Franchisors and their management teams which elect to ignore the mandates of federal and state franchise registration/disclosure laws—by failing to register when necessary, effecting disclosure as required or by engaging in fraudulent conduct—can expect to confront a litany of woe.

To begin with, almost all such laws enumerate and define “fraudulent” and “unlawful” practices in the broadest of terms, as elucidated below.

Further, franchise administrators possess broad powers under federal and state franchise registration/disclosure statutes to investigate franchise sales fraud and illegality. If they uncover fraud, these administrators can institute civil proceedings seeking broad remedies and, under many state franchise laws, can institute criminal proceedings as well—in both instances targeting not just the franchisor itself, but also the franchisor's officers, directors and managers.

Finally, many state franchise administrators also have the power to unilaterally suspend a franchisor's registration—meaning that, until the franchise administrator is satisfied that no wrongdoing has occurred, or until that administrator's lawsuit against the franchisor has been heard and determined, absolutely no franchise sales activity can take place in that state.

In this column, we shall review how federal and state franchise laws define what conduct is prohibited; the broad investigative powers possessed by federal and state franchise administrators; the criminal and civil proceedings they can institute; and, who may be held liable for statutory violations.

Prohibited Practices—FTC Franchise Rule

The Federal Trade Commission Franchise Rule specifically identifies the following as unfair and deceptive acts or practices and thereby authorizes the FTC to proceed against the violator:

(a) To fail to furnish to any prospective franchisee, within the timeframes required by the Rule, a disclosure document which accurately, clearly and concisely sets forth all of the information required to be disclosed under the Rule.

(b) To fail to keep the disclosure document current as of the close of the franchisor's most recent fiscal year (franchisors have 120 under the revised FTC Franchise Rule, following the close of their fiscal years, to revise their disclosure documents so that they are current in all respects).

(c) To make any representation to a prospective franchisee regarding “financial performance information” (representations about actual or potential sales, income or profits of existing or prospective franchised or company-owned units) unless conveyed and substantiated as required by the Rule.

(d) To make any claim or representation, whether in franchise advertising material or in oral statements made by salespersons, which is inconsistent with or contrary to the information disclosed in the franchisor's disclosure document.

(e) To fail to return any funds or deposits collected from prospective franchisees (such as down payments) which the franchisor's disclosure document declares are, in fact, refundable.

(f) To fail to furnish a copy of the franchisor's disclosure document upon the reasonable request of a prospective franchisee earlier in the sales process then the FTC Franchise Rule otherwise requires.

(g) To present for signing a franchise agreement whose terms materially differ from the specimen franchise agreement featured in the franchisor's disclosure document unless the franchisor informs the prospective franchisee of such material differences at least seven days before contract execution.

(h) To disclaim or require a prospective franchisee to waive reliance on any representation made in the franchisor's disclosure document (note, however, that under the FTC Franchise Rule, franchisees may voluntarily waive specific contract terms in the course of negotiations).

Prohibited Practices—State Franchise Registration/Disclosure Statutes

Though each state franchise registration/disclosure statute varies from the others, sometimes in material ways, virtually all of them have in common the following delineation of prohibited, illegal, fraudulent and/or unlawful practices:

(a) Making any untrue statement of a material fact in connection with the offer or sale of any franchise, whether in the franchisor's disclosure document; franchise advertising; or, in statements by the franchisor's salespersons or other personnel.

(b) Omitting from any franchise disclosure document any material fact which is required to be stated therein.

(c) Omitting to state a material fact necessary to make disclosures actually made not misleading (that is, telling a “half truth” in the disclosure document, franchise advertising or in person).

(d) Engaging in any act, practice or course of business which may or would operate as a fraud or deceit upon any person.

(e) Failing to register the franchise disclosure document (unless an exemption from registration is available).

(f) Failing to immediately amend or revise a franchise disclosure document upon the occurrence of a material change to the facts set forth therein.

(g) Making any offers or sales of franchises at a time when a current franchise registration is not in effect (unless an exemption from registration is available).

