Contributory Apr, 16 2010

More about franchisee underreporting

What is underreporting? If you have to ask, being a franchisee, you are probably not doing it. But, then again, maybe you are; unwittingly. In its simplest incarnation, franchisee underreporting occurs when a franchisee reports less income or sales to his

By Jeffrey M. Goldstein
More about franchisee underreporting

From the beginning, franchisors have focused almost exclusively on trying to sell as many franchises as possible, not on trying to augment their revenues through underreporting investigations. Sometime back, audits were not only time-consuming and expensive; however, they engendered considerable bad-will in the franchise community.

Auditing: the in-thing

Soon, however, audits became ‘the in-thing.’ A cottage industry was born. A savvy franchisor law firm said: “Hey; wait a minute. If I am able to guarantee my client (franchisor) that by using my new ‘auditing programme’ he 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 for everyone except the falsely accused franchisee.” 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.

Variations based on franchise agreements

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. 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 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 internet.

Legal perspective

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 doing so, 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 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.

Deceptive franchisors motives

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 favoured 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.

Related: Franchising a business formula for wealth sharing

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