Disclosure Basics Under Federal and State Franchise Laws

Transcription

1 International Franchise Association 46 th Annual Legal Symposium May 5-7, 2013 JW Marriott Hotel, Washington, DC Disclosure Basics Under Federal and State Franchise Laws Lauren Fernandez FOCUS Brands Atlanta, Georgia Timothy O Brien* Virginia State Corporation Commission Richmond, Virginia Felicia N. Soler Kaufmann Gildin Robbins & Oppenheim, LLP New York, New York *The opinions expressed by Mr. O Brien in this paper and during the oral presentation are his own and do not necessarily represent the views of the Virginia State Corporation Commission or NASAA.

2 TABLE OF CONTENTS I. INTRODUCTION... 1 II. DISCLOSURE UNDER FEDERAL LAW... 1 A. Introduction To The FTC Franchise Rule... 1 B. To Whom Must Disclosure Be Effected?... 1 C. What Must Be Delivered?... 2 D. When Must Disclosure Be Effected? E. How Must Disclosure Be Made? F. Duty To Amend The FDD G. FTC Revised Franchise Rule Exemptions H. Penalties For Noncompliance III. DISCLOSURE UNDER STATE LAWS A. History Of The State Registration/Disclosure Laws B. To Whom Must Disclosure Be Effected? C. What Must be delivered? D. When Must Disclosure Be Effected? E. How Must Disclosure Be Made? F. Duty To Amend The FDD G. Typical Disclosure Issues Raised By State Examiners H. Exemptions From State Disclosure Requirements I. State Penalties for Noncompliance IV. CONCLUSION i

3 I. INTRODUCTION It was almost immediately after franchising came of age in the late 1950's and the decade of the 60's that the criminal community including organized crime began perpetrating deceit and fraud on victims who believed they were investing their money to become franchisees of legitimate businesses. Instead, those unsuspecting victims were purchasing phantom, non-existent franchises. To eradicate that fraud and criminality, the first franchise-specific law of any kind was enacted by the state of California in And since that time, fourteen more states and the Federal Trade Commission ( FTC ) have followed suit, each enacting their own franchise-specific law requiring franchisors to prepare and disclose prospective franchisees with a franchise disclosure document ( FDD ). This paper focuses on the disclosure requirements of the federal FTC Franchise Rule and the fifteen states featuring their own franchise-specific disclosure laws. 1 Although fourteen of those fifteen states also require franchisors to file an application or notice with the state before offering or selling franchises in the state, giving them the name registration/disclosure states, that registration process will not be addressed in this paper. II. DISCLOSURE UNDER FEDERAL LAW A. Introduction To The FTC Franchise Rule In 1978, seven years after the state of California enacted the first franchise-specific law, the FTC promulgated what is colloquially referred to as the FTC Franchise Rule, 2 the first, and to this day only, franchise-specific law at the federal level. Governing alongside, and not preempting, state franchise registration/disclosure statutes, the FTC Franchise Rule would apply to franchise sales activity throughout the United States, its territories and possessions. The FTC Franchise Rule remained unchanged for many years following its adoption. Then, in 1995, the FTC initiated a regulatory review of the FTC Franchise Rule, seeking to improve the Rule to respond to the massive economic, societal and technological changes which had transpired since its enactment. Following 12 years of extensive public hearings and workshops, the FTC comprehensively revised the FTC Franchise Rule on January 22, Accompanying the 2007 revisions to the FTC Franchise Rule was the Commission s Statement of Basis and Purpose 4 (referred to hereafter as the SBP ), which serves to amplify and clarify the revised FTC Franchise Rule s requirements and prohibitions. B. To Whom Must Disclosure Be Effected? The 2007 revisions to the FTC Franchise Rule significantly changed the landscape of franchise disclosure protocol which had subsisted since California enacted the first franchise registration/disclosure statute in Since that time, franchisors had been 1

4 required both under the FTC Franchise Rule and under every state franchise law to furnish their disclosure documents directly to the prospective franchisee. However, the 2007 revisions to the FTC Franchise Rule dramatically changed this platform by permitting a franchisor to effect disclosure upon a franchisee s representative in lieu of the prospective franchisee himself/herself/itself. Indeed the FTC Franchise Rule accomplishes this by including in the definition of a prospective franchisee any agent, representative or employee of the prospective franchisee. 5 The SBP explains the rationale behind the change: Indeed, in some instances a prospective franchisee may be a corporation or other entity, not an individual. Thus, delivery in such circumstances can only be made upon a representative. Even individuals may wish to have their attorney or other agent receive the disclosures on their behalf, and the Rule should accommodate that possibility. 6 A few questions have arisen in connection with this expanded approach. For example, if an agent, representative or employee of the prospective franchisee instead of the prospective franchisee itself is disclosed, who may confirm receipt of the FDD? Can it be just the individual who was disclosed and not the prospective franchisee himself/herself/itself? The answer appears to be yes under the above-quoted provisions of the SBP. C. What Must Be Delivered? Under the FTC Franchise Rule, a franchisor must, as under state franchise registration/disclosure laws, prepare and disseminate to prospective franchisees an FDD containing all material information necessary for them to make informed investment decisions. Unlike the state franchise law protocol, however, no registration of the franchisor, or prior review and approval of its FDD by the FTC, is required by the FTC Franchise Rule. The FTC Franchise Rule s disclosure requirements create a disclosure floor which all franchisors have to comply with nationwide and which all franchise regulating states must accept. The FDD consists of required federal and state cover pages and 23 substantive Items, each of which seeks to elicit material information pertaining to a particular subject or a related group of subjects. 7 The first page of the FDD must be the FTC Franchise Rule cover page, which sets forth the franchisor s name, type of business organization, principal business address, telephone number, address, primary homepage address and a sample of the primary business trademark or service mark that franchisees will use in their businesses. A brief description of the franchised business follows. Then appear disclosures regarding the total investment necessary to begin operation of the subject franchise. Standard disclosure language follows next: the requirement that the franchisor furnish its FDD to the prospective franchisee at least 14 calendar days before the franchisee signs any binding agreement with, or makes any payment to, the franchisor or its affiliate; the fact that the terms of the franchise agreement itself, and not the FDD, will govern the franchise relationship; a suggestion that the prospective 2

