The Regulation of Franchising
A series of laws have been enacted to regulate various aspects of franchising. These laws were the result of a public policy debate that began in the early 1970’s to combat alleged abuses in franchising. These laws regulate franchisor conduct before the sale of the franchise, during the term of the relationship and upon termination of the franchise. If a commercial relationship falls within the definition of a "franchise" as set forth in these laws, it will be subject to a variety of legal requirements and restrictions. Failure to comply can result in lawsuits by private parties and/or penalties, civil fines, injunctions and even criminal prosecution by a government authority.
Federal Regulation of the Sale of Franchises
At the federal level, on October 21, 1979, the Federal Trade Commission issued a Trade Regulation Rule (the "Original FTC Rule" or "FTC Rule") requiring, among other things, disclosure of specified categories of information to a prospective franchisee. However, beginning on July 1, 2008, franchisors were required to comply with the Amended FTC Franchise Rule entitled, "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities" ("Amended FTC Franchise Rule" or "FTC Franchise Rule"). The Amended FTC Franchise Rule maintains the benefits of the Original FTC Franchise Rule, preventing unfair and deceptive practices identified in the original rulemaking through pre-disclosure of material information necessary to make an informed purchasing decision and prohibition of specified misrepresentations.
Under the FTC Franchise Rule a commercial business arrangement is a "franchise" if it satisfies three definitional elements. Specifically, a franchisor must:
- 1. promise to provide a trademark or other commercial symbol;
- 2. promise to exercise significant control or provide significant assistance in the operation of the business; and
- 3. require a minimum payment of at least $500 during the first 6 months of operations.
The FTC Franchise Rule defines a prospective franchisee as any person (including any agent, representative, or employee) who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship. These disclosures must be made to a prospective franchisee at least fourteen (14) calendar days prior to the execution of any franchise document or the payment of any consideration for the franchise. By requiring the franchisor to provide this information, the FTC Franchise Rule is intended to reduce the prospective franchisee's investigative costs by providing comprehensive materials about the franchise and the franchisor, enabling the prospective franchise buyer to make comparisons with other franchise offerings. A second goal of the FTC Franchise Rule is to discourage high-pressure sales tactics and to provide the prospective purchaser with a "cooling-off" period before returning any signed documents or making any payments to the seller.
Application of the FTC Rule
Only if a relationship meets all of the jurisdictional elements of a franchise will the requirements of the FTC Franchise Rule apply. These elements are as follows:
- the offer, sale or distribution of goods, commodities or services by a business (the "franchisee");
- the identification or association of the franchisee’s business with a trademark, service mark, trade name, advertising or other commercial symbol of another person (the "franchisor"); or requirements that the franchisee meet quality standards in connection with the use of the mark or symbol;
- significant control by the franchisor over the business operation of the franchisee, or significant assistance by the franchisor to the franchisee (the FTC Franchise Rule enumerates certain controls and assistance, any one of which will satisfy this standard, including site approval, hours of operation, production techniques); and
- direct or indirect initial payment or commitment to make an initial payment by the franchisee to the franchisor, as a condition of obtaining or commencing the franchise operation, of $500 or more at any time before or within the first six (6) months of the relationship.
This definition of a franchise, in application, is quite broad. Anytime payment of $500 or more is made to enter into a commercial relationship associated with a trademark or service mark where the seller asserts some form of control over or assistance to the business operation, a franchise within the meaning of the FTC Franchise Rule probably exists. However, the Franchise FTC Rule does not cover pure product distribution arrangements where the purchaser only buys good at bona fide wholesale prices for resale.
Exemptions from the FTC Rule
Even if a commercial relationship meets the FTC Franchise Rule’s definition of a franchise, the seller of the relationship may not be subject to the FTC Franchise Rule’s disclosure obligations if the commercial relationship falls within one of the following specific exemptions to the FTC Franchise Rule:
- Fractional Franchises. A fractional franchise relationship exists when an established distributor adds a franchised product line to its existing line of goods. To be exempt from the FTC Franchise Rule, the franchisee must have more than two (2) years' prior management experience in the same business as the franchise, and the proposed relationship must be anticipated to represent no more than twenty percent (20%) of the dollar value of the franchisee’s projected gross sales during the first year of operation.
- Leased Departments. The FTC Franchise Rule exempts arrangements by which an independent retailer sells goods or services from the premises of another, larger retailer, but only if the larger retailer does not restrict the "lessee's" sources of supply.
- Minimal Investments. The FTC Franchise Rule exempts from its disclosure requirements sales of franchises where the "initial" required payment within six (6) months after commencing operation of the franchised business is less than $500.
- Oral Agreements. The FTC Franchise Rule exempts purely oral relationships that lack any written evidence of a material term of the franchise relationship or agreement, as a matter of policy, to avoid problems of proof in its enforcement. However, the exemption does not apply when there is any writing, even if unsigned, with respect to a material term, such as a purchase of goods or equipment.
- Petroleum Marketers and Resellers. The FTC Franchise Rule exempts petroleum marketers and resellers covered by the Petroleum Marketing Practices Act ("PMPA"). The most common types of franchises falling under this exemption are gasoline franchise stations.
- Large Initial Investments. The FTC Franchise Rule exempts franchise sales where the prospective franchisee makes an initial investment totaling at least $1 million, excluding the cost of unimproved land and any franchisor (or affiliate) financing.
- Large Franchisees. The FTC Franchise Rule exempts franchise sales to large entities; namely, those that have been in any business for at least five (5) years and have a net worth of at least $5 million.
