Tag: franchise fraud

“Earnings Claims” Regulation – Public Comments Help Prevent Unfair Restrictions

October 13th, 2016

Takeaway: Demonstrating our value to early stage franchisors, WTP public comments help eliminate proposed regulations that would have prevented new franchisors from providing profit information.

Generally speaking, the most important type of information that a franchisor can provide to prospective franchisees concerns the profits earned by businesses operating under their brand.  This type of information, as well as information on gross revenues, is called a Financial Performance Representation (“FPR”) or “earnings claim” under the laws governing franchise sales in the United States.  Unfortunately, while the FTC Franchise Rule requires certain disclosures to prospective franchisees (through provision of a Franchise Disclosure Document or “FDD”), and requires that any FPR that a franchisor provides be included in Item 19 of the FDD, it does not provide substantive guidance on what can and cannot be provided in an FPR.  Instead, it simply requires that there be a “reasonable basis” for providing that information to prospective franchisees.

While the FTC does not require filing and approval of the FDD prior to selling franchises, several U.S. states require that the FDD be reviewed and approved before a franchise is sold in that state (a process called “registration”).  Among the most prominent registration states are California, Illinois, New York, Maryland and Virginia.  Those states’ review of FDDs are informed and guided by policy statements issued by the North American Securities Administrators Association (“NASAA”), of which each state’s franchise regulatory authority is a member.  Since 2015 NASAA has been considering issuance of a Financial Performance Representations Commentary.

The original proposed FPR Commentary, issued for public comment on October 1, 2015, contained many useful provisions.  However, proposed Section 19.7 would have drastically interfered with new franchisors’ ability to provide truthful, factual information to prospects.  It read:

19.7 Item 19 — FPR Disclosing Gross Profit or Net Profit of Company-Owned Outlets When Franchisor Has No Operational Franchises.

QUESTION: If a franchisor has no operational franchises, can the franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?

ANSWER: No. A franchisor with no operational franchises cannot make an FPR disclosing gross profit or net profit based on company-owned outlet data alone.

The proposed commentary’s reason for this blanket ban was a concern that franchisees are likely to incur higher operating costs than company-owned locations, and without operating franchisees the new franchisor would not have a way to know if its costs were lower (or higher) than franchisees would experience. Therefore, to provide net profit information to prospective franchisees based solely on the company-owned data would be misleading.

This proposed commentary, if enacted, would have severely limited the ability for the many early stage franchisors that we represent to compete in recruiting franchisees – which is already tough enough for a start-up! Moreover, while it is appropriate for the commentary to highlight issues that franchisors need to consider when deciding whether its FPR has a “reasonable basis” and is not materially misleading, an outright ban under all circumstances deprives prospective franchisees of information they wish to know.

Accordingly, on October 27, 2015 we submitted our public comments objecting to proposed Section 19.7 on those bases.  With our client’s approval, our comment included an early stage franchisor’s net profit FPR, redacted to remove the name of the franchisor and its principal owners.  The numerical presentation was accompanied by a paragraph explaining why revenues and expenses increased over a period of years, and also warning about the franchisor principals’ level of experience in the industry and therefore why its business performance probably would exceed that of new franchisees.  The public servant who leads the NASAA Franchise Project Group told the author that the example was “particularly helpful.”

On September 14, 2016, after lengthy internal deliberations among the project group members, NASAA issued a revised version of the proposed FPR Commentary for public comment.  While not specifically addressing comments received, what is notable is that former Section 19.7 no longer exists.  Instead, no distinction is made between franchisors with or without operating franchises, and rather new Section 19.10 reads in part as follows:

19.10 Item 19 — Gross Profit or Net Profit FPR Based on Company-Owned Outlets Alone

QUESTION: Can a franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?

ANSWER: Yes. A franchisor can make an FPR disclosing gross profit or net profit based on company-owned data alone if it has a reasonable basis to make the FPR and includes the following information: (a) gross sales data from operational franchise outlets, when the franchisor has operational franchise outlets; (b) actual costs incurred by company-owned outlets; and (c) supplemental disclosure or adjustments to reflect all actual and reasonably expected material financial and operational differences between company-owned outlets and operational franchise outlets. These differences consist of fees and other expenditures required by the franchise agreement, disclosed in the Franchise Disclosure Document, or that are otherwise known or reasonably should have been known by the franchisor.

The remainder of the answer explains the need to adjust the presentation to disclose franchise royalties and other fees that a company-owned outlet does not pay, and also to adjust the costs of goods sold upward if the company-owned locations receive more favorable pricing from suppliers than franchisees will experience. The latter is a tricky issue and new franchisors either will need to be very careful to make sure that actual franchisee pricing is the same, or increase the costs of goods sold by a specific percentage in the presentation and explain the basis for the increase in footnotes.

Nevertheless, this is a major win for new and early stage franchisors, since they are likely to retain the freedom to provide prospects the information that they desire and to compete in franchise sales. It was our pleasure to be able to influence this regulatory outcome in favor of companies that want to use franchising to grow their brand and create entrepreneurial opportunities in the U.S.A.

Appeals Court Upholds “Silent Fraud” Jury Verdict under Franchise Investment Law

June 10th, 2014
David Cahn

David Cahn

Take-away: If your franchise offering document is silent on key issues, you can be liable if your people “oversell” to a potential franchisee. Better to deal with the issue in carefully vetted writing than to be surprised by something your people say off the cuff.