5 franchisee review the FDD and franchise agreement with an advisor, such as an attorney or an accountant; and, information sources which prospective franchisees can access to obtain more information on franchising. The FTC Franchise Rule permits franchisors to state on their FTC Franchise Rule cover pages any alternative formats which those franchisors make available for their franchisees to review FDDs (paper, e- mail, web access CD-ROM, etc.). Finally, the FTC Franchise Rule cover page must identify the FDD s Issuance Date, which is an arbitrary date selected by the franchisor and is usually the date that the subject FDD is finalized and/or put into use. Following this FTC Franchise Rule cover page is the state cover page required by all franchise registration/disclosure states. (see discussion in Section III.C. of this paper below for a summary of the contents of the state cover page). The FDD then presents the substantive disclosures required by the FTC Franchise Rule and non-preempted state franchise registration/disclosure law provisions in a series of 23 Items. The first four FDD Items relate to the business of the franchising company itself, the principals of that company and the backgrounds of both. Accordingly, in Item 1 of the FDD is information pertaining to the identity and business form of the franchisor (e.g. corporation, partnership, proprietorship or other business organization); the franchisor's principal business address; the name and address of any corporate parent or affiliate (if that affiliate either offers franchises in any line of business or provides products or services to the franchisees of the franchisor); whether the franchisor has any "predecessors" (i.e. other entities from whom the franchisor acquired the majority of its assets); a description of the franchisor's business; and, a description of the franchises offered by the franchisor. Also in Item 1 is a detailed description of the prior business experience of the franchisor, including the length of time it has conducted a business of the type to be franchised; the length of time the franchisor has offered franchises for sale; and, whether the franchisor has offered franchises in other lines of businesses. Finally, franchisors must disclose in Item 1 any laws or regulations specific to the operation of their franchises (as distinct from those applicable to business in general) and a general description of the competition franchisees will encounter. In Item 2, franchisors must set forth the names, positions and titles of their officers, directors, and other principals and executives who have management responsibility, including their principal occupations and employers over the past five years. Item 3 of the FDD sets forth information regarding the pertinent criminal and civil litigation history of both the franchisor; its officers, directors and other principals; and, if applicable, its parents and affiliates (if they guarantee the franchisor s performance, have themselves offered franchises under the franchisor s principal mark or have had government litigation commenced against them). These required litigation disclosures include whether the franchisor or its officers, directors and other principals have pending against them any administrative, criminal or material civil actions alleging a violation of franchise, antitrust, or securities law or alleging fraud, unfair or deceptive practices, or 3

6 comparable allegations; civil actions (other than ordinary routine litigation incidental to the business) which are material in the context of the number of franchisees and the size, nature or financial condition of the franchise system; and whether, in the ten year period immediately prior to the FDD s issuance date, the franchisor or any of its officers, directors or other principals has been convicted of a felony or been held liable in a civil action involving allegations of franchise, antitrust or securities law violations or allegations of fraud, unfair or deceptive practices (or comparable allegations). The FDD must provide the following information for cases that are required to be included in Item 3: the case title; case number or citation; the initial filing date; the names of the parties; the forum; the relationship of the opposing party to the franchisor; a summary of the legal and factual nature of each claim in the action; the relief sought or obtained; if the action is pending, the status of the action; and any conclusions of law or fact. Included in the litigation which must be disclosed in Item 3 is material litigation commenced by the franchisor against its franchisees involving the franchise relationship during the prior fiscal year (excluding actions or proceedings involving suppliers or other third parties, or indemnification for tort liability). The FTC has noted that materiality is to be determined from the viewpoint of a reasonable prospective franchisee and that the requirement to disclose franchisor-initiated litigation is to be interpreted broadly to cover most suits. In an effort to relieve this disclosure burden on franchisors, the FTC Franchise Rule permits the grouping of all such actions or proceedings against franchisees under common headings with only the applicable case names, courts and file numbers listed, as opposed to more extensive case summaries. For example, a franchisor which initiated five royalty collection suits during its preceding fiscal year could satisfy its disclosure obligation by listing the aforementioned information concerning each such suit under the heading Royalty Collection Suits, without the need to provide any additional explanation or elaboration. In Item 4 of the FDD, the franchisor is required to disclose any bankruptcy history of the franchisor, its officers, directors, partners, managers, affiliates and predecessors. Having addresses the franchisor-related disclosures, the FDD then turns its attention to just what monies a franchisee has to spend in order to acquire and commence operation of the franchise in question. These are particularly crucial disclosures for prospective franchisees. In Item 5 of the FDD, a franchisor must disclose its initial fees and any conditions under which those fees are refundable. If initial fees are not uniform, the franchisor must disclose the range or formula used to calculate the initial fees which it received in the fiscal year before the issuance date of the FDD, and the factors that determined this amount. Initial fees means all fees and payments, or commitments to pay, for services or goods received from the franchisor or any affiliate before the franchisee s business opens, most certainly including any initial franchise fee or equivalent which a franchisee must pay in consideration of the franchisor s execution of the franchise agreement. 4

