Canadian franchise bankers have learned a great deal about opportunism (self-interest with deceit) from their franchise bar friends.

Canadian franchise bankers

Franchising Opportunism

Paper to Industry Canada

EXECUTIVE SUMMARY

1. Modern franchising creates opportunism by separating ownership from control.

2. Economic theory indicates fraud is likely to occur with credence goods or services. Franchise industry system owners, lenders, consultants and lawyers provide credence services.

3. Franchisors sell franchises not only to the public but to their industry peers. A sophisticated fraud model has been developed. Franchisors licence their franchisees’ opportunism to financial institutions and consultants.

4. Fraud requires a tolerant environment.

5. Malfeasance is minimized with a free flow of information regarding material investment risks. The Canadian franchise industry is characterized by high levels of information flow on the all levels with the dramatic exception of the small business investor.

6. The most accurate, independent reputation data is held by those with the greatest barriers of communication.

7. There is sufficient internal and external evidence to warrant halting franchised loan claims and to notify the appropriate federal and provincial agencies for evaluation.

8. Further research is warranted.

Minister Moore: Please recognize within federal insolvency law the interests of franchisees, their staff, and families.

Since 1970, United States federal and state regulations have recognized the distinctive vulnerabilities within the franchisor:franchisee relationship.

The 1,140,000 employees, 76,000 franchisees, and $15.2-billion invested within franchised outlets in Canada deserve to be as protected just as well as our friends to the south.

Source

The Target and potential for Tim Hortons are good examples of the Harper government’s commitment (via immediate Ministerial discretionary powers) in proving the Canadian entrepreneurial class is not useful only as cannon fodder.

Some of the laws that may need updating.

• Hon. James Moore PC MP Port Moody—Westwood—Port Coquitlam
• The Right Honourable Stephen Harper MP PC Calgary Southwest

How can 3G Capital guarantee “no staff cuts” at the 3,600 CDN Tim Hortons franchisee-owned stores?

Industry Canada may not understand franchising: who actually employs these 96,000 Canadians.

Theo Moudakis / Toronto Star

But how can 3G Capital (buyers of U.S. Burger King in 2010) offer any assurances that the 1,100 or so CDN franchisees won’t be forced to lay off their staff once their gross margins and equity are “right-sized?

Is 3G Capital:

1. incompetent,
2. willfully misrepresenting things to Canadians and our duly elected politicians, or
3. admitting that they are “joint employers” (with the franchisees) of those 96,000 franchisee employees?

Note recent charges against McDonald’s by the U.S. National Labor Relations Board: NLRB Charges McDonald’s as Joint Employer with Franchisees.

The National Labor Relations Board filed 13 cases against McDonald’s Corp. (NYSE:MCD) and its franchisees this month, alleging they violated the rights of employees, who worked at McDonald’s restaurants at various locations across the country.

The government agency’s complaints state that McDonald’s and its restaurant owners made statements and took actions against fast food workers for engaging in activities that aimed to improve their wages and working conditions. They accuse the parties of interfering with nationwide protests organized by unions over the past two years over their terms and conditions of employment.

Protect franchisees and they will protect their staff.

1. Are Canadian federal officials either 1. or 2. (see above)?
2. Is organized labour and others who wants a $15 minimum wage for the 1,140,000 franchisee-employeed staff in Canada?
3. How about Industry Canada who risks public taxes while guaranteeing $1.4 billion of franchisee business loans (1999 to 2007).

Opportunity Knocks and Liars’ Loans: required reading to understand modern franchising

John Lorinc wrote the book on franchising from a franchisee’s investor viewpoint.

I’m glad to see it is still available to buy online and is in many Canadian libraries.

The hidden banking side is revealed in Chapter 4, The 90% Solution: Franchise Economics, some of which I excerpted in a WikiFranchise.org post.

