FTC Releases Franchise Rule Compliance Guides

On May 8, 2008, the FTC released its comprehensive Compliance Guide (the 'Compliance Guide'), which addresses, at length, various disclosure and compliance issues arising under the Amended Rule. On June 6, 2008, NASAA released its 2008 Guidelines wherein it adopted, in substantial part, the Amended Rule. It is expected that NASAA will release its FDD Commentary later this year, and it is expected that the commentary will address in great detail additional compliance issues under the Amended Rule.

The Compliance Guide contains a thorough analysis of the Amended Rule, including a discussion of: 1) the types of relationships that are covered by the Amended Rule; 2) exemptions and exclusions available under the Amended Rule; 3) disclosure obligations under the Amended Rule; and 4) the specific requirements for a franchise disclosure document ('FDD') under the Amended Rule, including an item-by-item analysis and sample disclosures for each item. The Compliance Guide also provides instructions for preparing FDDs; instructions for updating FDDs; a detailed discussion of financial performance representations, both within and outside of the FDD; and a lengthy discussion of the requirement that all financial performance representations be reasonable. Finally, the Compliance Guide addresses additional prohibitions under the Amended Rule, including prohibitions against providing contradictory information for prospective franchisees; prohibitions against the use of 'shill' testimonials in the sale of franchisees; prohibitions against failing to make earlier disclosures upon request from a prospective franchisee; prohibitions against failing to furnish an updated FDD to a prospective franchisee upon reasonable request; prohibitions against failing to alert prospective franchisees to unilateral modifications of the franchise transaction documents; prohibitions against disclaimers and waivers, including, specifically, prohibitions against the franchisor disclaiming, in the franchise agreement or otherwise, any of the statements made by the franchisor in its FDD; and the prohibition against failing to make promised refunds.

The Compliance Guide is an extraordinarily thorough document that provides detailed, 'plain English' explanations of many of the provisions of the Amended Rule, particularly those not addressed in the superseded NASAA UFOC Guidelines. It is important to note, however, that the Compliance Guide is not authoritative; compliance is ultimately judged against the Amended Rule and the accompanying SBP.

Key Issues

While space does not permit a summary of each and every topic addressed, the following list highlights some of the key issues addressed by the FTC in the Compliance Guide.

Under the Amended Rule, as under the original rule, a business arrangement is a franchise if it satisfies the following three elements: 1) right to use a trademark or other commercial symbol; 2) the exercise of significant control or significant assistance by the franchisor in the operation of the business; and 3) minimum payment of at least $500 during the first six months of operation. Of the three elements, clearly, the second element ' significant control or assistance ' is the most difficult to define with precision.

In the Compliance Guide, the FTC addresses the issue of when control or assistance is 'significant,' and it explains that in order to be deemed significant, control or assistance must relate to the franchisor's overall method of operation, not just a small portion of the franchisee's business. Some examples of significant control cited by the FTC include control over site selection and approval, site design, or appearance requirements and production techniques. Examples of significant types of assistance include 'formal sales, repair or business training programs; establishing accounting systems; furnishing management, marketing or personnel advice; selecting site locations; furnishing system-wide networks and Web sites; and, furnishing a detailed operating manual.' The FTC also reaffirmed its longstanding position that ordinary controls over trademarks, health, or safety restrictions required by law and assisting distributors in obtaining financing to be able to transact business do not amount to significant control or assistance under the Amended Rule.

Amended Rule Exemptions

The Amended Rule carries forward the limited exemptions available under the original rule, including exemptions for fractional franchises, leased departments, franchise relationships requiring the payment
of $500 or less before or within
six months after commencement
of operation of the franchisee's
business, and oral agreements. It also exempts transactions covered by the federal Petroleum Marketing Practices Act; certain 'sophisticated investor' transactions, such as transactions involving initial investments in excess of $1 million (excluding the cost of unimproved land and franchisor financing), and transactions with franchisees who have five years of business experience and a net worth in excess of $5 million, and transactions including certain franchisor insiders.

