ANALYSIS OF THE FTC'S OCTOBER 15, 1999 PROPOSED REVISIONS TO THE FRANCHISE TRADE REGULATION RULE
Prepared by Carl E. Zwisler And members of the Franchise and Distribution Practice Group of Jenkens & Gilchrist, PC Washington, DC, Dallas, TX and Los Angeles, CA
Carl E. Zwisler resides in the Washington, D.C. office of Jenkens & Gilchrist. He acknowledges the contributions of Delia Burke and Jamila Braswell in the Washington, D.C. office and Kenya Scott of the Dallas, TX office for their assistance in preparing this Analysis.
Jenkens & Gilchrist, PC 1999
PROPOSED COMPREHENSIVE CHANGES TO FTC RULE WOULD PROVIDE MAJOR BENEFITS AND POTENTIAL PROBLEMS FOR FRANCHISORS
On the twentieth anniversary of its effective date, the FTC has proposed comprehensive changes to the Federal Trade Commission's Franchising Trade Regulation Rule (16 CFR 436.1, et. seq., hereinafter referred to as the "FTC Rule" or the "Rule"). After hearing comments from interested parties throughout the franchising community over a period of four years, the FTC announced its 150-page Revised Proposed Rule ("Proposed Rule" or "Proposal") at the 1999 annual meeting of the American Bar Association Forum on Franchising. The text of the Proposed Rule accompanies this analysis. It invites interested parties to submit comments on the Proposed Rule changes to the FTC by December 22, 1999. Rebuttals to comments may be filed for 40 days, which may be followed by hearings, revisions and additional comments. Although implementation of the Proposal is unlikely for one year or more, those concerned about the ultimate shape of the Rule should provide their comments to the FTC before December 22.
The following pages contain our analysis of the Proposed Rule, principally from the perspective of franchisors which must comply with it. The principal objective of our analysis is to identify proposed changes which might have an impact on the way franchisors conduct their franchise disclosure practices, and to identify possible conflicts and ambiguities in the language of the proposed instructions for preparing a disclosure document. We have not sought to answer the 40 questions to which the FTC has invited responses. Because the Commission states its questions plainly repeating them in this analysis would add little.
Nor have we suggested how the Rule should be changed to address issues which we have identified. Because our objective is to identify how the proposed changes would differ from present practices, we only have compared and contrasted the proposed disclosure document changes to the UFOC. How the Proposal would change the virtually unused FTC disclosure format is described by the FTC in the Notice accompanying the Proposed Rule.
Whereas the Rule currently permits use of either the UFOC disclosure format or the format prescribed in the FTC Rule, the Proposed Rule contemplates only one disclosure format, the FTC's revised version of the UFOC which is set forth in the Proposed Rule. Although most disclosure requirements would remain identical to those contained in the current UFOC, several material changes have been proposed. Not all of them are discussed by the FTC in its Notice. We summarize proposed changes to the UFOC in Part III of our analysis. Additional state disclosure requirements would be preempted by the FTC, unless the FTC determines that they provide greater protection for franchisees than the requirements of the Rule. The Proposal would permit franchisors to continue using multi-state documents containing state specific disclosures.
In reviewing the language of the Proposal, we have based our comments on the literal language of the Proposal. We note that in several sections the proposed language is virtually identical to that found in the text of the Rule. However, the Interpretative Guides issued after the Rule was first published sometime clarified or changed what those terms appeared to mean. (See, e.g., the Updating Requirements and Required Payment definition.)
The Commission does note that the Proposal may impose requirements on franchisors subject to orders it has previously issued and has invited persons subject to these orders to petition for relief. It has not explained how previous Interpretative Guides on Interpretative Advisory Opinions would affect franchisors' duties under the Proposal. Insofar as interpretations or clarifications have been rendered because of imprecise or ambiguous language in the Rule, shouldn't the clarifications be incorporated in the language of the Proposed Rule?
The Proposed Rule provides more exclusions and exemptions than the current Rule. The Proposal expressly permits use of electronic media, including the Internet, to transmit disclosure documents and signatures and outlines procedures for making electronic disclosures. It also raised questions about how franchisors may control their liability for "financial performance representations" found on or linked to their Web pages.
Part I How Would the Proposed Rule Change Disclosure Procedures, and Who Is and Is Not Entitled to Receive Disclosures?
The type of transactions which the Proposed Rule would cover has been narrowed. The Rule would no longer apply to "business opportunities," franchises for locations outside the United States, franchises requiring an investment of more than $1.5 million which is not financed by the franchisor, franchises sold to a corporation which is five years or more old and which has a net worth exceeding $5 million, and franchises sold to certain owners and managers of franchisors.
The Proposed Rule continues exemptions from coverage for sales of "fractional franchises," "leased departments," franchises governed by the Petroleum Marketing Practices Act ("PMPA") and "oral franchises." The Commission has proposed retaining the 1970's vintage $500 minimum payment threshold for establishing compliance obligations under the Rule, but uses a "required payment" definition which may exclude continuing royalty payments from the calculation.
