# Disclosure Requirements and Prohibitions Concerning Franchising

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URL: https://www.frixlaw.com/law-library/documents/fr%3AE7-5829

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** March 30, 2007
- **Citation:** 72 FR 15444

## Text

FEDERAL TRADE COMMISSION
16 CFR Parts 436 and 437
Disclosure Requirements and Prohibitions Concerning Franchising
Disclosure Requirements and Prohibitions Concerning Business Opportunities

AGENCY:

Federal Trade Commission.

ACTION:

Final rule.

SUMMARY:

The Federal Trade Commission (the “Commission” or “FTC”) amends its Trade Regulation Rule entitled “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures” (“Franchise Rule” or “Rule”) to streamline the Rule, minimize compliance costs, and to respond to changes in new technologies and market conditions in the offer and sale of franchises. Part 436 sets forth those amendments to the Franchise Rule pertaining to the offer and sale of franchises. Part 437 sets forth a revised form of the original Franchise Rule pertaining solely to the offer and sale of business opportunities. This document provides background on the Franchise Rule and this proceeding; discusses the public comments the Commission received; and describes the amendments the Commission is making based on the record. This document also contains the text of the final amended Rule and the Rule’s Statement of Basis and Purpose (“SBP”), including a Regulatory Analysis.

EFFECTIVE DATES:

The effective date of the final amended Rule is July 1, 2007. Permission to use the original Franchise Rule, however, will continue until July 1, 2008. After that date, franchisors and business opportunity sellers must comply with the final amended Rule only.

ADDRESSES:

Requests for copies of the final amended Rule and the SBP should be sent to: Public Reference Branch, Room 130, Federal Trade Commission, 600 Pennsylvania Avenue, NW, Washington, D.C. 20580. The complete record of this proceeding is also available at that address. Relevant portions of the proceeding, including the final amended Rule and SBP, are available at www.ftc.gov.

FOR FURTHER INFORMATION CONTACT:

Steven Toporoff, (202) 326-3135, Division of Marketing Practices, Room 286, Bureau of Consumer Protection, Federal Trade Commission, 600 Pennsylvania Avenue, NW., Washington, D.C. 20580.

SUPPLEMENTARY INFORMATION:

The final amended Rule retains most of the original Rule’s pre-sale disclosures.
1

Part 436 pertains to franchising—business arrangements that offer purchasers the right to operate under a trademark or other commercial symbol and that typically offer a specific format or method of doing business, such as chain restaurants and hotels.
2

Part 436 modifies the original Rule, however, by reducing inconsistencies with state franchise disclosure laws, by adopting, in large measure, the disclosure requirements and format of the Uniform Franchise Offering Circular (“UFOC”) Guidelines used by the 15 states with pre-sale franchise disclosure laws.
3

Part 436 of the final amended Rule, however, is not identical to the UFOC Guidelines. In several instances, part 436 is narrower. For example, part 436 does not incorporate the UFOC Guidelines’ mandatory cover page risk factors, disclosures pertaining to brokers, or detailed disclosures pertaining to franchisees’ computer equipment requirements. Part 436 also permits a phase-in of audited financial statements.

1

See
16 CFR Part 436. Provisions of the original Rule are cited in this document as 16 CFR 436.[ ]. Citations to the final amended Rule are cited simply as 436.[ ] or 437.[ ], respectively. The text of the final amended Rule is set forth in Section VII.

2
The specific definition of the term “franchise” is discussed below in connection with section 436.1(h).

3
We were assisted in the effort to reduce inconsistencies between the original Rule and UFOC Guidelines by NASAA’s submission of a document entitled “Comparison of UFOC and Proposed FTC Disclosure Requirements” (“NASAA Comparison”) (Jan. 8, 2002). A copy of this document is on the public record in this proceeding.

Further, part 436 of the final amended Rule corrects a problem with the UFOC Guidelines identified in the rulemaking record. Specifically, the record establishes that the current Item 20 of the UFOC Guidelines—a provision requiring the disclosure of franchisee statistics—results in inflated turnover rates. Part 436 of the final amended Rule corrects this problem, based upon suggestions contained in the record.

In a few instances, part 436 of the final amended Rule is broader than the UFOC Guidelines, addressing franchise relationship issues that the rulemaking record establishes are a prevalent source of franchisee complaints. To that end, part 436 of the final amended Rule provides additional information to prospective franchisees with which to assess the quality of the franchise relationship before they buy, including: (1) franchisor-initiated litigation against franchisees pertaining to the franchise relationship; (2) protected territories; (3) the use of confidentiality clauses; and (4) trademark-specific franchisee associations.

Finally, part 436 of the final amended Rule updates the original Rule and UFOC Guidelines by addressing new marketing techniques and new technologies. For example, part 436 permits franchisors to comply with pre-sale disclosure obligations electronically. It also updates territorial protection disclosures to address sales via the Internet, catalogs, and telemarketing.

Part 437 of the final amended Rule pertains to business opportunity ventures. Business opportunities, such as vending machine routes and rack display ventures, typically do not involve the right to use a trademark or other commercial symbol and the seller must provide purchasers with locations for machines or equipment or with clients.
4

Based upon the rulemaking record, the Commission has proposed that business opportunities covered by the original Rule should be addressed in a separate, narrowly-tailored trade regulation rule. On April 12, 2006, the Commission published a Notice of Proposed Rulemaking (“Business Opportunity NPR”) for a separate Business Opportunity Rule.
5

Pending completion of the proceeding initiated with that notice, business opportunities presently covered by the requirements of the original Rule will remain covered, as set forth as part 437 of the final amended Rule.

4
The definition of “business opportunity” is discussed below in connection with section 437.2(a).

5
71 FR 19054 (Apr. 12, 2006).

Part 437 of the final amended Rule differs from the original Rule in three respects only. First, references to “franchisor” and “franchisee” in the original Rule have been changed to “business opportunity seller” and “business opportunity purchaser,” respectively. Second, the original Rule’s definition of “franchise” set out at section 436.(2)(a) has been changed to “business opportunity” and the first part of the original definition—the “franchise” elements—have been deleted; the definition now focuses on the second part of the original definition—the business opportunity elements. Third, part 437 sets forth a new exemption for franchises that comply with, or are exempt from, part 436. Except for these three changes, all disclosures and prohibitions in part 437 are identical to those of the original Franchise Rule.

STATEMENT OF BASIS AND PURPOSE

I. INTRODUCTION

A. Overview of the Original Franchise Rule

The Commission promulgated the original Franchise Rule on December 21, 1978.
6

Based upon the original rulemaking record, the Commission found widespread deception in the sale of franchises and business opportunities through both material misrepresentations and nondisclosures of material facts.
7

Specifically, the Commission found that franchisors and business opportunity sellers often made material misrepresentations about: the nature of the seller and its business operations, the costs to purchase a franchise or business opportunity and other contractual terms and conditions under which the business would operate, the success of the seller and its purchasers, and the seller’s financial viability. The Commission also found other unfair or deceptive practices pervasive: franchisors’ and business opportunity sellers’ use of false or unsubstantiated earnings claims to lure prospective purchasers into buying a franchise or business opportunity, and franchisors’ and business opportunity sellers’ failure to honor promised refund requests. The Commission concluded that all of these practices led to serious economic harm to consumers.
8

6
43 FR 59614 (Dec. 21, 1978). Along with the original Rule, the Commission published a Statement of Basis and Purpose (“original SBP”), 43 FR 59621 (Dec. 21, 1978) and later Final Interpretive Guides to the Rule (“Interpretive Guides”), 44 FR 49966 (Aug. 24, 1979). Since promulgation of the original Rule in 1978, the Commission staff has also issued more than 100 advisory opinions to help assist the public in interpreting various Rule provisions.

7
Original SBP, 43 FR at 59625.

8

Id.
, at 59627-39.

To prevent deceptive and unfair practices in the sale of franchises and business opportunities and to correct consumers’ misimpressions about franchise and business opportunity offerings, the Commission adopted the original Franchise Rule, which is primarily a pre-sale disclosure rule. The original Rule did not purport to regulate the substantive terms of the franchise or business opportunity relationship. Rather, it required franchisors and business opportunity sellers to disclose material information to prospective purchasers on the theory that informed investors can determine for themselves whether a particular deal is in their best interest.
9

9
The Commission used the same approach in other trade regulation rules.
See, e.g.,
Funeral Rule, 16 CFR Part 453; Used Car Rule, 16 CFR Part 455.

B. The Rule Amendment Proceeding

This Rule amendment proceeding began with a regulatory review of the Franchise Rule in 1995.
10

To initiate the Rule Review, the Commission published a
Federal Register
notice seeking public comment on whether there was a continuing need for the Rule and, if so, how to improve it in light of industry changes since its promulgation in 1978. In response to this notice, the Commission received 75 written comments.
11

10
60 FR 17656 (Apr. 7, 1995).

11
Written Rule Review comments are cited as: [Commenter] RR [comment number]. A list of all commenters during the Rule Review and Rule amendment proceeding, and the abbreviations used to identify each, is set forth in Attachment A to this document. Many of the comments in this proceeding are available online at: www.ftc.gov.

In addition, the Commission staff held two public workshops, in which a total of fifty individuals participated. The workshops were transcribed.
12

The first workshop—held on September 11-13, 1995, in Bloomington, Minnesota—focused on the comments on the Rule, in particular whether the Commission should retain the Rule and, if so, whether the Commission should reduce inconsistencies between federal and state pre-sale disclosure law by incorporating in the Rule the UFOC Guidelines adopted by each of the 15 states with franchise disclosure laws.
13

Participants also discussed issues arising from business opportunity sales. The second workshop—held on March 11, 1996, in Washington, D.C.—focused on the Franchise Rule’s application to sales of franchises to be located outside the United States.

12
Rule Review transcripts are cited as [Commenter] RR, [Sept.95] or [Mar.96] Tr.

13
The UFOC Guidelines disclosure format is similar in many respects to the original Rule’s disclosure requirements. To reduce compliance costs and burdens, the Commission has permitted franchisors to comply with the original Rule by using the UFOC Guidelines format, provided that they did so completely and accurately.
See
60 FR 51895 (Oct. 4, 1995) (authorizing states to use revised UFOC Guidelines). A copy of the UFOC Guidelines can be found at the corporate finance section of the North American Securities Administrators Association website: www.nasaa.org. It should be noted, however, that the UFOC Guidelines address only required pre-sale disclosures. Other provisions of state law applicable to franchise sales—such as the time for making disclosures, disclosure document updating provisions, and exemptions—vary according to each state’s franchise statute or regulations.

As a result of the Rule Review, the Commission determined that the Franchise Rule continues to serve a useful purpose and that it should be retained. The Commission also determined to modify the Rule in order to reduce inconsistencies with the UFOC Guidelines, while updating the Rule to address new technologies developed since the original Rule was promulgated. Accordingly, in February 1997, the Commission published an Advance Notice of Proposed Rulemaking (“ANPR”).
14

The ANPR solicited comment on several proposed Rule modifications which would, among other things, create a separate trade regulation for business opportunity sales, revise the Rule’s disclosure requirements to mirror those of the UFOC Guidelines, limit the Rule’s application to sales of franchises located in the United States, and permit electronic disclosure. In response to the ANPR, the Commission received 166 written comments.
15

The staff also held six public workshops on the issues raised in the comments, as set forth below.
16

14
62 FR at 9115 (Feb. 28, 1997).

15
Written ANPR comments are cited as: [Commenter] ANPR [comment number].

16
In general, the first day of each public workshop discussed specific issues announced in advance. Participants at these meetings were selected based upon their comments or interest in the subject matter. The second day of each conference was an open forum in which the public was invited to express their views on any franchise or business opportunity issue. ANPR workshop transcripts are cited as: [Commenter] ANPR [date] Tr.

