How To Develop A Franchise System: Part 10: Regulatory Framework
The laws that regulate the franchising industry are different at the federal and state level. Additionally, each state has different laws that regulate franchising within its borders. We will look at compliance to the Registration and Disclosure laws applicable in 14 states, such as California, Illinois, New York, Virginia, Michigan, and others. We'll also examine the laws in detail related to an Item 19 disclosure, the Financial Performance Representation, and what type of statements could get you into legal trouble.
As a franchisor, you need to make sure your franchise system is compliant in the appropriate locations. Working with qualified franchise lawyers to develop your system and Franchise Disclosure Document is vital.
Let’s take a look at the regulatory framework for franchising. Remember that the state laws are not fully preempted by federal law; there are more restrictive laws at the state level. You still have to comply with the FTC Rule, but you also have to comply with the rules in that state. State registration laws are required to be met before you can make an offer in that state. So if you are a corporation in that state or you are selling into that state, making a franchise offer in that state, you have to comply with the laws in that state.
Registration or disclosure laws at a state level apply in 14 states that have filing or registration laws. With some lawyers, they’ll debate whether it’s 14 states or 11; generally there are 14 states most people consider to be in this bucket of disclosure or registration filing states. The registration framework is in the states of California, Hawaii, Illinois, Indiana is a filing state only, Maryland is a registration state, Michigan is a filing state, Minnesota, Oregon is a filing state, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin are the registration and filing states.
So in those states you are sending your documents in to the state regulator in advance, and in those states which are registration states and not filing states, you will generally get comments back and you’ll make some changes to your agreements and your disclosure documents if necessary; and you can’t use or offer franchises in those states, generally, until you’ve gotten state approval to do so.
What state’s law apply? It’s where the franchisee’s principal place of business is located, where will the franchisee be opening up their location. So if you are in Pennsylvania and you are offering a franchise in Maryland, you have to have your documents approved by the state regulator in Maryland because that’s a registration state. Where is the franchisor’s business located? If you are a franchisor in Maryland while your potential franchisee is in Pennsylvania, which is not a registration state, you as a franchisor need to get your documents reviewed prior to making offers outside of your state. That’s not true in every state, but it is true in some states. You have to be very careful of making sure that your lawyers will explain to you which states you need to be registered in.
Regarding franchise relation laws, we’ll start to look at issues around terminations, renewals, transfers, discrimination, product sourcing, and those laws will override your franchise agreements unless you’re carefully writing your franchise agreements to be in compliance. You have to make certain that when you’re working on the development of franchise documents, that even if it looks like you are answering questions in a bucket area, or your attorney says to you they believe this is the correct way, working with qualified franchise lawyers is essential because what you don’t want to have is thinking you have rights in an agreement when the local law is overriding the expressed terms of your agreement. That’s not good for you, and it’s not good for the potential franchisee.
Additional state filing requirements are important to understand. In California, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota and Washington, you have to seek approval in advance of your marketing material for prospective franchisees. In California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota and Washington, those states are going to require you to have anybody who’s a sales agent, a broker, fill out a disclosure form and submit those. In a group of states, California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia and Washington, it’s not sufficient just to have an audited financial statement; you need the auditor’s consent for their documents to be in your disclosure documents. So there’s no point not knowing that, sending it to the state regulators, and getting it bounced back for something that’s a fairly routine experience.
There are exemptions to state registration, a handful of them; something to be aware of is that large franchisees, those franchisees that have been in business for five years or longer, those franchisees with a minimum net worth of $5 million dollars, may provide you with an exemption that you can offer them a franchise without going through state registration. Large initial investments, where the initial individual investment is at least $1 million dollars will allow you to exclude financing received on the franchise system.
Other exemptions that will take place are sales to existing franchisees, franchisee to franchisee transfers, isolated franchises in some states where not more than one sale is going to take place in a 12-month period, sales to insiders at your corporation may not need to meet state registration because it’s an insider transaction. There are exemptions for large net worth and experienced franchisors, so you’ll see that many franchisors, once they reach a certain size, will apply for an exemption in the state and if the state has the exemption, they may not need to register going forward because of their size.