- "Insiders" (Officers, Directors, General Partners, Managers and Owners). The FTC Franchise Rule exempts "insiders" (officers, directors, general partners, managers and owners) of an entity before it becomes a franchisor provided such individuals have been associated with the prospective franchisor within sixty (60) days of the sale and have been involved with the prospective franchisor for at least two (2) years.
Exclusions from the FTC Rule
In addition to the above exemptions, the FTC Franchise Rule also excludes (a) bona fide employee-employer relationships; (b) general business partnerships; (c) relationships created by, membership in a retailer-owned cooperative association (for example, farmer cooperatives for the sale of farm products); (d) relationships with testing or certification services (for example, electronic products approved by Underwriter's Laboratories and bearing its logo); and (e) "single" trademark licensing relationships.
- Contradictory Information. The FTC Franchise Rule prohibits franchise sellers from making any statement that contradicts the information disclosed in the franchisor’s disclosure document. Prohibited contradictory statements include those made orally, visually, or in writing.
- Use of "Shill" Testimonials. The FTC Franchise Rule prohibits franchise sellers from using fictitious references or "shills" misrepresenting that any person has purchased or operated one of the franchisor's franchises, when that is not the case, or that any person can give an independent and reliable report about the experience of any current or former franchisee, when that is not the case.
- Requested Early Disclosures. The FTC Franchise Rule prohibits franchise sellers from failing to furnish disclosure documents to a "prospective franchisee" earlier than fourteen (14) days in advance of execution of a binding agreement or the making of a payment, if requested.
- Updated Disclosures. The FTC Franchise Rule prohibits franchise sellers from failing to furnish, upon reasonable request, any updated disclosures prepared under the FTC Franchise Rule's general updating requirements to a prospective franchisee who has previously received a basic franchise disclosure document.
- Unilateral Modifications. The FTC Franchise Rule prohibits franchise sellers from presenting a franchise agreement for signing that has terms and conditions materially different from those in the copy of the agreement attached to the disclosure document, unless the franchise seller has informed the prospective franchisee of the differences at least seven (7) calendar days before execution of the franchise agreement.
- Disclaimers and Waivers. The FTC Franchise Rule prohibits franchise sellers from disclaiming or requiring a prospective franchisee to waive reliance on any representation made in the disclosure document or in its exhibits or its amendments.
- Promised Refunds. The FTC Franchise Rule prohibits franchise sellers from failing to make refunds as promised in the disclosure document or in a franchise or other agreement.
Franchise Disclosure Documents
In addition to the disclosure document, the franchisor also must furnish a copy of the proposed franchise agreement and any other agreements to be signed by the prospective franchisee. The FTC Franchise Rule deals only with full disclosure and does not regulate any terms of the franchise relationship. No filing or registration of the disclosure document need be made with the Federal Trade Commission.
The FTC Franchise Rule applies in all 50 states and U.S. territories and is intended as a minimum level of protection for prospective purchasers. If the protection afforded under state law is greater in states that have adopted similar specific franchise regulations, the FTC Franchise Rule defers to state law. However, where any portion of the state law provides less protection to a purchaser, the corresponding portion of the FTC Franchise Rule will apply. For instance, the FTC Franchise Rule supersedes less stringent state requirements with respect to the "cooling-off" periods following delivery of a disclosure document (before a purchaser may sign any documents or pay any money to the franchisor). Many states that have adopted franchise regulations require the disclosure format, which will be discussed later. In such states, the FTC Franchise Rule disclosure format may not be accepted for registration.
The information contained in the disclosure document must be updated (i) annually (within 120 days of the close of the fiscal year); (ii) or quarterly (within a reasonable time after the close of each quarter); and (iii) in the event of any material changes in financial performance information. Failure to comply with the FTC Franchise Rule may result in an FTC action for injunction, a cease and desist order, monetary damages and civil penalties of up to $11,000 per violation. There is no federal private right of action available to an individual for a violation of the FTC Franchise Rule. However, the FTC may require a franchisor to repay money to the purchaser of a franchise that was sold in violation of the FTC Franchise Rule. Further, several state courts have taken the view that violations of the FTC Franchise Rule constitute violations of the states’ consumer protection laws (also known as "little FTC Acts").
Federal Regulation of Business Opportunities
On December 8, 2011, the FTC adopted the final amendments to its Trade Regulation Rule entitled "Disclosure Requirements and Prohibitions Concerning Business Opportunities" (the "FTC Business Opportunity Rule") and the final rule went into effect on March 1, 2012. However, prior to the adoption of the FTC Business Opportunity Rule, the offer and sale of "business opportunities." was regulated under the Original Franchise Rule. The Original FTC Rule was intended to correct abusive practices in business arrangements in which the purchaser sells goods supplied by the seller through outlets obtained by the seller.
State Regulation of Franchise Offers and Sales
The state of California adopted the first state franchise statute in 1971. Since 1971, 15 states (including California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin) have enacted laws regulating the offer and sale of franchises. With the exception of Michigan and Oregon, these states require the franchisor to register the franchise offering with a designated state agency prior to the offer and sale of franchises. Oregon requires only a full disclosure of all of relevant information relating to the franchise to the prospective franchisee in advance of purchase. The State of Michigan requires disclosure complying with its statute, as well as the filing of a notice of the franchisor’s intent to offer and sell franchises in the state. In most instances, the registration process involves administrative review of the required disclosure materials. If the examiner is satisfied that (1) the required disclosure format has been used (i.e., that all required categories of information have been covered and all questions answered; the examiner makes no determination regarding the inclusion of all relevant information or the accuracy of the information contained in the disclosure materials) and (2) that the franchisor has sufficient financial capacity to offer franchises in the state (or is willing to escrow or defer collection of initial fees and other payments due from the franchisee until the franchisee’s business is in operation), the franchisor will usually secure registration in that state to offer and sell franchises. Occasionally, a state administrative agency will deny registration due to the precarious financial condition of the franchisor or the background of its principal managers.
