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It ain’t fraud if you know better


Owning a business is the dream of a lot of people, but buying a business can be a nightmare. To facilitate the process, business brokers attempt to hook up sellers and buyers, and they know that getting a worn-out seller with a naive buyer is a very tricky endeavor that often goes sour before or after the sale.

Everybody knows that nobody wants to sell a gold mine, but they do want to put the best face on what they’ve got to sell and make a plausible story for why the owner wants out. Often the sale is due to the “owner’s health,” which can mean just about anything. Sometimes, the seller or the seller’s agent pooh-poohs the scant income on the tax returns, implying that the business throws off a lot of cash that never gets reported.

Business brokers run the full gamut from extraordinarily knowledgeable and helpful to pure cosmeticians. There is one business brokerage firm that I love to work with because of their expertise and integrity–the Kingsley Group, in Springfield, Missouri.

Some business brokers are people who may have bought a business brokerage franchise, but lack the depth of experience to really understand how to find the right business for the right buyer and to assemble the right package of materials (financial statements, tax returns, inventories, asset lists, customer lists, intellectual property, contracts, etc.) so that the business being sold is fairly portrayed to the buyer. The pressure on the broker to close a deal gets ahead of the idea of making sure that the business for sale is presented fairly and completely and that the buyer knows what the buyer is getting into. Even if financial statements show an exaggerated picture of value, a court isn’t necessarily going to come to the rescue of the buyer.

A recent Arkansas Court of Appeals decision, Sunbelt Business Brokers of Arkansas v. James, involving a couple of Subway sandwich shops, describes a fairly common set of events. James got a bunch of financial statements from Sunbelt, showing substantial income for the owner, but the revenues and profits of the business didn’t even come close in the first year to what the seller supposedly earned in previous years. James sued the business broker, its agent and the former owner for fraud, and the trial court awarded her a handsome settlement. Sunbelt had provided James with a cash-flow statement on Sunbelt’s form which showed a nice salary for the previous owner, even though in the trial the owner admitted that no salary had been taken.

But fraud requires not only proof of misrepresentation and proof of intent to misrepresent, but proof that the buyer justifiably relied on the misrepresentation to her detriment. The appellate court thought that the buyer knew better than to have relied on the amateurish cash-flow statement. James was a financial services advisor and financial consultant and her husband was a CPA, formerly chief financial officer for a company that owned a string of Subways in another state. Before closing, they asked for and received tax returns and other more reliable information about the health of the Subway stores they bought through the business broker.

Even though the issue of whether reliance is justified is a fact issue for the trial court, the Arkansas Court of Appeals was certain enough to reverse the verdict, finding that there was no reliance and thus no fraud, when the buyers surely knew better than to believe the misinformation they were given.

Any experienced lawyer will advise that proving all the elements of fraud is very, very tough. Even though misrepresentation in business transactions is common, it’s really difficult to prove to a judge or jury that the misrepresentation happened, that it was intentional, that it was “material” (meaning significant, not trivial), and that the victim relied on the misrepresentation and was damaged as a result.

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About Harry Styron

I'm a lawyer who lives in Branson, Missouri, whose professional interests involve real estate, construction and local government.

5 responses »

  1. Yes, nine elements of fraudulent inducement are almost impossible to prove to the courts, especially where franchising is involved. Obviously, law, process, and procedure has been developed to render prospective franchisees merely expendable resources for the franchisors and the other special interests.

    Franchisees will not win fraudulent inducement/concealment cases in arbitration or the courts because under contract law, if they were made whole, this could threaten the entire franchise system. Public policy apparently deems that franchisees are calculated sacrifices to the industry of franchising.

    It is apparent that franchising was regulated by the FTC in 1979 to prevent fraudulent inducement to contract claims against franchisors, and brokers, who, apparently, under the FTC Rule have no legal obligation to disclose MATERIAL proprietary performance statistics concerning units in the system to new buyers, or to investors in the franchise systems.

    This is unique treatement when the seller, who profits, doesn’t have to disclose to the buyer. Perhaps this is why the FTC, instead of the SEC, regulates the retail franchise sector, where most franchisees operate on an intrastate basis.

    Unfortunately, ineffective and captured regulatory policy as is demonstrated in the FTC Rule governing the sale of franchises invites intentional torts and fraud. The franchisors and other interests, however, know that the law protects them from fraudulent inducement/omissions in the sales process and this insulation from fraud invites fraud.

    The courts, of course, use their discretion to determine “reliance” and in the instance above, we see that they protected federal regulatory policy which is to protect the franchisor and his franchisees who survive from those who fail and feel they were fraudulently induced to contract. The big franchisors like Subway have a blank check that extends to their franchisees who sell and transfer their units only after the franchisor approves the sale to the new franchisee.

