April 30, 1997
Donald S. Clark, Secretary
RE: 16 CFR Part 436 -- Comment
Dear Secretary Clark:
This letter is in response to the Commission's request for public comments on possible revisions to the Trade Regulation Rule on Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures, 16 CFR, Part 436 (the "Rule").
A. The Franchise Rule
1. While many problems remain to be resolved regarding disclosure, the critical issues for members of the American Franchisee Association (AFA), i.e., current franchisees, involve abuses within the ongoing franchise relationship. Unfortunately, we hear from current franchisees that the FTC accepts as their #1 priority Franchise Rule violation cases only. If the nature of a franchisee's complaint hints at the relationship between the franchisor and franchisee after the sale, the FTC declines to take action. This is curious for an agency that has a broad statutory mandate to oversee any "unfair or deceptive act or practice" under Section 5.
Is it unfair for a franchisor to induce a franchisee to invest to create a business and then put up a new outlet or point of distribution to directly compete with its own franchisee? Of course it is.
Is it unfair for a franchisor to induce a franchisee to invest to create a business and then refuse to allow the franchisee to sell the store to anyone other than the parent company? Of course it is.
Is it unfair for a franchisor to induce a franchisee to invest to create a business and then have them sign a contract in which they give up not only the legal protections of their own home state but their right to a jury trial? Of course it is.
Technically, the FTC can focus on these deceptive post-sale practices. However, our members feel the need is so great in this area alone that they have very little confidence the Commission would be effective if it chose to take up enforcement of these types of relationship issues.
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 rather than suffer the abuses of both a government agency and their franchisors.
With regard to the question, "are there specific Rule disclosure requirements that no longer serve a useful purpose?" we suggest it is time to change one word in the title of Item 17, "Renewal, Termination, Transfer and Dispute Resolution." "Renewal" is a misnomer. "Re-license," "re-write" or even "re-franchise" is a more accurate description of what actually happens at the end of the initial contract term. Most franchisees find that when it is time to "renew," they are not "renewing" their existing franchise agreement, but are entering into a wholly new franchise agreement, often with materially different financial and operational terms. They are presented these "renewal" contracts on a "take it or leave it" basis and are under enormous coercion pressures to sign--especially if the old agreement contains a post-termination covenant not to compete. This is truly "holding a gun to the head" of the "renewing" franchisee.
Once the Commission changes the word "renewal," however, it must also prohibit franchisors from communicating either verbally or in writing the metaphor to prospective franchisees that buying a franchise is like buying a house, where one builds equity in one's property, or to use the personal, where one builds equity in oneself. Buying a franchise is, in fact, more like renting an apartment than owning a home because franchisees must decide whether or not they will sign the new franchise agreement upon "renewal."
The use of the "buy your own franchise-own your own home" metaphor is prevalent in the advertisements of many franchises and is also used constantly in the personal communications between the franchise salesperson and prospective franchisee. In the same manner that the Commission has recently increased its scrutiny of the advertising practices of certain beer, liquor and tobacco companies for unfairness, misleading consumers and/or perpetrating fraud, it must take similar action against franchisors.
The misleading nature of franchise ads that infer "buying a franchise" is like "buying a house" causes significant economic harm to those consumers who do buy the franchise, only to find out 10, 15 or even 20 years later upon "renewal" that they have no equity. Use of this metaphor through advertising is the first fraud committed upon unsuspecting prospects and the concept remains in their hearts and minds as they build their local franchised business.
B. The UFOC Guidelines
2. If the affirmative obligation of disclosure remains, then the Commission should revise the Rule based on the UFOC guidelines disclosure requirements. The UFOC guidelines provide considerable improvement over the FTC Rule as adopted in 1979. Conformity with the UFOC guidelines will reduce the cost of compliance by new and established franchisors.
Many of the disclosures required offer information about issues that most prospective franchisees do not even consider important at the time they buy their franchise. It is even difficult for their advisors, unless they are well-versed in franchise law, to understand what the impact the disclosed items, other than upfront costs and ongoing fees, will have on the franchisee. Prospective franchisees are interested in two things; 1) in how much it will cost them to get into the franchise and 2) how much money they can make running the franchise. The most useful purpose for all of the other UFOC disclosures is when the franchisee starts losing money or the relationship between the franchisor and franchisee begins to deteriorate. That is often the first time a franchisee will actually read all of the UFOC.
3. The Commission should modify the litigation disclosures to disclose lawsuits filed by franchisors against franchisees in addition to suits by franchisees against franchisors. Prospective franchisees should be interested in the pattern of litigation of the franchisor against franchisees, if any. This is a serious ommission in the UFOC guidelines.
Because many franchise agreements require that franchisees give up their rights to a jury trial and include mandatory arbitration provisions, the Commission should consider requiring disclosure of arbitration decisions. The fact that the arbitration occurred plus knowledge gained from the experience of an arbitration proceeding is material to the decision on whether or not to purchase a franchise.
