FTC PUBLISHES STAFF REPORT ON PROPOSED FRANCHISE RULE AMENDMENTS

On August 25, 2004, the FTC released its long-awaited Staff Report on the proposed amendments to the FTC Franchise Rule. This staff report, which consists of 400-plus pages, contains the staff’s recommendations on the pending amendments to the Franchise Rule. The Staff Report is based on the rulemaking record created during the FTC’s Advance Notice of Proposed Rulemaking issued in 1997 and the Notice of Rulemaking Proceeding issued in 1999. The staff report consists of: (i) a discussion and analysis of the issues and comments appearing in the rulemaking record; and (ii) the text of the proposed amended rule whose adoption the staff is prepared to recommend to the Commission.

The proposed amended rule reflects evolutionary rather than revolutionary changes to a rule which has not changed in the nearly 25 years since it became effective on December 21, 1979. These changes affect both the form and content of the disclosure documents provided to prospective franchisees, as well as the procedures by which disclosures are made. Indeed, it will alter--for all franchisors--the manner in which they offer and sell franchises in the United States.

This release describes some of the most notable proposed changes.

A. Proposed Changes to Persons and Transactions Covered by the FTC Rule

1. International sales are excluded from coverage. The proposed rule is limited to offers and sales of franchises that will be located in the United States, its territories, or possessions. Franchises to be located outside of the U.S., no matter where the offer is made or whether the franchisor or proposed franchisee is a U.S. company or resident, would not be covered by the Rule.

2. The “business opportunity” definition is eliminated and, as a result, businesses previously covered only by the Rule’s business opportunity definition are no longer covered. The Commission is considering issuing a separate “business opportunity” rule.

3. The bona fide wholesale price exemption is expanded to include payments made for inventory that is leased; the current rule exempts only payments made for inventory that is purchased for resale.

4. Four exemptions have been added:

a. Franchise relationships covered by the Petroleum Marketing Practices Act. This exemption codifies the prior exemption granted in a special exemption proceeding under Section 18(g) of the FTC Act.

b. Transactions in which the franchisee’s estimated investment totals at least $1 million (excluding: (i) any financing received from the franchisor or an affiliate; and (ii) real estate costs), as long as the prospective franchisee signs an acknowledgement verifying the grounds for the exemption.

c. Franchisees (and their parents or any affiliates) that have been in the business for at least five years and have a net worth of at least $5 million.

d. “Insider transactions” in which one or more individuals who own at least 50 percent of a new franchisee and who have had (within 60 days prior to their franchise purchase) either a management association with the franchisor or who own at least a 25 percent ownership interest in the franchisor.

5. Four current exclusions are eliminated, although the FTC staff indicates that it reflects no substantive changes since these relationships never were covered. These exclusions are employer/employee and general partnerships, certification and testing services, cooperative associations, and single trademark licenses.

B. Proposed Changes in the Disclosure Document

The rarely-used FTC disclosure document format is abandoned. The proposed rule uses the existing UFOC Guidelines as the basic template, both in terms of organization and content. From that template, the FTC staff has recommended numerous changes. Many changes are modest, but some are significant. In any case, it is likely that franchisors will need to make changes in most, if not all, of their disclosure Items in order to comply with the disclosure document format required under the proposed rule. Here is a brief list of some (but not all) of the more notable proposed changes.

1. Item 2. Disclosures about franchise brokers are no longer required.

2. Item 3.:

a. Litigation disclosures must include the franchisor’s parent if the parent guarantees the franchisor’s performance.

b. Litigation disclosures are required for material civil actions in the prior fiscal year where the franchisor was a plaintiff and where the action involves contractual obligations between the franchisor and a franchisee relating to the franchise business operations. The proposed rule, however, allows disclosure about these types of action in a much more summary manner than other litigation disclosures.

c. Litigation disclosures concerning currently effective injunctive or restrictive orders involving government entities and relating to a franchise or certain other enumerated actions are expanded to include any affiliate that has offered or sold a franchise in any line of business within the past ten years.

d. No litigation disclosures about franchise brokers are required.

3. Item 6. Disclosure is required about payments required to be made directly to third parties.

4. Item 8. Disclosure is required about any suppliers in which an officer of the franchisor owns an interest.

5. Item 11. Detailed disclosures about computer specifications have been eliminated.

6. Item 12.

a. Franchisors that do not offer an exclusive territory must insert a required caveat that mentions potential competition from the franchisor and/or other franchisees.

b. Disclosures are required about any restrictions on the franchisee from soliciting or accepting orders from consumers located outside of the exclusive territory as well as the franchisee’s right to utilize other channels of distribution to offer goods and services, such as Internet or catalog sales.

7. Item 19.

a. All franchisors must include a mandatory preamble describing the franchisor’s options and obligations with respect to making earnings claims, whether or not the franchisor makes an earnings claim.

b. Information about costs and expenses is no longer treated as earnings information for purposes of disclosure in Item 19.

8. Item 20.

a. The tables used to present information on franchise and company outlet size and turnover are revised; the new drafting instructions are designed to avoid double-counting.

b. The list of franchisees terminated after the prior fiscal year-end is fixed at 10 weeks prior to the date of issuance of the disclosure document, rather than on a floating date based on the date of application.

c. Disclosure is required about the existence of confidentiality agreements and, if such agreements are used, a special caveat is required

d. Disclosure is required about the existence of and contact information for certain trademark-specific franchisee organizations associated with the franchise system.

