An Overview of Federal Franchise Law
Franchising is regulated at both the federal and state level. Federal franchise law (the “Franchise Rule“) applies throughout the United States in all fifty states and territories. Additionally, certain states have passed laws to supplement the Franchise Rule. These state level laws vary and only apply at the state level. As a result, franchising requires an understanding of the federal requirements and the laws applicable to all states where the franchisor wants to franchise.
Prepare and issue an FDD
The federal Franchise Rule imposes an obligation on all franchisors to develop and maintain a “Franchise Disclosure Document” which is often referred to as the “FDD”. This legal document must be disclosed to prospects before any offer is extended or any funds are received. Franchises can only be offered and sold by disclosure of the FDD and observation of a federally mandated waiting period.
The consequences of failing to prepare or properly disclose a prospect can be severe. The Federal Trade Commission oversees the Franchise Rule and state regulators oversee compliance with their state laws. Additionally, mistakes often support civil claims by private litigants who are unhappy with the franchisor.
The Purpose of the Franchise Disclosure Document
The federal franchise rule is designed to protect prospective franchisees by ensuring they receive accurate and complete information about the franchise opportunity they are considering. The disclosure document is designed to contain key information about the franchise system, including the franchise agreement, fees, financial performance, and other essential details. This transparency helps potential franchisees make informed decisions and reduces the risk of fraud or misleading practices in the franchise industry.
The Contents of the Franchise Disclosure Document
The Federal Rule imposes an obligation to disclose certain information in twenty-three (23) distinct areas. Each area of disclosure is referred to as an “Item”. The Franchise Rule includes specific criteria for each Item and the Federal Trade Commission (“FTC”) and the North American Securities Administration Association, Inc. (“NASAA”) issue compliance guidance for franchisors and adopt certain rules for franchisors to follow when creating or updating its disclosures. Compliance requires a partnership between legal and business because the legal requirements are often nuanced and varied. Each disclosure document is unique to the brand. We have included a a 10,000 foot overview of each Item below:
Item 1: The Franchisor And Any Parents, Predecessors, And Affiliates
The first Item requires Franchisors to provide information on their corporate structure and identify certain related parties, like their parent or affiliate entities. Additional information is provided about each entity in order to disclose the nature and experience of the business. This Item also requires Franchisors also describe the franchise offering itself, the nature of the competitive market, and disclose industry specific laws and regulations that impact the franchised business.
Item 2: Business Experience
Leadership is a key part of any franchise system. Item 2 requires Franchisors to list their directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of the franchise offering. Persons with management responsibility must be disclosed regardless of whether they are employed by franchisor, a parent, or affiliate and regardless of professional title. The information disclosed encompasses all employment over the past 5 years.
Item 3: Litigation
Item 3 requires Franchisors to disclose information about certain civil or criminal actions involving the franchisor, its predecessors or affiliates, or its leadership. This Item encompasses various types of actions brought by the franchisor or against the franchisor and its related parties. For example, franchisors disclose if they have filed suit against franchisees for breach of the franchise agreement, failure to pay funds, or failure to adhere to a restrictive covenant.
Item 4: Bankruptcy
Franchisors must disclose any bankruptcy filing in the past 10 years from the franchisor, predecessor, parent, affiliate, officer, general partner, or any individual required to be listed in Item 2.
Item 5: Initial Fees
Item 5 requires franchisors to disclose what a prospect must pay to the franchisor to initially become a franchisee. The most common fee is referred to as the Initial Franchise Fee, but this section encompasses all fees paid to the franchisor prior to starting operations of a franchised business.
Item 6: Other Fees
Item 6 contains a details for all ongoing fees required to be paid to the franchisor or collected by the franchisor during the operation of the franchised business. For example, any royalty fees, technology fees, and transfer fees are contained in Item 6.
Item 7: Estimated Initial Investment
Disclosure documents must contain an estimate of the total amount a franchisee will need to spend to launch the franchised business. Item 7 includes all costs estimated to be incurred from the time the franchise agreement is signed until a certain amount of time after opening (typically 3 months). The disclosures in this Item should be based off the franchisors experience and is provided as a range of costs to recognize differences in market and costs of goods or services.
Item 8: Restrictions On Sources Of Products And Services
Franchisors must disclosed when they require a franchisee to provide products or services in a particular way or from a particular provider. Franchises in general are designed to require all franchisees to follow the same processes and systems; however, the degree of control and the suppliers of the products or services vary by franchisor. When the franchisor provides the services through its entity, a parent or an affiliate, they must disclose revenue gained and compare the revenue generated from required purchases to their total revenue, along with additional information.