On January 23, 2007, the FTC adopted a final amended Franchise Rule ("Amended FTC Franchise Rule"). As of July 1, 2008, all franchisors must prepare and distribute disclosure documents that, at a minimum, comply with the disclosure format of the Amended FTC Franchise Rule. Under the Amended FTC Franchise Rule, states may impose additional requirements under state law consistent with the Amended FTC Franchise Rule.
Prior to July 1, 2008, the disclosure statement that a franchisor must prepared for filing in the states that had laws regulating the offer and sale of franchises was called is the Uniform Franchise Offering Circular ("UFOC"). The UFOC was generally prepared by a franchisor in accordance with the Guidelines for Preparation of a Uniform Franchise Offering Circular (known as the "UFOC format"), promulgated by the North American Securities Administrators Association ("NASAA") on April 25, 1993.
Although, the Amended FTC Franchise Rule harmonizes the federal and more rigorous state disclosure requirements, the requirements are not identical. In response to the Amended FTC Franchise Rule, NASAA released its 2007 Interim Disclosure Guidelines ("2007 Interim Guidelines"), which streamlined and modified the disclosure requirements in the old UFOC format. The 2007 Interim Guidelines also included detailed instructions for a Uniform Franchise Disclosure Document ("UFDD").
In 2008, NASAA released its 2008 Franchise Registration and Disclosure Guidelines ("2008 Disclosure Guidelines") to assist franchisors in the preparation of the required disclosures for states requiring pre-sale disclosure and/or registration. The 2008 Disclosure Guidelines also dictated that as of July 1, 2008, all franchisors would be required to prepare and distribute disclosure documents that, at a minimum, conformed with the disclosure format of the Amended FTC Franchise Rule. Under the Amended FTC Franchise Rule, states may also impose additional requirements under state law consistent with the Amended FTC Franchise Rule.
In 2008, the UFOC was replaced with a revised format called the Franchise Disclosure Document ("FDD") rendering the UFOC obsolete. Although the current FDD includes most of the rules found in the old UFOC, there were material changes included in the newer FDD format.
Registration does not indicate that the disclosure document has been approved by the state or that the disclosure document has been prepared in compliance with the relevant guidelines. Further, registration does not act as a bar to a franchisee or the state later bringing an action against a franchisor based on information contained in or omitted from its disclosure document.
Like the FTC Franchise Rule, each state franchise disclosure law defines a "franchise." Although the state law definitions are not uniform, for state law purposes, a franchise generally will be deemed to exist when a business relationship contains all of the following elements:
- a contract or agreement, which can be express or implied or oral or written (note that an oral franchise relationship, even though exempt from the FTC Franchise Rule, may still be regulated by state law);
- between two or more persons;
- by which a franchisee is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system prescribed or suggested in substantial part by the franchisor (a few states substitute the concept of a community of interest in the marketing of goods and services for the marketing plan element of the definition);
- the operation of the franchisee’s business pursuant to such plan or system is substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising or other commercial symbol designating the franchisor or its affiliate; and
- the person granted the right to engage in such business is required to pay something of value (e.g., cash, notes or property) in order to establish the relationship, which would constitute a franchise fee.
Caution must be exercised in concluding that a particular commercial relationship is not considered a "franchise" merely because it is not called a franchise or does not require payment of a formal franchise fee. Any money paid to a seller of a business relationship will be considered a franchise fee unless it can be proven otherwise. As previously mentioned under the discussion of the FTC Franchise Rule, a pure distributorship arrangement, where the distributor buys only a commercially reasonable quantity of inventory of tangible goods at bona fide wholesale prices, will not be considered a franchise relationship under most state statutes or the FTC Franchise Rule.
Each of the state franchise registration statutes has a provision exempting certain types of franchises from some or all of its requirements. These exemptions usually apply only to the registration and disclosure requirements of the statutes. As a result, an exempt franchisor may still be subject to the disclosure, antifraud and unfair or prohibited practices provisions of the state law. Furthermore, a franchisor may meet the criteria for a state exemption, but not be eligible for an exemption from the FTC Franchise Rule. Nevertheless, exemptions from registration/disclosure statutes may free the franchisor from the expense and delay of review by a state administrator. On September 9, 2012, NASAA adopted the NASAA Model Franchise Exemptions ("NASAA Model Franchise Exemptions"), which provided for the following franchise exemptions: (i) fractional franchises exemption; (ii) experienced franchise exemption; (iii) sophisticated purchaser exemption; and (iv) discretionary exemption. Depending upon the type of exemption being relied upon by a franchisor, the franchisor may be required to file a Notice of Exemption with the state administrator.
Although these exemptions are common to many of the registration states, each state statute is unique and must be examined carefully before relying on an exemption provision. Furthermore, several states have specific procedures that must be followed to obtain certain exemptions, as well as procedures for the revocation of exemptions. For example, the franchisor may have to file a disclosure document or other documents for the state’s review to obtain an exemption. Further, an exemption under a state law does not extend to the FTC Franchise Rule, unless the relationship is also exempt under the FTC Franchise Rule on the same or a different basis.
As is the case under the FTC Franchise Rule, a franchisor must update its disclosure document to reflect any material changes in the information contained in the disclosure document circular or the occurrence of events that need to be disclosed to prospective franchise buyers, including changes relating to the financial condition of the franchisor, fees paid by the franchisee, litigation of the franchisor and others. The regulatory states require that any material change in the franchised program or the franchisor's financial condition be reflected in the disclosure document within a "reasonable time" after such material change occurs and that the changes to the disclosure document be filed with the state. Some states will require suspension of sales activity during the time in which an amendment to the disclosure document is being processed by the administrator.
