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Appeals Court Upholds "Silent Fraud" Jury Verdict under Franchise Investment Law




by:
David L. Cahn
Whiteford, Taylor & Preston L.L.P. - Baltimore Office

 
August 12, 2014

Previously published on August 6, 2014

Take-away:  If your franchise offering document is silent on key issues, you can be liable if your people “oversell” to a potential franchisee.  Better to deal with the issue in carefully vetted writing than to be surprised by something your people say off the cuff.  

The case:  A recent Michigan Court of Appeals decision, reinstating a jury verdict against a cellular communications store franchisor, shows the potency of franchise investment and disclosure laws in protecting franchisees against misleading sales tactics, if the information provided does not contradict the franchise disclosure document presentation.

The facts: In Abbo v. Wireless Toyz Franchise, L.L.C., Abbo was a failed franchisee and area developer of cellular communications stores. Looking back, he alleged that an officer of Wireless Toyz provided misleading information in the “discovery day” presentation.

As background, you need to understand something about the business model of cellular franchises. Their profitability can be affected by “hits” (discounts given in the sale of phones); “chargebacks” that decrease store commission revenue; the franchisor’s bargaining power with cell phone carriers; the hidden costs of purchasing inventory from the franchisor; and ultimately the number of cell phone sales necessary to make a profit.

None of these issues was dealt with in any meaningful way in Wireless Toyz’s franchise disclosure document (“FDD”). Since the FDD was silent, that left wide areas about which prospective franchisees could ask for additional information, and left the franchisor’s executives, eager to sell franchises, vulnerable to providing answers outside the FDD.  In this particular case, the franchisee directly asked a senior franchisor executive about revenue deductions from “chargebacks” and “hits,” and the franchisor executive apparently said that chargebacks constituted “only five to seven percent” of total commissions and that Wireless Toyz stores outside of Michigan (the home state) had been “subject to only ‘very minor’ hits.”   In fact, neither statement was accurate.

The FDD’s Item 19 Financial Performance Representation said that there were 181 average new activation contracts each month, and an average of $222.31 in commissions per activation.  However, the presentation did not mention “hits” or the minimal amount of revenue (net of the cost of cellular devices) earned by the stores, and it also did not detail the extent of chargebacks and how they impacted the actual net commissions earned per activation.

After a jury trial, the jury found that the franchisor had failed to provide material facts necessary to make the FDD’s statements not misleading under the circumstances of their presentation, and also that it was liable for creating false impressions when responding to the prospective franchisee’s direct questions regarding “hits” and “chargebacks.”  The Michigan Franchise Investment Law (like its statutory cousin, the Maryland Franchise Registration and Disclosure Law) creates an affirmative legal duty to disclose all material facts necessary to avoid creating a false impression.

In this case, Wireless Toyz made a corporate decision not to provide information on the extent of chargebacks in Item 19 of the FDD, even though that information was clearly relevant to the picture of commission revenue generated per activation.  The “gasoline on the fire” in this case was the “five to seven percent” estimate provided by the franchise salesperson in response to a direct question.
Initially, despite the jury’s findings, Wireless Toyz came out ahead: the trial court overturned the jury verdict because of the following, very common, franchise agreement provision:

Except as provided in the [Disclosure Document] delivered to the Franchise Owner, the Franchise Owner acknowledges that Wireless Toyz has not, either orally or in writing, represented, estimated or projected any specified level of sales, costs or profits for this Franchise, nor represented the sales, costs or profit level of any other Wireless Toyz Store.

The jury concluded that, despite this language in the contract, Abbo was reasonable in relying on the verbal statements on matters not addressed in the FDD.  Moreover, because the verdict was for misleading omissions, the jury presumably found that the failure to provide additional clarifying information both in and out of the FDD presentation was what misled the franchisee.

The appellate court agreed with the jury, not the trial judge.

There was a dissenting opinion at the appellate level, and it is likely that Wireless Toyz will seek to have the Michigan Supreme Court review the decision.  However, that court is not obligated to do so and may not want to substitute its opinion for that of the jury.  As in many franchise cases, Wireless Toyz’s chances were not terribly good once it allowed a jury to deliberate regarding its actions.

In an era when about two-thirds of franchisors now provide written financial performance information in their FDD, this decision is an important reminder to franchisors of the risk of providing only partial information in the FDD - particularly if the franchisor has access to accurate (if not necessary encouraging) information on unit-level expenses or deductions from revenue.

For example, in a quick service food system, if a franchisor has a standard accounting system, then it should have access to franchisees’ costs of ingredients and packaging supplies as well as their labor costs. (And, since the franchisee will use these figures to calculate its tax deductions from gross revenue, the amount of those costs probably will not be understated.)

That sort of information is important to prospective franchisees and is almost certainly data that they will seek from the franchisor.  It is better to disclose fully in the FDD instead of hoping your salespeople don’t get asked about it or that, if asked, they answer accurately.



 

The views expressed in this document are solely the views of the author and not Martindale-Hubbell. This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.
 

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