Federal and State Regulation

Federal Trade Commission (FTC)

● 1979 adopted its trade regulation rule 436 (The FTC Rule)
● Which specifies the minimum amount of disclosure that must be made to a prospective
franchisee in any of the 50 states/countries
● 3rd edition, pending proposals that would change the landscape of how franchising is
regulated in the US.

Federal Trade Commission (FTC)

● FTC Rule Modifications

● Electronic Registrations
● Coordinated Review of UFOs

FTC Rule Modification

● Considering a major overhaul to its nearly 25 y.o. disclosure format.

● Expected to repeal its format in favor of a somewhere expanded version of the UFOC
guidelines, which is likely to take place by early 2004.
● Current and prospective franchisors should consult their qualified franchise legal advisors
for additional information.

Electronic Registration

● Allows franchisors, prospective franchisors, and their advisors to use the internet to
access registered UFOs

Coordinated Review of UFOs

● Allows a franchisor to register its UFOC in two or more states at the same time.
● Developed a formal protocol to offer coordinated franchise review
● CR-FRAN (Coordinated Franchise Review)
- Franchisors will file documents and pay the required fees in all states in which
they seek registration.

Lead Examiners are responsible for coordinating the comments by and among each state and
within 30 days of the filing must deliver to the franchisor.
Two types offered and regulates of the FTC Rule

1. Package and Product Franchises

Three Characteristic:
1.1 The franchisee sells goods or services that meet the franchisor’s quality standards.
1.2 The franchisor exercises significant assistance in the franchisor’s method or
operation.
1.3 The franchisee is required to make payment

2. Business Opportunity Venture

Three Characteristic:
2.1 Franchisees sell goods or services that are supplied by the franchisor or a person
affiliated with the franchisor.
2.2 The franchisor assists the franchisee in any way with respect to securing accounts for
the franchisee or securing locations or sites for vending machines or rock displays or
providing the services of a person able to do either.
2.3 Franchisee are required to make a payment or a person affiliated with the franchisor
at any time within 6 mos. after the business opens.

FTC Rule Exempts

1. Fractional franchises
2. Leased department arrangements
3. Purely verbal agreements

FTC Rule Excludes

1. Relationship between employer/employees and among general business partners

2. Membership in retailer-owned cooperatives
3. Certification and testing services
4. Single trademark licenses

FTC Rule requires that the disclosure document must be given to a prospective franchisee
at the earlier of either:

1. The prospective franchisee’s first personal meeting with the franchisor

2. Ten business days prior to the execution of a contract
3. Ten business days before the payment of money relating to the franchise relationship
Disclosure Document

● Franchises must receive a copy of all agreements that will be asked to sign at least 5
business days prior to the execution of the agreements.

Eligibility Document

● Provide standards for screening each system based on five (5) major criteria and loan
conditions that must be met during the term of the SBA-guaranteed loan.
● Small Business Administration (SBA) in 1998 a central registry of eligible franchise
systems to accomplish two objectives of eliminating.

Two objectives of eliminating:

● Unnecessary review of the franchise agreement and documents that creates lengthy
processing delays
● Inconsistent decisions among different SBA field offices regarding the same franchise
system

● 2001 since approved over 4, 000 loans to franchisees with a total principal amount over
a billion amount of money

Five (5) major criteria and loan conditions:

1. Control
2. Leasing from franchisor
3. Renewal
4. Transfer
5. Default and termination

1. Control

- Franchisor may not control its franchisee to the point that the franchisee does not have
the independent right to both profit from its effort.

2. Leasing from franchisor

- Franchisors may not terminate any real estate unless an uncured default has occurred
under the terms of the real estate lease or the franchise agreement.
3. Renewal

- Offered to the franchise may not be less favorable to the franchisee than either;
a. Terms of the franchisor’s then-current form of a franchise agreement
b. Renewal terms offered by the franchisor to other comparable renewing
franchisees.

4. Transfer

- Franchisee must be free to transfer its interest in the franchised business at any time to a
franchisee meeting the franchisor’s qualifications.

5. Default and termination

- Franchise agreement must identify

a. All events of default
b. Those events of default that will constitute the basis for termination of the
franchise agreement
c. Written notice of termination if each default
d. Default- are grounds for automatic termination and for which there is no
opportunity to cure and for all other defaults.
e. The time for a cure that the franchisor will give for all other defaults.

During the term of SBA guaranteed loan

Franchisors may terminate the franchise agreement only for automatic terminations and
uncured defaults.