4. The Commission should modify the franchisee statistics disclosures (Item 20). The North American Securities Administrators Association (NASAA) Franchise Advisory Committee has recently formed a task force to address this issue. Basically, the tables in Item 20 are not easy for a prospective franchisee to read and determine i) how many new sales have occurred and ii) how many total franchised units are in existence. Transfers should not be included in the closing totals since a transferred unit does not actually close. If the Commission starts with the number of units operating at the end of the previous year, adds the number of openings and subtracts the number of terminations, the end result should equal the number of units operating at the end of the current year for which disclosure is being made.
However, any and all changes of ownership in the unit for whatever reason should be listed separately in Item 10, i.e., "Changes of Ownership--Reacquired by the Franchisor, 3; Cancelled (or Terminated), 3; Not Renewed, 4; Transfers, 20; Left the System (or Other), 3--Total Changes of Ownership, 33" with the last known home address of the franchisees listed. For instances of two events triggering a change in ownership, i.e., the franchisor terminated the franchisee and then approved a transfer to another buyer, the change in ownership would be listed as "Termination-Transfer, 13." A prospective franchisee should be alerted to a disproportionately high number of "changes of ownership," and the nature of those changes.
5. Franchisors routinely require current and outgoing franchisees to sign "gag orders" or "confidentiality statements" to inhibit them from speaking with prospective franchisees, the press and the government. This is just one of a number of procedural devices used by franchisors that prevent franchisees and dealers from exercising their basic legal and constitutional rights. The Commission must modify the Rule to prohibit franchisors from using such gag order provisions. The Commission can supply appropriate language for confidentiality statements to prevent outgoing franchisees from utilizing or benefitting from franchisor-developed trade secrets. The Commission has to make it clear to franchisors that they are circumventing the law and violating their disclosure obligations when they prohibit current or former franchisees from discussing their experiences with prospective franchisees.
Additionally, the FTC must prohibt franchisors from:
All of these provisions violate the spirit of federal and state due process constitutional law. They clearly come within the purview of the Commission under Section 5.
6. The Commission should continue the three-year phase-in of audited financial statements for start-up franchisors that did not previously utilitize audited financial statements.
C. Business Opportunities
In the absence of any effective enforcement of unfair and deceptive acts or practices contained in franchise contracts, the Commission should limit its enforcement efforts to business opportunities.
E. Earnings Disclosures
The North American Securities Administrators Association (NASAA) has been working for the past eighteen months on language that would mandate franchisors provide earnings claims. NASAA is using the phrase "Financial Performance Information (or Disclosures)" rather than "earnings claim."
If the required pre-sale disclosure of information is important, then it is a fatal flaw of the FTC Rule that disclosure of some measure of financial performance is not required. It is inherently misleading (by omission) not to disclose such financial performance information.
At the September 1995 Minnesota Public Workshop Conference on the Rule, FTC staff clarified for a commenter that of the franchise enforcement cases undertaken by the agency during the time period studied in the GAO's July 1993 Report (Federal Trade Commission Enforcement of the Trade Regulation Rule on Franchising), all 100% of the cases cited had to do with fraudulent or misleading earnings information provided to prospective purchasers.
Franchisors have had nearly twenty years since the promulgation of the Franchise Rule to volunteer earnings information and the majority have not done so. Why? Because the market that buys franchise concepts that are unprofitable runs out of money, goes out of business and wants to do nothing but leave their shameful franchise experience behind. This former franchisee is a consumer that has suffered significant economic harm yet the FTC does not think a franchisor's failure to provide earnings information in these cases is necessarily "deceptive or unfair?"
Franchisors regularly receive financial information from their franchisees, on a weekly or monthly basis, in the form of royalty reports. Start-up franchisors should not be spared providing financial performance information. Supposedly, start-up franchisors have based their new franchise system on a "proven" way of doing business. This proof should include historical financial performance information on the operating prototype.
The current practice of allowing the majority of franchisors to withold financial performance information allows those companies with unprofitable franchise concepts to continue to sell franchises--to unsuspecting consumers. Once required to disclose historical financial performance information to potential purchasers, many franchise concepts which do not provide an appropriate return on investment or standard of living to its franchisees, will be unable to sell new franchises. The market will then have determined which franchise chains will grow and prosper. Those franchise concepts that remain will thereby avoid the accusation that all a franchisee did was buy him/herself a "low paying job."
Concerns of Franchisees
At the FTC Public Workshop held in Minnesota (September 1995), Eileen Harrington asked what our franchisee members would think about being required to provide earnings claims information to their franchisor. I suggested then that the FTC needs to have its own discussions with franchisees about these issues and not just limit its information gathering to the franchisors or hired counsel who can afford to travel and spend three days discussing these items. In lieu of the FTC meeting face-to-face with franchisees in that kind of meeting, I offer the following information.
In November of 1995 we asked approximately 100 AFA member franchisees who were linked on a voice-mail network to answer the following question: "If it was mandated that franchisors had to provide earnings information, irregardless of what your current franchise agreement stated, if franchisees were required to provide certain [financial] information to franchisors, how would you feel about it?" We also asked them to let us know what was currently required of them.
What follows are five comments from November of 1995 that may provide additional insight to the Commission regarding how franchisees feel about providing earnings information. These comments were transcribed directly from their telephone responses to our question.
