, 806 F.2d 24, 28 (2d Cir. 1986). "Irreparable harm" means injury that is actual and imminent. Tom Doherty Assoc., 60 F.3d at 37. If a monetary award will provide adequate compensation for the injury suffered, a preliminary injunction should not issue. Id. at 37-38.

However, where the requested preliminary injunction will do more than preserve the status quo, the court "should require a more substantial showing of likelihood of success" on the merits. S.E.C. v. Cavanagh, 155 F.3d 129, 136 (2d Cir. 1998) (quoting S.E.C. v. Unifund SAL, 910 F.2d 1028, 1039 (2d Cir. 1990)). In other words, the moving party must demonstrate a. clear or substantial likelihood of success on the merits

  where (1) the injunction sought `will alter, rather
  than maintain, the status quo' — i.e., is properly
  characterized as a "mandatory" rather than
  "prohibitory" injunction; or (2) the injunction
  sought `will provide the movant with substantially
  all the relief sought, and that relief cannot be
  undone even if the defendant prevails at a trial on
  the merits.

Jolly v. Coughlin, 76 F.3d 468, 473 (2d Cir. 1996) (quoting Tom Doherty Assoc., 60 F.3d at 33-34); see also Koppell v. New York State Bd. of Elections, 153 F.3d 95, 96 (2d Cir. 1998).

Upon consideration of an application for a preliminary injunction, the court must follow the requirements of Fed. R.Civ.P. 52(a), and set forth its findings of fact and conclusions of law. Inverness Corp. v. Whitehall Lab., 819 F.2d 48, 49 (2d Cir. 1987). This rule "serves several purposes. First, it aids the appellate court in understanding the ground or basis for the trial court's decision [and][s]econd, the rule encourages the trial judge to ascertain the facts with due care and render a decision in accord with the evidence and the law." Davis v. New York City Hous. Auth., 166 F.3d 432, 433-34 (2d Cir. 1999) (citations omitted).

Therefore, the Court's findings of fact, as ascertained from the parties' pleadings, affidavits, memoranda of law, and the extensive hearing transcripts, are set forth below. The Court's conclusions of law are also set forth in the Discussion section that follows.

FINDINGS OF FACT

  1. Southland is a Texas corporation with its
    principal place of business in Dallas, Texas.
    Complaint ("Cplt."), ¶ 1. Southland maintains an
    office in the Eastern District of New York at 135
    Maxess Road, Melville, New York. Id.
  2. Southland operates and franchises the nationwide
    7-Eleven chain of retail convenience stores. Cplt.,
    ¶ 6.
  3. Froelich is a resident of Suffolk County, New York
    and in July 1996 was granted a franchise to operate
    a 7-Eleven store ("Froelich Store") at Peconic
    Street and First Avenue in Lakeland, New York
    (store number 2423-16539). Cplt., ¶ 8; June 24 Tr.,
    at 7.*fn4
  4. The Froelich Store is located in Market 2423,
    which encompasses that part of Long Island lying
    roughly east of the Sagtikos Expressway, all of
    which is in Suffolk County. There are eighty-one
    7-Eleven stores in Market 2423. The Market Manager
    is Robert Cadigan. June 24 Tr., at 6.
  5. Prior to opening his own 7-Eleven franchise,
    Froelich worked for approximately fifteen years at
    a 7-Eleven store operated by former defendant
    Thomas Hudson ("Hudson Store"), located on Hospital
    Road in East Patchogue, New York. June 24 Tr., at
    7, 124-25; June 25 Tr., at 13-14.
  6. Froelich has a college degree in business
    management and has an accounting background. June
    24 Tr., at 125-27; Selected Exhibits Submitted by
    Plaintiff in Support of its Objections ("Pl.Ex.")
    3, at 181.
  7. In late January 1997, an investigation was
    commenced by Southland concerning the operation of
    both the Froelich Store and the Hudson Store. June
    24 Tr., at 17-21. That investigation revealed to
    Southland that for many years at the Hudson Store,
    and at the Froelich Store since shortly after
    Froelich began operating that store, merchandise
    sales had been fraudulently reduced. June 24 Tr.,
    at 19-20, 26-28, 84-85, 107-116, 142-43; Pl.Ex. 8.
  8. This under reporting of merchandise sales, the
    gross profit of which Southland shares with its
    franchisees, was carried out by means of a scheme
    which consisted of Froelich's (and Hudson's)
    exaggeration of Instant Lotto sales — which are
    deducted from total sales to insure proper
    reporting of merchandise sales — and the deducting
    of such exaggerated Instant Lotto sales from total
    sales, thereby under reporting merchandise sales to
    the extent of the exaggerated sales. June 24 Tr.,
    at 19-20, 26-28, 84-85, 107-116, 142-43; Pl.Ex. 8.
  9. The scheme operated as follows, by way of example.
    If total sales, in a hypothetical day, were $3000,
    of which $500 represented actual Instant Lotto
    sales, the proper reporting would be: total sales
    less Instant Lotto sales equals total merchandise
    sales ($3000 less $500 equals $2500). Under the
    franchise agreement, Southland and the franchisee
    would

