Litigating fraud claims for franchisees: some powerful franchisors exaggerate or misrepresent the earnings potential of their businesses - often costing franchisees their life savings and their dignity. You can help these small-business victims of fraud.

Many people who sign franchise agreements with reputable franchisors end up financially successful. But there is a flip side to these stories. Not all franchisors are well established. Some get into business over their heads, and the entire system eventually collapses. Others oversell their product by exaggerating its profit potential or making blatantly false claims.

In those situations, a general business litigator might conclude that the franchisee could easily recover lost investment money by bringing a claim of fraud or negligent misrepresentation, or both. Surely the franchisee, like any other defrauded party, should be able to get his or her money back, right?

Theoretically, yes. But in reality, a franchisor that defrauds someone out of his or her entire life savings is far less likely to be sued than is a business that, for example, sold a consumer a defective stereo.

Consider the plight of John Smith, an imaginary failed franchisee. While in the process of opening a restaurant in his Minnesota hometown, John was approached by a California franchisor, XYZ Corp. XYZ's representative told John that its franchisees had average revenues of $800,000 per year and a "bottom-line" annual profit of $100,000.

The glossy sales brochure also cited a study showing that 90 percent of franchised businesses--but only 18 percent of nonfranchised businesses--will succeed during their first five years of operation. The sales representative said, "Now John, I consider you better than average. Don't you? You certainly aren't in the bottom 10 percent, right?"

John decided to invest in what seemed to be a "sure thing." He opened the franchise restaurant and operated it for 15 months. But his franchise never generated revenues greater than $300,000 a year, and he lost his entire $500,000 investment.

Like any franchisee looking at a failed or failing franchise venture, John is in an unenviable position. He had been successful enough to save money to pay a franchise fee and set up a business. He now sits in his lawyer's office with a failed business and $500 to his name.

And like many failed franchisees, John has significant marital issues. He always had a good job and a steady family life. Now he now lacks money and self-respect and fears he is heading for a divorce. Until he finally closed the restaurant's doors, John worked 50 to 80 hours a week at a business where he made no money. His wife never saw him, but, unlike the typical workaholic, he didn't even have the satisfaction of providing a good income for his family.

John's primary practical problem is that he has no money to pursue a lawsuit. And even if he won, he wouldn't necessarily end up financially solvent. Even a franchisee with enough money to pay an attorney (or at least pay costs in a contingent fee arrangement) may be disinclined to do so if his or her entire recovery will go to creditors.

Yet John is in a slightly better position than some other failed franchisees, because his restaurant was not open for a long time. Many business owners continue to operate for several years after they should have stopped and completely miss the contractual or statutory period for bringing a claim. Franchise agreements often contain contractual statutes of limitations ranging from 90 days to two years. Even John, who recognized relatively quickly that he had to close, may still have problems with a contractual statute of limitations.

Fortunately, John resisted the franchisor's suggestion to sell his franchise back for a few pennies on the dollar. Almost every franchise agreement requires that a transferring franchisee sign a release of all claims against the franchisor when the franchisor agrees that the franchise agreement and/or the franchisee's business assets may be transferred to another owner.

John also did not sign a general release of claims during his 15 months as a franchisee in exchange for some consideration from the franchisor, such as royalty forgiveness.

Potential claims

The first step for John's attorney is to investigate his available legal claims. John may have a claim for common law fraud or negligent misrepresentation, as well as statutory claims available to consumers or franchisees. All 50 states have some sort of consumer protection statute that may or may not apply to franchisees. (1)

Relevant statutes include those in the state in which the contract was signed or delivered; the franchisor resides; the franchisee resides; the franchise is to be operated; and the fraudulent statements were made. (2) In John's case, his lawyer may consider whether John has claims under Minnesota and California law.

No matter how John's legal claims are captioned, the lawyer representing him will have to establish that

* the franchisor made false or misleading statements

* the franchisee relied on them

* the franchisee was entitled, as a matter of law, to rely on the statements

* the franchisee suffered damages as a result of the fraud and/or is entitled to rescind the agreement at issue.

John will have to establish that the statements made to him about franchisee success rates and actual or expected earnings were false or misleading, or both. The franchisor may try to argue that statements regarding earnings can never be "false" because they are just "projections," "puffing," or rough estimates.

