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, the federal law trumps the state law.
In order to ensure that lawful business operations, it’s vital to understand both the federal and state statutes that apply to you and your company or business.
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.
History of Franchise Disclosure 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 FTC 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.
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. Below are the 23 items, including the necessary contents for each section.
THE FTC RULE REGULATES FRANCHISE DISCLOSURE DOCUMENTS, ENSURING TRANSPARENCY IN THE FRANCHISE PURCHASE.
- 436.6 Instructions for Preparing Disclosure Documents
It is legally required that any franchisor 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:
1. The franchisor or any predecessors/affiliates
This item must contain the name and address of the franchisor and any affiliates or predecessors to the franchise. In some cases, the franchisor may have a parent entity that doesn’t fully engage in, yet nevertheless their names must be listed in the document.
Item 1 also contains a description of the franchises that the franchisor offers, including information about the general market for the business’ products.
2. Business experience
This item of the franchise disclosure document provides a thorough list of the franchise’s directors, trustees, officers, and any other significant figures within the company. Anyone with management responsibility within the franchise should be included in this list, despite that they may not be an employee or affiliate of the franchise.
Any litigation that involves the franchisor or any of the individuals listed in the previous item is disclosed here. This includes pending actions and even legal issues that may have taken place within the past 10 years. Routine litigation, such as employment or slip and fall, does not need to be disclosed in the document. Even confidential settlements must be disclosed (any case in which the franchisor paid a nominal amount).
In the instance that a franchisor does not have or has not had litigation to report, they must explicitly state that “No litigation is required to be disclosed in this item.”
This portion of the FDD describes the current financial situation of the franchisor. A 10-year long bankruptcy history of the franchisor, parents, affiliates, and other primary figures must be disclosed in this item.
Just as in the previous item, if the franchisor has no history of bankruptcy to report, they must explicitly state the lack thereof.
5. Initial fees
Within Item 5, the franchisor outlines all of the fees associated with the initial purchase of the franchise. Often, these sections provide an estimated range for each fee, including a predicted minimum and maximum. A key item listed here is also the initial franchise fee.
6. Other fees
Here, the franchisor lists all other fees associated with purchasing and running the franchise. Some of these fees may be one-time, while others are recurring. This section is presented in a table. Furthermore, the franchisor discloses whether or not any of these fees are refundable and whether they apply evenly to all franchisees within the franchise system.
7. Estimated Initial investment
Item 7 specifies the estimate for the entire initial investment. This investment is divided into seven different categories, which are displayed in the form of a table. These categories include:
- Initial franchise fee
- Training expenses
- Real property (purchased or leased)
- Initial inventory
- Security deposits, business licenses, and other prepaid expenses
- All additional funds, which the franchisor must describe.
8. Restriction on sources of products and services
This item defines the franchisor’s relationship with suppliers. This item describes whether or not franchisees may use outside suppliers. Typically, any outside suppliers that the prospective franchisee wishes to use must be approved by the franchisor.
9. Franchisee’s obligations
Item 9 provides a table form list of the franchisee’s obligations within the franchise agreement. Often, this table cross references different portions of the document, guiding the reader to different parts of the FDD.
Here, the franchisor discloses the financing structure that they (or affiliates) directly or indirectly offer. Some franchisors do not offer any form of financing and must disclose this. On the other hand, some do and must provide a written arrangement of any indirect offer of financing.
11. Franchisor’s Assistance, Advertising, Computer Systems, and Training
Item 11 is often one of the longest portions of the FDD, as it involves many different pieces of information. Here, the franchisor must state all of their own obligations throughout the ongoing operation of the business.
This section of Item 11 discloses the methods the franchisor uses to select the new business site. Additionally, this portion includes any lease negotiations, the process of selecting a contractor, and the process for obtaining the required signs or fixtures for the business.
The franchisor must also disclose their advertising programs, including the media that they use to complete these programs. Any advertising funds are also listed here to give the franchisee full awareness on the subject.
In some cases, a franchisee must purchase and learn to operate POS or other computer systems to run their business. This section describes the necessary training and fees associated with this portion.
This section explains what protected territory the franchisee will receive. Item 12 greatly varies from franchise to franchise, depending on company specifics.
With the purchase of a franchise comes the right to use company trademarks. For many franchisees, the right to use a popular trademark is an attractive feature of the franchising business model. This section of the FDD explains what the company’s different trademarks are and how they can be used.
14. Patents, copyrights, and proprietary information
Much like the previous item, this part of the FDD discloses any pending or current patents, copyrights, or other relevant proprietary information for the franchisee.
15. Obligation to participate in operation of the franchise business
While Item 9 breaks down the franchisee’s responsibilities in a table form, Item 15 provides a more specific explanation of what these responsibilities entail. The responsibilities of a franchisee can be extensive and complex so a simple list doesn’t quite cut it. A careful review of Item 15 can give the franchisee an idea of what the real day-to-day of owning a franchise will look like. Often, but not always, these obligations are laid out in an easy-to-follow table, which the franchisee may review.
16. Restrictions on what the franchisee may sell
Here, the franchisee can see a breakdown on what they may and may not sell. Typically, this pertains to the goods or services offered by the franchise. Here, the franchisor may include any limitations on the products that the franchisee may sell. Often, the franchisor also specifies whether or not the franchisee must purchase products from preapproved suppliers.
17. Renewal, termination, transfer, and dispute resolution
Item 17 is another vital portion of the FDD. Here, the franchisee can find any restrictions related to the termination or transfer of the Franchise Agreement. Here also, the franchisor is obligated to disclose the methods used to resolve legal dispute. Some franchisors prefer to settle disputes through arbitration, rather than the court system. The franchisor’s preferred method of dispute resolution is good to know, as it can help a franchisee prepare for any future issues.
18. Public Figures
Item 18 discloses any public figures that may be involved with the franchise. If the franchise sale is associated with any public figures, the franchisor must disclose any benefits given to the person, any roles or duties they have in business management, and how much the public figure has invested.
19. Financial Performance Representations
The FTC Rule specifies that the Financial Performance Representation (FPR) must be a reasonable representation of the financial performance of the company. Franchisors must be able to provide the resources and data used to comprise their FPR upon request. They must also be explicit in warning franchisees that the report is not a guaranteed report of projected performance.
This section of the FDD provides a table outline of all the company’s franchised locations from the previous three years. These tables often outline state-by-state locations and compare the number of outlines at the beginning of the year to the end of the year. This item of the FDD gives any prospective franchisee a good idea of the size and success of their desired franchise.
21. Financial Statements
Franchisors are expected to include audited financial statements for the prospective franchisee’s review. While start-up franchisors likely can not provide the required audited statements, they are expected to provide other documents, including unaudited opening balance sheets and second fiscal year selling franchises. As soon as the required audited statements are available for preparation, the franchisor is expected to do so.
All agreements and contracts that the potential franchisee is expected to sign is are provided in this section of the document. Here, franchisors include the franchise agreement, non-disclosure agreements, and any other applicable contracts.
The receipts in this section verify that the prospective franchisee received the franchise disclosure document
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.
- 436.8 Exemptions
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 franchise law.