FTC Staff Report on Franchise Rule Attracts Many Comments

The summaries below are arranged approximately in the order of the number and range of comments that addressed a specific topic.

To read the comments in full, go to the FTC's Web site at http:// www.ftc.gov/os/comments/franrulestaffrpt/index.htm, where all of the comments have been uploaded electronically (including scans of those received only in print).

Financial Performance/Earnings Claims

No area of the proposed Rule drew as much attention as disclosure of financial information, Item 19 in the UFOC. As would be expected, franchisee representatives criticized the Commission for making many financial disclosures voluntary, while franchisor representatives focused on the difficulties in updating fast-changing financial information.

The American Franchisee Association (AFA) termed this part of the proposed Rule a “missed … opportunity to correct a fatal flaw of the FTC's Franchise Rule 25 years after its inception. The single most vital piece of information a prospective investor needs before purchasing a franchise is earnings information. FTC Staff's failure to require that franchisors provide prospective franchisees with financial performance information in the form of an earnings claim is as unconscionable as it is incomprehensible.”

The Illinois Attorney General's criticism was less sweeping, but it pointed out ways in which franchisors can provide misleading information while meeting the letter-of-the-law on financial disclosures. The Illinois AG offered four specific incidences in which UFOC disclosures give franchisees an unclear picture:

• Use of affiliates' financial information instead of franchisees';
• Use of industry-wide financial information instead of franchisees';
• Combinations of franchisees' revenue with company-owned stores' cost data; and
• Use of gross sales data but not net revenue data.

Jeffrey Haff, principal, Jeffrey S. Haff & Associates (Minneapolis), excoriated the FTC for not mandating uniform disclosure of earnings claims. In the real world, “franchisors give franchisees [financial information] numbers on a cocktail napkin or in some other secretive manner,” Haff wrote, “and the person who provides the information usually receives a commission if the franchisee signs up. These circumstances do not encourage truthfulness.” Haff also pointed out the flaw in the FTC's claim that earnings reports from franchisees are not reliable and thus should not be used as the basis of earnings disclosure statements. If they were so difficult to get correct, why would banks ever lend to franchisees, he asked.

Paul Steinberg (affiliation unknown) suggested that a franchisor be limited to earnings claims that “reasonably relates to the particular chain (or at least industry sector) being sold by that franchise salesman.”

On the other side of the ledger, franchisor Cendant Corporation observed that the financial disclosure requirement of Item 19 could be interpreted to cover financial information contained in public statements or interviews by company executives. By their very nature, these interviews “are often vague and indefinite; essentially advertising promised actions in the future or mere opinion,” Cendant VP of Federal Government Relations Kimberly Hunter-Turner wrote. She continued, calling those statements “mere … puffery,” and thus said they should be disqualified as “clear and unequivocal terms and promises made to a specific prospective franchisee.” Hunter-Turner suggested that FTC differentiate between general public statements and specific promises made to influence a prospective franchisee's decision to invest. Comments from Kaufmann Feiner and several other law firms made the same point.

Jenkens & Gilchrist offered revised language that would make it clear that franchisors are not liable for immediately sharing with a prospective franchisee every piece of information they receive on a daily basis through automated reporting systems, but that franchisors must share relevant information in a timely manner.

Integration Clauses

The ability of franchisors to disclaim, by the use of integration clauses and signed waivers, oral promises made by “rogue salespersons” or inaccurate written information has long been a thorn in the side of franchisee advocates and attorneys. Not surprisingly, it was the second-most addressed part of the proposed Rule. The FTC's proposal would create some limits on franchisors' use of integration clauses.

The State Bar of California noted a general concern that even the limited restrictions on integration clauses proposed by the FTC could result in longer UFOCs with “more legalese” because franchisors will try to cover every eventuality in what could be a decades-long relationship with a franchisee.

The California Bar and the Sonnenschein, Nath & Rosenthal LLP (Chicago) made a similar point that the FTC already has authority to sue when a franchisor makes fraudulent statements in a disclosure document. Imposing regulatory-based restrictions could be viewed as “an attempt to legislate a change in common law,” the law firm wrote.

Two commenters pointed to New York State's franchise law as a model for holding franchisors responsible for fraudulent actions by their salespeople, while remaining within the confines of current disclaimer rules.

But franchisee advocates stood staunchly at the opposite end of the room. They argued that the proposed restrictions are far too weak. “Claims in a brochure designed and intended to promote franchise sales should not be overridden by language buried somewhere in a 100-page disclosure document,” wrote Bruce Napell and Peter Singler, The Law Office of Peter A. Singler (Sebatstopol, CA). “Permitting integration clauses which invest with the force of law the false statement that that the franchisee limited its reliance to the disclosure documents undermines both the reliability and the integrity of the required disclosures.”

