American Association of Franchisees & Dealers
P.O. Box 81887
May 4, 1997
RE: Franchising Comment re 16 CFR Part 436
Comment of Robert L. Purvin, Jr.
16 CFR Part 436
Note: This comment reflects the personal views of the commentator, and is not the official opinion of the American Association of Franchisees and Dealers, except where specifically indicated.
Commentary to Item 4 of FTC Notice of Proposed Rule Making, "Earnings Disclosures"
Next to the failure of the FTC to identify and proscribe unfair and abuses trade practices within the franchise industry (see the General Comment below), the failure of the FTC to mandate the disclosure of available earnings data that are material and relevant to making an informed investment decision by a prospective purchaser of a franchise is perhaps the most objectionable aspect of the current FTC rule, and therefore is the focus of this comment.
Although generally this commentator agrees with the FTC analysis that prescribed mandatory disclosure is not the desired solution (and may even provide a significant burden on the franchisees the rule purports to protect), the rule should definitely be amended to require franchisors to disclose all material and relevant financial data in its possession essential to making an informed decision on the value of offered franchise opportunity. It seems an anomaly that the FTC rule permits franchisors to escape disclosure of material financial data, when in every other instance of investor or consumer protective regulation or legislation, sellers are required to disclose all material information relevant to a purchase decision!
The source of this anomaly is revealed in the comparison of franchise disclosure regulation to disclosure regulation in the securities industry. Under federal securities laws and applicable rules (e.g., SEC Rule 10-5), it is unlawful for any seller of securities to offer or sell a security by means of a material misrepresentation of material information, or by the omission to state material information, which is relevant to the decision to purchase the security. Simply stated, the Rule in securities disclosures is that all material information known to the seller must be disclosed, and the seller is liable (by private right of action, no less) for misrepresentation. It is most relevant to note that with respect to unregistered securities (which are comparable to the sale of franchises in non-registration states) federal law further requires disclosure by offering circular of all material information without limiting the disclosure requirements of the rule. It is especially notable that securities sold pursuant to a private offering exemption in which an offering circular is not mandated by federal law, nevertheless are subject to the mandate of full disclosure. Often, a private offering circular provides a safe haven for issuers so that they cannot be found to have failed to provide all relevant disclosure.
There is no reason why franchisors should not be placed under the same or similar mandate by the FTC franchise rule as issuers of securities have long accepted. The Rule should simply state that it is unlawful for any franchiser to offer or sell a franchise in the United States by means of a misrepresentation of a material fact or facts, or by the failure to state a material fact or facts, including material facts concerning earnings. At a basic minimum, it should be a violation of the Rule for any franchisor to refuse to respond to a reasonable request for data (accessible to the franchisor) on a confidential basis from qualified prospective purchasers (prospects who have already been invited to apply for a franchise).
By applying this well settled standard of disclosure to franchising, all of the objections raised by franchisors to mandated earnings disclosure are solved. Foremost, only facts which are known (or should be known) need be disclosed. Franchisors need not be mandated to make disclosure within their offering circulars, but rather can use their offering circular as a safe haven to insure their disclosure satisfies the requirements of the rule for full and accurate disclosure.
In truth, most franchisors would like to extol the virtues and successes of their systems. Earnings claims are more often dampened by cautious legal counsel than by the franchisor's marketing team. However, franchisors have legitimate concerns over the reliability of information they receive from their franchisees, their lack of earnings information, and the cost of acquiring, compiling and publishing data. In many instances these concerns are justified. For this reason, the AAFD has encouraged the disclosure of available data rather than mandatory earnings claims.
The disclosure of known Risk Factors, known defects, known data that is available for disclosure, are all well accepted practices in most areas of consumer protection. Certainly, franchisors can comply with these accepted norms.
As to the questions posed by the FTC for comment:
(21) To what extent do franchisors represent that either the Rule or the Commission prohibits them from making earnings representations? Is there a need to clarify the Rule to make clear that neither the Commission nor the Rule prohibits franchisors from making earnings representations?
Surveys conducted by the AAFD of prospective franchise owners have uniformly demonstrated the belief by most franchise purchasers that franchisors are prohibited by law from making earnings claims, and that purchasers are nevertheless protected by 'federal regulation" of franchises offered for sale. Exculpatory language in offering circulars does little to correct investor's "false sense of security" engendered by the official look and feel of Uniform Franchise Offering Circulars. It is unimportant to determine who is to be faulted for the false impression conveyed by offering circulars, negligent or intentional misrepresentation by franchisors, inadvertence in the design of the Rule itself, or the negligence or gullibility of buyers. The plain truth is that buyers should be educated to insist on receiving financial data, and franchisors should not be able to deny access to data within their possession or scope of knowledge. The Rule should be amended to require disclosure to prospective purchasers, as follows: "You have a right to receive any material financial information and data within the franchisor's knowledge, and it is a violation of the FTC Franchise Disclosure Rule for the franchisor to deny your reasonable requests for financial data."
