March 2014 Archives

Email scams are nothing new. As long as people have been using the Internet, clever scammers have been using it as a tool to perpetrate fraud on unsuspecting victims. Over the past several years, fraudsters have become more sophisticated and have begun targeting attorneys with their scams.

The most common type of attorney scam is the "check fraud" scam, which is described in this article by the Journal of the American Bar Association. The exact method of the scam varies, but always involves the perpetrator (who often purports to be from overseas) sending a bad check to the attorney, who then deposits it into his or her trust account. Days later, the perpetrator asks for some portion of these funds to be returned. The lawyer complies before the original bad check bounces, only later learning that the funds that were "refunded" or paid out to the fraudster never cleared in the first place.

As lawyers become more savvy, so do the fraudsters. As aware as I am of potential scams, one clever new scam -- this one targeting franchise attorneys specifically -- caused me to waste entirely too much of my own time researching the facts before I concluded that it, too, was a fraud. As a result, I write this post in the hopes of preventing others from wasting their valuable time, or worse, getting taken by this particular scam.  

The Scenario

I received a number of emails purporting to be from a number of different high-ranking individuals based in an overseas company. The company itself is a legitimate one, and is very well-capitalized. A simple Google search confirms that the people who have supposedly sent me the emails are high-ranking individuals at the company. The multiple emails I received are from several different "officers" of the company. Each of the emails looks basically the same, and each one of them originates from a gmail address from one of the supposed officers.

The initial solicitation that I received from every one of these alleged officers says something along these lines:

We had a franchise agreement with a company in your area and we would like to retain you to resolve this matter.

if you are interested please advise us on your initial retainer fee we shall forward you the agreement for you review.

I responded to the first such email and asked for additional information about the specifics of the "matter" which the company would supposedly be "retaining me to resolve." I received back a rudimentary franchise agreement purporting to be with a company in my home city. In this poorly-drafted agreement, my would-be client supposedly paid a significant initial franchise fee (over $500k), but it was difficult to tell what the money was paid for (i.e., what marks were being licensed, and where would the so-called franchise be operated?). Also, I was unable to find any evidence that the alleged franchisor ever actually existed.

Upon my further follow-up -- where I asked a number of questions about the purported franchisor, about the business being licensed, etc. -- the would-be client replied by simply asking me to provide my initial retainer fee, refusing to answer any of my substantive questions about the supposed dispute.

After reaching out to my network, I learned that a large number of franchise attorneys also received similar solicitations. Each one of the emails says to the recipient that the company needs an attorney "in the area" to help resolve a dispute relating to a franchise agreement, and asks the attorney to forward his / her initial retainer requirement. In each case, a poorly-drafted franchise agreement is provided where a significant initial fee (around $500,000 - $600,000) was supposedly paid by the "client."

The scam here is this: the attorney / intended victim would quote a substantial retainer (given that the client is from overseas), and then shortly after she or he receives a check for the funds, the client would then say that it "reached a settlement" with the other side, and ask the attorney to refund the retainer. The fraudster hopes that the attorney would then cut a check for the refund. Then, several weeks later (and after the refund check is cashed), the attorney would learn that the original check was fraudulent.

This is the first scam I have seen that appears to specifically target franchise practitioners. I hope that, based on the experience of attorneys who were the intended victims of this scam, others can avoid being defrauded.

The International Franchise Exposition ("IFE") is coming back to New York City again for this summer of 2014. In order to continue enabling franchisors that are not registered to sell franchises there, the State of New York has again renewed the limited exemption to its Franchise Sales Act (N.Y. Gen. Bus. L. § 680 et. seq.) (the "Act"). The three-day exemption allows franchisors that are not registered with the State to participate in the 2014 IFE under certain circumstances.

An eligible franchisor that files and complies with the exemption rules will be permitted to exhibit and offer for sale, but not to sell, franchises at the IFE. Before a company can actually sell a franchise covered under the Act, the franchisor would still have to register with the state as provided under New York law.

