Recall the differences between federal and state law:
There are many different types of laws in the US, including federal law, state law, and even local or municipal law. As far as franchising is concerned, the relevant law and regulation is divided between federal and state.
Federal law is the law of the United States and applies evenly to all citizens. So, if you are a franchisor or franchisee in the US, all federal franchise laws apply to you and must be followed. Federal law is created by the Congress and both houses (the Senate and the House of Representatives) must pass a bill. Then, this bill must be signed by the President before it can become a federal law. Federal law encompasses immigration law, social security laws, civil rights laws, patent/copyright laws, federal criminal laws, and bankruptcy law. In other words, these issues are under federal jurisdiction.
On the other hand, state law applies only to specific states. State statutes may say one thing in one state but something different in another. Citizens are not only subject to federal law but also to the law of their state. While federal laws are created by Congress, state laws are enacted by the legislature of the state. Then, once these laws are drafted, they are put into action when signed by the governor. State laws regulate criminal violations, welfare, and Medicaid, personal injuries or medical malpractice, workers’ compensation, real estate matters, among other issues.
So, how do federal and state law work together? That’s where the preemption doctrine comes in. The preemption doctrine, an outgrowth of the Supremacy Clause of the Constitution, says that federal law takes precedence over state law in any areas where they may conflict. Consider this simplistic example:
The federal government upholds a law that says that citizens are free to wear whatever color shirt they prefer. If the state of Missouri, for instance, passes a law that restricts citizens from wearing red shirts, the federal law preempts the state law. In other words, federal law trumps state law.
In order to ensure lawful business operations, it’s vital to understand both the federal and state statutes that apply to you and your company or business.
The Basics of Federal Franchise Law
The Federal Trade Commission (FTC) is the federal governing body of franchise law in the US. This agency works to ensure fair and honest business practices in the US, aiming to elevate the consumers understanding of choice and competition in the market. The FTC enforces laws that advance consumer interests and represents these consumers when working with federal and state legislatures.
Learn More: Franchise Law: What Is It?
History of Franchise Disclosure and Federal Franchise Law
The FTC is a federal agency established in 1914, geared towards preventing unfair methods of competition. It wasn’t until 1978, however, that the federal government began regulating the sale of franchises through the Federal Trade Commission’s Franchise Rule (the FTC Rule). The Rule enacted at the time is now referenced as “The Original Rule,” as the Rule has been amended over the years.
The Original Franchise Rule was established in 1978 after the Commission “found widespread deception in the sale of franchises and business opportunities through both material misrepresentations and nondisclosures of material facts.” With the Rule, the FTC hoped to prevent deceptive or unfair practices in the sale of franchises by requiring disclosure within the franchisor/franchisee relationship. This objective has not changed since the Rule was initially created.
The FTC is a federal agency, established in 1914, that regulates consumer protection legislation, ensuring a free and fair competition in the marketplace.
While the Original Rule did regulate disclosure, it failed to express specifically which pieces of information a franchisor must disclose to a prospective franchisee. The Original Rule also conflicted with the Uniform Franchise Offering Circular (UFOC), which regulated disclosure at the state level. So, the Rule was revised , ultimately resulting in the 2007 Rule used today. Not to mention, the UFOC has since been erased, as the FTC Rule began regulating the same disclosure requirements.
In 2007, the federal franchise law, or more specifically the the FTC Franchise Rule, was updated to more clearly and precisely outline federal disclosure requirements in the sale of franchises. Many of these new amendments served to create more unified regulations between the state and federal level, as the Original Rule often conflicted with disclosure laws enacted in Franchise Registration States. The 2007 amended FTC Rule also set a new floor (or minimum requirement) for disclosure in the franchise sale process and affirmed that federal franchise filing was not required.
Federal Franchise Laws You Should Know About
In the next few sections we discuss the laws governing the Franchise Disclosure Document (FDD). We also cover the relevant sections specifically the 436.6 – Instructions for Preparing Disclosure Documents, 436.2 – Obligation to furnish documents, and 436.8 – Exemptions.
The Franchise Disclosure Document (FDD)
The 2007 Rule applies to all franchisors in the US and lists 23 categories that each franchisor must disclose to any prospective franchisee. These categories are disclosed within a Franchise Disclosure Document (FDD), which the FTC legally mandates.
THE FTC RULE REGULATES FRANCHISE DISCLOSURE DOCUMENTS, ENSURING TRANSPARENCY IN THE FRANCHISE PURCHASE.
Learn more about the history of the FDD and see the full breakdown of the 23 categories here.
436.6 Instructions for Preparing Disclosure Documents
The federal franchise law requires all franchisors to include all the necessary disclosure information. The FTC, however, also promulgates specific instructions regarding the preparation of the FDD.
First and foremost, all required information must be clearly and concisely expressed in a single, printable or tangible document. The prospective franchisee must be able to tangibly hold the document in some form or another.
