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Disclosure Requirements and Prohibitions Concerning Franchising

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AGENCY:

Federal Trade Commission.

ACTION:

Final rule.

SUMMARY:

The Federal Trade Commission (the “Commission” or “FTC”) amends its Trade Regulation Rule entitled “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures” (“Franchise Rule” or “Rule”) 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. Part 436 sets forth those amendments to the Franchise Rule pertaining to the offer and sale of franchises. Part 437 sets forth a revised form of the original Franchise Rule pertaining solely to the offer and sale of business opportunities. This document provides background on the Franchise Rule and this proceeding; discusses the public comments the Commission received; and describes the amendments the Commission is making based on the record. This document also contains the text of the final amended Rule and the Rule’s Statement of Basis and Purpose (“SBP”), including a Regulatory Analysis.

EFFECTIVE DATES:

The effective date of the final amended Rule is July 1, 2007. Permission to use the original Franchise Rule, however, will continue until July 1, 2008. After that date, franchisors and business opportunity sellers must comply with the final amended Rule only.

ADDRESSES:

Requests for copies of the final amended Rule and the SBP should be sent to: Public Reference Branch, Room 130, Federal Trade Commission, 600 Pennsylvania Avenue, NW, Washington, D.C. 20580. The complete record of this proceeding is also available at that address. Relevant portions of the proceeding, including the final amended Rule and SBP, are available at www.ftc.gov.

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FOR FURTHER INFORMATION CONTACT:

Steven Toporoff, (202) 326-3135, Division of Marketing Practices, Room 286, Bureau of Consumer Protection, Federal Trade Commission, 600 Pennsylvania Avenue, NW., Washington, D.C. 20580.

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SUPPLEMENTARY INFORMATION:

The final amended Rule retains most of the original Rule’s pre-sale disclosures.[1] Part 436 pertains to franchising—business arrangements that offer purchasers the right to operate under a trademark or other commercial symbol and that typically offer a specific format or method of doing business, such as chain restaurants and hotels.[2] Part 436 modifies the original Rule, however, by reducing inconsistencies with state franchise disclosure laws, by adopting, in large measure, the disclosure requirements and format of the Uniform Franchise Offering Circular (“UFOC”) Guidelines used by the 15 states with pre-sale franchise disclosure laws.[3] Part 436 of the final amended Rule, however, is not identical to the UFOC Guidelines. In several instances, part 436 is narrower. For example, part 436 does not incorporate the UFOC Guidelines’ mandatory cover page risk factors, disclosures pertaining to brokers, or detailed disclosures pertaining to franchisees’ computer equipment requirements. Part 436 also permits a phase-in of audited financial statements.

Further, part 436 of the final amended Rule corrects a problem with the UFOC Guidelines identified in the rulemaking record. Specifically, the record establishes that the current Item 20 of the UFOC Guidelines—a provision requiring the disclosure of franchisee statistics—results in inflated turnover rates. Part 436 of the final amended Rule corrects this problem, based upon suggestions contained in the record.

In a few instances, part 436 of the final amended Rule is broader than the UFOC Guidelines, addressing franchise relationship issues that the rulemaking record establishes are a prevalent source of franchisee complaints. To that end, part 436 of the final amended Rule provides additional information to prospective franchisees with which to assess the quality of the franchise relationship before they buy, including: (1) franchisor-initiated litigation against franchisees pertaining to the franchise relationship; (2) protected territories; (3) the use of confidentiality clauses; and (4) trademark-specific franchisee associations.

Finally, part 436 of the final amended Rule updates the original Rule and UFOC Guidelines by addressing new marketing techniques and new technologies. For example, part 436 permits franchisors to comply with pre-sale disclosure obligations electronically. It also updates territorial protection disclosures to address sales via the Internet, catalogs, and telemarketing.

Part 437 of the final amended Rule pertains to business opportunity ventures. Business opportunities, such as vending machine routes and rack display ventures, typically do not involve the right to use a trademark or other commercial symbol and the seller must provide purchasers with locations for machines or equipment or with clients.[4] Based upon the rulemaking record, the Commission has proposed that business opportunities covered by the original Rule should be addressed in a separate, narrowly-tailored trade regulation rule. On April 12, 2006, the Commission published a Notice of Proposed Rulemaking (“Business Opportunity NPR”) for a separate Business Opportunity Rule.[5] Pending completion of the proceeding initiated with that notice, business opportunities presently covered by the requirements of the original Rule will remain covered, as set forth as part 437 of the final amended Rule.

Part 437 of the final amended Rule differs from the original Rule in three respects only. First, references to “franchisor” and “franchisee” in the original Rule have been changed to “business opportunity seller” and “business opportunity purchaser,” respectively. Second, the original Rule’s definition of “franchise” set out at section 436.(2)(a) has been changed to “business opportunity” and the first part of the original definition—the “franchise” elements—have been deleted; the definition now focuses on the second part of the original definition—the business opportunity elements. Third, part 437 sets forth a new exemption for franchises that comply with, or are exempt from, part 436. Except for these three changes, all disclosures and prohibitions in part 437 are identical to those of the original Franchise Rule. Start Printed Page 15445

STATEMENT OF BASIS AND PURPOSE

I. INTRODUCTION

A. Overview of the Original Franchise Rule

The Commission promulgated the original Franchise Rule on December 21, 1978.[6] Based upon the original rulemaking record, the Commission found widespread deception in the sale of franchises and business opportunities through both material misrepresentations and nondisclosures of material facts.[7] Specifically, the Commission found that franchisors and business opportunity sellers often made material misrepresentations about: the nature of the seller and its business operations, the costs to purchase a franchise or business opportunity and other contractual terms and conditions under which the business would operate, the success of the seller and its purchasers, and the seller’s financial viability. The Commission also found other unfair or deceptive practices pervasive: franchisors’ and business opportunity sellers’ use of false or unsubstantiated earnings claims to lure prospective purchasers into buying a franchise or business opportunity, and franchisors’ and business opportunity sellers’ failure to honor promised refund requests. The Commission concluded that all of these practices led to serious economic harm to consumers.[8]

To prevent deceptive and unfair practices in the sale of franchises and business opportunities and to correct consumers’ misimpressions about franchise and business opportunity offerings, the Commission adopted the original Franchise Rule, which is primarily a pre-sale disclosure rule. The original Rule did not purport to regulate the substantive terms of the franchise or business opportunity relationship. Rather, it required franchisors and business opportunity sellers to disclose material information to prospective purchasers on the theory that informed investors can determine for themselves whether a particular deal is in their best interest.[9]

B. The Rule Amendment Proceeding

This Rule amendment proceeding began with a regulatory review of the Franchise Rule in 1995.[10] To initiate the Rule Review, the Commission published a Federal Register notice seeking public comment on whether there was a continuing need for the Rule and, if so, how to improve it in light of industry changes since its promulgation in 1978. In response to this notice, the Commission received 75 written comments.[11]

In addition, the Commission staff held two public workshops, in which a total of fifty individuals participated. The workshops were transcribed.[12] The first workshop—held on September 11-13, 1995, in Bloomington, Minnesota—focused on the comments on the Rule, in particular whether the Commission should retain the Rule and, if so, whether the Commission should reduce inconsistencies between federal and state pre-sale disclosure law by incorporating in the Rule the UFOC Guidelines adopted by each of the 15 states with franchise disclosure laws.[13] Participants also discussed issues arising from business opportunity sales. The second workshop—held on March 11, 1996, in Washington, D.C.—focused on the Franchise Rule’s application to sales of franchises to be located outside the United States.

As a result of the Rule Review, the Commission determined that the Franchise Rule continues to serve a useful purpose and that it should be retained. The Commission also determined to modify the Rule in order to reduce inconsistencies with the UFOC Guidelines, while updating the Rule to address new technologies developed since the original Rule was promulgated. Accordingly, in February 1997, the Commission published an Advance Notice of Proposed Rulemaking (“ANPR”).[14] The ANPR solicited comment on several proposed Rule modifications which would, among other things, create a separate trade regulation for business opportunity sales, revise the Rule’s disclosure requirements to mirror those of the UFOC Guidelines, limit the Rule’s application to sales of franchises located in the United States, and permit electronic disclosure. In response to the ANPR, the Commission received 166 written comments.[15] The staff also held six public workshops on the issues raised in the comments, as set forth below.[16]

Topic(s)LocationDates
Trade Show PromotersWashington, D.C.July 28-29, 1997
Business OpportunitiesChicago, ILAugust 21-22, 1997
UFOC, Internet, International, Co-branding, Alternatives to Traditional Law EnforcementNew York, NYSeptember 18-19, 1997
Business OpportunitiesDallas, TXOctober 20-21, 1997
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UFOC, Internet, International, Co-branding, Alternatives to Traditional Law EnforcementSeattle, WANovember 6-7, 1997
Business OpportunitiesWashington, D.C.November 20-21, 1997

A total of sixty-five individuals participated in the various ANPR public workshops, including franchisees, franchisors, business opportunity sellers and their representatives, state franchise and business opportunity regulators, and computer consultants.

After the ANPR workshops, the Commission published a Notice of Proposed Rulemaking (“Franchise NPR”) in October 1999.[17] Focusing on franchise sales only, the Franchise NPR included the text of a proposed revised Franchise Rule and a detailed discussion of each proposed Rule revision. Among other things, the Franchise NPR addressed: (1) the application of the Franchise Rule to franchise sales outside the United States; (2) the scope of certain existing disclosure requirements, such as those regarding litigation and franchisee statistics; (3) new disclosure requirements, such as those for franchisee associations; and (4) new instructions permitting disclosure via the Internet. It also proposed creating exemptions from the Franchise Rule for sophisticated prospective franchisees.

The Franchise NPR also specified the process the Commission would follow in amending the Franchise Rule, as it pertains to franchise sales. Pursuant to the Commission’s Rules of Practice, 16 CFR 1.20, the Commission determined to use a modified version of the rulemaking process set forth in section 1.13 of those Rules.[18] Specifically, the Commission announced that it would publish an NPR, with a 60-day comment period, followed by a 40-day rebuttal period. In addition, pursuant to Section 18(c) of the FTC Act, the Commission announced that it would hold hearings with cross-examination and rebuttal submissions only if an interested party requested a hearing. The Commission also stated that, if requested to do so, it would contemplate holding one or more informal public workshops in lieu of hearings. Finally, pursuant to 16 CFR 1.13(f), the Commission announced that staff would issue a Report on the Franchise Rule (“Staff Report”), which would be subject to additional public comment.[19]

In response to the Franchise NPR, the Commission received 40 comments.[20] Overwhelmingly, the comments supported the proposed revisions, albeit with fine-tuning.[21] No commenters requested a hearing, although, as noted, the Franchise NPR allowed for them.[22] The staff also determined that the record was fully developed for franchise issues, requiring no additional public workshops to explore further Rule amendment issues.

Pursuant to the Rule amendment process announced in the Franchise NPR, the Commission’s Bureau of Consumer Protection issued a Staff Report on the Franchise Rule in August 2004.[23] The Staff Report explained in detail the history of the Rule amendment proceeding. It also summarized the issues raised during the various notice and comment periods, in particular those that arose in response to the Franchise NPR. For each Franchise NPR issue, the Staff Report discussed: (1) similarities and differences between the proposed revised Rule approach and both the original Rule and the UFOC Guidelines approaches; (2) pertinent comments; and (3) the staff recommendations on franchise issues for inclusion in a final amended Rule.

Forty-five commenters responded to the Staff Report.[24] For the most part, the commenters supported the proposed Rule revisions pertaining to franchising.[25] Several, however, voiced concern about the scope of one or more Rule provisions, or offered various suggestions to fine-tune the Rule to avoid ambiguities.[26] In other instances, several commenters raised issues for further discussion in anticipated Compliance Guides, or offered interpretations of Rule provisions for inclusion in the Compliance Guides.[27] In several instances, franchisee representatives reiterated views previously expressed during the various comment periods to the effect that the proposed revised Rule is deficient because it does not mandate disclosure of financial performance data[28] or does not adopt various substantive franchise relationship provisions.[29] As explained in greater detail below, the Commission has considered each of these comments in determining the form and content of the final amended Rule.

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C. Continuing Need for the Rule

Based upon the original rulemaking record and the Commission’s law enforcement experience extending nearly 30 years,[30] the Commission concludes that a pre-sale disclosure rule continues to serve a useful purpose. Overwhelmingly, the comments submitted during the Rule amendment proceeding supported the continued need for the Franchise Rule.[31] For example, some commenters emphasized that pre-sale disclosure is still necessary to prevent fraud.[32] Others observed that pre-sale disclosure is a cost-effective way to provide material information to prospective purchasers about the costs, benefits, and potential legal and financial risks associated with entering into a franchise relationship. These commenters also stressed that the Rule assists prospective franchisees in conducting a due diligence investigation of the franchise offering by providing information that is not readily available, such as the franchisor’s litigation history and franchisee termination rates.[33] Other commenters noted that pre-sale disclosure helps franchisees understand the franchise relationship they are entering better than they could absent such disclosure, thereby reducing potential conflicts in franchise systems and post-sale litigation costs.[34] Indeed, some commenters expressed the view that repeal of the Franchise Rule might actually increase franchisors’ costs and compliance burdens by opening the door for individual states to enact franchise disclosure laws that may be inconsistent, making it difficult for franchisors to conduct business on a national basis.[35] One commenter noted that retaining a uniform pre-sale disclosure rule enables prospective franchisees to comparison shop for the best franchise offering.[36]

On the other hand, many franchisees and their advocates criticized the Rule for not going far enough. They urged the Commission to address in this rulemaking a variety of post-sale franchise contract or “relationship” issues, including prohibiting or limiting the use of post-contract covenants not to compete,[37] encroachment of franchisees’ market territory,[38] and restrictions on the sources of products or services.[39] Indeed, some franchisees asserted that if the Rule cannot address post-sale relationship issues, then the Commission should abolish the Rule.[40]

To address post-sale relationship issues by adopting rule provisions that prohibit or limit the use of certain contract terms would require record evidence demonstrating specific unfair acts or practices. The FTC Act defines an unfair act or practice as one that is “likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition.”[41] The Act also requires that, to justify an industry-wide rule, such practice be prevalent.[42] This proceeding did not yield adequate evidence to support a finding of prevalent acts or practices that meet each of the three prerequisites for unfairness as articulated in Section 45(n) of the FTC Act.

With regard to the first prerequisite, substantial injury, the record shows that some franchisees in several franchise systems have suffered post-sale harm in the course of operating their franchises, and in some instances this injury may be ascribable to acts or practices of a franchisor.[43] The record, however, leaves open the related questions of whether such franchisor acts or practices are prevalent and whether the injury resulting from acts or practices is substantial, when viewed from the standpoint of the franchising industry as a whole, not from just a particular franchise system.

With regard to avoidability of injury, the unfairness analysis falls short. A franchise purchase is entirely voluntary. The Franchise Rule ensures that each prospective franchisee receives disclosures—expanded in key respects by the current amendments—that explain the terms and conditions under which the franchise will operate. Prospective franchisees can avoid harm by comparison shopping for a franchise system that offers more favorable terms and conditions, or by considering alternatives to franchising as a means of operating a business. Prospective franchisees are also free to discuss the nature of the franchise system with existing and former franchisees, as well as trademark-specific franchisee associations, and the amended Rule facilitates such discussion by providing prospects with contact information. Under these circumstances, the Commission cannot categorically conclude that prospective franchisees who voluntarily enter into franchise agreements, after receiving full disclosure, nonetheless cannot reasonably avoid harm resulting from a franchisor enforcing the terms of its franchise agreement.[44]

The third element requires an analysis of whether injury to franchisees deriving from specific franchisor acts or practices outweighs countervailing benefits to the public at large or to competition. In our law enforcement experience investigating relationship issues in individual franchise systems, it has been the case that the franchisor actions allegedly causing harm to individual franchisees also frequently generate countervailing benefits to the system as a whole or to consumer welfare overall that may or may not be Start Printed Page 15448outweighed by the alleged harm to franchisees. Commenters advocating that the Rule include unfairness remedies have asserted injury, but have failed to bring forth evidence that such injury outweighs potential countervailing benefits that arise from the alleged acts or practices. Therefore, the Commission declines to impose industry-wide provisions mandating substantive terms of private franchise contracts that would impact on the entire franchise industry, not just those franchise systems that are the subject of commenters’ complaints.[45] Notwithstanding this determination, the Commission, in pursuit of its law enforcement mission can consider whether individual franchisors’ conduct constitutes an unfair act or practice on a case-by-case basis.

Nonetheless, the Commission concludes that the record is sufficient to show that misunderstandings about the state of the franchise relationship are prevalent, and some more disclosure is warranted to ensure that prospective franchisees are not deceived about the quality of the franchise relationship before they commit to buying a franchise. Franchisee concerns about relationship issues persuade us that better disclosure is necessary to ensure that prospective franchisees are fully informed about the relationships that they will be entering. To that end, part 436 of the final amended Rule expands the Rule’s pre-sale disclosures in a few instances to address franchise relationship issues, as detailed throughout this document.

D. Overview of the Final Amended Rule

The final amended Rule maintains the benefits of the original Rule, preventing deceptive and unfair practices identified in the original rulemaking through pre-sale disclosure of material information necessary to make an informed purchasing decision and prohibition of specified misrepresentations. At the same time, part 436 of the final amended Rule reduces unnecessary compliance costs. First, part 436 covers only the sale of franchises to be located in the United States and its territories. Second, based upon the record, the Commission also has created several new exemptions for sophisticated franchise purchasers, including exemptions for large investments and large franchisees with sufficient net worth and prior experience.

Part 436 of the final amended Rule also reduces inconsistencies between federal and state pre-sale disclosure requirements. Since the original Rule was promulgated, NASAA, which represents the 15 states with pre-sale franchise disclosure laws, has developed a standard disclosure document, the UFOC. The Commission, as a matter of policy, has in the past permitted franchisors to comply with the Franchise Rule by furnishing prospective franchisees with a UFOC, even in the 35 states without franchise disclosure laws.[46] The Commission found that the UFOC Guidelines, taken as a whole, offer consumers the same or greater consumer protection as that provided by the original Rule. As a result, the UFOC Guidelines already are used by the vast majority of franchisors to comply with the Rule,[47] and, in fact, the UFOC Guidelines have become the national franchise industry standard.[48] Further, as NASAA noted, the UFOC Guidelines were developed with significant input from franchisors, franchisees, and franchise administrators, and were subject to public hearings and notice and comment.[49] Therefore, the UFOC Guidelines, like the Franchise Rule, reflect a balance of interests among all affected parties.

Overwhelmingly, franchisors, franchisees, and franchise regulators urged the Commission throughout the Rule amendment proceeding to adopt the UFOC Guidelines disclosure format. These commenters include a broad range of interests, such as NASAA, the International Franchise Association (“IFA”), the American Bar Association’s Antitrust Section, the American Franchisee Association, the State Bar of California Business Law Section, and major franchisors, such as Cendant, Marriott, YUM! Brands, 7-Eleven, Arby’s, and Starwood Hotels and Resorts.[50]

Accordingly, part 436 of the final amended Rule closely tracks the UFOC Guidelines. Nevertheless, part 436 is not identical to the UFOC Guidelines. In a few instances, part 436 omits or streamlines a UFOC Guidelines disclosure requirement that the Commission believes is unnecessary or is overly burdensome—for example, mandatory cover page risk factors, broker disclosures, and detailed computer equipment disclosures. As explained in greater detail below, part 436 of the final amended Rule also avoids problems with Item 20 of the UFOC Guidelines (the disclosure of statistical information on franchisees in the system) that were revealed during the proceeding and that were examined in detail by a number of commenters, including NASAA.

Part 436 of the final amended Rule also retains a few provisions from the original Rule that are not in the UFOC Guidelines, because the Commission believes they are necessary to prevent deception. For example, part 436 of the final amended Rule retains the original Rule’s requirement that, in some instances, franchisors disclose information about a parent. Similarly, part 436 retains the original Rule’s phase-in of audited financial statements, Start Printed Page 15449thereby preserving flexibility not present in the UFOC Guidelines.

At the same time, part 436 of the final amended Rule adds to the UFOC Guidelines a few narrowly tailored disclosures based upon the Commission’s law enforcement experience and the rulemaking record, mostly to prevent deception involving the nature of the franchise relationship.[51] For example, as explained in greater detail below, part 436 of the final amended Rule expands the UFOC Guidelines’ Item 3 litigation disclosure requirements to include the disclosure of franchisor-initiated litigation. In addition, part 436 of the final amended Rule goes beyond the UFOC Guidelines’ Item 20 franchisee statistics disclosures to require disclosure of information about the franchisor’s use of confidentiality clauses and the existence of trademark-specific franchisee associations. In addition, in a few instances, part 436 of the final amended Rule requires franchisors to make prescribed statements to clarify issues that the record established are often misinterpreted by prospective franchisees, particularly in the area of protected territories and financial performance representations.

Further, part 436 of the final amended Rule updates the original Rule and UFOC Guidelines by addressing changes in the marketplace and new technologies. For example, as explained below, part 436 of the final amended Rule permits franchisors to furnish disclosures electronically and enables franchisees to use electronic signatures. Part 436 of the final amended Rule also updates the original Rule and UFOC Guidelines to address the impact of the Internet on a franchisor’s business operations. Specifically, part 436 requires more disclosure about the affect of the Internet on sales restrictions imposed on franchisees and any right of franchisors to compete online. It also addresses financial performance representations made on the Internet.

Finally, part 436 of the final amended Rule contains a few provisions and prohibitions that are necessary to make the Rule effective, to facilitate compliance, and to prevent deception. For example, part 436 of the final amended Rule prohibits a franchisor from unilaterally altering the material terms and conditions of its franchise agreements, unless the franchise seller informs the prospective franchisee about the changes within a reasonable time before execution. Part 436 of the final amended Rule also prohibits the use of shills, who are persons paid or otherwise given consideration to provide a false favorable report about the franchisor’s performance history.

E. Continued Application of Commission and NASAA Precedent

As noted throughout, most of the provisions of the original Rule have been retained in the final amended Rule. Accordingly, the original SBP remains valid, except to the extent of any conflict with the final amended Rule. In the event of any conflict, this document supersedes the original SBP. In the same vein, all former informal staff advisories remain a source of Rule interpretation, except where this SBP contradicts a staff advisory. To the extent that any member of the public is concerned that a previous advisory may no longer be applicable in light of the final amended Rule, we invite that person or entity to seek further clarification from the Commission or the staff.[52]

Further, the Commission anticipates issuance of new Compliance Guides on part 436 that will replace the original Interpretive Guides.[53] Because much of part 436 of the final amended Rule is based upon the UFOC Guidelines, the Commission anticipates that Compliance Guides will likely incorporate, in large measure, the UFOC Guidelines’ existing sample answers and NASAA’s previously issued commentaries on the UFOC Guidelines, to the extent such sample answers and commentaries do not deviate from the final amended Rule.[54] The Commission intends that the staff coordinate the issuance of Compliance Guides, and future interpretations of part 436 of the final amended Rule, with NASAA’s Franchise and Business Opportunity Project Group in order to minimize differences between FTC and state Rule interpretations.

II. THE LEGAL STANDARD FOR AMENDING THE RULE

A. Section 18 Rulemaking

Section 18(d)(2)(B) of the FTC Act states that “[a] substantive amendment to, or repeal of, a rule promulgated under subsection (a)(1)(B) shall be prescribed, and subject to judicial review, in the same manner as a rule prescribed under such subsection.”[55] Thus, the standard for amendment or repeal of a Section 18 rule is identical to that for promulgating a trade regulation rule pursuant to Section 18.

Additionally, an SBP must address four factors: (1) the prevalence of the acts or practices addressed by the rule; (2) the manner and context in which the acts or practices are unfair or deceptive; (3) the economic effect of the rule, taking into account the effect on small businesses and consumers; and (4) the effect of the rule on state and local laws.[56] These four factors are discussed in detail throughout this document. In the next section, we summarize our findings regarding each of these factors.[57]

1. The effect of the rule on state and local laws

The Commission begins with the effect of the final amended Rule on state and local laws, because that factor is unusually prominent in this proceeding. As noted above, 15 states have pre-sale franchise disclosure laws in the form of the UFOC Guidelines. The rulemaking record shows that, as a practical matter, the UFOC Guidelines are, in fact, the national disclosure standard for the franchise industry. Therefore, by design, the overwhelming effect of the final amended Rule on state franchise law will be to mesh more closely with it and Start Printed Page 15450enhance its effectiveness by promoting consistency and extending its reach to nationwide scope.[58] Moreover, the overwhelming majority of commenters throughout the Rule amendment proceeding, including NASAA and other state law advocates, urged the Commission to update the original Rule by adopting the UFOC Guidelines to bring greater uniformity to the field of franchise pre-sale disclosure.[59] Accordingly, in considering the factors outlined above, the Commission has given great weight to state franchise laws and their impact on the market, as well as the desire of all parties in the field to reduce inconsistencies between federal and state franchise disclosure laws.

The Commission has also carefully weighed the benefits of any suggestion to revise the Rule that would compound inconsistencies between the Rule and the UFOC Guidelines. Only in very few instances, an existing weakness in the UFOC Guidelines compels deviation from those Guidelines. The chief example is the revision to the Item 20 franchise statistics disclosures. Part 436 of the final amended Rule adopts a proposal submitted by NASAA to eliminate revealed problems with UFOC Item 20 in a streamlined fashion that provides prospective franchisees with material information about the franchise system, while reducing unnecessary compliance burdens.

The Commission also has adopted several suggestions offered by state regulators, mostly through NASAA, for streamlining the Rule. For example, in part 436 the Commission has revised the financial performance claim disclosures to eliminate the original Rule’s requirements that: (1) existing franchise performance data be prepared according to generally accepted accounting principles; (2) financial performance data be presented to a prospective franchisee in a separate financial performance document; and (3) cost information alone trigger the Rule’s financial performance disclosure and substantiation requirements.

2. Deceptive practices

The original Rule remedied through pre-sale disclosure five types of harmful material misrepresentations or omissions that were found to be widespread —specifically, misrepresentations about: (1) the opportunity being offered for sale (2) costs; (3) contractual terms; (4) success of the seller and prior purchasers; and (5) the seller’s financial viability. Each part 436 disclosure amendment to the original Rule addresses one of these five types of misrepresentations or omissions of material information.[60]

a. Misrepresentations about the franchisor and the franchise system

In the original rulemaking, the Commission found that franchisors and business opportunity sellers routinely misrepresented the nature of the business. For example, franchisors misrepresented how long they had been in business or the extent of their directors’ and officers’ prior business experience. Such misrepresentations mislead consumers acting reasonably under the circumstances into believing that the franchise offered for sale is a safe or low risk investment.

To prevent such deception, the original Rule required franchisors and business opportunity sellers to disclose background information on the franchisor or business opportunity seller and the business, including: the name and address of the franchisor or business opportunity seller and any parent company; the name under which the franchise or business opportunity seller does or intends to conduct business; its trademarks; the prior business experience of the franchisor or business opportunity seller and its directors and officers; and the business experience of the franchisor or business opportunity seller —e.g., experience selling franchises under the same or different trademarks, as well as the franchisor or business opportunity seller’s other lines of business.

Part 436 of the final amended Rule continues to address misrepresentations about the nature of the franchisor and the franchise system by requiring the same disclosures as did the original Rule. In a few instances, part 436 expands on these disclosures to remedy aspects of this type of misrepresentation that have been revealed by our enforcement experience or the record developed here. Specifically, part 436 of the final amended Rule requires franchisors to disclose information about the franchisor’s predecessors. Similarly, based upon the Commission’s law enforcement experience in over 50 franchise cases, part 436 also remedies misrepresentations about those controlling the franchise system by requiring not only disclosures about directors and officers, but also about other individuals who have management responsibility relating to the sale or operation of the franchises being offered for sale.

b. Misrepresentations about costs

In promulgating the original Rule, the Commission recognized the harm to franchisees and business opportunity purchasers resulting from misleading cost representations. Representing that costs of buying and operating a franchise, for example, are less than they actually are is likely to mislead prospective franchisees, acting reasonably under the circumstances, into believing that the franchise is more financially attractive than is actually the case. Obviously, cost representations are highly material. Thus, the original Rule required franchisors and business opportunity sellers to disclose fully not only the initial fee, but continuing costs throughout the relationship. For example, franchisors must disclose required purchases or leases for, among other things, inventory, signs, supplies, and equipment. In addition, the Commission was concerned about undisclosed indirect payments to the franchisor or business opportunity seller, and therefore required franchisors and business opportunity sellers to disclose the basis for calculating payments to the franchisor or business opportunity seller from suppliers that franchisees or business opportunity purchasers are required to use. Similarly, franchisors and business opportunity sellers must disclose any interest or payments made to celebrity endorsers.

Part 436 of the final amended Rule retains these required cost disclosures. It also adopts a few additional cost disclosures that the states found necessary to address related misrepresentations or omissions, or misrepresentations revealed by our law enforcement experience or the record developed here. These include, for example, a description of laws or regulations specific to the industry in which the franchise operates. Obviously, a franchisee’s operating costs Start Printed Page 15451may increase if he or she must incur hidden costs in the form of compliance with various industry-specific regulations governing the particular field. Part 436 of the final amended Rule also adopts the UFOC Guidelines’ required disclosure of fees that the franchisee is expected to pay within the first three months of operation (or other reasonable time for the industry), as well as more details about payments, such as to whom a payment is to be made and whether a payment is refundable. At the same time, part 436 of the final amended Rule updates cost disclosures by requiring, for example, additional information about any required computer systems, based upon the UFOC Guidelines. Each of these UFOC provisions is designed to prevent misrepresentation of the costs required to commence operation of a franchised outlet.

c. Misrepresentations about contractual terms

Another area of deception identified in the original rulemaking record concerns the underlying franchise or business opportunity contract. For example, the Commission found that franchisors may misrepresent the extent of promised assistance, or fail to disclose restrictions and other obligations imposed on the franchisee. Accordingly, the original Rule specified a number of disclosures pertaining to the legal obligations of both parties under their agreement. Specifically, the original Rule required franchisors, for example, to disclose information about contractual requirements to use designated suppliers, financing arrangements, product sales restrictions and protected territories, site selection, and training programs. In addition, franchisors had to disclose basic terms of the contract, such as the duration, renewal and termination rights, assignment rights, and covenants not to compete.

Part 436 of the final amended Rule retains these disclosure requirements. Adopting the UFOC Guidelines approach, however, the contract disclosures are required to be presented in easy-to-read tables, with references to the franchise agreement, rather than in the form of more detailed descriptions. In addition, part 436 updates the disclosures by, for example, requiring franchisors to explain how they use the term “renewal” in their system.

d. Misrepresentations about success

False or misleading representations about the success of franchise systems and business opportunities were perhaps the most prevalent misrepresentations identified in the original rulemaking record. These included misrepresentations about: the number of franchisees or business opportunity purchasers, the expected growth of the system, and, most important, the financial performance of existing purchasers.

To remedy misleading success claims, the original Rule required franchisors and business opportunity sellers to disclose statistics about the system, including the number of purchasers in the system, the number of purchasers who left the system in the previous year, and why they left (i.e., termination, cancellation, non-renewal, reacquisition). The original Rule also required franchisors and business opportunity sellers to furnish the names and contact information for at least 10 current purchasers. This information enabled prospective purchasers to verify the seller’s claims of success, and it gave prospective purchasers additional sources from which to obtain financial performance data.

The original Rule also remedied misleading success claims by requiring franchisors and business opportunity sellers to disclose lawsuits filed by purchasers against them pertaining to their relationship and counterclaims filed by a franchisor or business opportunity seller in response to a suit filed by a purchaser. The existence of such lawsuits is material because this information would likely influence a prospective purchaser’s decision about what can be a sizeable investment in a franchise or business opportunity. The nature of the relations between the seller and the purchaser, as reflected in litigation, is of central importance.

In the original rulemaking, the Commission also sought to ensure the accuracy and reliability of any financial performance claims made by a franchisor or business opportunity seller. Accordingly, the Commission prohibited the making of earnings claims unless the franchisor or business opportunity seller possessed a reasonable basis for the claim, along with written substantiation, at the time the claim was made. In addition, the seller had to set forth the claim in a separate earnings claims statement containing the bases and assumptions underlying the claim. Franchisors and business opportunity sellers were also required to warn prospective purchasers that there is no assurance that they will achieve the same level of earnings.

Part 436 of the final amended Rule retains each of these disclosures, and it expands on them by requiring franchisors to provide, consistent with the UFOC Guidelines, the names of up to 100 franchised outlets, as well as contact information for former franchisees. Part 436 of the final amended Rule also provides additional sources of information about the franchise system, including the disclosure of trademark-specific franchisee associations. These provisions prevent misrepresentations by giving prospective franchisees additional sources of information with which to assess franchisor claims. With respect to financial performance representations, it follows the more streamlined approach of the UFOC Guidelines. Specifically, part 436 of the final amended Rule eliminates the need for a separate earnings claims document. Instead, the required information is incorporated into the text of the disclosure document itself (Item 19).

Finally, as discussed throughout this document, franchisees have brought to the Commission’s attention what they believe to be abusive practices in franchising. These practices include encroachment of territories, imposition of source of supply restrictions, modification of original franchise agreements as a precondition for renewal, and the use of disclaimers to limit liability for misrepresentations, among others. As detailed in Section I.C. above, the Commission declines to attempt to promulgate a franchise relationship law and, further, concludes that the record does not support the promulgation of such a law. Nonetheless, the record is sufficient to support requiring additional disclosures that will help inform prospective franchisees about the quality of the franchise relationship. These include: expanded litigation disclosures to include franchisor-initiated litigation against franchisees; a warning of the consequences to a franchisee when a franchisor offers no exclusive territory; a statement of what the term “renewal” means in the franchise system; and a disclosure of the use, if any, of confidentiality clauses. Taken together, each of these amended disclosures in part 436 will enable prospective franchisees to better assess the quality of the franchise relationship, and their likely success as franchisees.

e. Misrepresentations about financial viability

In the original rulemaking record, the Commission found that franchisors and business opportunity sellers often misrepresented or failed to disclose material information about their financial viability. As a result, prospective purchasers invested thousands of dollars in systems having Start Printed Page 15452a poor financial history, or even facing bankruptcy. Obviously, a franchisee’s investment, for example, is at risk if the franchisor is not able to perform its contractual obligations as promised. To remedy these practices, the original Rule required franchisors and business opportunity sellers to disclose bankruptcy information, as well as to provide audited financial information. The final amended Rule continues to require these disclosures.

3. The economic effect of the rule

At every stage of the Rule amendment proceeding, the Commission solicited comment on the economic impact of the Rule, as well as the costs and benefits of each proposed Rule amendment. In finalizing the final amended Rule, the Commission has carefully weighed these costs and benefits, reducing compliance costs wherever possible. Thus, for example, part 436 reduces compliance costs by limiting the Rule’s scope of coverage to the sale of franchises to be located in the United States and its territories.[61]

In the same vein, part 436 of the final amended Rule reduces compliance burdens where the record establishes that the abuses the Rule is intended to address are not likely to be present. Thus, part 436 of the final amended Rule retains the exemptions in the original Rule as the ones for fractional franchises and leased departments. Part 436 of the final amended Rule also incorporates the Commission’s long-standing policies exempting from Rule coverage franchises covered by the Petroleum Marketing Practices Act, as well as instances where the only required payments made by the franchisee are for inventory at bona fide wholesale prices. Further, part 436 of the final amended Rule adds new exemptions for large investments of at least $1 million (excluding unimproved land and any amounts financed by the franchisor), investments by large franchisees with five years of business experience and $5 million net worth, and for franchise sales to company insiders who are already familiar with the company’s operations.

The Commission also has limited the required disclosures of part 436 in order to minimize compliance burdens. For example, the Commission has declined to adopt two UFOC Guidelines provisions on the grounds that such provisions are unnecessarily burdensome, without corresponding benefits to prospective franchisees. These provisions are mandatory risk factors (choice of law and venue) on the disclosure document cover page and the disclosure of franchise broker information in Items 2, 3, and 4 of the UFOC Guidelines.

Further, for each disclosure item, the Commission considered less costly disclosure alternatives. For example, part 436 of the final amended Rule requires the disclosure of franchisor-initiated litigation. In response to concerns raised by franchisor representatives, Item 3 of part 436 makes clear that this disclosure is limited to a one-year snap-shot in time and franchisors need only update the disclosure on an annual basis. Franchisors also can reduce costs by grouping similar franchisor-initiated suits under a single descriptive heading, in lieu of detailed summaries for each suit.

Similarly, the Commission has adopted in part 436 a narrow requirement to disclose independent trademark-specific franchisee associations. Franchisors must make this disclosure only if the franchisee association asks to be included in the franchisor’s disclosure document, and the association’s request must be updated on an annual basis.

Part 436 of the final amended Rule also reduces the franchisors’ burdens associated with making financial performance claims. Among other things, the original Rule specified that: (1) all financial performance claims must be geographically relevant to the franchise being offered for sale; and (2) all historical earnings data from existing franchisees must be presented using generally accepted accounting principles. Moreover, the original Rule required franchisors to disseminate financial performance information in a separate document. Part 436 of the final amended Rule eliminates these requirements.

Part 436 of the final amended Rule also promotes efficiency and reduces compliance costs by enabling franchisors to use their own judgment in deciding how to disseminate disclosure documents. For example, part 436 permits franchisors to furnish disclosures electronically through a variety of media, including CD-ROM, Internet website, and email. Individual sections of the disclosure document also allow more flexibility than the original Rule, again to promote efficiency and reduced compliance costs. For example, Item 5 permits franchisors to disclose either fixed fees or ranges of fees. Similarly, Item 11 permits franchisors to summarize computer system requirements, in lieu of more extensive disclosures.

In amending the Rule, the Commission has been guided by a preference for an approach that prohibits identified harmful practices and eschews burdensome affirmative compliance obligations that may only be warranted for some few unscrupulous actors. Thus, part 436 of the final amended Rule drops the original Rule’s across-the-board obligation to furnish disclosures early in the sales process—at the first personal meeting between the prospective purchaser and the franchise seller. Instead, part 436 of the final amended Rule allows greater flexibility, requiring that franchisors furnish disclosures early in the sales process only if the prospective franchisee requests them at that point. Similarly, part 436 of the final amended Rule eliminates burdensome waiting periods in some instances. Thus, in lieu of the original Rule’s mandate that all franchisors furnish copies of their completed franchise agreements at least five business days before execution, part 436 targets potential fraud directly by prohibiting a franchisor from failing to disclose unilateral changes to a franchise agreement seven days prior to its execution. As a final example, part 436 of the final amended Rule prohibits a franchisor from failing to furnish a copy of its most recent disclosure document and any quarterly updates to a prospective franchisee, upon reasonable request, before the prospect signs the franchise agreement. This prohibition is in lieu of suggestions that the Commission impose onerous disclosure updating obligations on an ongoing basis.

Finally, in numerous instances the Commission has rejected suggestions to impose certain additional requirements upon franchisors, and has opted instead to address the underlying issues that prompted those suggestions through redoubled consumer education efforts. For example, several commenters in the rulemaking record urged the Commission to expand the disclosure document to provide prospective franchisees with more general information about the nature of franchising. Others suggested more disclosure on post-termination obligations to third-party vendors, obligations to purchase from specific suppliers, and sources of financing, among others. While there is merit in their suggestions, the Commission has concluded that the appropriate vehicle Start Printed Page 15453to disseminate such information is through consumer education materials, not through the Rule itself. To that end, the cover page of the disclosure document set forth in part 436 of the final amended Rule references the Commissions’ Consumer Guide to Buying a Franchise, where such background information is furnished. This approach enables prospective franchisees to obtain desirable information without imposing new compliance burdens on franchisors.

4. Statement of prevalence

The Commission promulgated the original Rule based upon its finding of prevalent deception in the offer and sale of franchises and business opportunity ventures, leading to significant consumer injury. That finding retains its validity and the final amended Rule retains almost all of the original Rule’s disclosure requirements for both franchises and business opportunity sellers. In the franchise context, modifications of those requirements have been driven by four considerations: the goal of harmonizing the Rule with the UFOC Guidelines; the need to update the original Rule to address new technologies; to reduce unnecessary compliance burdens; and, based on the record developed here, to remedy prevalent nondisclosure on issues relating to the franchise relationship.[62]

This last category of modifications constitutes the most significant additions to the original Rule. Throughout the Rule amendment proceeding, franchisees have complained repeatedly about various practices in franchising that they believe are abusive. These practices include encroachment of territories, source of supply restrictions, modification of franchise agreements upon renewal, and the use of confidentiality clauses to prevent franchisees from speaking with prospects. To address these issues, franchisees urged the Commission to promulgate a substantive franchise relationship law. As detailed above in Section I.C., the applicable legal standard that could theoretically support promulgation of such a law has not been met. Nonetheless, the Commission is persuaded by evidence in the record that nondisclosure of material information about franchise relationships is prevalent and the record supports additional disclosures that will help obviate deception of prospective franchisees.

To that end, part 436 of the final amended Rule adopts a few new disclosures that provide prospective franchisees with material information about the quality of the franchise relationship or with sources of information about such relationships. For example:

  • In section 436.5(c), the Item 3 requirements to disclose information about franchisor litigation have been amended to encompass franchisor-initiated litigation, such as suits to collect royalty payments, in order to ensure prospective franchisees have material information about the nature of the franchisor’s relationship with its franchisees;[63]
  • In section 436.5(l), the Item 12 requirements to disclose information about territories contain a new warning to prospective franchisees about the consequences of not having an exclusive territory— that, as a result of having no exclusive territory, the franchisee “may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control;”
  • In section 436.5(q), the Item 17 requirements to disclose information about renewal of the franchise mandate that a franchisor describe what the term “renewal” means for its system, and state what has been absent from disclosure to date—that franchisees will be required to sign a different agreement when renewing, as opposed to extending the term of their original agreement.

These new disclosure requirements are tailored to address the prevalent franchisor nondisclosure of material information that prospective franchisees need to avoid forming the kind of misconceptions about these three key aspects of the franchise relationship that have prompted the franchisee complaints noted in this record.

III. SECTION-BY-SECTION ANALYSIS OF PART 436

A. Section 436.1: Definitions

In many instances, the part 436 definitions of the final amended Rule are substantively similar to those contained in either the original Rule or UFOC Guidelines. These include the terms: “affiliate,” “fiscal year,” “fractional franchise,” “franchise,” “franchisee,” “franchisor,” “leased department,” “person,” “prospective franchisee,” and “sale of a franchise.” Part 436 of the final amended Rule, however, adds several new definitions to the original Rule, including the terms: “action,” “confidentiality clause,” “disclose, state, describe, and list,” “financial performance representation,” “franchise seller,” “parent,” “plain English,” “predecessor,” “principal business address,” “required payment,” “signature,” “trademark,” and “written.” At the same time, part 436 of the final amended Rule eliminates four of the original Rule’s terms, and their definitions, that are no longer necessary: “business day,”[64] “time for making of disclosures,”[65] “personal meeting,”[66] and “cooperative association.”[67]

Section 436.1 of the final amended Rule is very similar to the corresponding section of the proposed Rule published in the Franchise NPR, but makes the following revisions: (1) substitutes a definition of “confidentiality clause” for the definition of “gag clause;” (2) omits proposed definitions of “Internet,” “officer,” and “material;” and (3) makes non-substantive revisions to improve readability, organization, and precision throughout, as well as some substantive revisions in response to the comments. The following sections discuss each definition of part 436 of the final amended Rule.

1. Section 436.1(a): Action

Consistent with the original Rule,[68] section 436.5(c) of the final amended Start Printed Page 15454Rule requires a franchisor to disclose certain legal actions involving the franchisor and its directors and officers. The original Rule did not define the term “action.” Section 436.1(a) in the final amended Rule is nearly identical to the definition proposed in the Franchise NPR, and closely tracks the UFOC Guidelines’ definition of the term “action.”[69] That definition is: “Action includes complaints, cross claims, counterclaims, and third-party complaints in a judicial action or proceeding, and their equivalents in an administrative action or arbitration.”[70] The definition differs from the UFOC Guidelines definition only in that it refers to a “judicial action or proceeding,” in lieu of just a “judicial proceeding.” This modification addresses one commenter’s observation that some states may retain the distinction between an “action” at law and a “proceeding” in equity.[71] Clearly, both types of legal matters must be disclosed.

The Commission has declined to adopt an additional suggestion that “complaints” referred to in the definition of “action” be limited to “served complaints.”[72] Such a narrowing of the definition of “action” would be inconsistent with the UFOC Guidelines. Moreover, it would effectively enable a franchisor to avoid disclosing potentially material litigation, even though it had notice of an action, merely because it was not served with the papers yet or had successfully avoided service of process. In the Commission’s law enforcement experience, it is not uncommon for defendants to know that a Commission action was filed prior to service either by learning of the suit from co-defendants or as a result of an asset freeze.[73]

In the same vein, IL AG suggested that the term “action” should refer to both “ filed” and “served” complaints.[74] A reference to “filed complaints” is unnecessary, however, and would be inconsistent with the UFOC Guidelines: the definition of action already refers to “complaints . . . in a judicial action or proceeding” and “complaints . . . in . . . an arbitration,” meaning that a complaint has already been filed. Accordingly, the Commission declines to adopt these additional revisions to the definition of “action.”

2. Section 436.1(b): Affiliate

Many of the part 436 disclosures pertain to both the franchisor and its affiliates.[75] The original Rule defined the term “affiliated person” to mean a person:

(1) Which directly or indirectly controls, is controlled by, or is under common control with, a franchisor; or (2) Which directly or indirectly owns, controls, or holds with power to vote, 10 percent or more of the outstanding voting securities of a franchisor; or (3) Which has, in common with a franchisor, one or more partners, officers, directors, trustees, branch managers, or other persons occupying similar status or performing similar functions.[76]

Section 436.1(b), like the corresponding definition in the proposed Rule, harmonizes federal and state law, closely following the UFOC Guidelines by defining “affiliate” to mean: “an entity controlled by, controlling, or under common control with, another entity.”[77] This is slightly broader than the UFOC Guidelines’ definition, however. The UFOC Guidelines’ definition uses the narrower term “franchisor” in place of “another entity.” This slight departure from the UFOC Guidelines is necessary for the “large franchisee” exemption, section 436.8(a)(5)(ii), as discussed below in the section covering that exemption.[78]

3. Section 436.1(c): Confidentiality clause

Part 436 of the final amended Rule requires franchisors for the first time to disclose the use of confidentiality clauses that prohibit or restrict existing or former franchisees from discussing their experience with prospective franchisees.[79] Accordingly, section 436.1(c) of the final amended Rule adds to the original Rule definitions the term “confidentiality clause,”[80] defined as follows:

any contract, order, or settlement provision that directly or indirectly restricts a current or former franchisee from discussing his or her personal experience as a franchisee in the franchisor’s system with any prospective franchisee. It does not include clauses that protect a franchisor’s trademarks or other proprietary information.

As explained below, the confidentiality clause disclosure requirement is intended to prevent deception in the offer and sale of franchises by assisting prospective franchisees in verifying a franchisor’s claims. Specifically, this disclosure requirement is tied to the requirement to disclose contact information for existing franchised outlets.[81] Knowing that a franchisor uses a confidentiality clause enables prospective franchisees to understand that a former or current franchisee may be prohibited from speaking about his or her experience and will make efforts to contact other former or current franchisees not subject to such a clause. This being the disclosure’s purpose, the operant definition is limited to confidentiality clauses impinging on communications between current or former franchisees and prospective franchisees only.[82] It would not cover clauses that prohibit communications between current or Start Printed Page 15455former franchisees and, for example, the media.

After carefully considering the comments, the Commission has rejected suggestions to limit the definition of confidentiality clause to cover only broad clauses that prohibit all communications by current or former franchisees[83] or only circumstances where all or at least 20% of franchisees are under speech restrictions.[84] These suggestions are narrower than necessary and would defeat the very purpose of the confidentiality clause disclosure. Moreover, as stated throughout this document, the Commission favors bright-line standards that enable franchisors, prospective franchisees, and law enforcers to know when a Rule provision applies without resort to fact-finding. In this instance, the parties should know whether the confidentiality clause is applicable without having to first determine the exact number of franchisees under speech restrictions at any given period.

Finally, the definition expressly excludes confidentiality agreements designed to protect proprietary information. Many commenters—both franchisor and franchisee representatives alike—agreed that proprietary information should be exempted from the definition because a franchisor has a reasonable and legitimate concern about protecting its trademark and business secrets.[85] One commenter suggested that the Commission make clear that the existence of a confidentiality agreement cannot be considered “proprietary information.”[86] Otherwise, according to this commenter, a franchisor could attempt to circumvent the confidentiality agreement disclosure by having a prospective franchisee sign an agreement stating that the existence of a confidentiality agreement is itself “proprietary.” The Commission, however, intends that the term “proprietary information” be limited to trade secrets and intellectual property, the type of information that, if disclosed, would put a franchisor at a competitive disadvantage.

4. Section 436.1(d): Disclose, state, describe, and list

Section 436.1(d) sets forth the definition of the terms “disclose,” “state,” “describe,” and “list,” which are used throughout part 436. This is another definition not contained in the original Rule. The proposed definition published in the Franchise NPR was taken from the UFOC Guidelines, stating that these terms mean “to present all material facts accurately, clearly, concisely, and legibly in plain English.”[87]

The Commission is persuaded that franchisors should have flexibility in presenting their disclosures, provided that the disclosures are clear and legible. The Staff Report recommended that franchisors should be required to make disclosures in at least 12 point upper and lower case type.[88] This recommendation generated two comments, however, asserting that the Commission should not mandate 12 point type. The commenters noted that 12 point type may result in some of the Rule’s charts being split into two sections. They suggested that smaller fonts, especially in charts, can be very readable and result in reduced compliance costs.[89] The Commission agrees. Accordingly, part 436 of the final amended Rule does not mandate any specific font size: franchisors may choose any font size, provided that their disclosures are clear and likely to be noticed, read, and understood by a reasonable prospective franchisee.

Two additional Staff Report commenters sought refinements to section 436.1(d), as proposed therein. One commenter opined that the definition could be interpreted to mean that a franchisor must disclose “every material fact regarding the offered franchise, rather than disclosing all material facts pertaining specifically to the disclosures required pursuant to the Rule.”[90] The Commission believes that this reading of the definition is strained and expressly notes that it does not intend such a reading. Throughout the final amended Rule, the topic on which the franchisor is required to “present all material facts accurately, clearly, concisely, and legibly in plain English” is clear. Moreover, nothing in the record suggests that a virtually identical definition in the UFOC Guidelines has generated the problems anticipated by this commenter. This being the case, the Commission is disinclined to deviate from the UFOC Guidelines on this issue. Therefore, the Commission adopts the definition as quoted above.

Another commenter urged that the definition specify that the meaning of “disclose,” “state,” “describe,” and “list” incorporates the concept that the language must be “understandable by a person unfamiliar with the franchise business.”[91] The Commission believes that the final amended Rule’s definition of “plain English” in section 436.1(o) gives more direction to franchisors in preparing their disclosures than the more general phrase “understandable by a person unfamiliar with the franchise business.” Therefore, we decline to adopt this suggestion.

Finally, we note that three commenters urged the Commission to define separately the term “material.”[92] In particular, they asserted that it is unclear whether materiality should be determined from the franchisor’s or the prospective franchisee’s viewpoint. For example, isolated instances of franchisee-initiated lawsuits might not be material to a franchisor (i.e., not affecting the franchisor’s financial status), but could be highly material to a prospective franchisee seeking information on the quality of the franchise relationship.[93]

The original Rule defined “material, material fact, and material change.”[94] The Commission, however, believes that such definitions are not necessary. An understanding of materiality under the final amended Rule can best be gained by looking to long-established Commission jurisprudence. “Materiality” is a cornerstone concept of that jurisprudence. To be clear on this important point, the Commission, when interpreting Section 5, regards a representation, omission, or practice to be deceptive if: (1) it is likely to mislead consumers acting reasonably under the circumstances; and (2) it is material; that is, likely to affect consumers’ conduct or decisions with respect to the product at issue.[95] Accordingly, it is amply clear that “materiality” is determined by the reasonable consumer standard, or in franchise matters, by the reasonable prospective franchisee standard. Moreover, since violations of the Franchise Rule constitute violations of Section 5, we believe that the Section Start Printed Page 154565 deception jurisprudence provides adequate guidance on what the term “material” means in the Franchise Rule context.