Delivery requirements for disclosures have been modified in several material respects. Franchise sellers no longer need to worry about when a first personal meeting occurs or the impact of federal holidays on their calculation of 14 or 5 business days. The first personal meeting requirement would be discarded, and bright line standards of 14 days and 5 days would be substituted for them. Documents may be delivered by electronic means, including the Internet, computer discs and compact discs, and traditional hand written signatures would not be required if the franchisor could otherwise demonstrate that the prospective franchisee received the disclosure documents. Franchisors still would be charged with maintaining records of all disclosure documents given to prospective franchisees, regardless of form, and electronically delivered documents must be accessible and readable through the date of the sale of each franchise.
The FTC would retain its requirement that no extraneous materials be included in the disclosure document, and it would not allow electronic forms to contain anything but prescribed text. Although use of links providing access to sections and documents contained in the disclosure package would be permitted, links to other materials would remain prohibited. Music, photographs, banner ads, etc. would also be prohibited. The Proposal would not prohibit delivery of other information about the franchise, so long as it does not conflict with the prescribed disclosure.
The Proposed Rule includes three discreet updating requirements:
(1) Annual updating of all disclosed information is required within 90 days after the franchisor's fiscal year end. Despite the fact that several states have extended their annual report or renewal requirements to 120 days after fiscal year end to accommodate receipt of financial statements from seasonally overburdened auditors, the FTC would stick to the 90- day standard.
(2) Quarterly updates of information "to reflect any material change in the franchisor or relating to the franchised business of the franchisor" would be required. Those revisions need not be integrated into the disclosure document, but may be attached to it.
(3) At least five days before completed franchise agreements are delivered to prospective franchisees, franchisors would be required to give franchisees notice of "any other known material change in the franchisor, the franchised business or franchise agreement ." Only earnings claims updates are now required to be delivered if annual and quarterly reports do not reflect material changes to earnings claims. This notice ("five-day notice") needs not be integrated into or attached to the disclosure documents. The Proposed Rule does not even require it to be written.
Curiously, the description of the items which must be updated differ depending upon when the update is to be made. Moreover, the quarterly and five-day updating requirements use somewhat ambiguous standards. E.g., is a franchisor's decision to sell products through the Internet required to be disclosed under the quarterly and five-day standards if the decision is not prohibited by the franchise agreement and does not require an amendment of the franchise agreement?
FURNISHING AND PREPARING DISCLOSURE DOCUMENTS (§ 436.2)
A. Scope of the Rule (§ 436.2)
The Proposed Rule's scope is limited to the sale of franchises for locations in the United States, its possessions, or territories. The Rule does not restrict any jurisdiction the Commission may have over foreign franchise sales under Section 5 of the FTC Act. Is Puerto Rico covered?
B. Obligation to Furnish Documents (§ 436.2(a))
Clarifies that franchisors' sales representatives and third-party franchise sellers will be individually liable for their failure to provide prospective franchisees with the required disclosure documents.
C. 14-Day Disclosure Review Period (§ 436.2(a)(1))
Eliminates the first personal meeting trigger and the need to count "business days." A 14 calendar day review period is substituted.
D. Five-Day Contract Review Period (§ 436.2(a)(2))
Substitutes a five calendar day review period for the former five business day review period.
E. Furnishing Disclosures (§ 436.2(b))
Clarifies that documents may be delivered by paper or electronically. If documents are sent by first class mail, they are presumed to be received after three days. No presumptions are proposed for other forms of delivery. Because evidence of the date of mailing first class mail may be difficult to retain, franchisors may be unwise to rely on this presumption unless they prepare certificates of mailing similar to certificates of service used when serving pleadings in a law suit.
F. Contents of Disclosures (§ 436.2(c))
Makes franchisors, franchisor's sales representatives and third-party franchise sellers individually liable for the content of a disclosure document if they know or should have known of a violation.
INSTRUCTIONS FOR ELECTRONIC DISCLOSURE DOCUMENTS (§ 436.7)
· All of the proposed rules regarding electronic disclosure are new rules.
A. Consent (§436.7(a))
New provision. Franchisors would be required to obtain franchisees' consent to provide electronic disclosure (§436.7(a)).
B. Notice and Receipt (§§436.7(b))
New provision. Sellers must provide electronic disclosure simultaneously with a written copy of the UFOC cover page, table of contents and two copies of the receipt (§436.7). It is unclear how the franchisor is to simultaneously deliver the paper notice and disclosure and what methods delivery would satisfy this requirement. This requirement may effectively eliminate electronic disclosure as a viable option.
C. Preservation of Disclosure (§436.7(c))
Substantially same. Applies the present requirements of disclosure preservation to electronic disclosures.
D. Single Document (§436.7(d))
New provision. Provides for the electronic disclosure to appear in a single document as does paper disclosure. Electronic disclosure should be capable of being viewed as a whole without having to activate "pop-up" screens, entering a search or clicking on a link.
E. Features (§436.7(e))
New provision. Provides for the electronic disclosure to appear in a single document as does paper disclosure. Electronic disclosure should be capable of being viewed as a whole without having to activate "pop-up" screens, enter a search term or click on links to view the disclosures.