Topic(s)

Location

Dates

Trade Show Promoters
Washington, D.C.
July 28-29, 1997

Business Opportunities
Chicago, IL
August 21-22, 1997

UFOC, Internet, International, Co-branding, Alternatives to Traditional Law Enforcement
New York, NY
September 18-19, 1997

Business Opportunities
Dallas, TX
October 20-21, 1997

UFOC, Internet, International, Co-branding, Alternatives to Traditional Law Enforcement
Seattle, WA
November 6-7, 1997

Business Opportunities
Washington, D.C.
November 20-21, 1997

A total of sixty-five individuals participated in the various ANPR public workshops, including franchisees, franchisors, business opportunity sellers and their representatives, state franchise and business opportunity regulators, and computer consultants.

After the ANPR workshops, the Commission published a Notice of Proposed Rulemaking (“Franchise NPR”) in October 1999.
17

Focusing on franchise sales only, the Franchise NPR included the text of a proposed revised Franchise Rule and a detailed discussion of each proposed Rule revision. Among other things, the Franchise NPR addressed: (1) the application of the Franchise Rule to franchise sales outside the United States; (2) the scope of certain existing disclosure requirements, such as those regarding litigation and franchisee statistics; (3) new disclosure requirements, such as those for franchisee associations; and (4) new instructions permitting disclosure via the Internet. It also proposed creating exemptions from the Franchise Rule for sophisticated prospective franchisees.

17
64 FR 57294 (Oct. 22, 1999).

The Franchise NPR also specified the process the Commission would follow in amending the Franchise Rule, as it pertains to franchise sales. Pursuant to the Commission’s Rules of Practice, 16 CFR 1.20, the Commission determined to use a modified version of the rulemaking process set forth in section 1.13 of those Rules.
18

Specifically, the Commission announced that it would publish an NPR, with a 60-day comment period, followed by a 40-day rebuttal period. In addition, pursuant to Section 18(c) of the FTC Act, the Commission announced that it would hold hearings with cross-examination and rebuttal submissions only if an interested party requested a hearing. The Commission also stated that, if requested to do so, it would contemplate holding one or more informal public workshops in lieu of hearings. Finally, pursuant to 16 CFR 1.13(f), the Commission announced that staff would issue a Report on the Franchise Rule (“Staff Report”), which would be subject to additional public comment.
19

18
16 CFR 1.13.

19
Franchise NPR, 64 FR at 57324.

In response to the Franchise NPR, the Commission received 40 comments.
20

Overwhelmingly, the comments supported the proposed revisions, albeit with fine-tuning.
21

No commenters requested a hearing, although, as noted, the Franchise NPR allowed for them.
22

The staff also determined that the record was fully developed for franchise issues, requiring no additional public workshops to explore further Rule amendment issues.

20
Franchise NPR comments are cited as: [Commenter] NPR [comment number].

21
Many commenters enthusiastically supported the Commission’s overall approach to revising the Rule.
E.g.
, IL AG, NPR 3, at 10; PMR&W, NPR 4, at 1; Holmes, NPR 8, at 1; H&H, NPR 9, at 2; Baer, NPR 11, at 1; NFC, NPR 12, at 2; Lewis, NPR 15, at 1; IFA, NPR 22, at 3; AFC, NPR 30, at 3; J&G, NPR 32, at 1; Tricon, NPR 34, at 1; Marriott, NPR 35, at 2.

22
Accordingly, no Presiding Officer was established in this proceeding.
See
Rules of Practice, 16 CFR 1.13(c).

Pursuant to the Rule amendment process announced in the Franchise NPR, the Commission’s Bureau of Consumer Protection issued a Staff Report on the Franchise Rule in August 2004.
23

The Staff Report explained in detail the history of the Rule amendment proceeding. It also summarized the issues raised during the various notice and comment periods, in particular those that arose in response to the Franchise NPR. For each Franchise NPR issue, the Staff Report discussed: (1) similarities and differences between the proposed revised Rule approach and both the original Rule and the UFOC Guidelines approaches; (2) pertinent comments; and (3) the staff recommendations on franchise issues for inclusion in a final amended Rule.

23

See
Bureau of Consumer Protection,
Staff Report to the Federal Trade Commission and Proposed Revised Trade Regulation Rule
(16 CFR Part 436) (Aug. 2004) (“Staff Report”). The Staff Report is available at: www.ftc.gov/os/2004/08/0408franchiserulerpt.pdf. In September, 2004, the Commission published a notice in the
Federal Register
announcing the availability of, and seeking comment on, the Staff Report.
See
69 FR 53661 (Sept. 2, 2004). The announcement is also available at: www.ftc.gov/os/2004/08/040825franchiserulefrn.pdf.

Forty-five commenters responded to the Staff Report.
24

For the most part, the commenters supported the proposed Rule revisions pertaining to franchising.
25

Several, however, voiced concern about the scope of one or more Rule provisions, or offered various suggestions to fine-tune the Rule to avoid ambiguities.
26

In other instances, several commenters raised issues for further discussion in anticipated Compliance Guides, or offered interpretations of Rule provisions for inclusion in the Compliance Guides.
27

In several instances, franchisee representatives reiterated views previously expressed during the various comment periods to the effect that the proposed revised Rule is deficient because it does not mandate disclosure of financial performance data
28

or does not adopt various substantive franchise relationship provisions.
29

As explained in greater detail below, the Commission has considered each of these comments in determining the form and content of the final amended Rule.

24
Staff Report comments are cited as “[Commenter], at ___ .” These comments simply refer to the commenter and not to a specific comment number. After the Franchise NPR, the Commission’s Secretary’s Office discontinued the practice of assigning a specific comment number to each comment.

25
E.g.
, Bundy, at 1; Cendant, at 1 (representing Ramada, Days Inn, Howard Johnson, Travelodge, Knights Inn, Super 8 Motel, Wingate Inn, AmeriHost, Century 21, Coldwell Banker, ERA, Sotherby’s Intl Realty, Avis, and Budget); IFA, at 1; IL AG, at 1; J&G, at 1; Kaufmann, at 2 (representing Kaufmann, Feiner, Yamin, Gildin & Robbins; YUM! Brands [Pizza Hut, KFC, Taco Bell, Long John Silvers, and A&W]; 7-Eleven, Inc.; and Arby’s [Arby’s and T.J. Cinnamons Classic Bakery]); Marriott, at 2; NASAA, at 2; Piper Rudnick, at 1; Spandorf, at 1; Starwood, at 1 (representing Four Points Hotels, Sheraton Hotels,Westin Hotels, and Luxury Collection Hotels); Wiggin and Dana, at 1.

26
Fourteen comments focused solely on a single issue. For example, eight comments addressed only the original Rule’s exclusion for cooperatives (Affiliated Foods; CHS; Graber; IDC; NCBA; NCFC; NGA; Riezman Burger). Additional one-issue comments were received on: the disclosure of franchisee associations (AAFD); the single trademark exclusion (Pillsbury Winthrop); the sophisticated investor exemptions (NADA); the Petroleum Marketing Practices Act (Chevron); the disclosure of parent information (PREA); and integration clauses (Lagarias). Two comments were beyond the scope of the Staff Report: Marks (urging Commission to adopt franchise arbitration standards); Koutsoulis (opposing the proposed merger of two franchisors).

27
Compliance Guides, which the Commission anticipates staff will issue on part 436, would update existing Interpretive Guides issued in 1979.
See generally
Interpretive Guides, 44 FR 49966. Compliance Guides on part 437 will be issued by staff once any rulemaking on business opportunity ventures is concluded.

28
E.g.
, Selden, at 2; Haff, at 1-3; Blumenthal, at 1; Karp, at 2; Steinberg, at 1.

29
E.g.
, Blumenthal, at 1; Karp, at 3; Steinberg, at 1-2.

C. Continuing Need for the Rule

Based upon the original rulemaking record and the Commission’s law enforcement experience extending nearly 30 years,
30

the Commission concludes that a pre-sale disclosure rule continues to serve a useful purpose. Overwhelmingly, the comments submitted during the Rule amendment proceeding supported the continued need for the Franchise Rule.
31

For example, some commenters emphasized that pre-sale disclosure is still necessary to prevent fraud.
32

Others observed that pre-sale disclosure is a cost-effective way to provide material information to prospective purchasers about the costs, benefits, and potential legal and financial risks associated with entering into a franchise relationship. These commenters also stressed that the Rule assists prospective franchisees in conducting a due diligence investigation of the franchise offering by providing information that is not readily available, such as the franchisor’s litigation history and franchisee termination rates.
33

Other commenters noted that pre-sale disclosure helps franchisees understand the franchise relationship they are entering better than they could absent such disclosure, thereby reducing potential conflicts in franchise systems and post-sale litigation costs.
34

Indeed, some commenters expressed the view that repeal of the Franchise Rule might actually increase franchisors’ costs and compliance burdens by opening the door for individual states to enact franchise disclosure laws that may be inconsistent, making it difficult for franchisors to conduct business on a national basis.
35

One commenter noted that retaining a uniform pre-sale disclosure rule enables prospective franchisees to comparison shop for the best franchise offering.
36

30
As of the date of this Notice, the Commission has filed more than 210 suits against more than 650 defendants (both franchises and business opportunities) for Franchise Rule violations since the Rule was promulgated in 1978.
See also
Business Opportunity NPR, 71 FR 19054 (Apr. 12, 2006) (discussing the Commission law enforcement history in combating business opportunity covered by the Franchise Rule).

31
E.g.
, H&H, ANPR 28, at 2; Kaufmann, ANPR 33, at 2; NCL, ANPR 35, at 2; SBA Advocacy, ANPR 36, at 2-3; IL AG, ANPR 77, at 1.
See also
Staff Report, at notes 15-16.
But see, generally
, Winslow (opposing the Rule).

32
E.g.
, Kaufmann, ANPR 33, at 3 (“Both the Rule and . . . state franchise laws have gone a long way toward eradicating massive franchise frauds and, by doing so, have restored franchising’s reputation for integrity and thus cleared the marketplace for the offerings of legitimate franchisors.”).

33
E.g.
, Marks, ANPR, 19 Sept. 97 Tr., at 8-9, 29; Wieczorek, RR, Sept.95 Tr., at 62-63.
But see
Winslow, at 21.

34
E.g.
, H&H, ANPR 28, at 2; SBA Advocacy, ANPR 36, at 2; Zarco & Pardo, ANPR 134, at 1; ABA Antitrust, RR 22, at 7.

35
E.g.
, WA Securities, ANPR 117; Shay, RR, Sept.95 Tr., at 104.

36
Kaufmann, ANPR 33, at 3.

On the other hand, many franchisees and their advocates criticized the Rule for not going far enough. They urged the Commission to address in this rulemaking a variety of post-sale franchise contract or “relationship” issues, including prohibiting or limiting the use of post-contract covenants not to compete,
37

encroachment of franchisees’ market territory,
38

and restrictions on the sources of products or services.
39

Indeed, some franchisees asserted that if the Rule cannot address post-sale relationship issues, then the Commission should abolish the Rule.
40

37
E.g.
, Brown, ANPR 4, at 3; AFA, ANPR 62, at 3; Slimak, ANPR 130; Leap, ANPR 147; Vidulich, ANPR, 22 Aug. 97 Tr., at 21.

38
E.g.
, Brown, ANPR 4, at 2; Donafin, ANPR 14; AFA, ANPR 62, at 1; Buckley, ANPR 97; Zarco & Pardo, ANPR 134, at 2.

39
E.g.
, Brown, ANPR 4, at 2; Weaver, ANPR 17; Colenda, ANPR 71; Haines, ANPR 100; Chiodo, ANPR, 21 Nov. 97 Tr., at 293-94.

40
See
AFA, ANPR 62, at 1 (“Our members feel so strongly about the Commission’s inability to deal with substantive issues of concern to them, they would rather work to abolish the FTC rule than suffer the abuses of both a government agency
and
their franchisors.”).

To address post-sale relationship issues by adopting rule provisions that prohibit or limit the use of certain contract terms would require record evidence demonstrating specific unfair acts or practices. The FTC Act defines an unfair act or practice as one that is “likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition.”
41

The Act also requires that, to justify an industry-wide rule, such practice be prevalent.
42

This proceeding did not yield adequate evidence to support a finding of prevalent acts or practices that meet each of the three prerequisites for unfairness as articulated in Section 45(n) of the FTC Act.