The specific requirements for each of the above referenced exemptions are explained in detail both in the text of the Amended Rule and in the accompanying SBP. The Compliance Guide adds critical additional information pertaining to the $1 million large-investment exemption. The Amended Rule provides that when calculating the value of a conversion franchisee's 'initial investment' in the franchise, the amount of the conversion franchisee's original investment in the outlet may be considered. In other words, if a franchisee was converting from a Burger King franchise to a McDonald's franchise, McDonald's can consider the cost of the buildout of the Burger King restaurant when calculating the amount the franchisee's initial investment in the McDonald's franchise. In the Compliance Guide, the FTC extended that principle to transfers. According to the Compliance Guide, 'the prior investment to a party other than the franchisor ' the transferring franchisee ' does not preclude application of the large investment exemption.' Thus, the purchase price paid by the prospective franchisee to the transferring franchisee may be considered in determining whether the transaction meets the $1 million minimum investment threshold for the large-franchisee investment exemption.

Contents of the FDD

The Compliance Guide also clarifies certain disclosure FDD disclosure requirements under the Amended Rule.

For example, with respect to the Item 3 requirement that franchisors identify material civil actions 'involving the franchise relationship commenced in the last ended fiscal year,' the Compliance Guide identifies an exception to the notion introduced in the SBP that any action commenced by the franchisor against the franchisee would both pertain to the franchise relationship and would be material to a prospective franchisee. According to the Compliance Guide, 'one notable exemption may involve isolated, non-traditional franchise sales. Where a franchisor sues a franchisee based upon a franchise agreement for a non-traditional outlet ' such as an outlet in a hospital or in military facility ' the particulars of that agreement and any suit to enforce it is not necessarily material to the sale of traditional franchises under the franchisor's standard franchise agreement.'

Also in Item 3, the Amended Rule requires that all material terms of any settlement of an action required to be disclosed must be set forth in the FDD. However, the Compliance Guide permits franchisors to withhold the terms of an otherwise disclosable confidential settlement, if the settlement agreement was entered into before the franchisor commenced franchise sales. Also, according to the Compliance Guide, any franchisor that historically used only the original FTC Franchise Rule (as opposed to the more common NASAA UFOC Guidelines) or is new to franchising need only disclose confidential settlements entered into after the effective date of the new Rule. The FTC's position appears to be in conflict with the views expressed by the franchise regulatory states, and this discrepancy will likely be addressed in the forthcoming NASAA FDD Commentary.

The Compliance Guide's discussion of the disclosure requirements in Item 7 also provides some interesting new information. The Compliance Guide observes that Item 7 generally provides low- and high-range estimated initial investments for a typical franchised outlet, but there are situations where a franchisor may sell a pre-existing outlet previously owned by the franchisor or its affiliate. According to the Compliance Guide, 'ordinarily the investment made in purchasing a company-owned store need not be reflected in the Item 7 estimated initial investment disclosure. However, if in the preceding fiscal year, the sales price of a company-owned outlet exceeded the highest initial investment for a franchised outlet sale, then the franchisor should disclose that fact in a footnote in Item 7.' According to the Compliance Guide, the footnote should disclose by how much the sale of the company-owned outlet in the preceding fiscal year exceeded the highest estimated initial investment.

In Item 8, the FTC attempted to clarify the broad requirement to identify any required supplier in which any officer of the franchisor owns an interest. With regard to the term 'officer,' the Compliance Guide calls for a disclosure of not just officers of
the franchisor, but also any person with 'management or policy-making authority.' Moreover, according to the Compliance Guide, the term 'interest' is quite broad, and it includes any direct ownership from which the officer derives income or other financial benefits. According to the Compliance Guide, direct ownership of stock in a supplier-company would be a disclosable interest, but ownership of shares of a mutual fund or a stock if the stock was held in a trust where the officer did not have the ability to exercise control over the investment would not be disclosable.

The FTC has provided further clarification regarding this issue in its amended Franchise Rule FAQs (http:\www.ftc.govbcpfranchise amended-rule-faqs.shtm). In FAQ 19, in response to a question regarding the scope of this Item 8 disclosure, the FTC states that a de minimis ownership interest would not be material to an investment decision by a prospective franchisee. But the FTC further explains that there is no fixed threshold for determining whether an interest de minimis, and the franchisor must examine the totality of the circumstances. According to the FTC, the more direct an officer's interest is in a supplier (e.g., ownership of a controlling interest in the suppliers stock), the more likely it is that the staff would deem the ownership interest to be material.

