HIGHLIGHTS AND ANALYSIS:

THE REVISED FEDERAL TRADE COMMISSION FRANCHISE RULE

By: David J. Kaufmann and David W. Oppenheim

Kaufmann, Feiner, Yamin, Gildin & Robbins LLP

New York City

© Commerce Clearing House, Inc. and Kaufmann, Feiner, Yamin, Gildin & Robbins LLP, 2007

TABLE OF CONTENTS

  1. INTRODUCTION………………………………………………………………………………..1
  2. BACKGROUND - - THE GENESIS OF FEDERAL AND STATE FRANCHISE REGULATION………………………………………………………………………………….. 4
  3. THE FTC’S REGULATORY REVIEW OF THE FRANCHISE RULE…………………….6
  4. FTC FRANCHISE RULE TO BE MAINTAINED - - BUSINESS OPPORTUNITY

REGULATION TO BE SEPARATELY ADDRESSED……………………………………..8

  1. NO REGULATION OF THE FRANCHISOR-FRANCHISEE RELATIONSHIP …………8
  1. UFOC DISCLOSURE MODEL ADOPTED AND EXPANDED; COMPARISON

OF REVISED RULE VS. CURRENT UFOC DISCLOSURE REQUIREMENTS………..10

  1. THE DEMISE OF THE UFOC GUIDELINES………………………………………………..26
  1. ELECTRONIC DISCLOSURE…………………………………………………………………27
  1. TIMING REQUIREMENTS - - WHEN DISCLOSURE MUST BE EFFECTED…………..29
  1. INTERNATIONAL TRANSACTIONS EXCLUDED FROM REVISED RULE COVERAGE……………………………………………………………………………………. 34
  1. USE OF “PLAIN ENGLISH” MANDATED………………………………………………….35
  1. FINANCIAL PERFORMANCE REPRESENTATIONS/”EARNINGS CLAIMS”…………35
  1. RESPONSIBILITY FOR EFFECTING DISCLOSURE……………………………………..42
  1. WHO MAY RECEIVE DISCLOSURE………………………………………………………..43
  1. LIABILITY FOR CONTENTS OF DISCLOSURE DOCUMENTS…………………………44
  1. DISCLOSURE POSSIBLY REQUIRED OUTSIDE OF THE DISCLOSURE

DOCUMENT…………………………………………………………………………………….46

  1. UPDATING DISCLOSURE DOCUMENTS………………………………………………….47
  1. EXEMPTIONS…………………………………………………………………………………..48
  1. PROHIBITED CONDUCT……………………………………………………………………..52
  1. REVISED RULE IMPACT ON STATE FRANCHISE LAWS………………………………54
  1. EFFECTIVE DATE OF REVISED FTC FRANCHISE RULE/

”PHASE-IN” PERIOD………………………………………………………………………….55

  1. REVISED RULE “TO DO” LIST FOR FRANCHISORS……………………………………56
  1. TABLE OF REVISED FTC FRANCHISE RULE VARIATIONS FROM

UFOC GUIDELINES……………………………………………………………………………60

  1. SAMPLE REVISED FTC FRANCHISE RULE DISCLOSURE DOCUMENT…………..60
  1. CONCLUSION…………………………………………………………………………………..60

1

HIGHLIGHTS AND ANALYSIS: THE REVISED

FEDERAL TRADE COMMISSION FRANCHISE RULE

By: David J. Kaufmann and David W. Oppenheim[*]

Kaufmann, Feiner, Yamin, Gildin & Robbins LLP

New York City

  1. INTRODUCTION

The future of franchise regulation has arrived.

On January 22, 2007, the Federal Trade Commission (“FTC”) approved a comprehensively revised FTC Franchise Rule (16 CFR Part 436) - - the nation’s sole federal franchise regulation - - fundamentally transforming the Rule for the first time since it was first adopted in 1978. As a result, the regulation of the offer and sale of franchises in the United States will experience its most dramatic transformation since the advent of federal and state franchise disclosure laws and regulations in the 1970’s.

Accompanying the revised FTC Franchise Rule (the “Revised Rule”) is the Commission’s “Statement of Basis and Purpose” (“SBP”) amplifying and clarifying the Revised Rule’s requirements and prohibitions.

As detailed below, the Revised Rule takes effect on an optional basis on July 1, 2007 and on a mandatory basis on July 1, 2008, after which all franchise disclosure documents nationwide must comply with the Revised Rule’s modified requirements.