    Maybe this protection of franchising could be justified if prospective buyers of franchises had access to the material facts of unit profitability and unit failure of the system BEFORE the contract was signed.

    Apparently, the ABA is happy with the FTC Rule and doesn’t want any changes to franchise regulation that would negatively impact their interests.

    Reply
    • Carol, thanks for your comments.

      In the Arkansas case I described, franchising was involved on two levels: the business that was sold was a Subway franchise and the Sunbelt business broker that assisted with the sale of the Subway franchise was also a franchise operation.

      The business brokerage was a franchise, which sets franchisees up with a “system” for portraying themselves as competent business brokers, regardless of the franchisee’s abilities and character. Someone who is comfortable with purchasing a franchise might be somewhat blind to a franchise business broker’s lack of expertise, giving too much credence to the form of the presentation materials and not giving enough scrutiny to their substance.

      I wouldn’t recommend purchasing a business without independent professional advice from a CPA, a lawyer and an insurance specialist, all familiar with the type of business being purchased. Advice from commissioned salespeople may be good or bad or in between, but I wouldn’t rely on it.

      As Carol’s comments suggest, franchising is a big deal, and her take on it is that the franchisors have the upper hand with one-sided contracts and the protection of the legal establishment, including the American Bar Association and the Federal Trade Commission.

      The franchise agreements that I have reviewed, mostly for the food and lodging industry, are indeed onerous. Generally, I have reviewed them when the franchisee comes to me wanting out of the agreement. I agree with Carol that the cards are stacked against the franchisee when the business is unsuccessful. When it is successful, the franchisee sometimes wants out because of the belief that the franchise fees are too high for the benefit of being associated with the franchisor.

      Though many franchisees are successful, franchise ownership is certainly not for everyone.

  2. Thanks –honest Harry Styron — for your comments!

    I worry about the VETS and their family members who have been made targets of the franchisors because of THE PATRIOT EXPRESS LOAN initiative passed in mid 2007, and pushed to the Congress and the SBA by the big franchisors and the banks and lenders as a means of lessening the coming deep recession.

    The recent 90% SBA guarantee really puts VETS and family members at risk when the material risk factor of past performance statistics of units within a franchisor’s system do not have to be disclosed under current regulation by the seller of the franchise. The “onerous” contracts are routine when selling to Mom and Pop Franchisees and, in my opinion, the deception in regulation is a national disgrace.

    This government subsidy of franchisors and the banks and lenders is invisible to the average buyer of a franchise who believes that the SBA wouldn’t guarantee loans for franchises that have low or no-profitability experience for founding franchisees and a high failure rate of founding franchisees.

    I’m not opposed to franchising if the SELLER, who profits, is responsible for disclosure of material risk statistics in their possession to the buyer of the franchise. I realize and understand that the rationale is that the winners in franchising must not be taken down by the losers — the rationale of the public good — the greatest good for the greatest number of people. But, I believe that the “lie” of the FTC Rule in 1979 was unneccesary. In really free markets, franchisors should have to compete for the cheap labor and cheap “venture” capital of franchisees by disclosing the odds of material risk of the investment in the franchise to the new buyers.

    The tainting of our courts is an unfortunate consequence of the hidden subsidy of the franchisors and the other special interests who profit from franchising because of the the dishonest and ineffective regulation that is apparently condoned by The Congress and the Executive.

    Honest attorneys like Richard Solomon, a Texas attorney, advise that the White Collar Mafia are at work using their contracts to lie, cheat, and steal the life savings of innocent and naive middle class Americans.

    Good that there are honest attorneys like you and many others who are willing to blow the whistle on bad regulation and bad franchisors and inform the public. I especially appreciated the article published by The American Business Law Journal, 01 Jan 3003, available on the All Business Site, entitled “Franchising Fraud –the Continuing Need for Reform” which dealt with the “inducement” problems of current regulation and federal and state regulatory policy that is upheld by our courts.

    Reply
  3. Mr. Styron, I just stumbled on to your inaccurate comment that other than Kingsley “all others (business brokers) are the pits.” Since you have not had any dealings with my firm or the hundreds of hard working, trained and skillful business brokers in the US, I would respectfully ask that you retract or modify your written statement to allow that there may be other honest business brokers who perform their duties with integrity and professionalism.

    Sincerely
    Carl Grimes

    Reply
  4. I agree with your further comment that any buyer should seek the counsel of their attorney and accountant when going to sell a business. I would recommend this for the seller as well. My firm places ethics over anything else. That said we understand both parties should enter into such events with their “antennas up” and expect a full due diligence process. If you can’t verify something, it didn’t happen.

    Furthermore, while most brokers represent the seller there should be a ethical duty to disclose everything and put forth a deal that both parties are happy with – that is what builds long term viability in this industry.

    Reply

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