The Compliance Guide also provides clarifying statements concerning a franchisor's disclosure obligations in Item 20 of the FDD, pertaining to identification of current franchisees, confidentiality requirements with franchisees, and franchisee associations. The Compliance Guide explains that in the case of franchisees operating from home, franchisors may substitute a post office box or current e-mail address in place of the home address of the existing franchisee, and the franchisor should only provide the current telephone number of the franchisee if the franchisee has a separate line in his or her home devoted to the franchised business. If not, the franchisee's e-mail address should be provided.

With regard to the new requirement in the FDD that the franchisor disclose whether it enters into confidentiality agreements with current or former franchisees, the Compliance Guide explains that this disclosure obligation is narrow and limited solely to agreements that restrict a franchisee's ability to discuss his or her personal experience as a franchisee in the franchise system. Critically, according to the Compliance Guide, this obligation also would not be triggered if a franchisee is restricted from discussing only the specific terms of a settlement, but is otherwise free to discuss his or her experience ' including having a dispute with the franchisor.

Finally, with respect to the obligation to identify franchise-sponsored or -endorsed franchise associations, the Compliance Guide notes that a franchisor will be deemed to 'sponsor' the association if it provides tangible benefits such as financial assistance, office space, equipment or personnel, and it will be deemed to 'endorse' the association if it actively promotes the 'awareness of the association, its membership, or growth.' On the other hand, if a franchisor simply recognizes the existence of the association or even agrees to meet with its members without more support, a franchisor will not be deemed to 'sponsor or endorse' the association.

Inconsistencies

As set forth above, the Compliance Guide plainly provides that to the extent there are any inconsistencies between the Compliance Guide and the Amended Rule, the latter controls. According to the FTC, the Amended Rule's text and the explanatory SBP is 'the starting point and ultimate authority in compliance with the Amended Rule.'

Certain portions of the Compliance Guide appear to be inconsistent with the Amended Rule and/or the SBP.

For example, the Compliance Guide's sample disclosure for Item 22 includes all FDD exhibits, not just those exhibits or agreements that the franchisee may be required to sign as a condition to entering into the franchise relationship. But Item 22 of the Amended Rule requires franchisors to attach only copies of all proposed agreements relating to the franchise offering that the franchisor provides or for which the franchisor may make arrangements.

In addition, with regard to the requirement that franchisors identify all 'franchise sellers' in the Item 23 Receipt, it appears that the Compliance Guide permits a franchisor to include an exhibit identifying all franchise sellers employed by the franchisor. The Amended Rule and the SBP, however, only permit the franchisor to identify those particular franchise sellers who will have contact with the prospect during the sales process.

In these instances where there is a conflict between the Compliance Guide and the Amended Rule or the SBP, practitioners should follow the Amended Rule and/or SBP as opposed to the Compliance Guide.

Conclusion

The FTC's Compliance Guide is an excellent resource for understanding the Amended Rule and it will prove invaluable to franchisors and their counsel as they achieve compliance with the requirements of the new franchise regulation. The FTC intends to update the Compliance Guide periodically to address additional disclosure and compliance issues that arise under the Amended Rule. Any inconsistencies between the Compliance Guide, on the one hand, and the Amended Rule, the SBP or the forthcoming NASAA Commentary, on the other, will be addressed through revisions in the Compliance Guide.

David W. Oppenheim is a partner in the New York City law firm of Kaufmann, Feiner, Yamin, Gildin & Robbins, LLP. He can be contacted by phone at 212-755-3100 or by e-mail at [email protected].

Perhaps you've heard: On Jan. 23, 2007, the Federal Trade Commission adopted the comprehensively revised FTC Franchise Rule ('The Amended Rule') and released the 'Statement of Basis and Purpose' ('SBP'), which clarified the Amended Rule's requirements and prohibitions. Compliance with the Amended Rule has been optional since July 1, 2007, and became mandatory on July 1, 2008.

