Highlights From the New Franchise Rule

Patrick Maslyn
April 2, 2007 — 1,679 views  
Become a Bronze Member for monthly eNewsletter, articles, and white papers.

On January 22, 2007, the Federal Trade Commission (the “FTC”) announced its adoption of a revised Trade Regulation Rule, “Disclosure Requirements and Prohibitions Concerning Franchising” (the “New Rule”). The New Rule formally adopts much of the UFOC Guidelines’ approach to franchise disclosure and follows substantially the Notice of Proposed Rulemaking published by the FTC in 1999, so the franchise community generally should not be surprised by the revisions in the New Rule. Nonetheless, the New Rule makes some significant changes to current franchise disclosure requirements, which may not be commonly known or may require some additional explanation. 

The New Rule and the Statement of Basis and Purpose (“SBP”) for the New Rule are available on the FTC’s website at: http://www.ftc.gov/os/2007/01/R511003Fra nchiseRuleFRNotice.pdf .

The FTC expects to issue Compliance Guides to further clarify the application of the New Rule.

As a service to our clients, the Hunton & Williams Franchising & Distribution practice group has prepared the following brief overview of some of the significant changes contained in the New Rule.

1. Some Integration Clauses Are Now Prohibited

The FTC has addressed franchisee complaints that franchisors seek to disclaim responsibility for disclosures made in their disclosure documents by declaring the use of broadly crafted integration clauses or waivers a prohibited practice. This prohibition does not apply to all integration clauses — only to those integration clauses that have the effect of disclaiming any of the information in the disclosure document or its attachments.

In light of this new prohibition, franchisors should carefully review their existing agreements to confirm that the use of their form of integration clause will not be deemed to be a prohibited practice. In addition, pre-sale franchisee disclosure questionnaires that many franchisors use to assist in franchise compliance should be carefully reviewed to ensure that, by completing the questionnaire, prospective franchisees are not required to waive reliance on the offering circular as a condition of closing.

2. Disclosure of Franchisee Confidentiality Clauses

The New Rule will require that franchisors disclose in Item 20 whether any franchisees or former franchisees have signed confidentiality agreements in the three previous fiscal years. This new requirement is intended to be triggered only by those types of confidentiality restrictions that limit a franchisee’s ability to communicate with a prospective franchisee about their overall experience in the franchise system. Where applicable, a franchisor must simply include a standard disclosure indicating that some franchisees (and former franchisees) may not be able to speak freely. Additional disclosures about the nature and reasons for the confidentiality clauses are permitted, but optional.

3. Franchisor-Initiated Litigation

One of the most discussed additions to the disclosure requirements under the New Rule is that franchisors must now disclose litigation against franchisees relating to the franchise relationship. There has been much concern expressed about this requirement’s potential to add significantly to the Item 3 disclosures, but in its final form, it is unlikely to be overly onerous for three reasons. (1) In most cases where a franchisor initiates litigation against a franchisee, the franchisor will face a counterclaim which would already require disclosure in Item 3. The New Rule does not require any additional disclosure in this case. (2) A franchisor will only be required to disclose franchisor-initiated litigation filed or pending during the last fiscal year. (3) The FTC intends the disclosures relating to these cases to be in a brief, summary form and franchisors may group individual cases, where appropriate.

4. New Exemptions

The New Rule retains the so-called minimum payment, fractional franchise, leased department, and oral agreement exemptions contained in the original Franchise Rule and adds two new exemptions.

Contracts governed by the Petroleum Marketing Practices Act are exempt from the New Rule. Although the FTC has exempted these relationships by petition in the past, the New Rule makes the exemption explicit and the SBP unequivocally states that the exemption is to be read broadly to apply to nonpetroleum branded services sold under the same franchise agreement.

ii. Sophisticated Investors
The FTC has identified three categories of sophisticated investor transactions in which a franchisor need not provide a disclosure document under the New Rule. These transactions include sales:
(1) requiring a large investment ($1 million, excluding unimproved land and money obtained through the franchisor); (2) to large franchisees; and (3) to insiders.

5. Electronic Disclosure

Many franchisors have been providing electronic disclosure documents since 1997, when the FTC first opined as to the circumstances under which electronic disclosure would be permitted.  The New Rule updates the FTC’s policy of permitting electronic disclosure and provides greater latitude to franchisors.  Now, electronic disclosure is allowed so long as the prospective franchisee may “store, download, print, or otherwise maintain the document for future reference.” Although a form of receipt must be included as Item 23, no specific form of electronic or written receipt is required to be executed by the prospect and retained by the franchisor.

6. Annual Update Timing

The New Rule gives franchisors an additional 30 days to update their disclosure documents following the close of their fiscal year. Offering circulars must now be updated within 120 days of the franchisor’s fiscal year end. The New Rule retains the requirement that offering circulars be updated at least quarterly, if there are any material changes.

7. Franchisee Associations

Item 20 of the offering circular must now include the name, address, telephone
number, email address and web address of any franchisor-formed franchisee
association and any independent franchisee associations which (1) are formally organized under a state law and (2) request to be included in the disclosure document. Independent franchisee associations must renew their request to be included in the disclosure document each year.

8. Disclosure Triggers

One of the most significant changes in the New Rule from a compliance perspective is the elimination of the “first personal meeting” disclosure requirement.  Under the New Rule, franchisors need only provide a prospective franchisee at least 14 calendar days prior to signing. If the franchisor unilaterally changes the franchise agreement (or related agreements), the franchisor now must allow the prospective franchisee 7 calendar days to review the proposed changes. No additional review period will be required where changes to the agreements are negotiated.

9. Brokers

The New Rule changes the treatment of brokers substantially, creating the potential for a huge increase in the use of brokers. Brokers will no longer be required to provide disclosure documents under the New Rule. In addition, franchisors will no longer be required to include disclosures about their brokers in the offering circular (as had been required under the UFOC Guidelines).  Brokers will continue to be liable under the New Rule for any false claims they make.

10. Effect of Phase-in on Non-Format Elements

The New Rule will become effective on July 1, 2007. On that date, franchisors have the option to begin using the New Rule and cease using the original FTC Rule. All franchisors must comply with the New Rule no later than July 1, 2008.  We understand from the FTC that this means that franchisors can choose between all of the provisions of the New Rule and all of the provisions of the original FTC Rule, but they may not pick elements of each. So, for example, a franchisor using the UFOC Guidelines disclosure format after July 1, 2007 must continue to give a UFOC to prospects at the first personal meeting, but their integration clauses are not intended to be a prohibited practice.

11. State Implementation

The New Rule will not preempt any inconsistent state law that offers franchisees more protection to franchisees and prospective franchisees. It remains to be seen how the various states that require franchise disclosure and registration will (or will not) conform their statutes and regulations to the New Rule.

Patrick Maslyn

Hunton & Williams