Haff & Associates described the disclaimers as “the final nail in the coffin” for inexperienced franchisees. Taken to its extreme, a franchisor could claim (even in a printed sales brochure) that each franchise grosses $2 million in annual revenue, and the owner earns $200,000/year, then disclaim it in fine print, wrote Jeffrey Haff.

AFA made a similar point about real-world conditions, as compared to an idealized world envisioned in the staff report: “The prevalent use by many franchisors 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-sales process by ensuring franchisees have truthful and accurate information from which to make sound investment decisions.”

Initial Fees

Many comments zeroed in on fee and cost disclosures in Item 7 of the UFOC. Franchisee advocates noted that disclosure of initial fees might significantly understate the total investment the franchisee will face, but franchisors noted that requiring broader disclosure would leave franchisors with an impossible task of anticipating a wide range of expenditures over which it has no influence.

Jenkens & Gilchrist and Dorsey & Whitney, as well as several franchisors, cited the impracticality of universal fee disclosure. Costs that a franchisee would incur to operate many businesses, not the unique franchise (office supplies, for example) do not belong in Item 7, they argued. The International Franchise Association made the additional point that some third-party costs are unknown to the franchisor, which the FTC had acknowledged in the Staff Report.

John M. Tifford, writing on behalf of Piper Rudnick LLP, offered language that might address some of the issues: “In addition to the above-listed ongoing fees which you must pay to us and/or our affiliates, you will need to secure goods and services on an ongoing basis from many other suppliers. We urge you to carefully review with your business advisors the number, nature, and estimated amount … ”

Gust Rosenfeld P.L.C.'s (Phoenix) solution is that disclosure should be required for payments “made by a franchisee directly to a third party in satisfaction of what otherwise would be a payment obligation on the franchisor or its affiliate.” Examples would include: suppliers that a franchisor dictates a franchisee must use; mandated upgrades and remodeling; and cooperative advertising. Language offered by The State Bar of California would take a similar route to make explicit when the franchisor does require the franchisee to make some types of payments to third parties, and the formula for calculating those fees.

Bundy & Morrill P.S.'s suggestion: “Disclose the total amount (in a range, if appropriate) of all obligations to third parties during the initial term of the franchise that will be necessary to operate the franchise business (including real estate leases and equipment leases) that the franchisee may be required to personally guaranty.”

Brokers

Franchise brokers' allegiances can be unclear to prospective franchisees, and so the FTC's willingness to shed more light on brokers is considered important. In general, franchisors pointed out the difficulty of listing all potential sales representatives in the UFOC, but they did not raise major objections to the proposed rule. Franchisors and franchisees mostly offered technical clarifications about the details of disclosure.

One of the few stronger suggestions came from Michael Seid, Michael Seid & Associates (West Hartford, CT), a consultant to franchisors and large franchisees. “The existing Rule has been flawed for a number of years as it only required disclosure at the first personal meeting,” he wrote. The FTC ignores the reality that brokers meet prospects by phone or e-mail first, and that the person might already be “sold” on the franchise before the face-to-face meeting that triggers the disclosure requirement. Seid recommended disclosure “at the commencement of any active relationship between the broker and the prospective franchisee.”

The State Bar of California

The Association commented that newcomers to the industry often confuse brokers and subfranchisors. The Bar recommended that subfranchisors be defined directly in the UFOC, not in guidance documents.

Franchisee Associations

FTC's proposed new requirement for franchisors to disclose the existence and contact information for independent associations of the systems' franchisees was well-received. Many commenters supported the idea, and no commenters opposed it.

Several franchisee representatives proposed to strengthen the new rule. Robert L. Purvin, Jr., chairman of the American Association of Franchisees & Dealers (AAFD), was one of at least six commenters who suggested that FTC drop the requirement that the association of franchisees be incorporated. Purvin, Robert Taylor, chief of the Franchise Bureau, and the Illinois AG pointed out that a franchisee association does not have to be incorporated to serve a legitimate purpose. Purvin cited his own group, AAFD, as an example; AAFD is a trust that has “chapters” created from groups of franchisees of a single franchisor.

AFA was one of several groups that told FTC to modify or eliminate a possible disclaimer about franchisee associations. AFA pointed out that the second sentence of the disclaimer (see below) seriously undermines the credibility of the independent franchisee associations:

“The following independent franchisee organizations have asked to be included in this disclosure document. We do not endorse these organizations and their members may not represent all franchisees in the [name of franchisor] franchised system.”