As is the case with any comprehensive regulation, when substantial revisions (like in the Amended Rule) are enacted, there are countless issues regarding interpretation. While the comprehensive SBP that accompanied the Amended Rule clarifies many issues, particularly those not addressed under the original Rule or in the North American Securities Administrators Association ('NASAA') 1993 UFOC Guidelines, franchisors and practitioners have been searching for further guidance (at the federal level from the FTC and at the state level from NASAA) as the mandatory compliance date approaches.

Compliance Guide

On May 8, 2008, the FTC released its comprehensive Compliance Guide (the 'Compliance Guide'), which addresses, at length, various disclosure and compliance issues arising under the Amended Rule. On June 6, 2008, NASAA released its 2008 Guidelines wherein it adopted, in substantial part, the Amended Rule. It is expected that NASAA will release its FDD Commentary later this year, and it is expected that the commentary will address in great detail additional compliance issues under the Amended Rule.

The Compliance Guide contains a thorough analysis of the Amended Rule, including a discussion of: 1) the types of relationships that are covered by the Amended Rule; 2) exemptions and exclusions available under the Amended Rule; 3) disclosure obligations under the Amended Rule; and 4) the specific requirements for a franchise disclosure document ('FDD') under the Amended Rule, including an item-by-item analysis and sample disclosures for each item. The Compliance Guide also provides instructions for preparing FDDs; instructions for updating FDDs; a detailed discussion of financial performance representations, both within and outside of the FDD; and a lengthy discussion of the requirement that all financial performance representations be reasonable. Finally, the Compliance Guide addresses additional prohibitions under the Amended Rule, including prohibitions against providing contradictory information for prospective franchisees; prohibitions against the use of 'shill' testimonials in the sale of franchisees; prohibitions against failing to make earlier disclosures upon request from a prospective franchisee; prohibitions against failing to furnish an updated FDD to a prospective franchisee upon reasonable request; prohibitions against failing to alert prospective franchisees to unilateral modifications of the franchise transaction documents; prohibitions against disclaimers and waivers, including, specifically, prohibitions against the franchisor disclaiming, in the franchise agreement or otherwise, any of the statements made by the franchisor in its FDD; and the prohibition against failing to make promised refunds.

The Compliance Guide is an extraordinarily thorough document that provides detailed, 'plain English' explanations of many of the provisions of the Amended Rule, particularly those not addressed in the superseded NASAA UFOC Guidelines. It is important to note, however, that the Compliance Guide is not authoritative; compliance is ultimately judged against the Amended Rule and the accompanying SBP.

Key Issues

While space does not permit a summary of each and every topic addressed, the following list highlights some of the key issues addressed by the FTC in the Compliance Guide.

Under the Amended Rule, as under the original rule, a business arrangement is a franchise if it satisfies the following three elements: 1) right to use a trademark or other commercial symbol; 2) the exercise of significant control or significant assistance by the franchisor in the operation of the business; and 3) minimum payment of at least $500 during the first six months of operation. Of the three elements, clearly, the second element ' significant control or assistance ' is the most difficult to define with precision.

In the Compliance Guide, the FTC addresses the issue of when control or assistance is 'significant,' and it explains that in order to be deemed significant, control or assistance must relate to the franchisor's overall method of operation, not just a small portion of the franchisee's business. Some examples of significant control cited by the FTC include control over site selection and approval, site design, or appearance requirements and production techniques. Examples of significant types of assistance include 'formal sales, repair or business training programs; establishing accounting systems; furnishing management, marketing or personnel advice; selecting site locations; furnishing system-wide networks and Web sites; and, furnishing a detailed operating manual.' The FTC also reaffirmed its longstanding position that ordinary controls over trademarks, health, or safety restrictions required by law and assisting distributors in obtaining financing to be able to transact business do not amount to significant control or assistance under the Amended Rule.

Amended Rule Exemptions

The Amended Rule carries forward the limited exemptions available under the original rule, including exemptions for fractional franchises, leased departments, franchise relationships requiring the payment
of $500 or less before or within
six months after commencement
of operation of the franchisee's
business, and oral agreements. It also exempts transactions covered by the federal Petroleum Marketing Practices Act; certain 'sophisticated investor' transactions, such as transactions involving initial investments in excess of $1 million (excluding the cost of unimproved land and franchisor financing), and transactions with franchisees who have five years of business experience and a net worth in excess of $5 million, and transactions including certain franchisor insiders.

