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Franchisors Beware - Two Recent Cases Highlight Ways Misleading or Inaccurate FDD Representations Can Open the Door for Franchisee Suits

November 7, 2011

For over three decades, franchise disclosure documents (FDDs) have been an integral part of franchise sales.  Mandated by the Federal Trade Commission (FTC) and various individual states, FDDs are required in part to ensure that prospective franchise investors receive sufficient information before committing to develop a particular franchised business.  Although most franchisors have a good grasp of required disclosure obligations, even experienced franchisors can encounter problems when they fail to remain vigilant about the accuracy of the information communicated in their FDDs.  As two recent cases show, franchisors that fail to carefully consider and verify FDD representations run the risk of facing serious legal challenges from disgruntled franchisees.

The most basic disclosure requirements of the FTC Franchise Rule are that an FDD must be in plain English and not be misleading or contain any misrepresentations.  These requirements seem simple enough; how then do franchisors find themselves facing legal challenges stemming from FDD representations?  One area in which a franchisor can easily end up in hot water is with respect to Item 7 disclosures.  Item 7 requires that a franchisor provide certain information about a franchisee's estimated initial investment, including cost ranges for various categories of expenses.  A franchisor may be tempted to manipulate these figures in an effort to lowball the start-up costs and thereby entice prospective franchisees looking for "more bang for their buck."  This temptation should be resisted, however, as a recent federal district court case in Maryland highlights.  In Love of Food I, LLC v. Maoz Vegetarian USA, Inc., BFG ¶ 14,633 (D.Md. July 7, 2011), the court determined that a franchisee's assertions of common law fraud against a franchisor for alleged understatements of start-up costs in its disclosure document were sufficient to survive a motion to dismiss.  In so holding, the court relied on a 1999 case, Motor City Bagels, LLC v. American Bagel Company, in which the Fourth Circuit held that a jury could find that a disclosure document containing low cost estimates contained false statements of fact because the estimates were not based on the latest available data and did not accurately reflect past or present circumstances.  The Love of Food court cited Motor City Bagels with approval, and observed that while Motor City Bagels involved alleged miscalculations of approximately 20%, the facts of the present case suggested a potential miscalculation of 85% or more.  The court also noted that the disclosure document at issue in Love of Food specifically encouraged the plaintiff franchisee to rely on the initial investment estimates by itemizing costs and providing sub-estimates for each category, and by noting that the estimates were based on the franchisor's lengthy experience in the industry.  Acknowledging that in some contexts, cost projections are considered statements of opinion and therefore cannot constitute fraud, the court determined that this case could be one of the exceptions where erroneous projections could supply a basis for fraud under relevant state law.

Financial information is an understandably easy target for potential claims of misrepresentation, as such information represents an important part of a franchisee's decision-making calculus.  Financial information is not the only type of FDD information that can provide the basis for a franchisee claim, however - a recent ruling out of North Dakota illustrates how seemingly minor and innocuous statements elsewhere in a disclosure document can also expose a franchisor to potential claims.  In JMF, Inc. v. Medicine Shoppe Int'l, Inc., BFG ¶ 14,692 (D.N.D. Sept. 19, 2011), the U.S. District Court for the District of North Dakota held that a franchisor could have breached the anti-fraud provisions of the North Dakota franchise law through an alleged misstatement in Item 20 of its FDD that it projected opening 0-1 new stores in the state.  Although projected openings statements may seem to be unlikely fodder for challenge, in this case, the plaintiff franchisees operated under agreements with "most favored nations" provisions, which were understood by the franchisees to allow them to convert to more favorable terms if the franchisor offered such terms to a new franchisee in the jurisdiction.  The franchisees renewed their franchise agreements, and, aware of the FDD that projected the opening of new stores, sought to convert their renewal agreements to the new terms contained in the FDD based on the "most favored nations" provisions.  The franchisees at that point became aware that the franchisor never intended to offer new franchises under the relevant trade name in North Dakota (or any other state in which current franchisees operated under contracts with similar "most favored nations" clauses) so as to avoid triggering the clauses' benefits for franchisees.  The franchisees subsequently brought suit against the franchisor asserting various claims, including violation of the anti-fraud provisions of the North Dakota Franchise Investment Law.  In evaluating the anti-fraud claim, the court noted that the franchisor's FDD projected the opening of 0-1 stores in North Dakota, while in reality, the franchisor did not intend to offer any franchises in the state.  The court reasoned that if the franchisor made such statements in conjunction with assurances regarding the "most favored nations" clauses as a way to defraud or commit deceit, it could find that the franchisor violated the state franchise statute.  Accordingly, the court found that genuine issues of fact existed with regard to whether the franchisor violated the law's antifraud provisions, and denied the franchisor's motion for summary judgment.

A franchisor should keep in mind that while a prospective franchisee may not always closely scrutinize the FDD when it is delivered, the document could later come under the magnifying glass if a franchisee believes that its business is not performing as well as expected and seeks to use statements made in the FDD against the franchisor.  To minimize the exposure to potential claims from disgruntled franchisees, all franchisors should be meticulous about ensuring that their FDDs are accurate, up-to-date and compliant with federal and state law.  Additionally, franchisors should avoid the temptation to massage information provided in the FDD, particularly financial information such as the initial investment estimates provided in Item 7.  To further protect against potential claims, franchisors should take care to ensure that all necessary contextual information and footnotes are included in the FDD - for example, clarification that actual franchisee expenses may vary, that market costs differ, etc.  By taking these steps and taking care to confirm the accuracy of FDD information and representations, franchisors can best position themselves to shield against future franchisee claims.