But what if the numbers are misleading?
Charles Modell, a deservedly-so prominent franchisor lawyer, in his guest column in the September issue of Franchise Times, correctly opined that a thoroughly prepared financial performance representation is a pivotal piece. A carefully prepared Item 19, which has a reasonable basis and full and fair disclosure of the material facts and assumptions underlying it, is key information that a prospective franchisee seeks to obtain and can help a franchisor lawfully sell franchises.
Because Item 19 deals with the most frequently asked question by a prospective franchisee, “How much money can I make?” and its corollaries (what can I expect my sales to be; what are my costs likely to be; what kind of profits do franchisees like me typically experience), the way in which the franchisor can lawfully present a financial performance representation is the most heavily regulated part of the franchise sales process.
When a franchisor lawfully makes a financial performance representation to a prospective franchisee, it can reduce a franchisor’s exposure to litigation. For example, making a financial performance representation in the FDD avoids potential exposure from rogue franchise sellers making one outside of the FDD and not in the format required by various state and federal laws. Nonetheless, illegal FPRs do occur, whether in Item 19 of the FDD or outside of it.
What happens if a franchisor provides a financial performance representation to a prospective franchisee in a way that violates the law? Then what? In those circumstances, what rights might a victimized franchisee then have?
While Modell is correct that the law permits a franchisor to use a “subset” of franchisees in its Item 19 disclosure, such permission is not an invitation for the franchisor to simply cherry-pick its highest performing stores, whose numbers are atypical, as doing so would result in the FPR lacking the requisite “reasonable basis.” Likewise, it is unlawful for a franchisor to claim, in Item 19, that it does not make FPRs to its prospective franchisees, but to then in fact make one to get that prospect to sign up.
While the mere provision of an FPR outside of Item 19 of the FDD is unlawful, a franchisor gets into particular trouble when such a representation is also false and/or misleading. This could include a franchisor that operates multiple flags providing a prospective franchisee with an FPR from another of its flags, deeming it “representative” of what the prospective franchisee might do under a different flag, while either not having the knowledge or basis that the flags would perform similarly, due to a lack of experience, or actually knowing that the particular flag’s results are likely to vary from the more established and higher performing other flag.
A franchisor who makes an illegal FPR cannot escape liability by utilizing cleverly drafted disclaimers or franchisee questionnaires, although there are a few judicial decisions to the contrary.
As Judge Patrick Schiltz succinctly explained, when analyzing the issue under the Minnesota Franchise Act, in Randall v. Lady of America Franchise Corp.: “The disclaimer cannot change the historical facts; if the dishonest franchisor made misrepresentations, then he made misrepresentations, no matter what the franchise agreement says. Thus, the disclaimer can only be an attempt to change the legal effect of those misrepresentations. That is precisely what” the act’s “anti-waiver language forbids.”
So, what happens when a franchisor makes an illegal FPR, inside or outside the FDD, which a franchisee relied upon to its detriment, and the law does not permit the franchisor to avoid liability through cleverly drafted disclaimers? Approximately 15 states have franchise registration/disclosure statutes that are parallel to the FTC Franchise Rule and provide various remedies, which typically include rescission of the franchise agreement and rescission damages.
Even in states where there is not a franchise statute or similar state “Little FTC Act,” common law typically affords a victimized franchisee the same right to rescind the franchise agreement and recover damages.
While the concept of rescission damages may sound complex, it is a fairly easy calculation of the total amount invested in the franchise business, plus the total amount owed, plus the value of any uncompensated time for services rendered by the franchisee for which he/she did not receive reasonable compensation, less the salvage value of the remaining assets of the franchise, and, potentially, plus attorneys’ fees and costs.
For franchisees who have been victimized by an illegal financial performance representation, they should be aware of these potential remedies, which can be maximized with the help of experienced franchisee counsel.
J. Michael Dady is the founding partner of Dady & Gardner in Minneapolis. Reach him at firstname.lastname@example.org or 612-359-9000. Kristy Zastrow is a partner at Dady & Gardner. Reach her at email@example.com or 612-359-3502..