December 15, 1999 Mr. Donald S. Clark, Secretary Re: 16 CFR Part 436 (page references to NPR) Dear Mr. Clark: THE GOAL The most important goal Illinois would like to reach, and the reason for the comments that follow, is to meld the UFOC Guidelines and the FTC Franchise Rule into one basic, uniform disclosure document. The advantages to franchisors who must comply and prospective franchisees who must read and compare opportunities, make this effort very worthwhile. PREEMPTION It is essential to federal/state cooperation and the common goal of uniformity that regulators and franchisors know which FTC proposals in fact preempt state statutes and regulations. The general statement that states may impose other requirements if they provide greater protection for franchisees than the FTC Rule is a helpful beginning, but additional guidance is necessary now and after the FTC Rule is finalized. The questions that follow are examples of our concern:
DEFINITIONS Will the elimination of the four previously exempt categories on p. 70 #12 and footnote 242 cause more problems for franchisors if franchisees and courts interpret these deletions as meaning these categories are no longer exempt? Why is there no definition of "subfranchisor", which may be confusing to new franchisors and prospective franchisees? The unique status of simultaneously being a franchisee purchaser, and a franchisor that will make sales and service those ultimate franchisees, should be explained. [p. 61, 135] §436.1 "Disclose" [p.11, 100] implies that disclosure will be written when the definition requires that "....facts (are to be stated)...legibly in plain English." However, the comments for §436.8 (c) [p. 69] permit an oral statement or faxed update of a material change. This conflict should be resolved by not permitting an oral update. According to §436.1 "Franchise" [p. 12 & 13] "three long-standing Commission policies" have modified the definition of "franchise." Number two refers to a relationship being a franchise "regardless of any failure on the franchisor's part to perform as promised." What does this mean and where does this "modify" definition (g) on p. 101? GAG CLAUSES A broadly based, contractual "gag clause" is so offensive to the state and federal systems of presale disclosure that the §436.1 (k) definition described on pp. 13, 51 & 132 should be followed up with a ban on non-proprietary gag clauses. The ability of a prospective franchisee to freely discuss a present or former franchisee's experiences with the franchisor may be the single most important step in a buyer's due diligence investment evaluation.
Permitting gag clauses, and only requiring disclosure of such communication blockades, would also prevent franchisee association members from speaking among themselves, as well as to prospects. This would neutralize the value of franchisee associations and violate §17 of the Illinois Franchise Disclosure Act:
The abuse of gag clauses can also lead to evasion of litigation disclosure requirements if both parties are barred from disclosing the outcome of court or arbitration results, or the basic terms of a settlement. Item 3 of the UFOC provides in pertinent part for the following disclosure:
Confidentiality clauses in litigation should be considered void under current UFOC Guidelines regarding Item 3 and the FTC should do likewise. An FTC prohibition against non-proprietary gag clauses in contracts, court orders and settlements would be appropriate for the protection of prospective franchisees and the furtherance of full presale disclosure. ELECTRONIC DISCLOSURE §436.7 (b) instructs the seller to "simultaneously" furnish the prospective franchisee with a paper summary document... containing...[(1) The cover page, (2) table of contents and (3) two copies of Item 23 Receipt (see pages 64 -66 & 135, 136)] . To comply with the "simultaneous" requirement, will the franchisor's only choice be to physically deliver a package containing the disclosure on disk accompanied by the hard copy documents? The precise obligation of the franchisor and alternatives for compliance should be explained. DISCLOSURE UPDATES §436.8 (c) Updating Disclosures - deals with two stages in the disclosure process:
There is no apparent requirement that these updates be in writing, nor is there a description as to how the franchisor is to "notify" the prospect. The definition of "Disclose" [§436.1 at p.11 and p. 100] implies that the disclosure must be in writing when it speaks of facts being started "legibly." This should be clarified to avoid any claim that notice was in fact given orally to the prospect. Oral notification is the ammunition for rescission litigation. There is also a difference between updates after quarterly reports and updates required at the time of the five day disclosure.