7 In Item 6 of the FDD, franchisors must disclose in a table all of the additional fees that the franchisee must pay to the franchisor or its affiliates, or that the franchisor or its affiliates impose or collect in whole or in part for a third party, throughout the term of the franchise relationship. This requires disclosure of fees such as royalties; service fees; advertising fees; training fees; lease payments; and, product purchase charges. With respect to each such fee or payment, the time for payment must be specified; whether the fees are uniformly imposed must be disclosed; the formula used to compute such fee or payment (if applicable) must be set forth; and, the franchisor must state whether any such fee or payment is refundable, in whole or in part, and if so, under what circumstances. Franchisors must also disclose in Item 6 the voting power of any franchisor-owned units on any fees or charges imposed by cooperatives in which such units participate (advertising cooperatives, purchasing cooperatives and so forth). If franchisor-owned units will have controlling voting power over such cooperatives, then the franchisor must disclose the maximum and minimum fees that may be imposed by such entities. If any of the foregoing fees may increase, then the franchisor must disclose the formula that determines the increase or the maximum amount of the increase. The title and column headings of the Item 6 table are proscribed by the FTC Franchise Rule and should be prepared in exact accordance therewith. The types of fees disclosed in the first column of the table, however, should be customized for the particular FDD. The following table is an example of an Item 6 table prepared in accordance with the requirements of the FTC Franchise Rule: ITEM 6 OTHER FEES (1) (2) (3) (4) Type of fee Amount Due Date Remarks Continuing Royalty 5% of Gross We electronically Gross Revenues Revenues debit your bank includes all account on the first revenues from the Thursday of every franchised month, based on Business. your weekly sales reports for the month. Advertising Fee 2% of Gross We electronically Revenues debit your bank account on the first Thursday of every month, based on your weekly sales reports for the month. Payments for When we or affiliate We and our 5

8 Products and Services You Buy from Us or Affiliates require. affiliates may serve as non-exclusive Approved Suppliers. If you choose to buy from us or affiliates, you must pay the prices we or our affiliates set. In Item 7 of the FDD, franchisors have to describe in detail all payments which their franchisees have to expend in order to fulfill their initial investment requirements. In tabular form, the franchisor must disclose information about all "pre-opening" expenditure obligations, including the initial franchise fee itself; the cost of purchasing or leasing the franchised business' premises; construction and other "build out" costs; equipment; inventory; advertising; training; signs; working capital; legal and accounting fees; security deposits; insurance payments; and, utility bills. With regard to each of these categories of expenditures, franchisors must specify when and to whom such payments are going to be made, how such payments are determined, and whether part or all of any such payment is refundable. Also included in the Item 7 table are any additional funds that must be spent for other required expenses the franchisee will incur during the initial period of operations. The FTC Franchise Rule defines a reasonable initial period as at least three months or a reasonable period for the applicable industry. If all or any part of a franchisee's initial investment will or may be financed by the franchisor, then the down payment required, the estimated effective annual interest rate imposed and the estimated loan repayment schedule itself must be specified. Like the Item 6 table, the title and column headings of the Item 7 table are proscribed by the FTC Franchise Rule and should be prepared in exact accordance therewith. The types of expenditures disclosed in the first column of the table, however, should be customized for the particular FDD. The following table is an example of an Item 7 table prepared in accordance with the requirements of the FTC Franchise Rule: ITEM 7 ESTIMATED INITIAL INVESTMENT YOUR ESTIMATED INITIAL INVESTMENT (1) Type of expenditure (2) Amount Initial Franchise Fee $12,000 - $30,000 Real Property See Note 2 (3) Method of payment Lump Sum (4) When due At signing of Franchise Agreement (See Note 1) (5) To whom payment is to be made Us 6

9 Construction/Remodeling/ Leasehold Improvement 0 - $200,000 See Note 3 Inventory (yard signs, riders, etc.) $5,000 - $20,000 Office Equipment & 0 - $70,000 Supplies;Decor, Fixtures See Note 4 & Furnishings Computer Hardware And 0 - $12,500 Software See Note 5 Signs 0 - $20,000 See Note 6 Additional Funds $50,000 - (3 Months) $90,000 See Note 7 Total. $67,000 - $442,500 As contractor or landlord requires Lump sum As seller requires As seller requires As seller requires As expenses occur As contractor or landlord requires When incurred As supplier requires As supplier requires As supplier requires Payroll weekly, other purchases Contractor or landlord Seller Seller Seller Seller Employees, sellers of goods and services Item 8 of the FDD provides information pertaining to the obligation of a franchisee to purchase goods, services or equipment from the franchisor and/or designated third parties. If a franchisee has to purchase or lease goods, services, supplies, equipment or real estate from the franchisor or its designee, the details of those transactions must be set forth in Item 8. If a franchisee has to purchase such goods, services, supplies and/or equipment from third parties, either from suppliers approved by the franchisor or in accordance with specifications issued by the franchisor, then the details of those transactions also must be set forth in Item 8. A franchisor must also disclose if an officer of the franchisor owns a material interest in a supplier with whom franchisees will (or may) deal with. Further, a franchisor must disclose in Item 8 whether it (or any of its affiliates) may or will derive revenue or other consideration from required purchases or leases by its franchisees and, if so, the precise basis by which the franchisor or its affiliates may or will derive such revenue. In such circumstance, the franchisor must disclose its total revenues (derived from its most recent annual audited financial statements); its revenues from all required purchases and leases of products and services; and, the percentage of the franchisor s total revenues derived from such required purchases or leases (with parallel disclosure required if it is the franchisor s affiliate which is receiving revenues based on franchisee purchases of goods or services). In all circumstances, the franchisor must disclose the estimated proportion which the franchisee s required purchases and leases (from designated sources and/or approved suppliers) bear to the entirety of purchases and leases by the franchisee of goods and services required to establish and operate the franchised business. If a purchasing or distribution cooperative exists in the subject franchise network, this fact must be disclosed in Item 8. Critically, if a designated supplier will make payments to the franchisor as a result of franchisee purchases from that supplier, the precise amount of that payment (percentage or flat amount) must be disclosed - - as must any circumstance in which a 7