5. Section 436.1(e): Financial performance representation

This section of part 436 defines the term “financial performance representation” to mean:

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. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables.[96]

This definition comes into play in one of the most important sections of the final amended Rule, section 436.5(s), corresponding to Item 19 of the UFOC Guidelines. Like Item 19, it governs the making of financial performance representations.[97] The definition incorporates the original Rule’s approach, in that it specifies that a financial performance representation may be in an “oral, written, or visual” format.[98] To ensure that part 436 covers implied financial performance representations, the definition also refers to financial performance representations that are made both “expressly or by implication.”[99] It also retains the original Rule’s reference to financial performance representations made in the general media.[100] At the same time, section 436.1(e) adopts several aspects of the UFOC Guidelines definition, including references to “actual” and “potential” performance (to capture both historical financial performance and projections),[101] as well as the use of charts, tables, and mathematical calculations.[102]

Two aspects of the definition of the term “financial performance representation” generated significant comment: whether the Commission should treat information about costs and expenses as financial performance representations;[103] and whether the Commission should interpret the definition’s express inclusion of any “representation in the general media” to include all financial information available on a franchisor’s website or through a franchisor’s speeches and press releases.[104] Each of these interpretive issues is discussed in the sections immediately below.

a. Treatment of cost and expense information

In the Franchise NPR, the Commission made it clear that the section 436.1(e) definition of “financial performance representation” is not intended to reach disclosures of expense information, and specifically sought comment on this issue.[105] Most commenters who responded on this issue felt that disclosures of expense information should not fall within the definition.[106] Some, however, sought additional clarification. For example, the IL AG urged the Commission to modify the definition of “financial performance representation” to expressly exclude expense disclosures mandated in Items 5-7 of the final amended Rule (initial fees, ongoing costs, and initial investment), offering the following additional sentence: “Expenses required in Items 5, 6, and 7 of the disclosure document are not to be considered performance claims and do not contradict Item 19 requirements.”[107] Others went further, arguing that the dissemination of any expense information should not trigger the Item 19 disclosure requirements.[108]

Start Printed Page 15457

Notwithstanding language to the contrary in the original Interpretive Guides,[109] the Commission is persuaded that expense information alone is insufficient to enable prospective franchisees to gauge their potential earnings with any degree of specificity that could rise to the level of a financial performance claim.[110] The Commission explained in the Franchise NPR and now reiterates here that mere disclosure of cost information does not, in its view, constitute a financial performance representation triggering Item 19 disclosure obligations. The Commission intends that the explanation that mere expense disclosures alone do not constitute a financial performance representation, coupled with the deliberate omission of any mention of expense information from section 436.1(e) of the final amended Rule, will be enough to address this issue.

b. General media claims

Section 436.1(e) of the final amended Rule retains the original Rule’s provision governing the making of financial performance representations in the general media. Under the original Rule, a general media financial performance representation, like all other financial performance representations, must have a reasonable basis and state the number and percentage of outlets earning the claimed amount, among other substantiation and disclosure requirements.[111] There is no comparable provision in the UFOC Guidelines.[112]

In the Franchise NPR, the Commission proposed that the term “financial performance representation” should broadly include the dissemination of financial performance information via the Internet.[113] The majority of commenters who addressed this issue, however, questioned whether financial performance information posted online should constitute “financial performance representations,” thus triggering the Rule’s disclosure and substantiation requirements.[114] These commenters asserted that the Commission should not deem financial performance information posted on a franchisor’s website to be financial performance representations under the Rule, unless the information is located in a section of a website that solicits franchise purchasers or otherwise specifically targets prospective franchisees.[115] In their view, financial performance information on a franchisor’s website—including links to press releases, interviews, or articles—is intended to educate the general public about the company, rather than to attract prospective franchisees.[116] Indeed, some posted information may consist of copies of publicly filed reports, such as 10-Qs and 10-Ks, that are submitted to the SEC.[117] At least one commenter feared that equating online financial performance information with financial performance representations under the Rule would have a chilling effect, unreasonably restricting the kinds of materials a franchisor could have on its website: “Does this mean that a franchise company, unlike any other business, must choose between taking advantage of articles or press releases about itself on its own web site page or risk the claim that a prospective franchisee has been given unauthorized non-Item 19 financial data?”[118]

Two Staff Report commenters broadened this argument beyond the online context to encompass franchisors’ speeches and news releases. In the Interpretive Guides, the Commission described “general media” broadly to include: “advertising (radio, television, magazines, newspapers, billboards, etc) as well as those contained in speeches or press releases.”[119] David Kaufmann, for example, asserted that the inclusion of speeches and news releases harms franchisors by making it difficult for them to disseminate financial performance information in “speeches, press interviews, and other forums not specifically geared to the franchise sales process.”[120] He urged the Commission to permit franchisors and their executives to disseminate financial performance information to the public freely, unless copies are subsequently used in the franchisor’s franchise marketing effort.

Based upon the comments, the Commission is persuaded that it is unwarranted to sweep broadly into the part 436 definition of “financial performance representation” all financial performance information posted online or appearing in press releases or speeches. The dissemination of financial information online and in press stories and releases is for the benefit of more than prospective franchisees, including investors, potential suppliers, and members of the general public.[121] Further, the Commission believes that the commenters’ concerns are well-founded with respect to publicly filed reports required by the SEC. The Commission agrees that such filings are already publicly available and, more important, have indicia of reliability. Indeed, the dissemination of false financial data by publicly traded franchisors is already illegal. Thus, to impose the Rule’s substantiation and disclosure requirements with respect to SEC filing Start Printed Page 15458would be pointless, unworkable, and unduly burdensome.

With respect to the dissemination of other financial performance information, the Commission believes that a distinction should be made between information disseminated in advertisements directed at franchisees—be it in print, radio, television, or Internet—and information disseminated to the general public. We are convinced that deeming financial performance information disseminated publicly to be “financial performance representations” under the Rule would have a chilling effect, discouraging franchisors from furnishing truthful information to the public. However, where a franchisor utilizes financial performance information disseminated, or intended to be disseminated, to the general public in its franchise promotional materials (e.g., in a brochure or franchisee section of a website), includes in its franchise promotional materials a reference to general financial information on its website, or otherwise repeats the general financial information to prospective franchisees (such as in a face-to-face meeting with an audience of prospective franchisees), such information will be deemed “financial performance representations,” triggering part 436’s disclosure and substantiation requirements.[122]

The Commission anticipates that staff will address the narrowed scope of general media financial performance representations in the Compliance Guides. This is consistent with the approach historically adopted, whereby the Commission explained the scope of general media claims in the Interpretive Guides, providing illustrative examples and more detailed discussion than is possible in the text of the Rule itself. As an initial matter, the Commission anticipates that staff will retain in the Compliance Guides the original Interpretive Guides’ determination that communications about financial performance made to the trade press and directly to lenders do not constitute general media financial performance representations.[123] At the same time, the Commission anticipates that staff will add SEC filings, speeches, and news releases to the list of communications not constituting financial performance representations under the final amended Rule. There is one important caveat, however. Where the franchisor directs the speeches or news releases to prospective franchisees or uses copies of speeches or news releases in marketing materials aimed at prospective franchisees, then such materials will constitute general media financial performance representations under the Rule.

6. Section 436.1(f): Fiscal year

Several Rule disclosures are based upon the franchisor’s fiscal year.[124] Section 436.1(f) retains the original Rule definition of the term “fiscal year,” making clear that it “refers to the franchisor’s fiscal year.”[125] This issue generated no comment.

7. Section 436.1(g): Fractional franchise

Section 436.1(g) of the final amended Rule adopts the definition of the term “fractional franchise” that was proposed in the Franchise NPR with only minor language changes to improve clarity. This definition comes into play in section 436.8(a)(2) of the final amended Rule, which retains the original Rule’s exemption for fractional franchises.[126] In most instances, the fractional franchise exemption arises where an existing business seeks to expand its product line through a franchise meeting two criteria: (1) the franchisee or its principals have more than two years of experience in the same line of business; and (2) the parties reasonably expect that the franchisee’s sales from the new line of business will not exceed 20% of its total sales.[127]

Section 436.1(g) clarifies the scope of the original “fractional franchise” exemption by adding greater precision and specificity.[128] First, it incorporates the Commission’s long-standing policy that the parties must “anticipate that sales arising from the relationship will not exceed 20% of the franchisee’s total volume in sales during the first year of operation.”[129] Second, it makes explicit what previously has been only implied: that the parties must have “a reasonable basis” to assert the exemption.[130]

During the Rule amendment proceeding, a few commenters suggested that the Commission broaden the fractional franchise exemption. Two commenters urged the Commission to broaden the first prong of the fractional franchise exemption —“experience in the same type of business”—to exempt franchisees with experience in the same industry or selling similar or complementary goods or services.[131] The suggestion that the exemption be broadened to “experience in the same industry” goes far beyond the underlying rationale that supports the fractional franchise exemption—namely, the notion that prior experience in the same line of business reduces the likelihood of fraud or deception because the fractional franchisee likely will be familiar with the products to be offered for sale through the franchise relationship.

The Commission does not believe that a franchisee in any particular economic sector necessarily has sufficient experience to operate a different franchise within the same sector. For example, we would not necessarily expect a muffler shop franchisee to automatically understand the financial risks of operating a quick-lube service station, although both operations are in the automotive repair industry. Nor would we expect a franchisee operating a small fast-food kiosk in a mall to necessarily appreciate the risks of operating a large, sit-down full-service restaurant, although both are in the food service industry.

Nevertheless, the Commission has never required experience in the identical type of business. Rather, the sale of similar goods may qualify for the exemption. As explained in the current Start Printed Page 15459Interpretive Guides, “the required experience may be in the same business selling competitive goods or in a business that would ordinarily be expected to sell the type of goods to be distributed under the franchise.”[132] This approach is reasonable because a prospective franchisee who is already familiar with the goods or services of the franchise can better assess the financial risk involved in entering into a relationship with the franchisor.

Our reluctance to expand the fractional franchise exemption also holds true with respect to the sale of “complementary goods.” What may be viewed as “complementary goods” in any particular line of business may be quite subjective. For example, reasonable minds may differ whether the introduction of ice cream sales at a donut/coffee shop is “complementary.” While certain products may make complementary sales combinations—such as ice cream and donuts—it does not necessarily follow that a donut shop franchisee is experienced with the risks involved with marketing and selling ice cream.

While the Commission declines to revise the Rule to broaden the types of experience needed to qualify for the fractional franchise exemption, we agree that the exemption should be expanded with respect to the types of individuals whose experience can qualify for the exemption.

The original definition specified that, in determining whether a relationship qualified as a the fractional franchise exemption, a franchisor could consider the prior experience of the franchisee “or any of the current directors or executive officers thereof.”[133] Marriott recommended that the prior experience of an officer or director of an affiliate or parent of the franchisee should also be deemed a sound basis for the “experience” prong of the definition. Marriott noted that the Staff Report recommended the same approach in connection with the prior experience prerequisite of the “large franchisee” exemption.[134]

We are persuaded by Marriott’s arguments that a broad reading of the fractional franchise exemption is warranted when determining which individuals may qualify as having the requisite prior experience. The principal factor in applying the fractional franchise exemption of part 436 is whether the business seeking to expand can obtain practical guidance and direction from someone within the business with prior experience. It makes little difference whether the business can call upon its own directors or officers for guidance or whether the business can call upon those of a subsidiary, as long as those individuals have prior experience in the same line of business. As in the large franchisee exemption, we recognize that franchisors may establish subsidiaries for limited liability or tax purposes. In such instances, the operations of the franchisor and its subsidiaries are likely to be close, such that the prior experience of one is available to help direct the business decisions of the other. We believe the same is no less true in the fractional franchise context.

Finally, one commenter, focusing on the second prong of the fractional franchise exemption, recommended that any franchise arrangement that accounts for less than 25% of the franchisee’s business in the next year should be exempt from the Rule, even if the fractional franchisee has had no prior experience with the products or services being added to his or her product line.[135] In short, this commenter would delete the prior experience prong from the fractional franchise definition. We reject this suggestion.

The Commission believes that prior experience is a necessary component of the fractional franchise exemption. A business owner seeking a new opportunity is no different from a novice when it comes to entering into a type of business with which he or she is unfamiliar.[136] It is precisely in such circumstances that the prospective franchisee needs the material disclosures the Rule affords in order to make an informed decision whether to invest in the opportunity. What distinguishes a fractional franchisee from novices and business owners generally is that the fractional franchisee has prior experience with the goods and services being offered for sale, and thus is less in need of the Rule’s protections. Indeed, the record is devoid of any data from which we could conclude that ongoing businesses seeking to expand into unfamiliar areas do not continue to need the Rule’s protections. Accordingly, we believe retaining the prior experience prerequisite for the fractional franchise exemption is a sound approach.

8. Section 436.1(h): Franchise

The original Rule defined “franchise” broadly to encompass both franchises and business opportunity ventures. A franchisor was covered by the original Rule if it represented that the business arrangement it offered entailed the following three elements: (1) permission to use the franchisor’s trademark; (2) significant franchisor control over the franchise operation or significant franchisor assistance to the franchisee; and (3) a required payment from the franchisee to the franchisor.[137] Similarly, a business opportunity seller was covered by the original Rule if the seller represented that the business arrangement it offered entailed: (1) supplying the buyer with goods or services to market to the public; (2) providing location assistance or accounts for vending machines or other equipment; and (3) charging a required payment from the opportunity purchaser.[138]

Like the proposed section 436.1(h) published in the Franchise NPR, this section of the final amended Rule focuses exclusively on franchise sales, eliminating the business opportunity section of the definition. The amended definition is also more precise than the original definition. Specifically, the amended definition clarifies two issues that the Commission’s Rule enforcement experience suggests are not well understood: (1) that a business relationship will be deemed a franchise if it satisfies the three elements of a franchise, regardless of the nomenclature used to label or describe it;[139] and (2) that a business relationship will be deemed a franchise if the franchisor represents that the relationship being offered has the characteristics of a franchise, regardless of any failure on the franchisor’s part to perform as promised.[140]

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Early in the Rule amendment proceeding, a few commenters offered suggestions for modifying the definition of “franchise.” For example, one commenter urged the Commission to adopt the states’ definition of the term “franchise.”[141] However, there is no single state definition of the term “franchise.”[142] Nevertheless, the Rule’s definition is entirely consistent with the principles underlying the various state definitions, and the Commission concludes that there is no persuasive argument to modify the definition further.

Another commenter voiced concern over the Commission’s policy that a business relationship will be deemed a franchise “if it is offered or represented as having the characteristics of a franchise, irrespective of whether or not the relationship independently meets the actual . . . definition of a franchise.”[143] He stated that such an approach would be a mistake, “raising the form of a description of a business relationship to a level which would control over the actual substance of the relationship.”[144]

There are two distinct issues here: (1) whether the Rule should apply to a business relationship that the parties call a “franchise,” even if the relationship does not satisfy the three definitional elements of a franchise; and (2) whether the Rule should apply to a business relationship that is represented as satisfying the three definitional elements of the term “franchise,” even if the relationship, in fact, does not satisfy those elements—e.g., because of the seller’s non-performance. The commenter correctly asserted that the Rule should not cover situations where the parties mistakenly use the term “franchise” to describe their business relationship. A business relationship constitutes a franchise only if, as promised or represented, it satisfies the three elements of the term “franchise,” and nothing in the “franchise” definition is to the contrary.

The clarification in the amended definition addresses the second issue—whether representing a business relationship as satisfying the three definitional elements of the “franchise” definition (as opposed to merely calling a relationship a franchise) is sufficient to bring a business relationship under the Rule. The original Rule took the position that it was sufficient, and the Commission believes that position remains sound.[145] A prospect seeking to purchase an opportunity that is represented as being a franchise should receive a disclosure document in order to make an informed investment decision. The prospect should not have to investigate whether or not the seller, post-sale, actually delivers a franchise or some other type of opportunity. For example, a start-up company may seek to sell its first franchised outlet, advertising that, for a $500 fee, it will license its mark and provide significant assistance to buyers. Under these circumstances, a prospect should receive a disclosure document before the sale because, as represented, the business offered satisfies each of the three elements of a franchise. This is true, even if the franchisor, in fact, lied and has no ability to perform as promised, such as having no right to the trademark offered or having no staff to provide promised assistance, facts that may only be discovered by the purchaser post-sale. In short, the seller should not be able to raise as a defense to a post-sale Rule violation that it, in fact, offered a non-franchise business arrangement if, at the time of sale, its representations about the business satisfied the definition of a franchise.[146]

9. Section 436.1(i): Franchisee

The original Rule defined “franchisee” as: “any person (1) who participates in a franchise relationship as a franchisee . . . or (2) to whom an interest in a franchise is sold.”[147] The definition proposed in the Franchise NPR was “any person who is granted an interest in a franchise.” Section 436.1(i) of the final amended Rule adopts an even more precise version: “Franchisee means any person who is granted a franchise.”[148] This narrowing of the definition is in response to commenters who voiced concern that the phrase “an interest in a franchise” is too broad, arguably sweeping in shareholders of publicly traded companies and other investors.[149] The amended definition’s focus on the granting of a franchise (as opposed to an interest in a franchise) is also consistent with the states’ approach, thereby reducing unnecessary inconsistencies.[150]

10. Section 436.1(j): Franchise seller

Section 436.1(j) of the final amended Rule defines the term “franchise seller.” This term and its definition are needed in order to delineate easily all parties subject to one or more provisions of the final amended Rule.[151] Consistent with Start Printed Page 15461long-standing Commission policy, the definition also makes explicit that an individual franchisee seeking to sell his or her own outlet is excluded from Rule coverage:[152]

Franchise seller means a person that offers for sale, sells, or arranges for the sale of a franchise. It includes the franchisor and the franchisor’s employees, representatives, agents, subfranchisors, and third-party brokers who are involved in franchise sales activities. It does not include existing franchisees who sell only their own outlet and who are otherwise not engaged in franchise sales on behalf of the franchisor.

The definition incorporates several suggestions submitted during the Rule amendment proceeding. First, the definition expressly includes “subfranchisors,” a category of franchise sellers not mentioned in the Franchise NPR’s proposed definition of “franchise seller.”[153] The inclusion of subfranchisors in the definition is entirely consistent with current Commission policy[154] and the UFOC Guidelines.[155]

Second, the definition narrows the express exclusion of sales of a franchise by an existing franchisee. One commenter noted that this exclusion should apply only in those situations where an existing franchisee transfers ownership in his or her franchise to a purchaser without any continuing obligation to the purchaser. He suggested that the Rule make clear that the exclusion does not apply where an existing franchisee is engaged in repeated franchise sales.[156] The Commission agrees. If an existing franchisee engages in repeated franchise sales, he or she will be covered by the final amended Rule as either the franchisor’s agent, broker, or subfranchisor. To clarify this point, the definition narrows the existing franchisee exemption to those existing franchisees “who are otherwise not engaged in franchise sales on behalf of the franchisor.”[157]

Finally, the definition addresses one commenter’s concern that the term “franchise seller” should exclude a franchisor’s employees who are not actively involved in franchise sales.[158] We agree. To that end, the definition makes clear that the franchisor’s employees, representatives, agents, subfranchisors, and third-party brokers are covered only if they “are involved in franchise sales activities.”

The Commission has considered, but declines to adopt, two additional suggestions with respect to the “franchise seller” definition. J&G suggested that the Commission define the term “broker” in the Rule itself and proposed the following, narrow definition: individuals who: (1) are not employed by franchisors or subfranchisors; (2) are compensated pursuant to a written agreement for qualifying prospects; and (3) are active participants in the sales process.[159] The commenter also proposed that the definition specifically exclude certain individuals who arguably might be involved in a franchise sale, including franchisees,[160] trade show promoters, website owners, the mass media, or others who may be paid for referrals, but “who do not spend more than an hour with a prospective franchisee, or engage in substantive discussions with a prospective franchisee about the terms of a franchise agreement.”[161]

The Commission believes that a separate definition of the term “broker” is unnecessary in part 436. In the original Rule, franchise brokers were jointly and severally liable with franchisors to prepare and to furnish prospective franchisees with disclosure documents.[162] In contrast, under part 436 of the final amended Rule, brokers are no longer obligated to prepare or to furnish disclosure documents, as explained later in this document. The preparation and distribution of the disclosure document is the sole responsibility of the franchisor. Rather, coverage of brokers under the final amended Rule is limited to prohibitions.[163] For example, any franchise seller, including brokers, cannot make statements that are inconsistent with those found in the franchisor’s disclosure document.[164] Because brokers are no longer liable for the preparation and distribution of disclosure documents and the term “broker” does not appear in the final amended Rule outside the definition of “franchise seller,” no separate definition of the term “broker” is warranted.

In a similar vein, Frannet, a franchise referral company, urged the Commission to distinguish between franchise brokers and middlemen. The company agreed that anyone who sells franchises should be included in the definition of a franchise seller.[165] According to Frannet, middlemen or finders who just arrange for prospects to meet franchisors—but do not negotiate price or terms for the franchisor, or sign franchise agreements on behalf of a franchisor—should not be deemed brokers.

With respect to “brokers,” we reject the suggestion that brokers are distinguishable from middlemen or finders. When promulgating the original Rule, the Commission defined the term “broker” broadly to mean “any person other than a franchisor or a franchisee who sells, offers for sale, or arranges for the sale of a franchise.”[166] Similarly, in the original SBP, the Commission clarified that a broker acts on behalf of a franchisor and receives compensation for arranging a franchise sale.[167] The term “broker,” therefore, has not been limited to those persons who negotiate contract terms or sign franchise agreements and accept payments on behalf of a franchisor.[168]

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The Commission declines to follow a different approach in adopting the final amended Rule. As noted above, the final amended Rule prohibits franchise sellers from engaging in certain conduct that may deceive prospective franchisees during the sales process. In order to prevent deceptive sales practices, the prohibitions section of the final amended Rule is broad, covering all persons engaged in sales activity. Accordingly, the Commission intends that the term broker in the “franchise seller” definition to mean a person who: (1) is under contract with the franchisor relating to the sale of franchises; (2) receives compensation from the franchisor related to the sale of franchises; and (3) arranges franchise sales by assisting prospective franchisees in the sales process.[169]

11. Section 436.1(k): Franchisor

The original Rule defined “franchisor” as: “any person who participates in a franchise relationship as a franchisor, as denoted in paragraph (a) of this subsection.”[170] The final amended Rule streamlines the original definition: “any person who grants a franchise and participates in the franchise relationship.”[171] Consistent with the UFOC Guidelines, the definition also makes clear that, “[u]nless otherwise stated, it includes subfranchisors.”[172]

In considering revisions to the “franchisor” definition, the Commission has rejected three additional suggestions. First, one commenter opined that it is unclear whether the phrase “and participates in the franchisor relationship” is intended to modify “any person who grants a franchise,” or is intended to include persons other than those who grant a franchise. She urged the Commission to revise the definition narrowly to mean the person who signs the agreement granting a franchise.[173]

The commenter’s suggested change is unwarranted. The two definitional phrases are read conjunctively. To be considered a “franchisor,” a person must satisfy two definition elements: (1) granting a franchise; and (2) participating in the franchise relationship. Further, the second definitional element—participating in the franchise relationship—is necessary to distinguish a franchisor (who has post-sale performance obligations), from others involved solely in the initial franchise sales process (such as a broker). Indeed, this commenter’s proposed substitute definition could inappropriately sweep within the definition of “franchisor” third-party brokers or other agents who are authorized by the franchisor to sign the franchise agreement, but who have no post-sale performance obligations. We therefore decline to adopt this suggestion.

Second, NASAA urged the Commission to expand the definition to include shareholders of privately-held corporations.[174] Although NASAA did not elaborate, its suggestion is apparently designed to make it easier to hold owners of closely-held corporations liable for violations of the final amended Rule. We do not believe, however, that a mere showing that an individual is a shareholder in a privately held corporation can suffice, without more, as a legal basis for subjecting that individual to liability to pay potentially significant civil penalties or consumer redress[175] for Rule violations committed by the corporation or those actively in control of it. At any rate, where warranted, the Commission’s enforcement experience indicates no difficulty in proving up the necessary level of participation in the violative conduct to justify civil penalties, or the requisite control over the corporation and knowledge of its violative activity to justify recovery of consumer redress. We therefore decline to adopt NASAA’s suggestion on this issue.

12. Section 436.1(l): Leased department

The final amended Rule retains the original Rule’s exemption for leased department arrangements.[176] A leased department is created when a retailer rents space from a larger retailer in order to conduct business. For example, a jeweler may rent space from a department store to sell jewelry and watches. Technically, this relationship may be a franchise because the jeweler becomes associated with the department store’s trademark, and the department store may impose what arguably could be considered control over the operation, such as operating hours. As noted in the original SBP, these types of relationships need not be protected by the Rule because the likelihood of deception is not great, the retailer-lessee typically being experienced and able to assess the value of the location. Moreover, the risk is small because the retailer-lessee’s financial liability to the retailer-grantor is limited to rent.[177]

Section 436.1(l) of the final amended Rule defines the term “leased department” as:

an arrangement whereby a retailer licenses or otherwise permits a seller to conduct business from the retailer’s location where the seller purchases no goods, services, or commodities directly or indirectly from: (1) the retailer; (2) a person the retailer requires the seller to do business with; or (3) a retailer-affiliate if the retailer advises the seller to do business with the affiliate.[178]

No commenter raised any substantive concerns about the leased department exemption. One commenter, however, suggested that the Commission expand the definition of leased department to Start Printed Page 15463include “co-branding” arrangements.[179] Co-branding, a relatively new marketing development in franchising, enables a franchisee to use the trademarks and sell the goods or services of more than one franchise system. For example, an outlet that sells Taco Bell foods might also sell Pizza Hut pizza, or a gasoline franchise, such as Shell, may operate an on-site Subway Shop or 7-Eleven store.

The Commission declines to adopt this suggestion. The issue of Rule compliance in co-branded arrangements was raised in the ANPR[180] and discussed in detail at the staff’s New York public workshop conference on September 18, 1997. The ANPR commenters generally agreed that the current Rule and UFOC Guidelines are sufficient to address any deception issues that may arise in co-branded franchise arrangements. The same view was expressed by the participants at the New York workshop.[181] Indeed, no franchisee or state regulator voiced any concerns to the contrary.[182] Therefore, taken as a whole, the record does not support the need to adopt new rule provisions specifically addressing co-branding.[183]

13. Section 436.1(m): Parent

Section 436.1(m) of the final amended Rule defines the term “parent” as “an entity that controls another entity directly, or indirectly though one or more subsidiaries.” Several commenters suggested that because several Rule provisions address parent disclosures,[184] the Commission should expressly define that term.[185] Although the Rule proposed in the Franchise NPR did not define this term, the Commission believes this point is well-taken. Accordingly, part 436 of the final amended Rule expressly defines the term “parent.”[186]

One commenter suggested an alternative definition: “Parent means an entity that directly or indirectly has an 80% or greater ownership interest in the franchisor.”[187] The commenter, however, did not state the basis for his recommendation. Indeed, in promulgating the original Rule, the Commission did not adopt an ownership test, but focused on control.[188] We believe that is the proper approach.[189] It is the control and resulting influence over the direction of the franchisor—not mere ownership—that is material to a prospective franchisee.

14. Section 436.1(n): Person

Section 436.1(n) of the final amended Rule retains the original Rule’s definition of the term “person”—“any individual, group, association, limited or general partnership, corporation, or any other entity.”[190] This is identical to the proposed version of this definition in the Franchise NPR. During the Rule amendment proceeding, a few commenters offered suggestions to modify the definition. Warren Lewis, for example, suggested that the Commission add the following to the definition: “An individual is not an entity.”[191] Mr. Lewis maintained that this change would make it clear throughout the Rule that “person” means an individual or business entity; while entity means only a business entity. As another example, IL AG and J&G suggested that the definition of “person” reference limited liability companies.[192]

The term “person” is defined in many Commission rules, as referring to a party, regardless of whether the party is an individual, organization, or business entity.[193] Where necessary, the rule text distinguishes between parties by using the more specific terms—individual, organization, or entity. We believe that these more specific terms are clear, and, therefore, we need not distinguish between individuals and entities in the definition of “person,” as suggested. The Commission also finds that the term “entity” is sufficient to cover limited liability companies, as well as other forms of business arrangements.

15. Section 436.1(o): Plain English

Part 436 of the final amended Rule adopts the UFOC Guidelines requirement that disclosure documents be prepared in plain English.[194] Section 436.1(o) defines “plain English” as:

the organization of information and language usage understandable by a person unfamiliar with the franchise business. It incorporates short sentences; definite, concrete, everyday language; active voice; and tabular presentation of information, where possible. It avoids legal jargon, highly technical business terms, and multiple negatives.[195]

This definition is one of several features of the final amended Rule that are designed to preserve the integrity of Start Printed Page 15464disclosure documents. Application of these writing standards will enhance the legibility and understandability of disclosure documents, thereby reducing the likelihood of franchisee deception, confusion, or misunderstandings.

16. Section 436.1(p): Predecessor

Section 436.1(p) adopts the UFOC Guidelines’ definition of “predecessor” as: “a person from whom the franchisor acquired, directly or indirectly, the major portion of the franchisor’s assets.”[196] This definition comes into play in several substantive provisions of the final amended Rule, where the Commission is adopting the UFOC Guidelines requirement that franchisors disclose material information about their predecessors.[197] The original Rule did not require the disclosure of predecessor information. However, as discussed later in this document—in particular in connection with Item 3 litigation disclosures and Item 4 bankruptcy disclosures—predecessor disclosures are necessary to prevent fraudulent franchise sales.[198] Our law enforcement experience demonstrates that, in some instances, franchisors reincorporate under a new name as a simple way to avoid disclosing damaging information.[199] The disclosure of predecessor information will prevent such efforts to circumvent the final amended Rule.

17. Section 436.1(q): Principal business address

The final amended Rule requires the disclosure of the principal business address of the franchisor, as well as any parent, predecessors, and affiliates.[200] Section 436.1(q) defines the term “principal business address” to mean: “the street address of a person’s home office in the United States. A principal business address cannot be a post office box or private mail drop.”[201] This definition was not included in the original Rule. Nevertheless, the Commission finds that this definition is necessary to enable a prospective franchisee to contact the franchisor easily, as well as to facilitate effective law enforcement.

The proposed version of section 436.1(q) has been slightly revised to improve its precision, as suggested in one Staff Report comment. Initially, the definition of principal business address referred to the franchisor’s home office. J&G correctly observed, however, that the disclosure of a principal business address applies not only to a franchisor, but to others, such as a predecessor, as well.[202] Accordingly, the definition has been revised to refer to the more general “person’s home office”—be it the franchisor, parent, predecessor, or affiliate.

18. Section 436.1(r): Prospective franchisee

The final amended Rule retains a streamlined version of the definition of the term “prospective franchisee” set forth in the original Rule at 16 CFR 436.2(e). Specifically, section 436.1(r) defines the term to mean “any person (including any agent, representative, or employee) who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship.”[203] This is identical to the version of this definition proposed in the Franchise NPR.

The amended definition addresses several comments raised during the Rule amendment proceeding. First, one commenter voiced concern about who may receive a disclosure document, suggesting that the Commission permit any representative of the franchisee to receive the disclosures.[204] The Commission agrees that representatives of a prospective franchisee should be permitted to accept delivery of the disclosure document on the prospective franchisee’s behalf. Indeed, in some instances a prospective franchisee may be a corporation or other entity, not an individual. Thus, delivery in such circumstances can only be made upon a representative. Even individuals may wish to have their attorney or other agent receive the disclosures on their behalf, and the Rule should accommodate that possibility. We believe that the reference to agent, representative, or employee in section 436.1(r) is sufficient for this purpose. Further detail about who may accept disclosures for a prospective franchisee is best addressed in the Compliance Guides.[205]

One commenter also questioned the use of the word “approaches” in the definition. Specifically, the commenter feared that the definition would include someone surfing the Internet who “approaches” a franchisor’s website.[206] We believe this concern is unwarranted. The “prospective franchisee” definition states that the parties must “discuss the possible establishment of a franchise relationship.” This limiting language makes clear that for an individual to become a “prospective franchisee” he or she must communicate with the franchisor about a franchise offering. Merely perusing a franchisor’s website alone does not turn an ordinary Internet surfer into a prospective franchisee. Accordingly, no further revision to the “prospective franchisee” definition is warranted.

19. Section 436.1(s): Required payment

The making of a “required payment” (or a commitment to make a “required payment”) is one of the definitional elements of the term “franchise.”[207] Section 436.1(s) defines the term “required payment” to mean:

all consideration that the franchisee must pay to the franchisor or an affiliate, either by contract or by practical necessity,[208] as a condition of obtaining or commencing operation of the franchise. A required payment does not include payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or lease.

The only substantive difference between the provision as proposed in the Start Printed Page 15465Franchise NPR and the final amended Rule provision is the addition of the second sentence. There is no corresponding definition in the original Rule.

During the Rule amendment proceeding, several commenters raised concerns about the scope of the “required payment” definition. Specifically, commenters voiced concern whether the definition: (1) covers royalty payments; (2) covers payments to obtain or commence the franchise relationship; (3) excludes payments for inventory; and (4) includes payments to third parties. Each of these issues is discussed in greater detail below.

a. Royalty payments

As noted above, the definition of “required payment” uses the phrase “consideration that the franchisee must pay.” IL AG interpreted the word “consideration” as excluding royalty payments. It urged the Commission to clarify that royalties can constitute a required fee. Otherwise, “it will be too simple, even for traditional franchisors, to evade franchise laws.”[209]

The Commission has always considered royalty payments to be a form of required payment under the Rule and nothing in the definition of “required payment” is to the contrary.[210] Royalty payments constitute a direct form of consideration flowing to the franchisor in exchange for the ability to conduct business. Indeed, if royalties were excluded from the required payment definition, then any franchisor could avoid Rule coverage by charging a large post-sale royalty fee in lieu of an initial franchise or related fee. The Rule uses the term “consideration” not to imply that only an upfront franchise fee constitutes a required payment under the Rule, but to avoid the circular use of the word “payment” in the definition of “required payment.” Also, alternatives such as “funds, or moneys” are too limited because they would preclude payments in-kind.

b. Payments to obtain or commence a franchise

One commenter voiced concern that because the definition of “required payment” covers payments made “as a condition of obtaining or commencing operation of the franchise,” it would encompass ordinary business expenses paid to the franchisor. He urged the Commission to narrow the definition by specifying that a required payment must be made “for the right to enter into the franchise relationship.”[211]

The Commission declines to adopt this suggestion. The phrase “right to enter into a franchise relationship” is too narrow, suggesting that the required payment definitional element should be limited to payments made solely for the right to enter into the business, such as an up-front franchise fee. However, the Commission has made clear that the required payment element is not limited to up-front fees alone: “Often, required payments are not limited to a simple franchise fee, but entail other payments which the franchisee is required to pay to the franchisor or an affiliate.”[212] The Interpretive Guides further provide as examples of required payments equipment rentals and real estate leases.[213] Thus, expenses incurred in the ordinary course of business and paid to a franchisor or its affiliate may constitute a required payment. Otherwise, unscrupulous franchisors could easily circumvent the Rule by refraining from imposing any up-front fee in favor of charging for ordinary business expenses, such as training or other services, or purchases of equipment or unreasonable amounts of inventory.[214]

c. Payments for inventory

As a matter of Commission policy, reasonable amounts of inventory purchased at bona fide wholesale prices have not been interpreted to constitute a “required payment” under the original Rule.[215] This is commonly referred to as “the inventory exemption.” David Gurnick urged the Commission to update the Rule by incorporating the inventory exemption into the definition of “required payment.”[216] (As noted above, the definition proposed in the Franchise NPR did not exclude payments for inventory.) Another commenter agreed with Mr. Gurnick and urged further expansion of the exemption to include not only inventory for resale, but inventory for lease. Otherwise, the situation could arise where inventory obtained from a company is intended for resale—thus taking it outside of the Rule—but later on leased to a customer—thus arguably creating a franchise relationship retroactively.[217]

The Commission has concluded that the definition of “required payment” should incorporate the inventory exemption as these commenters suggested. Since the Rule’s inception, the Commission’s policy has been that reasonable purchases of inventory for resale at bona fide wholesale prices are not construed to be a “required payment.” The Interpretive Guides state that it is “virtually impossible to draw a clear line between start-up inventory that is purchased at the franchisee’s option, and that which is purchased as a matter of practical or contractual necessity.”[218] Therefore, the final amended Rule provision incorporates this policy, and extends it to encompass inventory purchased for lease as well as resale, there being no distinction, as a practical matter, between the two categories.

d. Payments to third parties

Howard Bundy urged expansion of the concept of “required payment” to include payments made to third parties. According to Mr. Bundy, franchisors can effectively “hook” a prospective franchisee if they can get the prospect to expend funds early in the sales process, such as paying travel expenses:

In franchising, it has become common to use the “takeaway close” to entice prospects to travel to the franchisor’s headquarters as a condition precedent to receiving a disclosure document. Likewise, we see instances of franchisors requiring a franchisee to contract with or pay for demographic or real estate services with technically “unaffiliated” entities as a condition precedent to being “approved” as a franchisee.[219]

To address this concern, Mr. Bundy suggested that the Commission modify the definition of “required payment” to include, after the word affiliate: “or to a vendor, financing provider or other third party that the prospective Start Printed Page 15466franchisee is required to deal with either by contract or practical necessity or to any third party as a condition precedent to obtaining the Franchise Disclosure Document.”[220]

Mr. Bundy’s suggestion generated one rebuttal comment. David Gurnick observed that defining “required payment” to include third-party payments would be: “a radical departure from the Commission’s long-standing policy regarding the definition of a franchise, would create a major inconsistency between the Franchise Rule and the state franchise laws, and would extend coverage to arrangements which the Rule was never intended to regulate.”[221] Observing that all businesses make payments to vendors and service providers, he also asserted that the Bundy proposal would be overbroad: “For example, ‘practical necessity’ may dictate that a business use a Microsoft software product or that an employee of the business fly to an airport that is served by only one airline.”[222] Mr. Gurnick added that if a franchisor establishes a company to receive some monetary benefit from prospects, those funds would already fall within the “required payment” definition as a payment to an affiliate.[223]

It is true that the Commission has never considered ordinary business payments to third parties as a “required payment” under the Rule. Indeed, doing so could sweep very broadly. Ordinary business expenses paid to third parties, such as the cost of installing telephone lines, insurance, and occupancy fees—expenses typically incurred by all businesses—can hardly be deemed a precondition imposed by the franchisor for obtaining or commencing operation of a franchise. Rather, a third-party payment constitutes a required payment only if the third party collects and remits the payment on behalf of the franchisor.[224]

Nonetheless, a franchisor may direct or encourage a prospective franchisee to incur some costs in order to advance the franchise sale. The prospective franchisee may incur these costs and make these kinds of payments without the benefit of pre-sale disclosures. Encouraging a prospect to incur expenses to advance the franchise sale could conceivably increase the likelihood that he or she will go through with the deal without a thorough due-diligence investigation. Therefore, the Commission has incorporated into the final amended Rule an express prohibition barring a franchisor from failing to furnish a copy of its disclosure document to a prospective franchisee early in the sales process, upon reasonable request.[225] This prohibition enables a prospective franchisee to ask to see a copy of the franchisor’s disclosure document before agreeing to travel to company headquarters or purchase demographic data, for example. The Commission believes this approach will better address concerns about pre-disclosure third-party payments than would an unworkable alteration of the definition of the term “required payment.”

20. Section 436.1(t): Sale of a franchise

The part 436 disclosure obligations are triggered only when there is an offer for the sale of a franchise.[226] Section 436.1(t) defines the term “sale of a franchise” as follows:

an agreement whereby a person obtains a franchise from a franchise seller for value by purchase, license, or otherwise. It does not include extending or renewing an existing franchise agreement where there has been no interruption in the franchisee’s operation of the business, unless the new agreement contains terms and conditions that differ materially from the original agreement. It also does not include the transfer of a franchise by an existing franchisee where the franchisor has had no significant involvement with the prospective transferee. A franchisor’s approval or disapproval of a transfer alone is not deemed to be significant involvement.

Like the original Rule provision, the final amended provision embodies the concept that franchisees extending or renewing an existing franchise agreement, where there is no interruption in business operations, will not be deemed to be entering into a sale, unless their new agreement contains terms and conditions materially different from their original agreement.[227]

The final amended Rule provision differs substantively from the provision as proposed in the Franchise NPR[228] because it incorporates the Commission policy, as stated in the Interpretive Guides, that the term “sale of a franchise” does not encompass the transfer of a franchise by an existing franchisee where the prospective purchaser has no significant contact with the franchisor.[229] Under long-standing Commission policy, a franchisor or subfranchisor must provide disclosures to prospective franchisees, but “a person who purchases a franchise directly from an existing franchisee, without significant contact with the franchisor, is not a prospective franchisee.”[230] Where a franchisor is not involved in the private sale of an existing franchise, the franchisor makes no representations to the prospective new purchaser. If there is any fraud in the private sale, it could be only by the current franchisee owner, and pre-sale disclosure by the franchisor would not likely prevent it. Accordingly, section 436.1(t) of part 436 makes clear that a transfer without significant involvement of the franchisor is not the sale of a franchise within the ambit of the Rule. Further, the franchisor’s mere approval or disapproval of the purchaser alone is not considered to be significant involvement.[231]

At the same time, the Commission declines to adopt several suggested narrowing modifications to the definition of “sale of a franchise.” H&H urged the Commission to exclude from the definition of “sale of a franchise” the modification of an existing franchise agreement where there is no interruption in the franchisee’s business operation.[232] The firm observed that material modifications to existing franchise agreements typically arise in two situations: (1) a settlement of litigation or other disputes with franchisees, in which the franchisor makes concessions; and (2) management initiative with the involvement of independent franchisee associations or franchisee advisory councils.[233] According to H&H, these modifications typically entail no new investment and both sides are familiar with the Start Printed Page 15467franchise terms: “An offer to exchange different forms of agreement or add an addendum to existing franchise agreements does not establish a new franchise relationship—that relationship already exists and will continue regardless of the decision the franchisee makes.”[234]

The Commission agrees that disclosure is unwarranted where an existing franchisee and the franchisor merely seek to amend their ongoing contractual relationship. In such circumstances, the material information the franchisee needs is the actual revised franchise agreement itself that spells out the terms and conditions that will govern the parties’ ongoing relationship. Requiring franchisors to furnish a new disclosure document whenever there may exist agreed upon material changes in a contract is likely to be an unwarranted formality, the cost of which is probably not outweighed by any tangible benefit to the existing franchisee. In any event, franchise agreement modifications, most obviously those without any new payment, would not constitute a “sale.” The definition of “sale of a franchise,” therefore, need not be revised to address this concern.

H&H further contended that disclosure is never warranted for renewals, asserting that a renewing franchisee makes no investment decision: “His decision relates to whether to continue a relationship, with which he should be intimately familiar at that point, under the terms of a new form of franchise agreement. The UFOC does little to help him understand the terms of that agreement.”[235] After considering this suggestion, we are unconvinced that renewals should always be excluded from the definition of “sale of a franchise.”

As discussed in greater detail below in connection with section 436.5(q)—Item 17’s renewal disclosure—franchisees and their representatives have voiced concern about renewals, arguing that franchisors control the governing terms and conditions and offer renewals on a take-it-or-leave-it basis.[236] Franchisees, they have asserted, not only lack bargaining power over the renewal agreement, but also often must accept new onerous terms because they are frequently subject to covenants not to compete that effectively prevent them from continuing in the same business independently. Especially in an age of new technologies and changes in franchise marketing, renewal contracts may be significantly different from original contracts that franchisees signed 10 to 20 years ago. A renewing franchisee, for example, may reasonably wish to see Item 20 closure rates for franchises operating under the new franchise agreement. Accordingly, the Commission concludes that where the franchise agreement contains terms and conditions materially different from the original agreement, the renewing franchisee needs advance disclosures in order to make an informed renewal decision.[237]

21. Section 436.1(u): Signature

The original Rule contained no definition of “signature.” To facilitate the use of electronic signatures, however, section 436.1(u) of the final amended Rule updates the UFOC Guidelines by adding such a definition: “a person’s affirmative step to authenticate his or her identity. It includes a person’s handwritten signature, as well as a person’s use of security codes, passwords, electronic signatures, and similar devices to authenticate his or her identity.” No comments were submitted on this definition, but the Commission has refined the language of the proposed definition to achieve greater precision and clarity, expressly including the descriptor “handwritten,” substituting “electronic” for “digital,“ and adding the phrase “to authenticate his or her identity.”

22. Section 436.1(v): Trademark

Section 436.1(v) of the final amended Rule defines the term “trademark.” The original Rule did not define this term. Consistent with long-standing Commission interpretation of the term and the UFOC Guidelines, the final amended Rule definition is broad, including “trademarks, service marks, names, logos, and other commercial symbols.”[238] No comments were submitted on this definition, and it is identical to the version of the definition published in the Franchise NPR.

23. Section 436.1(w): Written or in writing

The final amended Rule updates the original Rule and UFOC Guidelines to permit the use of electronic disclosures.[239] To that end, section 436.1(w) of the final amended Rule defines the term “written or in writing” to include not only printed documents, but:

any document or information . . . in any form capable of being preserved in tangible form and read. It includes: type-set, word processed, or handwritten document; information on computer disk or CD-ROM; information sent via email; or information posted on the Internet. It does not include mere oral statements.[240]

No comments were submitted on the Franchise NPR’s proposed definition, and only minor non-substantive changes in language were made to improve clarity.

B. Section 436.2: Obligation To Furnish Documents

Section 436.2 of the final amended Rule retains the original Rule’s requirement that franchisors provide prospective franchisees with advance written disclosures.[241] It also retains, in streamlined form, elements of the original Rule’s requirement that a franchisor “furnish the prospective franchisee with a copy of the franchisor’s franchise agreement . . . prior to the date the agreements are to be executed.”[242] The final amended Rule provision follows the basic concepts of the corresponding provision of the proposed Rule published in the Franchise NPR, but, as explained below, it reflects important refinements suggested by the comments, and its language has been reorganized to improve clarity.

Section 436.2 of part 436 covers four issues relating to the basic obligation to provide a disclosure document. First, it describes the geographical scope within which the disclosure obligation applies. Second, it establishes the time frame for fulfilling that obligation. Third, it limits the obligation of the franchisor to furnish to the prospective franchisee an advance copy of the completed franchise agreement—apart from the disclosure document—to only those circumstances when the franchisor makes material unilateral changes to the agreement while the offer is still under consideration. Fourth, and finally, the provision sets forth the specific actions Start Printed Page 15468that constitute the furnishing of disclosures. Each of these aspects of section 436.2 generated comments. The following sections discuss those issues and the various views of the commenters.

1. Geographical scope of the Rule’s application

Section 436.2 of the final amended Rule makes clear that the part 436 disclosure requirements and prohibitions are limited to “the offer or sale of a franchise to be located in the United States of America or its territories.”[243] This provision of part 436 is substantively identical to the corresponding provision in the proposed Rule. The original Rule did not address whether pre-sale disclosure is required for sales of franchises to be located outside the United States and its territories, and this issue has remained an unsettled area of franchise law. This issue was raised early in the proceeding and, based upon the record developed, the Commission concludes that application of part 436 to franchises to be located outside the United States and its territories is unwarranted at this time.[244]

The record reveals overwhelming support among various franchise interests for limiting the reach of the part 436 to sales of domestic franchises.[245] Among other things, the commenters noted that foreign franchise purchasers are large sophisticated investors represented by counsel and do not need the Rule’s protections. Some commenters made the point that the Commission developed the Franchise Rule in response to problems occurring in the domestic market.[246] Indeed, a disclosure document addressing the American market may be irrelevant and potentially misleading when applied to a purchase of a franchise to be located outside the United States, due to the vast differences between American and foreign markets, cultures, and legal systems.[247] Further, many risks to the prospective franchisee arise from economic conditions and cultural values in those countries, not in the United States. To be relevant, a franchisor arguably would have to prepare individual disclosure documents tailored to each specific foreign market. Not only would such a requirement put American franchisors at a competitive disadvantage with franchisors from countries lacking comparable disclosure regulations, but it is likely that any possible benefits of such a requirement would not outweigh the extraordinary costs and burdens involved.[248]

At the same time, the Commission has rejected suggestions to limit the scope of the Rule further to exclude sales of franchises to be located in American territories.[249] The FTC Act gives the Commission authority to promulgate trade regulation rules involving unfair or deceptive acts or practices[250] “in or affecting commerce.”[251] The FTC Act includes multiple references to territories in its definition of commerce,[252] including commerce “in any territory of the United States.”[253] The record does not suggest any convincing rationale for contraction of the exercise of that authority as expressed through part 436 of the final amended Rule. Residents of American territories rely on American law for protection, and the Franchise Rule is part of that protection.

2. Section 436.2(a): Time frame for making disclosures

Part 436 of the final amended Rule substantially revises the original Rule’s timing for making franchise disclosures. Under the original Rule, franchisors and brokers had to furnish prospective franchisees with disclosure documents at the earlier of two time periods: (1) the first personal (face-to-face) meeting; or (2) “the time for making disclosures,” which was defined as 10 business days before the execution of the franchise agreement or payment of any fees in connection with the franchise sale.[254] The final amended Rule streamlines the timing provision in two respects. First, part 436 eliminates the first personal meeting disclosure trigger. Second, part 436 replaces the original 10-business day trigger with a 14 calendar-day disclosure trigger. Both of these revisions were included in the Rule proposed in the Franchise NPR, but have been slightly revised for clarification and better organization. Each is discussed in greater detail below.

a. Elimination of the first personal meeting trigger

The Franchise NPR’s proposal to eliminate the first personal meeting disclosure trigger prompted overwhelming support from franchisors and their representatives, as well as NASAA.[255] These commenters asserted Start Printed Page 15469that the first personal meeting trigger has become obsolete in the electronic age, where even large investments are made by telephone or via the Internet.[256]

Some franchisees and their advocates, however, maintained that the first personal meeting trigger continues to serve a useful purpose. For example, one franchisee representative asserted that there is no basis to believe that personal meetings will completely become a thing of the past, and warned that eliminating the current first personal meeting disclosure trigger would enable franchisors to induce a high level of commitment on the part of prospects through protracted discussions without providing the disclosure document, with the result that “the 14 day cooling off period will then start when the franchisee has already decided to make the investment.”[257]

The Commission believes that a first personal meeting trigger alone does little to ensure that a prospective franchisee will receive disclosures early in the sales process.[258] While at the time the Rule was promulgated it may have been routine, or perhaps necessary, to have a face-to-face meeting early on, that is no longer true. Nowadays, a franchisor and a prospect may have numerous telephone conversations or send documents to each other via fax or email long before any personal meeting occurs. Therefore, after carefully considering the comments, the Commission is persuaded that the first personal meeting trigger has become largely obsolete and should be deleted.

Nonetheless, the Commission shares commenters’ concern about a franchisor influencing a prospective franchisee’s decision before the prospect receives the franchisor’s disclosures.[259] To address this concern, the Staff Report recommended adoption of a new provision to prohibit franchise sellers from refusing to honor a prospective franchisee’s reasonable request for a copy of the franchisor’s disclosure document during the sales process.[260] The Commission has determined to follow this recommendation. Accordingly, 436.9(e) of the final amended Rule specifies that it is an unfair or deceptive practice to “[f]ail to furnish a copy of the franchisor’s disclosure document to a prospective franchisee earlier in the sales process than required under § 436.2 of this part, upon reasonable request.” This prohibition does not mean that a franchisor must tender a disclosure document to any person who may desire a copy. Rather, it applies where the parties have already conducted specific discussions or negotiations or otherwise taken steps to begin the sales process. This promotes the goal of early disclosure in the sales process without reliance on the obsolete personal meeting trigger. It also is likely to impose only a de minimis burden, if any, on franchisors, who presumably have a disclosure document already prepared when discussing a sale with a prospective franchisee.

b. Fourteen calendar-days

Section 436.2(a) of the final amended Rule requires franchisors to furnish disclosures “at least 14 calendar-days before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale.” The Franchise NPR proposed this modification of the original Rule’s “10 business day” disclosure trigger. Commenters who addressed this issue unanimously agreed that a 14 calendar-day disclosure trigger is clearer than the original Rule’s “10 business day” trigger.[261] One commenter, however, urged the Commission to clarify further how to count the 14 days to “resolve any question as to whether or not the day on which the documents are delivered, or the day on which they are signed, may be counted for purposes of compliance with the Rule.”[262] The Commission intends that the 14 days commence the day after delivery of the disclosure document and that the signing of any agreement or receipt of payment can take place on the 15[th] day after delivery. This ensures that prospective franchisees have at least a full 14 days in which to review the disclosures.[263]

Section 436.2(a) of the final amended Rule also tightens the language used in the proposed version of this provision to describe the events that trigger the 14-day disclosure requirement.[264] The original Rule required a franchisor to provide its disclosure document:

ten (10) business days prior to the earlier of (1) the execution by a prospective franchisee of any franchise agreement or any other agreement imposing a binding legal obligation on such prospective franchisee, about which the franchisor, franchise broker, or any agent, representative, or employee thereof, knows or should know, in connection with the sale or proposed sale of a franchise, or (2) the payment by a prospective franchisee, about which the franchisor, franchise broker, or any agent, representative, or employee thereof, knows or should know, of any consideration in connection with the sale or proposed sale of a franchise.[265]

In the proposed Rule, section 436.2(a) would have altered this formulation by eliminating the franchisor’s knowledge as a triggering factor, and rephrasing the remaining factors. Specifically, the proposed provision would have conditioned the disclosure obligation on either “the prospective franchisee sign[ing] a binding agreement or pay[ing] any fee in connection with the proposed franchise sale.”

Several commenters, focusing on the use of the terms “binding agreement” and “pays any fee,” criticized the perceived overbreadth of this proposed provision. For example, H&H and Start Printed Page 15470Tricon urged inclusion of the phrase “with the franchisor or an affiliate of the franchisor,” arguing that these limiting words are needed because “the franchisor cannot control whether a prospective franchisee proceeds to commit with independent third parties (e.g., lessor of real estate) before expiration of the cooling off period.”[266]

On the other hand, Howard Bundy urged broadening the Rule so that a franchisor would be required to provide the disclosure document at least 14 days before the prospective franchisee signs a binding agreement, pays any fee in connection with the proposed franchise sale, or is required to travel or make other financial commitments as a precondition to receiving additional information.[267] Mr. Bundy’s concern was that prospective franchisees may risk losing significant sums of money to pursue a franchise before they receive any disclosures about the franchise offer.

The Commission believes that the concern that prompts Mr. Bundy’s suggestion is adequately addressed by section 436.9(e) —the new prohibition barring franchisors from failing to furnish disclosures earlier in the sales process upon reasonable request. A prospect can always ask the franchisor for a disclosure document before undertaking such obligations as signing a binding agreement, paying any fee in connection with the proposed franchise sale, or incurring travel or other costs. Thus, a broad disclosure trigger such as Mr. Bundy advocates is not necessary.

Furthermore, the Commission agrees with the commenters who suggested that this provision should be more carefully tailored so as not to be overly inclusive or imprecise. Accordingly, the final provision specifies that disclosure must be made at least 14 calendar-days “before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale.” Addition of the underscored language adds clarity and precision, and puts appropriate limits on the provision’s reach.