The courts have rejected this defense where the earnings claims appear to have no basis in historical fact. For example, in Commercial Property Investments, Inc. v. Quality Inns International, Inc., a federal appeals court found that a fraud claim could go forward against a hotel franchisor that stated that a franchisee could expect at least 60 percent occupancy rates in the first year of operation, although the franchisor knew other franchisees were doing far worse. (3)

Similarly, in Motor City Bagels, LLC v. American Bagel Co., a federal district court found that an Indiana Franchise Act claim may have existed where the franchisor understated start-up costs by 20 percent. (4) And a Texas appellate court, in Carousel's Creamery, LLC v. Marble Slab Creamery, Inc., reversed a lower court ruling that dismissed a franchisee's negligent misrepresentation claim in a case alleging lost earnings. (5)

For John's claim that the XYZ representative's statements about success rate were fraudulent, the elements of false and misleading statements, actual reliance, and damages should be rather easy to establish. A recent article in Fortune Small Business magazine examined the common claim that franchised businesses are less likely to fail than independent businesses. (6)

Many franchisors stopped making this claim after the International Franchise-Association (IFA), an organization that is extremely protective of its predominantly franchisor membership, issued a letter urging members not to use this sort of data to sell franchises. The letter starts out as follows:

   It has come to our attention that some IFA-member
   companies may be providing information
   about franchising that is long out
   of date and no longer presents an accurate
   picture of the sector.

      Of particular concern is information
   claiming that the success rate of franchised
   establishments is much greater than that of
   independent small businesses.

      Many years ago, the U.S. Department of
   Commerce conducted studies about franchising
   which presented such statistics.
   That information is no longer valid. The
   agency stopped conducting such studies in
   1987.

      We strongly urge you to remove any information
   from your Web site and published
   materials that make such a claim. The
   use of such data, in the absence of current
   research, could mislead prospective franchisees
   who are attempting to conduct responsible
   investigations. (7)

But some franchise salespeople still cite these statistics as a reason to sign a franchise agreement. (8)

Disclosures and disclaimers

Even assuming that John can prove that the information he was given was false and misleading, that he relied on it, and that it caused his damages, he still will have to overcome any impediments to his claims contained in the franchise documents that he received from the franchisor.

The Federal Trade Commission (FTC) and certain states require franchisors to provide a Uniform Franchise Offering Circular (UFOC) to prospective franchisees so that they may have sufficient information to decide whether to buy the franchise. The UFOC must contain 23 items, one of which (item 19) is whether the franchisor provides earnings claims to its franchisees. (9)

It is illegal to provide earnings claims to franchisees that are not in the prescribed FTC format. (10) So, under the FTC's Franchise Rule, a franchisor that states that it provides no earnings claims, but actually does, has committed an unlawful act. (11)

Some courts have turned the policy of the required FTC disclosures on its head. Many franchisors print up and distribute documents with earnings claims and success-rate claims in them and then require franchisees to sign a separate "checklist" document indicating that no representations were made regarding earnings claims, earnings expectations, or success rates of franchised units. When faced with a fraud claim, the franchisor may point to these signed checklists and argue that the franchisee could not reasonably rely on any fraudulent statements about earnings or success rates that were in fact presented to him or her. (12)

One would think that this Alice-in-Wonderland argument--"Sure, I broke the law and committed fraud, but I made him sign a document swing I didn't"--would get nowhere in the courts. Sadly, several courts have determined that fraudulent statements made by franchisors may be disclaimed by boilerplate contract language. (13)

There are few enforceable legal transactions in the United States that are as one-sided as a franchise contract. Although the terms of franchise contracts have become progressively worse for franchisees in the past 10 years, one California court described the gross disparity between franchisor and franchisee that existed even as long ago as 1996:

   Although franchise agreements are commercial
   contracts, they exhibit many of the
   attributes of consumer contracts. The relationship
   between franchisor and franchisee
   is characterized by a prevailing, although
   not universal, inequality of economic resources
   between the contracting parties.
   Franchisees typically, but not always, are
   small businessmen or businesswomen or
   people ... seeking to make the transition
   from being wage earners and for whom the
   franchise is their very first business. Franchisors
   typically, but not always, are large
   corporations. The agreements themselves
   tend to reflect this gross bargaining disparity.
   Usually they are form contracts the franchisor
   prepared and offered to franchisees
   on a take-or-leave-it basis.

