Franchise Fraud -Churning

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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, specify 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.


            Under Item 20, Franchisors are also required to provide the prospective franchisee with the contact information for all current franchisees, or for all franchisees in the state where they are offering to sell franchises if there are 100 or more franchises in the state, or for at least 100 franchisees in contiguous states and the next closest states.  If a franchisor has fewer than 100 current franchisees, contact information must be provided for all of them.


            Also under Item 20, Franchisors must provide the prospective franchisee with contact information for every franchisees who: 1) has had an outlet terminated, canceled, not renewed, or otherwise voluntarily or involuntarily ceased to do business under the franchise agreement during the most recently completed fiscal year; or 2) has not communicated with the franchisor within 10 weeks of the disclosure document issuance date. 


            One might think that contacting former franchisees would be quite useful, as they have no ongoing investment in the franchise business and might speak more openly.  However, there are a few obstacles to gathering information from former franchisees.  First, under Item 20, in order to protect the privacy of former franchisees, the Franchise Rule calls for the disclosure of only limited contact information: the name, city and state, and current business telephone number of a former franchisee. While the Franchise Rule provides that a franchisor should only use the “last known” telephone number if the current business telephone number is unknown, one has to question how many former franchisees keep their former franchisor updated with current contact information. 


            The second obstacle is what are known as “confidentially agreements” or “gag orders” between former franchisees and franchisors.  Franchisors are required to disclose if franchisees have signed confidentiality agreements with the franchisor during the last three fiscal years that restrict a current or former franchisee from discussing his or her personal experience as a franchisee in the franchisor’s system. These confidentiality agreements typically arise as part of the resolution of a dispute between the franchisor and franchisee, and as such, might restrict a franchisee from disclosing relevant information about the franchise.  The unfortunate result of these confidentiality agreements is that it allows franchise misrepresentation by preventing prospective new franchisees from learning potentially negative details about the franchise.  All of which may result in the prospective franchisee unknowingly purchasing a franchise in a system that has a history of low or no profitability and high failure rates of franchisees.  It should  be further noted that current and ex-franchisees of systems have no duty under the law to disclose information about their businesses to prospective franchisees.  By having former franchisees under a confidentiality agreement or gag order, franchisors that practice franchise fraud or franchise churning "inhibit prospective franchisees from learning the truth about the franchising opportunity as they conduct their due diligence investigation of a franchise offer." (Federal Register Franchise Rule, page 15505.)


            While not foolproof, a careful review of Item 20 can disclose some red flags which might help to prevent you from falling victim to franchise fraud or churning.  Is there a high turnover rate?  What are the reasons for the turnover rate?  Does the franchisor require confidentiality agreements of its current and/or former franchisees which would prevent you from getting relevant information as you conduct your pre-purchase due diligence?  Again, before you purchase a franchise, you should seriously consider having an experienced franchise law attorney review this information with you, as well as reviewing the other disclosures in the FDD and the contents of the Franchise Agreement.  Doing so may save you tens of thousands of dollars in the long run.  The old saying, “penny smart, pound foolish,” is critical to remember when making such an important and financially significant investment.  

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