The case: A recent Michigan Court of Appeals decision, reinstating a jury verdict against a cellular communications store franchisor, shows the potency of franchise investment and disclosure laws in protecting franchisees against misleading sales tactics, if the information provided does not contradict the franchise disclosure document presentation.

The facts: In Abbo v. Wireless Toyz Franchise, L.L.C., Abbo was a failed franchisee and area developer of cellular communications stores. Looking back, he alleged that an officer of Wireless Toyz provided misleading information in the “discovery day” presentation.

As background, you need to understand something about the business model of cellular franchises. Their profitability can be affected by “hits” (discounts given in the sale of phones); “chargebacks” that decrease store commission revenue; the franchisor’s bargaining power with cell phone carriers; the hidden costs of purchasing inventory from the franchisor; and ultimately the number of cell phone sales necessary to make a profit.

None of these issues was dealt with in any meaningful way in Wireless Toyz’s franchise disclosure document (“FDD”). Since the FDD was silent, that left wide areas about which prospective franchisees could ask for additional information, and left the franchisor’s executives, eager to sell franchises, vulnerable to providing answers outside the FDD. In this particular case, the franchisee directly asked a senior franchisor executive about revenue deductions from “chargebacks” and “hits,” and the franchisor executive apparently said that chargebacks constituted “only five to seven percent” of total commissions and that Wireless Toyz stores outside of Michigan (the home state) had been “subject to only ‘very minor’ hits.”   In fact, neither statement was accurate.

The FDD’s Item 19 Financial Performance Representation said that there were 181 average new activation contracts each month, and an average of $222.31 in commissions per activation. However, the presentation did not mention “hits” or the minimal amount of revenue (net of the cost of cellular devices) earned by the stores, and it also did not detail the extent of chargebacks and how they impacted the actual net commissions earned per activation.

After a jury trial, the jury found that the franchisor had failed to provide material facts necessary to make the FDD’s statements not misleading under the circumstances of their presentation, and also that it was liable for creating false impressions when responding to the prospective franchisee’s direct questions regarding “hits” and “chargebacks.” The Michigan Franchise Investment Law (like its statutory cousin, the Maryland Franchise Registration and Disclosure Law) creates an affirmative legal duty to disclose all material facts necessary to avoid creating a false impression.

In this case, Wireless Toyz made a corporate decision not to provide information on the extent of chargebacks in Item 19 of the FDD, even though that information was clearly relevant to the picture of commission revenue generated per activation. The “gasoline on the fire” in this case was the “five to seven percent” estimate provided by the franchise salesperson in response to a direct question.

Initially, despite the jury’s findings, Wireless Toyz came out ahead: the trial court overturned the jury verdict because of the following, very common, franchise agreement provision:

Except as provided in the [Disclosure Document] delivered to the Franchise Owner, the Franchise Owner acknowledges that Wireless Toyz has not, either orally or in writing, represented, estimated or projected any specified level of sales, costs or profits for this Franchise, nor represented the sales, costs or profit level of any other Wireless Toyz Store.

The jury concluded that, despite this language in the contract, Abbo was reasonable in relying on the verbal statements on matters not addressed in the FDD. Moreover, because the verdict was for misleading omissions, the jury presumably found that the failure to provide additional clarifying information both in and out of the FDD presentation was what misled the franchisee.

The appellate court agreed with the jury, not the trial judge.

There was a dissenting opinion at the appellate level, and it is likely that Wireless Toyz will seek to have the Michigan Supreme Court review the decision. However, that court is not obligated to do so and may not want to substitute its opinion for that of the jury. As in many franchise cases, Wireless Toyz’s chances were not terribly good once it allowed a jury to deliberate regarding its actions.

In an era when about two-thirds of franchisors now provide written financial performance information in their FDD, this decision is an important reminder to franchisors of the risk of providing only partial information in the FDD – particularly if the franchisor has access to accurate (if not necessary encouraging) information on unit-level expenses or deductions from revenue.

For example, in a quick service food system, if a franchisor has a standard accounting system, then it should have access to franchisees’ costs of ingredients and packaging supplies as well as their labor costs. (And, since the franchisee will use these figures to calculate its tax deductions from gross revenue, the amount of those costs probably will not be understated.)

That sort of information is important to prospective franchisees and is almost certainly data that they will seek from the franchisor. It is better to disclose fully in the FDD instead of hoping your salespeople don’t get asked about it or that, if asked, they answer accurately.

Restaurant and retail franchisors: could this be you in 2014?

January 3rd, 2014

The case of Wojcik v. Interarch, Inc., currently pending in the U.S. District Court for the Northern District of Illinois against the fast casual restaurant franchisor Saladworks, LLC, contains a factual scenario that should serve as a valuable reminder for existing franchisors who are updating their Franchise Disclosure Document (“FDD”) for use in 2014, for companies beginning the offer of franchise rights, and for prospective franchisees who are investigating opportunities.   Bottom Line: Franchisors need to be careful not to underestimate site development costs, ongoing operating costs, and the challenges of opening locations in geographic areas not familiar with their brands. 

During 2011, one of the plaintiffs, David Wojcik of suburban Chicago, investigated development of a Saladworks franchise restaurant.   Saladworks is based in suburban Philadelphia, and the bulk of Saladworks locations are within 250 miles of Philadelphia.  When Mr. Wojcik attended Saladworks’ “Discovery Day” to learn more about the franchise, Saladworks’ executives took him to their “Gateway” location, which they described as being typical in terms of physical appearance and menu offerings.   They also told him that Saladworks’ designated commercial real estate firm Site Development, Inc.  (“SDI”) and a designated architecture firm would help Wojcik find a location and design his restaurant.