(h) Requiring a franchisee to waive the rights and protections afforded by state franchise registration/disclosure laws.

(i) Making any untrue statement of fact, or omitting material facts, in any application or report submitted to any franchise administrator.

(j) Failing to disseminate the registered (when necessary) franchise disclosure document to prospective franchisees within the timeframes required by law.

(k) Failing to disseminate to prospective franchisees all franchise and franchise-related agreements, in form ready for execution, within those timeframes specified by law.

(l) Making any representation to a prospective franchisee which is inconsistent with the franchisor's disclosure document.

(m) Failing to file franchise advertising (in those seven states requiring such filings).

(n) Failing to maintain books and records (financial statements, records of franchise sales, disclosure document receipts and similar records) for a statutorily required period of time.

(o) Violating any order issued by a franchise administrator.

Government Investigations

The powers granted to federal and state franchise administrators to investigate franchise fraud are extremely broad.

Typically, federal and state administrators are authorized to conduct such investigations as they deem necessary to determine whether any person has violated any provision of the subject franchise statute. They may subpoena witnesses, compel their attendance, examine them under oath and require the production of books or papers which the administrator deems relevant or material to the inquiry. While the target of an investigation may refuse to respond to questions or to produce documents on the ground that it may tend to incriminate him or her, many states confer upon their franchise administrators the power to confer immunity upon such investigative targets—following which the target must then testify. Alternatively, some state statutes provide that no investigative target is excused from responding to questions or producing documents, even if it subjects that target to self-incrimination, provided that if the target gives such testimony or furnishes such documents after validly claiming his or her privilege against self-incrimination, he or she may not thereafter be prosecuted concerning any transaction regarding which the compulsory testimony or evidence concerned (it being specifically provided, however, that the individual testifying is not otherwise exempt from prosecution and punishment for perjury committed while testifying).

Government investigations of possible franchisor violations may be opened for any of a variety of reasons. It may simply be that one or more state franchise administrators see franchise advertising that they consider suspect. Or it may be that one or more prospective or actual franchisees of a network have filed complaints against the franchisor alleging fraud, misrepresentation or some other violation of state law. As well, the franchise-regulating states routinely communicate among themselves, such that if one state detects what it considers to be fraudulent activity engaged in by a franchisor, the other state administrators will quickly be advised and may open investigations of their own. And it should certainly be noted that federal and state franchise officials are almost always present at significant franchise trade shows—indeed, those routinely attending such shows may get to know them over the course of time. They are on the lookout for new franchisors who have not registered and who do not know or follow the rules of the industry.

Regardless of how or why a government investigation of possible franchise fraud is opened, the franchisor and/or its personnel who are being targeted should be prepared to respond to all subpoenas and other requests for information in a timely and complete fashion, but only after having first consulted counsel.

Civil Proceedings

If in the course of their investigations federal or state franchise administrators uncover franchise fraud, they are statutorily empowered to institute civil proceedings seeking various forms of relief, including:

(a) Preliminary and permanent injunctions to enjoin the illegal acts or practices or to enforce compliance with the applicable franchise law.

(b) The appointment of a court-ordered receiver to seize and maintain any and all monies or property, obtained by a franchisor through statutorily violative conduct.

(c) Restitution on behalf of those victimized by statutorily proscribed conduct.

(d) Damages on behalf of persons injured as a result of illegal acts or practices.

(e) Disgorgement of monies derived by a franchisor through illegal acts or practices.

(f) Imposition of fines and penalties.

(g) Rescission of all franchise agreements unlawfully entered into (designed to put the negatively affected franchisee back in the economic position it would had been in had it not entered into an agreement with the franchisor).

Who May Be Held Liable For State Franchise Law Violations?

Under many state franchise registration/disclosure laws, it is not just the franchisor itself which may be held liable for any violations thereof. Instead, the range of persons who may be liable beyond the franchisor may be very broad and include, under limited circumstances, the franchisor's officers, directors, employees, salespersons, and sales brokers. It is almost always a precondition to the imposition of liability upon such individuals and corporations other than the franchisor itself that they either participated in the statutory wrongdoing or knew about it and did nothing to stop it. But under laws which extend liability to such individuals and entities beyond the franchisor, their liability is, in the legal jargon, “joint and several,” meaning that a federal and state franchise administrator may seek to hold liable for the entire amount of damages both a franchisor itself and/or some or all of the other individuals or entities recited above.

