HIGHLIGHTS AND ANALYSIS: THE REVISED FEDERAL TRADE COMMISSION

FRANCHISE RULE

By: David J. Kaufmann and David W. OppenheimKaufmann, Feiner, Yamin, Gildin & Robbins LLP

New York City

© Commerce Clearing House, Inc. and Kaufmann, Feiner, Yamin, Gildin & Robbins LLP, 2007

TABLE OF CONTENTS

I. INTRODUCTION……………………………………………………………………………….. 1

II. BACKGROUND - - THE GENESIS OF FEDERAL AND STATE FRANCHISE REGULATION………………………………………………………………………………….. 4

III. THE FTC’S REGULATORY REVIEW OF THE FRANCHISE RULE……………………. 6

IV. FTC FRANCHISE RULE TO BE MAINTAINED - - BUSINESS OPPORTUNITYREGULATION TO BE SEPARATELY ADDRESSED…………………………………….. 8

V. NO REGULATION OF THE FRANCHISOR-FRANCHISEE RELATIONSHIP ………… 8

VI. UFOC DISCLOSURE MODEL ADOPTED AND EXPANDED; COMPARISON OF REVISED RULE VS. CURRENT UFOC DISCLOSURE REQUIREMENTS……….. 10

VII. THE DEMISE OF THE UFOC GUIDELINES……………………………………………….. 26

VIII. ELECTRONIC DISCLOSURE………………………………………………………………… 27

IX. TIMING REQUIREMENTS - - WHEN DISCLOSURE MUST BE EFFECTED………….. 29

X. INTERNATIONAL TRANSACTIONS EXCLUDED FROM REVISED RULE COVERAGE……………………………………………………………………………………. 34

XI. USE OF “PLAIN ENGLISH” MANDATED…………………………………………………. 35

XII. FINANCIAL PERFORMANCE REPRESENTATIONS/”EARNINGS CLAIMS”………… 35

XIII. RESPONSIBILITY FOR EFFECTING DISCLOSURE…………………………………….. 42

XIV. WHO MAY RECEIVE DISCLOSURE……………………………………………………….. 43

XV. LIABILITY FOR CONTENTS OF DISCLOSURE DOCUMENTS………………………… 44

XVI. DISCLOSURE POSSIBLY REQUIRED OUTSIDE OF THE DISCLOSUREDOCUMENT……………………………………………………………………………………. 46

XVII. UPDATING DISCLOSURE DOCUMENTS…………………………………………………. 47

XVIII. EXEMPTIONS………………………………………………………………………………….. 48

XIX. PROHIBITED CONDUCT…………………………………………………………………….. 52

XX. REVISED RULE IMPACT ON STATE FRANCHISE LAWS……………………………… 54

XXI. EFFECTIVE DATE OF REVISED FTC FRANCHISE RULE/”PHASE-IN” PERIOD…………………………………………………………………………. 55

XXII. REVISED RULE “TO DO” LIST FOR FRANCHISORS…………………………………… 56

XXIII. TABLE OF REVISED FTC FRANCHISE RULE VARIATIONS FROMUFOC GUIDELINES…………………………………………………………………………… 60

XXIV. SAMPLE REVISED FTC FRANCHISE RULE DISCLOSURE DOCUMENT………….. 60

XXV. CONCLUSION………………………………………………………………………………….. 60

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HIGHLIGHTS AND ANALYSIS: THE REVISEDFEDERAL TRADE COMMISSION FRANCHISE RULE

By: David J. Kaufmann and David W. Oppenheim*

Kaufmann, Feiner, Yamin, Gildin & Robbins LLPNew York City

I. INTRODUCTION

The future of franchise regulation has arrived.

On January 22, 2007, the Federal Trade Commission (“FTC”) approved a comprehensively revised FTC Franchise Rule (16 CFR Part 436) - - the nation’s sole federal franchise regulation - - fundamentally transforming the Rule for the first time since it was first adopted in 1978. As a result, the regulation of the offer and sale of franchises in the United States will experience its most dramatic transformation since the advent of federal and state franchise disclosure laws and regulations in the 1970’s.

Accompanying the revised FTC Franchise Rule (the “Revised Rule”) is the Commission’s “Statement of Basis and Purpose” (“SBP”) amplifying and clarifying the Revised Rule’s requirements and prohibitions.

As detailed below, the Revised Rule takes effect on an optional basis on July 1, 2007 and on a mandatory basis on July 1, 2008, after which all franchise disclosure documents nationwide must comply with the Revised Rule’s modified requirements.

* Mr. Kaufmann is Senior Partner of New York City’s Kaufmann, Feiner, Yamin, Gildin & Robbins LLP, which represents many of our nation’s largest and most prestigious franchisors. Mr. Kaufmann authored New York’s franchise statute, the New York Franchise Act; is an advisor to the organization of state and federal officials responsible for devising and coordinating franchise regulatory activity nationwide (the North American Securities Administrators Association Franchise Project Group); serves on the Governing Committee of the American Bar Association Franchise Forum; is past Chair of the New York State Bar Association Franchise Law Committee; appears in McKinney’s New York Statutes as an expert on franchising; serves as the New York Law Journal’s franchise columnist; chairs all Practising Law Institute programs on franchising nationwide; and, served as Special Deputy Attorney General of New York assigned to the Franchise Section of that office.

Mr. Oppenheim, is a partner at New York City’s Kaufmann, Feiner, Yamin, Gildin & Robbins LLP. Recognized by Franchise Times as a “Hot Shot Lawyer Under 40”, Mr. Oppenheim handles some of the firm’s most critical and sensitive matters ranging from regulatory disputes, annual registration and renewal efforts for some of the nation’s largest franchisors, obtaining preliminary and permanent injunctive relief in disputes between the firm’s franchise clients and their franchisees and serving as the lead franchise attorney in some of the largest franchise mergers and acquisitions in the franchise arena. Mr. Oppenheim is a frequent author and speaker on franchising and distribution system subjects.

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Gone is the old FTC Franchise Rule’s (the “original Rule”) own disclosure format (rarely used, since a disclosure document based thereon was unacceptable to the franchise regulating states). Gone soon will be the current version of the Uniform Franchise Offering Circular (“UFOC”), the franchise disclosure document format conceived and implemented by the franchise regulatory states, and approved for use by the FTC, to facilitate multistate franchise disclosure. Now, the UFOC has been “federalized”, essentially coopted by the revised FTC Franchise Rule as the federal government’s new disclosure platform, significantly augmented by various additional and modified disclosure obligations.

Given the FTC Franchise Rule’s continuing limited preemptive effect, the Revised Rule’s “UFOC plus” disclosure requirements will serve as the new franchise disclosure “floor” which in the future all franchisors must comply with (meaning that the franchise regulating states must now amend their disclosure regulations and, in certain instances, their statutes to incorporate this new disclosure “floor”). And by necessity, today’s UFOC Guidelines (specifying the franchise regulating states’ requirements concerning the contents and preparation of the UFOC) will soon disappear, unless such states retain the Guidelines only to address any disclosure obligations they may require that go beyond the revised FTC Franchise Rule’s obligations.

In lieu of the UFOC Guidelines, the FTC released the aforementioned SBP and the staff of the FTC will soon issue its Franchise Rule Compliance Guides addressing at length various disclosure issues arising under the Revised Rule (said Compliance Guides being analogous to the FTC’s “Final Interpretative Guides” which accompanied the promulgation of the original Rule).

Whether the franchise community will continue to refer to a disclosure document as a “UFOC” out of force of habit after the Revised Rule’s mandatory effective date of July 1, 2008 remains to be seen - - the formal title ascribed to it by the revised FTC Franchise Rule is simply, “Franchise Disclosure Document”.

Much else has been reshaped by the revised FTC Franchise Rule, as this report will reveal. The old question as to whether the FTC Franchise Rule applied to international transactions has been answered with finality: no, it does not. Pure electronic disclosure is permitted, leaving to history the days when franchise disclosure documents had to be handed out in paper form. The “first personal meeting” and “ten business day/five business day” timing requirements for effecting disclosure have been modified. Giving out “cost only” information to prospective franchisees will no longer be deemed furnishing financial performance representations (formerly known as “earnings claims”). And a series of new, broad exemptions from disclosure obligations are afforded by the Revised Rule.

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The Revised Rule and the FTC’s Statement Basis and Purpose are remarkable documents, reflecting vision; intellect; a thorough understanding of the importance and workings of franchising in the United States; and, a dedicated commitment to ascertain the needs, wants and desires of franchising’s “players” (franchisors, franchisees and those professionals who serve them) and harmonize those desires with the interests of franchisees in particular and the general public at large. As well, the Revised Rule reflects a stunning commitment to address and incorporate the vast demographic, economic, societal and technological changes which have transpired since the original FTC Franchise Rule became was adopted in 1978.

The franchise sector owes a sincere debt of gratitude to those responsible for the FTC’s promulgation of the Revised Rule - - in particular, Steven Toporoff (FTC Franchise Program Coordinator); Eileen Harrington (FTC Deputy Director, Bureau of Consumer Protection); Lois C. Greisman (FTC Associate Director, Division of Marketing Practices); Lydia B. Parnes (FTC Director, Bureau of Consumer Protection); and, Deborah Platt Majoras (Chair, Federal Trade Commission).

In this report, we shall:

Address the genesis of federal and state franchise regulation; review the methodology which the FTC staff utilized to conduct its review of the original FTC Franchise Rule and promulgate the Revised Rule;

Address each substantive change wrought by the Revised Rule;

Closely analyze how current Uniform Franchise Offering Circular (“UFOC”) disclosure documents will have to be modified to comply with the new disclosure requirements of the Revised Rule;

Address the preemptive effect of the revised FTC Franchise Rule upon current state franchise registration and disclosure statutes;

Explore the impact of the Revised Rules’ effective date and phase-in period;

Set forth a “to do” list of activities which franchisors should immediately undertake in order to transition to the Revised Rule;

Furnish a table (Exhibit A) identifying each Revised Rule vs. UFOC variance; and,

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Present a sample franchise disclosure document (Exhibit B) tailored to meet the Revised Rule’s disclosure requirements and mandates while satisfying non-preempted state franchise law edicts.

The full text of the revised FTC Franchise Rule and its accompanying Statement of Basis and Purpose follows this report.

II. BACKGROUND - - THE GENESIS OF FEDERAL AND STATE FRANCHISE REGULATION

The FTC Franchise Rule was promulgated in 1978 at a time when fraud and criminality had penetrated the franchise arena.

Modern franchising, as we know it, had its advent in the 1950’s and 60’s. Before then, only soft drink companies and their authorized bottlers, oil refiners and their independently owned service stations, and automobile manufacturers and their dealers utilized franchising to any significant extent - - along with a few meaningful “business format” franchisors such as Howard Johnson’s (not today’s lodging chain, which had its genesis in 1954, but rather a network of hundreds of “orange roof” restaurants known nationwide for outstanding ice cream, hot dogs and other quality food served at reasonable prices).

It was in the 1950’s and 60’s that modern franchising as we know it truly took off. McDonald’s, Pizza Hut, Burger King, H&R Block, Holiday Inn, Baskin-Robbins, Kentucky Fried Chicken - - they all geared up and franchised out during this explosive period. The very popularity, growth and economic rewards of franchising, both to franchisors and franchisees, led to the need for its regulation. What happened was simple. Fly-by-night, unethical and often criminal operators - - reading press accounts in the late 1950’s and 60’s of the millions to be made in franchising - - decided to enter the franchise arena and proceeded to victimize many. Tens of thousands of people around the country lost millions of dollars to criminal franchise enterprises - - enterprises which, utilizing slick brochures and outright criminality, sold non-existent franchises to people whose life savings were lost to franchise fraud. So bad was the situation that 60 Minutes did a major “hit piece” on franchising featuring a scam perpetrated by a New Jersey outfit known as “Wild Bill’s Family Restaurants” (the principals of which ultimately were indicted by a federal grand jury).

The states reacted first to this broadscale criminal invasion of the franchise arena, with California in 1971 enacting the first ever franchise specific law - - the California Franchise Investment Law,1 which requires a franchisor, prior to offering or

1 California Franchise Investment Law, California Corporations Code, Div. 5, Parts 1-6, Section 31000 et. seq.

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selling franchises in that state, to register itself and its franchise disclosure document, and disseminate that document to prospective franchisees before accepting any money or signing any contract, with stiff criminal and civil liabilities for franchisor non-compliance. Over the following decade, fourteen other key states enacted parallel legislation (Maryland,2 Virginia,3 Wisconsin,4 Illinois,5 Minnesota,6 Indiana,7 New York,8

North Dakota,9 South Dakota,10 Michigan,11 Hawaii,12 Oregon,13 Washington,14 and Rhode Island).15

It was also in 1971 that the Federal Trade Commission announced its initiation of a rulemaking proceeding with the goal of promulgating a trade regulation rule governing franchise sales activity.16 Following years of proposals, hearings, comments and data analysis, the FTC concluded that rampant fraud existed in the franchise arena, necessitating federal regulation:

Specifically, the Commission found that franchisors and business opportunity sellers often made material misrepresentations about: the nature of the seller and its business operations, the costs to purchase a franchise or business opportunity and other contractual terms and conditions under which the business would operate, the success of the seller and its purchasers, and the seller’s financial viability. The Commission also found other unfair or deceptive practices pervasive: franchisors’ and business opportunity sellers’ use of false or unsubstantiated earnings claims to lure prospective purchasers into buying a franchise or business opportunity, and franchisors’ and business

2 Maryland Franchise Registration and Disclosure Law, Ann. Code of Maryland, Business Regulation, Title 14, Section 14-201 et. seq.3 Virginia Retail Franchising Act, Virginia Code, Title 13.1, Ch. 8, Section 13.1-557 et. seq.4 Wisconsin Franchise Investment Law, Wisconsin Stats., Ch. 553, Section 553.01 et. seq.5 Illinois Franchise Disclosure Act, Illinois Compiled Statutes, Ch. 815, Section 705/1 et. seq.6 Minnesota Statutes, Ch. 80C, Section 80C.01 et. seq.7 Indiana Code, Title 23, Article 2, Ch. 2.5, Section 1 et. seq.8 New York General Business Law, Art. 33, Section 680 et. seq.9 North Dakota Franchise Investment Law, North Dakota Century Code Ann., Title 51, Ch. 51-19, Section 51-19-01 et. seq.10 South Dakota Franchises for Brand-Name Goods and Services Law, South Dakota Codified Laws, Title 37, Ch. 37-5A, Section 37-5A-1 et. seq.11 Michigan Franchise Investment Law, Michigan Compiled Laws, Ch. 445, Section 445.1501 et. seq.12 Hawaii Franchise Investment Law, Hawaii Rev. Stat., Title 26, Ch. 482E, Section 482-E1 et. seq.13 Oregon Franchise Transactions Law, Oregon Revised Statutes, Title 50, Ch., 650, Section 650.005 et. seq.14 Washington Franchise Investment Protection Act, Revised Code of Washington, Title 19, Ch. 19.100, Section 19.100.010 et. seq.15 Rhode Island Franchise and Distributorship Investment Regulations Act, General Laws of Rhode Island, Title 19, Ch. 28.1, Section 19-28, 1-1 et. seq.16 36 Fed. Reg. 21607 (November 11, 1971).

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opportunity sellers’ failure to honor promised refund requests. The Commission concluded that all of these practices led to serious economic harm to consumers.17

Accordingly, the original FTC Franchise Rule was adopted on December 21, 1978 and took effect on October 21, 1979. Under the original Rule, franchisors were required to effect full pre-sale disclosure prior to the offer or sale of any franchise through a disclosure document whose format was specified by the Rule18 and in the FTC’s “Interpretative Guides” which accompanied the Rule.

Importantly, the fifteen states identified above which had enacted franchise registration and disclosure statutes refused to permit an FTC format disclosure document to be utilized, instead demanding compliance with each state statute’s particular disclosure format. To eliminate the confusion engendered by these varying (and sometimes conflicting) state disclosure requirements, the state franchise administrators - - acting first under the umbrella of the Midwest Securities Commissioners Association and then, as today, under the umbrella of the North American Securities Administrators Association (“NASAA”) - - in the mid 1970’s promulgated the “Uniform Franchise Offering Circular” (commonly referred to as the “UFOC”), a disclosure document format which, if prepared in accordance with NASSA’s UFOC Guidelines,19 satisfied the disclosure requirements of all state franchise registration and disclosure statutes.

To facilitate disclosure compliance by national and regional franchisors encountering two varying disclosure formats - - one federal, one state - - the FTC in its 1979 Interpretative Guides expressly permitted franchisors to utilize the UFOC disclosure format instead of the FTC’s own disclosure format.20

III. THE FTC’S REGULATORY REVIEW OF THE FRANCHISE RULE

The FTC Franchise Rule remained static following its adoption in 1979 while franchising grew exponentially to become a major force in the American economy, with some reports suggesting that today 40% of all retail sales in the United States are consummated at franchised outlets.

Accordingly, the Federal Trade Commission initiated a regulatory review21 of the FTC Franchise Rule in 1995, seeking public comment on whether there was a continuing need for the Rule and, if so, how the Rule could be improved to respond to 17 SBP at pages 3-4 (citing original Statement of Basis and Purpose accompanying the original Rule, 43 FR59621, at 59627-39).18 16 CFR §436.1.19 CCH Bus. Franchise Guide ¶5750.20 FTC Interpretative Guides, 44 Fed. Reg. 49970-71, August 24, 1979, §I(D)(1).21 60 Fed. Reg. 17,656 (April 7, 1995).

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the massive economic, societal and technological changes which transpired following the Rule’s deployment in 1979. In response to the Commission’s review notice, the FTC received 75 written comments and held two public workshops at which 50 individuals participated (the “Rule Review”).22

Following the Rule Review, the FTC concluded that its franchise rule needed to be amended and, toward that end, the FTC published an Advance Notice of Proposed Rulemaking (“ANPR”)23 seeking comment on several possible Rule modifications. In response to the Commission’s ANPR, the FTC received 166 written comments and held six public workshop conferences at which 65 people participated (including franchisors, franchisees, state regulators and consultants).24

The next step in the Franchise Rule revision process took place in October, 1999 with the Commission’s publication of a Notice of Proposed Rulemaking (“NPR”) further suggesting how the Commission was considering revising the FTC Franchise Rule.25

Attached to this NPR was a proposed revised Franchise Rule and an invitation for the public to submit comments and, if deemed desirable, request a public hearing (no one asked for such a hearing). The FTC received 40 comments in response to its NPR. Further, during this time the FTC consulted with officials who administered state franchise registration and disclosure statutes and internally utilized the services of FTC attorneys, accountants, economists and other experts to assist it in determining how to revise its Franchise Rule.

