With renewal season fast approaching, we thought it would be useful to review a few issues that franchisors and their counsel typically encounter during this period, including filing deadlines, registration exemptions, and potentially available workarounds that permit a franchisor who, for one reason or another, does not have an updated offering circular to continue offering franchises under specified conditions.
There are 14 registration states: California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin. Before offering to sell or selling franchises in these 14 states, the franchisor must apply to the appropriate state agency to register the franchise and submit the offering circular (along with any required forms and fees) to the state administrator for approval. Generally, until the state administrator has approved the offering circular, the franchisor cannot offer to sell or sell franchises that will be located within that state or to a resident of that state. While the remaining states (commonly referred to as “non-registration states”) do not have registration statutes, the franchisor must nevertheless comply with the FTC Rule to offer to sell or sell franchises in those states. In the non-registration states, once the initial offering circular has been drafted, or, in the case of a renewal, once the offering circular has been updated, the franchisor may immediately provide the offering circular to prospective franchisees.
Generally, a franchise registration or exemption is valid for a one-year period; however, the registration states vary with respect to the date from which this one year period runs. For example, California (registration only), Hawaii, Minnesota, New York, Rhode Island, and South Dakota tie the registration or exemption (if applicable) period to the franchisor’s fiscal year end, and the franchisor must generally submit its renewal application or exemption notice (if applicable) within 90-120 (depending on the state) days after its fiscal year end. On the other hand, Illinois, Indiana, Maryland, Michigan, North Dakota, Virginia, Washington, and Wisconsin tie the registration or exemption (if applicable) period to the anniversary of the effective date, and the franchisor must generally submit its renewal application or exemption notice (if applicable) up to 30 days (depending on the state) prior to the anniversary date.
In the registration states, if the franchisor does not file its renewal application and, if necessary, obtain approval of the offering circular prior to the applicable expiration date, the franchisor will “go dark” in that state – i.e., the franchisor cannot offer to sell franchises in that state until the franchisor has filed the application and, if necessary, obtained approval from the state. If the prior registration has expired, the franchisor may be required file an initial application or a reinstatement application. Unless the franchisor has an effective state registration, the franchisor will "go dark" in the non-registration states if the franchisor fails to update the offering circular within 90 days after its fiscal year end.
Exemptions from Registration
Since the franchise registration process may delay completion of deals, restrict sales practices, require public disclosure of information, and increase costs, many franchisors seek exemptions from registration. If the exemption criteria are satisfied, the franchisor is not required to register the offering circular prior to offering to sell the franchise and, in some circumstances, may be able to avoid the state and federal disclosure obligations. The exemption requirements vary significantly by state, and generally, the franchisor will bear the burden of proving that the sale was exempt. Accordingly, if the franchisor plans to rely on an exemption, the franchisor should carefully review the requirements for the exemption in the respective registration state to ensure that the transaction meets the state’s criteria. A brief overview of some common exemptions follows:
Experienced/High Net Worth Franchisor. Nine of the registration states (California, Illinois, Indiana, Maryland, New York, North Dakota, Rhode Island, South Dakota, and Washington) provide a registration exemption that is commonly referred to as the “large franchisor,” “experienced franchisor,” or “seasoned franchisor” exemption. To qualify for this exemption, the franchisor (or the franchisor’s parent (generally, a company owning at least 80% of the franchisor)) must meet certain minimum net worth and experience requirements, which vary by state. Franchisors that satisfy the requirements for this exemption must comply with the filing requirements, if any, of the respective state, which include filing certain forms and paying a fee; however, state administrators only verify that the franchisor meets the exemption requirements and do not review and approve the contents of the offering circular and other documents. Franchisors that qualify for this exemption are still required to provide pre-sale disclosure to prospective franchisees; however, the required disclosures are not necessarily the same as those for registered franchisors.
- Net Worth. To meet the net worth requirement, the franchisor must have a minimum net worth of $5 million (for California, Illinois, Indiana, New York (New York also a “super large” franchisor exemption, which we will not discuss), and Washington) or $10 million (for Maryland, North Dakota, Rhode Island, and South Dakota), as evidenced by the franchisor’s most recent financial statements. If the franchisor cannot satisfy the requisite minimum net worth requirement, the franchisor can rely on its parent’s financial statements, provided that the franchisor has a minimum net worth of $1 million. If the franchisor uses its parent’s audited financials in Maryland, Rhode Island, and South Dakota, the parent will be required to guarantee unconditionally the franchisor’s obligations.
- Experience. States having the “large franchisor” exemption, with the exception of New York, require the franchisor to have a minimum number of years of franchising or operational experience. The state statutes vary significantly on this requirement. Franchisors should be aware that, if they rely on the experience of their parent, changes in the parent’s ownership or organization could result in loss of this exemption.
Existing Franchisees . Eight registration states (California, Hawaii, Maryland, Michigan, New York, Rhode Island, Washington, and Wisconsin) provide an exemption from registration for sales of additional franchises to existing franchisees. While this exemption varies by state, there are some common themes, including: (1) the sale is to the same franchisee (or, in some states, an owner of the existing franchised business); (2) the franchisee has a minimum amount of experience in the financial and operational aspects of the franchised business; and (3) the new franchised business is similar to the one currently operated by the franchisee. In California and New York, if the franchisor relies upon this exemption, the franchisor must file a required notice of sale with the state.
High Net Worth Franchisees. Rhode Island and Washington provide an exemption from registration for franchisees who have a high net worth and who are accredited investors. In both states, the franchisee’s income in each of the previous two years must have exceeded $200,000, and in Washington, the franchisee also must have a net worth in excess of $1,000,000.
