April 30, 1997
BY HAND DELIVERY
Donald S. Clark, Secretary
Re: 16 CFR Part 436 - Comment
Dear Mr. Clark:
Following are Hogan & Hartson's comments in response to the Federal Trade Commission's (the 'FTC" or "Commission") Request for Comments Concerning Trade Regulation Rule on Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures ("the Franchise Rule" or "the Rule") published in the Federal Register on February 28, 1997.
Hogan & Hartson's Franchise Practice
Hogan & Hartson is a firm of approximately 500 lawyers in eight cities and seven countries which was founded in 1904. Our Franchise Group, based in Washington, D.C., provides a full range of services to meet the legal needs of start-up and mature companies that offer goods and services through franchising and other distribution methods. The firm's franchise lawyers have practical experience in structuring a wide variety of domestic and international franchise arrangements and in counseling franchisors on sensitive franchise relations issues. Members of the group have handled franchise company merger and acquisition transactions, and related public and private financing, in the U.S. and throughout the world.
The Franchise Group has considerable experience in the interpretation and application of federal and state laws governing franchising. Franchise Group attorneys routinely assist franchisors in establishing cost-effective franchise sales compliance programs and in systematizing state registration of franchise offerings. We have created and obtained registration under all state franchise disclosure laws of a single, "multi-state" offering circular thereby eliminating for franchisors the compliance risks inherent in the maintenance of numerous state-specific documents.
Among the Franchise Group's members are nationally known trial lawyers specializing in the representation of franchisors in suits against franchisees to enforce contractual and intellectual property rights, as well as in the defense of claims brought by franchisees, including antitrust claims and class actions. The group's litigators also represent franchisors in suits with third parties that involve franchise-related issues. Members of the group have vast experience in negotiating with franchisee associations on critical issues and in the mediation and arbitration of domestic and international franchise disputes. We are also experienced in the representation of franchisors before Congress, the Federal Trade Commission and other federal and state governmental bodies.
FTC Franchise Rule - Generally
In reviewing existing and proposed public policy, Hogan & Hartson's perspective is shaped by a bias in favor of competition over regulation. Nonetheless, we recognize that government-mandated dissemination of information about franchises may have a pro-competitive effect by permitting the marketplace to function more efficiently. Accordingly, we favor pre-sale disclosure of franchise offerings as required by the FTC Franchise Rule. Our support of the Franchise Rule also reflects our belief that required disclosure is the most cost-effective and least intrusive means of regulating franchising.
Disclosure of relevant information as provided for by the Franchise Rule enables investors to make informed decisions about franchise offerings. Such disclosure also minimizes the incidence of both fraud and divergent expectations concerning the franchise relationship. However, despite these pro-competitive effects, we are mindful that the compliance costs associated with excessive disclosure regulation can create barriers to entry by new and small franchising companies, generally the greatest source of marketplace innovation. While we are uncertain where the line between "just enough" and "too much" disclosure should be drawn, we believe nevertheless that it is incumbent upon policy makers reviewing new or additional disclosure obligations to consider carefully this issue.
Applicability of the Rule to International Transactions
For the reasons set forth below, Hogan & Hartson supports the FTC's proposed clarification that the Rule does not apply to "outbound" international transactions whereby U.S. franchisors license persons to operate franchises outside of the U.S. 1/
The international franchise market, and the sales practices therein, is dramatically different from the domestic franchise market. In fact, many franchisors do not have a program for attracting prospective foreign franchisees. New franchisees may be individuals, companies or investment groups that approach franchsors about franchising possibilities abroad. Franchisors may enter into a wide range of business arrangements with these parties and grant international franchises pursuant to joint venture, area development and master franchise agreements. Even among agreements in the same category (e.g., area development agreements), there are materially different terms depending upon the nature and capability of the other party, the territory for which rights are granted, local laws, tax considerations and commercial customs.
Unlike the domestic market, negotiation of terms is the norm, not the exception. As a result, these highly-negotiated arrangements bear little resemblance to most domestic franchise offerings and are not amenable to "standardized" disclosure. We also note that the investors interested in international franchise relationships are typically sophisticated foreign nationals who have considerable capital and/or expertise regarding the market in which they will be developing the franchise system.
