Greenberg Traurig Alert
Franchise Sales: FTC Disclosure Requirements Update Expected in June
By James A. Ullman, Greenberg
Traurig, Phoenix Office
View or download the PDF version of this Alert
The Federal Trade Commission (FTC), the agency charged with federal regulatory
enforcement of franchise sales in America, issued a Notice of Proposed Rulemaking
with the intention of modifying the disclosure rule (the "Rule").
The Rule is properly known as "Disclosure Requirements and Prohibitions
Concerning Franchise and Business Opportunity Ventures," 16 C.F.R. §436,
et seq (1979). The comment period has now expired and
the Federal Trade Commission indicated on Dec. 3, 2001 in the Federal
Register that its staff report will be issued in June 2002. In the interim,
the current Rule remains in effect.
|"The intention of the FTC is
to require franchisors to provide information to prospects so that
potential franchisees will be more informed prior to purchasing
Overview of the Existing Regulatory Environment
Since the Rule went into effect in October 1979, franchisors selling
franchises in the United States have been required to prepare and submit
to a prospect a comprehensive disclosure document which contains a proposed
franchise agreement and any and all other collateral documents required
by the franchisor to establish the franchise relationship. Examples of other
collateral documents are subleases, guaranties, restrictive covenants, and
lease assignments. The disclosure document contains twenty items, each with
multiple subparts. The intention of the FTC is to require franchisors to
provide information to prospects so that potential franchisees will be more
informed prior to purchasing a franchise. Essentially, the disclosure document,
known as an offering circular, contains information relating to the following
- The franchisor, affiliated, related or predecessor companies. (Emphasis
in this disclosure is to identify the businesses that affiliated or related
companies are or have been involved with and whether there has been prior
franchising history in any of the disclosed businesses.)
- The business experience of the principals, officers, directors, partners
or those who have management responsibility. A five-year work history
- Litigation and material arbitration.
- Disclosure of entities or key individuals who have filed for relief
under the bankruptcy laws within the previous seven years.
- The initial fee required to be paid for franchise rights contemplated
under the agreement.
- Recurring, ongoing or occasional fees payable to the franchisor (e.g.
royalties, advertising fees, transfer fees).
- The initial investment required by a franchisee from execution of
documents through the first three months of operation, disclosed in chart
form. The disclosure is made by the franchisor’s presentation on a high-to-low
range for most costs associated with the opening of the business (e.g.
construction, acquisition, leasehold improvements, furnishings, equipment,
signs, opening inventory, security deposits, advertising, professional
fees, working capital).
- Restrictions on sourcing of products and services – the franchisor
must disclose obligatory purchases, restrictions on sourcing from third
parties, and any rebates that the franchisor may receive from required
- Franchisee’s obligations – disclosure is made by cross-referencing
sections in the offering circular to specific provisions within the proposed
- Financing arrangements offered by franchisor, its affiliated or related
- Franchisor’s obligations - this disclosure is broken down between
requirements of the franchisor before the business is opened and those
obligations subsequent to the commencement of business. (There is also
a requirement to detail training information, including the number of
hours of training offered by the franchisor, whether the training is on
the job or in a classroom, and who is responsible for the training, and
what materials are utilized.)
- The territory - indicates to prospects whether the territory is protected
and, if so, whether that territory is based upon geographical radius,
population, or some other formula devised by the franchisor.
- Intellectual Property - information pertaining to the trademarks,
copyrights, patents, and other proprietary information to be licensed,
and the status of those assets.
- Obligation of the franchisee to participate in the operation of the
business. If the franchisee must operate the business, that information
must be disclosed. If the franchisee can hire a manager to perform the
day-to-day operations, the requirements for approval of a manager must
- Restrictions on what the franchisee may sell.
- Renewal, termination, transfer, and dispute resolution. This disclosure
is done in chart form, cross-referencing the appropriate sections of the
franchise agreement and summarizing conditions within the agreement.
- The use of public figures – if the franchisor uses public figures
in the sales and promotion of its franchises, information related to the
contractual nature of the relationship must be disclosed.
- Earnings claims – if the franchisor chooses to disclose either gross
sales or net profits from its franchisees (or in some circumstances, company
owned stores), then a specific form of disclosure must be utilized. Disclosure
of actual or projected sales results must be contained within the offering
circular, and no verbal representations are permitted under federal law.
- A comprehensive list of franchises by states, indicating transfers,
cancellations, nonrenewals and abandonments from the system, including
year-end totals for the prior three fiscal years.
The FTC disclosure requirements as specified within the Rule contain
a baseline for franchise disclosure promulgated by the federal entity charged
with the responsibility of franchise regulation. However, there are several
states that require additional registration and merit review prior to authorizing
a franchisor to sell or advertise franchises within their jurisdictions.
These are California, Illinois, Maryland, Minnesota, New York, North Dakota,
Rhode Island, South Dakota, Virginia, Washington, and are known as "registration
states." Certain states require filing fees without any merit review - Florida,
Hawaii, Indiana, Iowa, Michigan, South Dakota, Texas, Utah, and Wisconsin.
The FTC has ruled that if a state has a more stringent requirement than
the federal mandate (i.e. the requirement tends to give more disclosure
to a prospective franchisee), then the state regulations supersede federal
requirements. State regulations are promulgated by the North American Securities
Administrators Association (NASAA). It is unclear whether NASAA will revise
their disclosure document so that it contains the identical information
as mandated by the FTC.
Overview of Proposed Modifications
There are numerous modifications that have been identified by the FTC
in this Notice of Proposed Rulemaking. The modifications are the first substantial
amendment to the Rule in a generation. Some of the proposed modifications
- The ability to provide disclosure to franchise prospects through the
Internet, which is broadly defined to capture communications between computers
and computer, television, telephone, facsimile or other communication
- The requirement to use "plain English" in disclosures.
- The disclosure period and review period are changed to fourteen calendar
days before the franchisee signs a binding contract or pays any fee (as
opposed to the current requirement which provides disclosure to be made
at the earlier of the first personal meeting or ten business days before
execution of the contract or payment of franchise fees).
- More specificity relating to franchisor-mandated site selection criteria
and to the nature of the franchisor’s training program.
- Revised disclosures of the franchisor’s present plans to operate a
competing distribution system of similar goods or services to those being
franchised at present.
- Amendment to the "earnings claims" or performance disclosures that
a franchisor may choose to make which permit information about the performance
of all company or franchised outlets.
- Substantial revisions to the current disclosure obligations pertaining
to the number of franchises and their status over the last three years,
e.g., transferred, terminated, repurchased by the franchisor.
- Clarification to the "Rule" as applying to franchise sales within
the United States solely.
- Revision to litigate disclosure, specifically the use of franchisor
gag clauses in confidential settlements.
- Exemptions for sophisticated franchisee investors.
© 2002 Greenberg Traurig [This an update to a GT Alert previously published
in November 1999.]
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