January 28, 2008

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After Nearly 30 Years, FTC Franchise Rule Gets A Makeover!

  FRANCHISE LAW UPDATE:

            Beginning on July 1, 2008, franchisors must comply with the amended Federal Trade Commission ("FTC") rule entitled, "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities" ("Franchise Rule").[1]  The Franchise Rule requires that franchisors provide certain information to potential franchisees for the purpose of evaluating the business and making an informed investment decision.  These required disclosures are contained in a Franchise Disclosure Document ("FDD").  Between July 1, 2007 and July 1, 2008, franchisors may continue to follow the original Franchise Rule[2] or may choose to comply with the amended Franchise Rule.

 The FTC amended the Franchise Rule to account for changes in technology, to attempt to make disclosures required under the Uniform Franchise Offering Circular ("UFOC") Guidelines[3] more uniform among all franchisors, and to provide potential franchisees with additional information concerning the quality of the franchise.  Additionally, the FTC's original Franchise Rule also applied to business opportunities.  Business opportunities include, for example, vending machines and display racks.  In connection with the amendments to the Franchise Rule, business opportunities will be regulated under a separate rule.[4]  The FTC's Franchise Rule does not preempt more rigorous state law.[5]  Therefore, the UFOC was considered the document of choice for the majority of franchisors because it met the requirements of the Franchise Rule and the stricter pre-sale disclosure and registration requirements of those states requiring pre-sale disclosure and/or registration.            

Although, the amended Franchise Rule harmonizes the federal and more rigorous state disclosure requirements, the requirements are not identical.  In response to the amended Franchise Rule, the NASAA released a Franchise Interim Statement of Policy ("Policy") to assist franchisors in the preparation of the required disclosures for states requiring pre-sale disclosure and/or registration.[6]  The NASAA's Policy includes detailed instructions for a Uniform Franchise Disclosure Document ("UFDD").

            In order to meet federal and state law requirements, franchisors must be aware of the significant changes in the amended Franchise Rule.  Prior to July 1, 2008, franchisors should revise their current UFOC or FDD and evaluate alternative methods of delivery for the required information.

Summary of Changes in the Amended Franchise Rule

            Some of the major changes in the amended Franchise Rule include modifications, additions, exclusions or simplifications of timeline and disclosures related to: confidentiality; delivery of the FDD or UFDD; electronic delivery; exemptions from the Franchise Rule; outbound international franchise sales; the parent company; franchise brokers; litigation; suppliers; computer systems; territories; franchisee associations; financial statements; annual revisions; and financial performance representations.

Confidentiality Clauses

            Under the amended Franchise Rule, franchisors must disclose the use of confidentiality clauses that prevent or limit existing or former franchisees from discussing their experiences with prospective franchisees.[7]  This disclosure is intended to allow prospective franchisees to better evaluate whether the information they receive from existing or former franchisees is complete and to determine which current or former franchisees to contact for information about their franchise experience.

Timeline for Delivery

            The FDD must be furnished to prospective franchisees in advance.  Under the original Franchise Rule, franchisors had to provide the required disclosures at the earlier of: (a) the first face-to-face meeting or (b) 10 business days before the execution of the franchise agreement or the payment of any fees in connection with the franchise sale.[8]  The amended Franchise Rule eliminates the first personal meeting trigger.  However, a prospective franchisee may request a copy of the disclosure document earlier in the sales process,[9] and the required disclosures must be provided at least 14 calendar days "before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale."[10]

        The amended Franchise Rule changes the circumstances under which the franchisor must give the prospective franchisee a specified amount of time to review a copy of the complete franchise agreement.  Under the original Franchise Rule, franchisors and brokers had to provide the prospective franchisee with a copy of the completed franchise agreement and related documents at least five business days before the date of execution.[11]  The amended Franchise Rule alters this period to seven calendar days and such contract review period is only mandatory where the franchisor makes unilateral changes to the franchise agreement or a related document.[12]  Therefore, negotiated changes will not trigger any mandatory contract review period, under the amended Franchise Rule.

Electronic Delivery

            The amended Franchise Rule defines accepted methods for delivery of the required disclosures.[13]  Under the amended Franchise Rule the FDD may be hand-delivered, faxed, emailed or otherwise delivered by the required date.  The franchisor can also furnish directions for accessing the document on the Internet by the required date.  The franchisor can also send a paper or electronic copy (for example, CD-ROM) to the address specified by the franchisee by first-class United States mail at least three calendar days before the required date.