Failure to comply with state franchise disclosure regulation may result in a variety of adverse consequences, including not only civil suits by injured private purchasers of a franchise, but also civil fines and criminal prosecution. These penalties may be imposed on officers, directors, employees, salespersons and franchise sales brokers who participated in an illegal sale.
State Regulation of the Franchise Relationship
In addition to the regulation of the offer and sale of franchises, another body of state franchise regulation has emerged in recent years in reaction to franchisee claims of unfair or discriminatory treatment. Legislation has been adopted by about 20 states dealing with such aspects of the franchise relationship as (1) establishing good cause grounds and prior written notice procedures for termination and nonrenewal of franchises; (2) limiting the right of a franchisor to restrict transfers of franchises; (3) prohibiting discrimination among franchisees in charges for fees and in the sale of goods and service; (4) protecting franchisees from the placement of additional franchisor or franchisee owned outlets in a franchisee's market that diminishes the franchisee's revenue and profit; and (5) limiting the right of a franchisor to restrict the sources of supply from which a franchisee buys the operating assets, goods and supplies required for the development and operation of its business. These statutes specifically override the express contractual language of the franchise agreement and impose their own standards upon the franchise relationship. Among the most notorious of these laws is the Iowa Franchise Relationship Act, enacted in 1992 and substantially amended in 1995, and the much older Wisconsin Fair Dealership Act, which has generated hundreds of lawsuits.
State Regulation of Business Opportunities
Twenty-six states (including Alaska, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia, and Washington and Wisconsin) have adopted business opportunity laws that regulate the offer and sale of certain commercial relationships. While these laws were initially intended to regulate particular types of distribution arrangements, the lack of clarity and uniformity in the definitions of a "business opportunity" has resulted in coverage of franchise offerings as well.
The vast majority of the state business opportunity laws require disclosures similar to those required by the FTC Biz Op Disclosure Document ("FTC Biz Op Disclosure Document") adopted by the FTC on March 1, 2012. However, most of these laws require only payment of a fee and filing with the state administrator, who typically gives little or no review to the filed disclosure document. State business opportunity laws also may impose specific bonding or other financial responsibility requirements, irrespective of the franchisor’s financial condition. Some of the administrators of state business opportunity laws issue an advertising number, which the business opportunity seller must place on all advertising within the state as proof of registration.
Due to the varied purposes of these state laws, the definitions of business opportunity relationships also vary widely. However, the most common definition of a business opportunity is the sale or lease of any product, equipment, supplies or services to a purchaser upon an initial payment of more than $500 for the purpose of enabling the purchaser to start a business, and in which the seller makes one or more of the following representations:
- the seller will provide or assist the purchaser in finding locations for the use or operation of vending machines, racks, display cases or other similar devices or currency-operated amusement machines or devices on premises neither owned nor leased by the purchaser or seller;
- the seller will purchase any or all products made, produced, fabricated, grown, bred or modified by the purchaser using in whole or in part the supplies, services or chattels sold to the purchaser;
- the seller guarantees that the purchaser will derive income from the business opportunity or that the seller will refund all or part of the price paid for the business opportunity or any of the products, equipment, supplies or chattels supplied by the seller if the purchaser is unsatisfied with the business opportunity; or
- upon payment by the purchaser of a fee or sum of money to the seller, the seller will provide a sales or marketing program that will enable the purchaser to derive income in excess of the price paid for the marketing plan.
The third and fourth paragraphs of the definition are of greatest concern to franchisors, particularly those who make earnings claims to franchisees. If earnings claims are made, this may constitute a “guarantee” for purposes of the business opportunity laws. Even if no earnings claims are made, the franchisor still risks classification as a business opportunity. In any franchise sale, the franchisor makes, at a minimum, an implied representation that the franchisee will derive income. The entire franchise package that is presented to a prospective franchisee often implies that the franchisee will derive profit in excess of his initial fee, and therefore may amount to a representation that the marketing program will enable the purchaser to derive income exceeding the price paid. There does not appear to be any judicial interpretation of these elements of the business opportunity definition. Consequently, it is imperative that companies operating in business opportunity states carefully review their programs with counsel to determine whether compliance is required.
Exemptions from Business Opportunity Requirements
Business opportunity laws also exempt certain types of distribution arrangements. Among typical business formats exempted under the business opportunity laws are:
- A sales or marketing program sold in connection with a federally registered trademark or service mark.
- A sales or marketing program sold in connection with the licensing of a "registered trademark." Franchise law experts are divided as to whether state trademark registration of the franchisor's mark, in the absence of a federal trademark registration, will qualify for this exemption. Several business opportunity states have adopted the informal position that a "registered trademark" requires a federal registration. The franchisor should carefully investigate this issue before relying on this exemption.
- Business relationships that are subject to the FTC Franchise Rule. The franchisor that complies with the FTC Franchise Rule may be exempt from the requirements of a state business opportunity law.
Other exemptions may exist for specific industries, experienced sellers or buyers, sales of ongoing businesses, renewals or extensions, employer/employee relationships and general business partnerships. Under the business opportunity statutes of Texas, Kentucky and Nebraska, franchisors satisfying the states’ exemptions must file a one-time notice of exemption (along with the appropriate fee) before franchises can be sold in these states. In the states of Florida and Utah, annual exemption notices must be filed to maintain the states’ exemptions.
What Is An Offer?
