Franchise Disclosure and Sales Regulation

Douglas C. BerryGraham & Dunn

Shannon McCarthyGraham & Dunn

Franchise sales regulated by federal and state laws Federal law regulates only disclosure Some states regulate registration and disclosure Regulation falls into three types:

• Federal law governs pre-sale disclosure (and no state specific regulation)

• State law governing pre-sale registration and disclosure• Pre-sale disclosure based on federal law with unique state

penalty

Overview

Federal laws govern pre-sale disclosures to prospective franchisees

Federal: Federal Trade Commission (FTC) “Amended Franchise Rule”

• Governs disclosure only

State: May enact regulations more stringent than FTC • Registration and disclosure

Keep in mind that many states also regulate post-sale relationship

Applicable Regulations: Pre-Sale Disclosures

States that require both registration and disclosure:

Registration

California New York

Hawaii North Dakota

Illinois Rhode Island

Indiana South Dakota

Maryland Virginia

Michigan Washington

Minnesota Wisconsin

Franchise registration must be reviewed annually• Generally 90 to 120 days after end of fiscal year

Illegal to offer unregistered franchise• If offering has not been registered or if registration lapses,

cannot make sale or offer of sale• Penalties are hefty

• Fines, right to rescind, damages, attorneys’ fees, criminal penalties

Registration States, cont.

Registration must be updated/amended during registration year in the event of a “material change”

Material change: any change likely to be important to reasonable investor

• Examples:• Change in financials• Change in terms of franchise• Change in key officers• Material litigation or government action• Change in ownership

Registration States, cont.

Federal law applies to all franchise sales in the US State registration laws can be triggered if one or more of

the following occur within a state:• The prospect is a state resident• The offer originates from that state• The offer is received in that state• Pre-sale meetings take place in that state• The offer is accepted in that state• The franchised business is located in that state• The franchise territory is entirely or partially in that state

More than one state law can apply to a transaction

What Law Governs

A Franchise Disclosure Document (FDD) approved in one state may not be the same as an FDD used in another state

• State-specific changes mandated by regulator (e.g. fee deferral)• Parent guarantee vs. no guarantee• Use of addenda

May not be currently registered in a particular state Implicated state may have unique rules relating to

negotiated changes (California)

What Law Governs and Why It Matters

Heart of federal regulation and most state regulation is presale disclosure

Purpose: help prospect evaluate a franchise offering by providing information about:

• The franchise business• The franchise agreement• The relationship of the parties• The franchisor’s experience• The franchisee’s costs of purchasing the franchise

Regulatory Purpose

There are some exemptions from disclosure under FTC States have own exemptions; some different from FTC’s Many state “exemptions” exempt only from registration;

state disclosure rules still may apply Even where exempt from registration and disclosure

under state law, federal law may still require disclosure; or vice versa:

No clear outcome if explicitly exempt from disclosure under federal law, but not exempt under state law

Exemptions

Disclosure document requires specified disclosures in a specified format pertaining to 23 separate “items”

Must also include:• Specimen copy of standard form franchise agreement• Copies of ALL agreements franchisee may be required to sign• Franchisor’s audited financial statements• Table of contents of operations manual (unless the prospect is

given access to the complete manual pre-sale)

FDD Disclosure

Most state franchise statutes contain broad antifraud provisions borrowed from federal securities statutes

These provisions make it unlawful:• To make any false statement in the disclosure document• To fail to disclose information required to be included in the disclosure

document• To make any false statement relating to any material fact either in the disclosure

document or in any communication with a franchise prospect• To make any misleading statement about any material fact in the disclosure

document or in any communication with a franchise prospect, or fail to make a statement if doing so would be misleading

• To make any disclosure outside a disclosure document relating to profits, revenues, etc. – an earnings claim (financial performance representation)

Additional Antifraud Protections

Criminal penalties• Example: In California, “any person who willfully employs,

directly or indirectly, any device, scheme, or artifice to defraud in connection with the offer or sale of any franchise or willfully engages, directly or indirectly, in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with the offer, purchase, or sale of any franchise shall upon conviction be fined not more than one hundred thousand dollars ($100,000) or imprisoned in the state prison, or in a county jail for not more than one year, or be punished by both that fine and imprisonment.”

