Amendments to the Federal Trade Commission Franchising Rule (Rule) approved early this year significantly improve the position of franchisors seeking to expand into the USA.
The amendments to the Rule, originally promulgated in 1978, will be introduced progressively with voluntary compliance from 1 July 2007 until 1 July 2008 when compliance becomes mandatory.
The amendments will reduce the costs associated with initial marketing to prospective franchisees and the preparation of financial statements and other aspects of the disclosure documentation.
Removal of the requirement to provide a disclosure document
One of the most significant amendments is the removal of the requirement to provide a disclosure document or Uniform Franchise Offering Circular (UFOC) at the earlier of the ‘first personal meeting’ with the franchisee or 10 business days before the receipt of any money or the execution of an agreement.
The UFOC must include a copy of the standard franchise agreement to be used and the past three years financial statements of the franchisor prepared in accordance with compliant auditing standards. The difficulty with this provision for overseas franchisors was that in order to market to prospective franchisees in the USA they would need to make a significant investment in having their final form UFOC prepared in advance. Otherwise they would be incapable of providing this documentation on first contact with prospective franchisees.
The amended Rule provides that the UFOC need not be provided until 14 days prior to the receipt of any money or the execution of an agreement. This amendment permits overseas franchisors to market to and line up a number of potential franchisees before deciding whether to incur the significant legal and accounting fees associated with preparation of the UFOC.
Audited financials requirement relaxed
The amended Rule has also relaxed the previous requirement that the audited financials to be provided with the UFOC must be prepared in accordance with the US Generally Accepted Auditing Standards. Foreign franchisors may now use financials prepared in accordance with their national Generally Accepted Accounting Principles if this also satisfies the US Securities and Exchange Commission’s (SEC) requirements regarding financial statements disclosed by foreign companies when offering securities on US exchanges.
However, since the SEC currently requires a reconciliation of any significant variations to the US standards, Australian franchisors will still incur some cost in having an accountant ensure that their financials conform with this requirement.
Greater flexibility in negotiation process
Under the original Rule the final form of the franchise agreement had to be provided to the franchisee five days before execution. This has been amended such that the terms of the agreement can be amended up until execution unless the franchisor unilaterally makes a change, in which case seven calendar days notice must be provided before the agreement can be entered into. This amendment will create greater flexibility in the negotiation process and benefit both foreign and US franchisors.
Electronic disclosure provision
Another amendment of particular benefit to overseas operators is that the Rule now expressly provides for electronic disclosure (eg by email) and execution (eg by passwords or electronic signatures). This amendment makes it clear that a hard copy UFOC need not be provided.
Replacement of computer hardware and software disclosure obligation
A more general disclosure obligation has replaced that relating to the computer system hardware and software that franchisees will be required to use in their businesses. Previously, the franchisor was required to specify the brand, type and function of each component as well as listing approved compatible equivalents.
Exemptions to application of the Rule
The amendments introduce three exemptions to application of the Rule. Sales of franchises to the following ‘sophisticated investors’ do not require disclosure at all:
- Franchisees making a total initial investment of at least US$1 million, excluding unimproved land and funds loaned by the franchisor.
- Sales to franchisees with a net worth of at least US$5 million and at least five years business experience.
- Sales to officers, owners or managers employed by the franchisor for at least two years prior to the sale.
Possible increase to compliance costs
It should be noted that not all of the amendments to the Rule benefit franchisors and some increased compliance costs may be incurred in relation to the following amendments:
- Disclosure as to relevant history of any parent company of the franchisor, including any bankruptcy proceedings or other litigation is now required.
- The disclosure requirements in relation to the nature of past litigation involving the franchisor have been expanded.
- The franchisor must disclose whether its franchisees will be restricted in the avenues that they may use for marketing (eg internet) and whether the franchisor reserves any right to continue using these marketing channels.
- Franchisors must disclose whether they have used confidentiality clauses to restrain existing or former franchisees from discussing their experiences with the system with prospective franchisees.
- Franchisors must disclose if any of their officers have an interest in any approved supplier.
After nearly three decades, the recent amendments to the US franchising disclosure requirements were well overdue. The amendments, particularly that to the ‘first personal meeting’ requirement, remove significant barriers faced by foreign franchisors considering expanding their franchise systems into the USA. Though the amendments make this move more attractive, franchisors should bear in mind that some state-specific franchise sales laws will continue to apply in a number of US states and that local advice should be sought as to compliance with these laws as well as the amended Rule.
Phillips Fox has changed its name to DLA Phillips Fox because the firm entered into an exclusive alliance with DLA Piper, one of the largest legal services organisations in the world. We will retain our offices in every major commercial centre in Australia and New Zealand, with no operational change to your relationship with the firm. DLA Phillips Fox can now take your business one step further − by connecting you to a global network of legal experience, talent and knowledge.
This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.