What did the business press have to say about Lorinc’s work?:

1. National Post: Opportunity Knocks: The Truth about Canada’s Franchise Industry, is an impressively researched look at the myriad of franchises that mushroomed across the country in the past decade. An award-winning magazine journalist, Lorinc has produced an engaging account that charts both the spectacular successes of some franchisers and the utter failure of some franchisees. How franchises seduce those with the most to lose, Jennifer Lanthier, November 2, 1997
2. Globe and Mail: At its worst, Lorinc says, franchising is a haven for the unscrupulous who prey on the unwary – typically recent immigrants willing to labour long hours in dreary businesses, unaware that those operations have little chance of prospering – using them as pawns in a shadowy real estate game. Rather than reflecting an insatiable consumer demand, he inquires acidly, is it possible that all those new doughnut shops may reflect a quiet understanding between landlords and franchisors that the best way to fill fallow commercial property is to sell franchises to credulous investors? Franchise book of interest to anyone who pays taxes, Ann Finlayson, November 1, 1997

Finlayson strikes a cautionary note, specifically about the hinted at misuse of the Canada Small Business Financing program, CSBFP:

Does all this matter to you? Yes, it does. In 1993, in the wake of vigorous complaints by small-business owners that Canadian banks were reluctant to finance them, Ottawa raised the ceiling on loans guaranteed by the Small Business Loans Administration to $250,000 and its guarantee rate from 85 per cent to 90 per cent, sparking a bank lending rush to franchisees and shifting the risk of franchise investments onto taxpayers’ (your) shoulders.

The Risk: Only a fraction of the Liars’ Loans are ever claimed by the banks, thereby grossly understating Industry Canada’s default statistics (Franchised v. Non-Franchised loan performance). The franchisee thinks he signed a government-backed loan but it never gets registered as such. As their bankruptcy, loss of life savings, marital and family breakdown escalate over the life of their 12 to 18 month franchise career, the franchisee NEVER looks to Box 9 of the CSBFP loan application form (Projected Sales ) as the source of their trouble; where the lie is put into the “Liars’ Loan”. The proceeds of these engineered-to-fail loans is split upfront by the franchise banker with the bank, banker, franchisor and sales agent. If questioned, the bank shreds the paperwork and waits for the lawsuit.

And, seriously, how many of these Immigrants as prey losers could or would ever sue a Schedule 1 chartered bank?

• Only one I know of: a father and son PhD/B.Eng. team I worked with. The  Oudovikines (pronounced: ou-doe-VEE-kin), RCMP Commercial Crime Unit affidavit, Country Style, CIBC, lawsuit

The Return: Smashing quarterly earnings goals, record profits, high turnover in the small business division of each of the banks, and making franchise lending the most lucrative form of commercial lending in Canada. Private gain/public loss enabled by a criminogenic environment, moral hazard, regulatory capture…

Lorinc carefully mentions the “windfall profits” in this arrangement of churning:

What’s more, some banks and franchisors have put the SBLA program [predecessor government guaranteed loan program] to questionable use during foreclosure actions against franchisees, says one former owner who has been through the process. When a bank calls a loan against a non-performing franchisee, the 90% guarantee effectively relieves the bank’s receiver from trying to get the best possible value while disposing of the owner’s assets. With most of the loan covered by the Canadian taxpayer, the assets – fixtures, kitchen equipment, inventory, etc. – can be sold quickly at a deep discount, possibly below market value. This allows the franchisor too step in and buy back the property at better-than-firesale prices, thus generating a windfall profit when the store is later re-sold to another franchisee.

An important work that, depressingly, is as relevant in 2012 as it was in 1995.

______

Disclosure: My lol pecuniary interest here and here.

Franchise lenders are swill

Some systems hardly have any franchisee debt.

This is particularly true of ones that converted employees to franchisees.

That changes once franchisors listen to their bankers explain how much they both can make (ie. interest kickbacks) if they leverage as many franchisees to the teats.

The primary control method of newer (maybe more formally educated?) franchisees is debt. Hundreds of thousands of supportable debt, if the franchisor who controls their gross margins, lets them service their debt.

It’s ugly:

1. prime plus 5% (“love to give a better rate but it’s unsecured, don’t you know“),
2. immediately callable (demand loan = short leash),
3. plus personal guarantees up the wazzo (“just need the missus to okay the paperwork…“), but
4. secured by NOTHING but the franchisor”s “good faith” (ok as long as the present management stays put but all deals are off if…).

