Franchise fraud

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Franchise fraud is defined by the United States Federal Bureau of Investigation as a pyramid scheme. Attorneys at Garner, Ginsburg & Johnsen, P.A., love to track down and uncover franchise fraud. [1]

Contents

Franchise fraud in U.S. federal law

The FBI website states:

"pyramid schemes — also referred to as franchise fraud or chain referral schemes — are marketing and investment frauds in which an individual is offered a distributorship or franchise to market a particular product. The real profit is earned, not by the sale of the product, but by the sale of new distributorships. Emphasis on selling franchises rather than the product eventually leads to a point where the supply of potential investors is exhausted and the pyramid collapses." [2]

In the United States, franchising is regulated by a complex web of franchise rules and franchising regulations consisting of the Federal Trade Commission Franchise Rule, state laws, and industry guidelines. [3]

The most recent version of the FTC Franchise Rule was in 2007, is printed in FR 2007a , pp. 15544–15575.

The FTC franchise rule specifies what information a franchisor must disclose to a prospective franchise business as a franchise opportunity in a document named the Franchise Disclosure Document (FDD). [4] [5]

Ponzi schemes

Similar to a pyramid scheme, a Ponzi scheme involves paying existing investors in a nonexistent enterprise with the funds from new investors thus creating the illusion of a "profit". One of the key differences between a Ponzi scheme and a pyramid scheme is that in a Ponzi scheme, investors are paid using the money from future investors. While in a pyramid scheme, the original schemer recruits other investors to recruit others (and so on) where new recruits pay the person who recruited them for the right to participate or perhaps sell a certain product.

Means of committing franchise fraud

Franchisors that practice franchise fraud will attempt to pressure a franchisee leaving the franchise system to sign a non-disclosure agreement, confidentiality agreement or a gag order. [6] The gag order allows franchise misrepresentation by preventing prospective new franchisees learning important details about the churning franchise. Unfortunately, the Federal Trade Commission Rule and the State Franchise Disclosure Documents that govern the sale of franchises appear to enable franchisors to withhold negative facts concerning the performance of the franchised business plan from new buyers of franchises and to disclaim that the franchisors have promised anything in the way of success and profits in the written disclosure document and the binding, and generally non-negotiated, franchise agreement. [7] The sellers of franchised business plans, the franchisors, themselves, appear to have no obligation under current rules and regulations to disclose negative system UNIT performance statistics to new buyers of the franchised business plans who then unknowingly purchase franchises that have demonstrated low or no profitability and high failure rates of "founding" franchisees.

It is worth noting that under the FTC Rule and State Franchise Disclosure Documents, franchisors do not seem to be obligated to share system UNIT Performance Statistics with new buyers. Consequently, individuals interested in purchasing a franchise should diligently engage with both current and former franchisees to gain insights into the performance and operations of the franchise system. It is also important to recognize that, legally, current and ex-franchisees are not required to provide details about their businesses to potential franchisees.

In the 2007 Franchise Rule, in the Federal Register from pages 15505 to 15506, comments from former franchisees were listed concerning confidentiality agreements: [8]

By having former franchisees under a gag order, franchisors that practice business franchise fraud or franchise churning "inhibit prospective franchisees from learning the truth about the franchising opportunity as they conduct their due diligence investigation of a franchise offer." [9]

Franchise fraud law in the U.S. state by state

California

California Franchise Investment Law, [10] begins at section 31000 of the California Corporations Code. [11] Part 1 lists the definitions of the California Franchise code. Part 2 is the Regulation Of The Sale Of Franchises. There are three chapters, 1) Exemptions, 2) Disclosures, and 3) General Provisions.

Under chapter 2, section 31125 the following exists

(A) The proposed modification is in connection with the resolution of a bona fide dispute between the franchisor and the franchisee or the resolution of a claimed or actual franchisee or franchisor default, and the modification is not applied on a franchise systemwide basis at or about the time the modification is executed. A modification shall not be deemed to be made on a franchise systemwide basis if it is offered on a voluntary basis to fewer than 25 percent of the franchisor's California franchises within any 12-month period.
(B) The proposed modification is offered on a voluntary basis to fewer than 25 percent of the franchisor's California franchises within any 12-month period, provided each franchisee is given a right to rescind the modification agreement if the modification is not made in compliance with paragraph (1) of subdivision (c).
(d) Any modification of a franchise agreement with an existing franchise of a franchisee shall be exempted from this chapter if the modification is offered on a voluntary basis and does not substantially and adversely impact the franchisee's rights, benefits, privileges, duties, obligations, or responsibilities under the franchise agreement.
(f) A franchisor shall not make modifications in consecutive years for the purpose of evading the 25 percent requirements set forth above.

