May 7, 2015 - Franchise Articles by |

LADIES OF THE NIGHT AND FRANCHISEE UNDERREPORTING

What is franchise underreporting? If you have to ask, and you’re a franchisee, you’re probably not doing it. But, then again, maybe you are; unwittingly. In its simplest incarnation, franchisee underreporting occurs when a franchisee “reports” to his franchisor less income or sales than what he actually makes or earns. Franchise underreporting is a very dangerous area of franchisee wrongdoing, and courts have little sympathy for franchisees who fail to report all revenues.

Historically franchisors have focused almost exclusively on trying to sell as many franchises as possible, not on trying to augment their revenues through under reporting investigations. Not only were audits time-consuming and expensive, but they engendered considerable bad-will in the franchise community.

Soon, however, audits became “the in-thing.” A cottage industry was born. A savvy franchisor law firm said: “Hey; wait a minute. If I’m able to guarantee my franchisor client that by using my new “auditing program” it will be able to at least cover my lawyer’s fees with the increased revenues from the alleged franchisee under reporters this will be a ‘win-win’ situation; at least for everyone but the falsely accused franchisee under reporter. Some franchisors, including one of the very biggest coffee and doughnut franchisors in the world, in consultation with leading “statistical wizards” from mathematical departments of major universities, thereafter devised cutting-edge forensic models capable of easily identifying underreporting. These models were so effective and potent that they were able to definitively identify underreporting even where none existed.

Their methodologies, although far too complex for common folks, like franchisees and their lawyers, to understand, can be seen in part in the following example. Let’s assume for the moment that there is a breakfast franchise that actually requires franchisees to raise their own hens to provide eggs to use in their kitchens to cook for its retail customers. The “unique concept” is that the breakfast restaurant franchisees raise their own hens. Certainly one of the assumptions of the underreporting model would be to determine the productivity of each hen; here, let’s assume that one of the new “hen experts” hired to work on the attorney’s staff opines that on average one hen lays about 260 eggs per year. And, let’s assume that during the last year the average franchisee had in its coop five hens. This leaves us with about 1300 eggs per year. And, let’s assume that each egg would capture $5.00 of revenue. And, now let’s assume that the annual audit of a particular franchisee shows that “egg revenues” are only $4500. Clearly the franchisee is underreporting; isn’t he?

However, let’s also assume that the hens live next to a busy and noisy commercial rail way line that disturbs the sleep of the hens. Let’s also assume that two of the hens during the year of the audit were genetically impeded so that they needed 60 minutes of average resting time before laying another egg, when the average rest time is 30 minutes. And, let’s further assume that two of the hens are very old, so they rest about 12-15 hours every three days, rather than the same time only every ten days. Let’s also assume that one of the hens is aggressive and kills one of the other hens every two months; hence a new hen is required to be introduced to the “hen crew” 6 times per year.

And, let’s also assume that during the last year the franchisee went through eight different chefs, each of whom was less talented than the preceding chef. Incorrect orders; egg shells frequently in the orders; dropped eggs; eggs left on the counters and not refrigerated. Let’s assume this led to 10 of every 50 customers sending their egg dishes back to the kitchen as inedible. Let’s also assume that because the franchisor’s advertising on behalf of the franchisee was ineffective or non-existent, the franchisee himself, at his own expense, was forced to send out his own “two-for-one” coupons allowing the customer to obtain two egg breakfasts for the price of one.

Does any of this matter? The answer is, it depends. If you have the money to hire an attorney to fight the audit, then these things would matter; if you don’t have the money to hire an attorney to fight the audit, then these things won’t necessarily matter. Is this fair? No. Is franchising fair? No. Is our economic system fair? No. Why should franchising, a very significant component of the world’s general economic system, be any more fair than the rest of the economy?

From a legal point of view, clauses regarding audits vary widely among franchise agreements. Some agreements permit surprise visits by franchisors; others don’t permit such blitz’s. Some agreements permit only on-site reviews of documents; others allow the franchisor’s representatives to fill 20 large banker’s boxes with every piece of paper that can be found in the franchisee’s store and then take them off-site. Some agreements permit the examination of only a very few specifically identified documents; others allow the franchisor’s representatives to peruse the franchisee’s personal tax returns and home mortgages. Some agreements permit the examination of limited business files on personal computers, and some allow the computers to be carted away. Some prohibit franchisors from searching through franchisees’ physical files; others allow franchisors to rummage through every box and drawer that can be found. With the advent of franchisor-mandated POS systems, many of which, as an aside, have turned out to be technical debacles, some of these underreporting issues don’t arise, since franchisors are able to use the POS systems to beam into franchisees’ stores via the internet.

There are, of course, other non-agreement based legal issues associated with audits.

Although the overwhelming majority of franchise breaches are curable, almost all underreporting violations permit automatic termination, without any cure period. Even in those cases where the franchise agreement does not explicitly permit automatic termination for underreporting, courts have almost universally held that under the common law an underreporting breach is so material as to not require a cure period.

The last general group of legal issues regarding audits focuses on the reasons why the franchisor might choose to audit the particular franchisee. In this regard, although no franchisee will want to hear this answer, a franchisor’s termination based on proven underreporting is usually permissible regardless whether the underreporting was significant, or only miniscule; regardless whether the underreporting audit was undertaken with bad motive, or without malice; regardless whether the underreporting was the sole motivating circumstance, or was only pretext; regardless whether the underreporting was long-standing, or merely fleeting; and regardless whether the underreporting was intentional, or mistaken.

All this being said, though, clearly there are those franchisors who will act reasonably and fairly to evaluate the circumstances surrounding any alleged underreporting. In so doing, they will take into consideration many of the above mitigating circumstances and issues particular to the accused franchisee. Some franchisors include language in their franchise agreements that provide that if underreporting is shown to be less than a specified percentage the costs of the audit will be paid for by the franchisor. This franchisor flexibility is usually found on the part of franchisors whose franchise agreements contain relatively ancient audit language in their franchise agreements that substantially limit the scope of permissible audits.

The real problem with underreporting arises, however, where an audit is in fact undertaken in bad faith, or for an ulterior motive (to allow a franchisor to realign a market’s exclusive territory or to allow a franchisor to purchase for itself or to re-sell to a favored franchisee the alleged under reporter’s store at a sub-market price). In these cases, many franchisee lawyers, many times at the demands and instructions of their franchisee clients, spin their wheels on trying to show that the franchisor undertook such an audit with a bad or improper motive. This strategy, however, is usually doomed. Although such emotive defenses and charges certainly naturally jump out of the morass, they usually have little legal punch. The covenant of good faith and fair dealing in most circumstances is an unwelcome intruder into such court proceedings. However, in this regard there might be a few esoteric arguments that can be culled from an isolated and unexplored state franchise statute.

Many times, however, the franchisee himself — not an underreporting audit — seals the fate of the targeted franchisee. For instance, hotel franchisors who permit their front desk staff to rent the same room three to four times per night to ladies of the night (who usually operate on a cash basis), can be easily discovered without a full underreporting audit; especially if the auditor is one of the regular evening guests.

Jeff Goldstein and other lawyers with the Firm have regularly dealt successfully with franchise underreporting claims on behalf of franchisees who were falsely accused of hiding revenues. As noted above, intentional manipulation of franchise revenues is viewed by almost all courts to be a material breach of contract subjecting the franchisee to immediate franchise termination at the time of discovery. 

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