Franchise Rule
Federal RegisterOct 22, 1999
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FEDERAL TRADE COMMISSION
16 CFR Part 436
Franchise Rule
AGENCY: Federal Trade Commission.
ACTION: Notice of proposed rulemaking.
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SUMMARY: The Federal Trade Commission (the ``Commission'' or ``FTC'')
is commencing a rulemaking to amend its Trade Regulation Rule entitled
``Disclosure Requirements and Prohibitions Concerning Franchising and
Business Opportunity Ventures'' (the ``Franchise Rule'' or ``the
Rule''), based upon the comments received in response to its Advance
Notice of Proposed Rulemaking (``ANPR'') and other information
discussed in this notice. The Franchise Rule requires the pre-sale
disclosure of material information to prospective franchisees about the
franchisor, the franchised business, and the terms and conditions that
govern the franchise relationship.
DATES: Comments must be submitted on or before December 21, 1999.
Rebuttal comments may be submitted on or before January 31, 2000.
ADDRESSES: Written comments should be identified as ``16 CFR Part 436--
Franchise Rule Comment'' and sent to Secretary, Federal Trade
Commission, Room 159, 600 Pennsylvania Avenue, NW., Washington, DC
20580. To encourage prompt and efficient review and dissemination of
the comments to the public, all written comments should also be
submitted, if possible, in electronic form, on either a 5\1/4\ or a
3\1/2\ inch computer disk, with a label on the disk stating the name of
the commenter and the name and version of the word processing program
used to create the document. Programs based on DOS are preferred. Files
from other operating systems should be submitted in ASCII text format
to be accepted. The Commission will also accept comments submitted to
the following E-mail address: ``[email protected]''. In addition,
commenters may leave a short comment on a telephone hotline number
designated for this purpose only: (202) 325-3573.
FOR FURTHER INFORMATION CONTACT: Steven Toporoff, (202) 326-3135, or
Myra Howard (202) 326-2047, Division of Marketing Practices, Room 238,
Bureau of Consumer Protection, Federal Trade Commission, 600
Pennsylvania Avenue, NW., Washington, DC 20580.
SUPPLEMENTARY INFORMATION:
The Commission invites interested parties to submit data, views,
and arguments on the proposed changes to the Rule and to address
specifically the questions set forth in Section H of this notice. The
comment period will remain open for 60 days. All comments will be
available on the public record and, to the extent practicable, placed
on the Commission's Internet web site: http://www.ftc.gov>. After the
close of the comment period, the record will remain open for another 40
days for rebuttal comments. If necessary, the Commission will also hold
hearings with cross-examination and post-hearing rebuttal submissions,
as specified in section 18(c) of the Federal Trade Commission Act, 15
U.S.C. 57a(c). Parties who request a hearing must file within the 60-
day period a comment in response to this notice and a statement
explaining why they believe a hearing is warranted and how they would
participate in a hearing. Parties interested in a hearing must also
designate specific facts in dispute and submit a summary of their
expected testimony within the comment period. In lieu of a hearing, the
Commission will also consider requests to hold additional informal
public workshop conferences to discuss the issues raised in this notice
and the comments.
Section A. Background
The Commission is publishing this notice pursuant to section 18 of
the Federal Trade Commission (``FTC'') Act, 15 U.S.C. 57a et seq., and
Part 1, Subpart B, of the Commission's Rules of Practice. 16 CFR 1.7,
and 5 U.S.C. 551 et seq. This authority permits the Commission to
promulgate, modify, and repeal trade regulation rules that define with
specificity acts or practices that are unfair or deceptive in or
affecting commerce within the meaning of section 5(a)(1) of the FTC
Act. 15 U.S.C. 45(a)(1).
1. The Franchise Rule
The Commission promulgated the Franchise Rule on December 21,
1978.1 Based upon the original rulemaking record, the
Commission found a serious informational imbalance between prospective
franchisees and their franchisors, enabling franchisors to defraud
prospective franchisees through both material misrepresentations and
nondisclosures of material facts.2 The Commission concluded
that these practices led to serious economic harm to
franchisees.3
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\1\ 43 FR 59614 (December 21, 1978).
\2\ Statement of Basis and Purpose (``SBP''), 43 FR 59621, 59625
(December 21, 1978).
\3\ Id.
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To prevent fraudulent franchise sales practices, the Commission
adopted a pre-sale disclosure rule. The Franchise Rule does not purport
to regulate the substantive terms of the franchise relationship.
Rather, it requires franchisors to disclose material information to
prospective franchisees on the theory that an informed consumer can
determine whether a franchise deal is in his or her best interest. The
Franchise Rule provides prospective franchisees with four basic types
of material disclosures. First, there are disclosures about the nature
of the franchisor and the franchise system. For example, the franchisor
must disclose the business background of the franchisor and its
officers, their litigation history--including suits filed by
franchisees concerning the franchise relationship--and statistics on
the number of franchisees who have left the system. Second, there are
disclosures that enable a prospective franchisee to assess the
franchisor's financial viability and, thus, ability to perform as
promised. These disclosures include the bankruptcy history of the
franchisor and its officers, as well as the franchisor's audited
financial statements. Third, there are disclosures about the material
costs of the franchise, as well as the terms and conditions that govern
the franchise relationship. Finally, there are disclosures that enable
prospective franchisees to conduct their own due diligence
investigation of the franchise offering, including the names and
addresses of current franchisees.
2. Initial Franchise Rule Review and Request for Comments
In April 1995, as part of its continuing review of FTC trade
regulation rules, the Commission published in the Federal Register a
request for comment on the Rule (``Rule Review Notice'') 4
to determine the Rule's current effectiveness and impact. The Rule
Review Notice sought comment on the standard regulatory review
questions, such as the costs and benefits of the Rule, what changes in
the Rule would increase the Rule's benefits to consumers, how would
those changes affect compliance costs, and what changes in the
marketplace and new technologies may affect the Rule.5
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\4\ 60 FR 17656 (April 7, 1995).
\5\ References to the Rule Review comments are cited as: the
name of the commenter, RR, commenter number (e.g., NASAA, RR,
Comment 43). Commission staff also held two public workshop
conferences on the Rule. References to the two Rule Review public
workshop transcripts are cited as: name of commenter, Sept. 95 Tr or
March 96 Tr, respectively (e.g., D'Imperio, Sept. 95 Tr, and
Ainsley, March 96 Tr).
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[[Page 57295]]
3. Advanced Notice of Proposed Rulemaking
Based upon the comments received during the Rule Review, the
Commission tentatively determined to retain the Franchise Rule, but
sought additional comment on possible amendments to the Rule. To that
end, in February 1997, the Commission published an ANPR, 6
seeking comment on specific issues, including: (1) Whether the
Commission should separate the disclosure requirements for business
opportunities from those for franchises; (2) whether the Commission
should revise the Rule's pre-sale disclosures based on the Uniform
Franchise Offering Circular (``UFOC'') Guidelines promulgated by the
North American Securities Administrators Association (``NASAA''); (3)
whether the Commission should modify the Rule to clarify that the Rule
does not reach the sale of franchises to be located or operated outside
the United States, its territories, and possessions; and (4) whether
the Commission should permit franchisors to comply with the Franchise
Rule's disclosure obligations by posting disclosure documents on the
Internet? On the assumption that the Commission would revise the Rule
based upon the UFOC Guidelines model, the Commission solicited
additional comment on specific disclosure items, including: (1) Whether
the Commission should modify the litigation disclosures (UFOC Item 3)
to require franchisors to disclose law suits filed by franchisors
against franchisees; (2) whether the Commission should improve the
franchisee statistics disclosures (UFOC Item 20) and if so, how; (3)
whether the Commission should modify the Rule to prohibit franchisors
from using ``gag clauses'' that restrict former or existing franchisees
from speaking with prospective franchisees or other parties; and (4)
whether the Commission should modify the financial performance
disclosure requirements (UFOC Item 19) to require franchisors to
include specific preambles in their disclosure documents to provide
prospective franchisees with more information about financial
performance claims.
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\6\ 62 FR 9115 (February 28, 1997).
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The ANPR elicited 166 written comments.7 In addition,
Commission staff held six public workshop conferences on the Rule in
Washington, D.C. (2 workshops); Chicago, Illinois; New York, New York;
Dallas, Texas; and Seattle, Washington. Sixty-seven individuals
8 participated in the public workshops, including
franchisees, franchisors, business opportunity sellers, and their
representatives, state franchise and business opportunity regulators,
and computer consultants. The workshop conferences generated
transcripts totaling 1,548 pages.9 Based upon the comments
and the evidence discussed herein, the Commission proposes to amend the
Rule in the form set forth infra at Section I.
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\7\ The Commission received comments through three means: (1) In
writing (108 comments); (2) by E-mail (36 comments); and (3) by
telephone (22 comments). Of the 166 comments, 121 were submitted by
franchisees or their representatives; 34 were submitted by
franchisors or their representatives, and the remainder did not
specify any affiliation. A list of commenters and the abbreviations
used to identify each is attached as Attachment A.
\8\ A list of public workshop participants and the abbreviatins
used to identify each is attached as Attachment B.
\9\ References to the public workshop conferences are cited as:
the name of the commenter, date 97 Tr at ____ (e.g., Simon, 18 Sept
97 Tr at 146).
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Section B. The Continuing Need for the Franchise Rule
Based upon the record, the Commission believes that the Franchise
Rule continues to serve a useful purpose. In response to the ANPR,
commenters who address this issue overwhelmingly urge the Commission to
retain the Franchise Rule.10 These commenters, including
NASAA,11 the International Franchise Association
(``IFA''),12 National Consumers League
(``NCL''),13 and prominent franchisors,14 note
that pre-sale disclosure is a cost-effective way to provide material
information to prospective franchisees, is necessary to prevent fraud,
and enables franchising to flourish. Commenters also observe that pre-
sale disclosure helps to reduce economic injury to franchisees by
enabling them to understand fully the nature of the franchise
relationship and the financial and legal commitments they will be
undertaking.15
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\10\ E.g., Baer, Comment 25, at 2; Hogan & Hartson, Comment 28,
at 2; Kaufmann, Comment 33, at 2-3; SBA Advocacy, Comment 36, at 2-
3; Kestenbaum, Comment 40, at 1; IL AG, Comment 77, at 1. At the
same time, several commenters urge the Commission to streamline the
Rule and to create greater uniformity with state franchise
regulations. E.g., Bruce, Comment 3, at 1; Baer, Comment 25, at 2;
Kaufmann, Comment 33, at 3; IL AG, Comment 77, at 5; Cendant,
Comment 140, at 2.
\11\ NASAA, Comment 120, at 1-4.
\12\ IFA, Comment 82, at 1-2.
\13\ NCL, Comment 35, at 2.
\14\ E.g., Cendant, Comment 140, at 1-2. See also Better Homes &
Gardens Real Estate Service, Re/Max Corporation, and The Prudential
Real Estate Affiliates, Inc., (RR Comment 24, at 1); Snap-On, Inc.
(RR Comment 27, at 1); Little Caesars (RR Comment 31, at 1); The
Southland Corporation (7-Eleven) (RR Comment 47, at 1); Medicap
Pharmacies (RR Comment 48, at 1); Forte Hotels (RR Comment 52, at
1).
\15\ E.g., Hogan & Hartson, Comment 28, at 2; SBA Advocacy,
Comment 36, at 2; Zarco & Pardo, Comment 134, at 1. The record
reveals that franchisees may suffer loses of several hunded thousand
dollars. E.g., Slimak, 22 Aug 97 Tr at 26 ($289,000 loss);
Lundquist, 22 Aug 97 Tr at 48 (half a million dollar loss). See also
NCL, Comment 35, at 2.
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While almost all franchisors responding to the ANPR support the
Rule,16 existing franchisees and their advocates continue to
criticize the Rule because it does not address what they believe to be
the greatest problem in franchising today: abusive franchise
relationships.17 They believe that the Commission should use
its unfairness authority under section 5 of the FTC Act to prohibit,
for example, post-term covenants not to compete,18
encroachment of franchisees' markets,19 and restrictions on
the sources of products or services.20 They also urge the
Commission to ban franchisors from requiring mandatory arbitration,
waiver of jury trials, and choice of venue and choice of law
provisions, which they believe often impede a franchisee from bringing
suit or favor franchisors in litigation.21
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\16\ But see Winslow, Comment 84, at 1.
\17\ E.g., Brown, Comment 4, at 2-3; Purvin, Comment 81, at 4.
\18\ E.g., Rachide, Comment 32, at 3; AFA, Comment 62, at 3;
Slimak, Comment 130, at 1; Vidulich, 22 Aug 97 Tr at 21.
\19\ E.g., Brown, Comment 4, at 2; Manuszak, Comment 13, at 1;
AFA, Comment 62, at 1; Buckley, Comment 97, at 3; Zarco & Pardo,
Comment 134, at 2.
\20\ E.g., Colenda, Comment 71, at 1; Slimak, 22 Aug 97 Tr at
26; Chiodo, 21 Nov 97 Tr at 293-94.
\21\ E.g., Brown, Comment 4, at 3; Bell, Comment 30, at 1;
White, Comment 54, at 1; AFA, Comment 62, at 3; Johnson, Comment 67,
at 1.
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Based upon the record and the Commission's law enforcement
experience over the last twenty years, the Commission believes that
pre-sale disclosure is necessary to protect prospective franchisees
from fraudulent and deceptive franchise sales practices. Pre-sale
disclosure provides prospective franchisees with material information
needed to conduct their own due diligence investigation of the
offering, as well as information that prospective franchisees might not
otherwise be able to obtain on their own, such as the franchisor's
litigation history, failure rates in the franchise system, and audited
financial information. Further, complaints from franchisees about
various contractual issues are prevalent and strongly suggest that pre-
sale disclosure is necessary to ensure that prospective franchisees are
better informed about the relationship they will be entering, including
issues such
[[Page 57296]]
as rights to protected territories and product source restrictions.
At the same time, the Commission recognizes that pre-sale
disclosure addresses only some of the issues franchisees may face in
the course of operating their franchises. From the significant number
of complaints filed by existing franchisees, the Commission has no
doubt that some franchisees are dissatisfied with their franchise
purchase, believe a serious imbalance of power exists between
franchisors and franchisees, or otherwise believe that franchise
contracts are oppressive. Nonetheless, the record does not support the
Commission's ability to broaden the Rule to address substantive
franchise relationship issues.
As an initial matter, franchise relationships are matters of
contract law that traditionally have been regulated at the state level.
Indeed, several states, even those without franchise disclosure laws,
have some type of franchise relationship law. In contrast to the
states, the Commission traditionally does not regulate or set the terms
of private contracts in franchising or in any other economic
sector.22
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\22\ For example, the Commission's Funeral Industry Practices
Rule, 16 CFR 453, requires funeral homes to disclose pre-sale the
costs of its goods and services, but does not regulate the terms and
conditions of private funeral services contracts. Similarly, the
Used Motor Vehicle Trade Regulati0n Rule (``Used Car Rule''), 16 CFR
455, requires used car sellers to disclose pre-sale whether the car
comes with a warranty, but does not purport to regulate the terms
and conditions of private used car sales.
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Further, the Commission believes that a widespread misconception
exists about the scope of its unfairness jurisdiction. ``Unfairness''
is a term of art that has a specific legal meaning that has been
developed by the Commission over time 23 and adopted by
Congress in 1994. Section 5 states that the Commission does not have
authority to declare an act or practice unfair unless it meets three
specific criteria: (1) The act or practice causes or is likely to cause
substantial injury; (2) that is not outweighed by countervailing
benefits to consumers or to competition; and (3) is not reasonably
avoidable.24 Accordingly, before the Commission could
consider a rulemaking prescribing the substantive terms of private
contracts,25 the Commission would need evidence not only of
substantial harm, but also specific data that would enable the
Commission to weigh the purported harm against any countervailing
benefits to the public at large or to competition. In addition, the
Commission would need evidence showing that franchisees cannot
reasonably avoid the alleged harm.
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\23\ See FTC v. Orkin Exterminating Co., 108 F.T.C. 263 (1986),
aff'd, Orkin Exterminating Co. v. FTC, 849 F.2d 1354 (11th Cir.
