Countdown Begins for the Revised FTC Franchise Rule and UFOC

The Cover Page

• The UFOC will now be titled a “Franchise Disclosure Document” rather than an “offering circular.”
• Risk factors will be included only if required under state law.
• Franchisors must include their e-mail addresses and Internet home pages, and must include a statement that the franchisee may wish to receive the UFOC in a different format (eg, in writing or electronically).

Table of Contents

• The titles of several disclosure items will change (see below).

Item 1 The Franchisor, and any Parent, Predecessors, and Affiliates

• Adds required disclosures about franchisor's direct and indirect parent companies.
• Must disclose competition from any entity in which an officer of the franchisor owns an interest.

Item 2 Business Experience

• Broker disclosures omitted.

Item 3 Litigation

• Adds disclosure of litigation involving a parent who guarantees the franchisor's obligations.
• Adds required disclosure of franchisor-initiated lawsuits against franchisees during the last fiscal year on issues involving the franchise relationship.
• Broadens the types of affiliates about whom the franchisor must disclose government agency litigation.

Item 4 Bankruptcy

• May expand bankruptcy disclosures by including a franchisor's affiliates (beyond those who offer franchises under the franchisor's principal mark), predecessors and parent companies, officers, general partners, and other persons who occupy a similar status or perform similar functions.

Item 5 Initial Franchise Fee

• Title changed to “Initial Franchise Fees Paid to the Franchisor.”
• No substantial changes.

Item 6 Other Fees

• Expanded to include payments that the franchisee is required to pay a third party, and the formula or maximum amount by or to which a fee may increase.

Item 7 Initial Investment

• Title changed to “Estimated Initial Investment.”
• No substantive change. Item 7 estimates must include both pre-opening expenses and those incurred during the “initial period of operations” of at least 3 months following opening or other reasonable period in the industry. The FTC dropped its proposal to deviate from the current UFOC Guidelines by requiring a break-even analysis.

Item 8 Restrictions on Sources of Products and Services

• Adds disclosure of suppliers in which an officer of the franchisor owns an interest.

Item 9 Franchisee's Obligations

• No substantive changes.

Item 10 Financing

• No substantive changes.

Item 11 Franchisor's Obligations

• Title changed to “Franchisor's Assistance, Advertising, Computer Systems, and Training.”
• Reduces the level of detail required to be disclosed about computer hardware, software, and point-of-sale systems, in favor of general description.

Item 12 Territory

• Must include a required statement if no exclusive rights are granted.

Item 13 Trademarks

• Must now state the franchisee's rights if the franchisee is required to modify or discontinue use of a trademark under any circumstances.

Item 14 Patents, Copyrights, and Proprietary Information

• Must disclose, in terms of requirements and rights under the franchise agreement, whether the franchisor must take affirmative action when notified of an infringement, and what rights the franchisee has if it must modify or discontinue use of patented or copyrighted matters.
• Must disclose not only the general nature of proprietary information, but also the terms and conditions under which the franchisee may use it.

Item 15 Obligation to Participate in the Actual Operation of the Franchise Business

• Reduces the UFOC's disclosures by limiting disclosures of limitations on whom a franchisee may hire as an on-premises supervisor, and that person's required successful completion of training, to franchisees who are individuals (ie, not business entities).
• The Proposed Rule requires disclosure only of obligations to participate personally in the direct operation of the business, whereas the NASAA commentaries require disclosure of all agreements that are binding on the franchisee's owners.

Item 16 Restrictions on What the Franchisee May Sell

• No substantive changes.

Item 17 Renewal, Termination, Transfer and Dispute Resolution

• Must add an explanation of the franchisor's renewal policies, including any obligation to sign a new franchise agreement on different terms.

Item 18 Public Figures

• No substantive changes.

Item 19 Earnings Claims

• Title changed to “Financial Perform- ance Representations.”
• Franchisors now must state that they are permitted to provide financial performance information if there is a reasonable basis for the information and if it is included in the UFOC.
• Cost and expense information is no longer considered an earnings claim.
• Franchisors may now provide historical financial information about subsets of the franchise system, if one discloses the number and percentage of outlets that attained or surpassed the stated results, based on the number of outlets in the subset (rather than the number of outlets in the entire franchise system, as the UFOC currently requires).
• Item 19 does not cover the providing of actual operating results for a specific outlet being offered for sale to prospective purchasers of that outlet (and eliminates the required delivery of the identity of the prior owners of the outlet during the preceding 3 years).