The penultimate step in the Franchise Rule revision process took place in August, 2004 - - the issuance of an FTC Staff Report, the last administrative act required of the Commission prior to its adopting the Revised Rule.26 The Staff Report, 271 pages long and containing another 137 pages of exhibits, memorialized the findings and conclusions of the FTC staff’s decade long review of franchising and franchise regulation; proposed the text of a revised Rule which the staff recommended the Commission adopt (virtually identical, with slight modifications, to the Revised Rule ultimately promulgated by the FTC); and, afforded a very brief comment period within which “fine tuning” suggestions would be received by the Commission. In response to the Staff Report, the FTC received 45 comments which for the most part supported the proposed Rule revisions suggested by the Commission’s staff.27

IV. FTC FRANCHISE RULE TO BE MAINTAINED - - BUSINESS OPPORTUNITY REGULATION TO BE SEPARATELY ADDRESSED

22 SBP at 4.23 62 Fed. Reg. 9115 (February 28, 1997).24 SBP at 5-6.25 64 Fed. Reg. 57,294 (October 22, 1999).26 FTC Rules of Practice, §1.13(f).27 SBP at 8.

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An essential issue addressed by the FTC over the past decade was whether the Franchise Rule continued to serve a useful purpose and thus should be maintained or, in the alternative, whether it now served no useful purpose and should be discarded.28

The SBP reveals that comments submitted to the FTC, coupled with the Commission’s law enforcement experience over the past three decades, overwhelmingly supported maintenance of the FTC Franchise Rule as a deterrent to fraud and as a cost-effective way to provide material information to prospective franchisees so they may assess the costs, benefits and potential risks involved in entering into a franchise relationship.29 However, the 2004 Staff Report recommended that the then forthcoming revised FTC Franchise Rule - - which originally subsumed and governed both the offer and sale of franchises and business opportunities - - be confined to franchising alone, with the Commission addressing the regulation of business opportunity sales separately through a subsequent rulemaking endeavor.30

The Commission accepted its Staff’s recommendation. Accordingly, the Revised Rule consists of two distinct segments - - one confined exclusively to the regulation of franchising (16 CFR Part 436, the subject of this report) and the other setting forth, for the time being, the original Rule’s requirements and restrictions pertaining to business opportunity sales (16 CFR Part 437) (with the FTC initiating a separate rulemaking on April 12, 2006 addressing how its business opportunity regulation should be revised).31

V. NO REGULATION OF THE FRANCHISOR-FRANCHISEE RELATIONSHIP

Despite calls from many franchisee advocates that the revised FTC Franchise Rule govern franchisor-franchisee relationships to address what some of these advocates suggest are “abusive franchise relationships”, the Revised Rule does no such thing.

Franchisee advocates suggested in particular that the FTC fashion its Revised Rule to prohibit the enforcement of franchise agreement post-term covenants not to compete; franchisors’ alleged “encroachment” of franchisees’ “market territories”; and, restrictions on franchisee sourcing of products and services, among other practices.32

Indeed, some franchisees suggested that if the Revised Rule did not address post-sale relationship issues, then the FTC should abolish the Franchise Rule altogether.33

28 62 Fed. Reg. at 9,120.29 SBP at 9.30 Staff Report at 12.31 71 Fed. Reg. 19054 (April 12, 2006).32 SBP at 10.33 SBP at 10 and Staff Report at 7, n. 27, citing American Franchisee Association (“Our members feel so strongly about the Commission’s inability to deal with substantive issues of concern to them, they would

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However, the Revised Rule deliberately avoids any regulation of the franchise relationship, with the SBP explaining why:

To address post-sale relationship issues by adopting rule provisions that prohibit or limit the use of certain contract terms would require record evidence demonstrating specific unfair acts or practices. The FTC Act defines an unfair act or practice as one that is “likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition.” The Act also requires that, to justify an industry-wide rule, such practice be prevalent. This proceeding did not yield adequate evidence to support a finding of prevalent acts or practices that meet each of the three prerequisites for unfairness as articulated in Section 45(n) of the FTC Act.

With regard to the first prerequisite, substantial injury, the record shows that some franchisees in several franchise systems have suffered post-sale harm in the course of operating their franchises, and in some instances this injury may be ascribable to acts or practices of a franchisor. The record, however, leaves open the related questions of whether such franchisor acts or practices are prevalent and whether the injury resulting from acts or practices is substantial, when viewed from the standpoint of the franchising industry as a whole, not from just a particular franchise system.34

While not imposing any regulation of the franchise relationship itself, the revised Rule does feature a series of new disclosure requirements - - found neither in the original Rule nor in the UFOC Guidelines - - designed to enable prospective franchisees to better assess the quality of their forthcoming franchise relationships and their likely success as franchisees. These include disclosures concerning litigation commenced by franchisors against their franchisees; the existence of network-specific franchisee associations; whether franchisees are restricted by their franchisors from freely communicating their experiences with prospective franchisees; and, other such subjects, as addressed in this report below.

VI. UFOC DISCLOSURE MODEL ADOPTED AND EXPANDED; COMPARISON OF REVISED RULE VS. CURRENT UFOC DISCLOSURE REQUIREMENTS

rather work to abolish the FTC rule then suffer the abuses of both a government agency and their franchisors”).34 SBP at 10-11.

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As discussed above, the original FTC Franchise Rule featured its own format for the disclosure document which the Rule mandated be furnished to prospective franchisees prior to the offer or sale of any franchise. That FTC Franchise Rule disclosure format was distinctly different, however, from the UFOC disclosure format required to be used by those fifteen states which feature franchise registration and disclosure statutes.

While under the original Rule the FTC permitted franchisors to utilize the state UFOC disclosure format in lieu of the Rule’s own format, the converse generally did not hold true. That is, virtually all of the franchise regulating states would not accept for registration or use an FTC Franchise Rule formatted disclosure document. So it was that the vast majority of franchisors in the United States utilized the UFOC disclosure format, since by doing so all federal and state disclosure requirements could be satisfied.

Realizing this; attempting to lessen unnecessary inconsistencies between federal and state franchise disclosure laws; and, recognizing that a uniform disclosure platform utilized nationwide helps facilitate “comparison shopping” among franchise systems by prospective franchisees, the Revised Rule abandons the original Rule’s disclosure format and instead requires franchisors to exclusively utilize the UFOC disclosure format, but with key changes - - the Revised Rule modifies and adds to those disclosures mandated under the UFOC Guidelines (which, under the aegis of NASAA, and as adopted by each franchise regulating state, contains instructions for preparing a UFOC disclosure document). Many in the franchise community thus refer to the disclosure requirements of the revised FTC Franchise Rule as “UFOC plus”.

In furtherance of this new disclosure regime, the Revised Rule incorporates much of the UFOC Guidelines’ substantive text and instructions (modified to advance the Revised Rule’s “UFOC plus” disclosure requirements). However, purely explanatory materials in the UFOC Guidelines and NASAA’s Commentaries thereto are not incorporated in the Revised Rule. In lieu thereof, the Commission staff is expected to release its “FTC Franchise Rule Compliance Guides”, addressing at length various disclosure issues (said Compliance Guides being analogous to the FTC‘s “Final Interpretative Guides” which accompanied the promulgation of the original Rule).35

Set forth below is an item-by-item comparison of the Revised Rule’s disclosure requirements versus those mandated today by the UFOC Guidelines. Set forth in Exhibit A to this report is a summary of these variations.

Cover Page

35 SBP at 15-16.

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The Revised Rule introduces a brand new disclosure document cover page,36

one featured neither in the original Rule nor in the UFOC Guidelines.

First, the Revised Rule requires that the cover page of the disclosure document reference certain FTC resources that prospective franchisees can access in connection with their deliberations, including the Commission’s publication Consumer Guide to Buying a Franchise and the FTC’s toll free telephone “help” line.

In addition, the Revised Rule embraces the “pure” electronic disclosure authorized thereunder by requiring franchisors to include on the disclosure document cover page their email and primary home web page addresses. Franchisors are also authorized to designate on the cover page the specific individual that a prospective franchisee should contact to obtain a disclosure document in an alternative medium (if the subject franchisor desires to make its disclosure document available by alternative means).

Moreover, the Revised Rule’s mandated cover page eliminates the original Rule’s “…information required by the Federal Trade Commission… to protect you” verbiage, which may have been deemed to imply FTC approval or extensive oversight of the disclosure document, and substitutes instead the following warning which must be set forth in bold type: “Note, however, that no governmental agency has verified the information contained in this document”.

Finally, the Revised Rule’s cover page does not mandate the two mandatory risk factors required by the UFOC Guidelines concerning choice of venue and choice of law. However, the Revised Rule anticipates that the states may continue insisting upon the incorporation of such risk factors, and thus permits franchisors to “…include additional disclosures on the cover page… to comply with state pre-sale disclosure laws”.

Item 1: The Franchisor and Any Parents, Predecessors and Affiliates

The Revised Rule carries forward the original Rule’s disclosure requirements pertaining to the franchisor and, if applicable, its corporate parent and affiliates while also harmonizing its required disclosures with those mandated by the UFOC Guidelines (by requiring disclosure concerning the franchisor’s predecessors, regulations specific to the industry in which the franchised business will operate and the general competition which prospective franchisees are likely to face).

36 Revised Rule, §436.3.

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The Revised Rule imposes varying disclosure requirements concerning a franchisor’s corporate parent. If that parent does not itself serve as a franchisor of another concept or furnish products or services to franchisees of the network to which the disclosure document relates, then only the name and principal business address of the franchisor’s corporate parent need be set forth. On the other hand, adopting the UFOC Guidelines’ platform, the Revised Rule requires extensive disclosure regarding the franchisor’s predecessors and such of its corporate parents and affiliates which offer franchises in any line of business or provide products or services to the subject franchisor’s franchisees, including detailed information regarding their prior business experience.

Item 2: Business Experience

No disclosure of franchise brokers is required under the Revised Rule, in stark contrast to previous federal and current state franchise disclosure requirements. The SBP explains why:

Unlike franchisors, brokers do not create or implement franchisor policy, nor do they oversee performance of post-sale obligations to the franchisee. Accordingly, prospective franchisees are less likely to give decisive weight to an individual broker’s expertise or background in assessing the merits of purchasing a franchise… Further, the disclosure of brokers would also be cumbersome, especially for large franchise systems that may employ hundreds of brokers nationally.37

However, given the only limited preemptive effect of the Revised Rule (see Topic XX below), so long as state franchise registration/disclosure statutes continue to mandate broker disclosure, franchisors utilizing a single disclosure document nationwide will have to continue disclosing brokers in Item 2 of their disclosure documents, as the SBP itself confirms.38

And it also remains the case that franchise brokers will remain liable under Section 5 of the Federal Trade Commission Act for any acts of fraud or misrepresentations they engage in.39 Further, franchise brokers fall within the Revised Rule’s definition of “franchise seller” and thus are subject to various Revised Rule prohibitions (such as making statements to prospective franchisees which are inconsistent with those found in the franchisor’s disclosure document) though brokers are no longer liable, as they were under the original Rule, for the preparation and distribution of disclosure documents.

37 SBP at 91.38 SBP at 90 n. 328.39 SBP at 91.

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In most other respects, Revised Rule Item 2 mirrors UFOC Guidelines’ Item 2 by requiring a franchisor to disclose the names and backgrounds of the franchisors officers, directors and all other individuals who will have management responsibility relating to the franchises being offered. However, the Revised Rule features one significant variation: the notion that included among those possessing the required “management responsibility” subjecting them to disclosure include the officers, directors and other management personnel of the franchisor’s corporate parent and/or affiliates. (“…Item 2 requires a franchisor to identify all individuals who have management responsibility over the franchises, regardless of any formal title. This is true even if the individual happens to be an officer of a parent or an affiliate.”)40

Presumably, the Revised Rule seeks to require the denomination of such of a franchisor’s corporate parent or affiliate officers, directors and management as have direct involvement in the franchisor’s sales and/or operational activities. However, the Revised Rule does not explicitly state this, which may pose a problem: conceivably, all officers, directors and key management personnel of a franchisor’s corporate parent may be legally deemed to have management responsibility over the subsidiary franchisor’s activities. For example, in A.J. Temple Marble and Tile, Inc. v. Union Carbide Marble Care, Inc. et al.,41 both a trial and an intermediate appellate court in New York held “presumptively liable” for violations of the New York Franchise Act allegedly committed by a subsidiary franchisor the chairman of the board of that franchisor’s ultimate corporate parent, the Union Carbide Corporation, even absent any allegation that this individual did anything, failed to do anything or even knew anything about the subsidiary franchisor’s activities. It took New York’s highest court, the Court of Appeals, to reverse this holding on very narrow grounds (the Court of Appeals decision actually hinged on a comma placed in the “control person” liability section of the New York Franchise Act).

We do not believe that the Commission’s intent in the Revised Rule is to have all of a franchisor’s corporate parent’s officers, directors and management personnel identified in Item 2 of the franchisor’s disclosure document under the theory that, simply by virtue of their service to the franchisor’s parent, they have “management responsibility over the franchises”. We look forward to clarification of this issue in the FTC’s forthcoming Franchise Rule Compliance Guides.

Item 3: Litigation

40 SBP at 93, n.335.41 162 Misc. 2d 941, 618 N.Y.S.2d 155 (1994), Aff’d. 625 N.Y.S.2d 904 (1995), Aff’d. as modified, 87 N.Y.2d 574, 640 N.Y.S.2d 849 (1996). In the interest of full disclosure, it should be noted that this author’s law firm served as trial and appellate counsel for both Union Carbide Marble Care, Inc. and the Union Carbide Corporation.

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The Revised Rule significantly expands beyond UFOC Guidelines requirements the types of litigation which a franchisor must disclose in Item 3 of its disclosure document by mandating disclosure of material litigation commenced by franchisors against their franchisees involving the franchise relationship during the prior fiscal year (excluding actions or proceedings involving suppliers or other third parties, or indemnification for tort liability).

“…(T)he Commission is convinced that franchisor-initiated litigation is material information that prospective franchisees need in order to assess a critical aspect of the franchise relationship - - the nature of disputes and the level of litigation within a franchise system”,42 asserts the SBP. “We now believe that (the UFOC Guidelines’ Item 3 disclosure requirements) should be broadened to include additional information about the state of the franchise relationship”.

The requirement that franchisors disclose litigation they commenced against franchisees is circumscribed by the Revised Rule. First, as noted above, only litigation commenced during the franchisor’s prior fiscal year need be disclosed. “We believe this ‘snap-shot’ in time is sufficient to reveal the franchisor’s practice of initiating litigation, as well as to reveal the types of franchise relationship problems that typically arise in the franchise system”,43 notes the SBP. Moreover, the SBP makes clear that franchisors must report such franchisor-initiated litigation only annually, with no intrayear updating required.44 Whether the franchise regulating states will concur with this annual update approach - - almost all of them, as elucidated below, require immediate amendment of a franchisor’s UFOC upon a material change to the facts set forth therein - - remains to be seen. However, we are hopeful that the states will recognize that the Revised Rule’s approach is not that every given franchisor-initiated is material, but rather that it is the trend or overall pattern of such litigation which is material, necessitating only annual updates.

Nor does the Revised Rule require franchisors to disclose all litigation they commenced against their franchisees, only “material” litigation (with the SBP noting that materiality is to be determined from the viewpoint of a reasonable prospective franchisee and that the FTC intends the disclosure of franchisor-initiated litigation to be interpreted broadly to cover most suits).45

In an effort to relieve the burden on franchisors, the Revised Rule permits them to group all such actions or proceedings against franchisees under common headings and, as to each, set forth only the applicable case name, court and file number. Thus,

42 SBP at 105-106.43 SBP at 108-109.44 SBP at 109.45 SBP at 109-110.

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for example, a franchisor which initiated five royalty collection suits during its preceding fiscal year could satisfy its disclosure obligation by listing the aforementioned information concerning each suit under the heading, “Royalty Collection Suits”, without the need to provide any additional explanation or elaboration.

Note, however, that if a franchisor-initiated action or proceeding is followed by a franchisee counterclaim, then the foregoing “summary disclosure” principle does not apply but, instead, such a counterclaim must be fully disclosed in the same manner as all other franchisee litigation commenced against the franchisor.

In another marked expansion of UFOC Guidelines disclosure requirements, the Revised Rule mandates that disclosure be effected with regard to all affiliates of a franchisor which guarantee the franchisor’s performance or, with regard to government actions and proceedings, an affiliate which has offered or sold franchises in any line of business within the last ten years (the UFOC Guidelines only require disclosure in instances where the franchisor’s affiliates offer franchises under the franchisor’s principal trademark).

In virtually all other respects, Revised Rule Item 3 mirrors current UFOC Guidelines requirements concerning litigation disclosures (including the requirement that all litigation settlements, including confidential settlements but excluding settlements favorable to the franchisor, be explicitly disclosed).

Item 4: Bankruptcy

Revised Rule Item 4 is virtually identical to UFOC Guidelines Item 4 with one exception: the Revised Rule requires a franchisor to disclose the bankruptcy history not just of the franchisor, its parent, predecessor, affiliates, officers or general partners, but also “…any other individual who will have management responsibility relating to the sale or operation of franchises offered by this document…”.

Item 5: Initial Fees

There is no variation in this item from the UFOC Guidelines.

Note, however, that the SBP explicitly states that: “…(N)othing in Item 5 or any other provision of (the Revised Rule) prevents the parties from negotiating fees”. As will be discussed below in this report, the Revised Rule actually contemplates that which is forbidden by the states: negotiations which may result in greater franchisee obligations then those specified in the subject disclosure document (the general rule in the franchise regulating states is that negotiations can only result in concessions to franchisees).

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Item 6: Other Fees

The Revised Rule contains no variation for this item from the UFOC Guidelines. Critically, the Revised Rule abandons an approach suggested in the 2004 FTC Staff Report - - that franchisors be required to disclose payments which franchisees are required to make to third parties (such as suppliers). “…(T)he disclosure of third party fees in Item 6 would be overbroad, resulting in the mandatory disclosure of information that might not be readily obtainable by the franchisor… The Commission is persuaded that the Item 7 and Item 8… disclosures are more than sufficient to advise prospective franchisees of the likely purchase obligations incurred in operating a franchise”,46 notes the SBP.