Item 9: Franchisee's Obligations
Franchisors must disclose the franchisees obligations on an enumerated list of items provided in the rule. A sample of required disclosures includes: site selection and acquisition; pre-opening purchases; site development and pre-opening requirements; training; opening schedule; fees; compliance with policies/operating manual; use of trademarks and proprietary information; development and quotes; advertising; building condition; and other requirements.
Item 10: Financing
Some Franchisors finance the fees they impose, offer loans, or have agreements with third party lenders. Item 10 requires all Franchisors to disclose the terms for any financing that is offered to franchisees by the franchisor, its agents, or affiliates (directly or indirectly). The required disclosures are specified in the rule.
Item 11: Franchisor's Assistance, Advertising, Computer Systems, And Training
Item 11 requires Franchisors to disclose whether they have an obligation to provide certain types of assistance in training franchisees, assisting in launching the franchised business, and assistance in operating a franchised business. Franchisors also disclose restrictions on the operational manual and provide its table of contents.
Item 12: Territory
Franchises are designed to provide individuals with a limited right to operate a franchised business in a specific geographic location. Franchise agreements do not typically convey broad nationwide rights. Instead, rights are limited to a specific defined territory. Item 12 describes the metrics used to generate a franchise territory. It also contains certain information regarding the exclusivity or non-exclusivity of the territory, along with certain reservations and limitations. Individual territories are established during negotiations and included in the franchise agreement.
Item 12: Territory
Franchises are designed to provide individuals with a limited right to operate a franchised business in a specific geographic location. Franchise agreements do not typically convey broad nationwide rights. Instead, rights are limited to a specific defined territory. Item 12 describes the metrics used to generate a franchise territory. It also contains certain information regarding the exclusivity or non-exclusivity of the territory, along with certain reservations and limitations. Individual territories are established during negotiations and included in the franchise agreement.
Item 13: Trademarks
One of the key benefits of a franchising is the ability to operation under a single brand name. In the United States, trademarks can exist at common law, but federal registration is required to obtain full federal trademark protection. All trademarks claimed by the franchisor, along with their registration status and certain other information, must be disclosed in Item 13.
Item 14: Patents, Copyrights, And Proprietary Information
Franchisors develop the “know-how” and teach franchisees how to follow the franchise system. The know-how is often protected through copyright laws or confidentiality agreements. Franchisors must disclose the existence of certain intellectual property they provide to franchisees and explain the extent the information can be used by franchisees.
Item 15: Obligation To Participate In The Actual Operation Of The Franchise Business
Businesses require varying degrees of oversight and management. Item 15 requires Franchisors to disclose the extent of involvement required by the person signing the franchise agreement during the operation of the franchised business. Franchisors often establish criteria for management and other responsible parties and require certain training and standards. They may also require managers to sign restrictive covenants or agree to protect confidential information.
Item 16: Restrictions On What The Franchisee May Sell
Franchising conveys the right and obligation to conduct business as a franchisee. Systemwide uniformity of goods and services is often required. This Item requires franchisors to disclose a franchisees obligation to offer certain products or services and limitations on offering any other products or services.
Item 17: Renewal, Termination, Transfer, And Dispute Resolution
The initial franchise agreement is for a specific term which is often from 5 to 20 years in length. As a result, these agreements must plan for the good, bad and ugly. Item 17 contains disclosures of the conditions or requirements for a franchisee to renew the franchise agreement when the initial term is going to expire. It also includes conditions allowing for termination, dispute resolution, and other obligations under the franchise agreement. This disclosure is directly tied to the franchise agreement the prospect will sign, essentially highlighting these areas.
Item 18: Public Figures
If a Franchisor uses a public figure to advance its franchising efforts, then it must disclose certain information to prospects in its Item 18. For example, franchisors must disclose compensation or other benefits (such as equity) given or promised to any public figure and disclose the extent of the public figures involvement and investment interest in the company.
Item 19: Financial Performance Representations
Item 19 is often one of the most important areas of the FDD. This Item contains any financial performance representation made (historic or forecasted) by the Franchisor. Franchisors must adhere to strict rules on disclosure and typically cannot disclose any information not contained in the confines of this Item. Careful consideration is required when crafting an Item 19 financial performance representation.
Item 20: Outlets And Franchisee Information
Item 20 provides system wide information on company owned and franchised outlets through five separate tables of data. These disclosures include certain basic information on open, closed, and transferred outlets, along with a future forecast developed by the franchisor. Franchisors also disclose contact information for all existing franchisees and certain prior franchisees or exited the system.
Item 21: Financial Statements
Item 21 contains financial statements for the franchisor during the prior three year period. There is a phase in period for emerging brands at the federal level; however, most registration states require audited financials before doing business in their state. Further, any unaudited financials are provided with an alert advising prospects that the financials have not been audited. For this reason, most franchisors obtain audited financials when launching the franchise.
