RUDNICK, WOLFE, EPSTIEN, & ZEIDMAN
WRITER'S DIRECT LINE:
May 13, 1997
Mr. Donald S. Clark
Re: 16 CFR Part 436
Dear Mr. Clark:
This comment is submitted in response to the Federal Trade Commission's ("FTC") request for comments contained in its Advance Notice of Proposed Rulemaking ("ANPR") that appeared in the February 28, 1997 issue of the Federal Register (Fed. Reg. Vol. 62. No. 40, pp. 9115-9127). The ANPR is the FTC's most recent request for comments with respect to its trade regulation rule entitled "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures," 16 CFR Part 436 ("FTC Rule"). This firm has submitted comments on behalf of the firm as well as for certain clients of the firm on two previous occasions. Our firm's attorneys also have participated as invited panelists at the FTC workshops held in Minneapolis in September 1995, and in Washington, D.C. in March 1996. In the interest of brevity, we will not repeat our earlier comments.
Franchising has not remained static since October 21, 1979 when the FTC Rule went into effect; for this reason, the FTC Rule should be reevaluated to ensure that it is accomplishing its regulatory objectives of providing meaningful pre-sale information to prospective franchisees, and sufficient time for them to review this information prior to purchasing a franchise. It has become apparent that the FTC Rule is neither needed nor workable for international transactions -- an ever increasing area of franchisor interest -- while, at the same time, the "business opportunity" definition in the FTC Rule needs refinement. The benefits of other possible FTC Rule modifications are not as obvious. We expect that the FTC staff has received, and will continue to receive, requests to expand the compliance responsibilities imposed on franchisors. This, in turn, will increase the compliance burdens and expenses of franchisors. The FTC has 171/2 years of experience in administering and enforcing the FTC Rule (and states with similar laws have even more experience) to use as a basis for evaluating any such requests, and we would urge the FTC to reject these requests unless the need is demonstrated by specific, established, quantifiable evidence of both consumer injury and prevalence. Unlike new regulations where actual experience is lacking and, therefore, proposals must be considered in light of their anticipated impact or, possibly, their current impact in analogous, circumstances, the strength and weaknesses of the FTC Rule are well-known; accordingly, there should be a high burden of proof based upon empirical evidence of consumer injury and prevalence to support any requested change that would impose additional compliance burdens on franchisors.
The following comments are organized in the same manner as the issues were presented in the ANPR.
I . Modifications to the Franchise Rule Disclosure Requirements
By way of background, we should note that members of the firm include individuals who previously worked at the FTC and who participated in the drafting, interpretation, and enforcement of the FTC Rule. Others participated in the initial FTC rulemaking proceeding which led to the promulgation of the FTC Rule. Others have served on committees of the North American Securities Administrators Association ("NASAA") (and its predecessor Midwest Securities Administrators Association) which recommended revisions to the Uniform Franchise Offering Circular ("UFOC") Guidelines. Today, members of the firm serve on a NASAA committee considering the issue of mandatory earnings claims. Moreover, on an annual basis, our firm drafts, revises, updates and/or files state franchise registrations on behalf of over 150 franchisors.
a. Explicit Exemptions
At the outset, we urge the FTC to consider incorporating into the FTC Rule a number of the exemptions that are recognized in state franchise registration/disclosure laws. For example, of the 15 states with franchise registration/disclosure laws, 13 states exempt from registration and disclosure requirements the renewal or extension of an existing franchise and/or additional franchise sales to existing franchisees (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, Washington, and Wisconsin). Nine states exempt sales to banks, financial institutions and institutional investors (Hawaii, Illinois, Maryland, Michigan, Minnesota, New York, South Dakota, Washington and Wisconsin). Eight states exempt sales by fiduciaries or court officials (Hawaii, Maryland, Michigan, Minnesota, Oregon, Rhode Island, South Dakota and Washington). Five states exempt large and/or sophisticated franchisees (Illinois, Maryland, Rhode Island, Washington and Wisconsin). Four states exempt infrequent or isolated sales (Indiana, Minnesota, New York and Washington), and another (Illinois) routinely grants discretionary exemptions in such circumstances. Because the FTC Rule may impose an independent obligation on franchisors to provide disclosure in these transactions, the usefulness of the state law exemption is often nullified because of the absence of a similar exemption from the FTC Rule. We know of no evidence to suggest that these state exemptions have led to consumer injury in the 20 years since their inception, and would urge the FTC to give serious thought to adding similar exemptions to the FTC Rule.