When a franchisor in a state without franchise or business opportunity laws deals with a state that also has no such laws, only the requirements of the FTC Franchise Rule with respect to delivery of a disclosure document to the prospective purchaser apply. However, when dealing with state franchise and business opportunity registration laws, the critical principle to remember is that the state law must be complied with prior to any offer or sale of a franchise or a business opportunity in the state. In addition, should the franchisor be located within a state with a franchise registration/disclosure law, the franchisor generally will be required to secure effective registration in its home state before offering, or selling franchises anywhere. As a result, it is important to understand what type of franchisor sales activity constitutes an "offer."
Although most state statutes contain a definition of an "offer," they generally are unclear as to what pre-sale conduct by the franchisor does and does not constitute an offer. Typically, an offer is defined as "every attempt to offer, dispose of, or solicit an offer to buy a franchise." Because state regulations construe this definition broadly, almost any contact with a prospective franchisee could be characterized as an offer. In some states, simply mailing a brochure describing a franchise network to a prospective franchisee in another state may constitute an offer of a franchise.
Certain discussions may be conducted between the franchisor and a potential franchisee without triggering state registration/disclosure laws. It is theoretically possible for the franchisor and prospective franchisee to discuss the franchise network generally without the franchisor being deemed to have made an offer, but it is imperative that no terms of the actual sale be referred to during the discussions. As a practical matter, such contacts are not advisable. A state may take the view that the franchisor's communications were specific enough to be considered an offer, and the penalties for making an offer of an unregistered franchise can be severe. Any mention of initial fees, royalties, potential earnings or costs associated with the start-up of the franchise will bring the discussion within the meaning of an "offer." If the franchisor engages in such discussions with a franchisee who is protected by a state registration law and the franchisor is not validly registered, its conduct could be illegal.
Several statutes exclude certain activities from the definition of an offer. For example, most states provide that an offer made through advertising during a television or radio program originating out of state is not an offer for purposes of the statute. Additionally, an exemption exists in most states for the advertisement of a franchise in a newspaper circulated within the state, provided that two-thirds of the newspaper's circulation occurred outside of the state during the last 12-month period. The franchisor should be aware, however, that, absent a prior registration or exemption, placing advertising for the sale of franchises in a state requiring registration of franchise offers will constitute an illegal offer.
Most franchise registration states require that all advertising and promotional materials that offer franchises for sale be submitted to the state administrator for review seven (7) days prior to first publication or use in the state. State statutes generally define "advertising" expansively to include any communication used in connection with the offer and sale of a franchise, which would include recorded telephone messages, form letters, and TV and radio scripts as well as audiovisual presentations. Moreover, some states exclude from the registration of advertising materials "tombstone" ads placed by a franchisor, which are ads containing no more than skeletal information about the franchisor, the franchise and the total dollar investment required. In addition, website content is generally exempt from advertisement filing requirements if (i) the franchisor discloses its URL address on its disclosure document’s cover page in any franchise registration application; and (ii) does not direct the website content to any specific person (e.g., such as through e-mail).
Under the FTC Franchise Rule, franchisors may furnish disclosure documents to prospective franchisees in any fashion they elect, including hand delivery, email, granting access over the internet, fax or, by mailing to the prospective franchisee the FDD in either paper or tangible electronic form (such as on a computer disk or CD-ROM) by first class U.S. mail at least three (3) days before the required disclosure date.
One of the most revolutionary aspects of the 2007 revisions to the FTC Franchise Rule, which captures not only recent technological innovations but seeks to anticipate and capture as well developments which surely will follow, is its authorization for franchisors to engage in "pure" electronic disclosure, subject to certain limitations. First, before effectuating disclosure, franchisors are required to advise prospective franchisees of the formats in which the disclosure document is available so that those prospects may request delivery by a method they can easily use. And second, although franchisors are permitted to utilize navigational tools (such as scroll bars, internal links and search features) in the disclosure document, franchisors are prohibited from using any electronic enhancements -- such as audio, video, other multimedia, pop-up screens and external links -- which a franchisor could otherwise utilize to call attention to favorable portions of its disclosure document and/or distract prospective franchisees from less than favorable disclosures.
Notwithstanding the obvious benefits of pure electronic disclosure for franchisors (e.g. reduction in costs, efficiency, and reliable records), the process would be impossible if, as in the past, a franchisor had to obtain a manually signed disclosure document receipt from each prospective franchisee. Accordingly, the FTC Franchise Rule now expressly permits a franchisee to sign the receipt either manually or by using security codes, passwords, electronic signatures, or similar devices to authenticate his or her identity. The FTC Franchise Rule also authorizes franchisors to include instructions in their franchise disclosure document receipts regarding how the receipts should be returned to the franchisor (for example, by mail to a specified street address, internet transmission, email, or fax to a specified fax line number).
Thus, the FTC Franchise Rule permits disclosure document receipts to be executed electronically, but clearly puts franchisors in the position of always having in place a protocol designed to capture proof of such electronic receipts not only for FTC Franchise Rule compliance but also in defense of any litigation claim that disclosure was not properly effected.
To assure that its conduct complies with state law, the franchisor should do the following prior to advertising for, or engaging in, any substantive discussions about the franchise with a prospective franchisee:
- If the franchisor is headquartered in a state that has enacted a franchise registration or business opportunity law that applies to the franchisor's program, the franchisor must register the franchise in its home state.
- For each prospective franchisee, the franchisor must determine the franchisee's state of residence, the state in which the offer of the franchise will be made, where the offer will be accepted, and where the franchised business will be conducted. If any of these states have registration laws with which the franchisor has not complied, the franchisor should consult legal counsel as to the application of such laws. If the laws apply, registration in those states must precede any sales activities.