   Some courts and commentators have
   stressed the bargaining disparity between
   franchisors and franchisees is so great that
   franchise agreements exhibit many of the
   attributes of an adhesion contract and
   some of the terms of those contracts may
   he unconscionable.... Indeed such contracts
   are sometimes so one-sided, with all
   the obligations on the franchisee and
   none on the franchisor, as not to be legally
   enforceable. (14)

After being "sold" his franchise, John was told to read a 200-page Franchise Offering Circular and a 40-page Franchise Agreement. Like most prospective franchisees, he did not read these documents. And like nearly all new single-unit franchisees, he did not have an experienced franchise attorney review either of the documents.

In short, this was not a business deal between Mark Cuban and Donald Trump. It was a one-sided transaction between a deceptive franchisor and an uninformed franchisee.

The FTC rule and applicable state laws, rules, and regulations are designed to help franchisees and punish franchisors that violate those rules. The FTC rule and the UFOC requirement were never intended to serve as a shield for franchisors that choose to sell franchises by false and misleading statements. As one New York court said regarding the state's franchise statutes:

   Keeping in mind the policies underlying
   the enactment of the Franchise Act and the
   deliberate incorporation of broad antifraud
   provisions into the statute, the court
   finds that the legislature intended to prevent
   a franchisor from contracting out of
   the liability imposed on the franchisor under
   the act by the inclusion of merger and
   waiver clauses. (15)

In one Massachusetts case, the court described the public policy against contracting out of fraud liability:

   We continue to believe that parties to contracts,
   whether experienced in business or
   not, should deal with each other honestly,
   and that a party should not be permitted to
   engage in fraud to induce the contract.

   "In obedience to the demands of a larger
   public policy, the law long ago abandoned
   the position that a [written] contract must
   be held sacred regardless of the fraud of
   one of the parties in procuring it." (16)

A franchisee who has been given bogus earnings claims and false success claims is not trying to add to the parties' agreement. A franchisee, for example, is not asking that the contract be amended to force the franchisor to actually make 90 percent of all franchised businesses into successful ventures. The franchisee is stating that he was given false information on which he relied in choosing to buy the franchise, and now the franchisee's claim is based on that fraud. Some courts have butchered the analysis of fraud-in-the-inducement claims, saying they are barred by the parol evidence rule. The Tenth Circuit explained the proper analysis as follows:

"One who is fraudulently induced to execute a written contract by the oral misrepresentation of the opposite party may always show that fact in evidence when he bases his defense on fraud in inducing the making of the contract," and "he may do this even though the contract sued on provides that all the agreements or representations between the parties are contained therein." (17)

For a disclaimer to be effective, it must be specific and actually negate the representation at issue. (18) Too many attorneys fight the legal enforceability of the disclaimer but simply concede that its language covers the alleged fraud. This is a particularly bad strategy in a jurisdiction where the law regarding parol evidence is not in your client's favor, or one with cases finding that fraud may be easily disclaimed in the contract that was procured by the fraud.

Franchisee victories come far easier when the factual issue is fought first. Read the contract closely and see what is actually disclaimed by the language of the franchise agreement. If an attorney can prove that fraudulent statements were made, then the disclaimer is being used to perpetuate a fraud. Most judges or arbitrators will read such a disclaimer as narrowly as possible.

Whatever the law may be in your jurisdiction, the judge or arbitrator will want to know why he or she should help your client. Most will be inclined to help an inexperienced franchisee who was sold a bill of goods by a franchisor making clearly false statements, regardless of the law. (19) An attorney who argues the law without stressing equitable concerns does the client a great disservice. Few judges or arbitrators will refuse to look at all the circumstances surrounding the fraud. Explain what yours are. (20)

Litigating a franchise fraud case presents unique practical and legal challenges. But an attorney who reviews the relevant documents, facts, and law can help a failed franchisee recover lost investment money and even some of the self-respect that was taken by the franchisor's fraud.