Litigation

In general, the disclosure rules about litigation were well-received. Several commenters supported the FTC's “compromise” about obligations by franchisors to list lawsuits going back 1 year, though the Illinois AG suggested that litigation updates could be made more frequently, akin to the rules for financial updates. NASAA sought more, and lobbied for a broad inclusion of litigation and bankruptcy “of any person, or entity, whether a parent or affiliate, who guarantees the franchisor's performance.”

Franchisors pointed out that the litigation disclosure rules could be made less burdensome on franchisors and could give franchisees' more attention to the most relevant litigation. Cendant Corp noted that the Rule should not require disclosure of “nuisance” litigation that often is levied against large, public companies, and is not “material” to how an individual franchisee would fare. The International Franchise Association questioned the value of including litigation filed against a parent company of a franchisor, noting that this could exponentially increase the disclosures without providing information directly relevant to how a particular franchise can be expected to perform. Several franchisor attorneys echoed these points.

In commenting on parent litigation, Sonnenschein Nath noted that the parent's financial information, disclosed elsewhere in the UFOC, would give a franchisee sufficient information about the likely ability of the franchisor to meet its obligations, including the impact of adverse litigation.

Gust Rosenfeld suggested that FTC make it clear that franchisors are not required to seek out every piece of potential litigation that has been filed but not yet served.

Robert S. Burstein, writing comments for Wiggin and Dana (Conshohocken, PA), offered several ways adjustments to how litigation information is shown in the UFOC that would be clearer and would avoid double-counting.

Furnishing Documents

In general, the FTC received compliments for its expansion of ways that franchisors can provide documents to franchisees. One commenter suggested that the new delivery rules be made national so that state preemptions do not create confusion.

Yet, Kaufmann Feiner noted that the allowance for all-electronic dissemination of disclosure materials could be interpreted otherwise. The firm suggested clarification that franchisors “can communicate its disclosure format information in any fashion and at any time prior to furnishing the document that it chooses.”

Several commenters pointed out issues that can arise when documents are changed and must be reissued for a franchisee review period. Gust Rosenfeld would expand some franchisors' obligations to include “any related agreements,” not just the UFOC, when the franchisor unilaterally makes changes to a document. These would be for furnishing revised UFOCs and documents at least 7 days in advance of a franchisee signing them (not the 14 days' “cooling off period” after the provision of the UFOC itself).

Jenkens & Gilchrist pointed out that FTC perhaps left too much leeway about what can be changed in a document without triggering the requirement that a new one be furnished for a 7-day review. The FTC states that “fill-in the blank” provisions do not trigger the requirement for a new document. But Jenkens & Gilchrist noted that those fill-ins sometimes include very important items, such as a franchisee's geographic area, or even the initial fee. These should obviously trigger a new document.

Marriott International wrote that it “strongly supports” the FTC's position that franchisee-initiated changes to a UFOC do not re-trigger the disclosure period. It asks for more clarification that a negotiation that changes terms to benefit both parties, but was initiated by the franchisee, does not require the 7-day waiting period.

A comment submitted by the Sonnenschein Nath touched on the same issue, noting that negotiations, regardless of who initiates them, are “give and take.” The firm wrote that the issue could largely be solved by striking the word “solely” from that part of the Rule.

As a separate issue, franchisors asked for clarification on when a prospective franchisee that requests disclosure documents must really be considered a legitimate prospect. Providing full documentation to casual inquirers is costly and should not be mandated, they wrote.

Confidentiality Clauses

Franchisee advocates have long criticized confidentiality clauses in UFOCs as overly broad, and they found some elements of the proposed revisions to their liking. AFA praised FTC's definition of what can be protected through a confidentiality clause, and commenters on both sides of the aisle agreed that franchisors have the right to protect their trademarks and other proprietary information through confidentiality agreements.

AFA, NASAA, and several individual law firms wrote that FTC should require ' rather than make voluntary, as has been proposed ' data on the number of franchisees who have signed confidentiality clauses in the previous 3 years.

Large-Investor Exemption

The large-investor exemption of $1 million was not controversial, although not universally praised, either. Most comments focused on clarifying the exemption, rather than changing it.

The International Franchise Association and Piper Rudnick asked what constitutes “real estate” for a large investor. Marriott International picked up on the same theme ' in Marriott's case suggesting that real estate or financing for real estate provided by the franchisor be included in the exemption calculation (it is excluded under the proposal as it is now written). Marriott suggested that FTC confirm that transfers of major properties (such as a Hilton Hotel becoming a Marriott) qualify for the exemption. Starwood Hotels sought the same exemption in its short comment.