Item 7: Estimated Initial Investment

The Revised Rule is entirely consistent with the UFOC Guidelines’ treatment of this Item.

Item 8: Restrictions on Sources of Products and Services

The Revised Rule is mostly consistent with the UFOC Guidelines’ treatment of this Item, but expands disclosure beyond the Guidelines by requiring the identification of any supplier in which an officer of the franchisor has an interest.

Item 9: Franchisee’s Obligations

The Revised Rule features no variation from the UFOC Guidelines for this item, but makes clear that - - as is the case under the UFOC Guidelines - - disclosures concerning not just the core franchise agreement, but also any ancillary agreements embracing franchisor or franchisee obligations, must be effected.

Item 10: Financing

The Revised Rule is entirely consistent with the UFOC Guidelines’ treatment of this Item.

Item 11: Franchisor’s Assistance, Advertising, Computer Systems and Training

Revised Rule Item 11 disclosure requirements are virtually identical to those imposed by the UFOC Guidelines with one exception: the Revised Rule does not 46 SBP at 119.

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require franchisors, as do the Guidelines, to identify each computer hardware component and software program required to be utilized by franchisees by brand, type and principal functions. Instead, in a variation unopposed by NASAA (which administers the UFOC Guidelines), the Revised Rule only requires franchisors generally to describe the computer systems to be used by franchisees; any required purchase and maintenance costs and obligations; and, whether the franchisor will have access to information contained in those systems.

Item 12: Territory

In an effort to address the plethora of new technologies and market developments which have transpired since the original Rule was promulgated in 1978, the Revised Rule expands upon same by mandating disclosure about competition which a franchisee can expect to experience not just from other company-owned or franchised outlets but, as well, from activities over the internet, through catalog sales, telemarketing or any alternative channel of distribution engaged in by the franchisor or other franchisees. Further, disclosure beyond the UFOC Guidelines is required by the Revised Rule regarding restrictions which the franchisor may place on its franchisees precluding them from conducting business outside of their respective territories.

Also going beyond current UFOC Guidelines requirements is a special admonition which the Revised Rule requires be set forth in Item 12 of a franchisor’s disclosure document if it does not confer any territorial protection upon franchisees: “You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control”.

The Revised Rule specifically rejects franchisee demands that the FTC regulate “encroachment” or ban it altogether under Section 5 of the FTC Act. “The Commission’s view is that the granting of a protected territory is fundamentally a private contractual matter for the parties to determine for themselves. While the record establishes franchisees’ concerns about encroachment, it falls far short of supporting a conclusion that not granting a protected territory in a franchise agreement constitutes an unfair practice within the meaning of the FTC Act. Nor does the record support a conclusion that a franchisor’s expansion where there are existing franchisees is an unfair practice”, asserts the SBP. “For these reasons, the Commission has determined that the criteria for an industry-wide prohibition on encroachment have not been made” .47

Item 13: Trademarks

Revised Rule Item 13 features no variation from the UFOC Guidelines.47 SBP at 134-135.

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Item 14: Patents, Copyrights and Proprietary Information

The Revised Rule features one variation from the UFOC Guidelines for this item: the requirement that a franchisor disclose not only patents it has been granted by the United States Patent and Trademark Office, but also patents applied for to the USPTO.

Item 15: Obligation to Participate in the Actual Operation of the Franchise Business

The Revised Rule features no variation from the UFOC Guidelines treatment of this Item.

Item 16: Restrictions on What the Franchisee May Sell

The Revised Rule features no variation from the UFOC Guidelines’ treatment of this Item.

Item 17: Renewal, Termination, Transfer and Dispute Resolution

While the Revised Rule adopts UFOC Guidelines Item 17 - - which requires franchisors to summarize in a table various franchise agreement provisions addressing term, renewal, termination, transfer and dispute resolution - - the Revised Rule requires one additional disclosure not required by the UFOC Guidelines: precisely what the term “renewal” means in the subject franchise system (a disclosure which should be set forth in subsection [c] of the Item 17 table).

“…(T)he record is persuasive that many prospective franchisees may not appreciate the legal import of the term ‘renewal’. Indeed, franchisees are often surprised to discover that ‘renewal’ means the continuation of their franchise relationship under potentially vastly different terms”,48 states the SBP in explaining this new disclosure requirement. “We do not suggest any particular form of explanation, however, because that will depend upon the individual policies of each franchisor. If applicable, the franchisor must also state that franchisees may be asked to sign a contract with materially different terms and conditions then their original contract”.49

Item 18: Public Figures

The Revised Rule features no variation from the UFOC Guidelines’ treatment of this Item.

48 SBP at 147.49 SBP at 148.

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Item 19: Financial Performance Representations

(A more detailed analysis of this subject may be found below in Section XII, “Financial Performance Representations/Earnings Claims”.)

Critically for franchisors, and consistent with both the original Rule and the UFOC Guidelines, the Revised Rule provides that disclosure of financial performance information (colloquially referred to as “earnings claims”) will not be mandatory but will remain strictly optional.

Also important both to franchisors and franchisees, information regarding a franchisee’s prospective costs or expenses, standing alone, does not constitute a “financial performance representation” under the Revised Rule, in stark contrast to the UFOC Guidelines (which consider the dissemination of such information, standing alone, to constitute the making of a financial performance representation). The SBP notes that the franchise regulating states, through NASAA, concur with this new approach of excluding “cost only” disclosures as falling within the ambit of financial performance representations.50 Whether all such franchise regulating states will adopt this approach, and amend their regulations (or, if necessary, their statutes) accordingly, remains to be seen. Accordingly, under the Revised Rule, franchisors are free to disclose to prospective franchisees such expense or cost information even in the absence of any Item 19 disclosure of same at least in the 35 states featuring no franchise disclosure statutes and, hopefully, in the other 15 which do.

Moreover, the Revised Rule requires the use of two mandatory disclosures found neither in the UFOC Guidelines nor in the original Rule - - the first confirming that the FTC Franchise Rule in fact permits franchisors to disclose financial performance information in their disclosure documents if they choose to do so and the second, to be used only when the subject disclosure document contains no Item 19 financial performance representations, stating this fact and warning prospective franchisees not to rely on any unauthorized financial performance representations they may otherwise receive.

As detailed below, the Revised Rule greatly liberalizes a franchisor’s ability to furnish earnings claim-type information to the general media, on websites, in speeches and in SEC filings without being deemed to have made a financial performance representation - - unless, that is, the franchisor proceeds to incorporate such material in its franchise advertising or other promotional materials, in which case the Revised Rule accords such information the status of financial performance representations.

50 SBP at 34-35, n.105.

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Finally, the Revised Rule liberalizes a franchisor’s ability to disclose financial performance information limited to a subset of company-owned and/or franchised units.

Item 20: Outlets and Franchisee Information

With the full support of the franchise regulating states (represented by NASAA), the Revised Rule entirely reworks the UFOC Guidelines’ disclosure tables which summarize the status of a franchisor’s network (which identify, among other things, the number of units in the network, the number of transfers, franchisor re-acquisitions or terminations of franchised units, and the projected number of units the franchisor anticipates opening over the coming year) to eliminate a “double counting” problem brought to the FTC’s attention, as detailed below.

Revised Rule Item 20 also narrows current UFOC Guidelines disclosure requirements pertaining to personal contact information of former franchisees; addresses the issue of “churning” by requiring a franchisor selling a specific existing unit to provide the prospective franchisee with a history of that unit, including the names, addresses and telephone numbers of each previous owner and the reason for the change(s) in ownership during the franchisor’s prior three fiscal years; addresses a franchisor’s use of “confidentiality clauses” which may restrict current franchisees from discussing their experiences with prospective franchisees; and, notably, requires the disclosure of independent trademark-specific franchisee associations.

Let us first address the “double counting” problem extant under the UFOC Guidelines and, with NASAA’s full support, corrected by the Revised Rule. Essentially, under the UFOC Guidelines, Item 20 tables must be set forth summarizing the status of a franchisor’s network and detailing the number of franchised units that were transferred, terminated, not renewed, reacquired by the franchisor or otherwise “ceased to do business”, such that a single event could be counted as two, three or even four separate events. As noted by the SBP, under the UFOC Guidelines a franchisee may abandon an outlet; its franchisor may thereafter send a termination letter to the franchisee; the franchisor may then reacquire the outlet; and, thereafter, the franchisor may sell it to another franchisee. Although the outlet changed franchisee ownership only once, under the UFOC Guidelines, the subject franchisor could be deemed required to disclose this sequence as three distinct events: “ceased to do business”, “termination” and “reacquisition”.

Revised Rule Item 20 seeks to remedy this “double counting” problem first by setting forth precise definitions to avoid category “overlap” and, with regard to the disclosure of multiple events, adopting a “last in time” approach (such that, under the above example, only a franchise reacquisition would be disclosed in Item 20, with no disclosure addressing the preceding franchisee abandonment or the franchisor’s

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subsequent termination of the franchise). However, in those situations where a single outlet changed ownership two or more times within the same fiscal year, the Revised Rule requires footnotes to the Item 20 tables describing the types of changes involved and the order in which the changes occurred.

Turning to the required disclosure of former franchisees required to be identified in Item 20, the Revised Rule actually narrows - - due to privacy concerns - - the delineation of what must be set forth. The Revised Rule thus requires franchisors to disclose only the name, city and state, and current business telephone number or, if unknown, the last known home telephone number of former franchisees, eschewing the UFOC Guidelines requirement that the last known home address and home telephone number of every former franchisee be set forth. (The Revised Rule permits franchisors to substitute alternate contact information at the request of the former franchisee.) Also to address privacy concerns, the Revised Rule requires franchisors to advise prospective franchisees in the disclosure document that, if they become franchisees, their contact information may be disclosed to other franchise purchasers after they leave the franchise system.

Revised Rule Item 20 advances an entirely new disclosure requirement not found in the original Rule or the UFOC Guidelines pertaining to the issue of “churning” (the repeated sale of the same unit to sequential franchisees). In response to franchisees and their advocates expressing great concern about isolated instances of alleged “churning”, Revised Rule Item 20 requires a franchisor selling a previously franchised unit now under its control to disclose the following information for that unit covering the franchisor’s last five fiscal years: contact information for each franchisee owner of the subject unit; the time period when each such previous owner controlled the unit; the reason for each previous change of ownership (such as termination, non-renewal, transfer or cessation of operations); and, the time period(s) when the franchisor retained control of the unit.

Interestingly, the Revised Rule gives franchisors the option of setting forth these “churning” disclosures outside of the disclosure document itself (either in a disclosure document addendum or, if the disclosure document has already been furnished, in a supplement thereto). The SBP suggests that the Revised Rule follows this approach to avoid the situation where a franchisor, having already disclosed a prospective franchisee, thereafter determines to offer a previously franchised unit to that franchisee, which conceivably could necessitate the franchisor preparing (and registering where necessary) an amended UFOC containing the above-referenced unit specific data.51

However, as most readers are aware, every state franchise registration/disclosure statute explicitly prohibits, except in very narrow circumstances (such as the furnishing of supplemental earnings claim information), the dissemination of any disclosures 51 SBP at 170-171.

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required by law to prospective franchisees other than in the franchisor’s disclosure document. We anticipate that these franchise regulating states, when amending their regulations and/or statutes to incorporate the new franchise disclosure “floor” mandated by the Revised Rule, will follow the Revised Rule’s paradigm of permitting such “churning” information to be disclosed outside of the franchisor’s core disclosure document.

Revised Rule Item 20 also treads new regulatory ground by requiring franchisors to disclose whether, during the previous three fiscal years, their franchisees signed confidentiality clauses - - whether in a franchise agreement, settlement agreement or any other contract - - which restricts such franchisees from freely communicating with prospective franchisees concerning the former’s experience in the franchise system. If they do, then such franchisors must feature the following prescribed statement in Item 20 of their disclosure documents: “In some instances, current and former franchisees sign provisions restricting their ability to speak openly about their experience with [name of franchise system]. You may wish to speak with current and former franchisees, but be aware that not all such franchisees will be able to communicate with you”.

The SBP explains the logic behind this new requirement: “Attempts to restrict franchisee speech through confidentiality provisions may deceive prospects by effectively eliminating one crucial source of information, namely those current and former franchisees who may have a dispute with the franchisor or are otherwise disgruntled. Indeed, a franchisor, if it wished to do so, could attempt to use confidentiality provisions to ensure that prospects speak with only those franchisees who are successful or otherwise inclined to give a positive report”.52

The Revised Rule in such circumstances does give franchisors the option of disclosing the number and percentage of current and former franchisees who have entered into confidentiality agreements, as well as the circumstances under which such agreements were signed. Note, too, that the Revised Rule’s definition of the term “confidentiality clause” is defined in a fashion which the SBP asserts “…would not cover clauses that prohibit communications between current or former franchisees and, for example, the media”.53 Nor does it subsume confidentiality clauses which protect a franchisor’s intellectual property or proprietary information or which relate to specific negotiated franchise agreement terms and conditions (so long as the subject franchisee is otherwise free to communicate with prospective franchisees about his/her/its experience).54

52 SBP at 173.53 SBP at 29-30.54 SBP at 175.

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The Revised Rule’s last significant expansion of UFOC Guidelines Item 20 concerns its requirement that franchisors disclose contact information for each trademark-specific franchisee organization associated with the subject network, whether a “captive” association created, sponsored or endorsed by the franchisor or an “independent” franchisee association which, to be disclosed, must be incorporated or otherwise organized under state law and must annually request inclusion in the franchisor’s disclosure document (a request that must annually be renewed no later than 60 days after the close of the subject franchisor’s fiscal year). Note that a franchisor has no affirmative duty to verify any independent association’s continued existence at the end of each fiscal year.

Item 21: Financial Statements

Item 21 of the Revised Rule varies from the UFOC Guidelines in three respects.

First, while the Revised Rule generally requires a franchisor’s financial statements to be prepared in accordance with generally accepted accounting principles (“GAAP”), just as the UFOC Guidelines do, the Revised Rule goes further by permitting foreign franchisors alternatively to prepare financial statements “…as permitted by the Securities and Exchange Commission” (SEC). As explained in the SBP:

The SEC permits foreign companies registering securities to prepare financial statements using accounting procedures other than United States GAAP under limited circumstances. The first prerequisite is that such statements be prepared according to a comprehensive body of accounting principles. The company must also disclose the specific comprehensive body of accounting principles used to prepare the statements and explain material differences between the principles and United States GAAP. The company must also reconcile its statements with United States GAAP. For example, through additional notes, franchisors must reconcile figures for net income and total shareholders’ equity for the period presented. Finally, the statements must provide all additional disclosures required by United States GAAP and applicable SEC regulations.55

The SBP also observes that, even if a foreign company reconciles its financial statements to United States GAAP, the SEC nevertheless insists that said company must audit the financial statements in accordance with the United States generally accepted auditing standards (“GAAS”) and the auditor must comply with United States standards for auditor independence.56

55 SBP at 185.56 SBP at 185, n. 661.

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The Revised Rule’s second deviation from UFOC Guidelines 21 requires a franchisor to include in its franchise disclosure document its corporate parent’s financial statements if that parent “…commits to perform post-sale obligations for the franchisor” (and also, as under the UFOC Guidelines, if said corporate parent guarantees the franchisor’s obligations to its franchisees, in which event a copy of the guarantee must be included in the disclosure document).

“To the extent that a prospective franchisee is asked to rely on a parent to perform post-sale contractual obligations, or relies on a parent’s guarantee, the financial stability of the parent becomes a material fact that should be disclosed”, states the SBP in explaining this new Revised Rule requirement.

While the Revised Rule’s logic is clear, nevertheless its precise application may be subject to varying interpretations regarding when a franchisor’s corporate parent may be deemed to have committed “…to perform post-sale obligations for the franchisor”. For example, what if the subject franchise agreement requires franchisees to purchase goods or services from the franchisor’s parent - - does this activity alone trigger the need for the parent’s financial statements to accompany the franchisor’s in Item 21? We surmise that the answer would be “no”, since the franchisor’s parent in such circumstances is only acting as a supplier and is not performing “post-sale obligations for the franchisor” (which, in this example, has no obligation to its franchisees to itself sell goods or services). However, as noted, interpretations of this new Revised Rule language may vary and we thus look forward to the forthcoming FTC Franchise Rule Compliance Guides to shed further light on this issue.

The third and final Revised Rule variation from the UFOC Guidelines permits start-up franchisors that do not yet have audited financial statements to phase-in audited statements within a three year period, including an entirely unaudited opening balance sheet for that franchisor’s first full or partial fiscal year selling franchises. The Revised Rule conditions such permission upon the start-up franchisor preparing audited financial statements as soon as practicable; utilizing unaudited financial statements in a format that conforms as closely as possible to audited statements; and, stating in its disclosure document that it has not been in business for three years or more and thus cannot include all of the audited financial statements otherwise required by Revised Rule Item 21.

Further, the SBP cautions that: “The term ‘start-up’ is to be read narrowly, meaning entities that are new to franchising and that ordinarily have not prepared audited financial statements to date. Any non-franchise company that has prepared audited financials in the ordinary course of business must include such audited financials in its disclosure document if it decides to begin offering franchises. The phase-in is also not intended for spin-offs, affiliates, or subsidiaries of a franchisor,

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where the franchisor has been engaged in franchising or has prepared audited financial statements for any other purpose.57

Item 22: Contracts

The Revised Rule does not vary from the UFOC Guidelines treatment of Item 22.

Item 23: Receipts

The Revised Rule adopts the UFOC Guidelines requirement that franchisors include an acknowledgment of receipt at the very rear of their disclosure documents.

To facilitate the “pure” electronic disclosure protocol introduced by the Revised Rule (see detailed discussion below), the Rule authorizes “electronic” receipts (and continues to authorize the handwritten signature receipts contemplated by the UFOC Guidelines). The Revised Rule accomplishes this by defining the word “signature” as: “A person’s affirmative step to authenticate his or her identity. It includes a person’s handwritten signature, as well as a person’s use of security codes, passwords, electronic signatures, and similar devices to authenticate his or her identity”.