A franchisor planning to offer and sell franchises in a registration state is required to file with the state its proposed disclosure document, certain application materials and a fee. Initial application fees currently range from $125 to $750. Also, the franchisor will usually be required to make certain changes or additional disclosures in its disclosure document to comply with nonuniform requirements of that state. As a general rule, these changes relate to notice of default prior to termination, good cause for termination, the enforceability of post-termination covenants and jurisdiction and venue provisions. Only in rare circumstances will the state administrator object on the grounds of fairness to particular terms of the franchise agreement and require modification of the agreement. However, several states take the position that they have the power to do so if the state administrator finds some aspect of the franchise particularly unfair or prejudicial to the franchisee.
The degree to which administrators review the adequacy of franchise disclosure documents varies widely from state to state, and even within a state, depending on the particular franchise examiner. Factors that affect the review process include the length of time the franchisor has offered and sold franchises, whether the state knows of any prior franchise law violations by the franchisor, whether the disclosure document has been prepared by legal counsel known to the state administrator's staff and the franchisor's general reputation. Most initial franchise registrations receive at least one comment letter from the state, generally including requests for changes to the disclosure document, questions, requests for disclosure of additional information and/or other concerns of the administrator. After all of the administrator's concerns and requests have been satisfied through compliance or negotiation, the administrator will grant effective registration. This procedure usually takes from two to six weeks, but could take as long as six months, depending upon the quality of the disclosure document initially submitted to the state and the workload of the administrator's office.
State registration requirements delay a franchisor's expansion plans, and cause the franchisor to incur legal costs and filing expenses. Changes required by individual states may result in several different forms of disclosure document, some of which may conflict. As a result, considerable time and expense may be involved in maintaining state registrations and state specific disclosure documents.
From a legal perspective, however, registration with the states can result in benefits. The franchise administrator generally is also the state enforcement officer, and an administrator's resolution of various issues relating to the franchise offering can give the franchisor some degree of comfort that the disclosure document complies with state law. The administrator's interpretation also may be binding upon the state in any subsequent enforcement proceeding. Unfortunately, opinions or interpretations of state administrators may not be binding upon private parties suing under state franchise laws.
The disclosure requirements of the FTC Franchise Rule and various state laws also impose certain burdens upon the franchisor relating to its financial condition. These burdens take two forms. First, the disclosure document requires disclosure of the franchisor's financial statements, the preparation and/or auditing of which may be costly and time-consuming. Second, most state franchise law administrators will review a franchisor’s financial condition prior to allowing the franchisor to offer or sell franchises and may require, as a condition of registration of the franchise offer, the escrow or deferral of collection of initial fees and other payments by the franchisee until the franchisee's business is in operation.
Financial Statement Requirements
The disclosure document must include the franchisor's audited financial statements for three previous years in which the franchisor has been in business (the audit may be qualified). The FTC Franchise Rule, however, prescribes a procedure under which the franchisor may commence sales with audits being phased in over a three-year period. The UFOC format requires audited balance sheets for a period of two years and a statement of operations, stockholder's equity and cash flows for a three year period. The UFOC format allows for a waiver of this requirement, in the discretion of each state administrator, only if the franchisor has never previously had an audit. If the franchisor does not have audited financial statements, it may substitute the audited financial statements of its parent company if the parent company guarantees the franchisor's performance under the franchise agreement.
If the franchisor is new and has no parent company willing to guarantee its obligations, it may establish a subsidiary (or its parent company could establish another subsidiary) that would prepare an audited opening balance sheet, or audited statements for the period it has been in business. If neither the franchisor nor the guaranteeing parent company has audited financial statements, the franchisor or its parent company will have to incur the expense of having its financial statements audited for the prior three years or forego franchising in the registration states that do not accept the FTC format offering circular.
Amending Registrations and Disclosure Documents
To ensure that the disclosure document contains accurate and timely information for the franchisee, the FTC Franchise Rule requires that it be revised within 120 days after the end of the Franchisor's fiscal year and updated on a quarterly basis within a reasonable time after the close of each quarter to reflect any "material changes." Although the FTC Franchise Rule requires only quarterly updates, the franchisor may elect to do so more frequently. This may become necessary where accurate oral representations are being made that may be contrary to outdated information contained in the disclosure document.
The FTC Franchise Rule's annual and quarterly updating requirement does not apply if the franchisor complies with the FTC Franchise Rule by using a FDD format that is registered in any state. In such case, the FTC Franchise Rule's updating requirements will be satisfied if the FDD UFOC format is renewed or amended in accordance with state law in the states in which the franchisor is registered.
Renewal under state law ordinarily is required on an annual basis. A few states require, instead of renewal, that an annual report be made within 120 days of the franchisor's fiscal year end. Each renewal or annual report requires the preparation of an updated disclosure document and current financial statements. This newly submitted data is subject to the same review by the regulatory states as the initial disclosure document filing and registration.
Failure to initiate the process of renewal in a timely fashion may result in a gap between the date of expiration of the existing registration and the effective date of the succeeding registration. During this interim period, the franchisor cannot offer or sell franchises within the regulatory state without violating its laws. Therefore, it is necessary to maintain a log and a tickler system for initiating renewals and annual reports in a timely manner.
Amendments under state registration laws must be made within a "reasonable time" after the occurrence of a material change. A franchisor must, therefore, amend its disclosure document and registrations in the event of a material change in the information contained in the disclosure document, or the occurrence of an event that requires the addition of information to the disclosure document. A reasonable time is generally thought to be within 30 days after the material change occurs.