Item 20 List of Outlets

• Title changed to “Outlets and Franchisee Information.”
• Changes the form and content of the tables used in presenting franchisee- and franchisor-owned outlets statistics.
• Avoids current “double counting” problem by including only the first event to occur if a franchised outlet has been through multiple status changes in a single fiscal year.
• Adds required disclosure of “Confidentiality Agreements” signed by franchisees during the franchisor's last 3 fiscal years that restrict them from discussing their personal experiences with the franchisor.
• Adds new required disclosure of trademark-specific franchisee associations (eg, those sponsored by or endorsed by the franchisor, and independent franchisee associations which are incorporated and ask specifically to be included in the franchisor's disclosure document annually within 90 days after the franchisor's fiscal year end).
• Prohibits using phony references or “shills.”

Item 21 Financial Statements

• Audited financials must be prepared in accordance with GAAP, or as permitted by the SEC, and as revised by governmental mandate.
• Need not include separate audited financial statements for a parent company, unless the parent guarantees or commits to perform the franchisor's obligations. An affiliate's audited financial statements may be used in lieu of the franchisor's if the affiliate guarantees the franchisor's performance. Such guarantees must be attached to the UFOC.
• Phase-in requirements for audited financial statements for startup franchisors are clarified: A startup franchisor that does not have audited financial statements does not need an audit for its first partial or full fiscal year.

Item 22 Contracts

• No substantive changes.

Item 23 Receipts

• Modified to reflect the revised disclosure timing requirements discussed above.
• Adds the new and potentially unwieldy requirement that the receipt include the name, address, and telephone number of each “franchise seller” offering the franchise. This definition of “seller” includes sub-franchisors and third-party brokers, as well as the franchisor and its employees, representatives, and agents who “are involved in franchise sales activities.”

The public may comment on the Proposed Rule until Nov. 12, 2004, following which the FTC staff will have an unspecified time to review these comments and make its final recommendation to the FTC. In turn, the FTC will have an unspecified time to consider and adopt such (or none) of the changes as it may determine. Assuming the FTC does so, there is expected to be a phase-in period to provide time for registration states to coordinate state laws and regulations and for franchisors to implement the new disclosures.

On Aug. 25, 2004, the Federal Trade Commission (FTC) released its long-anticipated report on its proposed changes to the FTC Rule on Franchising and Business Opportunity Ventures (FTC Rule). When the new FTC Rule comes into effect, franchisors will have to make significant changes to their existing disclosure documents and follow new rules for how and when they are delivered to prospective franchisees. There are also new exemptions for large transactions and large franchisees, and the FTC Rule will not apply to international franchise locations.

The FTC Rule has not been changed since it was originally issued in December 1978. However, in October 1999, after years of study, the FTC issued a Notice of Proposed Rulemaking (NPR) that proposed substantial revisions to the FTC Rule (Proposed Rule). The revised FTC rule as proposed in 1999 was further modified by the August 2004 Staff Report. This article outlines the key elements of the latest version of the Proposed Rule, which includes the recent staff report changes.

The Proposed Rule would change the coverage of the existing FTC Rule, including the following:

• It will apply only to franchises for locations in the United States, its possessions, and territories.
• It will no longer cover “business opportunities.”
• It will retain exemptions for franchise fees under $500, “fractional franchises,” “leased departments,” franchises governed by the Petroleum Marketing Practices Act, and “oral franchises.”
• It will delete the exclusions for general partnerships, employer-employee relationships, cooperatives, certification and testing services, and single-trademark licenses (commenting that the exclusions are unnecessary because they were not included in the first place).
• It will not apply to franchises: (a) requiring an investment exceeding $1 million, excluding real estate and amounts financed by the franchisor or its affiliate; (b) sold to a franchisee that is 5 or more years old with a net worth exceeding $5 million; or (c) “insider” transactions in which at least 50% of the owners of the franchisee were 25%-owners or managers of the franchisor.

