Under the FTC's Franchise Rule, a franchisor is permitted, but not required, to answer that all-important question asked by would-be franchise buyers: "how much money can I make?" A franchisor that chooses to make a "financial performance representation" ("FPR") must put the representation in its Franchise Disclosure Document ("FDD"). The representation can take one of two forms. It can be: (1) an earnings claim based on historical performance of operating units; or (2) a projection of possible future performance. Allowing franchisors to make FPRs based on projections of future performance is still fairly new to franchising; the allowance of "future projections" was added when the Franchise Rule was amended in 2007.
In either case, the touchstone requirement for an FPR is whether the franchisor has a reasonable basis for making it. As a related requirement, the franchise company must also be able to produce written substantiation for any claim to prove the "reasonable basis."
Since the Franchise Rule was amended in 2007, there hasn't been much litigation over financial performance representations. Cases regarding representations of future performance are even more rare, which makes a recent Maryland court decision on the topic, Hanley v. Doctors Express Franchising, LLC, all the more noteworthy. A summary of the case is below (click to follow the link).
Doctors Express Franchising, LLC (“DRX”) is a Maryland-based franchisor of urgent medical care centers. Hanley is a former franchisee that owned a DRX franchise in Des Peres, Missouri.
Hanley sued DRX alleging (among other things) violations of Maryland Franchise Registration and Disclosure Law, as well as common law fraud through both active misrepresentation and intentional failure to disclose material facts. Hanley also named several of DRX officers individually, contending that they are joint and severally liable for DRX’s violations of Maryland law. The decision is on a Rule 12(b)(6) Motion to Dismiss brought by DRX.
The Alleged Misrepresentations
Hanley alleged that DRX made misrepresentations in its 2009 Franchise Disclosure Document (“FDD”), which Hanley received from DRX in January 2010, as well as in other pre-sale documents given to Hanley by DRX. These included a document entitled “Doctors Express Financial Data and Operating Assumptions” given to Hanley by his lender, First Financial, a lending institution apparently affiliated with DRX. Hanley alleged that he relied on the representations when he signed his franchise agreement in March 2010.
The allegedly fraudulent statements included FPRs made both in Item 19 of DRX’s FDD and in the “Operating Assumptions” document he received from First Financial. The FPRs were based on the experience and data of DRX’s affiliate, which had been operating since 2006, and provided information for its performance in 2007 and 2008. The allegedly false statements included:
FPRs stating that DRX franchisees would open with and sustain average per-patient revenue of $125, with a volume of 45 patients per day.
- Hanley alleged that DRX knew that, because medical service providers must be credentialed and contract with third-party (insurance / Medicare) payers, franchisees average per-patient revenues were “far below” $100, and that even its highest-performing franchisee treated an average of 27 patients per day.
An estimated initial investment range of between $466,220 and $602,720.
- Hanley alleged that DRX knew this number to be too low, and that in DRX’s 2010 FDD (filed with the California Department of Corporations 2 weeks after Hanley executed his agreement), the number was stated to be between $508,500 and $693,000. Hanley alleged his actual investment to be more than $1 million.
An “additional funds” / working capital line item as part of the initial investment Item 7, estimated by DRX to be between $50,000 and $90,000 for the first 3 months of operation.
- Hanley alleged that DRX knew these numbers to be low because (due to 2009 changes in Medicare law) franchisees were not able to become fully credentialed / contracted with insurance payers by the time they opened, and that while waiting for credentials, franchisees were forced to accept substantial reductions in fees. Hanley alleged that the approval of many insurance company contracts are delayed far past the opening date, a fact that DRX knew and concealed from him.
Hanley alleged that DRX knew that using the experience and data of its affiliate for its FPRs and advertising was materially misleading to prospective franchisees because the affiliate was not representative of the experience of new franchisees. This is because the affiliate opened in 2006, several years before major changes to Medicare enrollment procedures made it difficult or impossible to open fully credentialed and contracted, and the affiliate was not required to use expensive vendors.
DRX’s Motion to Dismiss
DRX moved to dismiss the fraud claims by arguing: (1) the representations in the FDD were labeled as estimates and projections, not statements of fact, and therefore were not actionable; and (2) Hanley expressly disclaimed his reliance on statements outside of the FDD and Franchise Agreement, and as a result could not claim that his reliance on them was reasonable.
- Estimates and Projections Can Be Actionable
As to the first argument, DRX argued that its FDD warned prospective franchisees that the projections and estimates could not be relied upon to accurately predict future performance. In essence, DRX argued that its statements based on the affiliate’s performance were not misrepresented, and therefore, could not be fraudulent.
Quoting Jaguar Land Rover North America, LLC. v. Manhattan Imported Cars, Inc., 738 F.Supp.2d 640 (D. Md. 2010), Hanley responded by arguing that “inaccurate projections of . . . future profitability and inaccurate planning volumes could . . . be considered fraudulent if there was evidence that the [defendant] knew they were inaccurate at the time they were made.”
The Court agreed with Hanley and refused to dismiss the fraud claim, citing Motor City Bagels, LLC v. American Bagel Co., 50 F.Supp.2d 460 (D. Md. 1999) (by providing estimate of projected startup costs, “the defendants thus also made a representation of a present fact — that they knew of no information that would make the projection in the UFOC improbable”). The Court also found that Maryland law specifically prohibits “[a] disclosure that is knowingly inaccurate because it omits material information known to the franchisor.” Md. Code. Bus. Reg. §14-227(a)(1)(ii).
- Disclaimers Do Not Make Reliance by Franchisee Unreasonable
In support of its second argument, DRX pointed to disclaimers in Item 19 of DRX’s FDD that warned prospective franchisees that actual expenses would vary from business to business, and that prospects should make their own independent investigation prior to buying a franchise. Similarly, DRX argued that Item 7 of the FDD warned prospects that it was an estimate only. DRX also argued that the Franchise Agreement’s: (a) integration clause; and (b) contractual acknowledgement that Hanley was not relying on any representations outside of the FDD or Franchise Agreement defeated any claim by Hanley that his reliance was reasonable.
The Court disagreed, finding that Maryland law prohibits a franchisor “from requiring a prospective franchisee to agree to a release, assignment, novation, waiver, or estoppel that would relieve a person from liability” under Maryland franchise law. Md. Code. Bus. Reg. §14-226. As such, the Court found the disclaimer void.
Based on the findings summarized above, the Court refused to dismiss Hanley’s fraud claims. Hanley will be permitted to take discovery and continue pursuing his claims against DRX.
The Hanley case serves as a reminder to franchisors of the importance of ensuring that they have a reasonable basis for each of their financial representations and cost projections. When basing FPRs or cost projections on the results of company-owned operations, it is critical to ensure that significant variations between the franchise business model and company-owned businesses are both accounted for and adequately explained to prospective franchisees.