Q&A: offer and sale of franchises in USA

Laws and agencies regulating the offer and sale of franchises

What is the legal definition of a franchise?

The Federal Trade Commission’s Trade Regulation Rule on franchising (the FTC Rule) regulates the offer and sale of franchises nationwide. The FTC Rule defines a ‘franchise’ as any continuing commercial relationship or arrangement in which the terms of the offer or contract specify, or the franchisor promises or represents, orally or in writing, that:

• the franchisee will have the right to operate a business that is identified or associated with the franchisor’s trademark or to offer, sell or distribute goods, services or commodities that are identified or associated with the franchisor’s trademarks;
• the franchisor will exert or has the 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
• as a condition of obtaining or commencing operations of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.

If any of these elements is missing, the relationship will not be covered by the FTC Rule, regardless of how it is characterised.

In addition, many states have franchise ‘registration/disclosure’ or franchise ‘relationship’ laws (or both) that define franchises. More than one state’s law may apply to a particular relationship.

Under most state franchise laws, there are three elements that constitute a franchise. Somewhat similar to the FTC Rule, these state definitions require payment of an initial or ongoing fee (or both) by the franchisee for the use of the franchisor’s system and proprietary mark, and a substantial association of the franchised business with the franchisor’s proprietary mark. They differ from the FTC Rule in that the third element varies by state and requires either a ‘marketing plan or system’ substantially prescribed by the franchisor, or a ‘community of interest’. A marketing plan usually exists where advice or training is given regarding the operation of the franchised business and the sale of the franchisor’s products or services. A community of interest is typically defined as an ongoing common financial interest between the franchisor and the franchisee in the operation of the franchised business.

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

The Federal Trade Commission (FTC) regulates franchises under federal law. The FTC also has a Business Opportunities Rule that does apply in the relatively rare situation where there is no written franchise agreement or where the total of the required payments or commitments to make a required payment to the franchisor or an affiliate of the franchisor that are made at any time from before to within six months after commencing operation of the franchisee’s business is less than US$615. Since it is rare that a franchise programme falls within the FTC Rule definition of a business opportunity venture, this discussion will not cover such ventures.

The FTC Rule requires disclosure by franchisors before any offer or sale is made, unless an exemption applies. The FTC Rule does not govern the ongoing franchisor-franchisee relationship; rather, it only imposes presale disclosure requirements and does not require any registration or filing. In addition, 14 states have laws regulating the offer and sale of, and requiring pre-offer filings or registration of, franchises, as well as imposing pre-offer and presale disclosure requirements. They are: California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. Oregon regulates offers and sales, but requires no filing. In addition, 21 states, as well as the District of Columbia, Puerto Rico, and the US Virgin Islands, have statutes that regulate the terms of the franchisor-franchisee relationship. These states are: Alaska, Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Kentucky, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. The areas of primary concern under state relationship laws are the termination, renewal and transfer of franchise rights.

Generally, state franchise statutes apply when:

• the offer originates within the state;
• the offer is directed by the franchisor to a prospective franchisee within the state or to a resident of that state;
• the offer is received within the state;
• meetings between the franchisor and prospective franchisee occur in the state; or
• the franchised business will be operated in, or the franchise territory is, entirely or partially in the state.

However, these jurisdictional factors vary by state, so franchisors need to be aware of the possible application of multiple states’ franchise laws. In addition, approximately half of the states have ‘business opportunity’ laws that require similar registration or disclosure procedures. Exemptions from them are usually available to franchisors that license a registered trademark; however, exemption filings must be made in certain states in order to qualify for the exemptions.

Describe the relevant requirements of these laws and agencies.

The FTC Rule requires franchisors and franchise brokers to make presale disclosures to prospective franchisees. States with franchise registration or disclosure laws also require presale disclosures to the prospective franchisee. Additionally, these states require the franchise offering to be registered with the state. Certain state franchise registration or disclosure periods differ from the FTC Rule in terms of the time period for presale disclosures and annual update or renewal registrations. Also, the information to be disclosed under state franchise registration or disclosure laws varies slightly, and state franchise regulators often write comment letters to franchisors requiring that disclosure documents be modified to meet the states’ particular concerns before a registration application is approved. As a result, a registration application may be delayed, sometimes for weeks or even months. Some states are more difficult to register in than others.

