A Primer on U.S. Franchise Legislation: How it differs from Canadian Franchise Legislation

Transcription

1 A Primer on U.S. Franchise Legislation: How it differs from Canadian Franchise Legislation By Edward (Ned) Levitt Aird & Berlis LLP Toronto And George J. Eydt Hodgson Russ LLP Toronto Ontario Bar Association 11 th Annual Franchising Law Conference: Mastering a Recovering Economy November 2, 2011 Toronto, Ontario

2 TABLE OF CONTENTS Page A Primer on U.S. Franchise Legislation: How it differs from Canadian Franchise Legislation I. Introduction... 1 II. Overview of U.S. Franchise Law... 1 III. Overview of Canadian Franchise Law... 2 IV. Issue by Issue Differences between Canadian and U.S. Franchise Legislation... 3 A. Registration State Franchise Laws are not pre-empted by the FTC Rule Scope of State Review Registration Package... 5 B. Exemptions from Disclosure and Registration Large/Seasoned Franchisor Fractional Franchise Isolated Sale Sophisticated Franchisee Large Investment by Franchisee Insider Exemption... 8 C. Scope of Disclosure Material Fact versus Prescribed Disclosure Ancillary Materials (e.g., FTC Compliance Guide) D. Clear and Concise Rule E. Information in the Disclosure Document Parents, Affiliates and Predecessors Background of Officers and Directors Litigation and Bankruptcy Costs, Investment, Working Capital Advertising Funds Computers and Electronic Cash Registers, Location Selection, Timing for Opening Patents, Copyrights and Proprietary Information i-

3 TABLE OF CONTENTS (continued) Page 8. Dispute Resolution Public Figures Financial Performance Representations Existing Franchises / Franchise Closures / Projected Openings Financial Disclosure a. Standards b. Avoiding the Requirement for Parental Disclosure Prescribed Statements / Certificates / Receipts F. Disclosure for Sales Agents G. Use of Wrap-Around Disclosure H. Triggers for Disclosure I. Electronic Delivery J. Annual Updates versus Continual Updates K. Supplemental Disclosure L. Remedies Limitation Periods Private Right of Action M. Relationship Laws N. Business Opportunity Laws V. Conclusion ii-

4 A Primer on U.S. Franchise Legislation: How it differs from Canadian Franchise Legislation I. Introduction The franchise markets in both the United States and Canada have grown in breadth, depth and vibrancy since the early 70 s. Parallel to that growth has been the steady increase of franchise expansions between the two countries, which has accelerated in the last several years. As a result, franchisors and those who advise them increasingly find themselves being confronted by the legislative regimes of the other country and the challenges they bring. This paper intends to compare and contrast some of the most significant aspects of franchise regulations in the United States and Canada. The reader is cautioned that this paper does not presume to cover every aspect of such regulation and resort must be made to the legislation itself for complete and accurate information. II. Overview of U.S. Franchise Law Franchise legislation has been a reality in the United States since the enactment of the California Franchise Investment Law in 1970 (effective on January 1, 1971). Today, both federal and state laws govern the sale of franchises. The Federal Trade Commission s franchise rule (the FTC Rule ) became effective on July 21, 1979 and was significantly revised effective July 1, It requires franchisors to provide a franchise disclosure document ( FDD ) to prospective franchisees before any offer or sale is made, unless an exclusion or exemption applies. No registration of the FDD is required. Fifteen states have enacted their own pre-sale franchise laws. 1 These state franchise laws also require pre-sale disclosure and typically require some form of pre-sale registration with the state. In addition, a number of states have specific laws governing the relationship between the franchisor and the franchisee after the sale is completed. 2 While the definition of franchise varies under these laws, for convenience the required elements can be summarized as follows: (i) the grant of a right to operate a business in association with the grantor s trademark or trade name, (ii) with significant control or assistance by the grantor (under state laws this element is sometimes replaced with a community of interest between the parties or the use of a prescribed marketing plan ) and (iii) payment of a franchise fee to the grantor. All three of these elements must be present for a franchise to exist, except under New York law where payment of a franchise fee combined with either one of the other two elements constitutes a franchise. If a company falls within this definition, and is not subject to a statutory exclusion or exemption, then there is a wide range of pre-sale disclosure and registration requirements and relationship restrictions in the United States. 1 2 California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Michigan, Minnesota, Missouri, Nebraska, New Jersey, Virginia, Washington, Wisconsin, Puerto Rico and the U.S. Virgin Islands.

5 III. Overview of Canadian Franchise Law From 1971 until 2001, Alberta had the distinction of being the only province in Canada with franchise specific legislation. That legislation required the registration of a prospectus-like document, which had to be approved by the Alberta Securities Commission, at great cost and delay to franchisors. In 1995, following a study of the statute and its effectiveness conducted at Laurentian University, the statute was repealed and replaced with the current Franchises Act, which is primarily a disclosure statute. 3 On January 31, 2001 Ontario became the second province to enact franchise legislation, The Arthur Wishart Act, 4 which was fashioned similarly to the current Alberta statute. Soon thereafter, Prince Edward Island (July 2006) and New Brunswick (June 2007) followed suit with similar franchise statutes of their own. 5 Manitoba, at the time of this writing, is poised to become the fifth province with such legislation. 6 While there are some differences among the various provincial franchise statutes, at their core, they are remarkably similar. Even Manitoba, the newest province with such legislation, has chosen a similar approach in its statute and presumably will do likewise in the regulations to the statute, which are expected shortly. There is no federal franchise legislation and none is expected. The provinces have chosen the disclosure approach, with no registration and a smattering of relationship regulation, i.e. the right for franchisees to associate and the implied covenant of fair dealing in all franchise agreements. The similarity of the provincial statutes and regulations allows for the creation of one FDD for use in all of the regulated provinces. There are a lot of similarities in the definition of a franchise among the provinces. 7 All but the Alberta statute extend the reach of the statutes to what is commonly referred to as business opportunities. Like in the United States, the key elements of the definition include the grant to a franchisee of a right to sell or distribute products and services, in association with the franchisor s trademarks, with significant control by or significant assistance from the franchisor and with a payment or payments by the franchisee to the franchisor. The definitions of a franchise in the provincial statutes, except for Alberta, are broad enough to capture distribution arrangements that may not have been intended to create franchise relationships. 3 Franchises Act, RSA 2000, c F-23 [ Alberta Act ]. 4 Arthur Wishart Act (Franchise Disclosure), 2000, SO 2000, c 3 [ Ontario Act ]. 5 Franchises Act, RSPEI 1988, c F-14.1 [ PEI Act ]; Franchises Act, SNB 2007, c F-23.5 [ NB Act ]. 6 The Franchises Act, SM 2010, c. 13 [ Manitoba Act ] [Note: This Act is not yet in force]. 7 Ontario Act, s. 1(1); Alberta Act, s. 1(1)(d); PEI Act, s. 1(1)(b); NB Act, s. 1(1); Manitoba Act, s. 1(1). Page 2

6 IV. Issue by Issue Differences between Canadian and U.S. Franchise Legislation A. Registration Fourteen of the fifteen states that have a pre-sale franchise disclosure law require that either the Franchise Disclosure Document ( FDD ) or some form of notice be submitted to the state in advance of any offer to sell a franchise. 8 In a number of these registration states, the FDD is reviewed by a Franchise Examiner for compliance with the state s franchise disclosure and relationship laws. 9 While in other registration states, the FDD is not reviewed and is simply kept on file pending a franchisee complaint. 10 Until the state franchise filing or registration becomes effective, a franchisor is not permitted to have substantive contact with a prospect covered by the state franchise law. 11 Franchise counsel should carefully review the jurisdictional scope of state franchise laws because registration and disclosure obligations may arise even if the franchise is to be located outside the registration state, if the franchisee lives in, the franchise offer is made or accepted in, or negotiations take place in, the registration state. As stated earlier in this paper, none of the Canadian provincial franchise statutes require registration of the franchisor s FDD. 1. State Franchise Laws are not pre-empted by the FTC Rule The Interstate Commerce Clause of the United States Constitution gives the federal government the right to regulate commerce among the states. 12 Franchising falls within interstate commerce. The Supremacy Clause of the United States Constitution provides that the Constitution and federal laws enacted under the Constitution take precedence over or pre-empt state laws. 13 However, the federal government has the right to decide the extent to which federal law will pre-empt state law. The FTC Rule provides that: 8 Oregon does not have a pre-sale filing requirement. 9 California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia and Washington. 10 Except that Michigan requires only a notice filing. The FDD does not have to be submitted Except that Hawaii and Wisconsin allow pre-sale discussions before the required franchise filings have been made. US Const. Art. I, sec. 8, cl. 3. US Const Art. VI, sec. 2. Page 3

7 The FTC does not intend to preempt the franchise practices laws of any state or local government, except to the extent of any inconsistency with part 436. A law is not inconsistent with part 436 if it affords prospective franchisees equal or greater protection, such as registration of FDDs or more extensive disclosures. 14 As a result, state laws requiring registration and additional disclosures are valid. All state regulators accept use of a FDD that conforms to the FTC Rule. Therefore, one document, the FDD, can be used to satisfy both the federal and state disclosure requirements. Additional state disclosures are required and are typically addressed in the FDD by adding a state cover page and state specific addenda. Although there is no federal franchise law in Canada, it is worth considering the interaction of the various provincial laws when U.S. franchisors grant master franchises. It is very common for U.S. franchisors to grant the whole of Canada to a single master franchisee. Do any of the four provincial statutes take jurisdiction in such circumstances, thus requiring disclosure? All of these statutes apply if the franchise (in this case the master franchise) is to be operated partly or wholly in the particular province. 15 Only Alberta adds the requirement that the franchisee must also be resident in Alberta (or, if a corporation, have a permanent establishment in that province). 16 The belief in legal circles, untested in court, is that a master franchisee for Canada could successfully argue that disclosure is required under the various provincial statutes, except possibly Alberta. To be safe, U.S. franchisors should comply with the relevant provincial statutes when the master franchise grant is for the country of Canada. 2. Scope of State Review As a general rule, State Examiners only review the FDD for completeness and do not comment on the quality of the franchise offering. If the State Examiner determines that the FDD does not fully comply with the state s disclosure requirements, it will issue a comment letter detailing the deficiencies. All deficiencies must be resolved before the State Examiner will declare the FDD effective in the state. In some states this can be a time consuming process involving several rounds of comment and response. One exception to this general rule relates to the quality of the franchisor s financial statements. If the State Examiner is not satisfied with the financial health of a franchisor, in a number of states he or she may require the franchisor to post a bond, or escrow or otherwise defer receipt of any franchise fees until the franchisor has met all of its pre-opening obligations to the franchisee CFR (c). 15 Ontario Act, s. 2(1); Alberta Act, s. 3(1)(a); PEI Act, s. 2(1)(c); NB Act, s. 2(2). 16 Alberta Act, s. 3(1)(b). Page 4