The North American Automobile Dealers Association (NADA) and others proposed raising $1-million threshold or eliminating it altogether. NADA noted that automobile dealerships almost always exceed $1 million investments, but some investors are not necessarily sophisticated.

The State Bar of California said that clarification is needed on the time frame in which the $1 million is calculated ' is it startup of the franchise, or operation over a period of time? It recommends limiting the calculation it to the initial period, using language from Item 7.

Although the California State Bar's comments did not allude to the state's own large-investor policy, the law firm of Witmer, Karp & Warner said that the FTC should copy California's large-investor exemption rules, which require higher net worth and greater indication of business savvy.

State Preemption

State authorities weighed in on current and proposed rules regarding preemption. The Illinois AG asked that the proposed rule state very clearly that state laws might pre-empt some of the federal rules governing the UFOC. NASAA asked FTC to affirm in its compliance guides that states can require disclosure of additional risk factors and that these must be prominently disclosed on the cover sheet of the UFOC.

On the other hand, Sonnenschein Nath suggested relegating those state-mandated disclosures to exhibits attached to the UFOC, rather than as part of it. The law firm said it would represent a significant cost savings for national franchisors.

Bundy & Morrill made the biggest push for state exemption recognition. Howard Bundy recommended that the FTC create a 24th Item in the UFOC (though he said it should be shown as Item 23). He called the new Item 23 “Uniform Disclosures Required by State Law,” and said it would enable franchisors to comply with the disclosures in individual states without having to create as many unique UFOCs.

Threshold for Payment

The current Franchise Rule exempts franchise arrangements that cost less than $500 initially. FTC is not proposing to change that threshold, but it is proposing to include new language that considers not only the $500 payment in the first 6 months of an agreement, but also financial commitments made during those 6 months.

Bruce McDiarimid, Pillsbury Winthrop LLP (San Francisco), used an example of how this new language would suddenly bring one of his clients, a microbrewery, under coverage of the law. McDiarimid said that the revision would contradict several guidance letters from FTC, and he suggested that the change be withdrawn.

Commenter David Gurnick of Lewick, Hackman, Shapiro, Marshall & Harlan (Encino, CA) calculated that the threshold should be raised to $1300, to reflect the level of inflation since the threshold was set in 1979. He suggested that $1000 would be an acceptable compromise, plus automatic adjustments based on the Consumer Price Index.

Franchisee-Franchisor Relations: Territorial Protection & Renewals

Although the FTC and the UFOC do not address many post-sale issues, some very important areas are affected by the proposed rules. At or near the top of the list are the scope of what is meant by “exclusive territories” and the rights of a franchisor to renew a franchisee's contract. The FTC's proposed language in these two areas drew some attention.

Gust Rosenfeld pointed out that the language in Item 12 about exclusive territories does not reflect the real-world conditions of multiple channel sales. The firm suggested new UFOC language: “You will not receive an exclusive territory. You may face competition from us or from other franchisees in your area, or from other channels of distribution or competitive brands that we control.”

Bundy & Morrill, too, aim at the FTC's renewal language. The firm wrote that “there is a wide disconnect between what franchisees believe and understand based on the word 'renew' and what franchisors mean when they promise 'renewal' under certain conditions.” To try to get ahead of this issue ' which Howard Bundy predicted will be the basis for huge amounts of litigation in the next 5 years ' Bundy suggested stating in the UFOC that franchisors are not giving franchisees the right to renew contracts on the same terms as are in the UFOC that they are signing.

Sonnenschein Nath proposed this language to address the same issue: “The franchise agreement does not give you the option to continue the relationship when the term expires. Upon expiration, we may decide whether we want to continue the relationship with you and, if we do, the terms and conditions of our relationship going forward.”

Next month, we will look at some of the more general issues that were identified by commenters, such as the proposed elimination of the exclusion for purchasing cooperatives, the lack of a private right of action, arbitration provisions, and the alleged potential of the disclosures in UFOCs to aid terrorists.

In general, commenters were supportive of the proposed rule changes and praised the FTC for its detailed approach. An introductory statement in the comment from the law firm Kaufmann, Feiner, Yamin, Gildin & Robbins LLP (New York) called the Staff Report “a remarkable effort to ascertain, and as prudent, incorporate … the desires, needs, and policy positions both of franchisors who will be regulated by the forthcoming revised Franchise Rule, and franchisees whose interests are sought to be protected and advanced thereunder.”

