6 Warnings Signals of a Nervous Franchisee Prospect

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A franchisee who sued his franchisor for fraud learned the hard way why it's important to read the Franchise Disclosure Document, cover to cover, before buying a franchise.

A California franchisee of Big O Tires sued the company in California court, alleging that Big O defrauded him when it sold him a franchise.

The California Court of Appeals ruled against him because the disclosure document Big O gave to the franchisee before he bought contradicted each and every one of his claims.

Mr. Hailemariam purchased his Big O Tires franchise in February 2008. Before he bought the franchise, he received Big O's Uniform Franchise Offering Circular ("UFOC"). The UFOC was similar in content and structure to the Franchise Disclosure Document that franchisors are now legally required to give prospective franchisees.

After operating a store for little more than a year, Mr. Hailemariam closed it down due to financial difficulties. 'In August 2009, Mr. Hailemariam sued Big O in California state court alleging that the franchisor fraudulently induced him into purchasing a franchise.

Specifically, the franchisee alleged that Big O:

(1) told him (falsely) that he did not need experience to operate a tire store;

(2) provided exaggerated earnings claims;

(3) concealed from him that many of its franchisees had failed;

(4) told him that it would sell him tires at competitive prices, when the same tires were often available for less money from other sources;

(5) falsely stated that it develops new products and services; and

(6) had expertise in locating and outfitting stores.

Big O moved for summary judgment on the franchisee's claims. Based on a Colorado choice-of-law provision in the franchise agreement, the trial court held that Colorado law (and not California law) applied.

Reasonable Reliance

Under Colorado law, the Court said that a plaintiff claiming that he was defrauded must be able to show that he reasonably relied on the defendant's misrepresentation (or on the material facts that the defendant purposefully concealed).

Courts in Colorado apply the concept of "inquiry notice" when considering whether a plaintiff's reliance on alleged fraudulent statements was reasonable.

Quoting the Colorado Supreme Court, the Court summarized the doctrine as follows:

[W]hatever is notice enough to excite attention, and put the party upon his guard, and call for inquiry, is notice of everything to which such inquiry might have led. . . .

When a person has sufficient information to lead him to a fact, he shall be deemed conversant of it. . . . . The presumption is that, if the party affected by any fraudulent transaction or management might, with ordinary care and attention, have reasonably detected it, he reasonably had actual knowledge of it.

[As a result] [w]here the means of knowledge are at hand and equally available to both parties, and the subject of purchase is alike open to their inspection, if the purchaser does not avail himself of these means and opportunities, he will not be heard to say that he has been deceived by the vendor's representations.

Quoting Cherrington v. Woods 290 P.2d 226, 228 (Colo. 1955).

In other words, a person who receives a franchise disclosure document is supposed to read it. If he doesn't read the document, he can't later complain that he didn't know what was in it when he signed the franchise agreement. Moreover, if there was enough information in the disclosure document to allow the person to investigate the truth of the other party's claims, he can't later complain if he failed to do so.

The Franchisee's Fraud Claims

The Court held that statements made in the UFOC received by Mr. Hailemariam before he bought his Big O Tires franchise should be considered when determining whether he had access to those facts. Applying Colorado law to the facts, the Court examined each of the franchisee's fraud claims.

1. Exaggerated Earnings Claims

Regarding Mr. Hailemariam's claim that Big O exaggerated earnings claims in Item 19 of the UFOC, the Court examined Big O's UFOC, which stated: "BIG O DOES NOT GUARANTEE THE SUCCESS OR PROFITABILITY OF YOUR STORE IN ANY MANNER."

Big O also pointed to the actual language of Item 19, which included data from 211 stores. The data from the 211 stores supported Big O's own estimate of the average sales per store.

In Item 19 of the UFOC, Big O stated that it would provide substantiation for the data upon the franchisee's request, and stated that a franchisee should conduct an independent investigation of the information by contacting existing and former franchisees of the system that were listed in Item 20 of the UFOC.

But Mr. Hailemariam did neither of those things, and the Court found it significant that he failed to make those inquiries.

2. Concealing Failed Franchises

Regarding the franchisee's claim that Big O concealed from him the failure rate of its franchisees, Big O again pointed out that Item 20 of the UFOC contradicted Mr. Hailemariam's claim.

Specifically, Big O showed that the UFOC specifically listed the number of transferred, cancelled, and terminated franchises during the periods specified in the UFOC - and that if Mr. Hailemariam had bothered to read the UFOC, he would have known exactly what the failure rate was.

3. Tire Sale Prices

Turning to the allegation that Big O misrepresented to Mr. Hailemariam that it would sell him tires at competitive prices, Big O again referred to the UFOC. Big O argued, and the Court found it significant that, Big O did not guarantee any specific supply of tires, and the franchise agreement did not contain any provision obligating Big O to supply tires to franchisees at competitive prices.

What the franchise agreement did say is that Big O was only required to provide tires to franchisees "to the extent available," and that Big O could set the recommended prices for the tires.