F. Accessibility (§436.7(f))
Substantially same. Provides that electronic disclosures be available to the franchisee at least until the agreement is signed.
G. Record Retention (§436.7(g))
Substantially same. Adds time requirement. Franchisors would be required to keep paper copies of all materially different disclosures they have used for three years. Note that this requirement may be less than the applicable statute of limitations for other laws.
EXEMPTIONS (§ 436.9)
A. Minimum Payment Exemption (§ 436.9(a))
Substantially similar to FTC Rule. Exempts business ventures with an investment of less than $500 from the Rule. There is a question as to whether twenty years after the effective date of the Rule, the minimum investment should still be fixed at $500. The Commission may want to adjust that dollar amount for inflation. The definition of Required Payment may exclude franchises for which no initial fee is charged.
B. Fractional Franchise Exemption (§ 436.9(b))
Substantially similar to FTC Rule. Retains the fractional franchise exemption currently found at 16 CFR §436.2(a)(3)(i). It is unclear whether the fractional franchise exemption under the Proposed Rule would be subject to the same interpretation as the staff has articulated in interpretative advisory opinions. The Proposed Rule and commentary do not reference these interpretations and, thereby, raise a question as to their applicability.
C. Leased Department Exemption (§ 436.9(c))
Substantially similar to FTC Rule. Retains the leased department exemption currently in the Rule. In the proposed section, the Commission does clarify the definition, but it does not take this opportunity to clarify the application of the exemption to co-branding agreements.
D. Petroleum Marketers and Resellers Exemption (§ 436.9(d))
New provision. Creates a new exemption for petroleum marketers and resellers covered by the Petroleum Marketing Practices Act ("PMPA"). This section is based upon exemptions previously granted by the Commission; however, it leaves unanswered the question as to whether disclosure is required when other businesses (e.g. convenience stores, fast food, ice cream shop) operate in these exempt gasoline franchise establishments.
E. Sophisticated Investor Exemption (§ 436.9(e))
Modifies provision. Sets forth two new exemptions, which collectively can be referred to as "sophisticated investor" exemptions: (1) the large investment exemption; and (2) the large corporate franchisee exemption. The large investment exemption requires an investment of $1.5 million. But the Rule does not specify how this amount is to be calculated: Is it the initial investment described in Item 7? Is it the amount of the investment over the term of the franchise? or Is it some other calculation?
The large corporate franchisee exemption applies to corporations that have a net worth of five million dollars. There are many aspects of this exemption that are unclear.
First, the exemption only applies to "corporations" and not LLC's or partnerships. Second, it is unclear whether the exemption will apply to affiliated companies that have a consolidated net worth of five million dollars. Third, it is unclear whether a franchisee which is owned by a company that meets the five million dollar criterion will qualify as a sophisticated investor. Finally, if a franchisee is acquired by another company, may the franchisee claim the experience of the predecessor company as all or part of the five years experience required?
F. Officers and Owners (§ 436.9(f))
New provision. Sales to franchisees which are at least 50% owned by individuals who within 60 days of the sale have been an officer, director, managing agent or an owner of the franchisor would be exempt, provided their status has existed for at least 24 months.
G. Oral Contracts (§ 436.9(g))
Identical to FTC Rule.
INSTRUCTIONS FOR UPDATING DISCLOSURE DOCUMENTS
A. Annual Updates (§ 436.8(a))
Identical to FTC Rule. Requires yearly updating of the disclosure document. Ninety days after the close of the fiscal year, the franchisor must then prepare a revised disclosure document. This section is identical to the current Rule at 16 CFR §436.1(a)(22). However, many states have recognized that ninety days is not sufficient time for franchisors to furnish updated financial statements and have allowed disclosure one hundred and twenty days after the fiscal year.
B. Quarterly Updates (§ 436.8(b))
Identical to FTC Rule. Requires franchisors revise their disclosure document to reflect material changes at least on a quarterly basis. There is a discrepancy between what is required in the annual reports and what is required in the quarterly reports. The annual report section requires that "all information" be current while the quarterly report section requires that revisions be made to reflect "any material change in the franchisor or relating to the franchise business."
The quarterly update does not require that there be disclosure of material changes that have been made in the franchise agreement. These changes must be reflected in the annual and five-day material changes updates (§436.8(c). Both the Notice (§11) and the Interpretative Guides to the Rule (§C.4, CCH BFG 6225) describe the quarterly updating requirement as applying "to any material changes."
The quarterly update must be in writing, but it need not be integrated into the text of the offering circular.
C. Material Change (§ 436.8(c))
New provision. Requires franchisors to notify a prospective franchisee of material changes that have occurred after they have received disclosure documents at least five days before they sign franchise agreements. This section uses the language "material change in the franchisor, the franchise business, or franchise agreement" to describe what information must be disclosed. As noted above, the update sections all have a different explanation of what should be disclosed. The Notice (§11) describes the requirement as applying to "any material changes."
Unlike the annual and quarterly updates, five-day material change updates do not have to be in writing. Franchisors relying on oral disclosures of material changes will suffer the consequences of proving what they have disclosed whenever challenged.