The UFOC and FTC Rule disclosure standards contemplate a domestic franchise sale occurring in a particular state. For example, Item 20 of the UFOC Guidelines refers to the number of franchise sales "in this state. . . ." Other disclosures about the franchise offering, including litigation and bankruptcy history, franchisor's and franchisee's obligations, royalty rates, initial investment, fees and trademarks, are U.S.-specific. For these reasons, much of the information in a U.S. franchisor's offering circular is of limited relevance to an international transaction and may be confusing, if not misleading, to local investors. We believe that the voluminous record leading up to the FTC's adoption of the Franchise Rule amply demonstrates a concern for unfair or deceptive franchise practices in the U.S.. Section 5(a)(1) of the Federal Trade Act (the "FTC Act" or "Act") prohibits unfair methods of competition and unfair or deceptive acts or practices "in or affecting commerce". 2/ Commerce is defined by the Act to include "commerce... with foreign nations." 3/
We do not question the FTC's extraterritorial authority. 4/ However, as stated in a recent issue of the Franchise Law Journal: "A direct and substantial adverse effect on commerce of the U.S., either to a U.S. consumer or to competition in the U.S., has been and remains a jurisdictional requirement for action under the Act, including consumer protection actions under the Act." 5/ Accordingly, neither injury to foreign consumers, nor to foreign franchisees, even if caused by a U.S. franchisor's unfair or deceptive acts, is within the ambit of the Act unless there is a significant impact on commerce in the U.S. 6/ We submit that there is no evidence whatsoever of harm to U.S. consumers or competition as a result of U.S. franchisors not delivering offering circulars to foreign franchisees.
Foreign countries in which franchise operations are located have a far greater nexus to the franchise sales transaction than the U.S. These countries are capable of determining what laws are necessary to protect people and businesses within their borders. The disclosures required under the laws of that country, if any, are far more meaningful to local investors, whether foreign nationals or U.S. citizens, than those required under the FTC Rule or UFOC Guidelines. And, even in the absence of franchise-specific regulation, the business arrangement would be regulated by that country's commercial, competition, international trade and intellectual property laws.
The need for clarification by the Commission that the Rule does not apply to international transactions is particularly urgent in light of the recent decision by the U.S. District Court for the Southern District of Florida in Nieman v. Dry Clean USA, Inc., No. 95-1390-CIV (S.D. Fla. Mar. 26, 1997). In Nieman, the court held that a franchisor who accepted a non-refundable deposit before providing a disclosure document to an Argentinian citizen purchasing a franchise to be operated in Argentina violated the Florida Unfair and Deceptive Trade Practices Act (known as the "Little FTC Act") based on a violation of the FTC Rule's disclosure requirements. Clarification by the FTC that such international franchise sales are not within the purview of the Rule will prevent future mischief engendered by the Nieman decision.
The Revised UFOC Guidelines
While we favor national disclosure, this does not require the FTC to maintain its own disclosure format. Almost all franchisors prepare their disclosure documents in accordance with the UFOC Guidelines. The very few franchisors which use the FTC format either have extremely limited growth plans (which do not include sales in any franchise registration state), are seeking to avoid the more comprehensive disclosures required under the UFOC Guidelines, have performed inadequate research about franchise regulation and/or have relied upon the advice of unsophisticated counsel.
These reasons do not provide a sound basis for the continued existence of the vestigial FTC format. In its place, we would recommend that the FTC revise the Rule to establish the UFOC Guidelines as the national franchise disclosure standard. In doing so, we strongly recommend that the FTC incorporate NASAA's Commentary on the UFOC Guidelines dated June 21, 1994. With respect to the FTC's proposed modifications to Item 20 of the UFOC Guidelines, we would not oppose the revisions provided there is coordination with NASAA. 7/ Otherwise, franchisors would need guidance from the FTC on navigating the interstices between the requirements of the revised Rule and the UFOC Guidelines. We would not favor a regime which would hinder a franchisor's ability to use a uniform disclosure document to comply with both state and federal disclosure requirements.
Applicability of Rule to Business Opportunities
Hogan & Hartson's Franchise Group has little experience representing business opportunity sellers and our comments, accordingly, are limited in scope. We note, however, that business opportunity sellers and franchisors, although sharing a limited number of characteristics, operate sufficiently differently so as to merit separate regulation. For this reason, we support the FTC's development of separate regulation specific to the business opportunity industry.
