May 11, 1997
VIA OVERNIGHT COURIER
Re: 16 CFR Part 436
These comments are submitted in response to the Commission's solicitation of comments on the Franchise Rule as set forth in the advance notice of proposed rulemaking published on February 28, 1997. 62 Fed. Reg. 9115. While this firm represents a number of franchisor and franchisee clients, these comments reflect the views of the author and not this law firm or any client. The author has been involved in franchising matters for over twenty years.
These comments respond to the numbered questions in the advance notice of proposed rulemaking. However, because one matter deserves immediate attention by the Commission, the response to question 26 is provided first.
Response to Specific Commission Questions
26. The Commission should modify the Rule to clarify that it does not reach the sale of franchises to be located and operated outside the United States, its territories and possessions, regardless of where the sale takes place or who the parties are. At the Commission workshop on international franchise sales held in March 1996, there appeared to unanimous agreement among all of the participants that such "outbound" transactions should not be regulated by the Commission under the Rule. Unfortunately, the message has not gotten through to all affected parties.
Recently, the United States District Court for the Southern District of Florida held that an Argentinean franchisee had a cause of action under the Florida Little FTC Act because the franchisor did not provide the prospective franchisee with the disclosure document required by the Rule and ordered rescission of the monies paid to the franchisor. See Nieman v. Dryclean U.S.A. Franchise Company, Inc. (S.D. Fla., Case No. 95-1390-Civ-Ferguson, March 26, 1997), a copy of which is attached. The fact that the Rule's applicability to an "outbound" sales transaction is still so unclear that a franchisor has had to refund franchise fees suggests that the Commission should issue an interim policy statement at a early date (in advance of rulemaking) clarifying that the Rule does not apply to an outbound transaction. The Rule should then be amended to make this situation clear.
In addition, the Rule should also be amended to clarify that it does not apply to an "inbound" transaction where a foreign franchisor might sell rights to a foreign franchise to operate a franchised business in the United States. This situation should also be clarified in an interim policy statement.
In addressing this issue, the Commission could limit applicability of Rule to transactions which involve a prospective franchisee domiciled in the United States where the franchise is intended to be operated in the United States. All other transactions could be excluded from the Rule's coverage. This would address both of the above comments on "outbound" and "inbound" transactions.
1. and 2. There may be a continuing need for the Commission's Franchise Rule, but there is a greater need for uniformity and simplification. On the issue of uniformity, in order to achieve uniformity in disclosure and reduce the costs to franchisors, the Commission should adopt the disclosure requirements of the Uniform Franchise Offering Circular ("UFOC") in lieu of the Rule's disclosure requirements because that is the document used by almost every franchisor who sells in multiple states. This can be done by revising the Rule to incorporate the UFOC Guidelines verbatim, or by simply cross-referencing the UFOC Guidelines currently adopted by NASA and as they may be amended from time to time with the concurrence of the Commission.
Consistency in interpretation of the applicable disclosure requirements would certainly benefit everyone involved in franchising, both franchisors and franchisees. In this regard, it would be helpful for the Commission to retain its limited preemptive requirement that six provisions of the current Rule would still apply when the UFOC format is utilized: scope of the rule, persons covered by the rule, timing of disclosures, contracts to be executed, certain prohibitions and refunds. See Interpretive Guides §I. D. 1, Business Franchise Guide (CCH) ¶6227. As discussed below, there are several other situations that should be added to this limited preemptive statement.
However, the Commission may wish to revisit the persons covered by the Rule because the Commission's definition is different from that of the registration/disclosure states. If the Commission chooses to retain its own definition of who is covered by the Rule, the Rule should be revised to make clear that the Commission's various exemptions and exclusions also should apply even when the UFOC format is used. See 16 C.F.R. §436.2(a)(3) and (4).
At the present time there is a lack of uniformity of interpretation of the UFOC Guidelines among the various states. If the Commission is going to adopt the UFOC Guidelines, some mechanism should be set up to provide for uniform interpretation of various issues that arise, perhaps by means of a joint NASAA and Commission committee. To clarify the intent, scope or purpose of particular provisions of the UFOC Guidelines, the Committee periodically could issue advisory opinions similar to those issued by the Commission at the current time, Interpretive Guides similar to those which the Commission has issued, or a Commentary similar to what NASAA issued on June 21, 1994.
In revisiting the Rule and the UFOC Guidelines, the Commission should reexamine carefully all of the disclosure requirements to see if their scope can be reduced and simplified. Too much subjective analysis has to go into a determination of what has to be disclosed and disclosure documents are becoming larger and larger. A simplified form of disclosure of matters more relevant to the franchisee, perhaps along the lines of several foreign countries who have recently adopted disclosure laws, should be considered.
