Difficulties in Proving Franchise Fraud and Damages

December 30, 2020Articles The Legal Intelligencer

Proving franchise fraud and real damages is difficult. Despite helpful laws and regulations concerning the offer and sale of franchises, even where actual violation of these laws and regulations exist, recovery of an entire investment and lost profits is increasingly rare. Most of these cases are resolved by arbitration, and franchisee losses are rarely reported. Those resolved by courts give us a glimpse of reality. The federal case of MTR Capital v. Lavida Massage Franchise from the U.S. District Court in the Eastern District of Michigan is instructive.

Regulation and laws are designed to prevent fraud.

The Federal Trade Commission rule governing the offer and sale of franchises requires formal and uniform disclosures of basic information deemed important to prospective franchisees in a franchise disclosure document (FDD). The FDD of a mature franchisor contains 23 separate items of disclosure, together with three years of audited financial statements and metrics concerning the history of the franchisor and its leaders, their litigation and bankruptcy history, operational requirements, financial representations, audited financial statements for three years, contact information for the prospect to contact franchisee that are in the system and who have left the system, and all contracts reasonably anticipated to be signed in connection with the franchise relationship. The prospective franchisee uses the FDD as a starting point to begin its diligence.

The FTC requiring that an FDD be given is merely a regulations which can be enforced by the FTC. It is not a law which grants a prospect a private right of action to enforce. Some states have pre-sale franchise regulations and laws with anti-fraud provisions governing sales to their citizens. Some states have no pre-sale laws, but have “Little FTC Acts” that grant a private right of action missing from the FTC rule. Typically, the Little FTC Act is contained in a state law, consumer protection/deceptive trade practices act. Still other states have no franchise specific rules or laws, and litigants rely on common law causes of action for redress.

Liability for an inaccurate FDD.

Just because franchise sales are regulated does not mean that franchisors are strictly liable for damages. To the contrary, most of these rules, regulations and statutes require intentional conduct and reasonable reliance. The MTR Capital case is a very good example where technical violations are insufficient for substantial damages.

In MTR Capital, a federal district court sitting in Detroit was called upon to resolve the claims of a Florida massage franchisee given an inaccurate and stale FDD regarding the number of franchisees that had opened and closed. The court concluded that the franchisor had violated the Florida Little FTC Act, the Florida Deceptive and Unfair Trade Practices Act (“FDUTPA”). The court also concluded that MTR Capital’s claims for fraudulent inducement and misrepresentations, and Florida Franchise Act failed, for a variety of reasons.

The court found that the Florida Franchise Act claim, as well as the fraud and misrepresentations claims failed because the franchisee could not satisfy the requirement of detrimental reliance. The court cited the disclaimer clause and integration clauses to conclude that the franchise was not purchased based on any specific performance projection and that the remainder of the inducement claims were based on puffery. The court ruled that the inaccuracies in the FDD were due to franchisor sloppy record keeping and not intentional conduct, so the inducement claims were dismissed.

Causation can be an overwhelming issue.

The MTR Capital court was required to decide damages for violation of the FDUTPA claim. This is basically a strict liability claim but damages need to be proven. MTR Capital claimed it lost its entire investment of $541,644.83, including operating costs and salaries. The franchisor, however, convinced the court that once MTR Capital signed the franchise agreement, the losses were caused by MTR’s own mismanagement. The evidence introduced showed that MTR’s franchise was in the bottom 10% in customer satisfaction, received poor online reviews, had high rates of staff turnover, overspent on its construction budget, and failed to effectively advertise. The court concluded that mismanagement severed the causal chain between any FDD misstatements and the losses suffered by MTR once it began operations. Normally, Florida courts look for a gap in value between what was promised and what was delivered to measure actual damages under the FDUTPA. The court determined that MTR’s actual damages were best represented by the franchise fee, $39,000 and was not awarded the entire value of its lost investment.

Lessons learned.

Franchisees cannot prove loss of their entire investment merely by showing franchisor inaccuracies or incompetence. Franchisors that provide future performance representations, with franchise agreements containing questionnaires to ensure franchisees did not rely on anything outside of the FDD, and integration clauses, stand a very good chance of defeating franchisee claims. Even when such claims survive, the burden of proving damages requires the franchisee to demonstrate proper and efficient operation. Franchise fraud cases are easy to allege, but the successful cases are spectacular but rare.

Reprinted with permission from the December 30 issue of The Legal Intelligencer. (c) 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.