3. Section 436.2(b): Modified contract review period

Part 436 of the final amended Rule significantly narrows the circumstances under which a franchisor must furnish a prospective franchisee with a copy of the completed franchise agreement in advance of the date of execution. The original Rule required that franchisors and brokers furnish prospective franchisees with a copy of the completed franchise and related agreements at least five business days before the date of execution.[268] The proposed Rule published in the Franchise NPR retained this requirement.[269] During the Rule amendment proceeding, several franchisors and their supporters, as well as NASAA, urged the Commission to eliminate the contract review period.[270] PMR&W, for example, asserted that the delay resulting from the mandatory disclosure period often harms prospective franchisees:

In practice, the 5-day rule typically hurts rather than aids franchisees, since the “price” of an additional concession by the franchisor is an additional 5-day delay. Franchisees often are more time sensitive than franchisors, either because of a financing commitment or a lease option that might be expiring or the need to attend a training program. As a result, the 5-day rule can discourage a franchisee from requesting last-minute changes. Thus, the current provision, especially now that business opportunities are not covered, has little potential benefit to either franchisor or franchisee and may, in fact, discourage, rather than promote, last minute negotiations.[271]

Similarly, Marriott noted that the timing of closing the deal is often critical to the franchisee:

as loan commitments may expire, options to acquire sites may expire or financial commitments may be required to prevent the site from being sold or leased to a different entity. Securities offerings may be held up until franchise agreements are executed. Interest rates may change so as to make a project unavailable unless commitments are promptly made.[272]

The Staff Report recommended that the contract review period be restricted to instances where the franchisor unilaterally modifies its standard franchise agreement. It also recommended substituting “seven calendar-days” for the Franchise NPR provision’s “five days,” to be consistent with the revision of the former 10-day disclosure trigger to 14 calendar-days.[273] After careful consideration of the record, the staff recommendation, and the rationale for that recommendation, the Commission has decided to modify the text of this Rule requirement in the manner recommended in the Staff Report. Section 436.2(b) of the final amended Rule specifies that it is a Rule violation for any 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 the prospective franchisee 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 Commission intended the original Rule’s five business day review requirement to advance two goals: (1) to ensure that prospective franchisees would have time to review and understand the franchise and any related agreement before undertaking significant financial and legal obligations; and (2) to prevent fraud by discouraging a franchisor from unilaterally substituting pages or Start Printed Page 15471otherwise altering agreements presented to the prospective franchisee for signing.

The first concern—providing time to study the franchise and related agreements—is already served by the Rule’s basic disclosure requirement.[274] Attached to each disclosure document is a copy of the franchisor’s basic agreement and any related agreements. At the very least, these documents enable prospects to review the basic terms and conditions governing the franchise system. Based upon the Commission’s experience in enforcing and administering the Rule, it also appears that franchisors routinely use standardized franchise agreements. Last-minute changes to a franchise agreement, therefore, most likely arise at the franchisee’s initiation. When a prospective franchisee is the party introducing contract modifications, redisclosure by the franchisor is hardly warranted. Thus, section 436.2(b) expressly states that “[c]hanges to an agreement that arise out of negotiations initiated by the prospective franchisee do not trigger this seven calendar-day period.”

Further, the Commission does not believe that the Rule should impede a prospective franchisee’s ability to negotiate agreement changes. The delay inherent in a mandatory contract review period may discourage negotiations if a prospective franchisee believes that he or she will suffer as a result of the delay. As Marriott noted, the timely signing of a franchise agreement may be a prerequisite for other parts of the overall deal, such as obtaining leases and loans. Indeed, in most instances a prospective franchisee is in the best position to judge how much review time is warranted and, as a practical matter, can seek additional review time, if desired.

Nonetheless, the possibility of fraud remains a concern. To prevent a franchisor from substituting at the last minute provisions that differ materially from those in the agreements previously attached to the disclosure document, the final amended Rule includes two safeguards. First, section 436.2(b) retains a mandatory contract review period of seven full days[275] in situations where the franchisor has materially altered the terms and conditions of the standard agreements attached to the disclosure document.[276] The Commission intends that this not include situations where the only differences between the standard agreements and the completed agreements are “fill-in-the-blank” provisions, such as the date, name, and address of the franchisee.[277] Nor does it include instances where deviations from the standard agreement are initiated at the prospective franchisee’s request.

Second, the final amended Rule targets potential fraud directly by adopting a new prohibition, section 436.9(g), which prohibits a franchisor from unilaterally substituting provisions or pages in a franchise agreement resulting in a material change unless the franchisor first alerts the prospective franchisee about the change seven days before execution of the franchise agreement. This approach remedies deceptive unilateral modification of franchise agreements in a material way without imposing additional disclosure burdens.

In response to the Staff Report, a few commenters asked for additional clarification of the meaning of the term “negotiations initiated by the prospective franchisee.” For example, Gust Rosenfeld urged the Commission to make clear in the Compliance Guides that negotiated changes will be considered initiated by the prospective franchisee even where some of the changes favor the franchisor.[278] In the same vein, Marriott urged the Commission to change the Staff Report’s proposed language “Changes to a franchise agreement that result solely from negotiations initiated by the prospective franchisee . . . .” to “Changes to a franchise agreement that arise out of negotiations initiated by the prospective franchisee. . .”[279] Marriott contended that the original language—“result solely from negotiations initiated by the prospective franchisee”—could be read narrowly to exclude instances where both parties receive benefits during the negotiation.

The Commission recognizes that a negotiated franchise or related agreement may result in some changes favoring the franchisor. Whether or not a particular change benefits a particular party, however, is irrelevant. What is determinative is whether the prospective franchisee has knowledge of the change before signing the agreement. As long as the prospective franchisee opens the door to changing documents that previously have been presented for signing, any discussions about changes and any agreed upon changes are clearly made with the prospective franchisee’s knowledge. Under these circumstances, redisclosure would be unwarranted. To make this point clear, the final amended Rule adopts an edited form of Marriott’s suggested language noted above: “Changes to an agreement that arise out of negotiations initiated by the prospective franchisee do not trigger this seven calendar-day period.”

4. Section 436.2(c): Actions that constitute the furnishing of disclosures

Section 436.2(c) of the final amended Rule specifies what actions constitute furnishing required documents. Although the original Rule did not include such a provision, such specificity is needed now, given the wide array of disclosure formats and delivery mechanisms available in today’s marketplace. Accordingly, a franchisor will be considered to have furnished a disclosure document if:

(1) A copy of the document was hand-delivered, faxed, emailed, or otherwise delivered to the prospective franchisee by the required date; (2) Directions for accessing the document on the Internet were provided to the prospective franchisee by the required date; or (3) 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 United States mail at least three calendar days before the required date.[280] Start Printed Page 15472

The basic concepts of the final amended Rule provision track those in the corresponding provision proposed in the Franchise NPR, but the language has been revised, reorganized, and in some cases, expanded, to achieve greater clarity and specificity.[281]

C. Sections 436.3-436.5: The Disclosure Document

Sections 436.3-436.5 of part 436 set forth the substantive disclosures and attachments that franchisors must include in their disclosure documents, beginning with the cover page.

1. Section 436.3: Cover page

The cover page informs prospective franchisees that the disclosure document they are receiving contains important information about the franchise offer. The proposed Rule published in the Franchise NPR incorporated each item of information required in the original Rule’s counterpart,[282] with a few exceptions discussed below.[283] The final amended Rule provision follows the cover page proposed in the Franchise NPR, with minor editing for clarity.

The proposed cover page set forth in the Franchise NPR generated little comment. The few comments received generally suggested various improvements to the text of the cover page, many of which have been incorporated into the final amended Rule.[284] The substantive revisions to the cover page requirement fall into four broad categories. First, final amended Rule section 436.3(e)(4) requires that the cover page reference sources of additional background information that prospective franchisees can use in conducting their due diligence investigations, such as the FTC’s website and its Consumer Guide to Buying a Franchise.[285] This will enable prospective franchisees to find additional background information on franchising, including information on how to use a disclosure document.

Second, final amended Rule section 436.3(b) updates the cover page to embrace electronic disclosure. It requires franchisors to include on the cover page their email and primary home page addresses, so that prospective franchisees can communicate with the franchisor electronically. In the same vein, section 436.3(f) permits franchisors to state on the cover page how prospective franchisees may receive a copy of the disclosure document in an alternative medium.[286]

Third, final amended Rule section 436.3, like the proposed version published in the Franchise NPR, eliminates information from the original Rule’s cover page that might be misinterpreted as implying greater Commission oversight of franchising than is the case. Several franchisees contended that phrases in the original cover page—such as “information . . . required by the Federal Trade Commission” and “to protect you”—are misleading because they imply greater federal oversight of franchise offerings than actually exists.[287]

Fourth, to promote greater uniformity with state disclosure laws, final amended Rule section 436.3 has been revised to track more closely the UFOC Guidelines’ cover page elements.[288] For example, section 436.3 includes the franchisor’s name, logo, brief description of the franchised business, total purchase price as reflected in Item 5 (initial fees) and in Item 7 (estimated initial investment), and a notice that states may be able to provide sources of information about franchising.

With respect to cover page disclosure of the total purchase price, final amended section 436.3(e)(1) revises slightly the comparable UFOC Guidelines requirement,[289] based on the record developed here. Specifically, BI asserted that the total purchase price disclosure on the UFOC Guidelines cover page can be misleading. According to the firm, the cover page should put prospects on notice of the initial franchise fee that must be paid for the right to commence business under the mark. BI argued that the inclusion of the broader Item 5 initial fees would cloud the issue, making comparisons of initial franchise fees among competitors difficult: “For example, in cases where a franchisor sells or leases the premises of the franchised business to the franchisee, this payment would need to be included in Item 5, but would severely distort the amount of the initial franchise fee disclosed on the cover page.”[290]

The Commission’s view, however, is that the purpose of the cover page’s Start Printed Page 15473price disclosure is not simply to indicate the fee paid to the franchisor for using the franchisor’s mark, but to disclose the total costs paid to the franchisor associated with commencing business operations. In fact, limiting the disclosure to the initial franchise fee alone could be misleading because that could understate the totality of fees that must be paid to the franchisor in order to start the business. The cover page price disclosures will better enable prospective franchisees to assess their full potential business costs, and ultimately their financial risk, than a disclosure limited to the initial franchise fee alone.[291] Nevertheless, the Commission recognizes that it is possible to achieve the goal of informing prospective franchisees about the investment by referring to Item 7 alone—Initial Investment. Indeed, Item 5 is basically a subset of Item 7. Therefore, to maximize consistency between federal and state law, section 436.3 incorporates a modified version of the UFOC cover page references to Item 5 and Item 7, as follows: “The total investment necessary to begin operation of a [franchise system name] franchise is [the total amount of Item 7 (§ 436.5(g))]. This includes [the total amount in Item 5 (§ 436.5(e))] that must be paid to the franchisor or affiliate.”

In addition, section 436.3 diverges from the UFOC Guidelines in that it does not call for the two cover page risk factor disclosures required by the UFOC Guidelines regarding choice of venue and choice of law.[292] These two risk factors essentially repeat what franchisors already must disclose in Item 17 of the disclosure document.[293] Moreover, mandating the disclosure of these two risk factors on the cover page might incorrectly signal prospective franchisees that these are the most important risk factors to consider.[294] Nonetheless, section 436.3(g) of the final amended Rule expressly permits franchisors to “include additional disclosures on the cover page . . . to comply with state pre-sale disclosure laws.” This provision effectively permits franchisors to include state mandated risk factors on the cover page, without adopting risk factor requirements into the final amended Rule.[295]

The Commission has decided not to make further revisions in the cover page requirements that would call for additional education messages, notwithstanding several comments urging us to do so. For example, the AFA suggested that the Commission warn prospective franchisees that they are not purchasing their own business. To that end, the AFA would include the following warning on the cover page: “You will not own your own business. You will lease the rights to sell [company’s name] goods [services] to the public under the [company’s name] tradename and trademarks. This agreement will expire and you will have no rights to continue in operation upon expiration.”[296]

The Commission agrees in principle with the AFA’s broad point that prospective franchisees should be fully informed about the nature of franchising. However, the appropriate vehicle for educating prospects is through educational materials, not the final amended Rule itself. Indeed, the cover page advances this goal because it will reference the Commission’s Consumer Guide to Buying a Franchise, which contains the advice the AFA wants communicated.

2. Section 436.4: Table of contents

The final amended Rule section 436.4 retains the original Rule’s requirement for a table of contents, but, like the version of this provision proposed in the Franchise NPR, conforms to the UFOC Guidelines in the wording and the ordering of required disclosure items listed.[297] This provision generated minimal comment.

The final amended provision revises the proposed Rule provision’s use of the UFOC Guidelines headings in only a few instances to reflect more accurately the Rule requirements, as follows: (1) Item 1 is changed from “The Franchisor, its Predecessors, and Affiliates” to “The Franchisor and any Parents, Predecessors, and Affiliates;”[298] (2) Item 5 is changed from “Initial Franchise Fees” to “Initial Fees;”[299] (3) Item 7 is changed from “Initial Investment” to “Estimated Initial Investment;” (3) Item 11 is changed from “Franchisor’s Obligations” to “Franchisor’s Assistance, Advertising, Computer Systems, and Training;” (4) Item 19 is changed from “Earnings Claims” to “Financial Performance Representations;” (5) Item 20 is changed from “List of Outlets” to “Outlets and Franchisee Information;” and (6) Item 23 is changed from “Receipt” to “Receipts.”

3. Section 436.5(a) (Item 1): The franchisor and any parents, predecessors, and affiliates

Section 436.5(a) of part 436 sets forth the first of the final amended Rule’s substantive disclosure requirements. As Start Printed Page 15474proposed in the Franchise NPR,[300] it retains the original Rule’s requirement that franchisors disclose background information on the franchisor and any parents and affiliates.[301] It also expands the original Rule in three respects to maximize consistency with the UFOC Guidelines.[302] First, franchisors must now disclose information about their predecessors for the 10-year period immediately before the close of the franchisor’s most recent fiscal year.[303] This will prevent unscrupulous franchisors from hiding prior misconduct and avoiding disclosure obligations simply by assuming a new corporate identity.[304] Second, franchisors must disclose any regulations specific to the industry in which the franchise business operates, such as any necessary licenses or permits,[305] that may affect the franchisee’s operating costs and ability to conduct business.[306] Third, franchisors must describe the general competition prospective franchisees are likely to face.[307] This disclosure better ensures that the prospective franchisee can understand the likely economic risks in purchasing a franchise.[308]

The final amended rule provision tracks the proposed Rule published in the Franchise NPR, but is more narrowly tailored in its treatment of required disclosures about affiliates. Slight non-substantive modifications in the provision’s language and organization have also been made to improve clarity and precision. Two aspects of section 436.5(a) that prompted comment are discussed in the following sections: the required parent disclosures, and the required predecessor disclosures. Finally, various suggestions advanced by commenters but not adopted in the final amended Rule are discussed in the final part of this section.[309]

a. Parent disclosures

The retention of the original Rule’s parent disclosure requirement was not controversial for the vast majority of commenters, including NASAA.[310] A few comments, however, raised two concerns about it. First, a few franchisor representatives asserted that a separate parent disclosure is unnecessary because a parent, in most instances, would already be covered by the Rule’s broad definition of “affiliate”[311] — “an entity controlled by, controlling, or under common control with another entity.”[312] Other commenters questioned the relevance of a parent’s information, asserting that a parent is a legally distinct entity and that disclosing a parent may mislead prospective franchisees into believing that the parent exercises greater oversight or gives financial backing to the franchisor than actually exists. These commenters add that a parent disclosure simply clutters an already lengthy disclosure document.[313]

On the other hand, the materiality of parent information was demonstrated by Dr. Spencer Vidulich, a Pearle Vision franchisee. He related that his franchisor was bought by Cole National Corporation, which operates company-owned optical departments in Sears stores. In this instance, the disclosure of parent information would have alerted prospective Pearle Vision franchisees that their franchisor is owned by a company that operates competing outlets.[314]

Also, contrary to some commenters’ assertions, part 436 will not reach all parents when, for example, section 436.5(a) reaches only those affiliates that “offer franchises in any line of business or provide products or services to the franchisees of the franchisor.” As Dr. Vidulich suggested, it is possible that a parent does not sell franchises at all—falling outside the scope of the section’s coverage of “affiliates”—but nonetheless could operate competing company-owned outlets. A requirement Start Printed Page 15475that a franchisor identify any parent, therefore, is necessary to ensure that any parent not falling within Item 1’s limited use of affiliate will be disclosed.

Moreover, the Item 1 parent disclosure is significantly limited: franchisors must simply identify a parent.[315] In contrast with the Item 1 disclosures for affiliates and predecessors,[316] a franchisor need not disclose, for example, the parent’s business background, length of time selling franchises or engaging in other lines of business.[317] The Commission concludes that this limited disclosure will, at most, impose a minor burden for most franchise systems that is outweighed by the potential benefit to prospective franchisees.

b. Predecessor disclosures

Part 436 of the final amended Rule adopts the UFOC Guidelines’ requirement that franchisors disclose background information about any predecessors for 10 years.[318] During the rulemaking process, no commenters objected to the basic principle that predecessor information should be disclosed.[319] A few commenters, however, questioned the scope of the disclosure. One commenter asserted that the 10-year reporting period is too long, noting that Item 2 establishes only a five-year disclosure period for business experience of company officers and managers.[320] Another commenter urged the Commission to narrow the focus of Item 1 to require the disclosure of information about only any immediate predecessor.[321] The Commission is not convinced, however, that the burden of supplying 10 years of predecessor information—as the majority of franchisors already do to comply with the UFOC Guidelines—is so great as to justify deviating from the UFOC Guidelines on this issue.

c. Suggestions for additional disclosure requirements that the Commission has not adopted

IL AG urged the Commission to expand the scope of Item 1 in several respects. First, IL AG would expand the types of business organizations that must be disclosed under section 436.5(a)(5) to include “members with a controlling interest in the franchisor.” In its view, this is necessary to cover limited liability companies.[322] The Commission declines to adopt this suggestion because the examples of different types of entities included there is intended to be illustrative, not exhaustive, and additional examples of business organizations are unnecessary.

In addition, IL AG suggested that Item 1 be expanded to include the date when the franchisor was organized.[323] The Commission also declines to adopt this suggestion. The franchisor already must disclose how long it has been in business and has offered franchises. We believe that time period, not the date of organization, is most relevant to a prospective franchisee. Moreover, neither the original Rule nor the UFOC Guidelines requires this information, and the Commission is reluctant to introduce an inconsistency with the Guidelines on this point.

Finally, IL AG suggested that a description of the competition should include competitors of the franchisor’s affiliates.[324] We note that the UFOC Guidelines require only a “general description of the competition.” Depending upon the franchise system, competition of affiliates could be sizeable, especially with respect to large, publicly traded franchisors. We are not inclined to diverge from the UFOC Guidelines in the absence of evidence showing a problem on this point.

4. Section 436.5(b) (Item 2): Business experience

Consistent with the original Rule and UFOC Guidelines, section 436.5(b) of the final amended Rule requires the disclosure of the business experience of the franchisor’s directors, trustees, general partnerships, and certain executives.[325] It differs from the UFOC Guidelines’s Item 2, however, in two respects. First, it does not require a franchisor to disclose brokers.[326] Second, it expands the original Rule and UFOC Guidelines to prevent fraud by requiring the disclosure of prior experience of not only directors and executives, but other individuals who do not necessarily possess a title, but nonetheless will exercise management responsibility relating to the sale or operation of franchises being offered for sale. Additionally, this final amended Rule provision is narrower than its counterpart as proposed in the Franchise NPR, in that it deletes the proposed requirement to disclose prior experience of the officers or executives Start Printed Page 15476of any parent of the franchisor. Each of these issues is discussed in detail below.

a. Brokers

The original Rule did not require disclosure of brokers. The proposed Rule, however, tracking the UFOC Guidelines, required that franchisors “list all brokers.”[327] As noted above, based upon the comments, the final amended Rule does not include the UFOC Guidelines’ provision that franchisors identify its brokers in Item 2.[328] During the Rule amendment proceeding, a few commenters asserted that such disclosure is unnecessary.[329] For example, Frannet, a franchise broker, voiced concern that the proposed inclusion of brokers in Item 2 would require franchisors to disclose immaterial information about “literally hundreds of business brokers each of whom will receive a commission in the event that a prospect referred by any such person ultimately purchases a franchise,” resulting in a “voluminous” UFOC, with “no value to the prospective franchisee.”[330]

On the other hand, Michael Seid, a franchise industry consultant, strongly objected to the deletion of broker information from Item 2 because prospective franchisees often rely on statements made by brokers in deciding whether to purchase a franchise. In his view, prospective franchisees perceive brokers as being independent, third-party experts. He opined that listing them in a disclosure document would dispel that notion, making it clear that brokers are authorized agents of the franchisor.[331]

Some prospective franchisees may rely on a broker’s statements in the course of purchasing a franchise, and some brokers may make false claims—such as false financial performance representations. Nonetheless, the Commission is not convinced that broker disclosures are warranted in a franchise disclosure document.

Item 2 appropriately requires franchisors to disclose the background of those individuals who control the franchisor and those who actually manage franchisees. That information is material because prospective franchisees need to know the identity and business experience of the individuals in command of the franchisor in order to assess whether these individuals are likely to be able to perform as promised under the franchise agreement. Unlike franchisors, brokers do not create or implement franchisor policy, nor do they oversee performance of post-sale obligations to the franchisee. Accordingly, prospective franchisees are less likely to give decisive weight to an individual broker’s expertise or background in assessing the merits of purchasing a franchise.

Moreover, even if a broker were to make false claims, the prospective franchisee has the benefit of the franchisor’s disclosure document to assess those claims before purchasing a franchise. For example, a franchisor statement in Item 19 that it does not authorize the making of financial performance claims should raise doubts about a broker’s veracity if the broker were to make his or her own performance claims. Similarly, a franchisor’s statement in Item 3 that it has been sued by franchisees would dispel any claim by a broker that the franchisor has not been previously sued. The counteractive effect of the disclosure document gives the Commission reason to doubt that the inclusion of broker information among the required Item 2 disclosures would yield more than a scant benefit to prospective franchisees. Further, the disclosure of brokers would also be cumbersome, especially for large franchise systems that may employ hundreds of brokers nationally. Thus, the Commission concludes that this benefit would not likely outweigh the corresponding compliance costs and burdens.

Finally, the deletion of brokers from Item 2 as had been proposed in the Franchise NPR obviously does not curtail brokers’ liability for false claims. Franchise brokers, like virtually all other individuals conducing interstate commerce, remain liable under Section 5 of the FTC Act for their own misrepresentations. In short, while the Commission favors adopting UFOC Guidelines approach to the fullest extent possible, we believe this is one area where an exception is warranted.

b. Individuals with management responsibility

Section 436.5(b) of part 436 requires a franchisor to disclose not only the background of the franchisor’s directors and executives, but also “individuals who will have management responsibility relating to the sale or operation of franchises offered by this document.”[332] Individuals listed in Item 2 must also disclosure their litigation (Item 3) and bankruptcy (Item 4) histories as well. This provision ensures that franchisors cannot conceal a manager’s lack of experience, prior litigation, or bankruptcy history by simply avoiding giving the manager a formal title.[333] Although the language has been revised to achieve greater clarity and specificity, this aspect of this provision is conceptually very similar to the rule as proposed in the Franchise NPR.[334] The breadth of this provision is intended to leave no doubt that franchisors must disclose all individuals who in fact exercise management responsibility over the sale or operation of franchises being offered for sale, regardless of any formal title.[335]

Start Printed Page 15477

c. Parents

Part 436 as proposed in the Franchise NPR required franchisors to disclose the prior experience of a parent’s officers or executives.[336] This proposal, however, was criticized on the grounds that such a broad disclosure about directors and officers of a parent would clutter Item 2 with information “of marginal relevance and importance to prospective franchisees.”[337] In response to commenters’ persuasive arguments, the Commission has determined to omit the requirement from section 436.5(b).

The Commission has come to the view that the disclosure of prior experience of individuals associated with a parent of a franchisor is generally unnecessary. While in many instances a parent’s officers may exercise general management responsibilities that may affect the franchisor, they are not necessarily involved in managing the franchisor or its franchises. Because of their lack of direct control over the franchisor, background information on them is unlikely to be material to a prospective franchisee. Accordingly, the minimal benefit that might accrue to prospective franchisees from a disclosure of the prior experience of individuals associated with the franchisor’s parent would not likely outweigh the compliance costs and burdens.

5. Section 436.5(c) (Item 3): Litigation

Section 436.5(c) of the final amended Rule retains the original Rule’s requirements to disclose certain pending and prior litigation, as well as current injunctive or restrictive orders. Like the original Rule, the final amended Rule requires disclosure, in some instances, of litigation involving the franchisor’s parent.[338] Consistent with the UFOC Guidelines, however, part 436 expands on the original Rule by requiring franchisors to disclose actions involving not only the franchisor, its directors and officers, and affiliates, but predecessors as well.[339] In addition, section 436.5(c)(1)(i)(B), in accord with the UFOC Guidelines, now requires the disclosure of routine litigation that may impact the franchisor’s financial condition or ability to operate the business.[340] At the same time, as also proposed in the Franchise NPR, the Commission has determined that section 436.5(c)(1)(B)(ii) of the final amended Rule should expand on both the original Rule and UFOC Guidelines by requiring franchisors to disclose material franchisor-initiated litigation against franchisees involving the franchise relationship.

The comments on Item 3 focused on five broad topics: (1) whether and to what extent disclosures about a franchisor’s parent should be required; (2) to what extent disclosures about a franchisor’s affiliates should be required; (3) whether disclosure about out-of-court settlements favorable to the franchisor or settlements that by their terms are confidential should be required; (4) whether the Rule as proposed in the Franchise NPR needed clarification to avoid implying that dismissed actions should be disclosed in cases when no liability is imposed upon or accepted by the franchisor; and (5) whether and to what extent disclosure of franchisor-initiated litigation would be required. Each of these topics is discussed in the sections that follow.

a. Parent disclosures

The original Rule required the disclosure of litigation relating to a franchisor’s parent.[341] Part 436 as proposed in the Franchise NPR retained this broad approach. The Commission, however, has decided that the final amended Rule should narrow considerably the scope of the franchisor’s obligation to disclose litigation relating to a parent. As recommended in the Staff Report, the final amended Rule requires the disclosure of litigation relating to a franchisor’s parent only in the case of a “parent . . . who guarantees the franchisor’s performance.”[342]

The narrowed scope of the parent litigation disclosure responds to persuasive comments challenging the value of broad parent litigation disclosures to prospective purchasers and complaining of the burden to franchisors. Typical of these comments are those submitted by PMR&W, arguing that the parent litigation disclosure is confusing at best and offers little if any benefit to prospective franchisees, and noting that a publicly-traded parent may face countless securities fraud claims, for example, that would have to be disclosed, “overflowing [the disclosure document] with largely irrelevant parent litigation summaries, obscuring and diverting readers from the more important disclosures of franchisor litigation, and greatly increasing compliance burdens and costs.”[343]

Based upon review of the record, including the Staff Report, the Commission is persuaded that litigation involving a parent (which may be voluminous in the case of a publicly-traded parent) may have little bearing on the operation of the franchise system itself. Yet, the Commission does not believe that complete elimination of the parent litigation disclosure is justified. Rather, the Commission has determined to narrowly tailor the parent litigation disclosure to those circumstances where the parent guarantees the franchisor’s performance, as recommended in the Start Printed Page 15478Staff Report.[344] Where a parent, for whatever reason, induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor’s performance, the parent’s prior litigation history becomes material to the prospective franchisee and must be disclosed.[345] As noted throughout this document, background information on all parties having post-sale performance obligations is material to a prospective franchisee. There is no meaningful distinction between parents who make performance guarantees and franchisors with various contractual performance obligations.

b. Affiliates

As noted, the original Rule did not require the disclosure of litigation involving a franchisor’s affiliate. The proposed rule published in the Franchise NPR incorporated the UFOC Guidelines’ requirement that franchisors disclose litigation involving an “affiliate who offers franchises under the franchisor’s principal trademark.” Section 436.5(c) of the final amended Rule retains this concept, but modestly broadens the requirement, consistent with the Staff Report and Staff Report comments, to encompass: (1) litigation involving not only affiliates who offer franchises under the franchisor’s principal trademark, but also any affiliate who “guarantees the franchisor’s performance;” and (2) with respect to the requirement to disclose government injunctions or restrictive orders, actions involving an affiliate “who has offered or sold franchises in any line of business within the last 10 years.”[346]

The affiliate litigation disclosure provision generated limited comment.[347] One commenter urged the Commission to broaden Item 3’s scope to include litigation involving all affiliates, not just those under the franchisor’s principal trademark. The UFOC Guidelines’ narrow reach extends only to instances where affiliates offer franchises under the franchisor’s principal trademark. Arguably, this restrictive approach could allow a franchise system to hide derogatory facts about its litigation history by acquiring and operating a competing franchise system that uses a different mark. In such an instance, the newly-acquired franchisor would have no obligation to disclose its past litigation, falling outside the definition of both “predecessor” and “affiliate.” On the other hand, the record contains no suggestion that such instances are common. Thus, the Commission does not believe it warranted to require franchisors to disclose all affiliate litigation to address that hypothetical concern. Such a measure would be broader than necessary to address concerns documented in the record, would be burdensome, especially for large companies with multiple brands, and would not likely yield commensurate benefits to prospective franchisees.

Nevertheless, as noted above, the Commission has determined to expand the requirement to disclose affiliate litigation in two respects in order to provide prospects with material information. First, for currently effective government injunctive or restrictive orders delineated in section 436.5(c)(2), the final amended Rule adopts the Staff Report recommendation to broaden Item 3 affiliate coverage to include any affiliate who has offered or sold franchises in any line of business within the last 10 years.[348] In the Commission’s view, a government injunction or comparable order[349] (with or without a civil penalty or other redress), may be an indicator of fraud or other unlawful conduct.[350] Accordingly, a franchisor with a history of fraud or Rule violations should not be able to avoid disclosure of government actions against it merely by establishing a new corporation or switching trademarks. We believe this approach will result in the disclosure of material litigation history, without unduly burdening large, multi-brand franchise networks.

Second, section 436.5(c)(1) of the final amended Rule requires franchisors to disclose litigation involving not only affiliates that offer franchises under the franchisor’s principal trademark, but also any affiliate that guarantees performance. This responds to NASAA’s comment, urging the Commission to make clear that the term “affiliate” in Item 3 includes those guaranteeing performance, similar to the parent disclosure noted above.[351] As NASAA noted, there is no practical distinction between a parent and an affiliate who guarantees performance. In both instances, the prospective franchisee may rely on the guarantee in considering whether to purchase the franchise. Therefore, the litigation history of both parents and affiliates Start Printed Page 15479who guarantee performance is material and should be disclosed.

c. Settlements

With respect to settled actions, the original Rule required disclosure of any civil action a person subject to the provision “has settled out of court” in the previous seven fiscal years. It did not distinguish between confidential and nonconfidential settlements.[352] Consistent with the UFOC Guidelines, the Franchise NPR proposed that franchisors disclose the terms of any settled actions, expressly including confidential settlements.[353] Several commenters voiced concern about the requirement to disclose settlements—including confidential settlements.

Settlements Favorable to the Franchisor. PMR&W and Warren Lewis observed that Item 3 in the Rule as proposed in the Franchise NPR did not allow franchisors to omit settled litigation where the settlement is favorable to the franchisor or neutral.[354] Both commenters cited to the UFOC Guidelines,[355] which state that “settlement of an action does not diminish its materiality if the franchisor agrees to pay material consideration or agrees to be bound by obligations which are materially adverse to its interests.”[356] The point these commenters were making is that the UFOC Guidelines, by implication, would deem favorable or neutral settlements to a franchisor not material and would not call for their disclosure. The Commission believes this interpretation is correct, and intends that result in adopting the final version of this provision. Item 3, therefore, permits franchisors to omit settled litigation where a settlement is favorable to the franchisor or otherwise neutral.[357]

Confidential Settlements. With respect to the disclosure of confidential settlements, David Gurnick commented that the disclosure of any settlement terms that the parties agreed to keep confidential is bad policy because confidential settlements benefit both parties and the “opportunity for confidentiality is often an important dynamic to resolve a dispute.”[358] He urged that the Rule permit the disclosure of material facts about confidential settlements in the aggregate, so that the franchisor could make the disclosure about a group of cases, without violating the confidentiality of any one or more cases. For example, a franchisor could state: “we have settled 10 cases with confidentiality agreements. In each of these cases, we made payments to the franchisee in the mid five figure range.”[359]

Similarly, John Baer questioned the disclosure of exact dollar amounts or other confidential settlement terms. “This often can expose the franchisor to the choice of not being able to register its franchise in a particular state or making a disclosure and possibly breaching the terms of the confidential settlement agreement.”[360] He suggested that the Commission allow franchisors to disclose approximate dollar amounts, such as “the low four figures,” or, in the alternative, a range of figures.[361]

In keeping with the goal of reducing inconsistencies with the UFOC Guidelines, the Commission is disinclined, based on this record, to deviate from the UFOC Guidelines with respect to the scope of the confidential settlements disclosure. This issue was debated when NASAA revised the UFOC Guidelines in 1993, with input from many interested parties. Moreover, franchisors using the UFOC Guidelines format have been living under this policy on the state level for more than 10 years, apparently without much hardship.

Further, NASAA has recognized that the disclosure requirements concerning confidential settlements might raise breach of contract issues. Accordingly, the NASAA Commentary on the UFOC Guidelines specifically limited the disclosure to those settlements that were entered into after the adoption of the UFOC Guideline revisions on April 25, 1993. Item 3 of the final amended Rule incorporates a similar concept. The Commission recognizes that some small or regional franchisors who use the Franchise Rule format exclusively have not had the opportunity to phase-in confidential settlement disclosures. Based on this consideration, the Commission has added a footnote 2 to section 436.5(c)(3)(ii) of the final amended rule that specifies that “any franchisor who has historically used only the Franchise Rule format, or who is new to franchising, need not disclose confidential settlements entered prior to the effective date of this Rule.” Thus, franchisors historically using only the Franchise Rule format need not disclose confidential settlements entered into prior to the effective date of the final amended Rule, and only franchisors who have used the UFOC Guidelines format in the past must continue to disclose confidential settlements, as is the current practice.

John Baer raised a related point that the Commission finds persuasive. He asserted that it would be unfair to require the disclosure of confidential settlement agreements “if they were entered into by a company at a time when it was not yet engaged in franchise activities.”[362] It would be unreasonable to expect a non-franchisor to negotiate settlements with an eye toward the possibility that it may engage in franchise sales in the future. Accordingly, footnote 2 to section 436.5(c) of the final amended Rule provides that “franchisors need not disclose the terms of confidential settlements entered into before commencing franchise sales.”

d. Dismissed actions

As noted above, Item 3 requires a franchisor to disclose certain prior actions in which it has been “held liable.” Under this standard, a dismissal without any imposition or acceptance of liability on the franchisor’s part, would not have to be disclosed.[363]

In response to the Staff Report, two commenters observed that this Start Printed Page 15480limitation on prior actions is undercut by the inclusion in the proposed Franchise NPR version of Item 3 of a broad provision requiring franchisors and others to disclose if they have “been a defendant in a material action.” They observed that while dismissals without liability need not be disclosed under the “held liable” requirement of Item 3, they would have to be disclosed under the second more general “defendant in a material action” requirement. They urged the Commission to delete the “defendant in a material action” element of Item 3, to limit prior litigation disclosures to only those actions in which the defendant incurred liability.[364] In response to these comments, the Staff Report concluded that the drafting of the Franchise NPR’s version of Item 3 resulted in overbreadth, and therefore recommended that Item 3 be narrowed accordingly.[365]

The Commission has carefully considered this point. As noted above, the UFOC Guidelines clearly permit franchisors to limit the disclosure of prior actions to matters in which they were “held liable.” This approach is also consistent with the original Rule, which limited prior litigation to matters in which the franchisor “has been held liable . . . resulting in a final judgment or has settled out of court.”[366] Moreover, the language “been a defendant in a material action” is arguably redundant: if a defendant was not held liable in a prior action, then the underlying suit was not material. For these reasons, the phrase “been a defendant in a material action” included in the proposed Rule published in the Franchise NPR has been deleted from the final amended Rule.[367]

e. Franchisor-initiated litigation

One of the most important ways part 436 of the final amended Rule differs from both the original Rule and the UFOC Guidelines is that part 436 includes a requirement that franchisors disclose franchisor-initiated litigation.[368] Specifically, section 436.5(c)(1)(ii) requires a franchisor to disclose litigation in which it:

was a party to any material civil action involving the franchise relationship in the last fiscal year. For purposes of this section, “franchise relationship” means contractual obligations between the franchisor and franchisee directly relating to the operation of the franchised business (such as royalty payment and training obligations). It does not include suits involving suppliers or other third parties, or indemnification for tort liability.[369]

This final amended Rule provision is substantially the same as its counterpart proposed in the Franchise NPR.[370] Throughout the Rule amendment proceeding, franchisees and their representatives,[371] as well as the Small Business Administration,[372] urged the Commission to adopt such a requirement, asserting that franchisor-initiated litigation is material because it is a clear indicator of: (1) the quality of the franchisor-franchisee relationship; and (2) the extent to which the franchisor may be litigious. Others added that the original Rule and the UFOC Guidelines compelled franchisors to disclose franchisor-initiated litigation only if a franchisee subsequently filed a counterclaim. Yet, as these commenters noted, franchisees often do not have the financial resources to initiate a suit or to pursue a counterclaim.[373] Therefore, according to their argument, disclosure of franchise relationship litigation should not depend upon which party happens to have the resources to file a suit. Typical of these comments is the one submitted by NFA, an association of Burger King franchisees, stating that the disclosure of such information:

would be beneficial to potential franchisees, as it would allow such franchisees to be aware of any difficulties current or prior franchisees have encountered with the franchisor. In addition, the required disclosure of franchisor-initiated litigation would further aid potential franchisees by serving as an indicator of how franchisors resolve their disputes, and whether or not such franchisors are quick to resort to litigation in order to resolve disputes. The possibility of extensive litigation is important to a potential franchisee, as it may affect the calculation of costs involved in acquiring such a franchise. In addition, the continued threat of litigation from the franchisor may well affect later dealings between the parties, and as such is critical information of which the franchisee should be aware.[374]

A few commenters also maintained that compliance costs arising from such a disclosure are not great. For example, Seth Stadfeld observed that “once the initial changes are made [to the disclosure document], all that must be done is to update the disclosed litigation annually or sooner if material changes take place.”[375] The AFA was more blunt in its assessment:

The Commission has a choice. It can save franchisors a few pennies on a slightly larger offering circular Start Printed Page 15481or save a franchisee from investing hundreds of thousands of dollars in a franchise that he/she might not have invested in if he/she would have known all of the franchisor-initiated lawsuits against its own franchisees.[376]

In contrast, franchisors generally opposed the disclosure of franchisor-initiated litigation. Among other things, they asserted that franchisor-initiated litigation is immaterial[377] and would unnecessarily “bulk up” disclosure documents, thereby increasing compliance costs.[378] Others opined that the disclosure was unnecessary because, in their view, a franchisee aggrieved by a franchisor-initiated suit will surely file a counterclaim, which clearly must be disclosed under the original Rule.[379] Other franchisors asserted that the disclosure document already informs prospective franchisees about the state of the relationship.[380] Still others asserted that Item 3 litigation should be limited to suits that imply wrongdoing on the franchisor’s part: franchisor-initiated suits simply demonstrate that the franchisor is enforcing its rights under the franchise agreement.[381] Indeed, some franchisors argued that the disclosure could be misleading, wrongly implying that the franchisor has engaged in illegal or other misconduct.[382] In the same vein, some franchisors feared that a mandatory franchisor-initiated litigation disclosure might actually discourage franchisors from bringing suits, even meritorious suits, that are needed to maintain the integrity of the franchise system.[383]

Based upon the record developed in this proceeding, the Commission is convinced that franchisor-initiated litigation is material information that prospective franchisees need in order to assess a critical aspect of the franchise relationship—the nature of disputes and the level of litigation within a franchise system.[384] We recognize that the UFOC Guidelines’ Item 3, in limiting required disclosures to instances where a franchisee has filed a counterclaim, may have focused more narrowly on suits where arguably there was a greater probability of wrongdoing on a franchisor’s part. We now believe that this should be broadened to include additional information about the state of the franchise relationship. For example, we agree with the commenters who made the point that franchisor suits to enforce system standards could be viewed as a positive attribute, showing that the franchisor is willing to maintain uniformity for the benefit of the entire system. A franchisor’s willingness to protect its system is a material fact about the franchise relationship that should be disclosed to prospective franchisees.

Nevertheless, the Commission declines to broaden further the franchisor-initiated litigation disclosure of part 436, as some have suggested, to include litigation involving another franchise system owned by the franchisor, as well as litigation involving affiliates and third-party suppliers.[385] The core concern underlying the franchisor-initiated litigation requirement is the status of the relationship between the franchisor and its franchisees in the offered system.[386] Accordingly, the Commission has weighed the modest potential benefit of a broader litigation disclosure against the compliance costs and burdens, and decided not to require disclosures about litigation initiated by the franchisor’s affiliates, third-party suppliers, or other systems.

At the same time, the Commission also has considered various alternatives that franchisors assert would reduce franchisors’ compliance burdens. The alternative that garnered the most support was to tie the disclosure to a threshold level of suits.[387] For example, John Baer suggested a 5% threshold, under which a franchisor would not Start Printed Page 15482have to disclose litigation it initiated unless it has filed suit against at least 5% of the franchisees in its system.[388] Others suggested a higher percentage, such as 10%,[389] 15%,[390] or 20%,[391] while the IL AG suggested a lower percentage, such as 2%.[392]

The Commission is reluctant to tie the franchisor-initiated litigation disclosure of part 436 to a threshold. We believe it is impossible, given the limited record on this issue, to fashion a “one size fits all” approach for every franchise system in all industries. Moreover, any threshold would focus on the quantity of suits, suggesting that the sole purpose of the provision is to reveal litigiousness. When it comes to the state of the relationship, however, even a small number of suits initiated by a franchisor could be material to a prospective franchisee because they may reveal the nature of problems in the franchise system or show the franchisor’s willingness to enforce system standards.[393] With full disclosure, prospects can review the number and types of franchisors’ suits for themselves and draw their own conclusions about whether those suits are significant.

Turning more generally to Item 3 of the final amended Rule, it includes several refinements to the proposed rule that were offered during the proceeding, and that were recommended in the Staff Report. These refinements preserve the utility of the disclosure, while reducing compliance costs.[394] First, in order to minimize compliance burdens, the franchisor-initiated litigation disclosure requirement is limited to suits filed in the previous one-year period.[395] We believe this “snap-shot” in time is sufficient to reveal the franchisor’s practice of initiating litigation, as well as to reveal the types of franchise relationship problems that typically arise in the franchise system.[396]

Second, Item 3 permits franchisors to report franchisor-initiated litigation annually, not quarterly. That is, a franchisor would disclose all material litigation to which it was a party in the last fiscal year. This is intended to make it clear that quarterly updating requirements do not demand disclosure of franchisor-initiated actions filed in the 12 months prior to the date of the updated document. This approach improves on the proposed Rule’s “pending litigation” approach.[397] It also would have the additional benefit of reducing more frequent quarterly updating, which may be burdensome and perhaps impracticable in franchise registration states with more frequent updating requirements.[398]

Third, Item 3 incorporates a “materiality” standard.[399] This is consistent with both the original Rule and UFOC Guidelines.[400] Indeed, immaterial information, by definition, is unlikely to influence a prospective franchisee’s investment decision, while imposing unwarranted costs and unnecessarily lengthening disclosure documents.

As noted above in the discussion of section 436.1(d), materiality is determined from the viewpoint of the reasonable prospective franchisee. Accordingly, any franchisor-initiated litigation that goes to the quality of the franchise relationship being offered for sale is likely to be material. Indeed, the Commission intends the disclosure of franchisor-initiated litigation to be interpreted broadly to cover most suits. Nonetheless, we believe a requirement that franchisors disclose literally all franchisor-initiated suits goes too far. There may be instances where a franchisor-initiated suit might have no bearing on the specific franchise relationship being offered for sale. For example, franchisors may offer for sale “non-traditional” outlets operating a unique franchise agreement—such as the operation of an outlet on a military base. Franchisor-initiated litigation involving unique franchise agreements may be immaterial to the sale of “traditional” outlets operating under the franchisor’s standard franchise agreement. A blanket provision requiring disclosure of suits involving unique agreements might be overbroad and might unnecessarily increase the size of the Item 3 disclosure to the disadvantage of both prospective franchisees who must read it, as well as the franchisors who must prepare the disclosure. A “materiality” standard, therefore, will ensure that only suits shedding light on the type of relationship being offered for sale must be disclosed. Start Printed Page 15483

Fourth, as recommended in the Staff Report, Item 3 permits a franchisor to provide basic, summary information on its initiated litigation, without the need for long discussions on each and every case.[401] In addition, franchisors may list individual suits under one common heading, which will serve as the summary (for example, royalty collection suits). The franchisor would then merely list each applicable suit (case name, court, file number), without the need to provide any additional explanation.

Fifth, and finally, the final amended Rule clarifies the relationship between the disclosure of franchisor-initiated litigation and the disclosure of counterclaims. Staff Report comments by Wiggin & Dana noted that the rule proposed in the Franchise NPR did not explicitly address the filing of a franchisee counterclaim after a franchisor initiates a suit.[402] The firm questioned whether a franchisor-initiated case followed by a counterclaim would be treated as a franchisor-initiated case only—receiving the more narrow disclosure treatment—or whether the counterclaim would be considered like all other counterclaims—receiving the more extensive disclosure treatment.[403]

The Commission intends the franchisor-initiated litigation provision of the final amended Rule to expand upon the approach taken by the original Rule, not constrict it. Accordingly, franchisors must disclose any counterclaims in the same manner as they would have done under the original Rule, providing complete case summaries. Only in those instances where a franchisor initiates a suit—absent the filing of any subsequent counterclaim filed by the franchisee—does the franchisor-initiated litigation disclosure requirement apply.

The final amended Rule makes this point clear as follows. First, section 436.5(c)(3) provides instructions for all litigation that must be disclosed in Item 3. It requires, for each suit, the disclosure of the case title, number or citation, initial filing date, names of the parties, the forum, and the relationship of the opposing party to the franchisor. Following these basic disclosures are more specific disclosures (e.g., summaries of legal and factual claims, relief sought, conclusions of law) that pertain to all suits, except for franchisor-initiated litigation, which is covered in a separate section (section 436.5(c)(4)). Any counterclaim filed by a franchisee in a suit would be covered by the section 436.5(c)(3) disclosure requirements.

The next section—section 436.5(c)(4)—sets forth the instructions for “any other franchisor-initiated suit identified” in Item 3.[404] The use of the phrase “any other franchisor-initiated suit” is intended to limit the provision to suits in which no franchisee counterclaim has been filed. This section makes clear that, in lieu of the more comprehensive disclosure instructions of section 436.5(c)(3), a franchisor may disclose franchisor-initiated litigation “by listing individual suits under one common heading.” Accordingly, Item 3 affords the franchisor flexibility, permitting the disclosure of franchisor-initiated litigation either through the comprehensive disclosures of section 436.5(c)(3) or the more abbreviated disclosures of section 436.5(c)(4).

6. Section 436.5(d) (Item 4): Bankruptcy

Section 436.5(d) of the final amended Rule retains the original Rule’s disclosure of prior bankruptcies, including any parent’s bankruptcy.[405] Consistent with the UFOC Guidelines, it extends the original Rule by requiring franchisors to disclose bankruptcy information about predecessors and affiliates, to disclose foreign proceedings comparable to bankruptcy, and to make bankruptcy disclosures for 10 years, instead of the original Rule’s seven years limitation.[406]

Item 4 of the final amended Rule also incorporates several refinements based upon the record developed in this proceeding. The Rule as proposed in the Franchise NPR, at Item 4, would have required the disclosure of an affiliate’s prior bankruptcy only if the affiliate currently offers franchises under the franchisor’s trademark.[407] One commenter suggested that the bankruptcy disclosure should apply to all affiliates, consistent with the UFOC Guidelines.[408] We agree. It is clear that the UFOC Guidelines require franchisors to disclose the bankruptcy of any affiliate of the franchisor, not just those affiliates who offer franchises under the franchisor’s principal mark.[409] In order to reduce inconsistencies between part 436 and the UFOC Guidelines, we have revised the disclosure of an affiliate’s bankruptcy accordingly.[410]

In its response to the Staff Report, J&G also contended that the introductory paragraph of both the proposed Rule in the Franchise NPR and the Staff Report are unclear.[411] As recommended in the Staff Report, for example, this paragraph would require a franchisor to disclose “whether the franchisor, any parent, predecessor, affiliate, officer, general partner . . . filed for bankruptcy.”[412] J&G contended that it is unclear whether this language requires a franchisor to disclose the bankruptcy history of officers or affiliates of a predecessor, as well as officers of a parent or affiliate. To eliminate confusion on this point, the final amended Rule reads as follows: Start Printed Page 15484“Disclose whether the franchisor; any parent; predecessor; affiliate; officer, or general partner of the franchisor, or any other individual who will have management responsibility relating to the sale or operation of franchises offered by this document . . .”

The Commission has rejected, however, other suggestions to modify Item 4. Several commenters questioned the need to require predecessor and parent bankruptcy disclosures. They asserted that the additional disclosure burden is not outweighed by any benefit to prospective franchisees.[413] Consistent with our discussions in connection with Items 1-3, we believe that information about predecessors and parents is material and should be disclosed. Where a parent is in bankruptcy, for example, its assets include any franchisor-subsidiary. Under such circumstances, a prospective franchisee should be made aware that the franchisor in which it is considering investing might be sold, possibly to a competitor or to a company lacking prior franchise experience.

Further, David Gurnick suggested that the time period for reporting a bankruptcy should be reduced from 10 to five years.[414] J&G also observed that a 10-year obligation would compel the disclosure of a bankruptcy that was actually filed significantly earlier:

[I]t would seem that ten years from the date of the filing of a petition would be the appropriate beginning date. We are aware of one case in which an officer was involved with a company when a petition was filed in 1986, and the bankruptcy proceeding is still pending. Were it settled this month (December 1999), disclosure of that event would be required for a total of 23 years![415]

Although the 10-year reporting period may, in rare instances, result in the disclosure of a bankruptcy filed more than 10 years earlier, the Commission has determined that the 10-year reporting period is reasonable in order to give prospective franchisees a complete picture of the franchisor’s bankruptcy history. We are not inclined to deviate from the UFOC Guidelines on this point.

Finally, NaturaLawn urged the Commission to exclude from Item 4 the disclosure of personal bankruptcies. The company noted that personal bankruptcies can be filed for a variety of reasons, such as divorces, medical issues, or insurance claims.[416] The Commission believes that the disclosure of personal bankruptcy information is necessary to prevent deception or fraud. In many instances, prospective franchisees entrust considerable initial fees and ongoing funds to franchise managers for training and advertising, among other forms of post-sales assistance. Accordingly, prospective franchisees may rely to their detriment on claims made by such managers. The disclosure of a franchisor manager’s bankruptcy, therefore, would shed light on that manager’s ability to safeguard and use those funds properly. Under the circumstances, we see no compelling reason to omit a personal bankruptcy, especially since such an approach would also deviate from the UFOC Guidelines.

7. Section 436.5(e) (Item 5): Initial fees

Section 436.5(e) of the final amended Rule requires the disclosure of initial fees.[417] This disclosure is substantively similar to the comparable disclosure provision found in the original Rule at 16 CFR 436.1(a)(7). The final amended Rule, like the proposed Rule published in the Franchise NPR, follows the UFOC Guidelines in explicitly permitting franchisors to provide a range of fees, whereas the original Rule implicitly contemplated a fixed fee.

Item 5 of the final amended Rule is substantially similar to Item 5 in the proposed Rule published in the Franchise NPR, but it incorporates several technical revisions that the commenters suggested. One commenter recommended that the title of Item 5 should refer to “Initial Fees” instead of the proposed title, “Initial Franchise Fee,” recognizing that a prospective franchise may pay more than just one fee in order to acquire a franchise.[418] Consistent with that revision, references to “fee” in Item 5 have been revised as follows: (1) “these fees are refundable,” in place of “this fee is refundable;” and (2) “Initial fees mean,” in place of “initial fee means.”[419]

Second, another commenter correctly noted that the Franchise NPR version of Item 5 did not expressly define “initial fees” to include commitments to make payments to the franchisor. Rather, Item 5 as proposed in the Franchise NPR would have defined an initial fee only in terms of cash actually paid at the time of the sale.[420] The commenter’s point is well-taken. The “initial fees” disclosure requirements of Item 5 relate to the required payment element in the definition of the term “franchise.”[421] Under that definition, a “required payment” is not limited to cash, but expressly includes commitments to make payments to the franchisor at a later date. Otherwise, a franchisor could seriously undercut the Item 5 cost disclosure by requiring prospects to sign notes or other obligations in lieu of immediate payment. Accordingly, Item 5 of the final amended Rule expressly includes not just fees that are actually paid, but commitments to pay as well.[422]

Commenters also offered various proposals for modifying Item 5 that we believe are unwarranted. While Item 5 requires disclosure of “the range or formula used to calculate the initial fees paid in the fiscal year before the issuance date,” Howard Bundy urged that it require the disclosure of any contractual formulas for determining the current initial fee. Mr. Bundy opined that it is “important to have disclosure of any contractual formulas that will Start Printed Page 15485result in this prospect paying a different initial fee than the historic information would suggest.”[423]

The Commission’s view, however, is that as long as the prospect is aware of the amount to be paid before the sale, the method the franchisor used to derive that amount is not necessarily material. The Commission notes that Item 5 ensures that a prospective franchisee knows whether fees are uniform and, where they are not, enables the prospect to bargain for a lower rate. Item 5 supplies the prospect with some historical information that can aid in gauging the parameters of the franchisor’s willingness to negotiate fees. We believe that this is more useful by far than including in the disclosure document current contractual formulas. Thus, there is no reason to diverge from the UFOC Guidelines on this issue.

Three other commenters voiced concern about Item 5 as it relates to the negotiation of fees. The NFC asserted that Item 5 implies that a franchisee can seek to negotiate initial fees only if the franchisor already disclosed in its Item 5 a range of previously accepted fees. Such a result, in its view, restricts prospective franchisees’ ability to initiate fee negotiations.[424] The Commission’s intention is to promote the parties’ ability to negotiate terms and conditions, including fees and other costs. Full and accurate prior disclosure furthers that goal. Accordingly, nothing in Item 5 or any other provision of part 436 of the final amended Rule prevents the parties from negotiating fees.

David Gurnick suggested that the Rule permit a franchisor to disclose whether or not it will negotiate fees, and if it does so, permit disclosure of the conditions that may affect the negotiation.[425] Similarly, BI urged that franchisors be permitted to disclose that they may lower the initial fees.[426]

As noted above, however, Item 5 ensures that prospects know when fees may vary. This is sufficient to prompt them, if they wish, to negotiate for a fee level that suits them. A more extensive or detailed disclosure on this issue would only introduce needless nonconformity with the UFOC Guidelines without producing any appreciably increased benefit to prospective franchisees.

