To Disclose or Not to Disclose?

The Hanley Case

Thus, a recent federal district court decision in Maryland regarding what precisely constitutes “false representation” provides a noteworthy opportunity to see how at least one court dealt with the FPR issue. In Hanley v. Doctors Express Franchising, LLC, No. ELH-12-795, 2013 WL 690521 (D. Md., Feb. 25, 2013) former franchisees sued a franchisor of urgent care medical centers (“Doctors Express”), as well as the franchise broker (“Rhino 7″), for violation of Maryland franchising statutes, common law fraud and constructive fraud. After the conclusion of pleading, the defendants moved for a 12(b)(6) dismissal of all claims, alleging that the franchisees had failed to state claims on which relief could be granted. The court summarily dismissed the constructive fraud claims, but upheld the franchisees' Maryland statutory and common law fraud claims, giving a detailed analysis of a franchisor's responsibilities regarding financial projections in its FDD.

Doctors Express had provided an FPR to the franchisees, giving a projected financial outlook for a potential franchise based on the performance of a similar facility. This FPR explicitly informed potential franchisees of the source of these projections and stated that the estimates could not be relied upon to accurately predict franchise earnings. The franchisees purchased a franchise and opened a facility in early 2011. However, because of shortfalls in projected revenue, the facility closed after seven months. The franchisees subsequently sued Doctors Express, alleging material misrepresentations in its FPR.

The key point of contention in the case was the dispute over the scope of the duty owed by Doctors Express to the franchisees to give accurate information in its FPR. Maryland franchise law creates a private right of action for any franchise purchaser against a franchisor for selling a franchise “by means of an untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made ' not misleading.” Additionally, common law fraud can be asserted in cases involving purposeful misrepresentations of material facts detrimentally relied upon by a franchisee. According to the franchisees, Doctors Express had known of financial information that largely belied the rosy projections contained in its FPR at the time of contracting. Interestingly, Doctors Express had sent an operations memo to its existing franchisees that prohibited them from providing financial data to potential franchise purchasers. The franchisees claimed that this failure to disclose the actual earnings of its other franchisees, which were far below the projections contained in the FPR, constituted misrepresentations sufficient to create liability under both Maryland franchise statute and common law fraud.

Doctors Express claimed that, as its FPR constituted mere estimates based on financial data from a disclosed source, it had not made any factual assertions and, thus, could not be held liable for misrepresentation of fact. The court struck down this defense, seeming to find it especially important that, while FTC regulations and Maryland state law did not obligate Doctors Express to disclose financial projections, “having decided to make such a representation, Doctors Express was required to make a representation that was supportable based on what it knew at the time it made the representation.”

Doctors Express also asserted that disclaimers of liability in its FDD shielded it from the franchisees' claims. The court ruled that such disclaimers could not be used to defeat the provisions of the Maryland franchise law or common law fraud, but, instead, could only be used to determine the reasonableness of this reliance by the finder of fact, thus precluding dismissal of claims at the 12(b)(6) stage.

Perhaps the most intriguing portion of the decision was the court's denial of the motion to dismiss filed by the Doctors Express franchise broker. Rhino 7 argued that, as a mere broker, it had no knowledge of the alleged falsity of the representations made by Doctors Express in its earnings claim. The court ruled that, under Maryland's franchise law, such a lack of scienter is an affirmative defense and, thus, did not need to be alleged by the franchisees, but instead needed to be proven by Rhino 7 to avoid liability. However, under common law fraud rules, such a lack of knowledge needed to be proven by the franchisees. As such, the court granted Rhino 7's motion to dismiss regarding the franchisees' common law fraud claim, but upheld their Maryland franchise law claim.

Conclusion

While Hanley does not demonstrate any significant movement in the law governing FPRs one way or the other, it does demonstrate that FPR claims will not necessarily be readily dismissed, and that the absence of relevant information can be even more important in the context of financial disclosures than the actual accuracy of what is reported.

'

'

Rupert Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta-based law firm of Kilpatrick, Townsend & Stockton, and chairs the firm's Franchise Practice Group. He can be reached at 404-815-6355 or at [email protected]. Andrew Head is an associate at the firm, and he can be reached at 404-815-6412 or at [email protected].

'

'

'

'

'

Financial performance representations (“FPRs”), formerly referred to as “earnings claims,” have generated extensive discussion since franchise sales first became regulated in 1970. FPRs are, in plain English, projections of how a franchise might perform financially or historical financial performances. Most commentators on this subject note that such financial information is likely the first item a prospective franchisee will ask for in its discussions with a franchisor. However, federal and state government officials have steadfastly refused to make disclosure of this information mandatory. A franchisor has the right not to disclose any financial performance information in its negotiations with prospective franchisees. However, if a franchisor does elect to give this information to prospects, that information must be included in the franchise disclosure document (“FDD”) the franchisor is required to give to prospective franchisees, and cannot be false, misleading, or omit any information necessary to make it not misleading.