3. The Commission should not modify the litigation disclosures of Item 3 of the UFOC to require franchisors to disclose lawsuits filed by franchisors against franchisees in addition to lawsuits filed by franchisees against franchisors. If anything, there is perhaps too much litigation disclosure already which many franchisees may not find relevant or helpful. An alternative approach would be to have the franchisor make a disclosure that it has sued its franchisees if it has sued more than a certain percentage (e.g., 5%) of the franchisees in its system, which disclosure would generally describe the nature of those suits.
4. The Commission should modify the franchisee statistics disclosures in Item 20 of the UFOC Guidelines to clarify that they do not apply to the international operations of the franchisor. In other words, the disclosure should be only of the U.S. operations of the franchisor. In addition, the requirements relating to disclosure of subfranchisor statistics should be clarified.
5. It is not known to what extent franchisors use "gag orders" to inhibit former or existing franchisees from speaking with prospective franchisees or other parties. One of the most useful methods for prospective franchisees to gain information on the franchisor's system is to interview current or former franchisees. On the other hand, a franchisor must have the ability to protect its trade secrets from disclosure. Neither the Commission nor the states can force a current or former franchisee to speak with a prospective franchisee if he or she does not wish to do so or if to do so would violate a confidentiality obligation. There is no need for any kind of regulation in this regard.
6. The Commission should retain the three-year phase-in of financial statements of new entrants. Item 21 of the UFOC Guidelines should be modified to allow the use of unaudited financial statements during the phase-in period.
7. If the Commission uses the UFOC Guidelines as a model for revising the Franchise Rule, there are several other provisions which should be fine-tuned. Most importantly, as indicated in the response to Question 26 above, the Rule should be clarified to provide that it does not apply to international sales transactions. In addition, the Commission should reexamine the relevancy of disclosure of foreign operations or activities of the franchisor in Items 1, 3, 4, 6, 8, 10, 12 and 20. Perhaps the revised Rule should simply state that none of UFOC Items apply to the international operations or activities of the franchisor.
An issue which should be addressed in the revised FTC Rule is the subject of negotiated changes. The approach used by the Illinois Franchise Disclosure Act and its Regulations is most the most enlightened approach and should be adopted by the Commission. The Illinois Regulations provide:
There should also be a uniform definition of what constitutes a "material change" and how a franchisor must comply with the need to disclose this information. A franchisor should be allowed to provide information to a prospective franchisee on a "material change" in any form of writing as long as it is provided to the franchisee prior to the sale and given to the appropriate state authorities where the Offering Circular has been registered. The franchisor should be allowed to continue to sell as long and once that information is provided. As far as the registration states are concerned, a provision should be added to the Rule that the sale of a franchise after the material change disclosure is made but before the state administrators require additional information or modification is the sale of a registered franchise. A sample of such a provision is found in §11 of the Illinois Franchise Disclosure Act of 1987. 815 ILCS §705/11.
Finally, there are circumstances where a franchisor might have to give a prospective franchisee more than one state Offering Circular. That is a ridiculous waste of time, effort and money and the franchisee is not likely to read or use both documents. The Commission may want to clarify that only one Offering Circular need be given to a prospective franchisee.
If the Rule is revised to address the need for uniform rules on negotiated changes and material changes, and the need to give only one Offering Circular, those subjects should also be covered by the limited preemption provision of Section I.D.1. of the Commission's Interpretive Guides.
8-16. The Commission's questions regarding business opportunities ventures are dealt with together in this one response. Business opportunities ventures should not continue to be part of the same disclosure rule as franchises. Although this author's review of the FTC record which supported the promulgation of the FTC Rule revealed that more than half of the complaints which the Commission investigated were so-called "distributorship" or business opportunity situations, the real concern in those situations was that the business opportunity seller misrepresented the profits or success which the buyer might achieve and did not give the buyer adequate time to reflect on its investment decision. Many business opportunities sellers who made those types of misrepresentations were not around long enough whereby a disclosure document would be of any help to a defrauded buyer.
The Commission should re-examine the whole subject of business opportunities ventures. The real concern, the fraudulent misrepresentations which are made to prospective buyers, can be best dealt with by a simple anti-fraud provision and as adequate cooling off provision. The elaborate disclosure required by the FTC Rule is not necessary to protect the buyer of business opportunities ventures. The Commission should separate business opportunities ventures from the Franchise Rule and initiate a separate rulemaking proceeding to determine the best way to address those types of situations. In the process, the Commission should also address the fact that a large number of states have adopted business opportunities laws which have conflicting definitions of what constitutes a business opportunity and that they also call for unnecessary disclosure.
17-19. The Commission's questions regarding trade show promoters are dealt with together in one response. To the extent that trade show promoters are simply making space available to allow franchisors to present their franchises to prospective buyers, there is no need to regulate trade show promoters. To the extent that the trade show promoters are involved in helping to sell a particular franchise, however, they should be treated like a franchise broker and an appropriate disclosure made in the UFOC.