These exemptions vary from state to state, and you have to be careful that you don’t assume that just because you meet an exemption in one state, you’re now exempt in other states. Again, you’re dealing with an area of the law which experienced franchise counsel will understand, experienced franchise consultants will understand, but most general counsel - people that deal in franchising only occasionally - they may get tripped up on it, and it’s simple enough to just deal with experienced counsel.
21 jurisdictions regulate some aspect of the franchise relationship. 20 states have relationship laws that limit your rights to terminate franchises, and those limitations may be that you need good cause, that you have to give them advance notice, generally 30 to 120 days, that your term of renewal in good faith and notice in disputes - these are all areas where relationship laws are important; again, you’re going to be working with counsel and once counsel gives you advice you’re usually fine with that.
19 states are going to restrict your rights not to renew, so you may think that just because your contract ends that you don’t have to give the franchisee a renewal term, quite frankly that might be limited by good cause, an advance notice of non-renewal. Four states, California, Illinois, Michigan and Washington, require a non-renewing franchisor to actually repurchase the franchisee’s assets. So you have to be somewhat careful what states you’re going into and understand what happens at the end of the term as far as your restrictions not to renew a franchisee in those states.
The relationship law states, those states that may have issues related to non-renewal and termination and things like that, are Alaska, Arkansas, California, Connecticut, Delaware, District of Columbia has that rule, Hawaii, Illinois, Indiana, Iowa, Louisiana, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, North Carolina, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin.
Also keep in mind there is no right of private action under the FTC Rule. What that basically means is if a franchisor violates the federal trade commission’s franchise rule, you can’t generally sue the franchisor for the violation of the rule, it’s a regulatory matter, and only the FTC can take action against the franchisor. However, there are states that have what we call a “little FTC acts” which may provide you with additional rights to take action personally against the franchisor for violation of the rule. It depends upon the language in each state law, so if you are looking as a franchisee that you believe the franchisor may have violated the rule and it’s part of what you are looking to litigate or arbitrate over, just because there’s no private right of action under the federal rule, speaking to a qualified franchisee lawyer, they can tell you where there’s a baby FTC act or little state FTC act which may give you additional rights to take action and hold the franchisor’s feet to the fire.
Some states prohibit discriminating against similarly situated franchisees, and what we’re talking about there is negotiations. So those laws are in Hawaii, Illinois, Indiana, Minnesota, Washington, for instance; California requires disclosure of material changes within the last 12 months. And there are variations in initial franchise fees that have to be disclosed in Item 5 in various states. When you are a franchisor, especially when you’re a new franchisor, there’s always a sense that you should negotiate with the franchisee terms just to make the sale. Understand that that may need to be disclosed, and once it’s disclosed, you can expect all of the other franchisees that will follow are going to want a similar type of change to their documents if it’s beneficial.
It’s for that reason that most franchisors don’t negotiate a lot of terms in their franchise agreement, and when they do, they do for specific reasons and they make certain that only people that meet those conditions are able to get those terms. We recommend if you are negotiating regularly terms to your franchise agreement, you might as well just put it into the franchise agreement and give that same condition to all franchisees. Not only is it fairer, but it makes it a lot easier as well as the process of bringing franchisees on board much easier.
You must provide a disclosure document to prospective franchisees, and who is a prospective franchisee? A prospective franchisee is any person who approaches you or is accepted by you as a potential franchisee. It’s I know that you’re a potential franchisee, I am interested in you becoming my franchisee. Once that bridge has been crossed, clearly the person needs to get a disclosure document.
The difference would be, if I am exhibiting at a trade show and a person comes up and discusses the franchise with me, they haven’t yet crossed the barrier of being a potential franchisee, they’re just somebody who stopped by the booth. At a point in time, though, we both recognize we’re entering into discussions, the potential franchisee can then ask for a copy of the document. So the prospective franchisee is anyone who you and they have entered into discussions and the potential for them to become a franchisee is there.