After reviewing the FDD and going to “discovery day,” Mr. Wojcik convinced his wife Denise that they should sign the franchise agreement and that she should invest $90,000 that they used to purchase a single franchise license plus multi-unit development rights in suburban Chicago.  However, it cost the Wojciks substantially more to open their first Saladworks location than the estimated initial investment cost stated in the FDD, and the business failed within six months – both opening and closing during 2012.

The court decision, denying Saladwork’s and SDI’s motions to dismiss for the most part, is interesting on a couple of legal grounds, including the court’s holding that Saladworks could have violated several franchise agreement provisions by failing to “exercise its discretion in good faith,” and also holding that the site selection firm SDI assumed legal duties to the franchisee not to misrepresent its qualifications to provide site selection advice in suburban Chicago.  However, more instructive are the failed franchisee’s factual allegations concerning representations made to induce its franchise purchase, including those in the FDD.  As the court wrote:

“According to Wojcik, Saladworks misrepresented, among other things, that:

A. “Saladworks had the experience and expertise to support a franchisee’s introduction of its brand in the Chicago market and that Saladworks would be committed to success in this market”;

B. “Wojcik’s Illinois restaurants would basically replicate what he saw on discovery day at the Gateway Restaurant”;

C. InterArch and SDI “would be . . . strong positive factor[s]” in helping him develop his restaurants;

D. Wojcik “would receive a `standard location,'” thus making the financial information Saladworks included in its FDD for franchised restaurants at “standard locations” relevant and meaningful for him.

Wojcik also alleges that Saladworks omitted a number of material facts, including the following:

(1) Saladworks based the projected construction costs disclosed in its FDD on “site locations that did not require any substantial changes in use, e.g., that . . . previously [had] a restaurant on the site. . . .”

(2) “[W]ithin any market there can be material differences between particular sites that will substantially affect the performance of any particular franchise, such that, by inducing franchisees to believe that he or she would receive a `standard location,'” the franchisee was being misled and deceived into believing that SDI and Saladworks had developed some sort of process that eliminated the risk of poor site selection. . . .”

(3) InterArch—Saladworks’ designated architect—”had insufficient familiarity with the local building codes of Schaumburg or the other Illinois communities in which Wojcik was planning to build and InterArch was not licensed in Illinois.”

(4) “[The Saladworks] brand was most successful in a core market area, which included the area covered by an approximate 250-mile radius of Philadelphia. . . . [but] beyond the core market area, most of [Saladworks’] franchises were substantially under-performing in relationship to those that were located within the core market area,” thus making Saladworks’ disclosures about the financial performance of franchised restaurants at “standard locations” deceptive and misleading to a franchisee in Illinois.

(5) The two restaurants for which Saladworks supplied information about average operating costs obtained free labor from new franchisees in training, thus making the average operating costs Saladworks disclosed in its FDD materially misleading.

(6) Saladworks “did not intend to do `brand development advertising’ in Illinois,” and thus, a franchisee in Illinois would receive no benefit from its required contributions to Saladworks’ “Brand Development Fund.”

(7) InterArch, Saladworks’ designated architecture firm, charged a $5,000 “supervision fee,” in addition to its design fee, if the franchisee chose to have InterArch supervise construction of the restaurant.”

This case decision was in the context of Saladworks’ and SDI’s motions to dismiss (the architect, InterArch, had already settled), and many of the allegations recited above may not survive a motion for summary judgment on the failed franchisee’s misrepresentation claims.  For example, as the court also points out, the franchise agreement specifically warned the franchisee that its “Brand Development Fund” contributions did not have to be used to promote the franchisee’s restaurant (as opposed to other System restaurants), and a franchisee in a new region typically should negotiate that point.

However, some issues that renewing franchisors should carefully consider are:

(i) Do franchises outside of your core geographic area struggle, as compared to those in the core?  If so, your Item 19 Financial Performance Representation probably needs to highlight those differences and conspicuously warn prospects considering a franchise that would operate outside of “the core.”

(ii) If your Item 19 disclosure includes operating costs disclosures, are those impacted at all by the use of trainees in place of paid staff?

(iii) if you feel it is necessary to designate a commercial real estate company or architecture firm, be careful about how you promote their abilities, and consider (a) requiring the real estate firm to work with a local firm with whom it would share its fees, and (b) for states where the architect is not licensed, consider allowing the franchisee to select alternative architects upon payment of  a modest review fee to your designated designers.

(iv)  Are your Leasehold Improvement or construction estimates in Item 7 based on certain positive assumptions?  If so, carefully disclose them, and consider whether the high estimate should not include those optimistic assumptions.

From the point of view of a prospective restaurant or retail franchisee, the lesson of this case is to show the kinds of issues you should carefully consider in your due diligence before purchasing a franchise.   While litigation may help you recover if the franchisor is not completely truthful, better to figure it out beforehand!

How Can You Know If Your Business Is Ready To Franchise?

January 2nd, 2014

David Cahn

David Cahn

Do you think you’re ready to make your business a franchise? Ready to become the next Subway or Jiffy Lube? In this column, I’ll outline some key factors to consider as you make the important decision of whether and when to franchise your business methods. 