The problem with modifying the FTC Rule to add a separate trade show sales provision that would require franchisor-exhibitors, brokers and their agents to have readily available at trade shows for public inspection either a specimen copy of the disclosure document, or a letter explaining why they fall within the Rule's exclusions or exemptions, is which disclosure document to have available. Depending on which state the franchisor and/or franchisee is located in, the Offering Circular or Circulars which may have to be provided would vary. The only way this would work is if the Rule provided that franchisor would only have to have on display the multi-state document which complies with the Rule and not the individual document which may be required by one of the registration states, or that the document on display includes all state addenda. If the first approach were used, the FTC would need to coordinate its enforcement activities with the various registration states so that a franchisor participating in a trade show would not be deemed to be violating a state franchise law by displaying only the multi-state document. Perhaps this could also be handled by revising the FTC Interpretive Guides to provide that such a provision of the Rule would be covered by the Commission's limited preemption provision even though the state may have different or additional requirements. See Interpretive Guides, §I. D. 1.
20-25. The Commission's questions relating to earnings claims are dealt with in one response. It is not known to what extent franchisors represent either that the FTC Rule or the Commission prohibits them from making earnings representations. However, it appears that the majority of franchisors do not provide an earnings claim disclosure in their Offering Circular. Because financial performance data would be useful for franchisees, some mechanism must be devised to encourage franchisors to provide truthful and accurate information on sales and income. However, earnings claims should not be mandated by the Commission. The approach used in Item 19 of the UFOC Guidelines appears to be workable and should be retained.
27. The Commission should continue to use the term "personal meeting" for making disclosures as opposed to the term "first substantive discussion." The term "first substantive discussion" raises a variety of issues on the practicality of providing a disclosure document when a franchisor is first contacted by telephone or on the Internet by a prospective franchisee. How could such a provision be effectively and fairly administered? Would the franchisor have to provide a copy of the disclosure document to the prospective franchisee before a discussion could be held by telephone or through the Internet? Since franchisors receive many telephone calls from prospective franchisees, there would also be a danger that the franchisor would be in violation of the FTC Rule if a telephone inquiry turns into a substantive conversation. The Rule should be left as it is.
A better approach, which would simplify when disclosure is made, is to require only that the Offering Circular be provided ten (10) business days prior to taking any money or signing any contracts. This would be an adequate cooling off period and would give the prospective franchisee adequate time to find an attorney or other advisors.
28. Although the Commission could permit franchisors to comply with the Franchise Rule's disclosure obligations by posting disclosure documents on the Internet, some mechanism will have to be devised to allow the franchisor to confirm that the franchisee has received a hard copy of that document in order to comply with the Rule. Where a franchisor is registered in different states, the franchisor would have to make sure that the franchisee receives the document which is approved for use in a particular state. Perhaps the document which is placed on the Internet would have to have all of the state addenda attached in order to fulfill compliance with the local law.
29. Co-branding means a lot of different things. The concept initially developed when an existing franchisee added a second franchise operation on or adjacent to its existing premises. In those situations, the franchisee would have received disclosures from both franchisors and then have to make sure that the two franchise agreements were made consistent with each other. In those types of situations, the current disclosure system seems to work adequately.
In a situation where a franchisee might be buying multiple franchises to operate in one location at the same time, the franchisee is likely to obtain disclosure documents from the two franchisors. An issue arises as to whether two franchisors could or would want to provide one Offering Circular to the franchisee. As a practical matter, most franchisors probably would not want to enter into that kind of a disclosure document. However, if there is interest in doing so, the Franchise Rule should be amended to permit that type of a multiple disclosure document. Alternatively, however, those parties could establish a joint venture which could sell the multiple franchise operation and give an Offering Circular for that joint venture.
30. We believe that it would be prudent for the Commission to develop a program to reduce or waive civil penalties for certain violations of the Franchise Rule, particularly where there has been an inadvertent or de minimus first violation. This is particularly desirable because responding to the UFOC Guidelines requires a lot of subjective evaluation and there is no uniformity of interpretation among the states as to what is required. The penalty could be waived as long as the franchisor did not engage in the same or similar violation within some time period, e.g., one year.
31. The Commission can ensure the broadest participation by affected persons in the rulemaking process by holding regional meetings throughout the country and inviting a mixture of franchisors and franchisees to participate in those meetings.
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Thank you for this opportunity to provide comments on the FTC Rule. Simplification of the disclosure process would not only reduce costs but would make the disclosure more meaningful and useful to franchisees. I would be pleased to participate in a workshop on the various issues raised in this letter.
Very truly yours,
John R.F. Baer, P.C.