1988), cert denied, 488 U.S. 1041 (1989).
\24\ 15 U.S.C. Sec. 45(n) (added by The Federal Trade Commission
Act Amdnements of 1994, Pub. L. No. 103-312). In amendment the FTC
Act, Congress also made clear that the Commission may not declare an
act or practice unfair based upon public policy concerns alone. Id.
\25\ In Orkin, the seminal case in which the Commission
exercised its unfairness jurisdiction in the context of a commercial
contract, the Commission neither dictated nor revised the
substantive terms of the Orkin contract, but required Orkin to abide
by the contractual terms and conditions that Orkin itself freely
chose and offered to the public. 849 F.2d at 1363.
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While the Commission finds that franchisees and their advocates
suggest economic harm to individual franchisees may result from some
franchise practices, they have not shown to date that such harm is
substantial and not outweighed by countervailing benefits. Further, in
at least some instances, prospective franchisees could also avoid harm
by comparison shopping for a franchise system that offers more
favorable terms and conditions and by considering alternatives to
franchising as a means of business ownership. Thus, the Commission
continues to believe that pre-sale disclosure is the best available
vehicle, within its statutory authority, to address franchise
relationship issues and, as discussed below, proposes to enhance the
Rule's disclosures to enable prospective franchisees to investigate the
franchise relationship fully before they commit to buying a franchise.
This is totally consistent with the Commission's long-held view that
free and informed consumer choice is the best regulator of the market.
Section C. Discussion of Proposed Revisions to the Franchise Rule
1. The Proposed Rule Focuses on the Sale of Franchises
The proposed Rule focuses exclusively on the sale of franchises.
The Commission agrees with the overwhelming view of the commenters who
address this issue that franchises and business opportunities are
distinct business arrangements that require separate disclosure
approaches.26 For example, many of the Rule's pre-sale
disclosures, in particular those pertaining to the parties' detailed
relationship, do not apply to the sale of most business opportunities,
which typically involve fairly simple contracts or purchase agreements.
The Rule's detailed disclosure obligations may also create barriers to
entry for legitimate business opportunity sellers.27
Accordingly, the Commission intends to conduct a separate rulemaking
proceeding for business opportunity sales.
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\26\ E.g., Brown, Comment 4; Baer, Comment 25, at 5; Hogan &
Hartson, Comment 28; IFA, Comment 82, at 2; NASAA, Comment 120, at
4; Selden, Comment 133, at 2. But see NCL, Comment 35.
\27\ See Muncie, Comment 15, at 2.
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2. The Proposed Rule Is Based Upon the UFOC Guidelines
The proposed Rule is based upon the UFOC Guidelines' disclosure
model. Without exception, the commenters who address this issue--
including franchisors and franchisees alike--urge the Commission to
revise the Rule to mirror the UFOC.28 These commenters
emphasize that the UFOC has improved disclosures 29 and is
already used by the vast majority of franchisors.30 Further,
uniformity between federal and state franchise disclosure laws will
help to reduce compliance costs 31 and will facilitate
comparison shopping among franchise systems.32 Moreover, as
NASAA notes, the UFOC Guidelines were developed with significant input
from franchisors, franchisees, and other franchise administrators, and
they were subject to public hearings and notice and
comment.33 Indeed, the UFOC Guidelines have been well-
received by all interests involved in franchising and have become the
national industry standard.34
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\28\ E.g., AFA, Comment 62, at 2; IL AG, Comment 77, at 1; IFA,
Comment 82, at 1; Bundy, Comment 119, at 1; NASAA, Comment 120, at
2; Cendant, Comment 140, at 2.
\29\ E.g., Brown, Comment 4, at 1; Kaufmann, Comment 33, at 3;
AFA, Comment 62, at 2; IL AG, Comment 77, at 1; WA Securities,
Comment 117, at 1; NASAA, Comment 120, at 2-3.
\30\ E.g., Baer, Comment 25, at 2; Hogan & Hartson, Comment 28,
at 5-6; Kaufmann, Comment 33, at 3; Kestenbaum, Comment 40, at 1; WA
Securities, Comment 117, at 1.
\31\ E.g., Brown, Comment 4, at 2; Baer, Comment 25, at 2; AFA,
Comment 62, at 2; WA Securities, Comment 117, at 1; NASAA, Comment
120, at 3. Cendant observes that interpretations of the UFOC often
vary from state to state and asserts that the Commission's
interpretation of the UFOC would bring greater uniformity to the
field. Cendant, Comment 140, at 3.
\32\ Kaufmann, Comment 33, at 3.
\33\ NASAA, Comment 120, at 2.
\34\ E.g., Karp, 19 Sept 97 Tr at 90.
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The proposed Rule, however, differs from the UFOC Guidelines in
several respects. The Commission has reorganized the UFOC disclosures
to conform to the standard Code of Federal Regulations format, has
edited the UFOC disclosures for clarity, and has streamlined the
disclosures where possible. For example, the proposed Rule does not
include many of the UFOC Guidelines' detailed instructions, nor its
sample answers. In a few
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instances, the Commission has made substantive changes, enhancing the
UFOC disclosures by retaining broader provisions in the current Rule or
by adding new disclosures based upon the record and the Commission's
law enforcement experience. Each of these changes is discussed in more
detail below.
3. Title of the Rule
The Commission proposes to change the title of the Rule to
``Disclosure Requirements and Prohibitions Concerning Franchising.''
This proposed change is necessary to eliminate the current title's
reference to business opportunity ventures, which, as discussed above,
will be addressed in a separate rulemaking proceeding.
4. Proposed Section 436.1: Definitions
The proposed Rule begins with a definitions section that sets forth
each definition in alphabetical order. In many instances, the proposed
definitions are substantially similar to those already contained in the
Rule or in the UFOC Guidelines. In some instances, the Commission
proposes to revise a definition for clarity, or to update a definition
to embrace long-standing Commission policies. The Commission also
proposes to add a few new definitions that are needed to clarify new
Rule provisions or instructions (e.g., Internet). At the same time, the
Commission proposes to streamline the Rule by eliminating four
definitions that no longer serve a useful purpose: (1) ``business
day;'' 35 (2) time for making of disclosures; 36
(3) personal meeting; 37 and (4) cooperative
association,38 as discussed below.
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\35\ 16 CFR 436.2(f).
\36\ 16 CFR 436.2(g).
\37\ 16 CFR 436.2(o).
\38\ 16 CFR 436.2(l).
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a. Proposed Section 436.1(a) (``Action'')
Proposed section 436.1(a) adopts the UFOC definition of the term
``action.'' 39 It makes clear that disclosures involving
litigation include not only civil matters brought before a court, but
matters before administrative agencies and arbitrators. This definition
is also consistent with the Commission's current interpretation of the
term ``action.'' 40
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\39\ UFOC Item 3, Definitions, ii.
\40\ See Final Interpretive Guides, 44 FR at 49966, 49973
(August 24, 1979).
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b. Proposed Section 436.1(b) (``Affiliate'')
In keeping with the Commission's goal of revising the Rule to
mirror the UFOC Guidelines, proposed section 436.1(b) adopts the UFOC's
definition of the term ``affiliate.'' 41 This definition is
greatly streamlined from the current Rule definition, which defines
``affiliate'' in three parts as follows:
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\41\ UFOC Item 1, Instructions, v. In several UFOC disclosure
items, the term ``affiliate'' has a more restrictive meaning. In
those instances, the definition of ``affiliate'' is modified,
consistent with the UFOC Guidelines.
The term affiliated person means a person * * * (1) Which
directly or indirectly controls, is controlled by, or is under
common control with, a franchisor; or (2) Which directly or
indirectly owns, controls, or holds with power to vote, 10 percent
or more of the outstanding voting securities of a franchisor; or (3)
Which has, in common with a franchisor, one or more partners,
officers, directors, trustees, branch managers, or other persons
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occupying similar status or performing similar functions.
16 CFR Sec. 436.2(i).
c. Proposed Section 436.1(c) (``Disclose'')
Proposed section 436.1(c) is based upon the UFOC's definition of
the term ``disclose,'' which incorporates a ``plain English''
requirement.42 Currently, there is no comparable Rule
definition. The Commission, however, proposes to define the term
``plain English'' in a separate definition, as discussed below.
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\42\ UFOC Instruction 150.
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d. Proposed Section 436.1(d) (``Financial Performance Representation'')
Proposed section 436.1(d) adds an explicit definition of the term
``financial performance representation.'' 43 The current
Rule does not specifically define the term. To the extent that a
definition appears, it is cast as a prohibition: It is a violation of
section 5 to ``make any oral, written, or visual representation to a
prospective franchisee which states a specific level of potential
sales, income, gross, or net profit for the prospective franchisee, or
which states other figures which suggest such a specific level, unless
* * *'' 16 CFR Sec. 436.1(b).
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\43\ The Commission also proposes to use the term ``financial
performance representation,'' instead of the widely used ``earnings
claim.'' Some franchisors do not use ``earnings'' as a measure of
performance. For example, performance in the hotel industry is
typically measured by room occupancy rates.
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The Commission believes that the proposed definition of ``financial
performance representation'' combines the best features of both the
current Rule and UFOC definitions. Like the current Rule, proposed
section 436.1(d) retains the phrase ``or which states other figures
which suggest such a specific level,'' which the Commission believes is
necessary to ensure that franchisors understand fully that the Rule
covers the making of implied financial performance representations.
Following the UFOC approach, the definition also specifies that
financial performance information may include both historical
performance representations and projections and may be in the form of
charts, tables, and mathematical calculations. The Commission also
proposes to update the definition by clarifying that financial
performance representations include those disseminated through the
Internet.
e. Proposed Section 436.1(e) (``Fiscal Year'')
Proposed section 436.1(e) retains the current definition of the
term ``fiscal year'' set out at 16 C.F.R. Sec. 436.2(m)
f. Proposed Section 436.1(f) (``Fractional Franchise'')
Proposed section 436.1(f) slightly modifies the fractional
franchise exemption currently found at 16 C.F.R. Sec. 436.2(h). It
incorporates the Commission's long-standing policy that the parties
must anticipate that the additional sales will not exceed 20 percent of
total sales within the first year of operation.44 The
definition also makes explicit what previously has been only implied:
that the parties must have a reasonable basis to assert the
exemption.45
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\44\ See Final Interpretive Guides, 44 FR at 49968.
\45\ See Advisory 97-1 Bus. Franchise Guide (CCH) para. 6,481,
at 9,681-82 (1997); Advisory 96-2, Bus. Franchise Guide (CCH) para.
6,477, at 9,675 (1996).
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g. Proposed Section 436.1(g) (``Franchise'')
Proposed section 436.1(g) modifies the definition of the term
``franchise'' in three ways. First, the current definition of the term
``franchise'' was drafted broadly to cover both the sale of franchises
and business opportunities. In light of the Commission's proposal to
address business opportunity sales in a separate trade regulation rule,
the Commission believes the definition of the term ``franchise'' should
now be limited to ensure that it no longer captures ordinary business
opportunity sales. To that end, the Commission proposes to revise the
second definitional elements: significant control or assistance.
Specifically, the Commission proposes to revise the Rule to cover
franchisors that exert or have the authority to exert significant
``continuing control'' over the franchisee's method of operation. While
franchisors typically exert control throughout the franchise agreement
term, business opportunity sellers often do not exert control, or limit
their control to the initial stage of a
[[Page 57298]]
purchaser's business. In a similar vein, the Commission proposes to
revise the Rule to cover only franchisors that offer significant
assistance ``extending beyond the start of the business operation,''
recognizing that in many franchise systems the franchisor's assistance
extends beyond the initial phase of the business. For example, the
franchisor may offer ongoing advertising, training, and business
development plans. In contrast, a business opportunity seller's
assistance is often limited to the initial phase of the purchaser's
business, such as locating vending machines or providing purchasers
with an initial list of accounts.
Second, consistent with its goal of streamlining the Rule wherever
possible, the Commission also proposes to eliminate from the current
definition of ``franchise'' the alternative that the franchisee
``indirectly or directly [is] required to meet the quality standards
prescribed by [the franchisor.]'' 16 CFR Sec. 436.2(a)(1)(i)(a)(2). The
Commission believes that quality standards are simply one form of
control that a franchisor may impose on a franchisee. As long as the
Rule retains the more inclusive ``control'' element, the specific
``quality standards'' element appears to be unnecessary.
Finally, the Commission proposes to modify the definition of the
term ``franchise'' to incorporate three long-standing Commission
policies. The revised definition makes clear that: (1) A relationship
will be deemed a franchise if it meets the three definitional elements
of a franchise, regardless of what it may be called; 46 (2)
a business relationship will be deemed a franchise if it is offered or
represented as having the characteristics of a franchise, regardless of
any failure on the franchisor's part to perform as promised;
47 and (3) the term ``payment'' includes payments ``by
contract or by practical necessity.'' 48
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\46\ See Final Interpretive Guides, 44 FR at 49966.
\47\ SBP, 43 FR at 59699.70.
\48\ See Final Interpretive Guides, 44 FR at 49967.
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h. Proposed Section 436.1(h) (``Franchise Seller'')
Proposed section 436.1(h) introduces a new term--``franchise
seller.'' This definition combines the current terms ``franchisor'' and
``franchise broker'' into a single concept. The Commission believes
that this approach will streamline the Rule considerably. Currently,
whenever the Rule refers to the obligation to furnish disclosure
documents, it must specifically refer to both franchisors and franchise
brokers. Not only is this reference longer than necessary, it is
incomplete because it does not specifically include the franchisor's
employees, sales representatives, and agents who also may sell
franchises and have an obligation to furnish disclosures. Accordingly,
the term ``franchise seller'' refers to all parties having an
obligation to provide disclosure documents. At the same time, the
definition adopts long-standing Commission policy that a franchisee
seeking to sell its own outlet is not covered by the Rule.49
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\49\ See Final Interpretative Guides, 44 FR at 49969.
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i. Proposed Section 436.1(i) (``Franchisee'')
Proposed section 436.1(i) simplifies the current definition of the
term ``franchisee.'' The current Rule defines the term ``franchisee''
in an awkward and circular fashion: ``any person (1) who participates
in a franchise relationship as a franchisee, as denoted in paragraph
(a) of this section, or (2) to whom an interest in a franchise is
sold.'' 16 CFR Sec. 432.(d). The revised definition deletes unnecessary
references to other Rule sections and focuses on the grant of an
interest in a franchise, which is the core issue triggering a
franchisor's disclosure obligations.
j. Proposed Section 436.1(j) (``Franchisor'')
Similarly, proposed section 436.1(j) streamlines the definition of
the term ``franchisor.'' The proposed definition deletes unnecessary
references to other Rule sections and focuses on the grant of an
interest in a franchise.
k. Proposed Section 436.1(k) (``Gag Clause'')
Proposed section 436.1(k) introduces a new term--``gag clause.''
50 As discussed in greater detail below at Section C.8.t.,
the Commission proposes to amend the Rule to require franchisors to
disclose information about gag clauses, namely contractual provisions
that prohibit or restrict existing or former franchisees from
discussing with prospective franchisees their experiences as
franchisees. The proposed definition focuses exclusively on a
franchisee's ability to discuss his or her personal experience as a
franchisee within a franchisor's system. It does not include a
confidentiality agreement between a franchisor and a company officer
who happens to be a franchisee, and it excludes confidentiality
agreements created to protect a franchisor's trade secrets and other
proprietary information.
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\50\ In the ANPR, the Commission used the term ``gag orders.''
During the New York public workshop conference, several panelists
were confused by the use of the word ``order,'' noting that it
implied a court mandate. E.g., Forseth, 18 Sept. 97 Tr at 40;
Zaslav, id., at 55. Accordingly, the Commission will use the term
``gag clause,'' to avoid any implication that the Rule will address
only court imposed speech restrictions.