Other loan conditions

- Provides billing and collection services

- Controls accounts receivable
- Accepts payments from franchisee’s customers or third-party payors
- Services the franchisee’s accounts

Federal Trade Commission Analysis

Three components:

1. Trademark
2. Required payment
3. Significant Control and Assistance
Trademark

- Satisfied when the franchisee is given the right to distribute goods or services under the
franchisor.

Require Payment

- The payment may be required by the franchise agreement, and ancillary agreement
between the parties, or by practical necessity (such as required supplies that are only
available from the franchisor).

Significant Control and Assistance

The term “Significant” refers to the degree to which the franchisee is dependent upon the
franchisor’s superior business expertise.

The presence of any one of the following types of control or assistance may suggest the existence
of “significant control or assistance” sufficient to satisfy this prong of the definition of a
franchise:

Types of Control:

- Site approval
- Site design/appearance requirements
- Dictating hours of operation
- Production techniques
- Accounting practices
- Personnel policies/practices
- Required participation in, or financial condition to, promotional campaigns
- Restrictions on customers
- Restrictions on sales area or location

Types of Assistance:

- Formal sales, repair, or business training

- Establishing accounting systems
- Furnishing management, marketing, or personnel advice
- Site selection assistance
- Furnishing detailed operations manual
The Mechanics of the Registration Process

1. Information regarding the company and its Principal

2. Initial fee
3. Royalty
4. Advertising Fund
5. Other Fees Paid to Franchisor
6. Initial Investment
7. Sources for Products and Services
8. Franchisee's Obligations
9. Financing
10. Franchisor’s Obligation
11. Territory
12. Franchise Participation
13. Restrictions
14. Renewal, Termination; Transfer; Dispute Resolution
15. Public Figures
16. Earnings Claims
17. List of Outlet
18. Financial Statement

I. Overview of State Regulation of Franchise Sales

The registration states require not only pre-sale disclosure, but also registration of the franchise
offering with a state before the franchisor may lawfully make any offers or sales in that state.

For example, most, but not all, registration states require the filing of the Franchise Disclosure
Document (FDD) as a part of the registration application. Many, but not all, require the FDD to
include, usually in addendum form, certain disclosures required by state law.

Once an offering is registered, a franchisor must amend its registration any time a “material”
change occurs in the information on file with the appli- cable state agency.

A. Jurisdictional Scope of State Franchise Registration and Disclosure Laws

Under the registration laws, an offering must be registered (and required disclo- sure
completed) before a franchise is offered or sold in that state,
 To understand the jurisdictional scope of these laws, one must be familiar with what
activities constitute an offer and when an offer is deemed to be made or accepted in a specific
state.

State laws generally define an “offer” of a franchise to include “every attempt to offer or
dispose of, or solicitation of an offer to buy, a franchise or interest in a franchise for value.”

The following types of communications are generally considered offers requiring registration
of the franchise offering be- fore engaging in the specific act:

1. Oral or written contacts with a prospective franchisee to discuss the specifics of the
franchise opportunity.
2. Publication of a newspaper, magazine, radio or television advertising offering a franchise.
3. Distribution of promotional brochures and other franchise sales literature describing a
franchise opportunity.
4. Promoting a franchise opportunity at a trade show or franchise fair.

B. Exemptions from State Franchise Registration Requirements

A franchisor must register its franchise offering with a franchise registration state before
making any offers or sales in that state, unless an exemption from the state’s registration
requirement is applicable.

Exemptions generally are based upon:

1. characteristics of the franchisor or prospect, such as experience and net worth

2. characteristics of the transaction, such as an isolated sale, a transaction with an initial
investment over a certain threshold, or a sale by a franchisee for its own account.

II. Registering a Franchise Offering

A. When to File

1. Initial Applications

A franchisor must register its franchise offering in a franchise registration state before making
any offers or sales in that state, unless the offering is exempt from registration.

2. Renewal Applications

A franchisor must renew its franchise registration in a franchise registration state on an annual
basis.
 3. Amendment Applications

Franchisors must amend their franchise registrations and FDD upon the occurrence of any
material change in the information contained on file with the appli- cable state agency.

The FTC Rule defines a material change as “any fact, circumstance, or set of conditions which
has a substantial likelihood of influencing a reasonable franchisee or a reasonable prospective
franchisee

Types of events that would generally trigger the need to amend a franchisor’s franchise
registration include, but are not limited to:

1. terminating or failing to renew a substantial portion of the franchise system’s franchises

generally, or in the state in question;
2. a significant change in the franchisor’s management;
3. an adverse change in the franchisor’s financial condition;
4. any change in the terms of the franchise agreement itself (e.g., a change in the fees
imposed on franchisees); and
5. a significant change in corporate structure or ownership (e.g., a merger with another
company or franchise system).