Consequences

Potential personal liability of parent corporation, officers, directors, and other control persons

Remedial enforcement and civil penalties by regulatory agencies

Private remedies• Treble/punitive damages

• Rescission and restitution

• Attorneys’ fees

Consequences, cont.

Timing of disclosure varies, but as general rule:• Disclosure document must be given to franchise prospect at least

14 calendar days before the:• Execution of binding agreement; or• Acceptance of any payment• Do not count the day of delivery or day of signing

If execution copy of franchise agreement is materially different from standard form agreement, then franchisor also must give prospect seven calendar days between receiving execution copy and executing agreement

Timing of Disclosure

Select Disclosure Issues

Franchisor may not make any “financial performance representation” unless the same information is in the disclosure document

• Financial Performance Representation (FPR): “Any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits”

• FPR “includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables”

Financial Performance Representations

Salesperson tells Prospect, “The average franchisee earns $100,000 a year after the first year”

Franchisor directs Prospect to newspaper article that says franchisee store sales are $XX per month

Steering - Salesperson directs Prospect to talk finances with specific franchisee

Examples of Improper FPR

Salesperson tells Prospect average labor costs both in dollars and in percentage of revenues

Salesperson reviews franchisee’s business plan showing cost and revenue projections and:

• Salesperson impliedly accepts or comments on plan• Salesperson makes corrections to plan

Examples of Improper FPR, cont.

Franchise offered to Prospect must be same as one in current FDD and registered in the state

Rules dealing with negotiated changes in a franchise vary significantly from state to state

In several states, the fundamental assumption is that all franchisees will be treated equally, and have the same opportunities without regard to their individual bargaining power

Other states encourage negotiation Special rule in California

Negotiated Sales

Sales of franchise on terms different than those registered with state require disclosure of the negotiated terms to all future CA franchise prospects for the next 12 months and may require post-sale disclosure to the state

Must provide all future CA prospects a summary description of each material term that was negotiated within the last 12 months and information on how to request copies of the exact negotiated terms

If the negotiated terms do not favor the franchisee, a notice must be filed with the Department of Commerce and update the FDD disclosing the negotiated terms

Negotiated Sales - California

In many states, advertising materials used to recruit franchisees must first be filed with the state before being used (e.g., brochures, DVDs, website, banner ads)

• Three days before use: California• Five days before use: Illinois, Minnesota, North Dakota, Rhode

Island• Seven days before use: Maryland, New York, Washington

Persons involved with franchise sales must also be registered

Registration of Advertising/Sales Representatives

Post-Sale Regulation

FTC Amended Rule does NOT cover post-sale relationship Many states have statutes that govern the franchise

relationship after a franchise sale Some states do not require registration, but do regulate

relationships These laws vary widely

Post-Sale Regulation

State law may regulate various aspects of franchisor/franchisee relationship:

What is Covered

• Franchisee associations• Termination• Nonrenewal• Franchisee discrimination• Product pricing• Vendor rebates (disclosure)

• Competition with franchisee• Releases and waivers• Fairness of agreement• Venue of disputes• Choice of law

State law often prevents termination without good cause• Good cause: Franchisee has violated material provision of

franchise agreement

Before termination, franchisee usually must be given written notice of defaults; AND

Given a reasonable opportunity to cure its defaults • Typically 30 days

Termination without notice or opportunity to cure is rare exception and usually limited to a handful of fundamental breaches/situations (abandonment, insolvency, serial offender, unauthorized assignment)

Termination

State laws vary widely:• May prevent nonrenewal unless there is good cause• May prevent nonrenewal on significantly different terms• May allow nonrenewal, but require written notice as long as one

year in advance of expiration date and waiver of noncompete• May prevent nonrenewal where franchisor wants to retake

location or territory

Nonrenewal

Where applicable, state franchise statutes ban treating franchisees differently unless there is a legitimate reason for disparate treatment or different treatment related to differing terms of franchise agreement

Even where not covered explicitly, discrimination issue in common law doctrine of good faith

Discrimination

Record Keeping

Franchisors are required by many state laws to keep accurate and complete records of franchise sales

Accurate and complete records minimize liability risks Maintaining complete records from first contact may help

limit liability on future claims

Franchisors Must Keep Accurate Records

Uniform checklist should be used for every sale Checklist can be simple or sophisticated, but should be

implemented in some fashion The key is assigning a designated person who is

responsible for sales and co ntract control!