One indication of the overall positive reaction to the proposed changes came in the comments of the North American Securities Administrators Association, Inc. (NASAA), the organization that spearheaded the writing of the UFOC in 1993. “NASAA agrees with Commission staff that the additional disclosures suggested in the Staff Report would benefit prospective franchisees,” NASAA wrote. “We also agree that some disclosures currently required in the UFOC Guidelines could be stated more clearly, and we concur with many of the clarifications which the Commission staff proposed.” NASAA added that its members who oversee franchise issues at the state level support harmonizing the UFOC with the Franchise Rule when the Rule is completed.

Commenters who wrote from the perspective of franchisees were less sanguine about where the new regulation will wind up. They asked the FTC to take further steps to end the fundamental imbalance of power between franchisors and franchisees. For example, Erik H. Karp of Witmer, Karp & Warner LLP (Boston) termed the “Staff Report's view that that the FTC's authority does not extend to the relationship issues that predominate in franchise disputes and litigation … is simply wrong.”

The summaries below are arranged approximately in the order of the number and range of comments that addressed a specific topic.

To read the comments in full, go to the FTC's Web site at http:// www.ftc.gov/os/comments/franrulestaffrpt/index.htm, where all of the comments have been uploaded electronically (including scans of those received only in print).

Financial Performance/Earnings Claims

No area of the proposed Rule drew as much attention as disclosure of financial information, Item 19 in the UFOC. As would be expected, franchisee representatives criticized the Commission for making many financial disclosures voluntary, while franchisor representatives focused on the difficulties in updating fast-changing financial information.

The American Franchisee Association (AFA) termed this part of the proposed Rule a “missed … opportunity to correct a fatal flaw of the FTC's Franchise Rule 25 years after its inception. The single most vital piece of information a prospective investor needs before purchasing a franchise is earnings information. FTC Staff's failure to require that franchisors provide prospective franchisees with financial performance information in the form of an earnings claim is as unconscionable as it is incomprehensible.”

The Illinois Attorney General's criticism was less sweeping, but it pointed out ways in which franchisors can provide misleading information while meeting the letter-of-the-law on financial disclosures. The Illinois AG offered four specific incidences in which UFOC disclosures give franchisees an unclear picture:

• Use of affiliates' financial information instead of franchisees';
• Use of industry-wide financial information instead of franchisees';
• Combinations of franchisees' revenue with company-owned stores' cost data; and
• Use of gross sales data but not net revenue data.

Jeffrey Haff, principal, Jeffrey S. Haff & Associates (Minneapolis), excoriated the FTC for not mandating uniform disclosure of earnings claims. In the real world, “franchisors give franchisees [financial information] numbers on a cocktail napkin or in some other secretive manner,” Haff wrote, “and the person who provides the information usually receives a commission if the franchisee signs up. These circumstances do not encourage truthfulness.” Haff also pointed out the flaw in the FTC's claim that earnings reports from franchisees are not reliable and thus should not be used as the basis of earnings disclosure statements. If they were so difficult to get correct, why would banks ever lend to franchisees, he asked.

Paul Steinberg (affiliation unknown) suggested that a franchisor be limited to earnings claims that “reasonably relates to the particular chain (or at least industry sector) being sold by that franchise salesman.”

On the other side of the ledger, franchisor Cendant Corporation observed that the financial disclosure requirement of Item 19 could be interpreted to cover financial information contained in public statements or interviews by company executives. By their very nature, these interviews “are often vague and indefinite; essentially advertising promised actions in the future or mere opinion,” Cendant VP of Federal Government Relations Kimberly Hunter-Turner wrote. She continued, calling those statements “mere … puffery,” and thus said they should be disqualified as “clear and unequivocal terms and promises made to a specific prospective franchisee.” Hunter-Turner suggested that FTC differentiate between general public statements and specific promises made to influence a prospective franchisee's decision to invest. Comments from Kaufmann Feiner and several other law firms made the same point.

Jenkens & Gilchrist offered revised language that would make it clear that franchisors are not liable for immediately sharing with a prospective franchisee every piece of information they receive on a daily basis through automated reporting systems, but that franchisors must share relevant information in a timely manner.

Integration Clauses

The ability of franchisors to disclaim, by the use of integration clauses and signed waivers, oral promises made by “rogue salespersons” or inaccurate written information has long been a thorn in the side of franchisee advocates and attorneys. Not surprisingly, it was the second-most addressed part of the proposed Rule. The FTC's proposal would create some limits on franchisors' use of integration clauses.

The State Bar of California noted a general concern that even the limited restrictions on integration clauses proposed by the FTC could result in longer UFOCs with “more legalese” because franchisors will try to cover every eventuality in what could be a decades-long relationship with a franchisee.

