34.

The Practitioners Guide to Colorado Business Organizations

franchises and impose both disclosure and relationship requirements. Fourteen states have registration requirements, while other states have notice requirements or other laws that regulate the relationship between franchisors and franchisees.6 The rapid growth of franchising is fueled by the mutually beneficial relationship that franchising creates and the relatively low initial investment required by franchisees. Franchising benefits franchisors by allowing them to grow their businesses faster with less risk, and benefits franchisees by giving them an opportunity to own their own businesses using proven business concepts under uniform brands. Businesses that lend themselves to franchising typically are easy to duplicate, provide value (such as an established system or a well-recognized trademark), and provide franchisees with an acceptable rate of return on their investment. According to a study of the economic impact of franchising commissioned by the International Franchise Association, franchised businesses operated 909,253 establishments and provided 11 million jobs in the United States in 2005.7 In addition, franchised businesses operated 3.3 percent of all business establishments in the United States in 2005, and the number of franchised establishments grew at an annual rate of 4.3 percent between 2001 and 2005.8 With the expansion of franchising in the United States, more and more attorneys are finding themselves approached by business owners wanting to convert their current businesses into franchises, and by franchisees wanting guidance regarding the legitimacy of and legal issues related to a franchise business they are evaluating. The purpose of this chapter is to discuss the various federal and state requirements for the sale and operation of a franchise business and the ramifications of non-compliance.

34.2 FEDERAL DISCLOSURE LAW

Federal franchise law is exclusively focused on requiring franchisors to provide prospective franchisees with specific information regarding the franchise investment in the form of a disclosure document that complies with the requirements set forth in the FTC Rule.9 Before disclosure is required, however, the commercial relationship must fit within the definition of a franchise. Importantly, the definition of a franchise under the FTC Rule may differ from the definition of a franchise under state law, or vice versa. As such, a commercial relationship that does not qualify as a franchise under the FTC Rule may still qualify as a franchise under relevant state law. Moreover, the parties intent to create a franchise is not relevant to the determination of whether a franchise legally exists for federal or state law purposes, nor will language describing the relationship of the parties as anything other than a franchise be probative in the determination of whether a franchise relationship legally exists. The ultimate determination of the existence of a franchise is the reality of the parties relationship, oral and written promises, and past dealings between the parties. 34.2.1FTC Rule Definition Of A Franchise Under the FTC Rule, a franchise exists when there is a continuing commercial relationship whereby (1) the franchisee offers, sells, or distributes goods or services identified by the franchisors trademark, trade name, or other commercial symbol, or the franchisee is required or advised to meet the franchisors quality standards; (2) the franchisor either exerts a significant degree of control over

34-4

(3/10)

Franchises

34.2.1

the franchisees method of operation or gives the franchisee significant assistance in its method of operation; and (3) the franchisee is required, as a condition of obtaining or commencing the operation, to pay or make a commitment to pay the franchisor or its affiliate.10 The Trademark Element The trademark element is met under the FTC Rule if a party grants another party the right to use its trademark to offer, sell, or distribute goods or services. This element can be met absent an express prohibition against the use of the franchisors trademark.11 The Significant Control or Assistance Element Under the FTC Rule, significant control or assistance means that the franchisor is providing significant control over or assistance to the franchisees business. This element relates to the franchisors involvement in the franchisees entire method of operation. Whether the involvement is significant is based on the degree that the franchisee relies on the franchisors experience. Examples of activities that the FTC has determined qualify as significant control include: Site approval; Site design or appearance requirements; Imposing operating hours; Establishing production methods and standards; Imposing mandatory accounting practices; Mandating personnel policies and practices; Promotional campaigns requiring the franchisees participation or financial contribution; Restrictions on customers; and Location or sales area restrictions. Examples of activities that the FTC has determined qualify as significant assistance include: Formal training programs; Site selection assistance; Operating advice (e.g., providing a detailed operations manual); and Providing management, marketing, or personnel advice. The Fee Element The fee element is met if the franchisee makes a direct or indirect payment of at least $500 prior to or during the first six months of operations to the franchisor or its affiliates. Like the other two elements, the fee element is interpreted broadly. That said, deferring any payment for six months will avoid the fee element under the FTC Rule. This does not mean, however, that the fee element will not be met under the relevant state law. Examples of sums paid to the franchisor or its affiliate that meet the fee element include: Initial franchise fees; Rent;

(3/10)