D. Updated Audited Information (§ 436.8(d))
Identical to FTC Rule. Part II What Additional Prohibitions Does the FTC Propose to Impose on Franchisors?
The Proposed Rule would restrict franchisors' practices in two significant ways. First, the FTC would prohibit the use of merger and integration clauses in franchise or related agreements which "disclaim or require prospective franchisees to waive reliance on any representation made in the disclosure document or its exhibits or amendments." Merger and integration clauses are used in contracts to limit the interpretation of the rights and duties of the parties to what is actually written in a contract. They are found in all kinds of contracts, particularly in extensive negotiated agreements.
The Commission has proposed to ban their use because franchisors raise these clauses as defenses to claims of misrepresentation in franchise litigation. Some courts have concluded that franchisees may not reasonably rely upon oral or written statements or promises made by franchise sellers which are not included in written franchise agreements which contain merger and integration clauses. The Proposed Rule acknowledges that "a franchisor reasonably may seek to disclaim liability for unauthorized claims made by rogue salespersons, statements made by former or current franchisees, or even unattributed statements found in trade press." Nonetheless, the proposal suggests that "it is a violation of Section 5 for franchisors to use integration clauses essentially to shield themselves from liability for false or deceptive statements made in their disclosure documents." The Proposal does not explain how franchisors lawfully may efficiently or effectively shield themselves without using the merger and integration clauses it proposes to ban.
The FTC's suggestions that these issues may be overcome by requiring franchisees to initial negotiated changes to standard franchise agreements would not protect franchisors against claims, such as "the salesman told me I would not be terminated if I paid fees 30 days late, even though the agreement says it could be terminated for late payment."
Curiously, the Proposed Rule requires notice of material changes in information that should be included in the disclosure document to be given to prospective franchisees at least five days before a contract is signed. Under the Proposal, that information need not be presented in writing. Nonetheless, under the Proposal a franchisor would violate the Rule if it were to disclaim information that had been contained in a franchise offering circular previously delivered to a prospect which is no longer relevant or accurate.
In §436.10(d), the Commission proposes a modification of the "media earnings claims" standards contained in §436.1(e) of the Rule. Although the Proposal focuses upon dissemination of financial performance information to "prospective franchisees," the broad definition of prospective franchisees, coupled with references to "dissemination" would expose franchisors to substantial risks of violations if the requirements is not substantially clarified. For example, if a franchisor's Form 10-K which is filed with the Securities and Exchange Commission is available through the franchisor's Web site, and the Form 10-K includes "financial performance representations," the Rule would be violated if disclosures prescribed Item 19(3)(ii)(e) are not conspicuously disclosed in conjunction with it, and an Item 19 performance disclosure is not made in the offering circular.
A third new prohibition involves the use of shills to promote franchise businesses. Actors or public figures used in franchisors' advertising campaigns will need to exercise caution when making endorsements of franchises so as not to run afoul of prohibition against misrepresenting that they are able to provide "an independent and reliable report about the franchise or the experiences of any current or former franchisees." Clarification of the definition of "franchise seller" would mitigate that risk.
DELETED EXCLUSIONS (Notice § 12)
Exclusions for employer-employee and general partner relationships, cooperative associations, certification and testing services and single trademark licenses would be omitted. The Commission explains:
"Since the 1970's, the franchise community has become very familiar with the Rule's requirements, including the definition of the term franchise. In eliminating the four exemptions, however, the Commission is not signaling a substantive change in Commission Policy. Rather the elimination of the exclusions is simply part of the Commission's general effort to streamline the Rule." (§ 12)
Businesses which have relied on these exclusions, lawyers advising companies about whether they are subject to the Rule and courts asked to interpret the Proposed Rule are likely to have a different perspective on the benefits of "streamlining."
A. No Contradictory Statements (§ 436.10(a))
Substantially similar to FTC Rule. Prohibits franchisors from making any statements that are contradictory to those set forth in their disclosure documents.
B. Refunds (§ 436.10(b))
Substantially similar to FTC Rule. Prohibits franchisors from failing to honor their refund guarantees. This is similar to the comparable Rule provision found at 16 CFR § 436.1(h).
C. Written Substantiation (§ 436.10(c))
Substantially similar to FTC Rule. Prohibits franchisors from failing to make available to prospective franchisees and to the Commission upon reasonable request written substantiation for any financial performance representations made in an Item 19 disclosure. This provision is substantially similar to the current Rule provision found at 16 CFR §§ 436.1(b) and 436.(1)(c).
D. Financial Performance Statements (§ 436.10(d))
Franchise sellers would be prohibited from disseminating any financial performance representations to prospective franchisees, including representations made in the general media and on the Internet, unless the representation is included in Item 19 of the franchisor's disclosure document. Also, in conjunction with media and Internet financial performance representations, franchise sellers must disclose the number of outlets utilized in arriving at the representation and state the number and percentage of units which have attained or surpassed the stated results if the claim relates to past performance. An admonition that a new franchisee's financial results may differ from the claim also is required. Concerns with this Proposal stem from the possible liability it imposes on franchisors who choose to have web sites on the Internet. The first concern is who is a prospective franchisee? Does the web surfer who looks at the franchisor's web site become a prospective franchisee for purposes of this section? It is common for franchisors' web sites to have links to SEC documents, articles, reports and many other things related to the franchise? The Proposal does not clarify whether the franchisor would be held liable for the statements made in those documents based on the presence of the link in the franchisor's web site. In short, the terms "disseminate" and "prospective franchisee" are subject to broad interpretation, and the Proposal provides no guidance as to how franchisors may protect against inadvertent violations of this proposed requirement.
