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Sona MedSpa Arbitration Decision;

Is auditor letter a new ploy against Subway franchisees?


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Janet Sparks is the former
publisher of Continental
Franchise Review, an industry newsletter that covered the franchise community for more
than 30 years before being
acquired by Franchise Times
Corporation.

Janet can be reached
at 303-799-7398 or at
jsparks@franchisetimes.com

The final ruling in an American Arbitration Association (AAA) award, was made on April 9, 2007, awarding $400,000 to the franchisee-claimants of Sona MedSpa. The arbitrator’s decision was “guilty of negligent misrepresentation” on Count Two. All other claims by franchisees were denied, as were all counter-claims by franchisor respondents. But I find it interesting that the franchisor side of the arbitration seems to be having difficulty in conceding to the franchisees’ claim for victory. According to Kiran Mehta, Kennedy Covington, outside counsel for Sona MedSpa International, “The arbitrator ruled unequivocally that no fraud or intentional misrepresentation of any kind occurred.” He also stressed that the decision is confidential, although he could not point to any statute stating so.

This arbitration case and its resulting decision is unique in franchising, not only because it involves a renowned, but controversial, franchise executive, but also a private equity firm involved in the management of the franchisor with its high-profile partners. The arbitration decision brings up important issues addressing the “due diligence” requirements of private investment companies when they step into the franchise arena in purchasing a franchisor. According to W. Michael Garner, Dady & Garner, attorney for franchisee-claimants, the decision is not just about his clients winning. “It’s about a landmark decision that will have a huge effect on franchising because of all the merger and acquisition activity going on,” he said.

Reviewing the decision

Originally, the franchisees filed for arbitration in January 2006, on 11 counts, including Count One alleging fraud. In his decision, the arbitrator rejected ten of the counts, as well as all counter-claims by Sona MedSpa respondents, and adjusted the award to $400,000, stating that damages would only be allowed for claims through October 2006. Total damages sought at trial were $1.3 million. Another factor in his decision was based on the fact that the franchisees continued their business under their new skin care center name, and because of their high education level and income producing capabilities, compensation for loss of livelihood was minimized. In addition to their award, the franchisee claimants were also required to pay their portion of arbitration and legal fees.

In the 34-page Arbitration Award against Sona MedSpa International, a hair-removal and skin rejuvenation franchise, it first addresses respondents Sona Laser Centers, Sona MedSpa International, Inc., founder Dennis Jones and medical director Dr. George Wilson. The arbitrator states that under the weight of the evidence, he finds them guilty of negligent misrepresentation in providing faulty efficacy information on Count Two. As an abbreviated explanation, the evidence surrounds claims by Sona that its laser technology was faster and better than that of competing businesses. The evidence showed, according to the award, that Sona Laser Centers, Jones and Wilson encouraged franchisees to continue to use the flawed information—medical in nature—even though they knew they were passing it on to their customer/clients.

But secondly, the arbitration award addresses other respondents under Sona MedSpa International, Inc. naming them individually liable, again under Count Two. They include James H. Amos Jr. and daughter Heather Rose, former and current Sona CEOs respectively, as well as Carousel Capital Partners executives Jason Schmidly, Joseph Pitt and Nelson Schwab II, all members of Carousel’s Board of the General Partners. Carousel Partners was co-founded by Schmidly and Erskine Bowles, White House Chief of Staff under the Clinton Administration. Bowles is a now a senior advisor to the firm. Carousel had purchased a majority interest in Sona MedSpa International in May of 2004 with Amos and Rose.

According to the arbitrator, Sona, Carousel Capital, Amos and Rose failed to exercise ordinary care in determining the medical validity of the efficacy information taught to franchisees. He said that although they had conducted due diligence in the areas of business, financial and accounting investigation and evaluation, Amos and Rose made little effort to investigate the medical validity of the efficacy information. The Carousel Capital Partners due diligence was limited. It did not, according to the arbitrator, retain a dermatologist or other medical expert to verify the medical aspects of the information.

