The “franchise scam,” is one of the oldest and most common types of fraud throughout the world.  The scam, which is a type of “pyramid scheme,” involves the sale of a franchise or distributorship to an individual to sell a particular product.  However, the real money does not come from selling the product itself; rather, the money comes from continually selling new franchises or distributorships.  The scheme usually collapses when the supply of potential investors is exhausted.

On January 23, 2012, federal prosecutors charged Eric Stein, a/k/a “Robert Philips,” with operating a franchise scam in New York City.  Stein purportedly began the scam after completing an eight year prison sentence after pleading guilty to various fraud charges in 2001.  Federal law enforcement agents allege that Stein used internet and print ads to sell “distributorships” for a company known as “Return-A-Pet, LLC.”  Each distributorship, which purportedly cost between $5,000 and $50,000, gave the investor the right to sell pet tags that contained an 800 number and a registration number for pets.  The investor would then sell the pet tags to pet owners, who would register their pet with “Return-A-Pet.”   If the pet was ever lost, anyone who finds it would simply call the 800 number on the tag, and “Return-A-Pet would facilitate the return of the pet.

Federal law enforcement are alleging that, after a potential distributor signed a distribution agreement and paid the required distribution fee, they would either receive no tags, services, and other materials promised by Stein, or less than the promised number of tags, services, and other materials.  The complaint filed in the matter also states that various purported victims demanded refunds; however, Stein did not refund any money.

Under federal law, individuals charged in a franchise fraud scheme are usually prosecuted under the federal wire fraud statute and/or the federal mail fraud statute.  These statutes make it a federal crime to use the wires or the mail, respectively, in furtherance of a scheme to defraud.  Convictions for both wire fraud and mail fraud carry a penalty of up to 20 years in federal prison.  Many states also have specific state laws prohibiting franchise fraud.

In the present case, if Stein is convicted, he would face up to 40 years in federal prison.  It will be interesting to see what defenses are raised by Stein in this case.  In some cases, legitimate businesses simply grow too quickly and cannot provide the services they promise without an actual intent to defraud.  In other cases, business owners simply get in over their heads and cannot meet their obligations.  However, in the present case, it does not help that Stein has previously served prison time for engaging in various frauds and swindles.

The only way in which the alleged scheme in the Stein case differs from the traditional pyramid scheme is that, in a pyramid scheme, investors are encouraged to sell more distributorships as their primary source of income, rather than selling the product itself.  As new distributorships or franchises are sold, money is kicked up the chain to the person who originated the scheme.  Therefore, the profits generated by that person grow exponentially as new members are recruited in the scheme.

This article was written by New Jersey criminal defense lawyer Nace Naumoski.