If a franchisor wishes to make a ‘financial performance representation’ (FPR) to prospective franchisees, the franchisor must strictly comply with the FTC Rule’s requirements regarding FPR disclosure, as well as any applicable state law requirements. The FTC Rule defines an FPR as ‘any representation, including any oral, written or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits or net profits’. Franchisors should exercise caution when making an FPR. If the franchisor does not strictly comply with the FTC’s requirements, the franchisor must not make an FPR to prospective franchisees. Franchisors are prohibited from making FPRs unless: the franchisor has a reasonable basis for making the FPR; the franchisor has written substantiation for the FPR at the time the FPR is made; and the franchisor includes the FPR in its disclosure document together with certain other required disclosures.

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.

Does any law or regulation create a requirement that must be met before a franchisor may offer franchises?

A franchisor must be in compliance with any applicable state registration and disclosure requirements before that franchisor may offer franchises.

Are there any laws, regulations or government policies that restrict the manner in which a franchisor recruits franchisees or selects its or its franchisees’ suppliers?

No.

What is the compliance procedure for making pre-contractual disclosure in your country? How often must the disclosures be updated?

Disclosure is made to prospective franchisees by using a disclosure document in a format that conforms to the requirements of the FTC Rule. The FTC Rule expressly permits franchisors to comply with presale disclosure obligations electronically (via CD-ROM, email or a download from a website), as long as they do so in compliance with the procedural requirements set forth in the FTC Rule.

The FTC Rule requires that disclosure be made to a prospective franchisee at least 14 calendar days before the franchisee signs any franchise or other binding agreement with, or makes any payment to, the franchisor or any of its affiliates in connection with the proposed franchise sale, or earlier than those 14 calendar days if the prospective franchisee has ‘reasonably requested’ such earlier disclosure. In addition, certain state laws require that disclosure be made earlier in the sales process than the FTC Rule does.

A franchisor will be considered to have furnished a disclosure document if:

• a copy of the document was hand-delivered, faxed, emailed or otherwise delivered to the prospective franchisee by the required date;
• directions for accessing the document on the internet were provided to the prospective franchisee by the required date; or
• a paper or tangible electronic copy (for example, computer disk or CD-ROM) was sent to the address specified by the prospective franchisee by first-class US mail at least three calendar days before the required date.

Additionally, it is a violation of the FTC Rule for a franchisor to alter unilaterally and materially the terms and conditions of the basic franchise agreement or any related agreements attached to the disclosure document without furnishing the prospective franchisee with a copy of each revised agreement at least seven calendar days before it signs the revised agreement. Changes to an agreement that arise out of negotiations initiated by the prospective franchisee do not trigger this seven-calendar-day period.

The FTC Rule pre-empts inconsistent state regulation but allows the states to impose higher disclosure standards or require additional disclosures. The North American Securities Administrators Association and the states have effectively adopted the FTC Rule as is, but may elect to impose additional requirements. Some states do, in fact, have a relatively small number of additional requirements. This allows franchisors to use a ‘multi-state’ form of disclosure that includes each state’s mandated modifications in addenda to the disclosure document.

Pursuant to the FTC Rule, disclosure documents must be updated within 120 days of the end of the franchisor’s fiscal year. Depending on the registration state, franchisors must update their disclosure documents (and state franchise registrations/exemptions) either 90, 110 or 120 days after the franchisor’s fiscal year-end, or within one year of the effective date of the registration.

Furthermore, franchisors generally must immediately update their FTC disclosure documents upon the occurrence of material changes. A material change is defined as:

Any fact, circumstance, or set of conditions which has a substantial likelihood of influencing a reasonable franchisee or a reasonable prospective franchisee in the making of a significant decision relating to a named franchised business or which has any significant financial impact on a franchisee or prospective franchisee.

