Court Watch

Fraud

In the eyes of the law, fraud is viewed as the odd child out. Pleading fraud is subject to its own rules, and the hurdles to proving fraud are substantial.

In pleadings, for example, the modern (i.e., over the last 50 years) requirements for almost every claim except one involving fraud have been streamlined ' making general statements about the theory of a case acceptable, with minimum factual allegations. However, in fraud cases, the facts must, as in older days, be pled with a higher level of specificity. More factual information must be provided in order to survive a motion to dismiss than would be the case in a breach of contract dispute.

Even when one gets past this initial threshold, there are many barriers to a successful fraud case. The elements to prove fraud include: 1) a statement must have been made; 2) that statement must have been false when made; 3) the party making the statement must have known it was false or had a careless disregard as to whether or not it was true; 4) the statement was made with the intent that the other party would rely upon it; 5) in fact, the other party must have relied upon it; 6) the reliance must have been reasonable under the circumstances; 7) the statement and the other party's reliance upon it must be the cause of damages; and 8) proof of the amount of damages.

Fraud claims have been out of favor with courts for centuries due to the fear that they will wreak havoc on commercial and consumer law because, in most cases, successful fraud claims override contract law, making the outcome of commercial and consumer suits less predictable and diminishing the value of a contract freely entered into by the parties. Certainty is the goal of contracts, and fraud undermines that goal.

The cases addressing fraud during the last few months present a wide cross-section of the issues that arise as a result of fraud claims, almost constituting a textbook on fraud. Some of these cases include the following:

Coca-Cola North America v. Crawley Juice, Inc.

In Coca-Cola North America v. Crawley Juice, Inc., Bus. Franchise Guide (CCH) ' 14,621 (E.D.N.Y. May 17, 2011), plaintiff Coca-Cola and defendant had entered into a one-year distribution agreement pursuant to which the defendant was granted a non-exclusive right to sell plaintiff's products in a specified region. Plaintiff ultimately terminated the Crawley and two others' distribution agreements because of their failure to pay for products ordered and delivered. The defendants counterclaimed on various grounds, including fraud. The fraud claim was predicated on oral statements made to the defendants, including statements that: 1) the distributors would be able to extend their agreements beyond one year; 2) they would be able to build an asset that would become salable at a point after they were fully developed; and 3) they would receive marketing and other support from the plaintiff.

After reviewing the distribution agreements, the court sided with the plaintiff. The evidence showed clearly that the agreement would expire after one year (and, in addition, was terminable upon 30 days' notice by either party), that it was not transferable without the plaintiff's consent, and that there were no written promises about marketing and other support. The distribution agreement also contained an integration clause stating that the document constituted the entire agreement among the parties, and there were no representations or warranties other than those contained in the signed agreement.

The court, noting that oral evidence cannot be used to contradict the clear terms of an agreement, ruled in favor of the plaintiff. The court also noted that fraud had not been pled with the degree of particularity required by law. Rule 9(b) of the Federal Rules of Civil Procedure requires that a plaintiff asserting fraud must adequately specify the claims made that are allegedly false, as well as when, where and by whom those statements were made. And while “scienter” (knowledge that the statement was false) did not require the same level of specificity to survive a motion to dismiss, nevertheless, the defendants needed to show some basis for the allegation of fraudulent intent. The court concluded that Coca-Cola's employees did nothing that would lead to a “strong inference of fraudulent intent,” and there was no “motive and opportunity or knowledge or reckless disregard sufficient to establish the element of scienter.”

Teng Moua v. Jani-King of Minnesota, Inc.

Teng Moua v. Jani-King of Minnesota, Inc., Bus. Franchise Guide (CCH) ' 14,665 (D. Minn. Aug. 30, 2011), addresses, among other theories of liability, fraud claims not too different than those discussed in Crawley. The facts in the case were complex because there were multiple plaintiffs, and the plaintiffs raised virtually all the claims that typically are raised by aggrieved franchisees ' common law fraud; violation of the Minnesota Franchise Act; violation of the implied covenant of good faith and fair dealing, breach of the express terms of the franchise agreement, among others. Thus it is difficult to summarize these facts with precise accuracy for purposes of this article. Ultimately, the plaintiffs' claims of fraud were dismissed.