34-5

 34.2.1

The Practitioners Guide to Colorado Business Organizations

Advertising assistance; Training; Security deposits; Payments for services; Royalties; and Payment for goods in excess of the bona fide wholesale price. 34.2.2FTC Rule Disclosure Requirement If a transaction falls within the definition of a franchise, then the franchisor must comply with the FTC Rules pre-sale disclosure requirements within a certain time frame, unless an exemption exists. Under the prior rule, the disclosure document was generally referred to in the industry as a Uniform Franchise Offering Circular (UFOC). Under the current version of the FTC Rule, the disclosure document is known as a Franchise Disclosure Document (FDD). The FTC does not require that franchisors submit their FDD to the FTC for review or registration as a condition to offering or selling franchises. The disclosure document must be prepared in accordance with a prescribed format and must be written in plain English. The current version of the FTC Rule requires that the FDD must be given to prospective franchisees no later than 14 calendar days before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale.12 Certain state laws have different delivery requirements.13 It is also important to understand that this delivery period is not a no talk period, and that the franchisor can continue to engage with the prospective franchisee during this time frame. In addition to the disclosure component of the document, the FDD also contains copies of other agreements the franchisee may be asked to execute at the beginning of the franchise relationship. The copies of the agreements attached to and forming a part of the FDD are not for execution. The prior rule required that one or more copies of each agreement proposed to be executed by a prospective franchisee be delivered to the prospective franchisee in completed form (i.e., in form for execution, with no blanks or open terms) at least five business days prior to the date the prospective franchisee signs a binding agreement or pays the franchisor any money. The current version of the FTC Rule eliminates the five-business-day rule and replaces it with a modified seven-day rule. Under the current version of the FTC Rule, there is no requirement to deliver completed documents to a prospective franchisee prior to the date that the prospective franchisee signs the agreements. In other words, if the franchisor furnishes a prospective franchisee with its standard form franchise agreements, there is no cooling-off period that must be observed by the parties the prospective franchisee may sign the standard contracts immediately upon receipt. However, if the franchisor unilaterally and materially alters its standard franchise or other agreement prior to presenting the documents to the prospective franchisee for signature, and the changes were not made at the request of the prospective franchisee, then at least seven calendar days before the prospective franchisee signs the franchise agreement or any contracts attached thereto, the franchisor must give the prospective franchisee a copy of all agreements the franchisor is asking the prospective franchisee to sign.14

34-6

(3/10)

Franchises

34.2.3

The FTC Rule consistently mandates that a franchisor must not omit to state any material facts that would be necessary to the franchisees decision to purchase a franchise or make any misleading statements to the franchisee. The franchisor cannot give additional advertising materials to the franchisee or make additional statements to the franchisee if they are inconsistent with the disclosures that are made in the disclosure documents. 34.2.3The Content Of The Franchise Disclosure Document The purpose of the disclosure document is to provide basic information about the franchisor and its predecessors and affiliates, the franchised business, and the franchise agreement. As discussed above, before the enactment of the current version of the FTC Rule, there were two formats that franchisors could choose from to prepare a disclosure document the format prescribed by the FTC Rule (FTC Format) and the format prescribed by the Uniform Franchise Offering Circular Guidelines (Guidelines Format). After July 1, 2008, the format proscribed by the current version of the FTC Rule MUST be used by all franchisors. The following section outlines the information required to be disclosed under the current version of the FTC Rule. The UFOC Guidelines have also been amended to adopt this general format.15 Information about the Franchisor, its Predecessors, and Affiliates Items 1 through 4 in the FDD embody information about the franchisor, its predecessors, and affiliates. This information includes identifying the franchisor, its predecessors, and its affiliates; providing biographical and professional information for the past five years for the franchisors officers, directors, and managers; and disclosing pertinent criminal and civil litigation and bankruptcy history involving the franchisor and its predecessors, management, and affiliates.16 The old Guidelines Format required in Item 2 that the franchisor disclose all franchise brokers used in the sale of the franchised business. The current version of the FTC Rule eliminates this broker disclosure requirement.17 However, it is important to note that not all registration states have agreed to omit the broker disclosure requirement, so many franchisors may still find they are required to prepare and include such disclosure information in their FDDs. Perhaps the most significant change to the disclosure requirements in this section is the disclosure required by the current version of the FTC Rule regarding the franchisors parent company. The FTC Rule now requires franchisors to disclose in Items 1, 3, 4, and 21 of the FDD information about the franchisors parent. This disclosure includes the parent companys name and principal business address; all pending and concluded litigation the parent is or was involved in; any bankruptcy issues related to the parent; and, in some cases, the parent companys financial information.18 Information about the Financial Investment Made by the Franchisee Items 5 through 7 in the FDD disclose the relevant information relating to the cost the franchisee will incur to obtain the franchise; the ongoing expenses the franchisee can expect to pay to the franchisor or its affiliate during the term of the franchise relationship; and a range of costs the franchisee can expect to incur for the initial investment in the franchise.