8 3. Registration Package A franchisor who wants to offer and sell franchises in a franchise registration state must submit its FDD along with specified application documents to the state franchise agency. As set out in the NASAA Guidelines 17 these application documents include: 1. Uniform Franchise Registration Application; 2. Franchisor s Costs and Sources of Funds; 3. Uniform Franchisor Consent to Service of Process; 4. Franchise Seller Disclosure Form; 5. Franchise Disclosure Document (varies by Franchise Filing State); 6. Application Fee; 7. Guarantee of Performance (if required); 8. Consent of Accountant to the use of the latest audit report in the Franchise Disclosure Document; 9. Advertising or promotional materials (if required by the Franchise Filing State. Certain states require that additional documents be submitted with the application. For example, California requires submission of a Customer Authorization of Disclosure of Financial Records and a Notice of Exemption for Internet Advertisement. The former gives the state the right to access any franchise sale records held by financial institutions and by signing the latter the franchisor agrees to comply with the state s rules when posting any Internet advertisement of franchise opportunities to a website. As stated earlier in this paper, none of the Canadian provincial franchise statutes requires registration of the franchisor s FDD. B. Exemptions from Disclosure and Registration Both federal and state laws provide a wide range of exemptions. Unfortunately, they are not uniform so an exemption that is available federally may not be available at the state level and vice versa. Some of the more commonly invoked exemptions include: 17 North American Securities Administrators Association ( NASAA ) 2008 Franchise Registration and Disclosure Guidelines (Amended and Restated UFOC Guidelines) issued June 30, Page 5

9 1. Large/Seasoned Franchisor New York exempts franchisors with a high net worth from its full registration and disclosure requirements. A franchisor with a net worth of (i) $5 million per audited financial statement, or (ii) $1 million with a parent net worth of $5 million per audited financial statement, is not required to register and has a moderate disclosure requirement. A franchisor with a net worth of (i) $15 million per audited financial statement, or (ii) $3 million with a parent net worth of $15 million per audited financial statement, is not required to register and has a minimal disclosure requirement. Other states provide exemptions based on franchisor net worth. 18 To be eligible, the franchisor must also meet an experience threshold, e.g., has been in business for 5 years and has at least 25 franchisees. Unfortunately, there is no corresponding large/seasoned franchisor exemption under the FTC Rule. None of the provincial franchise statutes exempt large franchisors or any franchisors from the general disclosure requirements. However, all of these statutes currently in force provide franchisors with an exemption from the requirement of including financial statements in FDDs, provided that the following criteria are met: (i) (ii) (iii) (iv) the net worth of the franchisor on a consolidated basis is at least $5,000,000 ($2,000,00 in PEI and New Brunswick) or $1,000,000 if the franchisor s parent company has a net worth of $5,000,000 ($2,000,000 in PEI and New Brunswick); 19 with some modifications depending on the province, in the five years immediately preceding the date of the FDD, the franchisor has at least 25 franchisees engaging in business at all times in Canada or a single jurisdiction outside of Canada; 20 with some modifications depending on the province, the franchisor has carried on the business being franchised for at least 5 years prior to the date of the FDD; 21 and with some modifications depending on the province, the franchisor, its associates, directors, general partners and officers has not had any 18 California, Illinois, Indiana, Maryland, North Dakota, Rhode Island, South Dakota, Washington and Virginia. 19 Ontario Act, s. 13(2); General, O Reg 581/00 [ Ont Reg ] s. 11(1)1.; Franchises Act Exemption Regulation, Alta Reg 312/2000 [ Alta Reg 312 ] s. 1(a); Franchises Act Regulations, PEI Reg EC232/06 [ PEI Reg ] s. 6(a); Disclosure Document Regulation, NB Reg [ NB Reg ] s. 8(1)(a). 20 Ont Reg, s. 11(1)2.; Alta Reg 312, s. 1(b)(i); PEI Reg, s. 6(b); NB Reg, s. 8(1)(b). 21 Ont Reg, s. 11(1)3.; Alta Reg 312, s. 1(b)(ii); PEI Reg, s. 6(c); NB Reg, s. 8(1)(c). Page 6

10 judgment, order or award made against any of them relating to fraud, unfair or deceptive practices, or a law regulating franchises Fractional Franchise The FTC Rule and seven state laws 23 provide an exemption from their disclosure requirements for fractional franchises. Generally, the fractional franchise exemption is available where (a) estimated sales of the franchisor s product in the first year do not exceed 20% of the franchisee s total sales and (b) the franchisee has at least 2 years experience in a similar business. Some states have additional requirements. In opinions regarding this exemption, the FTC Staff has stated that the franchisee s prior experience in the franchised business and factors that are likely to make the franchisee less dependent on the franchisor are relevant. These factors include the financial stature of the franchisee, individual goodwill and reputation, business sophistication and practical ability to disengage from the franchise relationship, if necessary. If the franchise system compliments the franchisee s existing and successful business, then the fractional franchise exemption may apply. All of the provincial statutes provide for an exemption from disclosure if it is anticipated or should be anticipated by the parties that the sales from the franchised business would not be greater than 20% of the total sales of the franchisee s existing business and the franchised business. 24 There is no requirement regarding the experience or qualities of the franchisee. 3. Isolated Sale Minnesota, Indiana and New York have exemptions permitting isolated sales (typically the sale of one franchise in the state within a certain period of time). The details of these exemptions should be reviewed before relying on them. No similar exemption exists in any of the provincial statutes. 4. Sophisticated Franchisee Under the FTC Rule, a franchise sale is exempt if the franchisee (or its parent or any affiliates) is an entity that has been in business for at least five years and has a net worth of 22 Ont Reg, s. 11(1)4.; Alta Reg 312, s. 1(b)(iii); PEI Reg, s. 6(d); NB Reg, s. 8(1)(d). 23 California, Michigan, Minnesota, New York, Oregon, South Dakota and Wisconsin. 24 Ontario Act, s. 5(7)(e); Ont Reg, s. 8; Alberta Act, s. 1(1) fractional franchise ; Franchises Regulation, Alta Reg 240/1995 [ Alta Reg 240 ] s. 4; PEI Act, s. 5(7)(e); NB Act, s. 5(8)(e). Page 7

11 at least $5 million. 25 Rhode Island, South Dakota and Wisconsin also have exemptions for high net worth franchisees. There is no exemption based on the net worth or any other characteristic of the prospective franchisee. 5. Large Investment by Franchisee Under the FTC Rule, a franchise sale is exempt if the franchisee s initial investment totals at least $1 million. Any financing received from the franchisor or its affiliate and the cost of unimproved land must be excluded. The prospective franchisee must verify the grounds for the exemption in writing. This exemption applies only if at least one individual prospective franchisee in an investor-group qualifies for the exemption by investing at the $1 million threshold level. 26 Maryland, Minnesota and South Dakota also have an exemption based on the size of the investment. Only in Ontario, there is an exemption from the disclosure requirements where the prospective franchisee is required to make a total investment to acquire and operate the franchise of more than $5,000,000 in one year Insider Exemption The FTC Rule also provides an exemption for franchisor principals who satisfy certain timing and experience requirements. 28 California, Rhode Island, South Dakota and Washington also have this type of exemption. There is an exemption from the disclosure requirements of all of the provincial statutes for the grant of a franchise to a person, for their own account, who has been an officer or director of the franchisor or of the franchisor s associate for at least 6 months CFR 436.8(a)(5)(ii) CFR 436.8(a)(5)(i). 27 Ontario Act, s. 5(7)(h); Ont Reg, s CFR 436.8(a)(6). 29 Ontario Act, s. 5(7)(b); Alberta Act, s. 5(1)(b); PEI Act, s. 5(7)(b); NB Act, s. 5(8)(b). Page 8

12 C. Scope of Disclosure 1. Material Fact versus Prescribed Disclosure 30 The FTC Rule no longer includes a definition of material. Instead the FTC has stated in the Statement of Basis of Purpose to the FTC Rule that it will rely on the jurisprudence developed around Section 5 of the FTC Act to determine what is material. Under this jurisprudence, material in the franchise disclosure context means information that is likely to affect a reasonable prospective franchisee s investment decision. The FTC Rule prescribes certain information that must be included in the FDD, all of which it considers material. It explicitly prohibits the inclusion of additional information: Do not include any materials or information other than those required or permitted by part 436 or by state law not pre-empted by part The stated reason for this prohibition is to prevent franchisors from including information that is non-material, confusing, or distracting from the core disclosures. This concept of prescribed disclosure was reinforced in the Statement of Basis of Purpose in a discussion concerning the definition of disclose, state, describe and list. 32 The FTC Rule defines these terms to mean to present all material facts accurately, clearly, concisely and legibly in plain English. During the request for comments phase of rulemaking, it was pointed out that this definition was confusing and could be interpreted to mean that the FDD must include all material information and not just that prescribed by the FTC Rule. The FTC Staff rejected this notion stating that a similar definition in the old UFOC guidelines did not create confusion. The Statement of Basis and Purpose does point out that the prohibition on adding to the FDD should be read narrowly and that franchisors are permitted to add footnotes and other clarifications to the FDD to ensure that the prescribed disclosures are complete and not misleading. 33 Most state franchise registration and disclosure laws contain anti-fraud provisions that prohibit making an untrue statement of material fact or omitting to state a material fact necessary to make a statement not misleading. These anti-fraud provisions relate to the information that is required to be in the FDD. Recent case law makes it unclear whether franchisors have a general obligation to disclose information that is material to a prospective franchisee if it falls outside the scope of the For a detailed discussion of this topic see Joseph Y. Adler and Michael R. Laidhold, Assessing Materiality in Franchise Disclosure Documents: A Canada-U.S. Analysis, Franchise Law Journal, Vol. 30, No. 4, Spring 2011, American Bar Association. 16 C.F.R (d). 72 Fed. Reg. at 15,455. Id at 15,516. Page 9