The California Bar and the Sonnenschein, Nath & Rosenthal LLP (Chicago) made a similar point that the FTC already has authority to sue when a franchisor makes fraudulent statements in a disclosure document. Imposing regulatory-based restrictions could be viewed as “an attempt to legislate a change in common law,” the law firm wrote.

Two commenters pointed to New York State's franchise law as a model for holding franchisors responsible for fraudulent actions by their salespeople, while remaining within the confines of current disclaimer rules.

But franchisee advocates stood staunchly at the opposite end of the room. They argued that the proposed restrictions are far too weak. “Claims in a brochure designed and intended to promote franchise sales should not be overridden by language buried somewhere in a 100-page disclosure document,” wrote Bruce Napell and Peter Singler, The Law Office of Peter A. Singler (Sebatstopol, CA). “Permitting integration clauses which invest with the force of law the false statement that that the franchisee limited its reliance to the disclosure documents undermines both the reliability and the integrity of the required disclosures.”

Haff & Associates described the disclaimers as “the final nail in the coffin” for inexperienced franchisees. Taken to its extreme, a franchisor could claim (even in a printed sales brochure) that each franchise grosses $2 million in annual revenue, and the owner earns $200,000/year, then disclaim it in fine print, wrote Jeffrey Haff.

AFA made a similar point about real-world conditions, as compared to an idealized world envisioned in the staff report: “The prevalent use by many franchisors 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-sales process by ensuring franchisees have truthful and accurate information from which to make sound investment decisions.”

Initial Fees

Many comments zeroed in on fee and cost disclosures in Item 7 of the UFOC. Franchisee advocates noted that disclosure of initial fees might significantly understate the total investment the franchisee will face, but franchisors noted that requiring broader disclosure would leave franchisors with an impossible task of anticipating a wide range of expenditures over which it has no influence.

Jenkens & Gilchrist and Dorsey & Whitney, as well as several franchisors, cited the impracticality of universal fee disclosure. Costs that a franchisee would incur to operate many businesses, not the unique franchise (office supplies, for example) do not belong in Item 7, they argued. The International Franchise Association made the additional point that some third-party costs are unknown to the franchisor, which the FTC had acknowledged in the Staff Report.

John M. Tifford, writing on behalf of Piper Rudnick LLP, offered language that might address some of the issues: “In addition to the above-listed ongoing fees which you must pay to us and/or our affiliates, you will need to secure goods and services on an ongoing basis from many other suppliers. We urge you to carefully review with your business advisors the number, nature, and estimated amount … ”

Gust Rosenfeld P.L.C.'s (Phoenix) solution is that disclosure should be required for payments “made by a franchisee directly to a third party in satisfaction of what otherwise would be a payment obligation on the franchisor or its affiliate.” Examples would include: suppliers that a franchisor dictates a franchisee must use; mandated upgrades and remodeling; and cooperative advertising. Language offered by The State Bar of California would take a similar route to make explicit when the franchisor does require the franchisee to make some types of payments to third parties, and the formula for calculating those fees.

Bundy & Morrill P.S.'s suggestion: “Disclose the total amount (in a range, if appropriate) of all obligations to third parties during the initial term of the franchise that will be necessary to operate the franchise business (including real estate leases and equipment leases) that the franchisee may be required to personally guaranty.”

Brokers

Franchise brokers' allegiances can be unclear to prospective franchisees, and so the FTC's willingness to shed more light on brokers is considered important. In general, franchisors pointed out the difficulty of listing all potential sales representatives in the UFOC, but they did not raise major objections to the proposed rule. Franchisors and franchisees mostly offered technical clarifications about the details of disclosure.

One of the few stronger suggestions came from Michael Seid, Michael Seid & Associates (West Hartford, CT), a consultant to franchisors and large franchisees. “The existing Rule has been flawed for a number of years as it only required disclosure at the first personal meeting,” he wrote. The FTC ignores the reality that brokers meet prospects by phone or e-mail first, and that the person might already be “sold” on the franchise before the face-to-face meeting that triggers the disclosure requirement. Seid recommended disclosure “at the commencement of any active relationship between the broker and the prospective franchisee.”

The State Bar of California

The Association commented that newcomers to the industry often confuse brokers and subfranchisors. The Bar recommended that subfranchisors be defined directly in the UFOC, not in guidance documents.

Franchisee Associations

FTC's proposed new requirement for franchisors to disclose the existence and contact information for independent associations of the systems' franchisees was well-received. Many commenters supported the idea, and no commenters opposed it.