Exemptions

            Exemptions are contained in a separate section of the amended Franchise Rule.  All of the exemptions from the original Franchise Rule are included, in addition to some new exemptions.  The following exemptions have been retained:  1) franchise sales under $500; 2) fractional franchises; 3) leased departments; and 4) oral contracts.[14]  The new exemptions provide that the amended Franchise Rule will not apply to franchise sales to: 1) franchisees making an initial investment of more than $1,000,000 (excluding unimproved land and franchisor financing);[15] 2) franchisees with five years of prior business experience and at least $5,000,000 net worth[16] (these two exemptions are collectively referred to as the "sophisticated investor exemptions");[17] or 3) the owners, directors and managers of the entity that becomes the franchisor (this new exemption is referred to as the "insider exemption").[18]

Outbound International Franchise Sales

            The amended Franchise Rule clarifies that the franchisor's obligation to furnish the required disclosures is limited to "the offer or sale of a franchise to be located in the United States of America or its territories."[19]

Parent Company Disclosure; Affiliate Disclosure

            The amended Franchise Rule expressly defines the term "parent" as "an entity that controls another entity directly, or indirectly through one or more subsidiaries."[20]  The franchisor must identify any parent companies in the FDD.  Under the amended Franchise Rule, parent or affiliate related litigation must also be disclosed where the parent or affiliate "guarantees the performance of the franchisor."[21]  Litigation involving an affiliate offering franchises under the franchisor's principal trademark must also be disclosed.[22]

No Broker Disclosure    

            The amended Franchise Rule does not require the disclosure of franchise brokers.  However, brokers remain subject to the prohibitions of the amended Franchise Rule.  Thus, broker liability for false statements is not eliminated.

Expanded Litigation Disclosure         

            The amended Franchise Rule requires franchisors to disclose franchisor-initiated litigation against franchisees pertaining to the franchise relationship.[23]  This disclosure is limited to suits filed in the previous one-year period.

Suppliers

        Franchisors must disclose any supplier in which an officer of the franchisor owns an interest.[24]

Computer Systems

            The amended Franchise Rule simplifies disclosures concerning required computer equipment.  Franchisors must provide a general description of the required use of computers and electronic cash registers;[25] however, franchisors will not be required to specifically identify each and every piece of hardware and software.[26]

Territory

            To address new technologies, the amended Franchise Rule requires additional information about protected territories.  The franchisors must disclose "whether the franchisor or an affiliate has used or reserves the right to use other channels of distribution, such as the Internet, catalog sales, telemarketing, or other direct marketing sales, to make sales within the franchisee's territory using the franchisor's principal trademarks."[27]

Franchisee Associations

The amended Franchise Rule requires additional information about trademark-specific franchisee associations.  The franchisor must disclose specific information listed in the amended Franchise Rule concerning any association created, sponsored or endorsed by the franchisor.[28]  In the case of independent franchisee associations the same identifying information must be included if the association is incorporated or otherwise organized under state laws and the association asks the franchiser, no later than 60 days after the close of the franchisor's fiscal year, to be included in the disclosures.[29]

Summary of Outlets

            The amended Franchise Rule streamlines the franchisee outlet disclosures to eliminate duplication of some outlets by using new categories for the outlet disclosure tables.  This item of the FDD contains five separate tables that contain data concerning how many franchises were terminated, sold or transferred in the last three years.[30]

Financial Statements

            The amended Franchise Rule retains the phase-in of audited financial statements for certain franchisors to provide franchisors with some flexibility.[31]  Generally, franchisors must include three years of audited financial statements prepared according to generally accepted accounting principals.[32]  The amended Franchise Rule allows the use of any accounting standards recognized by the Securities and Exchange Commission.[33]

Annual Revisions

            Under the amended Franchise Rule, annual revisions to the FDD must be made within 120 days after the close of the franchisor's fiscal year.[34]  This time period was expanded from 90 days because many franchisors had difficulty with obtaining audited financial statements within the 90 day period.[35]  The FTC reconciles the difference between 90 and 120 days by requiring that the franchisor's annual update include the first quarterly update.[36]  Quarterly updates for material changes must still be made within a reasonable time after close of the quarter.[37]

