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American Bar Association - Defending Liberty, Pursuing Justice

Fall 2008

Vol. 5, No. 1

Business Law

 

Franchising in the Real World
Part One: In the Beginning

Everyone wants a franchise, or they have an idea or a business they think should be franchised. If the business is or could be a franchise, what does it matter? From the business side, franchises are perceived as having less risk than starting up a new business from scratch. There appears to be an inherent assumption that if the business offered for sale is a franchise, it must necessarily be a more proven concept, tested and with certain assurances of startup and ongoing assistance. However, virtually anybody can franchise virtually anything, whether it makes sense or not.

All that is really required to franchise is to disclose certain things required by law. There are no requirements of minimum testing or operation of the business model to be franchised, no requirements for a minimum capitalization or financial condition of the franchise, no requirements as to what the franchisor must provide to do for its franchisees, and no restrictions on the franchisor other than what is committed in its contract with the franchisee. Most franchisors, however, will promise only the minimum necessary to get the franchised business started, and what is promised on an ongoing basis for continuing assistance are often illusory, catch-all phrases like “as deemed advisable” or “from time to time in its sole discretion.”

Franchises are defined at both the federal and the state level and are affected not only by franchise specific legislation, but also by a variety of state business opportunity and deceptive trade practices statutes and regulations. So long as a franchisor (or, more neutrally, “opportunity seller”) takes the proper steps in complying with the franchise laws, and any business concept can be offered up as a franchise and sold to others.

Any licensing or distribution arrangement can be a franchise with these three elements:

  1. Granting the right to use a trademark, trade name or other commercial symbol in the sale of goods or services;
  2. Providing continuing control or assistance, or prescribing the marketing plan or system to operate the business; and
  3. Requiring payment of a fee, direct or indirect, [typically includes any purchase from franchisor or an affiliate greater that $500].

The Laws

The sale of franchises is regulated federally by what is known as the FTC Franchise Rule (16 CFR section 346.1 et seq.) Franchising is also affected and regulated by different state laws, such as franchise registration laws, deceptive trade practices laws, business opportunity laws, and some have special franchise relationship laws.

The Way It Has Been

The FTC has regulated franchising since it first promulgated what is now known as the FTC Franchise Rule in 1979. The Franchise Rule imposed a series of restrictions and requirements primarily on the offer and sale of franchises, perhaps most significantly requiring the use of the prospectus to be given to all prospective franchisees. A number of states had already enacted similar laws that mandated the use—and in most cases the registration—of a Uniform Franchise Offering Circular (or UFOC) that was developed by state regulators through NASAA (North American Securities Administrators Association). Long story short, the UFOC format became the dominant form of disclosure and was the preferred alternative to the FTC’s original prospectus format, allowing franchisors to sell their franchises by using a form of prospectus that was more or less accepted in all states.

The Way It Is Going to Be Now

After efforts by state and federal regulators for a number of years, a single reconciled disclosure format has recently been adopted for use both in the registration states and in compliance with the Amended FTC Franchise Rule, 16 CFR section 346.1 et seq. The new, universal format is called the Franchise Disclosure Document (FDD). Its use was optional beginning July 1, 2007, and became mandatory July 1, 2008. Although substantially the same as the previous UFOC in the look and feel of the FDD, there have been some significant changes.

For those who do not deal regularly in this area but have some acquaintance with the UFOC, probably the most notable change is in item 19, formerly known as Earnings Claims, which have been renamed Financial Performance Representations. Anything constituting an earnings claims requires inclusion in the body of the UFOC or it could not be given. Now, the definition of a “financial performance representation” excludes providing estimated and actual costs in operating the business and so can be freely given without inclusion in the FDD. There has been much litigation over what information needs to be provided to prospective franchisees in violation of the item 19 requirements, which is discussed below. To a great extent, that it is unlikely to change under the new FDD format.

The FDD (in theory) can be provided in a single standardized version to prospects throughout the United States. However, if the prospects are located in certain states that are generally referred to as “registration states,” the franchisor must first register with a current version of the FDD, modified to meet state requirements.:

California         

Connecticut*

Florida*

Hawaii

Illinois  

Indiana

Maryland

Maine*    

Michigan

Minnesota

Nebraska*          

New York

North Carolina*

North Dakota

Rhode Island           

South Dakota

Utah*

Texas*

Virginia

Washington 

Wisconsin

*These are business opportunity states in which franchisors must register at least file a notice of exemption for compliance with the FTC. Some do not require the notice if a federally registered trademark is a part of the franchise.

Franchising Is a Partnership Between Opposites

With respect to the most significant interests and concerns of franchise clients, there is a great divergence of priorities between the franchisor and the franchisee.

