For decades, franchising has been a successful, proven, and widely-used business model in the United States that has benefited both franchisees and franchisors in equal measure.
However, it wasn’t always that way.
During the franchising boom of the 1950s and 1960s, reports of abuses and deception of franchisees by franchisors became all too common. The response? The FTC Franchise Rule.
Since its enactment, this law has helped to protect franchisees from fraud and deception while also strengthening franchising as a whole. But just what exactly is the FTC Franchise Rule? Here’s a detailed look at what it is, its history, how it’s enforced, and what Franchise Disclosure Documents are. Let’s take a closer look below!
The FTC Franchise Rule Explained
The FTC Franchise Rule is a Federal rule governed by the Federal Trade Commission (FTC) that defines practices that are considered deceptive or unfair in the United States franchising industry.
The main goal of the FTC Franchise Rule is to help the prospective franchisee make informed decisions and to provide for increased transparency by the franchisor in order to reduce any risk of fraud or deception. It’s important to note, though, that the rule doesn’t regulate the specific terms of any agreements between the franchisee and the franchisor. Instead, it aims to help potential franchisees clarify the terms of their relationship with the franchisor and to protect them from any unfair practices.
Specifically, the FTC Franchise Rule requires franchisors to make disclosures to franchisees in five key categories:
- The nature of the franchisor and its franchise system
- The franchisor’s financial viability
- The cost to buy and operate a franchise unit
- The terms and conditions that govern the franchisee-franchisor relationship
- Names and addresses of current franchisees that can be contacted for additional information and to verify the franchisor’s claims
These disclosures typically come in the form of the Franchise Disclosure Document (FDD), a document given by the franchisor to prospective franchisees which details 23 specific points about the franchise, such as fees and royalties to be paid by the franchisee, estimated initial investment costs for the franchisee, financing agreements, the rules governing the company’s franchise agreement with its franchisees, and the like.
History of the FTC Franchise Rule
The origins of the FTC Franchise Rule go back to the rapid growth of franchising in the post-World War II United States. Although franchising was becoming widely adopted during this period as many chain restaurants and stores expanded to accommodate the increasing suburbanization of the United States, reports of deception, fraud, and abuse by franchisors became all too common by the late 1960s.
Some franchisors attracted franchisees with misrepresentations regarding their company’s revenue and by leveraging celebrity endorsements from stars who had little to do with the business directly. In more extreme cases, some fraudulent franchisors even sold franchise units for business concepts that didn’t even exist, scamming unsuspecting entrepreneurs out of their hard-earned money.
To help protect entrepreneurs from fraud and abuse, the Federal Trade Commission started to examine franchising practices in 1970, with the rulemaking starting in earnest a year later in 1971. This culminated in the official enactment of the FTC Franchise Rule a few years later on October 21, 1979.
In January 2007, the FTC announced updates to the Franchise Rule starting in July of that year, which were fully implemented by July 2008. These changes saw the strengthening of disclosure rules to help inform franchisees, with the original Uniform Franchise Offering Circular being fully replaced by current Franchise Disclosure Documents starting in 2008.
How is the FTC Franchise Rule Enforced?
The rule has the full force of the law behind it and can be enforced through civil penalties in Federal court. The FTC Franchise Rule grants courts the ability to impose fines of up to $11,000 per compliance violation.
What are Franchise Disclosure Documents (FDDs)?
Franchise Disclosure Documents are documents prepared by franchisors for prospective franchisees that provide them with critical information about the franchise to help them determine if they’d like to move forward with buying a unit or not.
FDDs must be given to prospective franchisees at least two weeks before the completion of a franchise sale and is required to be updated annually or whenever a change happens to the franchise itself. FDDs are designed to not only provide prospective franchisees with the critical information they need on whether to move forward with purchasing a franchise unit or not, but also to protect franchisors against allegations of inadequate disclosure and misleading claims.
All FDDs are broken into 23 specific points, each of which is designed to disclose details about the franchisor. They include:
Item 1: The Franchisor and any Parents, Predecessors, and Affiliates
This section divulges the history and background of the franchisor, giving prospective franchisees a better understanding of the company.
Item 2: Business Experience
Item 2 offers a look at the main leaders of the franchisor, such as directors, partners, and the like. This helps franchisees understand who the leaders of the company are to help them in their research.