41
15 U.S.C. 45(n).

42
15 U.S.C. 57a.

With regard to the first prerequisite, substantial injury, the record shows that some franchisees in several franchise systems have suffered post-sale harm in the course of operating their franchises, and in some instances this injury may be ascribable to acts or practices of a franchisor.
43

The record, however, leaves open the related questions of whether such franchisor acts or practices are prevalent and whether the injury resulting from acts or practices is substantial, when viewed from the standpoint of the franchising industry as a whole, not from just a particular franchise system.

43
There are many factors that influence the success or failure of a franchisee, including downturns in the economy, shifting consumer preferences, or even franchisees’ own conduct. Accordingly, franchisor conduct post-sale may be only one factor that leads to injury to franchisees. The record is inconclusive, with respect to the franchising overall, as to whether franchisor acts or practices are a direct and primary cause of poor performance or failure by franchisees. In this regard, it is noteworthy that in its 2001 audit of the Commission’s Franchise Rule Program, the General Accounting Office (“GAO”) concluded that there are “no readily available, statistically reliable data on the overall extent and nature of [franchise relationship] problems.” United States General Accounting Office,
GAO Report to Congressional Requesters, Federal Trade Commission Enforcement of the Franchise Rule
, GAO-01-776, at 29 (July 31, 2001).
See also
Staff Report, at 10-11.

With regard to avoidability of injury, the unfairness analysis falls short. A franchise purchase is entirely voluntary. The Franchise Rule ensures that each prospective franchisee receives disclosures—expanded in key respects by the current amendments—that explain the terms and conditions under which the franchise will operate. Prospective franchisees can avoid harm by comparison shopping for a franchise system that offers more favorable terms and conditions, or by considering alternatives to franchising as a means of operating a business. Prospective franchisees are also free to discuss the nature of the franchise system with existing and former franchisees, as well as trademark-specific franchisee associations, and the amended Rule facilitates such discussion by providing prospects with contact information. Under these circumstances, the Commission cannot categorically conclude that prospective franchisees who voluntarily enter into franchise agreements, after receiving full disclosure, nonetheless cannot reasonably avoid harm resulting from a franchisor enforcing the terms of its franchise agreement.
44

44
See FTC v. J.K. Publ’ns, Inc.
, 99 F. Supp. 2d 1176, 1201 (C.D. Cal. 2000) (“With regard to [avoidability], the focus is on ‘whether consumers had a free and informed choice that would have enabled them to avoid the unfair practice.’”).

The third element requires an analysis of whether injury to franchisees deriving from specific franchisor acts or practices outweighs countervailing benefits to the public at large or to competition. In our law enforcement experience investigating relationship issues in individual franchise systems, it has been the case that the franchisor actions allegedly causing harm to individual franchisees also frequently generate countervailing benefits to the system as a whole or to consumer welfare overall that may or may not be

outweighed by the alleged harm to franchisees. Commenters advocating that the Rule include unfairness remedies have asserted injury, but have failed to bring forth evidence that such injury outweighs potential countervailing benefits that arise from the alleged acts or practices. Therefore, the Commission declines to impose industry-wide provisions mandating substantive terms of private franchise contracts that would impact on the entire franchise industry, not just those franchise systems that are the subject of commenters’ complaints.
45

Notwithstanding this determination, the Commission, in pursuit of its law enforcement mission can consider whether individual franchisors’ conduct constitutes an unfair act or practice on a case-by-case basis.

45
The Commission notes that it has voiced concern that government-mandated contractual terms may result in affirmative harm to consumer welfare. Contractual terms that are driven by market forces and forged by private parties acting in their own self-interest are the ones most likely to result in products being brought to market quickly and efficiently. The Commission therefore has authorized its staff to file a number of advocacy comments recommending against proposed state bills that would have unduly limited manufacturers in managing their distribution systems, such as by requiring exclusive territories, prohibiting or seriously burdening wholesaler terminations, or limiting the ability to reorganize a distribution system in response to changing competitive conditions.
See
,
e.g.
, Letter from Maureen Ohlhausen, Dir., Office of Policy Planning, et al., to the Hon. Wesley Chesbro, Cal. State Senate (Aug. 24, 2005) (comment on proposed beer franchise act); Letter from C. Steven Baker, Dir., Chicago Regional Office, to the Hon. Dan Cronin, Ill. State Senate (Mar. 31, 1999) (comment on proposed legislation on wine and spirits distribution);
cf
. Testimony of Jerry Ellig, Deputy Dir., Office of Policy Planning, before joint committee hearings of the Haw. state legislature (recommending against gasoline price control legislation, in part on grounds that repeal of anti-encroachment statute would be a more effective means of reducing prices (Jan. 28, 2003)).

Nonetheless, the Commission concludes that the record is sufficient to show that misunderstandings about the state of the franchise relationship are prevalent, and some more disclosure is warranted to ensure that prospective franchisees are not deceived about the quality of the franchise relationship before they commit to buying a franchise. Franchisee concerns about relationship issues persuade us that better disclosure is necessary to ensure that prospective franchisees are fully informed about the relationships that they will be entering. To that end, part 436 of the final amended Rule expands the Rule’s pre-sale disclosures in a few instances to address franchise relationship issues, as detailed throughout this document.

D. Overview of the Final Amended Rule

The final amended Rule maintains the benefits of the original Rule, preventing deceptive and unfair practices identified in the original rulemaking through pre-sale disclosure of material information necessary to make an informed purchasing decision and prohibition of specified misrepresentations. At the same time, part 436 of the final amended Rule reduces unnecessary compliance costs. First, part 436 covers only the sale of franchises to be located in the United States and its territories. Second, based upon the record, the Commission also has created several new exemptions for sophisticated franchise purchasers, including exemptions for large investments and large franchisees with sufficient net worth and prior experience.

Part 436 of the final amended Rule also reduces inconsistencies between federal and state pre-sale disclosure requirements. Since the original Rule was promulgated, NASAA, which represents the 15 states with pre-sale franchise disclosure laws, has developed a standard disclosure document, the UFOC. The Commission, as a matter of policy, has in the past permitted franchisors to comply with the Franchise Rule by furnishing prospective franchisees with a UFOC, even in the 35 states without franchise disclosure laws.
46

The Commission found that the UFOC Guidelines, taken as a whole, offer consumers the same or greater consumer protection as that provided by the original Rule. As a result, the UFOC Guidelines already are used by the vast majority of franchisors to comply with the Rule,
47

and, in fact, the UFOC Guidelines have become the national franchise industry standard.
48

Further, as NASAA noted, the UFOC Guidelines were developed with significant input from franchisors, franchisees, and franchise administrators, and were subject to public hearings and notice and comment.
49

Therefore, the UFOC Guidelines, like the Franchise Rule, reflect a balance of interests among all affected parties.

46
Authorization to use the UFOC Guidelines to comply with the original Rule’s disclosure requirements was first granted by the Commission in the Interpretive Guides, 44 FR at 49970-71, on the grounds that the UFOC Guidelines, taken in their entirety, provide equal or greater consumer protection as the original Rule. The Commission ratified this position following subsequent amendments to the UFOC requirements by the NASAA, most recently in 1993, 58 FR 69224 (Dec. 30, 1993).

Beginning on July 1, 2008, however, franchisors may use part 436 of the final amended Rule only. Permission to use the UFOC Guidelines will be withdrawn on that date because those Guidelines will no longer afford prospective franchisees equal or greater protection as part 436. This would not preclude consideration of any new or revised UFOC Guidelines promulgated by the states in the future.

47
E.g.
, H&H, ANPR 28, at 5-6; Kaufmann, ANPR 33, at 3; Kestenbaum, ANPR 40, at 1; WA Securities, ANPR 117, at 1.

48
E.g.
, IFA, NPR 22, at 4-5; Stadfeld, NPR 23, at 2; Karp, ANPR, 19 Sept. 97 Tr., at 90.

49
NASAA, ANPR 120, at 2.
See also
WA Securities, ANPR 117, at 1.

Overwhelmingly, franchisors, franchisees, and franchise regulators urged the Commission throughout the Rule amendment proceeding to adopt the UFOC Guidelines disclosure format. These commenters include a broad range of interests, such as NASAA, the International Franchise Association (“IFA”), the American Bar Association’s Antitrust Section, the American Franchisee Association, the State Bar of California Business Law Section, and major franchisors, such as Cendant, Marriott, YUM! Brands, 7-Eleven, Arby’s, and Starwood Hotels and Resorts.
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50
E.g.
, PMR&W, NPR 4, at 1; H&H, NPR 9, at 2; 7-Eleven, NPR 10, at 2; Lewis, NPR 15, at 5; NASAA, NPR 17, at 2-4; Bundy, NPR 18, at 6; Gurnick, NPR 21, at 2; IFA, NPR 22, at 4-5; Stadfeld, NPR 23, at 2; J&G, NPR 32, at 2; Marriott, NPR 35, at 2; Brown, ANPR 4, at 1; Duvall, ANPR 19, at 1; Baer, ANPR 25, at 2; Kaufmann, ANPR 33, at 3; SBA Advocacy, ANPR 36, at 3; Kestenbaum, ANPR 40, at 1; AFA, ANPR 62, at 2; IL AG, ANPR 77, at 1; WA Securities, ANPR 117, at 1; Selden, ANPR 133, at 1; Zarco & Pardo, ANPR 134; at 1; Cendant, ANPR 140, at 2.

Accordingly, part 436 of the final amended Rule closely tracks the UFOC Guidelines. Nevertheless, part 436 is not identical to the UFOC Guidelines. In a few instances, part 436 omits or streamlines a UFOC Guidelines disclosure requirement that the Commission believes is unnecessary or is overly burdensome—for example, mandatory cover page risk factors, broker disclosures, and detailed computer equipment disclosures. As explained in greater detail below, part 436 of the final amended Rule also avoids problems with Item 20 of the UFOC Guidelines (the disclosure of statistical information on franchisees in the system) that were revealed during the proceeding and that were examined in detail by a number of commenters, including NASAA.

Part 436 of the final amended Rule also retains a few provisions from the original Rule that are not in the UFOC Guidelines, because the Commission believes they are necessary to prevent deception. For example, part 436 of the final amended Rule retains the original Rule’s requirement that, in some instances, franchisors disclose information about a parent. Similarly, part 436 retains the original Rule’s phase-in of audited financial statements,

thereby preserving flexibility not present in the UFOC Guidelines.

At the same time, part 436 of the final amended Rule adds to the UFOC Guidelines a few narrowly tailored disclosures based upon the Commission’s law enforcement experience and the rulemaking record, mostly to prevent deception involving the nature of the franchise relationship.
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For example, as explained in greater detail below, part 436 of the final amended Rule expands the UFOC Guidelines’ Item 3 litigation disclosure requirements to include the disclosure of franchisor-initiated litigation. In addition, part 436 of the final amended Rule goes beyond the UFOC Guidelines’ Item 20 franchisee statistics disclosures to require disclosure of information about the franchisor’s use of confidentiality clauses and the existence of trademark-specific franchisee associations. In addition, in a few instances, part 436 of the final amended Rule requires franchisors to make prescribed statements to clarify issues that the record established are often misinterpreted by prospective franchisees, particularly in the area of protected territories and financial performance representations.

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A decision to retain any portion of the original Rule may be based upon evidence gathered during the original rulemaking and the Commission’s subsequent enforcement experience, as well as evidence adduced during the current rulemaking. Indeed, to the extent that nothing supplements evidence from the initial rulemaking, there is a presumption that the existing rule should be retained.
See Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co.
, 463 U.S. 29, 42 (1983).

Further, part 436 of the final amended Rule updates the original Rule and UFOC Guidelines by addressing changes in the marketplace and new technologies. For example, as explained below, part 436 of the final amended Rule permits franchisors to furnish disclosures electronically and enables franchisees to use electronic signatures. Part 436 of the final amended Rule also updates the original Rule and UFOC Guidelines to address the impact of the Internet on a franchisor’s business operations. Specifically, part 436 requires more disclosure about the affect of the Internet on sales restrictions imposed on franchisees and any right of franchisors to compete online. It also addresses financial performance representations made on the Internet.