Additionally, if a franchisor amends its disclosure document after the initial disclosure but before a sale is consummated, the amended document should be delivered to the prospective franchisee.

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?

Under the FTC Rule, if a sub-franchisor sells a franchise, it is jointly responsible with the franchisor for compliance with all franchise disclosure laws. Additionally, registration states require separate registration by the franchisor of the offer of sub-franchise rights and separate registration by the sub-franchisor of its offering of sub-franchises.

What due diligence should the parties undertake before entering a franchise relationship?

There are several resources a prospective franchisee should consult before entering into a franchise relationship. The prospective franchisee should review the franchisor’s franchise disclosure document, franchise agreement, and related agreements to understand the costs involved in acquiring and operating the franchised business, the system’s size and growth, the franchisor’s length of time in business, the franchisor’s financial health, the control exercised by the franchisor under the franchise agreement, the support and services offered by the franchisor, and the rights the franchisor has under the franchise agreement, such as events of default and termination. The prospective franchisee also should speak to as many as possible of the franchisor’s existing and former franchisees about their experiences with the franchisor and franchise system, using the contact information included in the franchise disclosure document. Other third-party resources (such as industry-specific trade associations, the Better Business Bureau, or other online resources) may have information on the franchisor’s business and operations, including direct commentary from existing and former franchisees. A prospective franchisee should evaluate competitive franchised brands to determine what makes the franchisor’s franchise system stand out from its competitors. To help guide the prospective franchisee through assessing the franchise opportunity, the prospective franchisee should consider engaging financial and legal advisers.

When evaluating a prospective franchisee, franchisors should establish a set of criteria, which should include whether: (1) the franchisee is a good fit for the franchise system; (2) the franchisee has the appropriate personal characteristics, business experience and marketing abilities to operate and promote the franchised business; (3) the franchisee intends to be personally involved in the management of the franchised business; (4) the prospective franchisee meets minimum capital requirements; and (5) the territory the franchisee desires is both available and aligns with the franchise system’s expansion plans.

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.

In the case of sub-franchising, how is liability for disclosure violations shared between franchisor and sub-franchisor? Are individual officers, directors and employees of the franchisor or the sub-franchisor exposed to liability? If so, what liability?

Under the FTC Rule, if a sub-franchisor sells a franchise, it is jointly liable with the franchisor for any violations. The FTC imposes liability on the officers and directors of corporate franchisors for violations of the FTC Rule.

Most state franchise laws expressly impose joint and several liability for disclosure violations on all partners, directors, principal officers, controlling persons, and employees who aid a violation or are responsible for compliance. Most state franchise laws specifically address sub-franchisors.

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

The general common law of fraud and misrepresentation applies to the offer and sale of franchises. Furthermore, most states have statutes that prohibit unfair and deceptive practices.

General contract, antitrust and fair-dealing principles affect the offer and sale of franchises. The Sherman Act, the Robinson-Patman Act, the FTC Act and the Clayton Act prohibit anticompetitive abuses in contract formation as well as general trade and commerce. These laws are also applicable to franchises. Moreover, federal civil rights statutes may apply if the franchisee can show prohibited discriminatory practices in the offer, sale, renewal or termination of a franchise.

There are private franchise associations that have established codes of conduct for their members; however, these do not have the force of law. US law does not have the concept of ‘culpa in contrahendo,’ but obligations of good faith could be applied to create a disclosure obligation beyond what is required by statute.

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? How does this protection differ from the protection provided under franchise sales disclosure laws?

Aside from the statutory causes of action available to franchisees, franchisees may also bring common law actions for franchisor violations related to the offer and sale of franchises. Under common law, unlike the franchise statutes, franchisees may not be able to obtain attorneys’ fees.

State common law and statutory fraud principles will provide franchisees with a cause of action for misrepresentations or false statements made during the franchise sales process. The remedy for general common law fraud and misrepresentation is usually direct, foreseeable damages, although courts also have the authority to award punitive damages in the case of egregious behaviour.

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31 March 2020