Try your commercial case with documents from the ATLA Exchange

The ATLA Exchange has many resources to help members assess and prepare business tort cases. For more information, contact the Exchange by phone at [phone] or by fax at [phone], or visit www.atla.org/exchange.

Court documents and document sets

Calabrese v. Square D Co. The plaintiff's appellate brief, memorandum in opposition to the defendant's posttrial motion for judgment as a matter of law, and the court's opinion and orders in a case in which an electrical engineer alleged that a company committed patent infringement by marketing a data-relay system similar to his invention. (No. LR3580)

Courtney v. Medical Manager Corp, The plaintiffs, complaint and memorandum of law in support of a motion for class certification in a case alleging breach of warranties of merchantability and fitness for a particular purpose in connection with the manufacture and distribution of computer software that was not Year 2000 compliant. (No. LR3400)

DeWald v. Knyal. The plaintiffs' second amended complaint and exhibits and the parries' trial briefs in a case alleging that a corporate partner improperly used partnership assets. (No. LR3471)

Executone of the Permian Basin, Inc. v. Executone Information Systems, Inc. The plaintiff's second amended petition and memoranda in opposition to the defendant's motions for summary judgment in a case alleging tortious interference with contract and business relations. (No. LR3566)

Feinberg v. Saunders, Kavp & Megrue, L.P. A joint pretrial order, the court's memorandum opinion, and the plaintiff's third amended complaint in a case alleging that an investment firm denied compensation to a consultant. (No. LR3404)

I.S. Design v. Gasho of Japan. The plaintiff's complaint, the defendants' memorandum of law in support of a motion for a directed verdict, the plaintiff's memorandum in opposition, and trial testimony of the plaintiff's architecture expert in a case alleging that a restaurant chain breached an oral contract by failing to pay a design consultant. (No. LR3476)

Johnson v. Epperly. The parries' briefs on a motion to correct errors in a case alleging that a business venture investor breached an oral contract and engaged in fraud. (No. LR3492)

Minnesota Mining & Manufacturing Corp. v. Chemque, Inc. The plaintiff's second amended complaint, the defendant's second amended answer and counterclaims and the plaintiff's answer to them, and jury questions in a case alleging prior disclosure of patented information and equitable estoppel. (No. LR3574)

Orita Land & Cattle Co. v. Chino Val ley Cattle Co. The defendant's memorandum of points and authorities in support of a new trial, the defendant's motion for summary judgment and the plaintiffs' memorandum in opposition, the parties' settlement conference brief, and the court's judgment on the special verdict in a case alleging fraud, conversion, and breach of contract for failure to deliver cattle. (No. LR3459)

State v. Johnson. The lessors' motion in limine, summary of damages, and the court's amended judgment of condemnation in a case alleging that the state owed compensation for condemning a business. (No. LR3363)

Watson v. Ralphs Grocery Co. The plaintiff's first amended complaint seeking damages and injunctive relief and its trial brief in a case alleging interference with prospective economic advantage where a worker was prohibited from delivering products to a grocery store. (No. LR3462)

Litigation packets

These packets include valuable materials such as depositions, corporate documents, and tips from experienced ATLA members.

Debt Collection Litigation Packet. This packet includes documents, forms, and information that will assist members in protecting their clients from abusive debt-collection practices, collecting debts on their clients' behalf, and tracking the collection process from the initial demand to the satisfaction of a monetary judgment. It also addresses issues such as the Fair Debt Collection Practices Act, accord and satisfaction, and bankruptcy.

Mandatory Arbitration Litigation Packet. This packet addresses mandatory arbitration clauses in nursing home admission contracts and other consumer, employment, and insurance contracts. It also contains defense motions to compel arbitration and plaintiffs' motions and memoranda in opposition, depositions, discovery requests, case law summaries, and other documents and materials.

EPS6DSBC 

Notes

(1.) For state statutes that provide some specific protection to franchisees, see, e.g., CAL. CORP. CODE [subsection] 31000-31516 (West 2005 & Supp. 2006); CAL. BUS. & PROF. CODE [subsection] 20000-20043 (West 2005 & Supp. 2006); IOWA CODE [subsection] 523H.1-H.17 & [section] 537A.10 (2005); N.J. STAT. ANN. [subsection] 56:10-1 to 10-29 (West 2005 & Supp. 2006); N.Y. GEN. BUS. LAW [subsection] 680-695 (Consol. 2005).