Becoming the owner of a franchised business (as the “franchisee”) can be a great option for someone who has entrepreneurial skills and motivation but doesn’t want to start a business “from scratch.”  But before you take the plunge and dive headlong into becoming a franchisor, it’s important to keep in mind the most important factors that will determine your success.

Signs That Your Business Is Ready To Franchise

The first hurtle to “franchise-ability” is whether your business has been consistently profitable over a substantial period of time.  Typically, if your business is in a mature industry, such as food service or printing, you need to have been in business at least three years and have a steady record of profits. You should also have multiple separate locations to disprove that notion that it’s only a local success.

A different rule applies to “new” industry or niche businesses. If a business presents a truly unique and innovative operating method, and has shown some profitability, then it may be in the business’ best interests to franchise quickly to gain regional recognition as the leader for that niche. For example, a fitness company that offers a new type of program and that has been developed locally should try to get into the market quickly and establish themselves as the dominant brand for that niche.

The second hurtle is having developed a business system that you can teach to franchisees and can be easily replicated in other locations.  Disclosures that must be given to prospective franchisees under U.S. and state laws have essentially mandated that a franchisor prepare some sort of “Operations Manual” to loan to active franchisees, and also that it plan out a new franchisee training program in advance of offering franchises.   Therefore, before franchising you need to carefully document both how to develop and operate the business you want to franchise, and also plan how you will train others to replicate your methods.

Another important question is whether you have a business name and/or logo that can obtain and maintain trademark protection.  Having a “strong Mark” for both marketing and legal purposes is very important to the long-term success of a franchise system, and if that factor is not present then you should carefully consider whether to re-brand and obtain trademark registration in advance of franchising.

Last but not least, will your prospective franchisees be able to obtain the capital that they need to open and operate franchises?  A prospective franchisor needs to talk with its bankers to develop a profile for a suitable franchisee that will have sufficient net worth (both total and liquid) to be able to personally qualify for financing.  You should then obtain informal commitments from financial institutions to finance candidates who have meet those qualifications and secure suitable locations or geographic territories from which to operate the franchise. You should consider what financing, if any, you would be willing to provide to new franchisees as part of a package to help them obtain a bank loan.

Franchising vs. Other Methods of Expansion

The main advantage that franchising has over expanding a business on your own is that you get to invest other people’s time, skills, and money to growing the business instead of borrowing against your business and personal assets or granting stock to outside investors. Having franchisees allow a business to play off of a diverse pool of talent that may attract different types of people to the business.

Many businesses have found that, by granting franchises, they can recruit talented individuals who will be driven to tremendous lengths to make their business a success. While incentives to the managers of company-owned remote locations can drive good short-term results, franchisees who risk their net worth on the enterprise have the ultimate incentive to develop the businesses for long-term profitability.

As the franchisor, your business will be less likely to be held liable for any claims of personal injury or employment discrimination that that may happen on the premises of a franchised unit, as opposed to one opened with borrowed or equity capital. Making sure that this liability shield is effective takes careful planning, but when properly executed it is a substantial benefit of franchising.

It’s not all good news however. After outside lenders or investors are repaid, company units may yield more profit to the brand founder than franchises. It can be more difficult and costly to terminate a misbehaving franchisee than a location manager. Finally, company owned units located near franchises could suffer revenue losses through competition with the franchises.

So You’ve Decided to Franchise…

With all of that in mind, and you’ve decided that your business is ready to franchise, there are a few things you should do before looking for your first franchisee.

  1. Develop the operating manual and training plan. Owners often create these items with the help of a consultant and with overall legal guidance.
  2. Put money aside. A thoughtful and responsible business owner should have at least $100,000 available for franchising purposes, including legal, development of training programs and operations manuals, and advertising for franchisees (both creative and placement). Also, a shrewd businessman might put away that money, spend half on the aforementioned items, and keep the rest on hand to show sufficient capitalization to obtain state franchise registration on favorable terms.
  3. Be prepared to do some hand-holding. Business owners that are looking to franchise need to be realistic when they look at the additional operating costs of getting a franchise up and running. They must spend money and time recruiting and supporting the new franchisees. Time away from the core-business means money for managerial costs for the original businesses that form the “prototype” for the franchises.

Conclusion

Potential franchisors need to accept that franchising successfully will require some short term sacrifices in terms of time and money. Done correctly and thoroughly can mean the growth of your business to larger regional or national markets. Improperly, underfunded, and rushed could mean the loss of the business entirely. Early investment in franchise resources and assistance will give the business a better chance at success and growth within your industry.

ABA Forum on Franchising’s “Wizard” proposals do not address arbitration issue

December 30th, 2013

At the October 2013 American Bar Association Forum on Franchising Convention, the keynote program was entitled “If I had a Wizards’s Wand” and concerned what each of the four presenters would change about franchising and the law, if they could. Rochelle “Shelley” Spandorf’s proposals as part of that program are summarized by reporter Janet Sparks in this BlueMauMau.com article . While Ms. Spandorf’s proposed changes are wonderful as far as they go (if not magical), unfortunately she did not clearly address one of the most important dispute resolution issues in the U.S. legal system, including franchising; the use of mandatory pre-dispute arbitration clauses to blunt weaker parties’ access to civil justice.