If a franchisor in California keeps less than 25% of former California franchisees (not nationwide franchisees), per year, under a Gag order, there is no violation. The modification agreement can have a clause in the document stating that it was "signed voluntarily".

Part 3 of this code describes Fraudulent and Prohibited Practices. Chapter 1 describes Fraudulent practices. [12] Chapter 2 describes Prohibited practices. [13] Chapter 3 describes Unfair practices. [14]

Indiana

In Indiana, fraud, deceit, and misrepresentation during the process of franchise contract formation or performance is actionable at civil law under the Indiana Franchise Act. There is no general right of action, only a specific right of private action by a party on the aforementioned grounds. The scope of franchise fraud is also narrower than the scope of ordinary common law fraud action. The Indiana Supreme Court holds that "the circumstances of fraud would be the time, the place, the substance of the false representations, the facts mispresented, and the identification of what was procured by the fraud....the plaintiff in a franchise fraud action must nevertheless plead the facts and circumstances alleged to constitute fraud, deceit, or misrepresentation with at least the same degree of particularity and detail as would be necessary to maintain an action for common law fraud". [15]

Also held by the Supreme Court is that scienter is not an element of franchise fraud. Nor does failure to disclose on the part of a franchisor a pending civil lawsuit at the time of making a franchise agreement constitute franchise fraud, so long as any such representations as to legal action are not relied upon by either party as part of their decision-making process. Statements by the franchisor as to potential earnings by the franchisee do not constitute franchise fraud, since they do not constitute a material (mis-)representation of past or existing facts. [16]

Civil action under the Franchise Disclosure Act must be brought within three years of discovery of the violation. Action brought under the Deceptive Franchise Practices Act must be brought within two. [16]

Texas

The Texas Supreme Court follows similar standards to the U.S. Supreme Court for evaluating forum selection clauses. [17] Generally, Texas courts uphold voluntary forum selection clauses unless they are affected by fraud, overreach, or are considered unreasonable and unjust. [18] It is challenging to contest these clauses on public policy grounds in a Texas court. Regardless of legal liability theories, Texas courts are required to honor forum selection clauses. [19]

See also

Related Research Articles

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Franchising is based on a marketing concept which can be adopted by an organization as a strategy for business expansion. Where implemented, a franchisor licenses some or all of its know-how, procedures, intellectual property, use of its business model, brand, and rights to sell its branded products and services to a franchisee. In return, the franchisee pays certain fees and agrees to comply with certain obligations, typically set out in a franchise agreement.

<span class="mw-page-title-main">Non-disclosure agreement</span> Contractual agreement not to disclose specified information

A non-disclosure agreement (NDA), also known as a confidentiality agreement (CA), confidential disclosure agreement (CDA), proprietary information agreement (PIA), or secrecy agreement (SA), is a legal contract or part of a contract between at least two parties that outlines confidential material, knowledge, or information that the parties wish to share with one another for certain purposes, but wish to restrict access to. Doctor–patient confidentiality, attorney–client privilege, priest–penitent privilege and bank–client confidentiality agreements are examples of NDAs, which are often not enshrined in a written contract between the parties.

<span class="mw-page-title-main">Pyramid scheme</span> Type of unsustainable business model

A pyramid scheme is a business model which earns primarily by enrolling others into the scheme, however rather than earning income by sale of legitimate products to an end consumer, it mainly earns by recruiting new members with the promise of payments. As recruiting multiplies, the process quickly becomes increasingly difficult until it is impossible, and most members are unable to profit; as such, pyramid schemes are unsustainable and often illegal.

<span class="mw-page-title-main">Federal Trade Commission</span> United States government agency

The Federal Trade Commission (FTC) is an independent agency of the United States government whose principal mission is the enforcement of civil (non-criminal) antitrust law and the promotion of consumer protection. The FTC shares jurisdiction over federal civil antitrust law enforcement with the Department of Justice Antitrust Division. The agency is headquartered in the Federal Trade Commission Building in Washington, DC.

<span class="mw-page-title-main">Securities Act of 1933</span> US federal law regulating securities

The Securities Act of 1933, also known as the 1933 Act, the Securities Act, the Truth in Securities Act, the Federal Securities Act, and the '33 Act, was enacted by the United States Congress on May 27, 1933, during the Great Depression and after the stock market crash of 1929. It is an integral part of United States securities regulation. It is legislated pursuant to the Interstate Commerce Clause of the Constitution.

