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Federal Franchise Disclosure Rule Changes Under Review By The Federal Trade Commission

The last several weeks have seen two legal developments of importance to franchisors. In early September California adopted a new law amending its Franchise Investment Law (the "CFIL") as of January 1, 2005 and its Finance Lenders Law ("Lenders Law") in regard to loans by franchisors effective on September 10, 2004. Just before that, on August 25, 2004, the Federal Trade Commission ("FTC") made available its Staff Report on proposed changes to its franchise disclosure rule ("Franchise Rule"). That report includes a proposed revised franchise rule ("Proposed Rule") as well as extensive discussion concerning the rationale for the proposed changes. Comments on the Staff Report may be made by the public until November 12, 2004.

Changes to the California Franchise Law: Franchise Investment Law

New Exemptions

The revised CFIL provides for exemptions, if certain conditions are met, from the registration and disclosure requirements of that law for the sale of franchises to:

• Any partner, executive officer or director of the franchisor.
• Any corporation or other business entity with total assets exceeding $5 million.
• Any individual with a net worth of $1 million or more or a gross income of $300,000 per year or more.
• Any business entity in which all the equity owners meet any of the foregoing criteria.

Electronic Disclosures

When disclosures are required, the revised CFIL allows the franchisor to provide copies of the disclosure document through electronic means in accordance with requirements imposed by rule or order of the California Commissioner of Corporations. Such rules have not yet been issued. This document may be considered attorney advertising in some jurisdictions. Some of the design images and photographs in this document may be of actors depicting fictional scenes.

Negotiated Terms

The revised CFIL also provides that a franchise may be sold on negotiated terms that differ from those disclosed in the disclosure document if certain conditions are met. These conditions have some important differences from California's current requirements for negotiated sales. One of these is that the negotiated terms, on the whole, must confer additional benefits on the franchisee.

There are likely to be tricky questions in regard to what negotiated changes "confer additional benefits." For instance, if the standard franchise term is five years and the franchisee negotiates a seven-year term, that confers the additional benefit of allowing the franchisee to continue in operation for an additional two years but also confers the additional obligation on the franchisee to continue operations an additional two years.

The franchisor is also required to provide to all prospective franchisees, in an appendix to the disclosure document, a summary description of each material negotiated term within the previous 12 months and a statement indicating that copies of the negotiated terms are available upon request. It is not clear whether this appendix, which may change frequently, has to be registered as an amendment to the disclosure document before it is used.

Changes to the California Franchise Law: Finance Lenders Law

The revised California Finance Lenders Law now excludes franchise loans from the scope of its coverage. If franchise loans were not excluded, franchisors making loans to their franchisees might be required to obtain a license under the Lenders Law and be subject to the regulations applicable to finance lenders.

A franchise loan is exempted if it is a loan from a franchisor to a current or prospective franchisee for the acquisition, construction, operation, development, equipping, expansion, contraction, merger, consolidation, recapitalization, reorganization or termination of a franchised business. If the loan is secured, it may be secured solely by the assets of the franchised business and not by property used by the borrower for personal, family or household purposes such as the borrower's personal residence. Also, the lender is required to fully and clearly disclose to the borrower, at or before the time the loan is made, the rates of interest, charges and costs of the loan.

Staff Report on Changes to the Federal Franchise Rule

Changes to the Franchise Rule have been under consideration for some time starting with the review of the Franchise Rule in 1995, followed by the publication of an advanced notice of proposed rule making in 1997 and the publication of a notice of proposed rule making in 1999 (the "1999 Proposal"). Generally, the Franchise Rule requires a franchisor to make extensive information about its franchise business available to a prospective franchisee at the outset of any contacts with the prospect.

The Staff Report provides useful guidance about the likely future of the Franchise Rule, and franchisors can reasonably anticipate that many of the proposed changes will eventually be adopted. However, when these changes will be adopted and the exact content of the changes that are adopted are still to be determined.

No Preemption

The recommended change to the Franchise Rule (the "Proposed Rule") would continue the complex relationship between the FTC's requirements and the requirements of state law. The Proposed Rule would not preempt the franchise disclosure laws of the states except to the extent they are inconsistent with the Franchise Rule. A state franchise disclosure law would not be inconsistent with the Franchise Rule if it affords prospective franchisees equal or greater protection, such as registration of disclosure documents or more extensive disclosures.

Changes to the Disclosure Document

Under the current Franchise Rule, the form of the disclosure document must follow the format set forth in the federal Franchise Rule or, alternatively, may follow (with certain limited exceptions) the format set forth in the Uniform Franchise Offering Circular (UFOC) guidelines adopted by the states. The same result is likely under the Proposed Rule but is not certain. The Staff Report says that the Proposed Rule, if adopted, would create a new "disclosure floor" with which all franchisors must comply.

The Staff hopes that the states will adopt the Proposed Rule to reduce inconsistencies between federal and state law. Finally, the Staff Report acknowledges that further guidance on this relationship is needed and recommends that the FTC address this issue in further compliance guides that should accompany the Proposed Rule if and when it goes into effect.

The changes in the content of the disclosure document set forth in the Proposed Rule might not significantly affect a franchisor that is using the UFOC form of disclosure document, except in certain circumstances. The FTC could decide that the UFOC is inadequate as to certain items under the new disclosure floor established by the Proposed Rule. If that were the case, franchisors would need guidance from the FTC as to what disclosures are needed beyond the requirements of the UFOC and would need the states to allow such additional disclosures. The more likely result is that the states will change the UFOC so that compliance with the revised UFOC will also be sufficient to comply with the federal Franchise Rule as changed.