13 prescribed disclosures. In Colorado Coffee Bean, LLC v. Peaberry Coffee, Inc. 34, the court held that franchisors must disclose such information outside the FDD. The plaintiff franchisee claimed that Colorado Coffee Bean had failed to provide pre-sale disclosure that the corporate stores owned and operated by Colorado Coffer Bean s parent were unprofitable. Colorado Coffee Bean argued that because its parent did not guaranty its performance under the franchise agreement, disclosure of its parent s financial statements in its FDD was not prescribed under the FTC Rule. It correspondingly argued that it was prohibited by Section 436.6(d) of the FTC Rule (quoted above) from including this additional information. The court rejected this argument. It relied on Section 436.1(a)(21) of the FTC Rule which provided that franchisors are not precluded from giving other non-deceptive information orally, visually or in separate literature so long as such information is not contradictory to the information in the FDD. The court used this language, which appears to be permissive in nature, to create a positive obligation. However, this provision which existed at the time of the relevant Colorado Coffee Bean franchise sale was deleted when the FTC Rule was amended in Apparently forgetting that it was deleted, the FTC, in the Statement of Basis and Purpose to the amended FTC Rule, still advocates its application and makes reference to Section 436.1(a)(21) as though it still appears in the amended FTC Rule. 35 It will be interesting to see what, if any, effect both the Colorado Coffee Bean case and the deletion of Section 436.1(a)(21) from the FTC Rule will have in practice. In addition to the specific disclosure items prescribed by the regulations to the various provincial statutes, each one requires that the FDD contain all material facts. 36 A Material Fact is defined in the Ontario statute 37, Manitoba statute 38 and the New Brunswick statute 39, (with the small, but significant difference, that means replaces includes in the first line in the New Brunswick Act, as is the case in the Alberta statute 40, the differences in the definition under the Alberta Act in brackets and italics and the differences in the definition under the PEI statute 41 in square brackets and underlined) as follows: Material Fact includes [(means)] any information about the business, operations, capital or control of the franchisor or franchisor s (its) associate or about the [franchise or] the franchise system[,] that would reasonably be expected to have a Colo. App. LEXIS 210 (Feb. 18, 2010). 72 Fed.Reg. at n.733; n Ontario Act, s. 5(4)(a); Alta Reg 240, s. 2(1); PEI Act, s. 5(4)(a); NB Act, s. 5(5). 37 Ontario Act, s. 1(1). 38 Manitoba Act, s. 1(1). 39 NB Act, s. 1(1). 40 Alberta Act, s. 1(1)(o) 41 PEI Act, s. 1(1)(l) Page 10

14 significant effect on the value or price of the franchise to be granted (sold) or the decision to acquire (purchase) the franchise. There are no Canadian cases which provide any real guidance or general rules as to what would constitute a Material Fact in any given situation. Accordingly, a conservative approach should be taken and any fact which could in any way be considered material to the prospective franchisee should be disclosed. 2. Ancillary Materials (e.g., FTC Compliance Guide) U.S. franchise regulators provide franchisors and their advisors with a wide range of commentary and guidance with respect to compliance with both the FTC Rule and state franchise law. In the FTC Rule Statement of Basis and Purpose, the FTC sets out its reasoning for revising or not revising each provision of the FTC Rule and responds to comments submitted by the U.S. franchise bar. The FTC Compliance Guide provides guidance regarding disclosure under the FTC Rule. Practitioners also have access to the FTC Rule Frequently Asked Questions (FAQs) and FTC Staff Opinions regarding the original Franchise Rule. All of these federal resources can be accessed on the FTC website. 42 The North American Securities Administrators Association (NASAA) has issued the 2008 Franchise Registration and Disclosure Guidelines (Amended & Restated UFOC Guidelines) which can be accessed on the NASAA website. 43 All of these materials are extremely helpful. Unfortunately, no government body in Canada provides any guidelines or commentary on compliance issues or practices regarding the various provincial franchise statutes. D. Clear and Concise Rule Section 436.1(d) of the FTC Rule provides that disclose, state, describe, and list each mean to present all material facts accurately, clearly, concisely, and legibly in plain English. Section 436.1(o) of the FTC Rule provides that Plain English means the organization of information and language usage understandable by a person unfamiliar with the franchise business. It incorporates short sentences; definite, concrete, everyday language; active voice; and tabular presentation of information, where possible. It avoids legal jargon, highly technical business terms, and multiple negatives. All but the Alberta statute provide that all information in a FDD and a statement of a material change be accurately, clearly and concisely set out Ontario Act, s. 5(6); PEI Act, s. 5(6); NB Act, s. 5(7). Page 11

15 E. Information in the Disclosure Document 1. Parents, Affiliates and Predecessors In Item 1 of the FDD, a franchisor must disclose (i) the name and principal business address of any parent or affiliate that offers franchises in any line of business or provides products or services to the franchisees of the franchisor, (ii) the name and principal business address of any predecessors during the past 10 years, and (iii) the prior business experience of any predecessor listed above and any affiliate that offers franchises in any line of business or provides products or services to the franchisees of the franchisor. There are striking differences between the U.S. approach and the Canadian approach for these disclosure items. Other than the requirement, contained in all of the provincial statutes other than the Alberta statute, that, if the franchisor is a subsidiary, the name and principal address of the parent must be included in the FDD, such information is not required to be disclosed. 45 In Item 3 of the FDD, a franchisor must also disclose the details of certain litigation pertaining to (i) a predecessor, parent or affiliate who induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor s performance, and (ii) an affiliate who offers franchises under the franchisor s principal trademark. No such disclosure is required in any of the provincial statutes. In Item 3 of the FDD, a franchisor must disclose whether (i) a predecessor, (ii) a parent or affiliate who guarantees the franchisor s performance, (iii) an affiliate who has offered or sold franchises in any line of business within the last 10 years, (iv) or any other person identified in Item 2 (Business Experience) is subject to a restrictive order pertaining to certain laws, including franchise and securities laws. Other than the requirement to disclose certain civil, criminal and administrative proceedings, judgments and orders involving a franchisor s associates, 46 there are no similar disclosure requirements in any of the provincial statutes. The definition of a franchisor s associate in the various statutes does not include predecessors. In Item 4 of the FDD, a franchisor must disclose whether a predecessor, parent or affiliate has been involved in a bankruptcy proceeding in the past 10 years. 45 Ont Reg, s. 2.1.v.; PEI Reg, Sch I, Part 2, s. 1(e); NB Reg, Sch A, Part 2, s. 1(e). 46 Ont Reg, ss ; Alta Reg 240, Sch 1, ss. 2-4; PEI Reg, Sch I, Part 2, ss. 3-5; NB Reg, Sch A, Part 2, ss Page 12

16 Similar disclosure is required under the various provincial statutes, except that the relevant time period is 5 years for New Brunswick and 6 years for all of the other provinces. 47 In Item 21 of the FDD, a franchisor may substitute for its own financial statements certain financial statements of its parent or affiliate, if the parent or affiliate absolutely and unconditionally guarantees the franchisor s performance under the franchise agreement. Conversely, if the parent s or the affiliate s financial statements are disclosed, then the parent or affiliate must provide a guaranty. The franchisor must also include certain financial statements for any parent that commits to perform post-sale obligations for the franchisor. Affiliate means an entity controlled by, controlling, or under common control with, another entity.parent means an entity that controls another entity directly, or indirectly through one or more subsidiaries.predecessor means a person from whom the franchisor acquired, directly or indirectly, the major portion of the franchisor s assets. There is no concept in any of the provincial statutes of guaranties by parent, affiliated or associated companies to the franchisor. Also, there is no requirement for disclosure of financial statements of any company other than the franchisor. In fact, it is likely that consolidated financial statements among several related companies, including the franchisor, would not satisfy the spirit and letter of the provincial statutes, which require the financial statements of the the franchisor to be attached to the FDD. The argument would be that a consolidated statement would not provide a prospective franchisee with a clear picture of the financial condition of the franchisor with whom the franchisee is contracting. 2. Background of Officers and Directors In Item 2 of the FDD, a franchisor must disclose the five year employment history for its directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of the franchise. There is no requirement in the provincial regulations to disclose information about anyone who is not a director, general partner or officer of the franchisor. In Alberta 48 and PEI 49, such disclosure is required only with respect to directors, general partners and officers who will have management responsibilities relating to the franchise. 47 Ont Reg, s. 2.6; Alta Reg 240, Sch 1, s. 5; PEI Reg, Sch I, Part 2, s. 6; NB Reg, Sch A, Part 2, s Alta Reg 240, Sch 1, s. 1(h). 49 PEI Reg, Sch I, Part 2, s. 2. Page 13

17 For Ontario 50 and New Brunswick 51, the disclosure must be made with respect to all directors, general partners and officers of the franchisor. 3. Litigation and Bankruptcy In addition to the litigation and bankruptcy information required for predecessors, parents and affiliates, the franchisor must provide its own litigation and bankruptcy history for the past 10 years. The FTC Rule sets out in detail the type of litigation that must be disclosed in Item 3 of the FDD. This litigation includes pending actions, convictions, liability in material civil actions and the terms of settlements. Disclosure is required for both franchisee and franchisor initiated actions. Disclosure includes foreign litigation (and arbitration proceedings) and foreign bankruptcy proceedings. There are some differences between the provincial statutes and the U.S. requirements relating to time periods, but the essence of this area of disclosure is similar for the provinces, requiring disclosure about certain criminal, civil and administrative proceedings, judgments and orders Costs, Investment, Working Capital Item 7 of the FDD must include an estimate of the initial expenditures and other payments required to begin franchise operations. These expenditures include the cost of acquiring or leasing real property, equipment, fixtures and other fixed assets, construction costs, inventory costs, monthly expenses, and working capital requirements. Working capital is referred to in the FTC Rule as additional funds and is an estimate of the funds needed to operate the franchise during a three month start-up period. The start-up period should be extended if warranted for the particular industry. The provincial regulations have similar requirements 53 except that there is no requirement, other than in Alberta, to provide information about working capital. The Alberta regulations provide that, if an estimate of working capital is given, it must have a reasonable basis and include the material assumptions underlying the preparation and presentation of the information. 54 If such an estimate is not provided, the FDD must 50 Ont Reg, s NB Reg, Sch A, Part 2, s Ont Reg, ss. 3-6; Alta Reg 240, Sch 1, ss. 2-5; PEI Reg, Sch I, Part 2, ss. 3-6; NB Reg, Sch A, Part 2, ss Ont Reg, s. 6.1.; Alta Reg 240, Sch 1, ss. 7 and 8; PEI Reg, Sch I, Part 3, s. 1; NB Reg, Sch A, Part 3, s Alta Reg 240, Sch 1, s. 10. Page 14

