Franchising Law Byron E. Fox Henry C. Su
The Federal Trade Commission's advance notice of proposed rulemaking to amend its Franchise Rule highlights consumer protection concerns with franchise sales in cyberspace.
* * *
On February 26, 1997, the Federal Trade Commission announced that it was again seeking public comments on possible revisions of its Franchise Rule--this time to address, among other things, changes in the marketing of franchises, such as sales through the Internet.(1) This announcement caps a year of intensive focus by the Commission on consumer protection issues in cyberspace.(2) Not surprisingly, new technologies and marketing practices continue to outstrip changes in law and policy, leaving many unsettled issues in their wake. Franchisors interested in marketing their franchises in cyberspace should enter the medium cautiously.
The Commission's Franchise Rule(3) was adopted in 1978 in response to widespread evidence of deceptive and unfair practices in the sale of the types of businesses covered by the Rule--namely, "package" or business format franchises, product or trade name franchises and business opportunity ventures.(4) The Franchise Rule requires disclosure of certain material facts about the particular business being offered for sale, provided in the form of a written disclosure statement.(5) A franchisor satisfies the disclosure requirements of the Rule if it prepares and uses a document that follows the Rule's prescribed format or the more commonly used format known as the Uniform Franchise Offering Circular (UFOC), last revised in 1993.(6)
Regardless of the format that is used, the disclosure statement must be furnished to a prospective franchisee at the earlier of the "time for making of disclosures" or the first "personal meeting."(7) The timing is critical. The Franchise Rule defines the "time for making of disclosures" as ten business days before the earlier of (1) the prospective franchisee's signing of a franchise agreement or other agreement imposing a binding legal obligation in connection with the sale or proposed sale of a franchise, or (2) the prospective franchisee's payment of any consideration in connection with the sale or proposed sale of a franchise.(8) The Rule defines the "personal meeting" as a face-to-face meeting between a franchisor or franchise broker and a prospective franchisee to discuss the sale or possible sale of a franchise.(9)
The Rule's obvious purpose is to ensure that prospective franchisees receive pre-sale disclosures about the franchise as early as possible. A prospective franchisee should not have to go into a face-to-face meeting where he or she may be pressured to sign a binding agreement without having had the opportunity to review carefully the disclosure documents, preferably with a knowledgeable advisor.(10) Nor should he or she be required to take the critical act of paying money or signing something without having seen the disclosure documents. This makes complete sense.
As the Commission has correctly recognized, commerce on the Internet dramatically changes the way franchises are marketed and sold. (11) Agreements can be signed, and consideration can be paid, without the transacting parties ever having to have a face-to-face meeting. A franchisor can make its disclosure documents available on its web site for downloading, and rapidly respond to a prospective franchisee's questions or comments about the franchise business by electronic mail.(12) On-line transactions and communications introduce an element of chaos into the Franchise Rule's orderly scheme for the provision of pre-sale disclosures. The curious consumer--a first-time, perhaps disoriented visitor to a new web site--might find himself or herself the unwitting purchaser of a business opportunity as a result of a couple of unintended keystrokes.
Moreover, the ease and rapidity with which important transactions can take place and important information can be disseminated over the Internet, and the relatively low cost of doing so, invite the perpetration of fraudulent and deceptive schemes.(13) Franchises and business opportunities are not immune to the crooks and confidence artists who have long preyed "on greed, loneliness, naiveté, and other human frailties."(14) The crime or unfair practice is essentially the same, but its consequences are more far-reaching; in cyberspace, the perpetrators can target more victims with greater precision and fewer resources, and can more easily abscond with the profits, leaving virtually no clues for law enforcement.(15)
Recent enforcement activities against fraudulent business opportunities that have used the Internet to reach their intended victims underscore the Commission's concerns. For example, last November, the Commission brought an action against The Mentor Network, Inc., of Irvine, California, the operator of a multi-level fund-raising business promoted over the Internet. The Commission's complaint alleged that the defendant was running an illegal chain or pyramid marketing program, a sales device under which distributors pay commissions to people up the chain or pyramid for the right to recruit new distributors to extend the chain or pyramid even further. Last month, the Commission filed a proposed consent judgment in settlement of the action.(16) Under the consent judgment, the defendant and its principal agreed, among other things, to refrain from operating any chain or pyramid marketing program.