10 franchisor provides material benefits to a franchisee based on that franchisee s purchase or particular products or services or the use of particular suppliers. Lastly, if the franchisor negotiates purchase agreements with suppliers for the benefit of franchisees, this circumstance must also be conveyed in Item 8. Item 9 of the FDD requires a franchisor to set forth, in a table cross-referencing the applicable provisions of the subject franchise agreement and FDD, all of the principal obligations which a franchisee must assume and discharge under the franchise agreement (and any franchise-related agreements), including: site selection and acquisition; pre-opening purchases and leases; site development; training; time within which the franchised unit must be opened; compliance with the franchisor's standards and policies; restrictions on products or services which may be offered from the franchised unit; warranty and other customer service requirements; territorial development and sales quotas; ongoing product or service purchase requirements; insurance; advertising; covenants not to compete; franchise transfer restrictions; renewal; and, obligations which the franchisee must assume following the expiration or termination of the franchise. Item 10 requires disclosure of any financing arrangements that a franchisor, its agent and/or affiliates offer directly or indirectly to a franchisee. The terms of each financing arrangement must be set forth in the FDD, including, among other pieces of information: the identity of the lender providing the financing and its relationship to the franchisor; the amount of financing offered or, if the amount depends on an actual cost that may vary, the percentage of the cost that will be financed; the annual percentage rate of interest charged; and whether the debt can be prepaid and the nature of any prepayment penalty. A franchisor offering financing must also annex specimen copies of any and all standard financing documents. The next series of Items in the FDD describes the franchise relationship itself -- who gives and who gets what throughout the term of the franchise. In Item 11, franchisors must disclose in detail all of the obligations which they will fulfill both prior to the opening of the franchised business and thereafter during the operation of that business, including: selecting, leasing or approving the premises of the franchised business; "building out" or otherwise developing the premises; purchasing, leasing or specifying equipment for the franchised business; furnishing sources of supply and/or specifications for goods and services used in the operation of the franchised unit; installing signs and fixtures at the business location; furnishing opening inventory, supplies and related materials; training the franchisee; establishing prices; engaging in advertising activities; establishing and maintaining administrative, bookkeeping, accounting, inventory control or other general operating procedures; and, describing in detail the franchisor's utilization of an operating manual to assist franchisees and their employees in the operation of the franchised business. The franchisor must also describe the requirements for franchised unit computerization. 8

11 A franchisor must also set forth extensive disclosures in Item 11 regarding its advertising programs and to what extent the franchisor is obliged to conduct advertising. These disclosures must include specifications regarding media the franchisor may use; whether media coverage is local, regional or national; the source of advertising (for example, an in-house advertising department or an outside advertising agency); whether the franchisor must spend any amount on advertising in the area or territory where the franchised unit is located; the circumstances under which franchisees will be permitted to use their own advertising materials; whether there is an advertising council composed of franchisees that advises the franchisor on advertising policies (and, if so, details regarding how members of the council are selected, whether it has any decisionmaking power and whether the franchisor has the power to form, change or dissolve the advertising council); whether the franchisee must participate in local or regional advertising cooperatives (including detailed disclosures regarding how those cooperatives are composed and administered); whether franchisor-owned outlets must contribute to the advertising fund; who administers the advertising fund; whether the fund is audited or not; whether the financial statements of the advertising fund will be available for review by franchisees; and, how advertising funds were used in the most recently concluded fiscal year. Site selection requirements and approval procedures also have to be addressed in Item 11, as must the typical length of time between the signing of the franchise agreement and the opening of the franchised business. Finally, Item 11 calls for a full and detailed description of the franchisor's training programs and the individuals who are in charge of those programs, including the location, duration and content of such programs; when training will be conducted; the experience of the franchisor's training instructors; any training-related charges which must be borne by franchisees; and, whether additional training programs and/refresher programs will be offered in the future. Item 12 of the FDD provides information relating to the territorial rights (if any) which will be accorded to franchisees under the franchise agreement. If such territorial rights are conferred, then the typical boundaries of a territory must be described in Item 12 (i.e. city, metropolitan area, county, state, radius of specific distance, population, number of registered vehicles or other variant); the rights of the franchisor to itself conduct business within that territory (by means of additional units, the internet, 800 telephone sales, catalogues or otherwise) must be discussed; the restrictions or rights of the franchisor or others to "invade" that territory must be specified; relocation rights must be addressed; and, the degree to which a franchisee will be restricted from soliciting sales or accepting orders from outside of its defined territory must be specified. If the franchisee's territorial rights are conditioned upon it satisfying sales quotas or other measures of market penetration, or if other circumstances or contingencies will permit the franchisor to modify a franchisee's territorial rights, then these must also be described in detail in Item 12. If no territorial rights are conferred upon the franchisee, then a special warning is required by the FTC Franchise Rule: You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control. 9