18 include a statement that additional funds will be required to finance operations until a positive cash flow is produced Advertising Funds The franchisor must disclose in Item 11 of the FDD whether the franchisee must participate in any advertising fund. If so, it must disclose: (i) who contributes to the fund; (ii) how much the franchisee must contribute to the fund and whether other franchisees must contribute a different amount or at a different rate; (iii) whether the franchisor-owned outlets must contribute to the fund and, if so, whether it is on the same basis as franchisees; (iv) who administers the fund; (v) whether the fund is audited and when it is audited; (vi) whether financial statements of the fund are available for review by the franchisee; (vii) how the funds were used in the most recently concluded fiscal year, including the percentages spent on production, media placement, administrative expenses, and a description of any other use; (viii) if not all advertising funds are spent in the fiscal year in which they accrue, how the franchisor uses the remaining amount, including whether franchisees receive a periodic accounting of how advertising fees are spent; and (ix) the percentage of advertising funds, if any, that the franchisor uses principally to solicit new franchise sales. Disclosure requirements regarding advertising funds receive differing treatment in the various provincial regulations. In Alberta there is no disclosure requirement. In PEI there is a requirement to simply describe the fund, and the amount or the basis of calculating the amount of the franchisee s required contributions. 56 Ontario and New Brunswick have similar regulations requiring a statement describing: 57 (i) the percentage of the fund that has been spent on national campaigns and local advertising in the 2 fiscal years immediately preceding the date of the disclosure document, and the percentage of the fund, other than the above percentage, that has been retained by the franchisor, the franchisor s parent or the franchisor s associate in the two fiscal years immediately preceding the date of the disclosure document, and another statement describing: (i) the projected amount of the franchisee s contribution or (in New Brunswick) the basis of calculating the franchisee s contribution, (ii) a projection of the percentage of the fund to be spent on national or local advertising campaigns for the current fiscal year, (iii) a projection of the percentage of the fund to be retained by the franchisor, the franchisor s parent or the franchisor s associate in the current fiscal year, and (iii) an indication of whether reports on advertising activities financed by the fund will be made available to the franchisee. 55 Alta Reg 240, Sch 1, s PEI Reg, Sch I, Part 2, s Ont Reg, s. 6.6.; NB Reg, Sch A, Part 3, s.9. Page 15

19 6. Computers and Electronic Cash Registers, Location Selection, Timing for Opening In Item 11 of the FDD, the franchisor must disclose whether the franchisor requires the franchisee to buy or use electronic cash registers or computer systems. If so, the franchisor must describe the systems generally in non-technical language, including the types of data to be generated or stored in these systems, and state the following: (i) the cost of purchasing or leasing the systems; (ii) any obligation of the franchisor, any affiliate, or third party to provide ongoing maintenance, repairs, upgrades, or updates; (iii) any obligations of the franchisee to upgrade or update any system during the term of the franchise, and, if so, any contractual limitations on the frequency and cost of the obligation; (iv) the annual cost of any optional or required maintenance, updating, upgrading, or support contracts; and (v) whether the franchisor will have independent access to the information that will be generated or stored in any electronic cash register or computer system. If the latter applies, the franchisor must describe the information that the franchisor may access and whether there are any contractual limitations on the franchisor s right to access the information. In Item 11 the franchisor must also disclose the franchisor s preopening obligations to the franchisee, including any assistance in locating a site and negotiating the purchase or lease of the site. If such assistance is provided, the franchisor must state: (i) whether the franchisor generally owns the premises and leases it to the franchisee; (ii) whether the franchisor selects the site or approves an area in which the franchisee selects a site. If so, state further whether and how the franchisor must approve a franchisee-selected site; (iii) the factors that the franchisor considers in selecting or approving sites (for example, general location and neighborhood, traffic patterns, parking, size, physical characteristics of existing buildings, and lease terms); and (iv) the time limit for the franchisor to locate or approve or disapprove the site and the consequences if the franchisor and franchisee cannot agree on a site. In Item 11 the franchisor must also disclose the typical length of time between the earlier of the signing of the franchise agreement or the first payment of consideration for the franchise and the opening of the franchisee s business. It must describe the factors that may affect the time period, such as ability to obtain a lease, financing or building permits, zoning and local ordinances, weather conditions, shortages, or delayed installation of equipment, fixtures, and signs. There are no comparable disclosure requirements in any of the provincial statutes. However, some of this information may be revealed under the provincial requirements to disclose the costs of establishing the franchise, the cost of operating the franchise (if being made) and, where appropriate, material facts. 7. Patents, Copyrights and Proprietary Information In Item 14 of the FDD, the franchisor must disclose whether the franchisor owns rights in, or licenses to, patents or copyrights that are material to the franchise. It must also, disclose (i) whether it has any pending patent applications that are material to the franchise; (ii) Page 16

20 describe any current material determination of the United States Patent and Trademark Office, the United States Copyright Office, or a court regarding the patent or copyright and how the determination affects the franchised business; (iii) describe claims asserted, issues involved, and effective determinations for any material proceeding pending in the United States Patent and Trademark Office or any court; (iv) whether an agreement limits the use of the patent, patent application, or copyright, state the parties to and duration of the agreement, the extent to which the agreement may affect the franchisee, and other material terms of the agreement; (v) disclose the franchisor s obligation to protect the patent, patent application, or copyright; and to defend the franchisee against claims arising from the franchisee s use of patented or copyrighted items; (vi) disclose any known patent or copyright infringement that could materially affect the franchisee, and (vii) if the franchisor claims proprietary rights in other confidential information or trade secrets, describe in general terms the proprietary information communicated to the franchisee and the terms for use by the franchisee. All but the Alberta regulations require a description of the rights the franchisor or the franchisor s associate has to the trademark, service mark, trade name, logo or advertising or other commercial symbol associated with the franchise. 58 Other than that, except for anything that might need to be disclosed as a material fact, there is no requirement to disclose information about intellectual property. 8. Dispute Resolution Item 17 of the FDD simply requires disclosure of the choice of forum and choice of law under the franchise agreement. However, many state regulators require that the State Cover Page contain a risk factor if out of state arbitration is required or out of state law governs the franchise agreement. The following is an example of these risk factors: THE FRANCHISE AGREEMENT REQUIRES THAT YOU SETTLE ALL DISPUTES WITH US BY ARBITRATION ONLY IN NEW YORK. OUT OF STATE ARBITRATION OR LITIGATION MAY FORCE YOU TO ACCEPT A LESS FAVORABLE SETTLEMENT FOR DISPUTES. IT MAY ALSO COST MORE TO ARBITRATE WITH US IN NEW YORK THAN IN YOUR HOME STATE. THE FRANCHISE AGREEMENT STATES THAT NEW YORK LAWS GOVERNS IT, AND ITS LAWS MAY NOT PROVIDE THE SAME PROTECTIONS AND BENEFITS AS LOCAL LAW. YOU MAY WANT TO COMPARE THESE LAWS. Section of the California Franchise Relationships Law provides that a provision in a franchise agreement restricting venue to a forum outside this state is void with respect to any claim arising under a franchise agreement involving a franchise business operating within this state. However, the Ninth Circuit Court of Appeals has held that this provision is pre-empted by the Federal Arbitration Act. 59 The fact that an arbitration clause trumps this 58 Ont Reg, s. 6.9.; PEI Reg, Sch I, Part 3, s. 13; NB Reg, Sch A, Part 3, s Bradley v. Harris Research, 275 F.3d 884 (9th Cir. 2001). Page 17

21 California venue provision is one reason that arbitration is often specified for dispute resolution in U.S. franchise agreements. The FTC Rule and state franchise laws each provide that a franchisee cannot contract out of its statutory protections. All of the provincial statutes provide that a franchisee cannot contract out of the provisions of the respective statute and that any provision in the franchise agreement restricting the application of the laws or the jurisdiction of the courts of the particular province are void with respect to any rights, obligations or claims (depending upon the wording of the particular statute) under the statute. 60 Each statute goes on to specifically preserve other rights or remedies any party to a franchise agreement may have at law. 61 Under the Ontario statute, disclosure is required of any internal or external mediation or other alternative dispute resolution process used by the franchisor in disputes with Franchisees and the circumstances when the process may be invoked. 62 Under the PEI Act 63 and the New Brunswick Act 64, one must include a description of any restrictions or requirements imposed by the franchise agreement, including any requirements relating to location or venue of such process. The regulations under the New Brunswick statute uniquely provide for a process of mediation. 65 However, the process is not mandatory, if a party chooses to decline a notice to mediate Public Figures In Item 18 of the FDD, a franchisor must disclose certain information concerning the compensation of, management involvement of, and investment by, public figures who are used in the franchise name or symbol or in advertising for the sale of franchises. A public figure is defined as a person whose name or physical appearance is generally known to the public in the geographic area where the franchise will be located. statutes. There is no comparable disclosure requirement in any of the provincial 60 Ontario Act, s. 11; Alberta Act, s. 18; PEI Act, s. 12; NB Act, s Ontario Act, s. 9; Alberta Act, s. 15; PEI Act, s. 10; NB Act, s Ont Reg, s PEI Reg, Sch I, Part 3, s NB Reg, Sch A, Part 3, s Mediation Regulation, NB Reg Mediation Regulation, NB Reg , s. 4. Page 18

22 10. Financial Performance Representations A financial performance representation is defined as any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables. 67 Absent from this definition is any cost or expense information. Therefore, cost or expense information may be freely given to a prospective franchisee. However, a franchisor may not disclose costs or expenses in a way that allows a prospective franchisee to calculate sales, such as a percentage of sales, without including a financial performance representation in the FDD. If a franchisor chooses to make a financial performance representation, it may only do so in Item 19 of the FDD. There must be a reasonable basis for the representation at the time it is made. The disclosure must include the factual basis and material assumptions used to determine the financial information being presented. The franchisor must specify whether the information is historic or prospective. The FTC Rule also contains certain prescribed statements and admonitions that must be included. A U.S. franchisor is not required to provide any financial performance representations. If no financial performance representation is made, then there is a prescribed statement for Item 19 of the FDD. In this case the only financial information that a franchisor may provide to a prospective franchisee are the actual records of an existing location under consideration by the prospect. Under the Ontario regulation, if an earnings projection (which is not defined) for the franchise is provided, a statement specifying the reasonable basis for the projection, the assumptions underlying the projection and a location where information is available for inspection that substantiates the projection must be included in the FDD. 68 Under the PEI regulation and the New Brunswick regulation, if an earnings projection is provided directly or indirectly, a statement must be included in the FDD specifying: 69 (i) the assumptions and bases underlying the projection, its preparation and presentation; (ii) that the assumptions and bases underlying the projection, its preparation and presentation are reasonable; (iii) the period covered by the projection; (iv) whether projection based on actual results of existing franchises or existing businesses of the franchisor, its associates or its affiliates of the same type as the franchise being offered and if so, the location/territories/markets of those franchises; (v) if the projection is based on a business operated by the franchisor, its associate or affiliate of the franchisor, that the CFR 436.1(e). 68 Ont Reg, s PEI Reg, Sch I, Part 3, s. 5; NB Reg, Sch A, Part 3, s. 5(1). Page 19

