Conference Review: Implementation of FTC Franchise Rule Draws Significant Attention at IFA Legal Symposium

Allowance for electronic disclosures to franchise prospects is the most prominent embrace of new technology, and panelists agreed that this will be beneficial to franchisors and franchisees. Electronic disclosure, in combination with elimination of the obligation to provide disclosure to a prospect at the first personal meeting, will generate significant savings for many franchisors, noted Buckberg, while the 'enhanced recordkeeping ' more nuances and supplemental information' will provide genuine prospects with more data to make an informed decision.

Key Issues

For franchise attorneys, the most important issue today is whether states with unique franchise laws will wholly adopt the federal rules or will retain their different requirements, thus perpetuating a two-tiered system in 'registration states.' The Franchise Rule requires the FTC to work with the states, through the North American Securities Administrators Association ('NASAA'), to try to produce a consensus and to minimize differences, noted Toporoff.

'We are still waiting for ' information about state harmonization with the Rule,' said Buckberg. 'At this time, it is not clear if we will have a national rule and a few state variations, or if we will still have 14 state registration requirements.'

Dale Cantone, who is an assistant attorney general in the Maryland Attorney General's Office, Division of Securities, and also the chair of NASAA's Franchise and Business Opportunity Project Group, assured conference attendees that NASAA members support the updated disclosure documents and rules. 'The new UFOC is better. We [NASAA] want states to use it. We hope states will adopt the new guidelines by July 1, 2008; this is why NASAA is moving more quickly than we typically do, so we can avoid a fight over pre-emption,' he said.

'I'm not aware of any state that's planning not to adopt the new Rule,' added Bob Tingler, franchise bureau chief, Illinois Attorney General's Office. Illinois is a registration state.

NASAA has prepared draft interim guidelines for franchisors that wish to file state registrations under the updated Rule after July 1, 2007, and it is encouraging states to allow use of the updated Rule during the transition period. The interim guidelines address both the concepts in the updated Rule that might conflict with state registration requirements, as well as offer a model cover page that can accompany disclosure documents during the transition year. 'There's not much that is different from the model cover pages on state disclosures that are currently in use,' said Cantone.

Comments on the draft NASAA guidelines were due by May 23, and NASAA's Franchise and Business Opportunity Project Group will meet in June to try to finalize the guidelines.

Facing a tight timetable to harmonize their laws with the updated Franchise Rule, states are willing to accommodate franchisors. For example, Tingler told a questioner at the IFA symposium that a franchisor can continue to sell new units in Illinois while filing either the old or the new franchise disclosure form. 'We will treat an application under the new Rule as a renewal, not a new franchise,' he said. 'If you are confident that your UFOC and your system complies with the new Rule, then you are welcome to use it.'

However, franchise attorneys on the discussion panels advised franchisors that surprises and delays will inevitably occur, and they urged franchisors to make sure they are cognizant of how each state will operate during the transition year. 'If I'm an existing franchisor, I would want others to test it first, and also to see the work product that my colleagues are doing,' said Barkoff. And Buckberg noted that even if a franchisor can revise its disclosure materials quickly, it will need time to educate its managers and staff throughout its system, so taking a go-slow approach might be more practical.

Yet, David Kaufmann, partner, Kaufmann, Feiner, Yamin, Gildin & Robbins (New York), suggested an alternative viewpoint in another panel discussion. Kaufmann advised franchisors not to wait until the traditional franchise renewal season of February to May because so many applications will be coming at that time, and examiners will be unfamiliar with them. If a franchisor's registration expires during a long examination process, it could be prohibited from selling franchises in a particular state until the documents are cleared, Kaufmann warned.

Tingler confirmed that state examiners are likely to have difficulty processing registrations quickly under the amended Rule, and delays or requests for greater-than-normal modifications to registrations could ensue.

Federal-State Rules Conflict

While the updated Rule and NASAA's discussions will undoubtedly reduce conflict between federal and state franchise laws, a few divergences might remain, including disclosure of brokers and the requirement of a disclosure on a first personal meeting.

Three states require registration of franchise brokers today, and Tingler said that he expects Illinois will retain its requirement. Cantone said that NASAA does not support broker disclosures in the UFOC, at present, though its stance is not binding on its members.

