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Franchise law

i Legislation

Franchising in the United States is regulated at both the federal and state levels. Therefore, it is imperative for a business considering expansion into the United States to determine whether its business arrangement constitutes a 'franchise' or 'business opportunity' and, if it does, to comply with all applicable federal and state laws.

Federal franchise legislation

As noted above, the FTC regulates franchising at the federal level under the FTC Franchise Rule. The FTC Franchise Rule (the FTC Rule) governs franchise offerings in each of the 50 states, the District of Columbia and all US territories. Under the FTC Rule, a business or licensing arrangement will be regulated as a franchise if it has three elements: (1) the franchisor grants the franchisee a right to use the franchisor's trademark; (2) the franchisor exerts or has the authority to exert a significant degree of control or assistance over the franchisee's method of operation; and (3) the franchisee pays the franchisor a fee of at least US$570. Even if the parties to a contract call it a licensing agreement, a distribution agreement, or explicitly state that it is not a franchise arrangement, if the three elements are present, then US franchise law will apply.

The FTC Rule requires that franchisors provide certain pre-contractual disclosures to potential franchisees. In addition, the FTC Rule prohibits certain unfair and deceptive trade practices, such as contradicting the information provided in an FDD. The FTC Rule is a disclosure-only rule. It does not impose a federal registration obligation, nor does it regulate the franchise relationship after the sale. Importantly, the FTC Rule does not include a private right of action and, therefore, only the federal government has standing to enforce the FTC Rule.

State franchise legislation

Certain states have passed franchise laws that build upon the federal franchise rules. These state franchise laws may regulate the offer and sale of franchises, impose additional FDD requirements, prohibit certain franchise agreement provisions, impose state registration obligations, or otherwise regulate the ongoing franchise relationship. Approximately 15 states have laws that regulate the offer and sale of franchises. Approximately nine additional states have franchise laws that regulate various aspects of the ongoing franchise relationship. Because the federal and state definitions of a franchise differ, franchisors contemplating sales activity in multiple states must evaluate each state's franchise act to determine the applicability and requirements of state law. To complicate matters further, franchise acts of multiple states may apply to a single franchise offering depending on where the franchise is to be located, the residence or domicile of the prospective franchise and where the offer was made and accepted.

Federal and state business opportunity laws

Finally, businesses considering US expansion must also comply with applicable business opportunity laws at the federal and state levels. The FTC, under the FTC Business Opportunity Rule, and approximately 26 states regulate the sale of business opportunities. The FTC Business Opportunity Rule defines a business opportunity as a commercial arrangement in which:

  1. a seller solicits a prospective purchaser to enter into a new business;
  2. the prospective purchaser makes a required payment; and
  3. the seller represents to the prospective purchaser that the seller will:
    • provide locations for the use or operation of equipment, displays, vending machines, or similar devices, owned, leased, controlled or paid for by the purchaser;
    • provide outlets, accounts or customers, including, but not limited to, internet outlets, accounts or customers for the purchaser's goods or services; or
    • buy back any or all the goods or services that the purchaser makes, produces, fabricates, grows, breeds, modifies or provides.

While the state definitions of business opportunities differ, most business arrangements that qualify as franchises will also meet the definition of at least some business opportunity laws. Like franchise sales laws, business opportunity laws typically require disclosure or registration, or both. However, most provide an exemption for franchises if the franchise offerings comply with the franchise registration and disclosure requirements under state and federal franchise laws.

ii Pre-contractual disclosure

Federal and state franchise laws impose pre-sale disclosure obligations and restrictions. First, the FTC Rule and most states require franchisors to provide prospective franchisees with the FDD upon reasonable request by the prospective franchisee, and no later than 14 calendar days before any agreement is signed or any money is paid. New York requires delivery of the FDD at the earlier of (1) the franchisor and prospective franchisee's first personal meeting or (2) 10 business days prior to the execution of any agreement or payment of any consideration.

The FTC Rule also requires advance disclosure of the specific franchise agreement to be executed by the parties. If no modifications have been made to the form franchise agreement included as an exhibit to the FDD (including filling in material terms), no additional disclosure requirements apply. If, however, the franchisor unilaterally and materially alters the form franchise agreement, the FTC Rule requires a secondary disclosure process and a seven-calendar-day waiting period before the agreement is signed or consideration paid. There are two exceptions to this requirement. First, the seven-day period does not apply to non-substantive 'fill-in-the-blanks' provisions. Second, if the franchisee initiates negotiations regarding changes to the franchise agreement, the seven-day period is unnecessary.