23 information may differ in respect of a franchise operated by the franchisee; and (vi) where information that substantiates the projection is available for inspection. ( Earnings Projection is defined 70 to include any information given by or on behalf of the franchisor or franchisor s associate, directly or indirectly from which a specific level or range of actual or potential sales, costs, income, revenue or profits from franchises or businesses of the franchisor, franchisor s associates or affiliates of the franchisor of the same type as the franchise being offered can easily be ascertained.) Under the New Brunswick regulation only, if such an earnings projection is not provided, a statement to that effect must be included. 71 Under the Alberta regulation, 72 if information is given or is to be given, by or on behalf of the franchisor or its associate, to a prospective franchisee from which a specific level or range of actual or potential sales, costs, income or profit from franchisee outlets or franchisor outlets can be easily ascertained, the information must: (i) have a reasonable basis at the time it is made; (ii) include the material assumptions underlying its preparation and presentation, whether it is based on actual results of existing outlets and the percentage of outlets that meet or exceed each range of results; and (iii) indicate the place where substantiating information is available for inspection by the franchisee. Under the Alberta regulation, if information is given in respect of a franchisor outlet, the franchisor must state that the information may differ in respect of a franchise outlet. 73 None of the provincial regulations specify that an earnings projection need be in writing to trigger the disclosure requirements, so it is assumed that oral statements could be construed to be earnings projections. 11. Existing Franchises / Franchise Closures / Projected Openings In Item 20 of the FDD, franchisors are required to provide status reports for both franchised and corporate units. These reports include: (a) a summary of the number of units open at the beginning and end of the year; (b) a state by state summary of unit transfers by franchisees; (c) a state by state summary of unit openings, terminations, non-renewals, reacquisitions by franchisor, and other closures; (d) the status of corporate units; and (e) a projection of franchised and corporate unit openings in the following year. Additionally, the franchisor must include contact information for its current roster of franchisees and contact information for each franchisee who left the system in the most recently completed fiscal year or who has not communicated with the franchisor within 10 weeks of the FDD s issuance date. 70 PEI Reg, s. 1(1)(c); NB Reg, s. 2(1). 71 NB Reg, Sch A, Part 3, s. 5(2). 72 Alta Reg 240, Sch 1, s Alta Reg 240, Sch 1, s. 16 Page 20

24 An FDD for Ontario 74 must include a list of the locations of all franchises in Ontario (under the PEI regulation 75 a list all franchisees of the franchisor, franchisor s associates or affiliates of the franchisor in Prince Edward Island, New Brunswick and Nova Scotia must be included and under the New Brunswick regulations 76 a list of all franchisees of the franchisor, franchisor s associates or affiliates of the franchisor must be included) of the same type being offered (or in Alberta 77, as the case may be, operating under the same trade-name as the franchise being offered). The business address, telephone number and name of the franchisee who operates the franchise (and, under the PEI regulation and the New Brunswick regulation, the business address and telephone number of the franchise) must be included. If there are less than 20 franchises in Ontario, in Alberta, in New Brunswick or, under the PEI regulation, in Prince Edward Island, New Brunswick and Nova Scotia, as the case may be, the list should include information about those franchises which are geographically closest to Ontario, Alberta, or Prince Edward Island, as the case may be, and, in the case of New Brunswick, information about the franchisees that currently operate franchises of the same type in Ontario, Quebec, PEI, Nova Scotia or the State of Maine, until information on 20 franchises or all franchises in the system is provided, but if there are less than 20 franchises operating in those provinces, then the requirement is to list the franchises that are operating elsewhere in Canada, until 20 are listed or all franchises are included. Under the New Brunswick regulation, if there are less than 20 franchises operating in Canada and the State of Maine, then the FDD must list franchises that are operating elsewhere, until 20 are listed or all franchises are included. Under the Alberta Act, the FDD must provide the addresses and phone numbers of all existing franchisor outlets presently operating in Alberta under the same trade name as the franchise being offered. An FDD must provide the name, last known address and telephone number of each franchisee in Ontario (for Alberta, in the total operating territory of the franchisor) who operated a franchise of the type being offered (in Alberta, which is operated under the same trade-name as the franchise being offered) that has been terminated, cancelled, not renewed or reacquired by the franchisor or otherwise left the system within the last fiscal year immediately preceding the date of the disclosure document. 78 Under the PEI regulation 79 the list must be of all franchisees of the franchisor, franchisor s associates or affiliates of the franchisor that operated a franchise in Prince Edward Island, New Brunswick or Nova Scotia of the same type as the franchise being offered and under the 74 Ont Reg, s PEI Reg, Sch I, Part 4, s NB Reg, Sch A, Part 4, s Alta Reg 240, Sch 1, s Ont Reg, s. 6.15; Alta Reg 240, Sch 1, s PEI Reg, Sch I, Part 4, s. 2. Page 21

25 New Brunswick regulation 80, the list must be of all franchisees of the franchisor, franchisor s associates or affiliates of the franchisor that operated a franchise in any jurisdiction from which the franchisor draws the list of current franchisees. Under the Ontario regulation 81 an FDD must describe for each closure of a franchise of the type being offered within the previous three fiscal years immediately preceding the date of the disclosure document, the reasons for the closure, including whether: (i) the franchisor or franchisor s associate terminated or cancelled the franchise agreement; (ii) the franchisor or franchisor s associate refused to renew the franchise agreement; or (iii) the franchisee refused to renew the franchise agreement or otherwise left the franchise system. Under the Alberta regulation 82, an FDD must provide information about closures of franchisee outlets or franchisor outlets operated under the same trade name as the franchise being offered, including the total number of franchises in the total operating territory of the franchisor within the previous 3 fiscal years that have: (i) been terminated or cancelled by the franchisor; (ii) not been renewed by the franchisor; (iii) been reacquired by the franchisor; or (iv) otherwise left the system. Only in New Brunswick must an FDD list all businesses of the same type as the franchise being offered that the franchisor, franchisor s associates or affiliates currently operate in New Brunswick, including the name and business address of each business Financial Disclosure 84 a. Standards Under the FTC Rule, the FDD must contain separate financial statements for the franchisor, any subfranchisor, and any parent that commits to perform post sale obligations for the franchisor or guarantees the franchisor s obligations. 85 In its response to Frequently Asked Questions, FTC Staff elaborated on the scope of a parent s commitment to perform post sale obligations and set out two distinct elements: (1) There must be an obligation to provide a good or service to the franchisee; and (2) the parent must commit to perform the obligation. The 80 NB Reg, Sch A, Part 4, s Ont Reg, s Alta Reg 240, Sch 1, s NB Reg, Sch A, Part 4, s Excerpt from George J. Eydt and Stuart Hershman, Bringing a Foreign Franchise System to the United States, 32 nd Annual Forum on Franchising, Oct 14-16, 2009 (Toronto), American Bar Association CFR Disclosure Item (u)(1)(v). Page 22

26 parent commits if it either assumes the obligation or the franchisor arranges for the parent to provide the good or service on its behalf. 86 Under the FTC Rule, required financial statements must be prepared under U.S. GAAP (generally accepted accounting principles) and audited under U.S. GAAS (generally accepted auditing standards. 87 This is problematic for foreign franchisors because many foreign jurisdictions do not require that a franchisor s financial statements be audited, and, even if audited statements are required, it is highly unlikely they would be prepared under U.S. GAAP and audited under U.S. GAAS. The FTC Rule provides an alternative to the U.S. GAAP requirement that may be useful to some foreign franchisors. Financial statements prepared under a foreign country s GAAP may be used if they meet U.S. Securities and Exchange Commission ( SEC ) requirements for the same. 88 FTC Staff has summarized the SEC requirements. 89 The financial statements must: (1) explain the material differences between the principles of U.S. GAAP and the foreign GAAP; (2) reconcile the statements with U.S. GAAP; (3) provide all additional disclosures required by U.S. GAAP and SEC regulations; 90 and (4) be audited under U.S. GAAS. In addition, the auditor must comply with U.S. standards for auditor independence. FTC Staff has further stated that a Canadian or other foreign accountant or accounting firm may audit financial statements for FTC Rule purposes if the accountant or accounting firm (1) is registered with the Public Company Accounting Oversight Board ( PCAOB ); and (2) recently audited one or more financial statements that have been filed with and accepted by the SEC. 91 Many larger accounting firms operating in Canada meet the SEC requirements, including having the requisite experience with SEC filers. For those Canadian franchisors with audited statements prepared under Canadian GAAP, reconciliation may prove less costly than having to provide audited statements in accordance with U.S. GAAP. In addition, Canadian GAAS is very similar to U.S. GAAS so that, in most cases, conversion to U.S. GAAS is relatively seamless. 86 See FAQ #4 at CFR Disclosure Item (u)(1) Id. See FAQ #17 at 90 SEC Form 20-F, Part III, Items 17 and See FAQ #17 at Some registration states, e.g., Illinois, may ask for evidence that the foreign auditor complies with these requirements. This request may be satisfied by referring the examiner to the list of Registered Public Accounting Firms posted on the PCAOB website ( ) and a letter from the auditor providing the names of SEC filers whose financial statements it has audited. Page 23

