[co-author: Taylor Vernon]

A recent case from Indiana demonstrates consequences to a franchisor that deviates from the contractually agreed audit method. In Noble Roman's Inc. v. Hattenhauer Distributing Co., an Indiana federal court granted a pizza franchisee (Hattenhauer) summary judgment on its franchisor's underreporting claim.

In 2014, Noble Roman's audited non-traditional franchisees who paid royalties based on reported sales. These audits included two of Hattenhauer's locations. The audits relied on a review of Hattenhauer's purchases from its distributor and estimates of Hattenhauer's rate of waste, product mix, and pricing to estimate gross sales. Noble Roman's did not review Hattenhauer's books and records or verify the information in the distributor reports.

Based on the audits, Noble Roman's concluded that Hattenhauer's locations underpaid royalties. Without giving prior notice, Noble Roman's tried to electronically withdraw funds from Hattenhauer's bank account to cover the unpaid royalties. Hattenhauer's bank rejected the attempted transfers. Noble Roman's then made more attempts to withdraw the money, without providing Hattenhauer notice.

Noble Roman's sued Hattenhauer, claiming it breached the Franchise Agreements by underreporting sales and failing to pay proper royalties. Noble Roman's argued its audits were authorized under the Franchise Agreements. Hattenhauer counterclaimed, alleging that Noble Roman's breached the Franchise Agreements by improper calculation of gross sales and unauthorized attempts to withdraw money. Hattenhauer argued that, pursuant to the Franchise Agreements, it was required to pay royalties on actual gross sales, not on sales that Noble Roman's believed it should have achieved.

The court rejected Noble Roman's argument, noting that royalties Noble Roman's sought to collect were not properly calculated and therefore were not owed-and that nothing in the Franchise Agreements gave Noble Roman's the right to collect unpaid royalties calculated based on an audit, by means of electronic withdrawals without Hattenhauer's consent.

Franchisors should pay particular attention to the contractual rights they can enforce against franchisees and not exceed those rights in the process of collection efforts.

Read: Noble Roman's Inc. v. Hattenhauer Distributing Co.