The FTC’s amendeddefinition of “creditor” within the Red Flags Rule is now in effect. 

The definition is narrower in scope, but under it, a franchisor may still qualify as a “creditor.” For instance, if you use a third-party servicer to obtain credit information on your behalf, or if you finance franchisee purchases of required equipment, you may be a “creditor.”

About the Red Flags Rule

Initially promulgated in November 2007, the Identity Theft Red Flags Rule was created to fight the rising tide of identity theft in the United States.  The Red Flags Rule requires “creditors” and “financial institutions” who administer “covered accounts” i to develop and implement a written program to identify, detect, and respond to “red flags,” ii or patterns or activities, that suggest attempted identity theft in connection with customer accounts that they administer.  The Red Flags Rule became effective on January 1, 2008, with actual enforcement ultimately beginning on December 31, 2010.

In July 2009, we advised franchisors to assess their exposure under the Red Flags Rule, and, if necessary, to create a compliance program that would satisfy their legal obligations under the Rule. 

To fully assess their obligations under the Red Flags Rule, franchisors must ask themselves two questions:

  1. am I a “creditor” as that term is defined in the Red Flags Rule? and
  2. do I, as a franchisor, administer “covered accounts”? 

The nature of a franchisor’s billing procedures, payment mechanisms and transactions with franchisees dictate whether these terms – “creditor” and “covered accounts” – apply to a franchisor and necessitate the franchisor’s compliance with the Red Flags Rule.

While the majority of franchisors would not fall under the definition of a “financial institution,” the initial definition of “creditor” under the first iteration of the Red Flags Rule was quite broad, making it possible for certain franchisors to qualify as creditors. 

Under the initial definition, a franchisor would qualify as a “creditor” if it, for example, made loans directly to a franchisee or prospective franchisee, arranged third-party financing for a franchisee or prospect or billed a franchisee for products or services rendered after having provided the products or services.  Under the amended definition of “creditor,” these activities by themselves no longer automatically qualify a franchisor as a “creditor” under the Red Flags Rule.

Do you regularly engage in one of these activities?

In December 2010, Congress enacted the Red Flag Program Clarification Act of 2010,iii narrowing the scope of entities classified as creditors.  The revised definition limits application of the Red Flags Rule to those entities that, during the ordinary course of business, regularlyengage in at least one of the following three activities:       

  1. in connection with a credit transaction, obtain or use consumer reports, directly or indirectly
  2. furnish information to reporting agencies in connection with a credit transaction or
  3. advance funds to or on behalf of a person, based on an obligation of the person to repay the funds or repayable from specific property pledged by or on behalf of the person.

Although the Clarification Act did not create any specific industry-wide exemptions, it has been said that these changes were primarily designed to exempt small businesses, accountants, doctor’s and lawyer’s offices and small stores from the requirements of the Red Flags Rule. 

The Clarification Act also empowers the FTC and other agencies such as the Commodity Futures Trade Commission and the Securities and Exchange Commission to make future determinations about including other types of creditors that offer or maintain accounts which are subject to a reasonably foreseeable risk of identity theft.  In April of this year, these agencies adopted rules and guidelines requiring certain entities that they regulate to adopt programs to detect “red flags” and to prevent identity theft.

In December 2012, the FTC issued an interim final rule amending the definition of “creditor” within the Red Flags Rule to ensure consistency with the Clarification Act.  The interim final rule went into effect in February 2013.

What the new definition of “creditor” means to franchisors

Of note is that to be defined as a “creditor,” the franchisor must “regularly and in the ordinary course of business” engage in one or more of the listed activities. 

Since most franchisors will make use of a consumer report when deciding whether to extend credit terms, a franchisor that offers a financing program is more likely than not to be defined as a “creditor” under the amended Red Flags Rule. 

You may be deemed a creditor under these conditions:

  • If you regularly obtain, or use a third-party servicer to obtain, consumer report information in connection with a credit transaction
  • If you use a third-party servicer to make a credit determination
  • If you regularly furnish information to a consumer reporting agency as part of your credit transactions
  • If you finance franchisee purchases – for example, by financing equipment needed for the franchise business.

A good time to review the way the Red Flags Rule applies to you

The revision of the Red Flags Rule’s definition of “creditor” may be an ideal opportunity for franchisors to re-assess whether the Red Flags Rule applies to them.  It is our view that few franchisors will be relieved of their obligations through the amended definition of “creditor.”  Therefore, if your franchise business is covered by the Red Flags Rule, it is imperative that you have an appropriate compliance program in place. 

Please contact us with questions about how the revised definition of “creditor” within the Red Flags Rule may impact you or how to best structure a Red Flags Rule compliance program for your franchise business.