The person who comes to the trade show booth clearly is not a potential franchisee yet; they may become one. But a potential franchisee is entitled, upon request, to receive a copy of your disclosure document.
You are allowed to give the disclosure document electronically, so many franchisors today will send the disclosure document by e-mail, by CD, it may be available for download from Dropbox, there are now e-signatures which allow the potential franchisee to sign the 23rd item of the disclosure document, Item 23. It’s very important to keep that because as often as not, in litigation, the question of whether the disclosure took place appropriately, that receipt will verify that you did have the 14 days required.
Most franchisors today will be developing an e-version of the disclosure document. What you can’t do in that, is the document is still a static document, so you’re not going to have scroll bars, you’re not going to have search features, there’s not going to be any pop-ups or animations or links outside the electronic version any more than there would be in a printed version. So again, working with proper legal counsel and proper consulting counsel, you’re not going to spend money on taking your document and putting it into a format which will violate the law. Even though quite frankly, many of us in franchising expect that in the next couple of years, these types of additional information, linking to the document, will become possible; as of today it’s still not allowed.
So you must provide a prospect a disclosure document when you sell a new franchise, when you’re developing additional franchises under a development agreement, when the franchisee is transferring to a new franchise, when the agreements are being renewed, and the rule of thumb is, whenever a new franchise agreement is being signed, provide a disclosure document. It’s inexpensive, the franchisee is entitled to receive it, and even if they’re not legally entitled to receive it, morally they should know what they’re getting in the document, and we always recommend, and most professionals do, just simply give the document and you don’t have to worry about whether it’s in the law or outside the law, it’s the proper thing to do.
When do you have to provide the document? Clearly, there’s a 14-day rule. Prior to 2007 we had a 10-day rule and a 5-day rule, it’s now been simplified, 14 calendar days prior to anybody signing a franchise agreement, the prospective franchisee has to have the document. Just to be real careful, you don’t count the first day, you don’t count the last day, it’s 14 days in the middle, and you can just quickly look at a calendar, before they can take any money or sign an agreement.
Again, 7 days before the contract is signed, the franchisee must have the contract substantially filled out. If there are any changes unilaterally made by the franchisor, other than changes requested by the franchisee that are in their interest, then that document has to be complete in their hands. So generally it’s a good format to make certain that any of the negotiations take place prior to the 7 days running in that 14-day period, so that when you get to the closing of the document, it’s a complete document and there are not delays. Again, don’t count the first day, don’t count the last day, 7 days in between, 7 full days, is what you need before you sign the franchise agreement.
When do you amend a franchise agreement? Franchise agreements and disclosure documents generally are changed once a year, the annual re-filing at the end of your calendar or fiscal year. You’re going to look at the document and you are going to change it, you may have changes in fees, you’re certainly going to have changes in Item 20, which is going to talk about any new franchisees in or franchises that are out, so that you get your Item 20 charts, you may have changes to the investment, that generally happens once a year.
But, during the year you may have an obligation to amend your disclosure document. It’s really when anything significant that would influence a prospective franchisee in making an investment decision happens. So, changes in franchise management personnel, if there are significant changes, not if there are minor changes. Mergers and acquisitions involving the franchisor. New litigation or significant developments in existing cases, whether you’ve lost a case, whether a case has been filed that is of a material nature, and your lawyers will tell you when you’ve reached that burden. Changes to the development of the franchise agreement - you’ve made a decision to change the agreement so that it’s no longer the agreement that is part of the old disclosure document, you need a disclosure document. If there’s been an excessive number of closures, if there’s been an adverse change in your financial condition, all of those will require you, if they’re material enough, you’re going to need to change your disclosure document.
What generally happens, if it’s one of the FTC states, one of the states that is not a regulatory or registration state, in those states it’s relatively quick. Your attorneys will make the change, the next day you’re offering franchises again. In the registration states, you may have a dark period where until the state regulator looks at your documents and re-approves them, you may not be able to offer franchises in those states. So updating and amending your disclosure documents is not something you do easily, you do it when it’s necessary, but you don’t avoid doing it because quite frankly avoiding doing it is not out of the law.