E. Disclaimers (§ 436.10(e))
New provision. Prohibits the use of merger and integration clauses in franchise and related agreements to disclaim or require a prospective franchisee to waive reliance upon any representation made in the disclosure document or its exhibits or amendments. This sweeping prohibition seems to forbid the use of negotiated changes unless the franchisor complies with the three requirements: "(1) the franchise seller identifies the changed terms and conditions; (2) the prospective franchisee initials the changes; and (3) the prospective franchisee has 5 days before signing the contract or paying any fee to review the revised contract."
These conditions will pose great difficulty to the parties when a document has been substantially negotiated and is likely to create more confusion than clarity in the reading and understanding of the document.
In addition, §436.10(e)(3) provides that to meet the exclusion from the section's requirements "the prospective franchisee [must have] 5 days before signing the contract or paying any fee to review the revised contract." It is unclear what this fee is, and there is no reference to it in any other part of the Proposed Rule. Furthermore, this prohibition related to the payment of a fee before the contract is signed is inconsistent with Proposed Rule §436.2(a)(2) which does not prohibit payment of a fee before the agreement is signed. It does require that a copy of the completed franchise agreement be provided to the franchisee at least five days before the franchisee signs the agreement.
This section is also inconsistent with the Commission's stated intention of encouraging negotiated changes. The benefits of merger and integration clauses are totally discounted by the Proposed Rule.
F. Shills (§ 436.11(f))
New provision. Adds a prohibition against franchisors' use of false references.
OTHER LAWS, RULES, AND ORDERS
A. Effect on Other Commission Laws (§ 436.11(a))
Substantially similar to FTC Policy.
B. Effect on Prior Commission Orders (§ 436.11(b))
Substantially similar to FTC Policy.
C. Preemption (§ 436.11(c))
Substantially similar to FTC Rule. Retains its prior preemption provision which provides that the Commission's rules preempt state and other laws only to the extent of inconsistency with the Rule. Also, if the other laws provide equal or greater protection, it is not inconsistent with the Rule. In Part III, we describe how the UFOC and proposed disclosure requirements differ.
SEVERABILITY (§ 436.12)
Substantially similar to FTC Rule.
Part III What Are the New Disclosure Requirements and How Do They Differ from Current UFOC Requirements?
INSTRUCTIONS FOR PREPARING DISCLOSURE DOCUMENTS A. Plain English (§ 436.6(a)) Substantially same. Reflects the present plain English requirement used by the UFOC, SEC and many states.
B. Responses (§ 436.6(b)) Substantially same. Reflects the present UFOC requirement of complete responses.
C. No Additional Materials (§ 436.6(c))
Substantially same. Adds multi-state disclosure for the FTC. Maintains its prior requirement that no additional materials be included in the disclosure, but it also allows franchisors to attach all applicable state specific addenda for use in multi-state disclosure documents.
D. Subfranchisors (§ 436.6(d))
Substantially same. "Subfranchisor" remains undefined.
Four definitions, which no longer serve a useful purpose, have been eliminated: Business Day, Time for Making Disclosures, Personal Meeting, and Cooperative Associations. Of the Proposal's 25 terms, 12 remain substantially the same, namely Action, Affiliate, Disclose, Fiscal Year, Franchisor, Leased Department, Material, Person, and Principal Business Address, Prospective Franchisee, Sale of a Franchise, and Trademark. Our comparisons are with the definitions in the Rule, and where applicable, the UFOC Guidelines.
D. Financial Performance Representation
Replaces "Earnings Claims". Expands the term to cover representations disseminated via the general media or Internet. Eliminates costs from the definition.
E. Fiscal Year
F. Fractional Franchise
Modifies term. Makes explicit that to qualify for the exemption parties must have a reasonable basis to anticipate that "sales arising from the relationship will not "exceed more than 20 percent of the franchisee's total dollar volume in sales during the first year of operation." Reference to newly defined term "officer" is troubling.
Modifies term. No longer encompasses business opportunities. The Proposal excludes business opportunities by requiring that either the franchisor's control be significant and continuing or that the franchisor's assistance be significant and extend beyond the start of the business operation.
H. Franchise Seller
New term. Refers to all parties having an obligation to provide disclosure documents, including a franchisor's employees, brokers and agents and makes them liable for compliance. The Proposal adopts the Commission policy that a franchisee seeking to sell its own outlet is not covered by the Rule. Disclosure delivery requirements would apply to franchise sellers (§436.2(a) and (b)), but the duty to prepare disclosure documents is imposed on franchisors (§436.2(c)).