Generally, the plaintiffs made three claims of fraudulent activity. First, plaintiffs claimed that defendant's statement “[i]f you buy more, you'll get more” was false. However, the court found that the defendant had a sliding franchise fee structure so that the more the franchisee paid, the more accounts would be assigned to him. Thus the statement was accurate. Second, the plaintiffs claimed that the defendant's statement that the janitorial business was “a good business” and could continue “for a long time” was untrue. The court decided that these statements were puffery as a matter of law and thus did not constitute statements of fact. Therefore, they could not lay the foundation for a fraud claim.

Third, the franchisees claimed that they were not informed that if they turned down an account offered by the defendant, the amount of that account would reduce the total amount of the accounts the defendant had committed to furnish to the plaintiffs. The plaintiffs also said that there had been other oral representations made to them before the franchises were sold. The evidence, however, showed that the reduction in accounts clearly had been set forth in the franchisor's franchise disclosure document, and that, as in Crawley, the plaintiff could not, as a matter of law, rely upon oral representations that were directly contrary to the terms of the franchise agreement. The plaintiffs had also put forth claims that the franchisor had made unlawful earnings (now referred to as “financial performance representations”). However, these claims were dismissed as being contrary to the written agreement among the parties to whom representations had been made outside of the franchise agreement or disclosure document.

7-Eleven, Inc. v. Spear

7-Eleven, Inc. v. Spear, Bus. Franchise Guide (CCH) ' 14,644 (N.D. Ill. Jun. 23, 2011), introduced an interesting twist on fraud claims. The facts, in their essence, showed that the defendant bought an existing unit from the franchisor, failed to maintain a net worth requirement, and was consequently terminated. The plaintiff brought suit against the franchisee to enforce various post-term obligations, and the defendant counterclaimed, alleging fraud. The fraud, it appeared, was that the franchisor knew that the store was not doing well and failed to release store-relevant information to the defendant when she was conducting her due diligence. The franchisor's disclosure document contained an earnings claim, but expressly denied in the earnings claim that any representations were being made with respect to stores that had been open for less than one year. The franchisor refused the franchisee's request for such information, even though that information was available to the franchisor.

On a motion to dismiss filed by the plaintiff on the basis that the franchisee had failed to state a claim for fraud, the court ruled in favor of the franchisor. The court found that there was no evidence of any inaccurate statements in the franchisor's disclosure documents, and that the failure of the franchisor to disclose historical information about the unit under consideration was not actionable because the franchisor had no duty to speak as to the historical performance of the store, and, in any event, there had been no representation of historical performance of any stores that had been operating for less than a year.

There is a certain irony in the 7-Eleven decision in that the U.S. disclosure rules, designed in part to encourage franchisors to make statements about financial performance, permit a franchisor more readily to provide information about the historical performance of existing units that are being sold even where there is no earning claim made in its disclosure document, but the federal and state laws and regulations do not require the franchisor to do so. Accordingly, because there was no legal requirement for disclosure, there was no duty to do so. The interesting question here is whether, if units operating less than one year had been included in the Item 19 disclosure, the franchisor would be required to disclose store level information for an existing unit, and if so, would the franchisor's failure to do so constitute an omission of a material fact necessary to make the information in the disclosure document not misleading. This question, however, was not before the court.

A Love of Food 1, LLC v. Maoz Vegetarian, Inc.

A Love of Food 1, LLC v. Maoz Vegetarian, Inc., Bus. Franchise Guide (CCH) ' 14,633 (D. MD. July 7, 2011), demonstrates that franchisors do not always win fraud claims. Love of Food contains some interesting rulings about statutes of limitations and the reach of franchise disclosure laws; yet, on the issue of fraud, the case proved to be franchisee-friendly.

In this case, the franchisor's disclosure document contained certain information in Item 7 about the initial investment that would be required of the franchisee. However, for the plaintiff, the total initial investment turned out to be approximately 85% more than the “high” range disclosed by the franchisor. The franchisee claimed the initial investment cost shown in the disclosure document was a representation of fact and was clearly misleading. The franchisor claimed the delineated costs were projections and statements of opinions and thus could not be deemed facts that the franchisee could use as the foundation for a fraud claim. The disclosure document represented that the cost numbers had been prepared based on the franchisor's 15 years of experience operating a system that had begun 23 years before.