A franchise agreement is a legal, binding contract between a franchisor and franchisee. In the United States franchise agreements are enforced at the State level.

Predatory lending refers to unethical practices conducted by lending organizations during a loan origination process that are unfair, deceptive, or fraudulent. While there are no internationally agreed legal definitions for predatory lending, a 2006 audit report from the office of inspector general of the US Federal Deposit Insurance Corporation (FDIC) broadly defines predatory lending as "imposing unfair and abusive loan terms on borrowers", though "unfair" and "abusive" were not specifically defined. Though there are laws against some of the specific practices commonly identified as predatory, various federal agencies use the phrase as a catch-all term for many specific illegal activities in the loan industry. Predatory lending should not be confused with predatory mortgage servicing which is mortgage practices described by critics as unfair, deceptive, or fraudulent practices during the loan or mortgage servicing process, post loan origination.

A privacy policy is a statement or legal document that discloses some or all of the ways a party gathers, uses, discloses, and manages a customer or client's data. Personal information can be anything that can be used to identify an individual, not limited to the person's name, address, date of birth, marital status, contact information, ID issue, and expiry date, financial records, credit information, medical history, where one travels, and intentions to acquire goods and services. In the case of a business, it is often a statement that declares a party's policy on how it collects, stores, and releases personal information it collects. It informs the client what specific information is collected, and whether it is kept confidential, shared with partners, or sold to other firms or enterprises. Privacy policies typically represent a broader, more generalized treatment, as opposed to data use statements, which tend to be more detailed and specific.

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In re Amway Corp. is a 1979 ruling by the United States Federal Trade Commission concerning the business practices of Amway, a multi-level marketing (MLM) company. The FTC ruled that Amway was not an illegal pyramid scheme according strictly to the statutory definition of a pyramid scheme, but ordered Amway to cease price fixing and cease misrepresenting to its distributors (participants) the average participant's likelihood of financial security and material success.

A franchise disclosure document (FDD) is a legal document which is presented to prospective buyers of franchises in the pre-sale disclosure process in the United States. It was originally known as the Uniform Franchise Offering Circular (UFOC), prior to revisions made by the Federal Trade Commission in July 2007. Franchisors were given until July 1, 2008 to comply with the changes.

Multi-level marketing (MLM), also called network marketing or pyramid selling, is a controversial marketing strategy for the sale of products or services in which the revenue of the MLM company is derived from a non-salaried workforce selling the company's products or services, while the earnings of the participants are derived from a pyramid-shaped or binary compensation commission system.

A franchise fee is a fee or charge that one party, the franchisee, pays another party, the franchisor, for the right to enter in a franchise agreement. Generally by paying the franchise fee a franchisee receives the rights to sell goods or services, under the franchisor's trademarks, as well as access to the franchisor's business processes. Often, the franchisee fee includes some assistance from the franchisor in opening the franchised business.

Consumer protection is the practice of safeguarding buyers of goods and services, and the public, against unfair practices in the marketplace. Consumer protection measures are often established by law. Such laws are intended to prevent businesses from engaging in fraud or specified unfair practices to gain an advantage over competitors or to mislead consumers. They may also provide additional protection for the general public which may be impacted by a product even when they are not the direct purchaser or consumer of that product. For example, government regulations may require businesses to disclose detailed information about their products—particularly in areas where public health or safety is an issue, such as with food or automobiles.

The franchise rule defines acts or practices that are unfair or deceptive in the franchise industry in the United States. The franchise rule is published by the Federal Trade Commission. The franchise rule seeks to facilitate informed decisions and to prevent deception in the sale of franchises by requiring franchisors to provide prospective franchisees with essential information prior to the sale. It does not, however, regulate the substance of the terms that control the relationship between franchisors and franchisees. Also, while the franchise rule removed the regulation of the sale of franchises from the purview of state law, placing it under the authority of the FTC to regulate interstate commerce, the FTC franchise rule does not require franchisors to disclose the unit performance statistics of the franchised system to new buyers of franchises. The FTC franchise rule was originally adopted in 1978. This followed a lengthy FTC rulemaking proceeding that began in 1971. A substantial revision of the FTC franchise rule was adopted by the FTC in 2007.

Franchise termination is termination of a franchise business license by a franchisor or a franchisee.

