Exemptions and Prohibitions in the New Franchise Rule

The New Franchise Rule deletes the four exclusions in the existing Rule for employer-employees and general partnerships, cooperative organizations, testing or certification services, and single trademark licenses, since a revised definition of 'franchise' in the Rule obviates the need for these exclusions. The New Rule retains the exemption for franchise sales under $500, fractional franchises, and leased departments, while adding an exemption for petroleum marketers governed by the Petroleum Marketing Practices Act, as well as for three categories of 'sophisticated investor.'

The 'sophisticated investor' exemptions eliminate disclosure obligations to persons who can, it is assumed, take care of themselves without government assistance. The first exemption applies to a franchise where a large investment is required. Exempt are transactions in which the prospective franchisee makes an initial investment of at least $1 million, excluding the cost of unimproved land and funds provided by the franchisor or its affiliates. The total initial investment in a multi-unit franchise is used in determining the required amount. The franchisee must sign
an acknowledgment certifying the investment will exceed $1 million and that the franchisee is aware of the Rule and knows that making an investment in that amount and signing the acknowledgment exempts the transaction from the Rule. If a franchisee-entity has more than one investor, the exemption will apply only if at least one individual invests more than $1 million in the project. A group of investors contributing less than $1 million each does not satisfy the exemption's requirements. If a conversion franchise is involved, the initial investment in the unit or units being converted can satisfy the $1 million threshold. For a franchise transfer, the amount of the sale is used to determine the investment for purposes of the exemption.

Another exemption exists under the New Rule for sales to large franchisee entities. This exemption depends both on a prospective franchisee's prior experience and net worth. The prospective franchisee must have a net worth of at least $5 million and have been in business, any business, for at least five years. To qualify, the franchisee entity ' an individual can be an 'entity' under this exemption ' can consider the prior experience and net worth of its parent and affiliates. One assumes that if the 'entity' is an individual, the net worth and business experience of his or her natural parents do not qualify in determining the applicability of the exemption. The final sophisticated investor exemption removes from the New Rule sales to persons who own a majority interest in a franchise if they have been officers, owners, or managers of the business being franchised for at least two years prior to the sale and were so at least 60 days prior to the sale. This 'insiders' exemption applies only to a franchise of the company for which the concerned purchasers work. It does not apply to officers, owners, or managers of any other business, even if that business is similar to that being franchised.

The New Rule also contains several new prohibited practices, one of which prohibits a 'franchise seller' from disclaiming, or requiring a franchisee to waive, reliance on any representation made in the disclosure document or its exhibits. As such, the New Rule makes clear that an integration clause in a franchise agreement will not nullify representations in a disclosure document. This prohibition does not apply to waivers resulting from negotiations between a franchisor and franchisee. Another new prohibition forbids the use of shills, individual and institutional, to give false information to franchise prospects in furtherance of the franchise sale.

The New Rule contains many additional provisions, including many new and altered definitions, which are worthy of attention. It is yet to be seen whether the franchise registration/filing states will honor the FTC New Rule's exemptions and whether the states that regulate business opportunities will consider being exempt from the FTC New Rule the same as complying with the rule for purposes of business opportunity rule exemptions and exclusions.

Daryl A. Hart is a member of Bartko, Zankel, Tarrant & Miller in San Francisco. He can be reached by phone at 415-956-1900 or by e-mail at [email protected].

The New Franchise Rule deletes the four exclusions in the existing Rule for employer-employees and general partnerships, cooperative organizations, testing or certification services, and single trademark licenses, since a revised definition of 'franchise' in the Rule obviates the need for these exclusions. The New Rule retains the exemption for franchise sales under $500, fractional franchises, and leased departments, while adding an exemption for petroleum marketers governed by the Petroleum Marketing Practices Act, as well as for three categories of 'sophisticated investor.'

The 'sophisticated investor' exemptions eliminate disclosure obligations to persons who can, it is assumed, take care of themselves without government assistance. The first exemption applies to a franchise where a large investment is required. Exempt are transactions in which the prospective franchisee makes an initial investment of at least $1 million, excluding the cost of unimproved land and funds provided by the franchisor or its affiliates. The total initial investment in a multi-unit franchise is used in determining the required amount. The franchisee must sign
an acknowledgment certifying the investment will exceed $1 million and that the franchisee is aware of the Rule and knows that making an investment in that amount and signing the acknowledgment exempts the transaction from the Rule. If a franchisee-entity has more than one investor, the exemption will apply only if at least one individual invests more than $1 million in the project. A group of investors contributing less than $1 million each does not satisfy the exemption's requirements. If a conversion franchise is involved, the initial investment in the unit or units being converted can satisfy the $1 million threshold. For a franchise transfer, the amount of the sale is used to determine the investment for purposes of the exemption.

Another exemption exists under the New Rule for sales to large franchisee entities. This exemption depends both on a prospective franchisee's prior experience and net worth. The prospective franchisee must have a net worth of at least $5 million and have been in business, any business, for at least five years. To qualify, the franchisee entity ' an individual can be an 'entity' under this exemption ' can consider the prior experience and net worth of its parent and affiliates. One assumes that if the 'entity' is an individual, the net worth and business experience of his or her natural parents do not qualify in determining the applicability of the exemption. The final sophisticated investor exemption removes from the New Rule sales to persons who own a majority interest in a franchise if they have been officers, owners, or managers of the business being franchised for at least two years prior to the sale and were so at least 60 days prior to the sale. This 'insiders' exemption applies only to a franchise of the company for which the concerned purchasers work. It does not apply to officers, owners, or managers of any other business, even if that business is similar to that being franchised.

The New Rule also contains several new prohibited practices, one of which prohibits a 'franchise seller' from disclaiming, or requiring a franchisee to waive, reliance on any representation made in the disclosure document or its exhibits. As such, the New Rule makes clear that an integration clause in a franchise agreement will not nullify representations in a disclosure document. This prohibition does not apply to waivers resulting from negotiations between a franchisor and franchisee. Another new prohibition forbids the use of shills, individual and institutional, to give false information to franchise prospects in furtherance of the franchise sale.

The New Rule contains many additional provisions, including many new and altered definitions, which are worthy of attention. It is yet to be seen whether the franchise registration/filing states will honor the FTC New Rule's exemptions and whether the states that regulate business opportunities will consider being exempt from the FTC New Rule the same as complying with the rule for purposes of business opportunity rule exemptions and exclusions.

Daryl A. Hart is a member of Bartko, Zankel, Tarrant & Miller in San Francisco. He can be reached by phone at 415-956-1900 or by e-mail at [email protected].