On January 22, 2007, the Federal Trade Commission (FTC) approved final amendments to the Franchise Rule (the “Rule”). The FTC’s stated purpose in amending the Rule is to “streamline the Rule, minimize compliance costs, and to respond to changes in new technologies and market conditions in the offer and sale of franchises.” The amended Rule preempts inconsistent state law and will serve as the industry disclosure standard following the phase-in period. The amendments are effective July 1, 2007, but franchisors may use the original Rule (or UFOC Guidelines) until July 1, 2008.
The purpose of this advisory bulletin is to highlight some of the FTC’s more significant amendments to the Rule. It does not purport to cover all of the changes contained in the near 400-page Staff Report. This advisory bulletin should not to be construed as legal advice. Franchisors and franchisees should consult with their attorney for advice on how these changes may impact their business.
The following is a summary of some of the significant changes made by the FTC amendments to the Rule by topic area.
Delivery of Information
The “Face to face” meeting and/or 10 day requirement has been eliminated. Under the amended Rule, franchisors must deliver their disclosure document 14 calendar days before the franchisee signs any agreement with or makes any payment to the franchisor.
Franchisors may now deliver disclosure documents to franchisees in a variety of ways, including, but not limited to, email, fax, hand-delivery, or over the Internet.
Exemptions from the Rule
- Substantial Investment Exemption. There is exemption from the Rule if the franchisee’s initial investment (excluding any financing received by the franchisor or an affiliate and the cost of unimproved land) totals $1 million or more and the franchisee signs an acknowledgment verifying the grounds for exemption. This exemption, however, does not relieve franchisors from their obligation to comply with any applicable state franchise disclosure and/or registration laws.
- Sophisticated Franchisee Exemption. There is an exemption from the Rule if the franchisee or any of its parents or its affiliates is an entity that has been in business for at least five years and has a net worth of at least $5 million.
- “Insider” Exemption. The offer or sale of a franchise is exempt from the Rule to certain franchisees who own an interest in the franchisor or who have experience as an officer or manager in the franchisor prior to the establishment of a franchise system.
Disclosure/Format of Information
The following are changes adopted by the Rule amendments to the disclosure or format of the information required to be contained in the franchise disclosure document by reference to the Item number.
Item 1: The Franchisor, and any Parents, Predecessors and Affiliates
- The franchisor must provide the name and address of any parent companies.
Item 2: Business Experience
- Biographical information for any individual with management responsibility relating to the sale or operation of franchises must be disclosed, including parents and affiliates.
Item 3: Litigation
- Pending litigation for material administrative, criminal or material civil actions involving the franchisor’s parent, predecessor, or affiliate must be disclosed if the parent, predecessor, or affiliate backs the franchisor financially or guarantees the franchisor’s performance, and the claims include allegations of franchise, antitrust or securities law violations, fraud and/or unfair or deceptive practices. All affiliate litigation of the same variety must be disclosed if it involves the franchisor’s principal trademark.
- Any “franchise relationship” litigation for the previous fiscal year must also be disclosed. “Franchise relationship” litigation is defined as actions between franchisor (or its affiliates, predecessors, affiliates, etc.) and franchisees which pertain to the franchised business. For example, a franchisor-filed lawsuit to terminate a franchisee under a franchise agreement.
Item 4: Bankruptcy
- Disclosure of a parent’s bankruptcy is required.
Item 12: Territory
- If the franchisor does not grant a protected territory, it must state in its franchise disclosure document: “You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we can control.”
- The franchisor must detail sales restrictions outside the franchisee’s territory, and whether the franchisee has the right to use other distribution channels, such as the Internet, catalog sales or direct marketing.
Item 13: Trademarks
- If a franchisor does not have a federally registered trademark it must state in its franchise disclosure document: “We do not have a federal registration for our principal trademark. Therefore, our trademark does not have many legal benefits and rights as a federally registered trademark. If our right to use the trademark is challenged, you may have to change to an alternative trademark, which may increase your expenses.”
Item 17: Renewal, Termination, Transfer and Dispute Resolution
- Franchisors must affirmatively disclose what the term “renewal” means for the franchise system. In particular, whether franchisees may be required to sign a new agreement that materially differs from their original contract.
Item 19: Financial Performance Representations
- Restrictions on “earnings claims” have been replaced by restrictions on “financial performance representations.” Financial information for subsets of existing outlets is permitted, subject to stringent requirements.
Item 20: Outlets and Franchisee Information
- Information on a franchisor’s outlets and franchisees must be presented in a set of five new tables.
The practical effect of the amended Rule will vary depending on the nature of each franchise system. For example, systems with a significant amount of “franchise relationship” related litigation will be heavily impacted, as the details of this type of litigation must now be disclosed. Franchisors with large initial investment requirements, or with high net worth, experienced or internally generated franchisees, may benefit from the new exemptions. All franchisors will benefit from the updated disclosure document distribution process, which provides for various types of electronic delivery. In addition, franchisors will appreciate the new clear 14-day delivery rule.
It is premature to determine whether the amended Rule will meet the FTC’s proposed objectives of streamlining disclosures, reducing compliance costs, and best responding to technological and market changes in the franchise industry. Regardless, franchisors, both new and established, need to carefully consider the FTC’s amendments and how these changes may affect their franchise system.