Continuing obligations of the franchisor
A franchisor attempting to sell franchises in the United States must comply with a patchwork of federal and state laws that regulate franchising. These involve detailed disclosure of the franchise opportunity at the federal level, as well as registration or notice filing requirements and additional disclosure obligations at the state level. While this update does not purport to provide an exhaustive overview of the interplay between these federal and state laws, it is intended to provide franchisors with a basic understanding of the purpose and scope of these laws - a necessary component of any US expansion plan.
Amended FTC rule
To enable prospective franchisees to make informed decisions and to protect against fraudulent franchise sales practices, pursuant to authorisation from the US Congress, in 1979 the Federal Trade Commission (FTC) promulgated its rule on the disclosure requirements and prohibitions concerning franchising and business opportunity ventures for the regulation of franchise systems in America.(1)
In 2007 the FTC updated this regulation to align it better with the various state franchise laws that had emerged since adoption of the FTC rule nearly 30 years earlier. The amended rule took effect in July 2008.(2) While the amended rule governs the sale of franchise systems in all 50 states, Washington DC and the US territories, it does not apply to the sale of franchises internationally.
The regulation defines a 'franchise' as a business relationship that includes three elements:
- the granting or licensing of a right to use a trademark or trade name;
- payment of a 'franchise fee' for the use of the mark or name, including both up-front fees and ongoing fees; and
- some variant of a community of interest, marketing plan, control or assistance.(3)
Franchise disclosure documents
In its current form, the amended rule serves only as a disclosure law; no registration or other filing is required of franchisors. Nevertheless, before offering any franchises for sale, every franchisor must complete a standardised form, the franchise disclosure document (FDD).
Formerly known as the uniform franchise offering circular, the FDD includes 23 separate items of disclosure, 21 of which are substantive. The franchisor must respond to each of the following items affirmatively or negatively:
- the franchisor and any parent, predecessors and affiliates;
- business experience;
- initial fees;
- other fees;
- estimated initial investment;
- restrictions on sources of products and services;
- franchisee's obligations;
- franchisor's assistance, advertising, computer systems and training;
- patents, copyrights and proprietary information;
- obligation to participate in the actual operation of the franchise business;
- restrictions on what the franchisee may sell;
- renewal, termination, transfer and dispute resolution;
- public figures;
- financial performance representations;
- outlets and franchisee information;
- financial statements;
- contracts; and
Under the amended FTC rule, a franchisor is required to provide a complete FDD for all of its prospective franchisees. These prospects include individuals, corporations, limited liability companies and other entities. Current franchisees acquiring an additional franchise from the franchisor are also considered to be prospective franchisees for cases where the current offering is materially different from the original franchise acquired.
A franchisor must generally provide the FDD to a prospective franchisee at least 14 calendar days before the earlier of:
- the franchisee executing the franchise agreement; or
- payment by the franchisee of any consideration in connection with the proposed sale of a franchise.
The 14-day period does not include the day on which the prospect receives the FDD, nor does it include the day on which the prospect signs the franchise agreement or makes payment to the franchisor. A handful of states - including Michigan, Oregon, New York, Rhode Island, Washington and Wisconsin - require different disclosure periods. Franchisors are responsible for complying with these laws.
Prohibition on unfair or deceptive acts or practices
Consistent with the purpose of the amended FTC rule, the FDD prohibits unfair or deceptive acts or practices by a franchisor. One of the most common fact patterns for alleged franchisor violations involving unfair or deceptive practices rests with Item 19 of the FDD, which regulates the financial performance representations, if any, that can be made to prospective franchisees during the sales process. Specifically, a franchisor may not provide a prospect with sales or earnings projections outside of the information contained in its Item 19 disclosure; similarly, franchisors that do not include financial performance information in Item 19 of the FDD may not discuss actual or projected sales or revenues.(4)
A franchisor that includes financial performance information in its Item 19 disclosure must have a reasonable basis for doing so and must take great care to ensure that the presentation of the information is not misleading (eg, Item 19 cannot omit certain information that, if otherwise included, would affect the interpretation of the figures presented). Item 19 is complicated; for example, while hard costs generally are not deemed to be 'sales or earnings projections' (except in a handful of states), costs as a percentage of overall revenue must be included in Item 19 if the franchisor wishes to discuss the percentages with prospective franchisees. Given these complexities, on reasonable request, franchisors are required to provide the FTC or prospective franchisees with written substantiation of the financial performance representation contained in their Item 19 disclosure.
A franchisor must guard against making assertions contrary to those that appear in its FDD. At the same time, when completing the FDD, it must be wary of making general misrepresentations that can include mis-statements, overstatements or unfulfilled promises.
Registration or notice filing laws
While every franchisor must comply with the amended rule, franchisors can also be subject to state franchise laws when one of the following occurs:
- a prospective franchisee resides in a state that regulates the offer and sale of franchises;
- a franchise will be located or operated in such a state; or
- the offer or sale of the franchise takes place in such a state.
Given the above criteria, it is possible that the sale of one franchise can trigger the franchise laws of multiple states. States that regulate the offer and sale of franchises can generally be organised into two categories:
- pre-offer and pre-sale registration states; and
- states that require notice filing.
The general rule in both categories is that a franchisor cannot discuss franchise opportunities with residents of that particular state - and sometimes even with non-residents that wish to operate a franchise in that state - until the franchisor has complied with the state's franchise laws.
Registration states typically follow a review and approval process of a franchisor's registration application, a process carried out by state franchise examiners. After reviewing the application, an examiner either approves the application or issues comments to the franchisor, many of which require the franchisor to make specific changes to the application before resubmitting it for approval. The process can at times be lengthy. The payment of registration fees is also required.