Gone is the old FTC Franchise Rule’s (the “original Rule”) own disclosure format (rarely used, since a disclosure document based thereon was unacceptable to the franchise regulating states). Gone soon will be the current version of the Uniform Franchise Offering Circular (“UFOC”), the franchise disclosure document format conceived and implemented by the franchise regulatory states, and approved for use by the FTC, to facilitate multistate franchise disclosure. Now, the UFOC has been “federalized”, essentially coopted by the revised FTC Franchise Rule as the federal government’s new disclosure platform, significantly augmented by various additional and modified disclosure obligations.

Given the FTC Franchise Rule’s continuing limited preemptive effect, the Revised Rule’s “UFOC plus” disclosure requirements will serve as the new franchise disclosure “floor” which in the future all franchisors must comply with (meaning that the franchise regulating states must now amend their disclosure regulations and, in certain instances, their statutes to incorporate this new disclosure “floor”). And by necessity, today’s UFOC Guidelines (specifying the franchise regulating states’ requirements concerning the contents and preparation of the UFOC) will soon disappear, unless such states retain the Guidelines only to address any disclosure obligations they may require that go beyond the revised FTC Franchise Rule’s obligations.

In lieu of the UFOC Guidelines, the FTC released the aforementioned SBP and the staff of the FTC will soon issue its Franchise Rule Compliance Guides addressing at length various disclosure issues arising under the Revised Rule (said Compliance Guides being analogous to the FTC’s “Final Interpretative Guides” which accompanied the promulgation of the original Rule).

Whether the franchise community will continue to refer to a disclosure document as a “UFOC” out of force of habit after the Revised Rule’s mandatory effective date of July 1, 2008 remains to be seen - - the formal title ascribed to it by the revised FTC Franchise Rule is simply, “Franchise Disclosure Document”.

Much else has been reshaped by the revised FTC Franchise Rule, as this report will reveal. The old question as to whether the FTC Franchise Rule applied to international transactions has been answered with finality: no, it does not. Pure electronic disclosure is permitted, leaving to history the days when franchise disclosure documents had to be handed out in paper form. The “first personal meeting” and “ten business day/five business day” timing requirements for effecting disclosure have been modified. Giving out “cost only” information to prospective franchisees will no longer be deemed furnishing financial performance representations (formerly known as “earnings claims”). And a series of new, broad exemptions from disclosure obligations are afforded by the Revised Rule.

The Revised Rule and the FTC’s Statement Basis and Purpose are remarkable documents, reflecting vision; intellect; a thorough understanding of the importance and workings of franchising in the United States; and, a dedicated commitment to ascertain the needs, wants and desires of franchising’s “players” (franchisors, franchisees and those professionals who serve them) and harmonize those desires with the interests of franchisees in particular and the general public at large. As well, the Revised Rule reflects a stunning commitment to address and incorporate the vast demographic, economic, societal and technological changes which have transpired since the original FTC Franchise Rule became was adopted in 1978.

The franchise sector owes a sincere debt of gratitude to those responsible for the FTC’s promulgation of the Revised Rule - - in particular, Steven Toporoff (FTC Franchise Program Coordinator); Eileen Harrington (FTC Deputy Director, Bureau of Consumer Protection); Lois C. Greisman (FTC Associate Director, Division of Marketing Practices); Lydia B. Parnes (FTC Director, Bureau of Consumer Protection); and, Deborah Platt Majoras (Chair, Federal Trade Commission).

In this report, we shall:

  • Address the genesis of federal and state franchise regulation; review the methodology which the FTC staff utilized to conduct its review of the original FTC Franchise Rule and promulgate the Revised Rule;
  • Address each substantive change wrought by the Revised Rule;
  • Closely analyze how current Uniform Franchise Offering Circular (“UFOC”) disclosure documents will have to be modified to comply with the new disclosure requirements of the Revised Rule;
  • Address the preemptive effect of the revised FTC Franchise Rule upon current state franchise registration and disclosure statutes;
  • Explore the impact of the Revised Rules’ effective date and phase-in period;
  • Set forth a “to do” list of activities which franchisors should immediately undertake in order to transition to the Revised Rule;
  • Furnish a table (Exhibit A) identifying each Revised Rule vs. UFOC variance; and,
  • Present a sample franchise disclosure document (Exhibit B) tailored to meet the Revised Rule’s disclosure requirements and mandates while satisfying non-preempted state franchise law edicts.

The full text of the revised FTC Franchise Rule and its accompanying Statement of Basis and Purpose follows this report.

  1. BACKGROUND - - THE GENESIS OF FEDERAL AND STATE FRANCHISE REGULATION

The FTC Franchise Rule was promulgated in 1978 at a time when fraud and criminality had penetrated the franchise arena.

