Vol. 13 No. 4 | Fall 2010
INSIDE THIS EDITION
THE FRANCHISE LAWYER
Beata Krakus (2013)
Forum on Franchising
Peaberry: Is the FDD Enough?
For over 30 years, franchisors have been subject to a comprehensive regulatory scheme governing the information that they are required to disclose to prospective franchisees. Specifically, franchisors' disclosures have been guided by the Federal Trade Commission's ("FTC") Franchise Rule (16 C.F.R. Part 436 et seq., the "FTC Rule") and the North American Securities Administrators Association's Uniform Franchise Offering Circular Guidelines (the "UFOC Guidelines") (collectively, the "Franchise Disclosure Regulations"). These Franchise Disclosure Regulations, which were promulgated to protect prospective franchisees, set forth specific disclosure requirements on the theory that informed investors can determine for themselves whether a particular franchise transaction is in their best interests. See 43 Fed. Reg. 59,614, 59,627-39 (Dec. 21, 1978) (Statement of Basis and Purpose to Franchise Rule). Franchisors, prospective franchisees, and their respective attorneys all rely on the Franchise Disclosure Regulations as a guide for what information is, and is not, required to be provided as part of a franchise sale.
There remains an open question, however: whether a franchisor whose Franchise Disclosure Document (the "FDD," formerly referred to in the franchise industry as the "UFOC") complies with the Franchise Disclosure Regulations can still be subject to liability for failure to disclose additional information. This question was recently addressed for the first time by the Colorado Court of Appeals in Colorado Coffee Bean, LLC v. Peaberry Coffee Inc., 09CA0130,__P.3d__, 2010 WL 547633 (Colo. App. Feb. 18, 2010) ("Peaberry"), and will be analyzed here.I. Peaberry's Facts
The plaintiffs in Peaberry, consisting of ten Peaberry Coffee franchisees (the "Franchisees"), filed various fraud and breach of contract claims against their franchisor, Peaberry Coffee Franchise, Inc. ("Peaberry"), its parent company, Peaberry Coffee, Inc. (the "Parent Company"), the Parent Company's COO and sole shareholder, and the Parent Company's vice president of franchising (collectively, the "Peaberry Defendants"). These claims rested largely on alleged misrepresentations and omissions made by the Peaberry Defendants in connection with the sale of franchises. Specifically, the Franchisees' claims involved two distinct nondisclosure theories: (1) failure to disclose that most of Peaberry's company-owned stores were not profitable; and (2) failure to disclose the Parent Company had substantial financial losses each year.
After seeking leave from the court, the Franchisees also filed claims against the law firm that represented the Peaberry Defendants in connection with Peaberry's franchise program. The Franchisees alleged that the firm aided and abetted the misrepresentations and omissions that formed the basis of the Franchisees' claims against the Peaberry Defendants. These claims, which were derivative of, and eventually bifurcated from, the claims pending against the Peaberry Defendants, will not be addressed here.II. The Trial Court's Findings
At the conclusion of the plaintiffs' case-in-chief, the trial court dismissed the Franchisees' claims under the Colorado Consumer Protection Act for lack of public impact. At the conclusion of trial, the court entered a decision in favor of the Peaberry Defendants on all claims. In doing so, it expressly found that the disclosures in Peaberry's UFOC – specifically, its "earnings claim" contained within Exhibit J to the UFOC – complied with the FTC's disclosure requirements and were not otherwise misleading or deceptive. But, the trial court nevertheless concluded that a franchisor cannot use its UFOC disclosures to "shield" itself from liability for fraudulent omissions. Rather, the trial court found in favor of the Peaberry Defendants based, in part, on the Franchisees' failure to prove reasonable reliance.
The trial court's findings regarding reasonable reliance were different for each of the Franchisees' distinct nondisclosure theories. With respect to Peaberry's failure to disclose net losses of the company stores, the trial court found that clauses contained within Peaberry's UFOC (in particular, the language in its earnings claim) precluded the Franchisees from proving reasonable reliance. In so holding, the trial court looked to: (1) language warning the Franchisees against inferring how their franchises would do based on gross sales of the company stores; and (2) language explicitly stating that the sales information provided to the Franchisees did not reflect costs or operating expenses. The trial court also concluded that because the Franchisees had access to publicly available store expenses, they could have independently determined the profitability of the company stores through reasonable due diligence.
With respect to the Franchisees' second nondisclosure theory relating to the Parent Company's financial information, the trial court found that the exculpatory clauses included in Peaberry's closing acknowledgment and franchise agreement prevented the Franchisees from establishing reasonable reliance. Those exculpatory clauses included an acknowledgment that the Franchisees were "not relying on any promises of [Peaberry] which are not contained in the [franchise agreement]."III. The Court of Appeal's Decision
The Colorado Court of Appeals affirmed the trial court's judgment in part, vacated it in part, and remanded it with directions. With respect to the nondisclosure claims, the Court of Appeals first addressed whether the trial court concluded that the Peaberry Defendants were under a duty to disclose the Parent Company's losses and/or the company-owned stores' profits. It was not clear to the Colorado Court of Appeals whether the trial court found such a duty existed, and it remanded the case to the trial court to make more specific findings on that element of the Franchisees' claims.