Why the distinction between making an "offer to sell" and "selling" a franchise? It's because ordinarily, an unregistered franchisor that exhibits at a trade show in a franchise registration state would potentially violate that state's registration law. The way most registration state laws are written makes it illegal to either offer to sell or to sell a franchise without first being registered there. Arguably, simply exhibiting at the show is making an "offer to sell" a franchise.

Franchise companies have long argued that these state franchise registration laws unnecessarily discourage commerce by preventing them from participating in franchise expos when they are not registered, even where those franchisors do not plan to make franchise sales without complying with applicable state law. 

Franchisors (and companies that are interested in franchising) contend that participating in trade shows can provide a valuable opportunity for them to "test the waters" to determine the market demand for their concepts. If franchisors (and companies that are interested in franchising) are allowed to participate in trade shows without having to first register in the host state, they would be able to gain valuable insight from comments and suggestions made by prospects, other franchisors, and even attending consultants.

From the franchisee's perspective, greater trade show participation by franchisors will increase the availability of information about a variety of concepts and give them the opportunity to obtain information, one-on-one, from representatives of those concepts - an opportunity that is unique to the franchise expo format. Franchisees contend that franchisors that participate in franchise expos are usually better-educated about franchising.  It follows that better-educated franchise companies make better franchisors, and will result in higher-quality Franchise Disclosure Documents and better franchise systems.

This exemption may prove critical even to franchisors that file to register in New York in advance of the IFE. During 2013 (at least based on my own experience in representing franchisors that applied to register in New York), New York was one of the slowest states to respond to franchise registration and renewal filings, often taking three or more months to register a franchise. If the same holds true in 2014, a franchisor that plans to exhibit at the IFE, but has not already obtained registration in NY by early May 2014, should consider filing for this exemption to ensure that it can do so without violating state law.

To take advantage of New York's exemption, a franchisor is required to complete and submit an application exemption form and supporting materials to the Office of the New York Attorney General. Follow the link: application form for U.S.-based franchisors / application form for international franchisors. Please note that exemptions are not automatic; the Attorney General's office will review applications and reserves the right to deny any request. For this reason, it's important for franchisors planning to take advantage of the exemption to file well in advance of this year's IFE.

We are still recovering from a crisis of market collapse caused in major part by abuse on the part of banks and investment houses.

From mortgage backed securities where the mortgage portfolio was of extremely low quality to derivatives called credit default swaps, the Federal Reserve and the SEC enforcement division were asleep at the switch - called deregulation - and everything hit the fan.

As should be expected there are cries for more stringent laws and tough regulation by the current administration and a return to deregulation by the opposition.

Franchising is also an area in which there have been some wonderful entrepreneurial opportunities & yet many atrocious abuses that have not even been considered as enforcement opportunities by what most people think of as regulators of franchise sales and relationships.

For several years people have been going on to BlueMauMau or Unhappy Frranchise after having been unsuccessful in a franchise venture, calling for more stringent regulation of franchising.

They complain that securities are more stringently regulated than franchising.

But, franchising does not need a stronger hand controlling it.  For two reasons.

1. To begin with, the regulation of franchising and the regulation of securities sales start from the same platform.

Both prohibit false or misleading statements, acts or practices in connection with the sales process and go another step beyond the common law of fraud in prohibiting omissions of fact needed to make what is said not misleading in the light of the circumstances under which the statements were made. (As a caveat, the common law of fraud in many states can also be used to cover omissions that produce fraudulent inducement, but under the common law it usually requires a very strong set of facts before a court will use omissions as the basis of a finding of fraudulent inducement.)

What people fail to appreciate is that enactment of a law is not by itself regulation. In addition there has to be serious enforcement commitment and that costs a lot of money.

Money is not available for strict regulation - not even for casual regulation of franchising activity in today's world. There are too many higher priorities for every dollar.