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l. Proposed Section 436.1(l) (``Internet'')
Proposed Section 436.1(l) is new. It defines the term ``Internet''
broadly to capture all communications between computers and between
computers and television, telephone, facsimile, and similar
communications devices. This definition is necessary because, as
explained in Section C.10. below, the Commission proposes to amend the
Rule to permit franchisors to comply with the Rule electronically,
including the use of the World Wide Web and E-mail.51
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\51\ The proposed definition is modeled, in part, after the
definition of ``internet'' set forth in the Commission's recently
published Request for Comment on the Interpretation of Rules and
Guides for Electronic Media, 63 FR 24996-97 and n.1 (May 6, 1998)
(``Internet Notice'').
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m. Proposed Section 436.1(m) (``Leased Department''
Proposed section 436.1(m) (``Leased Department''). Proposed section
436.1(m) greatly streamlines the Rule's leased department exemption.
Leased departments are one of four express Rule exemptions. Currently,
the Rule contains no definition of the term ``leased department.''
Rather, the concept is explained in the exemptions section of the Rule
as follows:
The provisions of this part shall not apply to a franchise * * *
[w]here pursuant to a lease, license, or similar agreement, a person
offers, sells, or distributes goods, commodities, or services on or
about premises occupied by a retailer-grantor primarily for the
retailer-grantor's own merchandising activities, which goods,
commodities, or services are not purchased from the retailer-grantor
or persons whom the lessee is directly or indirectly (a) required to
do business with by the retailer-grantor or (b) advised to do
business with by the retailer-grantor where such person is
affiliated with the retailer-grantor.
16 CFR 436.2(a)(3)(ii). The Commission believes that the proposed
revised definition is shorter, clearer, and easier to understand.
n. Proposed Section 436.1(n) (``Material'')
Proposed section 436.1(n) also streamlines the current definition
of ``material,'' which is currently defined as:
The terms material, material fact, and material change shall
include any fact, circumstance, or set of conditions which has a
substantial likelihood of influencing a
[[Page 57299]]
reasonable franchisee or a reasonable prospective franchisee in the
making of a significant decision relating to a named franchise
business or which has any significant financial impact on a
franchisee or prospective franchisee.
16 CFR Sec. 436.2(n). The proposed definition eliminates the Rule's
current reference to ``significant financial impact.'' The Commission
believes that this reference is redundant in that any circumstance
impacting upon a person's finances would also necessarily influence his
or her decision-making process. Accordingly, the proposed revision is
not a substantive change, but simply part of the Commission's effort to
streamline the Rule where possible.
o. Proposed Section 436.1(o) (``Officer'')
Proposed section 436.1(o) adds a new definition--``officer.''
52 Although several Rule disclosures pertain to the
franchisor's officers--such as the disclosures for litigation and
bankruptcies--the Rule currently does not specifically define the term
``officer.'' Rather, in the litigation disclosure, the Commission gives
examples of an officer, including ``the chief executive and chief
operating officer, financial, franchise marketing, training, and
service officers.'' 16 C.F.R Sec. 436.1(a)(2). The proposed definition
makes clear that franchisors must disclose information about all
officers, including de facto officers, with significant managerial
responsibilities for marketing and/or servicing franchises. The
Commission believes that this proposed Rule amendment is necessary to
eliminate any doubt that the Rule is to be read broadly, capturing all
individuals who function as officers, whether or not they are named in
the franchisor's incorporation papers or carry a particular corporate
title.53
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\52\ See NASAA UFOC Guidelines Commentary (June 21, 1994) Bus.
Franchise Guide (CCH) para.5,800, at 8,466 (Item 4 bankruptcy
disclosures).
\53\ See FTC v. P.M.C.S., Inc., No. 96-5426 (E.D. N.Y. 1996)
(franchisor fails to disclose ``silent partner'' with prior
bankruptcy); FTC v. Why USA, Inc., No. 92-1227-PHX-SMM (D. Ariz.
1992) (franchisor fails to disclose officers and their prior
litigation). See also Lay, 22 Aug 97 Tr at 6 (franchisee was not
informed that franchisor's director of franchising (who was not a
corporate officer) had been declared bankrupt).
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p. Proposed Section 436.1(p) (``Person'')
Proposed section 436.1(p) retains the Rule's current definition of
the term ``person'' set out at 16 CFR Sec. 436.2(b).
q. Proposed Section 436.1(q) (``Plain English'')
Proposed section 436.1(q), a new definition, defines the term
``plain English.'' This definition is necessary because, as discussed
below at Section C.9., the Commission proposes to adopt a requirement
that franchisors write their disclosure documents in plain English,
consistent with the UFOC Guidelines. The proposed definition of ``plain
English'' is modeled after the Securities and Exchange Commission's
(``SEC'') plain English requirement, set forth in the recently
promulgated mutual fund regulations.54
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\54\ Registration Form Used by Open-End Management Investment
Companies, SEC Release No. 33-7512, 17 CFR 274.11A.
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r. Proposed Section 436.1(r) (``Predecessor'')
Proposed section 436.1(r) introduces a new term--``predecessor.''
Because several of the proposed Rule's disclosures pertain to a
franchisor's predecessors, the Commission has incorporated the UFOC's
definition of that term.55 The Commission also proposes to
enhance the UFOC definition to make clear that the term ``predecessor''
includes any person from whom the franchisor has obtained the right to
use the trademark or trade secrets associated with the franchise
system.
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\55\ See UFOC Item 1.
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s. Proposed Section 436.1(s) (``Principal Business Address''
Proposed section 436.1(s) introduces a new term--``principal
business address,'' modeled after the UFOC's definition of that
term.56 The proposed definition makes clear that a
franchisor must use its principal street address, not a post office box
or private mail drop. The Commission believes the proposed amendment
will reduce fraud in franchise sales by making it easier for
prospective franchisees to find and investigate the franchisor and its
principals.
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\56\ UFOC, Item 1C, Instructions, i.
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t. Proposed Section 436.1(t) (``Prospective Franchisee''
Proposed section 436.1(t) follows the current Rule's definition of
the term ``prospective franchisee'' set out at 16 CFR Sec. 436.2(e).
However, where the definition refers to ``franchisor or franchise
broker,'' the Commission has revised the definition to substitute the
new term ``franchise seller,'' as discussed above.
u. Proposed Section 436.1(u) (``Required Payment''
Proposed section 436.1(u) is new. The current Rule does not
specifically define the term ``required payment.'' Proposed section
436.1(u) defines that term in accordance with long-standing Commission
policy that a payment can be required by contract or by practical
necessity.57
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\57\ See Final Interpretive Guides, 44 FR at 49967.
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v. Proposed Section 436.1(v) (``Sale of a Franchise''
Except for some minor editing, the definition of ``franchise sale''
is the same as that set out at 16 CFR Sec. 436.2(k).
w. Proposed Section 436.1(w) (``Signature'')
Proposed section 436.1(w) introduces a new term--``signature.'' As
discussed in Section C.10. below, the Commission proposes to amend the
Rule to permit franchisors to use electronic media to furnish
disclosure documents under certain conditions, provided prospective
franchisees confirm their identity by signing an acknowledgment of
receipt. Modeled after the Federal Reserve System's Interim Rule
Amending Regulation E, implementing the Electronic Fund Transfer Act
(``EFTA''),58 the proposed definition is flexible,
permitting franchisees to confirm their identity by alternative means,
such as the use of digital signatures and passwords.
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\58\ 63 FR 14528, 14531 (March 25, 1998).
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x. Proposed Section 436.1(x) (``Trademark'')
Proposed section 436.1(x) adopts the Commission's long-standing
definition of the term ``trademark'' to include service marks, logos,
and other commercial symbols.59
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\59\ See Final Interpretive Guides, 44 FR at 49966.
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y. Proposed Section 436.1(y) (``Written'')
Proposed section 436.1(y) defines the term ``written'' to include
electronic media, such as computer disk and the Internet. This
definition is necessary because, as discussed below at Section C.10.,
the Commission proposes to amend the Rule to permit franchisors to
furnish disclosures electronically. The proposed definition clarifies
that electronic media fall within the ambit of a ``written''
document.60
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\60\ See Internet Notice, 63 FR at 24996.
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5. Proposed Section 436.2: Furnishing and Preparing Disclosure
Documents
a. Scope of the Rule
Proposed section 436.2 begins with a new provision that limits the
Rule's scope to the sale of franchises in the United States, its
possessions, or territories. The overwhelming number of ANPR commenters
who address this issue urge the Commission to limit the Rule's
application to domestic franchise
[[Page 57300]]
sales.61 Only four commenters 62 urge the
Commission to enforce the Rule internationally, raising essentially
three arguments: (1) It would be inconsistent for a franchisor to
subject a foreigner to American law and American courts through
contractual choice of venue and choice of law provisions without
simultaneously extending the benefit of American law, namely pre-sale
disclosure; 63 (2) American citizens who purchase a
franchise abroad would not be protected by American law; 64
and (3) the Commission has jurisdiction over foreign franchise sales
and should not willingly restrict its own jurisdiction.65
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\61\ E.g., SBA Advocacy, Comment 36, at 9; Loeb & Loeb, Comment
63, at 2; IFA, Comment 82, at 3-4; Jeffers, Comment 116, at 7; CA
Bar, Comment 124, at 2-3; Cendant, Comment 140, at 2 and 4-5.
\62\ Brown, Comment 4, at 4-5, and Comments 6, 96, and 103;
Stubbings, Comment 21, at 1; Embassy of Argentina, Comment 132, at
1; Selden, Comment 133, at 2-3.
\63\ Brown, Comments 6, at 2; Embassy of Argentina, Comment 132,
at 1; Selden, Comment 133, at 2.
\64\ Selden, Comment 133, at 2. See also Stubbings, Comment 21,
at 1.
\65\ Brown, Comments 4, at 3; 6, at 2; 103, at 15-16.
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The Commission believes that the record adequately supports its
tentative finding in the ANPR that mandated pre-sale disclosure in
international franchise sales is unnecessary, may be misleading, and
may impede competition. The Commission developed a pre-sale disclosure
rule in response to problems occurring in the domestic
market.66 None of the four ANPR commenters noted above offer
data or other evidence tending to show that fraud or deception by
American companies engaging in international franchises sales is
prevalent.
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\66\ Hogan & Hartson reviewed the Commission's Rule, as well as
the UFOC Guidelines, and observed that many of the provisions are
limited to disclosures involving the domestic market. For example,
UFOC Item 20 refers to the number of franchise sales ``in this
state.'' Hogan & Hartson, Comment 28, at 3.
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Further, the record strongly supports the view that franchises are
sold internationally to sophisticated investors who are generally
represented by counsel or who otherwise can protect their own
interests. Moreover, there is no evidence in the record that a
disclosure document addressing the American market would be beneficial
to a prospective foreign investor. Just the opposite appears to be
true. Such a document may be irrelevant and potentially misleading when
given to a foreign investor (or an American investing in a foreign
market) because of vast differences between American and foreign
markets, cultures, and legal systems. Risks to the investor would arise
primarily from economic conditions and cultural values in those
countries, not in the United States. For a disclosure document to be
relevant, a franchisor would have to prepare individual disclosure
documents tailored to each specific foreign market. Such a requirement,
however, would very likely impose extraordinary burdens and costs on
franchisors and would impede competition with companies from countries
without similar disclosure obligations,67 despite the lack
of evidence in the record of fraud or deception in foreign franchise
sales.
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\67\ See Cendant, Comment 140, at 4.
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Finally, by limiting the application of the Rule to domestic
franchise sales, the Commission is not restricting its own
jurisdiction. Assuming that the Commission has jurisdiction over
foreign franchise sales,68 it will continue to do so even if
the Rule is amended as proposed in the ANPR. Accordingly, in
appropriate circumstances, the Commission may address unfair or
deceptive franchise sales abroad, consistent with its authority under
section 5.69
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\68\ See Branch v. FTC, 141 F.2d 31 (7th Cir. 1944). But see
Nieman v. Dryclean U.S.A. Franchise Company, Inc., ______ F.3d
______ (11th Cir. June 21, 1999).
\69\ Even some commenters favoring the ANPR proposal that the
Commission limit the Rule's scope acknowledge that the Commission
will retain its authority under section 5 to target American
companies that may fraudulently sell franchises abroad. E.g., Hogan
& Hartson, Comment 28, at 4.
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b. Proposed Section 436.2(a): Obligation To Furnish Documents
Proposed section 436.2(a) sets forth the Rule's two principal
disclosure obligations: It is a violation of section 5 of the FTC Act
for any franchise seller to fail to furnish prospective franchisees
with a copy of the franchisor's disclosure document and the completed
franchise agreement within the specific time frames discussed below.
Consistent with current Commission policy, this section also provides
that the obligation to furnish documents can be satisfied either by the
franchisor itself or by another franchise seller.\70\ At the same time,
it makes clear that all franchise sellers--including the franchisor's
sales representatives and third-party franchise sellers--can be held
individually liable for their failure to furnish prospective
franchisees with the required disclosure documents.
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\70\ See 16 CFR 436.2(g).
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c. Proposed section 436.2(a)(1): 14-Day Disclosure Review Period
Proposed section 436.2(a)(1) requires franchisors to furnish
prospective franchisees with disclosure documents 14 days before the
franchisee signs a binding agreement or pays any fee in connection with
the franchise sale. This provision modifies the current Rule provision
that requires franchisors to furnish disclosure document at the earlier
of the first personal (face-to-face) meeting \71\ or at least 10
business days before the franchisee signs a binding agreement or pays a
fee.\72\
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\72\ 16 CFR 436.1(a); 436.2(o).
\72\ 16 CFR 436.1(a); 436.2(f)-(g).
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In the ANPR, the Commission questioned whether the Rule's current
requirement that franchisors provide prospective franchisees with a
disclosure document at the first personal meeting continues to serve a
useful purpose. Recognizing that the term ``personal meeting'' may be
obsolete in light of the growing use of the telephone, facsimile
machines, and the Internet as vehicles of commerce, the Commission
asked whether the Commission should replace the term ``personal
meeting'' with the term ``first substantive discussion.'' \73\
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\73\ 62 FR at 9122.
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Several commenters agree that the term ``personal meeting'' has
become irrelevant in an era where even large investments are made by
telephone or via the Internet.\74\ Many franchisors and their
representatives, however, oppose changing the term ``personal meeting''
to ``substantive discussion.'' They believe that the term ``substantive
discussion'' is ambiguous,\75\ and would not reach Internet sales,
where presumably no actual discussion takes place.\76\ Others fear that
franchisors, who may receive countless telephone calls in a day, may
have to stop talking with callers, lest they trigger the Rule's
disclosure obligations.\77\ Several commenters urge the Commission to
[[Page 57301]]
eliminate the personal meeting trigger altogether and, as an
alternative, require franchisors to furnish disclosures a minimum
number of days prior to the franchise sale.\78\
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\74\ For example, Kennedy Brook observes that franchise sales
can occur entirely electronically ``where the contact is made over
the Web, where E-mail is exchanged, where telephone [calls] are
exchanged, where documents are sent out by Federal Express, and
where, in fact, there never is a face-to-face meeting.'' Brooks, 18
Sept 97 Tr at 160. See also NCL, Comment 35, at 4-5; SBA Advocacy,
Comment 36, at 9; Kestenbaum, Comment 40, at 2; IL AG, Comment 77,
at 3-4; Winslow, Comment 85, at 1.
\75\ E.g., Duvall, Comment 19, at 3; Baer, Comment 25, at 6;
Loeb & Loeb, Comment 63, at 2; Tifford, Comment 78, at 7-8; IFA,
Comment 82, at 4.
\76\ Hogan & Hartson, Comment 28, at 9. Kenneth Costello also
observes that in the SBP and Final Interpretive Guides the
Commission drew a distinction between sales via mail or telephone
and face-to-face meetings because the latter could be prone to high
pressure sales. He notes that Internet sales require an affirmative
action on the part of the prospective franchisee to investigate a
franchisor via modem, ``a connection that is even more readily
broken than a telephone call.'' Loeb & Loeb, Comment 63, at 2.
\77\ Baer, Comment 25, at 6.
\78\ Duvall, Comment 19, at 3; Baer, Comment 25, at 6; Tifford,
18 Sept. 97 Tr at 158-59.
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The Commission agrees that the personal meeting disclosure trigger
has become obsolete in the communications age where prospective sellers
now communicate with buyers through a wide array of communications
media, including facsimile machine, E-mail, and the Internet.
