Don’t Be a Victim of Franchise Fraud, aka, Churning -Consult a Franchise Attorney before You Buy
By Mario Herman, Esq.
Part one of this two part article provides insight into the importance of
Item 20 in the Franchise Disclosure Document. Understanding Item 20 and how
to use the information is an important component of a prospective
franchisee’s due diligence.
According to the FBI website:
Pyramid schemes, also referred to as franchise fraud or chain referral
schemes, are marketing and investment frauds in which an individual is
offered a distributorship or franchise to market a particular product. The
real profit is earned, not by the sale of the product, but by the sale of
new distributorships. Emphasis on selling franchises rather than the product
eventually leads to a point where the supply of potential investors is
exhausted and the pyramid collapses.
There are thousands of reputable franchises in the United States.
However, as a prospective franchisee you should remember that one of the
largest profit centers for franchisors can be the selling of franchises.
Therefore, with some franchisors, once you are hooked into signing the
franchise agreement and paying the upfront "franchise fee", the franchisor
has little concern as to whether you generate a profit. If you fail, the
franchisor will simply sell the franchise again. This form of franchise
fraud is known in the industry as "churning."
In the United States, franchising is regulated by a complex web of rules
and regulations, including the Federal Trade Commission (FTC) Franchise
Rule, state laws, and industry guidelines. The FTC Franchise Rule, and many
state laws, specifies what information a franchisor must disclose to a
prospective franchisee in a document entitled the Franchise Disclosure
Document (FDD). A careful review of this document is crucial before you buy
a franchise, and e investing in a qualified franchise law attorney to review
this document before you buy will be money well spent.
One of the disclosures a franchisor must make under the FTC Franchise
Rule in its FDD is Item 20: Outlets and Franchisee Information. Item 20
requires the disclosure of statistical information on the number of
franchised outlets and company-owned outlets for the preceding three-year
period. Under the latest version of the Franchise Rule, which went into
effect in 2008, the franchisor is required to set forth information in five
tables. The first table provides a system wide summary of outlets, detailing
the net changes in the number of outlets – both franchised and company-owned
– over the last three fiscal years. The second tracks transfers of outlets,
state by state, over the last three fiscal years. The third shows, state by
state, changes in the status of franchised outlets over the last three
fiscal years. Similarly, the fourth table displays, state by state, changes
in the status of company-owned outlets over the last three fiscal years.
Finally, the fifth table projects new outlet openings in each state, and
sets forth the number of franchise agreements that have been signed but have
not yet resulted in the opening of an outlet.
There are various terms used in these tables, which according to the FTC
have specific meanings:
"Transfer" means the acquisition of a controlling interest in a
franchised outlet, during its term, by a person other than the franchisor or
an affiliate. It covers private sales of an outlet by the existing
franchisee-owner to a new franchisee owner and the sale of a controlling
interest in the ownership of a franchise.
"Termination" means the franchisor’s termination of a franchise
agreement prior to the end of its term without providing any money or other
consideration to the franchisee (e.g., forgiveness or assumption of debt).
For example, a franchisor may decide to terminate a franchisee for failing
to abide by system health and safety standards. As a result, the franchisee
leaves the system without receiving any payment or other consideration, such
as cancellation of a debt owed to the franchisor.
"Non-renewal" means failure to renew a franchise agreement for a
franchised outlet upon the expiration of the franchise term. For example, a
franchisee may operate a franchise for period of 10 years. At the conclusion
of the 10-year term, the franchisor (or franchisee) may decide not to renew
the franchise agreement.
"Reacquisition" means the return of a franchise outlet during its term to
the franchisor in exchange for cash or some other consideration, including
the forgiveness of a debt. For example, during the course of a franchise
agreement, a franchisee may wish to terminate its relationship with the
franchisor, and the franchisor may agree to buy back the outlet for cash or
to forgive overdue royalty payments.
"Ceased operation" means the cessation of business operations for any
reason other than transfer, termination, non-renewal, or reacquisition. It
includes abandonment of the outlet by a franchisee. It also includes
franchisees in an "inactive" status.
In some instances, there may be multiple changes in ownership or multiple
owners of an outlet over the course of a fiscal year. For example, during a
single fiscal year, a franchisee may cease operations and the franchisor may
respond by terminating the franchisee’s franchise agreement. Where there are
multiple events such as these affecting a particular outlet, the Rule
provides that only the last event for that specific outlet need be reported.
In the example above, since termination was the last event, the change in
status should be reported only as a termination. Franchisors are permitted
to add a footnote to the chart to explain the series of status changes, but
except in the case of multiple franchise owners, are not required to do so.
Mr. Herman, based in Washington, D.C., represents franchisees domestically
and internationally in negotiation, mediation, arbitration, and litigation.