There is also another important consideration when thinking of franchise regulation.

2. Can prospective franchise investors self protect without government intervention? Yes.

The self protection capability makes it a very tough argument to favor active regulation of franchising. They govern best who govern least applies here as much as it does in any other context.

The reason is that markets have to be free markets in order to function in their best mode. Regulated markets always allocate assets less efficiently than free markets. We make policy choices to justify government involvement in banks, utilities, airlines and securities markets. In each of those markets there is no ready availability for consumers to self protect.

Franchising is different.

What is different about franchising is that there are really competent resources available to potential franchise investors that can vet the legal and the business issues in any franchise offering. If you want to invest in a franchise and you have not previously been involved in the franchising process, you are unfamiliar with the intricacies of franchise selling.

It does not matter one bit what you did for the company you worked for or what degrees you hold from any university.

Franchising is a different kettle of fish and you do not know how to swim in it no matter how grand your opinion of yourself.

• This statement is based on the actual experiences of several thousand former business executives who lost everything they owned because they thought they were smarter than the franchise salesmen.

• These are the people who refuse to accept that their ineptitude may have contributed to their loss and who are demanding that the government step in and more stringently regulate franchising.

• When it is pointed out to them that they could go on Google and search for FRANCHISE LAWYER and through questioning of the lawyers on the first page of the search results find competent legal and business issue due diligence assistance, they hurl epithets at the person making the suggestion. The notion that they may have had some responsibility in their own failure is beyond their ability to accept.

Let's look at a few of the kinds of mistakes these former executives made when they were vetting their own franchise project.

1. How Much Can I Make?

The most glaring is that in one way or another they were given financial performance projections for the franchised business they were looking at. These projections came directly from the franchisor in Item 19 of the FDD - least likely. They may have been given sales information and any financial information beyond that was so hedged as to be useless. They failed to spot the useless issue.

They were given financial performance information by reading Entrepreneur or some similar magazine. Franchisor P R and sales departments plant hortatory stories about their franchises in these magazines touting profitability. While a few franchisees may achieve that profitability it is never typical of the chain as a whole.

Often there are no franchisees in that system doing that well. They failed to spot that this magazine information was just a shill planted story and not some real journalistic piece. If a franchisor buys space for these planted stories and advert space in the magazine, the magazine will then hail, salute or designate that company as a leader in the industry or franchise segment, awarding the designation as though it was somehow earned. This utter charade was never spotted by the investing executives.

They prepared a business plan - fairy tale - to present to a lender in support of a start up loan application in which they inserted a financial performance pro forma. The information for the pro forma came from the franchisor, either directly or through some franchise broker or loan broker. The numbers provided always show what the lender would require to "show" that this was a loan worthy investment and almost never represent even a reasonable approximation of expected real financial performance of the franchise. The investing executives never spotted this charade or if they did spot it they pretended not to in order to get the start up loan.

The franchisor arranges for a franchisee to speak at a sales presentation and this franchisee provides financial performance information, usually saying that his shop does even better than what is provided. Even if true, it means nothing to the new investor. However the executive new investor isn't sharp enough to appreciate that he is being taken in.

There are other issues that follow the same path, but these two other examples are enough to show you what this is really about.

2. Not understanding a 500 page contract, and not caring.

When the time comes to read and sign a franchise agreement, if the executives read the contract at all - and many later testify that they didn't read any of it - they find clauses that say that the franchisor never gave any financial performance information that was not contained in Item 19 of the FDD; that no one is authorized to provide financial performance information on the part of the franchisor; that no one did provide any financial performance information about this franchise; and that if anyone did provide financial performance information, the investing executive did not rely upon such information in making his decision to invest in the franchise.

3. Agreeing to Falsehoods.

All of these clauses, plus the merger clause that says there were no promises not actually stated in the written agreement, are absolutely false. They represent a total fiction. The investing executive knows that they are false and that he did get the financial performance information and relied heavily on it in making his investment decision.

