An Overview of the New FTC Rule

By Kenneth R. Costello
February 28, 2007

On Jan. 22, 2007, after more than a decade of study, the FTC released its long-anticipated new Federal Trade Commission Rule on Franchising (the 'New Rule'). The New Rule comes into effect on a voluntary basis on July 1, 2007, with compliance becoming mandatory on July 1, 2008. Additional compliance guides are expected by July 1, 2007. 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.

This article outlines the key elements of the New Rule. The New Rule changes the coverage of the existing FTC Rule, including the following:

1) It applies only to franchises for locations in the United States, or its territories.

2) It no longer covers 'business opportunities.'

3) It retains exemptions for franchise fees under $500, 'fractional franchises,' 'leased departments,' and 'oral franchises,' and codifies exemptions for franchises governed by the Petroleum Marketing Practices Act.

4) It deletes 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).

5) It adds several new exemptions for: a) franchises requiring an investment exceeding $1 million, excluding unimproved land and amounts financed by the franchisor or its affiliate; b) franchises sold to a franchisee that is five 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 New Rule will change the timing of franchisor presale disclosures. An extensive discussion of this area can be found on page 5 of this issue of FBLA, but the highlights are:

1) The franchisor no longer must deliver the Uniform Franchise Offering Circular ('UFOC') at the 'first personal meeting' (first face-to-face meeting) with the prospective franchisee.

2) Franchisors must deliver the UFOC 14 calendar days (rather than 10 business days) before the franchisee signs any franchise or other binding agreement with, or pays any consideration to, the franchisor or any affiliate, or earlier upon a prospect's reasonable request.

3) Franchisors must deliver execution-ready copies of the UFOC and all other related agreements seven calendar days (rather than five business days) before they are executed. This waiting period applies only if the franchisor unilaterally (i.e., not in response to franchisee-initiated negotiations) makes material changes to the terms of the basic franchise agreement attached to the UFOC.

The New Rule changes the updating requirements as follows:

1) Annual updates must be made within 120 (rather than 90) days after the franchisor's fiscal year end.

2) The New Rule retains quarterly UFOC updates for material changes, but now requires notice to the franchisee (but not an amended UFOC) of any material changes to any financial performance representations (i.e., Item 19 earnings claims) about which the franchisor knows or should have known.

3) The New Rule prohibits waivers of any representation in the UFOC, but expressly permits negotiated changes.

4) The New Rule will allow the UFOC and contracts to be delivered either by paper or electronically via the Internet, e-mail, computer disks, or compact discs, 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 New Rule, the FTC has abandoned its rarely used disclosure format and has adopted the 1993 UFOC Guidelines developed by the North American Securities Administrators Association ('NASAA'), with 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. (Items with no substantive changes are omitted.)

The Cover Page

1) The UFOC will now be titled a 'Franchise Disclosure Document' rather than an 'offering circular.'

2) Risk factors will be included only if required under state law.

3) 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 (e.g., in writing or electronically).

Item 1: The Franchisor, and Any Parents, Predecessors, and Affiliates

1) Must identify franchisor's direct and indirect parent companies.

2) 'Subfranchisor' definition is expanded.

Item 2: Business Experience

1) Broker disclosures are omitted. This will make it much easier to engage outside brokers, but it remains to be seen whether states will agree.

2) Now covers all others with management responsibility (not just 'executives') relating to the sale or operation of the offered franchises.

Item 3: Litigation

1) Expands the scope of litigation disclosures to include a parent or affiliate who induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor's performance.

2) Adds required disclosure of franchisor-initiated lawsuits against franchisees during the last fiscal year on issues involving the franchise relationship.

Item 4: Bankruptcy

1) Expands bankruptcy disclosures by including a franchisor's parent and any other individual who will have management responsibility relating to the sale or operation of the franchise.

Item 8: Restrictions on Sources of Products and Services

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

Item 10: Financing

1) Removes requirement that the annual percentage rate disclosed be computed as provided by the Consumer Protection Credit Act. Now the rate of interest, plus finance charges, must be expressed on an annual basis.

Item 11: Franchisor's Obligations

1) Title changed to 'Franchisor's Assistance, Advertising, Computer Systems, and Training.'

2) Franchisors will welcome the reduction in the level of detail required to be disclosed about computer hardware, software, and point-of-sale systems to a more general description.

Item 12: Territory

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

Item 13: Trademarks

1) 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

1) 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.

2) 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

1) 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 (i.e., not business entities).

2) The New Rule requires disclosure only of obligations to participate personally in the direct operation of the business, whereas for the current UFOC, the NASAA commentaries require disclosure of all agreements that are binding on the franchisee's owners.

Item 17: Renewal, Termination, Transfer and Dispute Resolution

1) Title changed to 'The Franchise Relationship.'

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

Item 19: Earnings Claims

1) Title changed to 'Financial Performance Representations.'

2) 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.

3) Cost and expense information is no longer considered an earnings claim.

4) 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).

5) 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 three years.

Item 20: List of Outlets

1) Title changed to 'Outlets and Franchisee Information.'

2) Changes the form and content of the tables used in presenting franchisee- and franchisor-owned outlets statistics. This will require franchisors, particularly large franchisors, to devote a substantial amount of attention to reviewing the comings and goings of franchisees in recent years to conform the data to the new disclosure format.

3) Addresses current 'double counting' problem by requiring that if a single outlet has changed ownership two or more times during the same fiscal year, the UFOC must describe the types of changes involved and the order in which the changes occurred (with explanatory footnotes of the types and sequence of events).

4) When selling a formerly franchised outlet now under franchisor control, the franchisor must disclose specified information for the prior five fiscal years in a UFOC addendum or supplement (where UFOC already delivered), including city, state, and current business phone or, if unknown, last known home phone, and the time period each person (including the franchisor) owned it and the reason for each ownership change.

5) Adds required disclosure of 'Confidentiality Agreements' signed by franchisees during the franchisor's last three fiscal years that restrict them from discussing their personal experiences with the franchisor.

6) Adds new required disclosure of trademark-specific franchisee associations (e.g., 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 60 days after the franchisor's fiscal year end). It can be expected that prospective franchisees will contact such associations as part of their presale investigation, and it will be interesting to see how this may affect franchise sales for systems with rancorous franchisee associations.

7) Prohibits using phony references or 'shills.'

Item 21: Financial Statements

1) Audited financials must be prepared in accordance with GAAP and U.S. auditing standards, or as permitted by the SEC, and as revised by governmental mandate.

2) Must include separate audited financial statements for any subfranchisor, as well as for any parent that guarantees or commits to perform the franchisor's post-sale 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.

3) 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 23: Receipts

1) Modified to reflect the revised disclosure timing requirements discussed above.

2) Must include the name, address, and telephone number of each 'franchise seller' offering the franchise (fill in the blank for each transaction). 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.'

Kenneth R. Costello is a partner in the Los Angeles office of Bryan Cave LLP, a full-service international law firm. He can be contacted at 310-576-2100 or [email protected].