Furthermore, the franchisor is required to provide full information for each item in the FDD. If an item does not apply to the business, the franchisor is required to state that the category is inapplicable. In order to ensure a comprehensive FDD, the franchisor is also prohibited from including extra information or materials. The items of the franchise disclosure document include:
Before the FDD is furnished, the franchisor must inform the potential franchisee of the document’s format so that they may plan accordingly. The franchisor is also expected to keep sample copies available for three years after the FDD is last used.
Changes or Updates to the FDD
The FDD must be completely updated each year. That is, all 23 items must be reviewed and revised accordingly to reflect accurate data for the year. Failure to appropriately update the document within 120 days of the franchisor’s fiscal year end halts all of the franchisor’s sales activities.
While the current FTC Rule does not require disclosure updates any more often than each quarter, changes to Item 19 receive special treatment. Due to the fact that Item 19 discloses financial projections and representations, franchisors must immediately notify all potential franchisees of alterations to this part of the FDD.
Below are some additional key elements of the FTC Franchise Rule:
436.2 Obligation to furnish documents
Any franchisor must furnish a prospective franchisee with a copy of the most current disclosure document at least 14 days before the Franchise Agreement is signed. Furthermore, it is unlawful for the franchisor to change or alter any terms and conditions of the Franchise Agreement, or any other agreements attached to the disclosure document, at least seven days before signing.
There are certain scenarios wherein a franchisor can be exempt from the above-mentioned requirements. For instance, if the franchise relationship is a fractional franchise or is a leased department, the franchisor may be exempt from the provisions of part 436. Furthermore, if the franchisee is an entity in business for at least five years with a net worth of at least $5,715,500, then, too, the franchisor can be exempted.
Any prospective franchisor or franchisee should thoroughly review the FTC Franchising Rule. Another option is to hire an attorney that specializes in federal franchise law.
How to Stay Compliant With Federal Franchise Law
While franchising is a unique marketing and business expansion concept that creates exciting and lucrative avenues for both parties, it is essentially a business agreement that is bound by laws. The franchisor-franchisee relationship is of mutual give-and-take, which means that there are obligations for both sides. To ensure that both parties fulfill their set of responsibilities, franchising is regulated, requiring compliance with both federal and state laws.
It is best to seek legal advice from a franchise lawyer to ensure compliance with state and federal franchise laws. But to give you a quick snapshot of the legal obligations that govern the franchise process on either side, we discuss ways in which both parties can ensure compliance with the law:
Franchisee’s franchise law compliance requirements:
Payment of fees and royalty – Franchisees are required to pay their franchisors different fees such as the initial investment or licensing fee and ongoing royalty. They may also be required to pay fees for any marketing activities conducted by the franchisor. In addition they’re required to submit reports to the franchisor on a monthly and annual basis. It’s best to adhere to the set guidelines and time periods listed in the FDD and maintain accurate reports for the franchisor’s and your reference.
Abide by the quality and service standards and trademark usage – Franchisees must uphold the quality and service standards established by the franchisor. The right to sell the franchisor’s products and services under their brand name gives the franchisee a distinct advantage but it also comes with a set of responsibilities. To maintain the brand’s reputation, the franchisee should also take care to not devalue the brand name or trademark in any manner. Therefore, it’s best to ensure that the products, services, equipment, signage, promotional material, and uniforms are updated, as required. The agreement also outlines how the franchisee can use the franchisor’s trademark and signage.
Attend mandatory events and conferences – Franchisees are required to attend certain events and conferences as stated by the franchisor in the agreement. It’s best to save the dates ahead of mandatory events to ensure attendance. This will also help you keep abreast of any important updates or developments.
Steer clear of any territory disputes – Franchisees can only operate within the designated territory or pre-determined locations, as established in the franchise agreement. Any change in the location for any reason has to be agreed upon by the franchisor on a prior basis.
Renewal and Exit Strategy – The franchise agreement lists the duration of the license and strategy of exit, if required. It’s best to apply for a renewal prior to the expiry of the agreement to avoid any hiccups in running the unit.
Franchisor’s franchise law compliance requirements:
Draft an FDD in compliance with state and federal franchise laws – Every franchisor is required to provide the franchisee with a mandatory document called the Franchise Disclosure Document (FDD) – the legal basis of your agreement. It’s best to have a franchise lawyer prepare the FDD in accordance with federal and state law. Some states also require that the FDD be filed or registered with the state regulators in order for you to offer or sell your franchise.
Include all sections in the FDD – The FDD must include all 23 mandatory sections or items to ensure that the concerned parties have all the information required to make an informed choice. The items provide franchisees important information regarding territories, start-up costs, marketing fees, royalties, and more.
Provide FDD on time – Franchisors are required to give prospective franchisees the FDD at least 14 days prior to signing the agreement or accepting any payments.
Update FDD Annually – The FDD has to be updated annually. Some states even require that the FDD be approved and registered before the franchisor can offer or sell the franchise.
Hopefully our guide to federal franchise laws and tips on ensuring compliance will give you a better understanding of your legal obligations as well as what to expect from your franchisor. To make a careful choice, it’s highly recommended to read the FDD carefully or get it reviewed by your lawyer prior to purchase of the franchise.