A FRANCHISOR’S CRIMINAL CONVICTION: A CAUTIONARY TALE FOR FRANCHISING

On January 18, 2017, the Sixth Circuit Court of Appeals affirmed the criminal conviction of the founder of a Michigan pizza franchise for IRS fraud, filing false tax returns, and aiding in the impeding of IRS laws. 2017 WL 203537(January 16, 2017). The convictions involve the franchising and operation of various franchised locations and arose out of an investigation of the sale of franchises as "money laundering".

Franchisors and franchisees should take heed and ask themselves: Is there anything about the investigation, indictment and conviction of the franchisor which should be read as a cautionary tale for other franchisees and franchisors? Is there anything about my operation that might trigger a government investigation?

A Very Successful Franchise

The pizza franchise involved here was a very successful one, founded in 1996 as a stand-alone business which expanded rapidly, and then was quickly franchised. By 2010, the number of locations (including franchised locations) had doubled. What was somewhat unusual about the franchised system was that the franchisor retained an ownership in interest in most of the franchised locations. Nonetheless, it appeared that business was booming.

However, trouble was on the horizon. The Sixth Circuit states in its opinion that in 2009, the DEA received a tip that implicated the franchise, and a number of individuals, in a complicated scheme involving narcotics trafficking and money laundering. According to the Court, the DEA had been tipped that drug traffickers were investing in franchises to launder money, and that other improper business practices were widespread. The Court noted in its opinion: “A subsequent trash pull … revealed a list of fifty-four … franchise locations, many of which were owned by suspected narcotics traffickers.”

In 2013, the franchisor, and several associates and franchisees were indicted and charged with committing multiple tax offenses arising from a conspiracy to underreport taxable income and payroll taxes of nine franchises. See Press Release Department of Justice Office of Public Affairs July 16, 2013. The indictment alleged that from 2004 to 2011, the defendants conspired to divert business receipts, under-report wages and understate the true income and expenses of specified franchises. According to the indictment, the scheme resulted in certain of the franchises paying more than $2.1 million in unreported wages to employees and shareholders.

The franchisor was eventually tried and convicted of more than two dozen crimes, including filing false federal individual tax returns aiding and assisting the filing of false returns and engaging in a corrupt endeavor to obstruct and impede the IRS code.

What Does This Case Mean for Franchising?

While the vast majority of franchisors and franchisees operate their businesses completely above board, and in accordance with all laws, this case is still worthy of note and lessons should be learned for the mistakes by this franchise:

• Franchisors must carefully vet franchisees for an expanded list of potential problems. If a franchisor has any inkling that a franchise is being purchased to hide or launder money, no sale should go forward. If, for some reason, the franchisor still wishes to sell, despite misgivings, extremely careful investigation and attorney input are necessary;
• When a franchisor retains a financial interest in the franchise, the franchisor may be liable, civilly or criminally, for wrongdoings of the franchisee;
• If franchisors retain a financial interest in a franchise, the situation is ripe for abuse. Clearly the Federal Government is aware of this as well. It is likely that any such arrangement could invite enhanced government scrutiny;
• If a franchisor has any reason to suspect that a franchise location is involved in criminal activity, immediate legal advice should be sought to determine the franchisor’s responsibilities;
• When structuring any financial payments back to franchisees, whether as bonus incentives, or some for some other reason, extreme care must be made to appropriately document the financial transactions, and properly report the payments and receipts;
• Franchisors should include investigation of the criminal backgrounds of potential franchisees, and their associates, when considering a sale.

The facts presented in the Court’s opinion affirming the convictions may be far from those occurring within the operations of most franchises, but nonetheless, both franchisors and franchisees, but franchisors in particular, should understand that not only must they keep their own practices pristine, but they must also constantly be on the lookout for actions of others in their systems which might lead to circumstances inviting white collar criminal activity.