Federal, State Regulators Offer Updates

Question 35. Is a franchisor required to include in its Franchise Disclosure Document (“FDD”) a statement that the financing it offers includes a waiver of a jury trial that will also constitute a waiver of that right in litigation concerning its franchise agreement or other related agreements, if that is the case?

Answer: Yes. Section 436.5(j)(2) of the Franchise Rule requires a disclosure in Item 10 of the FDD of “whether the loan agreement requires franchisees to waive defenses or other legal rights,” and if so, the franchisor must “describe the relevant provisions.” Thus, a failure to disclose in Item 10 that the jury trial waiver in a financing agreement offered by the franchisor also waives that right in litigation involving the franchise or other related agreements would misrepresent the effect of the provision and violate the Franchise Rule where the other affected agreements lack an express jury trial waiver.

Question 36. Where Item 20 requires disclosures about “company-owned outlets,” is that term intended to include not only outlets owned by the franchisor, but also affiliate-owned outlets that are “substantially similar” to the outlets offered by the Franchise Disclosure Document?

Answer: Yes. The references in section 436.5(t) of the amended Franchise Rule to “company-owned outlets” include outlets owned by affiliates of the franchisor that are “outlets of a type substantially similar to that offered to the prospective franchisee.” (16 CFR ' 436.5(t)(1).) To be “substantially similar,” an affiliate's outlets need not conduct business under the same trademark and system. (Amended Rule Statement of Basis and Purpose, 72 Fed. Reg. 15444, 15502 n.603 (Mar. 30, 2007).) If the goods or services sold at the affiliate's outlets are “substantially similar” to the goods or services to be sold at the outlets offered by the FDD, those outlets must also be included with the franchisor's outlets in the Item 20 disclosures for “company-owned outlets.”

Section 436.5(t) of the amended Rule removed the limitation in section 16 of the original Rule specifying that disclosures about franchised and “company-owned outlets” were required only “with respect to the franchisor and as to the particular named business being offered.” (Original Rule Statement of Basis and Purpose, 43 Fed Reg. 59674, 59616 (Dec. 21, 1978).) This was one of many changes made “to align the final amended Rule more closely to the UFOC [G]uidelines,” (72 Fed. Reg. at 15501), including the instruction added to the Guidelines in 1993 to include affiliate-owned units that were “substantially similar” to the franchisor's outlets in the “company-owned outlet” disclosures in Item 20. (Bus. Fran. Guide (CCH) [FTC and UFOC Disclosure Materials Transfer Binder] ' 5772, p. 8450 (Instruction v).)

By requiring disclosures about “substantially similar” affiliate outlets in addition to outlets owned by the franchisor, the amended Rule prevents franchisors from hiding negative information. For example, franchisors cannot avoid disclosing a large number of repurchases of failed franchises by using an affiliate to repurchase them. (Amended Rule Statement of Basis and Purpose, 72 Fed. Reg. 15444, 15502 n.603 (Mar. 30, 2007).)

State-Regulation Level

At the state-regulation level, Dale Cantone, Maryland assistant attorney general, discussed the activities of the North American Securities Administrators Association (“NASAA”), for which he leads the franchise committee. “It's been one of our more active years, and we are engaged in many projects,” he said.

At the top of the list, NASAA is compiling comments that it received about area developers, subfranchisors, and other multi-unit franchise models, input that it sought earlier this year. “There has been a lot of uncertainty in this area and some license-taking [on disclosures],” he said. Indicative of lack of consensus in the area are a pair of comments that Cantone shared with the IFA Legal Symposium audience: “In one comment, we have been asked to specify the definitions of multi-unit operators, but in another request, we were told not to limit multi-unit operators to strict definitions.”

NASAA also has proposed a model set of exemptions that franchisors can use for state filings and has proposed that NASAA support work on an electronic database of franchise registration. “The time has come for electronic registration so that you can file from your desk with a push of a button,” he said, though warning that the database will likely have to be supported with an additional nominal fee for electronic filers. Cantone said that Wisconsin's electronic filing system could perhaps form the basis for a multi-state filing system.

The other panelist, Theresa Leets, senior corporations counsel, California Department of Corporations, provided insights about how California regulators view franchisors' ads that are used to attract potential franchisees. All ads must be submitted to the Department at least three days before their intended use. “Avoid rankings in the ads,” such as stating that a franchise system is the fastest-growing in its category, Leets advised. For franchisors that are determined to use rankings, substantiation must be shown on the ad (usually through a footnote) and must come from a credible source.

Also, Leets panned the use of Excel spreadsheets that are designed to enable prospective franchisees to enter their own data about revenues and costs of a franchise unit and therefore calculate their potential profit ' if those spreadsheets are designed to evade disclosure of franchise unit performance, as required in Item 19 of the FDD. When franchise sales representatives “offer to help” prospects fill in those numbers, Leets said they would probably subject the franchisor to an Item 19 disclosure.

Kevin Adler is associate editor of LJN's Franchising Business & Law Alert. He can be contacted at [email protected].

Representatives from the Federal Trade Commission, the Maryland Attorney General's Office, and the California Department of Corporations updated franchise attorneys about the latest developments in franchise regulation at the International Franchise Association's 44th Annual Legal Symposium.

