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Liberty CEO Talks Lawsuits & Franchising

VIRGINIA BEACH — CEO John T. Hewitt weighs in on how his franchising firm, Liberty Tax Service, is coping with the challenges of a lack of business loans for franchise owner-operators, the state of California suing the tax preparer and the federal government clamping down on tax refund loans.

Hewitt’s 41 years in the tax preparation industry, starting at H&R Block (NYSE:HRB), leaves him arguably its most seasoned leader. After his former employer turned down Hewitt’s vision of using software to prepare taxes, he branched out on his own in 1982. His company became Jackson Hewitt Tax Services (NYSE:JTX), a leader in electronic tax filings. The co-founder left the chain when Cendant Corporation, a conglomerate of hotel, real estate and car rental franchisors, bought it for $483 million.

John Hewitt founded Liberty Tax Services in 1997. According to WorldFranchising.com, the online publication of franchise researcher Source Book Publications, Liberty Tax Services has 3,468 franchise units and 77 company-owned units.

It is a tough environment for tax preparers on many fronts. On October 12, 2010, Meta Financial filed a report announcing that the Office of Thrift Supervision had determined that MetaBank had engaged in alleged deceptive practices, which were in violation of federal trade law. On October 18 the company announced that subsidiary MetaBank had been blocked from entering into contracts for refund loans.

That federal action is causing repercussions. On October 18 H&R Block, a tax preparation franchising firm that has over 4,000 franchised offices, sued HSBC Bank, saying that the bank was no longer backing up H&R Block’s tax-refund loans, but that its contract obliged it to do so.

Hewitt responds, “This new development adds a level of complication for many small tax preparation offices, as MetaBank is one of the few financial institutions still participating in refund loan product disbursements. Seemingly this directive might very well not allow MetaBank to continue offering products for tax-related programs. Many tax preparers will be left without any option to provide an accelerated refund loan.”

BMM: While on the topic of regulators and lawsuits, in 2009 Liberty Tax Service lost a deceptive ad suit to California’s Attorney General. Regarding the $1.2 million win, California Attorney General Jerry Brown said, “Liberty Tax Service lured cash-strapped Californians into paying for high-cost loans, when they could obtain tax refunds free from the IRS just weeks later.” He explained that Liberty Tax Service's print and television ads misled customers by promising "Most Refunds in 24 Hours."

"This ruling bars Liberty from deceptive advertising that blurs the line between IRS tax refunds and pricey loans," said Brown.

Pretty strong words. What happened?

Hewitt: About six years ago California went after Jackson Hewitt, H&R Block and Liberty, saying that we violated some obscure law. In our case they did not have a customer complaint. What happened is that they first settled with Jackson Hewitt. Jackson Hewitt paid them close to $4.5 million. Jackson Hewitt had been doing business in California since 1989. Liberty did not enter the California market until 2000. We are a lot smaller. So we said that we would settle. If Jackson Hewitt did X amount of products, and you penalized them for $4.5 million, we did 5 percent as many products that the complaint is about so we will settle for 5 percent of $4.5 million.

They said, “No, no, no, no. These are fines. You have to pay $2.5 million, or $3 million."

We said, “Wait a minute. We are only 5 percent as big.”

California sued all of us. As we were preparing for trial, H&R Block settled. It only paid $5 million. We said if H&R Block paid $5 million, we only handled 1 percent of the returns that Block did, so we are only guilty of 1 percent. We should only pay $50,000. But we will put a $250,000 offer on the table.

They would not take it. And we would not settle.

We took it to trial, and lost. I think the total judgment added up to $1.8 million.

Right now the lawsuit is at the Court of Appeals.

BMM: According to WorldFranchising, the state with the largest number of Liberty Tax franchises is California, with over 350 offices. Is this lawsuit affecting franchisees?

Hewitt: No, not at all. California did not sue the franchisees.