Finally, part 436 of the final amended Rule contains a few provisions and prohibitions that are necessary to make the Rule effective, to facilitate compliance, and to prevent deception. For example, part 436 of the final amended Rule prohibits a franchisor from unilaterally altering the material terms and conditions of its franchise agreements, unless the franchise seller informs the prospective franchisee about the changes within a reasonable time before execution. Part 436 of the final amended Rule also prohibits the use of shills, who are persons paid or otherwise given consideration to provide a false favorable report about the franchisor’s performance history.

E. Continued Application of Commission and NASAA Precedent

As noted throughout, most of the provisions of the original Rule have been retained in the final amended Rule. Accordingly, the original SBP remains valid, except to the extent of any conflict with the final amended Rule. In the event of any conflict, this document supersedes the original SBP. In the same vein, all former informal staff advisories remain a source of Rule interpretation, except where this SBP contradicts a staff advisory. To the extent that any member of the public is concerned that a previous advisory may no longer be applicable in light of the final amended Rule, we invite that person or entity to seek further clarification from the Commission or the staff.
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The Commission’s Rules of Practice prescribe procedures to follow in seeking such advice. 16 CFR 1.3.

Further, the Commission anticipates issuance of new Compliance Guides on part 436 that will replace the original Interpretive Guides.
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Because much of part 436 of the final amended Rule is based upon the UFOC Guidelines, the Commission anticipates that Compliance Guides will likely incorporate, in large measure, the UFOC Guidelines’ existing sample answers and NASAA’s previously issued commentaries on the UFOC Guidelines, to the extent such sample answers and commentaries do not deviate from the final amended Rule.
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The Commission intends that the staff coordinate the issuance of Compliance Guides, and future interpretations of part 436 of the final amended Rule, with NASAA’s Franchise and Business Opportunity Project Group in order to minimize differences between FTC and state Rule interpretations.

53
Throughout the Rule amendment proceeding, commenters have requested that the Commission explain or interpret various provisions in Compliance Guides. The Commission anticipates that staff will respond affirmatively to those requests. Compliance Guides on part 437 (the business opportunity section) will be issued after the conclusion of the business opportunity rulemaking proceeding.

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The Commission also recognizes that over the course of the years, franchisors have developed specific language approved by the states for compliance with the UFOC Guidelines. The Commission anticipates that part 436 of the final amended Rule will be interpreted, where consistent with the public interest, in a manner that conforms with historic industry practices.

II. THE LEGAL STANDARD FOR AMENDING THE RULE

A. Section 18 Rulemaking

Section 18(d)(2)(B) of the FTC Act states that “[a] substantive amendment to, or repeal of, a rule promulgated under subsection (a)(1)(B) shall be prescribed, and subject to judicial review, in the same manner as a rule prescribed under such subsection.”
55

Thus, the standard for amendment or repeal of a Section 18 rule is identical to that for promulgating a trade regulation rule pursuant to Section 18.

55
15 U.S.C. 57a(d)(2)(B). The Commission’s rulemaking standards applicable to the promulgation and amendment of a Section 18 rule require a preponderance of reliable evidence.
See
Statement of Basis and Purpose, Funeral Rule, 59 FR 1592 (Jan. 11, 1994); Credit Practices Rule, 49 FR 7740 (Mar. 1, 1984).

Additionally, an SBP must address four factors: (1) the prevalence of the acts or practices addressed by the rule; (2) the manner and context in which the acts or practices are unfair or deceptive; (3) the economic effect of the rule, taking into account the effect on small businesses and consumers; and (4) the effect of the rule on state and local laws.
56

These four factors are discussed in detail throughout this document. In the next section, we summarize our findings regarding each of these factors.
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56
Rules of Practice, 16 CFR 1.14(a)(1)(i)-(iv). In addition, the SBP must specify how the public may obtain a copy of the Rule’s final regulatory analysis. 16 CFR 1.14(a)(v). The current notice does not set forth a separate regulatory analysis. Instead, it incorporates the Commission’s regulatory analysis throughout the SBP portion of the notice. This notice, including the SBP, is being published in the
Federal Register
and posted on the FTC’s website at: www.ftc.gov.

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Support in the record for each factor is set forth in the substantive discussion of each provision of the final amended Rule.

1. The effect of the rule on state and local laws

The Commission begins with the effect of the final amended Rule on state and local laws, because that factor is unusually prominent in this proceeding. As noted above, 15 states have pre-sale franchise disclosure laws in the form of the UFOC Guidelines. The rulemaking record shows that, as a practical matter, the UFOC Guidelines are, in fact, the national disclosure standard for the franchise industry. Therefore, by design, the overwhelming effect of the final amended Rule on state franchise law will be to mesh more closely with it and

enhance its effectiveness by promoting consistency and extending its reach to nationwide scope.
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Moreover, the overwhelming majority of commenters throughout the Rule amendment proceeding, including NASAA and other state law advocates, urged the Commission to update the original Rule by adopting the UFOC Guidelines to bring greater uniformity to the field of franchise pre-sale disclosure.
59

Accordingly, in considering the factors outlined above, the Commission has given great weight to state franchise laws and their impact on the market, as well as the desire of all parties in the field to reduce inconsistencies between federal and state franchise disclosure laws.

58
As noted above, part 437 (the business opportunity section) of the final amended Rule is identical in all respects to the original Rule, except for its scope of coverage. Accordingly, the amendments to the original Rule set forth in part 437 will have no effect on state or local business opportunity laws.

59
The Commission intends to continue working with NASAA and individual states after the final amended Rule goes into effect in order to harmonize federal and state franchise disclosure laws. The Commission recognizes that the states have a wealth of experience in interpreting the UFOC Guidelines that form the basis of the final amended Rule. Accordingly, the Commission anticipates that the staff will coordinate with NASAA and the states in issuing future Compliance Guides and informal staff advisory opinions, in keeping with our goal of federal and state harmonization.

The Commission has also carefully weighed the benefits of any suggestion to revise the Rule that would compound inconsistencies between the Rule and the UFOC Guidelines. Only in very few instances, an existing weakness in the UFOC Guidelines compels deviation from those Guidelines. The chief example is the revision to the Item 20 franchise statistics disclosures. Part 436 of the final amended Rule adopts a proposal submitted by NASAA to eliminate revealed problems with UFOC Item 20 in a streamlined fashion that provides prospective franchisees with material information about the franchise system, while reducing unnecessary compliance burdens.

The Commission also has adopted several suggestions offered by state regulators, mostly through NASAA, for streamlining the Rule. For example, in part 436 the Commission has revised the financial performance claim disclosures to eliminate the original Rule’s requirements that: (1) existing franchise performance data be prepared according to generally accepted accounting principles; (2) financial performance data be presented to a prospective franchisee in a separate financial performance document; and (3) cost information alone trigger the Rule’s financial performance disclosure and substantiation requirements.

2. Deceptive practices

The original Rule remedied through pre-sale disclosure five types of harmful material misrepresentations or omissions that were found to be widespread —specifically, misrepresentations about: (1) the opportunity being offered for sale (2) costs; (3) contractual terms; (4) success of the seller and prior purchasers; and (5) the seller’s financial viability. Each part 436 disclosure amendment to the original Rule addresses one of these five types of misrepresentations or omissions of material information.
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As noted above, part 437 (the business opportunity section) of the final amended Rule is identical in all respects to the original Rule, except for its scope of coverage. Accordingly, there are no amendments in part 437 that must be addressed here.

a. Misrepresentations about the franchisor and the franchise system

In the original rulemaking, the Commission found that franchisors and business opportunity sellers routinely misrepresented the nature of the business. For example, franchisors misrepresented how long they had been in business or the extent of their directors’ and officers’ prior business experience. Such misrepresentations mislead consumers acting reasonably under the circumstances into believing that the franchise offered for sale is a safe or low risk investment.

To prevent such deception, the original Rule required franchisors and business opportunity sellers to disclose background information on the franchisor or business opportunity seller and the business, including: the name and address of the franchisor or business opportunity seller and any parent company; the name under which the franchise or business opportunity seller does or intends to conduct business; its trademarks; the prior business experience of the franchisor or business opportunity seller and its directors and officers; and the business experience of the franchisor or business opportunity seller —
e.g.
, experience selling franchises under the same or different trademarks, as well as the franchisor or business opportunity seller’s other lines of business.

Part 436 of the final amended Rule continues to address misrepresentations about the nature of the franchisor and the franchise system by requiring the same disclosures as did the original Rule. In a few instances, part 436 expands on these disclosures to remedy aspects of this type of misrepresentation that have been revealed by our enforcement experience or the record developed here. Specifically, part 436 of the final amended Rule requires franchisors to disclose information about the franchisor’s predecessors. Similarly, based upon the Commission’s law enforcement experience in over 50 franchise cases, part 436 also remedies misrepresentations about those controlling the franchise system by requiring not only disclosures about directors and officers, but also about other individuals who have management responsibility relating to the sale or operation of the franchises being offered for sale.

b. Misrepresentations about costs

In promulgating the original Rule, the Commission recognized the harm to franchisees and business opportunity purchasers resulting from misleading cost representations. Representing that costs of buying and operating a franchise, for example, are less than they actually are is likely to mislead prospective franchisees, acting reasonably under the circumstances, into believing that the franchise is more financially attractive than is actually the case. Obviously, cost representations are highly material. Thus, the original Rule required franchisors and business opportunity sellers to disclose fully not only the initial fee, but continuing costs throughout the relationship. For example, franchisors must disclose required purchases or leases for, among other things, inventory, signs, supplies, and equipment. In addition, the Commission was concerned about undisclosed indirect payments to the franchisor or business opportunity seller, and therefore required franchisors and business opportunity sellers to disclose the basis for calculating payments to the franchisor or business opportunity seller from suppliers that franchisees or business opportunity purchasers are required to use. Similarly, franchisors and business opportunity sellers must disclose any interest or payments made to celebrity endorsers.

Part 436 of the final amended Rule retains these required cost disclosures. It also adopts a few additional cost disclosures that the states found necessary to address related misrepresentations or omissions, or misrepresentations revealed by our law enforcement experience or the record developed here. These include, for example, a description of laws or regulations specific to the industry in which the franchise operates. Obviously, a franchisee’s operating costs

may increase if he or she must incur hidden costs in the form of compliance with various industry-specific regulations governing the particular field. Part 436 of the final amended Rule also adopts the UFOC Guidelines’ required disclosure of fees that the franchisee is expected to pay within the first three months of operation (or other reasonable time for the industry), as well as more details about payments, such as to whom a payment is to be made and whether a payment is refundable. At the same time, part 436 of the final amended Rule updates cost disclosures by requiring, for example, additional information about any required computer systems, based upon the UFOC Guidelines. Each of these UFOC provisions is designed to prevent misrepresentation of the costs required to commence operation of a franchised outlet.

c. Misrepresentations about contractual terms

Another area of deception identified in the original rulemaking record concerns the underlying franchise or business opportunity contract. For example, the Commission found that franchisors may misrepresent the extent of promised assistance, or fail to disclose restrictions and other obligations imposed on the franchisee. Accordingly, the original Rule specified a number of disclosures pertaining to the legal obligations of both parties under their agreement. Specifically, the original Rule required franchisors, for example, to disclose information about contractual requirements to use designated suppliers, financing arrangements, product sales restrictions and protected territories, site selection, and training programs. In addition, franchisors had to disclose basic terms of the contract, such as the duration, renewal and termination rights, assignment rights, and covenants not to compete.

Part 436 of the final amended Rule retains these disclosure requirements. Adopting the UFOC Guidelines approach, however, the contract disclosures are required to be presented in easy-to-read tables, with references to the franchise agreement, rather than in the form of more detailed descriptions. In addition, part 436 updates the disclosures by, for example, requiring franchisors to explain how they use the term “renewal” in their system.

d. Misrepresentations about success

False or misleading representations about the success of franchise systems and business opportunities were perhaps the most prevalent misrepresentations identified in the original rulemaking record. These included misrepresentations about: the number of franchisees or business opportunity purchasers, the expected growth of the system, and, most important, the financial performance of existing purchasers.