Aspects of Shelley’s proposals that seem particularly commendable are requiring all new franchisors to have some base of experience, creating a uniform national regisry of franchise sales registration, mandating the provision of a financial performance representation, and freeing states’ attorney generals to puruse enforcement rather than adminiistering a registration system. Moreover, while such legislation might appear to be substantially more burdensome to franchisors than the current legal regime of franchise sales regulation, the reality is that, even in the so-called “non-registration states” most franchisees do have the ability to pursue private civil actions for material violations of the FTC Franchise Rule; for example, see Final Cut, LLC v. Sharkey, 2012 Conn Super. LEXIS 98, 2012 WL 310752 (Conn. Superior Ct., Jan. 3, 2012) (franchisee prevails under Connecticut Unfair Trade Practices Act in claims that franchise sales were made in material violation of the FTC Franchise Rule).

However, on the issue of dispute resolution, it is unclear whether the proposal that U.S. federal courts have “exclusive jurisdiction” over U.S. franchise law claims would mean that franchisors could not require arbitration instead of court proceedings. This is particularly important with regard to the ability of franchisees to pursue group or class actions. Through many Supreme Court decisions authored by conservative justices, as well as legislation passed by Republican Congressional majorities, plaintiffs seeking class certification face a rigorous burden in U.S. courts. As many an attorney can attest, there are myriad difficulties (both ethical and practical) in representing substantial groups of franchisees pursuing common claims. However, in appropriate circumstances where common questions of fact predominate, particularly on liability, use of a group or class action is the most efficient (and sometimes the ony practical) way for parties who have suffered grievous financial losses to seek a remedy. Supreme Court decisions have made it extremely easy for parties to bar class or group actions by inserting an arbitration clause in their form contracts and refusing to remove them.

While reforms freeing state attorneys’ general to focus on claims enforcement might help improve failed franchisees’ access to justice, experience shows that attorney generals tend to focus on relief for large number of consumers rather than smaller numbers of small business owners. Unless a federal franchise law contains an express exemption from the Federal Arbitration Act for disputes between franchisors and franchisees, its benefits for franchisees may prove to be illusory.

Severe Consequences for Franchisor Executives: Personal Liability and Non-dischargeable debt

July 16th, 2013
David Cahn

David Cahn

“Do not pass Go, do not collect $200” is a phrase we all remember from the childhood game Monopoly. Like Monopoly, state franchise sales laws have rules and regulations that must be followed. A franchisor’s failure to follow these basic procedural rules for selling franchises can result in self-destruction.

On December 10, 2012, a decision in the case of In Re. Butler demonstrated a strict approach on the policy and procedures that a franchisor must follow for selling a franchise. The U.S. Bankruptcy Court sitting in North Carolina ruled that the owners of a franchise were personally liable to a franchisee for $714,000 plus interest in damages for violating the New York Franchise Law. The court further ruled that the franchise owners’ liability was non-dischargeable in bankruptcy.

Michael and Kathy Butler opened a small retail store to serve the marketing needs of small businesses. After much success, the Butlers formed PRS Franchise Systems LLC (“PRS”). Based in North Carolina, PRS Franchise handled all of the franchising for the PR Stores. PRS had obtained a one year license from New York to sell franchises to its residents, but subsequently PRS did not renew its New York registration on an annual basis.

In 2007, John Mangione, a New York resident, expressed interest in purchasing 20 PR Store franchises in the New York area. Because of Mangione’s interest, PRS submitted an application to renew its registration to sell franchises in New York. Before receiving approval of its renewal application, PRS sold 20 PR Store franchises to Mangione and received $716,000 in initial franchise fees between April and July 2007.

The franchise relationship was not to Mangione’s satisfaction, most of his PR Store locations were unsuccessful, and he ceased operating them by 2009. The Butlers also had a reversal of fortune and by 2009 they had dissolved PRS and filed for bankruptcy.

The Butlers argued that they were permitted to engage in franchise sale transactions while the application of renewal for registration was pending under New York Law. The court rejected this argument on the grounds that, while New York law does permit franchisors to sell franchises while renewal applications are pending, the law also requires the franchisor to give the buyer its last registered offering prospectus (also commonly known as the franchise disclosure document, or “FDD”), escrow the franchise fees paid in a separate trust account and then, once the renewal application is approved, provide the franchisee with the approved new prospectus and an opportunity to rescind the franchise agreement and have the fees returned. The court stated that even if PRS’ application was timely, PRS failed to escrow the initial franchise fees, provide Mangione with the registered prospectus after its approval in August 2007 and offer rescission as required by New York law. Instead, shortly after receiving initial franchise fee payments, PRS distributed the funds as sales commissions to its broker and as salaries for the principals of the company – the Butlers.

Because the Butlers directly engaged in the unlawful sale of the franchises to Mangione, and profited personally from his payments, the court found that the Butlers were personally liable to Mangione. The court stated that the remedies for an unlawful offer or sale of a franchise are: 1) rescission of the Franchise Agreement, 2) damages with 6% interest from the date of the transaction, and 3) reasonable attorney fees and costs. Therefore, the court found that Mangione was entitled to rescission of the franchise agreements and return of the $714,000 paid by him, plus 6% interest from May 7, 2007.

The next issue that the court addressed was whether the Butlers’ debt was dischargeable in bankruptcy. According to the court, a debtor’s debt is non-dischargeable if the money is obtained by “false pretenses, a false representation, or actual fraud.” The court found that the Butlers’ committed fraud by misrepresenting to Mangione that PRS had the legal right to sell franchises in New York, even though its registration was only pending, not approved. The court further stated that a debtor’s debt is non-dischargeable “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” The court stated that a debtor must prove: 1) the debt arose while the debtor was acting in a fiduciary capacity, and 2) the debt arose from the debtor’s fraud or defalcation. In this case, the court found that the Butlers’ failure to escrow the franchise fees, and their failure to return the funds to Mangione, each amounted to defalcation.