The Colorado Court of Appeals then turned to the trial court's conclusions regarding reasonable reliance as they related to each of the Franchisees' omission theories. It upheld the trial court's reliance findings relating to Peaberry's failure to disclose net losses of the company stores. However, it reversed the trial court's reliance findings relating to Peaberry's failure to disclose the Parent Company's losses. Specifically, the Court of Appeals concluded that the exculpatory clauses in the closing acknowledgment and franchise agreement – which under Colorado law "must be closely scrutinized" – addressed only affirmative representations outside the transaction documents, not failure to disclose material information altogether.
The Court of Appeals also concluded that the Franchise Disclosure Regulations did not protect the Peaberry Defendants from the Franchisees' nondisclosure claims relating to the Parent Company's financials. It did so despite an FTC Rule explicitly prohibiting franchisors from including a parent company's financial statements in a UFOC unless "(A) the corresponding unaudited financial statements of the franchisor are also provided, and (B) the parent absolutely and irrevocably has agreed to all obligations of the subsidiary." 16 C.F.R. § 436.1(a)(20)(i) (2003). In so holding, the Court of Appeals concluded that the FTC Rule only prohibited franchisors from disclosing a parent company's "financial statements," not other material information such as a parent company's general financial difficulties. Because the Court of Appeals found no conflict between the FTC Rule and the Franchisees' nondisclosure claims, it concluded that there was no federal preemption applicable to the Franchisees' common law claims.IV. Petition for Certiorari Review Pending
The Franchisees, the Peaberry Defendants and their attorneys are all seeking certiorari review of the Court of Appeals' decision. Two of the issues presented for review relate to the Franchise Disclosure Regulations. As of the date of this article, a decision from the Colorado Supreme Court regarding whether it will grant certiorari review of those issues is still pending.V. Peaberry's Aftermath
Before Peaberry, franchisors and prospective franchisees alike benefited from the certainty created by the clear disclosure guidelines set forth by the FTC (via the FTC Rule) and the states (via the UFOC Guidelines). Franchisors knew what to disclose and prospective franchisees knew what information they were, and were not, getting from franchisors about their franchise opportunities. After Peaberry, however, franchisors and franchisees also must look to each state's common law to determine what information, in addition to the information included in the FDD, must be disclosed to prospective franchisees. This leaves franchisors unable to predict what information they must provide about the franchise, the franchisor, and its affiliates until the courts better define what they will deem necessary for franchise transactions. It also leaves prospective franchisees unable to compare franchise offerings from franchisors in different states because the common law disclosure requirements may vary from state to state.
For example, despite the FTC's prohibition against disclosing a parent company's financial statements unless the parent company guarantees obligations of the franchising subsidiary, Peaberry may now require franchisors to disclose "general" financial information about their parent and affiliated companies, whether those companies serve as guarantors or not. This poses problems for franchisors and prospective franchisees, especially because the FTC's prohibition against such disclosures was meant specifically to protect prospective franchisees from basing purchase decisions on parent company performance that is not linked to the franchising company's success.
Further, Peaberry's guidance regarding what common law disclosures may have been necessary in that case only further complicates the landscape. In addressing the FTC's parent company disclosure requirements, the Colorado Court of Appeals suggested that: "[the FTC Rule's] plain language would not preclude a general comment especially if provided 'in separate literature,' such as, 'The franchisor is the wholly owned subsidiary of _______, which has not shown a profit during its ___ years of operation.'" Peaberry, 2010 WL 547633, at *10 (emphasis added). In a franchise sale, a franchisor's representations are usually limited to the FDD and the franchise agreement. Without any further clarification from Colorado's courts, it is unclear what "separate literature" the Colorado Court of Appeals could be referring to or how such "separate literature" should be provided or factor into the franchise sale.VI. Advice for Prospective Franchisees, Franchisors, and Their Respective Attorneys
The Peaberry case provides a good cautionary tale for franchisee attorneys. Prospective franchisees need to know what information is included in the FDD and related documents, and what information is not included in those documents. Franchisee attorneys should therefore advise their clients about potential additional information that may be relevant to a franchise sale, but that may not be included in the FDD. Similarly, franchisee attorneys should be prepared to ask franchisors for such additional information that they think will impact a potential franchisee's purchasing decision. And, if additional information is provided that is material to a franchisee's purchase, franchisee attorneys must make clear in any closing documents that information outside of the FDD and franchise agreement was relied upon by the franchisee in the franchise sale.
Franchisors and their attorneys should likewise note that the basic exculpatory clauses included in their FDDs and franchise agreements may not be sufficient. The trial court's and Colorado Court of Appeals' opinions both spent a considerable amount of time discussing these exculpatory clauses in Peaberry's UFOC, franchise agreement and closing acknowledgment. The Colorado Court of Appeals noted that the closing acknowledgment did not disclaim reliance on the Parent Company's financial statements or its financial condition. Thus, if a franchisor uses a closing acknowledgment, questionnaire or similar document to elicit information from prospective franchisees regarding what they were told and what they relied upon to make their decisions, the franchisor should include questions about whether the prospective franchisee was told or relied upon any information about the franchisor's parent or affiliated companies. A franchisee who states in a closing acknowledgment or questionnaire that it did not rely on the financial condition of a parent or affiliated company will have a more difficult task of claiming that the franchisor should have provided that information.
*Jeffrey A. Brimer and Sarah A. Mastalir participated in the Peaberry appeal discussed in this article as counsel for amicus curiae, the International Franchise Association.
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