To remedy misleading success claims, the original Rule required franchisors and business opportunity sellers to disclose statistics about the system, including the number of purchasers in the system, the number of purchasers who left the system in the previous year, and why they left (
i.e.
, termination, cancellation, non-renewal, reacquisition). The original Rule also required franchisors and business opportunity sellers to furnish the names and contact information for at least 10 current purchasers. This information enabled prospective purchasers to verify the seller’s claims of success, and it gave prospective purchasers additional sources from which to obtain financial performance data.

The original Rule also remedied misleading success claims by requiring franchisors and business opportunity sellers to disclose lawsuits filed by purchasers against them pertaining to their relationship and counterclaims filed by a franchisor or business opportunity seller in response to a suit filed by a purchaser. The existence of such lawsuits is material because this information would likely influence a prospective purchaser’s decision about what can be a sizeable investment in a franchise or business opportunity. The nature of the relations between the seller and the purchaser, as reflected in litigation, is of central importance.

In the original rulemaking, the Commission also sought to ensure the accuracy and reliability of any financial performance claims made by a franchisor or business opportunity seller. Accordingly, the Commission prohibited the making of earnings claims unless the franchisor or business opportunity seller possessed a reasonable basis for the claim, along with written substantiation, at the time the claim was made. In addition, the seller had to set forth the claim in a separate earnings claims statement containing the bases and assumptions underlying the claim. Franchisors and business opportunity sellers were also required to warn prospective purchasers that there is no assurance that they will achieve the same level of earnings.

Part 436 of the final amended Rule retains each of these disclosures, and it expands on them by requiring franchisors to provide, consistent with the UFOC Guidelines, the names of up to 100 franchised outlets, as well as contact information for former franchisees. Part 436 of the final amended Rule also provides additional sources of information about the franchise system, including the disclosure of trademark-specific franchisee associations. These provisions prevent misrepresentations by giving prospective franchisees additional sources of information with which to assess franchisor claims. With respect to financial performance representations, it follows the more streamlined approach of the UFOC Guidelines. Specifically, part 436 of the final amended Rule eliminates the need for a separate earnings claims document. Instead, the required information is incorporated into the text of the disclosure document itself (Item 19).

Finally, as discussed throughout this document, franchisees have brought to the Commission’s attention what they believe to be abusive practices in franchising. These practices include encroachment of territories, imposition of source of supply restrictions, modification of original franchise agreements as a precondition for renewal, and the use of disclaimers to limit liability for misrepresentations, among others. As detailed in Section I.C. above, the Commission declines to attempt to promulgate a franchise relationship law and, further, concludes that the record does not support the promulgation of such a law. Nonetheless, the record is sufficient to support requiring additional disclosures that will help inform prospective franchisees about the quality of the franchise relationship. These include: expanded litigation disclosures to include franchisor-initiated litigation against franchisees; a warning of the consequences to a franchisee when a franchisor offers no exclusive territory; a statement of what the term “renewal” means in the franchise system; and a disclosure of the use, if any, of confidentiality clauses. Taken together, each of these amended disclosures in part 436 will enable prospective franchisees to better assess the quality of the franchise relationship, and their likely success as franchisees.

e. Misrepresentations about financial viability

In the original rulemaking record, the Commission found that franchisors and business opportunity sellers often misrepresented or failed to disclose material information about their financial viability. As a result, prospective purchasers invested thousands of dollars in systems having

a poor financial history, or even facing bankruptcy. Obviously, a franchisee’s investment, for example, is at risk if the franchisor is not able to perform its contractual obligations as promised. To remedy these practices, the original Rule required franchisors and business opportunity sellers to disclose bankruptcy information, as well as to provide audited financial information. The final amended Rule continues to require these disclosures.

3. The economic effect of the rule

At every stage of the Rule amendment proceeding, the Commission solicited comment on the economic impact of the Rule, as well as the costs and benefits of each proposed Rule amendment. In finalizing the final amended Rule, the Commission has carefully weighed these costs and benefits, reducing compliance costs wherever possible. Thus, for example, part 436 reduces compliance costs by limiting the Rule’s scope of coverage to the sale of franchises to be located in the United States and its territories.
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In so doing, the Commission specifically rejected the suggestion that franchisors should prepare individual disclosure documents tailored to each specific foreign market. Not only would such a requirement put American franchisors at a competitive disadvantage with franchisors from countries lacking comparable disclosure regulations, the minimal benefits of such a requirement would not likely outweigh the extraordinary costs and burdens involved.

In the same vein, part 436 of the final amended Rule reduces compliance burdens where the record establishes that the abuses the Rule is intended to address are not likely to be present. Thus, part 436 of the final amended Rule retains the exemptions in the original Rule as the ones for fractional franchises and leased departments. Part 436 of the final amended Rule also incorporates the Commission’s long-standing policies exempting from Rule coverage franchises covered by the Petroleum Marketing Practices Act, as well as instances where the only required payments made by the franchisee are for inventory at bona fide wholesale prices. Further, part 436 of the final amended Rule adds new exemptions for large investments of at least $1 million (excluding unimproved land and any amounts financed by the franchisor), investments by large franchisees with five years of business experience and $5 million net worth, and for franchise sales to company insiders who are already familiar with the company’s operations.

The Commission also has limited the required disclosures of part 436 in order to minimize compliance burdens. For example, the Commission has declined to adopt two UFOC Guidelines provisions on the grounds that such provisions are unnecessarily burdensome, without corresponding benefits to prospective franchisees. These provisions are mandatory risk factors (choice of law and venue) on the disclosure document cover page and the disclosure of franchise broker information in Items 2, 3, and 4 of the UFOC Guidelines.

Further, for each disclosure item, the Commission considered less costly disclosure alternatives. For example, part 436 of the final amended Rule requires the disclosure of franchisor-initiated litigation. In response to concerns raised by franchisor representatives, Item 3 of part 436 makes clear that this disclosure is limited to a one-year snap-shot in time and franchisors need only update the disclosure on an annual basis. Franchisors also can reduce costs by grouping similar franchisor-initiated suits under a single descriptive heading, in lieu of detailed summaries for each suit.

Similarly, the Commission has adopted in part 436 a narrow requirement to disclose independent trademark-specific franchisee associations. Franchisors must make this disclosure only if the franchisee association asks to be included in the franchisor’s disclosure document, and the association’s request must be updated on an annual basis.

Part 436 of the final amended Rule also reduces the franchisors’ burdens associated with making financial performance claims. Among other things, the original Rule specified that: (1) all financial performance claims must be geographically relevant to the franchise being offered for sale; and (2) all historical earnings data from existing franchisees must be presented using generally accepted accounting principles. Moreover, the original Rule required franchisors to disseminate financial performance information in a separate document. Part 436 of the final amended Rule eliminates these requirements.

Part 436 of the final amended Rule also promotes efficiency and reduces compliance costs by enabling franchisors to use their own judgment in deciding how to disseminate disclosure documents. For example, part 436 permits franchisors to furnish disclosures electronically through a variety of media, including CD-ROM, Internet website, and email. Individual sections of the disclosure document also allow more flexibility than the original Rule, again to promote efficiency and reduced compliance costs. For example, Item 5 permits franchisors to disclose either fixed fees or ranges of fees. Similarly, Item 11 permits franchisors to summarize computer system requirements, in lieu of more extensive disclosures.

In amending the Rule, the Commission has been guided by a preference for an approach that prohibits identified harmful practices and eschews burdensome affirmative compliance obligations that may only be warranted for some few unscrupulous actors. Thus, part 436 of the final amended Rule drops the original Rule’s across-the-board obligation to furnish disclosures early in the sales process—at the first personal meeting between the prospective purchaser and the franchise seller. Instead, part 436 of the final amended Rule allows greater flexibility, requiring that franchisors furnish disclosures early in the sales process only if the prospective franchisee requests them at that point. Similarly, part 436 of the final amended Rule eliminates burdensome waiting periods in some instances. Thus, in lieu of the original Rule’s mandate that all franchisors furnish copies of their completed franchise agreements at least five business days before execution, part 436 targets potential fraud directly by prohibiting a franchisor from failing to disclose unilateral changes to a franchise agreement seven days prior to its execution. As a final example, part 436 of the final amended Rule prohibits a franchisor from failing to furnish a copy of its most recent disclosure document and any quarterly updates to a prospective franchisee, upon reasonable request, before the prospect signs the franchise agreement. This prohibition is in lieu of suggestions that the Commission impose onerous disclosure updating obligations on an ongoing basis.

Finally, in numerous instances the Commission has rejected suggestions to impose certain additional requirements upon franchisors, and has opted instead to address the underlying issues that prompted those suggestions through redoubled consumer education efforts. For example, several commenters in the rulemaking record urged the Commission to expand the disclosure document to provide prospective franchisees with more general information about the nature of franchising. Others suggested more disclosure on post-termination obligations to third-party vendors, obligations to purchase from specific suppliers, and sources of financing, among others. While there is merit in their suggestions, the Commission has concluded that the appropriate vehicle

to disseminate such information is through consumer education materials, not through the Rule itself. To that end, the cover page of the disclosure document set forth in part 436 of the final amended Rule references the Commissions’
Consumer Guide to Buying a Franchise
, where such background information is furnished. This approach enables prospective franchisees to obtain desirable information without imposing new compliance burdens on franchisors.

4. Statement of prevalence

The Commission promulgated the original Rule based upon its finding of prevalent deception in the offer and sale of franchises and business opportunity ventures, leading to significant consumer injury. That finding retains its validity and the final amended Rule retains almost all of the original Rule’s disclosure requirements for both franchises and business opportunity sellers. In the franchise context, modifications of those requirements have been driven by four considerations: the goal of harmonizing the Rule with the UFOC Guidelines; the need to update the original Rule to address new technologies; to reduce unnecessary compliance burdens; and, based on the record developed here, to remedy prevalent nondisclosure on issues relating to the franchise relationship.
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The Commission is also considering amendments to the original Rule as they pertain to business opportunity sales.
See
Business Opportunity NPR, 71 FR 19054 (Apr. 12, 2006).

This last category of modifications constitutes the most significant additions to the original Rule. Throughout the Rule amendment proceeding, franchisees have complained repeatedly about various practices in franchising that they believe are abusive. These practices include encroachment of territories, source of supply restrictions, modification of franchise agreements upon renewal, and the use of confidentiality clauses to prevent franchisees from speaking with prospects. To address these issues, franchisees urged the Commission to promulgate a substantive franchise relationship law. As detailed above in Section I.C., the applicable legal standard that could theoretically support promulgation of such a law has not been met. Nonetheless, the Commission is persuaded by evidence in the record that nondisclosure of material information about franchise relationships is prevalent and the record supports additional disclosures that will help obviate deception of prospective franchisees.

To that end, part 436 of the final amended Rule adopts a few new disclosures that provide prospective franchisees with material information about the quality of the franchise relationship or with sources of information about such relationships. For example:

• In section 436.5(c), the Item 3 requirements to disclose information about franchisor litigation have been amended to encompass franchisor-initiated litigation, such as suits to collect royalty payments, in order to ensure prospective franchisees have material information about the nature of the franchisor’s relationship with its franchisees;
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Multiple franchisor-initiated suits could indicate franchisees’ inability to comply with royalty payment obligations, or possibly a royalty boycott by franchisees. Suits to enforce system standards, on the other hand, could show active involvement by the franchisor in maintaining standards for the benefit of all franchisees within its system. In either case, this is information material to prospective franchisees attempting to determine the nature of the franchisor’s relationship with its franchisees.

• In section 436.5(l), the Item 12 requirements to disclose information about territories contain a new warning to prospective franchisees about the consequences of not having an exclusive territory— that, as a result of having no exclusive territory, the franchisee “may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control;”

• In section 436.5(q), the Item 17 requirements to disclose information about renewal of the franchise mandate that a franchisor describe what the term “renewal” means for its system, and state what has been absent from disclosure to date—that franchisees will be required to sign a different agreement when renewing, as opposed to extending the term of their original agreement.

