August 2008 Franchising World

By Joel R. Buckberg and Jillian M. Suwanski

Franchise sales activity that complies with federal and state laws and administrative regulations governing such activity rewards the franchisor and its personnel with peace of mind.  The franchisor who satisfies its disclosure obligations never has to face the potential havoc of alleged violations.  Although the success of the franchisee is not assured, the success of the franchise sale is not in doubt because of a disclosure violation.  Conversely, a franchisor who ignores or fails to execute properly its disclosure obligations can spend up to four years wondering if the other shoe will drop.

Does the franchisee have an opportunity to assert a “get out of jail free” card when buyer’s remorse overcomes the franchisor’s efforts to create and sustain a satisfied customer?  Will the regulators who get wind of the problem assert their law enforcement powers, or just make life difficult for the franchisor in its effort to register and sell franchises?  Can a franchisee sue the franchisor, even if the statute or regulation does not give an express right to bring an action for violation? 
 
Franchise sales law compliance distills to a few simple precepts:
• Deliver an accurate, accessible, complete and current franchise disclosure document to the right person on time;
• Limit offers and sales of franchises to states where and when such activity is lawful;
• Make no financial performance representations (aka earnings claims) other than in Item 19 of the current franchise disclosure document or a valid supplement; and,
• Respect the disclosure process mandated by the rules.

Te patchwork of federal and state franchise disclosure laws and other applicable laws impose penalties for violations in several genres:  Federal civil and criminal penalties pursued by the Federal Trade Commission; state civil and criminal penalties pursued by state regulatory authorities under state franchise disclosure laws; and state civil actions brought directly by aggrieved franchisees under state franchise disclosure laws and other state statutes or causes of action that courts have ruled are applicable to franchise transactions. 

Federal Penalties: The authority for the FTC’s Franchise Rule1 under Section 5 of the Federal Trade Commission Act mandates that the commission prevent unfair and deceptive acts and practices affecting commerce.  But Congress has not provided a federal private right of action to aggrieved franchisees who believe they are the victims of disclosure violations.  Redress under the FTC Act and Franchise Rule must proceed through an enforcement proceeding brought by the commission.  A private right of action was created by a federal court in 1947 for violations of federal securities disclosure rules under the Securities Exchange Act of 1934; no federal court has seen fit to do the same for the FTC Franchise Rule.

FTC Analysis:  In December 1984, the FTC published its Rule Enforcement Protocol2, based on the abuses detailed in the Statement of Basis and Purpose for the 1978 Franchise Rule that became effective in 1979.  Until the Protocol is updated for the 2007 Franchise Rule Revision, the 1984 Protocol offers some guidance on the evaluation criteria used by the FTC to decide when alleged violations need redress.  Assuming that the transactions at issue are indeed franchises, the FTC expresses its analysis in subsection (b) of the Protocol, which is paraphrased below:

1. Was the basic disclosure document provided to prospective franchisees? Did the disclosure document make all required disclosures completely and accurately?

2. Was the disclosure document delivered in a timely manner when required by the rule?

3. Did the franchisees have at least 10 business days after delivery to review the disclosures before they signed the franchise agreement and paid the franchisee fees or incurred other expenses?

4. Were earnings claims made? If so, was an earnings claims disclosure document (either separately or as part of Item 19 of the disclosure document) provided? Does there appear to be substantiation for any claims made?

5.  Were there any other rule violations?

6. How many franchises were sold in violation of the rule?

7. How much revenue was received by the franchisor from franchise sales in violation of the rule, and how does that compare to the franchisor’s current net worth?

8. What is the current or expected rate of franchise sales?

9. How much have franchisees lost? To what extent has their behavior after purchase contributed to or mitigated their losses? Conversely, to what extent has their franchisor’s behavior contributed to or mitigated their losses?

10. What percentage of the franchisor’s franchisees has experienced economic loss from their investments? Can this loss be attributed, in whole or in part, to Rule violations?

The revised rule has an extensive list of prohibited practices that will likely modify the FTC’s priorities for redress of disclosure law violations.3  To be sure, the top of the list is likely to be failure to deliver a disclosure document, use of a misleading disclosure document, and the improper dissemination of a financial performance representation (earnings claim).

