Franchisors can no longer use franchisee questionnaires during the franchise sales process, according to a new Statement of Policy effective January 1, 2023, issued by the North American Securities Administrators Association (“NASAA”), whose guidelines are followed in the 13 franchise registration states.
May 6, 2022
FTC Burgerim Action Offers A Cautionary Tale For Franchisors
The Federal Trade Commission (FTC) has recently signaled a new drive to bring federal enforcement action against franchisors who violate the franchise disclosure rules by engaging in misleading sales practices.
On Feb. 7, the FTC filed U.S. v. Burgerim Group USA Inc. against the fast-food burger franchisor and its owner Oren Loni, in the U.S. District Court for the Central District of California for using misleading sales practices to sell more than 1,500 franchises.
The FTC's Burgerim lawsuit, as well as the enforcement action taken by state regulators against Burgerim, provide important lessons for franchisers about the types of sales practices that franchisers must scrupulously avoid to prevent getting into legal trouble.
This is the first time the FTC has taken enforcement action against a franchisor since 2007. In contrast, from the period 1993 through 1999, the FTC filed 20 franchise court cases, according to a U.S. Government Accountability Office report. And in 2006 alone, the FTC brought six court cases against franchisors for violation of the Franchise Rule as part of a government sweep.
After the lawsuit was filed, Lina Khan, chair of the FTC, announced the agency's new approach in a tweet:
This action — our first under the Franchise Rule since 2007 — reflects a renewed commitment across the agency to protecting franchisees from illegal practices. As part of this work, we're making it easier for franchisees to report predatory practices to us.
Misleading Sales Practices Identified in the FTC's Lawsuit Against Burgerim
In the recent Burgerim lawsuit, in which the FTC is seeking injunctive relief and monetary penalties, the FTC alleges that Burgerim and its owner violated the Franchise Rule and misled franchisees when it sold more than 1,500 franchises, collecting millions of dollars in initial franchise fees which ranged from $50,000 to $70,000 for each franchise, by:
Making false verbal promises that it would assist franchisees every step of the way, including locking in a prime location, obtaining financing, acquiring architects and contractors, and providing ongoing support;
Making illegal verbal representations about the financial performance of existing locations and projected performance, as estimates for weekly or monthly sales figures and break-even points, when it did not include this information in Item 19 of the Franchise Rule;
Making false promises that it would refund the franchise fee if the franchisee was unable to obtain financing or secure a location, and failing to disclose in Item 5 the conditions under which it would give refunds;
Failing to disclose in Item 2 the names of the individuals who would have management responsibility relating to the sale or operation of franchises; and
Failing to provide the required contact information of prior franchisees, as required in Item 20, so that prospective franchisees could do their own due diligence.
The FTC lawsuit alleges that many franchisees undertook crushing debt and that "although Burgerim pocketed tens of millions of dollars in [franchise] fees, the majority of the people who paid them were never able to open restaurants."
In announcing the lawsuit, the FTC also noted that it has added a new reporting option specifically related to franchises where franchisees can report unlawful practices by franchisers.
Federal and State Laws Governing the Franchise Sales Process
Franchise sales in the U.S. are governed by the FTC's Franchise Rule, modeled after the securities laws, which requires franchisors to provide a detailed franchise disclosure document, or FDD, to prospective franchisees. The FDD must contain 23 specific categories of information, referred to as "Items,” including detailed descriptions of the:
Franchisor's experience and litigation history;
Fees and royalties;
Breakdown of the estimated startup costs to open a franchised location;
Franchisor's specific obligations to provide support or assistance;
Training including the subjects and number of hours on each subject;
Table of contents of the operations manual;
Number of franchises sold or closed in each state in the past three years;
Contact information of all existing franchisees and franchisees that left the system in the past year; and
Franchisor's audited financial statements.
At the federal level, the FDD does not have to be filed and approved by any federal agency. There is no private right of action under the Franchise Rule, but the FTC has the authority to bring enforcement action in its own name.
Some states have adopted "Little FTC Acts," which prohibit deceptive and misleading trade practices, and which incorporate by reference the FTC's rules, thereby giving franchisees the ability to sue for violations of the Franchise Rule at the state level.
In addition, 13 states — California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin — have their own state franchise sales practices laws, modeled after the federal Franchise Rule, and registration requirements.
To sell franchises in those states, franchisors must get their FDD approved by the state regulator and must update the FDD each year — or more frequently if there are material changes during the year.