At the top of the agenda is the FTC's finalization of a new Business Opportunities Rule. The rulemaking, first proposed in 2008, is on track to be issued as a final rule by the end of 2011, according to Craig Tregillus, FTC's Franchise Rule Coordinator, which would be a much faster pace than the revision of the Franchise Rule that was completed in 2007. “It's out of our shop and has moved to review by the full Commission,” said Tregillus.

Tregillus also mentioned that on March 28, the FTC released two new guidance statements about the Franchise Rule, the 35th and 36th that have been published. The questions that led to the issuing of the statements, as well as the statements themselves, are as follows:

Question 35. Is a franchisor required to include in its Franchise Disclosure Document (“FDD”) a statement that the financing it offers includes a waiver of a jury trial that will also constitute a waiver of that right in litigation concerning its franchise agreement or other related agreements, if that is the case?

Answer: Yes. Section 436.5(j)(2) of the Franchise Rule requires a disclosure in Item 10 of the FDD of “whether the loan agreement requires franchisees to waive defenses or other legal rights,” and if so, the franchisor must “describe the relevant provisions.” Thus, a failure to disclose in Item 10 that the jury trial waiver in a financing agreement offered by the franchisor also waives that right in litigation involving the franchise or other related agreements would misrepresent the effect of the provision and violate the Franchise Rule where the other affected agreements lack an express jury trial waiver.

Question 36. Where Item 20 requires disclosures about “company-owned outlets,” is that term intended to include not only outlets owned by the franchisor, but also affiliate-owned outlets that are “substantially similar” to the outlets offered by the Franchise Disclosure Document?

Answer: Yes. The references in section 436.5(t) of the amended Franchise Rule to “company-owned outlets” include outlets owned by affiliates of the franchisor that are “outlets of a type substantially similar to that offered to the prospective franchisee.” (16 CFR ' 436.5(t)(1).) To be “substantially similar,” an affiliate's outlets need not conduct business under the same trademark and system. (Amended Rule Statement of Basis and Purpose, 72 Fed. Reg. 15444, 15502 n.603 (Mar. 30, 2007).) If the goods or services sold at the affiliate's outlets are “substantially similar” to the goods or services to be sold at the outlets offered by the FDD, those outlets must also be included with the franchisor's outlets in the Item 20 disclosures for “company-owned outlets.”

Section 436.5(t) of the amended Rule removed the limitation in section 16 of the original Rule specifying that disclosures about franchised and “company-owned outlets” were required only “with respect to the franchisor and as to the particular named business being offered.” (Original Rule Statement of Basis and Purpose, 43 Fed Reg. 59674, 59616 (Dec. 21, 1978).) This was one of many changes made “to align the final amended Rule more closely to the UFOC [G]uidelines,” (72 Fed. Reg. at 15501), including the instruction added to the Guidelines in 1993 to include affiliate-owned units that were “substantially similar” to the franchisor's outlets in the “company-owned outlet” disclosures in Item 20. (Bus. Fran. Guide (CCH) [FTC and UFOC Disclosure Materials Transfer Binder] ' 5772, p. 8450 (Instruction v).)

By requiring disclosures about “substantially similar” affiliate outlets in addition to outlets owned by the franchisor, the amended Rule prevents franchisors from hiding negative information. For example, franchisors cannot avoid disclosing a large number of repurchases of failed franchises by using an affiliate to repurchase them. (Amended Rule Statement of Basis and Purpose, 72 Fed. Reg. 15444, 15502 n.603 (Mar. 30, 2007).)

State-Regulation Level

At the state-regulation level, Dale Cantone, Maryland assistant attorney general, discussed the activities of the North American Securities Administrators Association (“NASAA”), for which he leads the franchise committee. “It's been one of our more active years, and we are engaged in many projects,” he said.

At the top of the list, NASAA is compiling comments that it received about area developers, subfranchisors, and other multi-unit franchise models, input that it sought earlier this year. “There has been a lot of uncertainty in this area and some license-taking [on disclosures],” he said. Indicative of lack of consensus in the area are a pair of comments that Cantone shared with the IFA Legal Symposium audience: “In one comment, we have been asked to specify the definitions of multi-unit operators, but in another request, we were told not to limit multi-unit operators to strict definitions.”

NASAA also has proposed a model set of exemptions that franchisors can use for state filings and has proposed that NASAA support work on an electronic database of franchise registration. “The time has come for electronic registration so that you can file from your desk with a push of a button,” he said, though warning that the database will likely have to be supported with an additional nominal fee for electronic filers. Cantone said that Wisconsin's electronic filing system could perhaps form the basis for a multi-state filing system.

The other panelist, Theresa Leets, senior corporations counsel, California Department of Corporations, provided insights about how California regulators view franchisors' ads that are used to attract potential franchisees. All ads must be submitted to the Department at least three days before their intended use. “Avoid rankings in the ads,” such as stating that a franchise system is the fastest-growing in its category, Leets advised. For franchisors that are determined to use rankings, substantiation must be shown on the ad (usually through a footnote) and must come from a credible source.

Also, Leets panned the use of Excel spreadsheets that are designed to enable prospective franchisees to enter their own data about revenues and costs of a franchise unit and therefore calculate their potential profit ' if those spreadsheets are designed to evade disclosure of franchise unit performance, as required in Item 19 of the FDD. When franchise sales representatives “offer to help” prospects fill in those numbers, Leets said they would probably subject the franchisor to an Item 19 disclosure.

Kevin Adler is associate editor of LJN's Franchising Business & Law Alert. He can be contacted at [email protected].