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The New FTC Franchise Rule: What's New About It?

by Dennis Wieczorek

Over 12 years ago, the FTC announced that it intended to overhaul its Franchise Rule.  It now has finalized those changes.

Here is a brief summary of the most notable changes in the proposed Rule.

Effectiveness

Franchisors must comply with the Rule no later than July 1, 2008, but may voluntarily comply as early as July 1, 2007.

The delay in the initial effective date is intended to give individual states time to get up to speed on the Rule. Many franchisors, who typically end their fiscal years on December 31,  will begin complying with the new Rule when they file their annual renewals in Spring 2008 (late March/early April). Note that a franchisor cannot comply with various parts of the Rule on a piecemeal basis (e.g., start using e-disclosure but make no changes to the disclosure document), but rather must transition over to the new requirements in full.

E-Disclosure

Franchisors may deliver the disclosure document in hard copy or CD-ROM (as was permitted before), or via e-mail or via download from a web site. Franchisees must be advised of the different formats that are available, and the franchisee must be able to store and print the version made available by the franchisor.

Disclosure Delivery Rules

The first personal meeting delivery requirement has been eliminated. The disclosure document must be delivered no later than 14 calendar days before the franchisee signs any agreement or pays any consideration. However, the franchisee may reasonably request the document earlier in the process.

Final Agreement Delivery Rules 

The old "5 business day" rule has been eliminated. Now the form of agreement attached to the disclosure document serves as the final agreement for purposes of delivery. However, if the franchisor makes unilateral changes to the agreement, it must deliver the new version at least seven days before signing.

Substantive Disclosure Changes

(a) Franchisor-initiated litigation against franchisees now must be disclosed (under prior rules, only claims or counterclaims by franchisees had to be disclosed). The FTC allows summary disclosure of such litigation arising in the prior year and mandates updating of such disclosures only on an annual basis, rather than quarterly.

(b) Trademark-specific franchisee associations must be listed if the association asks to be so listed within 60 days after the end of the franchisor's fiscal year.

(c) If current or former franchisees have signed confidentiality clauses (previously referred to as "gag" clauses in FTC commentary) in agreements with the franchisor in the last three years, the disclosure document must contain required language about the existence of such clauses. The language basically puts prospects on notice that not all franchisees will be allowed to respond to inquiries from the prospect. The franchisor may add a statement indicating how many franchisees have signed such clauses and describing the circumstances in which such clauses were signed.

(d) The FTC has eliminated all disclosures about brokers. It remains to be seen whether the state regulators will accede to this position.

(e) Franchisors may provide summary disclosure about computers and technology requirements, rather than the detailed disclosure required under the UFOC.

(f) Parent company disclosures have been significantly reduced from the original Rule drafts.  The parent must be identified in Item 1 and any bankruptcy information must be disclosed in Item 4.  Otherwise, parent disclosures are required if the parent guarantees the performance of the franchisor or undertakes to provide post-sale services.

(g) If the franchisor does not provide any protected territory, the disclosure document must contain a warning legend about the franchisee's lack of exclusivity and the possibility of competition from other channels of distribution.

(h) The disclosure document must contain a description of the franchisor’s renewal policy and whether renewal entails a requirement that the franchisee execute a new, and possibly different, franchise agreement.

(i) The most significant change to the disclosure requirements is a completely revamped Item 20 (which shows changes in the number of  system outlets over a three-year period). The new disclosure document mandates a fully reconciled tabular summary of the inflow and outflow of franchised and company-owned outlets over the course of each year. It also establishes a separate table for transfers, which ultimately do not affect the total number of operating outlets. The Rule also contains definitions of specific events and creates rules to avoid double-counting of those events. For example, if the franchisor terminates a franchise but then repurchases the outlet, those rules would focus on the "last-in-time" event and, thus, it would be characterized as a repurchase.

Earnings Claims

First, they are now called "financial performance representations" and the FTC has confirmed that it will not mandate the use of such representations in the disclosure document. However, the FTC has added specific preambles to Item 19, indicating that franchisors are allowed to provide financial performance representations and that prospects should not rely on unauthorized representations.

Also, the FTC has determined that providing expense information does not constitute a financial performance representation and therefore it is not subject to the rules of this Item. Finally, the FTC eliminated a number of technical requirements, including GAAP compliance, geographical relevance, and others.

Updating Requirements

The FTC has lengthened the time period for the annual updating of the disclosure document from 90 to 120 days. The required quarterly updates, if necessary due to material changes, remain as before.

Exemptions 

Three new exemptions have been added:

(a) Large investment exemption: If investment exceeds $1 million, excluding unimproved land and amounts financed by the franchisor.

(b) Large franchisee exemption: If the franchisee has been in business for five years and has a net worth of $5 million or more.

(c) Insider exemption: If the franchisee is a principal owner of the franchisor or a franchisor executive with franchising responsibility.

Business Opportunities Now Excluded

Business opportunities are no longer a part of the Franchise Rule. The FTC is in the process of creating a separate Rule on business opportunities.

International Transactions Not Covered

The FTC confirmed that international transactions (where the franchise is to be operated outside the boundaries of the US and its territories and possessions) are not covered by the Rule.

Interplay with State Laws

The FTC Rule preempts inconsistent state regulation but allows the states to impose higher disclosure standards or require additional disclosures. The hope is that NASAA and the states will adopt the FTC Rule as is and will impose only minimal additional requirements.


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