27 b. Avoiding the Requirement for Parental Disclosure It is quite common for foreign franchisors new to the U.S. market to rely heavily on employees of their domestic franchise operations to provide training, opening assistance, and marketing assistance to U.S. franchisees. If these employees work for the parent, the parent s financial statements might have to be included in the FDD. Separating ownership of the foreign franchise operating company and the U.S. franchise operating company so that there is no parent/subsidiary relationship is one way to avoid parent financial statement disclosure. 92 Under this structure, the ultimate owners hold their interests in the U.S. operating company either directly (in a flow-through structure) or through a holding company that does not own or hold interests in the foreign operating company (in a corporate structure). The foreign franchise operating company providing assistance to U.S. franchisees on behalf of the U.S. franchise operating company therefore is an affiliate, not a parent. FTC Staff has stated that Section 436.5(u)(1)(iii) of the FTC Rule requires disclosure of a non-parent affiliate s financial statements only if the affiliate guarantees the franchisor s obligations. The FTC Staff has provided further leeway, 93 opining that the disclosure of parent financial information is required only when the franchisor s parent commits to perform post-sale obligations for the direct benefit of franchisees. Agreements between a franchisor and its parent for administrative and other services for the franchisor s internal purposes do not trigger the parent financial disclosure requirement. Because the FTC Rule uses the plural obligations, the performance of a single or isolated obligation alone is insufficient to trigger the disclosure. Arguably, Item 21 parent financials disclosure is intended to cover formal arrangements between the parent and franchisor for the benefit of franchisees or formal arrangements directly between the parent and the franchisees. The performance of post-sale obligations by a parent s employee for the benefit of franchisees does not trigger the Item 21 parent financial disclosures absent a formal commitment or guarantee on the part of the parent to perform. Franchisees must specifically look to the parent to provide the services (and not simply because an employee of the parent working for the franchisor provides the services). Under the provincial regulations, financial statements prepared at least to the standards applicable to review engagements set out in the Canadian Institute of Chartered Accountants handbook for the most recently completed fiscal year of the franchisor must be included in the FDD. 94 If 180 days have not yet passed since the end of the most recently completed fiscal year and financial statements have not been prepared and reported on for that fiscal year, financial statements for the previous fiscal year should be included. Exemptions exist under the various statutes from financial disclosure, depending upon net worth, number of franchisees operating over the last 5 years, business 92 Care should also be given to avoiding a master franchisor and sub-franchisor relationship between affiliates. 93 See FAQ #16 at 94 Ont Reg, s. 3; Alta Reg 240, s. 3; PEI Reg, s.5 ; NB Reg, s. 7. Page 24

28 experience of the franchisor in the type of business being offered over the last 5 years and track record for civil, criminal and administrative litigation. 95 The financial statements are those of the franchisor entity only and it is likely that consolidated financial statements of related companies would not comply with that requirement. Under the New Brunswick Act, if a franchisor relies on such an exemption, the Certificate required from the franchisor on disclosure must contain a statement that the franchisor meets the requirements of the Act and is therefore not including financial statements in the disclosure document Prescribed Statements / Certificates / Receipts The general format of the FDD is prescribed in the FTC Rule. It must contain a Cover Page, the 22 disclosure Items and two Receipt Pages. The content of the FTC Cover Page and the Receipt Pages are prescribed under the FTC Rule as are the Item headings. Certain of the disclosure Items must contain prescribed statements. A State Cover Page is also required to comply with state law. There is no general format for FDD s required under the various provincial statutes. However, there are a number of miscellaneous formatting requirements, including the following: Under the Ontario statute, the following statements must be included together in one section at the beginning of the disclosure document: A commercial credit report is a report which may include information on the franchisor s business background, banking information, credit history and trade references. Such reports may be obtained from private credit reporting companies and may provide information useful in making an investment decision. 2. Independent legal and financial advice in relation to the franchise agreement should be sought prior to entering into the franchise agreement. 3. A prospective franchisee is strongly encouraged to contact any current or previous franchisees prior to entering into the franchise agreement. 95 Ont Reg, s. 11; Alta Reg 312; PEI Reg, s. 6; NB Reg, s NB Reg, s. 8(2). 97 Ont Reg, s. 4. Page 25

29 4. The cost of goods and services acquired under the franchise agreement may not correspond to the lowest cost of the goods and services available in the marketplace. Additionally, the following statement must also be included in the FDD: 98 Mediation is a voluntary process to resolve disputes with the assistance of an independent third party. Any party may propose mediation or other dispute resolution process in regard to a dispute under the franchise agreement, and the process may be used to resolve the dispute if agreed to by all parties. Under the PEI statute and the New Brunswick statute, the following warnings must be included together in one section at the beginning of the FDD: A prospective franchisee should seek information on the franchisor and on the franchisor s business background, banking affairs, credit history and trade references. 6. A prospective franchisee should seek expert independent legal and financial advice in relation to franchising and the franchise agreement prior to entering into the franchise agreement. 7. A prospective franchisee should contact current and previous franchisees prior to entering into the franchise agreement. 8. Lists of current and previous franchisees can be found in this disclosure document. The FDD must include a certificate dated and signed by, in the case of a franchisor that is not incorporated, the franchisor, in the case of a franchisor that is incorporated and has only one director or officer, by that person, and, in the case of a franchisor that is incorporated and has more than one officer or director by at least two persons who are officers or directors certifying that the FDD: For Alberta: 100 Contains no untrue information of a Material Fact. Does not omit to state a Material Fact that is required to be stated. Does not omit a Material Fact that needs to be stated in order for the information not to be misleading. 98 Ont Reg, s. 5(2). 99 PEI Reg, s. 3(1)(a) and Sch I, Part 1; NB Reg s. 5(a) and Sch A, Part Alta Reg 240, s. 2(3) and Sch 2. Page 26

30 For Ontario: 101 Contains no untrue information, representations or statements. Includes every Material Fact, financial statement, statement and other information required by the Ontario statute and its regulations. For PEI: 102 Contains no untrue information, representation or statement, whether of a material fact or otherwise. Contains every material fact, financial statement, statement and other information that is required to be contained by the Act and the regulations made under it. Does not omit a material fact that is required to be contained by the statute and the regulations made under it. Does not omit a material fact that needs to be contained in order for this FDD not to be misleading. Under the Ontario statute, the items of disclosure contained in section 6 of the regulations must be, presented together in one part of the document. Under the Ontario, New Brunswick and PEI statutes, a FDD must be delivered as required as one document at one time. 103 Interestingly, the Manitoba statute deviates from this requirement by providing that, if the disclosure document is not delivered as one document, the delivery requirement is not met until the date of the delivery of the last document. 104 F. Disclosure for Sales Agents 105 A franchise seller means any person substantively involved in the offer or sale of the Franchise. Substantive contact with the prospective franchisee is required. Franchise sellers are required to register in a number of franchise registration states. This obligation is separate from the disclosure obligations under Item 2 of the FDD. Registration is accomplished by submitting a Franchise Seller Disclosure Form as part of the franchise registration package. A franchise broker is any person or entity representing the franchisor in offering or selling franchises, that is not an employee, officer, or director of the franchisor (or its affiliate). Franchise brokers must register as a franchise broker in certain states (New York and Washington) and file as franchise seller in other states. They are no longer required to be disclosed in Item 2 of the FDD. Franchise brokers must comply with the same disclosure rules as the franchisor. A broker s actions and statements are attributable to the franchisor. 101 Ont Reg, s PEI Reg, s. 4 and Sch II. 103 Ontario Act, s. 5(3); PEI Act, s. 5(3); NB Act, s. 5(2). 104 Manitoba Act, s. 5(3). 105 [Disclosure of Sales Agents] Page 27

31 There are no disclosure or registration requirements for franchise sales agents or brokers under the various provincial statutes. Although, both can be liable for various matters under the statutes. G. Use of Wrap-Around Disclosure As discussed above, the general format and content of the FDD is prescribed by the FTC Rule. Therefore, it is easier to convert a foreign disclosure document to the FDD format than to create a wrap around document. The use of U.S. FDDs in Canada is problematic. All but the Ontario statute specifically permit the use of foreign FDDs, provided that there is an addendum which adds any information required under the relevant provincial statute that is missing. 106 Ontario, a very important franchise market, does not have such a provision in its statute, but does not prohibit the use of such wrap-around disclosure. However, the Ontario statute requires the FDD to be clear and concise 107, which many believe would render the use of most U.S. FDDs, even with a provincial addendum, dangerous. The Prince Edward Island and New Brunswick statutes, on this issue, are somewhat schizophrenic, as they specifically allow for the use of foreign FDDs, but also have the clear and concise requirement. 108 With these issues in mind and the cost of conforming a U.S. FDD approaching the cost of creating a proper FDD for Canada from scratch, the prevailing practice is to not use U.S. FDDs in Canada. H. Triggers for Disclosure The basic disclosure obligation under the FTC Rule is as follows: If a franchisor offers a franchise for sale, it must provide a FDD to the prospective franchisee at least 14 calendar-days before the prospect signs a binding agreement with, or makes a payment to, the franchisor or its affiliate in connection with the proposed franchise sale. In calculating the number of days that have elapsed, franchisors may not include the delivery date or the date a binding agreement is signed or consideration is paid. The prospect must receive a full fourteen calendar days to review the FDD. To prove compliance with the delivery requirements, the franchisor must obtain a signed and dated Receipt Page. The franchisor should calculate the number of days starting from the date the Receipt is signed by the prospective franchisee and not from the date it delivered the FDD to the prospective franchisee. 106 Alta Reg 240, s. 2(2); PEI Reg, s. 3(2); NB Reg, s Ontario Act, s. 5(6). 108 PEI Act, s. 5(6); NB Act, s. 5(7). Page 28

32 While the amended FTC Rule does away with the first personal contact disclosure trigger altogether, it adds some new disclosure triggers not found either in the original Rule or under any state franchise registration and disclosure law. A Franchisor must, in addition to the basic disclosure obligation, furnish an FDD upon: 1. reasonable request by a prospective franchisee; [The franchisee may incur considerable expense before signing or making any payment to the franchisor.] 2. renewal of the franchise agreement, if the renewal agreement contains terms and conditions that differ materially from the expiring franchise agreement and there is a required payment for the right to enter into a new franchise agreement; and 3. a sale by an existing franchisee where the franchisor has significant involvement with the transferee. [Mere approval or disapproval of the transfer is not significant involvement. Requiring a new franchise agreement is significant involvement.] There is no FTC Rule requirement that a franchisor re-disclose to prospective franchisees upon amending its FDD. However, a franchisor must re-disclose using its most current FDD upon reasonable request by a prospective franchisee. If the Franchisor unilaterally and materially alters the terms of any standard agreement attached to the FDD and to be signed by the prospective franchisee, it must provide an execution copy at least 7 calendar days before signing. This 7 calendar day rule does not apply to situations where the only difference between the franchise agreement appearing in the FDD and the execution copy of the franchise agreement are fill-in-the-blank provisions, e.g. date, name and address of franchisee. If substantive contractual details - such as geographic area of a protected territory and interest rates - are not disclosed in the basic FDD or its attachments, then the completed document must be disclosed 7 calendar days before signing. 109 It is important to note that if the parties are negotiating substantive terms at the initiation of the prospect, then no additional waiting period is required. New York and Rhode Island still require that a franchisor provide its prospects with the FDD at the earlier of the first personal meeting or 10 business days before the execution of the franchise or other agreement or the payment of any consideration that relates to the franchise relationship. Michigan, Oregon and Washington require that a franchisor provide its prospect with the FDD at least 10 business days before the execution of any binding franchise or other agreement or the payment of any consideration, whichever occurs first. For all registration states, the FDD must be re-disclosed to prospective franchisees upon the occurrence of a material change. A material modification to an existing franchise agreement does not create a disclosure obligation, except under the California Franchise Investment Act. The FTC Staff has Fed. Reg n.277. Page 29