The specific requirements for each of the above referenced exemptions are explained in detail both in the text of the Amended Rule and in the accompanying SBP. The Compliance Guide adds critical additional information pertaining to the $1 million large-investment exemption. The Amended Rule provides that when calculating the value of a conversion franchisee's 'initial investment' in the franchise, the amount of the conversion franchisee's original investment in the outlet may be considered. In other words, if a franchisee was converting from a Burger King franchise to a McDonald's franchise, McDonald's can consider the cost of the buildout of the Burger King restaurant when calculating the amount the franchisee's initial investment in the McDonald's franchise. In the Compliance Guide, the FTC extended that principle to transfers. According to the Compliance Guide, 'the prior investment to a party other than the franchisor ' the transferring franchisee ' does not preclude application of the large investment exemption.' Thus, the purchase price paid by the prospective franchisee to the transferring franchisee may be considered in determining whether the transaction meets the $1 million minimum investment threshold for the large-franchisee investment exemption.

Contents of the FDD

The Compliance Guide also clarifies certain disclosure FDD disclosure requirements under the Amended Rule.

For example, with respect to the Item 3 requirement that franchisors identify material civil actions 'involving the franchise relationship commenced in the last ended fiscal year,' the Compliance Guide identifies an exception to the notion introduced in the SBP that any action commenced by the franchisor against the franchisee would both pertain to the franchise relationship and would be material to a prospective franchisee. According to the Compliance Guide, 'one notable exemption may involve isolated, non-traditional franchise sales. Where a franchisor sues a franchisee based upon a franchise agreement for a non-traditional outlet ' such as an outlet in a hospital or in military facility ' the particulars of that agreement and any suit to enforce it is not necessarily material to the sale of traditional franchises under the franchisor's standard franchise agreement.'

Also in Item 3, the Amended Rule requires that all material terms of any settlement of an action required to be disclosed must be set forth in the FDD. However, the Compliance Guide permits franchisors to withhold the terms of an otherwise disclosable confidential settlement, if the settlement agreement was entered into before the franchisor commenced franchise sales. Also, according to the Compliance Guide, any franchisor that historically used only the original FTC Franchise Rule (as opposed to the more common NASAA UFOC Guidelines) or is new to franchising need only disclose confidential settlements entered into after the effective date of the new Rule. The FTC's position appears to be in conflict with the views expressed by the franchise regulatory states, and this discrepancy will likely be addressed in the forthcoming NASAA FDD Commentary.

The Compliance Guide's discussion of the disclosure requirements in Item 7 also provides some interesting new information. The Compliance Guide observes that Item 7 generally provides low- and high-range estimated initial investments for a typical franchised outlet, but there are situations where a franchisor may sell a pre-existing outlet previously owned by the franchisor or its affiliate. According to the Compliance Guide, 'ordinarily the investment made in purchasing a company-owned store need not be reflected in the Item 7 estimated initial investment disclosure. However, if in the preceding fiscal year, the sales price of a company-owned outlet exceeded the highest initial investment for a franchised outlet sale, then the franchisor should disclose that fact in a footnote in Item 7.' According to the Compliance Guide, the footnote should disclose by how much the sale of the company-owned outlet in the preceding fiscal year exceeded the highest estimated initial investment.

In Item 8, the FTC attempted to clarify the broad requirement to identify any required supplier in which any officer of the franchisor owns an interest. With regard to the term 'officer,' the Compliance Guide calls for a disclosure of not just officers of
the franchisor, but also any person with 'management or policy-making authority.' Moreover, according to the Compliance Guide, the term 'interest' is quite broad, and it includes any direct ownership from which the officer derives income or other financial benefits. According to the Compliance Guide, direct ownership of stock in a supplier-company would be a disclosable interest, but ownership of shares of a mutual fund or a stock if the stock was held in a trust where the officer did not have the ability to exercise control over the investment would not be disclosable.