On some matters the Proposed Rule would require disclosure beyond those set forth in the UFOC. For instance:

• The current UFOC guidelines require that franchisors disclose certain litigation brought against them. The Proposed Rule would add that franchisors must also disclose material litigation initiated by the franchisor against franchisees involving the franchise relationship.
• The current UFOC guidelines require franchisors to list fees paid by the franchisees to the franchisor and its affiliates or collected by the franchisor on behalf of third parties. The Proposed Rule would require that the franchisor also disclose all required payments made directly to third parties and then either state the amount of such fees or that the amount of the fees is unknown.

This document may be considered attorney advertising in some jurisdictions. Some of the design images and photographs in this document may be of actors depicting fictional scenes.

New Exemptions

Beyond the disclosure content itself, there are a number of areas where the Proposed Rules would impact, often in a beneficial way, the requirements and timing of franchisor disclosures.

Certain franchise sales would be exempted from the disclosure requirements under the Proposed Rule. This would allow the franchisor not to make disclosures in federally exempted sales in states that have the same exemptions or in states which do not have state franchise disclosure requirements.

The Proposed Rule would exempt, among other things, sales of franchises where:

• The franchisee's estimated investment, excluding any financing received from the franchisor or an affiliate and excluding real estate costs, totals at least $1 million and the prospective franchisee signs an acknowledgement verifying the grounds for the exemption.
• The franchisee (and its parent company or any affiliated companies) is a corporation or other business entity that has been in business for at least five years and has a net worth of at least $5 million.
• The purchaser is owned (50% or more) by certain former officers, directors, managers or part owners of the franchisor.

Timing of Disclosures

The Proposed Rule would also change the much criticized disclosure timing requirements. The current Franchise Rule requires that the disclosure document be delivered at the earlier of the first face-to-face meeting between a franchisor representative and a prospective franchisee, or ten business days prior to the execution of an agreement or payment of any consideration by the franchisee. In addition, a copy of the complete franchise agreement and any related agreements to be signed by the parties must be given to the prospective franchisee at least five business days prior to the date the agreements are to be signed.

The Proposed Rule does away with the first face-to-face meeting trigger and requires that the disclosure document be delivered at least fourteen days before the prospective franchisee signs a binding agreement or makes any payment to the franchisor. In addition, the franchisor would be required to provide this disclosure document to a prospective franchisee even earlier in the sales process upon the franchisee's reasonable request.

The five day contract review period would also be abolished, but instead the Proposed Rule would require the franchisor, at least seven days before the prospective franchisee signs the franchise agreement, to furnish a copy of any franchise agreement that the franchisor unilaterally and materially changes from the form of franchise agreement attached to the disclosure document. This document may be considered attorney advertising in some jurisdictions. Some of the design images and photographs in this document may be of actors depicting fictional scenes.

Electronic Disclosure

The Proposed Rule would also, for the first time, allow disclosure by email or by providing a tangible electronic copy (such as a computer disc or CD ROM), but the electronic disclosures would have to meet certain criteria. For instance, the disclosure would need to be in a form that would permit the prospective franchisee to store, download, print or otherwise maintain the document for future reference. The franchisor could include scroll bars, internal links and search features in the electronic version for the sole purpose of enhancing the prospective franchisee's ability to move through the disclosure document. However, all other features – for instance, multimedia tools such as audio, video, animation or pop-up screens – would be prohibited. The prior proposal – that an electronic disclosure document could be used only with the consent of the franchisee – has been eliminated. This document may be considered attorney advertising in some jurisdictions. Some of the design images and photographs in this document may be of actors depicting fictional scenes.

Updating

The Proposed Rule would also make changes to the requirements for updating the disclosure document. First, the disclosure document would need to be revised within 120 days after the end of the franchisor's fiscal year, rather than 90 days as provided in the current rule.

Under the 1999 Proposal, franchisors would have been required to notify prospective franchisees of any material changes when furnishing disclosures and also when presenting the completed franchise agreement. The Proposed Rule would drop this requirement but would require franchisors, upon a prospective franchisee's reasonable request, to furnish a copy of the franchisor's most recent disclosure document and any quarterly updates before the prospective franchisee signs a franchise agreement. In addition, as under the current Franchise Rule, the franchisor would be required to notify prospective franchisees of any changes in a financial performance representation (called an "earnings claim" in the UFOC guidelines) at the time the disclosure document is furnished.

Negotiated Terms

The 1999 Proposal provided that a franchise agreement could contain negotiated contract terms different from those in the standard contract attached to the disclosure document if the franchisor identifies the changes, the prospective franchisee initials the changes and the prospective franchisee has five days to review the revised contract before signing it or paying a fee. The Proposed Rules drop this requirement and instead provide that the franchisor must inform the prospective franchisee of the changes within a reasonable time before execution. However, changes to a franchise agreement that result solely from negotiations initiated by the prospective franchisee would not trigger the seven day contract review period described above.

For More Information

Please contact Norman A. Bloch, Barry M. Block, or Stephen J. Butler or any member of our Antitrust, Competition & Distribution practice group for more information.

Disclosure

This advisory may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgement of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel. This document may be considered attorney advertising in some jurisdictions. Some of the design images and photographs in this document may be of actors depicting fictional scenes.