33 commented that the FTC Rule imposes no material modification disclosure where an existing franchisee and franchisor merely seek to amend their ongoing relationship and that the material information that the franchisee needs is the revised franchise agreement. 110 The California Franchise Investment Law contains a registration and disclosure requirement for material modifications to existing franchises. 111 A franchisor must deliver the FDD to each prospective franchisee. Prospective franchisee means any person (including any agent, representative or employee) who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship. In the case of a corporate prospect, the FDD can be furnished to, and the receipt signed by, a single officer. Although the FTC Compliance Guide is silent with respect to a limited liability company, by analogy, one would think that the FDD can be delivered to, and the receipt signed by, a manager, managing member or officer of a limited liability company. Similarly, if the prospective franchisee is a limited partnership, the general partner may receive and sign. For a general partnership or group of individuals, it is also reasonable to assume that one person can act as agent or representative for the other partner(s) or individual(s).but in the absence of a written statement signed by the other partners or individuals appointing a person as agent or representative, the FDD should be delivered to, and a signed receipt obtained from, each partner or individual. The provincial statutes are uniform on the triggering events for disclosure; the payment of any money or the signing of any agreement relating to the franchise. 112 They are also uniform on the time frame for disclosure; 14 days before the triggering event. 113 There is no guidance in the legislation as to whether or not the date of delivery can be included in the 14 days. All of the provincial statutes, except the Alberta statute, require disclosure on renewals or extensions of franchise agreement, unless there has been no interruption in the operation of the business operated by the franchisee under the franchise agreement and there has been no material change since the franchise agreement or latest renewal or extension of the franchise agreement. While not required by statute, the best practice is for franchisors to obtain signed receipts from prospective franchisees attesting to the date upon which they received the FDD. I. Electronic Delivery The FTC Rule permits franchisors to deliver the FDD in either paper or electronic form. Electronic form includes access to an internet copy on a website, by in pdf format, on a computer disk or CD-ROM, or by facsimile transmission 114. Before furnishing the FDD see Statement of Basis and Purpose at page 64. California Corp Code Ontario Act, s. 5(1); Alberta Act, s. 4(2); PEI Act, s. 5(1); NB Act, s. 5(1). 113 Ontario Act, s. 5(1); Alberta Act, s. 4(2); PEI Act, s. 5(1); NB Act, s. 5(1) CFR Page 30

34 electronically, a franchisor must advise the prospect on: (a) the formats in which the FDD is made available; (b) any prerequisites for obtaining the FDD in a particular format; and (c) any conditions necessary for reviewing the FDD in a particular form 115. Since this needs to be done before the FDD is provided, one place to provide this information might be, as the FTC Staff has suggested, on the franchise application form (or online screen). Alternatively, the franchisor can send prospects an in advance of sending the FDD. The following is a sample disclosure statement: We will be sending you our Franchise Disclosure Document ( FDD ) as a Pdf attachment to an . You will need to have a computer and an address that can receive an with a [Insert Size] MB attachment. Receiving our FDD may take a long time unless you have a broadband connection. You also need a copy of Adobe Reader, which you may already have on your computer, or which you can download for free at [Insert URL]. Please let us know if you anticipate any difficulty in receiving our FDD. If Electronic Disclosure is used, the FDD must be made available as a single document, with no extraneous content, with no links to or from external documents. Franchisors may, for the sole purpose of enhancing the prospects ability to maneuver within the document, use scroll bars, internal links and search features. All other features are prohibited, including audio, video, animation or pop-ups. The FDD must be in a form that permits each prospective franchisee to store, download and print, or otherwise maintain it for future reference. The franchisor must provide directions for downloading. If the receipt is to be signed electronically, the franchisor must provide directions for signing. An electronic signature includes security codes, passwords, electronic signatures and similar devices. The PEI and New Brunswick regulations are the only provincial regulations which permit delivery of disclosure documents via Multiple conditions attach to this option however. The principal conditions are that the sender has to ensure that the disclosure document is delivered in a single document or file, has only the content that is required, has no links to or from external documents or content, is delivered in a form that provides the reader with the option to store, retrieve and print the document and adheres to the content and format requirements of law CFR 436.6(g). 116 PEI Reg, s. 2(b); NB Reg, ss. 3(1)(b) and 3(2). Page 31

35 J. Annual Updates versus Continual Updates Under the FTC Rule, a franchisor must update its FDD annually within 120 days after the end of its fiscal year. 117 A franchisor must also update its FDD within a reasonable time after the end of each fiscal quarter to reflect any material changes. Fortunately for franchisors, certain disclosure requirements only require annual updating. For example, franchisor-initiated litigation in Item 3 of the FDD and the status of franchised and corporate units in Item 20 of the FDD must only be updated once a year. In addition, the FTC Rule now permits the first quarterly update to be incorporated into the annual update. 118 The FTC Rule mandates continuous updating in one area. When furnishing the FDD, the franchisor must notify the prospect of any material changes to the financial performance representations contained in Item 19. The term notify does not mean furnishing an updated FDD. The franchisor may inform the prospective franchisee of the material change to Item 19 in any reasonable manner, such as by . In contrast to the FTC Rule, most state franchise registration laws require continuous updating for material changes. These state laws usually require franchisors to cease offering and selling franchises until they file an amendment to the FDD and where applicable the Franchise Examiner declares it to be effective. One of the most difficult issues for franchisors is determining when a change is material. As discussed above, the FTC Rule no longer defines material change and franchisors are required to seek guidance from the relevant jurisprudence. In contrast, a number of states provide regulatory guidance as to what constitutes a material change. 119 Although not comprehensive, these regulations provide concrete examples of what will be considered material. For example, under New York s State Franchise Law Regulations material change includes, but is not limited to: 1. The termination, closing, or failure to renew; during a 3-month period, of the lesser of 10 or 10% of the franchises of a franchisor, regardless of location. 2. A purchase by the franchisor in excess of 5% of its existing franchises during 6 consecutive months. 3. A change in the franchise fees charged by the franchisor. 4. Any significant adverse change in the business condition of the franchisor or in any of the following: (i) The obligations of the franchisee to purchase items from the franchisor or its designated sources CFR 436.7(a). 16 CFR 436.7(c). They include Hawaii, Maryland, Minnesota, New York and Wisconsin. Page 32

36 (ii) (iii) (iv) (v) (vi) Limitations or restrictions on the goods or services which the franchisee may offer to its customers. The obligations to be performed by the franchisor. The franchise contract or agreements, including amendments thereto. The franchisor s accounting system resulting in a 5% or greater change in its net profit or loss in any 6 month period. The service, product, or model line. 5. Audited financial statements of the preceding fiscal year. 120 Unlike in the U.S., there is no requirement in Canada to do an annual update of the entire FDD. Rather, much of a Canadian FDD needs to be current and up to date each time the document is delivered to a prospective franchisee. The following is a list of certain items required in an FDD and the time frames in which they must be updated: 6. Unless indicated otherwise, each item of disclosure must be accurate and current to the date of delivery of the FDD. Some items of particular concern are: a) Directors and officers who might change from time to time; b) Costs of establishing the franchise; c) Litigation, insolvency proceedings and administrative proceedings; & d) List of existing franchisees. 7. As soon as new financial statements are prepared for the previous fiscal year, they must replace the existing financial statements used in the franchisor s standard form FDD. Such new financial statements must be prepared no later than 180 days following the end of the last fiscal year. 8. The following items relate to fiscal years: a) Advertising fund: - percentage of the fund spent on national campaigns and local advertising in the 2 preceding fiscal years 120 NY Code R & Regs Page 33

37 - percentage of the fund retained by the franchisor, the franchisor s parent or the franchisor s associate in the 2 preceding fiscal years - projection of the amount of the franchisee s contribution to the fund - projection of the percentage of the fund to be spent on national or local advertising campaigns for the current fiscal year - projection of the percentage of the fund to be retained by the franchisor, the franchisor s parent or the franchisor s associate in the current fiscal year b) Former franchisees: K. Supplemental Disclosure - name, last known address and telephone number for those who left the system in the last fiscal year - reasons for the closure of each franchise during the last 3 fiscal years Rule. Certain types of supplemental disclosure are expressly permitted under the FTC If a franchisor wishes to disclose only the actual operating results for a specific outlet being offered for sale, it need not comply with Item 19, provided the information is given only to potential purchasers of that outlet. This disclosure does not have to be part of the FDD and there is no specific timing requirement for it in the FTC Rule. Therefore, a franchisor can give actual records of an existing outlet at any time; provided at some point it gives the FDD and the required cooling off period. Because the language states actual records, franchisors should avoid providing any summary information and should disclose only the actual financial statements and other records that were produced for the outlet, except as set forth in the next paragraph. If a franchisor furnishes financial performance information according to Item 19, the franchisor may deliver to a prospective franchisee a supplemental financial performance representation about a particular location or variation, apart from the FDD. The supplemental representation must: (1) be in writing; (2) explain the departure from the financial performance representation in the FDD; and (3) be prepared in accordance with the requirements of Instruction (3)(i) through (iv) of Item 19. If a franchisor is selling a previously-owned franchised outlet now under its control, it must disclose the following additional information for that outlet for the last five fiscal years: (1) The name, city and state, current business telephone number, or if unknown, last Page 34

38 known home telephone number of each previous owner of the outlet; (2) the time period when each previous owner controlled the outlet; (3) the reason for each previous change in ownership (for example, termination, non-renewal, voluntary transfer, ceased operations); and (4) the time period(s) when the franchisor retained control of the outlet (for example, after termination, nonrenewal, or reacquisition). This information may be attached as an addendum to a FDD, or, if disclosure has already been made, then in a supplement to the previously furnished FDD. There are no requirements regarding earnings projections or other financial performance, other than as described above, under the various provincial statutes. L. Remedies Potential liability for failure to provide adequate disclose or failure to register, where applicable, is as follows: The FTC may (a) impose civil penalties of up to $11,000 per violation of the FTC Rule (b) require rescission, reformation, payment of refunds or damages, (c) issue cease-and-desist orders, or (d) combinations of these remedies. There is no private right of action for violations of the FTC Rule, although some state consumer fraud statutes (known as Little FTC Acts ) make any violation of the FTC Rule a state law violation. The FTC has imposed liability on the officers and directors of corporate franchisors. State regulators have powers that are similar to those of the FTC. Most state franchise and business opportunity laws, and Little FTC Acts also provide a private right of action for (a) rescission, damages, costs and attorneys fees, (b) sometimes multiple or punitive damages, and (c) willful violations of state laws may also result in criminal penalties, including fines and imprisonment. Most state laws expressly impose joint and several liability on all controlling persons, partners, directors, principal officers and employees who aid a violation or are responsible for compliance. 121 The Statement of Basis and Purpose states that the FTC may seek injunctive relief against any individual if he or she participated directly in the wrongful practice or had the authority to control the corporation. For an individual to be held liable to pay consumer redress, the FTC must show more than authority to control the corporation. It must show that the 121 The American Bar Association Forum on Franchising s, Fundamentals of Franchising, Rupert M. Barkoff and Andrew C. Seldon Editors (2004). Page 35