On the franchisor's motion to dismiss, the court ruled in favor of the franchisee, finding that the record showed neither how the cost estimates had been prepared nor the basis for the claims. Although the court listed numerous factors that might determine whether or not the representation was fraudulent, the 85% or more discrepancy clearly contributed to the court's decision. Also critical was that the issue was heard on a motion to dismiss, where it is assumed that the facts will be favorable to the party opposing the motion.

Those interested in this issue of whether the size of a discrepancy should be material should review a not-too-recent decision, Aron Allan, LLC v. Tanfran, Inc., 2006 WL 305971 (W. D. Mich. Feb. 8, 2006), where the franchisor provided the franchisee with conflicting and allegedly exaggerated revenue and income numbers. The court in Tanfran suggests that the provided financial information was so obviously spurious that the franchisee could not have reasonably relied on this information. In contrast to the Love of Food decision, the moral in Tanfran is: If you are going to lie, make it a whopper.

Conclusion

So, in summary, what do we learn from these cases about representing a prospective franchisee? To revisit elementary school, we have an example of the importance of the three “R's.”

• Reading: Make sure your client reads the franchise agreement, disclosure document, and any other information available about the industry, the franchisor and the territory targeted by the franchisee.
• [W]riting: Do not rely on promises from the franchisor unless they are in writing, especially if they contradict a provision of the franchise agreement or disclosure document.
• [A]rithmetic: Be skeptical of numbers, even if they are included in the disclosure document. If the prospective client is not financially savvy, the best money he or she can spend is to hire a competent accountant or financial adviser.

In the end, fraud is a pejorative term, for it suggests bad, immoral, unlawful and unethical conduct; thus, it is not surprising that courts exhibit hostility toward fraud claims.

Rupert M. Barkoff is a partner of Kilpatrick Townsend & Stockton LLP, resident in the firm's Atlanta office. He is a former chair of the American Bar Association's Forum on Franchising and the co-editor-in-chief of the Forum's Fundamentals of Franchising. He may be reached at 404-815-6366 or [email protected].

Fraud

In the eyes of the law, fraud is viewed as the odd child out. Pleading fraud is subject to its own rules, and the hurdles to proving fraud are substantial.

In pleadings, for example, the modern (i.e., over the last 50 years) requirements for almost every claim except one involving fraud have been streamlined ' making general statements about the theory of a case acceptable, with minimum factual allegations. However, in fraud cases, the facts must, as in older days, be pled with a higher level of specificity. More factual information must be provided in order to survive a motion to dismiss than would be the case in a breach of contract dispute.

Even when one gets past this initial threshold, there are many barriers to a successful fraud case. The elements to prove fraud include: 1) a statement must have been made; 2) that statement must have been false when made; 3) the party making the statement must have known it was false or had a careless disregard as to whether or not it was true; 4) the statement was made with the intent that the other party would rely upon it; 5) in fact, the other party must have relied upon it; 6) the reliance must have been reasonable under the circumstances; 7) the statement and the other party's reliance upon it must be the cause of damages; and 8) proof of the amount of damages.

Fraud claims have been out of favor with courts for centuries due to the fear that they will wreak havoc on commercial and consumer law because, in most cases, successful fraud claims override contract law, making the outcome of commercial and consumer suits less predictable and diminishing the value of a contract freely entered into by the parties. Certainty is the goal of contracts, and fraud undermines that goal.

The cases addressing fraud during the last few months present a wide cross-section of the issues that arise as a result of fraud claims, almost constituting a textbook on fraud. Some of these cases include the following:

Coca-Cola North America v. Crawley Juice, Inc.

In Coca-Cola North America v. Crawley Juice, Inc., Bus. Franchise Guide (CCH) ' 14,621 (E.D.N.Y. May 17, 2011), plaintiff Coca-Cola and defendant had entered into a one-year distribution agreement pursuant to which the defendant was granted a non-exclusive right to sell plaintiff's products in a specified region. Plaintiff ultimately terminated the Crawley and two others' distribution agreements because of their failure to pay for products ordered and delivered. The defendants counterclaimed on various grounds, including fraud. The fraud claim was predicated on oral statements made to the defendants, including statements that: 1) the distributors would be able to extend their agreements beyond one year; 2) they would be able to build an asset that would become salable at a point after they were fully developed; and 3) they would receive marketing and other support from the plaintiff.