(3/10)

34-7

 34.2.3

The Practitioners Guide to Colorado Business Organizations

Information about the Restrictions and Obligations on the Franchisee Items 8, 9, 15, and 16 describe the restrictions that the franchisor places on the franchisee regarding the sources of products and services the franchisee uses in the operation of the franchise; a description of the franchisees obligations under the franchise agreement via a cross-reference chart; a description of the individual franchisee owners obligations to participate in the operation of the franchise; and a description of the types of restrictions the franchisor places on the goods and services the franchisee may offer from its franchise. Information about the Franchisors Services to the Franchisee Items 10 and 11 describe the type of services the franchisor provides to the franchisee. Item 10 specifically describes any financing that the franchisor may provide. Item 11 describes the supervision, assistance, and services the franchisor will provide to the franchisee during the franchise relationship.19 Information about the Franchisees Territory Item 12 describes the area or territory granted to the franchisee. Information about the Franchisors Intellectual Property Items 13 and 14 describe relevant information relating to the franchisors trademarks, trade names, patents, copyrights, and proprietary information pertaining to the franchised business. Information about the Termination and Renewal of the Franchise Relationship Item 17 describes the terms of the franchise agreement relating to termination, renewal, noncompetition, dispute resolution, jurisdiction, and venue. Item 17 is prepared in chart form with crossreferences to the franchise agreement. Information about Financial Performance and the Financial Status of the Franchisor Any information that the franchisor is going to provide to a prospective franchisee concerning the financial performance is set out in Item 19. Item 19 information is optional and can include any information for which there is a reasonable basis and that suggests specific sales, income, or profits. Under the old Guidelines Format, information contained in Item 19 was called an Earnings Claim. The current version of the FTC Rule has renamed this section Financial Performance Representation. Some members of the franchise community have shorted the name to FPR. The most critical requirement to remember is that if a Financial Performance Representation is not made in the FDD, the franchisor cannot discuss any financial performance information with its prospective franchisees unless the information solely relates to the actual operating results of a specific unit being offered for sale and is given only to potential purchasers of that specific unit,20 or the information is provided to a lender providing financing to a prospective franchisee who agrees to maintain the information in confidence. If, on the other hand, the franchisor does include a Financial Performance Representation in Item 19, then the franchisor may discuss with the franchisee all of the financial information disclosed in the FDD. Notwithstanding the foregoing, prospective franchisees are free to speak with existing franchisees in the franchise system or former franchisees.

34-8

(3/10)

Franchises

34.2.3

The current version of the FTC Rule promotes the general policy in favor of franchisors providing prospective franchisees with information about financial performance. However, Financial Performance Representations remain voluntary under the FTC Rule. It is important to note that the FTC has materially departed from the Guidelines Format by excluding from the definition of Financial Performance Representations cost-only data or expenses regarding the franchised business. This enables franchisors to provide prospects with detailed cost and expense information. In addition, franchisors may provide prospects with detailed financial information in the FDD about a specific subset of franchised businesses that share common characteristics.21 For example, a franchisor may provide financial information to a prospective franchisee about franchisees in the San Francisco market that each carry significantly higher overhead costs and expenses, such as real estate, as compared to other franchisees in the system. Item 21 references the financial statements attached to the disclosure document. Except for the period between the formation of the franchisor entity and the end of the franchisors first partial or full fiscal year selling franchises, the franchisors financial statements must be audited.22 The current version of the FTC Rule allows for un-audited financial statements of a parent company in limited circumstances, but requires audited financial statements when a parent commits to perform post-sale obligations for the franchisor, or guarantees the franchisors obligations.23 The FTC Rule also allows franchisors to provide financial information in a format that complies with generally accepted accounting principals or, to assist international companies selling franchises in the United States, in any other format otherwise recognized and permitted by the Securities Exchange Commission.24 Information about the Number of Franchised and Franchisor-Owned Outlets In general, Item 20 discloses, in chart form, the number of franchisees that the franchisor has in the system for the most recent three-year period. This information also includes the number of franchisees that have been transferred, canceled, or terminated; not renewed; reacquired by the franchisor; and that have left the system during the franchisors prior year. Item 20 also provides information on the number of franchisor-owned outlets and projections of openings for the upcoming year. The current version of the FTC Format requires five charts rather than the three required under the Guidelines Format, and the charts have been re-designed to eliminate the potential for inaccurate counting of units an issue that existed under the Guidelines Format. The information contained in the five charts includes a system-wide summary of company-owned and franchised outlets, new openings and closures during the year, and the number open at the year-end.25 Also included is information about transfers, excluding franchisor re-acquisitions; turnover rate for individual franchised and companyowned outlets, including terminations; and non-renewals.26 Miscellaneous Information The remaining Items (Items 18, 22, and 23) describe any arrangements the franchisor has with a public figure (Item 18), any contracts that the franchisee must sign relating to the franchise being offered (Item 22), and a receipt page evidencing the franchisees receipt of the complete FDD (Item 23).27 The current version of the FTC Rule requires the franchisor to prepare a revised FDD within 120 days after the franchisors fiscal year-end.28 The failure to update the disclosure document within such period and to file for renewals in registration states prior to the expiration of any registration

