Introduction
Facts
Trial court's findings
Appeals court decision

Pending petition for certiorari review
Comment


Introduction

For over 30 years franchisors have been subject to a comprehensive regulatory scheme governing the information that they are required to disclose to prospective franchisees. Specifically, franchisors' disclosures have been guided by the Federal Trade Commission (FTC) Franchise Rule(1) and the North American Securities Administrators Association Uniform Franchise Offering Circular Guidelines. These franchise disclosure regulations, which were promulgated to protect prospective franchisees, set forth specific disclosure requirements based on the theory that informed investors can determine for themselves whether a particular franchise transaction is in their best interests.(2) Franchisors and prospective franchisees alike rely on the franchise disclosure regulations as a guide to what information is and is not required to be provided prior to a franchise sale.

However, the open question remains as to whether a franchisor that complies fully with the franchise disclosure regulations can still be subject to liability for failure to disclose additional information outside its franchise disclosure document. This question was recently addressed for the first time by the Colorado Court of Appeals in Colorado Coffee Bean, LLC v Peaberry Coffee Inc.(3)

Facts

The plaintiffs in Peaberry, consisting of 10 Peaberry Coffee franchisees, filed various fraud and breach of contract claims against:

  • their franchisor, Peaberry Coffee Franchise, Inc;
  • its parent company, Peaberry Coffee, Inc;
  • the parent company's chief operating officer and sole shareholder; and
  • the parent company's vice president of franchising.

The franchisees' claims rested, in large part, on two distinct non-disclosure theories: (i) the defendants' failure to disclose net losses of the parent's stores; and (ii) the defendants' failure to disclose the parent company's losses.

 

After seeking leave from the court, the franchisees also filed claims against the law firm that represented the defendants in connection with Peaberry's franchise programme. The franchisees alleged that the firm aided and abetted the misrepresentations and omissions that formed the basis of the franchisees' claims against the defendants. These claims – which were derivative of, and eventually bifurcated from, the claims pending against the defendants – are not addressed here.

Trial court's findings

At the conclusion of the plaintiffs' main case, the trial court dismissed the claims under the Colorado Consumer Protection Act for lack of public impact. At the conclusion of the trial, the trial court entered a decision in favour of the defendants on all claims. In doing so, it expressly found that the disclosures in Peaberry's franchise disclosure document – specifically, its 'earnings claim' contained within Exhibit J to the document – complied with the FTC's disclosure requirements and were not otherwise misleading or deceptive. Nevertheless, the trial court concluded that a franchisor cannot use its franchise disclosure document disclosures to shield itself from liability for fraudulent omissions. Rather, the trial court found in favour of the defendants based, in part, on the franchisees' failure to prove reasonable reliance.

The trial court's findings regarding reasonable reliance were different for each of the franchisees' distinct non-disclosure theories. With respect to Peaberry's failure to disclose net losses of the company stores, the trial court found that clauses contained within Peaberry's franchise disclosure document (in particular, the language in its earnings claim in Exhibit J) precluded the franchisees from proving reasonable reliance. In so holding, the trial court looked to: (i) language warning the franchisees against inferring how their franchises would do based on gross sales of the company stores; and (ii) language explicitly stating that the sales information provided to franchises did not reflect costs or operating expenses. The trial court also concluded that because the franchisees had access to publicly available store expenses, they could have independently determined the profitability of the company stores through reasonable due diligence.

With respect to the franchisees' second non-disclosure theory, relating to the parent company's financial information, the trial court found that the exculpatory clauses included in Peaberry's closing acknowledgement and franchise agreement prevented the franchisees from establishing reasonable reliance. Those exculpatory clauses included an acknowledgement that the franchisee was "not relying on any promises of [the franchisor] which are not contained in the [franchise agreement]".

Appeals court decision

The Colorado Court of Appeals affirmed the trial court's judgment in part, vacated it in part and remanded it with directions. With respect to the non-disclosure claims, the appeals court upheld the trial court's reliance findings relating to Peaberry's failure to disclose net losses of the company stores. However, it reversed the trial court's reliance findings relating to Peaberry's failure to disclose the parent's company-owned store losses. Specifically, the appeals court concluded that the exculpatory clauses in the closing acknowledgement and the franchise agreement – which, under Colorado law, "must be closely scrutinized" – addressed only affirmative representations outside the transaction documents, not failure to disclose material information altogether.