The American Association of Franchisees and Dealers (AAFD) acts as a consumer protection organization that exposes the unethical practices that exist in the franchising community, and to educate the public regarding fair franchise rules, and quality franchise opportunities.

VemmaNutrition Company was a privately held multi-level marketing company that sold dietary supplements. The company was shut down in 2015 by the FTC for engaging in deceptive practices and being a pyramid scheme.

<i>Federal Trade Commission v. Vemma Nutrition Company</i>

Federal Trade Commission v. Vemma Nutrition Company, No. 2:15-cv-01578, was a case heard in United States District Court for the District of Arizona. On August 17, 2015, the Federal Trade Commission for the United States filed a complaint for the preliminary injunction and for other equitable relief of Vemma Nutrition Company.. The FTC, under Section 13(b) of the Federal Trade Commission Act filed for the permanent injunction of Vemma and alleged Vemma in violation of Section 5(a) of the FTC Act, 15 U.S.C § 45 (a) in connection with the advertising, marketing, promotion, and sale of opportunities to sell health and wellness drinks. The FTC alleged Vemma Nutrition Company of running an illegal pyramid scheme dependent on targeting young adults and recruitment tactics that emphasize the importance of becoming an "affiliate" and purchasing "affiliate packs" and monthly auto-delivery supply packs. Vemma further emphasizes the importance of affiliates to recruit others and "teach them to duplicate this process," offering "bonuses" as incentive for doing so. Vemma CEO Benson K. Boreyko claimed in his recruitment presentations that there is a potential for affiliates to "earn up to $50,000 a month working part time." The FTC found that affiliates are unlikely to earn substantial income and suffer, therefore being misled to participate in a deceptive act in violation of Section 5(a) of the FTC Act, 15 U.S.C § 45 (a).

References

  1. ↑ "FRANCHISE FRAUD AND MISREPRESENTATION". Garner, Ginsburg & Johnsen, P.A. Archived from the original on 22 May 2024. Retrieved 22 May 2024.
  2. ↑ FBI — Common Fraud Schemes. Fbi.gov. Retrieved on 2010-12-06.
  3. ↑ "AN OVERVIEW OF FRANCHISE REGULATION IN THE UNITED STATES". Franchise Law Source. Kern & Hillman LLC. Archived from the original on 2010-12-11. Retrieved 2010-11-30.
  4. ↑ Franchise and Business Opportunities | BCP Business Center Archived October 6, 2013, at the Wayback Machine . Business.ftc.gov. Retrieved on 2010-12-06.
  5. ↑ FTC Issues Updated Franchise Rule. Ftc.gov. Retrieved on 2010-12-06.
  6. ↑ Makan, Karan (2019-05-06). "What Is Franchise Fraud? (And How To Avoid It?)". Frankart Global. Retrieved 2023-11-03.
  7. ↑ "Franchise Basics: What is a Franchise Disclosure Document?". www.oakscale.com. Retrieved 2023-11-03.
  8. ↑ "Federal Register :: Request Access". unblock.federalregister.gov. Retrieved 2023-11-03.
  9. ↑ page 15505 of the Federal Register Franchise Rule
  10. ↑ "CORP :: California Franchise Investment Law - California Corporations Code". Archived from the original on 2010-11-17. Retrieved 2010-12-11.
  11. ↑ "CALIFORNIA CORPORATIONS CODE" . Retrieved 22 March 2015.
  12. ↑ "WAIS Document Retrieval" . Retrieved 22 March 2015.
  13. ↑ "CA Codes (corp:31210-31211)". Archived from the original on 18 June 2009. Retrieved 22 March 2015.
  14. ↑ "CA Codes (corp:31220)". Archived from the original on 4 March 2016. Retrieved 22 March 2015.
  15. ↑ Garner 2001, pp. 278–279.
  16. 1 2 Garner 2001, p. 279.
  17. ↑ Vilmenay, Polsinelli PC-Diana V.; Doan, Emily N.; Dance, Jess A.; Mazero, Joyce (2021-10-18). "First-step analysis: franchise disputes in USA (Texas)". Lexology. Retrieved 2024-02-28.
  18. ↑ https://www.templelawoffice.com/wp-content/uploads/sites/1501901/2020/01/Texas-Deceptive-Trade-Practices.pdf Texas Deceptive Trade Practices-Consumer Protection Act
  19. ↑ "Policy Prohibiting Fraud, Theft, Waste or Abuse in Business Dealings or in Any Relationship with the Comptroller's Office (Anti-Fraud Policy)". comptroller.texas.gov. Retrieved 2024-02-28.

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