The Proposed Rule will change the timing of franchisor presale disclosures in the following ways:

• Franchisors will no longer be required to deliver the uniform franchise offering circular (UFOC) at the “first personal meeting” (first face-to-face meeting with the prospective franchisee).
• Franchisors must deliver the UFOC 14 calendar days, rather than 10 business days, before the franchisee signs any franchise or other binding agreement or pays any consideration, or earlier upon a prospect's reasonable request.
• Franchisors must deliver execution-ready copies of the UFOC and all other related agreements 7 calendar days, rather than 5 business days, before they are executed. However, this waiting period applies only if the franchisor unilaterally (ie, not in response to franchisee-initiated negotiations) makes material changes to the terms of the basic franchise agreement attached to the UFOC.

The Proposed Rule changes the updating requirements as follows:

• Annual updates must be made within 120 (rather than 90) days after the franchisor's fiscal year end.
• The Proposed Rule retains FTC Rule quarterly UFOC updates for any material changes, but adds required notice to the franchisee (but not an amended UFOC) of any material changes to any financial performance representations (ie, Item 19 earnings claims) about which the franchisor knows or should have known.
• The Proposed Rule prohibits waivers of any representation in the UFOC but expressly permits negotiated changes.
• The Proposed Rule will allow the UFOC and contracts to be delivered either by paper or electronically via the Internet, e-mail, computer disks, or CD-ROM, and eliminates the requirement for traditional handwritten signatures. The franchisee must be able to store, download, print, or otherwise maintain the documents for future reference. The electronic UFOC may include scrollbars, internal links, and search features, but no other technological developments such as audio, video, “pop-up” screens, or external links.

Under the Proposed Rule, the FTC has formally abandoned its rarely used disclosure format and adopted the 1993 UFOC Guidelines developed by the North American Securities Administrators Association (NASAA), which will entail a number of substantive and stylistic changes to many of the 23 UFOC disclosure items. Even Items that the FTC has left substantively untouched will need to be reorganized, edited, and streamlined by franchisors to comply with the FTC's new requirements. The following outline details some of the key substantive changes:

The Cover Page

• The UFOC will now be titled a “Franchise Disclosure Document” rather than an “offering circular.”
• Risk factors will be included only if required under state law.
• Franchisors must include their e-mail addresses and Internet home pages, and must include a statement that the franchisee may wish to receive the UFOC in a different format (eg, in writing or electronically).

Table of Contents

• The titles of several disclosure items will change (see below).

Item 1 The Franchisor, and any Parent, Predecessors, and Affiliates

• Adds required disclosures about franchisor's direct and indirect parent companies.
• Must disclose competition from any entity in which an officer of the franchisor owns an interest.

Item 2 Business Experience

• Broker disclosures omitted.

Item 3 Litigation

• Adds disclosure of litigation involving a parent who guarantees the franchisor's obligations.
• Adds required disclosure of franchisor-initiated lawsuits against franchisees during the last fiscal year on issues involving the franchise relationship.
• Broadens the types of affiliates about whom the franchisor must disclose government agency litigation.

Item 4 Bankruptcy

• May expand bankruptcy disclosures by including a franchisor's affiliates (beyond those who offer franchises under the franchisor's principal mark), predecessors and parent companies, officers, general partners, and other persons who occupy a similar status or perform similar functions.

Item 5 Initial Franchise Fee

• Title changed to “Initial Franchise Fees Paid to the Franchisor.”
• No substantial changes.

Item 6 Other Fees

• Expanded to include payments that the franchisee is required to pay a third party, and the formula or maximum amount by or to which a fee may increase.

Item 7 Initial Investment

• Title changed to “Estimated Initial Investment.”
• No substantive change. Item 7 estimates must include both pre-opening expenses and those incurred during the “initial period of operations” of at least 3 months following opening or other reasonable period in the industry. The FTC dropped its proposal to deviate from the current UFOC Guidelines by requiring a break-even analysis.

Item 8 Restrictions on Sources of Products and Services

• Adds disclosure of suppliers in which an officer of the franchisor owns an interest.

Item 9 Franchisee's Obligations

• No substantive changes.

Item 10 Financing

• No substantive changes.

Item 11 Franchisor's Obligations

• Title changed to “Franchisor's Assistance, Advertising, Computer Systems, and Training.”
• Reduces the level of detail required to be disclosed about computer hardware, software, and point-of-sale systems, in favor of general description.

