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It’s official
FTC revamps federal Franchise Rule
The long-awaited revisions to the Federal Trade Commission’s Franchise Rule have been released. Here’s Attorney David Kaufmann’s analysis of what’s important to note about the Revised Rule.
That’s not just the March breeze you are feeling. No, that’s the wind ushering in a new era of franchise regulation, one highlighted by vision, dedication and deep bow to technology.
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David Kaufmann is the senior partner at Kaufmann, Feiner, Yamin, Gildin & Robbins, LLP in New York City. He is the author of the New York Franchise Act; a franchise columnist, for the New York Law Journal; a member of the Advisory Committee for the North American Securities Administrators Association Franchise and Business Opportunities Committee; and a member of the Governing Committee, ABA Franchise Forum. |
On January 22, 2007, the Federal Trade Commission approveda comprehensively revised FTC Franchise Rule (Revised Rule), overhauling the federal government’s sole franchise regulation in a “top-down” fashion for the first time since it was promulgated in 1978. Accompanying the Revised Rule is the FTC’s “Statement of Basis and Purpose,” amplifying and clarifying the Revised Rule’s requirements and prohibitions. The regulation of the offer and sale of franchises in the United States will now undergo its most dramatic transformation since the enactment of federal and state franchise laws and regulations in the 1970s.
The revised FTC Franchise Rule takes effect on an optional basis on July 1, 2007, and on a mandatory basis on July 1, 2008. Between those two dates, the Revised Rule will undergo its “phase-in” period during which time franchisors may elect to compile their disclosure documents either under the edicts of the original Rule (including permission thereunder to follow today’s UFOC Guidelines) or those of the Revised Rule—but not a “mix and match” of both.
The Revised Rule is a visionary and remarkable accomplishment, reflecting the FTC’s dedicated commitment to ascertain in detail the current status of franchising; its role in the American economy; the needs and wants of franchising’s “players” (franchisors, franchisees and those professionals who serve them) and the general public; and, a commitment to address and incorporate the vast demographic, economic, societal and technological changes which have transpired since the promulgation of the original FTC Franchise Rule in 1978.
Gone under the Revised Rule is the original Rule’s simultaneous coverage of both franchising and business opportunities. Instead, the Revised Rule consists of two distinct segments—one confined exclusively to the regulation of franchising and the other setting forth, for the time being, the original Rule’s requirements and restrictions pertaining to business opportunity sales (with the FTC last year initiating a separate rulemaking addressing how its business opportunity regulation should be revised).
Gone, too, is the original FTC Franchise Rule’s own format of disclosure. Instead, the Revised Rule adopts the franchise regulating states’ Uniform Franchise Offering Circular (UFOC) disclosure format, but with a twist: the Revised Rule layers on additional disclosure requirements (and some modified disclosure requirements) from those currently required by the UFOC format—“UFOC-plus” as it were. Mirroring state UFOC mandates, the Revised Rule requires disclosure documents to be prepared in “plain English”
Despite calls from many franchisee advocates that the Revised Rule substantively govern franchisor-franchisee relationships, it does no such thing. Instead, the Revised Rule features a series of new disclosure requirements designed to enable prospective franchisees to better the assess the quality of their forthcoming franchise relationships and their likely success as franchisees.
Among the most important new (or modified) disclosures required by the revised FTC Franchise Rule—disclosures required neither under the original Rule nor under any state franchise law or regulation—are the following:
• A summary of all material litigation commenced by franchisors against their franchisees over the prior year (currently, only franchisee litigation against franchisors is required to be disclosed).
• An identification of any officers, directors or management personnel of a franchisor’s corporate parent who will exercise management responsibility relating to the sale or operation of franchises offered by the subject disclosure document.
• Disclosure of all government litigation against any franchisor affiliate which sold franchises in any line of business within the past 10 years.
• A statement as to whether any officer of the franchisor owns an interest in any supplier franchisees are required to do business with.
• Expanded disclosures regarding how the franchisor or an affiliate may compete with franchisees through alternative channels of distribution, such as the Internet, catalog sales, telemarketing, co-branding or the establishment of units at “nontraditional locations” situated within a franchisee’s territory.
• If no exclusive territorial rights are conferred upon franchisees, a special disclosure warning of possible adverse consequences.
• A clear explanation of what the term “renewal” means in the subject franchise system.
• Required “Item 19” financial performance representation (“earnings claim”) preambles, to the effect that the law permits franchisors to make financial performance representations in their disclosure documents and that, if none appear, any representations otherwise forthcoming from franchise personnel about past or projected franchise revenues or profits should be disregarded and instead reported to government agencies.
