Discovering That Your Franchisor Client Has Violated The Franchise Disclosure Laws

To paraphrase a popular bumper sticker: "It Happens." Even the most diligent franchisor has made mistakes when selling franchises. They forgot that President's Day does not count as a business day. They did not realize that Rhode Island requires prior registration of their offering. They may have misstated a material fact in their offering circular.

Violations of the franchise law can result in serious consequences to a franchisor. Under federal law, violations can result in penalties of up to $10,000 per occurrence. Under many state laws, violations give franchisees the right to rescind their purchase, and/or recover damages, essentially giving franchisees a "put" that can be exercised for a number of years. Some state laws impose criminal penalties for violations. When the history of the franchisor is written, the manner in which it dealt with such violations will determine whether the violations are an insignificant footnote, or a major event in the life of the system.

Discovering the Violation

Quite often, the franchisor, or its attorney, will discover a violation soon after it occurs. In these cases, prompt action on the part of the franchisor may minimize or entirely negate the damage caused by the violation.

Once a franchisor discovers its mistake, it must decide whether and how to disclose the violation. If it is a mistake that permeates the entire system, the franchisor might decide not to take any action whatsoever, and "let sleeping dogs lie." The obvious problem with this course of action is that the violation remains a ticking time bomb that can be triggered if only one franchisee decides it has concerns about its relationship with its franchisor, and seeks advice from competent legal counsel.

In most cases, the franchisor will want to address the problem. Those choosing to do so should bring the "mistake" to the attention of affected franchisees. Doing so does alert a franchisee to a problem for which the franchisee may have recourse. However, if the ink is barely dry on the franchise agreement, the franchisor's liability will likely be limited to rescinding the transaction and returning the initial franchise fee to the franchisor. If the relationship is still in the "honeymoon phase", the franchisee may not give the notice a second thought.

Giving this notice provides significant advantages to the franchisor should subsequent issues develop between franchisor and franchisee. In some states the statute of limitations on a franchisee's claim is shortened once a claim is discovered by the franchisee. For example, in California, a four-year statute can be reduced to one year by disclosing the error to the franchisee, irrespective whether anything more is done by the franchisor. Cal. Bus. & Prof. Code ¶ 31303 (1999).

Case law suggests that once a franchisee is notified of a violation, if they do not act promptly, their rights may be limited even in the absence of a limiting statute. For example, in Two Men and a Truck/International v. Two Men and a Truck/Kalamazoo, 949 F. Supp. 500 (W.D. Mich. 1996), the court held that if a franchisee does not tender the benefits conferred upon it upon learning of a violation, the franchisee's subsequent attempt to rescind the contract may be denied.

A Step Beyond - Offering to Rescind the Transaction

By not only notifying the franchisee of the violation, but also formally offering to rescind the transaction, the franchisor may further limit, and even eliminate, its liability to the franchisee. That one year California statute of limitations referred to above is shortened to 90 days once a rescission offer is made. Cal. Bus. & Prof. Code ¶ 31303 (1999). In Michigan, if a proper rescission offer is made before a lawsuit is commenced, the franchisee will no longer have any right to sue for damages or rescission under the Michigan franchise law. Mich. Comp. Laws ¶ 445.1531 (1989).

In states that do not specifically limit by statute the franchisee's right to sue following an offer of rescission, a court may impose those limitations. In C.D. Lulling v. Barnaby's Family Inns, Inc., 499 F. Supp. 1353 (W.D. Wisc. 1980), the franchisor discovered that it had not registered its franchise in Wisconsin. After negotiations with the Wisconsin Commissioner of Securities, the franchisor mailed a rescission offer to each of its Wisconsin franchisees. Each franchisee rejected the offer, and a court subsequently held that under those circumstances, no action for rescission could be maintained by the franchisees. Id. at 1361.