The Revised Rule requires franchisors to retain a copy of all such Item 23 receipts for at least three years; allows franchisors to include specific instructions on the Item 23 receipt as to how prospective franchisees should submit or transmit same; and, while as noted above the Revised Rule does not require disclosure in Item 2 of any franchise brokers acting on the franchisor’s behalf, nevertheless the Rule requires that any franchise broker, as a franchise “seller” under the Rule, be disclosed in the Item 23 receipt by name, address and telephone number (with the SBP noting that, if a franchisor employs multiple brokers, it need not create individualized disclosure documents for each prospective franchisee identifying precisely which broker the franchisee dealt with but, instead, may propound an Item 23 receipt with a “fill in the blank” space in which identifying information concerning the brokers in question can be set forth).58

VII. THE DEMISE OF THE UFOC GUIDELINES

Given the Revised Rule’s essentially coopting the UFOC disclosure format as its own, augmenting and modifying same in that fashion detailed above, the UFOC Guidelines - - which, as administered by NASAA, specifies the franchise regulating states’ collective requirements concerning the contents and preparation of the UFOC - - will by necessity cease being operative at the expiration of the Revised Rule’s phase-in

57 SBP at 191.58 SBP at 194, n. 699.

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period (save to the extent they are retained by the states solely to address current or future state disclosure requirements that surpass those of the Revised Rule - - see `Section XX below).

Simply stated, the UFOC at that time will entirely cease falling under the aegis of NASAA and the franchise regulating states. Instead, as adopted and augmented by the Revised Rule’s “UFOC plus” disclosure requirements, the UFOC will essentially have been “federalized”. By necessity, the UFOC Guidelines will cease to have any force or effect following the conclusion of the Revised Rule’s phase-in period except with regard to any disclosure obligations the franchise regulating states may now or in the future require that go beyond the Revised Rule’s disclosure mandates (for example, the states may continue to mandate disclosure in UFOC Item 2 addressing the identity of franchise brokers acting on a franchisor’s behalf, a feature of today’s UFOC not adopted by the Revised Rule).

In fact, from a technical perspective, the UFOC itself will entirely disappear at the conclusion of the Revised Rule’s phase-in period, having been entirely supplanted by the Revised Rule’s preemptive and heightened disclosure edicts. Whether the franchise community will continue to refer to a disclosure document as a “UFOC” out of force of habit remains to be seen - - the formal title ascribed to it by the Revised Rule is simply, “Franchise Disclosure Document”.

The Revised Rule incorporates much of the UFOC Guidelines’ substantive text and instructions (modified to advance the Revised Rule’s “UFOC plus” disclosure requirements). However, purely explanatory materials in the UFOC Guidelines and NASAA’s Commentaries thereto are not incorporated in the Revised Rule. To fill this instructional void, the Revised Rule was accompanied by the FTC’s “Statement of Basis and Purpose”. Further, the Commission is currently promulgating its “FTC Franchise Rule Compliance Guides”, addressing at length various disclosure issues, amplifying certain Revised Rule mandates and otherwise furnishing guidance on Rule compliance, with the SBP noting that these forthcoming Compliances Guides will likely incorporate the UFOC Guidelines’ existing sample answers and NASAA’s previously issued commentaries on the UFOC Guidelines (to the extent they do not conflict with the Revised Rule).59

Indeed, the SBP makes clear that not only the forthcoming Compliance Guides, but also the FTC’s future interpretations of the Revised Rule, will be accomplished in close coordination with NASAA’s Franchise and Business Opportunity Project Group in order to minimize differences between Revised Rule and state Rule interpretations.60

59 SBP at 15-16.60 SBP at 17 n. 59.

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VIII. ELECTRONIC DISCLOSURE

One of the most revolutionary aspects of the Revised Rule, which captures not only recent technological innovations but seeks to anticipate and capture as well developments which surely will follow, is its authorization for franchisors to engage in “pure” electronic disclosure.

Under the Revised Rule, franchisors may furnish disclosure documents to prospective franchisees in any fashion they elect, including hand delivery; e-mail; granting access over the Internet (as long as the franchisor, by the required disclosure date, furnishes directions to prospective franchisees regarding just how to do so); fax; or, by mailing to the prospective franchisee the disclosure document in either paper or tangible electronic form (such as on a computer disk or CD-ROM) by first class U.S. mail at least three days before the required disclosure date.61

To ensure the integrity of disclosure documents, the Revised Rule prohibits franchisors from using any electronic enhancements - - such as audio, video, other multimedia, pop-up screens and external links - - which a franchisor could otherwise utilize to call attention to portions of its disclosure document it deems favorable and/or distract prospective franchisees from less than favorable disclosures. However, under the Revised Rule, franchisors engaging in electronic disclosure may utilize navigational tools (such as scroll bars, internal links and search features) to enhance prospective franchisees’ ability to maneuver through electronic disclosure documents, so long as they do so for the prospective franchisee’s benefit and not to draw the prospect’s attention to (or away from) certain disclosure items.62

One feature of the electronic disclosure protocol set forth in the Revised Rule will probably prompt more concern than is necessary. We speak of the requirement that: “Before furnishing a disclosure document, the franchisor shall advise the prospective franchisee of the formats in which the disclosure document is made available, any prerequisites for obtaining the disclosure document in a particular format, and any conditions necessary for reviewing the disclosure document in a particular format”.63

This is a brand new requirement designed to ensure that prospective franchisees know whether or not they will receive a disclosure document in a form they can easily use.64

Under this requirement, according to the SBP:

61 Revised Rule, §436.2(c).62 Revised Rule, §436.6(d).63 Revised Rule, §436.6(g).64 SBP at 205-206.

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For example, a franchisor would disclose if it furnishes disclosures via CD-ROM only. In addition, the franchisor must disclose if there are any special conditions to reviewing a disclosure document. The franchisor would disclose, for example, whether the prospective franchisee’s computer must be capable of reading pdf files or whether any specific applications are necessary to view the disclosures (such as Windows 2000 or DOS, or a particular Internet browser).65

The concern might be that this requirement - - that a franchisor inform prospective franchisees of the format(s) in which its disclosure document will be made available - - will completely undermine the possibility of pure electronic disclosure by interposing a “paper notice” requirement. The Revised Rule does not suggest when such “disclosure format” information must be furnished to prospective franchisees; how that information should be furnished (oral/written/”plain vanilla” e-mail/other); or, how a franchisor can later demonstrate that, in fact, it effected such “format disclosure”.

However, given the Revised Rule’s visionary and enlightened authorization of “pure” electronic disclosure protocol, insisting on a paper “format disclosure” document is not what the Revised Rule requires. Instead, the SBP makes clear that a franchisor will be able to freely communicate its disclosure format information in any fashion it chooses - - in person; telephonically; in writing; through e-mail; in franchise application forms; through marketing materials; by regular mail; or, otherwise - - as long as the franchisor can subsequently demonstrate that, in fact, it effected such “format disclosure”.66

Finally, pure electronic disclosure would be impossible if, as today, a franchisor would have to obtain a manually signed receipt from each prospective franchisee acknowledging his/her/its receipt of the subject franchise disclosure document. Accordingly, while the Revised Rule, like the UFOC Guidelines, requires an Item 23 “Receipt” form and further requires franchisors to retain copies of signed receipts for each completed franchise sale effected over at least the prior three years,67 the Revised Rule now defines the term “signature” as including “…a person’s handwritten signature, as well as a person’s use of security codes, passwords, electronic signatures, and similar devices to authenticate his or her identity”.68 The Revised Rule also authorizes franchisors to include instructions in their Item 23 receipts regarding how same should be returned to the franchisor (for example, by mail to a specified street address, email, or fax to a specified fax line number).69

65 SBP at 206.66 SBP at 206, n. 743.67 Revised Rule, §436.6(h).68 Id. at §436.1(u).69 Revised Rule, §436.5(w)(8).

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Thus, the Revised Rule permits Item 23 receipts to be executed electronically, but clearly puts franchisors in the position of always having in place a protocol designed to capture proof of such electronic receipts not only for Rule compliance but also in defense of any litigation claim that disclosure was not properly effected.

IX. TIMING REQUIREMENTS - - WHEN DISCLOSURE MUST BE EFFECTED

The original FTC Franchise Rule’s “disclosure triggers” are supplanted under the Revised Rule by an entirely new paradigm.

The original Rule required a franchisor to furnish its disclosure document to a prospective franchisee at the earlier of: (i) the “first personal meeting” between a franchisor and such prospective franchisee (i.e., the first face-to-face meeting held for the purpose of discussing the sale, or possible sale, of a franchise), or (ii) ten business days prior to the execution by the prospective franchisee of any franchise agreement or the payment by such prospective of any monies or other consideration to the franchisor.70

The original Rule also required that a copy of all franchise and franchise-related agreements to be entered into between the parties, in a form ready for execution by them, be furnished to the prospective franchisee at least five business days prior to the date of execution or the payment of any monies.71

However, the SBP observes that: “While at the time the (original) Rule was promulgated it may have been routine, or perhaps necessary, to have a face-to-face meeting early on, that is no longer true. Nowadays, a franchisor and a prospect may have numerous telephone conversations or send documents to each other via fax or email long before any personal meeting occurs”.72

The SBP also suggests that the current Rule’s “ten business day” requirement may be unnecessarily confusing (because federal holidays are excluded thereunder, some of which are not observed in every state).

Accordingly, the revised FTC Franchise Rule eliminates the current “first personal meeting” disclosure trigger, the “ten business day” trigger for disclosure documents and the “five business day” trigger for franchise agreements in form ready for execution. Instead, the Revised Rule simply requires franchisors to furnish their disclosure documents to prospective franchisees fourteen days (calendar days, not

70 16 CFR §§436.1(a) and 436.2(g).71 Id. at §436.1(f).72 SBP at 70-71.

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business days) before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or its affiliate.73

This “bright line” disclosure trigger, suggests the SBP, will eliminate guesswork on the part of franchisors regarding when they must furnish disclosures. And to eliminate confusion as to when the required fourteen day disclosure period has elapsed and the franchise agreement can thus be signed or money accepted, the SBP specifies that the fourteen days commence the day after delivery of the disclosure document, such that the signing of any agreement or receipt of payment can take place fifteen days later (the point being to give prospective franchisees a full fourteen calendar days to review the subject disclosure document).74

The Revised Rule’s elimination of the “first personal meeting” disclosure trigger will greatly reduce franchisors’ disclosure burdens in one material respect: under the Revised Rule, such franchisors need no longer furnish disclosure documents at trade shows, franchise sales “seminars”, “opportunity days” or any other gatherings where they meet and confer with prospective franchisees. This could result in significant cost savings to franchisors while concurrently easing their compliance burden.

Eliminated altogether under the Revised Rule is any general requirement that a franchisor furnish any franchise or franchise-related agreement in a form ready for execution to a prospective franchisee five business days (or, indeed, at any time) prior to the franchisee’s execution thereof. The SBP suggests that this prior FTC Franchise Rule requirement, designed to give prospective franchisees time to study the subject franchise agreement, is already served by the Rule’s basic disclosure requirement that a franchisor’s franchise and franchise-related agreements be appended to its disclosure document (the SBP noting that changes thereto will most likely arise at the franchisee’s initiation, thus hardly warranting redisclosure). Indeed, the SBP notes that a franchisee’s desire to negotiate changes to a franchise agreement may actually have been negatively impacted by the original Rule’s five day “execution ready” contract review period, since each such negotiated change would trigger another five business day review period which could serve to the detriment of the prospective franchisee.75

However, if the franchisor has unilaterally and materially altered the terms of any standard franchise or other agreement attached to its disclosure document, then in such limited circumstance that franchisor is required by the Revised Rule to furnish an “execution ready” copy of that agreement to its prospective franchisee seven calendar days prior to the franchisee’s execution thereof. Again, negotiated changes to a franchisor’s standard form of franchise agreement will not trigger this limited franchise

73 Revised Rule, §436.2 at 7(a).74 SBP at 72.75 SBP at 75-76.

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agreement disclosure requirement, nor would instances where the only changes made by the franchisor to the standard contract consist of “fill in the blank” provisions such as the date, name and address of the franchisee.76

While the Revised Rule does away with the contract disclosure trigger altogether (except in limited circumstances) and simplifies the disclosure document dissemination trigger, it also adds new disclosure obligations and triggers not found either in the original Rule or in any state franchise registration and disclosure statute.

First, the Revised Rule requires franchisors to furnish copies of their disclosure documents to prospective franchisees upon reasonable request earlier in the sales process than is otherwise required by the Rule.77 The SBP suggests that this requirement will alleviate situations where prospective franchisees must expend considerable monies before receiving any disclosure about the subject franchisor:

Because prospects may incur a variety of costs in determining whether to consider a particular franchise offering, a franchisor’s withholding of its disclosure document can result in economic injury. For example, as discussed above in connection with the timing of making disclosures, early disclosure may prevent injury by enabling prospects to review the franchisor’s disclosure document before agreeing to pay money to advance the sale, such as incurring travel expenses to visit company headquarters.

Further, the Commission is convinced that this prohibition is also necessary in light of our decision to eliminate the original Rule’s mandatory face-to-face disclosure trigger… The Commission recognizes that… absent early disclosure, a franchise seller could influence a prospective franchisee’s investment decision well before the prospect could verify the franchisor’s claims through the disclosure document, or before the prospect expends funds reviewing the offering. To address these concerns, we are persuaded that it is proper to require franchise sellers to furnish disclosures earlier than the standard 14 calendar-days disclosure trigger, upon the franchisee’s reasonable request.78

The Revised Rule continues the original Rule’s requirement that disclosure be effected to existing franchisees who are renewing their franchises only if the renewal agreement contains terms and conditions that differ materially from the expiring

76 Revised Rule §436.2(b) and SBP at 76.77 Revised Rule, §436.9(e).78 SBP at 248.

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agreement.79 However, under this Rule provision, the existing franchisee must make a “required payment” for the right to enter into a new franchise agreement and/or either into a renewal agreement containing materially different terms and conditions for disclosure to become obligatory; merely entering into an entirely new franchise agreement without any required payment, or entering into a new franchise agreement for a fee which does not feature materially different terms and conditions than the expiring one, or extending an existing franchise agreement for a fee, would not be deemed a “sale of a franchise” for Rule purposes and thus would not trigger disclosure.80

Critically, the Revised Rule carries forward the original Rule’s philosophy that a franchisor is under no disclosure obligation whatsoever with regard to the sale or other assignment of a franchise by an existing franchisee where the franchisor has no significant involvement with the transferee. (In this respect, the Revised Rule varies from the Staff Report’s recommendation, which would have obligated franchisors to furnish disclosure documents to existing franchise transferees with whom the franchisor has absolutely no contact.) In explaining why disclosure is not necessary under such circumstances, the SBP asserts: “Where a franchisor is not involved in the private sale of an existing franchise, the franchisor makes no representations to the prospective new purchaser. If there is any fraud in the private sale, it could only be by the current franchisee owner, and pre-sale disclosure by the franchisor would not likely prevent it… Further, the franchisor’s mere approval or disapproval of the purchaser alone is not considered to be significant involvement”.81

Note, however, that in those many circumstances where a franchisor enters into a new franchise agreement with an assignee-franchisee, such conduct would indeed constitute the franchisor’s “significant involvement” in the transaction triggering the need for disclosure.

Also benefiting franchisors is the SBP’s observation that the Revised Rule imposes no “material modification” disclosure requirement similar to those which used to be extant (and, to a very limited degree, still are extant) under the California Franchise Investment Law. “The Commission agrees that disclosure is unwarranted where an existing franchisee and the franchisor merely seek to amend their ongoing relationship. In such circumstances, the material information the franchisee needs is the actual revised franchise agreement itself…Requiring franchisors to furnish a new disclosure document whenever there may exist agreed upon material changes in a contract is likely to be an unwarranted formality…”,82 contends the SBP.

79 Revised Rule, §436.1(t).80 Id. See also, SBP at 63, 65, n. 237.81 SBP at 63-64.82 SBP at 64.

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Lastly, the Revised Rule creates yet another new disclosure trigger under which franchisors obligated to redisclose with their most recent disclosure documents, upon reasonable request, any prospective franchisees who are in the sales “pipeline”.83

Regarding this requirement, the SBP states: “(The Revised Rule) recognizes that the information contained in a disclosure document may become out-of-date by the time a prospect who relies on such information is ready to sign a franchise agreement. It prevents deception by enabling such prospective franchisees, if they wish, to get any updated disclosures prepared by the franchisor. At the same time, the (Revised Rule) imposes no continuous updating requirement on franchisors. Rather, it strikes the appropriate balance, preventing deception by enabling a prospective franchisee to gain access to the most current updated disclosures prepared by the franchisor, while imposing no new affirmative disclosure obligations on the franchisor”.84

A franchisor should note, however, that notwithstanding the above-quoted SBP statement and the express provisions of Revised Rule Section 436.9(f), franchisors in the franchise regulating states will nevertheless have to continue furnishing updated disclosure documents to prospective franchisees who are in the sales “pipeline” whenever there is a material change to the facts set forth in the disclosure document originally furnished to such prospects. Simply stated, the franchise regulating states uniformly require franchisors to swiftly update their disclosure documents whenever there is such a change in the material facts set forth therein (see discussion at Section XVII below, “Updating Disclosure Documents”); usually require franchisors to cease offering and selling franchises while they do so; and, almost uniformly require franchisors to redisclose prospective franchisees in the “pipeline” with such updated disclosure documents. Accordingly, the Revised Rule’s less stringent redisclosure requirement, as set forth above, will likely be available to franchisors only in those 35 states which feature no franchise registration/disclosure statutes of their own (unless the franchise regulating states determine to change their philosophy on the subject and amend their regulations/statutes accordingly).

X. INTERNATIONAL TRANSACTIONS EXCLUDED FROM REVISED RULE COVERAGE

The original FTC Franchise Rule did not explicitly address its geographic scope, leaving open the issue of its applicability to the sale of franchises to be situated outside of the United States. This omission has, in the past, given rise to some disparate judicial decisions as to whether the original Rule applied to “pure outbound” franchise sales (i.e., the offer and sale of a franchise by a United States franchisor to a foreign individual or entity when the subject unit[s] will be situated outside of the United States).

