The Exemption That Wasn't: Accredited Investor and the Net Worth Trap
A California franchisor wants to offer a single-unit franchise to a prospective franchisee. The franchisor's attorney advises that the offer is exempt under the 'accredited investor' exemption in Corporations Code section 31102(a)(3) because the prospect has a net worth of $1.2 million, including a $700,000 primary residence. The prospect's annual income is $120,000. The franchisor does not deliver an FDD, relying on the exemption. The franchisee later loses money and complains to the DFPI. The DFPI investigates and finds that the franchisor did not file any notice of exemption and that the franchisee's net worth calculation improperly included the primary residence. The franchisor argues that the exemption is self-executing and no filing is required. The franchisee argues that the exemption does not apply because the net worth threshold was not met when excluding the residence, and that the franchisor violated disclosure laws.
1. Is the offer exempt under the accredited investor exemption? Analyze the net worth calculation and the filing requirements.
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California's accredited investor exemption is found in Corporations Code section 31102(a)(3) and Rule 260.102.13 of the DFPI. It requires that the franchisee have a net worth of at least $1 million, excluding the value of the primary residence, or annual income of at least $200,000 (or $300,000 jointly). The prospect's net worth is $1.2 million, but $700,000 is the primary residence. Excluding the residence, net worth is $500,000, which is below $1 million. Annual income is $120,000, below $200,000. Therefore, the prospect does not qualify as an accredited investor. The exemption is not available. Additionally, even if the exemption applied, California requires a notice filing with the DFPI within 15 days after the first sale. The franchisor did not file. The exemption is not self-executing without the required notice. The franchisor violated the disclosure requirements by not delivering an FDD. The DFPI may order rescission and impose penalties.
2. What steps should the franchisor have taken to properly rely on an exemption, and what are the consequences of the failure?
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To rely on the accredited investor exemption, the franchisor must ensure the franchisee meets the definition, which requires excluding the primary residence from net worth. The franchisor should have obtained a financial statement or affidavit verifying net worth and income. If the franchisee qualified, the franchisor must file a notice of exemption with the DFPI within 15 days after the first sale, along with the required fee. The franchisor should also have maintained records. Because the franchisee did not qualify, the franchisor should have delivered an FDD and complied with the 14-day waiting period. The failure to do so constitutes an offer and sale of a franchise without registration or exemption, violating section 31110. The consequences include rescission rights for the franchisee, civil penalties, and administrative fines. The franchisor may also face a cease and desist order. The franchisor's argument that the exemption is self-executing is incorrect because California requires the notice filing.