Franchisors in about 30 countries are required to prepare a franchise disclosure document (“FDD”), but the format varies considerably. For example, lengthy and detailed FDDs are required in the United States, Australia, China, Brazil, certain Canadian provinces, and several other countries. Shorter disclosures, focusing on certain issues, are required in Mexico and France. This article explores the feasibility of the preparation and use of an international FDD.
Brief Summary of U.S. FDD Requirements
In the United States, federal and state franchise and business opportunity laws require preparation of an FDD and registration with state authorities before offering, negotiating or selling a franchise or business opportunity. Many state franchise laws also regulate the relationship between franchisors and franchisees, including with regard to such subjects as franchise terminations, non-renewals, transfers, supply arrangements, good faith and fair dealing and other matters. There are 38 states, comprising about 90% of the population of the United States, that have some form of franchise or business opportunity law. The Federal Trade Commission (“FTC”) FDD requirements apply in all 50 states. The language of FDDs and materials registered with states, including all agreements, must be in English.
The FTC Franchising Rule (“FTC Rule”) defines a franchise as having three essential elements:
- a franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark . . . or to offer, sell, or distribute goods, services . . . that are identified or associated with the franchisor’s trademark;
- the franchisor will exert or has authority to exert a significant degree of control over the franchisee's method of operation, or provide significant assistance in the franchisee's method of operation; and
- the franchisee . . . makes a required payment or commits to make a required payment. Required payment is defined broadly and only excludes a bona fide wholesale price for goods for resale. For example, the following payments are all considered required payments: royalties, training fees, management and consulting fees, advertising and marketing payments, all fees for services, payments for equipment, payments and royalties for software (except possibly off-the-shelf software for resale to customers).
The FTC Business Opportunity Rule covers certain business opportunity ventures, where the seller:
- secures retail outlets or accounts for the purchaser; or
- secures sites or locations for vending machines, rack displays, or any other product sales displays; or
- provides services or a person (or company) for securing sites, outlets, accounts; and
- the franchisee is required to pay a fee. 16 C.F.R. 437.
The FTC Business Opportunity Rule requires only a simplified one or two page disclosure document.
The coverage of the FTC Rule is as broad as the FTC's authority under the Federal Trade Commission Act. It therefore may cover transactions that are primarily international or intrastate, as long as interstate commerce is affected, as defined under the federal case law under the FTC Act.
The state franchise and business opportunity laws vary in their definitions and scope of coverage. While there are many similarities with the FTC Rule definition, in some states the coverage is broader and in some states the coverage is narrower, than the FTC Rule. For example, in New York, coverage is broader because no trademark license is required. In about ten business opportunity states, coverage is much broader than the FTC Business Opportunity Rule because it applies to any sale of a business opportunity where a marketing plan is sold or provided.
Use of International Franchise Disclosure Document (“IFDD”) for U.S. Outbound Franchising
It is common for larger U.S. franchisors to prepare and use a uniform IFDD for outbound transactions. This is normally used as just a starting point, with consultation by local counsel in each international jurisdiction as to whether the IFDD should be used, and if so, what modifications should be made. The reasons for using such an outbound IFDD are as follows:
- International Master Franchising. Many U.S. franchisors use master franchising in international franchising, but not in their domestic U.S. franchising. In that event, use of the domestic U.S. unit FDD would not be helpful in international franchise offerings. This is true whether the master franchisee is a subfranchisor, area representative, or area developer. Therefore to satisfy any foreign franchise law disclosure, a U.S. franchisor that offers master franchises must prepare an FDD that discloses the international master franchise offering.
- The Relative Complexity of a U.S. FDD. The average U.S. FDD without exhibits is about 50 pages, and with exhibits is about 150 pages. Many exceed 300 pages. The 2008 changes to the U.S. FDD added significant complexity and length. I am not aware of any foreign FDDs that are as long, although each country has additional requirements that must be addressed. It is therefore likely that an IFDD based on U.S. disclosure requirements will satisfy most of the requirements, but not all, of other jurisdictions.
There are also arguments against using an IFDD for U.S. outbound franchising, including:
- Need to Customize Due to Local Legal Requirements. Even a 50-page U.S. law based IFDD will not satisfy all of the needs of any other jurisdiction. Some, such as Ontario, Canada, will require following the exact order of presentation of the local requirements, meaning that the disclosure must be re-written in any event. Most will require disclosures not found in a U.S.-based FDD. Examples include: (i) in France, there must be a discussion of the market in the form of a report on research done on market conditions; (ii) in China, there must be added a detailed description of how the franchisor has operated at least two company-owned operations for at least one year.
- Need to Customize Due to Local Conditions. To the extent that the disclosure discusses issues that vary with the market, those need to be deleted or localized or at a minimum disclaimers added. For example, Item 7 of a U.S. FDD is an estimate of total startup costs of a franchisee. At a minimum, a disclaimer must be added to state that these numbers apply only in U.S. markets or whatever other markets they are based on, and may vary considerably in the target market.
