Many of the frequent franchisee complaints centered on material misrepresentations and nondisclosure of material facts by franchisors in the sales process. Of particular concern was unsubstantiated claims of profitability.
As a result, beginning in 1970, states took action to attempt to regulate the industry. Today, 15 states have franchise laws requiring presale disclosures, including California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin. Of those states, only Oregon does not also have laws requiring franchise registration, and Michigan and Oregon do not require a filing of the presale disclosures. Although each state registration law has its own peculiarities, the statutes are for the most part similar, and all:
- Contain definitions of the term franchise
- Require franchises to register with designated state officials before being offered for sale
- Require certain disclosures be made to prospective franchisees –and–
- Require a cooling-off period before the franchise offer may be accepted by a prospective franchisee
In 1979, the FTC enacted its “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures” (Franchise Rule). In 2007, the FTC approved amendments to the Franchise Rule. The amended FTC Rule (the “FTC Rule”) has many similarities to the state franchise registration statutes and requires certain disclosures be made to prospective franchisees and a cooling off period before the franchise can actually be sold. However, two notable differences between the FTC Rule and State Franchise Registration Statutes exist: (1) there is no registration requirement under the FTC Rule and (2) there is no private right of action if the FTC Rule is violated.
Only the FTC can bring actions if a franchisor fails to comply with the FTC Rule. Violation of the FTC Rule by a franchisor can potentially result in FTC-assessed civil penalties of up to $11,000 per violation, and possibly rescission, reformation, payment, or refunds or damages. The FTC can also issue cease-and-desist orders. However, a private litigant, such as a franchisee, cannot initiate suit against the franchisor to enforce the FTC Rule because there is no private right of action under the FTC Rule. Thus, the FDD provides key information to a potential franchisee, but not a basis for a cause of action. Federal courts have held that the FTC Rule may not be enforced by private lawsuits
The purpose for the adoption of the FTC Rule was the relatively low business sophistication of prospective franchisees. The FTC determined that the answer was to require disclosure requirements and cooling off periods before a prospective franchisee could sign a binding agreement or pay money to a franchisor.
The FTC seeks to facilitate informed decisions and to prevent deception in the sale of franchises by requiring franchisors to provide prospective franchisees with essential information prior to the sale.
The FTC Rule requires all franchisors to prepare, file, and submit to all potential franchisees a disclosure document prior to agreement on the franchise and receipt of money known as a “Franchise Disclosure Document” (FDD), formerly known as a “Uniform Franchise Offering Circular” (UFOC) until the 2007 revision of the FTC Rule. The FDD includes certain disclosures mandated by the FTC Rule and state statutes. While the form of the FDD is very similar among the various states, counsel should note that each state has its own peculiarities and the document used to sell franchises in each registration state may be different in certain respects from that used in other jurisdictions. Typically, these state peculiarities are addressed in the form of addenda to the FDD and to related agreements so that a single FDD may be used in all 50 states.
Under the FTC Rule, a franchisor must provide its FDD to a prospective franchisee at least 14 calendar days before entering into any binding agreement with or receiving any payment from the franchisee. State rules may differ. For example, in New York and Michigan, the FDD must be provided at the earlier of the first personal meeting with the franchisee or 10 business days before the franchisee signs a binding agreement with, or makes a payment to, the franchisor.
An FDD includes 23 sections called Items, and numerous exhibits. The body of a typical FDD can range from 30 to 50 pages. The entire FDD, including exhibits, often will be over 200 pages. Any agreements that are relevant to the franchise opportunity, such as the franchise agreement, must be included as exhibits to the FDD. Audited financial statements of the franchisor must also be included in the FDD, although the amended FTC Rule allows a phase- in period where a start-up franchisor does not need to include audited financial statements.
The goal of the FTC Rule is to require presale-disclosure designed to forestall material misrepresentations or omissions. The FDD provides detailed information on the franchise company, including its history, the officers, any litigation history, estimated investment, an overview of the business concept, and a copy of the franchise agreement.
A current list of franchise owners’ names and telephone numbers is also a required component, allowing prospective franchisees the opportunity to contact and speak with current franchisees. The purpose of the FDD is to provide sufficient information on a company to help a prospective franchisee make a more informed decision. The FDD is also presented in a manner that is consistent, straight forward and relatively easy to understand.
The intent of the FDD is to provide buyers with vetted and validated information that can be used to make a decision. FDD’s are required to be provided to candidates at least 14 days before a sale can be completed, and it must be updated annually or whenever a material change occurs in the business. Reading an FDD is a lot like reading a public company’s 10K, but without as much detail. There are two purposes to the FDD: to protect franchisees, and to protect the franchisor against allegations of misleading claims. In fact, a properly prepared FDD can also serve as an effective sales tool for prospective franchisees.