This case demonstrates the danger to the franchisor’s executives if their company fails to follow franchise sales rules. A violation of such rules can, without additional evidence of factual fraud or misrepresentation, result in those executives being held personally liable to the franchisee and being unable to obtain a discharge of that judgment in their personal bankruptcy proceedings.

AUTHOR’S NOTE: THIS POST WAS CO-WRITTEN BY KATELYN P. VU, A SUMMER ASSOCIATE AT WHITEFORD TAYLOR & PRESTON AND 2015 J.D. CANDIDATE AT UNIVERSITY OF BALTIMORE LAW SCHOOL

Another Court Ruling Shows Franchisors the Value of Providing an Item 19 FPR

May 10th, 2013
David Cahn

David Cahn

Takeaway: Franchisors cannot rely on disclaimers in the contracts and FDD to protect against claims of providing false financial information.

The Case: In a recent decision, Long John Silver’s Inc. v. Nickleson, decided February 12, 2013, the U.S. District Court for the Western District of Kentucky once again showed the danger of a franchisor relying on disclaimers in its contracts and the Franchise Disclosure Document (“FDD”) to defeat claims that it provided false financial performance information in selling a franchise. The court denied summary judgment for the franchisor of A&W Restaurants, Inc. (“A&W”) and will allow the franchisee’s claims of fraud and violation of franchise sales laws to be decided at trial. The case is particularly noteworthy because the franchise purchased was the claimant’s fourth from the same franchisor.

A&W’s FDD had what is known a “negative disclosure” in Item 19 concerning the provision of information about the sales or profits at existing franchises, specifically saying “[w]e do not make any representations about a franchisee’s future financial performance or past financial performance of company-owned or franchised outlets.” The Minnesota-based franchisee alleged that, in connection with considering purchase of a franchise to open a new “drive in” model A&W restaurant, the franchisor provided “information, including financial projections, which was laden with false data.” These allegations, if true, would mean that A & W provided a financial performance representation (“FPR”) outside of its FDD, in violation of federal and state franchise sales laws.

A&W followed the usual route of trying to get the franchisee’s claims thrown out before trial on the argument that, in light of the disclaimers in Item 19 of the FDD and in various parts of the franchise agreement, as a matter of law the franchisee could not “reasonably rely” on the information provided. The court rejected the argument that the disclaimers could be used to flatly bar the franchisee’s claim that A&W provided misleading information in violation of the Minnesota Franchise Act, because that law (like the Maryland Franchise Registration & Disclosure Law) contains a provision making “void” any waivers of conduct contrary to the franchise sales law. Instead, the franchisor will be permitted to use the disclaimers at trial as evidence to persuade the jury that the franchisee could not have reasonably relied on the “projections.”

The court also ruled that the disclaimers could not be used to deny the franchisee a trial on its claim of common law fraud (under Kentucky law) with regard to its allegation that the projections were based on false data about other locations’ sales or earnings. In the words of the court, “A broadly-worded, strategically placed disclaimer should not negate reliance as a matter of law where A&W allegedly shared objectively false data to induce Defendant to enter into the Franchise Agreement.” Therefore summary judgment was denied and the franchisee’s fraud claim will proceed to trial, with A&W potentially liable for punitive damages if the franchisee prevails on that claim.

Further thoughts: Given that the franchisee in this case already owned three other A&W restaurants at the time it purchased the franchise at issue, it would hardly be surprising if it demanded and received specific financial performance information about the other “drive-in” models. A logical question is, if A&W had included sales and earnings data in Item 19 of the FDD that it provided to this franchisee, would it have been less likely to have faced the allegations made in this case? In this author’s opinion, based on more than 15 years of representing franchisors and franchisees, A&W would have been in a better position to defend itself if it had included such data in Item 19. The reason is that the data would have been reviewed by A&W’s attorneys and probably by upper management, who would have been more likely to make sure that the presentation was accurate and not misleading. Once the presentation is in the FDD, most franchise salespeople will be less likely to “go off script” and provide information that is more optimistic than Item 19.

However, even if the franchise seller did provide information beyond the written FPR, at trial the franchisor would have been able to point to the data provided in Item 19 and say, “Look, we gave the franchisee the data in the FDD and made it easy for him to investigate further, so it is ridiculous to believe he relied on something are franchise salesperson said.” In that situation it may be more likely than not that the jury would agree with the franchisor. By contrast, by denying its franchise seller use of an Item 19 FPR, A&W made it difficult to both comply with the law and convince qualified candidates to purchase the franchise – setting up a scenario where a jury may believe that the franchise seller “went over the line.”

Sylvan Learning, Inc. Fighting Franchise Act Claim

April 24th, 2012

David Cahn

During 2012 Sylvan Learning, Inc. and its corporate affiliates are fighting a claim of violating of the Maryland Franchise Registration & Disclosure Law and fraudulent conduct in its sale of tutoring center franchise rights, after having its motions to dismiss the fraud claims denied by the U.S. District Court in Baltimore.

