An Item 19 Continues to Be an Effective Shield against Fraud Claims

2009 continued to be a year in which courts found that by providing earnings information in an Item 19 franchisors were able to prevail in cases in which the franchisee asserted claims for fraud surrounding alleged misleading earnings claims. Due to the length of time it takes a case to arise and percolate through the court system, each of these cases involves franchisees who received disclosure under the prior UFOC Guidelines. However, as the cases all relate to a franchisee's ability to rely on the earnings information there is no reason to believe the result would differ under the FDD format.

In Rocky Mountain Chocolate Factory, Inc. v. Anderson, et al., the franchisees alleged in a counterclaim that the Item 19 earnings claim in the UFOC was misleading in that it only provided gross sales information and the notes stated that the franchisor did not have access to, or knowledge of franchisees' cost information. In fact, the franchisees alleged, the franchisor had such knowledge, through the collection of franchisee financial statements, and therefore the Item 19 was misleading. The U.S. District Court for the District of Colorado had no trouble finding against the franchisee because the Item 19 provided that the earnings claim did not reflect the costs of sales or operating expenses, and stated that the franchisor does not make or authorize its sales personnel to provide such data. As such, the court found that even if the franchisor had such information, the defendants were on notice that it would not be provided. Therefore, prospective franchisees were on notice of their obligation to conduct appropriate due diligence by inquiring with individual franchisees regarding operating expenses.

Likewise, in Sherman, et al. v. Ben & Jerry's Franchising, Inc., et al., the U.S. District Court for the District of Vermont found that the franchisee could not have reasonably relied on the franchisor's alleged earnings misrepresentation in Item 19 of the UFOC because it contained explicit warnings and disclaimers related to the franchisee's expected profits. In Sherman, the franchisee alleged that a misleading earnings claim fraudulently induced her to enter into the franchise relationship. However, the Item 19 included in the UFOC clearly stated that the franchisor does not represent that any franchisee or franchise can expect to obtain the reported results and that actual results vary from unit to unit. Therefore the court found that it was incumbent on the prospective franchisee to conduct its own investigation and that such a party could not later sue on a claim of fraud because they relied on the representations.

Similarly, in Kiddie Academy Domestic Franchising, LLC v. Faith Enterprises DC, LLC, a case in which the franchisor did not otherwise provide an Item 19 earnings claim, the U.S. District Court for the Northern District of Maryland found that while the franchisor may have adopted a franchisee's pro formas when its employee said "they look okay to me", the franchisee could not prevail on a fraud claim because the franchisee ultimately received tax returns for the units for sale that differed from the pro formas. The court concluded that as a result, the franchisee should have conducted an investigation into the discrepancies and therefore could not have reasonably relied on the pro formas. Significantly, the Court found that "reliance is not justified if, under the circumstances, he has discovered something which should serve as a warning…and he has not made an investigation of his own." Certainly, had the franchisor provided an Item 19 earnings claim with appropriate notes and warnings, this would have further solidified the franchisor's defense.

While the New FTC Rule prohibits a franchisor from requiring a franchisee to disclaim reliance on the FDD, nothing prohibits a franchisor from properly stating what the Item 19 consists of, and what factors may impact a franchisee's performance. Indeed, the New FTC Rule requires specific admonitions that a franchisee's individual financial results may differ from those stated in the Item 19. Moreover, in FAQ 27, the FTC provides language that a franchisor which makes an Item 19 financial performance representation, may use to disclaim financial representations made outside of the Item 19.

Accordingly, the warnings and disclaimers that accompany an Item 19 will no doubt continue to have some benefit in subsequent litigation brought by a franchisee.

Lane Fisher and Joseph Dunn are partners in the Philadelphia-based law firm Fisher Zucker, LLC. Lane has represented franchisors for more than 20-years, written extensively on many aspects of franchising, and is a frequent speaker on franchise issues. Joe has practiced law for nearly 15-years and has represented franchisors in both private practice and as in-house counsel.