Accordingly, proposed section 436.2(a)(1) streamlines the Rule by
eliminating the first personal meeting trigger. As long as the
prospective franchisee has a minimum number of days in which to review
the franchisor's disclosures, that should suffice to combat deceptive
franchise sales. A pre-sale review period can also function as a
``cooling-off'' period, enabling prospective franchisees to resist high
pressure sales techniques. The Commission also proposes to streamline
the Rule further by creating a bright line 14-day review period in lieu
of the Rule's current ``10 business days'' provision. The term ``10
business days'' may be unnecessarily confusing because franchisors must
remember to include all federal holidays, some of which are not
observed in every state. In addition, in most instances, 10 business
days as a practical matter amounts to 14 days.
d. Proposed Section 436.2(a)(2): Five-Day Contract Review Period
Proposed section 436.2(a)(2) streamlines the Rule further by
requiring franchisors to afford prospective franchisees at least five
days to review the completed franchise agreement. This would modify the
current Rule provision found at 16 CFR 436.1(g) that requires
franchisors to furnish prospective franchisees with a copy of the
completed agreement ``at least 5 business days prior to the date the
agreements are to be executed.'' The Commission recognizes that five
business days usually means seven days. However, the Commission
believes that a seven-day contract review requirement might be
burdensome for both franchisors and franchisees who often want to sign
a franchise agreement quickly in order to cement their deal.\79\ The
Commission believes that a five-day review period strikes the right
balance between affording prospective franchisees time to review the
completed contract and accommodating the parties' desire to move the
deal forward.
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\79\ E.g., Wieczorek, 6 Nov 97 Tr at 25-26.
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e. Proposed Section 436.2(b): Furnishing Disclosures
Proposed section 436.2(b) provides some additional guidance on what
constitutes ``furnishing'' disclosures. It makes clear that franchisors
can comply with the Rule's timing provisions by delivering a paper
copy, or transmitting an electronic copy of documents, before the
required date. It also clarifies that franchisors who wish to mail
documents should do so by first class mail and by adding an additional
three days in order to ensure that the prospective franchisee receives
the documents in the time frame required by the Rule. Otherwise, it is
possible that a prospective franchisee may receive a copy of the
completed franchise agreement, for example, only a day or two before he
or she is scheduled to sign the agreement. The Commission believes that
this clarification is essential if the Commission, as proposed above,
shortens the timing provision for reviewing completed contacts from
``five business days'' to a bright line ``five days.''
f. Proposed Section 436.2(c): Form of the Disclosures
Proposed section 436.2(c) provides that it is a violation of
section 5 of the FTC Act for a franchisor to fail to include the
information and follow the instructions set forth in sections 436.3-
436.8 of the Rule. It also clarifies the standard of liability for Rule
violations. Currently, franchise brokers are jointly liable with the
franchisor for the content of a disclosure document. Proposed section
436.2(c) makes clear that franchise sellers other than the franchisor
will be liable for the content of a disclosure document only if they
knew or should have known of the violation. This is consistent with the
standard of individual liability for section 5 violations, as
articulated by numerous courts since the Rule was promulgated in the
1970's.\80\
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\80\ See FTC v. Amy Travel Serv., 875 F.2d 564, 573 (7th Cir.
1989); FTC v. Minuteman Press, Bus. Franchise Guide (CCH) para.
11,516 at 31,253 (E.D.N.Y. 1998); United States v. The Building
Inspector of America, 894 F. Supp. 507, 518-20 (D. Mass. 1995); FTC
v. Jordan Ashley, Bus. Franchise Guide (CCH) para.70,570 at 72,096
(S.D. Fla. 1994); FTC v. Kitco of Nevada, 612 F. Supp. 1282, 1292
(D. Minn. 1985); Under this standard, the Commission has brought
numerous actions naming not only owners and corporate officers, but
others who are instrumental in the fraud. E.g., FTC v. FutureNet,
Inc. No. 98-1113 GHK (AIJx) (C.D. Cal. 1998); FTC v. Internet Bus.
Broad., Inc., No. WMN-98-495 (D.Md. 1998); United States v. Toys
Unlimited Int'l, Inc., No. 97-08592 Highsmith (S.D. Fla. 1997); FTC
v. Audiotex Connections Inc., No. CV-97-726 (DRH) (VVP) (E.D.N.Y.
1997).
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6. Proposed Section 436.3: The Cover Page
Proposed section 436.3 requires all franchisors to begin their
disclosures with an FTC cover page that informs prospective franchisees
that they are receiving important information about the franchise
offering. The Commission proposes to modify the current cover page
requirement, however, to address several suggestions raised in response
to the ANPR. For example, a few franchisees and their supporters urge
the Commission to require more background information on franchising,
its risks, and applicable laws.\81\ They also contend that phrases in
the current cover page such as ``information * * * required by the
Federal Trade Commission'' and ``to protect you'' are misleading
because they imply greater federal oversight of franchise offerings
than actually exists.\82\ Several franchisors also urge the Commission
to coordinate with the states to produce a single, uniform cover
page,\83\ and a few question the value of risk factors and whether the
Commission could, as a practical matter, require the disclosure of risk
factors on a national basis.\84\
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\81\ Heron, Comment 80, at 1. See also G. Gaither, Comment 69,
at 1; Dady & Garner, Comment 127, at 3.
\82\ See Murphy, Comment 2 at 2; Maloney, Comment 38, at 1;
Heron, Comment 80, at 1; Kezios, 18 Sept 97 Tr at 10; Karp, 19 Sept
97 Tr at 89-90.
\83\ E.g., Simon, 18 Sept 97 Tr. at 9; Kestenbaum, id. at 9-10;
Cantone, id. at 10.
\84\ Cendant, Comment 140, at 3; Forseth, 18 Sept 97 Tr at 11-
12; Simon, id., at 12-13, Kestenbaum, id., at 12.
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The Commission agrees with those commenters who urge the Commission
to promote greater uniformity with state disclosure laws. Accordingly,
proposed section 436.3 includes the UFOC requirements that the cover
page include, for example, the franchisor's name, logo, brief
description of the franchised business, total purchase price, and a
notice that comparative information is available. The Commission,
however, is not inclined to adopt the UFOC's requirement that
franchisors disclose specific risk factors on the cover page. First,
the Commission notes that the two current UFOC mandated risk factors
(choice of venue and law) merely repeat what is already required to be
disclosed in the disclosure document itself.\85\ Moreover, including
these two risk factors in the FTC cover page might incorrectly signal
prospective franchisees that these are the most important risk factors
for
[[Page 57302]]
consumers to consider. Second, as a practical matter, the Commission
cannot formulate a list of specific risk factors that would be relevant
to all franchise systems on a national basis, nor does the Commission
have the ability to require risk disclosures on an individual franchise
system basis. Nonetheless, the Commission recognizes that state
franchise examiners may require franchisors to include various risk
factors on the cover page and that such disclosures may serve a useful
purpose. In an effort to harmonize federal and state disclosure laws,
proposed section 436.3 makes clear that franchisors are permitted to
include risk factors on the cover page, if they are required to do so
under state law.\86\
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\85\ For example, the choice of venue and choice of law
disclosures repeat what is already disclosed in the text of Item 17.
\86\ See Tifford, 18 Sept 97 Tr at 15-16.
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Proposed section 436.3(b) also updates the current cover page
provision to reflect the growing use of the Internet by franchisors.
Accordingly, it requires franchisors to include their E-mail address
and Internet home page, if applicable, on the cover page. This
information should enable a prospective franchisee to communicate more
readily with the franchisor. Proposed section 436.3(g)(2) also requires
franchisors to include additional statements on the cover page if they
wish to comply with the Rule electronically, such as the Internet.
These requirements are explained more fully below at Section B.10.
Based upon the comments received, the Commission also proposes to
include references to additional resources to enable prospective
franchisees to conduct a due diligence investigation of the franchise
offering. To that end, proposed section 436.3(g)(3) includes a
reference to the Commission's home page \87\ where consumers can find
resources on franchising, and a reference to the Commission's Guide to
Buying a Franchise.\88\ In addition, proposed section 436.3(g)(4) adds
new language to the cover page pointing out the difference between a
disclosure document and a franchise agreement and stresses the need for
prospective franchisees to understand their contract.\89\
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\87\ See Heron, Comment 80, at 4.
\88\ See Cordell, 6 Nov 97 Tr at 156.
\89\ One commenter notes that only a minority of prospective
franchisees use competent counsel before making an investment
decision. He suggests that the Commission essentially require
franchisees to seek professional guidance before making an
investment decision. Murphy, Comment 2, at 1. The Commission
believes such a regulation would be overly intrusive. Nonetheless,
in keeping with Mr. Murphy's suggestion, the Commission proposes
strengthening the cover page's consumer education message by
replacing the current Rule language (``If possible, show * * *''),
with the stronger ``Show your contract and this disclosure document
to an advisor, like a lawyer or an accountant.''
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Finally, proposed section 436.3 eliminates arguably misleading
information from the current cover page, namely, the phrases
``information * * * required by the Federal Trade Commission'' and ``to
protect you.'' To the extent that some prospective franchisees may
misinterpret the phrase ``to protect you'' as implying a greater role
on the Commission's part, the disadvantages of including such language
would appear to outweigh any minimal benefit. Nonetheless, proposed
section 436.3 retains the statement that the Commission has not checked
the disclosures for accuracy. The Commission believes this statement is
essential to warn prospective franchisees not to rely on the
franchisor's disclosures at face value.
7. Proposed section 436.4: Table of Contents
Proposed section 436.4 sets forth a table of contents, which tracks
the order of the required disclosures. For the most part, the proposed
table of contents follows the text set forth in the UFOC Guidelines.
The titles of four disclosure items, however, have been changed. The
Commission believes that these changes better capture the essence of
the respective disclosure provisions. First, Item 7 has been changed
from ``Initial Investment'' to ``Estimated Initial Investment.''
Second, Item 11 has been changed from ``Franchisor's Obligations'' to
``Franchisor's Assistance, Advertising, Computer Systems, and
Training.'' Third, Item 19 has been changed from ``Earnings Claims'' to
the more inclusive term ``Financial Performance Representations.''
Finally, Item 20 has been changed from ``List of Outlets'' to ``Outlets
and Franchisee Information.''
8. Proposed Section 436.5: The Required Disclosure Items
Proposed section 436.5 sets forth the required disclosure items.
For the most part, these proposed disclosures are substantially similar
to the disclosure requirements specified in the UFOC Guidelines. The
Commission, however, believes it is important to retain a few current
Rule disclosure provisions that are broader than the comparable UFOC
provisions and to enhance the UFOC disclosures in a few instances based
upon the record and the Commission's law enforcement experience.
a. Proposed Section 436.5(a): Item 1 (The Franchisor, Its Parent,
Predecessors, and Affiliates)
Proposed section 436.5(a) is modeled after UFOC Item 1.\90\ It
requires the disclosure of background information on the franchisor, as
well as its parent, predecessors, and affiliates. Proposed section
436.5(a) improves the comparable Rule disclosures currently found at 16
CFR 436.1(a)(1), (a)(3), and (a)(6) in three material respects. First,
franchisors must disclose information about their predecessors. This
provision is necessary to prevent franchisors from avoiding disclosure
obligations by simply assuming a new corporate name.\91\ Second,
franchisors must disclose any regulations specific to the industry in
which the franchise business operates, such as necessary licenses or
permits, that may affect the franchisees' ability to conduct business
as well as costs.\92\ An explanatory footnote accompanies the Rule's
text to help franchisors distinguish between general and industry-
specific regulations. Third, franchisors must describe the general
competition prospective franchisees are likely to face, which better
ensures that prospective franchisees will understand the likely
economic risks in purchasing a franchise. The Commission believes that
a disclosure about likely competition is warranted in light of numerous
franchisee complaints concerning competition issues.\93\
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\90\ In response to the ANPR, no commenters raised any concerns
about UFOC Item 1, upon which proposed section 436.5(a) is based.
\91\ E.g., FTC v. Wolf, Bus. Franchise Guide (CCH) para. 10,401
(S.D. Fla. 1994); FTC v. Inv. Dev., Inc., Bus. Franchise Guide (CCH)
para. 9,326 (E.D. La 1989).
\92\ E.g., FTC v. Car Checkers of America, Inc., Bus. Franchise
Guide (CCH) para. 10,163 (D.N.J. 1993); U.S. v. Lifecall Sys.,Inc.,
Bus. Franchise Guide (CCH) para. 9,677 (D.N.J. 1990).
\93\ E.g., Packer, Comment 10, at 1; Manuszk, Comment 13, at 1;
Gray, Comment 22, at 1; Lopez, Comment 123, at 1.
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At the same time, proposed section 436.5(a) retains one feature of
the current Rule, namely the disclosure of information about any parent
of the franchisor. The Commission believes that information about a
franchisor's parent may be highly material to a prospective franchisee.
For example, a parent corporation may directly compete with the
franchisees by offering franchises under a different trademark or by
operating or acquiring a competing franchise system.\94\ For this
reason, the Commission decided to require the disclosure of information
about a parent when it promulgated the Rule originally, even though it
recognized
[[Page 57303]]
that the UFOC Guidelines had no comparable disclosure requirement.\95\
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\94\ See Vidulich, 22 Aug 97 Tr at 16-17.
\95\ SBP, 43 FR at 59639.
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b. Proposed Section 436.5(b): Item 2 (Business Experience)
Proposed section 436.5(b), another anti-fraud provision, requires a
franchisor to disclose the business experience of the company's
officers. The Commission has long recognized that the business
experience of the franchisor and its officers is material because it
provides the ``prospective franchisee with an important indication of
the franchisor's competence and financial soundness.'' 96
Proposed section 436.5(b) is substantially similar to UFOC Item
2.97 However, the Commission proposes to add a provision
requiring franchisors to disclose the business experience of any
director, trustee, general partner, officer, and subfranchisor of any
parent who will have management responsibility relating to the offered
franchises. The Commission believes that information about all persons
having management responsibility is material to prospective
franchisees, regardless of whether the officer is associated with the
franchisor or the franchisor's parent.98
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\96\ SBP, 43 FR at 59640. See, e.g., FTC v. Car Checkers, Bus.
Franchise Guide (CCH) para. 10,163 at 24,043; FTC versus Nat'l
Consulting Group, Inc., Bus. Franchise Guide (CCH) para. 11,335
(N.D. Ill 1998); FTC v. Levinger, No. 94-0925-PHX RCB (D. Ariz.
1994). Cf. FTC v. Goddard Rarities, Inc., No. CV93-4602-JMI (C.D.
Cal. 1993).
\97\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 2, upon which proposed section 436.5(b) is based.
\98\ Cf. 16 CFR 436.1(a)(3).
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c. Proposed Section 436.5(c): Item 3 (Litigation)
Proposed section 436.5(c) is modeled after UFOC Item
3.99 It is one of the most important anti-fraud disclosures,
requiring franchisors to disclose certain material litigation involving
the franchisor, its parent, predecessors, and officers.100
Proposed section 436.5(c) improves the comparable Rule disclosures
currently found at 16 CFR Sec. 436.1(a)(4) in several material
respects. First, it would require franchisors to disclose litigation
involving predecessors for the first time. Second, it would require a
franchisor to disclose civil actions, other than ordinary routine
litigation, that may impact upon the franchisor's financial condition
or ability to operate the business.101 Following the UFOC
approach, proposed section 436.5(c) also includes three instructional
footnotes, the most important of which advises franchisors on how to
disclose settlement agreements that may have confidentiality clauses
(footnote 4).102 The other footnotes clarify when
franchisors must disclose dismissed civil actions (footnote 2) and the
inclusion of summary opinions of counsel (footnote 3).