12 In Items 13 and 14 of the FDD, all pertinent information concerning the franchisor's trademarks, service marks, tradenames, commercial symbols, copyrights and patents must be disclosed, including whether they are registered (or pending); whether they are disputed; the extent to which the franchisor will protect its franchisees' rights to use those names, marks, patents and copyrights; whether any infringing uses are actually known to the franchisor which could materially affect a franchisee's use thereof; and, a description of any relevant litigation concerning those names, marks, patents and copyrights. If the franchisor has no federally registered trademark, then the following warning must appear in Item 13: We do not have a federal registration for our principal trademark. Therefore, our trademark does not have many legal benefits and rights as a federally registered trademark. If our right to use the trademark is challenged, you may have to change to an alternative trademark, which may increase your expenses. Item 15 addresses the obligation of a franchisee to participate personally in the direct operation of the franchised business. If the franchisee is an individual, then Item 15 will inform that individual whether the franchised business must be under his direct onpremises supervision or whether the franchisee can, alternatively, hire a manager to conduct the on-premises supervision of that business. If the franchisee is a corporation or partnership, then the franchisor is required to identify who must conduct the onpremises management of the franchised business. FDD Item 16 addresses the issue of whether the franchise agreement places any restrictions on franchisees concerning the customers with whom they may deal, or the goods and services which they may offer for sale. Accordingly, you will find in Item 16 a description of any obligation imposed upon franchisees to sell or provide only those goods and services approved by the franchisor; the effect of such restrictions on the franchisees' right to sell or provide other goods or services; a description of any obligation pursuant to which franchisees must sell or provide all (and not just some) of the goods and services authorized by the franchisor; information concerning whether franchisees are restricted as to the customers to whom they may sell their goods and services; and, the extent to which the franchisor has the right to change the types of authorized goods and services which its franchisees may/must sell. Having already introduced the prospective franchisee to the franchisor and its principals; informed it of the payments and investments required to establish a franchised business; and, described in detail the nature of the franchise relationship once that business has been opened, the FDD turns its attention to subjects of critical importance - - the term of the franchise relationship; the ability of a franchisee to renew that relationship; the ability of a franchisor to terminate that relationship; whether franchisees are free to sell their franchises to third parties; applicable covenants not to compete; and, dispute resolution. In Item 17 of its FDD, a franchisor is required to include a table, cross-referencing the applicable provisions of its franchise agreement, which addresses: the length of the initial franchise term; the length of any renewal or extension term; any requirements that a franchisee must fulfill in order to renew or extend its franchise agreement; under what 10

13 circumstances either the franchisor or franchisee may terminate the franchise agreement; what obligations the franchisee must discharge following termination of its franchise agreement; whether the franchisor may sell or assign the franchise agreement; whether sale or assignment of the subject franchise by the franchisee is freely permitted, subject to prerequisites being fulfilled or altogether prohibited (including details regarding any franchisor rights of first refusal or approval concerning any such franchisee sale or transfer); what will transpire upon the death or disability of the franchisee (or, if a business entity, the individuals who manage the franchise on a dayto-day basis); a description of all covenants not to compete which bind the franchisee both during the term of the franchise and following its termination or expiration; whether and under what circumstance the franchise agreement may be modified; the terms and effect of any franchise agreement merger/integration clause (note that the revised FTC Franchise Rule specifically forbids franchisors from disclaiming the contents of their FDDs through any such merger/integration clause); whether franchisor-franchisee disputes are to be resolved by arbitration or mediation; where disputes will be litigated or arbitrated ( forum selection ); and, under what body of law franchisor-franchisee disputes will be decided ( choice of law ). Item 18 of the FDD requires a franchisor to disclose whether or not any "public figure" is associated with the franchise chain and, if so, if that public figure is being compensated. Item 19 addresses the all important subject of financial performance representations. A financial performance representation is any information which a franchisor seeks to impart to prospective franchisees which states, suggests or implies what sales, income or profits a franchisee can derive from the operation of a franchised business. Financial performance representations come in two varieties: a description of the past financial performance of franchised or nonfranchised units and a projection of the future performance of those units. So it is that, with the limited exception of imparting financial performance representations limited solely to the actual operating results of a specific unit being offered for sale, any and all information which a franchisor seeks to give to a prospective franchisee regarding levels or ranges of actual or potential sales, costs, income or profits from franchised or non-franchised units must be set forth in FDD Item 19 (or, if no financial performance representations are being given, that fact must be noted). FDD Item 20 seeks to impart information regarding the historic and prospective growth or contraction of the franchise network, coupled with the current status of that network in terms of the number of operational units. A franchisor must set forth five tables, four of which detail the status of the subject franchise network during each of the franchisor s three most recent fiscal years (how many franchised and company-owned units were open at the beginning of each year/end of each year; how many franchise transfers were effected, on a state by state basis; how many franchised units, again on a stateby-state basis, were terminated, not renewed, reacquired by the franchisor or ceased operations; identical information for company-owned units) and a fifth table featuring the franchisor s estimate of the number of franchises it will grant on a state-by-state basis over its coming fiscal year. 11