(2.) See, e.g., MINN. STAT. [section] 80C.19 (2005) (making Minnesota law applicable in some instances even when neither party is physically present in the state); Dollar Sys., Inc. v. Avcar Leasing Sys., Inc., 890 F.2d 165, 171-72 (9th Cir. 1989).

(3.) 938 F.2d 870, 875-76 (8th Cir. 1991).

(4.) 50 F. Supp. 2d 460, 469-70 (D. Md. 1999).

(5.) 134 S.W.3d 385 (Tex. Ct. App. 2004).

(6.) Anne Fisher, Hidden Risks, FORTUNE SMALL BUS., Dec. 2005/Jan. 2006, at 44.

(7.) Press Release, A Message from International Franchise Association President Matthew Shay (May 4, 2005), available at www.franchise. org/article.asp?article=1102&paper=93&cat=277 (last visited Apr. 21, 2006).

(8.) See, e.g., Curves, Why Buy a Franchise?, at www.buycurves.com/whybuy.aspx (last visited Apr. 21, 2006).

(9.) 16 C.F.R. [section] 436.1 (2006).

(10.) 16 C.F.R. [section] 436.1 (b), (c); see also 16 C.F.R. [section] 436.1 (f).

(11.) 15 U.S.C. [section] 45(a) (1) (2001).

(12.) See, e.g., FTC v. Minuteman Press, 53 F. Supp. 2d 248, 262-63 (E.D.N.Y. 1998).

(13.) See, e.g., Hardee's of Maumelle, Ark., Inc. v. Hardee's Food Sys., Inc., 31 F.3d 573 (7th Cir. 1994); Papa John's Int'l, Inc. v. Dynamic Pizza, Inc., 317 F. Supp. 2d 740, 747-48 (W.D. Ky. 2004); Carlock v. Pillsbury Co., 719 F. Supp. 791 (D. Minn. 1989), superseded by statute as stated in Twin Cities Galleries, LLC v. Media Arts Group, Inc., 415 F. Supp. 2d 967 (D. Minn. 2006).

(14.) Postal Instant Press, Inc. v. Sealy, 51 Cal. Rptr. 2d 365, 373-74 (Ct. App. 1996) (citations omitted).

(15.) A.J. Temple Marble & Title, Inc. v. Union Carbide Marble Care, Inc., 618 N.Y.S.2d 155, 159 (Sup. Ct. 1994), aff'd, 625 N.Y.S.2d 904 (App. Div. 1995).

(16.) McEvoy Travel Bureau, Inc. v. Norton Co., 563 N.E.2d 188, 194 (Mass. 1990) (quoting Bates v. Southgate, 31 N.E.2d 551, 558 (Mass. 1941)).

(17.) Thrifty Rent-A-Car Sys., Inc. v. Brown Flight Rental One Corp., 24 F.3d 1190, 1195 (10th Cir. 1994) (quoting Bowersock v. Barker, 96 P.2d 18, 19 (Okla. 1939), applying Oklahoma law); see also It's Just Lunch Int'l, LLC v. Polar Bear, Inc., No. Civ. 03-2485 WQH (JFS), 2004 WL 3406117 (S.D. Cal. Apr. 29, 2004).

(18.) See, e.g., Commercial Prop. Invs., 938 F.2d 870, 875; Carousel's Creamery, 134 S.W.3d 385, 394.

(19.) For example, the Texas Court of Appeals was willing to distinguish the case of an aggrieved franchisee from a case involving parties to a settlement agreement who were represented by counsel at the time of the allegedly fraudulent contract. Carousel's Creamery, 134 S.W.3d 385, 394.

(20.) In the famous case Broussard v. Meineke Discount Muffler Shops, Inc., the Fourth Circuit refused to certify a franchisee class action in part because "proof of reasonable reliance would depend upon a fact-intensive inquiry into what information each franchisee actually had...." (155 F.3d 331, 341 (4th Cir. 1998).) If your particular franchisee client knows very little and is a sympathetic plaintiff, that fact-intensive inquiry should be emphasized.

JEFF HAFF is a lawyer in Minneapolis.