83 Revised Rule, §436.9(f).84 SBP at 249-250.

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The Revised Rule expressly limits its jurisdictional reach to the sale of franchises to be located in the United States of America, its territories and possessions.85

The SBP explains:

85 Revised Rule, §436.2.

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The record reveals overwhelming support among various franchise interests for limiting the reach of the part 436 to sales of domestic franchises. Among other things, the commentors noted that foreign franchise purchasers are large sophisticated investors represented by counsel and do not need the Rule’s protections. Some commentors made the point that the Commission developed the Franchise Rule in response to problems occurring in the domestic market. Indeed, a disclosure document addressing the American market may be irrelevant and potentially misleading when applied to a purchase of a franchise to be located outside the United States, due to the vast differences between American and foreign markets, cultures, and legal systems. Further, many risks to the prospective franchisee arise from economic conditions and cultural values in those countries, not in the United States. To be relevant, a franchisor arguably would have to prepare individual disclosure documents tailored to each specific foreign market. Not only would such a requirement put American franchisors at a competitive disadvantage with franchisors from countries lacking comparable disclosure regulations, but it is likely that any possible benefits of such a requirement would not outweigh the extraordinary costs and burdens involved.86

The SBP notes, however, that the Federal Trade Commission retains its jurisdiction over such international franchise sales and has the ability, and may exercise its discretion, to bring fraud or other actions related to such sales in appropriate cases.87

XI. USE OF “PLAIN ENGLISH” MANDATED

In 1993, the UFOC Guidelines were amended by NASAA inter alia to require that franchise disclosure documents be prepared in “plain English”.88

Paralleling the UFOC Guidelines, the Revised Rule also requires that franchise disclosure documents be prepared in “plain English”, defining “plain English” to mean:

The organization of information and language usage understandable by a person unfamiliar with the franchise business. It incorporates the following six principles of clear writing: short sentences; definite, concrete, everyday language; active voice; tabular presentation of information; no legal jargon or highly technical business terms; and no multiple negatives.89

As is the case today under all federal and state franchise disclosure laws, the Revised Rule imposes no “plain English” requirement upon franchise or franchise-related agreements which may or will be entered into.

XII. FINANCIAL PERFORMANCE REPRESENTATIONS/”EARNINGS

86 SBP at 67-68.87 SBP at 67-68, n. 245.88 See UFOC Guidelines, General Instruction 150.89 Revised Rule, §436.1(o).

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CLAIMS”

One of the most critical disclosure requirements of the revised FTC Franchise Rule relates to the core issue of a franchisor’s financial performance representations (historically referred to as “earnings claims”).

On this subject, what the Revised Rule does not say is perhaps more critical than what it does. That is, as under the original Rule, the Revised Rule does not require franchisors to present financial performance representations (past or projected revenues, expenses or profits of company-owned and/or franchised units) in their disclosure documents, despite calls from certain franchisee advocates that disclosure of such information be obligatory. Instead, as has been the case, franchisors under the Revised Rule can elect to present financial performance representations in Item 19 of their disclosure documents, but will not compelled to do so. The SBP suggests why this conclusion was reached:

Based upon its assessment of the record as a whole, the Commission concludes that financial performance representations should remain voluntary. In reaching this conclusion, we recognize that false or misleading financial performance claims are the most common allegation in Commission franchise law enforcement actions. However, there is no assurance that mandating performance claims will in fact reduce the level of false claims. Given that many different industries are affected by (the Revised Rule), what makes a financial performance disclosure reasonable, complete, and accurate is quite varied.

…Mandating financial performance disclosures would also impose substantial new accounting, data collection, and review costs on all franchise systems…

Further, the record reveals that approximately 20% or more of franchisors choose to make financial performance disclosures. Accordingly, prospective franchisees can find franchise systems that voluntarily disclose such information. More important, a disclosure document is not the only potential source of financial performance information. Prospective franchisees can obtain financial performance information from a variety of third-party sources. For example, typical expenses, such as labor and rent, may be available from industry trade associations and industry trade press. Prospective franchisees may be able to discuss earnings and other financial performance issues directly with current and former franchisees, as well as with trademark-specific franchisee associations.90

However, the Revised Rule significantly alters in key respects the fashion in which franchisors may disseminate financial performance representations to prospective franchisees.

90 SBP at 153-154.

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First, under the original Rule, financial performance representations had to be furnished to prospective franchisees by means of a separate disclosure document containing same. Under the Revised Rule, and paralleling all state franchise law requirements, any financial performance representations and their substantiation must appear in Item 19 of the core disclosure document itself.

Moreover, the Revised Rule alters the definition of “financial performance information” to more closely parallel the UFOC Guidelines’ definition, capturing both historic and projected financial performance information and embracing the use of charts, tables and mathematical calculations imparting or subsuming financial performance claims.91

Importantly, the Revised Rule abandons the original Rule’s requirement that financial performance representations be geographically relevant to any given prospective franchisee, another step toward making the Revised Rule’s disclosure requirements more consistent with the UFOC Guidelines.92

And in a liberalization of UFOC Guidelines requirements, the Revised Rule eliminates the Guidelines’ requirement that a franchisor furnishing financial performance information compare the number of franchisees who have performed at a claimed level against all franchisees in its system, not merely against franchisees it has measured or against franchisees in a defined subgroup.93 Instead, the Revised Rule permits franchisors to disclose financial performance information about subgroups of existing franchisees, provided that such information has a reasonable basis and the franchisor discloses the nature of the subgroup’s attributes at issue (such as geographic location, degree of competition in the market area, freestanding vs. shopping center, length of time the outlets have operated, company-owned vs. franchised or other such distinguishing attributes); the precise dates of the reported financial performance information; the total number of outlets in operation in the relevant period and, if different, the number of outlets that had the above-described subset characteristics; the number of units of the subject universe whose actual financial performance data were used in calculating the financial performance representation (along with the number and percentage which achieved or surpassed the stated results); and, any other characteristics of the subset universe of outlets at issue that may differ materially from those of the outlet being offered to a prospective franchisee.94

Based upon the record, the Commission has concluded that eliminating the geographic relevance requirement, coupled with permitting broader disclosure of financial performance of subgroups, will remove obstacles that discourage franchisors from making financial performance data available to prospective franchisees. At the same time, Item 19 prevents franchisors from “cherry picking” their best locations as a basis for financial performance representations. Specifically, Item 19’s

91 Revised Rule, §436.1(e).92 SBP at 154.93 SBP at 155-157.94 Revised Rule, §436.5(s)(3).

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substantiation requirements ensure that franchisors disclose how they derived the performance results of subgroups, so that prospective franchisees can assess for themselves the sample size, the number of franchisees responding, and the weight of the results. In addition, these provisions require franchisors to disclose the material differences between the subgroup-units tested and the units being offered for sale, so that prospects can avoid drawing unreasonable inferences from the representations.95

In another critical policy shift, the Revised Rule abandons the original Rule’s requirement that historical financial performance representations be prepared in accordance with generally accepted accounting principles (“GAAP”).96 “The GAAP requirement is unnecessary and may impede franchisors’ ability to disclose financial performance information, to the detriment of both franchisors and prospective franchisees”, asserts the SBP.97 Instead, financial performance representations may be calculated in whatever fashion a franchisor desires, provided that such representations are reasonable and that the franchisor can satisfy its burden of establishing such reasonableness.98

Nothing in either the Revised Rule or the SBP states, as do the UFOC Guidelines, that predictions, forecasts or other Item 19 representations of a prospective franchisee’s future financial performance which are prepared in accordance with the statement on standards for accountants’ services on prospective financial information issued by the American Institute of Certified Public Accountants will be deemed to have the Revised Rule’s required “reasonable basis”. However, we note the Staff Report specifically stated that the Commission intended to incorporate just such a provision in the Commission staff’s forthcoming FTC Franchise Rule Compliance Guides,99 so presumably franchisors can continue to rely on this AICPA “safe harbor” if required to demonstrate the reasonableness of their prospective financial performance representations.

The revised FTC Franchise Rule radically departs from today’s law governing financial performance representations by excluding from the definition of that term a franchisor’s disseminating to prospective franchisees expense or cost information alone. This revised and narrowed definition of “financial performance representation” places the Revised Rule at odds with the current UFOC Guidelines definition of that term, but said revision was actually supported by NASAA during the comment process.100 Since the dawn of franchise regulation in the 1970’s, both franchisors and prospective franchisees have been frustrated by a franchisor’s legal inability to convey cost or operating expense information, standing alone, to prospective franchisees absent the franchisor’s making a full financial performance disclosure in Item 19 of its disclosure document. The Revised Rule removes that impediment and permits franchisors to do 95 SBP at 157.96 16 CFR §§436.1(c)(4) and 436.1(e)(2).97 SBP at 158.98 Revised Rule, §436.5(s)(3) and §436.9(c).99 Staff Report at 167, n. 535.100 SBP at 34-25, n. 106.

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just that - - convey costs and operating expense information to prospective franchisees without having to do so through Item 19 of the disclosure document (and this is the case even if absolutely no financial representation is set forth in said Item 19).

“…(T)he Commission is persuaded that expense information alone is insufficient to enable prospective franchisees to gauge their potential earnings with any degree of specificity that could rise to the level of a financial performance claim”, asserts the SBP. “The Commission…reiterates here that mere disclosure of cost information does not, in its view, constitute a financial performance representation triggering Item 19 disclosure obligations. The Commission intends that the explanation that mere expense disclosures alone do not constitute a financial performance representation, coupled with the deliberate omission of any mention of expense information from (the definition of “financial performance information” found in) the final amended Rule, will be enough to address this issue”.101

The Revised Rule expands upon the UFOC Guidelines by requiring franchisors to include certain specified preambles in Item 19 of their disclosure documents - - one of they set forth therein financial performance representations and two if they do not.

The first preamble confirms that the Franchise Rule permits franchisors to disclose financial performance information in their disclosure documents, a requirement designed to counter what the FTC views as a widespread falsehood utilized by errant franchisors that the FTC Franchise Rule actually forbids the dissemination of financial performance information.102 This preamble would also inform prospective franchisees that any financial performance information they receive which differs from that included in Item 19 of their franchisor’s disclosure document may be given only if: (i) the franchisor is furnishing the actual records of an existing outlet the prospective franchisee is considering purchasing, or (ii) the franchisor is supplementing information contained in Item 19 of its disclosure document (for example, by providing information about performance at a particular location or under particular circumstances).103

The Revised Rule requires that a second required preamble follow the above-referenced preamble in any disclosure document that does not set forth financial performance representations. Geared to preclude prospective franchisees from relying on unsubstantiated financial performance representations, that preamble reads as follows:

This franchisor does not make any representations about a franchisee’s future financial performance or the past financial performance of company-owned or franchised outlets. We also do not authorize our employees or representatives to make any such representations either orally or in writing. If you are purchasing an existing outlet, however, we may provide you with the actual records of that outlet. If you receive any other financial performance information or projections of your future

101 SBP at 36.102 SBP at 158-159.103 Revised Rule, §436.5(s)(1).

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income, you should report it to the franchisor’s management by contacting (name and address), the Federal Trade Commission, and the appropriate state regulatory agencies.104

The Revised Rule maintains the requirement that franchisors making financial performance representations disclose to prospective franchisees that their individual performance results may differ.105 Also maintained is the original Rule’s requirement that a statement appear in Item 19 to the effect that substantiation of financial performance representations will be made available to prospective franchisees upon reasonable request.106

As is the case under the UFOC Guidelines, franchisors under the Revised Rule are entirely free to disclose to prospective franchisees the actual operating results of a specific unit(s) being offered for sale without setting forth that information in the subject disclosure document, provided that such information is furnished only to prospective purchasers of that unit(s).107 Also in compliance with the UFOC Guidelines, a franchisor furnishing financial performance information in Item 19 of its disclosure document may supplement that representation outside of the disclosure document with information about a particular location or variation from the representations contained therein.108

One variation between the original Rule and the UFOC Guidelines is maintained by the Revised Rule - - the notion that financial performance representations made in the “general media” fall within the embrace of Item 19 requirements, restrictions and prohibitions (requiring identification of the universe of outlets under consideration, relevant dates of performance measurement, number and percentage of outlets of the measured universe that actually attained or surpassed the stated results, characteristics of the included outlets and so forth). The UFOC Guidelines do not address this issue, leaving franchisors free to have their executives send press releases or grant interviews to such publications as The New York Times, or post information on their websites, and disclose therein what clearly are financial performance data without falling within the embrace of state franchise law coverage (this is not the case, of course, with regard to franchise advertising placed in such general media). Under the original Rule, “general media” claims were deemed to include to not only explicit franchise sales advertising but also statements made in speeches or press releases.109

Critically, however, the Revised Rule abandons the original Rule’s philosophy by providing that financial performance representations contained in a franchisor’s press stories or releases, its filed reports with the Securities and Exchange Commission and postings to its website (but not that segment of its website devoted to franchise sales) do not fall within the embrace of the Revised Rule and thus need not be set forth or referenced in the franchisor’s disclosure document.110 Explains the SBP:104 Id. at §436.5(s)(2).105 Id. at §436.5(s)(3)(iv).106 Id. at §436.5(s)(3)(v).107 Id. At §436.5(s)(4).108 Id. at §436.5(s)(5).109 Final Interpretative Guides, 44 Fed. Reg. at 49,984 – 85.110 SBP at 38.

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…(T)he Commission is persuaded that it is unwarranted to sweep broadly into the Revised Rule’s definition of “financial performance representation” all financial performance information posted online or appearing in press releases or speeches. The dissemination of financial information online and in press stories and releases is for the benefit of more than prospective franchisees, including investors, potential suppliers, and members of the general public. Further, the Commission believes that the commentors’ concerns are well-founded with respect to publicly filed reports required by the SEC. The Commission agrees that such filings are already publicly available and, more important, have indicia of reliability. Indeed, the dissemination of false financial data by publicly traded franchisors is already illegal. Thus, to impose the Rule’s substantiation and disclosure requirements with respect to SEC filing would be pointless, unworkable, and unduly burdensome. With respect to the dissemination of other financial performance information, the Commission believes that a distinction should be made between information disseminated in advertisements directed at franchisees – be it in print, radio, television, or Internet – and information disseminated to the general public. We are convinced that deeming financial performance information disseminated publicly to be “financial performance representations” under the Rule would have a chilling effect, discouraging franchisors from furnishing truthful information to the public.111

Nevertheless, the SBP confirms that where a franchisor utilizes financial performance information disseminated, or intended to be disseminated, to the general public in its franchise promotional materials - - by copying favorable press interviews and distributing them to prospective franchisees, posting same on its website or repeating the generally released information in face-to-face meetings with prospective franchisees, such information becomes transformed into a “financial performance representation” fully embraced by the Revised Rule and, under these circumstances, required to be set forth in the franchisor’s disclosure document (or else the franchisor will have substantial liability for violating the Revised Rule’s financial performance information edicts).112 The SBP indicates that further guidance on this subject will be forthcoming in the Commission’s Compliance Guides.113

Lastly, the Revised Rule carries forward an original Rule disclosure requirement related to financial performance representations which is found neither in any state registration/disclosure statute nor the UFOC Guidelines - - the requirement that franchisors, when furnishing a disclosure document, “…notify the prospective franchisee of any material changes that the seller knows or should have known occurred in the information contained in any financial performance representation made in Item 19”. 114

The SBP notes that the original Rule required franchisors to notify franchisees at the

111 SBP at 38.112 SBP at 38-39.113 SBP at 39.114 Revised Rule, §436.7(d).

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time they furnished disclosure documents of any material changes to the information contained therein.115 They were, and now under the Revised Rule still are, permitted to do so outside of the disclosure document.116 However, such conduct may prove directly violative of state franchise registration/disclosure statutes, which is why if there is a material change to the financial performance information set forth in a franchisor’s disclosure document, such a franchisor almost always will amend that document to reflect the updated information (to comply with state statutory requirements) rather than convey any such changes outside of the disclosure document. As we will address later in this report (see “Updating Disclosure Documents” below), the difficulty addressed herein is only one associated with the Revised Rule’s mandates regarding when and under what circumstances a franchisor must (or need not) update its disclosure document.

XIII. RESPONSIBILITY FOR EFFECTING DISCLOSURE

Both franchisors and any franchise brokers they engaged were jointly and severally liable under the original FTC Franchise Rule for furnishing disclosure documents to prospective franchisees.117

Under the Revised Rule, however, only the franchisor will bear responsibility for ensuring that prospective franchisees receive disclosure documents. Franchise brokers will no longer have that responsibility: “The preparation and distribution of the disclosure document is the sole responsibility of the franchisor”, asserts the SBP. “…Coverage of brokers under the (Revised Rule) is limited to prohibitions. For example, any franchise seller, including brokers, cannot make statements that are inconsistent with those found in the franchisor’s disclosure document”.118

The revised FTC Franchise Rule imposes distinct disclosure obligations upon subfranchisors. In certain limited circumstances, through the Rule’s defining the term “franchisor” as including subfranchisors,119 subfranchisors become responsible for furnishing disclosure to prospective franchisees in the same manner as franchisors otherwise are. In addition, the Revised Rule directs that the disclosure document to be disseminated by subfranchisors include all required information about the franchisor and, to the extent applicable, the same information concerning the subfranchisor.120

Readers will note, however, that the Revised Rule does not define the term “subfranchisor”. However, the Revised Rule’s definition of the term “franchise seller” expressly includes “subfranchisors”,121 with the SBP clarifying that “subfranchisors are treated the same as franchisors under the Rule in narrow circumstances only: where the

115 16 CFR §436.1(d)(2) and §436.1(e)(6).116 SBP at 213-214, n. 769.117 16 CFR §436.1(a). See also Final Interpretative Guides, 44 Fed. Reg. at 49,969.118 SBP at 49.119 Revised Rule, §436.1(k)120 Revised Rule, §436.6(f).121 Revised Rule §436.1(j).

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subfranchisor steps into the shoes of the franchisor by both granting franchises, as well as by performing post-sale disclosure obligations.”122

We look forward to the forthcoming FTC Franchise Rule Compliance Guides’ assistance in further defining, and delineating among, franchise brokers, subfranchisors, other species of franchise “sellers” and what their distinct obligations are under the revised FTC Franchise Rule.

XIV. WHO MAY RECEIVE DISCLOSURE

Since the dawn of franchise regulation over thirty years ago, it has always been the case under federal and state franchise laws, rules and regulations that franchise disclosure documents must be furnished to the “prospective franchisee”.