Mandatory Earnings Claims
Required disclosure of detailed financial information about franchisee earnings may not only impose an undue burden on franchisors, but may provide franchisees with a false sense of security about their earnings potential, thereby diminishing the extent of the due diligence they perform in making their investment decision. Unlike securities investors, who generally have a passive relationship with the companies in which they purchase stock, prospective franchisees face a complex, long-term business relationship that typically demands a high level of personal investment, involvement and commitment.
It is infeasible for franchisors to provide the comprehensive information necessary for prospective franchisees to develop their own business plans and pro forma budgets. In fact, a prospective franchisee's personal knowledge of the local market may be the critical factor in determining the viability of the particular franchise. We also note that prospective franchisees of all but the most embryonic franchise systems already have ample means of eliciting and evaluating financial information. UFOC Item 20 ("List of Outlets"), for instance, includes the names, addresses and telephone numbers of at least 100 existing franchisees, as well as those of all franchisees which left the system during the previous year.
We also are concerned about the potential liability to which franchisors may be exposed if required to make earning claims. If, for instance, a geographic relevancy standard were applied, a franchisor would face considerable legal risk by expanding beyond its then-current geographical area or type of location. Most franchisors simply would be unable or unwilling to represent that the mandated information is relevant to a particular site.
Additionally, it is our experience that franchisees tend to treat historically-based gross revenues information -- the simplest financial information for most franchisors to disclose8 -- as indications of future performance (i.e., projections). Franchisors are, of course, unable to control the manner in which this financial information may influence a prospective franchisee's investment decision. Should this financial information create expectations that are not met, franchisors may be forced to expend significant sums to defend themselves.9
Few franchisors regularly receive profit and loss information from franchisees10 and, among these franchisors and franchisees, there is little uniformity in accounting practices. Further, even if all franchisees did expend the resources necessary to provide full financial statements in accordance with GAAP (which would be of no service to the franchisees themselves), it is unlikely that this information would accurately reflect the profitability of the franchised businesses due to tax planning considerations. To require disclosure of even summary profit and loss information would require most franchisors to revise their franchise agreements and would, undoubtedly, create friction in franchisor-franchisee relations.
Accordingly, we support the Commission's determination not to amend the Rule to mandate franchisor disclosure of earnings claims. We also support the Commission's proposal to require all franchisors who do not make earnings claims in their disclosure documents to include therein a specific statement that the FTC Rule permits disclosure of earnings claims based on reliable information. We believe that these required disclosures not only would correct misrepresentations by franchisors that the Rule prevents them from making earnings claims, but also would bring more market pressure to bear on franchisors to make reliable earnings claims. Such market pressures may result in a substantial increase in the amount of financial information disclosed to franchisees without the costs and other burdens attendant to a government mandate.
Co-Branding and Internet Sales
In recent years, franchisors have taken a variety of approaches to co-branding relationships. Some franchisors have chosen to offer co-branded products or services to their existing franchisees, while others offer co-branded franchises to franchisees new to both systems being offered. Franchisors also have taken various approaches to providing prospective franchisees disclosure about the co-branded offerings. Some well-established franchisors serving as the "anchor" franchise (i.e., an existing system of units to which another system's product or service will be added), have chosen to modify their existing disclosure documents to describe the co-branded franchise. Other franchisors have chosen to provide separate disclosure documents for each system or to provide additional disclosures about the co-branded products or services in an addendum to an existing disclosure document.
We believe that franchisors should continue to have great flexibility in preparing disclosures relating to co-branded offerings. Prescribing rigid rules for such a wide variety of multi-brand relationships is inherently impractical. For example, requiring franchisors to prepare a hybrid disclosure document may impose unnecessary burdens and expense on smaller franchisors. As long as the burden remains on franchisors to provide full and fair disclosure about the co-branded offerings, franchisors should be afforded great latitude in complying with their disclosure obligations.