FTC Administrative Remedies:  When the FTC decides that the threshold for action has been reached, it will likely issue an administrative subpoena for records of the franchisor, called a civil investigative demand.  The FTC has broad powers to obtain information as long as the inquiry is not unduly burdensome or unreasonably broad.  The respondent franchisor has the burden of showing the demand is unreasonable.  The FTC can then initiate its own civil administrative complaint, which after notice and a hearing, can result in the issuance of cease and desist orders or consent orders that will stop violations.  The FTC can also initiate a consumer redress administrative proceeding to obtain relief for franchisees that may include rescission of franchise agreements, refunds of franchise fees, payment of damages and other relief.  The FTC can levy fines of up to $11,000 per violation.
 
FTC Direct Action: If the FTC decides to skip the administrative remedies, it has the option to seek immediate relief from a federal district court against the franchisor in the form of a temporary restraining order.  This step occurs when there is fear that the assets necessary to address franchisee claims will disappear from the franchisor and prove difficult to trace.  More deliberate actions include an action against the franchisor for a preliminary and permanent injunction, an asset freeze that again assures preservation of assets to answer claims, and orders to make restitution.  The FTC Act allows a federal district court to use its full equitable powers to grant relief and prevent all persons involved from retaining the benefits of their violations of the FTC Act.
 
Finally, the FTC has powers to remedy violations that extend not only to franchisors, but to individuals associated with franchisors.  The FTC may prohibit individuals from engaging in any association with franchise selling activity.  Once liability of the franchisor is established, individual liability may be found if the individuals knew of the unlawful activity and either participated in it or had the power to control it, including by their failure to control employees whom they knew were engaged in unlawful conduct.  Asset freezes have been extended to the bank accounts of individual participants in disclosure violation schemes.
 
State Franchise Law Remedies:  Fourteen states have registration requirements4 that must be satisfied before franchises are offered and sold.  Six other states5 have laws that give franchisees remedies for disclosure violations, or condition the state’s exemption from its business opportunity law on compliance with the FTC Franchise Rule.  Virtually all of the disclosure statutes provide a private right of action for an aggrieved franchisee to seek rescission of the franchise agreement and to recover damages against a franchisor if the franchise is sold without first being registered.  All provide for claims when the disclosure document includes false or misleading statements, or omits statements necessary so that the document is not misleading.  Some provide defenses when the franchisee knew or should have known the relevant facts.  The private rights of action have statutes of limitation that stretch as long as four years after the transaction closes.  Many of the state registration statutes have anti-waiver restrictions that effectively negate any attempt by a franchisor to obtain an advance release of claims under the statute by a franchisee, as is often attempted with the use of closing questionnaires and certifications signed by franchisees.
 
Personal Liability: Virtually all provide for liability of control persons and those participate in or materially aid the transaction that is available to the private litigant.  A favorite new tactic of lawyers representing a franchisee is to sue not only the franchisor but all of the officers and directors of the franchisor as part of the case against the franchisor for compliance violations.  Imagine the unpleasant surprise of an outside director when process is received, or served by an armed process server, in a franchise compliance case.

State Administrative Remedies: Similar to the FTC’s power to investigate and pursue action against a recalcitrant franchisor, the registration states generally endow their regulatory bodies with law enforcement authority and administrative authority.  The state regulators, to a varying degree, have the power to subpoena documents and witnesses, conduct investigations (which can be civil and criminal), conduct hearings, issue cease and desist orders, sometimes without first conducting a hearing, bring civil actions for temporary, preliminary and permanent injunctive relief, order restitution, rescission offers, or other equitable relief, assess for investigation costs, and levy fines and penalties.  The range of civil fines extends from $100 to $100,000 per violation.  The state statutes also contemplate misdemeanors and felonies for willful violations and fraud.
 
The registration states have the added weight of being able to condition future registration for franchise selling on compliance with certain conditions.  The franchisor may be asked to provide a surety bond, to escrow initial fees with a bank in the registration state, to be released only when all pre-opening services have been performed to the satisfaction of the franchisee, to submit to quarterly and annual monitoring of its activities to assure that no further violations have occurred.