Regardless, brokers will not be allowed to run wild under the amended Rule. 'Keep in mind that brokers are covered by the Franchise Rule ' and as 'seller' must be listed in Item 23,' added Toporoff. 'They can't misrepresent ' and any number of the Rule's prohibitions apply to them. This is more important, from the FTC's perspective, than having them disclose in Item 2 on the UFOC, for example. We focus on their behavior.'

The new rule that prospects must be provided with disclosure documents 14 calendar days before signing a contract provides a 'bright-line' that is welcomed by franchisors and regulators alike. However, some confusion remains among franchise attorneys about the exception that requires immediate disclosure if based on 'reasonable request' by a prospect. Toporoff explained that 'reasonable' reflects a prospect who is already in the sales process, in contrast to a person who has merely made an inquiry. 'Time does not necessarily mean right now; we understand that a franchise representative might not have a UFOC on CD-Rom that's immediately available. But the document could be provided electronically on the next day,' said Toporoff.

Cantone added that state laws that require provision of the disclosure document on the first personal meeting have not been pre-empted by the updated Franchise Rule. 'NASAA may do away with the first personal meeting disclosure, but [state regulators on the NASAA committee] would have to consider why uniformity provides more consumer protection than the present system. However, we have agreed to consider it,' Cantone said.

Compliance During the Transition Year

Numerous franchise attorneys asked regulators about what is permitted during the transition period before the new disclosure document and procedures are mandatory on July 1, 2008. 'Come July 1, 2007, the updated Rule does not compel any franchisor to do anything different. And on July 1, 2008, you need to be completely into the new format,' said Toporoff. 'During the transition year, you cannot mix-and-match.'

Kaufmann noted that the one exception to Toporoff's declaration actually works in franchisors' favor. 'You can engage in electronic disclosure [with prospective franchisees] even without using the rest of the new Rule,' Kaufmann said. 'This is very useful.'

In citing how the transition period will work, Toporoff used the example of franchisors seeking to use one of the 'sophisticated investor' exemptions in the updated Rule. To use one of these exemptions, a franchisor would have to comply with the new Rule in its entirety at the time, Toporoff explained. One franchise attorney observed in response that his client faces a potential conflict, because if it adopts the new Rule in order to use a sophisticated investor exemption, its registration in the state where the investor is located might not be valid. Tingler and Cantone said that the situation described is exactly what NASAA is trying to resolve in the next month or two.

On the other hand, Kaufmann suggested that as the industry adapts to the updated Rule, many of these issues might become moot. 'Given the ease of disclosure under the updated Rule and its utility in [defending against] litigation, many large franchisors are deciding to disclose to every prospect anyway, despite the large franchisee exemption,' he said.

Kaufmann reiterated the benefits of planning now for the transition to the new required disclosure document and of being an early adopter. 'Most franchisors will probably wait until the spring ' but there will be a long line of others doing the same thing,' he warned.

Among the numerous actions that franchisors and counsel can take to prepare for filing under the amended Rule, Kaufmann recommended:

• Watching whether states deviate from the federal rules about matters such as cost disclosures (the updated Rule states that identifying a franchisee's costs of operation will not trigger mandatory financial performance disclosures);
• Preparing a list of all material litigation initiated by a franchisor against franchisees in the past year, which must be provided in the new disclosure documents;
• Considering how to best utilize the allowance for offering segmented financial performance information in Item 19;
• Being ready for requests by any independent franchisee association that wishes to have its contact information included in Item 20; and
• Developing electronic disclosure platforms that are convenient, cost-effective, and comply with regulations for confirmation of receipt by franchise prospects.

Kevin Adler is associate editor of this publication. He can be contacted at [email protected] or 301-270-2839.

With optional use of the updated Franchise Rule coming on July 1, 2007, and mandatory use beginning on July 1, 2008, the broad outlines of the Rule are well understood in the franchise industry even at this early point. Yet, as franchise attorneys work with individual clients, they are finding unique circumstances under which the Rule's guidance is confusing or even contradictory, particularly during the one-year transition period. Thus, two panel discussions at the International Franchise Association ('IFA') Legal Symposium on May 6-8 in Washington, DC, were the ideal opportunities for attorneys to raise what-if questions with regulators and their fellow franchise attorneys.

Franchise attorneys who see the changes in the Franchise Rule as incremental are interpreting it correctly, said Stephen Toporoff, franchise program coordinator for the FTC's Bureau of Consumer Protection. Speaking on both panels, Toporoff said the rule revision had four 'modest' goals:

• Reduce inconsistency between federal and state franchise laws;
• Reduce compliance costs for franchisors 'where warranted';
• Clarify for franchisees their relationships with franchisors; and
• Reflect technological innovation.