Mentor Network was just one of many entities targeted by the Commission as part of "Operation Missed Fortune," the broadest federal-state coordinated law enforcement and consumer-education effort ever initiated. Launched early last summer, the operation focused on "get-rich-quick self-employment" schemes, several of which have been pitched on the Internet.(17) As Joan Bernstein, Director of the Commission's Bureau of Consumer Protection, observed, the Internet unfortunately has provided confidence artists with a new way of dressing up "pyramids and other old schemes in new lingo so they can victimize vast numbers of consumers."(18) The fact that the Internet can be an efficient tool for recruitment inevitably attracts the criminal element, thereby drawing scrutiny by federal and state enforcement agencies.(19) Unfortunately, it also casts doubts on the efforts of legitimate marketers who would use the Internet as a medium for maximizing the flow of timely and accurate information to consumers.
In March 1996, the Commission settled several enforcement actions against an assortment of Internet marketers for allegedly deceptive advertising techniques.(20) The business opportunities promoted by these marketers included a program to operate a publishing and printing business at home,(21) a credit repair agency business opportunity,(22) an "ON-LINE Profits Made Easy" work-at-home business opportunity,(23) and a "U.S. Government Tracer Business Program" for making money tracking down people due refunds after they had paid off their mortgages.(24) Consent agreements involving each of these marketers became final last June.(25)
The settled actions against these business opportunities for making false and unsubstantiated earnings claims should remind franchisors and franchise brokers that whatever they want prospective franchisees to read on their web page can, and likely will be, read by enforcement agencies. Indeed, when the Federal Credit Repair Organization Act, which outlaws deceptive claims made by credit repair organizations, took effect this April 1st, the Commission announced that its staff had been surfing the Internet for credit repair advertisements.(26) Forty-seven advertisers with web sites were put on notice of the new laws and the Commission's efforts to combat deceptive claims. The Commission has demonstrated that it will take the fight against fraudulent and deceptive marketing practices into cyberspace. Just last summer, it seized the home page of marketers of display rack distributorships charged with making false earnings claims and using "shills" who posed as distributors praising the business, and turned the home page into a warning to consumers.(27) The marketers' "occupied" web site also linked to the Commission's own web site, where consumers could obtain more information about the pending case.
The Commission's enforcement activities(28) against fraudulent and deceptive marketing practices on the Internet shed some insight into the questions that the Commission has posed about the adequacy of its Franchise Rule in cyberspace. One question is whether the Rule should discard the use of the "personal meeting" as a triggering event for pre-sale disclosures in favor of a concept such as "first substantive discussion." The "personal meeting" identifies a point in time at which the parties would in fact have their "first substantive discussion" by defining the physical event--the face-to-face meeting between the parties in real space--that takes place. This definition gives clarity to the Rule's timing requirements; few situations exist where the parties cannot identify when they had their first "personal meeting." Obviously, the "personal meeting," as presently defined, has no meaning in cyberspace. Hence the Commission's dilemma.
On the other hand, the proposed concept of a "first substantive discussion" would doom the Rule to ambiguity. It attempts to mark a point in time based on the nature of the communication between the parties. Unfortunately, "what was said" and "when it was said" are the subject of frequent dispute in any litigation. This concept is therefore impractical. In the authors' view, the goals of the Rule would be better served if the concept of a "personal meeting" were amended to cover the first "cyberspace visit" by a prospective franchisee. The comments that follow about this proposal also address the Commission's second question--what allowances should be made to permit franchisors to comply with the pre-sale disclosure requirements of the Rule through the Internet.(29)
As the recent flurry of enforcement activities demonstrates, a web site can and should be monitored for compliance with the Franchise Rule. Questionable marketing practices can be brought to the attention of the Commission and the National Fraud Information Center's Internet Fraud Watch. More importantly, however, franchisors should be permitted to use the Internet as a more efficient tool for complying with the disclosure requirements under the Rule and the laws of States with registration or disclosure requirements applicable to franchises and business opportunities. The answers to the Commission's questions lie in prescribing a disclosure format for a franchisor's web site and its content. This approach is wholly consistent with what the Rule already does with respect to the format and content of written disclosure documents.
