Franchise Law

Interesting Article on The New Rule Changes regarding Franchising your Business.

FTC Rule Change: The Question Of When

By:
Franchise Update
FranchiseLawNews.com
NOVEMBER 08, 2005 08:11:00 AM

For those of you who have been living under a rock for the past 10 years, I have a newsflash: Since 1995, The Federal Trade Commission has been involved in a rule- making process to amend the FTC Rule (the "Rule") to change certain disclosure requirements and to recognize certain changes to the franchise business sales model and use of technology in the franchise sales process. What we know is the likely substance of the changes; what we don't know is when they'll be implemented.

There has been almost as much written about when the Rule changes will become effective, as about the Rule itself. The smart commentators are exercising restraint in making even the next estimate of when the Rule changes will become effective. If you are dying for the Rule change, blame the spammers, telemarketers, and junk faxers for consuming all of your regulatory resources.

Many of you remember, if not the entire process, many pieces along the way. After nearly a decade of soliciting comments on the Rule, receiving and reviewing countless written comments on the Rule, and holding six public workshops to address the Rule in a round-table fashion, the FTC released the Report Regarding Disclosure Requirements and Prohibitions Concerning Franchising last August and solicited public comments through November, leaving only the finalizing of the Rule, and drafting the Statement of Basis and Purpose to be completed and submitted to the Commission for review and approval. These final 2 steps have been completed, and the entire package is awaiting action by the Commission. There are no time limits within which the Commission must begin or complete the review, because the Commission has the authority and discretion to devote resources to the most compelling matters.

Ultimately, the Report proposes that the FTC should retain the Rule as it continues to serve a useful purpose. The Report essentially makes three broad recommendations to the FTC:
Narrow the Rule: The Report suggests that the Rule be narrowed to focus exclusively on franchises.

Adopt Changes to the Disclosures: The Report suggests that the Rule be revised in such a way that its requirements regarding disclosures be more consistent with NASAA's UFOC disclosure guidelines.

Regulations Affecting the Franchise Relationship are Unnecessary:
The Report suggests that further regulations affecting post-sales
franchisor-franchisee relationships are unnecessary.In addition, the Rule joins the 21st Century by permitting the use of electronic disclosure and eliminates disclosure for brokers (including their litigation and bankruptcy history), resolving a sea of uncertainty precipitated by the modern use of multi-broker franchise lead referral methods, which has suffered from overdisclosure in the past few years.

Narrowing the Rule:The Report recommends that the Rule be amended to focus solely on business-format franchises by revising the definition of "franchise," and thus eliminating coverage of business opportunities from the scope of the Rule. The Report stated that the principal concern regarding business opportunities is outright fraud. Under the new definition of "franchise," the franchisor would have to offer significant assistance "extending beyond the start of the business operation." This recommendation benefits franchisors significantly as business opportunities have traditionally generated a greater number of complaints and the disclosures required by the FTC can be more narrowly tailored to business format franchising.

Disclosure Changes:Many of the Report's recommendations are intended to update the Rule to be more consistent with the UFOC guidelines used in the various franchise registration states.

The major highlights regarding the new disclosure requirements are outlined below: Item 3: Litigation - Item 3 would require the same disclosures as the UFOC guidelines; however, franchisors would be required to disclose actions involving predecessors, as well as routine litigations impacting the franchisor's financial condition. Furthermore, the Rule would be expanded to require franchisors to disclose material franchisor-initiated litigation against franchisees involving the franchise relationship and permit like claims to be presented together-such as royalty collection actions. There is no 7- or 10- year carryover; the Rule would require disclosure of pending actions only. Actions involving "the franchise relationship" are defined as those contractual obligations between a franchisor and franchisee directly relating to the operation of the franchised business - like royalties and training obligations. It does not include third party or tort claims. This disclosure is different from the UFOC Guidelines and current Rule. The practical effect of these changes is that a franchisor will likely direct more resources to alternative forms of dispute resolution, which are not disclosable, prior to initiating an enforcement action against a franchisee.

Item 4: Bankruptcy - Item 4 extends the disclosure period to 10 years rather than the existing 7 years to match the UFOC Guidelines and retains the requirement to disclose a parent's bankruptcy.

Item 10: Financing - Item 10 would expand the current FTC Rule to require a franchisor to disclose all material terms and conditions of any financing agreements. Franchisors would be required to disclose the annual percentage rate of any financing and would require more disclosure about what the financing covers, waivers of defenses, and the franchisor's practice or intent to sell or assign the obligation to a third party.

Item 19: Earnings Claim - The new Rule significantly affects an earnings claim disclosure. Under the new Rule, the name of the disclosure is changed from "earnings claims" to "financial performance representation." The new Rule permits franchisors to provide financial performance information to prospective franchisees for all or a subgroup of company-owned and/or franchised outlets if it discloses the number and percentage of outlets that attained or surpassed the stated results based on the number of outlets in the subset rather than the number of outlets in the entire franchise system, along with any characteristics of the measured subset that differ from the offered unit. The new Rule eliminates the geographic relevance requirement under the Rule. The new Rule also adopts the approach taken under the UFOC format which permits franchisors to provide financial performance information within the body of the main disclosure document, thus eliminating the need for a separate earnings claim disclosure document.