Around 1970, when franchise regulation was first developing in the United States, very few franchisors, perhaps only 10% to 20%, made any financial performance representations to their prospects. They declined to do so for various reasons: the rules were very strict as to what could be disclosed; franchisors did not always have access to the data necessary to create an FPR; franchisors feared suits from prospective franchisees; and, in some franchise systems, the FPR would not have shown prospects a hopeful picture. The rules governing FPRs have been simplified over the years, but, still, only around 40% of franchisors elect to create FPRs.

Given their importance, one would expect FPRs to have been the subject of many lawsuits, but in fact, the opposite seems to be true. There are few cases alleging liability due to false or misleading FPRs. There are several reasons that might explain this phenomenon, including that franchisees are often not financially able to pursue these claims, and the claims, like almost all fraud-like causes of action, are difficult to prove. We also sense that franchisors use sound judgment in deciding whether or not to settle these claims, hence resulting in little in the way of litigation and reported decisions concerning FPRs.

The Hanley Case

Thus, a recent federal district court decision in Maryland regarding what precisely constitutes “false representation” provides a noteworthy opportunity to see how at least one court dealt with the FPR issue. In Hanley v. Doctors Express Franchising, LLC, No. ELH-12-795, 2013 WL 690521 (D. Md., Feb. 25, 2013) former franchisees sued a franchisor of urgent care medical centers (“Doctors Express”), as well as the franchise broker (“Rhino 7″), for violation of Maryland franchising statutes, common law fraud and constructive fraud. After the conclusion of pleading, the defendants moved for a 12(b)(6) dismissal of all claims, alleging that the franchisees had failed to state claims on which relief could be granted. The court summarily dismissed the constructive fraud claims, but upheld the franchisees' Maryland statutory and common law fraud claims, giving a detailed analysis of a franchisor's responsibilities regarding financial projections in its FDD.

Doctors Express had provided an FPR to the franchisees, giving a projected financial outlook for a potential franchise based on the performance of a similar facility. This FPR explicitly informed potential franchisees of the source of these projections and stated that the estimates could not be relied upon to accurately predict franchise earnings. The franchisees purchased a franchise and opened a facility in early 2011. However, because of shortfalls in projected revenue, the facility closed after seven months. The franchisees subsequently sued Doctors Express, alleging material misrepresentations in its FPR.

The key point of contention in the case was the dispute over the scope of the duty owed by Doctors Express to the franchisees to give accurate information in its FPR. Maryland franchise law creates a private right of action for any franchise purchaser against a franchisor for selling a franchise “by means of an untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made ' not misleading.” Additionally, common law fraud can be asserted in cases involving purposeful misrepresentations of material facts detrimentally relied upon by a franchisee. According to the franchisees, Doctors Express had known of financial information that largely belied the rosy projections contained in its FPR at the time of contracting. Interestingly, Doctors Express had sent an operations memo to its existing franchisees that prohibited them from providing financial data to potential franchise purchasers. The franchisees claimed that this failure to disclose the actual earnings of its other franchisees, which were far below the projections contained in the FPR, constituted misrepresentations sufficient to create liability under both Maryland franchise statute and common law fraud.

Doctors Express claimed that, as its FPR constituted mere estimates based on financial data from a disclosed source, it had not made any factual assertions and, thus, could not be held liable for misrepresentation of fact. The court struck down this defense, seeming to find it especially important that, while FTC regulations and Maryland state law did not obligate Doctors Express to disclose financial projections, “having decided to make such a representation, Doctors Express was required to make a representation that was supportable based on what it knew at the time it made the representation.”

Doctors Express also asserted that disclaimers of liability in its FDD shielded it from the franchisees' claims. The court ruled that such disclaimers could not be used to defeat the provisions of the Maryland franchise law or common law fraud, but, instead, could only be used to determine the reasonableness of this reliance by the finder of fact, thus precluding dismissal of claims at the 12(b)(6) stage.

Perhaps the most intriguing portion of the decision was the court's denial of the motion to dismiss filed by the Doctors Express franchise broker. Rhino 7 argued that, as a mere broker, it had no knowledge of the alleged falsity of the representations made by Doctors Express in its earnings claim. The court ruled that, under Maryland's franchise law, such a lack of scienter is an affirmative defense and, thus, did not need to be alleged by the franchisees, but instead needed to be proven by Rhino 7 to avoid liability. However, under common law fraud rules, such a lack of knowledge needed to be proven by the franchisees. As such, the court granted Rhino 7's motion to dismiss regarding the franchisees' common law fraud claim, but upheld their Maryland franchise law claim.

Conclusion

While Hanley does not demonstrate any significant movement in the law governing FPRs one way or the other, it does demonstrate that FPR claims will not necessarily be readily dismissed, and that the absence of relevant information can be even more important in the context of financial disclosures than the actual accuracy of what is reported.

'

'

Rupert Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta-based law firm of Kilpatrick, Townsend & Stockton, and chairs the firm's Franchise Practice Group. He can be reached at 404-815-6355 or at [email protected]. Andrew Head is an associate at the firm, and he can be reached at 404-815-6412 or at [email protected].

'

'

'

'

'