BI also urged that when the initial fee is negotiated rather than established by applying a formula or fixed calculation, the range of such negotiated initial fees in the prior fiscal year need not be disclosed.[427] The Commission’s view, however, is that providing a range of fees, regardless of how or why these ranges came about, is useful to prospective franchisees in the negotiation process. Such disclosure compels neither party to reach agreement on unacceptable terms: franchisors and prospective franchisees remain free to negotiate in and outside of any disclosed range. Accordingly, we see no reason to deviate from the UFOC Item 5 approach in this regard.[428]

8. Section 436.5(f) (Item 6): Other fees

Section 436.5(f) of the final amended Rule requires franchisors to disclose recurring or occasional fees associated with operating a franchise (e.g., royalties, advertising fees, and transfer fees). This requirement recognizes that a prospective franchisee’s investment is not limited to the initial franchise fee alone. Rather, a franchisee may incur considerable costs in the operation of the business, which will significantly impact upon his or her ability to continue in business and ultimately be successful. This provision covers payments made directly to the franchisor or an affiliate, or collected by the franchisor or affiliate for the benefit of a third party. This disclosure is substantially similar to the comparable original Rule disclosure found at 16 CFR 436.1(a)(8).[429] Following the UFOC Guidelines, the Rule, as proposed in the Franchise NPR, expanded the scope of this original Rule provision by requiring a disclosure about the existence of advertising and purchasing cooperatives from which franchisees may be required to purchase goods or services. The proposed Rule also required disclosure about the voting power of any franchisor-owned outlets in the cooperative and, if company store voting power is controlling, the range of required fees charged by the cooperative. This is material information about restrictions on prospective franchisees’ independence in operating the offered franchise, as well as the total costs of doing so.

The Commission has determined to adopt proposed Item 6 from the Franchise NPR, with some fine tuning. Accordingly, Item 6 of the final amended Rule incorporates a suggestion from both Warren Lewis and NASAA that the proposed title of Item 6 taken from the UFOC Guidelines (“Recurring or Occasional Fees”) be replaced with “Other Fees,” the term actually used throughout the disclosure.[430] The Commission believes this change improves the clarity of the Rule’s text and Item 6.

In addition, to conform more closely to the UFOC Guidelines, Item 6 of the final amended Rule requires that franchisors state explicitly what fees are non-refundable (rather than just stating the conditions when a fee is refundable).[431] Again, to conform more closely with the UFOC Guidelines, Item 6 requires franchisors to disclose whether continuing fees currently being charged are uniformly imposed on all franchisees.[432]

The Staff Report recommended expansion of Item 6 to require franchisors to disclose required payments made to third parties.[433] The Commission has decided not to adopt that recommendation. Early in the Rule amendment proceeding, NASAA urged this expansion of Item 6.[434] Another commenter supported this suggestion, noting that in the “vast majority of the franchise cases we see, the franchisee’s ongoing legal obligations to third parties far exceed the franchisee’s ongoing legal obligations to the franchisor. However, the franchisee cannot obtain the franchise without incurring the third-party obligations.”[435]

Eight Staff Report comments, however, opposed the proposed expansion of Item 6 to require the Start Printed Page 15486disclosure of payments made to third parties. Gust Rosenfeld’s comment is typical, noting that a franchisor may require franchisees to lease premises, obtain necessary licenses, and operate in compliance with applicable laws. “All of the payments to do these things are technically ‘required,’ but they are generally applicable to all businesses, and the franchisor does not control when they are made, to whom they are made, or what the amount is.”[436] Similarly, Piper Rudnick and IFA asserted that a required listing of all possible third-party suppliers of goods or services would expose a franchisor to liability if it forgot to include one or more.[437]

The Commission agrees that the disclosure of third-party fees in Item 6 would be overbroad, resulting in the mandatory disclosure of information that might not be readily obtainable by the franchisor and unnecessarily increasing franchisor’s compliance burden without any commensurate benefit to prospective franchisees. Moreover, estimates of initial payments to third parties are already covered by Items 7 and 8, as discussed below. Specifically, Item 7 requires franchisors to disclose estimates of pre-sale expenses paid during the initial period—typically the first three months—and also requires franchisors to “[l]ist separately and by name any other specific required payments (for example, additional training, travel, or advertising expenses) that the franchisee must make to begin operations.[438] Franchisors must also include an “additional funds” category to capture “any other required expenses the franchisee will incur before operations begin and during the initial phase of operations.”[439] Item 8 already requires franchisors to disclose franchisee obligations to make purchases from required or approved suppliers. These include obligations to purchase items such as supplies, equipment, inventory, computer hardware and software, and real estate. The Commission is persuaded that the Item 7 and Item 8 part 436 disclosures are more than sufficient to advise prospective franchisees of the likely purchase obligations incurred in operating a franchise.

9. Section 436.5(g) (Item 7): Estimated initial investment

Section 436.5(g) of the final amended Rule requires franchisors to set out in an easy-to-read table all the expenses necessary to commence business (e.g., rent, equipment, and inventory)—not just the initial fees covered by Item 5 and other fees covered by Item 6. It also requires franchisors to disclose any refund conditions. Comparable cost disclosures are found in the original Rule at 16 CFR 436.1(a)(7).[440] Consistent with the UFOC Guidelines,[441] Item 7 also extends the original Rule by requiring a franchisor to disclose not only payments that the franchisee must make to the franchisor or its affiliates, but also estimated payments the franchisee must make to third parties in some instances. For example, franchisors must estimate payments for utility deposits and business licenses. It also requires franchisors to include an “additional funds” category[442] that captures other expenses franchisees will incur during the “initial period” of operations.[443]

Item 7 generated little comment. In response to the Staff Report, Howard Bundy asserted that Item 7 is insufficient, failing to reveal a franchisee’s total initial investment because it does not include various payments to third parties beyond the first 90 days. Specifically, it misses real estate costs and equipment financing and leasing. Mr. Bundy urged the Commission to adopt the following:

Disclose the total amount (in a range, if appropriate) of all obligations to third parties during the entire initial term of the franchise that will be necessary to operate the franchised business (including real estate leases and equipment leases) that the franchisee may be required to personally guaranty.[444]

The Commission declines to adopt this proposal. By its terms, Item 7 of the UFOC Guidelines is designed to furnish prospective franchisees with material information about the likely expenses faced in the start-up phase of the franchise. Armed with such information, a prospective franchisee will know whether or not he or she has the financial ability to get the franchised outlet operational. Item 7 is not intended to capture all expenses made over the life of the franchise, which may vary depending upon such factors as the franchisee’s choice of suppliers and the terms he or she negotiates with them. For example, Item 7 recognizes that a franchisor may not know the exact amount of real property expenses. Rather than requiring an exact figure, Item 7 permits franchisors to give an estimate or a low-high range. If neither can be determined, Item 7 permits franchisors to simply describe property requirements, such as property size and type, and location. Moreover, prospective franchisees may be able to get more detailed estimates of long-term expenses by speaking directly with existing franchisees in their location, or with trademark-specific franchisee associations. For these reasons, the Commission is not inclined to deviate from the UFOC Guidelines Item 7 on this issue.

Item 7 of the final amended Rule is substantially similar to its counterpart in the Franchise NPR, but has been modified in a number of ways to adhere more closely to the UFOC Guidelines. For example, the Franchise NPR proposed that the Item 7 table be titled: “YOUR ESTIMATED INITIAL INVESTMENT FOR THE FIRST [REASONABLE INITIAL PHASE] MONTHS.”[445] As one commenter noted, however, the language proposed in the Franchise NPR is unnecessarily inconsistent with title of Item 7 table of the UFOC Guidelines, which is titled “YOUR ESTIMATED INITIAL INVESTMENT.”[446] Moreover, the “initial phase” referenced in UFOC Guidelines Item 7 pertains only to the Start Printed Page 15487“additional funds” category, not to the entire table.[447]

In addition, Item 7 as proposed in the Franchise NPR would have required franchisors to disclose “additional funds” required before operations begin and during the initial phase of the franchise.”[448] The Commission noted in the Franchise NPR that this language was intended to require a working capital disclosure that could assist prospective franchisees in understanding their break-even point. Several commenters opposed the Franchise NPR’s intention to capture working capital and a break-even point; they pointed out that such an approach goes beyond what the UFOC Guidelines require and asserted that this could be misleading without more detailed earnings information, such as in an earnings claim statement.[449] Indeed, one commenter argued persuasively that the Franchise NPR’s proposal could create a “back-door” mandatory earnings claim, a position contrary to the Commission’s view that earnings claims should be voluntary.[450] The Commission finds these arguments persuasive. Accordingly, the final amended Rule tracks the language of UFOC Guidelines Item 7 more closely, eliminating any implication that the Commission intends for franchisors to disclose either a working capital or breakeven point.

10. Section 436.5(h) (Item 8): Restrictions on sources of products and services

The original Rule required franchisors to disclose obligatory purchases, restrictions on sources of products and services, and the amount of any revenue the franchisor may receive from required suppliers.[451] The final amended Rule requires more detailed and extensive disclosures on these topics, consistent with the UFOC Guidelines. Specifically, section 436.5(h) of the final amended Rule requires franchisors to disclose whether it makes the criteria for approving suppliers available to franchisees.[452] In addition, franchisors must state whether, by contract or practice, the franchisor provides material benefits to franchisees who use designated or approved suppliers (e.g., permitting renewals or additional outlets). Finally, it requires franchisors to disclose the existence of purchasing or distribution cooperatives, and whether the franchisor negotiates purchase agreements with suppliers on behalf of franchisees. These highly material disclosures inform prospective franchisees about critical restrictions on how they will have to operate the franchise, which comprise a vitally important aspect of the franchise relationship.

During the course of the Rule amendment proceeding, franchisee advocates raised various concerns about Item 8. For example, several franchisees voiced concern about source restrictions that prevent them from obtaining supplies at lower market rates.[453] Commenters generally did not allege that franchisors fail to disclose source restrictions, but complained about the “abusive nature” of such restrictions.[454] Nevertheless, franchisee advocates questioned the sufficiency of the Item 8 disclosures. Specifically, Andrew Selden urged the Commission to expand the disclosure of supplier restrictions to require franchisors to disclose more information about their practices and intentions with respect to the provision of competitive alternative sources of supply.[455] Mr. Selden, however, offered no specific language for the Commission’s consideration. Robert Zarco urged the Commission to require franchisors to warn prospective franchisees that:

The company retains the right to approve all outside vendors supplying products to the franchisees. Our criteria generally focus on quality and concept-uniformity, but we reserve the right to modify the criteria for approving suppliers at any time. Additionally, there are no time limitations as to how long the review/approval of franchisee-endorsed vendors may take.[456]

The Commission agrees that full disclosure of source restrictions and purchasing obligations is warranted. To that end, the final amended Rule adopts the broader UFOC Guidelines’ Item 8 disclosures. Item 8 strikes the right balance between pre-sale disclosure and compliance costs and burdens. It is sufficient to warn prospective franchisees about source restrictions, purchase obligations, and approval of alternative suppliers, without requiring franchisors to disclose their past practices regarding approving alternative suppliers (which may be irrelevant to their current practices) or their future intentions (which may be proprietary information or misleading if the franchisor abandons the intended direction). Moreover, prospective franchisees can always ask existing franchisees or trademark-specific franchisee associations about a franchisor’s history of approving alternative suppliers, if this issue is important in their decision-making process.

With respect to the disclosure of revenues received from suppliers, Howard Bundy suggested that franchisors should disclose the dollar amount of any revenues received during some stated period, such as during the Start Printed Page 15488last year.[457] The disclosure of revenues from suppliers serves an “anti-conflict of interest” purpose, putting prospective franchisees on notice that the franchisor, by benefitting materially from a relationship with a supplier, may be motivated to require franchisees obtain goods or services from that supplier. Accordingly, the highly material fact is that the franchisor receives revenues from suppliers it requires franchisees to use, not the exact dollar amount received. By requiring franchisors to disclose the percentage of revenue derived from suppliers, Item 8 achieves that purpose, consistent with the UFOC Guidelines.

Finally, in response to the Staff Report, a few commenters offered various technical refinements to Item 8.[458] First, Piper Rudnick noted that Item 8 of the Staff Report would require disclosures about purchases from “suppliers . . . under the franchisor’s specifications[, including] obligations to purchase imposed by written agreement or by the franchisor’s practice.” The firm interpreted the phrase “imposed by written agreement” as modifying the word “supplier.” If so, it maintained that a franchisor would have no reason to know if a supplier has a written agreement.[459] We believe this is a strained reading of the provision: “written agreement” is intended to refer to “franchisor,” not to a “supplier.” Nevertheless, in order to avoid any confusion, we have modified Item 8 in the final amended Rule now to read as follows: “Include obligations to purchase imposed by the franchisor’s written agreement or by the franchisor’s practice.”[460]

Second, NASAA addressed the placement of footnote 5. Item 8, as proposed in the Staff Report, would require franchisors to disclose “whether the franchisor or its affiliates will or may derive revenue or other material consideration from required purchases or leases by franchisees,” and “if so describe the precise basis by which the franchisor or its affiliates will or may derive that consideration by stating . . .” Footnote 5 added: “Take figures from the franchisor’s recent annual audited financial statement . . . If audited statements are not yet required, or if the entity deriving the income is an affiliate, disclose the sources of information used in computing revenues.” NASAA observed that the footnote incorrectly seems to modify “precise basis,” when it should modify “franchisor’s total revenue.” It suggested moving the footnote to the end of section 436.5(h)(6)(i) so that it will modify “the franchisor’s total revenue.”[461] The final amended Rule adopts that suggestion.

11. Section 436.5(i) (Item 9): Franchisee’s Obligations

Section 436.5(i) of the final amended Rule adopts UFOC Item 9, as proposed in the Franchise NPR.[462] This disclosure gives prospective franchisees an easy-to-understand guide to 25 enumerated contractual obligations that are common in franchise relationships, with cross references to the specific sections of the franchise agreement and disclosure document that discuss each obligation in greater detail. There is no counterpart in the original Rule.

Item 9 generated only a few comments during the Rule amendment proceeding. One franchisor representative maintained that the disclosure is unnecessary. He urged that a franchisor be permitted to opt out of Item 9 if the franchisor provides prospective franchisees with a detailed table of contents or index to its franchise agreement.[463] Similarly, another franchisor representative suggested that the Item 9 disclosures should apply only to franchise agreements, but not to any accompanying “licenses, leases, subleases, guarantees, security agreement, load documents, software agreements, etc.”[464] According to this commenter, references to these ancillary agreements are burdensome and of little value to prospective franchisees. On the other hand, a franchisee representative asserted that Item 9 does not go far enough: “As currently structured, this disclosure is not worth the time and effort largely because it provides no benefit to the prospect.”[465] He suggested that franchisors use a remarks column to describe briefly the nature of each obligation.

The Commission believes that Item 9 serves a useful purpose. As stated throughout this document, franchisee complaints submitted during the Rule amendment proceeding supported better pre-sale disclosure about the nature of the franchise relationship.[466] Item 9 addresses that concern by providing a detailed table of contents to the franchise agreement, with the additional benefit of cross references to the relevant sections of the disclosure document. It facilitates review of a franchise offering by enabling a prospective franchisee to find and review the contractual provisions detailing their legal obligations, better ensuring that prospective franchisees are not mislead about the nature of the franchise relationship. Moreover, many franchisors already use the UFOC Guidelines and prepare an Item 9 table. Further, Item 9 should impose few costs or compliance burdens because franchisors need only reference existing materials, most likely the franchise agreement and disclosure document. To the extent that legal obligations are spelled out in any ancillary agreements, franchisors must direct prospects to those provisions as well.[467]

12. Section 436.5(j) (Item 10): Financing

Consistent with the UFOC Guidelines Item 10, section 436.5(j) of the final amended Rule requires a franchisor to disclose all the material terms and conditions of any financing agreements, which encompass: the rate of interest, plus finance charges, expressed on an annual basis; the number of payments; penalties upon default; and any consideration received by the franchisor for referring a prospective franchisee to a lender. This disclosure is comparable to the original Rule provision found at 16 CFR 436.1(a)(12).[468] The final Start Printed Page 15489amended Rule’s Item 10 closely tracks the version of this provision as proposed in the Franchise NPR, revised to improve the clarity and overall consistency of the Rule.[469]

Section 436.5(j), like UFOC Guidelines Item 10, extends the original Rule disclosures by requiring franchisors to disclose any interest on the financing in terms of the rate of interest, plus finance charges, expressed on an annual basis, consistent with such disclosures required in consumer credit transactions.[470] It also requires more disclosure than the original Rule about what the financing covers, waiver of defenses, and the franchisor’s practice or intent to sell or assign the obligation to a third party.[471]

Three commenters voiced concerns about Item 10. First, H&H suggested that leases referred to in Item 10 should be called “‘finance leases,’ a well-established term in commercial law.”[472] The Commission declines to adopt this suggestion. While “finance leases” may be a term of art used in commercial law, we do not believe that the UFOC Guidelines Item 10—upon which section 436.5(j) is based—is ambiguous or otherwise unclear. Deviating from the UFOC Guidelines on this point, therefore, is unwarranted.

Second, David Gurnick suggested that the Rule expressly permit negotiation of financial terms, and require disclosure indicating “that there are other sources of financing, such as banks, which the franchisee should consider.”[473] The Commission, of course, intends that franchisees be free to negotiate financing terms. The Commission does not believe that the text of the final amended Rule at Item 10 can be read to imply that negotiation of financial terms is not permitted, or that Item 10 contemplates any restriction of a franchisee’s choice of lender. Therefore, we believe it unnecessary to deviate from the UFOC Guidelines on this point.[474]

Finally, in response to the Staff Report, IL AG raised a technical issue about the sample Item 10 Financing Table, noting that “Equip. Lease” and “Equip. Purchase” have separate lines, while “Land/Constr.” has a single line. The form of the Item 10 Financing Table in the final amended Rule, however, is taken directly from the UFOC Guidelines, and the record does not reflect that this format has caused difficulty for franchisors or confusion on the part of prospective franchisees. We therefore decline to deviate from the UFOC Guidelines on this point.

13. Section 436.5(k) (Item 11): Franchisor’s assistance, advertising, computer systems, and training

Section 436.5(k) retains the original Rule’s disclosure of franchisor’s assistance obligations, including pre-opening assistance (e.g., site selection), as well as ongoing assistance (e.g., training).[475] Item 11 of the final amended Rule expands the original Rule, however, based upon the UFOC Guidelines’ more detailed assistance disclosure requirements, including disclosures relating to advertising assistance and computer system requirements.[476]

Section 436.5(k) requires franchisors to begin their Item 11 disclosure with the statement, in bold type, that “[e]xcept as listed below, [the franchisor] is not required to provide you with any assistance.” This alert counters any express misrepresentations to the contrary and corrects any misconception on the prospective franchisee’s part that a minimum degree of assistance is inherent in any franchise offer.[477] Item 11 also requires franchisors to explain in detail the franchisor’s site selection criteria and the franchisor’s training program. As noted above, this provision also requires franchisors to disclose the extent of any advertising assistance and the operation of local, regional, and national advertising councils or co-ops. These disclosures address a common franchisee complaint, namely, that franchisees do not get the quality or quantity of advertising they pay for.[478]

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Section 436.5(k) also addresses major technological changes in franchising since the original Rule was promulgated in 1978. Based upon UFOC Item 11, this provision requires material disclosure about the required use of computers and electronic cash registers.[479] For example, it requires franchisors to disclose whether they will have independent access to information and data stored on electronic cash register systems or software programs that the franchisee is required to use or buy.[480]

Item 11, as proposed in the Franchise NPR, would have adopted the UFOC Guidelines requirement that franchisors identify each piece of hardware and software by brand, type, and principal function, or to identify compatible equivalents and whether they have been approved by the franchisor.[481] The computer system disclosure was the only Item 11 issue that generated significant comment during the Rule amendment proceeding. Several comments asserted that the UFOC Guidelines Item 11 computer system disclosures are burdensome, not helpful to prospective franchisees, and are unnecessary because the costs associated with purchasing computers and related equipment are already disclosed in Items 5, 7, and 8.[482] Marriott, for example, explained that its Item 11 computer usage disclosure “results in four to five pages of disclosure in each of Marriott’s offering circulars yet provides little or no benefit to franchisees.”[483] In addition, one franchisor representative noted that many start-up franchisors are “not certain which computer system or software they expect to have the franchisees use. Provision should be made for these new franchisors.”[484]

The Commission believes that Item 11’s computer systems disclosures, which track the UFOC Guidelines’ disclosures, serve a useful purpose. There is no question that the costs a franchisee must incur to purchase or lease computer and related equipment or software, as well as any continuing maintenance or upgrade obligations and their associated costs, comprise information that is material to the prospective franchisee’s purchasing decision. Information about whether the franchisor will have access to information stored on the franchisee’s computers or electronic cash registers also is material, because such access very likely would be a key component of the relationship between the franchisor and franchisee. As noted throughout this document, the Commission is convinced that additional disclosures are warranted where they will likely prevent deception about the nature of the franchise relationship a prospective franchisee is deciding to enter.

Nonetheless, the computer usage disclosures as set forth in the UFOC Guidelines appear to go beyond what is material in some instances and likely would impose unwarranted compliance burdens. Specifically, we are disinclined to require a franchisor to identify each and every piece of hardware and software by brand, type, and principal function, or to identify compatible equivalents and whether they have been approved by the franchisor. We agree with the Franchise NPR commenters who observed that some franchisors (start-up franchisors in particular) may not have decided upon specific systems at the time of sale or, even if they did, that the technology very likely will change over the course of the franchise agreement. Thus, the compliance burden to prepare component-specific disclosures would not likely outweigh any tangible benefits to prospective franchisees.[485] We are persuaded that it is sufficient for franchisors to describe generally the computer systems to be used, if any; any required purchase and maintenance costs and obligations; and whether the franchisor will have access to information contained in those systems. This information not only will enable prospects to weigh the costs and benefits of purchasing a specific franchise, but will better enable prospects to learn if they will be at a technological disadvantage compared to other franchise systems in the industry.

On the other hand, one franchisee advocate, Howard Bundy, firmly defended the materiality and usefulness of detailed itemized disclosures about required computer systems. Specifically, Mr. Bundy voiced concern about franchisors that require franchisees to use proprietary technology that the franchisor has developed or plans to develop. Mr. Bundy asserted that this may negatively impact upon franchisees’ ability to fix flaws in software, for example. He contended that prospective franchisees should have the right to know whether they can use “off-the-shelf” products, and whether software can interface with common systems such as Microsoft Office or Outlook. Similarly, they should know whether accounting software complies with IRS standards or if they will get periodic updates.[486]

Mr. Bundy’s concern about the potential limitations of franchisor-developed software has merit. However, we believe the final amended Rule already addresses this issue. As noted above, section 436.5(k) requires franchisors to “describe the systems (which includes hardware and software components) generally in non-technical language, including the types of data to be generated or stored in these systems.” Thus, the “general description” requirement is broad enough to cover proprietary systems that can be obtained only from the franchisor. Moreover, section 436.5(k) will require the franchisor to disclose any obligation to provide ongoing maintenance, repair, upgrades, or updates. Taken together, these provisions are sufficient to capture instances where franchisors require the use of their own software.

Finally, we note that in response to the Staff Report, Gust Rosenfeld raised a technical point about the Item 11 disclosure of the franchisor’s operating manual. The firm noted that, under the UFOC Guidelines, franchisors must include the Table of Contents of the operating manual in the disclosure Start Printed Page 15491document, unless “the prospective franchisee views the manual before purchase of the franchise.”[487] The firm asserted that the Staff Report erred in recommending that the alternative to providing the Table of Contents be revised to permit a franchisor to “offer a prospective franchisee the opportunity to review the manual before buying the franchise.”

The Commission believes the Staff Report is correct. As a practical matter, we question how it could be proven that a prospective franchisee actually reviewed a manual. Even if a franchisor had a prospective franchisee initial each page of a manual, there is no assurance that the prospect actually “reviewed” the manual. For that reason, at most we can require a franchisor to afford a prospective franchisee the opportunity to review the manual. At the same time, we stress that the “opportunity to review” a manual must be a reasonable one. A franchisor would not satisfy its disclosure obligation if, for example, it offered to show the manual to a prospect only if the prospect agreed to fly across country to the franchisor’s corporate headquarters. In that regard, the opportunity to review a manual means that the franchisor must show the manual to the prospect (for example in person or online) and permit the prospect sufficient time to review it.

14. Section 436.5(l) (Item 12): Territory

Section 436.5(l) of the final amended Rule retains the original Rule’s disclosures concerning exclusive territories and sales restrictions.[488] Like the proposed Rule published in the Franchise NPR, the final amended Rule is closely modeled on the UFOC Guidelines. It therefore expands the original Rule’s disclosure requirements regarding territories in several respects. These new disclosure requirements cover: (1) the conditions, if any, under which a franchisor will approve the relocation of the franchisee’s business and the franchisee’s establishment of additional outlets; (2) any present plans on the part of the franchisor to operate a competing franchise system offering similar goods or services; and (3) in instances when a franchisor does not offer an exclusive territory, a prescribed warning about the consequences of purchasing a non-exclusive territory. In response to some comments, the Commission also has decided to make additional modifications to the text of Item 12 in order to update both the original Rule and the UFOC Guidelines to address new technologies and market developments, such as the Internet and alternative channels for distributing a franchisor’s goods.[489]

The Item 12 territory disclosures generated several comments. First, franchisees and their advocates urged the Commission to address “encroachment,” the practice by which a franchisor essentially competes with its franchisees by establishing franchisor-owned or new franchised-outlets in the same market territory, by purchasing and operating a competing franchise system, or by selling the same goods or services through alternative channels of distribution. Second, other commenters questioned the scope of Item 12, urging the Commission to require franchisors to disclose more information about their past expansion practices, as well as future expansion plans. Third, some commenters questioned the terminology used to describe territories, urging the Commission to avoid implying that a protected territory is inherent in the concept of franchising. Finally, several commenters offered different views on the form of warning that might be appropriate where a franchisor sells franchises without an exclusive territory. Each of these issues is discussed below.

a. Encroachment

Throughout the Rule amendment proceeding, franchisees and their advocates urged the Commission to address “encroachment.”[490] The commenters contended that encroachment may have a devastating effect upon an individual franchisee who does not have a contractually protected exclusive territory,[491] and some urged the Commission to ban encroachment as “an abusive and unfair” trade practice under Section 5 of the FTC Act.[492]

The Commission’s view is that the granting of a protected territory is fundamentally a private contractual matter for the parties to determine for themselves.[493] While the record establishes franchisees’ concerns about encroachment, it falls far short of supporting a conclusion that not granting a protected territory in a franchise agreement constitutes an unfair practice within the meaning of the FTC Act. Nor does the record support a conclusion that a franchisor’s expansion where there are existing franchisees is an unfair practice.

Section 5(n) of the FTC Act provides that an “unfair” practice is one that “causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition.” While the record suggests that some franchisees in several franchise systems may have been harmed by franchisor encroachment, the record leaves open the question whether encroachment is prevalent and whether the injury resulting from encroachment is substantial, when viewed from the standpoint of the franchising industry as Start Printed Page 15492a whole,[494] not just from a few franchise systems.[495] Second, assuming a regulatory regime of full and truthful pre-sale disclosure on the issue of territories, prospective franchisees can avoid potential harm from encroachment by shopping for a franchise opportunity that offers an exclusive territory. Finally, the record does not support a finding that harm to franchisees resulting from encroachment necessarily outweighs potential benefits (expansion of markets and increased consumer choice) to consumers or to competition. For these reasons, the Commission has determined that the criteria for an industry-wide prohibition on encroachment has not been met. Thus, the Commission declines to mandate specific contractual terms regarding territories.

b. Scope of the Item 12 disclosures

A few commenters urged the Commission to require franchisors to disclose more information about their past practices with regard to expansion into franchisees’ areas or their future plans to do so.[496] For example, Andrew Selden, a franchisee representative, suggested that “Item 12 should be elaborated to require full disclosure of past practice, current intention or future possibility of franchisor-sponsored competitive activities that have the prospect of impacting the franchisee’s business.”[497]

Franchisors addressing current development plans uniformly opposed any disclosure. H&H’s comment is typical. Most franchisors consider current development plans to be proprietary information “that would place them at a competitive disadvantage if they were to be made publicly available.”[498] The firm also stressed that franchisors need flexibility to adapt development plans to market realities. “Disclosure of development plans could lead to possible claims by franchisees who anticipated greater or lesser franchise development in a particular area.”[499]

Based on review of the record as a whole, the Commission has determined that requiring disclosure of past and planned future expansion is unwarranted. With respect to past expansion, prospective franchisees arguably can discover such information on their own by directly observing the number and location of outlets in their community and by speaking with current and former franchisees. Moreover, past practices are not necessarily a predictor of future intent. It is also unreasonable to require franchisors to disclose hypothetical possibilities about their future expansion. Indeed, by not granting an exclusive territory, the franchisor has effectively reserved to itself the unrestricted right to expand into new or existing locations or to sell its products or services via alternative channels of distribution.

The UFOC Guidelines require a franchisor to disclose only if the franchisor “may establish” other outlets in the area; it does not require the franchisor to disclose its specific plans for the franchisee’s territory. Franchisors need to elaborate on their expansion plans only if they have “present plans to operate or franchise a business under a different trademark and that business sells goods or services similar to those to be offered by the franchisee.”[500] Moreover, the Commission is inclined to the view that a franchisor’s development plan is proprietary information that a franchisor should not be required to make public.[501] It could also subject franchisors to future liability for fraud or misrepresentation should the franchisor alter, abandon, or delay its stated expansion plans. Further, requiring a franchisor to disclose plans to develop a territory may be costly and burdensome because the franchisor conceivably would have to prepare multiple Item 12 disclosures to focus on each franchise location. The disclosures already contained in Item 12 are sufficient to warn prospects about likely competition because any prospective franchisee who buys a franchise without any protected territory is essentially taking the risk that the franchisor will further develop the market area. For these reasons, we have determined not to deviate from the UFOC Guidelines on this point.

c. Terminology

The final amended Rule fine-tunes the terminology and organization of Item 12. As proposed in the Franchise NPR, Item 12 would have required that franchisors disclose information “concerning the franchisee’s market area with or without an exclusive territory.” It also referred to the franchisee’s “defined area.”[502] Several commenters raised concerns about the use of these terms.

First, BI opposed the use of the term “exclusive territory” in the Franchise NPR, urging the Commission to use the term “protected territory” instead. It asserted that the term “protected territory” is more descriptive of a franchisee’s typical contractual rights regarding its territory, if any.[503] Similarly, the firm opposed the use of the term franchisee’s “market area.” It maintained that the term “market area” is undefined and imprecise. BI advocated use of the term “location.”[504]

The NFC agreed, asserting that the term “market area” is a “charged word.”[505] According to the NFC, under franchisee agreements, franchisees have, at most, a right only to a specified location or narrowly defined geographic area. Use of the term “market area” may advance the false notion that the grant of a franchise inherently “confers upon a franchisee exclusive rights within the franchisee’s economic ‘market area,’ despite the terms of the subject franchise agreement.”[506] Similarly, the NFC opposed the use of the term “defined area.” In its view, the appropriate term should be “limited protected territory,” noting that an area is almost never granted unconditionally by a franchisor. The NFC advised that by using the phrase “limited protected territory” in lieu of “defined area,” the Commission could “actually reduce the misconception which otherwise may be engendered in the minds of prospective franchisees over what territorial protections, if any, they can expect to receive.”[507]

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The Commission agrees that terms such as “market area” and “defined area” are potentially misleading. Such terms inaccurately imply an inherent right to a territory, where, in fact, the right to a territory, protected or otherwise, is purely a matter of contract. Accordingly, we believe the term “exclusive territory”—as used in the UFOC Guidelines[508] —is more precise. While the term “exclusive territory” is, perhaps, not as “descriptive” as the terms “protected area,” or “limited protected territory,” its use is clarified for prospective franchisees through the disclosures set forth in paragraphs (5) and (6) of section 436.5(l). Accordingly, in the absence of a stronger showing that alternatives to “exclusive territory” are more accurate, the Commission has determined to revise Item 12 to adhere more closely to the UFOC Guidelines on this point, as recommended in the Staff Report.[509] Thus, the final amended Rule substitutes the words “location” or “exclusive territory” for “market area,” “area,” and “defined” area, as appropriate.

d. Warning

Item 12 of the final amended Rule fine-tunes and expands slightly the standard warning proposed in the Franchise NPR that is required in those instances when franchisors do not offer exclusive territories: “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 control.”[510]

Given the potential financial risks associated with a non-exclusive territory, the Commission believes that franchisors who do not offer an exclusive territory should warn prospective franchisees about such possible risks.[511] The Commission generally disfavors the use of warnings that merely repeat what is already expressly stated in the franchise agreement, but believes that a specific warning regarding exclusive territories is warranted in light of the volume and persuasiveness of franchisee complaints regarding territory issues.[512] As noted previously, the Commission is convinced that additional disclosures are warranted where they will likely prevent deception about the nature of the franchise relationship.

15. Section 436.5(m) (Item 13): Trademarks

The original Rule required a franchisor to list the trademark identifying the goods or service to be sold by the prospective franchisee.[513] Consistent with the UFOC Guidelines, section 436.5(m) of the final amended Rule requires franchisors to disclose whether the trademark is registered with the United States Patent & Trademark Office; the existence of any pending litigation, settlements, agreements, or superior rights that may limit the franchisee’s use of the trademark; and any contractual obligations to protect the franchisee’s right to use the mark against claims of infringement or unfair competition.

These expanded disclosures are consistent with the Commission’s long-standing policy of requiring franchisors to disclose the material costs and benefits of the franchise sale. One of the principal reasons that one may wish to purchase a franchise—as opposed to starting one’s own business—is the right to use the franchisor’s mark, which presumably creates an instant market for the franchisees’ goods or services.[514] For that reason, trademark usage is one of three definitional elements of the term franchise. Any pending litigation, settlement restrictions, or other potential limitations on the use of the trademark are material because they will necessarily affect the value of the trademark to a prospective franchisee and ultimately may impact the franchisee’s ability to continue operating the business.

Item 13 generated little comment. Howard Bundy suggested that franchisors should disclose not only pending trademark litigation, but all such litigation in the last 10 years.[515] The Commission declines to adopt this suggestion. The fact that the franchisor may have been involved in a trademark dispute a decade ago is not inherently material.[516] What influences a decision to purchase a franchise is whether there are any current restrictions or disputes over the trademark license. Obviously, any existing trademark restrictions or challenges not only may decrease the value of the mark and the goodwill associated with it, but may increase franchisees’ costs if they must switch to a different mark. Accordingly, we decline to deviate from the UFOC Guidelines by requiring more extensive disclosures on this point.

The Commission has determined to adopt staff’s recommendation to adhere more closely to the UFOC Guidelines on Item 13 than did the proposed Rule on two points. First, the Franchise NPR proposed that franchisors disclose how any infringement, opposition, or cancellation proceeding “affects the franchised business.”[517] This is unnecessarily inconsistent with the wording of the UFOC Guidelines, which state: “affects the ownership, use, or licensing” of the trademark.[518]

Second, the Franchise NPR included a footnote addressing the use of summary opinions of counsel: “Franchisors may include a summary opinion of counsel concerning any action if a consent to use the summary opinion is included as part of the disclosure document.”[519] The footnote, however, did not address the discretionary use of a full opinion letter, nor the need to attach the full opinion letter if a summary is used. On this point, the UFOC Guidelines state:

the franchisor may include an Start Printed Page 15494attorney’s opinion relative to the merits of litigation or of an action if the attorney issuing the opinion consents to its use. The text of the disclosure may include a summary of the opinion if the full opinion is attached and the attorney issuing the opinion consents to the use of the summary.[520]

The Commission adopts the UFOC Guidelines language in both instances.

In addition, the final amended Rule improves on the clarity and precision of the proposed Rule’s standard disclosure required when the franchisor’s trademark is not registered on the Principal Register of the United States Patent and Trademark Office. The proposed disclosure reads as follows: “If the trademark is not registered on the Principal Register of the U.S. Patent and Trademark Office, state: ‘By not having a Principal Register federal registration for [name or description of symbol], [name of franchisor] does not have certain presumptive legal rights granted by a registration.’”[521]

The final amended Rule’s disclosure is:

We do not have a federal registration for our principal trademark. Therefore, our trademark does not have as 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.[522]

16. Section 436.5(n) (Item 14): Patents, copyrights, and proprietary information

Section 436.5(n) of the final amended Rule adopts the UFOC Guidelines’ requirement for disclosure of information about the franchisor’s intellectual property. There is no comparable provision in the original Rule. Item 14 elicited no comment during the amendment proceeding.

Item 14 requires franchisors to describe in general terms the types of intellectual property involved in the franchise and any legal proceedings, settlements, and restrictions that may impact the franchisee’s ability to use such property.[523] If counsel permits, Item 14 allows a franchisor to include a counsel’s opinion or a summary of the opinion about legal actions, if the full opinion is attached.[524]

The final amended Rule differs from the Franchise NPR proposal, however, in several non-substantive respects to add precision and improve organization of the provision. Specifically, Item 14 of the final amended Rule separates those disclosures pertaining to patents from those pertaining to patent applications. At the same time, it also groups closely related disclosures—those for patents, patent applications, and copyrights—under a single common direction. For example, section 436.5(n)(1) of the Franchise NPR stated: “For each patent or copyright: (i) Describe the patent or copyright and its relationship to the franchisee; (ii) State the duration of the patent of copyright.” Section 436.5(n)(1) of the final amended Rule simplifies this language by eliminating the use of multiple directions. Instead, it says: “(1) Disclose whether the franchisor owns rights in, or licenses to, patents or copyrights that are material to the franchise. Also, disclose whether the franchisor has any pending patent applications that are material to the franchise. If so, state . . .” followed by the specific disclosure requirement for patents, patent applications, and copyrights.

Similarly, section 436.5(n)(1), as proposed in the Franchise NPR, referred to the “issue date.” The final amended Rule instead uses the correct language: “issuance date.” In the same vein, Item 14 of the final amended Rule corrects imprecise language that would have required the disclose of material determinations pending in “the U.S. Patent and Trademark Office or the U.S. Court of Appeals for the Federal Circuit.” In fact, patent and copyright determinations can be made in courts other than the U.S. Court of Appeals for the Federal Circuit, as noted in other sections of Item 14 (“Describe any current material determination of the United States Patent and Trademark Office, the United States Copyright office, or a court regarding the patent or copyright.”). The language now reads more broadly “pending in the United States Patent and Trademark Office or any court.”

Finally, Item 14, as proposed in the Franchise NPR, would have required franchisors to disclose the “length of time of any infringement.” However, it is possible that a franchisor may not know how long a third party has been infringing its rights. Accordingly, Item 14 of the final amended Rule adds the qualifying phrase “to the extent known.”

17. Section 436.5(o) (Item 15): Obligation to participate in the actual operation of the franchise business

Section 436.5(o) of the final amended Rule retains the original Rule requirement that franchisors disclose whether franchisees are required to participate personally in the direct operation of the franchise.[525] Like the corresponding provision in the Franchise NPR’s proposed rule, this section of the final amended Rule closely tracks the UFOC Guidelines’ Item 15. It therefore expands the original Rule on this point by requiring franchisors to disclose: (1) participation obligations arising not only from the parties’ franchise agreement, but from other agreements or as a matter of practice; (2) whether direct participation is recommended; and (3) any limitations on whom the franchisee can hire as a supervisor and any restrictions that the franchisee must place on his or her manager. If the franchisee operates as a business entity, the franchisor must also disclose the amount of equity interest, if any, that the supervisor must have in the franchise.

Item 15 generated little comment. In response to the Staff Report, NASAA and Washington Securities noted an inconsistency between the proposed final amended Rule and the UFOC Guidelines on the disclosure of whom a franchisee may hire as an on-premises supervisor and that person’s training. Whereas the UFOC Guidelines provide that these disclosures pertain to all franchisees, the Franchise NPR suggested that these disclosures should be limited to franchisees who are individuals, but not to business entities.[526] We agree with the commenters that the Franchise NPR’s proposed limitation was based upon an erroneous reading of the UFOC Start Printed Page 15495Guidelines, and the final amended Rule makes the appropriate correction.

NASAA also urged the Commission to consider expanding Item 15 to include the disclosure of “operating hours and the method used by franchisors to notify franchisees of changes in required operating hours.”[527] The Commission, however, declines to adopt this suggestion. While this information might be useful for prospective franchisees, it does not rise to the level of materiality such that non-disclosure of it may put prospective franchisees in jeopardy of being deceived. Moreover, no other commenter raised this point, and in the absence of a record dictating that we deviate from the UFOC Guidelines, the Commission is reluctant to do so.

Finally, NASAA and Washington Securities recommended that the Commission require franchisors to disclose in Item 15 all agreements regarding the franchise that apply to the owners of the franchise.[528] While this suggestion is rooted in the NASAA Commentary on the UFOC Guidelines, nothing in Item 15 of the UFOC Guidelines says that franchisors must present copies of the actual agreements to prospective franchisees. The Commission believes such a requirement would be duplicative and burdensome. Franchisors already must include in Item 22 copies of “all agreements proposed for use or in use . . . regarding the offering of a franchise, including the franchise agreement, leases, options, and purchase agreements.” Presumably, contracts with franchise owners would already be disclosed in Item 22. Thus, this suggested modification is unnecessary.

18. Section 436.5(p) (Item 16): Sales restrictions

Section 436.5(p) of part 436 retains the original Rule’s disclosures on sales restrictions. Like other disclosure requirements addressing how a franchisee may conduct business, this provision requires franchisors to disclose any restrictions limiting the goods or services that the franchisee may offer for sale or the customers to whom a franchisee may sell goods or services.[529] Consistent with UFOC Guidelines, Item 16 also extends the original Rule disclosures by requiring a franchisor to disclose whether the franchisor has the right to change the types of goods or services authorized for sale, as well as any limits on the franchisor’s right to make such changes. These disclosures better enable a prospective franchisee to understand the extent to which the franchisor has the contractual right to control sales, which may directly affect the prospect’s ability to conduct business, its independence from the franchisor, and ultimately, its profitability. No comments were submitted on the Item 16 sales restrictions disclosures, and the adopted version is almost identical to the version proposed in the Franchise NPR.[530]

19. Section 436.5(q) (Item 17): Renewal, termination, transfer, and dispute resolution

Section 436.5(q) adopts UFOC Item 17, which requires franchisors to summarize in tabular form 23 enumerated terms and conditions of a typical franchise relationship, such as the duration of the franchise agreement, rights and obligations upon expiration of the franchise agreement, post-term covenants not to compete, and assignment and transfer rights. The final amended Rule provision is almost identical to the proposed rule in the Franchise NPR, with only a slight modification, described below, with respect to the treatment of the term “renewal.”

The approach taken in the final amended Rule greatly streamlines the original Rule, which required franchisors to detail the rights and obligations already spelled out in the franchise agreement.[531] Item 17, therefore, reduces compliance burdens, while providing prospective franchisees with a detailed road map to the franchise contract, where they can read the various provisions in greater detail. At the same time, Item 17 expands on the original Rule by requiring disclosures pertaining to dispute resolution, including any arbitration or mediation requirements, as well as forum-selection and choice of law provision disclosures. For each enumerated contract term, the franchisor must cross reference the applicable franchise agreement provisions and briefly summarize the governing terms.[532]

Most of the comments submitted on Item 17 concerned the use of the term “renewal.” Franchisee advocates asserted that the term “renewal” is misleading.[533] In their view, the term implies that a franchisee, upon expiration of the franchise term, can continue operating the franchise under substantially similar terms and conditions. They observed, that in practice, franchisees who wish to continue operating their franchises at the end of the franchise term must often sign new contracts that impose materially different terms and conditions, such as higher royalty payments or the elimination of an exclusive territory. They asserted that renewing franchisees, in many instances, have no choice but to sign even the most abusive, one-sided renewal contracts because they have a substantial economic investment in their franchises and simply cannot walk away without incurring significant economic loss.[534] Worse, when a Start Printed Page 15496franchisee does walk away, he or she is often bound by a covenant not to compete, which restricts his or her ability to operate a similar business for a number of years.

Several franchisor representatives supported the view that the term “renewal” may be inappropriate. The NFC, for example, stated that the term “renewal” is somewhat ambiguous: it could mean either “a simple extension of the existing agreement under the same terms or—as is far more common—the grant of a ‘successor franchisor’ under the terms being offered at the time that the existing agreement expires.”[535] However, the NFC did not believe that the term “renewal” is misleading, and it was uncertain whether the ambiguity compels a revision of the Rule. J&G asserted that the term is potentially misleading,[536] and Tricon urged the Commission to avoid its use entirely.[537]

On the other hand, several commenters maintained that the term “renewal” is clear and requires no modification. For example, John Baer stated that “renewal” is a term of art in franchising and should not be changed. He also observed that the various state relationship laws use that term and “to revise it for disclosure purposes is likely to cause more confusion than clarity.”[538] Seth Stadfeld, a franchisee advocate, agreed, explaining that the term “renewal” refers to the relationship between the franchisor and franchisee, not to the underlying contract. He also shared Mr. Baer’s concern that the term is used in state relationship statutes and should not readily be changed.[539]

Several commenters suggested that the Commission adopt various disclosures or warnings for prospective franchisees that would explain the concept of renewal in greater detail. The IL AG, for example, suggested that franchisors make the following statement: “You should learn what changes in your agreement might occur and what rights you have when your contract expires. Renewal may change important contract terms.”[540]

While the record reveals that there may be confusion over the use of the term “renewal,” it does not show that use of the term is inherently deceptive. The Commission concludes that the term “renewal” is a franchising term of art, meaning that upon the expiration of a contract, the franchisees may have the right to enter into a new contract, where materially different terms and conditions may apply. Moreover, as several commenters noted, the term “renewal” is used in various state relationship laws, in addition to the UFOC Guidelines. In light of that background, the Commission is disinclined to mandate use of a different term or prohibit use of “renewal.” At any rate, a prospective franchisee may be just as prone to misinterpret the substitute language (e.g., “re-license”) as the term “renewal.” It short, any term may be misleading if prospective franchisees fail to understand the underlying concept that a franchisor may require a change in contract terms and conditions upon expiration of the original agreement as a condition of renewal. Therefore, the Commission has determined not to introduce nonconformity between federal and state approaches on the use of this term.

Nonetheless, the record is persuasive that many prospective franchisees may not appreciate the legal import of the term “renewal.” Indeed, franchisees often are surprised to discover that “renewal” means the continuation of their franchise relationship under potentially vastly different terms. To prevent potential deception with respect to use of the term “renewal,” Item 17 of the final amended Rule requires franchisors to explain their renewal policy in the summary field for provision Item 17(c) (requirements for franchisee to renew or extend).[541] We do not suggest any particular form of explanation, however, because that will depend upon the individual policies of each franchisor.[542] If applicable, the franchisor must also state that franchisees “may be asked to sign a contract with materially different terms and conditions than their original contract.”[543] While we are reluctant to add consumer education notices to the disclosure document, especially where the UFOC Guidelines require no parallel notice, we believe it is warranted in this instance, given the continued concern raised by franchisee advocates and others about renewals.[544]

20. Section 436.5(r) (Item 18): Public figures

Consistent with the UFOC Guidelines, Item 18 requires franchisors to disclose the involvement of a public figure in the franchise system, including his or her management responsibilities, total investment made in the franchise system, and compensation, if any. This section is substantively similar to the comparable disclosure provision of the original Rule found at 16 CFR 436.1(a)(19).[545] The final amended Rule adopts Item 18 as proposed, with only minor language changes for the sake of clarity and improved organization.[546]

Item 18 generated few comments during the Rule amendment proceeding. Start Printed Page 15497Two commenters questioned the utility of the disclosure. H&H noted that this Item is seldom, if ever, applicable and urged the Commission to delete it.[547]

The Commission has determined that the information required under Item 18 remains material in those instances, relatively uncommon though they may be, when a public figure creates his or her own franchise system or when a franchisor uses a public figure pitchman. A public figure’s ownership or management of a franchise system could create the impression of greater oversight or influence in the operation of the system, making the franchise offering appear to be a less risky investment. Similarly, a public figure pitchman’s endorsement of a franchise system may create the impression that the franchise system is sound or a low risk. How much weight a prospect may give a public figure endorser’s pitch may vary with the level of compensation received from the franchisor. If, for example, a pitchman is paid a nominal sum, then a prospective franchisee may be inclined to give the pitch more weight because the pitchman has little to gain financially and thus little motive to fabricate his or her pitch. Accordingly, the public figure disclosures concerning level of involvement and compensation are material and their potential benefits to prospective franchisees would outweigh their costs. To that limited degree, these disclosures still serve a useful purpose. In those more typical instances when no public figure is involved, Item 18 entails no additional compliance burden. On balance, therefore, the Commission is disinclined to deviate from the UFOC Guidelines on this point.

21. Section 436.5(s) (Item 19): Financial performance representations

Section 436.5(s) of part 436, a key anti-fraud provision, addresses the making of financial performance representations.[548] Consistent with the original Rule and the UFOC Guidelines, the final amended Rule permits, but does not require, franchisors to make such representations under limited circumstances. When a franchisor elects to make a financial performance claim, the franchisor must, among other things, have a reasonable basis for the representation[549] and disclose the basis and assumptions underlying the representation.[550] Franchisors also must include an admonition that a prospective franchisee’s actual earnings may differ.[551]

Bringing the original Rule’s provisions on financial performance representations into closer alignment with the UFOC Guidelines entailed several deletions or departures from the original Rule. Specifically, the final amended Rule differs from the original Rule in that:

  • It eliminates the requirement that franchisors who decide to make financial performance claims provide prospective franchisees with a separate financial performance claim document.[552] Instead, consistent with the UFOC Guidelines, it requires any performance claim to appear in Item 19 of the disclosure document itself;
  • It eliminates the requirement that all financial performance claims be geographically relevant to the franchise offered for sale;[553]
  • It eliminates the requirement that any historical financial performance claims must be based upon generally accepted accounting principles (“GAAP”);[554]
  • It permits franchisors, under specific circumstances, to disclose, apart from the disclosure document, the actual operating results of a specific unit being offered for sale;[555] and
  • It permits franchisors to furnish supplemental performance information directed at a particular location or circumstance.[556]

For the reasons explained below, the final amended Rule provision, however, diverges from Item 19 of the UFOC Guidelines by permitting greater disclosure of financial information about subsets of franchisor-owned or franchised outlets, provided the franchisor discloses specified information about the subset at issue. With certain additional refinements described in the following paragraphs of this section, including the preamble requirements, Item 19 of the final amended Rule closely tracks Item 19 as proposed in the Franchise NPR.[557]

Nearly all comments on the Item 19 disclosure requirements focused on four issues: (1) whether financial performance disclosures should be mandatory or voluntary; (2) whether the Rule should permit disclosure of financial performance information about geographical or other subsets of franchisor-owned or franchised outlets; (3) whether the Rule should retain the requirement that historical financial performance data be prepared according to GAAP; and (4) whether the Rule should require prescribed preambles. Each of these issues is discussed in the sections immediately below.[558]

a. Voluntary disclosure of financial performance information

The Franchise NPR proposed that the making of financial performance representations remain voluntary, as was the case under the original Rule[559] and UFOC Guidelines.[560] Many Start Printed Page 15498franchisees and their representatives, however, urged the Commission to mandate the disclosure of financial performance information.[561] In support of this recommendation, these commenters advanced a number of arguments: (1) that financial performance information is the most material information prospective franchisees need to make an informed investment decision;[562] (2) that franchisors already have performance information and it is a deceptive omission for them to fail to disclose this information; (3) that franchisors are in the best position to collect and disseminate performance information; (4) that a mandated financial performance disclosure would reduce the level of false and unsubstantiated oral and written financial performance claims; and (5) that more disclosure regarding performance would benefit the marketplace and competition.[563]

In contrast, franchisors and their advocates uniformly opposed mandatory financial performance disclosures, based on the following arguments: (1) it is impossible for the Commission to create a single performance disclosure format that will be relevant for all industries; (2) not all franchisors have the contractual right to collect extensive financial information with which to prepare a reasonable performance disclosure; (3) financial performance data collected from existing franchisees is not necessarily complete and accurate; (4) a mandatory performance disclosure would be misinterpreted as a guarantee of future performance, thus increasing litigation; and (5) mandating financial performance disclosures would have a negative impact upon the franchisor-franchisee relationship, subjecting franchisees to more extensive accounting oversight and audits.[564]

Based upon its assessment of the record as a whole, the Commission concludes that financial performance representations should remain voluntary. In reaching this conclusion, we recognize that false or misleading financial performance claims are the most common allegation in Commission franchise law enforcement actions.[565] However, there is no assurance that mandating performance claims will in fact reduce the level of false claims. Given that many different industries are affected by part 436, what makes a financial performance disclosure reasonable, complete, and accurate is quite varied. Thus, the Commission will not mandate a particular set of financial performance disclosures. However, if a franchisor chooses to make such disclosures, they, of course, must be reasonable, non-misleading, and accurate.

Mandating financial performance disclosures would also impose substantial new accounting, data collection, and review costs on all franchise systems. At the same time, it potentially could expose existing franchisees, upon whose data the franchisor would rely, to more extensive audits. In addition, existing franchisees might be subject to potential liability for indemnification should a franchisor, relying on the franchisees’ performance data, be found to have violated the Rule by failing to furnish accurate financial performance data.