(3/10)

34-9

 34.2.3

The Practitioners Guide to Colorado Business Organizations

(commonly 90 to 120 days after the franchisors fiscal year-end) results in the franchisor going dark. That is to say, the franchisor may not offer or sell franchises until the FDD is updated and reregistered, where applicable. Additionally, if the franchisor makes material changes to its disclosure document (i.e., those that have a substantial likelihood of influencing a reasonable prospective franchisee in making a significant decision related to the franchise, or those that have a significant financial impact on the franchisor, or changes that are defined by an applicable state as being material), the franchisor must prepare and file amendments with the registration states and re-disclose any prospects with the amended version of the disclosure document. Generally, the amendments must be filed with the applicable state within 30 to 90 days after the material change occurs. It should also be noted that certain registration states require franchisors to register their advertising before the advertising is used in a state. These states are California, Maryland, Minnesota, New York, North Dakota, Rhode Island, and Washington.29 34.2.4Consequences Of Non-Compliance The FTC Rule does not provide aggrieved individuals with a private right of action and is therefore only enforceable by the FTC. Remedies available to the FTC include imposing civil penalties up to $11,000 per violation;30 requiring that the franchisor rescind or reform the franchise agreement or pay the franchisee refunds or damages;31 and issuing cease-and-desist orders.32

34.3 STATE REGISTRATION AND DISCLOSURE LAWS

34.3.1Definition Of A Franchise The FTC Rule only preempts state law to the extent that state law is less restrictive than the FTC Rule.33 Even if a legal relationship is structured such that it falls outside of the FTC Rules definition of a franchise, a practitioner must determine whether the relationship is a franchise under relevant state law. Although the state definitions of the term franchise typically include the same three elements found under the FTC Rule, the interpretation of the three elements varies widely from state to state. The Trademark Element The trademark element, like the other elements, is broadly construed. For example, the California Court of Appeal, in interpreting Californias franchise definition, determined that the trademark element was satisfied even though the licensee was not permitted to use the licensors brand name and, in fact, never used it, because the name was communicated to customers of the licensee.34 Generally, state law requires a party to grant another party the right to use its trademark to offer, sell, or distribute goods or services. States may take two approaches to determine if the transaction meets the trademark element the license approach or the substantial association approach. The License Approach Under the license approach, the relationship includes an express authorization for a franchisee to use the franchisors trademark. There is no requirement that the trademark be part of the franchisees trade name, and authorization to display the franchisors logo in dealing with customers will

34-10

(3/10)

Franchises

34.3.1

satisfy this element. Some courts have also found a de facto license based on the conduct of the parties. Examples of circumstances where de facto licenses have been found by courts include where the franchisee: Has a duty to use its best efforts to promote the sale of branded products;35 Wears uniforms and displays the franchisors logo;36 Completes special training and fulfills warranties;37 Sells unique products that consumers associate with a specific manufacturer in an exclusive territory;38 and Follows detailed operating procedures, maintains facilities and equipment, and performs services following the manufacturers instructions.39 The Substantial Association Approach The substantial association approach is the more common approach taken by most states with franchise laws. Under the substantial association approach, the trademark element is satisfied if the franchisee associates with the franchisors trademark. Examples of circumstances where the trademark element was met through an analysis under the substantial association approach include: A branded product accounting for a significant percent of a franchisees overall sales; and A franchisee being permitted to promote its status as an authorized distributor and using advertising supplied by the franchisor.40 Marketing Plan or Community Interest Element Rather than use the significant control or significant assistance element, some state statutes use the marketing plan element or community interest element. Marketing Plan Element The marketing plan element requires that there be (1) a marketing plan, (2) prescribed, (3) in substantial part, (4) by the franchisor. Generally, a marketing plan exists when the franchisor presents a group of outlets to the public as a single unit with the appearance of some central management and uniform standards. The marketing plan does not have to be mandatory for one to exist, but may exist even if it is only suggested or recommended by the franchisor. Examples of activities that may meet the marketing plan element are: Advertising by the franchisor; Requirements for site selection, build-out, uniforms, or hours of operations; Limitations on the products, services, or customers; Providing training; Requiring approval of advertising or signage; and The use of an operations manual.41 Community of Interest Element The community of interest approach is broader than the marketing plan. Generally, a community of interest exists when the franchisor and the franchisee have a community of interest in the marketing of goods or services. Examples include:

(3/10)

34-11

 34.3.1

The Practitioners Guide to Colorado Business Organizations

Circumstances where the franchisor and franchisee share a continuing financial interest and a degree of interdependence;42 and Parties deriving fees from a common source (e.g., distributorship or license arrangement).43 The Fee Element The fee element is met if the franchisee makes a direct or indirect payment to the franchisor. This includes all sources of revenue paid by a franchisee to the franchisor or its affiliate for distribution rights. Some states include a threshold sum or time period similar to the FTC Rule and in most cases the threshold amount is quite low and the time period extends for the life of the contract or the entire length of the business relationship. 34.3.2State Registration Requirements There are 14 states that require that a franchisor register its FDD prior to offering or selling franchises in the state or to its citizens: California; Hawaii; Illinois; Indiana; Maryland; Michigan; Minnesota; New York; North Dakota; Rhode Island; South Dakota; Virginia; Washington; and Wisconsin. Of the registration states described above, California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, Virginia, and Washington require a full registration application. Indiana, South Dakota, and Wisconsin require that a franchisor file a notice of intent and a copy of its FDD. Michigan requires a franchisor to file a notice of intent and does not require that a copy of its FDD be provided. Filing fees to register in the registration states range from $125 to $750. In addition to the registration states, there are five business opportunity exemption states that require filings before a franchisor may offer or sell franchises in the state: Florida, Kentucky, Nebraska, Texas, and Utah. Filing fees for the business opportunity exemption states range from $25 to $100. Finally, there are six states that require a filing if the franchisor does not have its primary trademark fully registered with the United States Patent and Trademark Office: Connecticut, Georgia, Louisiana, Maine, North Carolina, and South Carolina. Filing fees for these states range from $10 to $250.

34-12

(3/10)

Franchises

34.4.2

34.3.3Consequences Of Non-Compliance Most of the registration and business opportunity states provide for a private right of action for aggrieved franchisees or prospective franchisees. Specifically, in these states, a franchisee may institute civil proceedings if the franchisor employs fraudulent or misleading acts in connection with the sale or offer of a franchise. A franchisee may also be able to bring a private right of action against a franchisor under the applicable states business opportunity laws or consumer fraud statutes. The action may be brought against the franchisors partners, directors, principals, controlling persons, and employees who aid a violation or who are responsible for franchise compliance. While the remedies vary, they may include damages, rescission of the franchise agreement, punitive damages, and treble damages. Willful violations can also lead to criminal penalties.

34.4 BUSINESS OPPORTUNITIES LAWS

34.4.1State Business Opportunities Laws In addition to the FTC Rule and the various state registration and disclosure requirements, the sale of a franchise may also be subject to various state business opportunities laws. These laws prohibit the sale or offer of a business opportunity without the proper disclosure, and if applicable, registration of a business opportunity sales disclosure document. Generally, states that have business opportunities laws define a business opportunity so broadly that it encompasses the typical franchise relationship. Fortunately, states that have business opportunities laws also have either exceptions to the definition or exemptions from the statutes applications that apply to franchisors and exclude the franchisors from the purview of the business opportunities statutes. These exceptions and exemptions include: Coverage by a franchise registration law in the state; Exclusion from the definition where the marketing program is in conjunction with the licensing of a state-registered trademark; Exclusion from the definition where the marketing program is in conjunction with the licensing of a federally registered trademark; or Compliance with the FTC Rule disclosure requirements. Generally, the business opportunities states disclosure requirements are similar to the franchise disclosure requirements and may be satisfied with the disclosure documents required for the registration of a franchise. 34.4.2Proposed Federal Business Opportunity Rule The FTC is interested in regulating businesses that are not subject to pre-sale disclosure requirements under federal or state law, such as multi-level marketing systems and work-from-home businesses. On April 5, 2006, the FTC issued a notice of proposed rule-making to solicit public comment for the creation of a federal rule designed to regulate business opportunities (Proposed Rule).

(3/10)

34-13