Franchisors Must Control the Sales Process

What to record in sales log or checklist (here is a start):• Confirm correct FDD sent• Date of disclosure and FDD document number• Date of FDD receipts• Dates of receipt of any money (initial fees or transfer fees)• Credit check completed• Summary of any negotiated changes and justification and

approvals (management and legal)• Names correct • Blank lines properly filled • Agreements are assigned by the right parties

What to Monitor

What to record in sales log or checklist:• Date final agreement is provided to prospect

• Effective date of agreement and applicable expiration date

• Opening date of unit

• Particularly if this becomes “Effective Date”

• Verification that all ancillary agreements (guaranty agreements, non-compete agreements, etc.) are signed by the right party

• Site approval acceptance

• Additional items may include record of contacts with prospect, market analysis/location approvals to be performed, background/credit checks of principals, etc. (we can assist)

What to Monitor, cont.

At a minimum, franchisor should retain:• Franchise registration applications• Salesperson registration forms required by states• Franchise registration approvals• Franchise advertisement registrations• Franchise applications from prospective franchisees• Forms used by salespersons documenting contacts with

prospects• Franchise prospects’ credit reports• Site approval information

Required Documents – Franchise Sales

At a minimum, franchisor should retain:• Disclosure documents (each version)• Disclosure receipts (and any other documentation necessary to

prove electronic delivery)• All executed franchise agreements (ensure that they are

complete and final)• Individual guaranties (if used)• Riders or addenda to all franchise agreements• Other operative documents signed by franchisee (leases,

assignments of leases, etc.)• All communications (emails, letters) with the franchisee and

franchisee’s attorney

Required Documents – Franchise Sales

Any post-contract amendments to franchise agreement All correspondence (emails, letters) with franchisee and

attorneys Training reports Inspection reports Memoranda relating to assistance provided to franchisee Customer complaints Notices of default and termination Transfers and assignments (approvals, releases)

Recommended Documents – Post-Sale

Questions?

International Sales

United States (state) law may apply if franchisee is a resident of state

Foreign law varies widely Trend toward American-style regulation, but less than

50% of countries have franchise-specific laws

It is a Big World

Pre-sale registration of franchise offerings is still rare Many countries will require pre-sale disclosure similar to

FDD• Information may be similar, but content of the disclosure

document may be radically different• May need to be given in native language• Where pre-sale disclosure is required, it generally must comply

with formal requirements of applicable law

Dangerous Generalizations

What this means:• Creating a disclosure document is not a simple task• It can be expensive and take time• Should be reviewed by local counsel

Disclosures may need to be updated and provided to existing franchisee annually (e.g., Australia)

Not unusual for a post-sale registration of some sort• This often needs to be made in language of country

Dangerous Generalizations, cont.

Many countries regulate post-sale aspects of franchise, and may mandate certain provisions in agreement relating to:

• Enforcement• Mediation• Termination and nonrenewal• Assignments• Choice of law and venue for disputes• Exclusive territories• Noncompetes and assignments• Cooling off periods

Dangerous Generalizations, cont.

Key thing to remember is that it can be expensive:• Is franchising in a country worth the cost?• Check first to determine if there is franchise law and what is

required• In almost all instances, it is okay to have general conversations with

a prospect, and even provide them with a United States FDD, but• Do not sign anything or accept any money until a disclosure

document is prepared and provided where required• Is our trademark and other IP protected?

• If not, then this will require trademark registrations (not cheap and not always fast and easy)

Do We Develop in this Country

Taxes • Get an assessment of any applicable tax laws• May affect structure of agreement

Import restrictions: can we get our products through customs?

Currency restrictions: can we get paid in US currency? Enforcement, training, and monitoring are expensive and

sometimes impossible Generally will need local counsel to provide insight to

franchise and non-franchising issues

Do We Develop in this Country, cont.

Most important issue in any international deal is quality and character of the other side

• Do they have the money?• Do they have the structure and experience?• Can they be trusted?

Other business issues• Cost of training, support, monitoring• Size of territory• Language• Brand translation• Currency and security

Do We Develop in this Country, cont.

Questions?

Thank YouDouglas C. Berrydberry@grahamdunn.com

206.340.9626

www.grahamdunn.com

Shannon McCarthysmccarthy@grahamdunn.com

206.340.9663