After three years of investigating inventory shortages in a five-store network, 7-Eleven was able to obtain a preliminary injunction against franchisees accused of underreporting in 7-Eleven v. Khan, 2013 U.S. Dist. LEXIS 146696 (E.D.N.Y). Little direct evidence demonstrated the diversion of cash and inventory, but the overwhelming circumstantial evidence led inescapably to the conclusion that systematic underreporting was occurring and that management was responsible for the losses.

In the 7-Eleven franchise system, the franchisee does not acquire ownership of the retail outlet. Instead, the franchisee’s ownership consists in the net income derived from operations, after deducting operating expenses and 7-Eleven’s 50 percent share of the gross profits. 7-Eleven requires its franchisees use a point-of-sale (POS) register system to record all sales on an electronic journal, accessible in real time by 7-Eleven. Items are typically bar-coded and scanned into the register. If cash payment is tendered by the customer, the register drawer opens and the customer is given change from the register. 7-Eleven can generate reports reflecting the register transactions and can reconcile those reports to cash reports and deposits required to be submitted by the franchisee. 7-Eleven finances the purchase of inventory for its stores and can reconcile the inventory levels to products sold.

7-Eleven engages a private company to physically count the inventory. When the inventory is short, the franchisee’s equity in the store is reduced. Inventory shortages can be masked by ringing sales that are not intended to be reported by using certain high-risk register keys that open the cash drawer. The asset protection department investigates stores that show excessive inventory shortages. One can use one of these high-risk keys in a series of item purchases to sell the item but not ring it into the cash register. Through these checks and balances, 7-Eleven can monitor the cash handling procedures and sales reporting in its stores.

When the franchisee sought to renew its franchise, 7-Eleven conducted a 12-month operational review and identified excessive inventory shortages in all five shops in 2010. 7-Eleven installed secret cameras at one of the stores, and concluded that through the use of the high-risk keys, systematic fraud was occurring in the five stores. 7-Eleven obtained a temporary restraining order, and then a preliminary injunction based on its underreporting analysis over three years of monitoring.

Some of the evidence adduced was that the five stores at issue had average inventory losses between 407 percent to 762 percent higher than average stores in the market. Secret shoppers were employed and the videotape demonstrated employees using the high-risk register keys to fraudulently underreport sales. In a randomly-chosen 39 hours of video, 6 percent of the transactions involved fraud. The payroll records also contained anomalies such as inadequate staffing “on the books” necessary to support 24-hour, seven-day-a-week operations. The videotape demonstrated that the cash from the sales that were not rung up was deposited in the cash drawers. Significantly, none of the video showed the cash was put in the employees’ pockets.

Given the cash was deposited in the register drawer, and no owners were shown to have pocketed the money, proof was necessary to show that cash from the fraudulent sales was attributed to the franchise owners. All five stores were managed by family members. Testimony at the hearing demonstrated that the family would rarely reconcile the cash register receipts with the sales, which would demonstrate that more cash was in the drawer than sales reported. Moreover, such reconciliation would be naturally expected given the size of the inventory shortages. Some of the video clips showed employees engaging in fraudulent sales with the owners present in the same footage. Use of the high-risk keys was statistically excessive, and most importantly, the family owners testified that they took little or no measures to discover the cause of the excessive inventory shortages.

Members of the family who owned the franchise were well-educated and had successfully opened and operated several other businesses. 7-Eleven analyzed the after-tax effect of engaging in a systematic underreporting scheme to show the after-tax benefit far outweighed the equity reduction in the value of the stores. This evidence rebutted the franchisees’ expert, who testified that the risk and trouble of engaging in such underreporting was outweighed by the actual cash skimmed. After taxes, 7-Eleven’s expert testified that the benefit would be minimal.

The court concluded that the evidence was overwhelming because of the number of employees engaging in the fraudulent practices, the presence of the owners in the stores, the lack of preventive measures to prevent the fraudulent practices and the retail business sophistication of the owner.

As can be seen, underreporting cases are built by assembling direct and circumstantial evidence. In this case, the time constraints prevented the taking of depositions and other discovery. It is possible that had discovery been taken, certain witnesses might have taken the Fifth Amendment privilege or other “smoking guns” may have been uncovered. The case does demonstrate the need for a franchise system to have several methods of collecting data to ensure sales-reporting integrity and the exacting proofs necessary to prove an underreporting case.

Craig R. Tractenberg is the team leader of the franchise practice at Nixon Peabody and an adjunct professor of franchise law at Temple University’s Beasley School of Law.