- Too Much Disclosure. In some jurisdictions and in some situations local counsel will advise that it is better not to give any disclosure or to just give a disclosure that is a much shorter document contemplated by local law. For example, an FDD for Mexico is a relatively short document, generally under ten pages, and can be expeditiously prepared. (However, while the IFDD might not be used in such jurisdictions, it might still be useful to assist local counsel to prepare a local FDD.)
In our experience, if a U.S. franchisor implements international franchise sales in a significant number of jurisdictions with disclosure requirements, and if that international franchise offering is significantly different than the U.S. domestic offering, then use of an IFDD can significantly reduce costs. Use of such an IFDD does not replace the need for local counsel to customize the disclosure for local laws and conditions, but it does provide a starting point to assist in that process. We keep the IFDD up to date for such clients just as we do the U.S. FDD, and the disclosures are in the same order, so that updating costs are minimal.
Use of an IFDD for Foreign Franchisors Inbound to the United States
Unfortunately, using an IFDD for foreign franchisors inbound to the United States requires significant customization and additional disclosures due to format requirements under the FTC Rule (which have also been largely adopted by the states). These requirements are that: (a) each disclosure item (the FTC disclosure guidelines are 143 pages long) must be responded to affirmatively or negatively; (b) each disclosure item must be presented in the specified order; and (c) there may be no additional disclosures. While an inbound IFDD could be used to collect information to begin preparing a United States FDD, it cannot lawfully be delivered or used in the U.S., due to these formatting requirements.
It is a common misconception that U.S. franchise law only requires updating once or twice per year. In actuality, a U.S. FDD must be updated frequently, when there are material changes. Most state laws require that the updates be made immediately whenever there are material changes, so the document is “evergreen.” The FTC Rule has more specific updating requirements, but since the FTC Rule does not preempt state laws, both must be followed. For example, although the FTC Rule requires updated franchisor financial statements quarterly, the state laws would require that new interim financial statements be provided promptly (before any new franchise offers or sales) if the financial statements show a material change.
Specifically, even in states that have no franchise laws, the FTC compliance guides say that there are four different updating requirements: (1) annual; (2) quarterly for material changes in financial statements; (3) "evergreen" updates for material changes to Item 19; and (4) the delivery of the FDD and the above updates upon "reasonable request" of a prospect. Data that becomes outdated at the end of the fiscal year also must be updated at that time to prevent the FDD from being inaccurate. Also under state fraud or misrepresentation laws and under common law, and under the state unfair business practice law ("little FTC Act"), it is safest to update the FDD whenever there is a material change. As stated above, in states with franchise laws, disclosure must be made immediately when there is a material change and before further offers or sales.
Unlike in many countries, no one selling franchises in the United States signs the FDD. However, an officer of the franchisor must sign state franchise registration and notice filings in about 15 states, which includes a personal certification that the FDD discloses all material facts, does not omit material facts and complies with law. Two notable attachments required in a U.S. FDD are all contracts that are to be signed (even if only signed by some but not all franchisees), and audited financial statements. The audited financial statements must be prepared by a U.S.-qualified auditor and must comply with U.S. Generally Accepted Auditing Standards (GAAS) and U.S. Generally Accepted Accounting Principles (GAAP), with very limited exceptions.
A few international franchisors have been able to use exemptions from U.S. disclosure requirements. A brief summary of exemptions from the FTC Rule are:
- Minimum Payment Requirement - Less than $500 before and during the first six months.
- Oral Franchises.
- Leased Departments.
- Petroleum Marketers and Resellers’ Exemptions.
- Fractional Franchises – If the franchisee is already engaged in a similar business, and the franchise business is reasonably anticipated to be less than 20% of the total.
- Large Investment Exemption - Initial investment of more than $1 million, excluding land and excluding financing.
- Large Franchisee - Franchisee or affiliates have been in business for more than five years and have a net worth of more than $5 million
- Insider Exemptions - Franchisee majority owner has been an officer, director, general partner, or manager or 25% owner of franchisor.
- Retail Cooperative Exemption.
There are approximately 30 different variations of state and FTC exemptions, which are generally very limited. Most only reduce state filing requirements, and do not eliminate the need for an FDD. Another limiting factor with exemptions is that they are not uniform; most exempt transactions are only exempt for the FTC or for a few states, but not both, and not for all states.
The risks of non-compliance are severe. The FTC has enforcement power and can impose fines of up to $10,000 per day. The FTC can also order restitution and seek criminal sanctions. Indictments may be sought against any principal (officers, directors, managers, owners, etc.), and against related entities and individuals. State franchise laws usually include remedies such as damages to franchisees, rescission (return of fees and charges paid and voiding of the contract), trebling of actual damages sustained by franchisees in the discretion of the court, and awarding of reasonable attorneys’ fees and litigation costs. Violation of these statutes also is frequently a crime. Personal, civil and criminal liability usually exists under the franchise law for responsible officers, directors and managers, and for related entities and individuals.
Outbound franchisors selling master franchises often use IFDDs to reduce costs. These are used as a starting point for customizing and localizing an FDD where necessary.
An inbound IFDD is difficult to use in the U.S., due to formatting requirements discussed above. While an inbound IFDD can be used as a starting point for preparing the U.S. FDD, foreign franchisors should not underestimate the complexity and cost of preparing a U.S. FDD and registering it with the states.