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Lawsuits signal rite of passage for burger chain.

AFTER SEVERAL YEARS OF ENJOYING ENTHUSIASTIC response to its gourmet burgers and chicken sandwiches, Memphis, Tenn.-based Back Yard Burgers Inc. appears to have encountered the underbelly of success as it gears up to fight four, and possibly more, franchise lawsuits.

The litigation comes at an especially inopportune time for the young company, which has been seeking to generate interest in its stock through promotional meetings with brokers. The stock, which went public in June 1993, trades on the NASDAQ Small-Cap Market and on the Chicago Stock Exchange.

The four suits, all filed around mid-to-late August by Little Rock lawyer Tim Dudley, allege that the company engaged in deceptive trade practices in violation of Federal Trade Commission regulations.

One suit, filed by Theresa Webb, a black North Little Rock resident who owns a franchise in Austin, Texas, also alleges racial discrimination by the company and sexual harassment by a district manager. Little Rock lawyer John Walker is handling that aspect of Webb's suit.

Dudley says the lawsuits generally have two common threads.

"One is all of the franchisees tell basically the same story about what representations were made to induce them to enter into the franchise agreement, so I think misrepresentation is one common thread," he says. "The other is that they all tell the same story about being forced to use suppliers that Back Yard Burgers told them to use, and we're contending that that's a federal antitrust violation."

Other allegations are that the company did not pass on expected rebates from certain suppliers and that it failed to properly use advertising fees. Dudley says advertising has been mostly confined to areas such as Little Rock, where there are corporate stores.

BYB Chairman and Chief Executive Officer Lattimore M. Michael says the company isn't responding specifically to the allegations, but plans to fight the suits.

"I'll just say that I think there's no merit to any of those allegations," Michael says. "And we're going to be filing a response, which will be a public document at that time, and would love for you to look at our responses and see what our answers are."

Michael says the company should file a legal response in the next week to 10 days.

In addition to Webb, lawsuits were filed by Jerry and Helen Morrison of Russellville and Chris Powell of Brownsville, Tenn. Scott Townsend, a Las Vegas franchisee, filed a counterclaim to a suit filed by BYB that alleged non-payment of royalties and trademark infringement. With the exception of Powell, each franchisee has one restaurant. Powell has two stores in Fort Walton Beach, Fla., and one in Pensacola, Fla.

There could likely be more suits.

"It looks like I'm going to file at least one more case, and I've had feelers from two or three other franchisees," Dudley says.

Although the lawsuits don't seek a specific dollar amount in compensation, Dudley estimates that his clients probably have lost $350,000-$500,000 each. Dudley, who recently left the well-connected firm of Wilson Engstrom Corum Dudley & Coulter for private practice, is reportedly handling the lawsuits on a contingency basis, though he won't comment on that.

Among the specific allegations in the suits are that franchisees were told they could start a franchise for about $325,000 and could expect to gross about $750,000 annually in sales. The representations allegedly were substantiated by the presentation of sales figures from other franchises.

Dudley says the franchises typically cost about $100,000 more than his clients were led to believe. He contends the representation made by BYB violated FTC regulations because the numbers were presented without a disclaimer.

The franchisees also contend that they were directed to purchase equipment and other supplies from designated suppliers, representing a "tying arrangement," in violation of federal law.

The BYB franchise agreement states that other than three food preparation items, franchisees are not required to purchase items from BYB or a suggested source. But Dudley says the contract was circumvented because another portion of the agreement says supplies can only be bought from approved suppliers, "and they would approve one supplier."

"I have one client who actually presented them with another supplier, exactly the same product, lower prices and they wouldn't approve it," he says.

Principals of Back Yard Burgers have ownership interests in at least two of the companies that are mandated or approved suppliers to the company. Michael and his father are the sole owners of Michael's Enterprise Inc., which owns the rights to Miz Grazi's spicy hot sauce that is used on a number of the company's food items. MEI sells the sauce, one of the three food items franchisees are required to purchase, at $25 a gallon to corporate and franchised restaurants.