Indeed, many questions and some litigation have cropped up over the years regarding when, in fact, a “franchisee” has been disclosed (for example, if only three out of four partners in a general partnership franchisee have been furnished a disclosure document, the franchisor’s disclosure burden has been deemed not fully satisfied by at least one court).

Some of this confusion may inadvertently be carried over by the Revised Rule. Specifically, the Revised Rule’s core disclosure mandate requires a franchisor to furnish its disclosure document to “…a prospective franchisee”.123 In turn, the Revised Rule defines the term “franchisee” as “…any person who is granted a franchise”.124 The Revised Rule thus discards the original Rule’s notion that disclosure must run to any person “…to whom an interest in a franchise is sold.”125 “This narrowing of the definition is in response to commentors who voiced concern that the phrase ‘an interest in a franchise’ is too broad, arguably sweeping in shareholders of publicly traded companies and other investors”,126 notes the SBP. However, under the Revised Rule’s new definition of “franchisee”, the question arises: precisely who is the “franchisee” required to be disclosed when the franchisee is a joint proprietorship or a partnership? Under most state laws governing partnerships, service upon one general partner is deemed service upon the partnership. By extension, disclosure under the Revised Rule to one partner in a partnership franchisee may be deemed disclosure upon the “franchisee”, with no need to disclose any other general partners. However, this notion conflicts with interpretations of state franchise law requirements pursuant to which all general partners of a partnership franchisee must be disclosed for the franchisor to have satisfied its disclosure obligation. We look forward to the FTC’s forthcoming Compliance Guides to shed light on this issue.

122 SBP at 205.123 Revised Rule, §436.2(a).124 Revised Rule, §436.1(i).125 16 CFR 436.2(d).126 SBP at 46.

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In a dramatic and critical policy shift, the Revised Rule changes the franchise disclosure protocol which has pertained since California enacted the first franchise registration/disclosure statute in 1971. Since that time, and under both the original Rule and every state franchise law, a franchisor has been required to furnish its disclosure document to the “prospective franchisee”. However, the Revised Rule dramatically changes this platform by permitting a franchisor to effect disclosure upon a franchisee’s representative in lieu of the franchisee himself/herself/itself. The Revised Rule accomplishes this by defining the term “prospective franchisee” as including “…any agent, representative or employee” of the prospective franchisee.127 “The Commission agrees that representatives of a prospective franchisee should be permitted to accept delivery of the disclosure document on the prospective franchisee’s behalf”, assets the SBP. “Indeed, in some instances a prospective franchisee may be a corporation or other entity, not an individual. Thus, delivery in such circumstances can only be made upon a representative. Even individuals may wish to have their attorney or other agent receive the disclosures on their behalf, and the Rule should accommodate that possibility”.128

The SBP suggests that further detail of how who may accept disclosures on behalf of a prospective franchisee will be set forth in the FTC’s forthcoming Compliance Guides.129 For the time being, however, it appears that franchisors no longer have to furnish disclosure documents directly to prospective franchisees but, instead, may furnish them to any representative of the prospective franchisee, perhaps even sending out the disclosure document in response to a telephone call placed by the prospective franchisee’s attorney or other adviser.

A few questions arise in connection with this new Revised Rule approach. If anyone other than the prospective franchisee itself is disclosed, who manifests receipt of the disclosure document? Can it be just the prospective franchisee’s attorney, advisor or other agent and not the prospective franchisee himself/herself/itself? The answer appears to be “yes” under the above-quoted provisions of the SBP. Nevertheless, we look forward to the forthcoming FTC’s Franchise Rule Compliance Guides to further clarify this issue.

XV. LIABILITY FOR CONTENTS OF DISCLOSURE DOCUMENTS

The original FTC Franchise Rule did not specifically state who was liable for the contents of a franchise disclosure document. It only provided that franchisors and franchise brokers were jointly and severally liable for furnishing such disclosure documents to prospective franchisees.130

The Revised Rule replaces this vacuum with both an express and an indirect denomination of those who bear liability for ensuring that the contents of a franchisor’s

127 Revised Rule, §436.1(r).128 SBP at 57.129 SBP at 57-58.130 16 CFR §436.1(a); Final Interpretative Guides, 44 Fed. Reg. at 49,969.

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disclosure document are prepared in accordance with the Rule’s requirements and are full, complete and truthful:

It is an unfair or deceptive act or practice in violation of Section 5 of the FTC Act for any franchisor to fail to include the information and follow the instructions for preparing disclosure documents set forth in (the Revised Rule). The Commission will enforce this provision according to the standards of liability under Sections 5, 13(b), and 19 of the FTC Act.131

Thus, the Revised Rule directly holds liable a franchisor (or, as applicable, a subfranchisor) for any failure to prepare a disclosure document in that fashion, and containing all of the disclosures, required by the Rule.

However, the Revised Rule only indirectly denominates those other than the franchisor who may be held liable for a franchisor’s disclosure violations - - that is, those who may bear liability under Sections 5, 13(b) and 19 of the FTC Act.

Just which of a franchisor’s personnel are intended to be embraced by this Revised Rule provision and thus may bear liability for franchisor disclosure violations? The SBP provides an answer:

…(T)he Commission is persuaded that liability for the content of a disclosure document must be based upon liability standards applicable in FCC enforcement actions under Sections 5, 13(b), and 19. In that regard, there is a distinction between the standard of liability for injunctive relief and that for redress. In general, case law establishes that an individual may be enjoined for corporate misconduct if he or she participated directly in the wrongful practice or had the authority to control the corporate defendant. In the franchise context, an officer or director of a franchisor may be enjoined against violating the Rule if the officer or director, for example, had authority to control or directly prepared, or directed others to prepare, false or otherwise inaccurate disclosure documents.

In order to hold an individual liable to pay consumer redress, however, the Commission must show more than just authority to control the corporation. It must show the individual possessed some level of knowledge or awareness of the misrepresentations. The Commission may establish the requisite knowledge by showing that the individual had actual knowledge of material misrepresentations, or an awareness of a high probability of fraud along with an intention avoidance of the truth.132

Thus, declares the SBP, an officer or director of a franchisor may be held liable under the Revised Rule for redress relating to a franchisor’s disclosure violations if that officer or director directed the franchisor’s employees to prepare false or misrepresented disclosures or failed to stop the company from using a disclosure

131 Revised Rule, §436.6(a).132 SBP at 198-199.

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document that one or more states had previously rejected as insufficient. In a similar vein, notes the SBP, a franchisor’s sales manager could be held individually liable for redress if that individual had authority to control those preparing disclosure documents and had knowledge that material disclosures set forth therein were false or otherwise inaccurate.133

On the other hand, franchisors should be greatly relieved that the Revised Rule’s provisions regarding “control person” liability have been dramatically narrowed from those suggested by the Staff Report, which would have held liable any officer or director of a franchisor which had “authority to control” a franchisor committing disclosure violations.134 Had the Commission adopted the Staff Report’s recommended language, then unintentionally, we believe, that language could have technically been deemed to embrace all senior officers or a corporate franchisor, since presumably they have the “authority to control” the contents of their company’s franchise disclosure document and could thus automatically assume liability for disclosure content failures that they did not know of, should not have known of, were not even aware of and had utterly no responsibility for.

Thankfully for franchisors, however, the SBP notes that the Commission deliberately redacted the Staff Report’s proposed “control person” liability provisions in that fashion detailed above.

XVI. DISCLOSURE POSSIBLY REQUIRED OUTSIDE OF THE DISCLOSURE DOCUMENT

Both the revised FTC Franchise Rule and the SBP suggest that franchisors may be required to engage in disclosure outside of their disclosure documents by furnishing to prospective franchisees material information not contained therein. This would counter the requirement of every state franchise registration/disclosure statute that all material information be included in a franchisor’s disclosure document and not separately parsed out.

Specifically, Section 436.10(a) of the Revised Rule states in its second sentence: “…(F)ranchisors may have additional obligations to impart material information to prospective franchisees outside of the disclosure document under Section 5 of the Federal Trade Commission Act”. No analogous provision is found either in the original FTC Franchise Rule or in any state franchise registration and disclosure statute.

At first blush, it may appear from the above-quoted provision of the Revised Rule that franchisors may be required to furnish additional material information to prospective franchisees outside of their disclosure documents and thus in contravention of virtually every state franchise registration and disclosure law (which insist that all material facts - - whether or not specifically required to be disclosed by state franchise laws or regulations or by the UFOC Guidelines - - must be contained in franchisors’ disclosure

133 SBP at 199-200.134 Attachment B to Staff Report, “Proposed Final Revised Rule”, §436.2(d).

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documents and, absent same, may never be communicated outside of those documents).

However, the Revised Rule, addressing various commentors’ concerns voiced following the Staff Report’s issuance, makes clear that all material information required to be incorporated in a franchisor’s UFOC by state law or by the UFOC Guidelines may, notwithstanding the above-quoted language suggesting to the contrary, in fact continue to be set forth in that franchisor’s disclosure document. First, Section 436.6(d) states: “Do not include any materials or information (in the disclosure document) other than those required or permitted by (the Revised Rule) or by state law not preempted by (the Revised Rule)” (emphasis added). The SBP then clarifies that the prohibition against setting forth “additional material” not required by the Revised Rule effectively only extends to ensuring “…that a franchisor does not bulk up a disclosure document with unnecessary information or features that will discourage a prospective franchisee from reading the document or distract a prospective franchisee’s attention from negative disclosures”.135 And the SBP further clarifies that the above-quoted Revised Rule provision suggesting that franchisors may have disclosure obligations to prospective franchisees outside of their disclosure documents, in probable contravention of state law, in fact is not meant to preclude franchisors in any fashion from setting forth in their disclosure documents any such “material information” required to be disclosed by either state franchise laws or the UFOC Guidelines:

Section 436.6(d) is not intended to preempt state law… (A) franchisor can always include information in a disclosure document that is required by state law. Typically, such state disclosures will arise in two circumstances. First, state law may require specific disclosures that go beyond those required by the Franchise Rule, or may contain a broad anti-fraud provision requiring franchisors to include in their disclosure document all material information. Second, a state franchise examiner may require, as a matter of discretion on a case-by-case basis, a particular disclosure in order to prevent deception by a franchisor. In either instance, the final amended Rule accommodates state interests by permitting the franchisor to add state information to its basic disclosure document.136

Thus, the Revised Rule and the SBP effectively remove any notion that a franchisor may be required to impart material information to prospective franchisees, including that required by state law, outside of that franchisor’s disclosure document and thus in violation of state franchise law requirements that all material information instead be contained in that disclosure document.

XVII. UPDATING DISCLOSURE DOCUMENTS

With minor variations, the Revised Rule continues the original Rule’s mandate regarding when franchise disclosure documents must be updated.

135 SBP at 202.136 SBP at 203.

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As under the original Rule,137 the Revised Rule requires that all information in a franchisor’s disclosure document be current as of the close of the franchisor’s most recent fiscal year.138 However, the Revised Rule affords franchisors 120 days (rather than the original Rule’s 90 days) following the close of their fiscal years in which to prepare such updated disclosure documents.139

Also identical to the original Rule’s mandate is the Revised Rule’s “quarterly update” protocol. Pursuant thereto, a franchisor - - following the close of each quarter of its fiscal year - - must prepare an attachment to its disclosure document to reflect any material change in the franchisor or relating to the franchise business of the franchisor, with each prospective franchisee receiving both the franchisor’s core disclosure document and the quarterly revision attachment for the most recent period available at the time of disclosure.140

In contrast to all state franchise registration and disclosure statutes, the revised FTC Franchise Rule (just like the original Rule) contains no general continuing update requirement compelling franchisors to revise their disclosure documents each and every time material changes to the facts set forth therein transpire. The only exception pertains to Item 19 financial performance representations (if any), where the Revised Rule requires franchisors to “…notify the prospective franchisee of any material changes that the seller knows or should have known occurred in the information contained in any financial performance representation made in Item 19”.141 Notably, the SBP states that such “material changes” to Item 19 information may be furnished to prospective franchisees outside of the disclosure document if the franchisor so chooses, “…in writing, or by telephone call, email, or other electronic transmission, provided that the franchisor can prove that it has informed the prospective franchisee about the material change to the (financial) performance data”.142

The Revised Rule’s quarterly update requirement and the SBP’s observation that the Revised Rule “…imposes no continuous updating requirement on franchisors”,143

appears to place the Revised Rule directly at odds with state franchise laws, which do indeed impose such a “continuing update” requirement on franchisors. However, given the Revised Rule’s only limited preemption (addressed in detail below), coupled with its express permission in Section 436.6(d) for franchisors to incorporate in their disclosure documents any material information “…required or permitted… by state law”, we believe that it is beyond dispute that franchisors under the Revised Rule may, in lieu of following the Rule’s “quarterly update” protocol, instead, following the franchise regulating states’ “immediate update” requirements.

XVIII. EXEMPTIONS

137 16 CFR §436.1(a)(22).138 Revised Rule, §436.7(a).139 Revised Rule, §436.7(a).140 Revised Rule, §436.7(d).141 Revised Rule, §436.7(d).142 SBP at 213-214, n. 769.143 SBP at 249.

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The Revised Rule carries forward those very few exemptions which the original Rule provided - - “fractional franchises”; leased departments; franchise relationships requiring the payment of $500 or less before or within six months after commencement of operation of the franchisee’s business; and, instances where no writing evidences any material term or aspect of the purported franchise relationship. (The original Rule’s exclusions from coverage for employment relationships, cooperative associations, testing or certification services and single trademark license agreements were intentionally deleted from the Revised Rule and are now only incorporated by reference in the SBP.)144

In addition to these, the Revised Rule affords a number of broad exemptions from disclosure not extant under the original FTC Franchise Rule or many state franchise registration/disclosure statutes.

The Revised Rule’s first new exemption pertains to petroleum marketers and resellers already embraced by the provisions of the federal Petroleum Marketing Practices Act (“PMPA”).145 In explaining this new exemption, the SBP recalls that, in 1980, the FTC granted a petition for an exemption from FTC Franchise Rule coverage filed by several oil companies, with the Commission then concluding that the Rule should not apply to such PMPA-regulated franchises because the PMPA established its own regimen of pre-sale disclosure duplicative of that required under the Franchise Rule.146

However, the PMPA exemption afforded by the Revised Rule will be available to non-petroleum franchises situated on the premises of petroleum (gasoline) retailers (such as convenience stores, car washes and fast food and ice cream shops) only if such non-petroleum franchises are granted in the same agreement as the petroleum franchise; if granted separately, they fall outside of the exemption.147 Asserts the SBP: “An individual who operates a gasoline station is just as much in need of pre-sale disclosure for the purchase of a non-related franchise, such as an ice cream store, as any other prospective franchisee”,148 asserts the SBP.

The Revised Rule also affords additional exemptions from disclosure that parallel those put in place by certain key franchise regulating states - - what the SBP refers to “sophisticated investor” transactions.

The first of these regards the sale of franchises which require “large investments”, specifically where the franchisee’s estimated investment - - excluding financing received from the franchisor (or its affiliate) and further excluding unimproved land - - totals at least $1 million and the prospective franchisee signs an acknowledgment confirming the grounds for the exemption,149 (which acknowledgment may be set forth in the subject franchise agreement itself, an addendum thereto or in a 144 SBP at 215, n. 777 and 240-242.145 15 U.S.C. §2801.146 SBP at 218; 45 Fed. Reg. at 51,766.147 SBP at 219.148 SBP at 219.149 Revised Rule, §436.8(5)(1).

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separate writing). The SBP notes that no state has an exactly duplicative exemption, although it observes that Illinois permits a franchisor to apply for such an exemption from both registration and disclosure where the investment for a single franchised unit exceeds $1 million, while Maryland exempts from registration - - but not disclosure - - the sale of franchises that require an initial investment of $750,000 or more.150

“The basis for the large investment exemption is not that ‘sophisticated’ investors do not need pre-sale disclosure, but that they will demand and obtain material information with which to make an investment decision regardless of the application of the Rule”,151 explains the SBP, which also notes that statistics suggest fewer than 5% of franchise systems will qualify for the exemption.152

As to how the required $1 million “investment” (excluding unimproved land costs and franchisor financing) should be calculated, the SBP states:

The Commission’s intent is that, for purposes of the large investment exemption, the level of a prospective franchisee’s investment should be limited to the “initial investment”, as set forth in Item 7. For that reason, the phrase “estimated investment” has been replaced in the Rule’s text with the phrase “initial investment”. Focusing on Item 7 when applying the exemption brings needed certainty to all parties, while ensuring that the exemption is narrowly focused to protect prospective franchisees making smaller investments.153

Critically, the SBP notes that the required $1 million investment necessary for a franchisor to take advantage of the Revised Rule’s new exemption “…need not be limited to a single unit… A multi-unit franchisee investing the threshold amount (or more) in a number of units is just as sophisticated as another franchisee investing a like amount in a single unit”.154

Also critically, under the Revised Rule the value of assets which are the subject of franchise conversation or transfer transactions will count when computing the required threshold:

The Commission’s view is at the definition of “Initial Investment” is broad enough to include conversion franchises and transfers without sacrificing necessary protection for franchise purchasers. Specifically, when considering a conversion franchisee’s “initial investment” in a franchise, it is reasonable to consider the conversion franchisee’s previous investment in the unit. Indeed, a strong argument can be made that a conversion franchisee is even more sophisticated than a new franchisee, having worked in the business for a period of time. Similarly, the sale of an

150 SBP at 220, n. 799.151 SBP at 223.152 SBP at 225-226.153 SBP at 230.154 SBP at 231.

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existing franchise would qualify for the large investment exemption in a transfer. The fact that a transferee will assume an existing contract or may renegotiate an existing contract with the franchisor should have no bearing on his or her level of sophistication as an investor, as long as he or she satisfies the monetary threshold.155

However, the SBP also makes clear that the $1 million investment exemption will apply only if at least one individual in a franchisee investor group qualifies as “sophisticated” by investing at the threshold level. Stated otherwise, a pooling of resources to reach that $1 million level among various individuals will not alone trigger the exemption.156 Asserts the SBP:

Clearly there is a significance difference between a single individual purchasing a franchise for $1 million, versus a group of ten, for instance, each contributing $100,000. Obviously, the larger the group of investors, the smaller each individual investor’s risk. In such a circumstance, the level of each individual investment provides no indicium of sophistication.157

Also not to be included when calculating whether the minimum exemption threshold has been reached is any money or financing furnished by the franchisor to the franchisee relating to the initial investment. “Otherwise, a franchisor could be tempted to increase the cost of the initial investment to qualify for the large investment exemption, while simultaneously offering to finance the deal itself, all without proper pre-sale disclosures”,158 notes the SBP.

