Denver Colorado Franchise Attorney Martin A. Mansfield, Jr.

This web page broadly outlines the most significant changes to the actual content of the FDD contrasted with the former UFOC requirements. 

Of necessity, this discussion is on the glossy side. The new FTC Rule provisions are intricate, with many subparts.

Introduction

The overall purpose of the FDD is uniform and non-deceptive disclosure of information the FTC considers most significant to a new and relatively unsophisticated franchise purchaser.  The FDD must contain all detailed disclosures as required by the new Rule and only those disclosures.  In addition, the franchisor must walk the difficult line between comprehensive disclosure of legal matters in the franchise agreement on the one hand and disclosure in a “plain English” manner on the other. 

As regards deceptive practices, the FTC has indicated the five most important pre-sale potential deceptions that it wants addressed in the FDD, specifically, misrepresentations about:

1.    The opportunity being offered for sale
2.    Costs
3.    Contractual terms
4.    Success of the seller and prior purchasers
5.    The seller’s financial viability.

This list is by no means exclusive, but knowledge of this list is useful in understanding the new FDD.

The FTC also wants the FDD to provide better disclosure of key aspects of the franchisor-franchisee relationship, including such items as territories, renewal of the franchise agreement, and franchisor-franchisee litigation.

The FDD is facially similar to the now defunct UFOC, and follows a similar format.  However, each Item in the FDD comes with multiple and detailed instructions that differ from those of the UFOC format.  
Although the FTC has mandated the use of the FDD after July 01, 2008, meaning that the existing form of UFOC has been abolished, it has left the door open for states to require additional disclosures more protective of franchisees in the FDD. 

Also, because the FTC will permit states to vary provisions if the state provisions are more protective of prospective franchisees, there will be other state variants.  This includes procedures to be followed by the franchisor, as well as the substance of the FDD and registration of the franchise.   For example, even though the FTC has eliminated the “first meeting” disclosure rule as noted under “Timing of Disclosures” below, a state may keep such a rule, insist on longer waiting periods, use other methods of calculating waiting periods, etc.  

The following topics do not cover all FTC-mandated disclosures.

USA Franchisees Only

The FTC has ruled that the FDD need only be given prospective franchisees of franchises to be located within the United States and its territories.   Therefore, even if the prospective franchisee comes to the USA to negotiate or sign the Franchise Agreement or receive training here, if the actual franchise operation is to be located in a foreign country, the FDD need not be presented to such a prospective franchisee.  This would appear to apply to franchises owned by U.S. citizens as well as foreign nationals, so long as the franchise is located entirely outside the United States and its territories.

 
Timing of Disclosures

No First Meeting Requirement:  The FDD is not required to be given at a first meeting with a prospective franchisee.   This is a departure from the current rule which does require disclosure at the first meeting (unless already given).  However, the FDD is required to be given “upon reasonable request” by a prospective franchisee.  The FTC has by comment limited the “reasonable request” requirement to situations “where the parties have already conducted specific discussions or negotiations or otherwise taken steps to begin the sales process.”  As a practical matter, the franchisor should be prepared to give the FDD to a prospect at the first meeting (or any meeting) in the event an FDD is requested. Group meetings such as discovery days or attendance at trade shows need to be evaluated in order to determine if actual sales discussions might occur or if only basic information will be tendered. The franchisor may interpose a requirement such as filling in an application before the actual sales process is begun.  Thus, ad hoc requests by phone or over the internet by interested parties need not be honored unless meaningful steps to become a franchisee, such as filling in an application, have been met.  One group that can benefit from this change is companies considering franchising who have not yet created an FDD and aren't sure they will franchise.  These companies can do some marketing of an exploratory nature involving personal meetings and won't be violating the law just because an FDD was not presented. 

14 Calendar Days:  For the FDD, the advance timing rule is 14 calendar days.  This means, according to the FTC comments, that the 14 days start the day after delivery of the FDD, so that payment or franchise agreement signing can take place on the 15th day after delivery.  Thus, if the FDD is delivered on a Tuesday, signing and payment may occur no earlier than the Wednesday two weeks later.  

7 Calendar Days:  For the FDD, the final franchise agreement need be presented at least 7 calendar days (no longer 5 business days) before signing and payment only if the franchisor unilaterally changes the agreement.  If the franchisee requests changes, the resulting agreement may be signed and payment of the franchise fee made without waiting the 7 calendar days, assuming that the only changes are those made in response to this negotiation.  The FTC assumes, as is usually the case, that most negotiated changes are at the request of the prospective franchisee, so it envisions few occasions when the 7-day rule will apply.  Thus, the purpose of this rule has changed – its purpose now is to protect the prospective franchisee from undisclosed franchise agreement changes by the franchisor, and not to provide another waiting period before signing.  Fill-in-the-blanks changes do not trigger the 7-day period.  We may assume that the 7 days are calculated the same as the 14 days, and that if the 7-day period does apply, then signing and payment may occur no earlier than the 8th day after delivery.  The 7-day rule does not automatically require a new FDD be presented, but one can envision times that it might.