b. Litigation Disclosures
We believe that the proposal to expand the litigation disclosure to include litigation commenced by a franchisor against its franchisees is unwise. The current litigation disclosure focuses primarily on allegations of conduct by a franchisor which a prospective franchisee might reasonably conclude reflects adversely on the franchisor's integrity (i.e., fraud, deceptive practices, violations of a franchise law, etc.), and regardless of whether such conduct is alleged in an action commenced by a franchisee or as a counterclaim in an action commenced by a franchisor; conversely, no disclosure typically is required about litigation involving claims on other subjects, because the conduct does not reflect positively or negatively on the franchisor. To require disclosure of franchisor litigation against a franchisee implies that there is something "wrong" in the franchisor's having commenced litigation against the franchisee; yet, there is no reason to conclude that such conduct is inappropriate. Clearly, to require disclosure of this type of litigation would likely have a chilling effect on a franchisor's willingness to pursue its legal rights against a franchisee, for fear that there will be a negative implication associated with the action. We know of no empirical evidence of consumer injury or prevalence during the past 171/2 years to demonstrate the need for an expanded litigation disclosure.
C. Gag Orders
We also are unclear about the proposal concerning "gag orders," including how they are defined, and why the FTC is concerned about them. If a "gag order" refers to confidentiality agreements, then we would note that under the UFOC Guidelines, a franchisor cannot avoid litigation disclosures through use of confidentiality orders. In non-litigation situations, confidentiality agreements can serve a useful and legitimate purpose, and the forced disclosure of the specific terms of such agreements may discourage creative settlements containing concessions by a franchisor that would not be made if these concessions would lead to similar demands by other franchisees. Discouraging settlements which involve franchisor concessions would be detrimental to franchisees. Again, we would ask what empirical evidence exists about consumer injury or prevalence during the past 171/2 years to demonstrate the need for regulation.
d. Financial Statements
We suggest that the FTC leave unchanged its current three-year period for "growing into" fully audited financial statements. Although our firm usually has been able to fashion solutions for franchisors who lacked audited financial statements when they first commenced franchise sales, we have had occasion to prepare an offering circular using the FTC disclosure format solely because the franchiser could not, within a reasonable time or at reasonable expense, secure an audited financial statement when it first commenced franchising activities. We believe these circumstances are atypical, have little potential risk of consumer injury, and remove a potentially serious barrier to new entrants to franchising; for this reason, we suggest that the FTC leave the three year grow-in period unchanged.
e. Franchisee Turnover
The FTC's concern about the potential for double-counting of franchises turnover in Item 20 of the UFOC has a simple solution, i.e., clarification by the regulators of the appropriate method of describing certain transactions. For example, most transfers by franchisees or reacquisitions by franchisors also involve the termination of an existing franchise agreement. Since the UFOC Item 20 chart has a column for both "transfer" and "reacquisitions" as well as "cancellations and terminations," either transaction would appear to require two entries. A simple clarification about the appropriate method of describing a transaction which would otherwise require two entries would solve this problem. A NASAA Committee also is currently reviewing this issue.
2. Distinguishing Between Disclosure Requirements for Business Opportunities and for Franchisors
It has become self-evident that a franchisor has very little in common with a business opportunity seller. The FTC's enforcement experience demonstrates that most of the consumer injury, and a significant portion of the FTC's enforcement activities, involves business opportunity firms.