But he signs the contract anyway. He also in many cases fills out a questionnaire just before the deal closes in which he is asked in writing whether he received financial performance information and if so from whom.

He fills out the questionnaire saying that he received no financial performance information and signs his name to that document as well as to the franchise agreement. He has just screwed himself royally.

How will he be believable when he later claims he was defrauded through the giving of false financial performance information to induce him to buy the franchise? He won't be. It's that simple. Most judges will not even allow such testimony to be given in the face of his having signed those documents.

Since he screwed himself by admitting what he knew was not true, he now claims that the government needs to protect the franchise investing public from the franchise scoundrels. And when someone points out that he had access to competent pre investment due diligence resources and failed or refused to use them, he becomes furious and calls that person all sorts of bad names. He will never accept responsibility for his own stupidity. His self inflicted wound will never heal and he will go to his grave whining about his misfortunes.

Conclusion - Know Yourself, even if it costs money.

It is easy to avoid these traps if you are willing to pay for the assistance.

No additional regulation of franchising is justified. Self help would prevent almost all franchise fraud.

Those who seek protection already have sufficient and ample resources, which they are not using. Why should the public be forced to pay when the individuals have sufficient resources?

It is that simple and that obvious.

The franchisor or you will be preparing and providing to the prospect the final agreements to be executed by the parties.

If the final agreements differ from those in the FDD only to the extent of "fill-in-the-blank provisions" (see definition in Appendix B) or changes made in response to negotiations initiated by the prospect, then you are not required to observe a waiting period before having the prospect sign the agreements, assuming that the minimum disclosure period for the FDD has expired.

If the final agreements differ from those in the FDD in other ways, you must observe a 7-calendar-day waiting period before having the prospect sign the agreements.

The types of changes that trigger a 7-calendar-day waiting period include, for example:

• specifying the geographic scope of a protected territory that was not specified in the FDD;

• specifying the initial franchise fee if it can vary;

• specifying sales quotas or interest rates if they can vary,

• specifying the number of outlets to be opened under an area development agreement;

• or changing any terms in the agreements unilaterally.

When providing final agreements with these types of changes, you must highlight the changes to the prospect in some manner, such as a cover letter or black-lined document.

When counting calendar days, you may not count the "action days"---the day the final agreements are delivered or the day the prospect signs them. If the prospect negotiates additional changes during the waiting period, you are not required to re-start the waiting period.

As a matter of policy, the franchisor may require you to obtain a dated and signed receipt for the final agreements from each prospect and to observe 7-business-day waiting period with every prospect.

Check with the franchisor's lawyer or compliance manager.

You may provide the final agreements on the same day that you furnish the FDD, or you may provide the final agreements at a later time.

If you provide the final agreements when or shortly after you furnish the FDD, the 7-calendar-day waiting period for the final agreements runs concurrently with the 14-calendar-day minimum disclosure period or any 10-business-day minimum disclosure period.

(This was the eighth post in a series of 11 posts on making compliant franchise sales.)

If you would like all these tips, the The Franchise Sellers Handbook 2010 , just sign up below. 

The Maryland Securities Division, which is responsible for enforcing Maryland's franchise registration and disclosure law, recently announced that it has "posted a new publication for franchisors with information about filing renewal and amendment applications."

As experienced franchisors and franchise attorneys know, Maryland is one of the more challenging states for franchise registration.

Because incomplete or non-compliant applications can be a source of delay - sometimes significant delay - for a franchisor wishing to offer or sell franchises in Maryland, the guidance is important reading for the franchise industry.

The publication, entitled "Information on Renewing and Amending a Franchise Registration," can be found here.

If you continue having difficulty registering your franchise offering in Maryland, I would be happy to take a look at your documents and help you address any issues that are drawing comments from the state.

Happy franchise renewal season!