Item 3: Litigation
This section discloses pending or completed litigation filed both by and against the franchisor. This offers transparency for both the franchisor and franchisee about any historical or current legal actions that the company has been involved in.
Item 4: Bankruptcy
This item divulges critical financial information, giving franchisees a view of the franchisor’s current financial situation. Franchisors are required to disclose any bankruptcies within the past 10 years, though have the flexibility to provide as much or as little context and specific information about each bankruptcy as they wish.
Item 5: Initial Fees
Item 5 discloses any initial fees that the franchisee is required to pay to the franchisor in exchange for buying a franchise unit. This section should be reviewed very carefully by the prospective franchisee to ensure that they fully understand their financial obligation should they choose to sign a franchise agreement with the company.
Item 6: Other Fees
This item lists fees to be paid by the franchisee that are not refundable and typically includes royalty fees, advertising fees, and the like.
Item 7: Estimated Initial Investment
This section is also critical for the franchisee, as it outlines any expenses that they may incur when purchasing a franchise unit. Some of these expenses typically include licenses, merchandise, and the like. This item is typically in a table format to lay out the expenses in a visual form.
Item 8: Restrictions on Sources of Products and Services
Although this section isn’t applicable to all businesses, it lays out the franchisor’s relationships with various suppliers. This helps the franchisee understand where their products are coming from and what their costs are.
Item 9: Franchisee Obligations
Item 9 details the franchisee’s job description. Usually presented in table format too, it lays out the various responsibilities associated with running a franchise unit on a day-to-day basis.
Item 10: Financing
This item details any financing options, if any, that the franchisor has available for its franchisees.
Item 11: Franchisor’s Assistance, Advertising, Computer Systems, and Training
This length section discloses the training programs and ongoing support that the franchisor offers its franchisees.
Item 12: Territory
Item 12 offers a look at any protected territories franchisees are entitled to with the company. This section typically varies greatly by franchisor.
Item 13: Trademarks
This item explains the various trademarks employed by the franchisor and how the franchisee can use them.
Item 14: Patents, Copyrights, and Proprietary Information
Item 14 divulges any current or pending patents, copyright, or proprietary information for the franchisee.
Item 15: Obligations to Participate in the Actual Operations of the Franchise Business
This section is similar to Item 9, but goes into more detail about the responsibilities and role of a franchisee. This gives the prospective franchisee more information about what their role would entail on a daily basis.
Item 16: Restrictions on What the Franchisee May Sell
Item 16 discloses any products or services that the franchisee is restricted or barred from selling. It also looks at whether franchisees must buy only from pre-approved vendors or not and, if so, which vendors they are and which products or services they sell.
Item 17: Exit Strategies and Dispute Resolution Procedures
Here, prospective franchisees will find detailed information on any restrictions related to the transfer or outright termination of a franchise agreement. The franchisor also divulges any methods used to settle legal disputes in this section, which is typically done either in a court of law or with arbitration.
Item 18: Public Figures
In this item, the franchisor must disclose any public figures associated with them, including their relationship with the company and investments with it.
Item 19: Financial Performance Representations
This section provides a reasonable representation of the franchisor’s financial performance. Franchisors are also required to inform prospective franchisees that any figures and statistics displayed in this section is not a guarantee in any way of how they could expect to do financially with the company.
Item 20: Outlets and Franchisee Information
This item offers a look at the company’s franchised locations from the prior three years in table format, often outlining them on a state-by-state basis.
Item 21: Financial Statements
Here, franchisors disclose any audited financial statements for the prospective franchisee to review. This is designed to give prospective franchisees a more detailed view of the company’s financial status.
Item 22: Contracts
All contracts and agreements the prospective franchisee are expected to sign are disclosed in this section. Franchise agreements, non-disclosure agreements, and other contracts are also included here.
Item 23: Receipts
This section verifies that the prospective franchisee received the FDD.
Succeed in Franchising by Understanding the FTC Franchise Rule!
Franchising has succeeded for decades in the United States thanks in large part to the effectiveness of the FTC Franchise Rule. By laying the groundwork for transparency and giving prospective franchisees the tools they need to make an informed decision about whether to buy a franchise or not, the regulation has ushered in a period of new growth in franchising since its adoption.
For both franchisors and franchisees, having a strong grasp of this rule is essential for success – and doing so can pay dividends for both parties!