14 In addition, franchise specific information is required: the names, unit addresses and unit telephone numbers of all currently operating franchisees must be set forth in Item 20 (usually by means of an exhibit thereto) as must the names, cities, states and current business telephone numbers (or, if unknown, the last known home telephone numbers) of every franchisee who had an outlet terminated, cancelled, not renewed or otherwise ceased doing business during the franchisor s most recently completed fiscal year (or who has not communicated with the franchisor within ten weeks of the issuance date of the FDD). Further, if franchisees signed confidentiality agreements during the franchisor s last three fiscal years which restrict or preclude their ability to communicate their experiences with prospective franchisees, this fact must be disclosed. Finally, a franchisor must disclose in Item 20 information regarding each trademark-specific franchisee organization associated with its franchise network (whether created, sponsored or endorsed by the franchisor or, if organized under state law and timely requesting inclusion in the franchisor s FDD, independent franchisee associations as well). In FDD Item 21, a franchisor must set forth its (and/or, in certain instances, its corporate parent s) audited income statements and balance sheets for the preceding three fiscal years. In FDD Item 22, all franchise and other contracts or agreements between the franchisor and its franchisees -- including not only the franchise agreement itself, but any financing agreements, lease agreements, option agreements, product purchase agreements, area development agreements and the like -- must be set forth in full. Finally, FDD Item 23 is a required receipt form -- that is, a receipt evidencing the fact that a prospective franchisee received a copy of the franchisor's FDD in accordance with law. Given the ability of franchisors to engage in electronic disclosure, this receipt can be downloaded and electronically transmitted back to the franchisor or, more traditionally, printed, signed, and mailed or hand delivered by the prospective franchisee. The franchisor is obliged to identify on each prospective franchisee s Item 23 receipt the name, business address and telephone number of each franchise seller (franchisor-employed salesperson or representative, franchise broker, subfranchisor) involved in offering and selling the franchise to the prospect. D. When Must Disclosure Be Effected? The FTC Franchise Rule requires franchisors to furnish their FDDs to prospective franchisees fourteen calendar days before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or its affiliate. To eliminate confusion as to when the required fourteen day disclosure period has elapsed and the franchise agreement can thus be signed or money accepted, the FTC s SBP specifies that the fourteen days commence the day after delivery of the FDD, such that the signing of any agreement or receipt of payment can take place fifteen days later. 8 Thus, 12

15 prospective franchisees have a full fourteen calendar days to review the FDD. To be cautious, many practitioners counsel a 16 day advance disclosure protocol. There is no general requirement under the FTC Franchise Rule that a franchisor furnish any franchise or franchise-related agreement in a form ready for execution (that is, with all names, addresses and individualized data set forth) to a prospective franchisee at any time prior to the franchisee s execution thereof. Instead, only if the franchisor has unilaterally and materially altered the terms of any standard franchise or other agreement attached to its FDD must that franchisor furnish an execution ready copy of that agreement to its prospective franchisee seven calendar days prior to the franchisee s execution thereof. Negotiated changes to a franchisor s standard form of franchise agreement will not trigger this limited franchise agreement disclosure requirement, nor will instances where the only changes made by the franchisor to the standard contract consists of fill in the blank provisions such as the date, name and address of the franchisee. 9 The FTC Franchise Rule features other disclosure obligations and triggers which must be complied with. First, the FTC Franchise Rule requires franchisors to furnish copies of their FDDs to prospective franchisees upon reasonable request earlier in the sales process than is otherwise required by the Rule. Second, the FTC Franchise Rule also requires that disclosure be effected to existing franchisees who are renewing their franchises if the franchisee must make a required payment for the right to enter into a new franchise agreement and/or if the renewal agreement contains terms and conditions that differ materially from the expiring agreement. 10 Lastly, the FTC Franchise Rule features another disclosure trigger under which franchisors are obligated to redisclose with their most recent FDDs, upon reasonable request, any prospective franchisees who are in the sales pipeline. Regarding this requirement, the SBP states: (The Rule) recognizes that the information contained in a FDD may become out-of-date by the time a prospect who relies on such information is ready to sign a franchise agreement. It prevents deception by enabling such prospective franchisees, if they wish, to get any updated disclosures prepared by the franchisor. 11 Critically, a franchisor is under no disclosure obligation whatsoever with regard to the sale or other assignment of a franchise by an existing franchisee where the franchisor has no significant involvement with the transferee. 12 E. How Must Disclosure Be Made? Under the FTC Franchise Rule, franchisors may furnish FDDs to prospective franchisees in any fashion they elect, including hand delivery; ; granting access over the internet; fax; or, by mailing to the prospective franchisee the FDD in either paper or tangible electronic form (such as on a computer disk or CD-ROM) by first class U.S. mail at least three days before the required disclosure date. One of the most revolutionary aspects of the 2007 revisions to the FTC Franchise Rule, which captures not only recent technological innovations but seeks to anticipate and 13