Further, the record reveals that approximately 20% or more of franchisors choose to make financial performance disclosures.[566] Accordingly, prospective franchisees can find franchise systems that voluntarily disclose such information. If prospective franchisees were to seek out such franchise systems, or demand the disclosure of such information from franchisors, ordinary market forces might compel an increasing number of franchisors to disclose earnings information voluntarily, without a federal government mandate. More important, a disclosure document is not the only potential source of financial performance information. Prospective franchisees can obtain financial performance information from a variety of third-party sources. For example, typical expenses, such as labor and rent, may be available from industry trade associations and industry trade press. Prospective franchisees may be able to discuss earnings and other financial performance issues directly with current and former franchisees, as well as with trademark-specific franchisee associations. For these reasons, we conclude that financial performance representations should remain voluntary, consistent with the original Rule and UFOC Guidelines.

b. Geographic relevance and subgroups

As noted above, Item 19 of the final amended Rule eliminates the original Rule’s geographic relevance requirement for financial performance representations.[567] This brings the Rule’s financial performance disclosure requirements into closer alignment with Item 19 of the UFOC Guidelines,[568] as proposed in the Franchise NPR.[569]

At the same time, the final amended Rule deviates from the Franchise NPR by omitting the UFOC Guidelines’ requirement that franchisors disclose the number and percentage of all Start Printed Page 15499existing outlets known to have attained a represented performance level.[570] Rather, for the reasons explained below, Item 19 of the amended Rule is consistent with the original Rule in requiring franchisors to disclose the number and percentage of existing outlets known to have attained the represented performance level in the area that formed the basis for the representation.[571]

The UFOC Guidelines require a franchisor to compare the number of franchisees who have performed at a claimed level against all franchisees in its system, not just against franchisees it has measured or against franchisees in a subgroup. For example, a franchisor may have statistics showing that nine out of 10 franchised stores in a particular location (such as Seattle) average $100,000 net profit a year. Yet, the UFOC Guidelines prevent the franchisor from disclosing truthful information about the universe the franchisor had measured—the 10 franchised outlets in Seattle. Rather, the franchisor would be forced instead to state 9 out of the entire number of all franchises nationwide (e.g., 9 out of 1,000) have earned the $100,000 claimed. This approach can mislead a prospective franchisee because it suggests that the franchisor has in fact measured the financial performance of all franchisees, when that may not be true. It also may deflate franchisees’ actual performance records. More important, a franchisor may decline to disclose performance information if, in order to do so, it must first incur the expense of conducting a system-wide franchisee performance analysis.

To correct this problem, Item 19 of the revised Rule permits franchisors to disclose truthful financial performance information about a subgroup of existing franchisees under limited conditions.[572] Specifically, the financial information furnished to prospective franchisees must have a reasonable basis and the franchisor must disclose: (1) the nature of the universe of outlets measured; (2) the total number of outlets in the universe measured; (3) the number of outlets from the universe that were actually measured; and (4) any characteristics of the measured outlets that may differ materially from the outlet offered to the prospective franchisee (e.g., location, years in operation, franchisor-owned or franchisee-owned, and likely competition).[573]

Few commenters addressed the revision of Item 19. Among those that commented on Item 19, a few specifically supported the elimination of the separate geographic relevance prerequisite.[574] On the other hand, IL AG voiced concern that eliminating the geographic relevance requirement would not prevent franchisors from “cherry picking” their best performing franchise locations and then allowing prospects to assume that their performance results will be similar.[575]

At the same time, other commenters supported allowing financial performance claims based on franchisee subgroups with the specified substantiation requirements. John Baer, for example, maintained that the disclosures for subgroups “provide franchisors with sufficient guidance about what characteristics of the outlets must be disclosed and how they may differ materially from outlets offered to a prospective franchisee.”[576] Similarly, Marriott observed that allowing disclosure of subgroup performance is laudable “especially when franchisors are frequently adopting new business strategies which may result in different [financial performance representations], depending upon whether the old or new system format is followed by the franchisees.”[577]

Based upon the record, the Commission has concluded that eliminating the geographic relevance requirement, coupled with permitting broader disclosure of financial performance of subgroups, will remove obstacles that discourage franchisors from making financial performance data available to prospective franchisees. At the same time, Item 19 prevents franchisors from “cherry picking” their best locations as a basis for financial performance representations. Specifically, Item 19’s substantiation requirements ensure that franchisors disclose how they derived the performance results of subgroups, so that prospective franchisees can assess for themselves the sample size, the number of franchisees responding, and the weight of the results. In addition, these provisions require franchisors to disclose the material differences between the subgroup-units tested and the units being offered for sale, so that prospects can avoid drawing unreasonable inferences from the representations.

c. GAAP

As noted, Item 19 of the final amended Rule eliminates the original Rule requirement that historical financial performance data must be prepared according to GAAP.[578] The Franchise NPR proposed retention of this requirement.[579] Without exception, the commenters who addressed this issue opposed the GAAP requirement. For example, NASAA advised that GAAP goes beyond what the UFOC Guidelines require and the accounting rules would discourage the making of financial performance representations:

Based upon the experience of states that register franchise offerings, many franchisors that currently include historical financial performance data in UFOC Item 19 may not prepare them according to GAAP. In some instances, a Start Printed Page 15500franchisor’s historical financial performance data presented may be accurate and material, yet may not be presented according to GAAP. In many other instances, the franchisor may not be aware whether the data presented is according to GAAP. This requirement would discourage franchisors that have a factual basis for making financial performance disclosures from doing so. In addition, this requirement likely would increase costs to franchisors who do choose to make historical financial performance disclosures by requiring them to obtain an accountant’s opinion as to whether their data is presented according to GAAP.[580]

Based upon an assessment of the record, the Commission has determined that the GAAP requirement is unnecessary and may impede franchisors’ ability to disclose performance information, to the detriment of both franchisors and prospective franchisees. GAAP is not the only approach to ensure the accuracy of historic performance data. Franchisors making historical performance representations should have the flexibility to formulate such representations, provided that such representations are truthful and reasonable. Indeed, franchisors always have the burden to establish that any financial performance representations are reasonable. Moreover, it is apparent that some franchisors using the UFOC format have disseminated non-GAAP compliant historic performance representations, without any pattern of deception identified by the states. Finally, eliminating the GAAP requirement is likely to reduce compliance burdens, while bringing greater uniformity to federal and state disclosure law.

d. Preambles

As noted above, Item 19 of the final amended Rule differs from the original Rule and the UFOC Guidelines by requiring franchisors to include prescribed preambles in their Item 19 disclosures. The preamble requirements are incorporated in Item 19 as proposed in the Franchise NPR.[581] The preamble requirements address two concerns. First, there is evidence in the record that some franchisors falsely state that the Commission or the Franchise Rule prohibits franchisors from making financial information available.[582] Second, our law enforcement experience tells us that prospective franchisees may rely on unsubstantiated financial performance representations.[583]

To prevent deception arising from these two practices, Item 19 requires franchisors to include in their Item 19 disclosures a prescribed preamble stating that the Rule permits the making of financial performance representations, if the representations are set forth in the franchisor’s disclosure document.[584] This statement counters any suggestion that the Franchise Rule prohibits franchisors from disclosing financial performance information. Armed with such material information, prospective franchisees could question why a franchisor does not provide financial performance data, if they wish, or shop for a system that discloses financial performance information. In addition, this preamble will discourage prospects from relying on unauthorized financial performance claims made outside of the disclosure document.

For those franchisors who elect not to disclose financial performance information, Item 19 requires a second preamble, warning prospective franchisees not to rely on unauthorized performance representations and to report the making of such unauthorized representations to the franchisor, the Commission, and appropriate state agencies.[585]

Several commenters supported the inclusion of preambles in Item 19 in order to clarify the state of the law regarding the making of financial performance representations. In particular, the first preamble would correct the common misstatement that the Rule actually prohibits the making of such representations. According to the AFA, for example, a clarification of the law is crucial: “[T]he great untruth that franchise salespeople have been allowed to perpetrate over the years is the following statement in one form or another—the federal government prohibits us from giving you information regarding the financial performance of [name of our] franchises.”[586]

Other commenters asserted that the preambles, coupled with market forces, will encourage the disclosure of financial data. For example, 7-Eleven stated: “We believe this approach—affirmatively informing would-be investors about the requirements under the Rule and the manner in which such information should be disclosed—when combined with the competitive force of the marketplace, ensures that earnings information can be identified and properly appraised by franchise investors.”[587]

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At the same time, the Commission has rejected various suggestions to require more strongly worded preambles. For example, Eric Karp would amplify the second preamble to warn prospects that, although the franchisor collects financial information, it does not disclose any, and he suggested including the phrase, “Consider why we are unwilling to do so.”[588] In effect, these commenters would turn the absence of a financial performance claim into a risk factor. The Commission rejects this approach. It does not necessarily follow that the absence of a financial performance disclosure necessarily signals a riskier investment. It could well be that a company bent on defrauding prospective franchisees would manipulate its numbers to create a stronger success image, while a successful but punctilious system might choose not to disclose numbers because it may not believe that it can make a reasonable disclosure that would be applicable to all potential buyers. In addition, any concern that prospective franchisees need to see actual earnings figures in order to judge success is mitigated by Item 20, which compels the disclosure of franchise turnover rates, as well as the names and addresses of current and former franchisees, who can be contacted for information.

22. Section 436.5(t) (Item 20): Outlets and franchisee information

Section 436.5(t) of the final amended Rule retains the original Rule’s requirement that franchisors disclose the number of franchised and franchisor-owned outlets; the names, business addresses, and business telephone numbers of current franchised outlets, and statistical information on franchise turn-over rates, in particular the number of franchises voluntarily and involuntarily terminated, not renewed, and reacquired by the franchisor.[589] To align the final amended Rule more closely to the UFOC guidelines, it also extends the original Rule by requiring franchisors to disclose the names, business addresses, and business telephone numbers of at least 100 current franchised outlets (as opposed to the original Rule requirement of at least 10 franchised outlets).[590] It also requires the disclosure of some contact information for former franchisees[591] who have left the franchise system in the last fiscal year. Finally, it also makes the disclosure more user-friendly than it was in the original Rule by requiring the statistical information to be presented in a tabular format.

Item 20 of the final amended Rule differs from the UFOC Guidelines model in several respects. First, it corrects a double-counting problem brought to the Commission’s attention during the Rule Review. Second, it requires more limited disclosure of personal contact information of former franchisees.[592] Third, when a franchisor resells a specific outlet it has reacquired, it mandates that the franchisor disclose the outlet’s prior franchisee-owners during the franchisor’s last five fiscal years. Fourth, it addresses franchisors’ use of “confidentiality clauses,” which effectively restrict franchisees from discussing their experiences with prospective franchisees. Finally, it requires the disclosure of trademark-specific franchisee associations.[593] We address each of these issues below.

a. Double-counting

As proposed in the Franchise NPR, the final amended rule avoids a problem with the UFOC Guidelines’ version of Item 20.[594] Like the UFOC Guidelines, the final amended Rule Item 20 requires disclosure of information about franchisees who have recently left the franchise system, as well as changes in ownership of franchised outlets. During the Rule amendment proceeding, no commenters opposed this requirement in principle, but commenters almost unanimously voiced concern that UFOC Item 20 is seriously flawed and needs to be fixed.[595] Specifically, UFOC Item 20 often results in franchisors “double-counting” changes in franchised outlet ownership, resulting in inflated turnover rates.

The Commission believes that the UFOC Guidelines’ “double-counting” problem is attributable to at least two factors. First, UFOC Item 20 requires franchisors to report changes in Start Printed Page 15502franchised outlet ownership according to five enumerated categories: (1) transferred; (2) canceled or terminated; (3) not renewed; (4) reacquired by the franchisor; or (5) reasonably known to have “ceased to do business.” The terms describing these categories, however, are undefined. The absence of precise definitions blurs the line between categories, resulting in a double-counting of outlet closures.[596] For example, a single transaction can quite correctly be characterized as either a transfer or a reacquisition. They are often two sides of the same coin: a franchisor’s assumption of control of a franchised outlet that has gone out of business reasonably could be captured either as a transfer by the franchisee, or as a reacquisition by the franchisor.

Second, even if the definitions were clear, UFOC Item 20 can be interpreted to require the disclosure of each of a series of events associated with a single outlet ownership change.[597] For example, after terminating a franchise agreement, the franchisor may reacquire the outlet. The franchisor could then either operate the outlet as a franchisor-owned store, or sell it to a new franchisee. In such a case, UFOC Item 20 arguably calls for the franchisor to report a termination followed by a reacquisition as two separate events. Similarly, a franchisee may abandon an outlet, and, in response, the franchisor may send the franchisee a termination letter, reacquire the outlet, and then transfer it to a new franchisee. Although the outlet has changed franchisee-ownership only once, the franchisor conceivably would report this event four times as a ceased to do business, termination, reacquisition, and transfer.[598]

The final amended Rule remedies the imprecision that characterized the delineated reporting categories. Item 20 of the final amended Rule sets forth precise definitions to avoid overlapping categories. Specifically, “termination” means “the franchisor’s termination of a franchise agreement prior to the end of its term and without paying consideration to the franchisee (whether by payment or forgiveness or assumption of debt).” “Non-renewal” occurs “when the franchise agreement for a franchised outlet is not renewed at the end of its term.” “Reacquisition” means “the franchisor’s acquisition of an outlet for consideration (whether by payment or forgiveness or assumption of debt) of a franchised outlet during its term.” “Transfer” means “the acquisition of a controlling interest in a franchised outlet during its term by a person other than the franchisor or an affiliate.”[599]

Beyond better defined reporting categories, commenters offered various suggestions to improve Item 20.[600] The approach suggested by NASAA garnered the most support. NASAA asserted that UFOC Item 20 needs to be revised in its entirety and, as noted above, submitted for the Commission’s consideration an alternative that was produced with the assistance of an Industry Advisory Committee.[601] Several other commenters submitted the same proposal or endorsed the NASAA proposal.[602] The Staff Report recommended that the NASAA suggestion be incorporated into the final amended Rule. After careful consideration, the Commission has determined to adopt NASAA’s proposal. It is the best way to solve the Item 20 double-counting problem. It will be easily understood by those in the industry, and it will provide prospective franchisees with the information they need without imposing undue compliance burdens on franchisors.

Accordingly, Item 20 of the final amended Rule contains five tables. Table No. 1 indicates the status of a franchisor’s system. It shows the number of franchised and company-owned outlets at the beginning and end of each of the last three fiscal years, and the total net change.[603]

Table No. 2 shows transfers, treating them separately from terminations and non-renewals. This is appropriate because, as NASAA observed, transfers do not affect the total number of outlets in a franchise system, and the mere fact that an outlet has been transferred tells nothing about the reason for the transfer: “While some transfers are Start Printed Page 15503problematic for franchisees or prompted from disputes, many other transfers simply reflect a desire on the part of the franchisee to cease operating a franchise or to pursue other opportunities.”[604] Nonetheless, the total number of transfers within a system is material because it goes to the stability within the franchise system over time. Table No. 2 indicates the number of franchise transfers in each state over the last three fiscal years.

Table No. 3 tracks the turnover rate of franchised outlets.[605] Franchisors must report, by state and for each of the last three fiscal years, the outlets at the start of the year, new outlets opened, terminations, non-renewals, reacquisitions by the franchisor, outlets that ceased to do business,[606] and outlets at the end of the year.

Table No. 4 tracks the turnover at company-owned outlets. Franchisors must disclose, for each of the last three fiscal years, the number of their outlets at the start of the year, new outlets, reacquired outlets, closed outlets, outlets sold to franchisees, and outlets at the end of the year.

Finally, Table No. 5 retains the current UFOC projected openings table. This table gives prospective franchisees insight into anticipated growth within the system by requiring the disclosure of both projected franchised and company-owned openings in the next fiscal year. It also reveals the number of franchise agreements signed in the previous year where a store has not yet been opened. This information is material because it enables a prospective franchisee to gauge how long it may take before his or her store actually becomes operational.

During the Rule amendment proceeding, Eric Karp submitted a variation of the NASAA proposal for the Commission’s consideration that would greatly expand the NASAA proposal. For example, according to the Karp proposal, Table No. 2 would require franchisors to disclose not only the number of transfers in each of the last three fiscal years, but also the number of completed transfers, requests for transfer that were denied, and those transfers in progress at the end of the fiscal year. His Table No. 3 would divide new outlets into two categories: new outlets that are newly developed and new outlets that were purchased from a franchisor. Mr. Karp also proposed a new table that would calculate a specific turnover rate, expressed as a percentage, by comparing the number of outlets at the beginning of a fiscal year with the number of outlets during the year that were terminated by the franchisor, non-renewed, repurchased by the franchisor, transferred to another franchisee, or ceased operations for other reasons. Finally, Mr. Karp would revise the new growth projection chart, requiring franchisors to disclose for each of the last three fiscal years: previously projected franchised new outlets; actual number of franchised new outlets; franchise agreements signed but outlets not in operation; and projected franchised new outlets for next fiscal year.[607]

The Commission is not persuaded to expand Item 20 as Mr. Karp suggested. The additional proposed disclosures would greatly increase the size of the already extensive Item 20 disclosure, potentially overwhelming prospective franchisees while increasing franchisor compliance costs. Further, to streamline the Rule and reduce inconsistencies with the UFOC Guidelines, we are disinclined to add new Item 20 charts that merely restate information that can already be gleaned from the existing charts. For example, the amended Item 20 disclosures enables prospective franchisees to calculate turnover rates for themselves from the data contained in Tables 1 and 3 by comparing outlets at the beginning of a fiscal year with the number of outlets closed during the year.

b. Identification of former franchisees

Section 436.5(t)(5) of the final amended Rule adopts the Franchise NPR proposal that franchisors disclose contact information for franchisees who have exited the franchise system in the most recently completed fiscal year, consistent with the UFOC Guidelines.[608] This disclosure, like the parallel disclosure of contact information for current franchisees, prevents fraud by giving prospective franchisees additional sources of material information about the franchisor, the nature of the franchise system and the franchisor-franchisee relationship. As explained below, the final amended Rule provision differs from the UFOC Guidelines and the Franchise NPR proposal, however, to address privacy concerns regarding the disclosure of personal contact information.[609]

The Franchise NPR, incorporating UFOC Guidelines Item 20, would have required franchisors to disclose the name and last known home address and telephone number of every franchisee that exited the system within the last fiscal year.[610] While the Commission believes that such information serves a valuable anti-fraud purpose—enabling prospective franchisees to obtain material information from those with hands-on experience with the franchise system—it can be achieved in a more limited fashion that also protects former franchisees’ privacy—notwithstanding that this type of information may be available in the public domain from such sources as telephone directories. To that end, the final amended Rule provision requires franchisors to disclose only the name, city and state, and current business telephone number, or, if unknown, the last known home telephone number of former franchisees. Further, to give prospective franchisees notice that their contact information may be disclosed even after they leave the franchise system, franchisors must state the following language in immediate conjunction with the list of former franchisees: “If you buy this franchise, your contact information may be disclosed in the future to other buyers when you leave the franchise system.”[611] To allow for greater flexibility, footnote 10 to the final amended Rule provides that franchisors may substitute alternative contact Start Printed Page 15504information at the request of the former franchisee, such as a home address, post office address, or a personal or business email address.

c. Identification of former franchisee-owners of a specific outlet being resold

Section 436.5(t)(6) of the final amended Rule extends the original Rule and UFOC Guidelines Item 20 by addressing turnover at a specific outlet. When a franchisor resells an outlet under its control that was previously owned by a franchisee,[612] Item 20 requires the franchisor to disclose contact information for each previous owner of that outlet, the time period when the previous owner controlled the outlet; the reason for each previous ownership change; and the time period(s) when the franchisor retained control of the outlet. As explained below, this provision is designed to prevent fraud in the resale of a specific franchised outlet, by giving prospective purchasers of that outlet sources of information with hands-on experience operating the outlet.[613]

During the Rule amendment proceeding, the IL AG asserted that a number of successive sales of a franchised outlet could indicate “churning,” the practice whereby a franchisor turns a blind eye to franchisee failures—or worse, encourages them—in order to sell the same outlet repeatedly. The IL AG urged the Commission to require franchisors to provide a prospect with a detailed site history when a buyer is being directed to a particular location. “This could be a three year history that would chart prior franchisees, their dates of operation, dates of store management by the franchisor for the site, and the reasons previous franchisees departed from that site.”[614]

The Commission agrees, but is convinced that a five-year reporting period is warranted in order to allow sufficient time to identify a trend.[615] As noted throughout this document, the Commission believes that more disclosure is warranted to give prospective franchisees information about the quality of the relationship between the franchisor and franchisee. Information about franchise operations at a specific unit advances that goal. Surely, significant turnover at a particular location might indicate a lack of promised support for the location, or worse, as the IL AG explained, a possible franchisor strategy to have the franchisee fail in order to resell the unit. We believe any compliance costs to the franchisor, therefore, are outweighed by the countervailing benefits to prospective franchisees.

In response to the Staff Report, two commenters raised questions about the application of this provision. Specifically, they observed that a franchisor might not have a particular unit in mind when it begins negotiations with a prospective franchisee. They speculated as to whether this provision would be triggered if a franchisor were to direct a prospect to a particular unit after the franchisor has furnished the prospect with a disclosure document. In particular, they noted that it would be an open question under state law as to whether a franchisor would have to redisclose including unit-specific disclosures, and whether redisclosure would trigger an additional 14 days before signing the agreement.[616]

The commenters urged that a franchisor be permitted to furnish the unit-specific disclosures outside the disclosure document, just as a franchisor may make supplemental financial performance claims outside of the disclosure document without triggering a redisclosure obligation.[617] The Commission believes these comments are well-taken. The purpose of this provision is to provide prospective franchisees with material information about a specific unit being considered for purchase. The need for furnishing this information must be balanced against the legitimate concerns of franchisors about compliance costs. On balance, the Commission is persuaded that a franchisor who recommends a specific unit after having made proper disclosure should have the option of providing the unit-specific information in a supplement to the disclosure document, if it so chooses. Accordingly, Item 20 provides: “This information may be attached as an addendum to a disclosure document, or, if disclosure has already been made, then in a supplement to the previously furnished disclosure document.”[618]

d. Confidentiality clauses

Section 436.5(t)(7) addresses franchisors’ uses of confidentiality clauses, as proposed in the Franchise NPR.[619] This is a new provision that is not in the original Rule or UFOC Guidelines. If, during the last three fiscal years, franchisees signed a confidentiality clause in a franchise agreement, settlement, or in any other contract with the franchisor, the franchisor must insert in their Item 20 disclosure the following prescribed statement: “In some instances, current and former franchisees sign provisions restricting their ability to speak openly about their experience with [name of franchise system]. You may wish to Start Printed Page 15505speak with current and former franchisees, but be aware that not all such franchisees will be able to communicate with you.” In addition, a franchisor may, at its option, also disclose the number and percentage of current and former franchisees who signed confidentiality agreements, as well as the circumstances under which such clauses were signed.

This provision was prompted by numerous comments from franchisees and their advocates urging the Commission to address the use of confidentiality clauses in franchising. Indeed, one quarter of the ANPR commenters (42 out of 166 commenters) and several speakers at public workshop conferences addressed the confidentiality clause issue, the majority opposing their use.[620] The most poignant example was a franchisee of an undisclosed franchise system who related that she had to speak quickly because she was on her way to sign a final agreement terminating her relationship with her franchisor. The agreement she was about to sign included a confidentiality clause.[621] These commenters complained that the use of confidentiality clauses is widespread,[622] and several commenters urged the Commission to ban the use of confidentiality clauses as a deceptive or unfair trade practice.[623]

Other opponents of confidentiality clauses—including state regulators and some franchisors—asserted that such provisions inhibit prospective franchisees from learning the truth as they conduct their due diligence investigation of a franchise offer. As noted above, current and former franchisees are often a valuable source of information about the franchise investment and can often verify or discredit the franchisor’s claims, especially financial performance representations.[624] Attempts to restrict franchisee speech through confidentiality provisions may deceive prospects by effectively eliminating one crucial source of information, namely those current and former franchisees who may have a dispute with the franchisor or are otherwise disgruntled.[625] Indeed, a franchisor, if it wished to do so, could attempt to use confidentiality provisions to ensure that prospects speak with only those franchisees who are successful or otherwise inclined to give a positive report.[626] In addition, one franchisee representative, contended that the harm flowing from confidentiality provisions goes beyond individual franchise sales, noting that such provisions intimidate franchisees into not testifying before legislative committees and public agencies, such as the Federal Trade Commission.[627]

On the other hand, several franchisors and their representatives opposed banning the use of confidentiality clauses. For example, David Kaufmann asserted that confidentiality provisions prevent disgruntled franchisees from inflaming others and enable franchisors to end bad relationships with problem franchisees without spending considerable resources. He contended that banning confidentiality provisions would discourage informal settlements with franchisees.[628] Others added that franchisors must have the ability to protect their trade secrets from disclosure.[629]

The Commission believes that the record does not support an outright ban Start Printed Page 15506on confidentiality clauses. Clearly there are instances where both franchisors and franchisees enter into such clauses voluntarily. As Marriott noted, franchisees in contract modification negotiations may seek or at least agree to confidentiality in order to gain certain advantages.[630] Under the circumstances, we cannot conclude that harm to franchisees from confidentiality clauses necessarily outweighs the potential benefits to franchisees, as well as franchisors. Nevertheless, based upon the record, the Commission is persuaded to adopt a balanced provision requiring franchisors to disclose their use of confidentiality clauses over the last three years. The Commission is convinced that franchisees often sign post-sale agreements containing confidentiality clauses in connection with dispute settlements and terminations. This practice may impede prospective franchisees’ ability to conduct due diligence investigations of franchise offerings, undercutting the primary goal of pre-sale disclosure.[631]

The Commission believes that the final amended Rule’s confidentiality clause disclosure requirement strikes the appropriate balance between informing prospective franchisees that franchisees in the system may not be able to share information with them, and minimizing compliance burdens. Of the various proposals offered by the commenters, a general disclosure notifying prospects about the franchisor’s use of a confidentiality provision garnered the most support. For example, Howard Bundy told us that “[i]n a perfect world I would have a list of those that are subject to [confidentiality provisions], so I didn’t have to make all those extra 75 calls. But I could live with or without that. It’s more important to disclose the fact that they do exist.”[632]

Other than the required statement explaining the nature of confidentiality clauses to prospects who may be unfamiliar with their use, any other disclosures—such as number and percentage or the reasons for the clauses—are entirely voluntary.[633] Moreover, we are unpersuaded that this approach would discourage settlements. Franchisors opting to pursue litigation in lieu of settlement in order to avoid the confidentiality disclosure would most likely have to disclose even more revealing information about the suit in their Item 3 disclosure.

Further, the confidentiality disclosure does not reach confidentiality clauses addressing specific contract negotiation terms and conditions.[634] We recognize that there may be instances where both franchisors and franchisees may not wish to discuss specific terms of an arrangement, such as the price paid for a franchise, or other concessions made to a franchisee. The confidentiality clause disclosure would be unwarranted, therefore, where the parties agree to a limited restriction that still enables franchisees to discuss their overall experience in the franchise system.[635]

In reaching our conclusion to adopt the confidentiality clause disclosure, we have carefully weighed suggestions to expand or to narrow the disclosure requirement. For example, we reject the suggestion that franchisors identify specific individual franchisees listed in Item 20 who are subject to a confidentiality clause.[636] We are persuaded that this suggestion goes beyond what is reasonably necessary to address the use of confidentiality clauses. No doubt a prospective franchisee’s due diligence investigation of the franchise offering would be more efficient if the prospect could eliminate from its contact list those franchisees under a confidentiality agreement. However, we believe this approach would impose an unnecessary burden on those franchise systems that list all of their franchisees in Item 20 on a national basis. Presumably, franchisors would have to update records continually on each individual franchisee. Moreover, a requirement that franchisors note which specific franchisees are subject to a confidentiality clause may have the unintended consequence of actually encouraging large franchisors to eliminate from their list of 100 franchisees those who are subject to confidentiality clauses, thereby leaving a biased list of only those franchisees who are most successful or satisfied with the system.

We also reject suggestions to limit the disclosure to only those circumstances where franchisees have signed broad provisions restricting all speech[637] or where a threshold level of franchisees have signed confidentiality clauses.[638] If the purpose of the confidentiality clause disclosure were primarily to shed light on the extent of problems in the franchise relationship, then we might agree. As noted above, however, the disclosure aims to make prospective franchisees aware of the use of confidentiality clauses. Armed with such knowledge, prospective franchisees would understand that: (1) a refusal by one or more existing franchisees to speak is not necessarily benign; and (2) that the sample of Start Printed Page 15507franchisees listed in the disclosure document might actually be skewed. More important, adopting a threshold would not address the use of confidentiality clauses to restrict speech by a minority of franchisees (such as franchisees located in a particular city), which might be the most relevant universe of existing franchisees to an individual prospective franchisee.

e. Franchisee associations

One important difference between the original Rule and UFOC Guidelines, on the one hand, and the final amended Rule, on the other, is the new requirement that franchisors disclose trademark-specific franchisee associations.[639] The obligation to disclose such associations differs depending upon whether the association is sponsored or endorsed by the franchisor or is an independent association. Section 436.5(t)(8) provides that identifying information—name, address, telephone number, email address and Web address, to the extent known—must be included for each association “created, sponsored, or endorsed by the franchisor.” For independent associations, the same identifying information must disclosed only if the independent association:

is incorporated or otherwise organized under state law and asks the franchisor to be included in the franchisor’s disclosure document during the next fiscal year. Such organizations must renew their request on an annual basis by submitting a request no later than 60 days after the close the franchisor’s fiscal year.[640]

During the Rule amendment proceeding, several franchisees and their representatives urged the Commission to adopt a trademark-specific franchisee association disclosure requirement. For example, one franchisee representative stated:

The UFOC Guidelines currently require disclosure of the existence of purchasing cooperatives known to the franchisor, but this is not adequate disclosure of a fact of growing importance to franchisees, which is the existence, or non-existence, of an autonomous franchisee association representing franchisees in that particular franchise organization. When an organization represents a substantial plurality of franchisees in the system, perhaps over 30%, and its existence is known to the franchisor, that fact should be disclosed, possibly by an additional category in the list of existing franchisees required in Item 20, as an additional and critical source of information about the franchise opportunity.[641]

Some franchisors did not oppose a disclosure of franchisee associations, especially franchisor-sponsored franchisee advisory councils. However, they voiced concern about any mandate to disclose all independent franchisee associations. In their view, independent associations are often small, informal groups of individual franchisees that may come and go at any time, and are often formed on the local or regional level without the knowledge or involvement of the franchisor.[642] In short, they fear liability for failing to disclose a franchisee association that they did not know exists.

Based upon the record developed in this proceeding, the Commission is convinced that a trademark-specific association disclosure is warranted under certain circumstances. The disclosure of trademark-specific franchisee associations—both those sponsored or endorsed by the franchisor and independent franchisee associations—will greatly assist prospective franchisees in their due diligence investigation of the franchise offering, thereby preventing misrepresentations in the offer and sale of franchises. We recognize that Item 20 already requires franchisors to disclose the names of, and some contact information for, franchisees in their systems. This disclosure requirement, however, is limited to not more than 100 franchisees. This is true even for medium and large franchise systems with several hundred, if not several thousand, franchisees. Therefore, it is possible for some franchisors to hand-select franchisees listed in their disclosure documents, revealing only successful franchisees who maintain a good relationship with their franchisor.[643] Moreover, a franchisor Start Printed Page 15508could use confidentiality clauses to achieve the same goal. Therefore, the Item 20 list of franchisees may not be a random sample or otherwise representative of franchisees within a particular system. One approach to counter any franchisor-bias in Item 20 is to require that franchisors disclose the existence of certain franchisee associations, providing prospective franchisees with an alternative view of the franchise system.

The record also suggests that individual franchisees often are reluctant to share information with prospective franchisees. For example, Howard Bundy told us that he often instructs his franchisee-clients to state only their “name, rank, and serial number and refer [the prospect] back to the franchisor for everything else.”[644] In his view, franchisees who speak in connection with a franchise sale might be deemed franchise brokers under state law and could be liable for any claims or damages resulting from the sale. Franchisees who volunteer information also might be subject to a defamation suit by the franchisor.[645] The trademark-specific franchisee association disclosure, therefore, is an important alternative source of information about the franchise system.[646]

Finally, a franchisee association disclosure is particularly important given that the final amended Rule does not mandate financial performance disclosures. One rationale for not mandating performance information is that prospects can contact franchisees directly to obtain such information. Indeed, franchisees are the best source of information about their own earnings. If true, then prospective franchisees, at the very least, should be able to contact as many existing and former franchisees as possible to learn about franchisee performance. A franchisee association disclosure may greatly assist prospective franchisees in their effort to obtain and review franchisees’ financial performance by providing an independent source of information.

At the same time, the disclosure of franchisee associations is very narrowly tailored to address franchisors’ concerns about the disclosure of independent franchisee associations. Specifically, Item 20 of the final amended Rule provides that a franchisor must list in its disclosure document independent trademark-specific associations only to the extent such associations make their existence known to the franchisor on an annual basis. This will reduce franchisors’ burdens by requiring franchisors to disclose only those independent associations actually known to them. It requires no special research or recordkeeping or updating requirements on a franchisor’s part. Accordingly, the compliance burden imposed by disclosing independent franchisee associations is minimal.

The final Rule amendment differs from the Franchise NPR, however, to add more precision. Specifically, Item 20 of the final amended Rule: (1) broadens the types of associations that qualify for inclusion as a trademark-specific franchisee association; (2) requires franchisee associations to request inclusion in the franchisor’s disclosure document within 60 days of the end of the franchisor’s fiscal year end; and (3) permits franchisors to add qualifying language alerting prospective franchisees that the associations listed in its disclosure document are independent associations. Each of these modifications is discussed in the section immediately below.

Item 20 of the final amended Rule requires franchisors to disclose only those independent franchisee associations that are incorporated or otherwise organized under state law. This differs slightly from the Franchise NPR and Staff Report, which recommended that only incorporated franchisee associations qualify for inclusion in a disclosure document.[647] The Commission is persuaded that informal, unorganized groups of franchisees are more akin to individual franchisees, than an association. In such instances, additional disclosure is unwarranted because a prospective franchisee can already speak with individual franchisees, whose contact information is also provided in Item 20. At the same time, the Commission agrees with Staff Report commenters that Item 20 should be read broadly to enable any organized independent franchisee association to seek inclusion in the franchisor’s disclosure document.[648] Accordingly, any organized independent association—whether it is incorporated, a partnership, limited liability company, or trust, among other forms of association—qualifies for inclusion under Item 20.

Item 20 of the final amended Rule makes explicit that an independent franchisee association’s request for inclusion in a disclosure document must be renewed annually by submitting a request for inclusion no later than 60 days after the close of the franchisor’s fiscal year. This is more precise than the Franchise NPR, which contains no specific time frame during which independent associations should submit their request to the franchisor.[649]

Third, Item 20 of the final amended Rule permits franchisors to include a limited disclaimer, if they wish. Specifically, Item 20 provides that a franchisor can add to the independent franchisee association disclosure the following statement: “The following independent franchisee associations have asked to be included in this disclosure document.”[650] We believe Start Printed Page 15509this statement makes clear that the franchisor is not necessarily endorsing or supporting the associations listed. This statement, coupled with the requirement that only an organized independent association must be disclosed and only upon the association’s request, strikes the right balance between pre-sale disclosure and compliance burdens.

At the same time, the Commission has rejected the suggestion offered by some commenters that independent franchisee associations seeking inclusion in the franchisor’s disclosure document should be representative of a significant number of franchisees in the franchise system.[651] These commenters urged the Commission to apply a threshold qualification test whereby a franchisor would not have to disclose an independent franchisee association unless the association represented a portion of system franchisees, such as 25% of system franchisees.[652]

The Commission recognizes that Item 20 may result in the disclosure of independent franchisee associations that are not necessarily representative of franchisees as a whole. However, we believe there is value in enabling prospective franchisees to speak with an association representing similar interests, even if not representative of the entire system. For example, a small independent association of franchisees in Anchorage, Alaska, might provide prospective franchisees with valuable information about local labor costs, financial performance data, as well as information about third-party suppliers. For this reason, we reject the notion that an independent association should be forced to establish that they represent a specific percentage of franchisees in a system. Rather, prospective franchisees can determine for themselves whether to contact independent franchisee associations and what weight to give any information such associations provide.

23. Section 436.5(u) (Item 21): Financial statements

Section 436.5(u) of the final amended Rule retains the original Rule’s basic requirement that franchisors disclose three years of audited financial statements prepared according to generally accepted accounting principals (“GAAP”).[653] To maximize consistency with the UFOC Guidelines, it expands the original Rule by incorporating the UFOC Guidelines’ requirement that financial disclosures be in a tabular format that compares at least two fiscal years. This provides prospective franchisees with information with which to assess financial trends, rather than just an isolated snap-shot of the franchisor’s finances.

The final amended Rule provision differs from UFOC Guidelines Item 2, however, in three respects. First, while it requires the use of GAAP, it also recognizes that what currently is “GAAP” may change by federal government oversight of the accounting profession. Accordingly, it provides that franchisors must use GAAP, as revised by any future government mandated accounting principles. It also allows flexibility by permitting accounting standards recognized by the Securities and Exchange Commission. Second, consistent with other provisions of the final amended Rule, it requires the disclosure of a parent’s financial information in limited circumstances. Specifically, a franchisor must include a parent’s financial statements if the parent has post-sale performance obligations or guarantees the franchisor’s performance. Third, Item 23 retains the Commission’s long-standing policy of permitting franchisors to phase-in audited financial statements over three years.[654]

Four aspects of section 436.5(u) that prompted comment are discussed in the following section: (1) the required use of GAAP in preparing financial statements; (2) the scope of a parent’s obligation to disclose financial information; (3) the obligation of subfranchisors to disclose financial information; and (4) the phase-in of audited financial statements. We discuss each of these issues below.

a. The requirement to prepare financial statements according to GAAP

Section 436.5(u)(1) of the final amended Rule requires franchisors to prepare financial statements according to “United States generally accepted accounting principles, as revised by any future government mandated accounting principles, or as permitted by the Securities and Exchange Commission.” This differs from the Franchise NPR, which proposed that franchisors use United States GAAP only in preparing their financial statements, consistent with the original Rule and UFOC Guidelines.[655]

During the Rule amendment proceeding, a few commenters opposed the Franchise NPR’s proposed requirement that foreign franchisors prepare financial statements according to United States GAAP only. These commenters asserted that this requirement would impose expenses and burdens on foreign corporations entering the American market. H&H’s comment was typical: “For companies located in many foreign countries, . . . a requirement to convert to US accounting standards would be enormously expensive.”[656] H&H urged the Commission to permit foreign franchisors to prepare financial statements that “conform to U.S. GAAP or otherwise to generally accepted accounting principles established in the country of the company’s domicile.”[657] IL AG, however, argued that foreign companies should follow United States GAAP or be permitted to reconcile their financial statements to United States Start Printed Page 15510GAAP through footnotes and explanations.[658]

As noted in our discussion of section 436.2 concerning the scope of the Rule, the sale of franchises outside the United States was not an important issue when the Commission promulgated the Franchise Rule in 1978. The Commission recognizes, however, that application of only United States GAAP in today’s global economy may impede competition from foreign franchisors. Accordingly, a more flexible approach is warranted, especially in the absence of any evidence in the record that financial statements prepared by foreign franchisors to date have been deceptive or misleading.

In determining whether to maintain the original Rule’s stance on the use of GAAP in Item 21 financial statements, the Commission focuses strongly on the primary purpose of a disclosure document, which is to provide prospective franchisees with material information in a clear and conspicuous manner. Consistent with that principle, the Commission believes that franchisors must present financial data in a format that is meaningful to American prospective franchisees, as well as to their advisors. To that end, the suggestion offered by IL AG—that foreign franchisors use United States GAAP or reconcile their financial statements to United States GAAP—adds needed flexibility, while reducing costs and burdens on foreign franchisors. As noted in the Staff Report, this is the very position adopted by the SEC for the registration of securities by foreign companies.[659]

The SEC permits foreign companies registering securities to prepare financial statements using accounting procedures other than United States GAAP under limited circumstances. The first prerequisite is that such statements be prepared “according to a comprehensive body of accounting principles.”[660] The company must also disclose the specific comprehensive body of accounting principles used to prepare the statements and explain material differences between the principles and United States GAAP. The company must also reconcile its statements with United States GAAP. For example, through additional notes, franchisors must reconcile figures for net income and total shareholders’ equity for the period presented. Finally, the statements must provide all additional disclosures required by United States GAAP and applicable SEC regulations.[661]

The Staff Report recommended that the final amended Rule permit foreign financial statements that satisfy the SEC criteria. The Commission has determined that that recommendation is sound. As a starting point, application of the SEC accounting standards ensures against deception by requiring foreign franchisors to establish that their financials are prepared “according to a comprehensive body of accounting principles.” Further, it adds flexibility and minimizes costs and burdens on foreign franchisors, while ensuring that prospective franchisees receive the same material financial information as they would receive from a domestic franchisor. The Commission has determined to adopt this flexible approach, given the absence of any showing or suggestion in the record that reconciled foreign financial statements are inherently deceptive or misleading.[662] At the same time, we recognize the possibility exists that American accounting principles may evolve over time. Under the circumstances, Item 21 updates the original Rule by adding language designed to ensure that financial statements are prepared according to United States GAAP, “as revised by any future government mandated accounting principles, or as permitted by the Securities and Exchange Commission.”[663]

b. Parent financial information

Section 436.5(u)(iv) of the final amended Rule requires a franchisor to disclose a parent’s financial statements in two circumstances: (1) when the parent commits to perform post-sale obligations for the franchisor; or (2) when the parent guarantees obligations of the franchisor. This narrows the Franchise NPR proposal, which would have required disclosure of parent financial information in all instances.[664] As with other Rule provisions, several commenters questioned the routine inclusion of parent information in a disclosure document. For example, PMR&W observed that the UFOC Guidelines specify only that state examiners may ask for audited financials of a parent, but the Guidelines do not mandate it. In its view, parent financial statements are not relevant and are rarely requested.[665] Warren Lewis suggested that the Commission require the disclosure of parent financial statements “only if (i) the company with the control chooses to guarantee the obligations of the franchisor or subfranchisor to the franchisee in writing, and (ii) a copy of the written guarantee is included in Item 21 or an exhibit.”[666]

Start Printed Page 15511

The Commission believes these points are well-taken and are consistent with our view expressed in other sections of this document that a franchisor need not disclose parent information in all instances. Therefore, proposed Item 21 has been modified to limit a parent’s financial information to those circumstances when the parent either: (1) commits to perform post-sale obligations for the franchisor; or (2) guarantees obligations of the franchisor. To the extent that a prospective franchisee is asked to rely on a parent to perform post-sale contractual obligations,[667] or relies on a parent’s guarantee, the financial stability of the parent becomes a material fact that should be disclosed.[668]

c. Subfranchisor financial information

Section 436.5(u)(iv) of the final amended Rule also requires the disclosure of financial information of any subfranchisor. During the Rule amendment proceeding, a few commenters opined that it is unnecessary to require routine financial statements of subfranchisors: financial statements should be provided only by the entity with whom the franchisee will have a contractual relationship.[669] The commenters, however, interpreted the term “subfranchisor” more broadly than it is used in the final amended Rule. As noted in our discussion of the term “franchisor” above, the term “subfranchisor” is limited in the Rule to circumstances where the subfranchisor steps into the shoes of the franchisor by selling and performing post-sale obligations. It does not reach those individuals who may be called “subfranchisors,” but who act like brokers, having no post-sale commitments to franchisees.[670] Where a person—be it subfranchisor or parent —commits to perform under the franchise agreement, its financial information becomes material in order to provide prospective franchisees with the opportunity to assess the person’s financial stability before risking their own investment.

d. Phase-in of audited financial statements

Section 436.5(u)(2) of the final amended Rule retains the original Rule provision permitting start-up franchise systems to phase-in audited financial statements within three years.[671] However, the final amended Rule streamlines the phase-in. Under the original Rule’s phase-in, a franchisor could furnish a balance sheet for “the first full fiscal year following the date on which the franchisor must first comply with [the Rule.]”[672] This can be problematic because it is often unclear when the franchisor’s first fiscal year ends. For example, a franchisor may have started selling franchises three months into its first fiscal year (e.g., in March 1, 2006, using a calendar fiscal year). At the conclusion of that fiscal year (December 31, 2006), the franchisor would have sold franchises for ten months. Yet, under the original Rule’s phase-in, the franchisor’s first fiscal year would not end until December 31, 2007, because the phase-in uses the language “first full fiscal year” after starting to sell franchises.[673]

To clarify the timing of the phase-in, section 436.5(u)(2) of the final amended Rule replaces the word “full” with “first partial or full fiscal year” so that a franchisor’s first fiscal year will end consistent with its general accounting practices, regardless of when the franchisor may have started offering franchises within that year.[674] Under this revised approach, the Commission will look to the close of the franchisor’s first fiscal year after selling franchises, regardless of whether that time period was a partial or full year.[675]

The phase-in of audited financial statements generated little comment during the Rule amendment proceeding. Franchisors, the AFA, and IL AG supported the phase-in.[676] One franchisee advocate, however, noted, among other things, that the states do not have a comparable provision. He also cited Small Business Administration statistics showing that only 25% of franchisors survive five years. “If we excuse audited financial statements for the first two years, for all practical purposes, even more investors will risk losing everything.”[677] On the other hand, John Baer not only supported the phase-in, as drafted in the Franchise NPR, but urged the Commission to make it preemptive.[678]

NASAA supported the phase-in generally, but raised two concerns. First, NASAA observed that the phase-in section of the Rule does not specifically reference GAAP, possibly leading franchisors to conclude that unaudited financial statements need not be prepared according to GAAP. It urged Start Printed Page 15512the Commission to apply GAAP to all financial statements, audited or unaudited.[679] We agree. There are two prerequisites for financial statements: (1) the data underlying the statement must be prepared according to GAAP (or according to SEC standards), and (2) the financials must be audited according to United States generally accepted audited standards (“GAAS”).[680] The phase-in of audited financials addresses only the second prerequisite—audits. Where a franchisor takes advantage of the phase-in, it nonetheless must satisfy the first prerequisite, preparing its financial data according to GAAP (or SEC standards).

Nevertheless, we believe that the final amended Rule already is clear on this point. As noted above, the introduction to Item 21 starts with the first prerequisite—that financial statements must be prepared according to “United States generally accepted accounting principles, as revised by any future government mandated accounting principles, or as permitted by the Securities and Exchange Commission.” Item 21 then discusses the second prerequisite—audits: with the exception of the phase-in of audited financials, “financial statements must be audited . . . using generally accepted United States auditing standards.” Thus, the Rule makes clear that the phase-in modifies the GAAS prerequisite only; the accounting prerequisite still continues to apply to all financial statements prepared under Item 21.[681]

NASAA also questioned the reference to “start-ups” in the phase-in provision. It voiced concern that: “[i]f a major corporation that has been in business for many years and then begins to franchise, that corporation should not enjoy the same exemption from disclosing audited financial statements as a new company that just organized as a true ‘start up’ franchise system.”[682] The NASAA Project Group suggested that franchisors that have been in any type of business for three years or more, not just the business of selling franchises, should be required to provide audited financial statements.[683]

The Commission believes NASAA’s point is well-taken, and, therefore we wish to clarify that for Item 21 purposes, the term “start-up” is to be read narrowly, meaning entities that are new to franchising and that ordinarily have not prepared audited financials statements to date. Any non-franchise company that has prepared audited financials in the ordinary course of business must include such audited financials in its disclosure documents if it decides to begin offering franchises.[684] The phase-in is also not intended for spin-offs, affiliates, or subsidiaries of a franchisor, where the franchisor has been engaged in franchising or has prepared audited financial statements for any other purpose.

24. Section 436.5(v) (Item 22): Contracts

Consistent with the UFOC Guidelines, section 436.5(v) requires franchisors to attach to the disclosure document a copy of all relevant agreements, such as the franchise agreement, leases, options, or purchase agreements.[685] This is substantively similar to the original Rule requirement that franchisors provide prospective franchisees with copies of relevant documents at least five business days prior to the date of execution.[686] The final amended Rule’s Item 22 is identical to the Item 22 proposed in the Franchise NPR.

Only one comment was submitted on Item 22. In response to the Franchise NPR, David Gurnick expressed concern that the term “contract” could be misinterpreted to suggest that Item 22 requires the disclosure of post-sale settlement agreements. He suggested that Item 22 should expressly state that “the contracts to be attached do not include forms of negotiated settlement agreements,” especially since the terms of any such agreements are unknown at the time of sale.[687] While it is possible that a franchisor may misread Item 22 to include future settlement negotiations, we do not believe this is likely. Item 22 refers to those contracts that involve the franchise offering at the time of the sale. Clearly, franchisors cannot disclose something that may only exist at some future date. Therefore, we decline to revise Item 22, as this commenter suggested.

25. Section 436.5(w) (Item 23): Receipts

Section 436.5(w) of the final amended Rule reduces inconsistencies with the UFOC Guidelines by adopting the UFOC Guidelines Item 23 requirement that franchisors include an acknowledgment of receipt in the disclosure document.[688] The original Rule has no counterpart. Like the cover page, the receipt serves an important educational purpose,[689] informing prospects that they have 14 calendar-days to review the disclosures, that they should receive certain attachments, and that they can report possible law violations.[690]

At the same time, Item 23 is flexible, affording franchisors and franchisees greater latitude in demonstrating receipt than the comparable UFOC Guidelines provision. Whereas UFOC Item 23 requires franchisors to acknowledge receipt with a handwritten signature, Item 23 updates the Rule by allowing the parties to use electronic acknowledgments of receipt. As discussed in the definitions section above, the term “signature” includes not only written signatures, but electronic Start Printed Page 15513signatures, passwords, security codes, and other devices that enable a prospective franchisee to easily acknowledge receipt, confirm his or her identity, and submit the information to the franchisor.[691]

Item 23 of the final amended Rule also incorporates several suggestions offered by commenters. For example, Warren Lewis advised that the title of Item 23 should be “receipts,” observing that the current industry practices is to have two receipts at the end of the disclosure document, one the franchisee retains as part of the disclosure document and the other returned to the franchisor.[692] He also urged the Commission to replace “franchisee’s signature” used in the Franchise NPR version of Item 23 with “prospective franchisee’s signature,” noting that some prospective franchisees object to signing receipts as “franchisees,” since this designation is inaccurate until they have actually signed the franchise agreement.[693] NASAA also suggested that the Commission clarify that the acknowledgment page must be placed as the last two pages of the disclosure document. It observed that “[t]he States that review franchise offerings have noted many instances where this page was buried in the middle of the disclosure document.”[694] We believe these suggestions are sound, and Item 23 of the final amended Rule reflects these changes.

Another commenter addressed the second paragraph of the Item 23 receipt. As proposed in the Franchise NPR, this paragraph stated, in relevant part: “If [name of the franchisor] offers you a franchise, it must provide this disclosure document to you 14 days before the earlier of: (1) the signing of a binding agreement; or (2) any payment to [name of franchisor or affiliate].” H&H urged the Commission to substitute “binding agreement” with “binding agreement with the franchisor or any of its affiliates.” The firm asserted that the franchisor cannot control whether a prospective franchisee proceeds to commit with independent, third parties before expiration of the 14 day period.[695] As noted in our discussion of the disclosure trigger above, we agree with this approach and have revised Item 23 of the final amended Rule accordingly.[696]

At the same time, we reject several suggestions offered in response to the Staff Report to modify Item 23. Four commenters noted that Item 23, as recommended in the Staff Report, requires franchisors to state the name, principal business address, and telephone number of each “franchise seller” in the receipt.[697] These commenters maintained that this disclosure requirement is a carry-over from the UFOC Item 2 requirement, now eliminated in the final amended Rule, that franchisors disclose brokers. They urged the Commission to delete the reference to “sellers” in Item 23 as well, asserting that this requirement would result in franchisors having to disclose potentially hundreds of names.[698]

As a preliminary matter, we note that UFOC Item 2 requires not only the naming of brokers, but a statement about their prior experience. Also, once an individual is named in Item 2, the franchisor must also disclose their litigation history in UFOC Item 3 and their bankruptcy history in UFOC Item 4. As discussed previously, we believe such extensive disclosures are unnecessary with respect to brokers. Nonetheless, we believe that a prospective franchisee should have contact information for any seller with whom he or she is dealing.[699] Accordingly, the disclosure of “sellers” in the Item 23 receipt is to be read narrowly, referring to the specific individual(s) dealing with the prospective franchisee. This approach is also helpful for law enforcement purposes, identifying who may be responsible for furnishing the disclosures. Accordingly, we believe there are sufficient grounds for retaining the seller disclosure in Item 23.

D. Section 436.6: General Instructions

Section 436.6 of part 436 sets forth the basic instructions for preparing a disclosure document. In the Franchise NPR, the Commission proposed two new sections that would set forth the basic instructions for preparing a disclosure document. The first section—Franchise NPR section 436.6—set forth general instructions applicable to all disclosure documents.[700] Specifically, the Franchise NPR proposed retaining the original Rule’s three basic instructions: (1) that disclosures be prepared clearly, legibly, and concisely in a single document; (2) that franchisors respond positively or negatively to each disclosure item; and (3) that franchisors do not add any materials to a disclosure document, except for information required or permitted by non-preempted state law. The proposed instructions also contained the Commission’s current policy that subfranchisors should provide disclosures about the franchisor, and, to the extent applicable, about themselves. Consistent with the UFOC Guidelines, disclosure documents would also have to be written in plain English.[701] None of these basic instructions generated any significant comment in response to the Franchise NPR or Staff Report.

In a second section—Franchise NPR section 436.7—the Franchise NPR proposed specific instructions pertaining to electronic disclosures.[702] In order to prevent fraud and circumvention of the Rule’s pre-sale disclosure requirements, the Franchise NPR proposed, among other things, that: (1) prospective franchisees consent to receiving electronic disclosures; and (2) franchisors using electronic media provide prospective franchisees with a paper summary document containing an expanded cover page, table of contents, and acknowledgment of receipt. In addition, it called for all disclosures to be in a form that would permit each prospective franchisee to download, print, or otherwise maintain the document for future reference. Multimedia features—such as audio, video, “pop-up” screens, and external links—would be prohibited in all disclosure documents. In order to facilitate the reading of an electronic disclosure document, however, the Franchise NPR proposed permitting franchisors to include navigational tools, such as internal links, scroll bars, and search features. Finally, the Franchise NPR proposed that franchisors furnishing disclosure documents electronically retain a Start Printed Page 15514specimen copy of their disclosures for a period of three years.

On June 30, 2000, Congress enacted the Electronic Signatures in Global and National Commerce Act (“E-SIGN”).[703] E-SIGN eliminates barriers to ecommerce by, among other things, giving legal effect to electronic transactions, including pre-sale disclosure, and permitting electronic signatures. Further, E-SIGN preserves certain consumer rights. Specifically, it provides that consumers must give their informed consent before engaging in electronic transactions and requires companies to disclose any rights consumers may have to receive paper records and to withdraw previously-given consent to receive electronic records. E-SIGN, however, limits such rights to “consumer” transactions, defining “consumer” to mean an “individual who obtains, through a transaction, products or services which are used primarily for personal, family, or household purposes.”[704] Thus, by its terms, E-SIGN may have prohibited restrictions such as those proposed in the Franchise NPR for electronic franchise disclosure.