B. The Filing and Registration Process

1. The Franchise Application

A franchisor must file an initial franchise registration application before making any offers or
sales of franchises in a registration state.

2. Electronic Filing

In an effort to cut down on the amount of paper produced in a franchise applica- tion, the
following registration states now provide the option to file franchise applications electronically:

3. Use of a Multi-State FDD in the Registration Process

In contrast to the prior prac- tice of using different disclosure documents for different registration
states, this practice has made the filing process more efficient as it takes less time and effort to
file one document in 13 states than 13 different documents in 13 different states.

C. Working with State Franchise Examiners

The goal of registration and disclosure counsel should be to obtain registration of the franchisor’s
franchise offering by the registration states as efficiently as possible. Failure to do so may result
in the franchisor being unable to lawfully offer and sell franchises in a registration state.
 D. Registration of Multi-Unit Franchise Offerings

Three structures of Multi-Unit Franchise:

- Area developer
- Area representative
- Subfranchise structure

III. Other Registration Duties

A. Compliance with Business Opportunity Laws

Many franchisors are exempt from such laws based on either of two common (but not
universal) exemptions or exclusions:

1. offering a “franchise” in compliance with the Amended Rule;

2. offering a marketing plan or sys- tem in conjunction with the licensing of a registered
trademark or service mark.

B. Registration of Salespersons

This form must be filed before the individual undertakes sales activity on behalf of the franchisor
in the applicable state.

Three misconceptions arise in this area.

1. The first relates to the person for whom the form must be filed.
2. The second misconception relates to the type of filing required when new salespersons
are brought into the franchise organization mid-year.
3. The third misconception relates to franchise sales organizations.

The registration and disclosure laws of Washington and New York impose separate filing
requirements on franchise sales agents and brokers. If the franchisor is using franchise sales
agents or brokers in either of these states,

C. Filing of Advertising and Promotional Materials

Most franchisors use franchise sales advertising in some form to solicit potential franchisees to
enter into the franchise system. State registration and disclosure laws broadly define an
“advertisement” to include any written, recorded, or spoken communications made in connection
with an offer or sale of a franchise.
 D. Satisfying Financial Assurance Requests

Many of the registration states will, however, require the franchisor to satisfy a financial
assurance condition imposed by the state if, in the opinion of the state examiner, the franchisor
does not have sufficient financial resources to meet its pre-opening obligations to new
franchisees.

The type of financial assurance condition varies by state and the circum- stances of individual
applications, but generally includes deferral of the payment of initial fees, escrow of initial fees,
posting of a surety bond, guarantee of performance by a parent entity, or infusion of additional
capital. Each of these conditions is discussed below.

1. Deferral of Payment of Initial Fees

Most of the registration states will allow a franchisor to satisfy a financial assurance request by
agreeing to defer the payment of initial fees until the franchisor’s and its affiliates’ pre-opening
obligations to the franchisee have been satisfied.

2. Escrow

Franchisors may also satisfy state financial assurance requests by setting up an escrow account in
a national bank in the state where initial fees paid by the franchisee are deposited.

3. Surety Bond

A surety bond is a form of third-party insurance that a franchisee can make a claim against if the
franchisor fails to satisfy its pre opening obligations to the franchisee. The franchisor must
provide the bond to the state for approval as a condition to the registration of the franchisor’s
franchise offering.

4. Guaranty of Performance

A franchisor can also satisfy a financial assurance request by providing guaranty by a qualified
third party, usually the franchisor’s parent company.

5. Capital Infusion/Debt Conversion

A franchisor facing a financial assurance request may also discuss with the state an infusion of
additional capital in the franchisor or a debt-to-equity conversion (to improve the franchisor’s net
worth or certain balance sheet ratios) as a means of meeting the request.
 E. Agents for Service of Process

State franchise registration and disclosure laws require that the state regulatory agency be
appointed by the franchisor as its agent for service of process.

IV. Enforcement
Public enforcement of compliance with the Amended Rule falls to the FTC, whereas public
enforce- ment of compliance with each state franchise registration and disclosure law falls to the
applicable state.

A. Remedies Under State Registration and Disclosure Laws

A franchisor may fail to comply with a state franchise registration and disclo- sure law in various
ways.

1. Civil Remedies

The state registration and disclosure laws often afford private parties the right to bring claims for
violations of these laws.

The potential relief accorded a private party typically takes two forms:

● claims for damages

● claims for rescission and restitution

2. Administrative Enforcement

As discussed above, responsibility for public enforcement of the franchise reg- istration and
disclosure laws falls to various public agencies, depending upon the state.

3. Criminal Penalties

Although not commonly imposed, the franchise registration and disclosure laws also provide for
criminal penalties for the willful violation of certain provisions of these laws.