Twenty-five states regulate the sale of business opportunities separately from the sale of franchises. The current FTC Rule "business opportunity" definition, as well as the proposed definition, differs from the "business opportunity" definition commonly employed by these 25 states. The proposed definition also is very broad and ambiguous in its reliance on an undefined "more than nominal assistance" standard, and we are concerned that it could bring within its scope traditional product distribution arrangements which never have been a consumer protection problem. As a possible alternative definition, we would urge the FTC to review the definition of "business opportunity" found in most state business opportunity statutes. Adopting the states' definition would have the additional benefit of making FTC Rule business opportunity sales coverage more similar to state business opportunity laws. Most importantly, however, we believe that the FTC should draw upon its own experience with business opportunity enforcement in fashioning a definition that would encompass the business opportunity arrangements which have been the source of most of the consumer injury, as well as focusing on the types of disclosures that are best suited for business opportunity purchasers.
3. Conditional Exemption for Trade Show Promoters
Our firm previously has filed comments on behalf of several business opportunity show promoters and has participated on their behalf in the FTC's September 1995 workshop. We believe that the FTC staff has correctly concluded that trade show promoters do not act as brokers, do not participate in the offer or sale of franchises, do not make sales recommendations, do not create materials used by franchisor-exhibitors to sell franchises, and, as a practical matter, lack the ability to monitor franchisor-exhibitor sales practices at their shows. Therefore, there is no reason to treat promoters as "franchise brokers" under the FTC Rule or to attempt to hold them accountable for conduct by exhibitors whom the promoters do not control and cannot effectively police.
4. Earnings Disclosures
Two of our firm's attorneys are members of a NASAA committee which currently is considering the issue of mandatory earnings claims. Each year, an increasing number of franchisors are including an earnings claim in their offering circular. The ANPR indicates that the FTC does not believe that it is unfair or deceptive for a franchiser to offer and sell franchises without making an earnings claim. The ANPR also suggests that the FTC is disinclined to require franchisors to make an earnings claim, believing that normal market forces and the availability of alternative sources of earnings information provide viable alternative choices for prospective franchisees. We agree with the FTC's conclusion, and would add that the existence of more aware and sophisticated franchisees, as well as greater acceptance among state and federal regulators of earnings claims, also has encouraged franchisors to make earnings claims. There are a number of reasons, having nothing to do with attempting to hide poor performance, why a franchisor may choose not to make an earnings claim. From our perspective in drafting earnings claims for franchisors, we have come to appreciate the complexity of this issue (and the ANPR suggests that the FTC also recognizes this fact), given the wide diversity among franchisors, the industries in which they operate, the financial benchmarks used in such industries to assess performance, the differences among systems with respect to the presence of franchisor-owned units to provide data or to use as a benchmark for assessing franchisee-supplied data, the reliability of the data submitted by franchisees, and franchisors' contractual rights to obtain data from franchisees upon which to base earnings claims. These and other factors also make it extremely difficult to draft a uniform mandatory earnings claim format which will provide useful information to all prospective franchisees. For these reasons, we also question the need for mandatory earnings claims.
We think it essential, however, that whatever policy the FTC selects with respect to mandatory earnings claims be consistent with the policies of the state regulators. Otherwise, franchisors who do not wish to make an earnings claim unless required to do so will be placed in an untenable position of trying simultaneously to comply with inconsistent policies. For example, if an earnings claim is required for a registration state but not required by the FTC and, thus, not needed in a non-registration state, how will a franchisor shield prospective franchisees in a non-registration state from the earnings claim required in a registration state? Federal and state regulators must develop a coherent and compatible earnings claim policy in order to ensure that franchisors will not be exposed to risks caused by inconsistent and uncoordinated federal and state policies.
5. New Marketing Practices and Technological Developments
a. International Transactions
Our firm previously submitted written comments urging the FTC to exclude international transactions from FTC Rule coverage, and appeared as panelists at the FTC workshop in March 1996 devoted exclusively to this subject to reiterate our strong belief that such transactions should be excluded. The ANPR indicates that the record strongly supports modification of the FTC Rule to exclude international sales. A recent, and as yet unreported, decision in the United States District Court for the Southern District of Florida entitled Nieman v. Dryclean U.S.A. Franchise Company, Inc. (95-1390-Civ) again highlights the problem currently facing franchisors engaged in international franchise sales transactions of potential legal liability predicated on the FTC Rule. In this case, the court, in applying the Florida Little FTC Act, denied summary judgment to a franchisor that sought to dismiss a claim brought against it based upon its alleged failure to provide pre-sale disclosure to an Argentine prospective franchisee, and granted summary judgment to the franchisee, ordering the return of a $50,000 deposit made in contemplation of the grant of a franchise. The Florida Act, like similar laws in other states, looks to the FTC Act and FTC interpretations for guidance on conduct deemed to be unfair and deceptive. As long as the FTC Rule does not specifically exclude international sales from its scope, franchisors will continue to run the risk of liability, and, as reflected in the Nieman action, the FTC's oft-expressed policy of not enforcing the FTC Rule in international franchise sales is no guarantee that the franchiser will be insulated from potential liability.