Several franchisee representatives proposed to strengthen the new rule. Robert L. Purvin, Jr., chairman of the American Association of Franchisees & Dealers (AAFD), was one of at least six commenters who suggested that FTC drop the requirement that the association of franchisees be incorporated. Purvin, Robert Taylor, chief of the Franchise Bureau, and the Illinois AG pointed out that a franchisee association does not have to be incorporated to serve a legitimate purpose. Purvin cited his own group, AAFD, as an example; AAFD is a trust that has “chapters” created from groups of franchisees of a single franchisor.

AFA was one of several groups that told FTC to modify or eliminate a possible disclaimer about franchisee associations. AFA pointed out that the second sentence of the disclaimer (see below) seriously undermines the credibility of the independent franchisee associations:

“The following independent franchisee organizations have asked to be included in this disclosure document. We do not endorse these organizations and their members may not represent all franchisees in the [name of franchisor] franchised system.”

Litigation

In general, the disclosure rules about litigation were well-received. Several commenters supported the FTC's “compromise” about obligations by franchisors to list lawsuits going back 1 year, though the Illinois AG suggested that litigation updates could be made more frequently, akin to the rules for financial updates. NASAA sought more, and lobbied for a broad inclusion of litigation and bankruptcy “of any person, or entity, whether a parent or affiliate, who guarantees the franchisor's performance.”

Franchisors pointed out that the litigation disclosure rules could be made less burdensome on franchisors and could give franchisees' more attention to the most relevant litigation. Cendant Corp noted that the Rule should not require disclosure of “nuisance” litigation that often is levied against large, public companies, and is not “material” to how an individual franchisee would fare. The International Franchise Association questioned the value of including litigation filed against a parent company of a franchisor, noting that this could exponentially increase the disclosures without providing information directly relevant to how a particular franchise can be expected to perform. Several franchisor attorneys echoed these points.

In commenting on parent litigation, Sonnenschein Nath noted that the parent's financial information, disclosed elsewhere in the UFOC, would give a franchisee sufficient information about the likely ability of the franchisor to meet its obligations, including the impact of adverse litigation.

Gust Rosenfeld suggested that FTC make it clear that franchisors are not required to seek out every piece of potential litigation that has been filed but not yet served.

Robert S. Burstein, writing comments for Wiggin and Dana (Conshohocken, PA), offered several ways adjustments to how litigation information is shown in the UFOC that would be clearer and would avoid double-counting.

Furnishing Documents

In general, the FTC received compliments for its expansion of ways that franchisors can provide documents to franchisees. One commenter suggested that the new delivery rules be made national so that state preemptions do not create confusion.

Yet, Kaufmann Feiner noted that the allowance for all-electronic dissemination of disclosure materials could be interpreted otherwise. The firm suggested clarification that franchisors “can communicate its disclosure format information in any fashion and at any time prior to furnishing the document that it chooses.”

Several commenters pointed out issues that can arise when documents are changed and must be reissued for a franchisee review period. Gust Rosenfeld would expand some franchisors' obligations to include “any related agreements,” not just the UFOC, when the franchisor unilaterally makes changes to a document. These would be for furnishing revised UFOCs and documents at least 7 days in advance of a franchisee signing them (not the 14 days' “cooling off period” after the provision of the UFOC itself).

Jenkens & Gilchrist pointed out that FTC perhaps left too much leeway about what can be changed in a document without triggering the requirement that a new one be furnished for a 7-day review. The FTC states that “fill-in the blank” provisions do not trigger the requirement for a new document. But Jenkens & Gilchrist noted that those fill-ins sometimes include very important items, such as a franchisee's geographic area, or even the initial fee. These should obviously trigger a new document.

Marriott International wrote that it “strongly supports” the FTC's position that franchisee-initiated changes to a UFOC do not re-trigger the disclosure period. It asks for more clarification that a negotiation that changes terms to benefit both parties, but was initiated by the franchisee, does not require the 7-day waiting period.

A comment submitted by the Sonnenschein Nath touched on the same issue, noting that negotiations, regardless of who initiates them, are “give and take.” The firm wrote that the issue could largely be solved by striking the word “solely” from that part of the Rule.

As a separate issue, franchisors asked for clarification on when a prospective franchisee that requests disclosure documents must really be considered a legitimate prospect. Providing full documentation to casual inquirers is costly and should not be mandated, they wrote.

Confidentiality Clauses

Franchisee advocates have long criticized confidentiality clauses in UFOCs as overly broad, and they found some elements of the proposed revisions to their liking. AFA praised FTC's definition of what can be protected through a confidentiality clause, and commenters on both sides of the aisle agreed that franchisors have the right to protect their trademarks and other proprietary information through confidentiality agreements.

AFA, NASAA, and several individual law firms wrote that FTC should require ' rather than make voluntary, as has been proposed ' data on the number of franchisees who have signed confidentiality clauses in the previous 3 years.