What are the penalties for violating the rules? The consequences will vary by jurisdiction. If you fail to timely deliver the disclosure document, make claims inconsistent with the disclosure document, or otherwise misrepresent the franchise being sold, you’re going to likely face some very unpleasant consequences. Under the laws of several states your franchisee may have private rights to bring a lawsuit against you based on a violation of that state’s franchise disclosure rules. What’s the result? In private actions, they may seek rescissions or damages for your violating the laws.
On a public level, there may be civil fines against the company or its executives, including personally; you may have cease and desist orders against the company or its executives personally; in some jurisdictions, there may be criminal penalties against the company or its executives. You may have rescission, you may have to pay damages, you’re going to have to disclose the violation in your disclosure documents for the next ten years. Public remedies are very harsh and while criminal penalties are incredibly rare, the requirement to offer rescissions can be very expensive. The requirements for fines can be very expensive, so it’s an area where it’s not easy to violate the law and when it happens there are significant penalties in play there.
What are the keys to staying out of trouble? Get a qualified lawyer and consultant, and make sure they’re qualified. How do you find out if they’re qualified? Look at those that are in the American Bar Association franchise forum. Go to the International Franchise Association (IFA) and see who their member lawyers and consultants are. Go to publications and trade shows that are put on by companies like Franchise Update. Once you have a list of lawyers or consultants, call their clients. Make sure that you’re dealing with somebody who doesn’t ‘occasionally’ do franchise law, but does it frequently. Look for the people that are being asked to speak by their peers at American Bar Association conferences, at franchise forums put on by the International Franchise Association. You want to be talking to the folks that the other experts in the industry want to listen to.
So you want to have training. You want to make sure that your franchise sales force or your recruitment force has been trained, that they on a regular basis have somebody come in to do refresher training for them, you want to make certain that both your inside sales department and if you make the decision to use a broker network, that they’re being supervised. You want to make sure you understand what the franchise sales management process is. Don’t think as a franchisor that even though you’re not involved in franchise sales that the franchise salespeople should know something more than you; get trained by yourself so that you know that the person making the offering is doing it in your name, by the law.
You want to make sure there’s clear communication of the process to the prospective franchisee at each stage, and you want to have good record keeping. This is a very transparent process, when it’s done well everybody knows what’s going on, you can tell the prospective franchisee what the steps are in your process. In fact, if you go to better franchisors’ websites, they’ll have a list of here’s the process you’re going to go through to become a prospective franchisee, we want an application, we want to have interviews, we want you to come down to a Discovery Day because we want you to do the following, and then there’ll be an approval committee. The prospective franchisee should know what’s going on with those stages.
There’s a period of time, once you make the decision to become a franchisor, when you’re going to be really excited about the prospect that in two, three, four months you’re going to be offering franchises. Can you talk about franchising now? To a certain extent, you’re limited to what you can say to prospective franchisees before your franchise disclosure document is complete. Saying too much or saying the wrong thing can result in a delayed or even a lost sale. You might even have to later on rescind the sale based upon a civil or criminal violation of the rule. So you should not discuss the terms of your potential franchise system with potential franchisees, and the type of things you shouldn’t be talking about are the size of territories, the fees, the earnings of the business, the projected earnings of the business, who may qualify to be a franchisee.
Remember, the laws that deal with franchising are primarily the laws dealing with the offering of a franchise. Prior to becoming a franchisor, you cannot offer somebody to be a franchise or say to somebody, “Once I become a franchisor I want you as a franchisee.” You have to be real careful of what you can do.
What can you say before the FDD is complete? You can say that you’re planning to become a franchisor, or are in the process of preparing your FDD. You can certainly talk about the excitement of becoming a franchisor and what the concept is all about. You can tell them that when you’re ready to begin to offer franchising you’ll be happy to discuss it with them. You can take the prospect’s contact information. Just don’t discuss the terms that are going to go into the franchise because quite frankly, until you and your consultant, or you and your consultant and your lawyer, agree upon what goes into the FDD, your strategy may change or your fees may change, and also you’re not authorized by law to have those type of discussions.