    share in the gross profit (merchandise sales less
    cost of goods sold) on the $2500 in merchandise
    sales. June 24 Tr., at 19-20, 26-28, 84-85,
    107-116, 142-43; Pl.Ex. 8.
  10. The scheme at Froelich's store involved the
      intentional exaggeration of Instant Lotto sales.
      Using the previous example as the correct method
      of reporting, Froelich would add an arbitrary
      amount, in this example $300, to the actual
      Instant Lotto sales of $500. This exaggeration
      would result in the deduction of $800 of Instant
      Lotto sales (instead of $500) from the
      merchandise sales: total sales less the inflated
      Instant Lotto sales equals (false) merchandise
      sales ($3000 less inflated amount of $800 equals
      false merchandise sales of $2200). Thus,
      Southland and the franchisee would share the
      gross profit only on the $2200 in reported
      merchandise sales, but not the gross profit on
      the diverted $300 in merchandise sales. June 24
      Tr., at 19-20, 26-28, 84-85, 107-116, 142-43;
      Pl.Ex. 8.
  11. As a result of Froelich's intentional
      understatement of merchandise sales, a
      non-curable Notice of Termination was delivered
      to Froelich on February 26, 1997. Pl.Ex. 2-5.
  12. The material breaches of the franchise agreement
      identified by Southland in the February 26, 1997
      Notice were that Froelich had devised and
      implemented a scheme, "utilizing fraudulent Lotto
      `post-voids,' . . . to divert funds to your own
      account, which would otherwise have been part of
      the deposited Receipts, thereby depriving
      7-Eleven of its rightful share of the Gross
      Profit in respect of the unlawfully diverted
      funds." Pl.Ex. 2-5, ¶ 3.
  13. The effective date of termination was recited in
      paragraph 8 of the Notice of Termination as
    the date of your receipt of this Notice of Material
    Breach and Termination, provided, however, that if
    it should be determined by a court of competent
    jurisdiction that this Notice of Material Breach
    and Termination is not effective immediately upon
    your receipt thereof, it shall be effective at 4:00
    p.m., March 5, 1997 or three (3) Business Days
    following the delivery to you of this Notice,
    whichever is later.

Pl.Ex. 2-5, ¶ 8.