Stop Orders

Many states grant their franchise administrators the power to issue “ex parte” stop orders (an order granted without prior notice to the franchisor) prohibiting any franchise sales activity by franchisors or their personnel alleged to be violating the franchise statute in question.

Other states—and the Federal Trade Commission—do not feature such “stop order” powers, but confer upon their administrators the functional equivalent: the ability to seek temporary restraining orders and preliminary injunctions against allegedly errant franchisors.

Stop orders, temporary restraining orders and preliminary injunctions are a franchisor's nightmare. The issuance of one of these decrees prohibits the franchisor from engaging in any franchise sales activity whatsoever in the subject jurisdiction. And as noted earlier, many state franchise administrators can issue such “stop orders” without even giving the franchisor any prior notice or opportunity to be heard.

Fines and Penalties

Under both the FTC Franchise Rule and state franchise registration/disclosure statutes, the government is empowered to seek and obtain fines and penalties from franchisors and their personnel who engage in violative activity.

The amounts of possible fines and penalties varies from jurisdiction to jurisdiction. Under the FTC Franchise Rule, the Federal Trade Commission is authorized to seek up to $11,000 per violation. In California, $10,000 per violation. In Illinois, $50,000 per violation. And in Hawaii, a civil penalty up to $100,000 is authorized per violation.

It is critical to recall that the foregoing fines and penalties are applicable to each violation of law committed by the franchisor. It is also critical to recall that federal and state franchise laws govern not just the sale of franchises but the mere offer of franchises.

Which means that if a franchisor in a state featuring a franchise registration/disclosure statute meets with 50 prospective franchisees at a trade show and offers each of those prospects a franchise—at a time when the franchisor is not registered—then that state's administrator is authorized to seek the statutorily specified fine multiplied times 50. Thus, if such activity took place in Hawaii, that franchisor could confront civil penalties of up to $5,000,000—all without having sold a single franchise in that state.

Making matters worse when franchise sales are, in fact, effected illegally is that the aforementioned civil penalties are payable over and above the other measures of financial relief sought by federal and state franchise administrators (such as restitution, rescission and damages, as detailed above).

Finally, compounding the grief an errant franchisor may find itself confronted with is the fact that both the Federal Trade Commission and one or more of the franchise-regulating states may concurrently move against illegal franchise sales activity, meaning that the subject franchisor may confront multiple sets of government fines and penalties.

Criminal Liability

Under the FTC Franchise Rule, the Federal Trade Commission may not itself institute criminal proceedings for Rule violations. The Commission may, however, refer to the U.S. Department of Justice for criminal prosecution any instances of criminal wrongdoing uncovered in the course of an FTC investigation.

By contrast, virtually all of the states featuring franchise registration/disclosure statutes provide for stiff criminal liability for certain violations thereof. As was the case with civil penalties (see above), criminal liability under these laws extends to each violation of law—that is, each illegal franchise offer (an offer made without required registration or disclosure) and each illegal sale (a sale accomplished without required registration, or without giving a franchise disclosure document to the prospective franchisee, or otherwise tainted by law).

The extent of criminal liability under state franchise registration/disclosure laws varies from jurisdiction to jurisdiction. For example, California deems violative conduct under its statute to be a misdemeanor (punishable by no more than one year in jail) while in Illinois such conduct is classified as a Class 2 felony and in Maryland as a felony punishable by up to five years imprisonment.

As is the case with civil actions, federal and state franchise administrators must adhere to their legislative “statutes of limitation”—the time in which a criminal proceeding must be instituted or else forever abandoned.

David J. Kaufmann is senior partner of Kaufmann Gildin & Robbins and authored the New York Franchise Act while serving as Special Deputy Attorney General of New York.