You can go talk to the press. It’s kind of an odd thing about the Franchise Rule. I can’t make you an offer to become my franchisee before the documents are done, I can’t tell you what the fees are, but you can give an interview to the press saying we’re going to become a franchisor. That’s not considered an offer, even though that then gets printed. So you can discuss the franchise, where you’re planning on having them, what type of fees you’re generally going to be charging, just never hand that document to a prospective franchisee because that then would be an offer. It’s an odd part of the law and may sound a little silly, but it is something you have to get used to.
We discussed earlier a very key area of the disclosure document, Item 19, which is a financial performance representation or what used to be called, back in 2007 and prior, an earnings claim. That may be a term that you don’t hear being used. What is an FPR, the financial performance representation? It’s any written, oral or visual statement to prospective franchisees that claims, suggests or provides a formula for calculating a specific range of fees, or level of fees, or potential sales, costs, income or profit. It generally is, if you’re giving somebody information upon which they can calculate sales and gross profit and bottom line profit, that’s a financial performance representation.
If you’re going to make an FPR disclosure, it has to be made in writing, and it has to be in Item 19 of the disclosure document. You’re going to need to have a reasonable basis, and you’re going to have to be able to substantiate that basis should somebody ask you to do so. You’re going to have to state the basis in your notes, and what assumptions you’re using. Today about 50% of all franchisors, which is considerably up from the past, are providing an FPR.
So what types of comments can be made? You need to have a reasonable basis, and you need to be able to substantiate that basis. Acceptable disclosures are the franchisor’s financial statements, the auditing to be required, the claims that you make in an FDD, the operating costs not linked to sales. It’s an odd thing in franchising, I can leave out an Item 19 disclosure which deals with sales and gross profit and a lot of information, so I can have no disclosure in Item 19; but I’m allowed under the rule to give somebody a list of the costs that they will have in their business so long as I don’t link them to sales, I’m just giving gross costs. It’s an odd part of the law that came about in the 2007 period.
You can certainly refer franchisees to existing franchisees. You can give the prospective franchisees the complete books and records of any business that you’re intending to sell to them. So if you have an existing business and you and the prospective franchisee are in discussions about purchasing that business, they’re certainly entitled to the books and records of that business. You can also give information separate from the franchisee to the franchisee’s lender, so long as you get assurances that the lender, the banker, is not going to give that information through the back door to the prospective franchisee. Occasionally the banker will call up for information which is not provided in the disclosure document and in discussion with your lawyers, you may decide that it’s a good idea to give the banker the information so that the franchisee can get a loan.
What are some of the triggers? People try to say things that they think don’t violate the rules of the financial performance representation. If you say to somebody, clearly your franchise is going to do $2000 a week, real easy - that’s a financial performance representation, you’re telling them what their sales are. If you say to them, the average franchisee does $2000 a week or that we have franchisees that do $2000 a week, you’re giving somebody an exact number from which to calculate their gross sales. Same thing goes if you say to them that Time Magazine or Newsweek did a study of your franchise system and found out that the average is $2000 a week, any time you give a number like that, you’re telling the prospective franchisee what they get. But what happens when you say to the prospective franchisee, you know that new Mercedes you were talking about, or that new Porsche you were talking about, you buy my franchise and you’ll be able to get that car next year at this time. They know how much the Mercedes costs. They know how much the Porsche costs. That’s an earnings claim.
If you say to them things like, figure a 10 percent return on your investment. Well, they know what the investment is from Item 7, telling them they’re going to get a 10 percent return on their investment gives them a number to calculate. If you say to them things like, a third of your sales will be gross profit, you’ve given them a number to calculate. Anything that you are giving them or writing down for them that takes them down a path where they can clearly calculate what their sales or profits will be, is a financial performance representation.