(22) Should the Commission modify the Rule to require all franchisors to make the following prescribed statement (quotation omitted), and (2) What alternative language would be appropriate? What would be the costs and benefits of such a disclosure?
Given this commentator's urging to amend the Rule to require disclosure of all material financial data within the franchisors scope of knowledge, the following prescribed statement should be made to all prospective franchise owners:
The FTC's Franchise Rule prohibits the offer or sale of a franchise by means of a material misrepresentation of financial information concerning the franchise opportunity being offered, or the failure to disclose material financial information with the franchisor's scope of knowledge. You have a right to receive any material financial information and data within the franchisor's knowledge, and it is a violation of the FTC Franchise Disclosure Rule for the franchiser to deny your reasonable requests for financial data.
Given the recommendation of this comment to require full disclosure of material information known to franchisors, the remaining questions posed by the FTC become moot.
Before leaning the subject of earnings claims, this commentator challenges the notion that franchisees should be encouraged to obtain financial information by talking to other existing and former franchise owners. This approach to "due diligence" has been endorsed by franchise consultants, and has been seemingly endorsed by the FTC. Franchisors are not likely accountable for disclosures made by other franchisees--and it is franchisors (not their franchisees) who need to he held accountable! The Rule should not allow franchisors to "pawn off" their disclosure responsibilities to their franchisees (even though it may be a prudent practice to "talk to existing and former franchisees").
Comment to Section 6, "Self Regulation and Alternatives to Law Enforcement."
In its comment, the FTC makes reference to a March 4, 1995 White House Memorandum which asked federal agencies "to consider if the intended goals of regulation can be achieved in a more efficient, less intrusive way, and whether private sector alternatives can better achieve the public good envisioned by the regulation." The FTC's comment states:
Sounds like the perfect argument for the Commission to simply recommend a private right of action for the enforcement of the Rule as has been urged by franchisee advocates for years.
As stated in the FTC's Advance Notice of Proposed Rulemaking inviting this comment, the Federal Trade Commission ("FTC") Act, 15 U.S.C. 57a et seq., grants the FTC authority "to promulgate, modify, and repeal regulation rules that define with specificity acts or practices that are unfair or deceptive in or affecting commerce within the meaning of Section 5(a)(1) of the Act. Notwithstanding several earlier comments, the FTC continues to ignore its authority to deal with unfair trade practices within the franchising community and focuses solely on deceptive practice issues. This commentator objects to the FTC's refusal to go to the heart of serious abuses in franchising practices, and I repeat my opening remark from my 1995 commentary:
The state of modern franchising demands vigorous investor and consumer protection. Unfortunately, the FTC Rule, as constituted, exacerbates and even promotes current franchise practices. The current FTC Rule provides no minimum standards of fair franchising practices. Indeed, with some minor exceptions dealing with termination rights, and the Iowa Franchise Law, there are virtually no federal or state laws that mandate minimum standards of franchisor/franchisee relationships. On the other hand, the existence of the FTC Rule is highly touted by the industry (and sometimes by the government) as an effective regulation which protects franchise purchasers and owners. More importantly, the Rule is relied upon by the consuming public as evidence that franchising is a safe path to business ownership and that franchise opportunities are safe, at least in part, as a result of substantial government regulation.
The FTC should also realize (and remember), mandated disclosure did not come into existence to protect consumers. It is important to recall that mandated disclosure was negotiated by franchisors to provide a safe harbor to avoid being accused of fraud. The purpose of the FTC Rule was to simply declare that misrepresentation in connection with the sale of a franchise was a fraudulent and deceptive practice covered by the Federal Trade Act. In a compromise with the franchising industry, the FTC agreed to allow franchisors to provide a disclosure statement to distance themselves from "oral representations." In this light, and from the perspective of a franchisee advocate, mandated disclosure (without minimum standards of fairness) created a rule drafted for the protection of the franchising industry and not the consumer.
In revising the FTC Rule, the Commission is urged to "get back to basics." The Federal Trade Act mandates the Commission to identify and proscribe "unfair trade practices. " The Commission needs to identify and proscribe unfair practices existing in the franchise relationship and create valid proscriptions for such practices. Misrepresentation in connection with the sale of a franchise is one practice that should be proscribed, but a franchising company should not be able to escape the glowing (and false) claims of its marketing program solely by writing sobering language in a disclosure statement or an offering circular -- even one drafted in plain English.
Robert L. Purvin, Jr.