The appeals court also concluded that the franchise disclosure regulations did not protect the defendants from the plaintiff's non-disclosure claims relating to the parent company's financials. It did so despite an FTC rule explicitly prohibiting franchisors from including a parent company's financial statements in a franchise disclosure document unless:

"(A) the corresponding unaudited financial statements of the franchisor are also provided, and (B) the parent absolutely and irrevocably has agreed to guaranty all obligations of the subsidiary."(4)

In so holding, the appeals court concluded that the FTC rule prohibited franchisors from disclosing only a parent company's "financial statements", not other material information such as its general financial difficulties. As the appeals court found no conflict between the FTC rule and the franchisees' non-disclosure claims, it concluded that there was no federal pre-emption applicable to the franchisees' common law claims.

Pending petition for certiorari review

The franchisees, the defendants and their attorneys are all seeking certiorari review of the appeals court's decision. Two of the issues presented for review relate to the franchise disclosure regulations. At the time of writing, a decision from the Colorado Supreme Court regarding whether it will grant certiorari review of those issues was still pending.

Comment

Before Peaberry, franchisors and franchisees alike benefited from the certainty created by the clear disclosure guidelines set forth by the FTC (through the FTC rule) and states (via the Uniform Franchise Offering Circular Guidelines). Franchisors knew what to disclose and franchisees knew what information they were and were not getting from franchisors about their prospective franchise opportunities. However, after Peaberry, franchisors and franchisees must also look to each state's common law to determine what information, in addition to that which is disclosed in the franchise disclosure document, must be disclosed to prospective franchisees. This leaves franchisors and franchisees unable to predict what information they can expect to receive about the franchise and the franchisor until the courts better define what they will deem necessary for franchise transactions.

For example, despite the FTC's prohibition against disclosing a parent company's financial statements unless the parent company serves as a guarantor of the franchising subsidiary, Peaberry may now require franchisors to disclose 'general' financial information about the parent and affiliated companies, regardless of whether those companies serve as guarantors. This poses problems for franchisors and franchisees, especially because the FTC's prohibition against such disclosures was meant specifically to protect franchisees from basing purchase decisions on parent company performance that is not linked to the franchising company's success.

Further, Peaberry's guidance regarding what common law disclosures may have been necessary in that case only further complicates the landscape. In addressing the FTC's parent company disclosure requirements, the Colorado Court of Appeals suggested that:

"[the FTC Rule's] plain language would not preclude a general comment especially if provided 'in separate literature,' such as, 'The franchisor is the wholly owned subsidiary of _______, which has not shown a profit during its ___ years of operation.'"(5)

In a franchise sale, franchisors' representations are usually limited to the franchise disclosure document and the franchise agreement. Without any further clarification from the Colorado courts, it is unclear what 'separate literature' the Colorado Court of Appeals could be referring to or how such separate literature should be provided or factored into the franchise sale.

Finally, franchisors should note that the basic exculpatory clauses included in their franchise disclosure documents and franchise agreements may be insufficient. The trial court and Colorado Court of Appeals opinions both spent a considerable amount of time discussing these exculpatory clauses in Peaberry's franchise disclosure document, franchise agreement and franchisee questionnaire. The Colorado Court of Appeals noted that the franchisee questionnaire did not disclaim reliance on the parent company financial statements or its financial condition. Thus, if a franchisor uses a questionnaire or similar document to elicit information from franchisees regarding what they were told and what they relied on to make their decisions, the franchisor should include questions about whether the franchisee was told or relied on any information about the franchisor's parent or affiliated companies. A franchisee which states in a questionnaire that it did not rely on the financial condition of a parent or affiliated company will have a more difficult task of claiming that the franchisor should have provided that information.

For further information on this topic please contact Jeffrey A Brimer or Sarah A Mastalir at Faegre & Benson LLP by telephone (+1 303 607 3500), fax (+1 303 607 3600) or email (jbrimer@faegre.com or smastalir@faegre.com).

Endnotes

(1) 16 CFR Part 436 et seq.

(2) See 43 Fed Reg 59,614, 59,627-39 (Dec 21 1978) (statement of basis and purpose to franchise rule).

(3) 09CA0130, --- P 3d ---, 2010 WL 547633 (Colo App Feb 18 2010).

(4) 16 CFR § 436.1(a)(20)(i) (2003).

(5) Peaberry, 2010 WL 547633 at * 10 (emphasis supplied).

An earlier version of this update first appeared in The Franchise Lawyer.

This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.