These new disclosure requirements are tailored to address the prevalent franchisor nondisclosure of material information that prospective franchisees need to avoid forming the kind of misconceptions about these three key aspects of the franchise relationship that have prompted the franchisee complaints noted in this record.

III. SECTION-BY-SECTION ANALYSIS OF PART 436

A. Section 436.1: Definitions

In many instances, the part 436 definitions of the final amended Rule are substantively similar to those contained in either the original Rule or UFOC Guidelines. These include the terms: “affiliate,” “fiscal year,” “fractional franchise,” “franchise,” “franchisee,” “franchisor,” “leased department,” “person,” “prospective franchisee,” and “sale of a franchise.” Part 436 of the final amended Rule, however, adds several new definitions to the original Rule, including the terms: “action,” “confidentiality clause,” “disclose, state, describe, and list,” “financial performance representation,” “franchise seller,” “parent,” “plain English,” “predecessor,” “principal business address,” “required payment,” “signature,” “trademark,” and “written.” At the same time, part 436 of the final amended Rule eliminates four of the original Rule’s terms, and their definitions, that are no longer necessary: “business day,”
64

“time for making of disclosures,”
65

“personal meeting,”
66

and “cooperative association.”
67

64
See
16 CFR 436.2(f).

65
See
16 CFR 436.2(g).

66
See
16 CFR 436.2(o). The original Rule required franchisors to provide disclosure documents at the earlier of the first “personal meeting” or “the time for making disclosures,” which generally meant 10 business days before the prospective franchisee paid any fee or signed any contract in connection with the franchise sale. The final amended Rule streamlines this requirement by eliminating those timing provisions in favor of a clear, bright-line 14 calendar-day provision. Accordingly, the terms “time for making disclosures,” “personal meeting,” and “business day” are obsolete.

67
See
16 CFR 436.2(l). Cooperative associations are one of four non-franchise relationships that the Commission has excluded from the final amended Rule. Unlike Rule exemptions (which are substantive limitations on the Rule’s scope), the original Rule exclusions are explanatory, helping the public better distinguish between franchise and non-franchise relationships. Accordingly, the Commission anticipates that staff will address non-franchise relationships—including the four exclusions—in the Compliance Guides instead of in the text of the amended Rule.

Section 436.1 of the final amended Rule is very similar to the corresponding section of the proposed Rule published in the Franchise NPR, but makes the following revisions: (1) substitutes a definition of “confidentiality clause” for the definition of “gag clause;” (2) omits proposed definitions of “Internet,” “officer,” and “material;” and (3) makes non-substantive revisions to improve readability, organization, and precision throughout, as well as some substantive revisions in response to the comments. The following sections discuss each definition of part 436 of the final amended Rule.

1. Section 436.1(a): Action

Consistent with the original Rule,
68

section 436.5(c) of the final amended

Rule requires a franchisor to disclose certain legal actions involving the franchisor and its directors and officers. The original Rule did not define the term “action.” Section 436.1(a) in the final amended Rule is nearly identical to the definition proposed in the Franchise NPR, and closely tracks the UFOC Guidelines’ definition of the term “action.”
69

That definition is: “
Action
includes complaints, cross claims, counterclaims, and third-party complaints in a judicial action or proceeding, and their equivalents in an administrative action or arbitration.”
70

The definition differs from the UFOC Guidelines definition only in that it refers to a “judicial action or proceeding,” in lieu of just a “judicial proceeding.” This modification addresses one commenter’s observation that some states may retain the distinction between an “action” at law and a “proceeding” in equity.
71

Clearly, both types of legal matters must be disclosed.

68
See
16 CFR 436.1(a)(4).

69
This definition is also consistent with the Commission’s interpretation of the term “action,” as discussed in the Interpretive Guides to the Franchise Rule. Interpretive Guides, 44 FR at 49973.

70
See
UFOC Guidelines, Item 3 Definitions, ii.

71
NFC, NPR 12, at 25.

The Commission has declined to adopt an additional suggestion that “complaints” referred to in the definition of “action” be limited to “served complaints.”
72

Such a narrowing of the definition of “action” would be inconsistent with the UFOC Guidelines. Moreover, it would effectively enable a franchisor to avoid disclosing potentially material litigation, even though it had notice of an action, merely because it was not served with the papers yet or had successfully avoided service of process. In the Commission’s law enforcement experience, it is not uncommon for defendants to know that a Commission action was filed prior to service either by learning of the suit from co-defendants or as a result of an asset freeze.
73

72
Lewis, NPR 15, at 7.

73
E.g.
,
FTC v. Joseph Hayes
, No. 4:96CV02162SNL (E.D. Mo. 1996).

In the same vein, IL AG suggested that the term “action” should refer to both “ filed” and “served” complaints.
74

A reference to “filed complaints” is unnecessary, however, and would be inconsistent with the UFOC Guidelines: the definition of action already refers to “complaints . . . in a judicial action or proceeding” and “complaints . . . in . . . an arbitration,” meaning that a complaint has already been filed. Accordingly, the Commission declines to adopt these additional revisions to the definition of “action.”

74
IL AG, at 2.

2. Section 436.1(b): Affiliate

Many of the part 436 disclosures pertain to both the franchisor and its affiliates.
75

The original Rule defined the term “affiliated person” to mean a person:

75
E.g.
, Sections 436.5(a) (Item 1); 436.5(c) (Item 3); 436.5(d) (Item 4); 436.5(h) (Item 8).

(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 occupying similar status or performing similar functions.
76

76
16 CFR 436.2(i).

Section 436.1(b), like the corresponding definition in the proposed Rule, harmonizes federal and state law, closely following the UFOC Guidelines by defining “affiliate” to mean: “an entity controlled by, controlling, or under common control with, another entity.”
77

This is slightly broader than the UFOC Guidelines’ definition, however. The UFOC Guidelines’ definition uses the narrower term “franchisor” in place of “another entity.” This slight departure from the UFOC Guidelines is necessary for the “large franchisee” exemption, section 436.8(a)(5)(ii), as discussed below in the section covering that exemption.
78

77
See
NASAA Commentary on the Uniform Franchise Offering Circular Guidelines (1999), Bus. Franchise Guide (CCH), ¶ 5790, at 8466 (“NASAA Commentary” or “Commentary”). The Commentary notes that this general definition of affiliate should be used throughout a UFOC, unless a particular disclosure Item defines it differently or limits its use. The record contains no indication that the UFOC Guidelines’ narrower definition is deficient or would impede the Commission’s ability to target affiliates in law enforcement actions, where warranted.

78
See
Triarc, NPR 6, at 2. The Staff Report recommended that the term “affiliate” mean “controlled by, controlling, or under common control with, the
franchisor or a franchisee
.”
See
Staff Report, at 21 (emphasis added). While this version was intended to capture franchisee affiliates, for purposes of the “large franchisee” exemption, it also had the unintended consequence of broadening affiliate disclosures generally. For example, section 436.5(d) (Item 4) requires a franchisor to disclose a prior bankruptcy of an affiliate. Defining “affiliate” expressly to include “franchisee” would arguably require a franchisor to list in its Item 4 bankruptcy disclosures the bankruptcy history of its franchisees’ affiliates. The final amended Rule does not follow this problematic recommendation.

3. Section 436.1(c): Confidentiality clause

Part 436 of the final amended Rule requires franchisors for the first time to disclose the use of confidentiality clauses that prohibit or restrict existing or former franchisees from discussing their experience with prospective franchisees.
79

Accordingly, section 436.1(c) of the final amended Rule adds to the original Rule definitions the term “confidentiality clause,”
80

defined as follows:

79
Section 436.5(t)(7).

80
Originally, the Commission proposed using the term “gag clause” to refer to such provisions. Franchise NPR, 64 FR at 57332. Several commenters, however, opposed the term “gag clause” because, in their view, it is pejorative. They prefer a neutral term, such as “confidentiality agreement,” “confidentiality clause,” “nondisclosure clause,” or “privacy clause.”
E.g.
, NFC, NPR 12, at 26; BI, NPR 28, at 10. Accordingly, the Commission has adopted the term “confidentiality clause.”

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

As explained below, the confidentiality clause disclosure requirement is intended to prevent deception in the offer and sale of franchises by assisting prospective franchisees in verifying a franchisor’s claims. Specifically, this disclosure requirement is tied to the requirement to disclose contact information for existing franchised outlets.
81

Knowing that a franchisor uses a confidentiality clause enables prospective franchisees to understand that a former or current franchisee may be prohibited from speaking about his or her experience and will make efforts to contact other former or current franchisees not subject to such a clause. This being the disclosure’s purpose, the operant definition is limited to confidentiality clauses impinging on communications between current or former franchisees and
prospective franchisees
only.
82

It would not cover clauses that prohibit communications between current or

former franchisees and, for example, the media.

81
See
section 436.5(t)(5).
See also
UFOC Guidelines Item 20 B.

82
At the same time, the confidentiality clause disclosure requirement is not designed to cover specific settlement terms if the franchisee is otherwise free to discuss his or her experience within the franchise system, including the existence of a litigated action with the franchisor.

After carefully considering the comments, the Commission has rejected suggestions to limit the definition of confidentiality clause to cover only broad clauses that prohibit
all
communications by current or former franchisees
83

or only circumstances where all or at least 20% of franchisees are under speech restrictions.
84

These suggestions are narrower than necessary and would defeat the very purpose of the confidentiality clause disclosure. Moreover, as stated throughout this document, the Commission favors bright-line standards that enable franchisors, prospective franchisees, and law enforcers to know when a Rule provision applies without resort to fact-finding. In this instance, the parties should know whether the confidentiality clause is applicable without having to first determine the exact number of franchisees under speech restrictions at any given period.

83
PMR&W, NPR 4, at 15.

84
NFC, NPR 12, at 33.

Finally, the definition expressly excludes confidentiality agreements designed to protect proprietary information. Many commenters—both franchisor and franchisee representatives alike—agreed that proprietary information should be exempted from the definition because a franchisor has a reasonable and legitimate concern about protecting its trademark and business secrets.
85

One commenter suggested that the Commission make clear that the existence of a confidentiality agreement cannot be considered “proprietary information.”
86

Otherwise, according to this commenter, a franchisor could attempt to circumvent the confidentiality agreement disclosure by having a prospective franchisee sign an agreement stating that the existence of a confidentiality agreement is itself “proprietary.” The Commission, however, intends that the term “proprietary information” be limited to trade secrets and intellectual property, the type of information that, if disclosed, would put a franchisor at a competitive disadvantage.

85
E.g.
, Baer, ANPR 25, at 3; AFA, ANPR 62, at 3; Zarco & Pardo, ANPR 134, at 4.

86
Bundy, NPR 18, at 3.

4. Section 436.1(d): Disclose, state, describe, and list

Section 436.1(d) sets forth the definition of the terms “disclose,” “state,” “describe,” and “list,” which are used throughout part 436. This is another definition not contained in the original Rule. The proposed definition published in the Franchise NPR was taken from the UFOC Guidelines, stating that these terms mean “to present all material facts accurately, clearly, concisely, and legibly in plain English.”
87

87
See
UFOC Guidelines, General Instruction 150. The phrase “plain English” is defined separately in section 436.1(o), consistent with the UFOC Guidelines.

The Commission is persuaded that franchisors should have flexibility in presenting their disclosures, provided that the disclosures are clear and legible. The Staff Report recommended that franchisors should be required to make disclosures in at least 12 point upper and lower case type.
88

This recommendation generated two comments, however, asserting that the Commission should not mandate 12 point type. The commenters noted that 12 point type may result in some of the Rule’s charts being split into two sections. They suggested that smaller fonts, especially in charts, can be very readable and result in reduced compliance costs.
89

The Commission agrees. Accordingly, part 436 of the final amended Rule does not mandate any specific font size: franchisors may choose any font size, provided that their disclosures are clear and likely to be noticed, read, and understood by a reasonable prospective franchisee.