 
Delivery defined:  The FDD is deemed delivered if:

1.    A copy was hand-delivered, faxed, emailed or otherwise delivered by the required date;
2.    Directions for accessing the FDD on the Internet were provided by the required date; or
3.    A physical copy (paper, CD-ROM, etc.) was mailed by first class U.S. mail at least 3 calendar days before the required date.

A receipt is required to prove delivery.  The document, if not paper, must be downloadable onto a computer.  Electronic documents must be single documents.  

Parents, Affiliates and Predecessors

The new FTC Rule clarifies what entities are parents, affiliates or predecessors of the franchisor for purposes of FDD disclosure.  

A parent is a controlling entity in a parent-subsidiary business structure.  

An affiliate is controlled by or under common control with another entity, but affiliate information need be disclosed only if the affiliate offers franchises or provides services to the franchisees of the franchisor.  This means that a franchisor who separates the franchise business from an affiliate comprising the common owner’s non-franchise business need not disclose such an affiliate.  However, the owner must take care that the non-franchise business does not provide any services to the franchisees.

A predecessor is a person or entity from whom the franchisor acquired most of the franchisor’s assets.  This means that if there is a predecessor, but if the major portion of the franchisor’s assets do not come from that predecessor, then that predecessor need not be disclosed.  This non-disclosure may apply to many instances where the franchisor had a prior business not related to the franchise being offered.

Brokers

A Franchise Broker will not be disclosed in the body of the FDD, unless it happens to constitute an individual with management responsibility relating to the sale or operation of the franchises.

 
Litigation and Bankruptcy

A broader array of litigation must be disclosed in the FDD than was required to be disclosed in the UFOC.  As a practical matter, in order to determine inclusion or exclusion, you need to assemble basic information on all litigation of all types in the last 10 years for review.  Litigation also includes settlements of any kind of disputes, whether or not they went to court or arbitration.

The litigation to be assembled includes not only that of the franchisor, but of any person disclosed in Item 2 Business Experience of the FDD, any predecessor, and any parent or affiliate.

As regards any franchisor-franchisee disputes, both franchisor-initiated and franchisee-initiated disputes are included, a departure from the UFOC, but franchisor-initiated may be disclosed more generally and even in groups by type of case.

Bankruptcies must be disclosed for the franchisor and any person disclosed in Item 2 Business Experience of the FDD, any predecessor, and any parent or affiliate.   So, it is important to revisit this as well to determine if any bankruptcy not disclosed in the UFOC might have to be disclosed in the FDD.  The time period is 10 years.

Initial Fees to the Franchisor

The FTC now accepts ranges of initial fees rather than just a single fixed amount.  The franchisor must disclose if fees are or are not uniformly imposed.  Fees are not required to be uniformly imposed.
 

Franchisor Assistance

The FDD requires more extensive disclosure of any advertising obligations of the Franchisor, and also of any advertising fund, coop or council.  The FDD has also expanded disclosure requirements pertaining to franchisor-required computer systems or POS systems.

Territories

The FDD will have stronger language about the disadvantages of the lack of an exclusive territory, if applicable.  Also, the franchisor must disclose in more detail whatever rights it retains to operate in the territory.

Trademarks

The FDD will have stronger language than required in the UFOC about the disadvantages of the lack of a federally registered U.S. trademark, if applicable.

Financial Performance Representations

The FDD will in practicality permit a wider range of what are often referred to as “earnings projections”.   An important change is the elimination of the requirement that these claims be based upon GAAP. Another is that the franchisor may be able to provide more information on franchisor-owned outlets. Also, if a particular outlet is to be sold, the financial records of that outlet may be provided.  Costs and expenses may be disclosed without being considered Financial Performance Representations.  The FDD adds two required statements to this section, namely that the FTC does not prohibit these claims also warning prospective franchisees not to rely on unauthorized claims and report any unauthorized claims to the authorities.

Because of these changes, more franchisors will be able to provide financial performance information in response to prospective franchisee demand for such information.   However, some states may still make this more difficult and could refuse to accept certain representations, as they do now.

These changes mean a franchisor will want to explore adding these representations to the FDD even if it did not in the UFOC.  It also means a franchisor must readdress applicable provisions of the franchise agreement to make sure it may obtain needed financial information from franchisees for any such disclosures.  However, the making of financial performance representations will increase a franchisor’s liability exposure to new franchisees who fail to perform at the represented level, even if the franchisee is the one responsible for the performance failure, and this might deter a franchisor from exposing itself to this risk.