Item 20: Outlets and Franchisee Information - Item 20 would expand the scope of the current FTC Rule to mirror the UFOC Guidelines; however, the proposed Rule would differ from the UFOC Guidelines in two respects. First, the proposed Rule would eliminate a double-counting problem by adopting and using a "first-in-time" approach. Second, the Rule would require a franchisor to identify any franchisees subject to a confidentiality agreement, presumably to advise prospects that certain franchisees have signed contracts restricting their ability to discuss the relationship. Franchisors can express this measure either in terms of the number or percentage of franchisees under a confidentiality order and explain the circumstance surrounding such orders. Franchisors must also disclose any franchisor created franchisee organizations and incorporated independent organizations that request inclusion.
The Report recommends that the existing five-business-day rule within which a franchisee must obtain a final version of his proposed franchise agreement with all of the blanks filled in, be changed to five calendar days with a three-day extension for mailing. The proposed Rule eliminates the "first personal meeting" trigger of when you must give disclosure in favor of a 14-day prior-to-sale disclosure requirement.

The information contained in a disclosure document will be required to be updated quarterly, but updates may be sent under a separate cover to franchisees who have already been disclosed. The plain English requirement has been retained and the Rule does not provide a private right of action to franchisees.

New Exemptions There are also exemptions for large/sophisticated franchisees that are part of the franchisor's ownership/management, and franchises that involve investments exceeding $1,000,000. The Report also makes clear that the proposed Rule would not apply to international franchise transactions.

Electronic DisclosureElectronic delivery of the disclosure document will be permitted without any requirement to deliver a paper copy of a Receipt. Documents may be transmitted by fax, e-mail, and electronic copies (cd-rom or similar medium), or through directions for accessing the document on the Internet. The prospect must be able to store, download, print or otherwise retain the document for future reference. While scroll bars, internal links and search options will be permitted, no enhancements, such as video, pop-up menus or similar techniques may be used. Before furnishing a disclosure document, the prospect must be advised of the formats in which the document is available and any computer programs needed to view or obtain the document. Franchisors who offer the document in different formats will be permitted to use a prescribed statement on the cover page of the disclosure document. Prospective franchisees will be permitted to execute a Receipt with an electronic signature and password and may return them by mail, e-mail or facsimile. In addition, franchisee representatives, like lawyers or accountants, will be permitted to receive a disclosure document and sign the Receipt on behalf of the prospect.

During the comment period, franchisee advocates sought to have the scope of the Rule extended to regulate post-sale abusive franchise relationships. Franchisees urged the FTC to adopt changes to the Rule prohibiting post-term covenants not to compete, prohibiting encroachments, and restricting regulations regarding approved products and services. The Report concluded, however, that the extensive pre-sale disclosures protect prospective franchisees from fraudulent and deceptive franchise sales practices and in turn protect prospective franchisees from abusive franchise relationships. Ultimately, the Report stated that the FTC lacks the statutory ability to broaden the Rule to address post-sale franchise relationship issues, as franchise relationships are private contractual matters that are regulated by the individual states. The Report noted that most injuries to franchisees can be prevented as franchise purchases are strictly voluntary.

The Report has recommended a Rule that will ensure ease of compliance as it is consistent with the requirements of the UFOC Guidelines. Once the FTC adopts a new Rule, each state will likely amend state laws to be more consistent with Rule changes.

By Lane Fisher

Francorp - Franchising

Here is an interesting article on franchising from CNN. There are countless stories out there about franchise companies mistreating the franchisees through improper disclosure and unfair dealings during the sales process.

New franchise rule: More disclosure, same high risks
A decade-in-the-making revision of the FTC's Franchise Rule requires franchise owners to disclose more data, but it doesn't bring the change franchisees say they most need: documented financial projections.


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February 29 2008: 5:17 PM EST



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(FORTUNE Small Business) -- If Beth Tomei had only known.

In November 2004, the Walnut Creek, Calif., fitness club owner signed a franchise agreement with the Butterfly Life women's fitness company in hopes of cashing in on the company's Curves-like business circuit training plan. Soon, however, she realized all was not right: she learned that 12 of the company's 16 California franchises were failing or had failed, she says; that the start-up costs would be close to twice those claimed in the company's franchise prospectus; and that the oral profitability claims she'd been given were mostly wishful thinking.

Today, down $450,000 in savings and home equity, she is part of a group of franchisees involved in a class arbitration claim against Butterfly Life.

"If they had been required to disclose more and do it more clearly, I think a lot of heartache could have been saved and would be saved for future franchisees," Tomei said. A Butterfly Life representative did not return calls for comment.