Item 12 Territory

• Must include a required statement if no exclusive rights are granted.

Item 13 Trademarks

• Must now state the franchisee's rights if the franchisee is required to modify or discontinue use of a trademark under any circumstances.

Item 14 Patents, Copyrights, and Proprietary Information

• Must disclose, in terms of requirements and rights under the franchise agreement, whether the franchisor must take affirmative action when notified of an infringement, and what rights the franchisee has if it must modify or discontinue use of patented or copyrighted matters.
• Must disclose not only the general nature of proprietary information, but also the terms and conditions under which the franchisee may use it.

Item 15 Obligation to Participate in the Actual Operation of the Franchise Business

• Reduces the UFOC's disclosures by limiting disclosures of limitations on whom a franchisee may hire as an on-premises supervisor, and that person's required successful completion of training, to franchisees who are individuals (ie, not business entities).
• The Proposed Rule requires disclosure only of obligations to participate personally in the direct operation of the business, whereas the NASAA commentaries require disclosure of all agreements that are binding on the franchisee's owners.

Item 16 Restrictions on What the Franchisee May Sell

• No substantive changes.

Item 17 Renewal, Termination, Transfer and Dispute Resolution

• Must add an explanation of the franchisor's renewal policies, including any obligation to sign a new franchise agreement on different terms.

Item 18 Public Figures

• No substantive changes.

Item 19 Earnings Claims

• Title changed to “Financial Perform- ance Representations.”
• Franchisors now must state that they are permitted to provide financial performance information if there is a reasonable basis for the information and if it is included in the UFOC.
• Cost and expense information is no longer considered an earnings claim.
• Franchisors may now provide historical financial information about subsets of the franchise system, if one discloses the number and percentage of outlets that attained or surpassed the stated results, based on the number of outlets in the subset (rather than the number of outlets in the entire franchise system, as the UFOC currently requires).
• Item 19 does not cover the providing of actual operating results for a specific outlet being offered for sale to prospective purchasers of that outlet (and eliminates the required delivery of the identity of the prior owners of the outlet during the preceding 3 years).

Item 20 List of Outlets

• Title changed to “Outlets and Franchisee Information.”
• Changes the form and content of the tables used in presenting franchisee- and franchisor-owned outlets statistics.
• Avoids current “double counting” problem by including only the first event to occur if a franchised outlet has been through multiple status changes in a single fiscal year.
• Adds required disclosure of “Confidentiality Agreements” signed by franchisees during the franchisor's last 3 fiscal years that restrict them from discussing their personal experiences with the franchisor.
• Adds new required disclosure of trademark-specific franchisee associations (eg, those sponsored by or endorsed by the franchisor, and independent franchisee associations which are incorporated and ask specifically to be included in the franchisor's disclosure document annually within 90 days after the franchisor's fiscal year end).
• Prohibits using phony references or “shills.”

Item 21 Financial Statements

• Audited financials must be prepared in accordance with GAAP, or as permitted by the SEC, and as revised by governmental mandate.
• Need not include separate audited financial statements for a parent company, unless the parent guarantees or commits to perform the franchisor's obligations. An affiliate's audited financial statements may be used in lieu of the franchisor's if the affiliate guarantees the franchisor's performance. Such guarantees must be attached to the UFOC.
• Phase-in requirements for audited financial statements for startup franchisors are clarified: A startup franchisor that does not have audited financial statements does not need an audit for its first partial or full fiscal year.

Item 22 Contracts

• No substantive changes.

Item 23 Receipts

• Modified to reflect the revised disclosure timing requirements discussed above.
• Adds the new and potentially unwieldy requirement that the receipt include the name, address, and telephone number of each “franchise seller” offering the franchise. This definition of “seller” includes sub-franchisors and third-party brokers, as well as the franchisor and its employees, representatives, and agents who “are involved in franchise sales activities.”

The public may comment on the Proposed Rule until Nov. 12, 2004, following which the FTC staff will have an unspecified time to review these comments and make its final recommendation to the FTC. In turn, the FTC will have an unspecified time to consider and adopt such (or none) of the changes as it may determine. Assuming the FTC does so, there is expected to be a phase-in period to provide time for registration states to coordinate state laws and regulations and for franchisors to implement the new disclosures.