Outlets (the Item 20 charts)

The FTC has changed these charts and has clarified what entries must be made when a given outlet has undergone multiple changes in order to avoid certain “double counting”.  For example, if an outlet is put into the charts as transferred and then later terminated or closed, this could double count that franchise.  Simple in theory, but potentially complicated in practice, especially as the number of franchised outlets grows.  It will probably be necessary to maintain a spreadsheet or list of the franchises, with the previous Item 20 entries of each.  Then, when the status of that outlet changes, one will know what number(s) to add/change. A franchisor will also have to know the year of each status change.

There will be 5 charts where there were 3 before, so all prior UFOC information will have to be reworked.

The FTC has gone into painful detail about these changes and considers this to be a major change.  

On a related matter, the FTC has also changed and made more specific the information about existing and former franchisees to be put in the lists of each and has added a required statement warning prospective franchisees that this information will be inserted about them if they buy a franchise.  For franchised units that change hands more than once within the 5 years preceding the date of the FDD, the information for all owners thereof during those years must be disclosed in the list.

Along with unit-specific financial representations, the franchisor may provide unit specific prior owner information in a supplemental document separate from the FDD.

If a franchisor requires a franchisee to sign a confidentiality clause, the FDD must contain specified language concerning this.  The FTC is concerned about “gag” clauses that prevent a former franchisee from speaking openly about the system, not clauses that protect the confidentiality of the franchisor’s proprietary and confidential information.  Despite this, further clarification is probably needed from the FTC on this point.

Franchisee Associations

New to the FDD is the requirement that specified information be given about that franchise’s franchisee associations.  If the association is sponsored or endorsed by the franchisor, this information must be given.  If it is independent, the information must be given at the request of the association.

Financial Statements

Financial statements remain required for the last 3 years (or less for younger franchisors).  Financial statements must still have at least 2 years columnar comparisons.  In limited situations, financial statements of parents must similarly be disclosed – when the parent commits to perform post-sale obligations for the franchisor or when the parent guarantees obligations of the franchisor.  Financials must still be updated quarterly on an unaudited basis.

As regards the annual financials, the balance sheet must be provided for the previous two fiscal year-ends, and statements of operations (profit and loss), stockholders equity, and cash flows for the previous three fiscal years.

Financial statements must conform either to GAAP, or any future government-mandated accounting principals (i.e. post-GAAP if applicable), or to SEC requirements.

Importantly, the FDD must also disclose the financials of any subfranchisor (or area developer) that are not merely brokers.  The test is if the sub does or does not have post-sale obligations to the franchisee.  This will trigger changes in area developer agreements.  This also applies to parent organizations of the franchisor.

Start-up franchisors have the following minimum requirements as respects audited financials:

Unaudited opening balance sheet for the first partial or full fiscal year selling franchises.

Audited balance sheet (and accountant opinion) as of the end of the first partial or full fiscal year selling franchises.  (This audit requirement is a year earlier than the old rule, but is just the balance sheet.  Whether this reduces the cost of the first audit remains to be seen.)

Audited: balance sheet, statement of operations, stockholders equity and cash flows as of the end of the second and subsequent fiscal years.  

Also, start-ups must prepare complete unaudited financials during the phase-in years  unless they state that they have not been in business for three years or more and cannot include all the financials.

Documentation and Receipt Retention

FDD documentation and receipts must be retained for at least 3 years.  Of course, receipts should be kept in a permanent file.  Electronic versions of the FDD are also subject to the 3 year rule.

 

There are three:

Franchisors must update their FDD within 120 days after the close of each fiscal year.

The FDD (including financials) must be updated each quarter to reflect any material changes.  Quarterly updates may be in the form of an addendum.

Franchisees must be informed of any material changes in financial performance representations at any time.

 

The new FTC rule retains the prohibition against statements contrary to disclosures in the FDD.  When applicable, this would include financial performance representations in the FDD.  If there are no such representations in the FDD, then none may be made to prospective franchisees.

 

Sales and Renewals of Existing Franchises

So long as the only involvement by the franchisor in a sale or transfer of an existing franchise is approval or disapproval, the FDD need not be provided to the buyer.  

Renewals that do not involve materially different terms and conditions from the old to the new franchise agreement and where there is no interruption in the franchise do not require an FDD.  

Tables

Except as discussed above, the tables in the FDD do not significantly differ from those in the UFOC.  

Summary

In summary, transition to the FDD will take considerable time and effort, but life under the FDD will not be worse for most franchisors than under the UFOC.  The response of franchise regulation states to the FDD is a key variable.  The more states that just adopt the FDD with minor variations, the more uniform compliance can be.

For new franchisors, creating the first FDD is only somewhat more difficult and time consuming than was creating the first UFOC.