After reviewing the distribution agreements, the court sided with the plaintiff. The evidence showed clearly that the agreement would expire after one year (and, in addition, was terminable upon 30 days' notice by either party), that it was not transferable without the plaintiff's consent, and that there were no written promises about marketing and other support. The distribution agreement also contained an integration clause stating that the document constituted the entire agreement among the parties, and there were no representations or warranties other than those contained in the signed agreement.

The court, noting that oral evidence cannot be used to contradict the clear terms of an agreement, ruled in favor of the plaintiff. The court also noted that fraud had not been pled with the degree of particularity required by law. Rule 9(b) of the Federal Rules of Civil Procedure requires that a plaintiff asserting fraud must adequately specify the claims made that are allegedly false, as well as when, where and by whom those statements were made. And while “scienter” (knowledge that the statement was false) did not require the same level of specificity to survive a motion to dismiss, nevertheless, the defendants needed to show some basis for the allegation of fraudulent intent. The court concluded that Coca-Cola's employees did nothing that would lead to a “strong inference of fraudulent intent,” and there was no “motive and opportunity or knowledge or reckless disregard sufficient to establish the element of scienter.”

Teng Moua v. Jani-King of Minnesota, Inc.

Teng Moua v. Jani-King of Minnesota, Inc., Bus. Franchise Guide (CCH) ' 14,665 (D. Minn. Aug. 30, 2011), addresses, among other theories of liability, fraud claims not too different than those discussed in Crawley. The facts in the case were complex because there were multiple plaintiffs, and the plaintiffs raised virtually all the claims that typically are raised by aggrieved franchisees ' common law fraud; violation of the Minnesota Franchise Act; violation of the implied covenant of good faith and fair dealing, breach of the express terms of the franchise agreement, among others. Thus it is difficult to summarize these facts with precise accuracy for purposes of this article. Ultimately, the plaintiffs' claims of fraud were dismissed.

Generally, the plaintiffs made three claims of fraudulent activity. First, plaintiffs claimed that defendant's statement “[i]f you buy more, you'll get more” was false. However, the court found that the defendant had a sliding franchise fee structure so that the more the franchisee paid, the more accounts would be assigned to him. Thus the statement was accurate. Second, the plaintiffs claimed that the defendant's statement that the janitorial business was “a good business” and could continue “for a long time” was untrue. The court decided that these statements were puffery as a matter of law and thus did not constitute statements of fact. Therefore, they could not lay the foundation for a fraud claim.

Third, the franchisees claimed that they were not informed that if they turned down an account offered by the defendant, the amount of that account would reduce the total amount of the accounts the defendant had committed to furnish to the plaintiffs. The plaintiffs also said that there had been other oral representations made to them before the franchises were sold. The evidence, however, showed that the reduction in accounts clearly had been set forth in the franchisor's franchise disclosure document, and that, as in Crawley, the plaintiff could not, as a matter of law, rely upon oral representations that were directly contrary to the terms of the franchise agreement. The plaintiffs had also put forth claims that the franchisor had made unlawful earnings (now referred to as “financial performance representations”). However, these claims were dismissed as being contrary to the written agreement among the parties to whom representations had been made outside of the franchise agreement or disclosure document.

7-Eleven, Inc. v. Spear

7-Eleven, Inc. v. Spear, Bus. Franchise Guide (CCH) ' 14,644 (N.D. Ill. Jun. 23, 2011), introduced an interesting twist on fraud claims. The facts, in their essence, showed that the defendant bought an existing unit from the franchisor, failed to maintain a net worth requirement, and was consequently terminated. The plaintiff brought suit against the franchisee to enforce various post-term obligations, and the defendant counterclaimed, alleging fraud. The fraud, it appeared, was that the franchisor knew that the store was not doing well and failed to release store-relevant information to the defendant when she was conducting her due diligence. The franchisor's disclosure document contained an earnings claim, but expressly denied in the earnings claim that any representations were being made with respect to stores that had been open for less than one year. The franchisor refused the franchisee's request for such information, even though that information was available to the franchisor.