• A liberalization of a franchisor’s ability to feature Item 19 financial performance representations related to subgroups of a franchise network that share a particular set of characteristics.
• A declaration that disseminating “cost/expense” only information to prospective franchisees does not constitute the making of a “financial performance representation” requiring Item 19 disclosure.
• A complete revamping of Item 20 to eliminate the “double-counting” problem which currently exists (in Item 20, tables must be set forth indicating how many franchised units were terminated, reacquired, transferred or ceased to do business—under current disclosure requirements, a number of such events affecting a single franchised unit could make it appear that there was far more turmoil and turnover in that network than there actually was).
• Whether a franchise unit may have been the subject of “churning” activity (the repeated sale of the same unit to different franchisees at different times).
• Whether franchisees are restricted from speaking freely to prospective franchisees about the former’s experiences by virtue of any confidentiality agreement.
• Identification of both “captive” franchise associations (those sponsored and/or endorsed by the franchisor) as well as “independent” franchise associations (which, to be disclosed, must be network-specific, organized under state law and must annually request disclosure).
• The ability of foreign franchisors to utilize financial statements which have not been prepared in accordance with United States “GAAP” but do satisfy Securities and Exchange Commission non-GAAP requirements.
Critically, the Revised Rule explicitly states that it applies only to the sale of franchises to be situated within the United States, its territories and possessions. Until now, there was some question as to whether the FTC Franchise Rule governed franchise sales activity outside the United States, leading to more than a little confusion in at least a few court cases.
The Revised Rule turns truly revolutionary by permitting franchisors to engage in “pure” electronic disclosure. Under the Revised Rule, gone are the days when disclosure documents had to be prepared and handed out in paper form. Now, the Revised Rule permits franchisors to disseminate their disclosure documents by e-mail; posting on the franchisor’s Web site; CD-ROM; fax; “snail mail”; or, like the old days, hand delivery (with Item 23 franchisee receipts, too, permitted to be executed and returned electronically).
The Revised Rule also eliminates current federal and state “disclosure triggers,” which require franchisors to furnish their disclosure documents to prospective franchisees at the earlier of the “first personal meeting” with a prospect or 10 business days prior to the franchisee’s execution of any contract or the payment of any money to the franchisor. Under the Revised Rule, the new disclosure “trigger” requires franchisors to furnish disclosure documents to prospective franchisees at least 14 days prior to the franchisee’s execution of any agreement or its payment of any money. As well, the current federal and state requirement that “execution-ready” contracts be furnished to prospective franchisees at least five business days before they are signed has been entirely scrapped (save for those instances in which a franchisor has unilaterally and materially modified those agreements from the samples set forth in its disclosure document, in which event the franchisor must furnish an execution ready copy of that modified agreement to the prospective franchisee at least seven days before the franchisee signs it).
What the Revised Rule does not say in one respect is almost as important as what it does. It does not require franchisors to furnish financial performance representations (historically referred to as “earnings claims”) in their disclosure documents if they elect not to do so. Indeed, as noted above, the Revised Rule permits franchisors to do something currently forbidden—furnish prospective franchisees with franchise cost or operating expense information standing alone even if no financial performance representations are set forth in the disclosure document.
In another striking change, the Revised Rule permits franchisors to furnish their disclosure documents not just to prospective franchisees themselves, but to their “representatives” (attorneys, accountants or other agents).
While the Revised Rule expands upon its protection of prospective franchisees through the increased disclosure requirements detailed above, it also contains a salutary benefit to franchisors—a series of “sophisticated-investor” exemptions from disclosure that did not exist under original Rule (for prospective franchisees which meet certain net worth, investment and/or experience parameters).
As has always been the case, the revised FTC Franchise Rule will not preempt the franchise laws of any state to the extent they afford more disclosure than the Rule requires. Thus, all state registration and disclosure requirements surpassing those of the Revised Rule will survive and continue in effect. However, the “UFOC-plus” elements of the Revised Rule essentially creates a new and preemptive disclosure floor which all franchisors must comply with and which the states will have to require and accept. While many of the more striking features of the Revised Rule—first and foremost “pure” electronic disclosure—have no analogs in extant state franchise laws, it is hoped that the remarkably cooperative and diligent efforts of both the FTC and the franchise-regulating states to harmonize their respective interests in a collegial and effective manner will prompt the states to adopt these Revised Rule features.
The revised FTC Franchise Rule and its accompanying Statement of Basis and Purpose are works of stunning achievement—global in vision; reflecting extraordinary intellect; and, subsuming a remarkable effort to ascertain and, as prudent, incorporate the desires and policy positions both of franchisors who will be regulated by the Revised Rule and franchisees whose interests are protected and advanced thereunder.