So again, the clear language of the UFOC rebutted Mr. Hailemariam's claims.

4. Store Location

Mr. Hailemariam claimed that Big O misrepresented that it had certain expertise in locating and outfitting stores, when in actuality the site he selected with Big O was not a profitable or good location. In response, Big O noted that the UFOC specifically told Mr. Hailemariam that the "final decision" regarding a store's location was left to him, and that Big O disclaimed any liability for that decision.

Because the UFOC stated that selection of a location was entirely the franchisee's responsibility, and not Big O's, the Court gave no credence to that claim, either.

5. Need For Experience

Considering Mr. Hailemariam's claim that Big O (falsely) told him that a franchisee did not need experience in the tire business, the Court found it significant that the UFOC contained this disclaimer:

BIG O DOES NOT GUARANTEE THE SUCCESS OR PROFITABILITY OF YOUR STORE IN ANY MANNER.

Mr. Hailemariam acknowledged this disclaimer in his Franchise Agreement, which the Court found significant in overcoming the fraud claim.

Failure To Read The UFOC

With regard to all of the franchisee's fraud claims, the Court found it significant that, on the cover page of the UFOC, Mr. Hailemariam was admonished to read the circular carefully and show it to an accountant. The franchisee admitted that he did neither.

The franchisee's failure to read the UFOC was especially significant because he negotiated with Big O for three years (since 2005) before executing the franchise agreement and consulted with an attorney in obtaining the lease for his store.

Despite this long period of time - and his having sought legal counsel to obtain a lease -- he paid little attention to Big O's franchise offering circular and franchise agreement, and never sought legal advice regarding them.

Under the doctrine of inquiry notice, the Court found that Mr. Hailemariam should be charged with knowing all of the information in those franchise documents.

Last, the Court gave considerable weight to an integration clause in the franchise agreement, where the franchisee acknowledged that he was "not relying on any promises of Big O which are not contained in the Big O franchise agreement . . . [or the] accompanying Franchise Offering Circular."

Based on the disclosures, statements, and disclaimers made in Big O's franchise offering circular and franchise agreement, the Court held that Mr. Hailemariam could not have reasonably relied on any of Big O's alleged misrepresentations or concealed material facts. As a result, the Court granted summary judgment in favor of Big O and against the franchisee. The Court of Appeals affirmed the trial Court's judgment in all respects.

Lessons For Franchisees and Franchisors

If you are considering buying a franchise, this case is a warning of the importance of actually reading your Franchise Disclosure Document before you sign on the dotted line. It also illustrates the importance of hiring an experienced franchise attorney to help you understand your legal obligations before committing to a franchise.

If you are a franchisor, this case shows why it's important to have a well-written and legally compliant Franchise Disclosure Document. Big O was able to win this lawsuit because its UFOC specifically contradicted each one of the franchisee's claims.

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7 Comments

It's unfortunate for this franchisee and his franchise investment.

However it's hard to feel sorry for him since he had plenty of time to read and study the disclosure document before signing.

And he could have gotten help from an experienced franchise attorney to help him before buying.

Matthew writes: "In other words, a person who receives a franchise disclosure document is supposed to read it.

If he doesn't read the document, he can't later complain that he didn't know what was in it when he signed the franchise agreement."

FDDs can be hard to read.

But, as the Court points out in this case, it would have been very easy for the franchisee to read the FDD and find out the truth.

When are you going to publish the '6 Warning signals'? Interesting article but not what i expected! Thanks

Paul, are you looking for pre-sale investigation articles?

Michael I was just wondering if there was actually an article somewhere that outlined the '6 warning signals of a nervous franchisee prospect' as spoken of in the headline to the above article on the Big O judgement. The headline and the content seem misaligned.
It was, nevertheless, an interesting article as here in the UK we have virtually no franchise legislation other than that which comes from the EU and as Consultants we are always advising franchisors to produce Voluntary Disclosure Documentation not least to protect themselves from the sort of allegations Big O faced.

Hey, Paul.

In the US and many Canadian provinces, it is mandatory to give a prospective franchisee the prescribed FDD.

The claims that the Big O franchisee made are all something a nervous franchisee should have checked out.

Or things that any prospect should be worried about.

And in this case, he would have saved his investment.

If a franchisee receives the FDD or is asked to sign a disclaimer, then it is going to be very hard for him to claim that he was defrauded later on -when things don't work out so well.

http://www.briggs.com/insights-publications-Franchise-Antitrust-Distribution-And-Dealer-Newsletter-Fall-2014.html

You cannot reasonably rely upon statements you said that you weren't relying upon.

But, and here is the rub- many franchise prospects only have a dim understanding of what representations they are relying upon.

Great counsel can help them make these assumptions clearer.

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About this Entry

This page contains a single entry by Matthew Kreutzer published on October 28, 2014 5:20 PM.

Legal & Strategic Considerations in Confronting System-Wide Changes was the previous entry in this blog.

If You Don't Protect Your Trade Secrets Now, You Will Hate Yourself Later is the next entry in this blog.

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