Disclosure Regulation Compliance Programs
A franchisor must develop and implement an effective disclosure regulation compliance program to protect itself and its franchise network. An effective compliance program will help a franchisor to avoid disclosure law violations and related "costs." These costs include payment of damages and rescission of franchises sold to franchisees who assert violations of disclosure document delivery requirements, attorneys fees' paid to defend the franchisor, payment of the franchisee's attorney's fees, civil fines and possibly criminal liability. In addition, there are many intangible costs of litigation including the time spent by the franchisor's employees and disruption to the franchisor’s organization.
An effective compliance program provides the mechanism by which the franchisor can maintain evidence of compliance. Extensive documentary evidence may be critical in defending claims of franchise sales regulation violations. Franchisors cannot take the chance of relying on verbal testimony of employees, especially years after the occurrence. As time passes memories fade, or at the time of trial a key employee may be unavailable or unfriendly to the franchisor. Furthermore, verbal testimony of the franchisor may be insufficient to overcome jury sympathy for the franchisee, especially where the franchisee has documentation that supports a claim. Records established in the ordinary course of business are essential to bolster employee testimony.
How does a franchisor establish an effective compliance program? The first element in developing a compliance program is determining the assignment of responsibility for compliance. Smaller franchisors tend to lodge this responsibility with outside counsel. Outside counsel should be selected carefully to insure that attorneys have compliance expertise and that the law firm has multiple attorneys that can handle questions and problems in the event of the absence of the primary attorney. Franchisors sometimes fail to establish an effective liaison between outside counsel and company personnel with responsibility for keeping disclosure information current and communicating with sales personnel. To do effective work, outside counsel must have a source of timely, complete and reliable information from the franchisor and a responsible manager to whom counsel can communicate compliance status and procedures.
Some franchisors attempt to implement a compliance program by assigning responsibility exclusively to a paralegal or a person without legal training. This approach contains a high risk of error, because effective compliance frequently involves legal analysis and factual evaluation that may be beyond the competence of paralegals and persons without legal training. In addition, such persons often do not have the internal "clout" to get things done or insist upon full compliance.
Franchisors with small legal departments may divide responsibility for disclosure compliance between their legal department and outside counsel. This is a problem only if the responsibilities are not clearly parceled out. Therefore, it is essential to establish a smooth working relationship between the legal department and outside counsel. Franchisors with larger legal departments typically delegate compliance responsibility exclusively to their legal departments. Both types of delegation can work effectively, provided that assignments are clear, the legal department has sufficient resources and exercises independent judgment, the opinions of the legal department are respected by management and disclosure regulation compliance has equal priority with other legal services performed by the legal department.
Whether compliance is delegated to outside counsel, the legal department, or both, it is important to delegate executive responsibility to a compliance officer whose perspective is broader than simply selling franchises. Sales personnel can view lawyers as interposing rules of sales conduct which are designed to inhibit sales. Sales personnel are less likely to be uncooperative with a senior executive. The lawyers and paralegals assigned to disclosure compliance must have extensive knowledge of disclosure regulation and the sources of essential information within the franchisor. In addition, there must be regular communication among the compliance officer, sales department and the legal department and/or outside counsel.
A second element found in an effective disclosure compliance program is the establishment of systems and operating procedures. Systems and operating procedures should be designed to effectively and timely implement registrations; renewals of registrations; amendments to registrations and disclosure documents; sales personnel training; disclosure document and document delivery; recording information relating to offers and sales of franchises; storage and retrieval of disclosure documents, receipts for disclosure documents, franchise and other agreements and sales information; and documenting franchisee defaults. Systems and procedures must be designed to create and preserve evidence that will enable the franchisor’s personnel to demonstrate compliance. It is not sufficient to comply with the disclosure laws -- it is also necessary to be able to prove compliance. Information must be gathered in a central place (i.e., the franchisor's home office). All regional personnel should be instructed to transmit specified information to this location. Potential problems are obvious when files are incomplete or poorly organized. When we perform compliance audits, we frequently find document and information storage and retrieval systems that are materially deficient.
There are no clearly delineated rules to guide a franchisor to always accomplish full disclosure. However, if franchisors are guided by the general standard of materiality, they will be right (and relatively safe) must of the time. That general standard is that a franchisor must disclose all information which could have a significant influence on the investment decision of a reasonable prospective franchise buyer. Under the standard, franchisors must disclose some warts and blemishes and these disclosures may result in lost sales. The alternative is significant legal exposure. It is better to lose a sale rather than have an infirm relationship with a franchisee because the sale of the franchise did not comply with the applicable law. If a franchisee becomes unhappy with his decision to buy a franchise, he may claim that the failure to disclose "material" information induced the purchase of the franchise when in reality it had no impact on the franchisee’s decision to purchase the franchise.
Most franchisors do not include historical or projected sales or profits of franchised businesses ("earnings claims") in their disclosure documents due to the concern that they will be unable to satisfy the burden of substantiation. Many franchisors candidly admit that it is difficult, if not impossible, to close a franchise sale without responding to questions from the prospective franchisee regarding sales and profits. Directing the prospective franchisee to talk to existing franchisees often is not sufficient. Existing franchisees may not be willing to take the time to answer all of a prospect's questions. Franchisees may consider this information private. Furthermore, start-up franchisors have no franchisees with which prospective franchisees can talk about the franchise program. After one or two years of franchising, most franchisors can make and substantiate some type of earnings claim, even if it is limited to the gross sales of existing franchised and franchisor operated outlets. The omission of earnings claims from the disclosure document offering circular can leave this element of franchise sales open to unauthorized statements by salespersons. Therefore even a limited claim, coupled with a statement that it is the only authorized claim, is a check on embellishment by sales personnel and may weaken a franchisee's claim of reliance upon alleged claims by sales personnel.