State “Little FTC” Acts: Although the FTC provides no private right of action, some states have enacted statutes that use similar language that proscribes unfair or deceptive trade practices.  Courts have concluded that violations of the FTC Franchise Rule satisfy the standards for deceptive practices in some states, even though these statutes are primarily directed to consumer protection, not business relationships.  These “little FTC Acts” provide franchisees the right to sue for actual damages, injunctive or declaratory relief, attorneys’ fees, court costs, and rescission based on unfair and deceptive practices committed in the conduct of trade or commerce. Other states, such as Texas, Maryland, Pennsylvania, Georgia, Louisiana, New Jersey and Illinois refuse to extend their consumer protection statutes to commercial transactions. 
 
Recent Case Experience: Florida has enacted a “little FTC Act” called the Florida Deceptive and Unfair Trade Practices Act, which is typical of the “little FTC Acts” of most states.  To establish a claim under the act, according to Florida case law, a plaintiff must allege a deceptive act or unfair practice, causation and actual damages.  A violation of the disclosure requirements of the FTC Act and FTC Rule will constitute a deceptive act or unfair practice under FDUTPA.  Earlier this year, a Florida appellate court found, in KC Leisure, Inc. v. Lawrence Haber, et al., that the plaintiff’s allegation of violation of the FTC Act for failure to provide the required disclosures prior to the sale of a franchise stated a valid cause of action for violation of FDUTPA. 
 
The court in KC Leisure, Inc. also decided that an officer of the franchisor could be held personally liable under FDUTPA and the Florida Franchise Act for the franchisor’s violation, so long as corporate liability is first established and the officer is a “direct participant in the improper dealings.”  The same is true for violation of the FTC Act and FTC Rule.  In a 1998 federal case in the Eastern District of New York, FTC v. Minuteman Press, et al., the court permanently enjoined a franchisor and one of its officers from making false earnings claims in violation of the FTC Act and the FTC Rule.  The court also held both the company and the officer liable and required payment of monetary damages to the affected franchisees for the following actions: falsely representing the gross sales levels that could be achieved and how much of gross sales would be profit, for making earnings claims without providing substantiating documentation and for making earnings claims that contradicted express statements in the UFOC that no earnings claims were being made.  Additionally, the court found the franchisor and a different officer liable and required payment of monetary damages to the affected franchisees for failure to disclose a required transfer-training fee imposed upon assignment or sale of a franchise.

Often, franchisors attempt to guard against claims by franchisees by requiring franchisees to sign, prior to the sale, an acknowledgement that no improper sales practices were committed and no misrepresentation or unlawful financial performance representations were made by the franchisor or its salespeople, agents, officers, and employees.  Franchisors should be cautious of relying solely on such acknowledgement documents and believing that they will eliminate the risk of penalties.  A New York appellate court recently found, in Emfore Corp. v. Blimpie Associates, Ltd., et al., that such acknowledgement documents cannot be used as a defense to claims under the New York Franchise Act.  The appellate court decision disallowed the use of a questionnaire/rider and side letter as waivers of fraud claims because such waivers are prohibited under the New York Franchise Act as they are under the anti-waiver provisions in other state disclosure statutes.  The franchisee was allowed to proceed with its claims under the New York Franchise Act and prohibited Blimpie from using the questionnaire/rider and letter signed by the franchisee as a defense. 
 
Good disclosure practices protect everyone.  Defending a compliance violation can rapidly escalate into an expensive exercise.  First and foremost are the legal fees associated with investigating the alleged violation.  More significant are the resource costs and management distraction that attend the effort to address the allegation of compliance violation.  The experience of most companies holds that burden of compliance violations exceeds the costs of compliance by a considerable margin.

Joel R. Buckberg is counsel and Jillian M. Suwanski is an associate of Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C. Buckberg, who is IFA’s franchise compliance program administrator, can be reached at 615-726-5639 or jbuckberg@bakerdonelson.com. Suwanski can be reached at 615-726-5558 or jsuwanski@bakerdonelson.com.
 
Sources of Information
1 16 C.F.R. §436, revised effective July 1, 2007; use of original Franchise Rule  permissible until July 1, 2008; 72 Federal Register 15444, March 30, 2007.
2 49 Federal Register 50632, December 31, 1984; 16 C.F.R. 14.17.
3  See 16 C.F.R. §436.9 for a complete list of prohibited practices.
4  California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin.
5 Florida, Iowa, Mississippi, Ohio, Oklahoma and Oregon.  

Not a Member? Join IFA
Forgot Login?