In light of E-SIGN, the Commission has reconsidered the Franchise NPR proposals. As explained below, the final amended Rule eliminates the Franchise NPR’s proposed electronic disclosure instructions—Franchise NPR section 436.7. In lieu of specific electronic disclosure instructions, the final amended Rule contains a broad general instructions section that covers the furnishing of all disclosure documents, paper and electronic alike. We discuss each general instruction immediately below.

1. Section 436.6(a): Requirement to follow the Rule’s disclosure and updating provisions

Section 436.6(a) of the final amended Rule provides that it is an “unfair or deceptive act or practice in violation of Section 5 of the FTC Act for any franchisor to fail to include the information and follow the instructions for preparing disclosure documents set out in Subpart C (basic disclosure requirements) and Subpart D (updating requirements) of the Rule. The Commission will enforce this provision according to the standards of liability applicable in actions under Sections 5, 13(b), and 19 of the FTC Act.”[705]

The original Rule specified that franchisors and franchise brokers are jointly and severally liable for furnishing disclosure documents. However, it did not specifically address who would be liable for a disclosure document’s content. During the Rule amendment proceeding, the Commission sought to clarify liability for preparing disclosures, proposing in the Franchise NPR that franchise sellers would be liable for the contents of a disclosure document if they knew or should have known of the violation.[706]

A few commenters voiced concern about the proposed standard. John Baer, for example, stated that the Franchise NPR proposal imposed an “impossible” standard of liability:

As anyone who has drafted an Offering Circular can testify, there is no certainty as to the nature of the information that has to be included in the various disclosure sections of the Offering Circular and reasonable persons often differ in good faith as to what has to be disclosed.[707]

He suggested that the Commission revise the standard to “make it a violation for a franchisor to fail to use ‘commercially reasonable good faith efforts’ to disclose the required information.”[708] Similarly, Tricon stated that the proposal would result in all employees being potentially liable for Rule violations, even those employees who are not involved in any franchise sales. According to Tricon, an employee should not be liable, even if that person had actual knowledge, unless that person:

(a) knew (or should have known) the legal significance of those facts, and (b) was in a position to influence the outcome of the matter. For example, a secretary could “know” that financial performance data was routinely provided to buyers, but neither knew the significance of doing so nor be in a position to stop the practice.[709]

In contrast, NASAA supported the view that franchisors and individual owners of franchisors should be held liable for Rule violations “regardless of whether they knew or should have known of the violation.”[710]

Based upon the comments, the staff recommended a revised liability standard in the Staff Report. The staff noted that all Commission trade regulation rules implement Section 5 of the FTC Act and, therefore, the final amended Rule should incorporate the standard of liability developed in Section 5 cases. Under Section 5 law, individuals can be enjoined in connection with a corporation’s law violations if they participated directly in them or had the authority to control them.[711] Applying this standard to the Franchise Rule, the Staff recommended that franchise sellers (for example, third-party brokers and franchisor employees) be liable for the content of a disclosure document if they either directly participated in the document’s creation or had authority to control it.

Several commenters voiced concern about the Staff Report’s proposed “direct participation or control” liability standard. In particular, the commenters asserted that the “authority to control” language is too broad. For example, David Kaufmann noted that all senior officers of a corporate franchisor technically could be deemed to have the authority to control the contents of a disclosure document and, therefore, could be deemed liable, even if they were unaware of the particular violation, or had no responsibility for it.[712] Mr. Kaufmann opined, however, that it is appropriate to hold an individual liable for directly participating in a content violation.[713]

J&G criticized the Staff Report’s proposed liability standard as imposing strict liability for all sellers even where their “control” is limited, attenuated, or indirect. According to J&G, under the standard recommended in the Staff Report, liability could be found for employees, advisors, consultants, attorneys, and accountants of a franchisor who “participate” in the preparation of a disclosure document or in the sales process in some manner. Outside consultants, advisors, and attorneys could be held liable even if Start Printed Page 15515they had no knowledge of the facts underlying the violation.[714]

On the other hand, Howard Bundy argued that those in a corporate structure who have “authority to control” content should be liable for conduct of the corporation. “This is consistent with what Congress and the SEC have mandated in the post-Enron world with regard to officers of a public corporation.”[715] Mr. Bundy stated that a broad standard is important to force responsibility for accuracy and completeness to the highest levels in the franchisor’s organization.

Because violations of part 436 constitute violations of Section 5, the Commission is persuaded that liability for the content of a disclosure document must be based upon liability standards applicable in FTC enforcement actions under Sections 5, 13(b), and 19. In that regard, there is a distinction between the standard of liability for injunctive relief and that for redress. In general, case law establishes that an individual may be enjoined for corporate misconduct if he or she participated directly in the wrongful practice or had the authority to control the corporate defendant.[716] In the franchise context, an officer or director of a franchisor may be enjoined against violating the Rule if the officer or director, for example, has authority to control or directly prepared, or directed others to prepare, false or otherwise inaccurate disclosure documents.[717]

In order to hold an individual liable to pay consumer redress, however, the Commission must show more than just authority to control the corporation. It must show the individual possessed some level of knowledge or awareness of the misrepresentations.[718] The Commission may establish the requisite knowledge by showing that the individual had “actual knowledge of material misrepresentations, or an awareness of a high probability of fraud along with an intentional avoidance of the truth.”[719] For example, an officer or director of a franchisor would be liable for redress if he or she directed the franchisor’s employees to prepare false or misrepresented disclosures, or failed to stop the company from using a faulty disclosure document that one or more states had previously rejected as insufficient.[720] Similarly, a franchisor’s sales manager could be held individually liable for redress where the sales manager has authority to control those preparing disclosure documents, and has knowledge that the disclosures are false, or otherwise inaccurate.[721]

2. Section 436.6(b): Formatting requirements

As proposed in the Franchise NPR, section 436.6(b) of the final amended Rule specifies that all disclosures must be prepared “clearly, legibly, and concisely in a single document.”[722] At the same time, it includes the UFOC Guidelines requirement that disclosures must be prepared using plain English. It also updates the UFOC Guidelines to address electronic disclosure: section 436.6(b) provides that disclosures must be in a form that “permits each prospective franchisee to store, download, print, or otherwise maintain the document for future reference.” This prevents deception, ensuring that prospective franchisees can review the disclosure document at will, as well as show a copy of the disclosure document to their advisors, if they wish to do so.[723] Thus, for example, a franchisor would violate section 436.6(b) if it sought to provide disclosures merely by permitting a prospect to glance at a paper copy of its disclosure document, providing a continuous loop video of its disclosure document at a trade show, or transmitting its disclosures via email or the Internet in a format that was incapable of being downloaded or printed. No comments addressed this issue. Accordingly, the final amended Rule adopts this provision as proposed in the Franchise NPR.

3. Section 436.6(c): Affirmative responses

Consistent with the original Rule and Franchise NPR, section 436.6(c) of the final amended Rule specifies that franchisors must respond affirmatively or negatively to each disclosure item.[724] If a disclosure item is not applicable, then the franchisor must respond negatively, including a reference to the type of information required to be disclosed by the Item. For example, a franchisor without any litigation would state something to the effect: “The franchisor has no litigation required to be disclosed by Item 3.” In addition, each disclosure item must contain the appropriate heading.[725] No comments addressed this issue. Accordingly, the final amended Rule adopts this provision as proposed in the Franchise NPR.

4. Section 436.6(d): Additional materials

The final amended Rule retains the original Rule’s policy prohibiting franchisors from including additional materials in their disclosures, except for information “required or permitted by this Rule or by state law not pre-empted Start Printed Page 15516by this Rule.”[726] This prohibition is necessary to ensure that franchisors do not include information that is non-material, confusing, or distracting from the core disclosures.[727] As proposed in the Franchise NPR, the final amended Rule also updates the original Rule by prohibiting the use of new technological developments, such as audio, video, and “pop-up” screens, and external links,[728] which could be used to call attention to favorable portions of a disclosure document or to distract prospective franchisees from damaging disclosures.[729] The Commission recognizes, however, that navigational features may benefit prospective franchisees by making it easier to read an electronic disclosure document.[730] To that end, the final amended Rule, consistent with the Franchise NPR, specifically permits the use of “scroll bars, internal links, and search features.”

The prohibition against adding to a disclosure document generated a number of comments during the Rule amendment proceeding. Several commenters voiced concern that the prohibition against adding to a disclosure document “is an unfair trap for franchisors and subfranchisors.” For example, Warren Lewis asserted:

[W]e note that a franchisor or subfranchisor sometimes needs to include information in a disclosure document that it believes is material or possibly material (even though the information is not required or permitted under federal or state law) or that it believes will help a prospect to better understand required information or its significance. Providing supplementary or explanatory information of this type should not be a rule violation, unless the information is excessive, misleading, or intentionally diversionary.[731]

The Commission believes that its long-standing policy limiting disclosures to only authorized or permitted materials is sound. As discussed above, this limitation is necessary to ensure that a franchisor does not bulk-up a disclosure document with unnecessary information or features that will discourage a prospective franchisee from reading the document or distract a prospective franchisee’s attention from negative disclosures. For example, it is entirely proper to prohibit a franchisor from including general advertising, testimonials, or— in the case of electronic media— multimedia tools, in its disclosure documents. On the other hand, the Commission recognizes that unique features of electronic media, such as scroll bars, internal links, and search features that may aid prospective franchisees in reviewing their disclosures. Such features serve a useful purpose in an electronic environment, and the final amended Rule specifically permits their use.[732]

In reaching this conclusion, we agree with the commenters’ concern that it may be desirable to include additional material information in a disclosure document to ensure that required disclosures are accurate. The prohibition on adding to a disclosure document should be read narrowly to prohibit the inclusion of materials that are not specifically required or permitted by the Rule.[733] Where the Rule requires a franchisor to make a disclosure, however, the franchisor always may add brief footnotes or other clarifications to ensure that the disclosure is complete and not misleading.

Finally, in response to the Staff Report, David Kaufmann asserted that the prohibition against adding to a disclosure document set forth at section 436.6(d) creates an inconsistency with state anti-fraud laws that require a disclosure document to contain all material information.[734]

Section 436.6(d) is not intended to preempt state law. As previously discussed, a franchisor can always include information in a disclosure document that is required by state law. Typically, such state disclosures will arise in two circumstances. First, state law may require specific disclosures that go beyond those required by the Franchise Rule, or may contain a broad anti-fraud provision requiring franchisors to include in their disclosure document all material information. Second, a state franchise examiner may require, as a matter of discretion, on a case-by-case basis, a particular disclosure in order to prevent deception by a franchisor. In either instance, the final amended Rule accommodates state interests by permitting the franchisor to add state Start Printed Page 15517information to its basic disclosure document.

5. Section 436.6(e): Multi-state documents

As proposed in the Franchise NPR, section 436.6(e) of the final amended Rule permits franchisors to “prepare multi-state disclosure documents by including non-preempted, state-specific information in the text of the document or in Exhibits attached to the disclosure document.”[735] This instruction will decrease compliance costs significantly, by enabling franchisors to use one, united disclosure document for both federal and state purposes. No comments were submitted on this issue. Accordingly, the final amended Rule adopts this provision, as proposed in the Franchise NPR.

6. Section 436.6(f): Subfranchisor disclosures

Consistent with the original Rule, section 436.6(f) makes clear that subfranchisors must disclose the required information about the franchisor, and, to the extent applicable, the same information concerning the subfranchisor.[736]

The Franchise NPR proposed that subfranchisors “should” disclose the required information. Howard Bundy suggested that the subfranchisor instructions be revised to replace “should disclose” with “shall disclose.”[737] He noted that the word “should” implies an advisory only, that is, that a subfranchisor has the discretion to include its own information in the disclosure document. We agree, and section 436.6(f) of the final amended Rule is revised accordingly.

At the same time, H&H voiced concern about subfranchisors’ disclosure obligations, correctly observing that “subfranchising” takes many different forms. For example, a subfranchisor may in fact function as a franchisor by signing a franchise agreement with a subfranchisee, or the franchisor may sign the franchise agreement, but delegate many support functions to the subfranchisor. In the first “example, the proposed [disclosure] requirement may lead to disclosure about the franchisor in a subfranchise offering that is irrelevant and, in some circumstances, could be misleading to prospective franchisees.”[738] As discussed above in connection with the definition of “franchisor,” subfranchisors are treated the same as franchisors under the Rule in narrow circumstances only: where the subfranchisor steps into the shoes of the franchisor by both granting franchises, as well as by performing post-sale disclosure obligations.[739] Accordingly, we believe that the subfranchisor instructions set forth at section 436.6(f) are clear and no additional revision is necessary.

7. Section 436.6(g): Disclosure of any prerequisites to receiving or reviewing disclosure documents

Section 436.6(g) requires that, before a franchisor furnishes a disclosure document, it must “advise the prospective franchisee of the formats in which the disclosure document is made available, any prerequisites for obtaining the disclosure document in a particular format, and any conditions necessary for reviewing the disclosure document in a particular format.”[740]

This provision was not previously noted in the Franchise NPR.[741] It is intended to prevent deception, by ensuring that prospective franchisees, prior to disclosure, know whether or not they will receive a disclosure document in a form they can easily review.[742] For example, a franchisor would disclose if it furnishes disclosures via CD-ROM only. In addition, the franchisor must disclose if there are any special conditions to reviewing a disclosure document. The franchisor would disclose, for example, whether the prospective franchisee’s computer must be capable of reading pdf files or whether any specific applications are necessary to view the disclosures (such as Windows 2000 or DOS, or a particular Internet browser). No comments were submitted on this proposed Rule amendment. Accordingly, the Commission adopts this provision in the final amended Rule.[743]

8. Section 436.6(h): Disclosure document recordkeeping

Section 436.6(h) of the final amended Rule requires franchisors to “retain, and make available to the Commission upon request, a sample copy of each materially different version of their disclosure documents for three years after the close of the fiscal year when it was last used.” This provision modifies slightly the language used in the Franchise NPR—which limited the recordkeeping instruction to electronic disclosure documents.[744] Section 436.6(h) now applies to all disclosure documents, regardless of the medium Start Printed Page 15518used.[745] This is consistent with E-SIGN, which generally prohibits discriminating between paper and electronic commerce. It is also consistent with standard business practices and state law requirements, and, therefore, should impose only a de minimis burden on franchisors. At the same time, a three-year recordkeeping provision will greatly assist the Commission in its law enforcement work, by ensuring the availability of evidence in rule enforcement actions.[746]

During the Rule amendment proceeding, a few commenters urged the Commission to adopt a longer recordkeeping requirement.[747] A longer recordkeeping provision, no doubt, might also assist franchisees who wish to bring common law actions with longer limitations periods. However, we believe such a step is unnecessary in light of the other Rule instructions ensuring that prospective franchisees can retain copies of their disclosures for future reference. In short, franchisees should safeguard their disclosure documents post-sale, and the Rule instructions, as noted above, accommodate that interest.

9. Section 436.6(i): Receipt recordkeeping

Finally, section 436.6(i) of the final amended Rule requires franchisors to “retain a copy of the signed receipt for at least three years.”[748] This section was proposed in the Franchise NPR in connection with the Item 23 receipt requirement. However, because this recordkeeping requirement is not a disclosure, but is more akin to an instruction, it has been moved to the final amended Rule’s general instructions section.

Section 436.6(i)’s three-year record retention period is consistent with the statute of limitations for trade regulation rule enforcement actions brought under Section 19 of the FTC Act.[749] Further, many franchise registration states already require franchisors to maintain complete records involving each franchise sales transaction.[750] Therefore, franchisors routinely ask for and retain some kind of receipt in the ordinary course of business to protect themselves from any future allegations that they sold franchises without disclosure. Thus, a recordkeeping requirement is likely to foster compliance with the Rule’s disclosure obligation without imposing significant compliance costs.[751]

E. Section 436.7: Updating Requirements

Section 436.7 of the final amended Rule specifies three updating requirements to ensure that franchisors’ disclosures are timely. In most respects, the updating requirements are identical to those set forth in the original Rule and Franchise NPR, and have generated few comments.

First, section 436.7(a) of the final amended Rule retains the current requirement that franchisors prepare annual updates after the close of their fiscal year,[752] but it has expanded the number of days in which franchisors are permitted to prepare updates from 90 to 120 days.

Second, sections 436.7(b) and (c) retain the requirement that franchisors update their disclosures within a reasonable time after the close of each quarter to reflect any material changes.[753]

Third, section 436.7(d) continues the original Rule’s policy that franchise sellers, when furnishing their disclosures, must notify prospective franchisees of any material changes that the seller knows or should have known in any Item 19 financial performance representations.[754] We discuss each of these provisions immediately below.

1. Section 436.7(a): Annual updates

As noted above, section 436.7(a) expands the time period proposed in the Franchise NPR for making annual updates from 90 to 120 days after the close of the franchisor’s fiscal year.[755] In response to the Franchise NPR, several commenters urged the Commission to adopt a 120-day requirement. For example, PMR&W stated that many franchisors have difficultly obtaining annual audited financial statements from their auditors within the current 90-day period. Because most franchisors use the calendar fiscal year, company auditors are usually overwhelmed at the beginning of the fiscal year, given the busy tax season. Recognizing this problem, many state franchise regulators allow franchisors 120 days to prepare updated disclosures.[756] For these reasons, the Commission is persuaded that the updating requirement should be expanded from the original Rule’s 90 days to 120 days. This revision has the potential of reducing franchisors’ compliance burdens, while potentially reducing inconsistencies with state updating policies.[757]

2. Sections 436.7(b)-(c): Quarterly updates

Sections 436.7(b) and (c) of the final amended Rule retain the original Rule and Franchise NPR requirement that franchisors update their disclosures at least quarterly to reflect any material changes.[758] This requirement generated no significant comment during the Rule amendment proceeding.[759] We believe it Start Printed Page 15519strikes the right balance between ensuring the timeliness of disclosures and reducing compliance burdens. Franchisors need to prepare quarterly updates only if there is a material change, and they may include the quarterly update in an addendum. In short, franchisors need not prepare new disclosure documents each quarter as a matter of course. We believe the current quarterly update requirement establishes a clear, bright line tied to each franchisor’s fiscal year. It has worked well and has generated few, if any, complaints during the 20 years that the Rule has been in existence.

Section 436.7(c) modifies the quarterly update provision proposed in the Franchise NPR, however, to accommodate the extension of the annual update from 90 to 120 days, as previously discussed. The obligation to update disclosures quarterly necessarily precedes the conclusion of the 120-day annual update period. Accordingly, additional clarification of the interrelationship between the annual and quarterly update requirements is warranted. To that end, section 436.7(c) provides that a franchisor’s annual update (120 days after the close of the fiscal year) “shall include the franchisor’s first quarterly update, either by incorporating the quarterly update information into the disclosure document itself, or through an addendum.” The following tables illustrate the point, by comparing procedures under the original Rule with those under section 436.7(c).

Hypothetical Using Procedures Under the Original Rule

December 31, 2005Fiscal year ends.
January-March, 2006First quarter of new fiscal year.
April 1, 2006Franchisor must use annual updated disclosure document.
Reasonable time after April 1, 2006Franchisor amends annual update with a quarterly update, if warranted.
Reasonable time after July 1, 2006Franchisor amends annual update (and any previous quarterly update) with a quarterly update, if warranted.
Reasonable time after October 1, 2006Franchisor amends annual update (and any previous quarterly update(s)) with a quarterly update, if warranted.
Reasonable time after January 1, 2007Franchisor amends 2006 annual update (and any previous quarterly updates(s)) with a quarterly update, if warranted.

Hypothetical Using Final amended Rule Procedures

December 31, 2005Fiscal year ends.
January-March, 2006First quarter of new fiscal year.
May 1, 2006Franchisor must use annual updated disclosure document containing any first quarter update either integrated in the body of the disclosure document itself or in an addendum.
Reasonable time after July 1, 2006Franchisor amends annual update with a quarterly update, if warranted.
Reasonable time after October 1, 2006Franchisor amends annual update (and any previous quarterly update(s)) with a quarterly update, if warranted.
Reasonable time after January 1, 2007Franchisor amends annual update (and any previous quarterly updates(s)) with a quarterly update, if warranted.

3. Section 436.7(d): Material changes to financial performance information

Section 436.7(d) retains the original Rule requirement that a franchisor notify prospective franchisees of any material changes to previously furnished financial performance information.[760] The Franchise NPR proposed a broader updating requirement that would have compelled franchisors to notify prospects of any material changes before delivery of the disclosure document.[761] This proposal generated several comments, both supporting and opposing the expanded updating proposal.

IL AG and Howard Bundy favored the broader updating requirement, but they would require all such updates to be in writing. The IL AG, for example, stated that “[o]ral notification is the ammunition for rescission litigation.”[762]

On the other hand, several franchisors opposed the updating requirement for various reasons. Marriott, for example, asserted the proposal would be extremely burdensome, imposing “an impossible burden on large franchisors, especially if they actually operate the business that they franchise because of the uncertainty of what constitutes ‘any material change’ and the requirement of ‘real time’ ongoing disclosure.”[763] Marriott would eliminate the proposed expanded update provision in its entirety.[764]

PMR&W and the NFC advised that the proposal is confusing. In particular, PMR&W found the relationship between the basic quarterly update provision and the proposed continuing update provision less than clear:

It is unclear whether these “material changes” must be more “material” than any changes disclosable in the quarterly updates. Start Printed Page 15520Depending on the answer to this question, is there any need to require quarterly updates when immediate updates are mandated; i.e., does the immediate update rule preclude the need for the quarterly update?[765]

In a similar vein, the NFC questioned whether a franchisor must provide a prospective franchisee with each and every quarterly update, as long as the prospect is in the sales cycle. If so, it asked how franchisors should determine whether prospects are no longer in the sales cycle.[766]

It is clear from the comments that there are two competing concerns. On the one hand, prospective franchisees should have all material information they need to make an informed purchase decision, regardless of when they entered the sales process. On the other hand, there are practical considerations, including the costs and burdens on franchisors to update each franchisee on a continuing basis, as Marriott observed. Indeed, at some point, the burden and cost to franchisors (which inevitably will be passed along to prospective franchisees or other consumers) outweighs the potential benefit of more frequent updating.

Based upon the record, the Commission is persuaded that, on balance, a continuing update requirement is unwarranted. We are convinced that franchisors should have a bright-line directive when they can be assured that they have complied with the Rule’s disclosure requirements. We believe that the original Rule’s quarterly update requirement is sufficient to ensure timely disclosures, while minimizing compliance costs.

Further, any prospective franchisee who has been in the sales cycle can always request a copy of the franchisor’s most recent disclosure document before he or she agrees to execute the franchise agreement. To facilitate that goal, the Commission has adopted a new prohibition that would bar franchisors from failing to honor a prospective franchisee’s reasonable request for a copy of the franchisor’s most recent disclosure document and/or quarterly update before he or she signs a franchise agreement.[767] We believe this prohibition is unlikely to increase franchisor’s compliance costs and burdens. Franchisors most likely will have updated disclosures documents prepared in the ordinary course of their business. With the advent of electronic communications, emailing a copy of the updated disclosure document to a prospective franchisee, or otherwise permitting a prospective franchisee to see a copy of the updated disclosure document on the franchisor’s website, would impose only a small cost.

At the same time, we are persuaded that the final amended Rule should retain the original Rule’s continuing update requirement for financial performance information.[768] The original Rule required franchisors to notify prospective franchisees of any material changes in a financial performance representation before the prospective franchisee pays a fee or signs the franchise agreement.[769] We believe this provision is sound, recognizing the particular materiality of financial data to prospective franchisees. Any false impression created by stale data at the time of sale is likely to cause significant injury to prospective franchisees who rely on financial data in making their investment decision.[770]

F. Section 436.8: Exemptions

Section 436.8 of part 436 sets forth exemptions from the final amended Rule. In the original Rule, the exemptions were set out in the middle of the Rule’s definitions, where they modified the term “franchise.”[771] To make the exemptions easier to find, the Commission has decided to move them to a separate “exemptions” section in the final amended Rule.[772]

Section 436.8 retains the original Rule exemptions for: (1) franchise sales under $500;[773] (2) fractional franchises;[774] (3) leased departments;[775] and (4) oral contracts.[776] Section 436.8 also adds two new exemptions, one for franchise sales involving petroleum marketers, and one for three categories of “sophisticated investors.” Finally, the final amended Rule deletes the original Rule’s four exclusions found at 16 CFR 436.2(a)(4)(i)-(iv) for non-franchise relationships involving: (1) employer-employees and general partnerships; (2) cooperative organizations; (3) testing or certification services; and (4) single trademark licenses.[777]

The final amended Rule section 436.8 is substantially similar in both form and content to its counterpart proposed in the Franchise NPR.[778] The principal difference is a lowering of the dollar threshold for the sophisticated investor “large investment” exemption from $1.5 million to $1 million. This and the other substantive differences between the proposed and final amended Rules are explained below.

1. Section 436.8(a)(1): Minimum payment exemption

Section 436.8(a)(1) retains the original Rule’s $500 required minimum payment exemption found at 16 CFR 436.2(a)(3)(iii). This exemption ensures that the Rule “focus[es] upon those franchisees who have made a personally significant monetary investment and who cannot extricate themselves from the unsatisfactory relationship without suffering a financial setback.”[779] As explained below, the Commission believes the exemption and its $500 Start Printed Page 15521threshold continue to serve a useful purpose.

During this Rule amendment proceeding, no commenter recommended eliminating or reducing the $500 minimum payment threshold. Several commenters, however, urged the Commission to raise the $500 minimum threshold, with some commenters suggesting a $1,000 threshold,[780] while others suggested a $2,500,[781] or a $5,000 threshold.[782] These commenters maintained that an upward adjustment is warranted to reflect the increase in costs since the Rule was promulgated in 1978. In addition, two commenters also urged the Commission to increase the thresholds periodically, perhaps every four years, to reflect the rate of inflation.[783]

In contrast, the IL AG urged the Commission to retain the $500 threshold in order to protect small investors.[784] In a similar vein, a franchisee representative urged the Commission to modify the minimum payment exemption to provide that the $500 threshold includes “both amounts the franchisee actually pays, but also any amounts that the franchisee, during the first six months, agrees to pay in the future—either by contract or by practical necessity.”[785]

The Commission has determined to retain the original Rule’s $500 minimum payment exemption. The original Rule included a threshold dollar amount to exclude transactions where the prospective franchisee was at risk to lose an amount of money too small to justify imposition of the expense and burden of preparing a disclosure document upon sellers. This is particularly true with less complex business opportunities, which, even today, may cost under $500. However, with the extraction of business opportunity regulation to a new rule separate from the Franchise Rule, it can be argued that any investment in a franchise, as a practical matter, will be a significant investment risk. This may suggest that the exemption may no longer serve a useful purpose.

We note that the Staff Report described research exploring the relevance of the $500 threshold to the amounts actually charged for initial franchise fees in the current market. The staff examined over 1,000 franchise profiles listed in Bond’s Franchise Guide (13[th] ed. 2001).[786] All but 41 of the franchise systems responding to Bond’s survey reported initial franchise fees of $5,000 or more (approximately 96% of reporting systems). Indeed, only 22 systems reported that an initial fee was “not applicable,” or that they charged an initial franchisee fee of $1,000 or less.[787] Thus, even a $5,000 threshold would not reduce significantly the number of franchisors that must comply with the Rule’s disclosure obligations.

Given the significant investment required to purchase nearly any franchise, a plausible argument could be made for eliminating the threshold altogether. However, the minimum payment exemption continues to serve a very narrow, but important, purpose: To the extent that a less complex business opportunity might come close to satisfying the elements of a franchise, the $500 threshold would help to make it clear that such opportunities are exempt from the Franchise Rule. Thus, the final amended Rule retains the minimum payment exemption.[788]

2. 436.8(a)(4): Petroleum marketers and resellers exemption

Section 436.8(a)(4) of the final amended Rule expressly exempts petroleum marketers and resellers covered by the Petroleum Marketing Practices Act (“PMPA”).[789] Although this exemption was not part of the original Rule, in 1980 the Commission granted a petition for an exemption from the Rule filed by several oil companies and oil jobbers, pursuant to Section 18(g) of the FTC Act.[790]

In considering the petition, the Commission noted that the most frequently cited complaint about the petroleum franchise industry concerned termination and renewal practices. The Commission also noted that, after the close of the original franchise rulemaking record, Congress had passed the PMPA, which specifically addressed those complaints, requiring, among other things, pre-sale disclosure of franchisees’ termination and renewal rights. In light of that legislation, the Commission concluded that the Franchise Rule was largely duplicative of the PMPA and related federal regulations.

In granting the petition, the Commission stated that the Rule “shall not apply to the advertising, sale or other promotion of a [petroleum] ‘franchise,’ as the term ‘franchise’ is defined by the [PMPA].”[791] The final amended Rule incorporates the 1980 exemption as an express Rule exemption.

Two commenters voiced concern about this exemption. J&G maintained that the exemption leaves unanswered whether disclosure is warranted when other businesses—such as convenience stores, fast food, and ice cream shops—operate in these exempt gasoline franchise establishments.[792] In the same vein, Chevron noted that the PMPA covers agreements not only for gasoline sales, but for other refiner-branded services or products at a gasoline station. For example, a Chevron gasoline station may also have a Chevron branded (or no brand) car wash, repair Start Printed Page 15522center, or mart. According to Chevron, all of these services or products are sold as part of a unified deal when the prospective franchisee purchases the franchised gasoline outlet. Therefore, the Commission should also exempt the sale of such tangential services or goods sold along with a gasoline station under a unified agreement.[793]

In response to these comments, the Commission intends that it be clear that the PMPA exemption should be read broadly to cover other branded services and products (such as a car wash or mart) sold to the prospective franchisee under the same franchise agreement as the gasoline station. The Commission believes that, as a practical matter, it may be impossible to divide a single franchise agreement for gasoline and other services into its component parts for disclosure purposes, and such an approach is inconsistent with the PMPA. Nevertheless, separate or subsequent sales of a franchise to a gasoline station owner, such as a 7-Eleven or Subway outlet, fall outside of the exemption. An individual who operates a gasoline station is just as much in need of pre-sale disclosure for the purchase of a non-related franchise, such as an ice cream store, as any other prospective franchisee.

3. Sections 436.8(a)(5) and (a)(6): Sophisticated investor exemptions

Sections 436.8(a)(5) and (a)(6) add three new exemptions to the final amended Rule, collectively referred to as the “sophisticated investor exemptions.” As noted, the sophisticated investor exemptions as adopted are substantially similar to their counterparts as proposed in the Franchise NPR.[794]

Franchisors enthusiastically supported the creation of sophisticated investor exemptions.[795] They maintained that franchising today often involves heavily-negotiated, multi-million dollar deals between franchisors and highly sophisticated individuals and corporate franchisees with highly competent counsel. In the course of such deals, prospective franchisees often demand and receive material information from the franchisor that equals or exceeds the disclosures required by the Rule. These commenters asserted that such business arrangements are not the kinds of franchise sales that the Commission originally intended to cover.

On the other hand, several franchisees and their advocates opposed the exemptions, or expressed reservations about them.[796] Some feared that while prospective franchisees may appear to be sophisticated—either because of their net worth or general prior business experience—they actually may have limited knowledge of the risks inherent in operating the specific franchise being offered. In short, these commenters advised the Commission to protect the wealthy, but inexperienced.[797]

Section 436.8(a)(5)(i)—the “large franchise investment” exemption—exempts franchise sales where the initial investment is at least $1 million, exclusive of unimproved land and franchisor financing. Section 436.8(a)(5)(ii)—the “large franchisee” exemption—exempts franchise sale to ongoing entities—such as airports, hospitals, and universities—with at least $5 million net worth and five years of prior business experience. Section 436.8(a)(6)—the “insiders” exemption—exempts franchise sales to the owners, directors, and managers of an entity before it becomes a franchisor.[798] Each of these exemptions is discussed in the section below.

a. Section 436.8(a)(5)(i): Large investment exemption

Section 436.8(a)(5)(i) exempts from the Rule franchise sales where the prospective franchisee makes an initial investment totaling at least $1 million, excluding the cost of unimproved land.[799] To ensure that the large investment exemption is not overly broad and does not create a loophole, section 436.8(a)(5)(i) sets forth additional safeguards beyond the $1 million threshold to preserve protection for the average investor.[800] First, section 436.8(a)(5)(i) makes clear that funds obtained from the franchisor (or an affiliate) cannot be counted toward the $1 million initial investment threshold. Second, section 436.8(a)(5)(i) requires the prospective franchisee to sign an acknowledgment that the franchise sale is exempt from the Franchise Rule because the prospective franchisee will be making an initial investment of at least $1 million.

i. Need for the large initial investment exemption

As noted above, franchisors urged the Commission to adopt a large initial investment exemption,[801] while franchisees either opposed it or offered suggestions to limit it.[802] Specifically, several franchisee commenters asserted that wealth or ability to make a large franchise investment does not necessarily equate with business sophistication. They urged the Commission to focus instead on the investor and his or her business background, rather than ability to pay alone.[803]

For example, Eric Karp criticized the notion of a large investment exemption because it does not consider the source of the prospective franchisee’s funds:

Did she re-mortgage her residence? Did he borrow from a friend or relative? Did they cash in their retirement fund? The investment standard also does not consider what other assets, liabilities, and Start Printed Page 15523income the prospective franchisee has from which one can estimate his or her financial sophistication and tolerance of risk.[804]

In lieu of the “investment” model offered by the Commission, Mr. Karp urged the Commission to consider SEC Regulation D,[805] which “properly focuses on the qualifications of the investor, not the size of the investment.” In his view, the large franchise exemption does the opposite. “The fact that a franchisee may be ready to invest a highly leveraged $1.5 million franchise investment does not prove that such a person is so sophisticated that a disclosure document would be of no benefit.”[806]

Mr. Karp also discounted the potential benefit of the large investment exemption to franchisors. According to Mr. Karp, the exemption would be of little benefit to the franchisor unless 100% of its franchise sales involved transactions over the threshold level. If so, he insisted, there is no additional compliance burden imposed by requiring disclosures be given to all prospective franchisees because the franchisor has to prepare the disclosures in any event.[807]

After reviewing the comments, we are persuaded that a large investment exemption is warranted. Since the Rule’s inception, the Commission has considered a prospective franchisee’s level of investment as one measure of sophistication. For example, in granting the Automobile Importers of America’s petition for exemption from the Rule under Section 18(g), the Commission observed:

Prospective motor vehicle dealers make extraordinarily large investments. As a practical matter, investments of this size and scope involve relatively knowledgeable investors or the use of independent business advisors, and an extended period of negotiation. The record is consistent with the conclusion that the transactions negotiated by such knowledgeable investors over time and with the aid of business advisors produce the pre-sale information disclosure necessary to ensure that investment decisions are the product of an informed assessment of the potential risks and benefits of the proposed investment.[808]

Accordingly, it is clear that investment level is one indicium of sophistication.

More important, we are convinced that franchisors should have a bright-line standard that will clearly indicate when and under what circumstances the sophisticated investor exemption will apply. An exemption based upon the specific business experience of each individual prospective franchisee would be burdensome to administer. For example, in some instances franchisors would not be able to take advantage of the exemption unless they first verified each prospective franchisee’s business background. Similarly, absent such verification, law enforcers would not be able to discern whether any specific franchise relationship was covered by the Rule. This approach could create a regulatory nightmare for both franchisors and franchise law enforcers.

We are also convinced that the large investment exemption offers tangible benefits to franchisors. Clearly, there are franchise systems, such as lodging, where the typical franchise investment is likely to exceed the large investment exemption’s monetary threshold. Accordingly, the large investment exemption will provide regulatory relief at least in those instances. We recognize that the large franchise investment exemption, however, will provide only limited relief for franchisors that sell franchises both above and below the threshold. In such instances, the franchisor must prepare disclosure documents in order to sell at levels below the threshold. Accordingly, the costs of providing disclosures to all franchisees, including those above the threshold, may not be large, but neither is the potential benefit to the purchaser. Indeed, the argument that sophisticated investors could benefit from disclosure misses the mark. The basis for the large investment exemption is not that “sophisticated” investors do not need pre-sale disclosure, but that they will demand and obtain material information with which to make an investment decision regardless of the application of the Rule. Where prospective franchisees are likely to demand and obtain pre-sale material information regardless of external prompting or compulsion, then the case for federal intervention is not compelling.

Further, the Rule’s costs and burdens are unwarranted in situations where the likelihood of abuse is low. This concept is incorporated into the statutory provision of the FTC Act that gives franchisors the right to petition the Commission for a trade regulation rule exemption, including an exemption limited to a specific set of facts.[809] Thus, a franchisor, if it wished, could petition the Commission for an exemption only for sales above a certain dollar figure (although to date none has done so). The large investment exemption need not be “all or nothing” to benefit franchisors. The very fact that franchisors uniformly supported the large investment exemption tends to confirm that it will provide them with some desired regulatory relief. On balance, we believe that a narrowly crafted large investment exemption offers the potential for reducing franchisors’ regulatory burdens and preserving Commission resources by reducing the number of exemption petitions, without sacrificing protections for the average investors the Franchise Rule was originally promulgated to protect.

ii. The $1 million investment threshold

Section 436.8(a)(5)(i) provides that franchise sales involving an investment of $1 million —excluding the cost of unimproved land and franchisor financing—qualify for the large investment exemption. We are convinced that a $1 million threshold strikes the right balance between providing relief for sophisticated investors and protecting consumers.

The large investment exemption proposed in the Franchise NPR incorporated a higher $1.5 million threshold, based upon the Commission staff’s analysis of the costs to purchase more than 1,350 franchises listed in various trade publications, including Enterprise Magazine’s The Franchise Start Printed Page 15524Handbook; (“Franchise Handbook”); Entrepreneur Magazine’s Franchise 500, and the International Franchise Organization’s Franchise Opportunities Guide.[810]

Very few single-unit franchises cost more than $1.5 million: the maximum estimated cost of establishing a franchise exceeded $1.5 million in only about 3% of the listed systems. Thus, an investment of $1.5 million most likely would involve the purchase of several units. For example, more than 90% of the franchise systems listed in the cited sources involve a maximum investment totaling less than $500,000. Thus, in order to qualify for the $1.5 million exemption, an investment in the vast majority of systems would involve the purchase of either a single large franchise—such as a hotel or the most expensive restaurant location—or multiple units.[811] Of the 12 restaurant systems listed in the Franchise Handbook with maximum investments of $1.5 million or above, all listed a minimum investment below $1.5 million to establish a location. Three listed less than $1 million as the minimum investment, and seven estimated the minimum investment to be between $1 million and $1.2 million, or the purchase of three or more units.[812]

During this proceeding no consensus emerged on the appropriate investment threshold for the large investment exemption. Several commenters supported the Franchise NPR’s proposed $1.5 million threshold.[813] Other commenters urged the Commission to increase the threshold. For example, NASAA recommended a $3 million threshold. In its view, a $1.5 million threshold may place too many transactions outside the Rule’s protections, because, according to NASAA, even unsophisticated investors may have access to $1.5 million to invest in a franchise.[814] On the other hand, several commenters suggested that the threshold should be lower. For example, McDonald’s suggested that the threshold should be set at $1 million.[815] The IFA proposed a variation on this theme. It supported a $1 million threshold, excluding land.”[816] It observed that a 1997 update to the Profile of Franchising identified 52 franchise companies offering franchises with an initial investment exceeding $1 million, excluding land. This equates to 4.4% or less of all franchise systems.[817] Thus, at a $1 million threshold for the exemption, more than 95% of all franchise systems would remain within the ambit of the Rule.[818] Some commenters recommended an even lower threshold. PMR&W, for example, recommended $500,000.[819]

The Commission gives particular weight to the statements offered by franchisors such as McDonald’s and Marriott that, in their experience, a $1 million investment is likely to involve sophisticated investors.[820] The Commission believes that a $3 million dollar threshold would be too high, effectively restricting the exemption to only the rarest of instances, mostly large hotel franchises. On the other hand, the suggested $500,000 threshold, in our view, is too low. There is insufficient record support for the proposition that investors at the $500,000 level are sophisticated. Thus, the Commission has adopted a $1 million threshold for the exemption.

Exclusion of unimproved land. The $1 million threshold for the large investment exemption excludes payments for unimproved land. The Commission believes that the inclusion of unimproved land in the exemption would have two negative consequences. First, inclusion of unimproved land would tend to inflate the initial cost of a franchise investment and place too many transactions outside the ambit of the Rule’s protections. As the IFA noted, approximately 52 franchise systems, or less than 5% of the universe of franchise systems, would qualify for an exemption with a threshold investment of $1 million, excluding unimproved land.

Second, the Commission has a strong preference for a bright-line standard that can be readily applied across franchise systems. It seems unworkable to require a franchisor to calculate on an offer-by-Start Printed Page 15525offer basis the cost of land, which could vary widely depending on local market conditions. A single, clear threshold is vastly superior, in our view. Accordingly, for these reasons, we believe that $1 million, excluding unimproved land, strikes the appropriate balance.

Finally, we note that the Staff Report, adopting language offered by the IFA in response to the Franchise NPR, proposed to exclude “real estate.” In response to the Staff Report, three commenters urged the Commission to clarify the meaning of the term “real estate” either in the Rule or in Compliance Guides. The IFA, for example, noted that the term “real estate” may encompass “raw land, buildings, leasehold improvements, fixtures, and the like.”[821] The IFA asserted that the value of the exemption would be diminished if all such items were excluded from consideration in determining whether an initial investment totals $1 million. It suggested that the term “real estate” be defined to exclude only the franchisee’s investment in unimproved land.[822] Similarly, Starwood urged that only “land” should be excluded, but “all real estate improvements and fixtures should be counted in the sum invested.”[823] Piper Rudnick offered yet a different version: “any real property acquired to establish and operate the franchised business.”[824]

After considering the comments, the Commission has concluded that the phrase “unimproved land” is more appropriate than “real estate.” As IFA noted, the exclusion of fixtures, equipment, and other improvements to property from the $1 million threshold would leave the exemption so narrow, that it would be useless in all but the most expensive franchise offerings, defeating the very purpose of the exemption. Excluding “real estate”—which is significantly broader than the more limited term “unimproved land”—would also impact disproportionately real estate-intensive companies—such as hotels and restaurants. The justification for a large investment exemption is that individuals investing $1 million or more are sufficiently sophisticated that they do not need the Rule’s protections. This rationale applies equally whether the prospective franchisee invests $1 million to purchase a building or the prospective franchisee buys equipment or other assets. Accordingly, excluding unimproved land from the large investment exemption’s $1 million threshold strikes the appropriate balance between providing franchisors with a clear threshold, while ensuring regulatory relief for large investments.

Exclusion of franchisor financing. Section 436.8(5)(i) does not count monies that are obtained through franchisor (or affiliate) financing toward the large initial investment exemption’s $1 million threshold. The exclusion of franchisor financing adds a measure of protection to the prospective franchisee because traditional lenders are very likely to require a due diligence investigation of the offering, whereas the franchisor or its affiliate likely would not.

A few commenters opposed the exclusion of franchisor-financing when calculating a prospective franchisee’s initial investment. For example, Marriott asserted that it does not believe that there are inherent risks that would justify excluding financing from the franchisor. Indeed, it feared that this exclusion might have the unintended effect of harming franchisees by discouraging franchisors from offering financing to prospects in order to qualify for the exemption.[825]

After careful assessment of the comments, the Commission has concluded that financing obtained from the franchisor or an affiliate should not be counted toward the large investment exemption threshold. Otherwise, a franchisor could be tempted to increase the cost of the initial investment to qualify for the large investment exemption, while simultaneously offering to finance the deal itself, all without proper pre-sale disclosures. In that regard, the Commission agrees with Eric Karp, who observed that the assumption that a prospective franchisee will have a sufficient level of equity tends to disappear “where a franchisee obtains financing from the franchisor or its affiliates or from a selling franchisee; in such instances, far less equity may be required.”[826]

Further, it is reasonable to assume that a lender, in order to minimize its own financial risk, will ensure that a prospective franchisee will conduct a due diligence investigation of the franchise offering. Indeed, by involving a lender, the prospective franchisee effectively ensures that there is an independent, sophisticated entity inserted into the sales process. This additional safeguard would be lost if sources of financing for purposes of the exemption included the franchisor and its affiliates.

iii. Acknowledgment

To take advantage of the large investment exemption, section 436.8(5)(i) requires the franchisor to obtain the prospective franchisee’s signed acknowledgment that the investment satisfies the $1 million threshold. This will reduce the opportunity for fraud by enabling the prospect to verify that the investment meets or exceeds the exemption threshold. Therefore, it will reduce the probability that the franchisor will misrepresent the initial cost of the franchise to qualify for the exemption, as well as provide a paper trail in the event an enforcement action becomes necessary.

Several commenters failed to understand the purpose of the acknowledgment or believed that it would serve no useful purpose. For example, BI stated: “We do not understand the purpose or the importance of the acknowledgment by the prospective franchisee of the application of the exemption. The acknowledgment does not protect the prospective franchisee, except, perhaps to put the prospect on notice that it may be entitled to receive a disclosure document.”[827]

Seth Stadfeld asserted that the acknowledgment requirement could be abused. “[F]ranchisors could further a fraud by playing up to and flattering the prospective franchisee into thinking that he is so sophisticated that he doesn’t need the disclosures that the little people need.”[828] On the other hand, Howard Bundy advised that the acknowledgment should be expanded. He would revise the Rule to read: “The franchisee’s estimated investment, excluding any affiliate financing, totals at least $1.5 million and the prospective franchisee signs an acknowledgment stating the basis for the exemption from the Rule and providing the CFR citation to the Rule and verifying the grounds for the exemption . . .”[829]

The Commission is convinced that the acknowledgment requirement serves a useful purpose. As previously noted, the acknowledgment will ensure that a Start Printed Page 15526prospective franchisee receives notice that the transaction is exempt from the Rule. This would tend to prevent fraud by enabling the prospective franchisee to verify the applicability of the exemption. Further, we believe that abuse of the acknowledgment requirement is unlikely. A prospective franchisee’s signing of the acknowledgment does not give rise to the exemption. A franchisor must furnish disclosures unless the specific criteria for the exemption is satisfied. Thus, whether a prospective franchisee is flattered into signing an acknowledgment is irrelevant. At the same time, we agree with Mr. Bundy that the acknowledgment should reference the Franchise Rule itself. This would enable a prospective franchisee to review the Rule, understand the exemption, and, ultimately, verify the exemption’s application. Accordingly, the acknowledgment requirement of the final amended Rule has been revised to incorporate these revisions.

iv. Meaning of “initial investment”

During the Rule amendment proceeding, several commenters voiced concerns about how to define “investment” for purposes of the large investment exemption. For example, J&G questioned: “Is it the initial investment described in Item 7? Is it the amount of the investment over the term of the franchise? Or is it some other calculation?”[830] The NFC voiced similar concerns and urged the Commission to clarify that the term “investment” means the franchisee’s estimated investment, as set out in Item 7 of the disclosure document.[831]

The Commission’s intent is that, for purposes of the large investment exemption, the level of a prospective franchisee’s investment should be limited to the “initial investment,” as set forth in Item 7. For that reason, the phrase “estimated investment” has been replaced in the Rule’s text with the phrase “initial investment.” Focusing on Item 7 when applying the exemption brings needed certainty to all parties, while ensuring that the exemption is narrowly focused to protect prospective franchisees making smaller investments. It is not farfetched to assume that a large universe of franchisees investing $100,000 or less today might actually pay more than $1 million (excluding unimproved land) to the franchisor during the course of a lengthy franchise agreement, especially when royalty and advertising fees, as well as ongoing product purchases, are considered. For that reason, a broad large investment exemption would effectively eviscerate the Rule’s protection.[832]

The term “initial investment,” however, need not be limited to a single unit. The Commission notes with approval the comments of H&H and the NFC, urging revision of the Rule to clarify that the threshold includes the total projected investment, whether in single- or multiple-unit transactions. As the NFC noted: “A multi-unit franchisee investing the threshold amount (or more) in a number of units is just as sophisticated as another franchisee investing a like amount in a single unit.”[833]

The Commission has carefully considered the Staff Report recommendation to place limits on the large investment exemption to protect investors who pool their resources to purchase a franchise at or above the threshold level.[834] The Commission shares the staff’s concern. Clearly there is a significant difference between a single individual purchasing a franchise for $1 million, versus a group of 10, for instance, each contributing $100,000. Obviously, the larger the group of investors, the smaller each individual investor’s risk. In such a circumstance, the level of each individual investment provides no indicium of sophistication. Accordingly, the Commission has added footnote 11 to the Rule to provide that the large franchise exemption applies only if at least one individual in an investor-group qualifies as “sophisticated” by investing at the threshold level.

Several commenters assessed this issue differently. IL AG suggested that each member of an investment group should be required to satisfy the $1 million investment threshold in order to be deemed “sophisticated.[835] In contrast, Marriott asserted that franchisees in large transactions typically form joint ventures or obtain financing from outside equity investors. Marriott maintained that there is little benefit in requiring a franchisee to break down the relative financial responsibilities of each equity investor in order to determine the application of the large investment exemption.[836] Marriott also noted that the list of investors may change over the course of contract negotiations, making it difficult to determine at the time of sale whether any single investor qualifies for the exemption.

The Commission has concluded, however, that the limitation in footnote 11 is necessary to ensure that the large investment exemption strikes the right balance between providing relief for franchisors where the likelihood of abuse is reduced, and ensuring continued protection for those prospective franchisees who, although wealthy, may lack business experience. As explained above, the large investment exemption is premised on the Commission’s assumption that ability to pay indicates sophistication. That assumption fails when no one investor standing alone is investing at the requisite threshold level. In short, sophistication does not arise merely by aggregating otherwise unsophisticated investors.

v. Conversion franchises and transfers

During this proceeding, several commenters questioned whether the large investment exemption would cover business arrangements such as conversion franchises and transfers. In a conversion franchise, a business owner has already invested in his or her existing business and now seeks to associate with a particular franchisor’s brand by entering into a franchise agreement with that franchisor. H&H stated that the term “‘investment’ should include the fair market value of an existing facility as part of the investment, so as to include an existing facility that is being converted to the franchise system.”[837]

In a similar vein, the NFC questioned whether a transfer of a franchise directly from a franchisee to a new purchaser Start Printed Page 15527can qualify for the exemption. It urged the Commission to include transfers in the definition of “investment,” where the purchasing franchisee pays an existing franchisee the threshold amount and then enters into a new franchise agreement with the franchisor. “[W]e . . . submit that franchisees making such an investment prior to the execution of the subject franchise agreement are as ‘sophisticated’ as their brethren who make the investment after executing that agreement.”[838]

The Commission’s view is that the definition of “initial investment” is broad enough to include conversion franchises and transfers without sacrificing necessary protection for franchise purchasers. Specifically, when considering a conversion franchisee’s “initial investment” in a franchise, it is reasonable to consider the conversion franchisee’s previous investment in the unit. Indeed, a strong argument can be made that a conversion franchisee is even more sophisticated than a new franchisee, having worked in the business for a period of time. Similarly, the sale of an existing franchise would qualify for the large investment exemption in a transfer. The fact that a transferee will assume an existing contract or may renegotiate an existing contract with the franchisor should have no bearing on his or her level of sophistication as an investor, as long as he or she satisfies the monetary threshold.

b. Section 436.8(a)(5)(ii): Large franchisee exemption

Section 436.8(a)(5)(ii) exempts from the final amended Rule franchise sales to large entities; namely, those who have been in any business for at least five years and have a net worth of at least $5 million.[839] The Commission is persuaded that large entities negotiating franchise deals—such as airports, hospitals, and universities—can obtain the benefits of the amended Rule without federal government intervention.

i. Need for the large franchisee exemption

In the Franchise NPR, the Commission proposed exempting franchise sales to large “corporate” franchisees.[840] For example, a fast food franchisor may sell a number of franchised outlets to a hotel chain. Such transactions often are heavily negotiated by sophisticated counsel who have significant experience in the franchise industry. Even if a large entity does not have prior experience in franchising, or in the franchised business in particular, it is reasonable to assume that it can nevertheless protect its own interests when negotiating a franchise deal.