  14. At Froelich's request, the March 5, 1997 date was
      deferred to March 7, 1997. Pl.Ex. 1, Affidavit of
      Robert Cadigan ("Cadigan Aff."), April 8, 1997, ¶
      9.
  15. Southland continued to investigate Froelich's
      store operation, at Froelich's request, to
      determine whether there was any basis for
      Southland to change its mind regarding the
      termination of the franchise agreement. Cadigan
      Aff., ¶ 10.
  16. On March 26, 1997 Froelich's attorney was
      notified that grounds for reconsideration of the
      termination did not exist, and that Southland
      intended to file a complaint in federal court the
      next day. Id.
  17. Southland filed its complaint in this Court on
      March 27, 1997 and submitted an Order to Show
      Cause on April 8, 1997 seeking preliminary
      injunctive relief.
  18. Southland is the largest operator and franchiser
      of convenience stores, with a worldwide network
      of over 14,000 7-Eleven company-operated and
      franchised locations. In the United States and
      Canada, there are approximately 3,000 7-Eleven
      stores that are operated by individuals under
      franchises granted by Southland. Cadigan Aff., ¶
      17.
  19. Southland requires, and the franchise agreement
      for each store provides for, accounting systems
      and controls that are designed to provide
      accountability for the operation of the store, as
      well as to determine and account for the "equity"
      position of the franchisee, i.e., the
      franchisee's Net Worth in the store's operations,
      which the franchisee is obligated to maintain
      above a certain minimum level. Cadigan Aff., ¶
      17.
  20. The franchisee's Net Worth is defined in the
      franchise agreements as "the cash register fund,
      the Cost Value of the Inventory, Store supplies,
      receivables, prepaids, refundable deposits, and
      any portion of the initial cost of an alcoholic
      beverage license employed in FRANCHISEE's
      operation of the Store which is charged to the
      Open Account and carried on the Bookkeeping
      Records . . .; less FRANCHISEE's payables and
      accruals from FRANCHISEE's operation of the
      Store, as reflected on the Financial Summaries."
      Pl.Ex. 2.-2, Exh. E.
  21. Southland exercises great control over the
      selection of store sites and their subsequent
      operation. For example, Southland selects the
      location of each store, purchases the land and
      constructs the store, or leases an appropriate
      structure, and prepares the store for operation,
      including the provision of all equipment
      necessary for it operation. Such equipment
      includes shelves, counters, cash registers,
      lighting and other fixtures, heating and cooling
      equipment, signs, and parking lot preparation.
      Cadigan Aff., ¶ 18.
  22. Each store generally represents an investment by
      Southland of hundreds of thousands of dollars by
      the time it opens. Under the franchise agreement,
      a franchisee is leased the store and equipment,
      and is licensed to use the 7-Eleven Service Mark,
      related trademarks, trade dress and system of
      operations, which licenses automatically
      terminate upon the end of the franchise
      relationship. Cadigan Aff., ¶ 18.
  23. Pursuant to the terms of the franchise agreement,
      the franchisee does not acquire ownership of the
      store, its premises or any of the physical plant.
      Rather, these remain the property of Southland.
      The franchisee's ownership interest is in the
      store's inventory, and the franchisee's primary
      ongoing financial interest is in the Net Income
      derived from the store's operations, which the
      franchisee draws against on a weekly basis.
      Cadigan Aff., ¶ 19.
  24. The term Net Income is defined in the franchise
      agreement as "Gross Income less operating
      Expenses." Pl.Ex. 2-2, Exh.E.
  25. Southland's financial interest is in receiving a
      percentage of the "Gross Profit" (Net Sales less
      Cost of Goods Sold) derived from operation of the
      store, which percentage is designated in the
      franchise agreement as the "7-Eleven Charge." The
      Net Income in which the franchisee has an
      interest, as mentioned above, is the amount
      remaining after deducting "Operating Expenses"
      (such as payroll and similar expenses) and the
      7-Eleven Charge from the Gross Profit. Operating
      Expenses do not include certain store repairs,
      replacement of equipment, insurance, real
      property taxes, any rental charge, electricity,
      heat or other utility costs, all of which are
      borne by Southland. Cadigan Aff., ¶ 20.
  27. Thus, prior to opening a store, a franchisee
      purchases an initial inventory, with the
      franchisee paying only part of the purchase price
      from his funds and Southland financing the
      balance. The amount financed by Southland and
      owed by the franchisee to Southland is maintained
      in an account known as the "Open Account."
      Subsequent purchases, expenses and revenues flow
      through the Open Account. Essentially, the Open
      Account is a running working capital account
      reflecting the cash operations of the store. The
      balance of the Open Account at any given time
      represents the amount of money that Southland has
      loaned or advanced to a franchisee to finance the
      operation of the store. Southland reserves the
      right to terminate its financing at any time.
      Cadigan Aff., ¶ 21; Pl.Exhs. 2-2 and 2-16.
  28. After operation of a store commences, a
      franchisee must ring up accurately, on cash
      registers provided by Southland, all sales of
      merchandise (with those transactions that are
      subject to sales tax and those that are not being
      separately identified), money orders, cigarettes,
      all cash payments to vendors and casual labor,
      and all other cash transactions. Cadigan Aff., ¶
      22.
  29. A franchisee also is required to deposit on a
      daily basis the cash received from each day's
      operation of the store. These deposits are made
      to a bank account designated by Southland and
      Southland credits the franchisee for the deposits
      which are applied in reduction of the outstanding
      balance of the Open Account. Cadigan Aff., ¶ 23.
  30. A franchisee is further required, under the
      Franchise Agreement, to furnish Southland with a
      daily "Cash Report" indicating the amount of
      sales for the day, the amount of cash deposited,
      and any additions or bona fide ...

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