The Revised Rule’s second “sophisticated investor” exemption is afforded to what the Staff Report terms “large franchisees”, defined as entities (including any parent or affiliates) which have been in business for at least five years and have a net worth of at least $5 million.159 “Even if a large entity does not have prior experience specifically in franchising”, observes the SBP, “it is reasonable to assume that it can nevertheless protect its own interests when negotiating a franchise deal”.160

The type of prospective franchisee entities eligible for this exemption include corporations, partnerships and other business entities. With regard to individuals, the SBP observes: “Nothing prevents an ‘entity’ under this provision from being an individual, but most individuals who have been in business for at least five years and have generated an individual net worth of at least $5 million are likely to have created a corporation or other formal organization through which to conduct business.161

155 SBP at 232.156 Revised Rule, §436.8(a)(5) (n. 11).157 SBP at 231.158 SBP at 228.159 Revised Rule, §436.8(a)(6).160 SBP at 233.161 SBP at 234, n. 845.

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The Revised Rule explicitly provides that a franchisor may consider the prior experience and net worth of the franchisee’s affiliates and parents when determining whether the franchisee qualifies as a “large franchisor”.162 This feature of the Revised Rule is in deference to the prevalent practice of franchisees forming separate operating entities for tax and/or liability reasons.

The third and last “sophisticated investor” exemption afforded by the revised FTC Franchise Rule is available when one or more purchasers of at least a 50% ownership interest in the subject franchise within 60 days of the sale has been, for at least two years, an officer, director, general partner or individual with management responsibility for the franchisor’s franchise sales program or the administration of its network or, in the alternative, when one or more of such purchasers has been an owner of at least a 25% interest in the franchisor.163 Similar exemptions may be found in the franchise registration and disclosure statutes of California, Washington and Rhode Island. Observes the SBP: “In such circumstances it can reasonably be assumed that the prospective franchisee already is familiar with every aspect of the business system and the associated risks”.164

Note that the “officer/director/partner/management” exemption afforded by the Revised Rule “…is company-specific: we do not mean to suggest that a manager of one company is sophisticated for all franchise sales. Rather, the exemption would apply only to a manager or other officers seeking to purchase a franchise of that very company”.165

The exemption thresholds stated above will not remain static. Instead, the Revised Rule states that the FTC may adjust them every four years to account for inflation.166

Omitted from the Revised Rule’s classification of “sophisticated investors” is a category one might have thought worthy - - existing franchisees renewing or extending their franchise agreements or purchasing additional outlets. While the SBP is silent on the issue, the 2004 Staff Report furnishes the FTC’s rationale: “While an argument could be raised that renewing franchisees already are familiar with the franchise system, that argument is undercut by the repeated submission of franchisee comments voicing concerns about renewal terms and conditions”, states the Staff Report. “For similar reasons, we see little benefit in adopting a broad exemption for additional franchise sales to existing franchisees. A franchisee’s experience within a franchise system alone is an insufficient basis to avoid pre-sale disclosure. In our experience, many franchise owners are not necessarily sophisticated about their franchisor, or are too busy operating their individual outlets to pay attention to developments within their franchise systems”.167

162 Revised Rule, §436.8(a)(5)(2) and SBP at 236-237.163 Revised Rule, §436.8(a)(6).164 SBP at 237.165 SBP at 238.166 Revised Rule, §436.8(b).167 Staff Report at 234.

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XIX. PROHIBITED CONDUCT

The original Rule’s list of prohibited practices - - making statements that contradict a franchisor’s disclosures, failing to make promised refunds and failing to make available written substantiation for financial performance representations - - is carried forward in the Revised Rule.168

In addition, and beyond the added prohibitions already identified earlier in this paper (failing to make disclosure documents available upon request to prospective franchisees earlier in the sales process than required by the Rule or failing to redisclose upon request prospective franchisees who were previously disclosed but are still in the franchise sales “pipeline”), the Revised Rule adds other prohibitions.

First, a franchisor would be prohibited from utilizing “shills” in the franchise sales process by falsely identifying an individual either as an actual franchisee or as one who otherwise could provide an independent and reliable report about the subject franchise or the experiences of current or former franchisees.169

In addition, the Revised Rule forbids a franchisor from disclaiming, or requiring a prospective franchisee to waive reliance on, any representation made in that franchisor’s disclosure document unless that franchisee waiver or disclaimer pertains to contract changes resulting from franchisor-franchisee negotiations.170 Vitally, the Revised Rule does not attempt to ban integration clauses or contractual waivers entirely. Instead, such provisions would only be prohibited from disclaiming disclosure document representations. Thus, as the SBP makes clear, franchisors may still utilize integration clauses and waivers to disclaim responsibility for unauthorized claims made by salespersons; statements made by former or existing franchisees; franchise advertising and marketing materials; unattributed statements found in the trade press; and, third party representations.171

Critically, the Revised Rule carves out from the aforementioned disclaimer/integration ban for franchise agreement changes negotiated by prospective franchisees - - and the SBP actually states that such negotiations and resulting waivers may result in terms less favorable to the franchisee than those disclosed in the franchisor’s disclosure document, in contravention of state regulatory approaches and case law addressing the subject (which until now have uniformly required that any negotiations with franchisees result in terms more favorable to the franchisee, nevertheless).

Asserts the SBP:

…(T)he Commission does not believe that the Rule should impede a prospective franchisee’s ability to negotiate agreement changes… The

168 Revised Rule at §436.9(a)(d) and (j).169 Revised Rule, §436.9(b).170 Id. at §436.09(i).171 SBP at 253.

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Commission recognizes that a negotiated franchise or related agreement may result in some changes favoring the franchisor. Whether or not a particular change benefits a particular party, however, is irrelevant… As long as the prospective franchisee opens the door to changing documents that previously have been presented for signing, any discussion about changes and any agreed upon changes are clearly made with the prospective franchisee’s knowledge.172

XX. REVISED RULE IMPACT ON STATE FRANCHISE LAWS

Just as was the case under the original FTC Franchise Rule, the Revised Rule specifically provides that it does not preempt the franchise law of any state except to the extent of any inconsistency with the Revised Rule (and a state law would not be deemed inconsistent with the Rule if it affords prospective franchisees equal or greater protection, such as registration of disclosure documents, or more extensive or additional disclosures).173

However, as noted throughout this report, the Revised Rule significantly adds to the current UFOC Guidelines disclosure requirements mandated by the states. Accordingly, under the above-referenced preemption language of the Revised Rule, these expanded Rule disclosure requirements create a new disclosure “floor” which not only will all franchisors soon have to comply with, but which the franchise regulating states will have to accept.

Of course, also as noted earlier, nothing in the Revised Rule’s preemption language prohibits any state from imposing disclosure requirements that go beyond the Revised Rule’s requirements (which would transform the Revised Rule’s “UFOC plus” platform into “UFOC plus plus”). By way of example, the franchise regulating states may continue to mandate that franchisors disclose in Item 2 of their disclosure documents the identities of any franchise brokers acting on their behalf, and retain the UFOC Guidelines solely to address such state specific disclosure obligations which surpass those of the Revised Rule.

Further, many of the more striking features of the Revised Rule - - most notably “pure” electronic disclosure and the Rule’s new exemptions - - have no analogues in state franchise registration and disclosure statutes. While clearly such Revised Rule provisions not addressing disclosure document contents will have no preemptive effect upon the franchise regulating states, it is hoped that the more visionary aspects of the revised FTC Franchise Rule will be adopted by them, lest these attractive Revised Rule features be confined for use only in the 35 states which do not have their own franchise disclosure statutes and are thus governed solely by the FTC Franchise Rule.

The ability of the franchise regulating states to swiftly incorporate the new “UFOC plus” disclosure mandates of the revised FTC Franchise Rule is complicated by the fact that, while many of those states require only regulatory amendments to accomplish this

172 SBP at 76-77.173 Revised Rule, §436.10(c).

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task (relatively easily done within a brief period of time), nine such states (Hawaii; Indiana; Maryland; Michigan; Minnesota; New York; North Dakota; and, Wisconsin) have franchise laws which themselves delineate what disclosures must be effected by franchisors (with some of these states amplifying such statutory requirements in regulations). Thus, at least some franchise regulating states may have to turn to their legislatures to adopt the Revised Rule’s disclosure requirements and other features.

The task of harmonizing the new disclosure “floor” created by the Revised Rule with the extant disclosure requirements of state franchise registration and disclosure statutes, as well as the hoped for adoption by those states of the Revised Rule’s new and visionary features, may prove fairly daunting. However, the government officials responsible for federal and state franchise law enforcement have traditionally proven remarkably collegial and dedicated in their efforts to harmonize federal and state franchise regulation in an effective manner, and indications are that they are in the midst of doing so even now, with NASAA and the FTC over the past number of years closely communicating and working together in anticipation of the promulgation of the revised FTC Franchise Rule.

Indeed, the SBP itself goes to great length to address just how closely the FTC is working with the franchise regulating states to achieve franchise regulatory harmonization. First, the SBP notes that the Commission’s forthcoming FTC Franchise Rule Compliance Guides “…will likely incorporate, in large measure, the UFOC Guidelines’ existing sample answers and NASAA’s previously issued commentaries on the UFOC Guidelines, to the extent such sample answers and commentaries do not deviate from the (Revised Rule)”, asserts the SBP. “The Commission intends that the staff coordinate the issuance of the Compliance Guides and future interpretations of (the Revised Rule) with NASAA’s Franchise and Business Opportunity Project Group in order to minimize differences between FTC and state Rule interpretations”.174

Moreover, the SBP notes that in an effort to assist the franchise regulating states: “The Commission intends to continue working with NASAA and individual states after the (Revised Rule) goes into effect in order to harmonize federal and state franchise disclosure laws”.175

XXI. EFFECTIVE DATE OF REVISED FTC FRANCHISE RULE/”PHASE-IN” PERIOD

The FTC’s announcement of its promulgation of the Revised Rule states: “The effective date of the (Revised Rule) is July 1, 2007. Permission to use the original Franchise Rule, however, will continue until July 1, 2008. After that day, franchisors… must comply with the (Revised Rule) only”.176

So it is that beginning July 1, 2007 and concluding one year later, the Revised Rule will undergo its “phase-in” period during which time franchisors may elect to

174 SBP at 16.175 SBP at 17.176 SBP at 1.

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compile their disclosure documents either under the edicts of the original Rule (including permission thereunder to follow today’s UFOC Guidelines) or those of the Revised Rule (in which event it would appear safe to follow the UFOC Guidelines only to the extent they address a disclosure item identically addressed by the Revised Rule). Naturally, under no circumstance may a franchisor pick and choose from the original Rule and the Revised Rule when compiling a disclosure document during this phase-in period.

Given the Revised Rule’s above-referenced preemption language, the franchise regulating states must begin accepting disclosure documents prepared under said Rule at the beginning of the Rule’s phase-in period (July 1, 2007) and may not wait until the Revised Rule’s mandatory effective date (July 1, 2008). Toward that end, the franchise regulating states, acting out of the aegis of the NASAA Franchise Project Group, are even now training their regulatory staffs regarding the requirements and prohibitions of the Revised Rule in anticipation of the Rule’s July 1, 2007 phase-in commencement date.

XXII. REVISED RULE “TO DO” LIST FOR FRANCHISORS

Given the Revised Rule’s rapidly approaching elective effective date of July 1, 2007, following which franchisors may opt to utilize the Rule’s new format when preparing their disclosure documents (the mandatory effective date is July 1, 2008), we thought it would be helpful to set forth those activities which a franchisor should undertake right away so it is capable of transmitting to the Revised Rule’s new disclosure platform in a timely fashion:

Determine when it will be optimal for the franchisor to migrate to the Revised Rule’s new disclosure format. It is widely anticipated that many, if not most, franchisors will do so during the 2008 “renewal season”: February – May, 2008, during which time franchisors on a calendar fiscal year - - and that includes almost all of them - - must cease selling franchises in the franchise regulating states while they prosecute their annual disclosure document amendment/renewal applications for registration, unless an exemption therefrom is available. We believe that this would be an error. The franchise regulating states collectively are inundated with thousands of applications for franchise registration renewal/disclosure document amendment during “renewal season”, resulting in a proverbial bakery line stretching out the door and around the block of franchisors waiting for their renewal applications to be examined and registration conferred (and recall that, under virtually all state franchise registration laws, franchisors must cease offering or selling franchisors during the period between the time they submit their amended disclosure documents for registration renewal and the time renewal is actually granted - - a practice colloquially referred to as “going dark”). The delay engendered by the onslaught of renewal applications received during this period will only be exacerbated by the states need to very closely examine amended disclosure documents prepared under the new Revised Rule template; until now, review of renewal applications was generally confined to

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examining blacklined variations from the franchisor’s previously registered disclosure document.

Accordingly, we strongly suggest that franchisors avoid migrating to the Revised Rule’s new disclosure platform during the 2008 “renewal season”. Instead, we advise franchisors to effect an intrayear disclosure document amendment either in the second half of 2007 or, at the very latest, in mid-May 2008 (with the understanding that, if the latter date is elected, the franchisor will have just processed to its annual registration renewals with the franchise regulating states a few months earlier). If a franchisor follows this suggestion, it should inform the franchise regulating states that its disclosure document amendment application is “non-material” in nature, such that the franchisor can continue utilizing its UFOC Guidelines disclosure document until the day registration of its Revised Rule document is granted, thus avoiding franchise sales “down time” (and, if possible, the franchisor should request a common amendment effective date - - one calibrated to give franchise regulators nationwide sufficient time to review and comment upon the new Revised Rule document - - so that, ideally, the new Revised Rule document will be effective everywhere on or about the same date).

Ascertain whether the franchise regulating states will have authorized electronic disclosure at the time the franchisor transitions to the Revised Rule platform and ensure that the franchisor’s revised disclosure document retains these state disclosures not preempted by the Revised Rule.

Franchisors should immediately ascertain which platforms and procedures for electronic disclosure would best suit their needs and practices; commence creating the infrastructure for such electronic disclosure platforms at the earliest possible time; ensure that they address the means they will utilize to capture and authenticate Item 23 receipts and, in connection therewith, provide for procedures to be followed to identify, and confirm receipt by, representatives of prospective franchisees identified and authorized by them to receive disclosure on the prospective franchisees’ behalf.

Identify the methods in which electronic disclosure prerequisites will be disclosed to prospective franchisees, recalling that franchisors may communicate such prerequisites in any manner they desire (whether by email, franchise application forms, marketing materials or otherwise) so long as they can verify that disclosure of such prerequisites was perfected.

Ascertain what Revised Rule exemptions the franchisor may qualify for. In this regard, it is vital to closely analyze each such Revised Rule exemption and determine its applicability to the universe of prospective franchisees.

An interesting dialogue is taking place in the franchisor community regarding whether franchisors should continue to engage in disclosure notwithstanding any available exemption therefrom. Many franchisors view disclosure not just

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as a legal obligation but, affirmatively, as a useful tool for imparting the benefits of and the realistic expectations to be derived from their networks and, defensively, as a tool to prove in any subsequent dispute the plethora of truthful information which the prospective franchisee received before executing his/her/its franchise agreement. Especially given the authority conferred by the Revised Rule to disseminate disclosure documents electronically, many franchisors are now considering whether to proceed with disclosure activity notwithstanding any available exemption therefrom.

Revise franchise and franchise-related agreements to make sure that any waivers, integration clauses, disclaimers and/or acknowledgments set forth therein specifically do not apply to the franchisor’s disclosure document representations.

Determine which individual to disclose on the cover page of the Revised Rule disclosure document as the “contact person” from whom prospective for can obtain disclosure documents in an alternative medium.

Prepare an Item 23 receipt setting forth the identity of the broker(s) utilized by the franchisor to offer and sell franchises or, if more than one is utilized, setting forth a “fill in the blank” space in which the identity of the specific broker dealing with a prospective franchisee will be inscribed.

Determine which officers, directors and management personnel of the franchisor’s parent and/or affiliates will have management responsibility for the franchises being offered and obtain required biographical information concerning each.

Obtain from all relevant counsel the necessary information to prepare a schedule of all material litigation commenced by the franchisor against any of its franchisees within the past fiscal year.

Obtain from all necessary counsel information pertaining to any litigation, either pending or concluded, which was commenced against such of the franchisor’s parent and/or affiliates which either guarantee the franchisor’s performance or sold franchises in any line of business within the past ten years. Ascertain which such litigation must be disclosed under the Revised Rule’s new Item 3 mandates.

Determine if the franchisor’s business platform may be advantaged by the Revised Rule’s conferral of authority to negotiate franchise agreement terms adverse to the franchisee (which is permitted by the Revised Rule only if it is the franchisee which instigates negotiations).

Arrange for IT personnel to summarize the computer hardware and software requirements imposed upon franchisees for inclusion in Item 11 of the Revised Rule disclosure document.

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Prepare an analysis of all modes of product or service distribution - - including the internet, catalogs, telemarketing, nontraditional locations, dual distribution and/or competitive networks or units operated under different names/marks - - for use in preparing Revised Rule Item 12’s new territorial disclosures.

Ascertain what, if any, patent the franchisor may have applied for at the USPTO which has not yet been granted.

Closely review all franchise termination, transfer, reacquisition, non-renewal and “cease to do business” activities which transpired in the franchise network during the prior three fiscal years. Where multiple such events transpired for the same franchise (such as abandonment by the franchisee, termination by the franchisor, and then reacquisition by the franchisor), determine which event came “last in time”. Following analysis of such information, set forth in tabular fashion that information required by Item 20 of the Revised Rule.

Prepare a new or amended Item 19, if desired, to take advantage of the Revised Rule’s authorization to utilize subsets of franchisees when preparing and imparting such disclosures.

Whether or not the franchisor features Item 19 financial performance representations in its disclosure document, prepare or update franchise advertising, marketing materials and presentations to incorporate “cost only” financial performance disclosures, as permitted by the Revised Rule.

Revise the franchisor’s internal communications policy regarding press releases, interviews, speeches and other communications which, under the Revised Rule, may now include financial performance (“earnings claim”) information - - if not intended to be communicated to franchisees as part of the franchise marketing effort - - even absent any Item 19 financial performance disclosures by the franchisor.