There are things, though, which you can say that are quite frankly not an FPR, they’re considered puffing statements. You have to be somewhat careful on what is puffery. But if you’re saying things like, you can make enough money to retire, you’re gonna make big money, the location is phenomenal and I bet it’ll be one of our top performers, our opportunity is the opportunity of a lifetime, those type of statements are generally considered puffery, but not always. It depends upon the 12 happy citizens in the jury box, and the judge. So be careful making those statements, certainly don’t make them on a routine basis. Talk to your lawyer, get trained in franchise sales, they’re really not necessary to make in any event, but if you make them make sure they’re not going to lead someone to understand what their sales or costs are going to be.
One place where you always want your prospective franchisee to get their information from is the franchisees that are in your franchise system already. In Item 20 of your disclosure document is a list and contact information for your existing franchisees. Don’t tell them who to call on the list; you’re not going to direct them to your best franchisees, the ones that are happy; have them call all of your franchisees or as many as they want to call. They can ask them the questions. Don’t script the questions for them. Don’t limit who they can call. You’re going to bring that franchisee on, and keep in mind, they’re going to be with you for 10 or 20 years. You don’t want to mislead somebody into a relationship and then have to live with them for the next 20 years. This is an open and honest process that can be done very well.
The prospect may also go to the general industry, go to Google and do searches and get information of their own. They have to be somewhat careful as a prospective franchisee doing that, because not all franchise systems are fungible; some franchise industries have companies that are highly respected doing really terrific, their franchise sales at the unit level are going up every single year and in the same industry, you’re going to find companies that are suffering because they’re undercapitalized or the product is not as good, the management is not as good. Getting information on an industry is quite good but you should never as a potential franchisee rely upon that as an indication of what another company will do, nor should a franchisor send somebody to get information about another company, because it may not be accurate to them.
What type of information is included in the financial performance representation? The idea of expecting to see a financial statement with a balance sheet and cash flow statements and income statements - you’re not generally going to see that. The type of data you’re going to see is, 99% of systems will include sales and revenue data. About half of the systems will provide some expense data. A handful of systems, though, will include unit income statements. On company-owned locations, about 60% of franchise systems will use the franchisee unit information, about 40% will use company-owned information, others will overlap and use both.
Those laws of what you can include in the statements are changing as we speak. There’s a proposal now by the group which oversees the state regulators to decide what goes into an FPR. So make certain that the lawyer you’re working with or the consultant you’re working with, when you’re viewing this program, are understanding what the current law is and how the law has changed in the last couple of months or last couple of years. There are some reasons. I personally like to have a financial performance representation in our clients’ documents. The information is important for prospective franchisees, it’s going to help a prospective franchisee do their due diligence and receive reliable information. It protects you as a franchisor from verbal statements by a rogue salesperson trying to get a commission check, because the franchisee is going to sign a statement in a supplemental representation later on that’s going to say, all the information I have about unit performance came from the disclosure document, and I didn’t hear any information that came from another source.
So having an Item 19 disclosure will protect you to a reasonably good degree from verbal statements made by a salesperson just trying to get a commission check and close the sale. It’s a good thing to have in there for that reason.
Why wouldn’t you include it? Sometimes the information you’re receiving from your franchisees isn’t reliable. Sometimes there’s an expense of requiring the data which is too burdensome. For new or small franchise systems, you just may not have enough data to make a meaningful representation. Keep in mind, having one location in Des Moines, Iowa may not be relevant to somebody who’s going to be opening up ten locations in Los Angeles. Is the information you have relevant?
Is the information that you have on the type of business that the franchisee will be offering? If your current offering is a full service restaurant but your new franchise offering is the same food product being offered in a QSR or in a fast casual, in a kiosk, in a different environment than what you’re running, with different labor costs and different advertising and different real estate - you may have a product and service which people love and respect, but it may not be that you have data sufficient enough to make an Item 19 disclosure. And you also have to realize that experienced franchisors with new or substantially modified systems, if you are a current franchisor, and what you’re going to be offering is going to be a limited offering or more expanded offering than your current system, similar to what I said before, you may not really be able to include, nor should you include, an Item 19 financial performance representation.