We have not reached a conclusion as to whether the language in the FTC Rule requiring franchisors to provide disclosure to prospective franchisees at the first "personal meeting" should be replaced with the requirement that franchisors provide disclosure at the time of the "first substantive discussion." Inclusion of the revised language begs the question as to what constitutes a "substantive" discussion. Accordingly, franchisors would need further guidance as to the types of discussions that would be considered "substantive" under the Rule. Moreover, although the revised language appears to make sense in the context of telephone discussions and discussions via electronic mail, the requirement may provide little guidance to franchisors with Web sites or who employ other means of selling over the Internet. In addition, the Commission would need to carefully consider the manner in which franchisors would obtain evidence of receipt of a disclosure document provided electronically or by other means.
We appreciate the Federal Trade Commission's consideration of our comments.
HOGAN & HARTSON, L.L.P.
Neil A. Simon, Esq.
1/ Certain commentators have distinguished between "pure" and "mixed" outbound transactions. See John Baer, Kenneth Costello, Gary Duvall, Joyce Mazero and Erik Wulff, Application of U.S. Franchise Laws to International Franchise Sales, 15 FRANCHISE L. J. 1 (Fall 1995). While we recognize this conceptual distinction, we believe that the location of the franchise, rather than the citizenship of the franchisee or location of the negotiation, is of paramount importance in determining FTC jurisdiction.
2/ 15 U.S.C. § 45 (a)(1)
3/ FTC Act § 4; 15 U.S.C. § 44
4/ In 1982, the Commission's extraterritorial reach was reduced in cases involving unfair methods of competition. The Foreign Trade Antitrust Improvements Act of 1982, adopted in response to the concern that U.S. antitrust laws were a barrier to export activities, amended the FTCA to clarify that it does not reach unfair methods of competition involving foreign commerce unless such activity has a "direct, substantial, and reasonably foreseeable effect" on domestic commerce. Foreign Trade Antitrust Improvements Act of 1982 § 403, amending FTC Act § 5(a); 15 U.S.C. § 45(a). Foreign commerce jurisdiction of the FTC relating to unfair or deceptive acts or practices was not affected by the legislation.
5/ Baer et al., supra note 2, at 62. See also Branch v. FTC, 141 F.2d 31 (7th Cir. 1944) (jurisdiction is based not upon the location of the activity abroad, but the location of the respondent's competitors in the U.S.).
6/ Cf. EEOC v. Arabian American Oil Co., 499 U.S. 244, 111 S. Ct. 1227, 113 L. Ed. 2d 274 (1991) (presumption against applying statute to extraterritorial conduct). But cf. SEC v. Kasser, 548 F.2d 109 (3d Cir.) cert. denied sub nom. Churchill Forest Industries, Ltd. v. SEC, 431 U.S. 938 (1977) (applying anti-fraud provisions of Securities Exchange Act to conduct only impacting abroad). See J. Turley, "When In Rome': Multinational Misconduct And The Presumption Against Extraterritoriality," 84 NW. U.L. REV. 598 (1990).
7/ We understand that NASAA is planning to address the "double-counting" problem in the three-year "Franchised Store Status Summary," whereby a given event may be listed in several categories and create the appearance of greater system turnover than actually occurred.
8 Most franchisors receive reports on gross revenues in order to verify royalty payments by franchisees which are typically based upon a percentage of revenues.
9 ". . there have been few decisions where the validity of numbers contained in offering documents have been challenged. . . Reported cases, of course, only give a glimpse of the potential liability that a franchisor might incur if it makes earning claims in a discipline and proper manner. Discussions with other counsel suggest that claims made based on faulty earning claims are more often than not, like most claims, settled outside the context of litigation and almost always before trial, and thus never become reported decisions. The fact that most franchisors do not currently include earnings claims in their disclosure documents would also reduce the number of controversies in which the accuracy of written, properly presented earnings disclosures were judicially evaluated." Barkoff, Rupert M. and Selden, Andrew C., "Thou Shalt Disclose Earnings Information! NASAA's Final Frontier -- Where No Regulator Has Gone Before," ABA Annual Forum on Franchising (1944), Vol. II, Tab 18, pp. 11-12 (footnote omitted).
10 Many franchisors require that franchisees provide information regarding their operating costs so that the franchisor can provide financial and operational advice regarding the business. Franchisors may also seek operating data and financial statements for credit purposes (since they are often in the position of a creditor of franchisees as a result of unpaid royalties). There is, however, a high level of non-compliance in many systems with regard to these reporting requirements and the information is received sporadically.
Donald S. Clark
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