In Next Generation Group, LLC v. Sylvan Learning Centers, LLC, Case CCB-11-0986 (decided Jan. 5, 2012), the plaintiff franchisee alleged that he agreed to develop and operate a new Sylvan Learning Center in Irving, Texas, in reliance upon representations from Sylvan that it would sell the plaintiff two existing Centers in nearby Arlington and Allen, Texas. According to the Amended Complaint, those representations were made orally by Sylvan’s agent to plaintiff’s principal both before and after the plaintiff signed the franchise agreement for Irving, but several weeks before the Irving location opened, Sylvan’s agent advised plaintiff’s principal “in writing that Sylvan had approved his acquisition of the Arlington and Allen Learning centers, respectively.” The parties executed letters of intent for the sale of both sites about two weeks before the Irving Center opened. However, about three weeks after the Irving Center opened, Sylvan’s same agent “informed [plaintiff] that Sylvan would not sell him the license and assets for any more franchises.” According to the Amended Complaint, Sylvan provided no explanation of its reversal of course. The franchisee claimed that Sylvan fraudulently induced it to develop and open the Irving location.

Sylvan argued for dismissal of the claims on the basis that the Irving franchise agreement contained an “integration clause” that prevented the plaintiff from relying on promises made outside that written agreement. The court rejected this, by quoting a prior court decision stating, “[T]he law in Maryland … is that a plaintiff can successfully bring a tort action for fraud that is based on false pre-contract promises by the defendant even if (1) the written contract contains an integration clause and even if (2) the pre-contractual promises that constitute the fraud are not mentioned in the written contract. Most of our sister states apply a similar rule. Greenfield v. Heckenbach, 144 Md. App. 108, 130, 797 A.2d 63, 76 (2002).” Sylvan’s problem is that the contractual “integration clause” did not disclaim any specific oral representations, and certainly not any concerning Sylvan’s willingness to sell the plaintiff additional existing franchised businesses. Without specific disclaimers as to representations made on that specific topic, the integration clause did not prevent pursuit of the claim.

While Sylvan could use the presence of the integration clause at trial to challenge whether the plaintiff reasonably relied on promises made outside of the Irving franchise agreement, based on the facts alleged the court stated, “there is reason to believe [plaintiff] could reasonably have relied on Sylvan’s representations” concerning the sale of the existing locations. Therefore, the court held that permitting the plaintiff to file a second amended complaint would not be “futile” and granted the plaintiff’s motion to do so.

After the plaintiff filed its Second Amended Complaint, Sylvan immediately moved to dismiss it on essentially the same grounds as asserted previously, and the court once again refused to dismiss the claims for fraud and violation of the Maryland Franchise Registration & Disclosure Law. Accordingly, the parties are now conducting discovery that may take most of 2012 to complete.

It is important to recognize that the proceedings in this case to date solely concern the sufficiency of the plaintiff’s factual allegations as a matter of law, and in later proceedings Sylvan’s representatives will provide information on what occurred with regard to this franchise sale. Nevertheless, the decision reiterates an important point for all Maryland business people – even if promises and statements are excluded from a particular written agreement, they may have legal consequences if the subsequent business relationship fails to meet the other party’s expectations.

Is That Really My Problem? Case Highlights Need to Verify Franchise Disclosure Data

November 7th, 2011

A recent decision in A Love of Food I, LLC v. Maoz Vegetarian USA, Inc. , Case No. AW-10-2352, Bus. Franchise Guide (CCH) ¶ 14,633 (decided July 7, 2011), the United States District Court for the District of Maryland, in denying a motion to dismiss, highlighted the need for franchisors to vigilantly update their government-required disclosure document to maintain its accuracy, while also providing a valuable reminder as to the geographic scope of state franchise sales laws’ application.

Misrepresentations in Franchise Disclosures

The franchise agreement at issue in the case was for a Maoz Vegetarian® quick-serve restaurant that the plaintiff opened and operated in the Dupont Circle neighborhood in Washington, D.C. The franchisee alleged that the startup cost estimates in the franchisor’s government-mandated disclosure document (then known as the Uniform Franchise Offering Circular, or “UFOC”) dramatically underestimated the actual startup costs for its franchise, and that the franchisor knew that the representations were inaccurate at the time it made them. They alleged that the franchisor’s actions constituted violations of the anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as fraud as a matter of the general common law of Maryland.

In a decision during 1999 in the case of Motor City Bagels, LLC v. American Bagel Co., Civ. No. S-97-3474, Bus. Franchise Guide (CCH) ¶ 11,654, another judge in the U.S. District Court for Maryland had held that a franchisor could have committed fraud by misrepresenting the initial investment costs in its UFOC by approximately 20 – 25%. By contrast, in this case the franchisee alleged that it had to spend more than twice the franchisor’s “maximum” estimate of $269,000 to open their restaurant, and that during 2008 the franchisor increased the “maximum” initial investment cost estimate in its UFOC by $225,000.

The UFOC specifically encouraged the franchisee to rely on the startup cost estimates in two ways. First, the UFOC specifically itemized various cost categories and provided sub-estimates for each category. Second, the UFOC pointed out that the estimates were based on the franchisor’s “15 years of combined industry experience and experience in establishing and assisting our franchisees in establishing and operating 23 [vegetarian restaurants] which are similar in nature to the Franchised Unit you will operate.”

The franchisor argued that cost projections were statements of opinion and could not constitute fraud because they were not susceptible to exact knowledge at the time they are made. However, the court held that erroneous projections could supply a basis for fraud under Maryland law in some cases. Whether projections were sufficiently concrete and material to qualify as statements of fact required a context-sensitive inquiry that could not be reduced to a single formula. An assessment of relevant factors—including the extent of the alleged discrepancy, whether the projection was based on mere speculation or on facts, and whether the projection was contrary to any facts in the franchisor’s possession—supported the conclusion that the franchisee had sufficiently stated a claim for fraud to proceed with factual discovery for its common law fraud and Maryland Franchise Law claims.