KFC Franchisee: Within the KFC system we feel that profit information about individual franchisees gives the franchisor a weapon to use against the franchisee. The franchisor can go after people who are very profitable and drive their profits down using a variety of tactics.
7-Eleven Franchisee #1: Southland provides the financial statements to its franchisees so we are used to that taking place. Franchisees provide the franchisor with day-to-day numbers on a regular basis. Southland, however, will distinguish between what they would consider "proper" expenses versus "discretionary" franchisee expenses. Their interest obviously is to bolster the anticipated income from a franchise operation. Some examples of things considered "customary" in many small businesses that Southland won't accept as proper includes expenses like if you use Brinks services for banking, or if you use your car or your pager for business, also certain business meetings or conventions they could decide were "discretionary" and not "proper."
H & R Block Franchisee: The current H & R Block franchise agreement requires tax returns. My contract pre-dates that so I only give gross information. To make sure I am paying the right amount of royalties, H & R Block requires that they can verify my deposits. H & R Block franchisees wouldn't be upset about it if providing this type of information was required. I make my P & L available to whomever asks. However, what about the accounting procedures utilized? A franchisor could force a guy out of business due to the amount of accounting fees that would have to be charged, by requiring certain financial statements that the franchisor wants simply to make it a compliance issues. Therefore, perhaps they should only require that portion of the tax return that reflects the business. By the way, franchisees can execute a document with the IRS that would send your tax return to whomever you designate.
Pearle Vision Franchisee: Quarterly financial statements are required in a fairly specific format. Balance sheets, too and we have to calculate certain performance ratios along with the quarterly financial statement and balance sheet. If there is a mandated earnings claim, what are they talking about doing? If the franchise system has 1,000 units, are they going to put in the financial statements of all 1,000 units? Will it be done on an inquiry basis--meaning, I get a UFOC and I want to see the financial statements on this outlet here or composite financial statements on all the outlets on the west side of town--I could agree with that. If someone wants financial information on my specific outlet to buy it, I would have no argument with them looking at my numbers or even at my numbers in a composite format generated by the franchisor.
7-Eleven Franchisee #2: Southland has all of the information anyway. They do all of the accounting work in our system. They have access to all our records. All franchisees' income and expense statements are stored on their computer. They don't require us to send them our income tax returns because they have all that information, they know how much we spend on payroll and all that stuff. The averages of those are included in our offering circular. The UFOC has the averages of the top third, middle third and bottom third in each district of the country that the franchisee is looking to buy a store in. They do not provide individual access unless you're going to purchase an existing store. Then they'll give you a past history of what the corporate store did. If it is a franchised store they leave it up to the franchisee to provide that to the prospective new franchisee.
20. Franchisors routinely represent that they are "prohibited by law" from making any earnings representations when in fact providing earnings claims is a voluntary disclosure which the majority of franchisors volunteer not to make. The Commission should make clear that documented earnings claims are permitted/encouraged by the FTC and that historical financial performance information should be discussed with current and former franchisees.
21. The Commission might choose to include the words "of its franchised outlets" in its suggested statement. Also, the second sentence of the suggested statement could be simplified by saying, "Do not rely on an information that is not substantiated in writing."
There would be no costs to including this kind of statement. The majority of franchisors currently include a statement of some sort in Item 19. They would simply replace their current statement with the Commission's revised language.
22. Franchisors that do not make earnings claims should also state that they do not allow their salespersons to make any such representations either orally or in writing.
23. "Stream of revenue contracts" should be considered as having made an earnings claim when they represent that a certain level of investment will result in a minimum value of business provided through the efforts of the franchisor.
24. The Commission should more thoroughly monitor the earnings claims made in print and electronic advertising. You have to look no further than last Thursday's edition of the Wall Street Journal to see examples of misleading advertisements with regard to earnings potential. For example, one franchisor consistently advertises by saying "60% to 80% gross profit margins." An advertisement for a master franchisee states "a proven method of making a fortune." Does anyone at the FTC call these people and ask for substantiation of such claims?
Consumers see the advertisement first, the franchise agreement second and then the franchisor's salesperson says something like "we are prohibited by law from making any earnings claims." But the damage has already been done--the consumer has seen the ad. The system in general lets franchisors sell (via advertisements) with one set of promises and agree to another set contractually. The FTC must enforce all of these aspects or the FTC must get out of the game altogther.
Finally, the FTC should banish the phrase, "we're the McDonald's of the industry," in all franchise advertisements and in all verbal communications between the franchise salesperson and the prospective franchisee. The phrase implies to a prospect a certain level of 1) financial success and 2) resources which most of the franchisors who use this phrase do not have.
H. Additional Issues
31. One way to ensure the broadest participation in the rulemaking process is to schedule face-to-face field meetings that franchisees can attend in various parts of the country. One day meetings are preferable, no more than two days are possible and the ease of flying into and out of the meeting location is of paramount importance. A survey instrument designed specifically for franchisees' response could also be disseminated via facsimile or mail to ensure direct franchisee input into the rulemaking process.
Very truly yours,
Susan P. Kezios