The state regulators in those states have independent authority to bring legal action against franchisors, and some of these states have regularly taken enforcement action against franchisors.
State Enforcement Actions Against Burgerim
With respect to Burgerim, four of these states — California,  Maryland, Indiana, and Washington — brought legal action against Burgerim in 2020 and 2021 to shut down its franchise sales in those states, even before the FTC's lawsuit this year.
Maryland and California have the reputation for being two of the toughest states when it comes to enforcement of the laws governing franchise sales.
In its announcement of the Burgerim lawsuit, the FTC thanked the California Department of Financial Protection and Innovation and the Office of the Maryland Attorney General for their assistance in the case.
In the state enforcement actions, state regulators described Burgerim's illegal sales practices, which included, In addition to the practices identified in the FTC lawsuit, the following:
Failing to disclose the telephone numbers for current franchise outlets and former franchisees, as required in Item 20. This information is important so that prospects can contact existing and former franchisees to get information about the system;
Failing to amend and update its FDD during the course of the year, after it sent out a letter to existing franchisees that it had retained bankruptcy counsel, to provide disclosure of the franchisor's deteriorating financial condition. State franchise registration laws require franchisors to amend the FDD if there are material changes during the year;
Failing to disclose an accurate count of the number of franchises sold, as required in Item 20;
Failing to disclose all of its affiliates as required in Item 1; and
Failing to disclose that one of the franchisor's executives had filed a petition for Chapter 7 bankruptcy, as required in Item 4.
According to the findings in the California order, in October of 2019, Burgerim stopped paying its employees and in November of 2019, [its owner] Oren Loni abandoned the corporate office in Encino, California, left the franchise agreements and documents behind, and fled the country. Franchisees were unable to get a hold of Burgerim or Loni.
The California order dictated that Burgerim cease and desist franchise sales in that state and ordered it to offer rescission to all existing franchisees to cancel their agreements and to compensate them for their losses. In addition, it imposed a whopping $4 million administrative penalty, in addition to an award for the state's investigation costs and attorney's fees.
The FTC's Burgerim lawsuit, as well as the state enforcement actions described above, provide illustrative examples of some of the common types of misleading sales practices that often trigger government enforcement action.
Burgerim's Flawed Growth Model
The Burgerim story also provides an important lesson for franchisors about how to manage the growth of a franchise system.
Franchisors generally derive income from franchisees from three different sources:
The initial franchise fee, which typically ranges between $40,000 to $60,000;
The ongoing royalties, which is typically six percent of gross revenues: and
The sale of products and equipment which franchisees are required to purchase from the franchisor or its affiliates.
Successful franchise systems place heavy reliance on garnering revenue from ongoing royalties as their franchisees increase sales. This approach aligns the franchisor's financial interests in earning royalties with the franchisees' interest in running a profitable business.
In contrast, franchisors that place heavy reliance on garnering revenue from the initial franchise fee are more likely to be overly focused on making the sales as opposed to helping the franchisees succeed.
The Burgerim story is a case study in placing too much attention on making money from selling the franchises instead of investing resources in helping the franchisees to succeed and thereby increase royalties.
According to the state enforcement actions and media reports, including a comprehensive report in Restaurant Business Magazine, Burgerim dedicated almost all of its efforts to increasing franchise sales.
It sold franchises to individuals who could barely afford the initial franchise fee and did not have the financial resources to actually open a store. And, Burgerim did not even bother to collect royalties from its franchisees from 2015 to May 2019.
As a result, these reports explain, it did not have the revenue stream to invest in providing resources and an organization to support the franchisees. Instead, it relied on commission-driven salespeople to generate revenue by collecting initial franchisee fees, who were sometimes overzealous in the promises which they made to prospects.
Burgerim's Illegal Practices in Providing Historical and Projected Revenue Information
The Burgerim story is also instructive in terms of the types of financial information which franchisors are allowed to provide to prospective franchisees during the sales process.
Under the Franchise Rule, franchisors have the option to include historical revenue information about their existing franchisees, or projected revenue figures, in Item 19 of the FDD.
If a franchisor elects to include such information, the information must be presented in a non-misleading manner, the franchisor must have a substantial basis for the information, and the franchisor must provide the supporting documentation to a prospective franchisee upon request.
Generally speaking, more than half of franchisors provide such information in Item 19 of their FDD. As a result, they are allowed to use this information in the sales process.