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\99\ Only one commenter, Gary Duvall, criticizes the current
UFOC Item 3 disclosure, upon which proposed section 436.5(c) is
based. Among other things, Mr. Duvall suggests that franchisors
should also be able to disclose cases that are resolved in their
favor, noting that it might be difficult to distinguish between a
dismissal without any liability from a settlement where both parties
received some benefit. Duvall, Comment 19, at 1-2. In addition, he
opposes the disclosure of confidential settlements, asserting that
it ``discourages settlement of disputes, and thereby encourages
prolonging of litigation and arbitration.'' Duvall, Comment 83, at
1. The Commission, however, finds that a franchisor can always err
on the side of caution and disclose a suit if it is not sure whether
or not it is covered by Item 3. In addition, nothing in the Rule
would prohibit a franchisor from making any consistent, truthful
information known to prospective franchisees outside of the
disclosure document. The Commission further believes that
confidential settlements provide prospective franchisees with
material information needed to assess the franchise offering. Mr.
Duvall has submitted no statistics or data to support his bald
assertion that the required disclosure of confidential settlements
causes harm. Accordingly, the Commission has no basis to conclude
that the benefits of such disclosure are outweighed by any costs.
\100\ See, e.g., FTC v. Inc. Dev., Inc., No. 89-0642 (E.D. La.
1989); FTC v. Hayes, No. 4:96CV06126SNL (E.D. Mo. 1996). See also
Marks, 19 Sept 97 Tr at 8.
\101\ This disclosure is entirely consistent with long-standing
Commission policy that a franchisor's continued financial viability
and ability to perform as promised is material to a potential
investor. See, e.g., SBP, 43 FR at 59650-51, and 59682.
\102\ When NASAA revised the UFOC in 1993, it explained that all
settlements must be disclosed, regardless of any confidentiality
clause they may contain. Recognizing that franchisors may have
contractual restrictions on disclosing the existence of confidential
settlements, NASAA made the disclosure requirement prospective--only
confidential settlements entered into after April 15, 1993, (the
date NASAA approved the revised UFOC Guidelines) must be disclosed.
Proposed footnote 4 makes clear that the Commission will follow the
NASAA approach.
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At the same time, the Commission proposes to enhance UFOC Item 3 by
retaining the current Rule provision requiring the disclosure of
litigation involving the franchisor's parent. In addition, the
Commission would require franchisors to disclose pending franchisor-
initiated law suits against franchisees on issues involving the
franchise relationship. Currently, the Rule (and UFOC Guidelines)
require franchisors to disclose only suits that franchisees have filed
against the franchisor. A franchisor must disclose suits it has
initiated only if the franchisee were to file a subsequent
counterclaim.\103\
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\103\ See 16 CFR 436.1(a)(4)(ii)(B); UFOC, Item 3, A.
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Based upon the record, the Commission finds that broader litigation
disclosures are warranted to alert prospective franchisees to potential
problems in the franchise relationship. In the ANPR, the Commission
solicited comment on whether it should amend the Rule's litigation
disclosures to require franchisors to disclose franchisor-initiated
litigation in all instances.104 Several commenters favor the
ANPR proposal, asserting that franchisor-initiated litigation is
material to prospective franchisees because it sheds light on problems
in the franchise relationship, as well as the extent to which the
franchisor is inclined to use litigation to resolve
disputes.105 Others oppose the ANPR proposal, maintaining
that franchisor-initiated litigation is immaterial to prospective
franchisees.106 To the extent a franchisee is aggrieved by a
franchisor-initiated suit, the franchisee, in their view, will surely
file a counterclaim, which all agree must be disclosed under current
law.107 They also contend that litigation should be limited
to suits that imply wrongdoing on the franchisor's part: franchisor-
initiated suits simply demonstrate that the franchisor is enforcing its
rights under the franchise agreement.108 They fear that
disclosing such litigation would have a negative connotation to
prospective franchisees, implying some wrongdoing on the franchisor's
part.109 They also contend that an expanded Item 3 would
``bulk up'' disclosure documents, thereby increasing compliance
costs.110 One franchisor representative suggests that if the
Commission were to require such a disclosure that it consider setting
forth a threshold: a franchisor would not have to make the disclosure
unless it has sued at least a certain percentage (i.e., 5%) of the
franchisees in its system.111
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\104\ 62 FR at 9120-21.
\105\ SBA, Comment 36, at 4-5; AFA, Comment 62, at 2; IL AG,
Comment 77, at 2; Lagarias, Comment 125, at 3; Selden, Comment 133,
Appendix B, at 2; Karp, 19 Sept 97 Tr at 98.
\106\ E.g., Kaufmann, Comment 33, at 4.
\107\ E.g., Quizno's, Comment 16, at 1; Kaufmann, Comment 33, at
4; IFA, Comment 82, at 1-2; Cendant, Comment 140, at 3.
\108\ E.g., Kestenbaum, Comment 40, at 1; Tifford, Comment 78,
at 3.
\109\ E.g, Kaufmann, Comment 33, at 4; Tifford, Comment 78, at
3; Cendant, Comment 140, at 3. On the other hand, Carl Jeffers, a
franchise consultant, suggests that the disclosure of franchisor-
initiated suits could be viewed as a ``positive attribute,'' showing
that the franchisor is willing to enforce its standards and
trademark, and is willing to eliminate aggressively continuing
violations of its franchise agreement. Jeffers, Comment 116, at 1-2.
\110\ E.g., Baer, Comment 25, at 3; Kaufmann, Comment 33, at 4.
See also Forseth, 18 Sept 97 Tr at 20.
\111\ Baer, Comment 25, at 3.
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After carefully considering the ANPR comments, the Commission
proposes to amend the UFOC Item 3 litigation
[[Page 57304]]
disclosures by requiring franchisors to disclose material information
about pending franchisor-initiated litigation involving the franchise
relationship. There is no doubt that a franchisor must disclose a
franchisor-initiated lawsuit if a franchisee files a counterclaim. In
many instances, however, franchisees do not have the financial
resources to hire an attorney to initiate a suit or to pursue a
counterclaim.112 Therefore, the disclosure of litigation
involving the franchise relationship should not depend upon which party
happens to have the resources and the ability to file a law suit.
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\112\ Peter Lagarias observes that ``[f]ranchisors are often
able to wield the threat of litigation, especially by threatening to
seek attorneys fees, to deter franchisees from suing or maintaining
lawsuits against them. Thus, while loss of a single lawsuit is
seldom significant to franchisors, loss of a lawsuit against their
franchisor is often fatal for franchisees.'' Lagarias, Comment 125,
at 3. See also Merret, Comment 126, at 1; Brandt, Comment 137, at 1;
Doe, 7 Nov 97 Tr at 267.
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More important, the Commission is persuaded that franchisor-
initiated suits may reveal material information to a prospective
franchisee. For example, a franchisor may routinely file suit to
collect royalties from franchisees. Such suits may show that
franchisees are unwilling to pay royalties, or are having difficulty
making their royalty payments. The royalty payments may be too high in
light of franchisees' actual earnings, or the franchisees may be
unsuccessful and cannot afford to pay the royalty fee. A pattern of
such suits is highly material to a prospective franchisee because it is
another source of information from which prospective franchisees can
assess the quality of the relationship with the franchisor and
likelihood of their own success. Moreover, as noted above, the
overwhelming number of commenters who responded to the ANPR are current
franchisees voicing various complaints about their relationship with
the franchisor. These franchisees continue to argue for more
substantive regulation of the franchise relationship. While the record
does not support such a drastic expansion of the Franchise Rule by the
Commission, it does support greater disclosure of suits initiated by
franchisors against franchisees pertaining to the franchise
relationship. Such disclosure no doubt would shed greater light on
problems within a franchise system.
At the same time, the Commission shares the commenters' concerns
that requiring additional disclosures may increase the costs and
burdens of preparing a disclosure document. Therefore, the Commission
proposes to limit the disclosure of franchisor-initiated litigation as
follows. First, the proposed disclosure is limited to ``material''
franchisor-initiated law suits. 113 Arguably, an isolated
suit against an individual franchisee might not be deemed material
given the number of franchisees in the system. Second, the proposed
disclosure is limited to suits involving the franchise relationship.
Franchisors need not disclose suits they initiated against suppliers,
advertisers, or other third parties. 114 Third, the proposed
disclosure is limited to pending lawsuits: there is no requirement that
franchisor-initiated suits be disclosed for a full 10 years, as
franchisors must do for suits alleging, for example, fraud. The
Commission believes that restricting the disclosure to pending lawsuits
is a good compromise that would likely be sufficient to show a pattern
of suits on the franchisor's part without ``bulking up'' the disclosure
document and imposing undue compliance costs.
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\113\ See Quinzo's, Comment 16, at 1.
\114\ Cendant notes that in vicarious liability cases (where a
customer sues the franchisor for alleged wrongdoings by the
individual franchisee), the franchisor often must sue the franchisee
to protect its interests and to obtain indemnification. Cendant
believes that such suits are really between the customer and the
franchisor and are not indicative of franchise system performance.
Cendant, Comment 140, at 3. The Commission agrees. Accordingly, the
proposed Item 3 disclosure would require franchisors to disclose
only those suits they initiate against franchisees involving the
franchise relationship. Most often, this would include suits for
failure to pay royalties or to comply with operations standards. It
would not extend to all suits filed by the franchisor against the
franchisee, such as suits for indemnification for actions outside
the franchise contract.
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Finally, the Commission wishes to explore further the suggestion
that a franchisor should be required to disclose franchisor-initiated
litigation only if the franchisor has sued at least a certain
percentage of franchisees in its system. At this time, however, the
record is insufficient for the Commission to determine the merits of
this suggestion. Accordingly, the Commission seeks comment on whether a
franchisor-initiated litigation disclosure should be tied to a
threshold and, if so, what threshold would be sufficient.
d. Proposed Section 436.5(d): Item 4 (Bankruptcy)
Proposed section 436.5(d) is substantially similar to UFOC Item 4.
115 It requires franchisors to disclose information about
any prior bankruptcies. Proposed section 436.5(d) enhances the
comparable Rule disclosures found at 16 C.F.R. Sec. 436.1(a)(5) in two
respects: (1) Franchisors would disclose bankruptcy information about
their predecessors and affiliates; and (2) franchisors would make the
disclosures for 10 years, instead of the current seven years. Proposed
section 436.5(d) also clarifies that franchisors must disclose foreign
proceedings comparable to bankruptcy. Proposed section 436.5(d) differs
from the UFOC Guidelines, however, by retaining the Rule's current
requirement that franchisors include information about a parent's prior
bankruptcy. 116
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\115\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 4, upon which proposed section 436.5(d) is based.
\116\ See 16 CFR 436.1(a)(5).
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e. Proposed Section 436.5(e): Item 5 (Initial Franchise Fee)
Proposed section 436.5(e) begins a series of three disclosures
concerning the total costs involved in purchasing and operating a
franchise. 117 Modeled after UFOC Item 5, it requires
franchisors to disclose information about the initial franchise fee,
including whether such fees are refundable. 118 Proposed
section 436.5(e) enhances the comparable Rule disclosures found at 16
CFR 436.1(a)(7) by enabling franchisors to provide a range of fees,
instead of a fixed fee. Arguably, a franchisor who offers a franchise
at a price that is not reflected in its disclosure document might
violate the Rule because the seller has not provided the prospect with
complete and accurate pre-sale disclosure of the price terms. In
effect, proposed section 436.5(e) clarifies that franchisors can
negotiate with a prospective franchisee over the initial franchise fee,
without potentially violating the Rule.
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\117\ Pre-sale disclose of cost information is prevalent in
Commission trade regulation rules. E.g., Trade Regulation Rule
Pursuant to the Telephone Disclosure and Dispute Act of 1992 (``900
Number Rule''), 16 CFR 308 at 308.3(b); Telemarketing Sales Rule, 16
CFR 310 at Sec. 310.3; Funeral Industry Practices Rule, 16 CFR 453
at 453.2.
\118\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 5, upon which proposed section 436.5(e) based.
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f. Proposed Section 436.5(f): Item 6 (Recurring or Occasional Fees)
Proposed section 436.5(f), the second cost disclosure, is
substantially similar to UFOC Item 6.\119\ It requires franchisors to
disclose recurring fees associated with operating a franchise (e.g.,
royalties, advertising fees, and transfer fees). This disclosure
recognizes that a prospective franchisee's investment is not limited to
the initial franchise fee alone. Rather, a franchisee
[[Page 57305]]
may incur considerable costs in the operation of the business that will
significantly impact upon his or her ability to continue operations and
ultimately be successful.\120\
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\119\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 6, upon which proposed section 436.5(f) is based.
\120\ The failure to disclose all material ongoing costs
involved in using a product or service is a violation of section 5.
See, e.g., FTC v. Minuteman Press Int'l, No. C-93-2496-DRH (E.D.N.Y.
1993); FTC v. SureCheK Sys. No. 1-97-CV-2015 (JTC) (N.D. Ga. 1997);
In the Matter of Jenny Craig, 1998 FTC Lexis 13 (February 27, 1998);
FTC v. Design Travel, No. C-97-0833 MHP (N.D. Cal. 1993); In the
Matter of General Motors, 102 F.T.C. 1741 (1983). Proposed section
436.5(f) is also consistent with many Commission trade regulation
rules that require sellers to disclose post-sale costs and
conditions that will impact upon the consumer's ultimate cost in
using the product or service. E.g., Appliance Labeling Rule, 16 CFR
305 at 305.11; 900 Number Rule, 16 CFR 308 at 308.3; Telemarketing
Sales Rule, 16 CFR 310 at 310.3.
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Consistent with the UFOC Guidelines approach, proposed section
436.5(f) enhances the comparable Rule disclosure provisions found at 16
CFR 436.1(a)(8) by adding a disclosure about advertising and purchasing
cooperatives from which franchisees are required to purchase goods or
services. The franchisor must also disclose the voting power of any
company-owned outlets in the cooperative and, if company store voting
power is controlling, the range of required fees charged by the
cooperative must be disclosed. These additional disclosures better
enable prospective franchisees to understand their total costs of
conducting business.
g. Proposed Section 436.5(g): Item 7 (Estimated Initial Investment)
Proposed section 436.5(g), the third cost disclosure, requires
franchisors to disclose additional expenses necessary to commence
business (e.g., rent, equipment, inventory) in an easy-to-read tabular
format. It is based upon UFOC Item 7, which addresses fees paid to
third parties.\121\ Proposed section 436.5(g) enhances the comparable
Rule disclosures found at 16 CFR 436.1(a)(7) by requiring franchisors
to disclose ``additional funds'' required before operations begin and
``during the initial phase of the franchise.'' This information is
essentially the same as a working capital disclosure. The UFOC defines
the term ``initial phase'' to mean at least three months or a
reasonable period for the industry. Franchisors must also identify the
factors, basis, and experience they have considered in determining the
level of additional funds. These disclosures assist prospective
franchisees to understand not only the costs of entering into the
business, but their likely operational costs until they can break even.
These enhanced disclosures are entirely consistent with the Rule's
general policy of requiring full cost and expense disclosures.
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\121\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 7, upon which proposed section 436.5(g) is based.
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h. Proposed Section 436.5(h): Item 8 (Restrictions on Sources of
Products and Services)
Proposed section 436.5(h) is one of several Rule provisions that
require franchisors to state with specificity the legal obligations and
restrictions imposed on the franchisee. Modeled after UFOC Item 8, it
requires the franchisor to disclose obligatory purchases, restrictions
on sources of products and services, the conditions under which the
franchisor will approve alternative supplies or products, and the
amount of any rebates the franchisor may receive from required
suppliers. Proposed section 436.5(h) enhances the current Rule
disclosures found at 16 CFR 436.1(a)(9)-(11) by requiring greater
disclosure about the circumstances under which the franchisor will
authorize substitute goods \122\ and whether, by contract or practice,
the franchisor provides material benefits to franchisees who use
designated or approved suppliers, such as permitting renewals or
providing additional outlets. It also requires the disclosure of
purchasing or distribution cooperatives and whether the franchisor
negotiates purchase arrangements with suppliers for the benefit of
franchisees. These additional disclosures enable prospective
franchisees to assess better their likely costs and benefits, as well
as their independence from the franchisor.
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\122\ In response to the ANPR, a few franchisees reported that
their franchisors failed to approve alternative suppliers or made it
difficult for franchisees to find alternative sources of supplies.
E.g., Chiodo, 21 Nov 97 Tr at 308-09; Hockert-Lotz, id at 325-327.