Modern franchising, as we know it, had its advent in the 1950’s and 60’s. Before then, only soft drink companies and their authorized bottlers, oil refiners and their independently owned service stations, and automobile manufacturers and their dealers utilized franchising to any significant extent - - along with a few meaningful “business format” franchisors such as Howard Johnson’s (not today’s lodging chain, which had its genesis in 1954, but rather a network of hundreds of “orange roof” restaurants known nationwide for outstanding ice cream, hot dogs and other quality food served at reasonable prices).

It was in the 1950’s and 60’s that modern franchising as we know it truly took off. McDonald’s, Pizza Hut, Burger King, H&R Block, Holiday Inn, Baskin-Robbins, Kentucky Fried Chicken - - they all geared up and franchised out during this explosive period. The very popularity, growth and economic rewards of franchising, both to franchisors and franchisees, led to the need for its regulation. What happened was simple. Fly-by-night, unethical and often criminal operators - - reading press accounts in the late 1950’s and 60’s of the millions to be made in franchising - - decided to enter the franchise arena and proceeded to victimize many. Tens of thousands of people around the country lost millions of dollars to criminal franchise enterprises - - enterprises which, utilizing slick brochures and outright criminality, sold non-existent franchises to people whose life savings were lost to franchise fraud. So bad was the situation that 60 Minutes did a major “hit piece” on franchising featuring a scam perpetrated by a New Jersey outfit known as “Wild Bill’s Family Restaurants” (the principals of which ultimately were indicted by a federal grand jury).

The states reacted first to this broadscale criminal invasion of the franchise arena, with California in 1971 enacting the first ever franchise specific law - - the California Franchise Investment Law,[1] which requires a franchisor, prior to offering or selling franchises in that state, to register itself and its franchise disclosure document, and disseminate that document to prospective franchisees before accepting any money or signing any contract, with stiff criminal and civil liabilities for franchisor non-compliance. Over the following decade, fourteen other key states enacted parallel legislation (Maryland,[2] Virginia,[3] Wisconsin,[4] Illinois,[5] Minnesota,[6] Indiana,[7] New York,[8] North Dakota,[9] South Dakota,[10] Michigan,[11] Hawaii,[12] Oregon,[13] Washington,[14] and Rhode Island).[15]

It was also in 1971 that the Federal Trade Commission announced its initiation of a rulemaking proceeding with the goal of promulgating a trade regulation rule governing franchise sales activity.[16] Following years of proposals, hearings, comments and data analysis, the FTC concluded that rampant fraud existed in the franchise arena, necessitating federal regulation:

Specifically, the Commission found that franchisors and business opportunity sellers often made material misrepresentations about: the nature of the seller and its business operations, the costs to purchase a franchise or business opportunity and other contractual terms and conditions under which the business would operate, the success of the seller and its purchasers, and the seller’s financial viability. The Commission also found other unfair or deceptive practices pervasive: franchisors’ and business opportunity sellers’ use of false or unsubstantiated earnings claims to lure prospective purchasers into buying a franchise or business opportunity, and franchisors’ and business opportunity sellers’ failure to honor promised refund requests. The Commission concluded that all of these practices led to serious economic harm to consumers.[17]

Accordingly, the original FTC Franchise Rule was adopted on December 21, 1978 and took effect on October 21, 1979. Under the original Rule, franchisors were required to effect full pre-sale disclosure prior to the offer or sale of any franchise through a disclosure document whose format was specified by the Rule[18] and in the FTC’s “Interpretative Guides” which accompanied the Rule.

Importantly, the fifteen states identified above which had enacted franchise registration and disclosure statutes refused to permit an FTC format disclosure document to be utilized, instead demanding compliance with each state statute’s particular disclosure format. To eliminate the confusion engendered by these varying (and sometimes conflicting) state disclosure requirements, the state franchise administrators - - acting first under the umbrella of the Midwest Securities Commissioners Association and then, as today, under the umbrella of the North American Securities Administrators Association (“NASAA”) - - in the mid 1970’s promulgated the “Uniform Franchise Offering Circular” (commonly referred to as the “UFOC”), a disclosure document format which, if prepared in accordance with NASSA’s UFOC Guidelines,[19] satisfied the disclosure requirements of all state franchise registration and disclosure statutes.

To facilitate disclosure compliance by national and regional franchisors encountering two varying disclosure formats - - one federal, one state - - the FTC in its 1979 Interpretative Guides expressly permitted franchisors to utilize the UFOC disclosure format instead of the FTC’s own disclosure format.[20]

  1. THE FTC’S REGULATORY REVIEW OF THE FRANCHISE RULE

The FTC Franchise Rule remained static following its adoption in 1979 while franchising grew exponentially to become a major force in the American economy, with some reports suggesting that today 40% of all retail sales in the United States are consummated at franchised outlets.