Modifies term. Narrows "franchisee" to any person granted an interest in a franchise. However, the Proposal does not define/clarify "interest".
K. Gag Clause
New term. Defines agreements with franchisees that prohibit or restrict existing or former franchisees from discussing with prospective franchisees their experiences as franchisees. The use of the pejorative term "gag clause" may be considered an affront to parties' right to privacy.
New term. Includes all communications between computers and between computers and television, telephone, facsimile, and similar communication devices. The Commission proposes to permit franchisors to comply with the Rule electronically through use of the World Wide Web and E-mail, among other means.
M. Leased Department
Expands current exemption. Eliminates references to controls by retailer over lessee's or licensee's business affairs. Should the exemption be expanded to include "co- branding arrangements" where a department is licensed or leased to the same person who owns the interest in the real property from which another business will continue to operate?
New term. Applies to "de facto officers," all those with "significant management responsibility for the marketing and/or servicing of franchises." The definition may be internally inconsistent. A chief financial officer may not have "significant management responsibility for marketing and/or servicing franchises," but the individual must be identified in Item 2. This proposal is likely to substantially expand Item 2 disclosures. It also permits expansive interpretation of the exemption for franchises sold to "officers" if the seller is a franchised company, but limits the exemption substantially for non-franchisors which "spin-off" business units to officers or managers (§436.9(f)). Unless modified, the term could eliminate the availability of the fractional franchise exemption to officers of businesses acquiring fractional franchises.
Same. The Proposal does not include limited liability companies in its definition.
Q. Plain English
Modifies term. Expands UFOC definition to include any person from whom the franchisor has obtained the right to use trademarks or trade secrets associated with the franchise system. Given "trade secret" technology licensed through many franchisors, this could create substantial additional Item 1-4 disclosures. Because the term trademarks is not limited to the principal trademark, retail franchises could confront disclosure requirements about several licensors if the scope of the proposal is not narrowed.
S. Principal Business Address
T. Prospective Franchise
Substantially same. Although this term has not changed substantively, in the context of dissemination of franchise information via Internet, it raises the issue of whether a viewer of a franchise Web site becomes a prospective franchisee because he or she "approaches" a franchise seller to "discuss the possible establishment of a franchise relationship.
U. Required Payment
New term. Similarly applicable to determination of whether payments satisfy the under $500 exemption in §436.9(a). It applies only to "consideration"(?) the franchisee must pay "as a condition of obtaining or commencing operation of a franchise." The language seems to only apply to initial fees, and not to ongoing royalty fees. If a franchisor does not require an initial fee or a fee to obtain a franchise, rather only requires on-going royalties, are the payments excluded from the $500 minimum threshold? The term in the FTC Rule has been interpreted through Interpretative Guides to apply to continuing fees as well.
V. Sale of a Franchise
New term. Provides a flexible definition of signature to accommodate electronic transmissions. Allows use of digital signatures and passwords.
Substantially same. Includes trademarks, service marks, logos, and other commercial symbols.
New term. Includes electronic media, such as computer disks and the Internet.
Adopts UFOC requirements that the cover page include the franchisor's name, logo, brief description of the franchised business, total purchase price, and a notice that comparative information is available.
Prohibits disclosure of specific risk factors unless they are required in the state or states where the disclosure is being used. Voluntary listing of risk factors would be prohibited.
Must include E-mail address and Internet home page, if applicable.
Must include statement of franchisee's rights to receive electronic or paper disclosure (if franchisor offers electronic disclosure).
Revised legend includes reference to the Commission's homepage and publications.
TABLE OF CONTENTS
· Follows UFOC Guidelines except for changing the titles of four disclosure items:
Item 7 changed from "Initial Investment" to "Estimated Initial Investment"
Item 11 changed from "Franchisor's Obligations" to "Franchisor's Assistance, Advertising, Computer Systems, and Training"
Item 19 changed from "Earnings Claims" to "Financial Performance Representations"
Item 20 changed from "List of Outlets" to "Outlets and Franchise Information"
REQUIRED DISCLOSURE ITEMS
A. Item 1 The Franchisor, Its Parent, Predecessor, and Affiliates
· Adds to UFOC Item 1 the requirement that a franchisor must disclose information about its parent. The Proposal does not provide a definition of "parent." Given that the definition of "affiliate" includes any entity typically referred to as a parent, it is not clear what the disclosure of "parents" adds to Item 1.
A. Item 2 Business Experience
· Adds to UFOC Item 2 the requirement that a franchisor must disclose the business experience of the directors, trustees, general partners, officers and subfranchisors of "the franchisor or any parent who will have management responsibility relating to the offered franchises." The Proposal does not provide a definition for "management responsibility", which creates an ambiguity in the disclosure requirement. "Officers" are defined as individuals with "significant management responsibility" for "marketing and/or servicing" franchises. If is not clear whether directors are presumed to have "management responsibility" or whether a parent's directors or other employees would have "management responsibility."
· Because the definition of officers includes de facto officers, disclosures required under this Item may be greatly expanded.
A. Item 3 Litigation
· Adds to UFOC Item 3 the requirement that a franchisor must disclose the litigation of its parent and others identified in Item 2. The expanded predecessor definition may substantially increase scope of persons about which disclosures are required.