As a franchisor, the primary concerns are compliance with applicable laws, ensuring control over its franchise system, and retaining the flexibility to change its business model. There is considerable tension between disclosing the minimum necessary in the FDD to comply with the FTC Franchise Rule and offering a franchise agreement that allows the franchisor control over the elements of the franchise business by making only minimal commitments to perform or to refrain from acting over the life of the relationship

 As a franchisee, the concerns are twofold: is the franchise a good investment, and will the franchisee get what they think they are buying?

Disclosure Basics

The FDD is a critical source of information, and counsel on both sides of the franchising fence should be aware of the information with which their clients will deal. Not only does the FDD contain copies of all contracts to be signed or that might be signed, but it is also a wealth of other information about the franchisor, highlighting critical obligations—or the lack thereof—on both sides.

Practice Tip

Franchisee clients often try to minimize legal fees by asking that only the franchise agreement be reviewed, but counsel should always require a copy of the FDD to review. Here are the items of information provided in an FDD.

  1. History of Franchisor and Franchise
  2. Officers, Directors and other Executives
  3. Litigation
  4. Bankruptcy
  5. Initial Fees
  6. Other Fees
  7. Initial Investment
  8. Restrictions on Sources of Products and Services
  9. Franchisee’s Obligations
  10. Financing
  11. Franchisor’s Obligations
  12. Territory
  13. Trademarks
  14. Patents, Copyrights, and Proprietary Information
  15. Obligation to Participate in Actual Operation
  16. Restrictions on What Franchisee May Sell
  17. Renewal, Termination, Transfer and Dispute Resolution
  18. Public Figures
  19. Financial Performance Representations
  20. List of Outlets
  21. Financial Statements
  22. Contracts
  23. Receipt

How the FDD Is Used

As a practical matter, this is how disclosure works in selling franchises:

  1. Every prospective franchisee must receive a FDD no later than 14 calendar days before signing any documents or paying any consideration, whichever occurs first. (No postdated checks!) An FDD can be provided electronically.
  2. Every franchisee must have the franchise agreement and any ancillary contracts in the form in which they are to be signed for seven calendar days, before they sign.
  3. Discussions with prospective franchisees and information provided must be consistent with the FDD. Information provided to a prospect inconsistent with or contradictory to any statement or other content of the FDD is a violation of the Franchise Rule.
  4. No “earnings claims or “financial performance representation” may be given to a prospective franchisee unless it is described in item 19 of the FDD.
    • A “financial performance representations” is any information given to a prospect by, on behalf, or at the direction of the Franchisor/Company or its representatives, from which a specific or range of actual or potential sales, income, or profit from franchised or Company owned units can be ascertained. This includes charts, tables, or mathematical calculations presented to demonstrate possible results based upon a combination of variables (such as multiples of price and quantity to reflect gross sales).

    • In other words, a franchisor cannot use numbers or financial data relating to the actual or projected performance of a franchise or similar operating units, unless prepared as required by Item 19 and included in the FDD.

    • These rules even apply to preliminary franchise information packets sent in response to inquiries and to information give to prospective lenders when franchisees seek financing after signing the Franchise Agreement.

  5. The franchisor must take special steps to conform to state law to legally exchange communications of any kind with anyone in the “registration” states.
  6. Terms of the franchise agreement may not be changed without affecting disclosure requirements and necessitating revision of the FDD regarding negotiability of those terms.

Laying Out the Rules

The FDD is a powerful tool for the franchisor in selling and for the franchisee in evaluating whether or not to purchase the opportunity. Basically it lays out the rules of the franchise game to be played by the parties. Part two of this article will highlight issues and pitfalls in the ongoing franchise relationship.

Useful Links

www.ftc.gov/bcp/menus/consumer/invest/business.shtm

Extensive information on franchising for consumers as well as FTC Franchise Rule text and recently issued compliance guidelines.

www.ftc.gov/bcp/franchise/netbusop.shtm

Listing of state business opportunity laws and agencies.

www.franchise.org

Site of the International Franchise Association, the first trade association for franchisors, now truly international and accepting franchisees.

www.aafd.org/

Site of franchisee association, which includes franchise-system-specific franchisee chapters.

www.nasaa.org/Issues___Answers/Legislative_Activity/Testimony/594.cfm

State regulators policy statements.

www.nasaa.org/Industry___Regulatory_Resources/Franchise/

Text of compliance guidelines for preparation and use of FDD in registration states available here.

Kat Tidd advises franchisors and franchisees, dealers, and entrepreneurs and serves as a consultant to other attorneys on franchise and business opportunity matters. Her firm is located in Dallas, Texas, and she can be reached through her website www.tiddlaw.com or by email at .

© Copyright 2008, American Bar Association.