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Federal Franchise Sales Law Updated

In response to changes in technology and market conditions, after 12 years of rule making proceedings on January 22, 2007 the Federal Trade Commission approved (by a 5-0 vote) a substantially revised FTC Franchise Rule (16 C.F.R. Part 436), our only federal franchise sales regulation. This regulation (the “New Rule”) has been significantly modernized for the first time since October 1978 (the “Old Rule”). In support of the New Rule, the FTC published a Statement of Basis and Purpose. It sets forth the agency’s rationale for many rule changes and provides detailed explanations of the New Rule’s requirements. The New Rule becomes effective on July 1, 2007, when franchisors may (but need not) provide prospects with franchise disclosures in accordance with its terms. Compliance is mandatory on July 1, 2008.

Brief History. Led by California, in the 1970’s some 15 states enacted franchise registration/disclosure laws to deal with franchise fraud. The FTC followed in October 1978 with the first federal disclosure law. Significantly, the states refused to follow the FTC’s disclosure format largely because they sought more comprehensive regulation. Through the North American Securities Administrators Association, in the 1970’s these states promulgated a more rigorous disclosure format called the “Uniform Franchise Offering Circular” (“UFOC”), together with instructions for their use (“UFOC Guidelines”).

To simplify compliance by franchisors facing two disclosure formats, in 1979 in its Interpretive Guides, the FTC allowed franchisors to satisfy its rule by use of the UFOC format. FTC Interpretive Guides, 44 Fed. Reg. 49970-71, 8/24/79, §I(D)(1). Since then franchisors have followed the UFOC format when complying with the franchise sales laws. By minimizing differences between federal and state regulations, the FTC expects that the New Rule will reduce compliance costs and modernize disclosure methods.

Set forth below are the most significant changes under the New Rule.

1. Franchise Business and Business Opportunity Regulation Addressed Separately. The Old Rule applied both to traditional franchise offerings and lower cost business opportunities such as rack distributorships and vending machine routes. The New Rule applies only to franchise offerings. The FTC will deal with business opportunity disclosures through a separate rulemaking effort. 16 C.F.R. Part 437.

2. No Regulation of Ongoing Franchise Relationships. Despite its power to regulate unfair trade practices and franchisee claims of abuses by franchisors, the FTC determined that such regulation is not yet needed. It found insufficient record evidence that such practices are widespread. Accordingly, like the Old Rule, the New Rule applies only to franchise offer and sale activity.

3. International Transactions Excluded. Because the Old Rule was unclear, the New Rule makes plain that its jurisdictional scope is limited to offers and sales of franchises to be located in the United States, its territories and possessions.

4. Pure Electronic Disclosure Embraced. Under the New Rule franchisors may provide disclosure documents in any manner they wish including by regular mail, e-mail, hand delivery, fax or access over the Internet (subject to certain conditions). They can furnish the disclosure document by mail with a paper copy or in tangible electronic form (CD Rom or computer disk). They may not use electronic enhancements (e.g., pop-up screens, ads or links), as any electronic version must resemble the paper version. Franchisors may use navigational devices (e.g., scroll bars), however, to help prospects deal with these electronic documents. Finally, franchisors may disclose electronically before July 2008 even if their documents don’t satisfy New Rule requirements until then.

5. Simpler Disclosure Timing Rules. Under the Old Rule, franchisors had to provide disclosure to prospects at the earlier of the “first personal meeting” or ten business days before the prospect pays or signs a binding contract. Under the New Rule, they must simply provide disclosure 14 business days before the prospect pays or signs a binding contract. Also, the FTC eliminated the requirement that franchisors give prospects five business days from when they provide the contract in final form and the time the prospect signs or pays.

6. Plain English. Echoing 1993 UFOC Guideline changes, the New Rule mandates that franchise disclosure documents be prepared in “plain English”. This requirement does not apply to franchise agreements.

7. Disclosure Document Changes. Among many changes to the disclosure document itself, the following are most significant.