On a motion to dismiss filed by the plaintiff on the basis that the franchisee had failed to state a claim for fraud, the court ruled in favor of the franchisor. The court found that there was no evidence of any inaccurate statements in the franchisor's disclosure documents, and that the failure of the franchisor to disclose historical information about the unit under consideration was not actionable because the franchisor had no duty to speak as to the historical performance of the store, and, in any event, there had been no representation of historical performance of any stores that had been operating for less than a year.

There is a certain irony in the 7-Eleven decision in that the U.S. disclosure rules, designed in part to encourage franchisors to make statements about financial performance, permit a franchisor more readily to provide information about the historical performance of existing units that are being sold even where there is no earning claim made in its disclosure document, but the federal and state laws and regulations do not require the franchisor to do so. Accordingly, because there was no legal requirement for disclosure, there was no duty to do so. The interesting question here is whether, if units operating less than one year had been included in the Item 19 disclosure, the franchisor would be required to disclose store level information for an existing unit, and if so, would the franchisor's failure to do so constitute an omission of a material fact necessary to make the information in the disclosure document not misleading. This question, however, was not before the court.

A Love of Food 1, LLC v. Maoz Vegetarian, Inc.

A Love of Food 1, LLC v. Maoz Vegetarian, Inc., Bus. Franchise Guide (CCH) ' 14,633 (D. MD. July 7, 2011), demonstrates that franchisors do not always win fraud claims. Love of Food contains some interesting rulings about statutes of limitations and the reach of franchise disclosure laws; yet, on the issue of fraud, the case proved to be franchisee-friendly.

In this case, the franchisor's disclosure document contained certain information in Item 7 about the initial investment that would be required of the franchisee. However, for the plaintiff, the total initial investment turned out to be approximately 85% more than the “high” range disclosed by the franchisor. The franchisee claimed the initial investment cost shown in the disclosure document was a representation of fact and was clearly misleading. The franchisor claimed the delineated costs were projections and statements of opinions and thus could not be deemed facts that the franchisee could use as the foundation for a fraud claim. The disclosure document represented that the cost numbers had been prepared based on the franchisor's 15 years of experience operating a system that had begun 23 years before.

On the franchisor's motion to dismiss, the court ruled in favor of the franchisee, finding that the record showed neither how the cost estimates had been prepared nor the basis for the claims. Although the court listed numerous factors that might determine whether or not the representation was fraudulent, the 85% or more discrepancy clearly contributed to the court's decision. Also critical was that the issue was heard on a motion to dismiss, where it is assumed that the facts will be favorable to the party opposing the motion.

Those interested in this issue of whether the size of a discrepancy should be material should review a not-too-recent decision, Aron Allan, LLC v. Tanfran, Inc., 2006 WL 305971 (W. D. Mich. Feb. 8, 2006), where the franchisor provided the franchisee with conflicting and allegedly exaggerated revenue and income numbers. The court in Tanfran suggests that the provided financial information was so obviously spurious that the franchisee could not have reasonably relied on this information. In contrast to the Love of Food decision, the moral in Tanfran is: If you are going to lie, make it a whopper.

Conclusion

So, in summary, what do we learn from these cases about representing a prospective franchisee? To revisit elementary school, we have an example of the importance of the three “R's.”

• Reading: Make sure your client reads the franchise agreement, disclosure document, and any other information available about the industry, the franchisor and the territory targeted by the franchisee.
• [W]riting: Do not rely on promises from the franchisor unless they are in writing, especially if they contradict a provision of the franchise agreement or disclosure document.
• [A]rithmetic: Be skeptical of numbers, even if they are included in the disclosure document. If the prospective client is not financially savvy, the best money he or she can spend is to hire a competent accountant or financial adviser.

In the end, fraud is a pejorative term, for it suggests bad, immoral, unlawful and unethical conduct; thus, it is not surprising that courts exhibit hostility toward fraud claims.

Rupert M. Barkoff is a partner of Kilpatrick Townsend & Stockton LLP, resident in the firm's Atlanta office. He is a former chair of the American Bar Association's Forum on Franchising and the co-editor-in-chief of the Forum's Fundamentals of Franchising. He may be reached at 404-815-6366 or [email protected].