9. Item 21.

Noteworthy here is the staff’s pullback from the financial statement disclosures proposed in its 1999 Notice of Proposed Rulemaking. Those disclosures could have imposed onerous financial reporting requirements on non-U.S. companies as well as U.S. subsidiaries of non-U.S. companies.

a. Audited financial statements must be prepared according to US GAAP, or as permitted by the Securities and Exchange Commission, or as revised by any future government-mandated accounting principles.

b. No financial statements from the franchisor’s parent are required unless the parent commits to perform post-sale obligations for the franchisor or guarantees the franchisor’s obligations. If a guarantee is used, a copy of the guarantee must be included in the disclosure document.

C. Proposed Changes in the Timing and Method of Making Disclosures

1. Disclosures must be made to a prospective franchisee at least 14 calendar days before the prospective franchisee signs a binding agreement or makes a payment to the franchisor or an affiliate in connection with the proposed franchise sale. The franchisor must, however, provide the disclosure document at an earlier date if a prospective franchisee reasonably requests it.

2. The 14 calendar day period begins the day after disclosure is made, which means that, in practical terms, 15 calendar days must elapse from the day of disclosure to the day of sale/payment.

3. No separate five business day period is required to review the completed franchise agreements, but if the franchisor unilaterally makes material changes to the terms of the basic franchise agreement (but not if the franchisor negotiates changes with the prospective franchisee), the franchisee must have the new agreements at least seven calendar days before a sale/payment can be made.

4. Disclosures may be made electronically as long as the prospective franchisee may store, download, print, or otherwise maintain the disclosure documents for future reference. Electronic versions may include scrollbars, internal links, and search features. All other features are prohibited.

5. Recordkeeping:

a. Sample copies of each materially different disclosure document version must be kept for three years after the close of the fiscal year when it was used.

b. Signed disclosure document receipts must be kept for three years after each completed franchise sale. The definition of “signed” has been expanded to also include various forms of electronic methods of identity authentication.

6. Annual updates to disclosure documents may be made within 120 days from the fiscal year-end, an extension from the current 90-day period.

7. Previously disclosed prospective franchisees who are still in the sales pipeline must be redisclosed with any revised or updated disclosure document. A franchisor also must notify a prospective franchisee about any material changes in any financial performance information contained in the disclosure document.

D. Enumerated List of Prohibited Practices

The proposed rule would prohibit certain practices. These include:

1. Making any claim or representation, orally, visually, or in writing, that contradicts the information required to be disclosed by the rule.

2. Using “shills” to provide bogus endorsements.

3. Disseminating any financial performance representations to prospective franchisees, except in the manner required in Item 19.

4. Failing to provide, to either prospective franchisees or the FTC upon request, written substantiation for any financial performance representations made in Item 19.

5. Failing to furnish a copy of the franchisor’s disclosure document to a prospective franchisee earlier in the sales process than the 14-day period required by the rule if a prospective franchisee reasonably requests earlier disclosure .

6. Failing to furnish existing disclosures to a prospective purchaser of an existing franchised outlet, upon reasonable request.

7. Failing 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.

8. Asking a franchisee to sign a franchise agreement containing terms and conditions materially different from those appearing in the disclosure document, unless the franchisor informs the prospective franchisee of the differences within a reasonable time before execution.

9. Disclaiming or requiring a prospective franchisee to waive reliance on any representation made in the disclosure document or in its exhibits or amendments, except that a prospective franchisee may voluntarily waive specific contract terms and conditions set forth in his or her disclosure document during the course of franchise sale negotiations.

10. Failing to return any funds or deposits in accordance with any conditions disclosed in the franchisor’s disclosure document, franchise agreement, or any related document.

E. What’s Next

1. The Staff Report will be published in the Federal Register this week.

2. The public will have an opportunity to file comments on the Staff Report during the 75-day period after the Federal Register publishes the Staff Report.

3. The staff will review the public comments and thereafter make a final recommendation to the Commission. There is no required time frame within which the staff must report to the Commission after the public comment period concludes.

4. The Commission will make a final determination about whether and, if so, how to amend the Rule. The Commission is not required to follow the staff’s recommendations in whole or in part. There is no required time frame within which the Commission must act after it receives the Staff Report.

5. Once the Commission promulgates the newly revised rule, there is likely to be a phase-in period so that franchisors can prepare to comply with the new rule. In addition, the FTC’s expectation is that the state franchise examiners will accept the new FTC disclosure document format for use in their states.

Conclusion

The FTC staff has clearly made a deliberate, thorough, and thoughtful review of the rulemaking record and listened carefully to all viewpoints. The staff’s conclusion appears to be that the basic regulatory rationale and requirements of the original Franchise Rule are sound and should be kept essentially intact, with changes focused on modifying the timing and content of disclosures to respond to marketplace needs and technological changes.

Interested persons have one more opportunity to present their views by filing their comments on the Staff Report between now and mid-November. Piper Rudnick will be filing comments. Please feel free to contact us if you have any questions or comments regarding these proposed changes and how they may impact you.