8. No Franchise Broker Information. Though they remain responsible for acts of fraud or deception they may commit, franchise consultants, their litigation or bankruptcy histories need not be disclosed.

9. Franchisor-Initiated Litigation. Under the Old Rule franchisors had to disclose material claims against them over a ten year period, whether by complaint or counterclaim, including arbitration claims. Also, under the New Rule, franchisors must disclose material claims that they commence against franchisees during the prior year. The FTC concluded that this represents important information that prospects need to evaluate potential franchise relationships, namely, the nature and scope of disputes in a franchise organization.

10. Less Disclosure of Computer Information. Under the New Rule franchisors need not disclose detailed information on hardware and software that franchisees must use. Rather, they need only disclose in general terms computer systems to be used by the franchisees, any purchasing and maintenance requirements and whether the franchisor can access information in the franchisee’s computer system.

11. Enhanced Territorial Disclosures. New disclosures beyond current UFOC requirements will be required to inform prospects of competition they may face, not just from other franchised or company-owned outlets, but also through other distribution channels such as the internet, catalog sales and telemarketing. Also, the New Rule requires disclosure of limits franchisors may place on franchisees on solicitations outside assigned territories. Further, if no territorial protection is granted, the New Rule mandates the following disclosure: “You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control.” Finally, the FTC refused demands of franchisee advocates that it regulate territorial “encroachment”. It said this aspect of the relationship was basically a private matter between the parties.

12. Renewal Disclosure. Disclosures on contract terms such as renewal, termination, transferability and dispute resolution will not change from the UFOC requirements with one exception regarding franchise renewal. The FTC acknowledged that many franchisees were astonished to learn that in order to renew their franchises, they had to accept materially different (and adverse) contract terms. Under the New Rule, franchisors must provide details on what “renewal” really means in their organizations.

13. Financial Performance (“Earnings”) Claims. As in the past, earnings claims will not become mandatory. In a break with the past, however, franchisors may provide information on a prospect’s likely expenses alone. That will not be an “earnings claim” for disclosure purposes. Also, the New Rule includes two mandatory disclosures; one to the effect that franchisors may include financial performance claims in the disclosure document if they wish and another to the effect that prospects should not rely on unauthorized earnings claims if the information is not properly disclosed in the document. Also, unless included in franchise advertising materials, the New Rule makes it easier for franchisors to air this type of information in the media generally, on web sites, SEC filings and elsewhere, without violating its terms.

14. Franchisee Information. The New Rule revises statistical disclosures on the franchisor’s network of outlets for the last three fiscal years, including the number of franchises in the system, the number of franchise terminations, transfers and re-acquisitions, projections of the number of franchises to be established in the coming year as well as contact information for former franchisees. Significantly, the New Rule requires disclosure on: (i) whether franchisees signed confidentiality provisions (“gag” clauses) that restrain them from talking openly with prospects about their experiences in the organization; and (ii) contact information for each trademark-specific association of franchisees affiliated with the chain, whether completely independent (so long as annual inclusion in the disclosure document is requested timely) or controlled by the franchisor.

15. Financial Statements. Chief among the changes in this area is that start-up franchisors without audited statements may phase them in over a three year period. With certain conditions, the New Rule permits use of an unaudited opening balance sheet for a franchisor’s first full (or partial) fiscal year. Audited statements must be prepared as soon as practicable, however. Query whether this change will pass muster with states that require audited statements under the UFOC Guidelines.

When conducting your franchise due diligence, keep in mind the free services of FranFinders expert franchise consultants.

This article highlights some of the many changes under the New Rule. It remains to be seen, however, whether and to what extent states with franchise disclosure statutes will embrace such changes. For decades franchisors have sought uniformity in U.S. franchise regulation. The New Rule represents a welcome development toward achieving that goal. For a detailed account on the New Rule, see FTC Disclosure Rules for Franchising and Business Opportunity Ventures, Commerce Clearing House (Chicago 2007).

By L. Seth Stadfeld

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