Corbin Williston posts at BlueMauMau is franchising “a modified Ponzi scheme?” Last week, a federal judge said it might be.

Janitorial franchises have long been a source of embarrasment for the franchise industry, and frequently attract purchasers with few assets and poor command of English. A 2001 report by the GAO on FTC enforcement of the Franchise Rule found that from 1993-2000, Coverall violations had affected 2591 investors, and JaniKing violations affected 900 investors.

Coverall is one of the largest franchisors, and has been aggressive in making earnings claims; in an August 2009 interview with Franchise Times, reporter Julie Bennet quoted Coverall making this claim:

Jacqueline Vlaming, Coverall’s general counsel, said, “Every franchise owner who runs it like a business can make money.”

Pius Awuah and 10 other franchisees related similar stories:

1.They paid Coverall North America a “franchise fee” in exchange for which
2.They were promised a minimum dollar amount of client accounts to service each month.
3.Coverall entered into the contract with the clients and billed the clients.
4.Coverall assigned the franchisees to clean the client premises, and
5.Coverall would remit money to the franchisees after deducting various charges.
The franchisees alleged in their Complaint that they were never given the amount of business they had been promised, and that the degree of control which Coverall exercised over them meant that as a matter of Massachusetts law that they were really employees of Coverall.

After filing suit, the franchisee attorneys uncovered damaging information and Coverall moved to seal court documents. In an interlocutory appeal, a 3 judge panel of the 1st Circuit Court of Appeals said in October 2009:

Coverall has been charged–it has not been found liable in this case–with activities that could be viewed as highly unattractive[cite omitted]

It is not necessarily the disclosure to competitors that makes the district court’s order a matter of concern. Others, including enforcement agencies and potential plaintiffs, may find the  disclosures of interest in ways that would not serve Coverall’s interests. [emphasis underlined in original]

The lawsuit continued and on March 23, 2010 the District Court ruled in favor of the “franchisee” plaintiffs, holding that they are in fact employees.

What has attracted attention within the franchise community is the Judge’s comments about Coverall’s assertion that its business was actually the sale of franchises. Traditionally industry trade groups such as the IFA have maintained that franchising is not an industry but rather a business model (although the IFA has on other occasions defined franchising as an industry).

Judge Young stated:

Describing franchising as a business in itself, as Coverall seeks to do, sounds vaguely like a description for a modified Ponzi scheme – a company that does not earn money from the sale of goods and services, but from taking in more money from unwitting franchisees to make payments to previous franchisees.

The Judge went on to say that he believed that in fact Coverall was in the business of janitorial services and that under Massachusetts law the “franchisees” were really employees of Coverall. But the use of the term “Ponzi scheme” and the interlocutory ruling have caused this case to gain wide attention.

Read more at: BlueMauMau