Finally, the FTC Rule and many state franchise acts identify certain pre-signing actions and conduct as 'unfair and deceptive'. One of the most commonly litigated pre-signing disclosure violations is an illegal financial performance representation. Except in limited circumstances, financial performance information may only be provided to prospects in Item 19 of the FDD. Sharing pre-signing financial performance information outside Item 19 constitutes an unfair and deceptive practice under the FTC Rule and violates most state franchise acts.

iii Registration

Although the FTC Rule does not impose a federal registration requirement, 15 states require registration of the franchise offering prior to the offer or sale of a franchise – California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. The registration process varies by state but generally requires franchisors to pay fees, submit a copy of their FDDs and file certain state-specific registration forms and documents. The registration states can be divided into 'notice' states and review states. Indiana, Michigan, South Dakota and Wisconsin are considered notice states, with the franchise offering considered 'effective' the day the complete application is received by the state. The remaining registration states undertake some level of review of the franchisor's FDD. As part of the registration process, each state reviewing the FDD application may require changes to the FDD to ensure that the FDD complies with state law. Franchisors that intend to offer franchises in multiple states typically prepare multi-state FDDs that include state-specific addenda to comply with any state-specific requirements that may be imposed during the registration process. Depending on the state, franchise registrations are granted either for a period of one year, or until a certain number of days following the franchisor's fiscal year end. To maintain a franchise registration and continue offering and selling franchises, franchisors must renew their registrations before the prior registration expires, by updating and filing their new FDD. In addition to the renewal requirements, a franchisor must also amend its franchise registration in the event of a material change to information contained in its FDD. Generally, a change to the franchise system that a prospective franchisee would reasonably want to know about before purchasing a franchise is considered material.

Besides ensuring compliance with state franchise registration requirements, franchisors must also comply with or be exempt from business opportunity registration requirements. As mentioned in Section IV.i, most franchisors will qualify for exemption from state business opportunity laws if the franchise offering complies with the FTC Rule and the franchisor has a registered trademark. Certain states, however, require a notice filing to claim exemption. Specifically, Kentucky, Nebraska and Texas require a one-time exemption filing, while Florida and Utah require annual exemption filings. If the franchise programme does not have a federally registered trademark, additional filing requirements will need to be satisfied to claim exemptions in states such as Connecticut, Georgia, Louisiana, Maine, North Carolina and South Carolina.

Because of these complex pre-sale disclosure and registration requirements, foreign-based franchisors that intend to enter the US market through the sale of unit or area development franchises should establish an internal franchise sales compliance programme. The programme should serve to help establish internal procedures to track prospective franchisee leads and otherwise satisfy disclosure and registration requirements, identify appropriate record-keeping requirements and organise periodic training for all franchise sales personnel and management.

iv Mandatory clauses

The FTC Rule requires franchisors to prepare an FDD that contains or prohibits several mandatory disclosure items. For example, the FTC Rule considers it an unfair and deceptive practice for franchisors to disclaim or require prospective franchisees to waive reliance on any representations made in FDDs. Franchisors must be mindful of this prohibition when crafting an integration clause to ensure that the disclosures contained in the FDD are not disclaimed or waived.

There are no mandatory contractual provisions required by either the FTC Rule or state statute. However, foreign franchisors should be aware that US franchise contracts are often more detailed regarding the rights of the parties than other jurisdictions because, under US law, any ambiguities will generally be resolved in favour of the non-drafting party. Franchisors operating in the United States generally address the following items in their franchise agreements: territorial rights and restrictions, product and service sourcing restrictions, default and termination rights, post-termination obligations and dispute resolution. For example, if a franchisor offers territorial protection, any limitations, exclusions or rights reserved to the franchisor should be expressly stated. US franchisors often reserve for themselves, and exclude from the franchisee's territorial rights, the development of franchises at certain 'non-traditional venues' and sales through alternative channels of distribution, including the internet, catalogue sales and direct retail distribution.

Likewise, it is often critical from a system-standard perspective for franchisors to restrict or limit the source from which franchisees may obtain products or services. Franchisors operating in the United States commonly reserve the right to designate single-source suppliers or approved suppliers (which may include themselves or an affiliate) or specify product standards and requirements in the franchise agreement to ensure a consistent consumer experience.

The inclusion of default and termination provisions, and specifying a franchisee's post-termination obligations in the franchise agreement, are crucial. When drafting default and termination provisions, as well as provisions governing non-renewal, franchisors should note that many states have enacted franchise relationship laws that can affect the enforceability of the contractual language. Drafting a default and termination provision and a renewal provision that accounts for common provisions of relationship laws, including incorporating 'good-cause' and 'opportunity-to-cure' language, can increase the franchisor's ability to enforce terminations and non-renewals.

Finally, franchisors considering franchise sales across multiple states should be mindful of any state-specific requirements and restrictions. For example, certain state franchise acts prohibit franchisors from, inter alia, waiving application of the state's franchise law, waiving franchisees' right to jury trials, limiting damages claims and requiring franchisees to consent to litigation in a forum outside the franchisees' states. As discussed above, franchisors engaged in multi-state offerings may use state-specific addenda to accommodate the varying state-specific requirements.

v Guarantees and protection

If the franchisee is a legal entity rather than an individual, the franchisor will typically require each of the entity's owners to provide a personal guarantee for the franchisee's obligations under the franchise agreement. In some cases, should the franchisee entity have a corporate parent or affiliate, it may be possible to obtain a corporate guarantee from the legal entity. The purpose of the guarantee is to ensure that if the franchisee entity fails to pay or perform under the franchise agreement, the guarantors must do so. A guarantee is normally broad in scope and covers not only the franchise agreement obligations, but also the obligations of the franchisee under any related agreements with the franchisor or its affiliates. No special guarantee form is required by law, and a guarantee's execution does not require witnessing or notarisation. Letters of credit, which are widely used in many countries, are rarely used in the United States. On occasion, a franchisor will accept a letter of credit in lieu of multiple guarantees from an owner of multiple franchise units in the event that the owner seeks to cap its potential liability at a specific amount.