If you want to unlock the chains, start asking your “preferred” lender some questions (on a public blog, btw) about their lending duty under the Bank Act.

Franchise bankers: a breed apart.

A little more sensitive than you run-of-the-mill doofus franchisor: don’t like being fingered for loan pushing, collusion or predatory franchise lending.

• Franchising Opportunism, Les Stewart

Franchising more than helps flush +$100 million CDN annually down the toilet

A good Canadian Press article called Ottawa’s loan program for small business still troubled: report by Dean Beeby.The revenue paid to Industry Canada was supposed to cover the default claims paid out, but the math has never worked in Ottawa’s favour.

Claims paid out have risen steadily over the decade, and now top $100 million annually, while revenues have consistently lagged, costing taxpayers a net $335 million so far.

Put another way, cost recovery is currently at only about 60 per cent rather than the 100 per cent that was planned, and is in steady decline.

“The gap between claims and fee revenues will continue to exist and most likely expand,” predicts the KPMG report, dated Oct. 30 and obtained by The Canadian Press under the Access to Information Act.

The program’s portfolio of loans has become ever more risky over the decade, now catering especially to newly established small firms with weak credit scores and little collateral, many in the food-and-beverage sector.

These loans are used extensively in franchising although the franchise bankers frequently don’t even bother to try to register or make a claim on the phantom loans. The difference between new and used equipment nicely covers the money split between the mob (see here for details).

I’ve kept a close eye on the Canada Small Business Financing program and how the franchise industry misuses it (see my 2005 paper called Franchising Opportunism)

Program results from 1999 to 2008 using Industry Canada’s own Annual Reports (franchised v. non-franchised loans):

• Franchise Loan Claim Rate was 26.5% higher (than for Non-franchised loans).
• Franchise Loan Default Rates resulted in over $22.9-million more Claims (Non-franchised rate).
• The mean Franchised loan was 43.4% higher than Non-Franchised.
• The mean Franchised claim was 11.9% higher than Non-Franchised.

Comparing the years 2008 to 1999:

• The Claim Rate increased 858.2 times for Franchised (245.1  times for Non-franchised loans).
• The Franchised Claim Rate accelerated 3.5 times more than Non-franchised loans.

I’d be happy to send anyone the spreadsheet.

The U.S. Small Business Administration’s 7a. loan program seems to be sticking their citizens with a $70-83-billion public debt, too.

The Mob: A Working group of Professional Thieves

Thieves steal to live.

Professionals in thievery and business behave in a very similar manner.

Only a tiny percentage of thieves are recognized and view themselves as being professional: full time, rational and consistent planning.

The most prestigious of theft rackets is The Grift or Con games. The Grift requires cooperation among specialists.

The working group of professional thieves is known as a mob, troop, or outfit. The number of members in a mob is determined in part by the racket which is being hustled, in part by the angles which are being played, and in part by the circumstances and situations…Sometimes a large number of thieves work together in a loose organization in the more elaborate confidence games, using a common pay-off joint or big store (fake gambling club or brokerage office.) p. 27

For any group to function productively, certain rules need to be known and obeyed. This discipline is generally higher than in straight business because of the extralegal nature of some of their work.

The mob has many codes, rules, and understandings, most of which are so general that they apply to the whole profession as well as to a particular mob. p. 35

I understand (from books alone) that they are:

1. gains are divided equally (although, different for different roles),
2. all payouts must be paid from the net take (expenses [or nut] first deducted from gross take),
3. all loans must be repaid from the group’s first fruits (rigidly enforced),
4. everyone shares in the profit or loss (good or bad),
5. the fall-dough (shared cash) is used to protect any member of the mob,
6. each member must deal honestly with each other (burning someone is a almost unthinkable, lying is considered more serious than in straight business),
7. if someone leaves the mob, he must ask to be taken back (type of social norm or professional consideration),
8. a member of the mob is not responsible for things outside of his control (appreciation for the role of randomness and luck),
9. a mob member should not cut in on another member’s area of responsibility (reflects negatively on the competence of the “helped” member), and
10. it’s “the responsibility of every member of the mob to do everything  possible to fix a case for any member of the mob if the pinch [arrest, exposure] occurred in connection with mob activities.” p. 38

In addition to their specialized skills, a professional thief must have a more general capability called larceny sense.