Large-Investor Exemption

The large-investor exemption of $1 million was not controversial, although not universally praised, either. Most comments focused on clarifying the exemption, rather than changing it.

The International Franchise Association and Piper Rudnick asked what constitutes “real estate” for a large investor. Marriott International picked up on the same theme ' in Marriott's case suggesting that real estate or financing for real estate provided by the franchisor be included in the exemption calculation (it is excluded under the proposal as it is now written). Marriott suggested that FTC confirm that transfers of major properties (such as a Hilton Hotel becoming a Marriott) qualify for the exemption. Starwood Hotels sought the same exemption in its short comment.

The North American Automobile Dealers Association (NADA) and others proposed raising $1-million threshold or eliminating it altogether. NADA noted that automobile dealerships almost always exceed $1 million investments, but some investors are not necessarily sophisticated.

The State Bar of California said that clarification is needed on the time frame in which the $1 million is calculated ' is it startup of the franchise, or operation over a period of time? It recommends limiting the calculation it to the initial period, using language from Item 7.

Although the California State Bar's comments did not allude to the state's own large-investor policy, the law firm of Witmer, Karp & Warner said that the FTC should copy California's large-investor exemption rules, which require higher net worth and greater indication of business savvy.

State Preemption

State authorities weighed in on current and proposed rules regarding preemption. The Illinois AG asked that the proposed rule state very clearly that state laws might pre-empt some of the federal rules governing the UFOC. NASAA asked FTC to affirm in its compliance guides that states can require disclosure of additional risk factors and that these must be prominently disclosed on the cover sheet of the UFOC.

On the other hand, Sonnenschein Nath suggested relegating those state-mandated disclosures to exhibits attached to the UFOC, rather than as part of it. The law firm said it would represent a significant cost savings for national franchisors.

Bundy & Morrill made the biggest push for state exemption recognition. Howard Bundy recommended that the FTC create a 24th Item in the UFOC (though he said it should be shown as Item 23). He called the new Item 23 “Uniform Disclosures Required by State Law,” and said it would enable franchisors to comply with the disclosures in individual states without having to create as many unique UFOCs.

Threshold for Payment

The current Franchise Rule exempts franchise arrangements that cost less than $500 initially. FTC is not proposing to change that threshold, but it is proposing to include new language that considers not only the $500 payment in the first 6 months of an agreement, but also financial commitments made during those 6 months.

Bruce McDiarimid, Pillsbury Winthrop LLP (San Francisco), used an example of how this new language would suddenly bring one of his clients, a microbrewery, under coverage of the law. McDiarimid said that the revision would contradict several guidance letters from FTC, and he suggested that the change be withdrawn.

Commenter David Gurnick of Lewick, Hackman, Shapiro, Marshall & Harlan (Encino, CA) calculated that the threshold should be raised to $1300, to reflect the level of inflation since the threshold was set in 1979. He suggested that $1000 would be an acceptable compromise, plus automatic adjustments based on the Consumer Price Index.

Franchisee-Franchisor Relations: Territorial Protection & Renewals

Although the FTC and the UFOC do not address many post-sale issues, some very important areas are affected by the proposed rules. At or near the top of the list are the scope of what is meant by “exclusive territories” and the rights of a franchisor to renew a franchisee's contract. The FTC's proposed language in these two areas drew some attention.

Gust Rosenfeld pointed out that the language in Item 12 about exclusive territories does not reflect the real-world conditions of multiple channel sales. The firm suggested new UFOC language: “You will not receive an exclusive territory. You may face competition from us or from other franchisees in your area, or from other channels of distribution or competitive brands that we control.”

Bundy & Morrill, too, aim at the FTC's renewal language. The firm wrote that “there is a wide disconnect between what franchisees believe and understand based on the word 'renew' and what franchisors mean when they promise 'renewal' under certain conditions.” To try to get ahead of this issue ' which Howard Bundy predicted will be the basis for huge amounts of litigation in the next 5 years ' Bundy suggested stating in the UFOC that franchisors are not giving franchisees the right to renew contracts on the same terms as are in the UFOC that they are signing.

Sonnenschein Nath proposed this language to address the same issue: “The franchise agreement does not give you the option to continue the relationship when the term expires. Upon expiration, we may decide whether we want to continue the relationship with you and, if we do, the terms and conditions of our relationship going forward.”

Next month, we will look at some of the more general issues that were identified by commenters, such as the proposed elimination of the exclusion for purchasing cooperatives, the lack of a private right of action, arbitration provisions, and the alleged potential of the disclosures in UFOCs to aid terrorists.