· Requires franchisors to disclose pending franchisor-initiated lawsuits against franchisees on issues involving the franchise relationship. The Commission seeks comment on whether a franchisor-initiated disclosure should be tied to a threshold and, if so, what threshold would be sufficient, e.g., disclosure required only if the franchisor has sued at least a certain percentage of franchisees of its system. Requiring disclosure of each suit at the expense of amending the offering circular and stopping sales in states which require that while amendments are processed may pose a disincentive to franchisors to protect the franchise network from non-complying franchisees.
· Emphasizes that all material settlement terms must be disclosed.
A. Item 4 Bankruptcy
· Adds to UFOC Item 4 the requirement that franchisors include information about bankruptcy history of any person identified in Item 2, including directors of the franchisor, as well as predecessors and parents and individuals associated with a parent who are identified in Item 2. The expanded predecessor definition may significantly expand the number of disclosures which must be made.
· Disclosure of affiliates' bankruptcies is limited to affiliates which offer franchises under the franchisor's principal trademark.
A. Item 5 Initial Franchise Fee
· Substantially same.
A. Item 6 Recurring or Occasional Fees
· Substantially same.
A. Item 7 Estimated Initial Investment
· New title defines period within which expenses are likely to be incurred.
· The Commission describes "initial phase" as the period of time until the franchisee is likely to break even, departing from NASAA's refusal to reference a break-even point when describing "initial phase" (§8.g. of Notice). N.b., franchisee costs are no longer included in the FTC's proposed financial performance representation (earnings claims) definition.
A. Item 8 Restrictions on Sources of Products and Services
· Substantially same.
A. Item 9 Franchisee's Obligations
· Substantially same. The Proposal initially refers to cross referencing between "applicable franchise agreement and disclosure document section(s)." The required legend refers to cross referencing between "franchise and other agreements and ... this disclosure document." Must franchisors still cross-reference agreements other than franchise agreements, e.g., leases, option agreements, license agreement?
A. Item 10 Financing
· Substantially same.
A. Item 11 Franchisor's Assistance, Advertising, Computer Systems, and Training
· New title.
· Requires explanation in greater detail of franchisors' site selection criteria and the nature of training programs.
· Requires additional disclosures concerning the extent of advertising assistance and the operation of local, regional, and national advertising funds.
· Requires greater disclosure about the required use of computers and electronic cash registers.
A. Item 12 Territory
· Requires new affirmative disclosure. Franchisors not offering exclusive territories must state: "You will not receive an exclusive territory. [Franchisor] may establish other franchised or company owned outlets that may compete with your location."
A. Item 13 Trademarks
A. Item 14 Patents, Copyrights, Proprietary Information
A. Item 15 Obligations to Participate in the Actual Operation of the Franchise Business
A. Item 16 Sales Restrictions
A. Item 17 Renewal, Termination, Transfer, and Dispute Resolution
A. Item 18 Public Figures
A. Item 19 Financial Performance Representation
· New title.
· Mandates legend explaining that the FTC does not prohibit financial performance representations and that they must meet prescribed criteria if they are given.
· Permits franchisor to select a subset of franchise outlets and compare their results for the purpose of presenting earnings claims.
· Does not address whether all financial information or securities documents which are on or linked to a franchisor's Web site or the Web site of a franchise seller or agent are subject to Item 19 disclosure. Unless franchisors restrict access to its Web site and links describing their financial performance, they may be required to make earnings claims under Item 19 and delete the material from their own Web site and linked sites.
A. Item 20 Outlets and Franchise Information
· Improves UFOC Item 20 by addressing the issues of double counting.
· Adopts a "first-in-time" approach where only the first of multiple ownership changes in a year would be reported.
· Proposes only first event related to a change of ownership of a franchisee in a year be disclosed. Commission asks several questions about the benefits of different approaches.
· Gag Clauses new requirement.
Requires franchisors to disclose their use of confidentiality agreements. The Proposed Rule refers to these agreements as "gag clauses." If franchisees have signed confidentiality agreements in any agreements, settlements or contracts with the franchisors in the last three years, the franchisor must include the following statement in Item 20: "In some instances, current and former franchisees sign provisions restricting their ability to speak openly about their experience with [name of franchise system]. While we encourage you to speak with current and former franchisees, be aware that not all such franchisees will be able to communicate with you."
Franchisors may provide supplemental information, such as the number and percentage of confidentiality agreements and further explanation about their use.
· Franchisee Association new requirement
Proposed section 436.5(t)(7) requires franchisors to disclose information about "trademark-specific" franchisee associations that are associated with the franchisor if the organization has been "created, supported, or recognized" by the franchisor and is incorporated. The franchisor only has to disclose the association if the association has made itself known to the franchisor.
Several aspects of this new request are unclear and undefined. First, the definition of a trademark-specific franchisee organization has not been provided. Second, it is unclear whether an association must be disclosed if it ceases to be supported or recognized by the franchisor. Third, it is unclear what the standards are for consideration as a franchisee organization. (E.g., Does merely claiming to be a franchisee association suffice? May an attorney purporting to represent a franchisee association insist that his name and phone number be inserted in the offering circular each year?). Finally, if this requirement only applies to incorporated associations, will associations organized as partnership and LLC's be unable to utilize this provision?
