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Think Franchise Regulatory Compliance is Expensive? Arbitrator Awards Former Franchisee Claim at 26 Times Franchisor's Net Worth in Buyer's Remorse Case

A Midwest franchisor of retail stores had a steady growth pattern and some good success stories among its franchisees. A sales person transmitted a one line claim about profit margin on the primary store produce that did not comply with Item 19 requirements. The prospects were MBAs with lots of business savvy. The CEO was unaware of the document until the termination of a store franchise that was not successful and another store under development. The franchisees filed for arbitration of their claims against the franchisor over the failures of their franchise investment. The arbitrator found that the document and the franchise sale violated state franchise law, which the sophisticated franchisee prospects relied on the earnings claim document despite all of the other diligence that they undertook, and awarded rescission. He also found the CEO had no knowledge of the document and was not personally liable for its use and the consequences. The award, which is extremely difficult to challenge on appeal because of the narrow scope of arbitration appeals allowed by law, amounted to 26 times the franchisor's disclosed net worth, 67% of its gross sales and 4 times its disclosed current assets. In this case, even buying back the underperforming store did not relieve the franchisor from liability.

For franchisees, those little pieces of paper may or may not equate to a lottery ticket or a "get of jail free" card. Rather than undertake a franchise development project that is ill advised and based on faulty data, franchisees would be well served by confirming that the franchisor stands behind those bits of extra information. Show them to the most senior person introduced to you. Find assurances that your reliance is well placed and appropriate, and not based on the words or documents received from just one person. If you receive contradictory materials, get clarity!

The case points out the importance of three key issues for franchisors. First, the choice of arbitration for domestic dispute resolution should be carefully made, where awards cannot be readily appealed, and which requires the upfront payment of a filing fee based on the amount in dispute and payment of fees for the time expended by the arbitrator. Second, the compliance training and close supervision of staff engaged in franchise selling activity is highly important for the financial health of the franchisor. Third, the use of a closing acknowledgment form or another means of verification that the franchisee is only relying on the Franchise Disclosure Document and authorized collateral material, which forces franchisees to attach any extraneous communications on which they are relying, is vitally important for the franchisor's protection against sales law violations of sales staff. Some franchisors make a video recording of the franchise sale closing at which the franchisee is asked about any earnings claim type material they may have received and relied upon in making their decision. The outcome of this case differs from recent decisions where the closing acknowledgment prevented franchisee claims of reliance on unauthorized earnings claims documents.

If you are interested in comprehensive compliance training for your staff at your offices, please contact Joel Buckberg, 615.726.5639 or jbuckberg@bakerdonelson.com.

Federal Trade Commission Announces Six Month Delay of Red Flags Rule Enforcement

The Federal Trade Commission announced on October 22, 2008 that it would delay enforcement of the new "Red Flags Rule" until May 1, 2009, from the original November 1, 2008 date. The reason for the delay is to give creditors and financial institutions more time to develop and implement identity theft prevention programs.

The purpose of the Rule is to reduce consumer exposure to identity theft. We believe the Rule is sufficiently broad in scope to cover certain franchise system transactions between a franchisor and its franchisees, and between franchisees and their retail customers. The key element of coverage involves the extension of credit for a covered account. By definition, cash and discrete single credit card payments are not covered by the Rule, nor, generally, are transactions with franchisees and retail customers that are legal entities making payments through corporate accounts. But routine, monthly royalty payment and open account transactions with individual franchisees, common in many franchise systems, could cause the franchise relationship to fall within the scope of the Red Flags Rule. Likewise, franchisee transactions with consumers that allow for payment of the purchase price for goods or services over time under open accounts, even by credit card in pre-authorized installment payments, could cause the franchisee to be covered under the Rule.

How could the Rule apply to a franchise environment? Probably the most common way it could apply is as follows. An individual franchisee with multiple locations routinely orders supplies and some retail inventory from the franchisor’s purchasing program on open account, billed and paid by check or Electronic Funds Transfer (EFT) monthly. The store manager responsible for the ordering is selling the inventory and supplies "out the back door," so the franchisee’s reports of gross sales reflect inconsistencies with the orders placed by the franchisee’s staff for supplies and inventory. In other words, the ratios are outside normal parameters. Under the Red Flags Rule, this fairly common scenario means that the franchisor should identify this circumstance and notify the franchisee that unusual activity is occurring in the account. Since much of this activity is automated, the connection between wholesale and retail sales levels should be programmed and calculated to produce a "red flag."

For more information on Red Flags Rule compliance and computer security issues, contact Betty Steele in Nashville at 615.726.5741 or bsteele@bakerdonelson.com.

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