The Great Conflict of Protecting Markets or Franchisees
We are recovering from a crisis of market collapse caused in major part by abuse on the part of banks and investment houses. From mortgage backed securities where the mortgage portfolio was of extremely low quality to derivatives called credit default swaps, the Federal Reserve and the SEC enforcement division were asleep at the switch – called deregulation – and everything hit the fan.
As should be expected there are cries for more stringent laws and tough regulation by the current administration and a return to deregulation by the opposition.
Franchising is also an area in which there have been some wonderful entrepreneurial opportunities and many atrocious abuses that have not even been considered as enforcement opportunities by what most people think of as regulators of franchise sales and relationships. For several years people have been going on to www.BlueMauMau.org after having been unsuccessful in a franchise venture, calling for more stringent regulation of franchising. They complain that securities are more stringently regulated than franchising. While recently that has not been so, there is a reason why franchising does not need a stronger hand controlling it.
To begin with, the regulation of franchising and the regulation of securities sales start from the same platform. Both prohibit false or misleading statements, acts or practices in connection with the sales process and go another step beyond the common law of fraud in prohibiting omissions of fact needed to make what is said not misleading in the light of the circumstances under which the statements were made. As a caveat, the common law of fraud in many states can also be used to cover omissions that produce fraudulent inducement, but under the common law it usually requires a very strong set of facts before a court will use omissions as the basis of a finding of fraudulent inducement.
What people fail to appreciate is that enactment of a law is not by itself regulation. In addition there has to be serious enforcement commitment and that costs a lot of money. Money is not available for strict regulation – not even for casual regulation of franchising activity in today’s world. There are too many higher priorities for every dollar.
There is also another important consideration when thinking of franchise regulation. That is whether there is already the ability for franchise investors to self protect without government intervention. The simple answer is that there is.
The self protection capability makes it a very tough argument to favor active regulation of franchising. They govern best who govern least applies here as much as it does in any other context.
The reason is that markets have to be free markets in order to function in their best mode. Regulated markets always allocate assets less efficiently than free markets. We make policy choices to justify government involvement in banks, utilities, airlines and securities markets. In each of those markets there is no ready availability for consumers to self protect. Franchising is different.
What is different about franchising is that there are really competent resources available to potential franchise investors that can vet the legal and the business issues in any franchise offering. If you want to invest in a franchise and you have not previously been involved in the franchising process, you are unfamiliar with the intricacies of franchise selling. It does not matter one bit what you did for the company you worked for or what degrees you hold from any university. Franchising is a different kettle of fish and you do not know how to swim in it no matter how grand your opinion of yourself. This statement is based on the actual experiences of several thousand former business executives who lost everything they owned because they thought they were smarter than the franchise salesmen. These are the people who refuse to accept that their ineptitude may have contributed to their loss and who are demanding that the government step in and more stringently regulate franchising.
When it is pointed out to them that they could go on Google and search for FRANCHISE LAWYER and through questioning of the lawyers on the first page of the search results find competent legal and business issue due diligence assistance, they hurl epithets at the person making the suggestion. The notion that they may have had some responsibility in their own failure is beyond their ability to accept.
Let’s look at a few of the kinds of mistakes these former executives made when they were vetting their own franchise project.
Possibly the most glaring is that in one way or another they were given financial performance projections for the franchised business they were looking at. These projections came directly from the franchisor in Item 19 of the FDD – least likely. They may have been given sales information and any financial information beyond that was so hedged as to be useless. They failed to spot the useless issue.
They were given financial performance information by reading Entrepreneur or some similar magazine. Franchisor P R and sales departments plant hortatory stories about their franchises in these magazines touting profitability. While a few franchisees may achieve that profitability it is never typical of the chain as a whole. Often there are no franchisees in that system doing that well. They failed to spot that this magazine information was just a shill planted story and not some real journalistic piece. If a franchisor buys space for these planted stories and advert space in the magazine, the magazine will then hail, salute or designate that company as a leader in the industry or franchise segment, awarding the designation as though it was somehow earned. This utter charade was never spotted by the investing executives.
They prepared a business plan – fairy tale – to present to a lender in support of a start up loan application in which they inserted a financial performance pro forma. The information for the pro forma came from the franchisor, either directly or through some franchise broker or loan broker. The numbers provided always show what the lender would require to “show” that this was a loan worthy investment and almost never represent even a reasonable approximation of expected real financial performance of the franchise. The investing executives never spotted this charade or if they did spot it they pretended not to in order to get the start up loan.
The franchisor arranges for a franchisee to speak at a sales presentation and this franchisee provides financial performance information, usually saying that his shop does even better than what is provided. Even if true, it means nothing to the new investor. However the executive new investor isn’t sharp enough to appreciate that he is being taken in.
There are other issues that follow the same path, but these four examples are enough to show you what this is really about.
When the time comes to read and sign a franchise agreement, if the executives read the contract at all – and many later testify that they didn’t read any of it – they find clauses that say that the franchisor never gave any financial performance information that was not contained in Item 19 of the FDD; that no one is authorized to provide financial performance information on the part of the franchisor; that no one did provide any financial performance information about this franchise; and that if anyone did provide financial performance information, the investing executive did not rely upon such information in making his decision to invest in the franchise.
All of these clauses, plus the merger clause that says there were no promises not actually stated in the written agreement, are absolutely false. They represent a total fiction. The investing executive knows that they are false and that he did get the financial performance information and relied heavily on it in making his investment decision. But he signs the contract anyway. He also in many cases fills out a questionnaire just before the deal closes in which he is asked in writing whether he received financial performance information and if so from whom. He fills out the questionnaire saying that he received no financial performance information and signs his name to that document as well as to the franchise agreement. He has just screwed himself royally.
How will he be believable when he later claims he was defrauded through the giving of false financial performance information to induce him to buy the franchise? He won’t be. It’s that simple. Most judges wouldn’t even allow such testimony to be given in the face of his having signed those documents.
Since he screwed himself by admitting what he knew was not true, he now claims that the government needs to protect the franchise investing public from the franchise scoundrels. And when someone points out that he had access to competent pre investment due diligence resources and failed or refused to use them, he becomes furious and calls that person all sorts of bad names. He will never accept responsibility for his own stupidity. His self inflicted wound will never heal and he will go to his grave whining about his misfortunes.
Since it is that easy to avoid these traps if you are willing to pay for the assistance, no additional regulation of franchising is justified. Self help would prevent almost all franchise fraud. Markets should not and will not be fettered by government intervention when those sought to be protected have ample resources to cure their own shortcomings. It is that simple and that obvious.