Substantial Investment. Illinois , Maryland, and Wisconsin provide an exemption from registration for franchises that require the prospective franchisee to make a “substantial initial investment.” The meaning of “substantial initial investment” varies by state: Illinois - $750,000; Maryland - $750,000; Wisconsin – at least $1,000,000 and does not exceed 20% of the franchisee’s net personal worth. The states also impose other requirements for this exemption. In Illinois, this exemption is only granted upon application by the franchisor, and even if the exemption is granted, the franchisor must provide disclosure to the franchisee.
Franchisor Insiders. California , Rhode Island, and Washington provide an exemption from registration for “franchisor insiders.” Each state has different criteria to determine if the prospective franchisee qualifies. In addition, Wisconsin exempts sales to franchisors to cover a franchisor’s acquisition of franchised businesses from its franchisees.
Experienced Franchisees. Although several states consider the franchisee’s experience as an element in determining the availability of several different exemptions, only California offers an exemption based solely upon this factor. Specifically, California exempts from registration franchise offers, sales and transfers to franchisees whose owners, within the 7 years prior to the sale or transfer, have had at least 2 years of experience in managing the financial and operational aspects of a business that is similar to the franchised business. In addition, such offers, sales, and transfers are also excluded from the disclosure requirements. The owners may not be controlled by the franchisor, and the franchisor must timely submit the required notice of exemption and pay the filing fee.
Sale/Transfer by Franchisee to Another Franchisee. One of the most logical exemptions from the registration requirements is the bona fide sale of a franchise by a franchisee to a third party purchaser. Thirteen of the registration states include an express exemption for such sales or transfers; furthermore, it is the unwritten policy of the Virginia State Corporation Commission to exempt such transfers from the registration requirements. For the exemption to be available, the sale by the franchisee cannot be “effected by or through” the franchisor. A franchisor’s exercise of the right to approve or disapprove a transfer does not constitute sufficient control for the transfer to be considered “effected by or through” the franchisor. Among the actions that courts have determined cross the line are: matching buyers and sellers; advice regarding financial terms of the sale; facilitating financing; requiring changes to the franchise agreement; and requiring the transferee to sign a new franchise agreement. Other common conditions of this exemption include: the transaction must be an isolated sale by the franchisee rather than a plan of distribution of franchises and the selling franchisee may not be an affiliate of the franchisor. Minnesota and South Dakota limit this exemption to one sale by a franchisee within a 12-month period.
Finally, franchisors should keep in mind that this exemption does not exempt them from providing disclosure in all states. Specifically, in New York, the franchisor must provide to the third party purchaser a copy of the currently registered offering circular (including all amendments). If this requirement is taken literally, a franchisor that satisfies the large franchisor exemption and therefore does not have a “registered” offering circular cannot provide the required disclosure and would be in violation of the New York statute. In practice, the State of New York permits such franchisors to use the offering circular that they use in accordance with the FTC Rule or other state registration statutes to provide such disclosure. Franchisors who are no longer offering franchises in New York and accordingly are no longer registered in New York are faced with a more significant problem. The unwritten policy is that the franchisor can provide a copy of the franchisor’s most recent offering circular along with updated information.
Franchisor’s Renewal of an Existing Franchise Agreement. Ten of the registration states (California, Hawaii, Illinois, Indiana, Maryland, Michigan, New York, North Dakota, Rhode Island, and Wisconsin) provide an exemption from registration for the extension or renewal of an existing franchise. For the exemption to be available, there must be no interruption in the operation of the franchised business. In addition, the statutes either expressly state, or have been interpreted by franchise practitioners to state, that the exemption only applies if there have been no material modifications to the franchise relationship. As a rule of thumb, many practitioners interpret this exemption as being available only if the parties have merely extended the franchise relationship without executing a new franchise agreement or modifying the terms of the expiring agreement by addendum. Minnesota, South Dakota, Virginia, and Washington do not have this exemption. Accordingly, franchisors must first register their offering circular with the state before renewing a franchise.
Workarounds for the Franchisor Who Has Gone Dark
So what happens if the franchisor “goes dark” (i.e., does not have an effective offering circular)? While this is not an enviable position, there may be a few options that would permit the franchisor to continue to sell in certain states notwithstanding an expired registration and/or ineffective offering circular. With respect to the registration states, the franchisor should carefully review the exemptions and exclusions discussed above to determine if the contemplated transaction satisfies the exemption requirements for the respective state and, where the franchisor no longer has an updated offering circular, to ensure that the exemption covers the state’s registration and disclosure requirements. For the non-registration states, the franchisor has two potentially available options:
Fee Deferral. Under the FTC Rule, if the payment that the franchisee is required to make to the franchisor or its affiliate from before, to within six months after, the franchised business commences operation is less than $500, the relationship is exempt from the Rule. Accordingly, if the franchisor defers payment of all fees for six months after the franchised business opens, the franchisor may continue to offer to sell and sell franchises in the non-registration states.
Sales Pursuant to an Existing Development Agreement. Pursuant to the FTC Rule, the franchisor may enter into new franchise agreements with a franchisee if those new agreements are executed pursuant to an existing development agreement, provided that the new franchise agreement is the same as the agreement appended to the franchisee’s development agreement.
Sales While Registration Pending
In two registration states, California and Rhode Island, even if the franchisor’s registration has expired, once the franchisor has filed its application for registration or renewal, the franchisor may offer (but may not sell) franchises in those states. The franchisor relying on this exemption should provide the offering circular as registered by the state to any prospective franchisee before executing any agreement with that franchisee.