Hotel Franchise Fraud

HOTEL FRANCHISE FRAUD

The simplicity by which a national hotel franchise company (franchisor) may perpetrate a fraud and deceit upon unsuspecting potential franchisees is classic.

As with any proposed franchise arrangement, the franchisor prepares an offering circular which is provided to the unwitting proposed franchisee. The offering circular, in relevant part, generally discloses all of the costs associated with the development of the hotel project such as the initial licensing fees and other related fees like royalty fees, marketing/reservation contributions, cooperative advertising, audit fees, accounting fees, etc. In addition, the offering circular sets forth other estimated initial investment expenses such as application fees, architectural fees, pre-construction fees, leasehold construction costs, costs of furniture, fixtures and equipment expenses, advertising expenses, etc. Therefore, it is fairly easy for a proposed franchisee to determine the costs associated with the development and initial operation of the project.

Additionally, offering circulars usually set forth the fact that the franchisor must approve the location of the proposed hotel. The factors which the franchisor may take into consideration, in approving a location, include the proximity to other similar franchised facilities and other lodging facilities, and to room demand generators such as airports, interstate highways, office parks, commercial developments, government and military installations, colleges and universities. Other than providing these site selection criteria, the franchisor usually states, in the offering circular, that the franchisor does not participate in any way in the site selection process. However, what control is left when the franchisor has the sole and absolute discretion to approve the location.

Generally, offering circulars also indicate that the franchisor does not offer or provide any financing arrangements for licensees, either directly or indirectly. Thus, it is left to the proposed franchisee to obtain its own financing or to contribute its own capital to the development of the project.

In order for the proposed franchisee to make an informed investment decision concerning whether or not it makes economic sense to enter into a franchise agreement and to expend the monies necessary to develop the hotel, the income side of the equation needs to be determined. Offering circulars usually provide average performance figures for selected franchised hotels. The information provided includes the Average Daily Rates (ADR), the Average Occupancy Rates (Avg. Occupancy) and the Revenue Per Available Room (RevPar) for a certain identified period of time.

For illustrative purposes, let’s assume that the offering circular contains the following information:

a. Average Daily Rate: $54.05.

A total of 66 franchised hotels, or 43% of 153 sampled hotels, in the study period, achieved or surpassed this Average Daily Rate, and 87 were below this rate. The lowest Average Daily Rate of the sample hotels was $34.84 and the highest was $82.50.

b. Average Occupancy Rate: 59.31%

A total of 70 franchised hotels, or 45.8% of the 153 sampled hotels in the study period achieved or surpassed this Average Occupancy Rate, and 83 were below this rate. The lowest Average Occupancy Rate was 26.16% and the highest was 93.52%.

c. Revenue Per Available Room: $32.06

A total of 58 franchised hotels, or 38.0% of the 153 sampled hotels in the study period, achieved or surpassed this RevPar, and 95 were below this amount. The lowest RevPar of the sample hotels was $11.31 and the highest was $73.40.

Obviously, with the uncertainty of these numbers, no one in their right mind would ever undertake to enter into a franchise relationship with this franchise chain. Hence, the need for the franchise company to come up with a way to convince the proposed franchisee that its potential RevPar numbers would not only be sufficient to satisfy the debt service and operating expenses for the project but to also generate a reasonable return on investment.

However, this is problematic for franchisor because it is not supposed to provide any additional income information to the prospective franchisee other than as set forth above. This is highlighted in the ultimately executed License Agreement where the franchisee is required to acknowledge that it has conducted an independent investigation of the hotel system and the business franchised, including current and potential market conditions, and competitive factors and risks, and recognizes that the business venture contemplated by the agreement involves business risks and that success will be largely dependent upon the franchisee’s ability as an independent business person. The franchisor expressly disclaims the making of, and the franchisee acknowledges that it has not received or relied upon any warranty or guarantee, express or implied, as to the potential volume, profits, or success of the business venture contemplated by this agreement, or that otherwise contradicts the information in the offering circular.

How does the franchisor overcome this problem? It is genius. It simply indirectly “cooks” the books with the willing assistance of an alleged independent company that the franchisor highly recommends and contracts with to prepare a feasibility study, which would generate reasonable RevPar numbers that the proposed franchisee could allegedly rely upon in determining the economic feasibility of the project.

Unfortunately for prospective franchisees, they are not told that the consulting company that is hired will not be functioning independently of franchisor, obtains a significant portion of its revenues from the franchisor and that the franchisor will actually be choosing the competitive set of hotels by providing numbers from another company that it simply delivers to the consulting company to be dropped into the feasibility study. Neither the consulting company nor the franchisor discloses this information to the prospective franchisee.

The issue with the competitive set chosen by the franchisor for all of the consulting reports that it delivers to all prospective franchisees is that the franchisor hotel is classified as an economy brand hotel. The competitive sets created by franchisor and delivered to the consulting company, which are then included in the consulting feasibility reports, are overweighed with mid-level hotels thereby substantially increasing the RevPar numbers.

It is based upon these artificially elevated RevPar numbers that all of the franchisees base their decisions to enter into franchise agreements. It is for this reason that a majority of franchisees lose their investment and are foreclosed upon and/or file bankruptcy.

However, the genius does not stop there. Every time that the franchisee requests a modification of the licensing agreement, no matter how small, the franchisor requests that a written modification be executed. Within this document, the franchisor includes a general release, releasing itself from the fraudulent activity relating to the establishment of the competitive set and any other issues that may have arisen.