This same "cure" opportunity may be available with respect to violations of the FTC Franchise Rule. Because there is no private right of action under the FTC Franchise Rule, there is no provision that would negate such a right through an offer of rescission. However, the FTC may not be inclined to pursue violators who initiate corrective action. In those instances where the FTC does seek redress, the courts may be disinclined to penalize such violators. In United States v. Protocol, Inc., CCH Bus. Franchise Guide, ¶ 11,184 (D. Minn. 1997), the government brought suit against a company for selling unregistered franchises. The company maintained that its business opportunities did not fall within the definition of a franchise under the FTC Rule. When the FTC disagreed, Protocol stopped selling its business opportunities, modified its program so as to clearly fall within the parameters of the Franchise Rule, and began complying with the Rule. The FTC continued to seek redress for past violations. The court granted summary judgment in favor of the government on the issue of whether the business opportunity constituted a franchise, and scheduled a trial to determine the penalties that should be assessed against "the franchisor."

At trial, the government argued that an injunction should be issued against Protocol to prohibit future violations of the Rule. The government also argued that the $10,000 per violation civil penalty should be interpreted as $10,000 for each day the franchisor was not in compliance with the Rule, and told the court that it was willing to reduce its civil penalty claim to only one year of penalties, or $3,650,000! The court ruled from the bench. On the issue of injunctive relief, the court found that in light of the voluntary corrective actions already initiated by Protocol, the government could not meet its burden of showing that a violation was likely to recur. The court stated that even if the government had met this initial burden, the court would then look to other factors in considering whether injunctive relief was appropriate, including "whether or not defendant seriously attempted to comply," and "whether or not defendant has changed their behavior." On the issue of a civil penalty, the court, no doubt with its previous analysis in mind, found there was no "knowing and deliberate violation" of the law. Therefore, while the government won its case on the applicability of the Franchise Rule, the court entered judgment for Protocol on the issues of civil penalties and injunctive relief. United States v. Protocol, Inc., Transcript, 4-96 Civil 703 (D.Minn. 1987).

Conducting a Rescission Offer

Absent the existence of a statute proscribing the details of a rescission offer, the conduct of a rescission offer can be relatively simple. The franchisor should prepare a letter to the affected franchisee(s) explaining the violation, and giving the franchisee(s) a reasonable time to decide whether to keep the franchise, or rescind. If a franchisee selects rescission, the franchise agreement is terminated, the franchisee returns all tangible consideration received from the franchisor, and the franchisor refunds all fees previously received. If the original sale included inventory that had already been sold, neither those items nor their purchase price would be returned.

For a violation that occurred as a result of a failure to disclose all material information, the rescission offer should include the corrected information so that the franchisee has all relevant facts when deciding whether or not to continue as a franchisee. If a revised Offering Circular is available, that document should be provided. If the violation involved, for example, the use of an outdated agreement, or if a new agreement has been implemented since the date the franchise was purchased, the franchisor may want to offer three choices to the franchisee: reject the rescission offer and continue under the agreement the franchisee signed; accept rescission of the old agreement, but instead sign the new agreement; or accept rescission and end the relationship. In these circumstances, the franchisee would need to be given a copy of the new offering circular, and if he or she elected to convert to the new agreement, the franchisor would have to comply with all waiting periods prior to allowing the franchisee to sign that agreement.

Some states mandate specific provisions that must be included in a rescission offer. For example, in Michigan, the offer must recite the provisions of the Michigan rescission statute and include an offer to pay interest of 13% per annum on the franchisee's investment. Mich. Comp. Laws 445.1531 (1989). In some states, the rescission offer must be registered with the State prior to submission to the franchisee. See, e.g., N.Y. Gen. Bus. Law. ¶ 691.2 (1989); N.D. Cent. Code ¶ 51-19-12 (1989).

Conclusion

When a franchisor discovers it has engaged in a violation of the franchise law, it should immediately discuss with counsel its alternatives. There are circumstances in which the best alternative might be to simply learn from the mistake, and not bring it to anyone's attention. In the case of an unregistered franchise in a state in which the franchisor hopes to expand its business, this is not a viable option since the registration process itself will result in disclosure of the unregistered franchises. In those circumstances, and in others in which the violation is relatively minor or may be of no concern to the affected franchisee, the best course of action will usually be to formally notify the affected franchisee, and perhaps offer to rescind the transaction.