The company's president, Joseph Weiss, has what Michael describes as a "minority interest" in American Modular Industries Inc., a company that manufactures many of the modular buildings that house BYB stores.

Although such arrangements are not unusual, especially among food and restaurant companies, stock brokers and shareholder watchdog groups generally frown on these "related party transactions," believing they can obscure underlying operating problems and aren't in shareholders' best interest.

Terminations Sought

Since the filing of the lawsuits, BYB has taken action to terminate the franchise agreements of all of those who have filed suits. Dudley is responding with injunctions in each case, excluding Townsend's.

Termination of the agreements of Webb and Townsend were initiated before they filed suit, but the Morrisons and Powell received notice of termination after filing. The stated reason for termination in all four cases was that the franchisees were behind in royalty payments, which Dudley acknowledges, but he believes the action was retaliatory because he doesn't think other delinquent franchisees have faced revocation.

Michael says he doesn't know how many franchises are behind in royalty payments. The company now has about 40 franchises and about 20 corporate stores.

He also notes that the restaurant company has "a lot of happy and successful franchisees" that are very supportive of the company.

The suing franchisees have, for the most part, not had much success with their stores. Powell, a franchisee since 1991, told Bloomberg Business News that he lost about $150,000 last year. Webb, a franchisee since June 1993, may be the exception. She says her store's sales have fared better than many, with gross sales last year of $825,000.

The Little Rock area stores, some of which have annual sales in the million-dollar range, have been among the most successful in the BYB system. In fact, the company's IPO, which raised about $8.9 million, enabled it to pay top dollar for the two largest franchises, Memphis and Little Rock. Subsequently, the owners of those two franchises, Weiss in Memphis and Tommy Hilburn in Little Rock, joined the company's board of directors.

In addition to the lawsuits, Back Yard Burgers is facing a particularly competitive period in the quick-service food industry, causing forced food prices to be driven down and negatively impacting operating margins. The company had an operating loss of $171,000 last year, compared with an income from operations of $1,000 in 1992.
Financial Snapshot

Back Yard Burgers Inc.
(in thousands, except per-share amounts)

 For Year Ended
 Jan. 1, 1994 Dec. 31, 1992

Total Revenues $5,935 $2,722
Operating Income (loss) (171) 1
Net Income 22 65
Net Income per share $0.01 N/A

Source: Annual Report

Also, controversy has enveloped the firm that handled BYB's initial offering, Franklin-Lord Inc. of Scottsdale, Ariz., which has been called to answer for alleged securities law violations. According to an Aug. 1 article in The Wall Street Journal, the firm and individuals associated with it have been charged by the Arizona Securities Division with "conspiring to 'rig' placement of an initial public offering so as to reap profits from subsequent trading."

The Securities Division is alleging wrongdoing in the case of two of five stocks underwritten and recommended by Franklin-Lord, of which BYB is one. But John Augustine, counsel for the division, says, "Our allegations don't relate to the Back Yard Burgers offering at all."

He wouldn't comment on whether his division is looking or has looked into Franklin-Lord's conduct in relation to the other companies. The Journal reported that in all five cases, the stocks have climbed, then weakened.

Michael says he's confident there is no suspicion regarding Franklin-Lord's handling of BYB.

"Those are investigations of Franklin-Lord, not an investigation of BYB," he says. "We were assured by the [Securities and Exchange Commission] that we're not under investigation."

The allegations facing Franklin-Lord, however, form just one more boomerang Back Yard Burgers has to duck as it tries to become consistently profitable and develop more widespread acceptance in the investment community.

In a sense, the litigation would appear to signal that the company is coming of age.

"It sounds like the kind of trouble Back Yard is having is some of the typical kind of events that happen with smaller franchise companies," Bloomberg quoted Allan Hickok, an analyst with Piper Jaffray Inc., as saying.

Michael expresses a similar sentiment.

"It is, from what I hear, almost inevitable at some point -- something like this happening," he says.
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Title Annotation:Back Yard Burgers Inc.
Author:Walters, Dixie
Publication:Arkansas Business
Date:Sep 12, 1994
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