Denver Colorado Franchise Attorney Martin A. Mansfield, Jr.

Introduction

After many years of work, the U.S. Federal Trade Commission (“FTC”) promulgated a new FTC Rule on Franchising that affects all franchisors anywhere in the United States.  In part, this new Rule

•    redefines franchising (and also business opportunities),
•    establishes a new disclosure document,
•    modifies the time period for making disclosure,
•    clarifies who is entitled to disclosure,
•    adds to the exemptions from the disclosure rule, and
•    permits and regulates electronic disclosure.  

This new Rule replaced became mandatory after July 1, 2008. 

Legal background

The United States Constitution gives the federal government the right to regulate interstate commerce, and the U.S. Supreme Court has defined interstate commerce to cover almost all commerce, even that many would consider local.  The “Supremacy Clause” of the U.S. Constitution provides that U.S. laws, if validly passed within the authority of the federal government, take precedence over conflicting state laws.  This is known as “preemption.”  However, the federal government can choose the extent to which it intends to preempt state laws, and may also choose not to preempt them.

The FTC started regulating franchising in the 1970’s, and so did some of the states, started by California.  The FTC permitted considerable state leeway in regulating franchising.  This meant that the federal FTC Rule did not preempt state franchise laws.  Over the decades the states that do regulate franchising have passed franchise regulations that differ considerably from the FTC Rule.  One significant variance was the Uniform Franchise Offering Circular (UFOC) disclosure format that was entirely different from the much simpler format provided for in the FTC Rule.  The FTC decided to permit use of the UFOC in lieu of its own disclosure format anywhere in the U.S.  The main reason it did so was its recognition that the UFOC better protects prospective franchisees.  Therefore, even though only a minority of states required the use of the UFOC, most Franchisors used only the UFOC format everywhere in the U.S. in order to only have to use one format rather than two.  

The FTC Disclosure Document

The FTC’s growing dissatisfaction with its own disclosure format was a primary reason for updating the FTC Rule in 2008.  Therefore, perhaps the most important part of the FTC Rule is the FTC Disclosure Document ("FDD").  Although similar to the now defunct UFOC, the actual content in each of the items differs, sometimes considerably, and in some cases much more detail is required.  In effect, the FTC has updated the UFOC format to a new document that addresses FTC concerns in the current franchise environment.  This new format is the Franchise Disclosure Document (FDD), which regulation states sometimes refer to as the Uniform Franchise Disclosure Document (UFDD).

 
The state administrators of the prior UFOC regulation states have also adopted the FDD format.  States may deviate from the FTC requirements for the document in order to accommodate state policies.  Also, the FDD requirement has no effect on state franchise review, registration, and franchisor-franchisee relationship laws.

The FTC Rule requires the FDD to be given a prospective franchisee at least 14 days prior to the signing of the franchise agreement or payment of money to the franchisor.

Impact on Franchise Agreements

The FTC Rule does not regulate franchise agreements as such, but will typically affect how most franchise agreements will be written. 

Exemptions

The FTC permits certain exemptions to the requirement of presenting the FDD to prospective franchisees.

The two most significant exemptions are the $1,000,000 initial investment (exclusive of unimproved land and franchisor-provided financing) exemption and the large entity purchaser ($5,000,000 net worth and five years in business) exemption which can apply regardless of the size of the investment.  

Each of these exemptions has a number of technical requirements.  But we do know that the $1,000,000 investment applies to multi-unit purchases as well as single unit, so a franchisee investing $200,000 each in 5 units meets the threshold just as much as a franchisee investing $1,000,000 in 1 unit. We also know that the $1,000,000 threshold must be met by at least one of the investors, so 10 investors putting in $100,000 each will not qualify.

A typical case of a $5,000,000 exemption would be a hospital purchasing a flower shop franchise.  

The FTC exemptions are not binding on the states, and do not preempt those of the states, so if a state does not recognize the $1,000,000 initial investment exemption, for example, then it does not apply in that state. 

Electronic Disclosure

The FTC Rule permits the FDD to be provided in certain non-paper formats.  However, the electronic version must look like the paper version, which leads to solutions such as PDF files that mimic the paper pages.  Navigation scroll bars, search features and internal links are permitted, so other solutions might work.  Multimedia tools such as audio, video, pop-up screens, or external links are not permitted.  Initially, therefore, simpler solutions might be better.  And, the prospective franchisee must be able to print or store the e-document rather than just view it.  Almost all franchisors provide prospective franchisees a PDF file of the FDD.

In order to use electronic disclosure, the franchisor must also advise prospective franchisees in one form or another of the format(s) in which electronic disclosure is available (there may be more than one), prerequisites to obtaining an electronic version, and conditions for reviewing the document in a particular format.  Also there are practical issues such as providing directions over the Internet on how to get an electronic document, actual delivery of the e-document, and a reliable means of recording individual document receipts.    

My current recommendation for franchisors wishing to use e-disclosure is to use a  PDF file.  For this, one must integrate the Franchise Agreement and Financial Statements into the single document containing the other parts of the document so that all may be put into one PDF file.  The e-document cannot be broken into multiple files.  And it probably makes sense to have PDF files on CD format for persons with slow Internet connections.  A complete  document will be around 100-300 pages, which is a large PDF file.  

Importantly, a franchisor need not provide access to e-documents to all persons who ask or make them universally available.  A franchisor may determine who is entitled to receive an FDD and when.  

Summary

In summary, the FTC Rule is mandatory throughout the USA.  The Rule preempts a few areas, including the disclosure document format and leaves most others to state discretion.  The Rule does not preempt state registration, review, or relationship laws.