Skewing Balanced Considerations in Franchising
I think I can see the beginning of a trend in franchise law for the purpose of enabling courts to deal with the worst influences in the industry. Unfortunately, if the trend continues, the way in which the law will change will adversely affect ethical franchisors that don’t deserve this.
For at least a dozen years the industry has watched while unscrupulous opportunists fleece franchise investors by aggressive misrepresentation of performance capabilities of their business models. This goes way beyond simply saying that franchises with little or no operating histories are “proven concepts”. It includes fabrication of spurious pro forma financial information, dodges like giving the information to SBA loan brokers instead of to the franchise investor and pretending it was not a representation to the franchise investor, and false claims that working with the franchisor represents savings in start up costs when after the fact it always becomes known that the opposite was the truth. The practices also include steering prospect to shill franchisees that are paid to provide endorsements and dodges far beyond what is stated here to illustrate the point.
The franchise industry does not police itself. The worst scoundrels are happily accepted into the IFA and display its Code of Ethics in all their adverts. They are also from time to time elected to officership in the IFA and rewarded with imprimatur that furthers the success of their scams. But the franchise industry is not the only one that does not police itself, so that isn’t seen as a big deal.
Prophylactics are inserted into franchise agreements and closing documents on franchise sales. The combination of merger clauses, acknowledgment clauses, non reliance clauses and the filling out of pre closing questionnaires in which franchisees acknowledge further that they were not told anything about the performance prospects of the franchise except what is contained in the FDD are believed to provide iron clad immunity from fraud and misrepresentation claims. Franchise investment law enforcement agencies have no budget to police compliance, and prosecutors have bigger fish to fry than to chase crooked franchisors.
To be fair, franchise investors have themselves partly to blame for not availing themselves of competent pre investment due diligence that vets the deal itself in addition to the legalities of the documentation. Never having vetted a small business investment in their lives, they stupidly believe they can outwit the professionals who sell toxic franchise opportunities. They sign the pre closing questionnaires saying they were not given information that they know they were given, out of fear that if they don’t sign off on the lie they might not be allowed to buy the franchise. This represents a level of stupidity that defies belief, but it is an everyday occurrence.
Most of these situations never enter the court system because crooked franchisors usually insert arbitration clauses into their contracts. Arbitration awards are almost never appealable, even if the arbitrator made an award contrary to applicable law. As of today, there is a case on the way to the Supreme Court in which the issue is whether there even are grounds for vacating arbitral awards for manifest disregard of applicable law. Some of them are finding their way into the courts, however, and these are the vehicles I see as harbingers of a potential sea change with regard to an important issue to all franchisors.
Up to now, courts have regarded franchise agreements as just another genre of commercial agreement with ordinary commercial agreement duties. Many have attempted to obtain rulings that there are implied covenants of good faith and fair dealing, and many have asked Congress for statutory confirmation of those extra fiduciary level obligations. All have failed, and for what has been perceived to be good reason.
Now, however, I see some judges wishing they had the latitude to impose fiduciary level responsibility on franchisors due to the egregious nature of the conduct the court is dealing with. The combination of franchise investment fraud and franchisor abuse during the franchise relationship is causing expressions of judicial outrage, and that is the kind of energy that leads to changes in the case law. If abuse and fraud remain unchecked, the industry can look to judges trying to find ways to correct the situation.
This is not what anyone wants, because implying obligations specifically targeted at franchising will place ethical franchisors at significant disadvantages in disputes where they clearly ought to be able to rely upon well drafted agreements for protection.
In the face of pre investment and relationship abuse, courts may be expected to look for “equitable” rationales that erode integration/merger clauses and the other barriers to dubious claims.
Courts will also look for ways to find implied duties for franchisors to consider the impact upon franchisee financial viability before adopting marketing programs, pursuing acquisitions, changing population density of their franchises, and a host of other regularly considered actions that as of today are not thought of as potentially actionable. The absence of impact studies has already been considered as evidence in encroachment cases. That makes it easier for doctrines of prior impact analysis to be adopted across a broad spectrum of conduct. The establishment of competently managed independent franchisee associations will take up the slack where government regulation has left a vacuum, and the presumed perquisites of system ownership will become significantly diluted.
I expect to see this over a period of about the next ten years if the situation is not corrected from within the industry. I think of it as whacking the golden goose, something people do all the time, much to the benefit of lawyers and the detriment of clients. Sarcastically I suppose I should be grateful that excesses go unchallenged within the industry. Lawyers need to make a living too, right? Seriously, the cost to investors is now so substantial and fatal that the invitation to correction is compelling.
Franchisors with integrity need to take the lead here. The unscrupulous are not only setting you up for a potential failure of legal protection, they are also taking franchise sales from you. People who could have invested in your franchises are being taken – literally – by scoundrels.