Indeed, the Commission stated in the Franchise NPR that a large franchisee exemption is a logical extension of the original Rule’s fractional franchise exemption. To qualify as a fractional franchisee, among other things, a prospect must have two years of experience in the same line of business. Thus, the fractional franchise exemption is very narrowly tailored, focusing only on persons who wish to expand their existing product lines. While the fractional franchise exemption is appropriate for individuals and small businesses seeking to expand, it may be unnecessarily narrow for larger, more sophisticated corporations seeking to become franchisees.[841]

The Staff Report proposed a large franchisee exemption identical to that in the Franchise NPR. Five franchisor representatives continued to support the proposed exemption,[842] while three franchisees opposed it for the same reasons previously voiced in response to the Franchise NPR.[843]

ii. Covered entities

The large franchisee exemption is intended to cover franchisees that are “entities.” In the Franchise NPR, the Commission proposed that the large franchisee exemption be limited to corporations. Many commenters supported the proposed exemption, but criticized its narrow application.[844] Specifically, several commenters urged the Commission to consider exempting other large entities, such as partnerships, finding no rationale for restricting the exemption only to corporations. The Commission agrees, and has expanded the provision in the final amended Rule to encompass corporations, partnerships, and similar arrangements.[845]

iii. Net worth

To qualify for the large franchisee exemption, section 436.8(a)(5)(ii) specifies that the prospective franchisee-entity must have a net worth of $5 million.[846] During the Rule amendment proceeding, several commenters opined that the exemption’s net worth prerequisite is overly restrictive.[847] H&H, for example, contended that a $5 million net worth threshold is too high, limiting the exemption to a small number of publicly-traded companies. “Many successful private companies do not seek to accumulate equity, but instead to maximize cash flow to their owners. Thus, such a high net worth requirement would prevent the exemption of many sophisticated investors.”[848] The firm urged a net worth requirement of $1 million.[849] On the other hand, Howard Bundy asserted that the $5 million net worth requirement is too low, sweeping in many very small companies. “That is a Start Printed Page 15528small enough net worth to not be indicative of the level of sophistication that would indicate no need for mandatory disclosures.”[850] The Commission believes that the $5 million net worth requirement strikes the right balance, granting relief to sophisticated entities, while protecting those entities for whom the purchase of a franchise would be a significant financial risk.

iv. Prior experience

In addition to requiring $5 million net worth, section 436.8(a)(5)(ii) requires large franchisees to have five years of prior business experience in any line of business, as proposed in the Franchise NPR. A few commenters opined that the prior experience prerequisite is unnecessary, and urged the Commission to focus only on the large franchisee’s net worth. The NFC, for example, asserted that: “Even if a large corporation does not have prior experience in franchising specifically, it is reasonable to assume that it can protect its own interests when negotiating for the purchase of a franchise.”[851]

On the other hand, Triarc urged the Commission to focus on prior experience in lieu of net worth. It noted that it is possible that a franchisee with 10 years of experience and 50 units may wish to finance its operation with debt rather than equity. Under the circumstances, this presumably sophisticated franchisee would fail the net worth test:

What if a large corporate franchisee with $20.0 million of net worth declares a $16.0 million dividend to its shareholders or otherwise does a recapitalization which takes its net worth below the threshold? Over the years, some gigantic companies that are financially healthy have had huge negative net worths and negative earnings. . . . We would suggest that net worth is often an indicator of how a company chooses to finance itself rather than of sophistication.[852]

After considering these arguments, the Commission concludes that both the $5 million net worth and five years experience prerequisites are necessary to ensure that the Rule continues to protect businesses with limited experience, limited assets, and, by inference, limited prior success. For example, a small sandwich shop franchisee is not necessarily sophisticated enough to purchase a hotel merely because the franchisee has operated one or more sandwich shops for five years. Similarly, several wealthy individuals who form a partnership without any prior business experience are not necessarily sophisticated merely because of their net worth. Both prerequisites are necessary to ensure that the large franchisee exemption does not create a loophole, putting small and unsophisticated entities at an unacceptable financial risk.

v. Affiliates and parents

Finally, section 436.8(a)(5)(ii) refines the proposed exemption published in the Franchise NPR, which used the term “corporation” and made no mention of parents or affiliates. As revised, a franchisor may consider the prior experience and net worth of the franchisee’s affiliates and parents when determining whether the franchisee qualifies as a “large franchisee.”

A few commenters noted that the prior experience and net worth prerequisites would essentially disqualify new corporations. They asserted that there are legitimate tax and liability reasons why an experienced franchisee may wish to establish a separate corporation for a particular franchise transaction. For example, according to Marriott, it is not unusual in the lodging and restaurant industries to form “special purpose entities (SPEs) . . . to insulate either a parent company or the individual investors from liability.”[853] If so, then such a new corporation would not meet the exemption’s net worth and prior experience prerequisites.[854] These commenters urged the Commission to permit the franchisor to consider the consolidated net worth and experience of franchisee affiliates and parents.[855] The Commission is persuaded that the net worth and prior experience prerequisites may not make sense when applied to franchisee spin-off subsidiaries or affiliates that are formed primarily for tax or limited-liability purposes. Accordingly, section 436.8(5)(ii) makes clear that a franchisor may aggregate commonly-owned franchisee assets in determining the availability of the large entity exemption:[856]

The franchisee (or its parent and any affiliates) is an entity that has been in business for at least five years and has a net worth of at least $5 million.[857]

c. Section 436.8(a)(6): Officers, owners, and managers exemption

Section 436.8(a)(6) of the final amended Rule adds a new exemption for officers, owners,[858] and managers of a business before it becomes a franchisor.[859] In such circumstances, it reasonably can be assumed that the prospective franchisee already is familiar with every aspect of the business system and the associated risks. Thus, disclosure would serve little purpose. Indeed, in some instances, a company may wish to offer units only to its owners, officers, and managers. If not exempt from the Rule, these companies would have to go through the burden and expense of creating a disclosure document for isolated sales to company insiders. To ensure that individuals qualifying for the exemption have recent and sufficient experience with the business, however, section 436.8(a)(6) is limited to individuals who have been associated with the company within 60 days of the sale and who have been involved for at least two years with the company.

Section 436.(8)(a)(6) refines the proposed Rule’s “insiders” exemption which would have limited the exemption to owners and officers. During the Rule amendment proceeding, several commenters urged the Commission to broaden the exemption to include “trustees, general partners and any individual who has or had management responsibility for the offer Start Printed Page 15529and sale of the franchisor’s franchises or the administration of the franchised network.”[860] In short, these comments urged that the exemption parallel the list of company insiders disclosed in Item 2. Seth Stadfeld, however, questioned the need for the exemption if the company is already providing disclosures to others.[861] Howard Bundy urged the Commission to limit the exemption to bona fide officers, fearing that a franchisor could attempt to skirt disclosure obligations by putting a prospective franchisee on the board of directors, for example, for a few days or weeks before the sale and removing him or her shortly thereafter.[862]

Based upon the record, the Commission has adopted the NFC’s suggestion that the exemption should cover not just owners and officers of a franchise system, but others with direct management experience.[863] It is reasonable to assume that managers and others with at least two years of direct experience in the business should be well-informed about its operations.[864] Where a non-franchised company wishes to sell a limited number of outlets to experienced company personnel only, it would be overly burdensome to force the company to create a disclosure document when the only beneficiaries of the disclosures are already knowledgeable individuals. The Commission notes that the exemption is company-specific: we do not mean to suggest that a manager of one company is deemed sophisticated for all franchise sales. Rather, the exemption would apply only to a manager or other officer seeking to purchase a franchise of that very company.

Howard Bundy’s concern that franchisors may abuse the exemption in an effort to skirt the Rule is adequately addressed. Specifically, in order to qualify for the exemption, the prospective franchisee must have served in one of the enumerated positions for at least two years. Moreover, their relationship with the company must be current: within 60 days of the sale. These prerequisites are likely to ensure that the prospect is in fact a bona fide officer or owner.

d. Section 436.8(b): Inflation adjustment

Section 436.8(b) of the final amended Rule provides that the Commission shall adjust the size of the monetary thresholds for the exemptions listed in section 436.8 every fourth year based upon the Consumer Price Index.[865] This would affect the minimum payment exemption,[866] as well as the three sophisticated investor exemptions. As explained below, this approach differs from the proposed inflation adjustment published in the Franchise NPR in two respects: (1) it sets a specific time period when the adjustments must occur (every fourth year); and (2) adds specificity by tying the adjustment to the Consumer Price Index.

In the Franchise NPR, the Commission proposed revising the amended Rule’s monetary thresholds once every four years to adjust for inflation.[867] The Commission believed that a four-year adjustment is necessary to ensure that the thresholds reasonably keep up with inflation.

The Franchise NPR proposal garnered three comments. PMR&W and John Bear agreed with the need for a threshold adjustment and supported the Franchise NPR proposal. The NFC supported the inflation adjustment, but offered a slightly different approach. It suggested that the Commission tie the threshold amounts automatically to reflect increases in the Consumer Price Index, while placing the burden on the franchisor to prove that it qualified for the exemption at the time in question.[868]

The Commission is persuaded that the final amended Rule should contain bright-line thresholds that are clear to both franchisor and franchisee alike. Thus, any adjustment to the Rule thresholds should be imposed only after an announcement to the public, where the effective date of the adjustment and the adjustment amount is clear. The most effective way to provide such notice is through Federal Register announcements and that the adjustments should be based upon a clear standard—the Consumer Price Index.[869] Accordingly, the Commission intends to publish every fourth year adjustments to the amended final Rule’s monetary thresholds based upon the Consumer Price Index. Finally, to add greater specificity, the final amended Rule makes clear that the term “Consumer Price Index” means “the Consumer Price Index for all urban consumers published by the Department of Labor.”[870]

4. Exclusions

Finally, the final amended Rule removes the four exclusions for non-franchise relationships found in the original Rule: (1) employer-employee and general partners; (2) cooperative associations; (3) certification and testing services; and (4) single trademark licenses.[871] In the original SBP, the Commission stressed that these four relationships are not franchises, but might be perceived as falling within the definition of a franchise.[872] To avoid any confusion, the Commission expressly excluded these four relationships from Rule coverage.

During the Rule amendment proceeding, several commenters opposed the removal of the exclusion for cooperatives for various reasons.[873] According to these commenters, the exclusion helps to distinguish between franchises and cooperatives, a distinction that may not be apparent to new cooperative members.[874] Second, removing the cooperative exclusion from the Rule could lead to costly Start Printed Page 15530litigation over Rule coverage issues.[875] Third, retaining an express exclusion in the Rule itself is needed to ensure that the Commission does not change its view and seek to enforce the Rule against cooperatives in the future.[876] Fourth, the value of retaining the exclusion outweighs any benefit from streamlining the Rule.[877]

The Commission appreciates the concern raised by these commenters. Nonetheless, we see no compelling reason to keep the exclusions in the Rule itself. As a preliminary matter, removing the exclusions from the Rule should not be equated with expanding the scope of part 436 to cover entities currently dealt with in these exclusions: the Commission continues to hold that these business relationships do not meet the criteria for such coverage. They simply do not satisfy the definitional elements of the term “franchise.” Removal of the exclusions from the Rule is part of the Commission’s effort to streamline the Rule.

Nevertheless, the Commission included the exclusions in the original Rule to clarify the limits of the term “franchise,” and for that reason the concepts embodied in the exclusions continue to serve a valuable consumer education function.[878] However, as with other sections of this document, we are disinclined to include general consumer education materials in the text of the final amended Rule itself, absent compelling evidence that such messages are warranted to address specific problems identified in the record. While the commenters asserted that confusion exists over the definition of the term “franchise,” not a single individual cooperative member voiced any confusion over the scope of the “franchise” definition, nor any concern about the distinction between franchises and cooperatives, during the entire Rule amendment proceeding. Under the circumstances, the proper forum to discuss limits to the definition of the term “franchise” is in this document and in future Compliance Guides. To that end, the Commission reaffirms the four exclusions and specifically adopts the discussion of the exclusions set forth in the original SBP at 43 FR 59708-10.

G. Section 436.9: Additional Prohibitions

The final amended Rule prohibits nine acts or practices that violate Section 5 of the FTC Act. The original Rule contained four of them, namely, prohibitions against: (1) making statements that contradict the franchisor’s disclosures;[879] (2) making financial performance representations without a reasonable basis and without written substantiation for the representation at the time the representation is made;[880] (3) failing to make available written substantiation for any financial performance representations;[881] and (4) failing to make promised refunds.[882]

Second, the final amended Rule adds two new prohibitions concerning the furnishing of disclosures. Specifically, section 436.9(e) prohibits franchise sellers from failing to furnish a copy of the basic disclosure documents to prospective franchisees early in the sales process, upon reasonable request. Section 436.9(f) prohibits franchise sellers from failing to furnish a prospect in the sales process who has already received the basic disclosure document with a copy of any updated disclosure document or quarterly update to an existing disclosure document, upon reasonable request, before the prospective franchisee signs a franchise agreement.[883]

Third, the final amended Rule adds two anti-fraud prohibitions designed to preserve the integrity of the disclosure document and franchise agreement. Section 436.9(g) prohibits franchise sellers from materially altering the terms and conditions of any franchise agreement presented to a prospective franchisee for signing, unless the seller informs the prospective franchisee of the changes seven days before execution of the agreement. Section 436.9(h) prohibits franchise sellers from disclaiming or requiring a franchisee to waive reliance on any representation made in a disclosure document or its exhibits or attachments.

Finally, section 436.9, based upon our law enforcement history and the obviously deceptive nature of the practice, adds a new anti-shill prohibition designed to prevent the use of paid testimonials or shill references. Specifically, section 436.9(b) prohibits franchise sellers from misrepresenting that any person has purchased a similar franchise or operated a similar franchise Start Printed Page 15531from the franchisor, or that any person can provide an independent and reliable report about the franchise or the experiences of any current or former franchisees. Each of these prohibitions is discussed in the following sections.

1. Section 436.9(a): Inconsistent statements

Section 436.9(a) of the final amended Rule retains the original Rule prohibition against making statements that contradict the information required to be disclosed in the disclosure document. Such prohibited contradictory statements include those made orally, visually, or in writing. Because the information in the disclosure document must be complete and accurate, any statements contradicting that information would be false or likely to mislead prospective franchisees. Moreover, such statements would likely influence the purchasing decision of a prospect giving reasonable interpretation to such statements.

This is particularly true of financial performance representations. Our law enforcement experience[884] and the record[885] show that franchisors often state in their disclosure document that they do not furnish financial performance claims, yet give prospective franchisees false or misleading financial performance data outside of the disclosure document. Thus, the purpose of this prohibition is to prevent deception and to preserve the integrity of the information disseminated to prospective franchisees by ensuring that all required information will be disclosed in the form of the disclosure document.[886]

2. Section 436.9(b): Shills

Section 436.9(b) of the final amended Rule prohibits the use of fictitious references or “shills.”[887] Specifically, it prohibits franchise sellers from misrepresenting that any person has actually purchased or operated one of the franchisor’s franchises or that any person can give an independent and reliable report about the experience of any current or former franchisee. Because information provided by shills is inherently false, it is likely to mislead prospective purchasers. Yet, a reasonable prospective purchaser would have no reason to doubt the shill’s statements. Also, because shills are represented as having experience with the franchisor or otherwise able to give an independent and reliable report about the franchisor, their statements are likely to influence the prospect’s purchasing decision. Indeed, the Commission’s law enforcement experience[888] shows that shills are often the glue that holds a scam together by allaying consumers’ concerns about the investment risks.[889]

The anti-shill provision generated only one comment. J&G expressed concern that actors or public figures used in a franchisor’s advertising campaigns “will need to exercise caution when making endorsements of franchises so as not to run afoul of prohibitions against misrepresenting that they are able to provide ‘an independent and reliable report about the franchise or the experiences of any current or former franchisees.’”[890]

The Commission finds the rulemaking record lacks any evidence that would shed light on the extent to which franchisors use actors or public figures to sell franchises, as opposed to selling products and services to the end-user. Based upon our law enforcement experience, we believe such practices are rare. More important, our primary concern is with preventing deception: we see little difference between a franchisor paying (or otherwise inducing) unknown individuals to deceive prospective franchisees, on the one hand, and paying (or otherwise inducing) actors or celebrities to deceive prospective franchisees, on the other. In each case, a franchisor should not be able to pay (or otherwise induce) individuals to lie about their purported experience in order to lure unsuspecting consumers to buy a franchise.[891] We are persuaded, therefore, that the anti-shill prohibition is entirely proper.

3. Section 436.9(c): Financial performance representations

Section 436.9(c) of the final amended Rule retains the original Rule’s prohibition on the making of financial performance representations, unless the franchisor has a reasonable basis and written substantiation for the representation at the time the representation is made. As discussed above in connection with Item 19, false and unsubstantiated financial performance claims have been prevalent in fraudulent sales, are highly material, and are inherently likely to mislead Start Printed Page 15532prospective franchisees acting reasonably under the circumstances.[892] Indeed, our law enforcement experience demonstrates that prospects rely on financial performance claims in making their investment decision.[893] Thus, this prohibition is necessary to prevent deception.

Section 436.9(c) of the amended Final Rule revises the original Rule, however, by permitting the franchisor to make financial representations in Item 19 of the disclosure document. This achieves greater uniformity with the UFOC Guidelines, by eliminating the original Rule’s requirement that a franchisor making financial performance claims furnish prospects with a separate earnings disclosure document.

4. Section 436.9(d): Availability of financial performance substantiation

Section 436.9(d) of the final amended Rule also retains the original Rule’s prohibition against failing to make available to prospective franchisees and to the Commission, upon reasonable request, written substantiation for any financial performance representation made in Item 19.[894] This prohibition is tied to the previous prohibition against the making of unreasonable and unsubstantiated financial performance representations. The prohibition against failing to make available written substantiation ensures that prospective franchisees and the Commission can review and verify the data underlying any performance representation, while relieving franchisors of the burden of having to present what could be voluminous data in the disclosure document itself. Knowing that their financial performance claims are subject to Commission review—coupled with the Commission’s authority to bring Rule enforcement actions for false or unsubstantiated claims—helps discourage the making of unsubstantiated claims, thus ultimately preventing fraud.

5. Section 436.9(e): Earlier disclosure upon request

Section 436.9(e) of the final amended Rule prohibits a franchise seller from failing to furnish a copy of the franchisor’s disclosure document to a prospective franchisee earlier than required, upon request.[895] Accordingly, any prospective franchisee in the sales process can obtain a copy of the franchisor’s disclosure document before the standard 14-day time for making disclosures set out in section 436.2 (14 calendar-days before the signing of a franchise agreement or payment of any fee in connection with the franchise sale). Because prospects may incur a variety of costs in determining whether to consider a particular franchise offering, a franchisor’s withholding of its disclosure document can result in economic injury. For example, as discussed above in connection with the timing of making disclosures, early disclosure may prevent injury by enabling prospects to review the franchisor’s disclosure document before agreeing to pay money to advance the sale, such as incurring travel expenses to visit company headquarters.

Further, the Commission is convinced that this prohibition is also necessary in light of our decision to eliminate the original Rule’s mandatory face-to-face disclosure trigger. As discussed in connection with section 436.2 above, the Commission is persuaded that the face-to-face meeting trigger is unnecessary given the explosion of alternative media since the original Rule was promulgated in the 1970s. Nonetheless, the Commission recognizes that several commenters voiced concern that, absent early disclosure, a franchise seller could influence a prospective franchisee’s investment decision well before the prospect could verify the franchisor’s claims through the disclosure document, or before the prospect expends funds reviewing the offering.[896] To address these concerns, we are persuaded that it is proper to require franchise sellers to furnish disclosures earlier than the standard 14 calendar-days disclosure trigger, upon the franchisee’s reasonable request.[897] The Commission believes this prohibition strikes the right balance between relieving franchisors of the burden to furnish disclosures at the first face-to-face meeting in all instances, and the prospective franchisee’s desire to review disclosures early in the sales process before investing significant time, effort, and money in considering the franchise offering.[898]

6. Section 436.9(f): Furnishing updated disclosures

Section 436.9(f) prohibits a franchisor from failing to furnish a prospective franchisee who has received a basic disclosure document with updated disclosures, upon the prospect’s reasonable request. Specifically, it prohibits the franchisor from failing to furnish “the franchisor’s most recent disclosure document and any quarterly updates to a prospective franchisee, upon reasonable request, before the prospective franchisee signs a franchise agreement.” Start Printed Page 15533

Section 436.9(f) recognizes that the information contained in a disclosure document may become out-of-date by the time a prospect who relies on such information is ready to sign a franchise agreement.[899] It prevents deception by enabling such prospective franchisees, if they wish, to get any updated disclosures prepared by the franchisor. At the same time, section 436.9(f) imposes no continuous updating requirement on franchisors.[900] Rather, it strikes the appropriate balance, preventing deception by enabling a prospective franchisee to gain access to the most current updated disclosures prepared by the franchisor, while imposing no new affirmative disclosure obligations on the franchisor.[901]

7. Section 436.9(g): Unilateral modifications

As previously discussed, the final amended Rule eliminates the original Rule’s requirement that franchisors in every case afford a prospective franchisee five business days to review the completed franchise agreement. The Commission concluded that the review period is unnecessary, provided that the franchise seller does not make any unilateral modifications to the basic form of the franchise agreement previously furnished to the prospective franchisee at the time of furnishing its disclosure document. Unilateral modifications of material contract terms by the franchise seller without notice to the prospective franchisee are likely to mislead a prospect who has been relying on a previous draft as setting forth the parties’ agreement.

Indeed, a franchise seller could commit fraud at the time of executing a franchise agreement by substituting material contract provisions, without notice to the prospective franchisee, that differ materially from those in the original standard contract attached to the disclosure document. To prevent such deception, we adopt a new prohibition barring franchise sellers from substituting provisions or pages in the agreement without first bringing such changes to the prospective franchisee’s attention at least seven days before execution of the agreement.

8. Section 436.9(h): Disclaimers and waivers

Section 436.9(h) prohibits franchise sellers from disclaiming or requiring “a prospective franchisee to waive reliance on any representation made in the disclosure document or in its exhibits or amendments.” This prohibition is intended to prevent fraud by preserving the completeness and accuracy of information contained in disclosure documents.

The Franchise NPR proposal to prohibit the use of disclaimers and waivers prompted comment on three issues: (1) the need for the prohibition; (2) the scope of the prohibition; and (3) the effect of the prohibition on parties’ ability to negotiate contract terms. The following section discusses each of these issues in detail.

a. Section 436.9(h) is necessary to prevent fraud by preserving the truthfulness of information contained in a disclosure document

During the Rule amendment proceeding, several franchisees and their representatives observed that franchisors routinely seek to disclaim liability for statements made in their disclosure documents through the use of contract integration clauses in their franchise agreements. By signing a franchise agreement containing such a clause, franchisees effectively waive any rights they may have to rely on information contained in the disclosure document.[902] The use of such clauses, therefore, may lead to deception by enabling franchisors to make incomplete, inaccurate, or even false statements in their disclosure documents, while prospects effectively waive reliance on any such statements by signing the franchise agreement.

To remedy this problem, several franchisee advocates and state regulators urged the Commission to prohibit the use of contract integration clauses as a means of disclaiming statements made in a disclosure document.[903] The IL AG, for example, asserted that such a prohibition would be a valuable addition to the Rule, noting that franchisees signing a franchise agreement may have no idea that they are waiving reliance on the disclosure document.[904] Similarly, the AFA stated:

The integrity of a franchisor’s disclosure document is critical to prospective franchisees. The prevalent use of integration clauses to disclaim liability for required disclosures undermines the very purpose of the Rule, which is to prevent fraud and misrepresentation in the pre-sale process by ensuring prospective franchisees have complete and truthful information from which to make sound investment decisions.[905]

A few commenters urged the Commission to expand on the prohibition that was proposed in the Franchise NPR. Howard Bundy, for example, urged prohibiting franchisors from disclaiming liability for any authorized statements, including those made in their written marketing material.[906] Seth Stadfeld advocated a ban on integration clauses in franchise agreements altogether. He asserted that such clauses are “the single greatest tool used by franchisors to evade responsibility for misrepresentations and omissions of material facts that take place in a franchise marketing program.”[907]

Franchisors, on the other hand, either opposed the prohibition on disclaimers or urged limitation on the prohibition’s scope. Several franchisors strongly asserted that integration clauses are necessary for two purposes. First, as J&G Start Printed Page 15534explained, franchisors have to be able to rely on the final franchise agreement as the manifestation of the intent of the parties. Second, franchisors must be able to disclaim liability for unauthorized statements made by a rogue salesman, such as unauthorized earnings claims.[908]

PMR&W asserted that the prohibition would effectively ban the use of integration clauses. The firm, however, suggested that the Commission could limit the prohibition by applying it only “if an integration clause or other contract provision specifically disclaims representations made in the disclosure document. Alternatively, or perhaps additionally, require a representation by the franchisor at the end of Item 17 that the information contained in the disclosure document is unaffected by any integration clause.”[909]

CA Bar observed that the disclaimer prohibition is likely to increase the use of legalese in disclosure documents. It opined that, if the prohibition is adopted, franchisors are likely to import legalese from their franchise agreements to the disclosure document in order to avoid any conflicting language. On the other hand, “[i]f the franchisor is able to include (and rely upon) an integration clause, it decreases that potential for problems arising from unintentional inconsistency.”[910]

Finally, a few franchisors suggested that the disclaimer prohibition is unnecessary. According to John Baer, for example, the Commission could always take action if a franchisor’s disclosure document contains false information.[911] In the same vein, J&G asserted that the basis for the prohibition is that integration clauses may deny a franchisee a remedy when franchisees litigate against franchisors. The firm noted, however, that only the FTC is authorized to bring a claim for violation of the Franchise Rule; the Commission’s ability to address false representations in a disclosure document will survive any integration clause between the franchisor and franchisee.[912]

After carefully reviewing the record, the Commission is persuaded that a limited disclaimer prohibition, rather than a total ban, is warranted. As an initial matter, the Commission is convinced that integration clauses and waivers serve valid purposes, including ensuring that a prospective franchisee relies solely on information authorized by the franchisor or within the franchisor’s control in making an investment decision. For example, a franchisor reasonably may seek to disclaim responsibility for unauthorized claims made by former or existing franchisees, or unattributed statements found in the trade press. Therefore, at the very least, integration clauses and waivers protect a franchisor from unauthorized statements or representations made by non-agent, third parties.[913]

At the same time, we are persuaded that franchise sellers should not be able to use integration clauses or waivers to insulate themselves from false or deceptive statements made in a franchisor’s disclosure document. This is particularly true of those sections of the disclosure document pertaining to matters other than the terms of the franchise agreement that cannot be negotiated, such as the franchisor’s prior business experience, litigation history, financial performance representations, and financial statements. The Commission has long recognized that the integrity of a franchisor’s disclosures is critical to prospective franchisees who rely on such information in making their investment decision. For that reason, disclosure documents must be complete, accurate, legible, and current. Further, as discussed above, the original[914] and final amended Rules also prohibit franchisors from making statements that contradict those in their disclosure documents. The use of integration clauses or waivers[915] to disclaim statements in the disclosure document that the franchisor authorizes would undermine the Rule’s very purpose by signaling to prospective franchisees that they cannot trust or rely upon the disclosure document.[916]

It is true that the Commission can bring law enforcement actions against false or deceptive disclosures, regardless of any contract integration clause or waiver. This encourages complete and accurate disclosure. Nevertheless, we believe that franchisees should not have to rely on Commission action post-sale to resolve conflict between a disclosure document and franchise agreement. Rather, we believe that section 436.9(h) will prevent pre-sale deception by encouraging franchisors to review their disclosures for accuracy prior to use, thereby avoiding post-sale conflicts and litigation.

Further, courts have limited the circumstances where integration clauses have the most potential for harm. Where there is fraud in the inducement, courts are likely to void the contract, regardless of any integration clause or waiver.[917] Start Printed Page 15535Finally, integration clauses or waivers are not likely to protect franchisors from private suits based upon fraudulent statements made in a disclosure document, even without Commission intervention.[918]

The Commission recognizes that an integration clause or waiver may be one way for a franchisor to narrow its disclosures efficiently in unique circumstances. For example, an ice cream store franchisor may make an Item 19 financial performance representation pertaining to units based in Florida. If the franchisor sells units in southern states, the Florida-based representation would be reasonable. However, if the franchisor were to sell a unit in Alaska, the franchisor might wish to use a contract integration clause to ensure that the financial performance representation is inapplicable to the particular sale in Alaska.[919]

Nevertheless, franchisors could protect themselves from liability without resort to integration clauses or waivers. For example, the ice cream store franchisor noted above, at the very least, could provide the prospective Alaskan franchisee with a disclosure document that deletes the Item 19 representation. In the alternative, the statement of bases and assumptions attached to the disclosure document could make clear that the financial performance representation pertains to Florida or other southern states only. Nothing in section 436.9(h) would prevent a franchisor from having a prospective franchisee sign a clear and conspicuous acknowledgment that the Florida-based performance representation does not apply to states such as Alaska.

Finally, we recognize the possibility that some franchisors may be tempted to import into their disclosure documents legalese from their franchise agreements, in an effort to avoid having conflicting provisions. Such a possibility, however, is addressed by the Rule’s requirement that disclosure documents be prepared in plain English.[920] On balance, however, we are persuaded that the benefit of promoting the reliability and integrity of substantive disclosures outweighs any possible loss of clarity in how the disclosures are presented.

b. Scope of section 436.9(h)

As noted above, section 436.9(h) is designed to address a specific problem brought to our attention during the Rule amendment proceeding: franchisors’ use of integration clauses to disclaim authorized statements made in disclosure documents or in their exhibits or attachments. By prohibiting this practice, the disclaimer prohibition preserves the integrity of the material information disclosed in a franchisor’s disclosure document, thus preventing deception. By its terms, section 436.9(h) does not reach statements made in a franchisor’s advertising materials.

A few commenters urged the Commission to adopt a broader prohibition that would prevent franchisors from disclaiming any authorized statement—whether in a disclosure document or promotional materials.[921] However, the Commission is persuaded that a broader prohibition would go beyond what is necessary to address the underlying issue identified in the record—the need to prevent deceptive disclosure documents. Further, franchise advertisements, like other industry advertisements, are already subject to Commission substantiation and anti-deception requirements under Section 5 of the FTC Act. Moreover, any franchisor who makes statements in promotional literature that are inconsistent with the disclosure document and franchise agreement would violate the section 436.9(a) ban on the making of contradictory statements.[922] Accordingly, a broader disclaimer prohibition is unwarranted to achieve the goal of preserving the integrity of franchisors’ disclosures.

c. Effect of section 436.9(h) on parties’ ability to negotiate contracts

Section 436.9(h) states that the disclaimer prohibition “is not intended to prevent a prospective franchisee from voluntarily waiving specific contract terms and conditions set forth in his or her disclosure document during the course of franchise sales negotiations.” This proviso is necessary because, in its absence, a franchisor might conclude that it is prohibited from agreeing to any terms or conditions not spelled out in the standard agreement attached as an exhibit to its disclosure document.[923] Clearly, franchise sellers and prospective franchisees should be free to negotiate the terms of the franchise agreement, as in all other commercial transactions. The Commission has no interest in preventing the parties from seeking the best deal possible, as long as the prospective franchisee understands in advance of the sale how the terms and conditions differ from the standard ones set forth in the disclosure document and has the opportunity to review the actual franchise agreement prior to the sale.

In response to the Staff Report, Howard Bundy voiced concern that the section 436.9(h) contract negotiation proviso is too broad and could subsume the Rule.[924] He feared that a franchisor could initiate negotiations and permit a person to become a franchisee only if he or she agrees to waive essential terms. Mr. Bundy urged the Commission to limit the proviso “to negotiations initiated by the prospective franchisee and that result in changes that are no less favorable to the franchisee than the standard terms.”[925]

The Commission recognizes that an integration clause may facilitate negotiations by releasing the parties from restraints imposed by the contractual terms previously disclosed in the disclosure document. The use of an integration or waiver clause, however, is unnecessary to permit contract negotiations. As previously discussed, the final amended Rule addresses how franchisors and prospective franchisees may negotiate contracts without violating the Rule. Specifically, section 436.2(b) provides that no mandatory contract review period is necessary where changes are made at the request of the prospective franchisee. This recognizes that where the prospective franchisee is fully informed about the contractual terms Start Printed Page 15536that will govern the relationship before signing the contract, no harm can result. Where changes to the contract are initiated by the franchisor, however, section 436.9(g) prohibits the franchisor from failing to point out the changes, and section 436.2(b) provides for a limited contract review period. These Rule provisions are sufficient to prevent fraud in the negotiation process, while preserving the integrity of the franchisor’s disclosures.

9. Section 436.9 (i): Refunds

Section 436.9(i) prohibits franchisors from failing to make refunds as promised in their disclosure document or in a franchise or other agreement. The failure to honor refund promises is an unfair practice in violation of Section 5.[926] It often results in substantial injury to franchisees that they cannot reasonably avoid.[927] Moreover, the record is devoid of any evidence suggesting that this harm is outweighed by any countervailing benefits.

Section 436.9(i) retains, but slightly revises, the original Rule’s prohibition against failing to make promised refunds. As set forth at 16 CFR 436.1(h), the original Rule prohibited franchisors and brokers from failing “to return any funds or deposits in accordance with any conditions disclosed pursuant to paragraph (a)(7) of this section.” This provision was limited to instances where the franchisor or broker makes an express refund promise in the disclosure document itself. It is possible, however, that a franchise seller may not make any specific promise in the disclosure document itself, but may do so either in the franchise agreement, or in a separate contract or letter of understanding. The harm resulting from the failure to honor a promised refund is the same, regardless of where that promise is written. Accordingly, section 436.9(i) makes clear that the failure to honor any written refund promise will constitute a Rule violation.[928]

H. Sections 436.10 and 436.11: Other Laws and Rules, and Severability

The last sections of the final amended Rule address three additional issues: (1) the final amended Rule’s effect on other Commission laws and rules; (2) preemption of state franchise laws that may be inconsistent with the Rule; and (3) “severability.” Each of these issues is addressed below.

1. Section 436.10(a): Relationship to other laws and rules

The first part of section 436.10(a) provides that the Commission does not approve or express any opinion on the legality of any matter a franchisor may be required to disclose by the Rule. At the same time, it makes clear that the Commission intends to enforce all applicable statutes and rules.[929] This is slightly broader than the same provision in the proposed Rule, which was limited to “trade regulation rules.”[930]

This provision clarifies the relationship between Franchise Rule disclosure and other statutes and rules enforced by the Commission. As stated in the original SBP, some of the Rule’s provisions may require franchisors to disclose practices that may raise legal issues, such as antitrust issues.[931] By requiring disclosure, the Commission does not approve of practices that might violate other Commission laws. In short, pre-sale disclosure does not create a safe harbor for franchisors engaging in otherwise unlawful conduct.[932]

During the Rule amendment proceeding, the NFC focused on the sentence that the “Commission also intends to enforce all applicable statutes and trade regulation rules.” The NFC contended that, under more recent case law, disclosure in some instances may shield a practice that otherwise might be a law violation. According to the NFC, a franchisor’s disclosure of certain product or sourcing restrictions, for example, may relieve the franchisor from antitrust “tying” liabilities.[933]

The NFC’s concerns are misplaced. Section 436.10 restates the general policy that disclosure alone does not shield a franchisor from otherwise illegal conduct. Section 436.10(a) does nothing more than state that the Commission will continue to enforce the laws it administers in accordance with its legal authority. If a disclosure makes conduct legal, as the NFC asserted, then the Commission obviously would have no reason to believe the franchisor has committed a law violation.

The second part of section 436.10(a) provides that “franchisors may have additional obligations to impart material information to prospective franchisees outside of the disclosure document under Section 5 of the Federal Trade Commission Act.”[934] During the Rule Start Printed Page 15537amendment proceeding, a few franchisors voiced concern that this provision does not give any guidance to franchisors about what specific information needs to be disclosed. For example, Piper Rudnick stated that “no matter how thorough or detailed the franchise offering circular may be, this sentence places all franchisors at risk of violating the Revised Rule by not also making whatever disclosure may be required by this open-ended and ambiguous disclosure obligation.”[935]

No franchisor need worry that it may violate the Rule for failing to include material information not specifically required or permitted by the Rule or state law. As for every other person over which the Commission has jurisdiction, franchisors must not engage in unfair or deceptive acts or practices. For example, Section 5 would prohibit a used car seller from misrepresenting a rebate program or from misrepresenting whether a used car had previous damage, even though the seller may otherwise comply with the Used Car Rule’s warranty disclosures.

2. Section 436.10(b): Preemption

Section 436.10(b) retains the original Rule’s preemption statement found at footnote 2:[936]

The FTC does not intend to preempt the franchise practice laws of any state or local government, except to the extent of any inconsistency with this Rule. A law is not inconsistent with this Rule if it affords prospective franchisees equal or greater protection, such as registration of disclosure documents or more extensive disclosures.

16 CFR Part 436, note 2.[937]

During the Rule amendment proceeding, several franchisors urged the Commission to preempt the field of pre-sale disclosure to ensure a single, national, disclosure standard.[938] The preemptive effect of the final amended Rule, however, is not a subject of Commission discretion. Rather, the preemptive effect of any federal law is fundamentally a question of Congressional intent.[939]

First, Congress can define explicitly the extent to which federal law preempts state law.[940] If Congress has explicitly addressed the issue of preemption in a statute, then the statutory language governs and no further analysis is required.[941] Even in the absence of explicit statutory language, state law is preempted where it regulates conduct in a field that Congress intended the federal government to occupy exclusively. Congressional intent to occupy a field may be inferred from a “scheme of federal regulation . . . so pervasive as to make reasonable the inference that Congress left no room for the States to supplement it,” or where an act of Congress “touch[es] a field in which the federal interest is so dominant that the federal system will be assumed to preclude enforcement of state laws on the same subject.”[942] In addition, Congress may choose to grant sufficiently broad regulatory authority to a federal agency as to permit the agency itself, by regulation, to provide expressly for the preemption of state law.[943]

Finally, state law is preempted to the extent that it actually conflicts with federal law. Thus, federal law will preempt state law where it is impossible for a private party to comply with both state and federal requirements.[944] In addition, preemption occurs where state law “stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress.”[945]

The Federal Trade Commission Act does not include any clause directly preempting state law or authorizing the Commission to do so. Furthermore, the legislative history of the Act and of the 1975 amendments to the Act establishing the Commission’s rulemaking authority indicate that Congress did not intend the Act to occupy the field of consumer protection regulation.[946] Any preemptive effect of the Franchise Rule, therefore, is limited to instances where it is impossible for a private party to comply with both state and the Commission regulations, or where application of state regulations would frustrate the purposes of the Franchise Rule.[947] In this regard, the Commission generally has declared the preemptive effect of Commission rules to be limited to the extent of an inconsistency only.[948] Accordingly, the amended Franchise Rule would not affect state laws providing greater consumer protection.[949]

We further note that preemption of state franchise disclosure laws would be inconsistent with the current policy on federalism, as announced in Executive Order 13132 on August 4, 1999.[950] Start Printed Page 15538Among other things, the Executive Order provides that federal agencies should carefully assess the necessity of limiting the policymaking discretion of the states and such actions should be taken “only where there is constitutional and statutory authority for the action and the national activity is appropriate in light of the presence of a problem of national significance.” It also encourages agencies, in appropriate circumstances, to defer to the states to establish standards. As noted above, there is no statutory basis for preempting the states in the franchise pre-sale disclosure arena, nor do we find any compelling reason to limit the states’ discretion in this field. Rather, by adopting the UFOC Guidelines in large measure, which the commenters agreed is superior to the current Franchise Rule, the states have taken a leadership role in this field. Under the circumstances, we must reject any suggestion that the Commission expand the Franchise Rule’s preemptive effect. There simply is no legal or policy basis for such an expansion.

3. Section 436.11: Severability

Finally, as proposed in the Franchise NPR,[951] section 436.11 contains a standard severability provision, stating that if any provision of this regulation is stayed or held invalid, the remainder will stay in force.[952] This provision is comparable to the severability provisions in other Commission trade regulation rules.[953] This provision generated no comments in response to both the Franchise NPR and Staff Report. Accordingly, the amended Rule adopts the severability provision proposed in the Franchise NPR.

IV. SECTION-BY-SECTION ANALYSIS OF PART 437

As noted above, part 437 of the final amended Rule continues to cover the offer and sale of business opportunities, such as vending machine and rack display promotions.[954] Except for the three changes discussed immediately below, part 437 is identical to the original Rule, imposing no new substantive disclosure requirements or prohibitions.

A. New definition for “business opportunity”

Section 437.2(a) of the final amended Rule defines the term “business opportunity” consistent with the original Rule’s business opportunity definitional elements. In so doing, it eliminates references to franchising, which are now addressed in part 437 of the final amended Rule. First, the term “franchise” in the original Rule definitions has been eliminated and substituted with the term “business opportunity.” Second, the franchise definitional elements of the original Rule’s “franchise” definition have been eliminated. Accordingly, the definitional elements of the term “business opportunity” are now identical to those set forth in the original Rule:

(a) The term business opportunity means any continuing commercial relationship created by any arrangement or arrangements whereby:

(1) A person (hereinafter “business opportunity purchaser”) offers, sells, or distributes to any person other than a “business opportunity seller” (as hereinafter defined), goods, commodities, or services which are:

(i)(A) Supplied by another person (hereinafter “business opportunity seller”); or

(B) Supplied by a third person (e.g., a supplier) with whom the business opportunity purchaser is directly or indirectly required to do business by another person (hereinafter “business opportunity seller”); or

(C) Supplied by a third person (e.g., a supplier) with whom the business opportunity purchaser is directly or indirectly advised to do business by another person (hereinafter “business opportunity seller”) where such third person is affiliated with the business opportunity seller; and

(ii) The business opportunity seller:

(A) Secures for the business opportunity purchaser retail outlets or accounts for said goods, commodities, or services; or

(B) Secures for the business opportunity purchaser locations or sites for vending machines, rack displays, or any other product sales displays used by the business opportunity purchaser in the offering, sale, or distribution of said goods, commodities, or services; or

(C) Provides to the business opportunity purchaser the services of a person able to secure the retail outlets, accounts, sites, or locations referred to in paragraphs (a)(ii)(A) and (B) of this section; and

(2) The business opportunity purchaser is required as a condition of obtaining or commencing the business opportunity operation to make a payment or a commitment to pay to the business opportunity seller, or to a person affiliated with the business opportunity seller.

B. Eliminating other references to franchising

Part 437 of the final amended Rule further eliminates all other references to franchising, by substituting for the terms “franchisor,” “franchisee,” and “franchise” used throughout part 437 the terms “business opportunity seller,” “business opportunity purchaser,” and “business opportunity.” This ensures that part 437 will cover only the offer and sale of business opportunities. For example, section 437.2(a)(3) retains, but modifies, the original Rule’s exemption for fractional relationships to cover business opportunities only: the term “fractional franchise” is replaced by the term “fractional business opportunity.”

C. Franchise exemption

Section 437.2(a)(3)(v) adds a new exemption to part 437 of the final amended Rule for those business arrangements that comply with the Franchise Rule, or are exempt from compliance with the Franchise Rule, as set forth in part 436. Accordingly, it is designed to eliminate potential overlap and duplicative compliance burdens between the franchise rule and the business opportunity rule, parts 436 and 437, respectively. Specifically, section 437.2(a)(3)(v) exempts from coverage of part 437 all business arrangements that comply with part 436, or that satisfy one or more exemptions to part 436. For example, businesses exempt from part 436 coverage pursuant to the fractional franchise exemption would not be subjected to coverage under part 437. This is an appropriate result because the same rationale underlying exemption of these types of businesses from part 436 would also dictate that they not be covered by part 437— i.e., in the case of a fractional franchise, the franchisor is not likely to deceive the prospective franchisee or to subject the prospective franchisee to significant investment risk. Therefore, imposing the requirements of either part 436 or part 437 would not be justified.

V. REGULATORY ANALYSIS AND REGULATORY FLEXIBILITY ACT REQUIREMENTS

Under section 22 of the FTC Act,[955] the Commission must issue a regulatory analysis for a proceeding to amend a rule only when it: (1) estimates that the Start Printed Page 15539amendment will have an annual effect on the national economy of $100,000,000 or more; (2) estimates that the amendment will cause a substantial change in the cost or price of certain categories of goods or services; or (3) otherwise determines that the amendment will have a significant effect upon covered entities or upon consumers.

In general, the commenters supported the proposed franchise amendments because they reduce inconsistencies with state franchise disclosure laws, reduce compliance burdens on franchisors that are not likely to engage in abusive practices that the Rule was intended to prevent, and update the original Rule to address new technologies. Only one commenter addressed the economic impact of part 436, voicing concern generally that the original and amended Franchise Rule impose unnecessary costs.[956] No commenter, however, indicated that the amendments would have an annual impact of more than $100,000,000, cause substantial change in the cost of goods or services, or otherwise have a significant effect upon covered entities or consumers.[957]

At the same time, some commenters questioned whether particular rule amendments pertaining to franchising might be unnecessary, or offered alternatives. Section III of this document analyzes these comments in detail. After careful consideration of the comments, and the record as a whole, the Commission has determined that there are no facts in the record, or other reasons to believe, that the part 436 amendments will have significant effects on the national economy, on the cost of goods or services, or on covered parties or consumers. In any event, to the extent, if any, these final rule amendments will have such effects, the Commission has previously explained above the need for, and the objectives of, the final amendments; the regulatory alternatives that the Commission has considered; the projected benefits and adverse economic or other effects, if any, of the amendments; the reasons that the final amendments will attain their intended objectives in a manner consistent with applicable law; the reasons for the particular amendments that the agency has adopted; and the significant issues raised by public comments, including the Commission’s assessment of and response to those comments on those issues.

The Regulatory Flexibility Act (“RFA”),[958] requires that the agency conduct an analysis of the anticipated economic impact of proposed rule amendments on small businesses. The purpose of a regulatory flexibility analysis is to ensure that the agency considers the impact on small entities and examines regulatory alternatives that could achieve the regulatory purpose while minimizing burdens on small entities. Section 605 of the RFA provides that such an analysis is not required if the agency head certifies that the regulatory action will not have a significant economic impact on a substantial number of small entities.[959]

The Commission believes that none of the amendments to the original Franchise Rule is likely to have a significant impact on small businesses. Most small businesses covered by the original Franchise Rule are likely to be business opportunity sellers, such as vending machine and rack display route sellers. These small businesses will continue to be covered by the same substantive provisions of the original Rule, through part 437. On the other hand, the numerous amendments to the original Franchise Rule that pertain to franchising—set out in part 436—will not apply to the offer or sale of business opportunities. In short, none of the amendments to the original Franchise Rule are likely to affect a substantial number of small businesses. Accordingly, the Commission has no reason to believe that the amendments will have a significant impact upon such entities.

Moreover, the Commission is adopting amendments that in large measure reduce inconsistencies with state law. In many instances, small businesses that sell franchises, especially those conducting business on a national basis, already comply with state disclosure laws in the form of the UFOC Guidelines. Accordingly, many of the amendments will impose no new compliance costs on either small or large businesses. Further, in some instances, the Commission has specifically narrowed a UFOC provision to reduce compliance costs, which will benefit small business franchisors in particular. For example, in considering the disclosure of computer systems, the Commission declined to adopt the states’ sweeping disclosure of computer system requirements, in favor of a more limited disclosure. In addition, the Commission will permit electronic compliance with the Franchise Rule, which holds the promise of reducing costs for all franchisors, including small business franchisors.

In a few instances, the part 436 amendments will impose new disclosure requirements on all franchisors. These amendments are designed to provide prospective franchisees with more information about the quality of the franchise relationship. In these instances, the Commission has taken great care to keep compliance costs to a minimum. For example, with respect to the new franchisor-initiated litigation disclosure, franchisors need only report such litigation for a period of one year. This contrasts with the original Rule’s seven-year reporting period (and the UFOC Guidelines 10-year reporting period) for prior litigation against the franchisor. Similarly, a franchisor may disclose franchisor-initiated litigation by grouping any suits under a single heading, as opposed to the original Rule and UFOC Guidelines approach for other litigation, which requires full case summaries.

Similarly, the Commission has narrowed the new disclosure of independent trademark-specific franchisee associations. Franchisors need not make this disclosure unless the association specifically asks to be included in the franchisor’s disclosure document. Further, such requests must be renewed by the association on an annual basis. In addition, franchisors need not update this disclosure on a quarterly basis. The Commission believes that these, and other efforts to narrow amendments to the Rule discussed throughout this document, will result in the easing of compliance burdens for all franchisors, especially small business franchisors.

Accordingly, the Commission concludes that the amendments to the original Franchise Rule will not have a significant or disproportionate impact on the costs of small business, whether they sell franchises or business opportunities. Based on available information, therefore, the Commission certifies that the Franchise Rule amendments published in this document will not have significant economic impact on a substantial number of small businesses. Start Printed Page 15540

Nonetheless, to ensure that no such impact, if any, has been overlooked, the Commission has conducted the following final regulatory flexibility analysis, as summarized below.

A. Need For And Objective Of The Rule

As previously discussed, the Commission is issuing these rule amendments to achieve four goals: (1) to reduce inconsistencies with state franchise disclosure laws; (2) to respond to changes in the marketing of franchises and new technological developments, in particular electronic communications; (3) to reduce compliance costs where the record and the Commission’s law enforcement experience shows that the abuses the Rule was intended to address are not likely to occur; and (4) to address the need for franchisors to disclose material information about the quality of the franchise relationship, the absence of which the record shows is a prevalent problem.

B. Significant Issues Raised By Public Comment, Summary Of The Agency’s Comment, Summary Of The Agency’s Assessment Of These Issues, And Changes, If Any, Made In Response To Such Comments

The Commission has reviewed the comments received during the Rule amendment proceeding and has made changes to the original Rule, as appropriate. Section III of this document contains a detailed discussion of the comments and the Commission’s responses. Among other things, the Commission, based upon the record, has narrowed the scope of part 436—the franchise section—by eliminating coverage of business opportunities, many of which are small businesses. In addition, part 436 will apply only to the sale of franchises to be located in the United States.

Further, part 436 of the final amended Rule reduces many inconsistencies with state franchise laws that use the UFOC Guidelines format. Accordingly, many of the rule amendments will impose no new compliance costs on small businesses, especially those that conduct, or plan to conduct, business on a national basis. Further, in some instances, the Commission has specifically narrowed a UFOC provision to reduce compliance costs, which will benefit small businesses in particular. For example, based upon the comments, the Commission declined to adopt the states’ sweeping disclosure of computer system requirements, in favor of a more limited disclosure. Most important, part 436 of the final amended Rule permits franchisors to furnish disclosure documents electronically, which holds the promise of reducing costs for all franchisors, including small business franchisors.

Where part 436 of the final amended Rule imposes new disclosure requirements, the Commission has carefully considered approaches that will reduce compliance burdens, especially on small businesses. For example, with respect to the new franchisor-initiated litigation disclosure, franchisors need only report such litigation for a period of one year. This contrasts with the original Rule’s seven-year reporting period (and the UFOC Guidelines 10-year reporting period) for prior litigation against the franchisor. Similarly, a franchisor may disclose franchisor-initiated litigation by grouping any suits under a single heading, as opposed to the original Rule and UFOC Guidelines approach for other litigation, which requires full case summaries. Similarly, the Commission has narrowed the new disclosure of independent trademark-specific franchisee associations. Franchisors need not make this disclosure unless the association specifically asks to be included in the franchisor’s disclosure document. Further, such requests must be renewed by the association on an annual basis. In addition, franchisors need not update this disclosure on a quarterly basis. The Commission believes that these, and other efforts to narrow amendments to the original Franchise Rule discussed throughout this document, will result in the easing of compliance burdens for all franchisors, especially small business franchisors.

C. Description And Estimate Of Number Of Small Entities Subject To The Final Rule Or Explanation Why No Estimate Is Available

The Commission cannot readily estimate the number of small entities subject to the final amended Rule. Franchising is a method of distribution, not an industry, nor an economic sector. Accordingly, businesses in a wide array of industries engage in the distribution of products or services through franchising, and the number of franchisors in any one economic sector is constantly changing.

Moreover, the SBA’s standards for determining size—based on either number of employees or annual receipts—are inapplicable to franchising.[960] For example, the most relevant SBA standards pertaining to franchising are arguably those for the retail sales industry. The most common “small business” threshold (measured in receipts) for the retail trade industry is $6 million.[961] However, these standards apply to franchisees engaging in retail sales activities, not to the franchisors that sell the underlying franchised units.[962]

Nonetheless, in the Franchise NPR the Commission estimated that there are 2,500 business format and product franchisors and 2,500 business opportunities covered by the original Rule.[963] The Commission estimated that as many as 70% of those 5,000 franchisors are small entities, including some start-up franchise systems and most business opportunities.[964] The Franchise NPR specifically asked for comment on these estimates. No comments were submitted. Accordingly, our best estimate is that 3,500 franchisors covered by the original Rule were small businesses, 2,500 of which were business opportunities.

Once business opportunity ventures are no longer covered by part 436 of the final amended Rule, the number of Start Printed Page 15541“small businesses” subject to the Rule amendments will be greatly reduced. Of the remaining 2,500 franchisors covered by part 436 of the final amended Rule, many are mature, well-established franchise systems, including many publicly traded companies. In the absence of additional information on the size of franchisors, we will estimate for purposes of this analysis that 1,000 franchisors (3,500 covered by the original Rule minus the exclusion of 2,500 business opportunities) will qualify as small businesses subject to the part 436 amendments. At the same time, each of the 2,500 business opportunities covered by the original Rule—most likely small entities—will remain covered by the identical disclosure requirements, as set forth in part 437.

D. Description Of The Projected Reporting, Recordkeeping, And Other Compliance Requirements Of The Rule, Including An Estimate Of The Classes Of Small Entities That Will Be Subject To The Rule And The Type Of Professional Skills That Will Be Necessary To Comply

As discussed in the Paperwork Reduction Act analysis of this notice (Section VI), the amendments will impose compliance requirements (e.g., disclosure) and minor recordkeeping requirements on franchisors. This may affect some small business franchisors. No additional recordkeeping or disclosure requirements are imposed on business opportunities that remain covered under part 437. The incremental cost of the part 436 amendments on franchisors is difficult to estimate. As suggested by the lack of comment on the subject, the Commission expects that the added costs of the amendments will be small. Finally, compliance with the amended Rule will require, in many instances, the professional assistance of an attorney to prepare disclosure documents.[965] However, franchisors (and business opportunity sellers) typically need such professional assistance in order to comply with state franchise and business opportunity disclosure laws, in particular the preparation of required financial statements. Accordingly, no new or additional professional skills are required as a result of amendments to the original Rule.

E. Steps The Agency Has Taken To Minimize Any Significant Economic Impact On Small Entities, Consistent With The Stated Objectives Of The Applicable Statutes, Including The Factual, Policy, And Legal Reasons For Selecting The Alternative(s) Finally Adopted, And Why Each Of The Significant Alternatives, If Any, Was Rejected

As discussed throughout this document, the Commission has considered all alternatives that would reduce compliance costs on all franchisors, including small business franchisors, while achieving the intended objectives of the Rule. For example, part 436 of the final amended Rule narrows the scope of the original Rule by eliminating coverage of business opportunities, many of which are small businesses. Part 436 of the final amended Rule, while reducing compliance with state pre-sale disclosure laws, minimizes compliance costs where possible. For example, part 436 of the final amended Rule narrows the disclosure of computer system requirements. Where a part 436 rule amendment expands the original Rule, it does so in a fashion designed to minimize compliance burdens. This is most evident regarding the new disclosures pertaining to franchisor-initiated litigation and independent, trademark-specific franchisee associations, as discussed above. Further, in many instances part 436 of the final amended Rule permits franchisors the flexibility to comply with Rule provisions in a manner that makes the most sense for their particular business. For example, franchisors can determine the best medium in which to furnish their disclosures, as well as to receive receipts from prospective franchisees.

Moreover, part 436 of the final amended Rule permits disclosure and recordkeeping electronically. This offers the promise of greatly reducing compliance costs, especially for small businesses. All franchisors, including small businesses, may furnish disclosures using the approach that is most economical for their business, whether that means furnishing a paper document, an electronic disclosure document made available to prospective franchisees through a password-protected website, or through email or CD-ROM.