39 individual possessed some level of knowledge of material misrepresentations or an awareness of a high probability of fraud along with an intention to avoid the truth. 122 The FTC acts against non-compliant businesses based primarily on complaints and annual national sweeps of internet, newspaper, and other advertising. 123 The hits generated by national sweeps are delegated to the FTC or to a state for further review. If the government Consumer Sentinel database shows matching consumer complaints, 124 the odds of a franchise system being screened for further investigation rises. The provincial statutes provide for the right of rescission for non-disclosure for up to two (2) years from the date of signing the franchise agreement or for up to sixty (60) days from the date of signing the franchise agreement for late or defective disclosure. 125 Much of the recent franchise litigation in Canada has centered around the question of whether or not a particular FDD was so defective as to amount to nondisclosure, thus providing the franchisee with a longer window to rescind the franchise agreement. 126 If rescission is successful, the franchisor must reimburse the franchisee for all moneys invested by the franchisee, whether with the franchisor or third parties, and any losses sustained by the franchisee. 127 Franchisees also have a statutory cause of action for damages for misrepresentations in the FDD or the failure of the franchisor to comply with the disclosure obligations contained in the particular provincial statute Limitation Periods The limitation period for a franchise related claim will vary depending on the cause of action. For a cause of action based on breach of a franchise statute, the limitation period will typically be prescribed by the franchise statute. For a cause of action based on a breach of the franchise agreement, the limitation period will vary be state and can be as long as 6 years Fed. Reg. at See Press Release, Federal Trade Commission, Operation Money Pit Targets Fraudulent Business Opportunity Schemes (Feb. 20, 1998), available at (describing fourteen actions announced as part of a mini-sweep targeting sellers of fraudulent business opportunities). See Consumer Sentinel, at (allowing various law enforcement agencies to access consumer complaints about various fraudulent activities). The Consumer Sentinel is a government database of consumer and other complaints from all possible sources. 125 Ontario Act, s. 6; Alberta Act, s. 13; PEI Act, s. 6; NB Act, s See Canada Inc. v. Dollar It Limited, 2009 ONCA 385, 95 OR (3d) 291; 310 DLR (4th) 683 < Melnychuk v. Blitz Limited, 2010 ONSC 566 < 127 Ontario Act, s. 6(6); Alberta Act, s. 14(2); PEI Act, s. 6(6); NB Act, s. 6(6). 128 Ontario Act, s. 7; Alberta Act, s. 9; PEI Act, s. 7; NB Act, s. 7. Page 36

40 2. Private Right of Action As mentioned above, there is no private right of action under the FTC Rule. However, some state consumer fraud statutes make violation of the FTC Rule a violation and provide for private right of action. Most state franchise laws provide for a private right of action. M. Relationship Laws A number of states have franchise laws governing the relationship between franchisor and franchisee after the franchise sale. By way of example, the Michigan Franchise Investment Law makes certain provisions of any franchise document void and unenforceable. These provisions include (1) a provision permitting a franchisor to terminate a franchise except for good cause, (2) a provision that permits a franchisor not to renew a franchise agreement of less than 5 years without compensating the franchisee by repurchase or other means for the fair market value of inventory, supplies, equipment, fixtures and furnishings (only applies where there is a non-compete) and (3) provisions regarding a franchisee s right to transfer ownership. Some of these relationship laws are extremely broad in scope and capture more than franchise relationships. Under the New Jersey Franchise Practices Act franchise means: A written agreement of a definite or indefinite period, in which: (i) a person grants to another person a license to use a trade name, trade mark, service mark, or related characteristics; and (ii) there is a community of interest in the marketing of goods or services at wholesale, retail, by lease, agreement or otherwise With respect to the community of interest element, New Jersey courts focus on the interdependence between the manufacturer and the dealer. Interdependence is measured largely by the relative size of the dealer s investment and whether the dealer is tied to one manufacturer. The New Jersey Franchise Practices Act applies only to a franchise where: (i) the franchisee is required to establish or maintain a place of business within New Jersey; (ii) gross sales of underlying product exceeds $35,000 for the 12 months preceding the suit; and (iii) more than 20% of franchisee gross sales are from the franchise. The Act s provisions cannot be waived by the franchisee. If the relationship constitutes a franchise, then the franchisor may not terminate or fail to renew the agreement without first giving written notice setting forth all the reasons for termination or non-renewal, at least 60 days in advance, except for: (i) voluntary abandonment (where 15 days notice is required); and (ii) an indictable offense directly related to the business (where termination can be immediate). In addition, the franchisor must have good cause to terminate or fail to renew. Under the Act, good cause means failure by the franchisee to substantially comply with those requirements imposed upon him or her by the franchise. All of the provincial statutes have similar, but very limited, relationship provisions. Essentially, the right of franchisees to organize themselves into associations is Page 37

41 protected 129 and there is an implied covenant of fair dealing in all franchise agreements. 130 All but the Alberta statute provide that the implied covenant of fair dealing includes the duty to act in good faith and in accordance with reasonable commercial standards. N. Business Opportunity Laws The sale of business opportunities or seller assisted marketing plans is regulated at the federal level under the FTC Rule and in a large number of states. 131 If a business opportunity law is applicable, pre-sale disclosure and registration obligations similar to those for franchises would apply. Some states require the seller to post a surety bond. The FTC has indicated that business opportunity complaints significantly outnumber franchise complaints; therefore, its enforcement efforts often focus on business opportunities. The FTC Rule defines a business opportunity as a business arrangement in which: (a) the seller supplies the buyer with goods or services; (b) the seller assists the buyer in securing outlets, accounts, or locations for the buyer or provides the buyer with display racks ; and (c)the buyer is required to make a $500 payment to seller during the first 6 months. The fee element in the FTC Rule definition of business opportunity is the same as the fee element under the FTC Rule definition of franchise. Therefore, if the franchise fee element is eliminated as discussed above, this would eliminate any doubt about whether the federal business opportunity definition applies. The definition of a business opportunity and the available exemptions and exceptions differ widely from state to state, making it difficult to generalize about their application. For ease of discussion only, the definitions have been summarized as follows 132 : (a) a seller furnishes goods or services; (b) for a payment of $500 or more; 133 (c) to enable the buyer to start a business; and (d) the seller represents to the buyer any one or more of the following: (i) the business arrangement may, will, or can earn the buyer more income than the cost of the program; (ii) the seller will buy back all or part of the buyer s output; (iii) the seller will find, or help find, locations for racks, vending machines, etc.; (iv) if the buyer becomes dissatisfied with the deal, the seller will refund the initial payment or buy back the deal; (e) for a fee, the seller will provide a marketing or operating plan; (f) a market exists for the products to be sold by the business opportunity; (g) the seller will sell, lease or distribute products; or (h) the seller will pay the buyer the difference between the buyer s initial payment and actual investment earnings. If any of the enumerated representations is made (and assuming all other statutory conditions are 129 Ontario Act, s. 4; Alberta Act, s. 8; PEI Act, s. 4; NB Act, s Ontario Act, s. 3; Alberta Act, s. 7; PEI Act, s. 3; NB Act, s Alaska, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia, and Washington Rochelle B. Spendorf and Mark A. Kirsch, The Accidental Franchise, ABA Forum on Franchising 2001, pg. 22 Some states have a lower fee threshold. Page 38

42 met and there no basis for an exemption exists), the arrangement qualifies as a business opportunity under state law. There are a wide variety of exemptions and exclusions, but they are not consistently available under the various state laws. Therefore an exemption that works in a number of business opportunity states may not apply in the balance of the business opportunity states. These laws do not apply to franchise companies that have a federally registered trademark and are in compliance with the FTC Rule, except that filings are required in a few states. 134 It is important that Canadian franchisors register their trademarks well in advance of bringing their system to the United States to avoid the added complication of having to comply with U.S. business opportunity laws. For example, Connecticut requires the submission of a disclosure document for approval. Although it accepts the FDD format, a Connecticut cover sheet must be added and the franchisor must file a cross-reference sheet showing where the disclosures required under the Connecticut law are located in the FDD. Specific business opportunity legislation does not exist in Canada. As mentioned above, through an expanded definition of a franchise in all of the provincial statutes, with the exception of Alberta, common business opportunity arrangements are caught by those statutes. V. Conclusion There are significant differences in the approaches taken by U.S. and Canadian legislators to franchise regulation. One of the most profound differences between U.S. and Canadian franchise legislation being the U.S. registration requirement. Registration creates additional hurdles for franchisors attempting to offer franchises in all U.S. states, including, the potential for delay, additional costs, and the escrow or deferral of franchise fees. On the other hand, state review does provide some measure of assurance that the franchisor has properly met its disclosure obligation. The U.S. registration requirement also influences the updating requirement in the U.S. Unlike in Canada where updating is continual, it would be impractical to require franchisors to amend their registered FDD every time there was change in information. Although material changes do dictate the filing of amendments in the U.S. franchise registration states. Another striking difference is the U.S. concept of prescribed disclosures versus the Canadian requirement to disclose all material facts. The latter standard leaves Canadian franchisors and their advisors to ponder the breadth of materiality. Other note worthy differences include the U.S. audited financial statement requirement and the U.S. sales agent and broker disclosure and filing requirements. The audit 134 Connecticut (one time); Florida (annually); Kentucky (one time); Nebraska (one time); Texas (one time); and Utah (annually). Page 39

43 requirement is a source of additional cost and often influences the corporate structure used by Canadian franchisors bringing their system to the United States.The sales agent and broker disclosure and filing requirement adds to the franchisors administrative burden. Finally, it is worth noting that U.S. franchisors and their advisors have access to a wide range of interpretive and other ancillary materials. Their Canadian counterparts have no such luxury and are left to rely on their skill in statutory interpretation and the scarce amount of case law that exists at this time Page 40