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In response to the ANPR, several commenters voice concern about
source restrictions that prevent franchisees from obtaining comparable
supplies at cheaper rates.\123\ For example, one franchisee states that
franchisors ``put you in an uncompetitive situation with other people
in the same business because you are paying higher than fair market
value for the price of the goods that you receive from them.'' \124\
These commenters generally do not allege that their franchisors failed
to disclose source restrictions, but complain about the abusive nature
of such restrictions. Other commenters, however, question the
sufficiency of UFOC Item 8, urging the Commission to expand Item 8 to
require franchisors to disclose more information about their practices
and intentions with respect to the provision of competitive alternative
sources of supply,\125\ or to require franchisors to include a specific
risk factor about sourcing restrictions in their Item 8
disclosure.\126\
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\123\ E.g., Manuszak, Comment 13, at 1; Weaver, Comment 17, at
1; Mueller, Comment 29, at 2; Gagliati, Comment 72, at 1; Buckley,
Comment 97, at 1; Rafizadeh, 7 Nov 97 Tr at 288-89; Slimak, 22 Aug
97 Tr at 26. See also Kezios, Comment 64, at 2-3.
\124\ Brickner, Comment 128. Brickner adds that he also must
purchase specific equipment from only one manufacturer and the
franchisor is the only supplier. Id. See also Buckley, Comment 97 at
3; Myklebust, Comment 101; Chiodo, 21 Nov 97 Tr at 293-94.
\125\ Selden, Comment 133, Appendix B, at 1.
\126\ Zarco, Comment 134, at 2. Harold Brown, a franchisee
advocate, also urges the Commission to prohibit direct and indirect
``kick-backs'' from third-party vendors to the franchisor. Brown,
Comment 4 at 3. The Commission, however, believes that proposed
section 436.5(h)(5), requiring the disclosure of revenue to the
franchisor from franchisee purchases, is sufficient to address this
issue.
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The Commission believes that the ANPR comments clearly support the
proposition that full disclosure about source restrictions and
purchasing obligations is warranted. Nonetheless, the Commission
believes that proposed section 436.5(h) strikes the right balance
between pre-sale disclosure and compliance costs and burdens, and is
sufficient to warn prospective franchisees about source restrictions,
purchase obligations, and approval of alternative suppliers.
i. Proposed Section 436.5(i): Item 9 (Franchisee's Obligations)
Except for some minor editing, proposed section 436.5(i) is
identical to UFOC Item 9.\127\ There is no counterpart in the current
Rule. Proposed section 436.5(i) requires franchisors to provide an
easy-to-understand table that cross references the sections of the
franchise agreement and disclosure document that explain the
franchisee's legal obligations in greater detail.\128\ The Commission
finds that this proposed disclosure serves an important consumer
protection function, giving prospective
[[Page 57306]]
franchisees an easy-to-understand roadmap to their franchise agreement
and disclosure document, without imposing great compliance costs or
burdens on franchisors. In addition, the significant number of comments
detailing franchise relationship problems would tend to support the
need to provide prospective franchisees with more guidance in
understanding and reviewing a franchise agreement.
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\127\ Only one commenter, Gary Duvall, raises any concern about
UFOC Item 9, upon which proposed section 436.5(i) is based. Mr.
Duvall suggests that the Commission permit a franchisor to opt out
of Item 9 if the franchisor provides prospective franchisees with a
detailed table of contents or index to their franchise agreement.
Duvall, comment 19, at 2. In an effort to harmonize federal and
state disclosure laws, however, the Commission is inclined to adopt
UFOC Item 9 in its entirety.
\128\ Proposed section 436.5(i) is consistent with other trade
regulation rules where the Commission has recognized that
information about legal risks to consumers is material. E.g., 900
Number Rule, 16 CFR 308 at 308.7 (obligations concerning billing
disputes); Negative Option Rule, 16 CFR 425 at 425.1(a)(1)(ii)
(minimum purchase obligations); Door-to-Door Sales Rule, 16 CFR 429
at 429.1(e) (obligations regarding cancellations); Warranty
Disclosures, 16 CFR 701 at 701.3(a)(5) (obligations to obtain
performance).
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j. Proposed Section 436.5(j): Item 10 (Financing)
Proposed section 436.5(j) requires the franchisor to disclose all
the material terms and conditions of any financing agreements,
including the annual percentage rate, the number of payments, penalties
upon default, and any consideration received by the franchisor for
referring a prospective franchisee to a lender. For the most part,
these disclosures are comparable to the disclosures lenders must make
under the Federal Reserve's Regulation M (Consumer Leasing), 12 CFR
213, and Regulation Z (Truth in Lending), 12 CFR 226. Based upon UFOC
Item 10,\129\ proposed section 436.5(j) enhances the current Rule
disclosures found at 16 CFR 436.1(a)(12) by requiring franchisors to
disclose any interest on the financing in terms of an Annual Percentage
Rate, consistent with other consumer credit transactions. It also
requires more disclosure about what the financing covers, waiver of
defenses, and the franchisor's practice or intent to sell or assign the
obligation to a third party. Proposed section 436.5(j) also makes clear
that the franchisor may provide this information in summary table
format, and Appendix A to the proposed Rule offers a sample table.
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\129\ As with most of the other disclosures, no commenters
raised any objections to UFOC Item 10, upon which proposed section
436.5(j) is based.
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k. Proposed Section 436.5(k): Item 11 (Franchisor's Assistance,
Advertising, Computer Systems, and Training)
Proposed section 436.5(k) requires franchisors to disclose their
obligations to franchisees with respect to pre-opening and ongoing
assistance (such as site selection, training, and advertising) in
tabular form, with cross references to the corresponding provisions of
the franchise contract.\130\ It expands the comparable Rule provisions
found at 16 CFR 436.1(a)(17)-(18) by requiring franchisors to explain
in greater detail their site selection criteria and the nature of their
training program. It also requires additional disclosures concerning
the extent of advertising assistance and the operation of local,
regional, and national advertising co-ops. Proposed section 436.5(k)
also addresses major technological changes in franchising since the
Rule was promulgated in the late 1970s. Specifically, it requires
greater disclosure about the required use of computers and electronic
cash registers.\131\ The Commission believes that these disclosures are
necessary to address frequent franchisee complaints about promised
assistance and related obligations. Each of these expanded disclosures
sheds greater light on the level of services and assistance promised to
prospective franchisees, as well as related franchisee obligations, and
therefore are material. The pre-sale disclosure of this information to
prospective franchisees is also likely to reduce misunderstandings and
conflict during the franchise relationship.
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\130\ Misrepresentations about promised support and assistance
are among the most common allegations in franchise cases and
continue to be a source of numerous franchisee complaints. E.G., FTC
v. Nat'l Consulting Group, Inc., No. 98 C 0144 (N.D. III 1998); FTC
v. Hayes, No. 4:96CV061126 SNL (E.D. Mo. 1996); FTC v. Int'l
Computer Concepts, Inc., No. 1:94CV1678 (N.D. Ohio 1994); United
States v. Megatrend Telecomm., Inc., No. 3:93 CV 22220 AVC (D.Ct.
1993); FTC v. Intellipay, Inc., Bus. Franchise Guide (CCH) para.
10,061 (S.C. Tx. 1992); FTC v. Blanc, Bus. Franchise Guide (CCH)
para. 10,032 (N.D. Ga 1992). See also Lundquist 22 Aug 97 Tr at 45;
Gray, comment 22, at 1; Dady & Garner, Comment 127, at 4; Mousley,
29 July 97 Tr at 4-7.
\131\ In response to the ANPR, a few commenters voiced concerns
about maintenance obligations regarding computer systems and related
equipment. E.g. Fetzer, 19 Sept 97 Tr at 42; Rafizadeh, 7 Nov 97 Tr
at 292. See also NCA-7 Eleven Franchisees, Comment 113, at 2.
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Two commenters, however, question the sufficiency of UFOC Item 11,
upon which proposed section 436.5(k) is based. One franchisee advocate
contends that the UFOC Item 11's short-hand references to the franchise
contract ``offend[s] the basic purpose of the disclosure statement,
namely, to provide the prospective franchisee with a reliably complete
description of what is being purchased.'' \132\ He urges the Commission
to require a franchisor to provide prospects with a more in-depth
analysis of each of the franchisor's obligations. A franchisor
representative raises a concern about the disclosures concerning
computer systems. UFOC Item 11, and by extension proposed section
436.5(k), require franchisors to disclose information about the nature
of their computer systems and any assistance available to franchisees
concerning such systems. This commenter does not disagree with the need
for the disclosure, but notes that many start-up franchisors are ``not
certain which computer system or software they expect to have the
franchisees use. Provision should be made for these new franchisors.''
\133\
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\132\ Brown, comment 4, at 5.
\133\ Kestenbaum, Comment 40, at 2.
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In light of the overwhelming number of comments urging the
Commission to adopt the UFOC format, the Commission finds no compelling
justification to expand Item 11, as suggested above. Requiring
franchisors to repeat in the disclosure document what they already
disclose in their contract would appear to impose costs on franchisors
without any clear benefit to prospective franchisees. Multiple
disclosure might greatly increase the size of a disclosure document,
making it more daunting to read. The Commission, however, is concerned
that the UFOC Item 11 disclosures concerning computer systems may not
provide adequate guidance to start-up franchisors. Specifically, a
start-up franchisor may require franchisees to use computer systems in
the future, but may not have the specific computer requirements
available at the time of the franchise sale. Based upon the record, the
Commission cannot assess the extent to which proposed section 436.5(k)
may impose undue costs or burdens on, or otherwise disadvantage, start-
up franchise systems. Accordingly, the Commission solicits additional
comment on this issue.
l. Proposed Section 436.5(l): Item 12 (Territory)
Proposed section 436.5(l) addresses exclusive territories, as well
as competition from franchisors selling similar goods or services under
the same or a different trade name. The Commission believes this
provision is one of the most important disclosure items, preventing
fraud and misleading statements concerning protected territories and
competition. Indeed, the Commission has brought a number of law
enforcement actions against false or misleading exclusive territory
representations.134 Proposed section 436.5(l) enhances the
current Rule's disclosures found at 16 CFR 436.1(a)(3)-(13) in several
respects, including requiring franchisors to disclose the conditions,
if any, under which they will approve the relocation of the
franchisee's business and the franchisee's establishment of additional
[[Page 57307]]
outlets. Franchisors must also disclose any present plans to operate a
competing franchise system offering similar goods or services or to
sell through alternative channels of distribution.
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\134\ E.g., FTC v. Int'l Computer Concepts, Inc., No. 1:94CV1678
(N.D. Ohio 1994); FTC v. O'Rourke, No. 93-6511 (S.D. Fla. 1993); FTC
v. Nat'l Bus. Consultants, Inc., Bus. Franchise Guide (CCH) para.
9,365 (E.D. La. 1989); FTC v. American Safe Mktg., Inc., Bus.
Franchise Guide (CCH) para. 9,350 (N.D. Ga. 1989); FTC v. American
Legal Distrib., Inc., Bus. Franchise Guide (CCH) para. 9,090 (N.D.
Ga. 1988); United States v. C.D. Control Tech., Inc., Bus. Franchise
Guide (CCH) para. 9,851 (E.D.N.Y. 1985).
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Unlike most disclosure items--which generated little comment in
response to the ANPR--UFOC Item 12 generated a significant number of
comments. In particular, franchisees and their advocates complain about
``encroachment,'' where a franchisor essentially competes with its
franchisees by establishing company-owned or new franchised-outlets in
the same market, or sells the same goods as the franchisee through
alternative channels of distribution.135 These commenters
contend that encroachment has a devastating effect upon an individual
franchisee who does not have a contractual right to an exclusive
territory,136 and they urge the Commission to ban
encroachment as an abusive and unfair practice. Other commenters urge
the Commission at the very least to expand the disclosures about
territories to include more information about the franchisor's past
practices and specific expansion plans.137 Finally, several
franchisees suggest that the Commission should strengthen the UFOC's
``encroachment'' risk factor. For example, one commenter suggests that
franchisors should be required to state: ``The company reserves the
right to increase the number of franchised or company-owned units in an
area. In the past, we have been known to put another outlet in close
proximity to an existing unit. This action generally has a negative
impact on the gross and/or net sales of the pre-existing unit.''
138
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\135\ E.g., Brown, Comment 4, at 2; Manuszak, Comment 13, at 1;
AFA, Comment 62, at 1; Orzano, Comment 73, at 1; Buckley, Comment
97, at 3; Marks, Comment 107, at 2; Zarco & Pardo, Comment 134, at
2.
\136\ E.g., Parker, Comment 10, at 1; L. Gaither, Comment 68, at
1; Vidulich, 22 Aug 97 Tr at 17; Christiano, 19 Sept 97 Tr. at 50;
Bundy, 6 Nov 97 Tr at 135.
\137\ For example, Andrew Selden suggests that ``Item 12 should
be elaborated to require full disclosure of past practice, current
intention or future possibility of franchisor-sponsored competitive
activities that have the prospect of impacting the franchisee's
business.'' Seldon, Comment 133, Appendix B, at 1. See also, Dady &
Garner, Comment 127, at 4.
\138\ Zarco & Pardo, Comment 134, at 2. See also G. Gaither,
Comment 69, at 1; Orzano, Comment 73, at 1; Dady & Garner, Comment
127, at 3; Cordell, 6 Nov 97 Tr at 136; Kezios, 6 Nov 97 Tr at 142.
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The Commission believes that proposed section 436.5(l) strikes the
appropriate balance, ensuring that prospective franchisees will receive
material information about the extent to which they will receive a
protected territory and/or are likely to face competition from the
franchisor. Disclosure about a franchisor's past practices and future
policies, however, appears to be unwarranted. A franchisor's past
policies and practices regarding territories and means of distribution
are arguably irrelevant because they do not necessarily shed any light
on the franchisor's practices that will govern a particular franchise
relationship.139 In the same vein, a franchisor's expansion
policies in one location may be irrelevant to a prospective franchisee
who intends to operate his or her outlet in another. Moreover,
prospective franchisees may be able to discover past practices on their
own by speaking with current and former franchisees.
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\139\ The Commission believes that the issue of encroachment is
essentially a contractual matter. Absent an express grant of a
protected territory, a franchisor is generally free to establish as
many outlets (company-owned or franchised) in any particular market
as it wishes. A few state courts (or federal courts applying state
law), however, have held that encroachment violates state implied
covenants of good faith and fair dealing. See, e.g., In re Vylene
Enter., Inc., 90 F.3d. 1472 (9th Cir. 1996).
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The Commission also believes it is unreasonable to require
franchisors to disclose hypothetical possibilities about future
expansion. Indeed, by not granting an exclusive territory, the
franchisor has effectively reserved to itself the unrestricted right to
expand the number of outlets or to sell its products or services via
alternative channels of distribution. For that reason, proposed section
436.5(l) provides that franchisors not offering exclusive territories
must state: ``You will not receive an exclusive territory. [Franchisor]
may establish other franchised or company owned outlets that may
compete with your location.'' Although the Commission generally
disfavors the use of risk factors that merely repeat what is expressly
or impliedly stated in the franchise agreement, the Commission agrees
that the disclosure of this specific risk factor is warranted in light
of the considerable number of franchisee complaints regarding
encroachment. Armed with such information, prospective franchisees can
shop for a competing franchise system that does offer protected
territories, if they so choose.
m. Proposed Section 436.5(m): Item 13 (Trademarks)
Proposed section 436.5(m) is intended to be identical to UFOC Item
13. It requires franchisors to disclose information about the principal
trademarks that will be licensed to the franchisee for use in operating
the outlet.140 This is an anti-fraud provision, ensuring
that franchisors do not misrepresent the value of the trademark
underlying the franchise system.
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\140\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 13, upon which proposed section 436.5(m) is based.