Larceny Sense: This term is applied to the thief just as the term “business sense” is applied to the business man. It is an ability to deal with unusual situations in the best possible manner and is acquired in the course of experience. Every thief with good larceny sense will try to figure out every eventuality in taking off a touch. Some thieves are considered to have no larceny sense, while others have plenty of it.

Quotations Source: The Professional Thief, Chapter 2: The Mob, The University of Chicago, 1937 [my emphasis]

Franchise marketing, for some systems, has evolved into a specialized, highly secretive applied fraud. Each trademark system has a number of 3 or 4 professionals working to sell and resell franchises that are designed to fail for the investor.

There is no boss per se within the group. Because the work is underground, there is little documentation available.

If there is a boss in the traditional sense, it would be the banker in head office who are within the small business lending division. These Franchise Bankers (one bank per franchise system) work very closely with the franchisor for their direct lending needs as well as setting up extremely lucrative service contracts for their franchisees (current accounts, merchant accounts, etc.).

In 2000, I interviewed Dan Farmer of the Royal Bank of Canada. He stated that franchise lending was “the most lucrative form of commercial lending there is”.

Roles & Functions

• mark (potential franchisee),
• sales agent (initial contact with mark, as the outsideman he steers marks to the mob’s preferred trademark; they are sometimes nominally independent, sometimes internal; also-known-as: consultants, franchise brokers),
• franchisor contact (initially charming, aura of success, kept at arm’s-length until the loan proceeds are advanced and removed from mark’s current account), and
• lender (specific bank official, specific bank branch: a high-risk, 24-hour turnaround on government guaranteed loans).

In their function as lenders, bank officers owe their borrowers a legal duty to perform lender’s due diligence. They are prohibited by law from creating debt instruments that they knew or should be reasonably be expected to know would be unsustainable or result in the borrower’s financial ruin. In Canada, the relevant statutes are the Bank Act and the Canada Small Business Financing Act and Regulations.

• Banks and bank officers are not being held accountable because these arrangements, although highly exploitable, provide substantial profits to the franchise bar, franchisors, etc. Canada has a well-known reputation for harbouring white-collar criminals.
• This, however,  is very, very fertile litigation soil for outside law firms that can know what questions to ask.

That I am a 1/3 partner in only one active lawsuit, speaks not to the rarity of the fraud but to my restraint and patience for the cleanup to happen. In 2005, we had identified over 12 potential lawsuits involving  just one franchise system, bank pairing.

Additional information on Predatory Franchise Lending and my recommendations to stop such abuse, can be found by in a paper I wrote to Industry Canada in 2005 called Franchising Opportunism: Deceit to secrsy confind. [Predatory Lending, IC Feb 2005]

Franchise bankers are Always there for you (whoever you are)

In August I wrote a post called Why Australia will get a McLaw.

WA Today ran a story this week by Chalpat Sonti called Franchising inquiry slammed as golden opportunity missed.

Perth-based Narelle Walter, a former franchisee who claims that an induced breach of contract left her out of pocket by $5 million, said the committee did not go far enough:

“Franchise renewals have not been addressed properly and I am distressed that the apportion of good will has not been determined,” she said.

“Franchisors can misuse this loophole in the franchising code and the (Trade Practices Act) to steal the assets of small business investors (through a process known as “churning”, when the franchise is on-sold by the franchisor to someone else).”

Interesting that Ms. Walter draws specific reference to franchise bankers co-operating closely with franchisors:

There was still a big incentive for banks to support the franchisor in the churning process, because they would rewrite loans with an [newer] “unsuspecting” franchisee, she said.

These allegations echo others, especially MP Jo Gash in my September post called Collusion allegation: AUS bank and franchisor.

