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Do Inadequate Disclosure And Ignorance Equal Fraud And Misrepresentation?

Author Richard Solomon is a conflicts and crisis management lawyer with 50 years of experience in business development, antitrust and franchise law, management counseling and dispute resolution including trials and crisis management.

Basing this upon my own experience with franchisees calling and asking for help to get out of a franchise relationship, over at least 35 years, there is a common and constantly recurring thread.

The franchisor in most instances made statements required by disclosure laws that were either true or at least not grossly and flagrantly untrue. The franchisee relied on the information provided; spoke with several franchisees (often to whom he was steered by the franchisor); had a "lawyer" "read" the FDD and "explain" the contract to him; made the investment (usually within the last two years); and is going broke. Breakeven was never achieved. Positive cash flow was either never achieved or is consumed by debt service. The franchisee cannot afford an attorney to do anything that might be helpful - not even a few thousand dollars to get help negotiating his way out of the franchise. By its terms the contract is not terminable by the franchisee for any reason.

The franchisee personally guaranteed the full performance of the franchise agreement. There is a disclaimer of having received financial performance representations other than as stated in the FDD. Often there were substantial financial performance representations made outside the FDD, but the franchisee acknowledged that they were not made and that even if he did come across any such information he did not rely upon any of it in making his investment decision.

If not able to negotiate some resolution to his dilemma, his only option is personal bankruptcy. He is already in the zone of insolvency, so that if a lawyer accepted a retainer from him it might well be clawed back by the bankruptcy trustee as a voidable preference. He has a wife and three children. His house is mortgaged for this investment. He is too old to be a good candidate for employment in many instances.

His problem is the product of ignorance. Few franchise investors have any inkling how to operate a small business. They don't come from small business experience, and they are almost never retailers. They don't know that food is one of the most risky investments there are. But it is still unlawful to cheat the ignorant or the stupid.

Getting to specifics, many franchises deal with selling products at retail to the public from stores, often in expensive malls. The franchisee gets a glass of the kool aid and doesn't ever look under the hood. He signs the franchise contract and a retail mall lease. But almost none of them shop around the general area to see (1) how the products are usually sold and (2) at what retail prices.

Why would anyone rent space in a mall to sell products that everyone usually buys in grocery stores? Shopping for the franchised product(s) around town usually would reveal that any consumer can buy the product(s) at retail for less than this mall shopkeeper buys it at "wholesale".

When I point this out to the soon to be bankrupt franchisee sitting in my office, the look on his face is one of amazement. He waited until he was ready to file for bankruptcy before comparison shopping his products. You would think anyone would know to do that. They almost never do it.

Single product retailer franchises are the worst. Whether it's olive oil or batteries, the franchisee must live or die on that one product category. He has nothing else to take up the slack that might allow him to sell at competitive prices. He has to buy from the franchisor or a designated vendor, which means he will never get the benefit of competitive pricing. There may indeed be buying power in the chain, but its value goes to the franchisor, not the franchisees.

They seem never capable of effective organization and therefore never have control over their supply chain. If they have any organization at all, it is organized like a social club with a web site on which they publish unsupportable statements of opprobrium about the franchisor, eliminating the potential to achieve any positive business accommodation. Militancy requires direction, and direction by a competent tactician costs money in excess of social club dues. The association never has a treasury capable of a competent budget for anything worth doing. The first thing they say when they call is that they do not have money for conflict. Without budgetary capability, they call some Chatty Cathy type lawyer who will work for peanuts and accomplish nothing.

How hard is it to figure that out? If you don't already know to do that, it is impossible. And yet it seems so simple and obvious. Will the franchisor ever disclose the price squeeze impact on his franchised business? Of course not ! Is that fraudulent failure to disclose a critical inherent defect in the franchise concept? Not yet according to the case law. Is it deceptive selling not to disclose that? Where does the franchisee begin to have a duty not to be an idiot? In his application to buy the franchise, the franchisee touted himself as an experienced and accomplished business person with many years of success. How can he later convince a judge or jury that he didn't know his ass from a hot rock? He has in most instances buried any likelihood that he has a viable case for having been deceived.

If he could get to a jury, he might get a sympathy verdict, usually not much good on appeal. If there is an arbitration dispute resolution procedure selected in the franchise agreement, he will never get to a jury. If the arbitration is under AAA Commercial Rules he might get an arbitrator who is not a lawyer from a firm that represents franchisors. But he may not get that lucky. When the AAA has Franchise Rules, he will almost never get an arbitrator who is not biased towards franchisors.

It won't matter because he won't have money to pay for representation anyway. He will wait until he is insolvent and then try to get a lawyer to represent him on a contingent fee. No lawyer who knows what he is doing will touch this person with a stick.

Can he change how his franchised business operates to add items or services that permit him to make some money and survive? Almost never. The operations manual does not provide for a right to change the business in that way. He will almost never get the franchisor's consent to make any such change. Why that is the fact is not important. That it is the fact is the key issue. Is there a duty to allow a failing franchisee to change the scope of his business? No court has ever held that there is any such duty. The so called requirement of "good faith and fair dealing" has never been used to require any such option.

No one who actually bought a franchise seems to have recognized in his due diligence that any franchisor who controls the supply chain can change the franchisee's prospects for financial return by the simple device of arranging for price changes in supplies and/or toggling the ops manual to add things for which extra fees are imposed. In this way the franchisor may enhance its profitability and rate of return at the franchisees' expense with absolutely no legal risk whatsoever. No court has ever addressed that issue, much less held that it may violate any legal mandate. The ops manual can't be used to rewrite the agreement, but the changes in the ops manual needed to reach this threshold are far more than this. These are but a very few of the scenarios I hear every month from franchisees seeking to get out of their franchise agreements. This is why I have come to believe that there is no need to tweak laws regulating franchising. All these problems can be corrected through the simple practice of seeking the assistance of competent franchise pre investment due diligence.

To be sure, there are several more extremely effective techniques to corroborate the investment potential - or lack thereof - of any small business investment. This could be far too long an article were I to explain how each of them works. But there are people out there who make a good living providing really effective insight into any small business investment prospect. There is no excuse for not availing yourself of their services when you are about to bet the farm investing in a business you have never operated before; based on a sales pitch that you have no way to corroborate; and in which you sign a draconian agreement that leaves only personal bankruptcy as the way out in almost every instance. Assumptions about the ability to resell a failing business require that you expect to find the greater fools than you were when you bought it. The "greater fool" theory of investing is an old Texas saloon hypothesis.

We should not change laws, and we certainly should never weaken the enforceability of contracts, no matter how harsh their terms, when there is another and less intrusive way to prevent the perceived problems. No one ever needs to be taken in by deals that have no future. The available techniques of pre investment due diligence make it possible to vet deals qualitatively, not only from a legal perspective, but also from a business and financial perspective. They go way beyond "reading the FDD" and just talking with existing franchisees. To be sure, they are more expensive that the "read the FDD" nonsense that most franchise investors now use (to their dismay), but value is more important than expense when you are risking everything you have.

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