United States: Franchise Sales In The New Millennium

The Federal Trade Commission (FTC), the agency charged with federal regulatory enforcement of franchise sales in America, has just issued a Notice of Proposed Rulemaking with the intention of modifying the disclosure rule (the "Rule"). The Rule is properly known as "Disclosure Requirements and Prohibitions Concerning Franchise and Business Opportunity Ventures," 16 C.F.R. §436, et seq (1979 ). Comments on the proposed revisions will be accepted through December 22, 1999. Rebuttal comments may be submitted on or before January 30, 2000. Subsequently, the Commission will determine whether hearings are required and ultimately will enact a revised Rule, probably in mid-to-late 2000. In the interim, the current Rule remains in effect.

Since the Rule went into effect in October 1979, franchisors selling in the United States have been required to prepare and submit to a prospect a comprehensive disclosure document which contains a proposed franchise agreement and any and all other collateral documents required by the franchisor to establish the franchise relationship. Examples of other collateral documents are subleases, guaranties, restrictive covenants, and lease assignments. The disclosure document contains twenty items, each with multiple subparts. The intention of the FTC is to require franchisors to provide information to prospects so that potential franchisees will be more informed prior to purchasing a franchise. Essentially, the disclosure document, known as an offering circular, contains information relating to the following broad subjects:

1. The franchisor, affiliated, related or predecessor companies. (Emphasis in this disclosure is to identify the businesses that affiliated or related companies are or have been involved with and whether there has been prior franchising history in any of the disclosed businesses.)
2. The business experience of the principals, officers, directors, partners or those who have management responsibility. A five-year work history is required.
3. Litigation and material arbitration.
4. Disclosure of entities or key individuals who have filed for relief under the bankruptcy laws within the previous seven years.
5. The initial fee required to be paid for franchise rights contemplated under the agreement.
6. Recurring, ongoing or occasional fees payable to the franchisor (e.g. royalties, advertising fees, transfer fees).
7. The initial investment required by a franchisee from execution of documents through the first three months of operation, disclosed in chart form. The disclosure is made by the franchisor’s presentation on a high-to-low range for most costs associated with the opening of the business (e.g. construction, acquisition, leasehold improvements, furnishings, equipment, signs, opening inventory, security deposits, advertising, professional fees, working capital).
8. Restrictions on sourcing of products and services – the franchisor must disclose obligatory purchases, restrictions on sourcing from third parties, and any rebates that the franchisor may receive from required suppliers.
9. Franchisee’s obligations – disclosure is made by cross-referencing sections in the offering circular to specific provisions within the proposed franchise agreement.
10. Financing arrangements offered by franchisor, its affiliated or related companies.
11. Franchisor’s obligations - this disclosure is broken down between requirements of the franchisor before the business is opened and those obligations subsequent to the commencement of business. (There is also a requirement to detail training information, including the number of hours of training offered by the franchisor, whether the training is on the job or in a classroom, and who is responsible for the training, and what materials are utilized.)
12. The territory - indicates to prospects whether the territory is protected and, if so, whether that territory is based upon geographical radius, population, or some other formula devised by the franchisor.
13. Intellectual Property - information pertaining to the trademarks, copyrights, patents, and other proprietary information to be licensed, and the status of those assets.
14. Obligation of the franchisee to participate in the operation of the business. If the franchisee must operate the business, that information must be disclosed. If the franchisee can hire a manager to perform the day-to-day operations, the requirements for approval of a manager must be specified.
15. Restrictions on what the franchisee may sell.
16. Renewal, termination, transfer, and dispute resolution. This disclosure is done in chart form, cross-referencing the appropriate sections of the franchise agreement and summarizing conditions within the agreement.
17. The use of public figures – if the franchisor uses public figures in the sales and promotion of its franchises, information related to the contractual nature of the relationship must be disclosed.
18. Earnings claims – if the franchisor chooses to disclose either gross sales or net profits from its franchisees (or in some circumstances, company owned stores), then a specific form of disclosure must be utilized. Disclosure of actual or projected sales results must be contained within the offering circular, and no verbal representations are permitted under federal law.
19. A comprehensive list of franchises by states, indicating transfers, cancellations, nonrenewals and abandonments from the system, including year-end totals for the prior three fiscal years.

The FTC disclosure requirements as specified within the Rule contain a baseline for franchise disclosure promulgated by the federal entity charged with the responsibility of franchise regulation. However, there are several states that require additional registration and merit review prior to authorizing a franchisor to sell or advertise franchises within their jurisdictions. These are California, Hawaii, Illinois, Indiana, Iowa, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, Wisconsin, and are known as "registration states." Certain states require filing fees without any merit review - Florida, Michigan, Texas and Utah. The FTC has ruled that if a state has a more stringent requirement than the federal mandate (i.e. the requirement tends to give more disclosure to a prospective franchisee), then the state regulations supersede federal requirements. State regulations are promulgated by the North American Securities Administrators Association (NASAA). It is unclear whether NASAA will revise their disclosure document so that it contains the identical information as mandated by the FTC.

There are numerous modifications that have been identified by the FTC in this Notice of Proposed Rulemaking. The modifications are the first substantial amendment to the Rule in a generation. Some of the proposed modifications are:

1. The ability to provide disclosure to franchise prospects through the Internet, which is broadly defined to capture communications between computers and computer, television, telephone, facsimile or other communication devices. The Internet disclosure can be accomplished so long as a table of contents is submitted in hard copy to a prospect, and the entire hard copy is given to a prospect upon request.
2. The requirement to use "plain English" in disclosures.
3. The disclosure period and review period are changed to fourteen calendar days before the franchisee signs a binding contract or pays any fee (as opposed to the current requirement which provides disclosure to be made at the earlier of the first personal meeting or ten business days before execution of the contract or payment of franchise fees).
4. More specificity in disclosures regarding the litigation history of the franchisor.
5. More specificity relating to franchisor-mandated site selection criteria and to the nature of the franchisor’s training program.
6. Revised disclosures of the franchisor’s present plans to operate a competing distribution system of similar goods or services to those being franchised at present.
7. Amendment to the "earnings claims" or performance disclosures that a franchisor may choose to make which permit information about the performance of all company or franchised outlets.
8. Substantial revisions to the current disclosure obligations pertaining to the number of franchises and their status over the last three years, e.g., transferred, terminated, repurchased by the franchisor.

The Notice of Proposed Rulemaking, a 150-page document promulgated by the FTC, can be downloaded from the world wide web at www.ftc.gov. Written comments to the FTC can be submitted directly to the Secretary, Federal Trade Commission, Room 159, 600 Pennsylvania Avenue, N.W., Washington, DC 20580, identified as "16 C.F.R. Part 36 – Franchise Rule".