But, if a franchisor elects not to include historical or projected revenue information in Item 19 of their FDD, then the franchisor is strictly prohibited from giving any historical or projected revenue figures whatsoever to prospects during the sales process.
This means a franchisor cannot tell a prospect — verbally, in writing, or by telephone, email, or text message — how much money existing franchisees are making. Of course, this prohibition goes against human nature because one of the first questions a prospective franchisee will ask is, "How much money can I make?"
Franchisors who do not provide revenue information in Item 19 are prohibited from answering this question in any form. Rather, the franchisor must tell the prospect that they must do their own due diligence.
In the case of Burgerim, the franchisor did not provide historical revenue information about its existing franchisees, or projected revenue information, in Item 19 of its FDD. As a result, its salespeople were prohibited from providing this information during the sales meetings.
According to the California order and the FTC lawsuit, Burgerim and its sales representatives regularly violated this prohibition. Specifically, according to the California order, Burgerim and its sales representatives provided the following financial performance representations and projected earnings statements to franchisees during initial sales meetings:
Franchisees make between $700,000 and $1,000,00 in the first year;
Franchisees enjoyed a 30-40% profit margin;
Other locations were making between $20,000 to $120,000 per month.
All of these statements were illegal, regardless of whether they were true or not, under the prohibitions of the federal and state franchise sales laws, given that Burgerim had opted not to include any historical revenue information in Item 19 of its FDD.
The federal and state enforcement actions against Burgerim provide a useful teaching tool for franchisors by identifying specific sales practices and growth models which franchisors must avoid in order to build a healthy and successful franchise system.
Complaint, dated Feb. 7, 2022, United States of America v. Burgerim Group USA, Inc., Burgerim Group, Inc., and Oren Loni, Case No. 2:22-CV-825 (C.D. Cal.), Docket No 1. https://www.ftc.gov/system/files/ftc_gov/pdf/2022.02.07_complaint_filed_002_0.pdf.
"Enforcement of the Franchise Rule," United States General Accounting Office, Report to Congressional Requesters, Report No. GAO-01-776 (July 2001). https://www.gao.gov/assets/gao-01-776.pdf.
"Federal, State Law Enforcers Complete Bogus Business Opportunity Sweep," Federal Trade Commission Release, December 12, 2006. https://www.ftc.gov/news-events/news/press-releases/2006/12/federal-state-law-enforcers-complete-bogus-business-opportunity-sweep.
Tweet,, dated Feb. 9, 2022, posted by Lina Khan, @linakhanftc. https://twitter.com/linakhanFTC/status/1491448545987407872.
"FTC Sues Burger Franchise Company That Targets Veterans and Others With False Promises and Misleading Documents," Federal Trade Commission Release, Feb. 8, 2022. https://www.ftc.gov/news-events/news/press-releases/2022/02/ftc-sues-burger-franchise-company-targets-veterans-others-false-promises-misleading-documents.
Franchise Rule, 16 CFR Parts 436 and 437. https://www.ftc.gov/legal-library/browse/rules/franchise-rule.
Order, dated Feb. 16, 2021, In the Matter of The Commissioner of Financial Protection and Innovation v. Burgerim Group USA, Inc., et al., FIL Org IDs 170427 and 237772 (California Dept. of Financial Protection and Innovation). https://dfpi.ca.gov/wp-content/uploads/sites/337/2021/02/Citations-DR-Burgerim-Group-USA-Inc..pdf.
Final Stop Order, dated Feb. 5, 2020, In the Matter of Burgerim Group USA, Inc., Case No. 2019-0213 (Securities Commissioner of Maryland). https://www.marylandattorneygeneral.gov/Securities%20Actions/2020/Burgerim_Group_Final_Stop_Order_020520.pdf.
"The Burgerim Disaster," Restaurant Business Magazine, Vol. 119, No. 2, March/April 2020. https://www.restaurantbusinessonline.com/emerging-brands/burgerim-disaster.
According to Franchise Times, a franchise discovery is the industry’s version of a show-and-tell. Prospective franchisees are brought to the brand’s corporate office for a day of interactions and education as the franchisor works to prove that it is the best option for attendees to invest in.
The Federal Trade Commission (FTC) has recently signaled a new drive to bring federal enforcement action against franchisers who violate the franchise disclosure rules by engaging in misleading sales practices.