Jurisdiction in Maryland and Application of New York Franchise Sales Law

The franchise agreement in this case only permitted the franchisee to open a restaurant in the District of Columbia, and in fact that is where the restaurant has been operated. The defendant franchisor maintains its principal place of business in New York, and the parties’ first meeting concerning a potential franchise sale took place at the franchisor’s New York office. The plaintiff franchisee was formed by Maryland residents and, at the time of the franchise purchase, “maintained its principal place of business” in Chevy Chase, Maryland. The parties had numerous telephone conversations during which the franchisor’s representatives were located in New York and the franchisee’s representatives were in Maryland. The franchisor sent its UFOC and the proposed franchise agreement contract to the franchisee’s address in Maryland.

Based on those facts, the court found that those activities were sufficient to allow it to exercise jurisdiction, meaning that it could require the franchisor to defend itself in Maryland.

The franchisee filed a claim for violation of the New York Franchise Sales Act on that basis that the law applied because the franchise sale was made from New York. The court, following the express terms of that law and a decision of the U.S. District Court for the Southern District of New York, found that the New York Franchise Sales Act protects franchisees in other states where offer and/or acceptance took place in New York. The rationale for extending the statute to situations such as this was to protect and enhance the commercial reputation of New York by regulating not only franchise offers originating in New York by New York-based franchisors.

The anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as those of other states such as California, also apply to franchise sales made from the state. However, to the author’s knowledge, New York is the only state that requires franchisors based within its borders to obtain state registration approval before selling franchises to out of state residents.

The takeaways:

(1) Franchisors need to be vigilant to monitor the actual initial investment costs being incurred to open new locations (whether company-owned or franchised) and promptly update initial cost estimates. Prospective franchisees should not assume that the franchisor is doing this, and should ask existing franchisees about their initial investments before buying franchise rights.

(2) If a franchise seller is discussing a franchise sale with a person located in state with a franchise sales law, then the franchisor needs to determine if it needs to obtain pre-sale registration approval from that state before selling the franchise.

(3) New York needs to amend its law to exempt out of state franchise sales from its registration requirements.

Holiday Inn case shows danger of deception

May 13th, 2011

A recent case with compelling facts shows that, despite attempts through written agreements and disclosure documents to shield franchisors from liability, deceptive conduct within the franchise relationship can still result in substantial liability for franchisors.

In Holiday Inn Franchising, Inc. v. Hotel Associates, Inc., 2011 Ark.App. 147 (Ark. Ct. Apps. 2011), the franchisee Hotel Associates, Inc. (“HAI”), is owned by J.O. “Buddy” House, one of the early Holiday Inn franchisees who was close friends with the chain’s founder.  The court found that, over the course of decades, House had developed a relationship with the executives of Holiday Inn Franchising, Inc. (“Holiday Inn”) founded in “honesty, trust and the free flow of pertinent information”, thereby creating a “special relationship” imposing a duty on Holiday Inn to disclose facts material to the ongoing relationship. 

In 1994, HAI, at the suggestion of a Holiday Inn executive, considered purchase of a rundown hotel in Wichita Falls, Texas to convert to a Holiday Inn.  House realized that the property would need expensive renovations and requested a 15 or 20 year term in the Holiday Inn franchise agreement.  Holiday Inn declined, but its Vice President of Franchising  “stated that, if House operated the hotel appropriately, there was no reason to think that he would not receive a license extension at the end of the ten years.” 

HAI signed a ten year franchise agreement in early 1995 and made extensive renovations before opening.  The hotel was successful and HAI received offers to sell for up to $15 million, but declined based on its belief that the franchise would be extended.  Meanwhile, Holiday Inn’s commission franchise salesperson was pursuing conversion of a nearby Radisson hotel at the end of HAI’s term and  prepared a business plan for that conversion in 1999.

In 2001, an employee of HAI spoke to a Holiday Inn representative about early relicensure, and was convinced to send Holiday Inn a $2,500 fee to obtain a Property Improvement Plan (“PIP”) for changes needed for relicensure.  The PIP required changes costing  $2 million dollars, and after going through 2 rounds of Holiday Inn PIPs, HAI spent about $3,000,000 — without ever being informed of  the business plan for the Radisson, which continued to be pursued.

In October 2002, when the hotel was fully renovated pursuant to the PIP and received a quality score of 96.05 (out of 100),  Holiday Inn informed HAI that the Radisson had applied for a license and was being considered as a possible “partial replacement” for HAI’s facility “if it left the system.”  After HAI protested, Holiday Inn stated that the Radisson application had been denied.  However, after several more twists and turns, the new franchise development team “prevailed” over the relationship managers, the Radisson was licensed and HAI’s facility was denied relicensure.  HAI sold it in 2007 for $5 million, before the real estate crash.

After a jury trial, HAI prevailed on claims against Holiday Inn of fraud and promissory estoppel, which means detrimental reliance on promises.  After appeal, HAI’s judgment was for over $10 million in compensatory damages and $12 million in punitive damages.  The case is notable because (a) HAI had no right to relicensure under the parties’ written agreement, but (b) the court found a “special relationship” that imposed a duty to disclose to the franchisee material information about the future of the business relationship, and (c) the court found that Holiday Inn’s course of conduct supported a punitive damages award.