It is apparent from the ANPR and the record that the FTC already has concluded, as we think it must, that the FTC Rule's pre-sale disclosure requirements should not apply to international transactions; thus, the remaining question is not whether, but how, this exclusion should be accomplished. We believe that any change must be made through Rule amendment. Previous public statements by the FTC of its policy not to enforce the FTC Rule in international transactions did not prevent decisions like Nieman, nor would FTC policy statements, by themselves, appear to be legally binding on the courts. Thus, only a formal FTC Rule amendment is likely to eliminate the risk of franchiser liability. Therefore, we would suggest that the preamble to the FTC Rule be modified by adding the following words at the end of the current preamble: "in connection with the offer and sale of a franchise to be located in the United States of America, its territories, or possessions." Thus, the preamble, as amended, would be:
In connection with the advertising, offering, licensing, contracting, sale, or other promotion in or affecting commerce, as "commerce" is defined in the Federal Trade Commission Act, of any franchise, or any relationship which is represented either orally or in writing to be a franchise, it is an unfair or deceptive act or practice within the meaning of Section 5 of that Act for any franchisor or franchise broker in connection with the offer and sale of a franchise to be located in the United States of America, its territories, or possessions,
b. Timing of Disclosures
We share the FTC's belief that the timing of disclosures should be reevaluated in the context of technological developments such as the Internet which, among other things, provide opportunities for a wider dissemination of pre-sale information about a franchisor. This, in turn, appears to have raised concerns at the FTC about the possibility of "preconditioning" prospective franchisees and, with it, consideration about requiring disclosure at an earlier time in the sales process than the FTC Rule currently requires. We have a different perspective.
We believe that the concerns about preconditioning are unsubstantiated by any empirical evidence of consumer injury or prevalence, and unrealistic in the actual context in which franchises are sold, i.e., franchisors typically want to make disclosure as early as possible to qualified prospects in order to be in a position to proceed purposefully to complete a sale. We also have concerns about imposing timing requirements for disclosure, such as the proposed "first substantive discussion," that by their nature are, and, we suspect, always will be, based on imprecise standards requiring subjective judgments with which reasonable persons could in good faith disagree. We think the current FTC Rule's alternative disclosure requirement of the "time for making of disclosures" -- which is ten business days prior to the payment of money or the purchase or commitment to purchase a franchise -- represents a far superior regulatory approach, by establishing an unambiguous, simple standard which is more than adequate, by itself, to achieve the FTC Rule's goal of providing prospective franchisees with sufficient time to review and verify the information contained in the offering circular. Further, we believe that the FTC should do everything possible to avoid placing franchisors in a position where compliance decisions must be based on imprecise standards, the inevitable consequences of any "first substantive discussion" or similar standard. For this reason, we suggest that the "time for making of disclosures" be the sole standard for the timing of required disclosures.
We also recommend that the FTC rescind its current requirement in FTC Rule Part 436. 1 (g) for a separate five business day waiting period from the time the prospective franchisee receives "a completed franchise agreement" to the time the franchise agreement may be signed. We believe the concern to which this provision is directed, i.e., that a franchisor will propose last-minute amendments without furnishing a prospective franchisee sufficient time to analyze the changes, is unrealistic in the actual context of how franchises are sold. In practice, franchisees request amendments to franchise agreements drafted by franchisors, and negotiations, as in most other commercial transactions, often continue to the last minute. At present, any last minute change delays the actual closing for five business days after a final agreement is reached, and often creates complications and expenses with respect to transactions which frequently accompany the franchise sale, such as franchisee loan commitments and pre-opening training schedules. The extra five business day waiting period burdens both franchisors and franchisees with no countervailing benefit to either party, and we would urge the FTC to remove it.