Consensus among panelists at the IFA Legal Symposium is that those goals were met, and compliance will become easier and less costly for franchisors as a result. 'The FTC did a great job assembling input from experts in the industry, representing franchisors and franchisees,' said Joel Buckberg, of Baker, Donelson, Bearman, Caldwell & Berkowitz, PC (Nashville), a panelist at the conference. 'It's a dynamic marketplace, and franchisees are better educated and better able to negotiate in their interests ' and the FTC deserves credit for realizing it.'

'I don't see major changes for practitioners arising from the updated Franchise Rule,' said Rupert Barkoff, partner, Kilpatrick Stockton LLP (Atlanta). 'But it was a very important exercise [for the FTC] to sit down and review the Rule in light of changes in technology and the franchise industry.'

Allowance for electronic disclosures to franchise prospects is the most prominent embrace of new technology, and panelists agreed that this will be beneficial to franchisors and franchisees. Electronic disclosure, in combination with elimination of the obligation to provide disclosure to a prospect at the first personal meeting, will generate significant savings for many franchisors, noted Buckberg, while the 'enhanced recordkeeping ' more nuances and supplemental information' will provide genuine prospects with more data to make an informed decision.

Key Issues

For franchise attorneys, the most important issue today is whether states with unique franchise laws will wholly adopt the federal rules or will retain their different requirements, thus perpetuating a two-tiered system in 'registration states.' The Franchise Rule requires the FTC to work with the states, through the North American Securities Administrators Association ('NASAA'), to try to produce a consensus and to minimize differences, noted Toporoff.

'We are still waiting for ' information about state harmonization with the Rule,' said Buckberg. 'At this time, it is not clear if we will have a national rule and a few state variations, or if we will still have 14 state registration requirements.'

Dale Cantone, who is an assistant attorney general in the Maryland Attorney General's Office, Division of Securities, and also the chair of NASAA's Franchise and Business Opportunity Project Group, assured conference attendees that NASAA members support the updated disclosure documents and rules. 'The new UFOC is better. We [NASAA] want states to use it. We hope states will adopt the new guidelines by July 1, 2008; this is why NASAA is moving more quickly than we typically do, so we can avoid a fight over pre-emption,' he said.

'I'm not aware of any state that's planning not to adopt the new Rule,' added Bob Tingler, franchise bureau chief, Illinois Attorney General's Office. Illinois is a registration state.

NASAA has prepared draft interim guidelines for franchisors that wish to file state registrations under the updated Rule after July 1, 2007, and it is encouraging states to allow use of the updated Rule during the transition period. The interim guidelines address both the concepts in the updated Rule that might conflict with state registration requirements, as well as offer a model cover page that can accompany disclosure documents during the transition year. 'There's not much that is different from the model cover pages on state disclosures that are currently in use,' said Cantone.

Comments on the draft NASAA guidelines were due by May 23, and NASAA's Franchise and Business Opportunity Project Group will meet in June to try to finalize the guidelines.

Facing a tight timetable to harmonize their laws with the updated Franchise Rule, states are willing to accommodate franchisors. For example, Tingler told a questioner at the IFA symposium that a franchisor can continue to sell new units in Illinois while filing either the old or the new franchise disclosure form. 'We will treat an application under the new Rule as a renewal, not a new franchise,' he said. 'If you are confident that your UFOC and your system complies with the new Rule, then you are welcome to use it.'

However, franchise attorneys on the discussion panels advised franchisors that surprises and delays will inevitably occur, and they urged franchisors to make sure they are cognizant of how each state will operate during the transition year. 'If I'm an existing franchisor, I would want others to test it first, and also to see the work product that my colleagues are doing,' said Barkoff. And Buckberg noted that even if a franchisor can revise its disclosure materials quickly, it will need time to educate its managers and staff throughout its system, so taking a go-slow approach might be more practical.

Yet, David Kaufmann, partner, Kaufmann, Feiner, Yamin, Gildin & Robbins (New York), suggested an alternative viewpoint in another panel discussion. Kaufmann advised franchisors not to wait until the traditional franchise renewal season of February to May because so many applications will be coming at that time, and examiners will be unfamiliar with them. If a franchisor's registration expires during a long examination process, it could be prohibited from selling franchises in a particular state until the documents are cleared, Kaufmann warned.