A prescribed web site would permit a prospective franchisee to negotiate, and even consummate, the purchase of a franchise or business opportunity entirely on-line. No transactions and no e-mail with the franchisor could occur, however, without the prospective franchisee first reading a short disclosure about the Franchise Rule's guidelines for on-line disclosures(30) and then registering his or her name, address and contact numbers on the web site. The registration would memorialize the first "cyberspace visit" that triggers the pre-sale disclosures under the Rule and create a log of visitors who are actually considering the purchase of the advertised franchise. Having registered, the prospective franchisee would be given a secure password or passkey with which to gain access to the franchisor's disclosure documents, to communicate with the franchisor and other franchisees by e-mail, and ultimately, to facilitate a private consummation of the sale complete with digital signatures and on-line transfers of consideration.
By registering, the prospective franchisee would represent to the franchisor as to his or her State of residence; he or she would then receive a prompt asking him or her to designate a method of delivery of disclosure documents that comply with the registration/disclosure laws of that State, if any. The delivery of the documents by file transfer protocol or by another method chosen by the prospective franchisee would fulfill the franchisor's obligations under the Rule. Features on the web site for doing on-line transactions could be locked until the requisite time had elapsed since the delivery of the disclosure documents. The web site would have hypertext links to the web sites of the federal and state regulatory agencies, just as written disclosure documents prepared under the 1993 UFOC format are accompanied by a schedule of the addresses and telephone numbers of state securities administrators.
Sophisticated tools for creating and maintaining web sites are available at relatively low cost to franchisors. They can be used to create a format for on-line disclosures that complies with the objects of the Franchise Rule.(31) The Commission should invite franchisors and franchise brokers to be part of the solution in making the Internet a not-so-wild place to do good business.
* * *
Mr. Fox is counsel, and Mr. Su an associate, in the Richmond, Va., office of Hunton & Williams, where they are members of the firm's antitrust, franchising and distribution law team. Mr. Fox lectures on franchise law at the University of Virginia School of Law.
1. The Commission's advance notice of proposed rulemaking is published in the Federal Register, 62 Fed. Reg. 9115 (Feb. 28, 1997), and on its web site, <http://www.ftc.gov>. The notice triggers a sixty-day comment period ending April 30, 1997. Written comments responsive to the advance notice should be identified as "16 CFR Part 436" and sent to Secretary, Federal Trade Commission, Room 159, Sixth Street and Pennsylvania Avenue, N.W., Washington, DC 20580, or e-mailed to FRANPR@ftc.gov. For other instructions, please refer to the notice.
2. Among other things, the Commission issued a staff report on February 11, 1997, entitled "Fighting Consumer Fraud: The Challenge and the Campaign," which reviews collaborative and comprehensive efforts to stop consumer fraud in cyberspace. On June 12, 1996, the Commission issued a staff report entitled "Consumer Protection Policy," which devotes a chapter to cyberspace issues.
3. Trade Regulation Rule: Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures, 16 CFR Part 436.
4. 16 CFR § 436.2(a).
5. 16 CFR § 436.1.
6. See 58 Fed. Reg. 69,224 (Dec. 30, 1993).
7. 16 CFR § 436.1(a).
8. 16 CFR § 436.2(g).
9. 16 CFR § 436.2(o).
10. The Rule requires that the disclosure statement be accompanied by a cover sheet with the following warning: "To protect you, we've required the franchisor to give you this information. We haven't checked it and don't know if it's correct. Study these facts and figures carefully. If possible, show them to someone who can advise you, like a lawyer or an accountant. Then take your time and think it over." 16 CFR § 436.1(d)(1). (Emphasis in the original.)
11. 62 Fed. Reg. 9115 ("[T]he Commission explored whether the Rule should be modified in light of increased sales of franchises and business opportunities through the telephone and the Internet. For example, one commenter observes that the day may come when franchise sales are conducted solely via computer without any "personal meeting.")
12. Of course, on-line communications involve an exchange of information; the franchisor will just as easily be able to learn something about the prospective franchisee. Professor Katsh makes the rather telling observation that "[e]lectronic interactions . . . are almost always also information transactions." M. Ethan Katsh, Law in a Digital World 108 (1995). An exchange of information about the parties to an electronic communication almost always occurs when those parties communicate on-line.
13. See Federal Trade Commission Staff Report, "Anticipating the 21st Century: Consumer Protection Policy in the New High-Tech, Global Marketplace," at 28-30 (May 1996), reprinted in 425 Trade Reg. Rep. (CCH), pt. 2 (June 12, 1996) [hereinafter, FTC Staff Report on Consumer Protection Policy].