16 capture as well developments which surely will follow, is its authorization for franchisors to engage in pure electronic disclosure, subject to certain limitations. First, before effectuating disclosure, franchisors are required to advise prospective franchisees of the formats in which the FDD is available so that those prospects may request delivery by a method they can easily use. 13 And second, although franchisors are permitted to utilize navigational tools (such as scroll bars, internal links and search features) in the FDD, franchisors are prohibited from using any electronic enhancements - - such as audio, video, other multimedia, pop-up screens and external links - - which a franchisor could otherwise utilize to call attention to favorable portions of its FDD and/or distract prospective franchisees from less than favorable disclosures. Notwithstanding the obvious benefits of pure electronic disclosure for franchisors (e.g. reduction in costs, efficiency, and reliable records), the process would be impossible if, as in the past, a franchisor had to obtain a manually signed FDD Item 23 receipt from each prospective franchisee. Accordingly, the FTC Franchise Rule now expressly permits a franchisee to sign the receipt either manually or by using security codes, passwords, electronic signatures, or similar devices to authenticate his or her identity. The FTC Franchise Rule also authorizes franchisors to include instructions in their Item 23 receipts regarding how the receipts should be returned to the franchisor (for example, by mail to a specified street address, internet transmission, , or fax to a specified fax line number). Thus, the FTC Franchise Rule permits Item 23 receipts to be executed electronically, but clearly puts franchisors in the position of always having in place a protocol designed to capture proof of such electronic receipts not only for Rule compliance but also in defense of any litigation claim that disclosure was not properly effected. F. Duty To Amend The FDD The FTC Franchise Rule requires that all information in a franchisor s FDD be current as of the close of the franchisor s most recent fiscal year. 14 The Rule affords franchisors 120 days following the close of their fiscal years in which to prepare their updated FDDs. 15 In addition to the requirement to update the FDD annually, the FTC Franchise Rule also imposes a quarterly update requirement. Specifically, franchisors must, within a reasonable time after the close of each quarter following their most recent fiscal year, prepare an attachment to their FDDs to reflect any material changes in the franchisor or relating to the franchise business of the franchisor. The attachment(s) must be delivered to prospective franchisees along with the core FDD. 16 Although the FTC Franchise Rule fails to define what constitutes a material change, changes in management personnel, mergers and acquisitions involving the franchisor, significant litigation or arbitration developments, significant changes in the franchisor s financial situation, and any other change that would influence a prospective franchisee s investment decision are likely material changes necessitating a quarterly update. 14

17 An exception to the general FTC Franchise Rule quarterly update protocol pertains to any financial performance representations set forth in a franchisor s FDD. If any such financial performance representation is contained in a franchisor s FDD, then the FTC Franchise Rule requires franchisors to notify their prospective franchisees of any material changes to such representations through the date - - and by the date - - that disclosure is required under the FTC Franchise Rule. 17 In stark contrast to state franchise law requirements, such material changes to financial performance information may be furnished to prospective franchisees outside of the FDD if the franchisor so chooses (through separate writings or other communications). 18 G. FTC Revised Franchise Rule Exemptions Although the FTC Franchise Rule affords exemptions from its disclosure requirements, those exemptions are confined to the 35 states featuring no franchise registration/disclosure laws of their own; are not preemptive on the franchise regulating states; and, unless an identical exemption is available thereunder, do not apply in the 15 states having such laws on their books. The FTC Franchise Rule exemptions are as follows: (1) Minimum Payment Exemption. The total of the required payments, or commitments to make a required payment, to the franchisor or an affiliate that are made any time from before to within six months after commencing operation of the franchisee s business is less than $500. (2) Fractional Franchise Exemption. The franchise relationship is a fractional franchise. The FTC Franchise Rule defines a fractional franchise as a franchise relationship that satisfies the following criteria when the relationship is created: (1) franchisee, any of the franchisee s current directors or officers, or any current directors or officers of a parent or affiliate, has more than two years of experience in the same type of business; and (2) parties have a reasonable basis to anticipate that the sales arising from the relationship will not exceed 20% of the franchisee s total dollar volume in sales during the first year of operation. 19 (3) The Leased Department Exemption. The franchise relationship is a leased department. The FTC Franchise Rule defines a leased department as an arrangement whereby a retailer licenses or otherwise permits a seller to conduct business from the retailer s location where the seller purchases no goods, services, or commodities directly or indirectly from the retailer, a person the retailer requires the seller to do business with, or a retailer affiliate if the retailer advises the seller to do business with the affiliate. 20 The common example of a leased department is a specially designated section such as a make up or jewelry counter at a shopping mall. The space for these types of businesses is typically leased by the mall to a third party retailer and the 15

18 mall will typically exercise controls over the retail operation (i.e., approval rights for all signage, marketing and products). (4) Large Investment Exemption. The franchisee s initial investment, excluding any financing received from the franchisor or an affiliate and excluding the cost of unimproved land, totals at least $1 million and the prospective franchisee signs an acknowledgement verifying the grounds for the exemption. The required $1 million investment (excluding unimproved land costs and financing from the franchisor or its affiliate) (the large investment exemption ) is typically calculated by reviewing the prospective franchisee s initial investment as would be set forth in Item 7 of an FDD prepared in accordance with the FTC Franchise Rule. 21 The required $1 million investment necessary for a franchisor to take advantage of the exemption need not be limited to a single unit. A multi unit franchisee investing the threshold amount (or more) in a number of units is just as sophisticated as another franchisee investing a like amount in a single unit. 22 It is important to note that the application of the $1 million investment exemption is more difficult when the franchisee entity is comprised of multiple investors. In that case, the exemption will apply only if at least one individual in a franchisee investor group qualifies as sophisticated by investing at the threshold level. 23 (5) Sophisticated Franchisee Exemption. The franchisee entities (including any parent or affiliates) have been in business for at least five years and have a net worth of at least $5 million. A large franchisee need not have five years of business experience in franchising or in the industry that the franchisee will enter as a result of the franchise. Instead, five years of business experience in any business will suffice. 24 The types of prospective franchisee entities eligible for this exemption include corporations, partnerships, other business entities and individuals. (6) Insider Transactions. One or more purchasers of at least a 50% ownership interest in the franchise: within 60 days of the sale, has been, for at least two years, an officer, director, general partner, individual with management responsibility for the offer and sale of the franchisor s franchises or the administrator of the franchised network; or within 60 days of the sale, has been, for at least two years, an owner of at least a 25% interest in the franchisor. 25 (7) Oral Agreements. There is no written document that describes any material term or aspect of the relationship or arrangement. (8) The PMPA Exemption. The franchise relationship is covered by the Petroleum Marketing Practices Act, 15 U.S.C

