Revised FTC Franchise Rule Alters the Landscape of Franchise Sales Disclosure Obligations

By David L. Cahn, Esq.

Franchise and Business Law Group

On January 23, 2007, the Federal Trade Commission adopted a revised trade regulation entitled “Disclosure Requirements and Prohibitions Concerning Franchising,” 16 CFR Part 436, as amended, 72 Federal Register 15444 (March 30, 2007). The revised “Franchise Rule” went into effect on a voluntary basis on July 1, 2007, and compliance becomes mandatory on July 1, 2008. The disclosure requirements in the revised Franchise Rule are based upon the Uniform Franchise Offering Circular (“UFOC”) guidelines, issued by the North American Securities Administrators Association (“NASAA”) in 1993,1 that had been the standard for franchise disclosure documents. The changes to the UFOC made by the revised Franchise Rule are “evolutionary, not revolutionary,” but nevertheless practitioners will have to make some adjustments to issue a Franchise Disclosure Document (or “FDD,” the new acronym of art) that complies with the revised Franchise Rule.

The most noteworthy features of the revised Franchise Rule are as follows:

1. All franchisors may now use electronic means to provide their disclosure documents to prospective franchisees. (This change took effect on July 1, 2007.) While electronic methods arguably were permitted prior to promulgation of the revised Franchise Rule, due to the Electronic Signatures in Global and National Commerce Act (“E-SIGN”), 15 U.S.C. 7001, the revised Franchise Rule confirms this and specifies acceptable methods and procedures for doing so.
2. More extensive disclosures concerning a franchisor’s parent company may be required. Of particular significant, the Franchisor must disclose: (a) a parent company bankruptcy during the prior 10 years; (b) if the parent “induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor’s performance”; (c) litigation disclosures required by a franchisor, principally administrative, criminal or civil actions alleging “a violation of a franchise, antitrust, or securities law, or alleging fraud, unfair or deceptive practices, or comparable allegations”; (d) for “any parent that commits to perform post-sale obligations for the franchisor or guarantees the franchisor’s obligation”, audited financial statements for the prior three fiscal years.
3. Franchisors do not have to provide information about “franchise brokers” within the body of the disclosure document, which will eliminate the often voluminous rosters of “franchise consultants” from companies such as “Fran-Choice” that have been exhibits in the UFOC. However, if a franchise broker plays a substantial role in the sale of the franchise, he or she must be named in the acknowledgement of receipt of the FDD.
4. Franchisors will be required to identify all litigation with franchisees during the prior fiscal year, whether initiated by the franchisor or the franchisee, except for claims by the franchisor demanding indemnification for tort liability. The disclosure of franchisor-initiated actions is permitted in a summary fashion; however, a complete disclosure is required should a franchisee assert counterclaims or initiate an action.
5. Disclosures regarding “earnings claims” (now called Financial Performance Representations, or “FPR”) have changed under the new Franchise Rule. First, the franchisor must explain in Item 19 of the FDD that it is permitted, but not required, to provide a FPR. Second, to encourage more franchisors to provide a FPR, the revised Franchise Rule permits franchisors to base the representation on a subset of franchisor or company-owned operations; the subset must, however, consist of stores that have common characteristics other than being the best performers!
6. In Item 20 of the FDD, the franchisor must disclose: (a) whether it has entered into confidentiality agreements or clauses with current or former franchisees regarding the franchise relationship (except for non-disclosure of a franchisor’s trade secrets or proprietary information, such as recipes); and (b) the existence of and contact information for an independent association of franchisees, if that association is an entity organized under a state’s law and requests inclusion in the FDD.
7. A new exemption from providing the FDD exists for franchises in which the franchisee’s initial investment is in excess of $1,000,000, not including the costs to acquire unimproved land. The exemption is applicable if the investment of more than $1,000,000 will be made by an individual or a married couple. Sales to franchisee entities that have a certain amount of net worth and years of experience as a franchisee (so-called “Sophisticated Franchisees”) are exempt by a different provision of the Franchise Rule.

State Franchise Registration and Disclosure

The regulators of the 13 states that require registration by franchisors before the offer or sale of a franchise have, at least on a temporary basis, adopted the FDD as a replacement for the UFOC, with the only additional requirement that the franchisor disclose certain “risk factors” on separate “state cover page.” Therefore, it appears that, beginning on July 1, 2008, there will be a virtually uniform system of franchise disclosure in all 50 states.

However, the substantive provisions of state franchise registration and disclosure laws remain in force, including prohibitions on requiring waivers of compliance with the statute and on requiring the franchisee to litigate outside its home state. In addition, the requirements of registration are unaffected, and several registration states still may require a new or financially troubled franchisor to escrow or defer receipt of initial payments by franchisees until the franchisor has performed its preopening obligations and the franchise is open for business.

Finally, one notable difference between the revised Franchise Rule and the Maryland Registration and Disclosure Law is that a franchisor must provide the FDD to a Maryland resident, or someone planning to open the franchise in Maryland, at the earlier of: (a) the first in-person meeting to discuss the franchise opportunity; or (b) 10 business days before selling the franchise. By contrast, the revised Franchise Rule just requires disclosure not later than 14 calendar days before a prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale.

Footnotes:

1The Guidelines for preparing a UFOC under the prior rules can be found at http://www.nasaa.org/content/Files/Uniform-FranchiseOfferingCircular.doc

2The current requirements imposed by registration states, including the full text of the guidelines for preparing a FDD, can be found on NASAA’s website at http://www.nasaa.org/content/Files/Franchise_Interim_State_Guidelines.pdf