Do You Have Underreporting Franchisees?

“Oh what a tangled web we weave when at first we practice to deceive.” I am always amazed at how creative some franchisees can be when they direct all their energy into deceiving their franchisor about gross receipts and royalties due.

A number of years ago, I was involved in a case representing the franchisor whose franchisee sent in royalty reports and cash register tapes (now we use modems) that appeared to match his deposits and returns. The franchisor knew something was amiss but on the surface could not pinpoint the methodology of the underreporting. Because the Franchise Agreement permitted the franchisor or its agents to initiate an inspection or audit without notice, my first step was to engage the services of two individuals who were formally with the IRS and were very experienced on the criminal and civil side of investigations for fraud. Having drafted the Franchise Agreement, we had included a provision that the franchisee would pay for the cost of professionals, investigators, accountants, and attorneys associated with an investigation if a shortfall was discovered. We therefore felt comfortable knowing that the franchisee would be responsible for the cost of proving his deception.

When the investigators were kept from running a grand total for each cash register, they knew it was only a matter of time before the franchisee’s methodology of underreporting would be discovered. After interviewing former employees and managers, the pattern was set and, once the franchisee’s suppliers’ records were obtained and examined against the cash register grand totals, the fox was in the cage.

In discovering underreporting, your Franchise Agreement should be drafted to enable you to initiate the steps required to discover fraud. Always review your plan to investigate underreporting with your attorney because you don’t want to be faced with a suit for unlawful inspection or bad faith violation of the right of privacy.

One of the lessons my client learned was the importance of periodic inspections which help franchisees to stay honest. After my client’s shock of learning the amount underreported, we took steps to solidify systems for future franchisees which would help the franchisor monitor reporting activity.

Every franchise business is unique, but they all have common traits.  By having proper controls in place and taking a proactive approach, you can trim any dishonesty out of your system to help curb underreporting franchisees.

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