19 H. Penalties For Noncompliance The FTC Franchise Rule directly holds liable a franchisor for any failure to prepare an FDD in accordance with the requirements of the Rule. However, the FTC Franchise Rule only indirectly denominates those other than the franchisor who may be held liable for a franchisor s disclosure violations. An officer or director of a franchisor may be held liable under the FTC Franchise Rule for redress relating to a franchisor s disclosure violations if that officer or director directed the franchisor s employees to prepare false or misrepresented disclosures or failed to stop the company from using an FDD that one or more states had previously rejected as insufficient. Against the franchisor and/or its officers and directors, the FTC is empowered to seek fines of up to $11,000 per violation in addition to other measures of financial relief such as restitution, rescission and damages. In addition, the FTC has the ability to seek temporary restraining orders and preliminary injunctions against an allegedly errant franchisor which would prohibit it from engaging in any further franchise sales activity whatsoever nationwide. Finally, while under the FTC Franchise Rule the FTC may not itself institute criminal proceedings for Rule violations, the FTC may refer to the United States Department of Justice for criminal prosecution any instances of criminal wrongdoing uncovered in the course of an FTC investigation. Notwithstanding the FTC s ability to seek redress for disclosure violations under the FTC Franchise Rule, there exists no private right of action for franchisees injured by Rule violations. However, aggrieved franchisees may commence legal proceedings complaining of FTC Franchise Rule violations under certain states Little FTC Acts - - statutes which, in essence, provide that any violation of the FTC Franchise Rule is deemed to also constitute a violation of the subject Little FTC Act. And since these Little FTC Acts almost universally confer upon individuals the right to commence legal proceedings for any violation of those laws, citizens in those states featuring Little FTC Acts can commence court proceedings against their franchisors complaining of violations of the FTC Franchise Rule. Technically speaking, they are doing so not under the FTC Franchise Rule itself but under their state s Little FTC Act. So it is that citizens of certain states - - those featuring Little FTC Acts - - can commence legal proceedings complaining of violations of the FTC Franchise Rule while citizens of other states may not. 17

20 III. DISCLOSURE UNDER STATE LAWS A. History Of The State Registration/Disclosure Laws The essence of state franchise registration/disclosure statutes is simple. Under these laws, no franchise may legally be offered or sold, no contract signed and no money paid unless the prospective franchisee first receives a comprehensive FDD designed to enable that prospect to make an informed investment decision. The fifteen states featuring their own franchise disclosure laws are California 26, Hawaii 27, Illinois 28, Indiana 29, Maryland 30, Michigan 31, Minnesota 32, New York 33, North Dakota 34, Oregon 35, Rhode Island 36, South Dakota 37, Virginia 38, Washington 39 and Wisconsin 40. Of those fifteen states, all but Oregon are so called registration/disclosure states because they also require a pre-sale filing with the state. In California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, Virginia and Washington, a franchisor must first register itself and its FDD, a daunting task for the uninitiated, before any franchise advertising appears, any franchise offers are made or any franchise sale is effected. In Indiana, South Dakota and Wisconsin, only a notice filing and dissemination of the FDD is required; that document is not reviewed prior to use. Michigan requires only the filing of a Notice of Franchise Offering. And, as stated above, under Oregon law, only disclosure is mandated, without any prior registration, filing or review requirement. With a few notable exceptions, the FTC Franchise Rule does not preempt state franchise registration/disclosure statutes. Instead, the FTC Franchise Rule governs side-by-side with state franchise registration/disclosure laws. The first exception is that the FTC Franchise Rule will preempt a state franchise registration/disclosure statute to the extent the state law does not afford prospective franchisees with equal or greater protection (such as registration of FDDs; more extensive or additional disclosures; or, regulation of the franchisor-franchisee relationship) than the Rule provides. The second exception is with respect to the required contents of a franchisor s FDD the FTC Franchise Rule s disclosure requirements create a disclosure floor which all franchisors have to comply with nationwide and which all franchise regulating states must accept. B. To Whom Must Disclosure Be Effected? One must pay close attention to the jurisdictional scope of each state s franchise law. By their terms, each state registration/disclosure statute governs all franchise sales activity that takes place in this state. But what do the words in this state mean? The answer to that question varies from jurisdiction to jurisdiction, and generally hinges upon where the offer to sell emanated from; where the acceptance of that offer was communicated from; where the prospective franchisee resides; and, where the franchised business will be located. Generally speaking, if any of these four factors is implicated within a franchise-regulating state during the franchise sales process, it is vital to investigate if that state s franchise law may govern the transaction. 18