A franchisor must also establish a procedure for disposition of inquiries from states in which the franchisor is not registered. The franchisor must determine which state laws are applicable by checking where the franchisee and its partners or shareholders are domiciled and where the franchise is to be located. The franchisor should avoid sending disclosure documents or other materials constituting an offer of a franchise into a state where the franchisor is not registered. It is permissible, however, to describe the franchisor's intent and status regarding registration and projected date of follow-up contact. However, a franchisor should not send advertisements into a state where the franchisor is not registered. Such conduct constitutes an illegal offer.
A franchisor must also develop procedures for evaluating developments and amending registrations and disclosure documents to reflect material changes. The compliance officer must engage in regular communication with the legal department or outside counsel and focus on such sensitive areas as litigation developments, increases in costs of developing the franchised business and adverse changes in the franchisor's financial performance or condition. In addition, a system must be established to determine the compliance requirements applicable to franchise transfers. A transfer involving an existing agreement is often an exempt transaction if the franchisor is not significantly involved in the transfer. Approval of the transferee by the franchisor is not considered significant involvement. However, if the franchisor requires the transferee to sign the "then current" form of franchise agreement or "brokers" the transaction, the transaction will not be protected by the exemption for intrafranchisee transfers.
The compliance officer should debrief all prospective franchisees before execution of documents to determine if unauthorized statements or promises were made to them by overzealous salespersons and whether sales personnel are complying with franchisor policies relative to disclosure regulation compliance.
Sales personnel should be carefully interviewed when hired and background checks should be conducted to determine whether they have been involved in criminal or civil cases, bankruptcy proceedings or illegal sales practices in prior employment positions. Salespersons should have an understanding of franchise sales regulation and should display a positive attitude toward compliance with regulation. Systems and procedures should include a disclosure regulation compliance training program for sales personnel. A franchisor should develop checklist type forms for sales personnel to complete during the sales process and these documents should be created routinely in the ordinary course of business.
When developing advertising materials, franchisors should avoid prohibited claims and misleading statements. No advertisement should contain an explicit or implicit statement that the purchase of the franchise is "risk free" or a "safe" investment or state that profits are assured or that losses are unlikely. Advertisements should not create unrealistic expectations by franchisees. A franchisor should avoid communicating unrealistic expectations relative to the efforts and time that the franchisee must put forth to make his business successful. In addition, a franchisor should avoid excessive claims relative to services to be performed by the franchisor or the progress of the franchisor's network or the franchisor's capability. These claims may cause the franchisee to distrust the franchisor or be disappointed in the franchise, if it does not meet the franchisee's unrealistic expectations.
The compliance officer, with the assistance of legal counsel, must also monitor changes in regulation of franchise offers and sales by identifying the sources of change (i.e., statutes, regulations, administrative policies or judicial decisions) and consider the impact of these changes on the franchise sales program. The compliance officer must stay abreast of such changes to insure that the franchisor stays in compliance with franchise sales regulation, which is modified from time to time.
Effectively Documented Relationships
A successful franchisor usually has developed a well-organized, complete and understandable franchise agreement. Though most franchise agreements are written in the traditional third person format (e.g., the parties are referred to as "Franchisor" and "Franchisee"), a growing number of franchise agreements are being drafted in the less formal first person (i.e., the franchisor is referred to as "we" and "us" and the franchisee is referred to as "you"). A first person document is more readable and less intimidating than the traditional third person format. A franchise agreement drafted in the first person is no less a binding and enforceable contract.
In addition to a less formal style of franchise agreement, franchisors should carefully consider other means to simplify their agreements. Good organization and simple, short sentences are both helpful. In addition, including in the agreement only the essential elements of the franchise relationship, and essential legal and procedural matters, contributes to a simple, user friendly document. The operations manual is the proper location for specifications, standards and operating procedures ("system standards") that describe and prescribe the operating and management systems of the franchisor's business. As noted above, the franchise agreement should give the franchisor the right to prescribe and modify system standards, incorporate them by reference into the franchise agreement and provide that a franchisee's failure to comply with one or more system standards, after notice and a reasonable opportunity to cure, is grounds for termination of the franchise agreement.
Most franchisors utilize collateral documents to supplement the franchise agreement. These may include subleases, collateral lease assignments, financing documents, rights of first refusal for additional franchises and software license agreements. The admonition to draft a well-organized and readily understandable franchise agreement applies equally to such collateral documents.
The operations manual should also be "user friendly." It must be well organized and simply written so as to be understandable not only to the franchisee but also to the managers of the franchisee's business. Writing a complete, well organized and readily understandable operations manual is more difficult than it might seem and requires good communications skills. The franchisor is, of course, the best source for the content of its operations manual, but a communications professional is usually the preferred resource for the organization and style of the operations manual.
The third document required in every franchised network is the disclosure document. Virtually all franchisors use the Uniform Franchise Disclosure Document ("UFDD") disclosure format prescribed by the North American Securities Administrators Association, which is discussed above. As of July 1, 2008, the NASAA Franchise Registration and Disclosure Guidelines ("NASAA Disclosure Guidelines") replaced the NASAA Uniform Franchise Offering Circular Guidelines ("NASAA UFOC Guidelines"). The NASAA Disclosure Guideline require disclosure documents to be written in "plain English," and to avoid legal terminology and the passive voice. Some state franchise law administrators interpret these rules to greatly limit the franchisor's choice of expression to communicate information about the franchisor and the franchise it offers. Compliance is best achieved, and the disclosure document is made a better communications device, if a disclosure document is written in the first person format and utilizes simple and short sentences.