At the same time, the Commission has rejected numerous suggestions to revise the original Rule that would result in significantly increased costs for all franchisors, in particular small business franchisors. For example, several commenters urged the Commission to mandate the disclosure of financial performance data. Other commenters urged the Commission to expand greatly the reporting of franchise turnover rates. Further, commenters suggested that the Commission incorporate into the disclosure document various risk factors or consumer education notices to prospective franchisees. As discussed above in Section III, the Commission finds that the benefits of these suggested amendments would not outweigh the compliance costs.

Finally, the Commission has determined to give franchisors ample time to come into compliance with the final amended Rule. To that end, franchisors can start using the final amended Rule on July 1, 2007, if they so choose. At the very latest, all franchisors must come into compliance with the final amended Rule by July 1, 2008. This approach will benefit large and more seasoned franchisors that wish to take advantage of the improvements incorporated in part 436 of the final amended Rule. At the same time, it permits small business franchisors, in particular, ample opportunity to consider the best and most cost-effective means to comply with part 436 of the final amended Rule.

VI. PAPERWORK REDUCTION ACT

In accordance with the Paperwork Reduction Act, as amended, 44 U.S.C. 3501-3520, the Office of Management and Budget (“OMB”) has approved the information collection requirements contained in the amended Rule through October 31, 2008, and has assigned OMB control number 3084-0107.

No comments were received in response to the Franchise NPR addressing the Commission’s paperwork burden estimates. Nonetheless, the Commission staff revised its approach to calculating the burden when seeking to extend the clearance for the Rule in 2002.[966] Specifically, taking into account that new entries are more likely to require additional time to prepare disclosures than their more seasoned counterparts, the Commission staff distinguished between existing entities covered by the Rule and the likely number of new entries when calculating compliance burdens.[967] This burden analysis approach was retained when Commission staff sought an extension of the clearance for the Rule in 2005.[968] As with the Franchise NPR, no paperwork Start Printed Page 15542related comments were received in response to the Commission’s 2002 and 2005 Notices.[969]

As set forth in the 2005 Notices, based on a review of trade publications and information from state regulatory authorities, staff believes that, on average, from year to year, there are approximately 5,000 American franchise systems, consisting of about 2,500 business format franchises and 2,500 business opportunity sellers, with perhaps about 10% of that total (500) reflecting an equal amount of new and departing business entrants.[970]

A. Part 436

Staff has calculated burdens based on the above estimates. Some franchisors, however, for various reasons, are not covered by the Rule in certain situations (e.g., when a franchisee buys bona fide inventory but pays no franchisor fees). Moreover, 15 states have franchise disclosure laws similar to the Rule. These states use a disclosure document format known as the Uniform Franchise Offering Circular (“UFOC”). In order to ease compliance burdens on the franchisor, the Commission has authorized use of the UFOC in lieu of its own disclosure format to satisfy the Rule’s disclosure requirements. Staff estimates that about 95 percent of all franchisors use the UFOC format. As noted throughout this document, revised part 436 tracks the UFOC Guidelines in large measure. Accordingly, the burden hours stated below reflects staff’s estimate of the incremental burden that part 436 may impose beyond information requirements imposed by states and/or followed by franchisors who use the UFOC.

Estimated annual hours burden for part 436: 19,500 hours.

As set forth in the 2005 Notices, staff estimates that, during the first year of clearance, the 250 or so new franchisors will require 32 hours to prepare their disclosure document (two more hours than under the original Rule) and the remaining 2,250 established franchisors will require six hours to update their existing disclosure document (three more hours than under the original Rule). After the first year, however, the time required for established franchisors should be the same as under the original Rule, as the new disclosure format becomes familiar. Accordingly, during the remaining two years of the clearance, staff estimates it will take three hours for established franchisors to update their existing disclosure document (same as the original Rule). Thus, the average annual hours burden for established franchisors during the three-year clearance period will be approximately 4 hours ((6 hours during first year of clearance + 3 hours during second year of clearance + 3 hours during third year of clearance) ÷ 3 years).

As set forth in the 2005 Notices, under the original Rule, covered franchisors may need to maintain additional documentation for the sale of franchises in non-registration states, which could take up to an additional hour of recordkeeping per year. This yields a cumulative total of 2,500 hours per year for covered franchisors (1 hour x 2,500 franchisors).

Part 436 of the amended Rule would also increase franchisors’ recordkeeping obligations. Specifically, a franchisor would be required to retain copies of receipts for disclosure documents, as well as materially different versions of its disclosure documents. Such recordkeeping requirements, however, are consistent with, or less burdensome, than those imposed by the states.

Thus, staff estimates the average hours burden for new and established franchisors during the three-year clearance period will be 19,500 ((32 hours of annual disclosure burden x 250 new franchisors) + (4 hours of average annual disclosure burden x 2,250 established franchisors) + (1 hour of annual recordkeeping burden x 2,500 franchisors)).

Estimated annual labor cost burden for part 436: $4,282,500.

One commenter, Lance Winslow, stated in response to the Staff Report that the average total cost to prepare a franchise disclosure document is $25,000-35,000.[971] The Commission agrees that many franchisors typically spend $25,000-35,000 on disclosure documents. Much of these costs, however, are not imposed by part 436, but by state law. For example, a large portion of the costs that franchisors typically pay for disclosures is the result of audited financial requirements and state registration requirements, costs that would continue to exist whether or not the Commission adopted the amended Rule. As stated above, staff’s burden estimates reflect the incremental burden that part 436 may impose beyond the information requirements imposed by states.

As set forth in the 2005 Notices, staff estimates that an attorney will prepare the disclosure document at $250 per hour. Accordingly, staff estimates that 250 new franchisors will annually each incur $8,000 in labor costs (32 hours x $250 per hour) and, during the first year of the clearance, established franchisors will each incur $1,500 in labor costs (6 hours x $250). During the remaining two years of clearance, staff estimates established franchisors will annually each incur $750 in labor costs (3 hours x $250 per hour). Thus, the average annual labor cost estimate for established franchisors during the three-year clearance period will be approximately $1,000 (($1,500 in labor costs during first year of clearance + $750 in labor costs during second year of clearance + $750 in labor costs during third year of clearance) ÷ 3 years).

Further, staff anticipates that recordkeeping under part 436 will be performed by clerical staff at approximately $13 per hour. Thus, at 2,500 hours of recordkeeping burden per year for all covered franchisors will amount to a total annual cost of $32,500 (2,500 hours x $13 per hour).

Thus, the total estimated labor costs under part 436 is $4,282,500 (($8,000 attorney costs x 250 new franchisors) + ($1,000 attorney costs x 2,250 established franchisors) + ($13 clerical costs x 2,500 franchisors)).

Estimated non-labor costs for part 436: $8,000,000.

In response to the Staff Report, Mr. Winslow stated that the costs of printing documents for his franchise system exceed $24,000 without postage.[972] Mr. Winslow further indicated that the number of disclosure documents sent out each year will increase under the amended Rule.[973] Finally, Mr. Winslow stated that franchisors will incur significant costs if they send disclosure documents electronically, including bandwidth fees and fees associated with hiring a contractor to create a searchable website.[974]

As an initial matter, in developing cost estimates, Commission staff consulted with practitioners who prepare disclosure documents for a cross-section of franchise systems. Accordingly, the Commission believes that its cost estimates are representative of the costs incurred by franchise systems generally. In addition, Mr. Winslow fails to provide a basis for his Start Printed Page 15543assertion that the demand for disclosure documents will increase as a result of the amended Rule. Finally, many franchisors establish and maintain websites for ordinary business purposes, including advertising their goods or services and to facilitate communication with the public. Accordingly, any costs franchisors would incur specifically as a result of electronic disclosure under part 436 appear to be low.

As set forth in the 2005 Notices, staff estimates that the non-labor burden incurred by franchisors under part 436 will differ based on the length of the disclosure document and the number of disclosure documents produced. Staff estimates that 2,000 franchisors (80% of total franchisors covered by the Rule) will print 100 disclosure documents at $35 each. Thus, staff estimates that 80% of covered franchisors will each incur $3,500 in printing and mailing costs ($35 for printing and mailing x 100 disclosure documents). Staff estimates that the remaining 20% of franchisors (500) will send 50% of the 100 documents electronically, with a cost of $5 per electronic disclosure. Thus, staff estimates that 20% of covered franchisors will each incur $2,000 in distribution costs (($250 for electronic disclosure [$5 for electronic disclosure x 50 disclosure documents] + $1,750 for printing and mailing [$35 for printing and mailing x 50 disclosure documents])).

Thus, the cumulative annual hours burden for part 436 of the amended Rule is approximately 19,500 hours ((32 hours of annual disclosure burden x 250 new franchisors) + (4 hours of average annual disclosure burden x 2,250 established franchisors) + (1 hour of annual recordkeeping burden x 2,500 total business format franchisors)). The cumulative annual labor costs for part 436 of the amended Rule is approximately $4,282,500 (($8,000 attorney costs x 250 new franchisors) + ($1,000 attorney costs x 2,250 established franchisors) + ($13 clerical costs x 2,500 total business format franchisors)). Finally, the cumulative annual non-labor costs for part 436 of the amended Rule is approximately $8,000,000 (($3,500 printing and mailing costs x 2,000 franchisors) + (($250 electronic distribution costs + $1,750 printing and mailing costs) x 500 franchisors)).

B. Part 437

As noted throughout this document, business opportunities covered by the original Franchise Rule will remain covered, without any substantive change, under part 437 of the amended Rule. Part 437 of the amended Rule imposes no additional disclosures, recordkeeping, or prohibitions.[975]

Estimated annual hours burden for part 437: 16,750 hours.

The burden estimates for compliance with part 437 will vary depending on the business opportunity sellers’ prior experience with the Franchise Rule. As set forth in the 2005 Notices, staff estimates that 250 or so new business opportunity sellers will enter the market each year, requiring approximately 30 hours each to develop a Rule-compliant disclosure document. Thus, staff estimates that the cumulative annual disclosure burden for new business opportunity sellers will be approximately 7,500 hours (250 new business opportunity sellers x 30 hours). Staff further estimates that the remaining 2250 established business opportunity sellers will require no more than approximately 3 hours each to update the disclosure document. Accordingly, staff estimates that the cumulative annual disclosure burden for established business opportunity sellers will be approximately 6,750 hours (2250 established business opportunity sellers x 3 hours).

Business opportunity sellers may need to maintain additional documentation for the sale of business opportunities in some states, which could take up to an additional hour of recordkeeping per year. Accordingly, staff estimates that business opportunity sellers will cumulatively incur approximately 2,500 hours of record keeping burden each year (2,500 business opportunity sellers x 1 hour).

Thus, the total burden for business opportunity sellers is approximately 16,750 hours ((7,500 hours of disclosure burden for new business opportunity sellers + 6,750 hours of disclosure burden for established business opportunity sellers + 2,500 of recordkeeping burden for all business opportunity sellers)).

Estimated annual labor cost burden for part 437: $3,595,000.

Labor costs are determined by applying applicable wage rates to associated burden hours. Staff presumes an attorney will prepare or update the disclosure document at $250 per hour. Accordingly, staff estimates that business opportunity sellers incur approximately $3,562,500 in labor costs due to compliance with the Rule’s disclosure requirements ((250 new business opportunity sellers x $250 per hour x 30 hours per business opportunity) + (2,250 established business opportunity sellers x $250 per hour x 3 hours per business opportunity)).

Staff anticipates that recordkeeping would be performed by clerical staff at approximately $13 per hour. At 2,500 hours per year for all affected business opportunities, this would amount to a total cost of $32,500 (2,500 hours for recordkeeping x $13 per hour). Thus, the combined labor costs for recordkeeping and disclosure for business opportunity sellers is approximately $3,595,000 ($3,562,500 for disclosures + $32,500 for recordkeeping).

Estimated non-labor cost for part 437: $3,887,500.

Business opportunity sellers must also incur costs to print and distribute the disclosure document. These costs vary based upon the length of the disclosures and the number of copies produced to meet the expected demand. Staff estimates that 2,500 business opportunity sellers print and mail 100 documents per year at a cost of $15 per document, for a total cost of $3,750,000 (2,500 business opportunity sellers x 100 documents per year x $15 per document).

Business opportunity sellers must also complete and disseminate an FTC-required cover sheet that identifies the business opportunity seller, the date the document is issued, a table of contents, and a notice that tracks the language specifically provided in part 437 of the Rule. Although some of the language in the cover sheet is supplied by the government for the purpose of disclosure to the public, and is thus excluded from the definition of “collection of information” under the PRA, see 5 CFR 1320.3(c)(2), there are residual costs to print and mail these cover sheets, including within them the presentation of related information beyond the supplied text. Staff estimates that 2,500 business opportunity sellers Start Printed Page 15544complete and disseminate 100 cover sheets per year at a cost of approximately $0.55 per cover sheet, or a total cost of approximately $137,500 (2,500 business opportunity sellers x 100 cover sheets per year x $0.55 per cover sheet).

Accordingly, the cumulative non-labor cost incurred by business opportunity sellers each year due to compliance with part 437 will be approximately $3,887,500 ($3,750,000 for printing and mailing documents + $137,500 for completing and mailing cover sheets).

Thus, the cumulative annual hours burden for part 437 of the amended Rule is approximately 16,750 hours ((30 hours of average annual disclosure burden x 250 new business opportunity sellers) + (3 hours of annual disclosure burden x 2,250 established business opportunity sellers) + (1 hour of annual recordkeeping burden x 2,500 total business opportunity sellers)). The cumulative annual labor costs for part 437 of the amended Rule is approximately $3,595,000 (($7,500 attorney costs x 250 new business opportunity sellers) + ($750 attorney costs x 2,250 established business opportunity sellers) + ($13 clerical costs x 2,500 total business opportunity sellers)). Finally, the cumulative annual non-labor costs for part 437 of the amended Rule is approximately $3,887,500 (($1,500 printing and mailing costs x 2,500 business opportunity sellers) + ($55 cover sheet costs x 2500 business opportunity sellers)).

Start List of Subjects

List of Subjects in 16 CFR Part 436 and 437

End List of Subjects

Advertising, Business and industry, Franchising, Trade practices.

VII. FINAL RULE LANGUAGE

Start Amendment Part

For the reasons set out in this document, the Commission revises

End Amendment Part Start Part

PART 436—DISCLOSURE REQUIREMENTS AND PROHIBITIONS CONCERNING FRANCHISING

Subpart A—Definitions
436.1
Definitions.
Subpart B—Franchisor’s Obligations
436.2
Obligation to furnish documents.
Subpart C—Contents of a Disclosure Document
436.3
Cover page.
436.4
Table of contents.
436.5
Disclosure items.
Subpart D—Instructions
436.6
Instructions for preparing disclosure documents.
436.7
Instructions for updating disclosures.
Subpart E—Exemptions
436.8
Exemptions.
Subpart F—Prohibitions
436.9
Additional prohibitions.
Subpart G—Other Provisions
436.10
Other laws and rules.
436.11
Severability.
Appendix A to Part 436—Sample Item 10 Table—Summary of Financing Offered Appendix B to Part 436—Sample Item 20(1) Table—Systemwide Outlet Summary Appendix C to Part 436—Sample Item 20(2) Table —Transfers of Franchised Outlets Appendix D to Part 436—Sample Item 20(3) Table—Status of Franchise Outlets Appendix E to Part 436—Sample Item 20(4) Table—Status of Company-Owned Outlets Appendix F to Part 436—Sample Item 20(5) Table—Projected New Franchised Outlets
Start Authority

Authority: 15 U.S.C. 41-58.

End Authority

Subpart A—Definitions

Definitions.

Unless stated otherwise, the following definitions apply throughout part 436:

(a) Action includes complaints, cross claims, counterclaims, and third-party complaints in a judicial action or proceeding, and their equivalents in an administrative action or arbitration.

(b) Affiliate means an entity controlled by, controlling, or under common control with, another entity.

(c) Confidentiality clause means any contract, order, or settlement provision that directly or indirectly restricts a current or former franchisee from discussing his or her personal experience as a franchisee in the franchisor’s system with any prospective franchisee. It does not include clauses that protect franchisor’s trademarks or other proprietary information.

(d) Disclose, state, describe, and list each mean to present all material facts accurately, clearly, concisely, and legibly in plain English.

(e) Financial performance representation means 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. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables.

(f) Fiscal year refers to the franchisor’s fiscal year.

(g) Fractional franchise means a franchise relationship that satisfies the following criteria when the relationship is created:

(1) The franchisee, any of the franchisee’s current directors or officers, or any current directors or officers of a parent or affiliate, has more than two years of experience in the same type of business; and

(2) The parties have a reasonable basis to anticipate that the sales arising from the relationship will not exceed 20% of the franchisee’s total dollar volume in sales during the first year of operation.

(h) Franchise means any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:

(1) The franchisee will obtain 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 trademark;

(2) The franchisor will exert or has 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

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.

(i) Franchisee means any person who is granted a franchise.

(j) Franchise seller means a person that offers for sale, sells, or arranges for the sale of a franchise. It includes the franchisor and the franchisor’s employees, representatives, agents, subfranchisors, and third-party brokers who are involved in franchise sales activities. It does not include existing franchisees who sell only their own outlet and who are otherwise not engaged in franchise sales on behalf of the franchisor.

(k) Franchisor means any person who grants a franchise and participates in the franchise relationship. Unless otherwise stated, it includes subfranchisors. For purposes of this definition, a “subfranchisor” means a person who functions as a franchisor by engaging in both pre-sale activities and post-sale performance.

(l) Leased department means an arrangement whereby a retailer licenses or otherwise permits a seller to conduct Start Printed Page 15545business from the retailer’s location where the seller purchases no goods, services, or commodities directly or indirectly from the retailer, a person the retailer requires the seller to do business with, or a retailer-affiliate if the retailer advises the seller to do business with the affiliate.

(m) Parent means an entity that controls another entity directly, or indirectly through one or more subsidiaries.

(n) Person means any individual, group, association, limited or general partnership, corporation, or any other entity.

(o) Plain English means the organization of information and language usage understandable by a person unfamiliar with the franchise business. It incorporates short sentences; definite, concrete, everyday language; active voice; and tabular presentation of information, where possible. It avoids legal jargon, highly technical business terms, and multiple negatives.

(p) Predecessor means a person from whom the franchisor acquired, directly or indirectly, the major portion of the franchisor’s assets.

(q) Principal business address means the street address of a person’s home office in the United States. A principal business address cannot be a post office box or private mail drop.

(r) Prospective franchisee means any person (including any agent, representative, or employee) who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship.

(s) Required payment means all consideration that the franchisee must pay to the franchisor or an affiliate, either by contract or by practical necessity, as a condition of obtaining or commencing operation of the franchise. A required payment does not include payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or lease.

(t) Sale of a franchise includes an agreement whereby a person obtains a franchise from a franchise seller for value by purchase, license, or otherwise. It does not include extending or renewing an existing franchise agreement where there has been no interruption in the franchisee’s operation of the business, unless the new agreement contains terms and conditions that differ materially from the original agreement. It also does not include the transfer of a franchise by an existing franchisee where the franchisor has had no significant involvement with the prospective transferee. A franchisor’s approval or disapproval of a transfer alone is not deemed to be significant involvement.

(u) Signature means a person’s affirmative step to authenticate his or her identity. It includes a person’s handwritten signature, as well as a person’s use of security codes, passwords, electronic signatures, and similar devices to authenticate his or her identity.

(v) Trademark includes trademarks, service marks, names, logos, and other commercial symbols.

(w) Written or in writing means any document or information in printed form or in any form capable of being preserved in tangible form and read. It includes: type-set, word processed, or handwritten document; information on computer disk or CD-ROM; information sent via email; or information posted on the Internet. It does not include mere oral statements.

Subpart B—Franchisors’ Obligations

Obligation to furnish documents.

In connection with the offer or sale of a franchise to be located in the United States of America or its territories, unless the transaction is exempted under Subpart E of this part, it is an unfair or deceptive act or practice in violation of Section 5 of the Federal Trade Commission Act:

(a) For any franchisor to fail to furnish a prospective franchisee with a copy of the franchisor’s current disclosure document, as described in Subparts C and D of this part, at least 14 calendar-days before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale.

(b) For any 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 the prospective franchisee 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.

(c) For purposes of paragraphs (a) and (b) of this section, the franchisor has furnished the documents by the required date if:

(1) A copy of the document was hand-delivered, faxed, emailed, or otherwise delivered to the prospective franchisee by the required date;

(2) Directions for accessing the document on the Internet were provided to the prospective franchisee by the required date; or

(3) 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 United States mail at least three calendar days before the required date.

Subpart C—Contents of a Disclosure Document

Cover page.

Begin the disclosure document with a cover page, in the order and form as follows:

(a) The title “FRANCHISE DISCLOSURE DOCUMENT” in capital letters and bold type.

(b) The franchisor’s name, type of business organization, principal business address, telephone number, and, if applicable, email address and primary home page address.

(c) A sample of the primary business trademark that the franchisee will use in its business.

(d) A brief description of the franchised business.

(e) The following statements:

(1) The total investment necessary to begin operation of a [franchise system name] franchise is [the total amount of Item 7 (§ 436.5(g))]. This includes [the total amount in Item 5 (§ 436.5(e))] that must be paid to the franchisor or affiliate.

(2) This disclosure document summarizes certain provisions of your franchise agreement and other information in plain English. Read this disclosure document and all accompanying agreements carefully. You must receive this disclosure document at least 14 calendar-days before you sign a binding agreement with, or make any payment to, the franchisor or an affiliate in connection with the proposed franchise sale. [The following sentence in bold type] Note, however, that no governmental agency has verified the information contained in this document.

(3) The terms of your contract will govern your franchise relationship. Don’t rely on the disclosure document alone to understand your contract. Read all of your contract carefully. Show your contract and this disclosure document to an advisor, like a lawyer or an accountant.

(4) Buying a franchise is a complex investment. The information in this disclosure document can help you make up your mind. More information on franchising, such as “A Consumer’s Guide to Buying a Franchise,” which Start Printed Page 15546can help you understand how to use this disclosure document, is available from the Federal Trade Commission. You can contact the FTC at 1-877-FTC-HELP or by writing to the FTC at 600 Pennsylvania Avenue, NW., Washington, D.C. 20580. You can also visit the FTC’s home page at www.ftc.gov for additional information. Call your state agency or visit your public library for other sources of information on franchising.

(5) There may also be laws on franchising in your state. Ask your state agencies about them.

(6) [The issuance date].

(f) A franchisor may include the following statement between the statements set out at paragraphs (e)(2) and (3) of this section: “You may wish to receive your disclosure document in another format that is more convenient for you. To discuss the availability of disclosures in different formats, contact [name or office] at [address] and [telephone number].”

(g) Franchisors may include additional disclosures on the cover page, on a separate cover page, or addendum to comply with state pre-sale disclosure laws.

Table of contents.

Include the following table of contents. State the page where each disclosure Item begins. List all exhibits by letter, as shown in the following example.

Table of Contents

1. The Franchisor and any Parents, Predecessors, and Affiliates

2. Business Experience

3. Litigation

4. Bankruptcy

5. Initial Fees

6. Other Fees

7. Estimated Initial Investment

8. Restrictions on Sources of Products and Services

9. Franchisee’s Obligations

10. Financing

11. Franchisor’s Assistance, Advertising, Computer Systems, and Training

12. Territory

13. Trademarks

14. Patents, Copyrights, and Proprietary Information

15. Obligation to Participate in the Actual Operation of the Franchise Business

16. Restrictions on What the Franchisee May Sell

17. Renewal, Termination, Transfer, and Dispute Resolution

18. Public Figures

19. Financial Performance Representations

20. Outlets and Franchisee Information

21. Financial Statements

22. Contracts

23. Receipts

Exhibits

A. Franchise Agreement

Disclosure items.

(a) Item 1: The Franchisor, and any Parents, Predecessors, and Affiliates.

Disclose:

(1) The name and principal business address of the franchisor; any parents; and any affiliates that offer franchises in any line of business or provide products or services to the franchisees of the franchisor.

(2) The name and principal business address of any predecessors during the 10-year period immediately before the close of the franchisor’s most recent fiscal year.

(3) The name that the franchisor uses and any names it intends to use to conduct business.

(4) The identity and principal business address of the franchisor’s agent for service of process.

(5) The type of business organization used by the franchisor (for example, corporation, partnership) and the state in which it was organized.

(6) The following information about the franchisor’s business and the franchises offered:

(i) Whether the franchisor operates businesses of the type being franchised.

(ii) The franchisor’s other business activities.

(iii) The business the franchisee will conduct.

(iv) The general market for the product or service the franchisee will offer. In describing the general market, consider factors such as whether the market is developed or developing, whether the goods will be sold primarily to a certain group, and whether sales are seasonal.

(v) In general terms, any laws or regulations specific to the industry in which the franchise business operates.

(vi) A general description of the competition.

(7) The prior business experience of the franchisor; any predecessors listed in § 436.5(a)(2) of this part; and any affiliates that offer franchises in any line of business or provide products or services to the franchisees of the franchisor, including:

(i) The length of time each has conducted the type of business the franchisee will operate.

(ii) The length of time each has offered franchises providing the type of business the franchisee will operate.

(iii) Whether each has offered franchises in other lines of business. If so, include:

(A) A description of each other line of business.

(B) The number of franchises sold in each other line of business.

(C) The length of time each has offered franchises in each other line of business.

(b) Item 2: Business Experience. Disclose by name and position the franchisor’s directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of franchises offered by this document. For each person listed in this section, state his or her principal positions and employers during the past five years, including each position’s starting date, ending date, and location.

(c) Item 3: Litigation. (1) Disclose whether the franchisor; a predecessor; a parent or affiliate who induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor’s performance; an affiliate who offers franchises under the franchisor’s principal trademark; and any person identified in § 436.5(b) of this part:

(i) Has pending against that person:

(A) An administrative, criminal, or material civil action alleging a violation of a franchise, antitrust, or securities law, or alleging fraud, unfair or deceptive practices, or comparable allegations.

(B) Civil actions, other than ordinary routine litigation incidental to the business, which are material in the context of the number of franchisees and the size, nature, or financial condition of the franchise system or its business operations.

(ii) Was a party to any material civil action involving the franchise relationship in the last fiscal year. For purposes of this section, “franchise relationship” means contractual obligations between the franchisor and franchisee directly relating to the operation of the franchised business (such as royalty payment and training obligations). It does not include actions involving suppliers or other third parties, or indemnification for tort liability.

(iii) Has in the 10-year period immediately before the disclosure document’s issuance date:

(A) Been convicted of or pleaded nolo contendere to a felony charge.

(B) Been held liable in a civil action involving an alleged violation of a franchise, antitrust, or securities law, or involving allegations of fraud, unfair or deceptive practices, or comparable allegations. “Held liable” means that, as a result of claims or counterclaims, the person must pay money or other consideration, must reduce an indebtedness by the amount of an Start Printed Page 15547award, cannot enforce its rights, or must take action adverse to its interests.

(2) Disclose whether the franchisor; a predecessor; a parent or affiliate who guarantees the franchisor’s performance; an affiliate who has offered or sold franchises in any line of business within the last 10 years; or any other person identified in § 436.5(b) of this part is subject to a currently effective injunctive or restrictive order or decree resulting from a pending or concluded action brought by a public agency and relating to the franchise or to a Federal, State, or Canadian franchise, securities, antitrust, trade regulation, or trade practice law.

(3) For each action identified in paragraphs (c)(1) and (2) of this section, state the title, case number or citation, the initial filing date, the names of the parties, the forum, and the relationship of the opposing party to the franchisor (for example, competitor, supplier, lessor, franchisee, former franchisee, or class of franchisees). Except as provided in paragraph (c)(4) of this section, summarize the legal and factual nature of each claim in the action, the relief sought or obtained, and any conclusions of law or fact.[1] In addition, state:

(i) For pending actions, the status of the action.

(ii) For prior actions, the date when the judgment was entered and any damages or settlement terms.[2]

(iii) For injunctive or restrictive orders, the nature, terms, and conditions of the order or decree.

(iv) For convictions or pleas, the crime or violation, the date of conviction, and the sentence or penalty imposed.

(4) For any other franchisor-initiated suit identified in paragraph (c)(1)(ii) of this section, the franchisor may comply with the requirements of paragraphs (c)(3)(i) through (iv) of this section by listing individual suits under one common heading that will serve as the case summary (for example, “royalty collection suits”).

(d) Item 4: Bankruptcy. (1) Disclose whether the franchisor; any parent; predecessor; affiliate; officer, or general partner of the franchisor, or any other individual who will have management responsibility relating to the sale or operation of franchises offered by this document, has, during the 10-year period immediately before the date of this disclosure document:

(i) Filed as debtor (or had filed against it) a petition under the United States Bankruptcy Code (“Bankruptcy Code”).

(ii) Obtained a discharge of its debts under the Bankruptcy Code.

(iii) Been a principal officer of a company or a general partner in a partnership that either filed as a debtor (or had filed against it) a petition under the Bankruptcy Code, or that obtained a discharge of its debts under the Bankruptcy Code while, or within one year after, the officer or general partner held the position in the company.

(2) For each bankruptcy, state:

(i) The current name, address, and principal place of business of the debtor.

(ii) Whether the debtor is the franchisor. If not, state the relationship of the debtor to the franchisor (for example, affiliate, officer).

(iii) The date of the original filing and the material facts, including the bankruptcy court, and the case name and number. If applicable, state the debtor’s discharge date, including discharges under Chapter 7 and confirmation of any plans of reorganization under Chapters 11 and 13 of the Bankruptcy Code.

(3) Disclose cases, actions, and other proceedings under the laws of foreign nations relating to bankruptcy.

(e) Item 5: Initial Fees. Disclose the initial fees and any conditions under which these fees are refundable. If the initial fees are not uniform, disclose the range or formula used to calculate the initial fees paid in the fiscal year before the issuance date and the factors that determined the amount. For this section, “initial fees” means all fees and payments, or commitments to pay, for services or goods received from the franchisor or any affiliate before the franchisee’s business opens, whether payable in lump sum or installments. Disclose installment payment terms in this section or in § 436.5(j) of this part.

(f) Item 6: Other Fees. Disclose, in the following tabular form, all other fees that the franchisee must pay to the franchisor or its affiliates, or that the franchisor or its affiliates impose or collect in whole or in part for a third party. State the title “OTHER FEES” in capital letters using bold type. Include any formula used to compute the fees.[3]

Item 6 Table

OTHER FEES

Column 1 Type of feeColumn 2 AmountColumn 3 Due DateColumn 4 Remarks

(1) In column 1, list the type of fee (for example, royalties, and fees for lease negotiations, construction, remodeling, additional training or assistance, advertising, advertising cooperatives, purchasing cooperatives, audits, accounting, inventory, transfers, and renewals).

(2) In column 2, state the amount of the fee.

(3) In column 3, state the due date for each fee.

(4) In column 4, include remarks, definitions, or caveats that elaborate on the information in the table. If remarks are long, franchisors may use footnotes instead of the remarks column. If applicable, include the following information in the remarks column or in a footnote:

(i) Whether the fees are payable only to the franchisor.

(ii) Whether the fees are imposed and collected by the franchisor.

(iii) Whether the fees are non-refundable or describe the circumstances when the fees are refundable.

(iv) Whether the fees are uniformly imposed.

(v) The voting power of franchisor-owned outlets on any fees imposed by Start Printed Page 15548cooperatives. If franchisor-owned outlets have controlling voting power, disclose the maximum and minimum fees that may be imposed.

(g) Item 7: Estimated Initial Investment. Disclose, in the following tabular form, the franchisee’s estimated initial investment. State the title “YOUR ESTIMATED INITIAL INVESTMENT” in capital letters using bold type. Franchisors may include additional expenditure tables to show expenditure variations caused by differences such as in site location and premises size.

Item 7 Table:

YOUR ESTIMATED INITIAL INVESTMENT

Column 1 Type of expenditureColumn 2 AmountColumn 3 Method of paymentColumn 4 When dueColumn 4 To whom payment is to be made
Total.

(1) In column 1:

(i) List each type of expense, beginning with pre-opening expenses. Include the following expenses, if applicable. Use footnotes to include remarks, definitions, or caveats that elaborate on the information in the Table.

(A) The initial franchise fee.

(B) Training expenses.

(C) Real property, whether purchased or leased.

(D) Equipment, fixtures, other fixed assets, construction, remodeling, leasehold improvements, and decorating costs, whether purchased or leased.

(E) Inventory to begin operating.

(F) Security deposits, utility deposits, business licenses, and other prepaid expenses.

(ii) List separately and by name any other specific required payments (for example, additional training, travel, or advertising expenses) that the franchisee must make to begin operations.

(iii) Include a category titled “Additional funds— [initial period]” for any other required expenses the franchisee will incur before operations begin and during the initial period of operations. State the initial period. A reasonable initial period is at least three months or a reasonable period for the industry. Describe in general terms the factors, basis, and experience that the franchisor considered or relied upon in formulating the amount required for additional funds.

(2) In column 2, state the amount of the payment. If the amount is unknown, use a low-high range based on the franchisor’s current experience. If real property costs cannot be estimated in a low-high range, describe the approximate size of the property and building and the probable location of the building (for example, strip shopping center, mall, downtown, rural, or highway).

(3) In column 3, state the method of payment.

(4) In column 4, state the due date.

(5) In column 5, state to whom payment will be made.

(6) Total the initial investment, incorporating ranges of fees, if used.

(7) In a footnote, state:

(i) Whether each payment is non-refundable, or describe the circumstances when each payment is refundable.

(ii) If the franchisor or an affiliate finances part of the initial investment, the amount that it will finance, the required down payment, the annual interest rate, rate factors, and the estimated loan repayments. Franchisors may refer to § 436.5(j) of this part for additional details.

(h) Item 8: Restrictions on Sources of Products and Services. Disclose the franchisee’s obligations to purchase or lease goods, services, supplies, fixtures, equipment, inventory, computer hardware and software, real estate, or comparable items related to establishing or operating the franchised business either from the franchisor, its designee, or suppliers approved by the franchisor, or under the franchisor’s specifications. Include obligations to purchase imposed by the franchisor’s written agreement or by the franchisor’s practice.[4] For each applicable obligation, state:

(1) The good or service required to be purchased or leased.

(2) Whether the franchisor or its affiliates are approved suppliers or the only approved suppliers of that good or service.

(3) Any supplier in which an officer of the franchisor owns an interest.

(4) How the franchisor grants and revokes approval of alternative suppliers, including:

(i) Whether the franchisor’s criteria for approving suppliers are available to franchisees.

(ii) Whether the franchisor permits franchisees to contract with alternative suppliers who meet the franchisor’s criteria.

(iii) Any fees and procedures to secure approval to purchase from alternative suppliers.

(iv) The time period in which the franchisee will be notified of approval or disapproval.

(v) How approvals are revoked.

(5) Whether the franchisor issues specifications and standards to franchisees, subfranchisees, or approved suppliers. If so, describe how the franchisor issues and modifies specifications.

(6) Whether the franchisor or its affiliates will or may derive revenue or other material consideration from required purchases or leases by franchisees. If so, describe the precise basis by which the franchisor or its affiliates will or may derive that consideration by stating:

(i) The franchisor’s total revenue.[5]

(ii) The franchisor’s revenues from all required purchases and leases of products and services.

(iii) The percentage of the franchisor’s total revenues that are from required purchases or leases.

(iv) If the franchisor’s affiliates also sell or lease products or services to franchisees, the affiliates’ revenues from those sales or leases.

(7) The estimated proportion of these required purchases and leases by the franchisee to all purchases and leases by the franchisee of goods and services in establishing and operating the franchised businesses. Start Printed Page 15549

(8) If a designated supplier will make payments to the franchisor from franchisee purchases, disclose the basis for the payment (for example, specify a percentage or a flat amount). For purposes of this disclosure, a “payment” includes the sale of similar goods or services to the franchisor at a lower price than to franchisees.

(9) The existence of purchasing or distribution cooperatives.

(10) Whether the franchisor negotiates purchase arrangements with suppliers, including price terms, for the benefit of franchisees.

(11) Whether the franchisor provides material benefits (for example, renewal or granting additional franchises) to a franchisee based on a franchisee’s purchase of particular products or services or use of particular suppliers.

(i) Item 9: Franchisee’s Obligations. Disclose, in the following tabular form, a list of the franchisee’s principal obligations. State the title “FRANCHISEE’S OBLIGATIONS” in capital letters using bold type. Cross-reference each listed obligation with any applicable section of the franchise or other agreement and with the relevant disclosure document provision. If a particular obligation is not applicable, state “Not Applicable.” Include additional obligations, as warranted.

Item 9 Table:

FRANCHISEE’S OBLIGATIONS

[In bold] This table lists your principal obligations under the franchise and other agreements. It will help you find more detailed information about your obligations in these agreements and in other items of this disclosure document.

ObligationSection in agreementDisclosure document item
a. Site selection and acquisition/lease
b. Pre-opening purchase/leases
c. Site development and other pre-opening requirements
d. Initial and ongoing training
e. Opening
f. Fees
g. Compliance with standards and policies/operating manual
h. Trademarks and proprietary information
i. Restrictions on products/services offered
j. Warranty and customer service requirements
k. Territorial development and sales quotas
l. Ongoing product/service purchases
m. Maintenance, appearance, and remodeling requirements
n. Insurance
o. Advertising
p. Indemnification
q. Owner’s participation/management/staffing
r. Records and reports
s. Inspections and audits
t. Transfer
u. Renewal
v. Post-termination obligations
w. Non-competition covenants
x. Dispute resolution
y. Other (describe)
Start Printed Page 15550

(j) Item 10: Financing. (1) Disclose the terms of each financing arrangement, including leases and installment contracts, that the franchisor, its agent, or affiliates offer directly or indirectly to the franchisee.[6] The franchisor may summarize the terms of each financing arrangement in tabular form, using footnotes to provide additional information. For a sample Item 10 table, see Appendix A of this part. For each financing arrangement, state:

(i) What the financing covers (for example, the initial franchise fee, site acquisition, construction or remodeling, initial or replacement equipment or fixtures, opening or ongoing inventory or supplies, or other continuing expenses).[7]

(ii) The identity of each lender providing financing and their relationship to the franchisor (for example, affiliate).

(iii) The amount of financing offered or, if the amount depends on an actual cost that may vary, the percentage of the cost that will be financed.

(iv) The rate of interest, plus finance charges, expressed on an annual basis. If the rate of interest, plus finance charges, expressed on an annual basis, may differ depending on when the financing is issued, state what that rate was on a specified recent date.

(v) The number of payments or the period of repayment.

(vi) The nature of any security interest required by the lender.

(vii) Whether a person other than the franchisee must personally guarantee the debt.

(viii) Whether the debt can be prepaid and the nature of any prepayment penalty.

(ix) The franchisee’s potential liabilities upon default, including any:

(A) Accelerated obligation to pay the entire amount due;

(B) Obligations to pay court costs and attorney’s fees incurred in collecting the debt;

(C) Termination of the franchise; and

(D) Liabilities from cross defaults such as those resulting directly from non-payment, or indirectly from the loss of business property.

(x) Other material financing terms.

(2) Disclose whether the loan agreement requires franchisees to waive defenses or other legal rights (for example, confession of judgment), or bars franchisees from asserting a defense against the lender, the lender’s assignee or the franchisor. If so, describe the relevant provisions.

(3) Disclose whether the franchisor’s practice or intent is to sell, assign, or discount to a third party all or part of the financing arrangement. If so, state:

(i) The assignment terms, including whether the franchisor will remain primarily obligated to provide the financed goods or services; and

(ii) That the franchisee may lose all its defenses against the lender as a result of the sale or assignment.

(4) Disclose whether the franchisor or an affiliate receives any consideration for placing financing with the lender. If such payments exist:

(i) Disclose the amount or the method of determining the payment; and

(ii) Identify the source of the payment and the relationship of the source to the franchisor or its affiliates.

(k) Item 11: Franchisor’s Assistance, Advertising, Computer Systems, and Training. Disclose the franchisor’s principal assistance and related obligations of both the franchisor and franchisee as follows. For each obligation, cite the section number of the franchise agreement imposing the obligation. Begin by stating the following sentence in bold type: “Except as listed below, [the franchisor] is not required to provide you with any assistance.

(1) Disclose the franchisor’s pre-opening obligations to the franchisee, including any assistance in:

(i) Locating a site and negotiating the purchase or lease of the site. If such assistance is provided, state:

(A) Whether the franchisor generally owns the premises and leases it to the franchisee.

(B) Whether the franchisor selects the site or approves an area in which the franchisee selects a site. If so, state further whether and how the franchisor must approve a franchisee-selected site.

(C) The factors that the franchisor considers in selecting or approving sites (for example, general location and neighborhood, traffic patterns, parking, size, physical characteristics of existing buildings, and lease terms).

(D) The time limit for the franchisor to locate or approve or disapprove the site and the consequences if the franchisor and franchisee cannot agree on a site.

(ii) Conforming the premises to local ordinances and building codes and obtaining any required permits.

(iii) Constructing, remodeling, or decorating the premises.

(iv) Hiring and training employees.

(v) Providing for necessary equipment, signs, fixtures, opening inventory, and supplies. If any such assistance is provided, state:

(A) Whether the franchisor provides these items directly or only provides the names of approved suppliers.

(B) Whether the franchisor provides written specifications for these items.

(C) Whether the franchisor delivers or installs these items.

(2) Disclose the typical length of time between the earlier of the signing of the franchise agreement or the first payment of consideration for the franchise and the opening of the franchisee’s business. Describe the factors that may affect the time period, such as ability to obtain a lease, financing or building permits, zoning and local ordinances, weather conditions, shortages, or delayed installation of equipment, fixtures, and signs.

(3) Disclose the franchisor’s obligations to the franchisee during the operation of the franchise, including any assistance in:

(i) Developing products or services the franchisee will offer to its customers.

(ii) Hiring and training employees.

(iii) Improving and developing the franchised business.

(iv) Establishing prices.

(v) Establishing and using administrative, bookkeeping, accounting, and inventory control procedures.

(vi) Resolving operating problems encountered by the franchisee.

(4) Describe the advertising program for the franchise system, including the following:

(i)The franchisor’s obligation to conduct advertising, including:

(A) The media the franchisor may use.

(B) Whether media coverage is local, regional, or national.

(C) The source of the advertising (for example, an in-house advertising department or a national or regional advertising agency).

(D) Whether the franchisor must spend any amount on advertising in the area or territory where the franchisee is located.

(ii) The circumstances when the franchisor will permit franchisees to use their own advertising material.

(iii) Whether there is an advertising council composed of franchisees that advises the franchisor on advertising policies. If so, disclose:

(A) How members of the council are selected.

(B) Whether the council serves in an advisory capacity only or has operational or decision-making power. Start Printed Page 15551

(C) Whether the franchisor has the power to form, change, or dissolve the advertising council.

(iv) Whether the franchisee must participate in a local or regional advertising cooperative. If so, state:

(A) How the area or membership of the cooperative is defined.

(B) How much the franchisee must contribute to the fund and whether other franchisees must contribute a different amount or at a different rate.

(C) Whether the franchisor-owned outlets must contribute to the fund and, if so, whether those contributions are on the same basis as those for franchisees.

(D) Who is responsible for administering the cooperative (for example, franchisor, franchisees, or advertising agency).

(E) Whether cooperatives must operate from written governing documents and whether the documents are available for the franchisee to review.

(F) Whether cooperatives must prepare annual or periodic financial statements and whether the statements are available for review by the franchisee.

(G) Whether the franchisor has the power to require cooperatives to be formed, changed, dissolved, or merged.

(v) Whether the franchisee must participate in any other advertising fund. If so, state:

(A) Who contributes to the fund.

(B) How much the franchisee must contribute to the fund and whether other franchisees must contribute a different amount or at a different rate.

(C) Whether the franchisor-owned outlets must contribute to the fund and, if so, whether it is on the same basis as franchisees.

(D) Who administers the fund.

(E) Whether the fund is audited and when it is audited.

(F) Whether financial statements of the fund are available for review by the franchisee.

(G) How the funds were used in the most recently concluded fiscal year, including the percentages spent on production, media placement, administrative expenses, and a description of any other use.

(vi) If not all advertising funds are spent in the fiscal year in which they accrue, how the franchisor uses the remaining amount, including whether franchisees receive a periodic accounting of how advertising fees are spent.

(vii) The percentage of advertising funds, if any, that the franchisor uses principally to solicit new franchise sales.

(5) Disclose whether the franchisor requires the franchisee to buy or use electronic cash registers or computer systems. If so, describe the systems generally in non-technical language, including the types of data to be generated or stored in these systems, and state the following:

(i) The cost of purchasing or leasing the systems.

(ii) Any obligation of the franchisor, any affiliate, or third party to provide ongoing maintenance, repairs, upgrades, or updates.

(iii) Any obligations of the franchisee to upgrade or update any system during the term of the franchise, and, if so, any contractual limitations on the frequency and cost of the obligation.

(iv) The annual cost of any optional or required maintenance, updating, upgrading, or support contracts.

(v) Whether the franchisor will have independent access to the information that will be generated or stored in any electronic cash register or computer system. If so, describe the information that the franchisor may access and whether there are any contractual limitations on the franchisor’s right to access the information.

(6) Disclose the table of contents of the franchisor’s operating manual provided to franchisees as of the franchisor’s last fiscal year-end or a more recent date. State the number of pages devoted to each subject and the total number of pages in the manual as of this date. This disclosure may be omitted if the franchisor offers the prospective franchisee the opportunity to view the manual before buying the franchise.

(7) Disclose the franchisor’s training program as of the franchisor’s last fiscal year-end or a more recent date.

(i) Describe the training program in the following tabular form. Title the table “TRAINING PROGRAM” in capital letters and bold type.

Item 11 Table

TRAINING PROGRAM

Column 1 SubjectColumn 2 Hours of Classroom TrainingColumn 3 Hours of On-The-Job TrainingColumn 4 Location

(A) In column 1, state the subjects taught.

(B) In column 2, state the hours of classroom training for each subject.

(C) In column 3, state the hours of on-the-job training for each subject.

(D) In column 4, state the location of the training for each subject.

(ii) State further:

(A) How often training classes are held and the nature of the location or facility where training is held (for example, company, home, office, franchisor-owned store).

(B) The nature of instructional materials and the instructor’s experience, including the instructor’s length of experience in the field and with the franchisor. State only experience relevant to the subject taught and the franchisor’s operations.

(C) Any charges franchisees must pay for training and who must pay travel and living expenses of the training program enrollees.

(D) Who may and who must attend training. State whether the franchisee or other persons must complete the program to the franchisor’s satisfaction. If successful completion is required, state how long after signing the agreement or before opening the business the training must be completed. If training is not mandatory, state the percentage of new franchisees that enrolled in the training program during the preceding 12 months.

(E) Whether additional training programs or refresher courses are required.

(l) Item 12: Territory.

Disclose:

(1) Whether the franchise is for a specific location or a location to be approved by the franchisor.

(2) Any minimum territory granted to the franchisee (for example, a specific radius, a distance sufficient to encompass a specified population, or another specific designation).

(3) The conditions under which the franchisor will approve the relocation of the franchised business or the franchisee’s establishment of additional franchised outlets. Start Printed Page 15552

(4) Franchisee options, rights of first refusal, or similar rights to acquire additional franchises.

(5) Whether the franchisor grants an exclusive territory.

(i) If the franchisor does not grant an exclusive territory, state: “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 control.”

(ii) If the franchisor grants an exclusive territory, disclose:

(A) Whether continuation of territorial exclusivity depends on achieving a certain sales volume, market penetration, or other contingency, and the circumstances when the franchisee’s territory may be altered. Describe any sales or other conditions. State the franchisor’s rights if the franchisee fails to meet the requirements.

(B) Any other circumstances that permit the franchisor to modify the franchisee’s territorial rights (for example, a population increase in the territory giving the franchisor the right to grant an additional franchise in the area) and the effect of such modifications on the franchisee’s rights.

(6) For all territories (exclusive and non-exclusive):

(i) Any restrictions on the franchisor from soliciting or accepting orders from consumers inside the franchisee’s territory, including:

(A) Whether the franchisor or an affiliate has used or reserves the right to use other channels of distribution, such as the Internet, catalog sales, telemarketing, or other direct marketing sales, to make sales within the franchisee’s territory using the franchisor’s principal trademarks.

(B) Whether the franchisor or an affiliate has used or reserves the right to use other channels of distribution, such as the Internet, catalog sales, telemarketing, or other direct marketing, to make sales within the franchisee’s territory of products or services under trademarks different from the ones the franchisee will use under the franchise agreement.

(C) Any compensation that the franchisor must pay for soliciting or accepting orders from inside the franchisee’s territory.

(ii) Any restrictions on the franchisee from soliciting or accepting orders from consumers outside of his or her territory, including whether the franchisee has the right to use other channels of distribution, such as the Internet, catalog sales, telemarketing, or other direct marketing, to make sales outside of his or her territory.

(iii) If the franchisor or an affiliate operates, franchises, or has plans to operate or franchise a business under a different trademark and that business sells or will sell goods or services similar to those the franchisee will offer, describe:

(A) The similar goods and services.

(B) The different trademark.

(C) Whether outlets will be franchisor owned or operated.

(D) Whether the franchisor or its franchisees who use the different trademark will solicit or accept orders within the franchisee’s territory.

(E) The timetable for the plan.

(F) How the franchisor will resolve conflicts between the franchisor and franchisees and between the franchisees of each system regarding territory, customers, and franchisor support.

(G) The principal business address of the franchisor’s similar operating business. If it is the same as the franchisor’s principal business address stated in § 436.5(a) of this part, disclose whether the franchisor maintains (or plans to maintain) physically separate offices and training facilities for the similar competing business.

(m) Item 13: Trademarks. (1) Disclose each principal trademark to be licensed to the franchisee. For this Item, “principal trademark” means the primary trademarks, service marks, names, logos, and commercial symbols the franchisee will use to identify the franchised business. It may not include every trademark the franchisor owns.

(2) Disclose whether each principal trademark is registered with the United States Patent and Trademark Office. If so, state:

(i) The date and identification number of each trademark registration.

(ii) Whether the franchisor has filed all required affidavits.

(iii) Whether any registration has been renewed.

(iv) Whether the principal trademarks are registered on the Principal or Supplemental Register of the United States Patent and Trademark Office.

(3) If the principal trademark is not registered with the United States Patent and Trademark Office, state whether the franchisor has filed any trademark application, including any “intent to use” application or an application based on actual use. If so, state the date and identification number of the application.

(4) If the trademark is not registered on the Principal Register of the United States Patent and Trademark Office, state: “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.”

(5) Disclose any currently effective material determinations of the United States Patent and Trademark Office, the Trademark Trial and Appeal Board, or any state trademark administrator or court; and any pending infringement, opposition, or cancellation proceeding. Include infringement, opposition, or cancellation proceedings in which the franchisor unsuccessfully sought to prevent registration of a trademark in order to protect a trademark licensed by the franchisor. Describe how the determination affects the ownership, use, or licensing of the trademark.

(6) Disclose any pending material federal or state court litigation regarding the franchisor’s use or ownership rights in a trademark. For each pending action, disclose:[8]

(i) The forum and case number.

(ii) The nature of claims made opposing the franchisor’s use of the trademark or by the franchisor opposing another person’s use of the trademark.

(iii) Any effective court or administrative agency ruling in the matter.

(7) Disclose any currently effective agreements that significantly limit the franchisor’s rights to use or license the use of trademarks listed in this section in a manner material to the franchise. For each agreement, disclose:

(i) The manner and extent of the limitation or grant.

(ii) The extent to which the agreement may affect the franchisee.

(iii) The agreement’s duration.

(iv) The parties to the agreement.

(v) The circumstances when the agreement may be canceled or modified.

(vi) All other material terms.

(8) Disclose:

(i) Whether the franchisor must protect the franchisee’s right to use the principal trademarks listed in this section, and must protect the franchisee against claims of infringement or unfair competition arising out of the franchisee’s use of the trademarks.

(ii) The franchisee’s obligation to notify the franchisor of the use of, or claims of rights to, a trademark identical to or confusingly similar to a trademark licensed to the franchisee.

(iii) Whether the franchise agreement requires the franchisor to take Start Printed Page 15553affirmative action when notified of these uses or claims.

(iv) Whether the franchisor or franchisee has the right to control any administrative proceedings or litigation involving a trademark licensed by the franchisor to the franchisee.

(v) Whether the franchise agreement requires the franchisor to participate in the franchisee’s defense and/or indemnify the franchisee for expenses or damages if the franchisee is a party to an administrative or judicial proceeding involving a trademark licensed by the franchisor to the franchisee, or if the proceeding is resolved unfavorably to the franchisee.

(vi) The franchisee’s rights under the franchise agreement if the franchisor requires the franchisee to modify or discontinue using a trademark.

(9) Disclose whether the franchisor knows of either superior prior rights or infringing uses that could materially affect the franchisee’s use of the principal trademarks in the state where the franchised business will be located. For each use of a principal trademark that the franchisor believes is an infringement that could materially affect the franchisee’s use of a trademark, disclose:

(i) The nature of the infringement.

(ii) The locations where the infringement is occurring.

(iii) The length of time of the infringement (to the extent known).

(iv) Any action taken or anticipated by the franchisor.

(n) Item 14: Patents, Copyrights, and Proprietary Information. (1) Disclose whether the franchisor owns rights in, or licenses to, patents or copyrights that are material to the franchise. Also, disclose whether the franchisor has any pending patent applications that are material to the franchise. If so, state:

(i) The nature of the patent, patent application, or copyright and its relationship to the franchise.

(ii) For each patent:

(A) The duration of the patent.

(B) The type of patent (for example, mechanical, process, or design).

(C) The patent number, issuance date, and title.

(iii) For each patent application:

(A) The type of patent application (for example, mechanical, process, or design).

(B) The serial number, filing date, and title.

(iv) For each copyright:

(A) The duration of the copyright.

(B) The registration number and date.

(C) Whether the franchisor can and intends to renew the copyright.

(2) Describe any current material determination of the United States Patent and Trademark Office, the United States Copyright Office, or a court regarding the patent or copyright. Include the forum and matter number. Describe how the determination affects the franchised business.

(3) State the forum, case number, claims asserted, issues involved, and effective determinations for any material proceeding pending in the United States Patent and