States that use this approach include California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, Virginia and Washington. Three other states are technically referred to as registration states (Michigan, South Dakota and Wisconsin), but generally accept a franchisor's FDD as registered when it is received.
Not all franchisors must undergo the registration process in these states. Rather, various states provide exemptions from registration for certain franchisors with:
- isolated sales (ie, those that sell only one franchise in the state);
- accredited investors (banking institutions, investment companies, individuals with a specific net worth or income or directors and officers of the franchisor);
- large franchisors (based on their net worth, number of existing units or years of experience in the line of business); or
- fractional franchises (systems in which a franchisee, any of its current directors or officers, or those of its parent or affiliate, has more than two years of experience in the same business and can reasonably anticipate sales from the franchise not exceeding 20% of the franchisee's total dollar volume in sales during the first year of operation).
Notice states typically follow a more straightforward approach that can generally be completed in a few days. In connection with these states, a franchisor needs only to complete and submit the respective state's notice application form, along with the requisite filing fees. There is no review process and no FDD submission requirement.
States that use this approach include Connecticut, Florida, Kentucky, Nebraska, Texas and Utah. Of these states, only Florida and Utah require annual notice filing by franchisors; the others allow one-time filings.
States without state franchise regulations
In states that do not regulate the offer and sale of franchises, disclosure by the franchisor according to the amended rule (using the FDD) is all that is required.
Business opportunity laws
Some states, such as Florida, do not separately regulate the offer and sale of franchises other than to require notice, as discussed above. However, Florida has a business opportunity law that will apply unless the franchisor completes a simple annual notice filing. Business opportunity laws carry their own disclosure and registration requirements, so it is important for franchisors to file for the necessary business opportunity exemptions with the applicable states.
These exemptions may not be available to a franchisor that does not have a US federally registered trademark, in which case the franchisor would incur significant expense to 'register' as a business opportunity in that particular state. Thus, it is important for a franchisor to take the necessary steps to register its mark with the US Patent and Trademark Office and investigate properly whether business opportunity laws may apply to its situation.
Numerous states have established laws that govern the relationship between franchisor and franchisee once the sale of a franchise is completed. Although this aspect of state regulation extends beyond the scope of this update, it should be noted nevertheless. Most significantly, state relationship laws affect the termination of franchisees and the non-renewal of franchise agreements. Some states also have anti-discrimination provisions that prohibit franchisors from treating similarly situated franchisees differently without cause.
A franchisor's obligation to investigate and operate within applicable state franchise laws does not end once the deal is penned. Rather, franchisors have a continuing obligation to ensure that the ongoing relationship with the franchisee - and the developments and disputes that often arise in such relationships - is consistent with applicable state franchise relationship laws.
Continuing obligations of the franchisor
In connection with the recruitment of prospective franchisees, franchisors must adhere to general requirements concerning the truth and accuracy of their statements. Misleading statements are prohibited. Franchisors must not circulate advertisements with financial information unless the advertisement complies with certain rules and restrictions regarding the presentation of such information.
At present seven states require franchisors to submit their advertising and promotional materials for approval by a state examiner before using them. These states are California, Maryland, Minnesota, New York, North Dakota, Rhode Island and Washington.
Additionally, some states require franchisors to place special disclaimers or notices on their advertisements. In fact, it is not uncommon for certain states to follow up with franchisors to request substantiation for certain statements made in those materials.
Certain events can trigger the need for a franchisor to amend its FDD. In particular, various states require that material changes to the franchisor or its FDD (eg, change in control or name of franchisor, commencement of litigation, material change in management, changes to initial investment figures or a significant number of franchisees leaving the system) or significant changes in its franchise agreement warrants the filing of an application to amend its franchise registration and the payment of various filing fees. While amendments must typically be filed and accepted with the appropriate state agency before the sale of additional franchises in that state, some states allow franchisors to have discussions with prospective franchisees pending such amendments.
With respect to timing, the amended rule requires a franchisor to amend its FDD at least quarterly to reflect material changes. However, state laws vary as to when exactly a franchisor must file an amendment to its FDD, ranging from "upon the occurrence of" the triggering event to "promptly" thereafter.
Updates and renewals
The amended rule requires a franchisor to update its FDD on an annual basis within 120 days of the end of its fiscal year. Similarly, registration states require a franchisor to update its FDD on an annual basis, albeit with additional requirements - the franchisor must also submit its current audited financial statements and various supplemental documents in each state in which it plans to continue selling franchises. Deadlines for these renewal applications vary throughout the registration states, but range from 90 days to 120 days after the end of the franchisor's fiscal year. The payment of renewal fees to the various states is also required.
Negotiated changes in franchise agreement
Finally, it is important to be aware that negotiated changes in a franchise agreement during the franchise sales process can trigger additional disclosure obligations under various state laws.
To franchisors looking to expand their systems into the United States, the franchise regulatory scheme might initially seem daunting. However, as this update illustrates, navigating the regulatory scheme becomes more comprehensible when organising franchise laws according to:
- their respective sources (ie, federal or state government); and
- when they are relevant to the franchisor (ie, before selling franchises or after franchise agreements have been signed).
Even so, franchisors should exercise necessary precautions, including obtaining a more detailed understanding of the necessary disclosure and registration requirements and ensuring that their entry into the US market through franchising is done in compliance with all applicable laws.
For further information on this topic please contact Jeffrey A Brimer, Sarah J Yatchak or Michael A Maciszewski at Faegre & Benson LLP by telephone (+1 303 607 3500), fax (+1 303 607 3600) or email ([email protected], [email protected] or [email protected]).
(2) 16 CFR § 436 as amended, 72 Fed Reg 15444 (March 30 2007).
(4) Id, defining 'financial performance representation' as:
"any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables."