Q&A: offer and sale of franchises in USA

Offer and sale of franchises

What is the legal definition of a franchise?

While federal and state jurisdictions share common definitional approaches, there is no universal definition of a franchise. Moreover, each jurisdiction has its own mix of definitional exclusions and exemptions.

Generally, a franchise is defined by the coexistence of three elements:

• a grant of rights to use another’s trademark to offer, sell, or distribute goods or services;
• the grantor (or franchisor) providing significant assistance to, or exercising control over, the grantee’s (franchisee’s) business, which may take the form of a prescribed marketing plan; and
• the payment of a required fee.

If these three elements exist, the business arrangement is a franchise and the franchisor must comply with the applicable laws.

What laws and government agencies regulate the offer and sale of franchises?

At the federal level, franchising is regulated by the Federal Trade Commission (FTC) primarily through the FTC’s Franchise Rule (the FTC Rule). The FTC also has a Business Opportunity Rule that can apply to franchises.

At state level, 14 states have laws that regulate pre-offer and pre-sale disclosures and require franchise registration. These states are California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. Oregon has a franchise-specific law that does not require documentation to be filed with the government. In addition, 25 states have business laws that apply to business opportunities or seller-assisted marketing plans. Most of these contain exemptions for franchisors that meet certain criteria. However, of those states, six impose pre-offer and pre-sale documentation filing requirements on franchisors. These states are Connecticut, Florida, Kentucky, Nebraska, Texas and Utah. Also, 25 states and territories have laws that regulate the terms of the franchisor–franchisee relationship (after the grant or sale of a franchise). These states are: Alaska, Arkansas, California, Connecticut, Delaware, Hawaii, Idaho, Illinois, Indiana, Iowa, Louisiana, Maryland, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, North Dakota, Rhode Island, Virginia, Washington and Wisconsin, as well as Puerto Rico and the US Virgin Islands. State relationship laws typically pertain to franchise terminations, renewals and transfers.

There are many exclusions and exemptions from both the FTC Rule and state laws, which are nuanced. There is no nationwide exemption from franchise laws.

Finally, the North American Association of Securities Administrators has guidance documents concerning franchise disclosures, which are deferred to by state regulators.

What are the principal requirements governing the offer and sale of franchises under the relevant laws?

The federal and state franchise laws and regulations are varied and include the following principal requirements:

• federal-level pre-sale franchise disclosure requirements;
• state-level pre-sale franchise registration and disclosure requirements; and
• state-level franchise relationship laws that govern the ongoing relationships between franchisors and franchisees, as well as between manufacturers and dealers or distributors, which impose requirements on terminations, renewals and transfers of franchises.

The federal and state laws regulating the offer and sale of business opportunities or seller-assisted marketing plans may also impose filing or disclosure requirements, or both.

What are the exemptions and exclusions from any franchise laws and regulations?

The FTC Rule exempts lease arrangements in which an independent retailer sells its own goods and services from premises leased from a larger retailer in that retailer’s store, instances where a franchisee is required to pay less than US$615 before or during its first six months of operations, oral franchise agreements, and ‘fractional’ franchises. In addition, the FTC Rule exempts petroleum marketers and resellers covered by the Petroleum Marketing Practices Act. It also contains the following three exemptions, collectively referred to as the ‘sophisticated investor exemptions’:

• large investment exemption, which exempts franchise sales where the initial investment is US$1,233,000 exclusive of unimproved land and franchisor financing;
• large franchisee exemption, which exempts franchise sales to ongoing entities with at least US$6,165,500 net worth and five years of prior business experience; and
• insiders’ exemption, which exempts franchise sales if one or more purchasers of at least a 50 per cent ownership interest in the franchise has been, within 60 days of the sale, and for at least two years, an officer, director, general partner, individual with management responsibility for the offer and sale of the franchisor’s franchises, or the administrator of the franchised network; or who has been, within 60 days of the sale, for at least two years, an owner of at least a 25 per cent interest in the franchisor.

Many of the FTC Rule exemptions do not have correlating exemptions under state franchise disclosure laws, but some state laws do have some similar exemptions.

Some of the exemptions or exclusions of most interest to franchisors available under state franchise registration or disclosure laws include, but are not limited to:

• large franchisors or experienced franchisors who exceed a specified net worth and who have had a minimum number of franchisees for a minimum period of time;
• offers or sales that are renewals, extensions, or substantially similar to franchises already owned by the franchisee;
• certain sales of a franchise by a franchisee or a sub-franchisor; and
• offers or sales to a financial institution or life insurance company.

Not all states have any or all of these exceptions, and they often apply only to registration, not disclosure. Because the FTC Rule applies to all states, an exemption under state law will not relieve a franchisor from its disclosure obligations under the FTC Rule.

Must franchisors satisfy any eligibility requirements in order to offer franchises? Are there any related practical issues or guidelines that franchisors should consider before offering franchises?

Neither federal nor state laws impose experience or similar threshold requirements as a prerequisite to offering franchises. However, some of the so-called registration states may require inexperienced franchisors to defer their collection of initial franchise fees until the franchisor has completed its initial obligations and the franchisee has opened for business. Fee deferral may also be required based on a state’s analysis of a franchisor’s financial condition. Of course, a franchisor must comply with any applicable registration and disclosure requirements before offering franchises.

Are there any legal restrictions or requirements relating to the manner in which a franchisor recruits franchisees or selects its or its franchisees’ suppliers? What practical considerations are relevant when selecting franchisees and suppliers?

No. The franchisor is generally free to contract with suppliers and franchisees of its choosing.

What procedures and formalities for pre-contractual disclosure are required or advised in your jurisdiction? How often must the disclosures be updated?

At the federal level, the FTC Rule requires that franchisors who offer franchises anywhere in the United States must prepare an FDD and provide the FDD to prospective franchisees at least 14 days before signing a franchise agreement or accepting any consideration for the right to enter into a franchise relationship. The FDD must include 23 disclosure items and certain required appendices. Disclosures must be updated annually 120 days after the franchisor’s fiscal year end and within a reasonable time after the close of each quarter to reflect material changes.

Fourteen states have pre-sale franchise disclosure and registration laws, though the disclosure period varies slightly by state. In these jurisdictions, a franchisor may not offer franchises in the state or to that state’s residents unless the franchise offering is registered with the state. State laws require that FDDs must be updated at least annually or upon the occurrence of a material change, though what constitutes a material change and the exact timing of the required update varies by state.

In the case of a sub-franchising structure, who must make pre-sale disclosures to sub-franchisees? If the sub-franchisor must provide disclosure, what must be disclosed concerning the franchisor and the contractual or other relationship between the franchisor and the sub-franchisor?

Both the franchisor and sub-franchisor are jointly liable for compliance with disclosure laws. A sub-franchisor must provide an FDD to prospective franchisees. Certain aspects of the sub-franchisor’s relationship with the franchisor must be disclosed in the sub-franchisor’s FDD, such as the parties’ trademark licensing arrangement. However, the parties’ fee arrangement need not be disclosed. Additional disclosures pertaining to the franchisor must be disclosed in the sub-franchisor’s FDD, including litigation and bankruptcy information about the franchisor.

What due diligence should both the franchisor and the franchisee undertake before entering a franchise relationship?

Prospective franchisees should review the FDD, franchise agreement and related documents detailing the terms of the franchise relationship to understand the costs involved, the control exercised by the franchisor and the support services offered. Prospective franchisees should also speak to as many of the franchisor’s current and former franchisees as possible. Prospective franchisees should also evaluate competing brands. Prospective franchisees should consider engaging financial and legal advisers, as well as industry-specific trade associations, to help assess the franchise opportunity.

Franchisors should establish criteria to assess each prospective franchisee, which should include:

• whether the franchisee is a good fit for the system;
• whether the franchisee has the appropriate experience (such as in business, management and human resources);
• whether the prospect meets minimum capital requirements;
• the availability of territory in the franchisee’s ideal market; and
• whether it makes sense for the franchisor to expand into that region.

What information must the disclosure document contain?

The FTC Rule requires a disclosure document to contain the following information:

• identifying information as to the franchisor and any of its controlling parent companies, predecessors and certain affiliates;
• business experience of the franchisor’s directors and officers and any other individuals who will have management responsibility relating to the sale or operation of the franchise;
• litigation history of the franchisor and its directors and officers;
• domestic and foreign bankruptcy history;
• all initial fees charged in connection with the purchase of the franchise;
• recurring and non-recurring fees to be paid by the franchisee;
• estimated initial investment;
• restrictions on sources of products and services;
• the franchisee’s obligations under the franchise or related agreements;
• financing arrangements;
• the franchisor’s obligations regarding assistance, advertising, computer systems and training;
• territory;
• trademarks;
• patents, copyrights, and proprietary information;
• the franchisee’s obligation to participate in the actual operation of the franchised business;
• restrictions on what the franchisee may sell;
• renewal, termination, transfer, and dispute resolution;
• public figures involved with the franchise;
• any financial performance representations the franchisor wishes to make to prospective franchisees;
• outlet and franchisee information, including contact information for former franchisees;
• audited financial statements prepared in accordance with United States generally accepted accounting principles or in a format that the United States Securities and Exchange Commission has approved;
• copies of any contracts the franchisee must sign in connection with the franchise; and
• an acknowledgment of receipt of the disclosure document.

Is there any obligation for continuing disclosure?

The purpose of the disclosure document is to provide information to persons and entities who are considering the purchase of a franchise. Thus, there is no requirement to provide disclosure documents on an ongoing basis to existing franchisees. However, subject to a number of exceptions, exemptions and qualifications, there is often a requirement to provide a disclosure document to an existing franchisee who is purchasing an additional franchise or renewing an existing one.

How do the relevant government agencies enforce the disclosure requirements?

The FTC is responsible for enforcement of the FTC Rule. Following investigation, the FTC may commence an enforcement action against a franchisor if a violation is discovered. Enforcement usually occurs through a court order, which will contain injunctive provisions enjoining the franchisor from continuing the violation.

Moreover, all of the state registration or disclosure statutes create their own enforcement structures. These statutes vest investigatory and prosecuting power in the state administrator. Also, state administrators have the authority to issue ex parte stop orders prohibiting franchise sales activities by individuals or entities whom the state administrator believes may be violating the franchise statute until a hearing can be conducted. Some state franchise statutes provide for criminal enforcement and private rights of action. Criminal enforcement on the state level usually occurs through the state attorney general’s office. Some have their own specialised franchise investigators. While certain states’ franchise laws also contain provisions that allow for criminal penalties for violations, they are rarely used.

What actions can franchisees take to obtain relief for violations of disclosure requirements? What are the legal remedies for such violations? How are damages calculated? If the franchisee can cancel or rescind the franchise contract, is the franchisee also entitled to reimbursement or damages?

The FTC Rule does not grant an aggrieved franchisee the right to bring a legal action. Only the FTC itself can maintain an action for violating the FTC Rule. The FTC may bring civil actions, which seek monetary penalties, injunctive relief and consumer redress. The FTC can require rescission, reformation, payment of refunds or damages, or some combination of these. The FTC can also issue cease-and-desist orders for franchisors who fail to comply with franchise laws. Civil penalties in federal actions allow for recovery of up to US$11,000 per day for each violation.

State registration or disclosure laws provide a private right of action for franchisees; these laws also authorise the state administrator directly, or through the state attorney general, to bring an action on behalf of the people of the state to enjoin unlawful acts or practices or to enforce compliance with the franchise laws. Available remedies under state franchise laws include denial or revocation of state franchise registration, consumer redress in the form of actual and sometimes consequential damages, or rescission, injunctions, civil penalties, and criminal sanctions for wilful violations.

All states have passed Deceptive Trade Practices Acts (DTPAs), sometimes referred to as ‘little FTC Acts’, which prohibit deceptive acts or practices in the conduct of trade or commerce. The acts are designed to protect consumers from unfair or deceptive trade practices by providing a private cause of action even when there might not be one under general principles of law or under the FTC Rule. Some states make failure to comply with the FTC Rule a per se violation of the DTPAs, while other states make it evidence of a violation. About half of the states provide minimum statutory damages, and many states allow the court to award triple damages or punitive damages.

What actions may franchisees or any relevant government agencies take in response to a franchisor’s failure to make required disclosures? What legal remedies are available? What penalties may apply?

The FTC may initiate an investigation or enforcement action against a franchisor for violation of the FTC Rule. This action can result in a court order that imposes penalties, such as recission of agreements or payment of fines, and enjoins the franchisor from continuing the violation. There is no private right of action available to franchisees under the FTC Rule. Only the FTC may pursue a violation of the FTC Rule.

States may also initiate an investigation or enforcement action against a franchisor for violation of a state registration or disclosure law (including business opportunity laws). States also routinely impose cease-and-desist orders, and require recission of agreements and payment of fines. Some state laws also provide for criminal liability for violations of state franchise laws.

FTC and state enforcement actions must usually be disclosed in a franchisor’s FDD.

In addition to any laws or government agencies that specifically regulate offering and selling franchises, what general principles of law affect the offer and sale of franchises? What industry codes of conduct may affect the offer and sale of franchises?

There are several general principles that apply to most contracts, such as common law concepts of fraud and misrepresentation.

Other than franchise-specific rules on what disclosures a franchisor should make to a potential franchisee or a franchisee should make to a sub-franchisee regarding predecessors, litigation, trademarks, fees, etc, are there any general rules on pre-sale disclosure that might apply to such transactions?

At the federal level, the Federal Trade Commission Act prohibits unfair methods of competition and unfair or deceptive acts or practices. The FTC Rule was adopted pursuant to that authority, but the general prohibition remains available to the FTC in appropriate cases.

At the state level, in addition to several franchise-specific statutes, there are deceptive trade practice acts that might apply to acts by the franchisor or master franchisee prior to and during the sales process. Statutory and common law fraud principles could also be applied to misrepresentations, for example.

What actions may franchisees take if a franchisor engages in fraudulent or deceptive practices in connection with the offer and sale of franchises?

In registration states, if a franchisor fails to provide proper disclosure or appropriately register, the franchisee may bring a claim under the applicable state law. Remedies available under state franchise laws may include rescission of the franchise agreement and damages. Similar relief is available for violations of business opportunity laws.

In addition, while there is no private right of action available to franchisees under the FTC Rule, states have passed unfair and deceptive trade practices acts, which are sometimes called Little FTC Acts. Many of these Little FTC Acts make violation of the FTC Rule a per se violation of the state’s Little FTC Act. Aggrieved franchisees may also bring claims under these little FTC Acts. Common remedies also include recission and damages, including punitive damages.

Law stated date

Give the date on which the above content is accurate.

31 March 2020