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Franchise Agreements

On Behalf of | Apr 8, 2010 | Business Transactions

The Federal Trade Commission (“FTC”) adopted in January, 2007, after a twelve-year regulatory review, a final amended Franchise Rule, with a Statement of Basis and Purpose and Regulatory Analysis. The 2007 Franchise Rule represents the first time the FTC has amended its Franchise Rule (the “Original Franchise Rule”) since 1978. Under this Franchise Rule all franchisors are required to use the new Franchise Disclosure Document (“FDD”) as opposed the Uniform Franchise Offering Circular (“UFOC”)

The FTC’s 2007 Franchise Rule adopts disclosure requirements that closely track the UFOC Guidelines. In some instances, however, the 2007 Franchise Rule omits or streamlines UFOC Guideline disclosure requirements, such as broker disclosures, cover page risk factors, and detailed computer requirements. In addition, the 2007 Franchise Rule incorporates new disclosure requirements not found in the UFOC Guidelines, including disclosures related to a franchisor’s parent, franchisor initiated litigation, confidentiality clauses and the existence of trademark-specific franchisee associations.

One major transactional change relates to the time a prospective franchisee must have the document in their hands before contacts can be signed or any money paid. The former rule said the UFOC had to be in hand for at least ten business days AND a completed, separate franchise agreement had to be delivered to the prospective franchisee for at least five business days. Under the new rule, there is a fourteen-calendar day minimum review period that simplifies the complexity of completing a franchise transaction. There is another seven calendar day period that kicks in if the franchise company makes unilateral and material changes to the franchise agreement or other agreement attached to the FDD.

Key Points Include:

Financial Statements Start up or new franchisors may phase-in the use of audited financial statements. In this case, the franchisor must clearly and conspicuously disclose that the franchise has not been in business for three or more years and cannot include all required financial statements. (There may still be requirements to submit audited opening balance sheets in registration states). Franchisees should make sure to review the financials carefully as always. The FTC will allow the use of financial statements prepared according to GAAP.
No Broker Disclosures The Amended FTC rule eliminates the broker disclosure requirement. However, the broker will need to be listed on the Receipt Page because the Receipt Page requires the franchisor to identify all “franchise sellers”.
Litigation. Franchisors will be required to disclose material franchisor-initiated litigation against its franchisees. The rule will be more lenient as a franchisor will only have to disclose actions that the franchisor filed during its last fiscal year – not the last 10 years. Further, a full description of the case will not be necessary. If a counterclaim is filed against a franchisee, the disclosure will need to be treated, as any other franchisee-initiated action and the regular, full disclosure will be required. (Franchisees will need to more fully investigate whether franchisor-initiated litigation occurred whether it is in the disclosure document or not).
Financial Performance Representations. The new rule encourages franchisors to provide financial performance representations but it is still voluntary. Franchisors may provide a more detailed cost and expense analysis that could be helpful for prospective franchisees. In addition, franchisors may provide financial representations based upon a subset that shares the same characteristics.

A Summary of the 23 Items
1) The Franchisor, Its Predecessors and Affiliates
Information about the franchisor, any predecessors and its affiliates. Disclosure includes a description of the business of the franchisor; previous business experience of the franchisor, its predecessors and affiliates; the business to be operated by the franchisees; and the general market for products or services offered by franchisees.
2) Business Experience
Information about the past five years’ work experience of all executives of the franchise system (i.e., officers, trustees, directors, and managers) including their main occupations and past employers.
3) Litigation
Disclosure of prior (up to 10 years) or present litigation. This includes the franchisor and anyone affiliated with it; i.e., predecessors, executives and franchise brokers
4) Bankruptcy
Disclosure of any bankruptcy that has occurred within the past ten years involving the franchise, its affiliates or predecessors.
5) Initial Franchise Fee
Information on all initial fees to the franchisor including the initial franchise fee.
6) Other Fees
Information on other fees that are paid to the franchisor; i.e., ongoing royalty payments and advertising fees.
7) Initial Investment
Now in a useful chart format, this disclosure summarizes the franchisor’s estimate of the typical investment costs of establishing a new franchise in their system.
8) Restrictions on Sources of Products and Services
This item outlines the requirements, if any, imposed upon the franchisee to buy or lease products or services from the franchisor or other designated authorized suppliers, and provides details of the specific restrictions imposed.
9) Franchisee’s Obligations
This item lists in chart format the franchisee’s obligations in 24 different categories: These categories include: site selection and acquisition, initial training, opening, compliance with system standards, territorial development, insurance, records and reports, and dispute resolution.
10) Financing
Describes and details any financing offered to the franchisee by the franchisor or affiliated third party.
11) Franchisor’s Obligations
The franchisor’s principal obligations under the franchise agreement. This includes a list of (1) services the franchisor is obligated to provide before the opening of the franchisee’s business and (2) the services the franchisor is obligated to provide after the opening. The remainder of this item includes detailed information on the franchisor’s advertising program, any required computer system or electronic cash registers, the operations manual, site selection criteria and procedures, and the franchisor’s training and assistance program.
12) Territory
This section outlines territorial rights and restrictions. It includes disclosure on exclusive territory granted, whether or not the franchisor can open another franchise within the geographical area, conditions for relocating the franchise, and any sales quotas imposed on franchisees.
13) Trademarks
Discloses information on who owns the trademarks of the franchise, how each trademark is protected, and how the franchisee will be allowed to use the trademarks.
14) Patents, Copyrights and Proprietary Information
The franchisor must disclose in this section information about any patents, copyrights, confidential information, or trade secrets relating to the franchise.
15) Obligation to Participate in the Actual Operation of the Franchise
Information on whether or not the franchisee is required to personally participate in the operation of the franchise.
16) Restrictions on What the Franchisee May Sell
Describes the product line, and discloses any restrictions for other products or services you may be allowed to offer your customers
17) Renewal, Termination, Transfer and Dispute Resolution
Disclosure of the required conditions for renewal, termination, and transfer of the franchise. Also provides information on the approved methods for resolving conflicts and disputes with the franchisor.
18) Public Figures
If a franchisor uses a public figure for endorsing the franchise, or uses a famous person in the franchise’s name or logo, it must disclose information on the compensation paid to the public figure, the amount of the public figure’s investment in the franchise, and the public figure’s involvement in the management of the franchisor.
19) Earnings Claims
The FTC does not require franchisors to provide earnings claims to franchisees. If a franchisor chooses to do so, there are strict rules as to the information provided in earnings claims.
20) List of Outlets
In this item, the franchisor must disclose information on: the number of franchise units; name, address and telephone numbers of all franchisees (up to 100); number of new franchises predicted for the upcoming year; and information and contact information on franchisees who have ceased to be franchisees.
21) Financial statements
Financial statements audited by an independent CPA must be provided. They include: (1) for the last three fiscal years — cash flow statements, statements of operations, and statements of stockholders’ equity; and (2) for the last two fiscal years — balance sheets.
22) Contracts
This section provides copies of all contracts franchisees will be expected to sign if they choose to buy the franchise.
23) Receipt
An acknowledgement of receipt of the UFOC.

Paul D. Creme is an attorney with Hamblett & Kerrigan PA. His practice is focused on business and corporate law. Of particular interest are the areas of software and emerging technologies. You can reach Attorney Creme at [email protected].