Because of the complexity of this issue and our firm's significant involvement with co-branding transactions, we will be submitting a separate comment to the FTC on this subject.
d. Stream of Revenue
The disclosure for use in the sale of janitorial franchises, pursuant to which franchisors who contractually agree to provide customer accounts to franchisees are required to make an earnings claims disclosure. We are unaware of other industries where there was even a suggestion that a similar requirement should exist. Unless the FTC has empirical evidence of consumer injury and prevalence in other areas, we do not believe that any FTC Rule modification is justified.
6. Alternatives to Burdensome Regulations and Enforcement
Our firm expends a significant amount of time reviewing, analyzing, and advising on compliance issues. The FTC Rule, its Interpretive Guides, and the over 100 staff advisory opinions to date are testament to the fact that compliance is no simple undertaking, and even the most conscientious franchisor compliance program can be subject to the whims of the franchisor's mailroom and record keeping capabilities. These problems are magnified for those franchisors whose sales activities are conducted from several locations. Thus, occasional technical violations are almost inevitable in any franchise system.
We strongly support the notion that "technical violations" of the FTC Rule -- a term we define as violations which are unlikely to cause consumer injury or to mislead a prospective franchisee acting reasonably -- should not result in a civil penalty or assessment. Indeed, the FTC, through its case selection criteria, has been doing informally what it now proposes to do formally, i.e., concentrate on fraudulent conduct causing consumer injury. A civil penalty waiver would simply recognize that occasional, inadvertent, and essentially harmless violations need not be treated in the same manner as serious violations. A waiver is not a carte blanche to franchisors to disregard FTC Rule obligations, and we see little chance that franchisors will take advantage of a civil penalty waiver to ignore FTC Rule compliance responsibilities. Moreover, we are confident that mechanisms can be built into any civil penalty waiver provision to limit the number or types of violations for which the waiver would apply.
A franchisor also should have the opportunity to cure purely technical violations without risk of liability. We are aware of instances where franchisors have refused to sell a franchise to a franchisee after learning of a technical violation during the sales process (such as furnishing an offering circular after the first personal meeting rather than at the meeting), despite the franchisee's desire to purchase the franchise and the inconsequential nature of the violation. Franchisors' reluctance to proceed is motivated by the fear of potential enforcement problems if the franchisee subsequently becomes dissatisfied, since a franchisee's "waiver" of the "violation" is against public policy, and no procedure currently exists to cure the violation or extinguish the potential liability. The FTC Rule should be amended to permit a franchisor to cure an enumerated list of technical violations through redisclosure and/or other specified corrective actions, plus a cooling-off period; thereafter, the violation should be deemed to be cured, and the franchisor should be permitted to resume sales negotiations with a franchisee.
We also recognize both the need for and the value of industry efforts to foster lawful and responsible conduct by its members. Self-regulation can be useful, but its limitations must be recognized. Industry's primary capabilities are in the areas of educational programs and peer pressure, and not as an enforcer responsible for stopping violations and redressing consumer injury. Self-regulation is not a surrogate for FTC enforcement, and should not be used as a backdoor method of privatizing enforcement actions which the FTC would not choose to commence itself.
We hope that the foregoing comments are helpful to you. Our firm has been intimately involved with all facets of domestic and international franchising activities since the 1970s, from issues related to the FTC Rule, such as counseling clients on compliance responsibilities, to preparing offering circulars, to representing franchisors involved in federal and state enforcement actions, to the ongoing relationships between franchisors and franchisees, to planning and implementing franchise and non-franchise distribution programs, to the anti-trust issues associated with distribution arrangements, to real estate, litigation, trademark and other intellectual property, and other related areas. The growth of franchising since the 1970s has been remarkable. Intelligent regulation has not stifled this growth, and we hope to continue working together with the FTC and state regulators to make pre-sale disclosure as useful as possible to prospective franchisees while keeping the compliance burdens on franchisors to a minimum.
RUDNICK, WOLFE, EPSTIEN & ZEIDMAN
By: John M. Tifford