U. Item 21 Financial Statements
· Requires substantially the same information as does Item 21. However, 436.5(iii)(C) requires the inclusion of financial statements for a "company controlling 80 percent or more of a franchisor." UFOC to Item 21 provides that "[a] company controlling 80% or more of a franchisor may be required to include its financial statements."
· Clarifies the phase-in requirements for the use of audited financial statements.
V. Item 22 -- Contracts
· Substantially same. Reflects the present contract inclusion requirement present in the UFOC.
A. Item 23 Receipt
· Incorporates the new timing requirement of proposed § 436.2(a)(1). The franchisor now must provide disclosure fourteen days before any binding agreement is signed or any fee is paid. The receipt provision contemplates the use of all forms of signatures as broadly defined in proposed section 436.1(w )(i.e. written signatures, digital signatures, passwords, security codes, and other devices). The franchisor may specify the method of receipt and the type of receipt designated will dictate the "signature" necessary to confirm receipt.
Part IV What Are the Principal Advantages and Disadvantages of the Proposed Changes for Franchisors?
The Proposed Rule contains many obvious advantages to franchisors, including additional exemptions from the Rule, application to domestic franchise locations only, and the clear right to make disclosures over the Internet. But the Proposal also contains several intended, and, perhaps unintended disadvantages for franchisors. Although the FTC's Proposal to accept comments from interested parties should eliminate many of the unintended ambiguities and other problems that we have identified, some problems undoubtedly will remain at the conclusion of the process.
Still unexplained is the relationship between the new Proposal and whatever position the NAASA Franchise Committee and the states with franchise disclosure laws will assume pertaining to the FTC's mandate that its version of the UFOC be used in all states. Also unclear is the effect of the FTC's previously issued Interpretative Guides, interpretative advisory opinions and exemptions, and the Commentaries issued by NAASA pertaining to the current UFOC. At this point, it is also unclear whether or how the disclosure requirements may be amended in the future without going through the multi-year process in which the FTC is now engaged.
Along with the advantages and disadvantages, the Proposal suggests several opportunities for clarification which are as yet unrealized. Issues relating to whether or what disclosures are required of companies engaged in co-branding, and how to treat non-exempt franchises which are offered in connection with PMPA-exempt franchises also could be clarified during the process of revising the Rule.
Set forth below are the principal advantages of the changes from the perspective of most franchisors. That list is followed by a summary of disadvantages from the perspective of most franchisors.
Advantages for Franchisors
1. The preemptive format may reduce inconsistent interpretations of disclosure requirements at the state level.
2. Earnings claims will not be mandatory.
3. Risk factor disclosures are eliminated from cover pages.
4. Only franchises for United States locations are covered.
5. Certain sales to sophisticated investors will be exempt.
6. Disclosure timing obligations are clarified.
7. Electronic means are permitted for delivery of disclosures.
8. Multiple counting of turnover information in Item 20 is reduced.
9. Certain sales to franchisors' officers or owners are exempt.
10. Statements of franchisees' expenses are eliminated from financial performance representations (earnings claims).
11. Earnings claims concerning fewer than all franchisees are approved.
12. No private right of action is asserted.
13. Disclosures about franchisors' obligations under agreements other than franchise agreements may be eliminated (Item 9).
Disadvantages for Franchisors
1. Merger and integration clauses are prohibited in franchise and related agreements.
2. Expanded definitions of predecessor and related disclosures, may substantially increase disclosure obligations in Items 1-4.
3. Required disclosure of (undefined) "parents" may substantially increase disclosure obligations in Items 1-4.
4. Disclosures of franchisor-initiated litigation against franchisees will increase disclosure and amendment burdens.
5. Bankruptcy disclosures about directors of franchisors, their predecessors and parents may discourage participation of qualified outside directors.
6. Disclosures about the existence of confidentiality agreements make their use sound unethical.
7. Mandatory parent financial disclosures of franchisor's subsidiaries which have audited financial statements increases costs and burdens for franchisors.
8. Expanded definition of "officers" to include "de facto officers" adds to disclosure burdens and creates uncertainty.
9. Simultaneous delivery of a paper notice with an electronic disclosure document is cumbersome.
10. The potential liability of franchisors for financial performance representations made on or linked to franchisor's Web sites is problematic.
11. More detailed disclosures about site selection, advertising and computer purchases increases disclosure burden.
12. Disclosure of a minimum of 100 franchisees may add to burdens.
13. The requirements for notice and authentication of negotiated agreements may impair negotiations or inadvertently expose franchisors to risks of violations.
14. Potentially conflicting state and federal requirements may create uncertainty for franchisors.
15. Ambiguous requirements to report about franchisee organizations may lead to unintentional violations or may promote disruption within franchise organizations.
16. Elimination of several exemption categories will create problems for those who have relied upon them.
17. Ambiguity in updating requirements may lead to inadvertent violations.