Financial Performance Representations

Financial performance representations, also known as "earnings claims" under the original Franchise Rule, may be included in the FDD.[38]  If the franchisor elects to include financial performance representations, they must appear in the text of the FDD and cannot be attached in a separate document.  Under the amended Franchise Rule, the inclusion of financial performance representations triggers disclosure and substantiation requirements.[39]  The amended Franchise Rule requires the inclusion of certain standard language prior to the financial performance representations.[40]

If you have any questions or require further information regarding franchise matters, please contact Jessica Benford (jbenford@rcalaw.com) or Renee Mitchell (rmitchell@rcalaw.com).

[1] Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities; Final Rule, 72 Fed. Reg. 15444 (March 30, 2007) (to be codified at 16 C.F.R. pts. 436 and 437).

[2] The FTC's initial Franchise Rule was promulgated in 1978.  See 43 Fed. Reg. 59614 (December 21, 1978).

[3] The North American Securities Administrators Association ("NASAA") created the UFOC Guidelines for use in states requiring pre-sale disclosure and/or registration in connection with the sale of a franchise.

See www.nasaa.org/content/Files/ UniformFranchiseOfferingCircular.doc.

[4] Supra nt. 1.

[5] Id.

[6] See www.nasaa.org/industry___regulatory_ resources/uniform_forms/3697.cfm.

[7] 72 Fed. Reg. at 15544; see section 436.1(c) of the amended Franchise Rule.

[8] See 16 C.F.R. §§ 436.1(a), 436.2(g) and 436.2(o).

[9] 72 Fed. Reg. at 15561; see section 436.9(e) of the amended Franchise Rule.

[10] 72 Fed. Reg. at 15545; see section 436.2(a) of the amended Franchise Rule.

[11] See 16 C.F.R. § 436.1(g).

[12] 72 Fed. Reg. at 15545; see section 436.2(b) of the amended Franchise Rule.

[13] 72 Fed. Reg. at 15545; see section 436.2(c) of the amended Franchise Rule.

[14] See 16 C.F.R. § 436.2.

[15] 72 Fed. Reg. at 15560; see section 436.8(a)(5)(i) of the amended Franchise Rule.

[16] 72 Fed. Reg. at 15560; see section 436.8 (a)(5)(ii) of the amended Franchise Rule.

[17] Supra nt. 1, p. 15522.

[18] 72 Fed. Reg.  at 15560; see section 436.8 (a)(6).

[19] 72 Fed. Reg. at 15545; see section 436.2 of the amended Franchise Rule.

[20] 72 Fed. Reg. at 15545; see section 436.1(m) of the amended Franchise Rule.

[21] 72 Fed. Reg. 15546-47; see section 436.5(c) of the amended Franchise Rule.

[22] Id.

[23] Id.

[24] 72 Fed. Reg. at 15548; see section 436.5(h) of the amended Franchise Rule.

[25] 72 Fed. Reg. 15550-51; see section 436.5(k) of the amended Franchise Rule.

[26] See supra nt. 1, p. 15490.

[27] 72 Fed. Reg. 15551-52; see section 436.5(l) of the amended Franchise Rule.

[28] 72 Fed. Reg. at 15559; see section 436.5(t)(8) of the amended Franchise Rule.

[29] Id.

[30] 72 Fed. Reg. 15555-59; see section 436.5(t) of the amended Franchise Rule.

[31] See supra nt. 1, p. 15509-12.

[32] 72 Fed. Reg. at 15559; see section 436.5(u) of the amended Franchise Rule.

[33] Id.; cf. Acceptance from Foreign Private Issuers of Financial Statements Prepared in Accordance with International Financial Reporting Standards without Reconciliation to U.S. GAAP, Securities Act Release No. 33-8879 (December 21, 2007).

[34] 72 Fed. Reg. at 15560; see section 436.7(a) of the amended Franchise Rule.

[35] See supra nt. 1, p. 15518.

[36] See supra nt. 1, p. 15519.

[37] See supra nt. 34.

[38] 72 Fed. Reg. 15544, 15554-55; see sections 436.1(e), 436.5(s) of the amended Franchise Rule.

[39] 72 Fed. Reg. 15554-55; see section 436.5(s) of the amended Franchise Rule.

[40] Id.

 

 

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