Tag: due diligence
May 10th, 2013
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.”
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.
(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.
August 13th, 2010
The final installment in this series focusses on the Franchisor’s selection of franchisees.
Evaluation of Franchise Prospects by Franchisors
In the recent economic climate, franchisors have been tempted to ease their qualifications for new franchise prospects. However, franchisors need to remember that they are investing in their franchisees just as much as their franchisees are investing in them, and must resist compromising their brand’s long-term growth for short-term cash flow.
The following considerations are frequently cited by industry experts as fundamental criteria for evaluating prospective franchisees. Regardless of the economic conditions a franchisor may be facing, it should remain loyal to these fundamental principles for determining the viability of candidates:
- Ability to learn and follow the franchisor’s system;
- Fitting with the franchise system’s “culture”;
- Having relevant business experience or general business acumen;
- Being located in a geographic and demographic area that favors the franchise concept;
- Having access to capital; and
- Having grounded and realistic expectations.
While the specific traits and skills needed to succeed in any particular franchise system obviously will vary, these fundamental requirements can generally be applied broadly across all franchise systems, regardless of the industry they are in.
The need to select quality prospects as franchisees is particularly important for new and early-stage franchisors, though it obviously remains critical for highly-developed franchise systems as well. While one “bad apple” may not be as detrimental to the brand image or the ability to sell franchises for larger systems, unsuccessful franchisees can cause significant administrative burdens, and quite possibly legal fees, for franchisors of all sizes. Signing an under-qualified franchisee as one of the first non-affiliated representatives of a franchise system may have dire effects on a new system’s ability to attract qualified franchisees. When counseling prospective franchisees, we recommend that they speak with as many existing and former franchisees as possible when performing their due diligence, and one or a few franchisees who are unhappy or unsuccessful, or who are simply unimpressive as people, can impact a prospect’s view of the franchise system as a whole.
By carefully screening and interviewing franchise prospects, franchisors can protect the quality and value of their franchise systems, enhance their ability to sell additional franchises, and avoid the headaches of franchise terminations and legal disputes. We regularly counsel our new franchisor clients that selecting quality franchisees must be a top priority for their long-term success.
Individual franchised outlets and franchise systems as a whole stand a greater chance of success if they are built around committed franchise owners who trust and believe in the franchisor and everything it has to offer. Franchisees and franchisors both benefit substantially when they carefully evaluate each other during the pre-sale courting process.
August 6th, 2010
Part 2 of this series focuses on how a prospective franchisee should investigate a specific Franchise Opportunity, after narrowing focus through self-evaluation:
After examining your capabilities and ambitions, the next step is to perform your due diligence and fully investigate the franchise opportunity you are considering. In addition to researching the opportunity directly, this also involves investigating competitive opportunities to make sure that the one you choose is the best fit for you. You should carefully read the franchisor’s Franchise Disclosure Document (“FDD”), and you should prepare questions and talk with the franchisor’s representatives regarding any issues or concerns you may have.
You also should contact existing franchisees to find out how their business is doing and what they feel the benefits are of being involved with the franchisor’s system and brand name. Franchisors are often willing to “assist” with this process, by referring prospects to their most successful franchisees. What may go overlooked, however, is the opportunity to gain information from former franchisees. The third table in Item 20 of the FDD provides valuable information concerning former franchisees. Franchisors are required in this table to list the numbers of terminations, non-renewals and reacquisitions during each of the three prior calendar years, as well as the number of franchisees who “Ceased Operations – Other Reasons”—which often means that the franchisee was simply forced to close their doors because they were unable to turn a profit. In addition, franchisors are required to provide contact information for all current franchisees and former franchisees who left the system during the past year. Both current and former franchisees can provide first-hand insight into numerous qualitative aspects of a franchisor’s system.
If the franchise system has been in existence for at least five years, also consider researching the availability of existing franchises through the Internet. It is a bad sign if many franchises are for sale and at low prices. It is a good sign if relatively few are for sale and at high prices. If you find no information through the Internet on this topic, then you should ask franchisees in locations near you about purchasing their business; and, if they express interest, pursue the topic to see their level of interest in “getting out” and their reasons for wanting to do so.
Other, often overlooked, aspects of a franchise system that can ultimately have a significant effect on franchisees’ profitability include supply and purchase arrangements established by the franchisor. A powerful purchasing cooperative can significantly improve a system’s franchisees’ bottom line. Among the required disclosures in the FDD, franchisors are required to state in Item 8 whether they receive rebates or commissions based on franchisees’ purchases of goods and services from suppliers. In a successful franchise system, the bulk of the franchisor’s revenue should come from franchisee royalties, and not from franchisees’ mandatory purchases from outside vendors. Moreover, quality franchisors do not force their franchisees to pay a premium over the fair market price for ingredients and other products central to the operation of the business.
Finally, is equally, if not more important to your potential for long-term success, to look beyond the FDD and the franchise system’s historical performance, and evaluate the current and future market for the franchisor’s goods or services. Just because you have a strong interest in a particular field or product and fall in love with a franchisor’s system and business methods does not mean that the general public will do the same. In addition, while joining a regional, national or international franchise system typically will have immediate name-recognition benefits, this may not be the case with a newer or smaller franchisor. If the franchisor’s name has little or no value, and the franchisor’s system is not unique or distinctive from the competition, then you should consider whether their franchise is worth the investment.
July 30th, 2010
A successful franchise relationship requires commitments and dedication on both sides of the table. Ultimately, franchisors and franchisees alike benefit from the franchisee’s operations only when those operations are profitable. Success in franchising requires matching the right franchise prospect with the right opportunity.
This series of posts discuss steps to be taken by franchisees and franchisors to help guide them to matches with real possibilities for success.