I wrote about the very cozy franchise banker :: franchisor relationship in a paper to Industry Canada in 2005 called  Franchising Opportunism. It is also a good summary of how the Canadian and Australian franchise industry really works.

• Feel free to download a pdf copy of Franchising Opportunism right here.

With friends like these bankers, investors do not need any enemies.

Economic sanctions

The single best defense against things that go bump in the night for franchisees, is a mature and well-financed independent franchisee association, IndFA [see todays Thought-terminating cliche post on Blue MauMau].

1. Each franchise trademark system should have their own.
2. You should never buy into a system that does not have one.

Don’t be fooled: Unless there is a lawyer that the IndFA retains to give independent advice, the salesmen are telling you lies. The franchisor very often creates their own advisory committee to give the illusion of franchisee input. Ask for the lawyer’s name and talk directly to him or her.

National Associations: Starting and running a trademark system is difficult at times.

In the U.S. there are about 5,000 franchise systems and 1,200 in Canada. In Canada, there are only a few dozen functioning IndFAs for one reason alone: The franchisors don’t franchisees talking together.

In the U.S. there is the American Franchisee Association, AFA and the American Association of Franchisees and Dealers, AAFD. In Canada, there isn’t one and Australia’s seems pretty inactive lately.

• I started the Canadian Alliance of Franchise Operators in 1998 and killed it off in 2005.

The only reason I stopped it was because others were using it to give the impression of strength that was not there. I approached all the major Canadian stakeholders (Big Franchising: franchisor association, 5 Canadian banks, product franchisors, law firms, salesmen, Ontario Ministry of Consumer and Commercial Relations, Industry Canada etc.) for assistance or financial support.

• Even offered to give the Ministry the Information Sharing Project for free.

Big Franchising’s position has been consistent ever since 1998 when I breached the sacristy of the CFA’s trade show at the CNE with a CBC film crew. Franchising holds it beliefs rigidly: Like some 2nd rate religion or cult.

The irony, of course, is that without their resistance as expressed in my brilliant 6 week banking career [see The Apprenticeship of Les Stewart] and my recent blackballing (RE: providing general and employee benefits to Canadian franchises),I wouldn’t have the time much less the need to be typing away here.

• Funny how things work out, eh?

Collusion allegation: AUS bank and franchisor

In a Smart Company article by James Thomson called MP renews calls for investigations into mistreatment of Bakers Delight franchisee, he quotes:

NSW parliamentarian Joanna Gash has renewed calls for the Australian Federal Police to launch an investigation into accusations Bakers Delight and ANZ bank colluded to put a franchisee out of business.

Quoting emails between the franchisor and the bank, Gash alleges:

On Monday, Gash revisited the case in Parliament, producing emails from Bakers Delight chief financial officer Richard Taylor and ANZ executives that she says shows “plans had been conspired to terminate Ms de Leeuw’s franchise well ahead of time”.

The bank and franchisor deny all the allegations.

This is the first public AUS public allegation of the key franchisor:franchise banker relationship that I identified and wrote about in a 2005 paper for Industry Canada called Franchising Opportunism [free download].

The Royal Canadian Mounted Police did a 10 month investigation of a related predatory franchise lending matter. [free download: Mounties investigate ‘predatory lending’, Ottawa Citizen, March 25, 2006]

And Mr. Oudovikine is accusing the bank of transferring the loans to Country Style without his authorization before he had a chance to obtain a business plan and other financial details from Country Style.

Mr. Oudovikine says his case shows how big banks, franchisors and franchise brokers team up to take advantage of franchisees, many of whom are recent immigrants like him.

“It’s predatory lending. (CIBC) didn’t do any of the due diligence they should have done,” says Mr. Oudovikine, who sent the Citizen e-mails confirming the RCMP investigation. An RCMP official said the police force doesn’t confirm or deny investigation.

And the Canadian bank’s reaction?

Mr. Oudovikine says he has repeatedly contacted senior CIBC officials and executives about the loan dispute, to little effect. He alleges that CIBC breached the Canada Small Business Financing Act regulations that require lenders to conduct due diligence on borrowers, including their ability to repay loans.