A Midwest franchisor of retail stores had a steady growth pattern and some good success stories among its franchisees. A sales person transmitted a one line claim about profit margin on the primary store produce that did not comply with Item 19 requirements. The prospects were MBAs with lots of business savvy. The CEO was unaware of the document until the termination of a store franchise that was not successful and another store under development. The franchisees filed for arbitration of their claims against the franchisor over the failures of their franchise investment. The arbitrator found that the document and the franchise sale violated state franchise law, which the sophisticated franchisee prospects relied on the earnings claim document despite all of the other diligence that they undertook, and awarded rescission. He also found the CEO had no knowledge of the document and was not personally liable for its use and the consequences. The award, which is extremely difficult to challenge on appeal because of the narrow scope of arbitration appeals allowed by law, amounted to 26 times the franchisor's disclosed net worth, 67% of its gross sales and 4 times its disclosed current assets. In this case, even buying back the underperforming store did not relieve the franchisor from liability.
For franchisees, those little pieces of paper may or may not equate to a lottery ticket or a "get of jail free" card. Rather than undertake a franchise development project that is ill advised and based on faulty data, franchisees would be well served by confirming that the franchisor stands behind those bits of extra information. Show them to the most senior person introduced to you. Find assurances that your reliance is well placed and appropriate, and not based on the words or documents received from just one person. If you receive contradictory materials, get clarity!
The case points out the importance of three key issues for franchisors. First, the choice of arbitration for domestic dispute resolution should be carefully made, where awards cannot be readily appealed, and which requires the upfront payment of a filing fee based on the amount in dispute and payment of fees for the time expended by the arbitrator. Second, the compliance training and close supervision of staff engaged in franchise selling activity is highly important for the financial health of the franchisor. Third, the use of a closing acknowledgment form or another means of verification that the franchisee is only relying on the Franchise Disclosure Document and authorized collateral material, which forces franchisees to attach any extraneous communications on which they are relying, is vitally important for the franchisor's protection against sales law violations of sales staff. Some franchisors make a video recording of the franchise sale closing at which the franchisee is asked about any earnings claim type material they may have received and relied upon in making their decision. The outcome of this case differs from recent decisions where the closing acknowledgment prevented franchisee claims of reliance on unauthorized earnings claims documents.