Friday, July 22, 2011

Startup Cost Projection in UFOC Might Constitute Fraud, Franchise Law Violations

This posting was written by Pete Reap, Editor of CCH Business Franchise Guide.

A vegetarian restaurant franchisee adequately alleged common law fraud and violations of the Maryland Franchise Disclosure Law against a franchisor, based on the franchise startup cost projections in the franchisor’s Uniform Franchise Offering Circular (UFOC), a federal district court in Greenbelt, Maryland, has decided. Thus, the franchisor’s motion to dismiss the claims was denied.

The franchisor’s motion to dismiss claims alleging violation of the New York Franchise Sales Law—on the ground that the New York statute did not apply to the parties’ relationship—was also denied.

Fraud Allegations

The allegations of fraud in the franchisee’s complaint were sufficiently detailed to satisfy particularity in pleading requirements, the court held. The franchisee was consistently specific regarding time, date, place, and contents of the allegedly fraudulent cost projections made by the franchisor.

The franchisee alleged that the startup cost estimates in the franchisor’s UFOC dramatically underestimated the actual startup costs for its franchise and that the franchisor knew that the representations were inaccurate at the time it made them. The franchisee’s factual averments about the franchisor’s knowledge were less specific, but heightened pleading was not required for the scienter element of fraud, according to the court.

The facts in this case made the franchisee’s claims even stronger than they were in an earlier case, Motor City Bagels, LLC v. American Bagel Co., (CCH Business Franchise Guide ¶11,654), in which the court held that a franchisor could have committed fraud by misrepresenting the initial investment costs in its UFOC, the court reasoned.

In this case, the alleged discrepancy between the UFOC and the actual startup costs was much greater than in Motor City, suggesting a potential miscalculation of 85 percent or more.

The UFOC specifically encouraged the franchisee to rely on the startup cost estimates in two ways. First, the UFOC specifically itemized various cost categories and provided sub-estimates for each category. Second, the UFOC pointed out that the estimates were based on the franchisor’s “15 years of combined industry experience and experience in establishing and assisting our franchisees in establishing and operating 23 [vegetarian restaurants] which are similar in nature to the Franchised Unit you will operate.”

The franchisor argued that cost projections were statements of opinion and could not constitute fraud because they were not susceptible to exact knowledge at the time they are made. However, erroneous projections could supply a basis for fraud under Maryland law in some cases, the court held.

Whether projections were sufficiently concrete and material to qualify as statements of fact required a context-sensitive inquiry that could not be reduced to a single formula. An assessment of relevant factors—including the extent of the alleged discrepancy, whether the projection was based on mere speculation or on facts, and whether the projection was contrary to any facts in the franchisor’s possession—supported the conclusion that the franchisee stated a claim for fraud.

New York Franchise Sales Law Claims

The New York Franchise Sales Act applied to the relationship between the Delaware franchisor, with its principal place of business in New York, and the franchisee’s operation of a restaurant in Washington, D.C. because the franchisor’s offer to sell the franchise originated from New York, the court ruled.

Important aspects of the franchise transaction occurred in New York. The initial in-person discussions regarding the franchisee’s potential purchase of a franchise took place there, the court noted. Both of the documents central to the parties’ franchise transaction—the franchisor’s UFOC and the franchise agreement—were mailed by the franchisor from its principal place of business in New York to the franchisee’s Maryland address.

Although neither the franchisee nor the franchised restaurant were located in New York, those facts alone were not dispositive because the New York Franchise Sales Act attempted to protect franchisees in other states where offer and/or acceptance took place in New York, according to the court.

The rationale for extending the statute to situations such as this was to protect and enhance the commercial reputation of New York by regulating not only franchise offers directed at New York from other states, but also those originating in New York, from New York-based franchisors, in the court’s view.

The July 7 opinion in A Love of Food I, LLC v. Maoz Vegetarian USA, Inc. will appear at CCH Business Franchise Guide ¶14,633.

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