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The current Rule provision addressing trademarks, section
436.1(a)(iii), merely requires the franchisor to identify its
trademarks. Following UFOC Item 13, proposed section 436.5(m) enhances
the current Rule requirements by requiring more detailed disclosures,
including whether the trademark is registered with the U.S. Patent &
Trademark Office,141 and the existence of any pending
litigation, settlements, agreements, or superior rights that may limit
the franchisee's use of the trademark. Proposed section 436.5(m) also
explains the franchisor's contractual obligations to protect the
franchisee's right to use the mark against claims of infringement or
unfair competition. These additional disclosures are entirely
consistent with the Commission's long-standing policy of requiring the
disclosure of material information about the costs and benefits of
entering into the franchise relationship.
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\141\ If the mark is not registered, the franchisor must provide
the following warning: ``By not having a Principal Register federal
registration for (name or description of symbol), (Name of
Franchisor) does not have certain presumptive legal rights granted
by a registration.''
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n. Proposed Section 436.5(n): Item 14 (Patents, Copyrights, Proprietary
Information)
Proposed section 436.5(n) is intended to be identical to UFOC Item
14.142 It is another anti-fraud provision, ensuring that
franchisors do not misrepresent the nature of their intellectual
property, such as secret recipes or manufacturing processes, the
existence of which often makes the purchase of a franchise an
attractive option, especially to consumers without prior business
experience. Like trademark limitations, restrictions on the use of the
franchisor's intellectual property are material because they not only
can seriously diminish the value of the franchise, but could undermine
the franchisee's ability to operate the business. No comparable
provision is found in the current Rule. In keeping with the goal of
reducing inconsistencies between federal and state disclosure law, the
Commission
[[Page 57308]]
believes that adopting UFOC Item 14 is warranted.143
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\142\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 14, upon which proposed section 436.5(n) is based.
\143\ Proposed section 436.5(n) is substantially similar to
other required disclosures. It complements Item 13, which requires
the disclosure of information about the franchisor's trademark, and
it parallels Item 3, which requires the disclosure of certain
litigation.
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o. Proposed Section 436.5(o): Item 15 (Obligation To Participate in the
Actual Operation of the Franchise Business)
Proposed section 436.5(o) is intended to be identical to UFOC Item
15.144 It requires franchisors to disclose whether
franchisees must participate personally in the direct operation of the
franchise.145 Proposed section 436.5(o) enhances the current
Rule disclosures found at 16 CFR 436.1(a)(14), however, in several
respects. It requires franchisors to disclose not only obligations
under the franchise agreement, but obligations to participate directly
arising from other agreements or as a matter of practice. Franchisors
must also state if direct participation is recommended. Proposed
section 436.5(o) also requires franchisors to disclose any limitations
on whom the franchisee can hire as a supervisor and any restrictions
that the franchisee must place on its manager. If the franchise is a
business entity, the franchisor must also disclose the amount of equity
interest that the supervisor must have in the franchise. Armed with
such disclosures, prospective franchisees will have a much better
understanding of the personal commitment required to operate the
franchise.
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\144\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 15, upon which proposed section 436.5(o) is based.
\145\ This requirement is consistent with the Commission's long-
standing view that prospective franchisees should be able to assess
their legal obligations under the franchise agreement, as well as
the degree of independence they will be able to exercise in
operating their business. SBP, 43 FR at 59662-63. Personal
participation requirements might also result in economic injury to
franchisees who, under their franchise agreement, are restricted
from engaging in other businesses or who have signed covenants not
to compete in the same business. Id.
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p. Proposed Section 436.5(p): Item 16 (Sales Restrictions)
Proposed section 436.5(p) is intended to be identical to UFOC Item
16.146 Like other Rule provisions governing a franchisee's
method of operation, it requires a franchisor to disclose any
restrictions limiting customers to whom the franchisee is permitted to
sell, or the goods or services that the franchisee may offer for
sale.147 Proposed section 436.5(p) enhances the current Rule
disclosures found at 16 CFR 436.1(a)(13) by also requiring the
franchisor to disclose whether the franchisor has the right to change
the types of authorized goods and services and whether there are limits
on the franchisor's right to make such changes. These disclosures will
better enable a prospective franchisee to understand the scope of the
franchisor's contractual rights regarding product sales.
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\146\ In response to the ANPR, no commenters raised any concerns
about UFOC Item 16, upon which proposed section 436.5(p) is based.
\147\ Sales restrictions can cause serious economic injury to
franchisees by limiting the scope of the franchisee's market and
ultimately the franchisee's profitability. SBP, 43 FR at 59661.
Comparable disclosures about the terms, conditions, and restrictions
on the use of goods and services are found in many Commission rules.
E.g., Telemarketing Sales Rule, 16 CFR 310 at 310.3; Negative Option
Rule, 16 CFR 425 at 425.1(a)(1)(ii); Disclosure of Warranty Terms
and Conditions, 16 CFR 701 at 701.3(a)(8).
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q. Proposed Section 436.5(q): Item 17 (Renewal, Termination, Transfer,
and Dispute Resolution)
Proposed section 436.5(q) is intended to be identical to UFOC Item
17. It requires franchisors to summarize in tabular form 23 enumerated
terms and conditions of a typical franchise relationship, such as the
duration of the franchise agreement, rights and obligations upon
termination, post-term covenants not to compete, and assignment and
transfer rights.148
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\148\ The Commission has recognized that the terms and
conditions governing the franchise relationship ``may well be the
most important provisions in a franchise agreement, since they limit
what the franchisee may do with his capital asset.'' Given the
length and complexity of the typical franchise agreement, such terms
and conditions are often overlooked or not fully appreciated. The
Commission has also recognized that there is often an informational
imbalance between franchisors and franchisees about the
relationship. ``This information imbalance makes the clear and
concise disclosure [about franchise relationship issues] essential,
if a prospective franchisee is to make an informed business
judgment.'' SBP, 43 FR at 59664.
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Proposed section 436.5(q) enhances the current Rule disclosures
found at 16 CFR 436.1(a)(15) by requiring disclosures about arbitration
or mediation of disputes, as well as forum-selection and choice of law
provisions. At the same time, it greatly streamlines the Rule's
disclosures. The Rule currently requires franchisors to detail the
rights and obligations already spelled out in the franchise agreement.
Proposed section 436.5(q), in contrast, requires franchisors to cross
reference the applicable contractual provisions in an easy-to-read
table with only a brief summary of each provision. This streamlined
approach reduces compliance burdens, while providing prospective
franchisees with a detailed road map to the contract, where they can
read the various provisions in greater detail.
In response to the ANPR, a few commenters offer specific
suggestions about UFOC Item 17, upon which proposed section 436.5(q) is
based. One commenter questions whether the Item 17 disclosure is
necessary in the first instance, suggesting that a franchisor be
permitted to opt out of Item 17, if it provides a detailed table of
contents or index to its franchise agreement.149 In
addition, several franchisees and their representatives state that the
term ``renewal'' in Item 17 is misleading. They maintain that the word
``renew'' implies that the franchisee is able to continue to operate
the franchise under substantially similar terms and conditions as under
the original franchise agreement. They assert, however, that in reality
franchisees who wish to continue operating the franchise upon
expiration must often sign radically new contracts that impose
substantially different terms and conditions, such as higher royalty
payments or the elimination of an exclusive territory. Further, they
assert that, in many instances, franchisees have no choice but to sign
even the most abusive, one-sided contracts because the franchisee has a
substantial economic investment in the franchise and simply cannot walk
away from it without incurring a significant economic
loss.150 Franchisees also note that if they do walk away
from the franchise, they are often bound by covenants not to compete
that restrict their ability to operate a similar business for a number
of years.151
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\149\ Duvall, Comment 19, at 2.
\150\ E.g., Bores, Comment 9, at 1; Rachide, Comment 32, at 1;
Chabot, Comment 37, at 1; Rich, Comment 65, at 1; Orzano, Comment
73, at 1; Geiderman, Comment 131, at 1; Vidulich, 22 Aug 97 Tr at
19-20; D'Alessandro, 22 Aug 97 Tr at 41; Chiodo, 21 Nov 97 Tr at
303-04.
\151\ For example, the AFA states:
``Renewal'' is a misnomer. ``Re-license,'' ``rewrite'' or even
``re-franchise'' is a more accurate description of what actually
happens at the end of the initial contract term. Most franchisees
find that when it is time to ``renew,'' they are not ``renewing''
their existing franchise agreement, but are entering into a wholly
new franchise agreement, often with materially different financial
and operational terms. They are presented these ``renewal''
contracts on a ``take it or leave it'' basis and are under enormous
coercion pressures to sign--especially if the old agreement contains
a post-termination covenant not to compete. This is truly ``holding
a gun to the head'' of the ``renewing'' franchisee.
AFA, Comment 62, at 2.
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As noted previously, the overwhelming number of ANPR comments were
submitted by franchisees who voice various franchise relationship
concerns.152 The stream of franchisee complaints about
relationship issues demonstrates that there is a continuing need for
complete
[[Page 57309]]
and clear disclosure about the basic contractual terms and conditions
that will govern the franchise relationship. In an effort to harmonize
federal and state disclosure laws, the Commission is inclined to adopt
UFOC Item 17 as set forth in the UFOC Guidelines. Nonetheless, the
Commission wishes to explore further whether the use of the term
``renewal'' is misleading. On the one hand, ``renewal'' appears to be a
term of art that is well understood in franchising to mean that the
parties enter into a new contract. Indeed, UFOC Item 17 specifically
distinguishes between renewals and extensions. Although not defined in
the Rule, the term ``extension'' implies that a franchisee can continue
to operate under the same terms and conditions for an additional
period. In contrast, it would appear that a ``renewal'' means that the
franchisee may continue in operation, but under modified conditions.
Given the number of comments on this issue, however, the Commission
wishes to explore further whether the term ``renewal'' is misleading
and possible alternatives that would be more useful.
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\152\ See supra at Section B.
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r. Proposed Section 436.5(r): Item 18 (Public Figures)
Proposed section 436.5(r) is intended to be identical to UFOC Item
18.153 It requires franchisors to disclose the involvement
of a public figure in the franchise system, including any management
responsibilities, the total investment made in the franchise system,
and any compensation received. A comparable disclosure provision is
currently found at 16 CFR 436.1(a)(19). This information helps
prospective franchisees understand the extent of any financial and
managerial commitments from the public figure, as well as any
obligations to the public figure. Prospective franchisees can then
decide for themselves whether an association with a public figure is
valuable to them.154
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\153\ In response to the ANPR, no commenter raised any concerns
about UFOC Item 18, upon which proposed section 436.5(r) is based.
\154\ See SBP, 43 FR at 59677-78.
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s. Proposed Section 436.5(s): Item 19 (Financial Performance
Representations)
Background. Proposed section 436.5(s), perhaps the most important
anti-fraud provision, addresses financial performance representations.
In the original rulemaking record developed in the 1970s, the
Commission found ``that franchises have been marketed through * * *
unsubstantiated claims regarding potential sales, income, [and] gross
or net profit of franchises.'' 155 The Commission's law
enforcement experience shows that the making of false or
unsubstantiated earnings representations continues to be prevalent.
Indeed, the making of false or unsubstantiated earnings representations
is the most frequent count alleged in Commission Franchise Rule cases.
Of the more than 150 Rule cases filed to date, all but three allege
false or unsubstantiated earnings claims.156
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\155\ Final Interpretive Guides, 43 FR at 59628.
\156\ E.g., FTC v. GreenHorse Communications, Inc., No. 98-CV-
245-M (D.N.H. 1998); FTC v. Nat'l Consulting Group, Inc., No. 98-C
0144 (N.D. Ill. 1988); FTC v. Hart Mktg. Enter., Ltd., No. 98-22-
CIV-T-23E (M.D. Fla. 1988); FTC v. Shelton, No. CV-N-97-00712-ECR
(RAM)(D. Nev. 1997); FTC v. Hayes, No. 4:96CV06126 SNL (E.D. Mo.
1997); FTC v. Tower Cleaning Sys., Inc., No. 96 58 44 (M.D. Pa.
1996).
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Although financial performance representations are highly material
to prospective franchisees, the Commission stated in the ANPR that it
was inclined not to mandate earnings disclosures.157 After
reviewing the Rule Review comments, the Commission acknowledged that
financial performance information is material to prospective
franchisees, but rejected mandating such disclosures in favor of a free
market approach. The Commission noted that approximately 20 percent of
franchisors choose to make earnings disclosures and that prospects, in
theory, can find franchise systems that voluntarily disclose earnings
information. Moreover, the Commission observed that prospective
franchisees can obtain earnings information from a variety of sources.
``For example, typical expenses, such as labor and rent, may be
available from industry trade associations and industry trade press.''
62 FR 9118. Prospective franchisees are also free to discuss earnings
and other performance issues with former and current franchisees.
Perhaps most important, the Commission noted that the record does not
provide a sufficient basis for the Commission to formulate an earnings
disclosure that would both be useful to and not mislead prospective
franchisees. The Commission also noted that mandating earnings
disclosures might impose burdens and costs on existing franchisees (who
would have to release their earnings information to their franchisor)
without any record support showing that such increased burdens and
costs are outweighed by benefits to prospective franchisees.
158
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\157\ 62 FR at 9118.
\158\ Id.
---------------------------------------------------------------------------
While rejecting mandated financial performance disclosures, the
ANPR explored whether the Commission should nonetheless revise the
Rule's performance disclosure requirements in two respects. First, the
Commission observed that some franchisors actually misrepresent that
the Commission or the Franchise Rule prohibits franchisors from making
performance information available.159 Second, the Commission
questioned whether prospective franchisees should be cautioned not to
rely on unsubstantiated earnings representations.160
Accordingly, the Commission solicited comment on whether the Rule
should be modified to require all franchisors to provide specified
preambles to their Item 19 disclosure that would explain financial
performance representations in greater detail.161 The
prescribed preamble would make it clear that franchisors can make
earnings disclosures if they have a reasonable basis to do so. At the
same time, it would discourage prospects from relying on unauthorized
earnings information.162
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\159\ Id.
\160\ Id.
\161\ The ANPR proposed that all franchisors state the following
in their Item 19 disclosure:
The FTC's Franchise Rule permits a franchisor to provide you
with information about the actual or potential sales, income, or
profits of its outlets, provided that there is a reasonable basis
for such information and the franchisor offers to provide you with
written substantiation. You should not rely on any information on
sales, income, or profits provided by a franchisor or its
salespersons if written substantiation is not offered.
Franchisors who do not make earnings disclosures would add the
following additional statement:
This franchisor does not make any representations about sales,
income, or profits. We also do not authorize our salespersons to
make any such representations either orally or in writing.
Id. at 9121-22.
\162\ Id. at 9119.
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In general, no new arguments were raised in response to the ANPR
either supporting or opposing mandatory earnings disclosures.
Franchisees and their allies continue to argue that earnings
information is material, that mandating earnings disclosures will curb
deceptive or false earnings claims already being made, and that it is a
material omission for franchisors to fail to disclose earnings
information they possess.163 They also contend that
prospects need historical earnings information in order to conduct a
due diligence investigation of the franchise offering.164 On
the other hand,
[[Page 57310]]
franchisors and their allies continue to oppose mandatory earnings
disclosures, maintaining that earnings information obtained from
franchisees is often unavailable or unreliable, that mandating the
disclosure of earnings information will increase litigation, and that
prospects can often obtain earnings information directly from current
and former franchisees.165 In addition, a few commenters
urge the Commission to coordinate its policy with NASAA to promote
uniformity between federal and state disclosure laws.166 One
franchisor suggests that the FTC prohibit states from mandating
earnings disclosures by preempting the field.167
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\163\ E.g., Brown, Comment 4, at 4; SBA Advocacy, Comment 36, at
8; AFA, Comment 62 at 4; Purvin, Comment 79, at 2; Lagarias, Comment
125, at 1-2; Dady & Garner, Comment 127, at 1-2; and Selden, Comment
133, at 2 and Appendix C; Lundquist, 22 Aug 97 Tr at 46-47.
\164\ E.g., Karp, 19 Sept 97 Tr at 100-01. Quoting several
business texts, Mr. Karp asserts that historical earnings
information is critical to any evaluation of a business. for
example, he cites Internal Revenue Service Ruling 59-60, Item D,
which provides that: ``detailed profit and loss statements should be
obtained and considered for a representative period immediately
prior to the required date of appraisal, preferably five or more
years.'' Mr. Karp believes that the failure of franchisors to
disclose historical earnings information deprives prospects of
material information that is essential in evaluating the franchise
offering.