Self- Evaluation Comes First for the Prospective Franchisee
When evaluating the purchase of franchise rights and ultimately selecting a particular opportunity to pursue, a prospective franchisee should use a deliberate process that examines your personal aspirations and capabilities, and then the value and benefits associated with particular franchise opportunities in your geographic market.
Many prospective franchisees get caught up in the dream of owing their own business or in the hype of a franchisor, and they may rush into an opportunity without truly evaluating their own capabilities and the long-term consequences of entering into a franchise relationship. Before diving into evaluation of individual franchise opportunities, you should ask yourself questions like: “Am I prepared to take on the risks and stresses of owning a business?” and, “Am I ready for the long-term time commitment of owning a business?” In addition, while many entrepreneurs may say that, from an ownership perspective, “a business is a business,” when selecting a franchise opportunity that will become and support your livelihood, you should carefully evaluate what industries match your skills and interests. While building toward an exit strategy may be your ultimate goal, you will have a much greater chance at success if you enjoy working in the business that you are growing.
Equally important with answering these basic questions is making sure that you have the funds necessary to finance the business’s development and to support you and your family through the initial stages of operations. There are several financing methods available to start a new business, and some franchisors offer financing of the initial franchise fee. You should investigate all of your financing options and choose the one that makes the most sense for you. In addition, determining how well your franchise needs to do for you to make a satisfactory living should involve a critical analysis of your unique circumstances and the historical performance of the franchise system: How much money do you need to be able to pull from the business? What have other franchisees told you? What information were you able to obtain from the franchisor? What have financing companies said? What have you figured out in your business plan? Analyzing the answers to all of these questions will be critical to determining whether you will be able to succeed as a franchisee.
If the initial investment will be over $100,000, you should seek an SBA-guaranteed bank loan, not only because it can be a good form of financing, but also because the loan officer will provide valuable feedback on whether the particular franchise under consideration is a path you should pursue. It is true that many large banks will not make loans for start up businesses, even those backed by a franchise. However, iIf a bank funds start-ups in the franchisor’s industry, but dismisses your application out of hand, then perhaps you should consider alternate opportunities.
Next week’s post will discuss investigation of specific opportuntites by a prospective franchisee who has complete his or her self-evaluation.
September 29th, 2009
Working with Consultants to Select a Franchise Opportunity
By: David L. Cahn & Jeffrey S. Fabian
While most ordinary consumers can rattle off the most famous franchised brands, there are hundreds of smaller brands with promising franchise systems struggling to reach and identify prospective franchisees. For entrepreneurs looking to invest their life savings—and more—what resources are available to assist in the process of selecting a franchise that best matches their resources and aspirations?
Magazines like Opportunity World are a great place for the fledgling franchise prospect to begin navigating the sea of franchise opportunities, and the Internet also provides a wealth of information on available franchise opportunities. However, for those seeking more personal guidance, franchise consultants, often referred to as “franchise brokers”, can provide one-on-one, personalized assistance in the selection of a franchise opportunity. Examples of consultant networks include FranChoice, FranNet, The Entrepreneur’s Source, and The Entrepreneur Authority.
Why work with Franchise Consultants?
Franchise consultants are specially trained to conduct personality and financial analyses of franchise prospects, thereby narrowing the industries and types of franchises to which they recommend to their clients. In addition, the consultant networks typically limit the number of directly competitive franchised concepts in their inventories, thereby further limiting the overall scope of a franchise prospect’s necessary investigations. Importantly, the consultant networks also typically scrutinize the franchisors in their inventories for “red flags”, such as potential solvency issues, excess franchise terminations or unit turnover, or substantial litigation with franchisees.
Franchise consultants are generally paid on a commission basis by the franchisors in their networks’ inventories, and receive their fees once the client pays his or her initial franchise fee to the franchisor. Therefore, few franchise consultants can afford to waste their time conducting in-depth evaluations and then linking prospects with franchises with which they are unlikely to be compatible. If the consultant knows certain franchisors will be unlikely to consider you as a candidate, or that you will not be able to obtain sufficient financing for certain concepts, then these franchises will be left off of the table when you and the consultant discuss your opportunities.
What do I need to be Aware of if I work with a Franchise Consultant?
Franchise consultants are typically paid on commission based on their referrals of candidates who ultimately enter into franchise agreements with the franchisors in their network’s inventory. Thus, they have the inventive to direct you only to those franchisors that work with the particular network to which they belong. As a result, even if you work with a reputable broker, you need to independently research the opportunities they propose, and remember that there may be other opportunities out there that are equally or better suited to you and your unique situation.
Obtaining answers to the following questions can help you in the process of selecting a consultant to help you in your search for a suitable franchise opportunity:
- What tools and assessments does the network use to help determine the franchises that you should consider?
- Does the consultant have experience in franchising? In what capacity?
- How long have they been a consultant? Do they have credible client references?
- What percentages of their clients live within sixty miles of your location? Consultants with local clients are motivated to make sure that their clients succeed, since their reputation in the community is important for obtaining word of mouth referrals.
- Do they provide other consulting or business coaching services, or are commissions from franchising their sole source of income?
Finally, you should be wary of any consultant who talks too much about how much money you can expect to make if you purchase any particular franchise. Such comments are likely to be illegal under franchise sales laws, and experienced franchise brokers should know to steer away from any claims about possible financial performance.
In summary, franchise consultants can provide specialized and personalized assessments in order to better match you with franchises suited to your goals, experience and capabilities. By researching and selecting a reputable consultant, you can feel more confident that the franchise you ultimately select will be right for you.
David L. Cahn is the Managing Member of Franchise & Business Law Group, a law firm located in Lutherville, Maryland. Jeffrey S. Fabian is an associate with the firm. They can be reached at (410) 583-0099, or online at www.franbuslaw.com.