14. FTC Staff Report on Consumer Protection Policy at 28. See generally Byron E. Fox & Henry C. Su, "Franchise Regulation--Solutions in Search of Problems?," 20 Okla. City U. L. Rev. 241, 264-65 (Summer 1995) (reviewing history of fraud and misrepresentation in the sales of franchises and business opportunities).
15. FTC Staff Report on Consumer Protection Policy at 28-29.
16. FTC v. Mentor Network, Inc., No. SACV 96-1104 LHM (EEx) (C.D. Cal. Mar. 18, 1997) (consent agreement), reported in 72 Antitrust & Trade Reg. Rep. (BNA) No. 1803, at 274 (Mar. 20, 1997). The defendants' settlement of the FTC charges, of course, in no way constitutes an admission of their guilt.
17. Another allegedly fraudulent pyramid scheme that has gotten press recently is the Global Assistance Network for Charities (GANC). According to the Commission's complaint, GANC markets in Internet newsgroups an opportunity for its members to earn money and to donate portions of that money to worthy charities. The North American Securities Administrators Association has issued an Investor Alert warning consumers of the dangers of such schemes and providing tips for investigating any business venture. See "Get-Rich-Quick Self-Employment Scams Target Those Needing Supplemental Income," NASAA Investor Alert, Nov. 5, 1996 (visited Mar. 26, 1997) <http://www.ftc.gov>.
19. The National Consumer League's Internet Fraud Watch has identified pyramid investment schemes and the misrepresentation of the profitability of work-at-home and other business opportunities as among the top Internet scams of recent months. See "Consumer Protection," 443 Trade Reg. Rep. (CCH) 3 (Oct. 16, 1996). To visit the web site for the Internet Fraud Watch Project, see <http://www.fraud.org> (visited Apr. 1, 1997).
20. "Cyberspace Scams the Same Old Frontiers," FTC Press Release, Mar. 14, 1996, FTC: Watch No. 453 (Mar. 27, 1996), available in LEXIS, Trade Library, FTCWAT File.
21. Matter of Bean d/b/a DMC Publishing Group, FTC File No. 952-3429, 61 Fed. Reg. 14309 (Apr. 1, 1996) (consent agreement) (allegations of false earnings claims).
22. Matter of Coryat d/b/a Enterprising Solutions, FTC File No. 962-3019, 61 Fed. Reg. 14311 (Apr. 1, 1996) (consent agreement) (allegations of false earnings claims).
23. Matter of Serviss d/b/a Excell Communications, FTC File No. 952-3436, 61 Fed. Reg. 14313 (Apr. 1, 1996) (consent agreement) (allegations of false earnings claims).
24. Matter of Smith d/b/a Starr Communications, FTC File No. 952-3431, 61 Fed. Reg. 14322 (Apr. 1, 1996) (consent agreement) (allegations of false earnings claims).
25. "Final Order Reporter: Internet Marketers," FTC Press Advisories, June 18 & 21, 1996, FTC: Watch No. 460 (July 1, 1996), available in LEXIS, Trade Library, FTCWAT File.
26. "FTC to Consumers--These Claims Are False; No More April Fools," FTC Press Release, Apr. 1, 1997 (visited Apr. 1, 1997) <http://www.ftc.gov>.
27. "Display Rack Marketer Hits Internet; So Does the FTC," FTC Press Release, June 27, 1996, FTC: Watch No. 460 (July 1, 1996), available in LEXIS, Trade Library, FTCWAT File.
28. The authors refer to the Commission only as a matter of convenience; we recognize that enforcement activities of such sweeping scope would not be possible without federal-state agency cooperation and assistance from consumer protection organizations and private citizens.
30. Because on-line transactions and communications do not observe the borders of the States or foreign nations, the on-line guidelines should be part of the Franchise Rule, and not of any State law, for the sake of cross-border uniformity. Anecdotal evidence suggests that the registration States have not focused on franchise fraud in cyberspace. They really have no choice other than to do so. If and when state regulators take an interest in on-line disclosure formats, then franchisors could be given the option of "registering" their web site with the agency or filing paper facsimiles of the pages. Franchisors and franchise brokers not using the on-line registration format would still be required in registration States to conduct their transactions on paper.
31. . Obviously, franchisors, like other businesses, will have to keep the content of their web sites up to date in order to comply with the regulatory prohibitions against misleading and erroneous information. An incentive, besides staying out of trouble, exists for doing this; web sites that are maintained properly are more likely to attract repeat and new visitors. Franchisors will get more value out of their investment in on-line resources if they focus on accurate and high quality content.