Communicating a Franchisor's Value Without Crossing the Line

Franchisees invest a substantial amount of time and money into buying a franchise. In return, they expect franchisors to provide value, such as a high return on their investment, brand recognition that will attract customers, training, advertising, marketing, and other operational assistance. One

way or another, almost every franchisor-franchisee dispute has, at its core, a contention by the franchisee that it is not getting the value that it expected to receive when it purchased the franchise. Too often the seeds of a future dispute are planted when the franchisee walks away from the franchise sales process with expectations of value that the franchisor cannot deliver.

Making Financial Performance Representations

To state the obvious, complying with the U.S. Federal Trade Commission's Amended Franchise Rule and the various state franchise laws is necessary to avoid future liability. Because failure to comply with the disclosure requirements for financial performance representations is the most common franchise law violation investigated by the FTC, it is important to know how franchisors typically get into trouble when making financial performance representations.

Many franchisors get into trouble by making financial performance representations in their franchise advertising, but not disclosing the information in their franchise disclosure documents. A franchisor that does not make financial performance representations in its franchise disclosure document must not make financial performance representations anywhere. This means that a franchisor that does not make a financial performance representation in its franchise disclosure document must not include information about sales or profits in its franchise marketing materials or even direct a prospective franchisee to sales or profit information in Web sites, Securities and Exchange Commission filings, speeches or news releases.

Complying with the new rule and the various state franchise laws is necessary to avoid crossing the improper disclosure line. Merely memorizing and complying with the federal and state laws governing franchise disclosure is not enough to shield a franchisor from liability.

Quite often franchisees who feel that they are not getting the value promised by franchisors, both during and after the franchise sales process, will include counts of common-law fraud in their complaints. The most obvious common-law fraud claim that a franchisee can make is that the franchisor made a fraudulent misrepresentation. To prove fraudulent misrepresentation, a franchisee must prove the following five elements:

1. The franchisor made a false statement of material fact,

2. The franchisor knew or should have known the statement was false,

3. The franchisor made the statement to induce the franchisee to buy the franchise,

4. The franchisee justifiably relied on the truth of the franchisor's statement, and,

5. The franchisee suffered a loss due to reliance on the franchisor's statement.

Statements Concerning Franchise Value

The most obvious fraudulent misrepresentation for which a franchisee can recover involves an affirmative false statement by the franchisor regarding the value of the franchise. For example, a franchisor is liable for fraud when it states that it owns trademarks and patents that will provide a competitive advantage to the franchisee when, in fact, the franchisor does not own any trademarks or patents.

Most franchisors, however, will not cross the fraudulent misrepresentation line so blatantly. It is more likely that a franchisor crosses the fraudulent misrepresentation line without even knowing it. For example, a franchisor can be liable for fraud even if it thought that it was expressing an opinion rather than stating a fact. Although opinions generally are not actionable as fraudulent misrepresentations, they may be fraudulent misrepresentations if the franchisee reasonably understood the franchisor's statement to be based on affirmative facts material to the franchisee's purchase of the franchise.

To avoid liability for claims of fraudulent misrepresentation, a franchisor must, of course, be truthful and accurate in its disclosures to prospective franchisees. But the franchisor must also clearly outline for the franchisee which of its statements are based on facts and which are only expressions of the franchisor's opinion.

Fraudulent Concealment

The less obvious common-law fraud claim that a franchisee can make is that the franchisor fraudulently concealed a material fact from the franchisee. Fraudulent concealment can include omission of a material fact or making a statement that is technically true, but is misleading because it does not include facts or circumstances that materially qualify the statement. Courts often say that a half-truth can be more misleading that an outright lie. Regardless of the type of fraudulent concealment, the elements are the same.

To prove fraudulent concealment, a franchisee must prove the following six elements:

1. The franchisor concealed a material fact from the franchisee,

2. The franchisor intended the concealment to induce a false belief by the franchisee,

3. The circumstances surrounding the franchisor's concealment imposed on the franchisor a duty to speak,

4. The franchisee could not have discovered the truth through a reasonable inquiry or was prevented from making a reasonable inquiry and justifiably relied on the franchisor's silence as a representation that the fact did not exist,

5. The concealed information was such that the franchisee would have acted differently had he been aware of the information, and,

6. The franchisee suffered a loss due to his reliance that the fact did not exist.

The concealment of actual facts affecting the value of the franchise may be sufficient to create a duty to speak.

In thinking about what could constitute fraudulent concealment, franchisors should consider the following situation: The franchise agreement allows the franchisor to change elements of the franchise system. The franchisor knows that it will institute changes to the franchise system a month after the franchisee signs the franchise agreement. The franchisor knows that the changes will greatly increase the franchisee's initial investment, but the franchisor does not disclose the changes or increased costs to the franchisee. This could be a material fact that would have affected the franchisee's decision to buy the franchise, so assuming the franchisee proves all of the elements, the franchisor could be liable for fraudulent concealment.

Antifraud Statutes

Even if a franchisor is not liable for common-law fraud, it still may be liable under federal or state antifraud statutes. Antifraud statutes often provide broader consumer protection than the common-law actions of fraud because the statutes do not require a plaintiff to prove all the elements of common-law fraud. For example, the Illinois Consumer Fraud Act does not require the plaintiff to prove actual reliance on the misrepresentation or omission, and the plaintiff may recover for innocent misrepresentations or omissions. So to avoid crossing the fraud line, franchisors should be aware of the provisions of applicable antifraud statutes.

If the franchisor rigorously complies with the federal and state franchise laws, it will be difficult, but not impossible, for a franchisee to prove fraud. The best way to avoid fraud claims when communicating a franchisor's value is for the franchisor to put itself in the franchisee's shoes and disclose to prospective franchisees what it would consider material if it were deciding to buy the franchise.

Sources of information:

W.W. Vincent and Company v. First Colony Life Insurance Co., 814 N.E.2d 960, 969 (Ill. App. Ct. 2004) setting forth the elements for common-law fraudulent misrepresentation.

Salkeld v. V.R. Business Brokers, 548 N.E.2d 1151, 1158 (Ill. App. Ct. 1989) where a franchisor was liable for common-law fraud for, among other things, misleading the franchisee as to the existence of trademarks and patents.

Schrager v. North Community. Bank, 767 N.E.2d 376, 382 (Ill. App. Ct. 2002) stating that an opinion can be the basis for a fraudulent misrepresentation claim if the plaintiff reasonably relied on the opinion as an assertion of fact.

Schrager, 767 N.E.2d at 384 setting forth the elements for common-law fraudulent concealment.

Washington Courte Condominium Association-Four v. Washington-Golf Corp., 643 N.E.2d 199, 216 (Ill. App. Ct. 1994) ("A seller has a duty to disclose facts which materially affect the value or desirability of the [opportunity], are known or accessible only to him, and that he knows are not known or accessible to a diligent buyer.").

Carmen Caruso is a principal and Brandi Van Leeuwen is an associate of the law firm Schwartz Cooper Chartered. They can be reached at ccaruso@schwartzcooper.com and bvanleeuwen@schwartzcooper.com.