\165\ See, e.g., Duvall, Comment 19, at 2; Hogan & Hartson,
Comment 28, at 7; Kaufmann, Comment 33, at 7; Tifford, Comment 78,
at 5; IFA, Comment 82, at 3; Jeffers, Comment 116, at 5.
\166\ Tifford, Comment 78, at 6; AFA, Comment 62, at 4; IL AG,
Comment 77, at 2; IFA, Comment 82, at 3.
\167\ Cendant, Comment 140, at 2.
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At the same time, several commenters support the ANPR proposed
preambles as an alternative to mandating earnings disclosures, noting
that this approach would rely on market pressures, not government
mandates, to encourage franchisors to disclose earnings information
voluntarily. For example, one commenter states:
We believe that these required disclosures not only would
correct misrepresentations by franchisors that the Rule prevents
them from making earnings claims, but also would bring more market
pressure to bear on franchisors to make reliable earnings claims.
Such market pressures may result in a substantial increase in the
amount of financial information disclosed to franchisees without the
costs and other burdens attendant to a government mandate.
Hogan & Hartson, Comment 28, at 8.168
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\168\ See also Duvall, Comment 19, at 2; Kaufmann, Comment 33,
at 7; Jeffers, Comment 116, at 5; Zarco & Pardo, Comment 134, at 6;
CA BLS, Comment 124, at 2.
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A few commenters, however, offer specific suggestions to improve
the proposed preambles. For example, some commenters voice concern that
phrases such as ``do not rely on'' unauthorized earnings information
may be misinterpreted as a disclaimer of liability where salespeople
routinely make false or unauthorized earnings claims.169
Another commenter voices concern that the first preamble proposed in
the ANPR could be misinterpreted as enabling franchisors to provide
earnings information outside of the disclosure document, as long as the
franchisor followed the Rule's requirements.170 Several
commenters also offer substitute language. For example, one commenter
notes that some industries--such as the hotel industry--do not use
sales, income, or profits as measures of performance.171 He
suggests that the preamble include the more inclusive term ``financial
performance'' to capture those industries. Another commenter recommends
that the term ``outlets'' be revised to make it clear that a financial
performance claim can be based on either company-owned or franchised
outlets.172 A few commenters also suggest that the
Commission add a provision stating that prospective franchisees should
report any unauthorized financial performance claims to the franchisor
and/or to the Federal Trade Commission and to state
authorities.173 Finally, NASAA suggests that the Commission
require franchisors who choose not to make earnings disclosures to make
the following statement:
\169\ SBA Advocacy, Comment 36, at 8; CA BLS, Comment 124, at 2;
Lagarias, Comment 125, at 4-5.
\170\ Kaufmann, Comment 33, at 15.
\171\ Wieczorek, 6 Nov 97 Tr at 183-84.
\172\ IL Ag, Comment 77, at 2. See also AFA, Comment 62, at 6.
\173\ WA Securities, Comment 117, at 3; NASAA, Comment 120, at
8; Zarco & Pardo, Comment 134, at 6; Kezios, 18 Sept 97 Tr at 91;
Tifford, 18 Set 97 Tr at 91-92.
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This information is very important to any prospective
franchisee, and our failure to provide it makes it more difficult
for you to make an informed decision about purchasing a franchise,
as well as increases your financial risks in purchasing a franchise
from us. Unless you obtain this type of information on your own,
your risks may be substantial.
NASAA, Comment 120 at 8.174
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\174\ See also Cordell, 6 Nov 97 Tr at 199-200.
Revised Financial Performance Disclosures. Based upon the record,
the Commission continues to believe that financial performance
disclosures should remain voluntary and that ordinary market forces are
sufficient to provide an incentive for franchise systems to make
performance information available to prospective
franchisees.175 At the same time, the Commission proposes to
amend the Rule by adopting the greatly streamlined UFOC Item 19
approach toward financial performance representations. First, following
the UFOC Guidelines, proposed section 436.5(s) would permit franchisors
to make financial performance claims in the text of their disclosure
documents, without the need to create separate ``earnings claim''
documents. Second, proposed section 436.5(s) would permit franchisors
to disclose truthful information about the financial performance of all
or a subgroup of franchisor-owned or franchised outlets, provided the
franchisor also describes the characteristics of the included outlets
that may differ materially from those of the outlet that is offered for
sale. In contrast, the current Rule permits such disclosures only if
the data is directly relevant to the prospective franchisee's
geographic market territory.176
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\175\ See Hogan & Hartson, Comment 28, at 7; Kaufmann, Comment
33, at 7; Tifford, Comment 78, at 5; IFA, Comment 82, at 3.
\176\ See 16 CFR 436.1(b)(1); 436.1(c)(1).
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Third, proposed section 436.5(s) incorporates two UFOC Item 19
provisions that greatly facilitate franchisors' ability to provide
prospects with performance information. A franchisor who provides a
prospective franchisee with the actual operating results of a specific
unit being offered for sale need not comply with the general Item 19
disclosure requirements provided that the franchisor gives the
information only to the potential purchaser of that unit and provides
the potential purchaser with the name and last known address of each
owner of the unit during the prior three years. In addition, a
franchisor who make Item 19 financial performance representations can
provide prospective franchisees with supplemental performance
representations directed at a particular location or circumstance,
apart from the disclosure document, provided that the franchisor
furnishes such supplemental performance representations in writing,
explains how it differs from the Item 19 disclosure, follows the Item
19 format, and leaves the information with the prospective franchisee.
Both of these enhancements, which have no parallel in the current Rule,
make it easier for franchisors to provide prospects with material
performance information narrowly tailored to the particular outlets in
question.
At the same time, proposed section 436.5(s)'s financial performance
disclosure provision differs from the UFOC approach in one significant
way. UFOC Item 19--as well as the current Rule--requires franchisors
who make financial performance disclosures to state the number and
percentage of the franchised outlets that have actually attained or
surpassed the stated performance claim. The Commission
[[Page 57311]]
believes that this disclosure may be misleading and may actually
discourage franchisors from making financial performance information
available to prospective franchisees. For example, a franchisor may
have statistics showing that 9 out of 10 franchised stores in a
particular location (such as Seattle) average $100,000 net profit a
year. Yet, the current UFOC and Rule requirements would prevent the
franchisor from disclosing truthful information about the universe the
franchisor has measured--the 10 franchised outlets in Seattle. Rather,
the franchisor would be forced instead to state 9 out of the entire
number of all franchises nationwide (e.g., 9 out of 1,000) have earned
the $100,000 claimed.
This approach arguably would prevent a franchisor who does not have
complete financial performance information on each and every franchise
in its system from making truthful performance representations about a
subset of franchisees, such as franchisees operating in a particular
geographic area or operating a particular kind of unit (e.g., kiosks in
shopping malls). Moreover, in the example noted above, a disclosure
that 9 out of 1,000 franchisees have earned the represented amount
($100,000) is misleading because it implies that 991 franchisees have
not earned the claimed amount when, in fact, the franchisor may not
have sampled or otherwise measured the remaining group of 991.
Accordingly, the Commission proposes to amend the Rule to permit a
franchisor to disclose historical financial performance information in
its Item 19 disclosures if there is a reasonable basis for such
information and the franchisor: (1) Discloses the nature of the
universe of outlets measured; (2) the dates during which the reported
level of financial performance was achieved; (3) the number of outlets
in the universe measured during the relevant period; (4) the number of
outlets from the universe measured whose performance were utilized in
arriving at the representation; (5) of the number of outlets whose data
was utilized, the number and percentage that actually attained or
surpassed the stated results; and (6) characteristics of the included
outlets that may differ materially from those being offered to the
prospective franchisee.177
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\177\ For example, a franchisor may state a historical
performance representation as follows:
Franchised outlets in Seattle earned $100,000 in 1998.
The Franchisor has sampled all of its franchised outlets in
Seattle during the period 1998. The sample included 10 outlets. Nine
of the 10 outlets responded. Of the nine responding franchised
outlets, all attained or surpassed net profits of $100,000. We note,
however, that each of the franchised outlets in Seattle has been in
business for over 10 years and is located in an urban center.
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Based upon the record, the Commission also proposes to adopt the
ANPR proposal that franchisors include prescribed preambles in Item 19
to clarify the law regarding financial performance claims. Among other
things, the first preamble corrects the common misrepresentation that
the Commission or the Rule actually prohibits the making of financial
performance disclosures.178 In light of the Commission's
extensive law enforcement history combating false and unsubstantiated
performance claims, the Commission also believes that the first
preamble is necessary to encourage prospective franchisees to consider
financial performance representations made in an Item 19 disclosure
only. In addition, the Commission believes that the second preamble,
which is used only if the franchisor does not disclose performance
information, is warranted to alert prospective franchisees that any
subsequent performance claims are unauthorized and, impliedly, should
not be relied upon.
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\178\ Several commenters state that such misrepresentations are
prevalent and urge the Commission to clarify the Rule to address
this problem. For example, Peter Lagarias states: ``I am personally
aware of franchisors (and sometimes even their lawyers) stating that
earnings claims are forbidden by the Commission's Rule. The
Commission should clarify in the Rule that the franchisor could
elect to make earnings claims but has elected not to make earnings
claims.'' Lagarias, Comment 125, at 4. See also Hogan & Hartson,
Comment 28, at 8; SBA Advocacy, Comment 36, at 8; AFA, Comment 62,
at 5; Purvin, Comment 79, at 2; Jeffers, Comment 116, at 5; CA Bar,
Comment 124, at 1.
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The proposed revised preambles incorporate many of the suggestions
offered in response to the ANPR. For example, some commenters voice
concern that phrases in the original preamble such as ``do not rely
on'' unauthorized performance information may be misinterpreted as a
disclaimer of liability in those instances where salespeople routinely
make false or unauthorized performance claims.179
Accordingly, the revised preamble deletes the reference to ``do not
rely'' in favor of a broader statement alerting prospective franchisees
that a franchisor can provide financial performance data ``only if the
information is included in the disclosure document.'' The proposed
revised first preamble also clarifies the law regarding financial
performance disclosures by noting two exceptions to the general rule
that performance claims must appear in Item 19: (1) Actual records of
an existing outlet for sale; and (2) supplemental performance
information about a particular location. The Commission also agrees
with the commenters who suggest that the second preamble include a
provision encouraging prospective franchisees to report any
unauthorized earnings claims to the franchisor, the Federal Trade
Commission, and state authorities.180
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\179\ SBA Advocacy, Comment 36, at 8; CA Bar, Comment 124, at 2;
Lagarias, Comment 125, at 4-5.
\180\ WA Securities, Comment 117, at 3; NASAA, Comment 120, at
8; Zarco & Pardo, Comment 134, at 6; Kezios, 18 Sept 97 Tr at 91;
Tifford, 18 Sept 97 Tr at 91-92.
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t. Proposed Section 436.5(t): Item 20 (Outlets and Franchisee
Information)
Proposed section 436.5(t) is another anti-fraud disclosure
provision. Based upon UFOC Item 20, it requires franchisors to disclose
in tabular form statistical information on the number of franchises and
franchisor-owned outlets, including the number of franchises that have
failed or otherwise ceased operations. It also requires franchisors to
provide prospective franchisees with the names and addresses of current
and former franchises, with which they can verify the franchisors'
representations and learn more about the franchise
relationship.181 For these reasons, the Commission agrees
that Item 20 is among the most material disclosure items.182
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\181\ SBP, 43 FR at 59670-73.
\182\ See Karp, 19 Sept 97 Tr at 95; Slimak, 22 Aug 97 Tr at 33.
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Proposed section 436.5(t) enhances the less comprehensive
disclosures found at 16 CFR 436.1(a)(16) by requiring franchisors to
disclose the names and addresses of former as well as current
franchisees. It also increases the number of franchisees about whom
information is disclosed from 10 to either all or at least 100. This
information prevents fraud by arming prospective franchisees with a
source of information with which they can conduct their own due
diligence investigation of the franchise offering. At the same time,
proposed section 436.5(t) corrects a ``double counting'' problem in
UFOC Item 20 that was identified during the Rule Review proceeding. As
explained below, proposed section 436.5(t) also improves UFOC Item 20
by addressing the use of gag clauses and trademark-specific franchisee
associations.
``Double Counting'' Issue. During the Rule Review, commenters
voiced concern that UFOC Item 20 is flawed
[[Page 57312]]
and needs to be fixed.183 Specifically, commenters observed
that franchisors may report a change in franchise ownership in multiple
categories, which may inflate the overall number of franchise closings.
Accordingly, in the ANPR, the Commission acknowledged this concern and
solicited comment on how UFOC Item 20 could be improved.184
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\183\ E.g., Simon, RR Tr. at 223-24; Perry, RR Tr. at 263.
\184\ 62 FR at 9121.
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In response to the ANPR, several commenters confirm the ``double
counting'' problem.185 However, only a few commenters offer
concrete solutions, as noted below, and no consensus has emerged on how
to correct the problem. Specifically, three commenters suggest that the
Commission solve the double counting problem by adding additional
categories to the Item 20 disclosure.186 Another commenter
believes that most double reporting problems are attributable to the
inclusion of transfers and reacquisitions in the UFOC Item 20 table
that summarizes franchised outlets. He suggests that transfers should
be reported in a separate column located on the side of the franchisee
statistics table and that reacquisitions be moved to the second UFOC
Item 20 table concerning company-owned outlets.187 At the
same time, this commenter suggests that franchisors report multiple
ownership changes only once, according to which event was ``first-in
time.'' 188 Other commenters suggest that the Commission
require franchisors to report multiple events according to a
predetermined order of priority.189 Specifically, the
Commission could require franchisors to report multiple ownership
changes only once, but eliminate ``picking and choosing'' of categories
by assigning a specific order of priority such as termination, non-
renewal, reacquisition, and transfer. For example, a franchisor might
report an ownership change as a termination, regardless of what other
events may have occurred before (abandonment of the property) or after
(reacquisition or transfer).
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\185\ E.g. Hogan & Hartson, Comment 28, at 6; AFA, Comment 62,
at 3; IL AG, Comment 77, at 2; Tifford, Comment 78, at 4; IFA,
Comment 82, at 2; Cendant, Comment 140, at 3; Karp, 19 Sept 97 Tr at
91.
\186\ For example, Robert Zarco recommends that the Commission
create 12 categories to capture various combinations of ownership
changes. Transfers, for instance, would be divided into four
distinct categories: (1) Transfers by the franchisee to the
franchisor; (2) transfers by the franchisee to the franchisor, but
ultimately re-franchised; (3) transfers by the franchisee directly
to a new franchisee; and (4) transfers by the franchisee directly to
a new franchisee more than once. Zarco & Pardo, Comment 134, at 6-7.
See also AFA, Comment 62, at 3; Karp, Comment 136, at 2-6.
\187\ Wieczorek, Comment 122, at 2.
\188\ Id.
\189\ Simon, 18 Sept 97 Tr at 23-24; Tifford, id. at 25-26. See
also Bundy, 6 Nov 97 Tr at 229.
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The Commission believes that proposed section 436.5(t) fixes the
double counting problem within the framework of the UFOC Guidelines.
Franchisors would start the disclosure by noting the states where they
have outlets (column 1) and the number of outlets opened at the
beginning of the fiscal year (column 2). Franchisors then note the
number of franchises with the same ownership at the end of the year
(column 3). Next, franchisors report on franchisees who have left the
system during the course of the term of the franchise agreement because
of one of three events--termination, reacquisition, and transfer
(columns 4-6). Franchisors then report outlets that were not renewed at
the end of the franchise term (column 7). To ensure that all outlets
are accounted for, there is a miscellaneous category ``outlets that
ceased operation or closed for other reasons'' (column 8). This
category would capture information about events such as an abandonment
of an outlet. To aid prospective franchisees in understanding the net
effect of changes in ownership, franchisors also report the total
number of outlets discontinued during the fiscal year (column 9).
Finally, to account for franchisees that have joined the system during
the fiscal year, franchisors report the total number of outlets in
operation at the end of the year (column 10).
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