It seems that Tomei may get her wish. Since 1995, the Federal Trade Commission (FTC) has been studying ways to update the Franchise Rule - the regulations governing the sale of franchises to aspiring business owners - to make it more consistent with state regulations. On July 1, the fruit of 13 years of internal meetings, public workshops and industry comment becomes real when the new and improved Franchise Rule goes into effect.

But while Tomei and other franchisees and franchisee advocates applaud the changes, many say the new rule falls short of being the far-reaching revision needed to protect prospective franchisees from the abuses reported in an FSB cover story two years ago, "Risk/Reward." Instead they, echo Susan Kezios, the president of the American Franchise Association franchisee group, who wrote in a recent industry trade publication article: "The FTC labored a dozen years to revise its Franchise Rule - only to give birth to a mouse."

Would You Pay $2 Million For This Franchise?
The new rule and its creation myth take up 133 pages in the Federal Register - its basic purpose is to define the information that franchisors must disclose in the document they provide prospective franchisees, currently known as the Uniform Franchise Offering Circular, or UFOC (California's Department of Corporations website collects a number of these, though not for the biggest franchisors; industry data firm FRANdata also sells them).

The new rules requires that franchisors provide additional information about subjects like franchisor-initiated lawsuits against franchisees; contact information for former franchisees who have left the franchise in the last year; franchise turnover; the dangers of buying non-exclusive territories; the franchisor's use of confidentiality clauses that stop current or former franchisees from talking about their experience with prospective franchisees; and contact information for independent franchisee groups.

This additional disclosure is good news for prospective franchisees, as it should help them make better decisions as they weigh an investment that can run from under $50,000 to more than $1.5 million.

"There are some very significant changes. By and large, more information for a franchisee is better. And they're getting more," said Michael Einbinder, a co-founder of New York law firm Einbinder & Dunn, which represents both franchisors and franchisees. "When I advise franchisee clients, if I see that a franchisor sued 35 franchisees last year, I worry because it means that they're trigger happy or they have a high failure rate."

Chris Schmitz, who owns or co-owns three Meineke Car Care Centers in Northern Virginia, agrees.

"I don't see how more information could ever be bad for franchisors," he said. "You want people who are confident that they're making a good investment. If you have nothing to hide, the more information that gets out, the better."

But what rankles some franchisees and their advocates is the omission of two big requests: the mandatory disclosure of earnings claims - projections of what a franchisee will make - and the franchisee's right to sue the franchisor if he feels that the company violated the FTC rule (known as a "private right to action").

Legal options for a disappointed franchisee
"They should be required to make earnings claims," said ex-Butterfly Life franchisee Tomei. "Then there's no chance to have something on a cocktail napkin or said in a seminar; the franchisor would have to back them up. It would close the opportunity for false the claims that are rampant in the business."

Bob Purvin, the CEO of the San Diego-based American Association of Franchisees & Dealers franchisee group, concurs.

"The lack of a private right of action and the lack of required performance data are pretty devastating," he said. "The first questions a prospective franchisee ask are, 'How much will I make?' and 'If you lie, can I bring legal action?' The original rule didn't provide those, and the new one still doesn't."

Of course, complaining is easy. As FTC staff attorney Craig Tregillus explains it, income projections would be impossible for young franchisors without a long history to make, and would have to be defined differently for each industry, from restaurants to rug cleaning. At the same time, he says, it would take an act of Congress - not of the FTC - to create a private right of action.

"Our only authority at the FTC is to do rulemaking within the FTC act," Tregillus said. "The courts have held that there is no private right of action under the act."

So You Want to Franchise Your Business?
In the end, what this means is that while the new rule will give prospective franchisees access to more and clearer data, it likely won't improve their odds.

"We have this wonderful fiction that franchisees should make these investments and franchisors can say, 'We don't provide any guidance.' They expect prospective franchisees, many of whom invest their life savings, mortgage their homes, and withdraw from 401(k)s, to make the investments without this information," said Eric Karp, a Boston franchise lawyer who teaches MBA courses in franchising at Babson College. "If financial disclosure information were given, I think the failure rate would go down."

That rate is hard to pinpoint, but in a 1994 study based on Census Bureau data on 20,000 new businesses, Wayne State University professor Timothy Bates found that 38% of franchise units failed over a four-year period, compared to 32% of independent startups. Today, Bates says he has seen no fundamental change in the failure rates he documented in the 1990s.

For former franchisee Tomei, the FTC's changes are good - just a few years too late.

"Had there been proper disclosure when I was looking at purchasing, there's no way I would have walked down this path," she said.

Have you had a good or bad experience franchising? Talk about it on our forum. And don't miss FSB's cover story on the dark side of franchising: "Risk/Reward"

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A road map for aspiring franchisers
What's a franchise territory worth?
Is my business franchise-worthy?
What are the steps to buying a franchise?