Accordingly, the Federal Trade Commission initiated a regulatory review[21] of the FTC Franchise Rule in 1995, seeking public comment on whether there was a continuing need for the Rule and, if so, how the Rule could be improved to respond to the massive economic, societal and technological changes which transpired following the Rule’s deployment in 1979. In response to the Commission’s review notice, the FTC received 75 written comments and held two public workshops at which 50 individuals participated (the “Rule Review”).[22]

Following the Rule Review, the FTC concluded that its franchise rule needed to be amended and, toward that end, the FTC published an Advance Notice of Proposed Rulemaking (“ANPR”)[23] seeking comment on several possible Rule modifications. In response to the Commission’s ANPR, the FTC received 166 written comments and held six public workshop conferences at which 65 people participated (including franchisors, franchisees, state regulators and consultants).[24]

The next step in the Franchise Rule revision process took place in October, 1999 with the Commission’s publication of a Notice of Proposed Rulemaking (“NPR”) further suggesting how the Commission was considering revising the FTC Franchise Rule.[25] Attached to this NPR was a proposed revised Franchise Rule and an invitation for the public to submit comments and, if deemed desirable, request a public hearing (no one asked for such a hearing). The FTC received 40 comments in response to its NPR. Further, during this time the FTC consulted with officials who administered state franchise registration and disclosure statutes and internally utilized the services of FTC attorneys, accountants, economists and other experts to assist it in determining how to revise its Franchise Rule.

The penultimate step in the Franchise Rule revision process took place in August, 2004 - - the issuance of an FTC Staff Report, the last administrative act required of the Commission prior to its adopting the Revised Rule.[26] The Staff Report, 271 pages long and containing another 137 pages of exhibits, memorialized the findings and conclusions of the FTC staff’s decade long review of franchising and franchise regulation; proposed the text of a revised Rule which the staff recommended the Commission adopt (virtually identical, with slight modifications, to the Revised Rule ultimately promulgated by the FTC); and, afforded a very brief comment period within which “fine tuning” suggestions would be received by the Commission. In response to the Staff Report, the FTC received 45 comments which for the most part supported the proposed Rule revisions suggested by the Commission’s staff.[27]

  1. FTC FRANCHISE RULE TO BE MAINTAINED - - BUSINESS OPPORTUNITY REGULATION TO BE SEPARATELY ADDRESSED

An essential issue addressed by the FTC over the past decade was whether the Franchise Rule continued to serve a useful purpose and thus should be maintained or, in the alternative, whether it now served no useful purpose and should be discarded.[28]

The SBP reveals that comments submitted to the FTC, coupled with the Commission’s law enforcement experience over the past three decades, overwhelmingly supported maintenance of the FTC Franchise Rule as a deterrent to fraud and as a cost-effective way to provide material information to prospective franchisees so they may assess the costs, benefits and potential risks involved in entering into a franchise relationship.[29] However, the 2004 Staff Report recommended that the then forthcoming revised FTC Franchise Rule - - which originally subsumed and governed both the offer and sale of franchises and business opportunities - - be confined to franchising alone, with the Commission addressing the regulation of business opportunity sales separately through a subsequent rulemaking endeavor.[30]

The Commission accepted its Staff’s recommendation. Accordingly, the Revised Rule consists of two distinct segments - - one confined exclusively to the regulation of franchising (16 CFR Part 436, the subject of this report) and the other setting forth, for the time being, the original Rule’s requirements and restrictions pertaining to business opportunity sales (16 CFR Part 437) (with the FTC initiating a separate rulemaking on April 12, 2006 addressing how its business opportunity regulation should be revised).[31]

  1. NO REGULATION OF THE FRANCHISOR-FRANCHISEE RELATIONSHIP

Despite calls from many franchisee advocates that the revised FTC Franchise Rule govern franchisor-franchisee relationships to address what some of these advocates suggest are “abusive franchise relationships”, the Revised Rule does no such thing.

Franchisee advocates suggested in particular that the FTC fashion its Revised Rule to prohibit the enforcement of franchise agreement post-term covenants not to compete; franchisors’ alleged “encroachment” of franchisees’ “market territories”; and, restrictions on franchisee sourcing of products and services, among other practices.[32] Indeed, some franchisees suggested that if the Revised Rule did not address post-sale relationship issues, then the FTC should abolish the Franchise Rule altogether.[33]