88
This presentation requirement would be consistent with the Commission’s approach in the original Rule.
See
16 CFR 436.1(b)(4).

89
Gust Rosenfeld, at 2-3; Wiggin & Dana, at 6-7.

Two additional Staff Report commenters sought refinements to section 436.1(d), as proposed therein. One commenter opined that the definition could be interpreted to mean that a franchisor must disclose “every material fact regarding the offered franchise, rather than disclosing all material facts pertaining specifically to the disclosures required pursuant to the Rule.”
90

The Commission believes that this reading of the definition is strained and expressly notes that it does not intend such a reading. Throughout the final amended Rule, the topic on which the franchisor is required to “present all material facts accurately, clearly, concisely, and legibly in plain English” is clear. Moreover, nothing in the record suggests that a virtually identical definition in the UFOC Guidelines has generated the problems anticipated by this commenter. This being the case, the Commission is disinclined to deviate from the UFOC Guidelines on this issue. Therefore, the Commission adopts the definition as quoted above.

90
J&G, at 2.

Another commenter urged that the definition specify that the meaning of “disclose,” “state,” “describe,” and “list” incorporates the concept that the language must be “understandable by a person unfamiliar with the franchise business.”
91

The Commission believes that the final amended Rule’s definition of “plain English” in section 436.1(o) gives more direction to franchisors in preparing their disclosures than the more general phrase “understandable by a person unfamiliar with the franchise business.” Therefore, we decline to adopt this suggestion.

91
IL AG, at 2.

Finally, we note that three commenters urged the Commission to define separately the term “material.”
92

In particular, they asserted that it is unclear whether materiality should be determined from the franchisor’s or the prospective franchisee’s viewpoint. For example, isolated instances of franchisee-initiated lawsuits might not be material to a franchisor (
i.e.
, not affecting the franchisor’s financial status), but could be highly material to a prospective franchisee seeking information on the quality of the franchise relationship.
93

92
Bundy, at 3; Cendant, at 3; IL AG, at 3. The Staff Report recommended deletion of this definition based on use of the term in the Rule text in at least two distinguishable ways, creating unnecessary confusion. Staff Report, at 68-9.

93
See
Cendant, at 3.

The original Rule defined “material, material fact, and material change.”
94

The Commission, however, believes that such definitions are not necessary. An understanding of materiality under the final amended Rule can best be gained by looking to long-established Commission jurisprudence. “Materiality” is a cornerstone concept of that jurisprudence. To be clear on this important point, the Commission, when interpreting Section 5, regards a representation, omission, or practice to be deceptive if: (1) it is likely to mislead consumers acting reasonably under the circumstances; and (2) it is material; that is,
likely to affect consumers’ conduct or decisions with respect to the product at issue
.
95

Accordingly, it is amply clear that “materiality” is determined by the reasonable consumer standard, or in franchise matters, by the reasonable prospective franchisee standard. Moreover, since violations of the Franchise Rule constitute violations of Section 5, we believe that the Section

5 deception jurisprudence provides adequate guidance on what the term “material” means in the Franchise Rule context.

94
16 CFR 436.2(n).

95
See generally Federal Trade Commission Policy Statement on Deception
, appended to
Cliffdale Assocs.
, 103 FTC 110 (1984).

5. Section 436.1(e): Financial performance representation

This section of part 436 defines the term “financial performance representation” to mean:

any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables.
96

96
The part 436 definition is nearly identical to the definition as proposed in the Franchise NPR, with slightly modified language in some places to improve clarity and precision. No commenter raised any concerns about the basic “financial performance representation” definition. Nevertheless, IL AG posed a number of questions about how the definition would be applied in various situations, such as representations based upon earnings of a franchisor’s affiliates or representations based upon industry data. IL AG, at 2. Questions such as these are best addressed in the Compliance Guides or in staff advisory opinions, where they can be analyzed in the context of specific facts.

This definition comes into play in one of the most important sections of the final amended Rule, section 436.5(s), corresponding to Item 19 of the UFOC Guidelines. Like Item 19, it governs the making of financial performance representations.
97

The definition incorporates the original Rule’s approach, in that it specifies that a financial performance representation may be in an “oral, written, or visual” format.
98

To ensure that part 436 covers implied financial performance representations, the definition also refers to financial performance representations that are made both “expressly or by implication.”
99

It also retains the original Rule’s reference to financial performance representations made in the general media.
100

At the same time, section 436.1(e) adopts several aspects of the UFOC Guidelines definition, including references to “actual” and “potential” performance (to capture both historical financial performance and projections),
101

as well as the use of charts, tables, and mathematical calculations.
102

97
The final amended Rule uses the broad term “financial performance representation,” rather than the original Rule’s more limited term “earnings claim.” This modification recognizes that some industries, such as hotels, use variables other than earnings to measure performance, such as room occupancy rates.
See
Franchise NPR, 64 FR at 57297.

98
The original Rule described performance information as “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.” 16 CFR 436.1(b) and (c).

99
To address implied claims, the original Rule used the term “suggests.” The proposed definition of “financial performance representation” published in the Franchise NPR similarly used that term. One franchisee representative observed that the word “suggests” in this context is flawed: it would not reach the furnishing of fragments of financial data from which a prospect may readily estimate or calculate earnings. Bundy, NPR 18, at 1. The Commission agrees that a franchisor can imply a performance claim by giving a prospect a few pieces of financial information from which the prospect can fill in the blanks and draw his or her own conclusion about a specific level of potential earnings. In addition, a franchisor can imply that a prospect can earn a specific level of income, such as by using a proxy for earnings (for example, “You will do so well that you can buy that Porsche.”).
See
Interpretive Guides, 44 FR at 49982. Both types of implied claims constitute financial performance representations that are, and should be, covered by the final amended Rule. To clarify this policy, the final amended Rule uses the phrase “states, expressly or by implication.” This phrase is widely used, for example, in connection with representations challenged under Section 5.
E.g.
,
FTC v. Prophet 3H, Inc.
, 06 CV 1692 (N.D. Ga. 2006);
FTC v. Morrone’s Water Ice, Inc.
, No. 02-3720 (E.D. Pa. 2002).

100
See
16 CFR 436.1(e).

101
This streamlines the original Rule, which addressed historical performance representations and projections in two distinct Rule provisions, 16 CFR 436.1(b) (projections) and 436.1(c) (historical information).

102
The staff of the Commission has adopted the same position in several informal advisory opinions.
E.g.
, Handy Hardware Centers, Bus. Franchise Guide (CCH) ¶ 6426 (1980) (The Rule’s “earnings claim requirements are applicable to ‘any oral, written, or visual representation.’”); Diet Center, Inc., Bus. Franchise Guide (CCH) ¶ 6437 (1983) (table with arithmetic calculations uniformly demonstrating net profits constitutes a financial performance representation).

Two aspects of the definition of the term “financial performance representation” generated significant comment: whether the Commission should treat information about costs and expenses as financial performance representations;
103

and whether the Commission should interpret the definition’s express inclusion of any “representation in the general media” to include all financial information available on a franchisor’s website or through a franchisor’s speeches and press releases.
104

Each of these interpretive issues is discussed in the sections immediately below.

103
See
Interpretive Guides, 44 FR 49982.

104
See
Interpretive Guides, 44 FR at 49984-85.

a. Treatment of cost and expense information

In the Franchise NPR, the Commission made it clear that the section 436.1(e) definition of “financial performance representation” is not intended to reach disclosures of expense information, and specifically sought comment on this issue.
105

Most commenters who responded on this issue felt that disclosures of expense information should not fall within the definition.
106

Some, however, sought additional clarification. For example, the IL AG urged the Commission to modify the definition of “financial performance representation” to expressly exclude expense disclosures mandated in Items 5-7 of the final amended Rule (initial fees, ongoing costs, and initial investment), offering the following additional sentence: “Expenses required in Items 5, 6, and 7 of the disclosure document are not to be considered performance claims and do not contradict Item 19 requirements.”
107

Others went further, arguing that the dissemination of any expense information should not trigger the Item 19 disclosure requirements.
108

105
Neither the original Rule nor the final amended Rule includes mention of expenses in the definition of “financial performance representation,” but the Commission indicated its intended interpretation in the Franchise NPR’s discussion of the definition of the term. Specifically, it stated that “[w]hile the Commission does not consider the disclosure of such expense information alone to constitute the making of a financial performance claim, others arguably may interpret some expense information as implying a financial performance representation, such as a break-even point. To avoid any confusion, the proposed definition of ‘financial performance representation’ . . . specifically omits expense information.” Franchise NPR, 64 FR at 57329. This interpretation is a departure from the Commission’s former policy, as articulated in the Interpretive Guides. The Guides expressed the view that cost information alone could be a financial performance claim because a prospective franchisee could use such information to calculate likely profits by simply selecting arbitrary sales figures. Interpretive Guides, 44 FR at 49982. It also departs from UFOC Guidelines Item 19, which expressly lists costs among the items of information that constitute an earnings claims.
See also
UFOC Guidelines, Item 19, Instructions i. Nevertheless, in light of the comments and the Commission’s long law enforcement history, the Commission, reiterating its Franchise NPR statement quoted immediately above, states its intent that expense information not be included in the part 436 definition of “financial performance representation.” As discussed above, the states agree.
See
NASAA, NPR 17, at 2.

106
E.g.
, IL AG, NPR 3, at 3; Baer, NPR 11, at 7; NFC, NPR 12, at 13; NASAA, NPR 17, at 2; BI, NPR 28, at 10.
But see
Bundy, NPR 18, at 2 (arguing that expense disclosures inevitably will lead prospective franchisees to extrapolate earnings without the protection of an Item 19 disclosure).

107
IL AG, NPR 3, at 8-9.
See also
Baer, NPR 11, at 7.

108
NFC, NPR 12, at 13. The NFC also suggested that the Commission modify the Rule to exclude from the definition of “financial performance representation” financial data furnished to existing franchisees.
Id
. The Commission concludes, however, that part 436 need not be revised to address this issue. A franchisor is always free to furnish truthful information about its system to

existing franchisees, especially if no additional franchise sales are contemplated. If the franchisor contemplates an additional franchise sale under materially different terms and conditions than the franchisee’s original purchase, then the existing franchisee, like any prospective franchisee, could be misled and therefore should receive financial performance disclosures in the form of an Item 19 disclosure. For example, an Item 19 disclosure will assist an existing franchisee operating in a shopping mall or urban area in the northeast to understand an earnings projection for an additional stand-alone outlet or outlet to be located in a rural section of the southwest.

Notwithstanding language to the contrary in the original Interpretive Guides,
109

the Commission is persuaded that expense information alone is insufficient to enable prospective franchisees to gauge their potential earnings with any degree of specificity that could rise to the level of a financial performance claim.
110

The Commission explained in the Franchise NPR and now reiterates here that mere disclosure of cost information does not, in its view, constitute a financial performance representation triggering Item 19 disclosure obligations. The Commission intends that the explanation that mere expense disclosures alone do not constitute a financial performance representation, coupled with the deliberate omission of any mention of expense information from section 436.1(e) of the final amended Rule, will be enough to address this issue.

109
Interpretive Guides, 44 FR at 49982.

110
At any rate, according to NASAA, franchisors do not routinely disseminate individualized expense information geared to a specific offering that might be used to insinuate an earnings level. NASAA, 17 NPR, at 2.

b. General media claims

Section 436.1(e) of the final amended Rule retains the original Rule’s provision governing the making of financial performance representations in the general media. Under the original Rule, a general media financial performance representation, like all other financial performance representations, must have a reasonable basis and state the number and percentage of outlets earning the claimed amount, among other substantiation and disclosure requirements.
111

There is no comparable provision in the UFOC Guidelines.
112

111
See
16 CFR 436.1(b)(5)(i); 436.1(c)(6)(i); 436.1(e)(5)(ii). Unlike other financial performance claims, a claim made in the general media need not be geographically relevant to the market in which franchises are being offered for sale.