The arbitrator ruled that the parties were guilty of negligent misrepresentation. But he didn’t stop there. He stated, “Let me make it clear that these named Respondents are not liable because they, or some of them, were simply “investors.”

Evaluating the decision

In evaluating the entire legal episode, Garner said, “It is about the due diligence that has to be performed by anyone who is buying a franchise company. They can’t simply buy a franchisor and ignore any possible misrepresentations that might have been made to existing franchisees.”

He feels it will be a landmark decision.

Although attorney Craig Tractenberg of Nixon Peabody isn’t sure it is a landmark case, he feels it is a very instructive decision. He said, “Equity firms that buy franchisors also buy the skeletons in the closet. But if they are smart they will not ignore this decision. There is clearly a lesson to be learned here.”

Tractenberg explained that if equity firms are just investors they have limited risk. But they must conduct due diligence because it is possible that they may later become involved in management and then will have obligations. In the Sona arbitration, he said, “It was their failure to act in their capacity of management, not just as mere investors.”

IFA response to decision

In March of 2006, Garner filed a formal complaint with the International Franchise Association against franchisor Sona MedSpa for widespread violations of the IFA Code of Ethics. The complaint was filed on behalf of seven franchisees. At that time, Terry Hill, vice president of IFA’s communications, said IFA could not pursue a complaint which was subject to arbitration, litigation or other disputes.

But in a statement from President Matthew Shay, he says,

“Based on the arbitrator’s decision, which overwhelmingly ruled against the plaintiffs, there is nothing that IFA deems worth pursuing. To call one relatively minor finding anything other than insignificant could frighten away other potential equity investors whose financial support provides the capital resources necessary for franchises to continue expanding and providing opportunities for prospective new investors. That could have a directly opposite effect and harm the very people some observers claim they’re trying to protect--franchise investors.”

Is auditor letter a new ploy against Subway franchisees?

Subway now requires purchasers of its restaurants to submit signed letters by auditors agreeing to the purchase price, according to documents received from anonymous sources. One sample letter states: “After reviewing the information in connection with the purchase of this Franchise with Mr. __, it appears that the purchase price fairly reflects the value of the Franchise Agreement and related items.” But it must further state: “I have not audited the books and records of Seller nor do I make any opinion, in any way, as to these books and records.” Subway explains that although these items have long been part of the store transfer process, it did make them clearer when they updated and streamlined their process in January of this year. The company says it advises the new purchaser to consult with an attorney, accountant or other financial consultants. In addition to confirming the creditworthiness of the new owner, the company requires a letter from an accountant indicating that he has advised the potential franchisee that it is OK to complete the transaction. The buyer must also verify that he or she has inspected the restaurant; and have had an opportunity to inspect the restaurant’s books and records.

Andrew Selden, Briggs and Morgan, who represents the North American Association of Subway Franchisees (NAASF), said, “An auditor would be a fool to sign something like that. He would have no expertise in making that kind of determination.” By doing so, Selden said the auditor would be putting his professional judgment on the line.

But Subway counters saying, “With regard to the accountant letter, we are finding that they are generally being provided.”

Are ongoing disputes harming system’s foundation?

Disputes between the company and franchisees have been ongoing for almost two years. Selden said this auditor’s letter is just one more thing that shows DAI has no interest in working with the franchisee community. “They just want to run things the way they want to run them,” he said. According to Selden, NAASF has been trying for a year and a half to engage DAI in constructive conversations about system standards, such as store inspections, audit and transfer standards, to no avail. “These are the things that make a big franchise system work effectively,” he said.

Update: Don Boroian

(Previous article: Franchise Times, CFR, May 2007)

Donald Boroian, founder and once again CEO of Francorp Inc., his 30-year-old franchise development company in Olympia Field, has been released from the Duluth Federal Prison Camp and is now in the Community Corrections Management program in his home state of Illinois.

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