Tax Prep 2009 sales per store (office)
Data: Franchise Times, WorldFranchising

The International Franchise Association signed an amicus brief in the appeals court because they [California's attorney general office] said we [the franchisor] were vicariously liable for the actions of our franchisees, even though what happened was that some of our franchisees in Los Angeles ran some ads that were not approved.

In the franchise agreement, it says that you cannot run ads that aren’t approved. Yet the franchisee violated that and ran ads in this little, teeny Penny Saver in northern Los Angeles in violation of Internal Revenue Service statutes. The franchisee ran them for two to three weeks without our permission. As soon as we saw them, we shut them down and stopped them from running the ads. The state held that not only did the franchisee break the law, but that we [the franchisor] were also responsible for breaking that law.

That is unprecedented. I don’t think there is any other court case or major court case where a franchisor is found guilty for a franchisee breaking the law.

California is a tough place to do business.

There was another thing that was very unusual with two of our products, loans and tax refunds. It works like this: A customer comes in and you say, “Sir, you have a $3,000 refund. Your fee to me is $200. If you pay this fee, then you get $3,000 in ten days. Or, if you don’t want to pay the $200, you can pay an additional $29 fee and we will withhold it from your refund. So instead of getting $3,000, you don’t pay me anything today, but you’ll get $3,000 less $200, less the $29 fee, in two weeks."

We are the only ones liable for this. Jackson Hewitt and Block, because they settled, aren’t subject to this. They [California] said the $29 is a loan, and subject to interest and all kinds of stuff.

Liberty has to give different disclosures to our customers than H&R Block or Jackson Hewitt. We said that we would settle for the same language as Block and Jackson Hewitt use. The court said “No, no.” So it is all at the appellate court now.

BMM: How tough is it right now to sell franchises?

Hewitt: It is a tough time.

In previous recessions when I have been a franchisor, franchise sales actually increased. As white-collar executives were laid off, they wanted to control their own destiny. They said they didn’t want to be put in the position again where they could be laid off. Many of them would take severance money and move into a franchise.

In this recession more people than ever are just frightened to death. That was especially the case back in 2008, when many potential buyers felt that the economy was going into a depression. Nowadays, even if they want a franchise, such as our franchise, which can be bought for a low investment of $70,000 that includes everything, people just do not have $70,000 in their checking account. They typically have cash tied up in their home, but they have not been able to draw equity out of their home for the last two years.

Or they have money in a 401k [retirement plan]. In 2008, the 401k plans became 200 1/2k’s. What I mean is that retirement funds lost 50 percent of their value. People just do not have discretionary money today, so a lot fewer people have money to take the leap to become self-employed. When you are self-employed, it is going to take you two, three or four years before being able to draw major cash out of the business.

It is a tough time to start a business, so franchise systems are down across the board in bringing in new franchisees.

BMM: How are you dealing with the shortage of franchise buyers?

Hewitt: On Wall Street they call me a serial entrepreneur. That is because this is the third company I have been successful with in making investors a lot of money. It is a lot easier for me to tap into money than for a lot of people. For example, Liberty Tax Services has a $100 million line of credit. And our line of credit is so good that it is only a little over LIBOR [London Interbank Offered Rate]. It is about 1.5 percent. It is not even a yearly line of credit but a five-year line of credit. And we still have three years left.

Liberty pays it back every year. At the end of the year we have no debt.

Liberty uses most of that money. Not for us, but to lend to franchisees to expand. We have lent franchisees $60 million over the last ten years to grow their businesses. So we go out and get the money. What we had to do over the last three years was finance more of that $70,000 in initial investment. We have never done that before.

On average, instead of people putting in the entire $70,000, we are now lending them a third of that to help transition into our franchise system. We have stepped up our lending to first-year franchisees. Normally in years past before the recession, we lent money to second-, third-year or older franchisees. But now we have to lend in order to pull new people into the business.

The second part of this interview with John Hewitt will be published shortly. In it Mr. Hewitt discusses his attempt to acquire H&R Block and Jackson Hewitt. He also provides insights into independent franchisee associations.

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