112
Although the UFOC Guidelines do not address general media claims, many of the states with disclosure laws require franchisors to register their advertisements in advance of their use.
E.g.
, Cal. Corp. Code § 31156 (1997) (franchisor must register advertising at least three business days before first publication); Md. Code Ann., Bus. Reg. § 14-225 (1998) (franchisor must register advertising at least seven business days before publication).

In the Franchise NPR, the Commission proposed that the term “financial performance representation” should broadly include the dissemination of financial performance information via the Internet.
113

The majority of commenters who addressed this issue, however, questioned whether financial performance information posted online should constitute “financial performance representations,” thus triggering the Rule’s disclosure and substantiation requirements.
114

These commenters asserted that the Commission should not deem financial performance information posted on a franchisor’s website to be financial performance representations under the Rule, unless the information is located in a section of a website that solicits franchise purchasers or otherwise specifically targets prospective franchisees.
115

In their view, financial performance information on a franchisor’s website—including links to press releases, interviews, or articles—is intended to educate the general public about the company, rather than to attract prospective franchisees.
116

Indeed, some posted information may consist of copies of publicly filed reports, such as 10-Qs and 10-Ks, that are submitted to the SEC.
117

At least one commenter feared that equating online financial performance information with financial performance representations under the Rule would have a chilling effect, unreasonably restricting the kinds of materials a franchisor could have on its website: “Does this mean that a franchise company, unlike any other business, must choose between taking advantage of articles or press releases about itself on its own web site page or risk the claim that a prospective franchisee has been given unauthorized non-Item 19 financial data?”
118

113
In the proposed Rule, the term “financial performance representation” expressly included “a representation disseminated in the general media
and Internet
.” Franchise NPR, 64 FR at 57297, 57332. (emphasis supplied.) In accordance with the discussion in this section of the SBP, the Commission has deleted this phrase to dispel potential readings that financial information posted on the Internet is
per se
a financial performance representation.

114
E.g.
, PMR&W NPR 4, at 16; H&H, NPR 9, at 14; NFC, NPR 12, at 23-24.

115
E.g.
, Gust Rosenfeld, at 7; Quizno’s, NPR 1, at 3; PRM&W, NPR 4, at 16; NFC, NPR 12, at 24; BI, NPR 28, at 9.

116
E.g.
, Quizno’s, NPR 1, at 3.
See also
BI, NPR 28, at 9.

117
E.g.
, Quizno’s, NPR 1, at 3; PMR&W, NPR 4, at 16; H&H, NPR 9, at 14; BI, NPR 28, at 9.

118
Quizno’s, NPR 1, at 3.

Two Staff Report commenters broadened this argument beyond the online context to encompass franchisors’ speeches and news releases. In the Interpretive Guides, the Commission described “general media” broadly to include: “advertising (radio, television, magazines, newspapers, billboards, etc) as well as those contained in speeches or press releases.”
119

David Kaufmann, for example, asserted that the inclusion of speeches and news releases harms franchisors by making it difficult for them to disseminate financial performance information in “speeches, press interviews, and other forums not specifically geared to the franchise sales process.”
120

He urged the Commission to permit franchisors and their executives to disseminate financial performance information to the public freely, unless copies are subsequently used in the franchisor’s franchise marketing effort.

119
Interpretive Guides, 44 FR at 49984-85. The Commission excluded, however, “communications to financial journals or the trade press in connection with bona-fide news stories, or directly to lenders in connection with arranging financing for the franchisee.”
Id
. at 49985.

120
Kaufmann, at 6.
See also
Cendant, at 2.

Based upon the comments, the Commission is persuaded that it is unwarranted to sweep broadly into the part 436 definition of “financial performance representation” all financial performance information posted online or appearing in press releases or speeches. The dissemination of financial information online and in press stories and releases is for the benefit of more than prospective franchisees, including investors, potential suppliers, and members of the general public.
121

Further, the Commission believes that the commenters’ concerns are well-founded with respect to publicly filed reports required by the SEC. The Commission agrees that such filings are already publicly available and, more important, have indicia of reliability. Indeed, the dissemination of false financial data by publicly traded franchisors is already illegal. Thus, to impose the Rule’s substantiation and disclosure requirements with respect to SEC filing

would be pointless, unworkable, and unduly burdensome.

121
Indeed, the staff previously has advised that the dissemination of financial performance information through bona fide news stories may generate benefits to the public that outweigh potential harm to prospective franchisees. “For example, such information may be useful to potential suppliers seeking growing businesses as customers; shopping center or mall developers seeking promising franchised systems as tenants; and financial analysts who follow market or industry trends. Accordingly, the exemption from the general media earnings claims disclosure requirements ensures that the Rule does not chill the free flow of newsworthy information about franchising or particular franchise systems.” Advisory 97-5, Bus. Franchise Guide (CCH) ¶ 6485 at 9687 (July 31, 1997).

With respect to the dissemination of other financial performance information, the Commission believes that a distinction should be made between information disseminated in advertisements directed at franchisees—be it in print, radio, television, or Internet—and information disseminated to the general public. We are convinced that deeming financial performance information disseminated publicly to be “financial performance representations” under the Rule would have a chilling effect, discouraging franchisors from furnishing truthful information to the public. However, where a franchisor utilizes financial performance information disseminated, or intended to be disseminated, to the general public in its franchise promotional materials (
e.g.
, in a brochure or franchisee section of a website), includes in its franchise promotional materials a reference to general financial information on its website, or otherwise repeats the general financial information to prospective franchisees (such as in a face-to-face meeting with an audience of prospective franchisees), such information will be deemed “financial performance representations,” triggering part 436’s disclosure and substantiation requirements.
122

122
See
Advisory 97-5, Bus. Franchise Guide (CCH) at 9687 (“By disseminating copies of [news articles containing earnings claims], the franchisor effectively ratifies the journalist’s words as its own and, in so doing, converts the article into an advertising piece designed to solicit prospective franchisees.”).

The Commission anticipates that staff will address the narrowed scope of general media financial performance representations in the Compliance Guides. This is consistent with the approach historically adopted, whereby the Commission explained the scope of general media claims in the Interpretive Guides, providing illustrative examples and more detailed discussion than is possible in the text of the Rule itself. As an initial matter, the Commission anticipates that staff will retain in the Compliance Guides the original Interpretive Guides’ determination that communications about financial performance made to the trade press and directly to lenders do not constitute general media financial performance representations.
123

At the same time, the Commission anticipates that staff will add SEC filings, speeches, and news releases to the list of communications not constituting financial performance representations under the final amended Rule. There is one important caveat, however. Where the franchisor directs the speeches or news releases to prospective franchisees or uses copies of speeches or news releases in marketing materials aimed at prospective franchisees, then such materials will constitute general media financial performance representations under the Rule.

123
Interpretive Guides, 44 FR at 49984-85 (“‘General media claim’ does not include communications to financial journals or the trade press in connection with bona-fide news stories, or directly to lenders in connection with arranging financing for franchisees.”).

6. Section 436.1(f): Fiscal year

Several Rule disclosures are based upon the franchisor’s fiscal year.
124

Section 436.1(f) retains the original Rule definition of the term “fiscal year,” making clear that it “refers to the franchisor’s fiscal year.”
125

This issue generated no comment.

124
E.g.
, section 436.5(a) (Item 1); section 436.5(c) (Item 3); section 436.5(e) (Item 5); section 436.5(t) (Item 20); section 436.5(u) (Item 21).

125
16 CFR 436.2(m).

7. Section 436.1(g): Fractional franchise

Section 436.1(g) of the final amended Rule adopts the definition of the term “fractional franchise” that was proposed in the Franchise NPR with only minor language changes to improve clarity. This definition comes into play in section 436.8(a)(2) of the final amended Rule, which retains the original Rule’s exemption for fractional franchises.
126

In most instances, the fractional franchise exemption arises where an existing business seeks to expand its product line through a franchise meeting two criteria: (1) the franchisee or its principals have more than two years of experience in the same line of business; and (2) the parties reasonably expect that the franchisee’s sales from the new line of business will not exceed 20% of its total sales.
127

126
The fractional franchise is one of several exemptions contained in the original Rule that are retained in the final amended Rule. In contrast, the UFOC Guidelines contain no exemptions. State exemptions, which vary from state to state, are set out in state statutes or regulations. In general, state franchise laws do not exempt franchisors from the basic obligation to furnish prospects with UFOCs. At most, states may exempt franchisors from state registration requirements.

127
In the original SBP, the Commission reasoned, with respect to fractional franchisees, that pre-sale disclosure is unwarranted where the prospective franchisee already is familiar with the products and services to be sold through the franchise and where the prospective franchisee faces a minimal investment risk. Original SBP, 43 FR at 59707.

Section 436.1(g) clarifies the scope of the original “fractional franchise” exemption by adding greater precision and specificity.
128

First, it incorporates the Commission’s long-standing policy that the parties must “anticipate that sales arising from the relationship will not exceed 20% of the franchisee’s total volume in sales during the first year of operation.”
129

Second, it makes explicit what previously has been only implied: that the parties must have “a reasonable basis” to assert the exemption.
130

128
The Commission believes that greater precision in the Rule text is warranted in light of numerous requests for advisory opinions on the scope of the fractional franchise exemption since the original Rule was promulgated.
See
,
e.g.
, Advisory 93-5, Bus. Franchise Guide (CCH),¶ 6449 (1993); Advisory 94-4,
id
., at ¶ 6460 (1994); Advisory 95-2,
id
., at ¶ 6467 (1995); Advisory 96-1,
id
., at ¶ 6476 (1996); Advisory 97-1,
id
., at ¶ 6481 (1997).

129
See
Interpretive Guides, 44 FR at 49968.

130
The proposed definition in the Franchise NPR formulated this as “The parties reasonably anticipate . . .” The final language is more precisely in line with basic concepts of FTC jurisprudence.

During the Rule amendment proceeding, a few commenters suggested that the Commission broaden the fractional franchise exemption. Two commenters urged the Commission to broaden the first prong of the fractional franchise exemption —“experience in the same type of business”—to exempt franchisees with experience in the same industry or selling similar or complementary goods or services.
131

The suggestion that the exemption be broadened to “experience in the same industry” goes far beyond the underlying rationale that supports the fractional franchise exemption—namely, the notion that prior experience in the same line of business reduces the likelihood of fraud or deception because the fractional franchisee likely will be familiar with the products to be offered for sale through the franchise relationship.

131
Piper Rudnick, at 4 (suggesting experience in the same basic industry should suffice); H&H, NPR 9, at 4 (complementary experience should suffice).

The Commission does not believe that a franchisee in any particular economic sector necessarily has sufficient experience to operate a different franchise within the same sector. For example, we would not necessarily expect a muffler shop franchisee to automatically understand the financial risks of operating a quick-lube service station, although both operations are in the automotive repair industry. Nor would we expect a franchisee operating a small fast-food kiosk in a mall to necessarily appreciate the risks of operating a large, sit-down full-service restaurant, although both are in the food service industry.

Nevertheless, the Commission has never required experience in the identical type of business. Rather, the sale of similar goods may qualify for the exemption. As explained in the current

Interpretive Guides, “the required experience may be in the same business selling competitive goods or in a business that would ordinarily be expected to sell the type of goods to be distributed under the franchise.”
132

This approach is reasonable because a prospective franchisee who is already familiar with the goods or services of the franchise can better assess the financial risk involved in entering into a relationship with the franchisor.

132
Interpretive Guides, 44 FR at 49968.

Our reluctance to expand the fractional franchise exemption also holds true with respect to the sale of “complementary goods.” What may be viewed as “complementary goods” in any particular line of business may be quite subjective. For example, reasonable minds may differ whether the introduction of ice cream sales at a donut/coffee shop is “complementary.” While certain products may make complementary sales combinations—such as ice cream and donuts—it does not necessarily follow that a donut shop franchisee is experienced with the risks involved with marketing and selling ice cream.

While the Commission declines to revise the Rule to broaden the types of experience needed to qualify for the fractional franchise exemption, we agree that the exemption should be expanded with respect to the types of individuals whose experience can qualify for the exemption.

The original definition specified that, in determin

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3AE7-5829. Public record. Not legal advice.