The FTC has provided further clarification regarding this issue in its amended Franchise Rule FAQs (http:\www.ftc.govbcpfranchise amended-rule-faqs.shtm). In FAQ 19, in response to a question regarding the scope of this Item 8 disclosure, the FTC states that a de minimis ownership interest would not be material to an investment decision by a prospective franchisee. But the FTC further explains that there is no fixed threshold for determining whether an interest de minimis, and the franchisor must examine the totality of the circumstances. According to the FTC, the more direct an officer's interest is in a supplier (e.g., ownership of a controlling interest in the suppliers stock), the more likely it is that the staff would deem the ownership interest to be material.

The Compliance Guide also provides clarifying statements concerning a franchisor's disclosure obligations in Item 20 of the FDD, pertaining to identification of current franchisees, confidentiality requirements with franchisees, and franchisee associations. The Compliance Guide explains that in the case of franchisees operating from home, franchisors may substitute a post office box or current e-mail address in place of the home address of the existing franchisee, and the franchisor should only provide the current telephone number of the franchisee if the franchisee has a separate line in his or her home devoted to the franchised business. If not, the franchisee's e-mail address should be provided.

With regard to the new requirement in the FDD that the franchisor disclose whether it enters into confidentiality agreements with current or former franchisees, the Compliance Guide explains that this disclosure obligation is narrow and limited solely to agreements that restrict a franchisee's ability to discuss his or her personal experience as a franchisee in the franchise system. Critically, according to the Compliance Guide, this obligation also would not be triggered if a franchisee is restricted from discussing only the specific terms of a settlement, but is otherwise free to discuss his or her experience ' including having a dispute with the franchisor.

Finally, with respect to the obligation to identify franchise-sponsored or -endorsed franchise associations, the Compliance Guide notes that a franchisor will be deemed to 'sponsor' the association if it provides tangible benefits such as financial assistance, office space, equipment or personnel, and it will be deemed to 'endorse' the association if it actively promotes the 'awareness of the association, its membership, or growth.' On the other hand, if a franchisor simply recognizes the existence of the association or even agrees to meet with its members without more support, a franchisor will not be deemed to 'sponsor or endorse' the association.

Inconsistencies

As set forth above, the Compliance Guide plainly provides that to the extent there are any inconsistencies between the Compliance Guide and the Amended Rule, the latter controls. According to the FTC, the Amended Rule's text and the explanatory SBP is 'the starting point and ultimate authority in compliance with the Amended Rule.'

Certain portions of the Compliance Guide appear to be inconsistent with the Amended Rule and/or the SBP.

For example, the Compliance Guide's sample disclosure for Item 22 includes all FDD exhibits, not just those exhibits or agreements that the franchisee may be required to sign as a condition to entering into the franchise relationship. But Item 22 of the Amended Rule requires franchisors to attach only copies of all proposed agreements relating to the franchise offering that the franchisor provides or for which the franchisor may make arrangements.

In addition, with regard to the requirement that franchisors identify all 'franchise sellers' in the Item 23 Receipt, it appears that the Compliance Guide permits a franchisor to include an exhibit identifying all franchise sellers employed by the franchisor. The Amended Rule and the SBP, however, only permit the franchisor to identify those particular franchise sellers who will have contact with the prospect during the sales process.

In these instances where there is a conflict between the Compliance Guide and the Amended Rule or the SBP, practitioners should follow the Amended Rule and/or SBP as opposed to the Compliance Guide.

Conclusion

The FTC's Compliance Guide is an excellent resource for understanding the Amended Rule and it will prove invaluable to franchisors and their counsel as they achieve compliance with the requirements of the new franchise regulation. The FTC intends to update the Compliance Guide periodically to address additional disclosure and compliance issues that arise under the Amended Rule. Any inconsistencies between the Compliance Guide, on the one hand, and the Amended Rule, the SBP or the forthcoming NASAA Commentary, on the other, will be addressed through revisions in the Compliance Guide.

David W. Oppenheim is a partner in the New York City law firm of Kaufmann, Feiner, Yamin, Gildin & Robbins, LLP. He can be contacted by phone at 212-755-3100 or by e-mail at [email protected].