Editorial

Oversold Franchisees: Methods to Calculate their Damages

Much of our practice is devoted to helping franchisees that have been promised the stars by franchisors, but have been provided far less — i.e., the franchisee has been “oversold” on a Franchise concept. Franchisees that have been oversold on a franchise concept often state to us that their franchisor (1) overstated the earnings that they could expect as a franchisee, and/or (2) failed to support and assist the franchisee in the operation of their business as the franchisor promised.

Depending on the circumstances involved in the case, a court can find that this “overselling” is mere salesmanship — thus preventing the franchisee from recovering. Alternatively, the court can find that the franchisor’s overselling is an unlawful misrepresentation that makes it liable to the franchisee for the franchisee’s damages. Therefore, the franchisor’s liability will expose it to the possibility of having to pay the franchisee for its damages that were caused by the franchisor’s actions.

Assuming that the franchisor oversold the franchisee, how do we arrive at a dollar amount that will properly compensate the franchisee for the damages that were caused by the franchisor’s actions? This article will focus on the different methods that courts often use to determine how to properly compensate oversold franchisees, which includes out-of-pocket damages, benefit-of-the-bargain damages, and contract rescission.

Out-of-pocket damages are usually defined as the losses that were directly caused by the franchisor’s misrepresentation. Losses typically considered under the out-of-pocket damages method include initial franchise fees, building costs, loans, and other start-up costs that were expended as a direct result of the franchisor’s misrepresentation. As with many damages analyses involving claims of misrepresentation, expert testimony may be needed to show the amount of loss sustained by the franchisee.

Alternatively, the benefit-of-the-bargain approach may be used to compensate the franchisee. The rationale of this method of damages calculation is to attempt to place the franchisee in the same position that they would have been in had the franchisor performed as promised. In short, benefit-of-the-bargain damages are calculated by finding the difference between the value of the franchise as promised by the franchisor, and the actual value of the franchise the franchisee received. Essentially, the franchisee is entitled to recover what it expected to receive when it entered into the franchise agreement. For example, assuming that the franchisor is liable for misrepresenting that the franchise would generate $300,000 in profits, and later the franchisee realizes that it will never make that amount, the difference between what it was promised, $300,000, and what the franchisee is actually making, would be the amount the franchisee would be entitled to recover from the franchisor.

Finally, in certain cases, rescission may be available to the franchisee. Rescission allows the franchisee to essentially void the contract and recover an amount that will put the franchisee in the same position he or she was in prior to signing the franchise agreement. Under a rescission theory, the franchisee is entitled to recover all of the money it has put into the franchise, including compensation for herself, minus the value of the franchise assets.

Also, punitive damages, attorneys’ fees, or both may be available in the event the franchisor has made actionable misrepresentations. Punitive damages are used to punish parties. State statutes or the common law are two potential sources attorneys look to in order to recover punitive damages and attorneys’ fees. For example, South Dakota allows punitive damages “[i]n any action for the breach of an obligation not arising from contract, where the defendant has been guilty of … fraud ….” S.D. Codified Laws § 21-3-2 (2005). Although punitive damages and attorneys’ fees are not automatically available in most fraud cases, they may be recoverable and are therefore an important aspect of damages that should not be overlooked.

Note that mitigation rules must be observed by franchisees in order for them to recover from their franchisors. Mitigation rules mandate that when determining damages for misrepresentation, the franchisee has a duty to mitigate its damages. That is to say, the franchisee must attempt to minimize any harm it suffers as a result of the franchisor’s actions — it cannot continue to take actions that increase the franchisor’s bill if it is avoidable for the franchisee to do so.

His article provides only a rough sketch of some of the different methods attorneys use to estimate damages for franchisees that have been oversold. The method used by courts to determine damages will depend on the case. This article is not exhaustive, and is not intended to provide legal advice to the reader on any given factual scenario. In order to insure that a franchisee is receiving valid and competent legal advice on its own situation, the franchisee should secure the services of a qualified franchise attorney.