Revise the contact information for franchisees which have left the system to eliminate their home addresses and telephone numbers. Substitute instead their names, cities, states and business telephone numbers (or, if unknown, their last home telephone numbers).

Analyze instances in which the same unit was repeatedly franchised to more than one franchisee in connection with Revised Rule Item 20’s required disclosure pertaining to possible “churning” activity.

Analyze any instance in the past fiscal year in which one or more franchisees have been or will be contractually precluded in any manner from freely communicating with prospective franchisees about their experiences in the franchise system.

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Prepare a schedule of all trademark-specific franchisee organizations which the franchisor sponsors, supports or endorses, and await request(s) from independent franchisee associations regarding their desire to be disclosed in Item 20 of the franchisor’s Revised Rule disclosure document (such requests must come within sixty days of the close of the franchisor’s fiscal year and need be honored only if the independent franchisee association is organized under state law).

Prepare to disclose the financial statements of the franchisor’s parent if that parent either guarantees the franchisor’s obligations or commits to perform post-sale obligations to franchisees on behalf of the franchisor.

Analyze whether franchise renewal practices require disclosure under the Revised Rule. If no fee is paid in connection with any franchise renewal - - whether the renewal agreement is identical or markedly different from the expiring agreement - - then no disclosure is required under the Rule. If the expiring contract is extended in return for a fee, same result. Similarly, if a new contract is entered into at renewal which contains no new material conditions differing from the expiring contract, even if a renewal fee is paid, then once again no disclosure is required by the Revised Rule.

Conduct comprehensive internal compliance training for all of the franchisor’s officers, management personnel, franchise salespersons, counsel and brokers regarding the requirements, restrictions and permissive grants of the Revised Rule.

XXIII. TABLE OF REVISED FTC FRANCHISE RULE VARIATIONS FROM UFOC GUIDELINES

Appended to this Report as Exhibit A is a table summarizing how the revised FTC Franchise Rule’s definitions, directives and disclosure requirements vary from and/or contrast with those of today’s UFOC Guidelines (as required for use by the franchise regulating states).

XXIV. SAMPLE REVISED FTC FRANCHISE RULE DISCLOSURE DOCUMENT

Appended to this report as Exhibit B is a sample franchise disclosure document geared to the new disclosure platform established by the revised FTC Franchise Rule, blacklined and annotated to convey such new requirements and to contrast how the document varies from one prepared under today’s UFOC Guidelines.

XXV. CONCLUSION

The revised FTC Franchise Rule and its accompanying Statement of Basis and Purpose are remarkably visionary, expansive and responsive. They reflect a commitment by the FTC to evolve the federal regulation of franchising in the United

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States to take into account the massive transformation of that critical component of the American economy over the past three decades and the changes in society, demographics, economics and technology since the original FTC Franchise Rule was first promulgated in 1978. The Commission is to be commended not only for its ambition in trying to achieve this goal but also for doing so in a fashion charged with intellect, imagination and balance.

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HIGHLIGHTS AND ANALYSIS: THE REVISED FEDERAL TRADE COMMISSION

FRANCHISE RULE

EXHIBIT A

SUMMARY OF REVISED FTC FRANCHISE RULE DISCLOSUREVARIATIONS FROM UFOC GUIDELINES

Topic Revised FTC Franchise Rule Variation From UFOC Guidelines

Remarks

DefinitionsAction SameAffiliate An entity controlled by, controlling, or under common

control with, another entity. Under UFOC Guidelines, disclosures about affiliates in certain Items are limited to some subcategories of affiliates. This is true to a lesser extent in the RR.

Confidentiality Clause

Any contract, order, or settlement provision that directly or indirectly restricts a current or former franchisee from discussing his or her personal experience as a franchisee in the franchisor’s system with any prospective franchisee. It does not include clauses that protect franchisor’s trademarks or other proprietary information.

This concept does not appear in the UFOC Guidelines.

Disclose, state, describe, and list

Each mean to present all material facts accurately, clearly, concisely, and legibly in plain English

UFOC Guidelines define “disclose” alone, but they also impose plain English requirement.

Financial performance representation

Any representation, including any oral, written, or visual representation to a prospective franchisee, including a representation in the general media that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables is a financial performance representation.

Replaces UFOC Guidelines term “Earnings Claim.”

Fiscal year The franchisor’s fiscal yearFractional franchise

A franchise relationship that satisfies the following criteria when the relationship is created: Franchisee, any of its current directors or officers, or

any current directors or officers of a parent or affiliate has more than 2 years of experience in the same type of business; and

Parties have a reasonable basis to anticipate that sales arising from relationship will not exceed 20% of franchisee’s total dollar volume in sales during first year of operation.

No parallel definition in UFOC Guidelines.

Franchise Any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises

No parallel definition in UFOC Guidelines; definition depends on law of state in

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Topic Revised FTC Franchise Rule Variation From UFOC Guidelines

Remarks

or represents, orally or in writing, that: A franchisee will obtain the right to operate a

business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;

The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.

question.

Franchisee Any person who is granted a franchise. No parallel definition in UFOC Guidelines; definition depends on law of state in question.

Franchise seller A person that offers for sale, sells, or arranges for the sale of a franchise. It includes the franchisor and the franchisor’s employees, representatives, agents, subfranchisors, and third-party brokers who are involved in franchise sales activities. It does not include existing franchisees who sell only their own outlet and who are otherwise not engaged in franchise sales on behalf of the franchisor.

No parallel definition in UFOC Guidelines; definition depends on law of state in question.

Franchisor Any person who grants a franchise and participates in the franchise relationship. Unless otherwise stated, definition includes subfranchisors. For purposes of this definition, a “subfranchisor” means a person who functions as a franchisor by engaging in both pre-sale activities and post-sale performance.

No parallel definition in UFOC Guidelines; definition depends on law of state in question.

Leased department

An arrangement whereby a retailer licenses or otherwise permits a seller to conduct business from the retailer’s location where the seller purchases no goods, services, or commodities directly or indirectly from: the retailer; a person the retailer requires the seller to do business with; or a retailer-affiliate if the retailer advises the seller to do business with the affiliate.

No parallel definition in UFOC Guidelines; definition depends on law of state in question.

Parent An entity that controls another entity directly, or indirectly through one or more subsidiaries.

Term used from time to time in UFOC Guidelines but not defined.

Person Any individual, group, association, limited or general partnership, corporation, or any other entity.

Only defined for purposes of Item 4: includes natural persons and legal entities listed in Items 1 and 2, but not anyone acting solely as franchisor's agent for service of process.

Plain English The organization of information and language usage understandable by a person unfamiliar with the franchise business. It incorporates short sentences; definite, concrete, everyday language; active voice; and,

Footnotes to General Instructions #150 of UFOC Guidelines give many specific examples of prohibited and

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Topic Revised FTC Franchise Rule Variation From UFOC Guidelines

Remarks

tabular presentation of information where possible. It avoids legal jargon; highly technical business terms, and multiple negatives.

preferred usages; none in the RR.

Predecessor SamePrincipal business address

Street address of a person’s home office in United States. It cannot be a post office box or private mail drop.

Unlike UFOC Guidelines, must be a street address and cannot be a post office box or private mail drop.

Prospective franchisee

Any person (including any agent, representative, or employee) who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship.

Not defined in UFOC Guidelines.

Required payment

All consideration that the franchisee must pay to the franchisor or an affiliate, either by contract or by practical necessity, as a condition of obtaining or commencing operation of the franchise. A required payment does not include payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or lease.

No parallel definition in UFOC Guidelines; definition depends on definition of “franchise fee” under law of state in question.

Sale of a franchise

An agreement whereby a person obtains a franchise from a franchise seller for value by purchase, license, or otherwise. It does not include extending or renewing an existing franchise agreement where there has been no interruption in the franchisee’s operation of the business, unless the new agreement contains terms and conditions that differ materially from the original agreement. It also does not include the transfer of a franchise by an existing franchisee where the franchisor has had no significant involvement with the prospective transferee. A franchisor’s approval or disapproval of a transfer alone is not deemed to be significant involvement.

No parallel definition in UFOC Guidelines; definition depends on law of state in question

Signature A person’s affirmative step to authenticate his or her identity. includes a person’s handwritten signature, as well as a person’s use of security codes, passwords, electronic signatures, and similar devices to authenticate his or her identity.

No parallel definition in UFOC Guidelines.

Trademark Includes trademarks, service marks, names, logos, and other commercial symbols.

No parallel definition in UFOC Guidelines.

Written or in writing

Any document or information in printed form or in any form capable of being preserved in tangible form and read. It includes: type-set, word processed, or handwritten document; information on computer disk or CD-ROM; information sent via email; or information posted on the Internet. It does not include mere oral statements.

No parallel definition in UFOC Guidelines.

Cover PageCombines former “FTC cover page” with former “state cover page,” with additional mandated disclosures. No required risk factors, but franchisors can add state risk factors. Must advise prospective franchisees that they must receive the disclosure documents 14 calendar days prior to signing a binding agreement or making a payment to the franchisor or an affiliate. Franchisor also has the option to include a statement about electronic

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Topic Revised FTC Franchise Rule Variation From UFOC Guidelines

Remarks

disclosure.Table of Contents

Several Items have different titles: 1. The Franchisor and any Parents, Predecessors,

and Affiliates 5. Initial Fees 7. Your Estimated Initial Investment 11. Franchisor’s Assistance, Advertising, Computer

Systems, and Training 19. Financial Performance Representations 20. Outlets and Franchisee Information 23. Receipts

Item 1 The Franchisor and any Parents, Predecessors, and AffiliatesParent Name and principal business address of any parents.Item 2 Business ExperiencePersons disclosed

Directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of franchises offered by disclosure document (this can include parent’s managers).

Brokers No disclosure required unless mandated by state law.Item 3 LitigationPersons involved Franchisor; a predecessor; a parent or affiliate who

induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor’s performance; an affiliate who offers franchises under the franchisor’s principal trademark; and, any person in Item 2.

Parents Disclose parent litigation if parent guarantees performance of franchisor

Affiliates Disclosure of government litigation required if affiliate has offered or sold franchises in any line of business within the last 10 years. Other litigation need be disclosed only for affiliates who offer franchises under franchisor’s principal trademark.

UFOC Guidelines limited affiliate disclosures to affiliates offering franchises under the franchisor's principal trademarks.

Actions by franchisors against franchisees

Material actions by franchisors involving franchise relationship (i.e., against franchisees) in past fiscal year. Suits involving franchise relationship include those directly relating to the operation of the franchised business, such as royalty payment and training obligation. May list such suits under a common heading such as “royalty collection suits” without providing detailed narrative.

Item 4 BankruptcySame, except that RR also requires disclosure of bankruptcy history of any individual, regardless of affiliation with the franchisor, who will have management responsibility relating to the sale or operation of franchises offered. (Also requires disclosure of any affiliate’s bankruptcy history).

Item 5 Initial FeesSame

Item 6 Other Fees

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Topic Revised FTC Franchise Rule Variation From UFOC Guidelines

Remarks

SameItem 7 Your Estimated Initial Investment

Same. Staff agrees with Commentary to UFOC Guidelines that owner’s salary can be excluded from “additional funds” estimate and will state this in Compliance Guide.

Item 8 Restrictions on Sources of Products and ServicesOfficer interests Must disclose any supplier in which an officer of the

franchisor owns an interest.Item 9 Franchisee’s Obligations

Same.Item 10 Financing

SameItem 11 Franchisor’s Assistance, Advertising, Computer Systems, and

TrainingTraining Training schedule does not require instructional material

but this must be disclosed in narrative form.Computers and Electronic Cash Registers

Simplified description of equipment – must be described generally in non-technical language.

Item 12 TerritoryAlternate distribution by franchisor

Expanded disclosures of whether franchisor or an affiliate has used or reserves the right to use other channels of distribution, such as the Internet, catalog sales, telemarketing, or other directmarketing sales, to make sales within the franchisee’s territory using the franchisor’s principal trademarks or other marks.

Compensation for orders within territory

Must disclose any compensation that the franchisor must pay for soliciting or accepting orders from inside the franchisee’s territory.

Alternate distribution by franchisee

Disclose whether the franchisee has the right to use other channels of distribution, such as Internet, catalog sales, telemarketing, or other direct marketing, to make sales outside of his or her territory.

Restrictions Disclose any restrictions on franchisee concerning sales outside territory.

New disclaimer language

If no exclusive territory, must state: “You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control.”

Item 13 TrademarksNew disclaimer language

If no federally registered trademark on Principal Register, state: “We do not have a federal registration for our principal trademark. Therefore, our trademark does not have many legal benefits and rights as a federally registered trademark. If our right to use the trademark is challenged, you may have to change to an alternative trademark, which may increase your expenses.”

Item 14 Patents, Copyrights, and Proprietary InformationSame, except that RR also requires disclosure of each pending patent application that is material to the

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Topic Revised FTC Franchise Rule Variation From UFOC Guidelines

Remarks

franchise, and as to each, state: type of application, serial number, filing date and title.

Item 15 Obligation to Participate in the Actual Operation of the Franchise BusinessSame

Item 16 Restrictions on What the Franchisee May SellSame.

Item 17 Renewal, Termination, Transfer, and Dispute ResolutionDefine meaning of the term “renew” in the franchise system. If applicable, state that franchisees may be asked to sign a contract with materially different terms and conditions than their original contract.

Item 18 Public FiguresSame.

Item 19 Financial Performance RepresentationsIntroduction State: “The FTC’s Franchise Rule permits a franchisor

to provide information about the actual or potential financial performance of its franchised and/or franchisor-owned outlets, if there is a reasonable basis for the information, and if the information is included in the disclosure document. Financial performance information that differs from that included in Item 19 may be given only if: (1) a franchisor provides the actual records of an existing outlet you are considering buying; or (2) a franchisor supplements the information provided in this Item 19, for example, by providing information about possible performance at a particular location or under particular circumstances.”

If no Item 19 disclosure is made

Also state: “We do not make any representations about a franchisee’s future financial performance or the past financial performance of company-owned or franchised outlets. We also do not authorize our employees or representatives to make any such representations either orally or in writing. If you are purchasing an existing outlet, however, we may provide you with the actual records of that outlet. If you receive any other financial performance information or projections of your future income, you should report it to the franchisor’s management by contacting [name, address and telephone number], the Federal Trade Commission, and the appropriate state regulatory agencies.”

Expenses Unlike UFOC Guidelines, provides that statements of expenses, standing alone, do no represent financial performance representation. Therefore costs and expenses can be disclosed without Item 19 disclosures.

If Item 19 disclosure is made

Financial performance representation may relate to the performance of all of the franchise system’s existing outlets or only to a subgroup of outlets that share a particular set of characteristics – for example, geographic location, type of location (such as free standing vs. shopping center), degree of competition in the market area, length of time the outlets have operated, services or goods sold, services supplied by the franchisor, and whether the outlets are franchised

Requirement for geographic relevance in the original FTC Franchise Rule deleted from the RR.

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Topic Revised FTC Franchise Rule Variation From UFOC Guidelines

Remarks

or franchisor-owned or operated.Item 20 Outlets and Franchisee InformationTables 5 tables. In each table, the years referred to are

specifically shown for each box, making tables easier to interpret.

Table 1 Systemwide Outlet Summary – Company-owned and franchised outlets open at beginning of period, opened, closed and open at end of period.

Table 2 Transfers of Outlets from Franchisees to New Owners (other than the Franchisor) –over past three years

Table 3 Status of Franchised Outlets – turnover rate for past three years

Table 4 Status of Company-Owned Outlets – turnover rate for past three years

Table 5 Projected Openings As Of [Last Day of Last Fiscal Year]Multiple Events If multiple events affected ownership of an outlet, report

the event that occurred last in time.If a single outlet changed ownership two or more times during the same fiscal year, use footnotes to describe the type of changes involved and the location in which the changes occurred.

Former Franchisees

Consistent with UFOC Guidelines, but disclosure of business telephone number instead of home telephone number if known. RR also requires the statement, “If you buy this franchise, your contact information may be disclosed to other buyers when you leave the franchise system.” At the request of the former franchisee, the franchisor may substitute alternate contact information, such as a home address, post office box, or a personal or business e-mail address.

Sale of previously owned franchise outlets now under Franchisor control

Must disclose additional information not required to be disclosed in the UFOC. Either in the disclosure document, or, if disclosure has already been made, then in a supplement, provide: Contact information for each previous owner; Time period when each previous owner controlled

the outlet; Reason for the change in ownership; Time period when franchisor controlled the outlet.

Confidentiality Clauses

If franchisees signed confidentiality clauses during the last three fiscal years, state: “In some instances, current and former franchisees sign provisions restricting their ability to speak openly about their experience with [name of franchise system]. You may wish to speak with current and former franchisees, but be aware that not all such franchisees will be able to communicate with you.”

Franchisee associations

Disclose information concerning each trademark-specific franchisee organization associated with the franchise system being offered, if the organization: (a) has been created, sponsored, or endorsed by the franchisor (if so, state relationship between the organization and the franchisor); or (b) is incorporated or otherwise organized under state law and asks the franchisor to be included in the franchisor’s disclosure document during the next fiscal year. Such requests

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Topic Revised FTC Franchise Rule Variation From UFOC Guidelines

Remarks

must be renewed annually no later than 60 days after the close of the franchisor’s fiscal year end.

Item 21 Financial StatementsSubfranchisors Must disclose all subfranchisors’ financial statements.Parents Include parent financials only if parent commits to fulfill

post-sale obligations of franchisor or guarantees obligations of franchisor (if so, guarantee must be included in disclosure document).

GAAP Financial statements must be according to U.S. GAAP unless otherwise permitted by SEC (entitles foreign franchisors to use non-GAAP financial statements if they reconcile them to U.S. GAAP through footnotes and explanations).

Start-up Franchisors

May phase-in the use of audited financial statements over a three year period, including the use of an unaudited opening balance sheet in year 1.

Item 22 ContractsSame

Item 23 ReceiptsSame. In addition, RR authorizes electronic receipts and requires franchisors to maintain copies of all UFOC Receipts for at least three years.

Prospect must receive the Disclosure Document 14 calendar days before signing a binding agreement with or making a payment to the franchisor or an affiliate. (UFOC Guidelines require 10 business days.)

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