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FRANCHISE FRAUD CLAIMS: THEIR AMERICAN DREAM OF BUSINESS OWNERSHIP ON TRIAL

Excerpted and updated, the following article by Carmen D. Caruso originally appeared in the ‘White Paper, a publication of the National Association of Certified Fraud Examiners. The article  was originally presented by Mr. Caruso before the Association’s meeting in Chicago, 1998.

"Franchising, a way to be "in business for yourself but not by yourself," is part of the American Dream of business ownership.  Franchising has 'spread to more than seventy industries and generated more than $1 trillion in U.S. sales annually.'  But too often, the dream of business ownership is shattered by sharp disputes between franchisors and franchisees - and trial lawyers may find that their next client is a franchisee, who is eager to allege claims against the franchisor."  

Franchisees that believe they have been defrauded may seek relief under the common law of the state where the alleged fraud occurred.  In addition, the franchisee may be protected by a state franchise law, a state Little FTC Act, or an industry-specific statute.   Finally, the franchisee may be able to state a RICO claim in federal court.
Any party that believes he or she may have been defrauded should act promptly to protect their legal rights by consulting an attorney.   Statutes of limitations vary in each state, and sometimes, a franchise or dealership agreement may impose a shortened limitations period.   

                            Common Law Fraud Claims

As a general definition, which may vary from state to state, proof of fraud requires:

1.        A verbal or written statement or representation that a certain fact is true, and which is intended by the speaker to induce reliance, and which is false or highly misleading when made.

2.        Actual reliance on the false statement (or material omission) by the prospective plaintiff, who changes his or her legal position by relying.

3.        Damages sustained by the person who relies on the false statement as a result of the reliance, and as a further result of the statement being false.

                                     Material Omissions

A variation of the general definition applies where a person having a duty to speak remains silent, and as a result, another party is misled by the silence.

                                        Promissory Fraud

In general, promises to do something in the future are not the basis for a fraud claim, even if it turns out that the promise is breached.  However, in circumstances where the person making the promise never intends to perform, and where that knowingly false promise is made as part of a scheme to defraud, then the promise may give rise to a promissory fraud claim.

                           Uniform Franchise Offering Circulars

In franchising, fraud claims are often based on statements made in Uniform Franchise Offering Circulars (UFOCs) if those statements are later determined to have been false.  

In addition, a franchisee might claim that he was defrauded by representations that were made, but which were not contained in the UFOC.   

                         Integration and “No Reliance” Clauses

However, franchise agreements typically provide that the agreement is complete as written, and that there are no other agreements, or promises, or “understandings.”  In addition, the franchise agreement may contain a recital that the franchisee acknowledges that he or she did not rely on any statements not contained in the actual franchise agreement.  

Depending on their exact wording, these types of clauses may prevent a franchisee from succeeding in a fraud claim even if the representation was made in a UFOC.   
Therefore, before signing a franchise agreement, it is important to determine exactly what representations are important for the investment decision, and to make certain that you have the legal right to rely on that representation.  

                                      State Franchise Acts

In those states such as Illinois that have enacted franchise protection statutes, franchisees usually turn to these laws as their primary effort to state an actionable claim.
A state franchising act will typically prohibit the sale of franchises that are not registered, or that are sold without providing a disclosure statement.  Careful analysis of a franchisor’s registration and offering circular is therefore the first step in analyzing a franchisee’s potential claims.  However, integration and no reliance clauses in the agreement must also be considered.

State franchise acts will specifically define and prohibit “fraudulent practices.”  For example, the IFDA provides:

In connection with the offer and sale of any franchise made in this State, it is unlawful for any person, directly or indirectly, to:
(a)        employ any device, scheme or artifice to defraud.
(b)        make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statement made in the light of the circumstances under which they are made, not misleading.
(c)        engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

The protection afforded by these provisions is limited primarily by the limited scope of disclosure that franchisors are presently required to make, which, as has been noted by many others, is in reality quite limited.  

The degree of intent that must be proven to state a fraud claim under the state franchising laws varies between states and even within the statutes of some states making generalization dangerous.   However, using the IFDA as an example, the plain language of the statute supports the argument that while intent must be proven to establish “fraud” or “deceit” in subparagraphs (a) and (c), the provisions of paragraph (b) serve to create strict liability for the “mak[ing] of any untrue statement of a material fact…”

                                     “Little FTC Acts”

In one form or another, all states have enacted a consumer fraud or deceptive trade practices act, commonly referred to as a “Little FTC Act.”  These statutes arguably fill a critical void created by Congress’ failure to create a private cause of action at the federal level for violations of the FTC Act or the Franchise Rule.

Because Little FTC Acts were enacted to protect consumers, there is a threshold issue of whether these statutes apply to franchising.  For franchisees, the strongest argument, which has been upheld in numerous states including Illinois and New Jersey, is that the franchisee is, in fact, a consumer in the context of the franchise sales process, particularly when purchasing directly from the franchisor.

The scope of actionable conduct under state Little FTC Acts is quite broad.  For example, the Illinois Consumer Fraud & Deceptive Business Practices Act (“ICFA”), 815 Ill. Comp. Stat. § 505/1 et seq., provides in pertinent part that:

"Unfair methods of competition and unfair or deceptive acts or practices, including but not limited to the use or employment of any deception, fraud, false pretense, false promise, misrepresentation or the concealment, suppression or omission of any material fact, with intent that others rely upon the concealment, suppression or omission of such material fact, … in the conduct of any trade or commerce are hereby declared unlawful whether any person has in fact been misled, deceived or damaged thereby.  In construing this section consideration shall be given to the interpretations of the Federal Trade Commission and the federal courts relating to Section 5 (a) of the Federal Trade Commission Act [15 U.S.C. § 45]."  


Virtually any deception in the franchise sales process, including but not limited to conduct rising to the level of intentional fraud, is arguably actionable under the Illinois and similar statutes.  Moreover, in Illinois, the legislature’s express directive that the courts should consider both judicial and FTC “interpretations” of the FTC act, created a private cause of action that arguably encompasses violations of the Section 5(a) of the FTC Act, which would further include (but not be limited to) Franchise Rule violations.  The availability of an action to redress Franchise Rule violations is arguably strengthened, but should not depend, on this express directive contained in the Illinois act, and that the same result should follow under the broad provisions of any comparable Little FTC Act.

Plaintiffs under a state’s Little FTC Acts, are generally not required to prove actual reliance upon the alleged fraudulent or deceptive practices that induced their franchise purchase. However, the plaintiff must still prove causation.