Item 22: Contracts
Franchising necessitates a contractual obligation between the franchisor and franchisee. The primary contract is the franchise agreement. A copy of the franchise agreement, along with any other contracts between the parties, is included in this Item by reference to an exhibit.
Item 23: Receipts
Franchisors must provide a receipt page to document the disclosure requirements and acknowledge that the franchise prospect obtained a copy of the FDD on a particular date. There are particularized requirements for disclosing the entire FDD and maintaining copies of signed receipt pages.
Federal Waiting Periods
Once the FDD is disclosed, a Franchisor must always observe a 14-day waiting period before any transaction can occur. Additionally, there is a 7-day waiting period that must be observed when certain changes are made to the franchise agreement.
Calculating the 14-day period does not include the day the FDD is disclosed or the day the franchise agreement is signed. Likewise, calculating the 7-day period does not include the day the franchise agreement is provided or signed.
No agreement can be signed and no money can exchange hands until this waiting period has passed. Many franchisors do not fully understanding how to calculate these periods or when the 7-day period is required. For example, the FDD does not typically define the franchisees territory. The territory is typically not a “fill-in-the-blank” provision. Therefore, the franchise agreement must usually be tailored for the specific franchisees territory and disclosed to the prospect so that the waiting period can be observed.
Adherence to the rules
The Franchise Rule contains prohibitions in Section 436.9. Specifically, it is an unfair or deceptive act or practice in violation of Section 5 of the Federal Trade Commission Act for any franchise seller covered by part 436 to:
(a) Make any claim or representation, orally, visually, or in writing, that contradicts the information required to be disclosed by this part.
(b) Misrepresent that any person:
(1) Purchased a franchise from the franchisor or operated a franchise of the type offered by the franchisor.
(2) Can provide an independent and reliable report about the franchise or the experiences of any current or former franchisees.
(c) Disseminate any financial performance representations to prospective franchisees unless the franchisor has a reasonable basis and written substantiation for the representation at the time the representation is made, and the representation is included in Item 19 (§ 436.5(s)) of the franchisor’s disclosure document. In conjunction with any such financial performance representation, the franchise seller shall also:
(1) Disclose the information required by §§ 436.5(s)(3)(ii)(B) and (E) of this part if the representation relates to the past performance of the franchisor’s outlets.
(2) Include a clear and conspicuous admonition that a new franchisee’s individual financial results may differ from the result stated in the financial performance representation.
(d) Fail to make available to prospective franchisees, and to the Commission upon reasonable request, written substantiation for any financial performance representations made in Item 19 (§ 436.5(s)).
(e) Fail to furnish a copy of the franchisor’s disclosure document to a prospective franchisee earlier in the sales process than required under § 436.2 of this part, upon reasonable request.
(f) Fail to furnish a copy of the franchisor’s most recent disclosure document and any quarterly updates to a prospective franchisee, upon reasonable request, before the prospective franchisee signs a franchise agreement.
(g) Present for signing a franchise agreement in which the terms and conditions differ materially from those presented as an attachment to the disclosure document, unless the franchise seller informed the prospective franchisee of the differences at least seven days before execution of the franchise agreement.
(h) Disclaim or require a prospective franchisee to waive reliance on any representation made in the disclosure document or in its exhibits or amendments. Provided, however, that this provision is not intended to prevent a prospective franchisee from voluntarily waiving specific contract terms and conditions set forth in his or her disclosure document during the course of franchise sale negotiations.
(i) Fail to return any funds or deposits in accordance with any conditions disclosed in the franchisor’s disclosure document, franchise agreement, or any related document.
State Laws Supplement the Federal Franchise Rule
States have the authority pass laws and enable regulatory bodies to create rules governing how businesses parties conduct business in their state. Some states have enacted specific rules tailored to franchisors and franchise relationship laws, while others have enacted laws generally effected the sell of a business opportunity. It is important to understand that the federal franchise rule establishes the minimum disclosure requirements. This is a floor, not a ceiling. State laws may impose additional oversight, change certain contract terms, or otherwise shape how franchisors operate within their state. States fall into five distinct categories:
Non Registration State
Some states have no state specific franchise laws. In these states, only the FDD is required.
Registration States
Some states require a franchisor to register the FDD and obtain state approval before offering any franchise. This is an annual process and is often very hands-on.
Annual Filing States
Some states require the franchisor to file a notice and pay an annual filing fee before offering franchises in their state.
One-time Filing States
Some states require the franchisor to file a one-time notice before offering franchises in their state.
Business Opportunity States
Certain states have passed business opportunity laws. Franchisors must register as a business opportunity in these states unless they have a federally registered trademark or another exemption applies.
Franchise laws can vary by state. The Franchise Legal Hub also maintains an overview of state franchise laws.