Tingler confirmed that state examiners are likely to have difficulty processing registrations quickly under the amended Rule, and delays or requests for greater-than-normal modifications to registrations could ensue.

Federal-State Rules Conflict

While the updated Rule and NASAA's discussions will undoubtedly reduce conflict between federal and state franchise laws, a few divergences might remain, including disclosure of brokers and the requirement of a disclosure on a first personal meeting.

Three states require registration of franchise brokers today, and Tingler said that he expects Illinois will retain its requirement. Cantone said that NASAA does not support broker disclosures in the UFOC, at present, though its stance is not binding on its members.

Regardless, brokers will not be allowed to run wild under the amended Rule. 'Keep in mind that brokers are covered by the Franchise Rule ' and as 'seller' must be listed in Item 23,' added Toporoff. 'They can't misrepresent ' and any number of the Rule's prohibitions apply to them. This is more important, from the FTC's perspective, than having them disclose in Item 2 on the UFOC, for example. We focus on their behavior.'

The new rule that prospects must be provided with disclosure documents 14 calendar days before signing a contract provides a 'bright-line' that is welcomed by franchisors and regulators alike. However, some confusion remains among franchise attorneys about the exception that requires immediate disclosure if based on 'reasonable request' by a prospect. Toporoff explained that 'reasonable' reflects a prospect who is already in the sales process, in contrast to a person who has merely made an inquiry. 'Time does not necessarily mean right now; we understand that a franchise representative might not have a UFOC on CD-Rom that's immediately available. But the document could be provided electronically on the next day,' said Toporoff.

Cantone added that state laws that require provision of the disclosure document on the first personal meeting have not been pre-empted by the updated Franchise Rule. 'NASAA may do away with the first personal meeting disclosure, but [state regulators on the NASAA committee] would have to consider why uniformity provides more consumer protection than the present system. However, we have agreed to consider it,' Cantone said.

Compliance During the Transition Year

Numerous franchise attorneys asked regulators about what is permitted during the transition period before the new disclosure document and procedures are mandatory on July 1, 2008. 'Come July 1, 2007, the updated Rule does not compel any franchisor to do anything different. And on July 1, 2008, you need to be completely into the new format,' said Toporoff. 'During the transition year, you cannot mix-and-match.'

Kaufmann noted that the one exception to Toporoff's declaration actually works in franchisors' favor. 'You can engage in electronic disclosure [with prospective franchisees] even without using the rest of the new Rule,' Kaufmann said. 'This is very useful.'

In citing how the transition period will work, Toporoff used the example of franchisors seeking to use one of the 'sophisticated investor' exemptions in the updated Rule. To use one of these exemptions, a franchisor would have to comply with the new Rule in its entirety at the time, Toporoff explained. One franchise attorney observed in response that his client faces a potential conflict, because if it adopts the new Rule in order to use a sophisticated investor exemption, its registration in the state where the investor is located might not be valid. Tingler and Cantone said that the situation described is exactly what NASAA is trying to resolve in the next month or two.

On the other hand, Kaufmann suggested that as the industry adapts to the updated Rule, many of these issues might become moot. 'Given the ease of disclosure under the updated Rule and its utility in [defending against] litigation, many large franchisors are deciding to disclose to every prospect anyway, despite the large franchisee exemption,' he said.

Kaufmann reiterated the benefits of planning now for the transition to the new required disclosure document and of being an early adopter. 'Most franchisors will probably wait until the spring ' but there will be a long line of others doing the same thing,' he warned.

Among the numerous actions that franchisors and counsel can take to prepare for filing under the amended Rule, Kaufmann recommended:

• Watching whether states deviate from the federal rules about matters such as cost disclosures (the updated Rule states that identifying a franchisee's costs of operation will not trigger mandatory financial performance disclosures);
• Preparing a list of all material litigation initiated by a franchisor against franchisees in the past year, which must be provided in the new disclosure documents;
• Considering how to best utilize the allowance for offering segmented financial performance information in Item 19;
• Being ready for requests by any independent franchisee association that wishes to have its contact information included in Item 20; and
• Developing electronic disclosure platforms that are convenient, cost-effective, and comply with regulations for confirmation of receipt by franchise prospects.

Kevin Adler is associate editor of this publication. He can be contacted at [email protected] or 301-270-2839.