The implication may be that all updates in the contract language that occur after the quarterly update need not be revealed to the prospective franchisee until five days before the contract is executed. It would seem to be important to the prospect and his or her lawyer to know as soon as possible about material contract changes. In response to question 11 of the Request for Comments [p. 94], seven calendar days would be better. Since the prospect is to receive the contract 14 days before signing contracts or paying consideration, the additional five, or seven, day period really just applies to any changes made. It is not just the review time that is important, it is having time to contact the prospect's advisor and schedule a meeting. ROYALTIES AS A FRANCHISE FEE Two provisions of the FTC Rule appear to support the conclusion that royalties, in combination with an initial franchise fee or absent an initial fee, can satisfy the $500 threshold of the franchise definition:
It would be helpful to specify that royalties can constitute franchise fees, or if "all consideration" and "commitment to pay" as a condition of obtaining or commencing business does not permit this interpretation, such an exclusion of royalties should be clearly stated. Royalties should be part of determining if a franchise fee is present or it will be too simple, even for traditional franchisors, to evade franchise laws. DISCLOSURE CONTRADICTIONS §436.10 Additional Prohibitions [pages 76, 79 & 138] declares it an unfair or deceptive act for a seller to (a) "make any claim or representation, orally, visually, or in writing, that contradicts the information required to be disclosed by this Rule." On the one hand the FTC comments on p. 79 recognizes the useful purpose merger and integration clauses can serve, but on p. 80 the comments reinforce the legitimate concern that the Rule itself addresses, which is the prohibition from "making any statements that contradict those in the disclosure document." Rule §436.10 (a) on p. 138 would appear to prohibit the integration or oral (or other statements) representations that contradict the disclosure document. However, to determine what if any conflict occurred, the integration clause would have to be disregarded. Can these divergent viewpoints or interpretations be resolved in the FTC Rule so that it will be easier to determine when and to what extent integration clauses will be valid? The best approach may be to prohibit integration clauses, but specify some limited exceptions. VOID WAIVERS
§436.10 (e) provides that it is an unfair or deceptive act for a seller to require franchisees "to waive reliance on any representation made in the disclosure document or its exhibits or amendments." This is a valuable addition to the FTC Rule, but it should also prohibit any waiver requirement regarding the FTC Franchise Rule, not just the representations made in disclosure documents. Waiver of material violations of the Rule should be prohibited too. Another question is raised by comparing §436.10 (e)(3) [p. 79, 138] that refers to negotiated changes requiring a five day period before signing or paying, with §436.2 (a)(2) [p. 20, 103], which only refers to a five day disclosure period before signing the agreement. [See pages 138 and 103]. Does this mean that: the initial obligation to disclose requires 14 + days before paying or signing a contract; 5 + days for negotiated changes before paying or signing; and 5 + days before signing if there are no negotiated changes? Does any problem result if a franchisor accepts a fee 15 days after delivery of the disclosure document the parties negotiate contract changes and six days before signing of the contract the franchisor delivers the new contract to the prospect? Is it necessary to refer to payment in §436.10 (e)(3) if §436.2 (a)(i) already requires a 14 day minimum before payment? It might be helpful to everyone if the §436.2 (a) disclosure provision is expanded to include the §436.10 (e)(3) disclosure requirement. In response to question 38.[ p. 99] of the Request for Comments, courts tend to respect what parties agree to, even if the franchisee had no idea what was being given up and despite being orally told something else. This antiwaiver provision is very appropriate. FRANCHISOR v. FRANCHISEE LITIGATION Item 3 - Litigation disclosure should include litigation brought by the franchisor against franchisees and the limitations described on page 29 appear to be reasonable. If the FTC deems it necessary to set a percentage limit as to the number of franchises in the system it should be a low number for larger franchise systems, such as 2%, and no threshold for the small system, such as fewer than 25 franchisees. [p. 26- 29, 107] RENEWAL, TERMINATION, TRANSFER Item 17 would be more clear if the terms "renewal" and "extension" were defined. Renewal would mean the end of one contract period and the beginning of another, and may contain different terms, except for provisions previously specified as perpetual rights. Extension would mean the continuation of current contract terms for a definite or indefinite period. [p. 39-41]. In addition to these definitions a statement should be added above the table on p. 124, such as:
FINANCIAL PERFORMANCE REPRESENTATION Item 19 should prevent franchisors from "cherry - picking" their best performing franchise locations and allowing prospects to assume their results will surely be just as good. If a franchisor is permitted to use a "subset" of franchises for earnings claims presentations, there should be comparative data for the rest of the franchise locations. Item 19 (3)(ii) could be strengthened to require basic results for those other locations. Item 19 of the UFOC mentions "costs" in the Instructions, but §436.5 (s) [p. 42-48, 126 -128] does not cite costs or expenses as a relevant part of earnings disclosure. If the prospect only sees "gross sales" or "gross operating income" the information may mask unsuccessful units that are actually losing money or barely paying for the franchisee's many business expenses without leaving any net profit. OUTLETS AND FRANCHISEE Item 20 - There was little doubt that Item 20 [p. 48-51, 128-133] needed to be revised to make it more informative and to avoid double counting of different events, and the FTC draft is a strong move in the right direction. However, the proposed chart doesn't solve the problem. This is very important information for the business buyer and should be designed to be easily understood by the prospect and relatively simple for the franchisor to prepare. If the chart is too big it should be split in two or narrative footnotes should complete the necessary data. In keeping with the purpose of disclosure, this chart should quickly inform prospective franchisees of facts that will be of concern to them and which will prompt the prospect to ask further questions of the franchisor. Some examples of data the buyer should be aware of are:
In answer to question 2. of the Request for Comments [p. 92], the definition of "financial performance representation" should include a statement that:
In answer to question 25. of the Request for Comments [p. 97], the prospective franchisee needs the broadest possible list of franchisees to contact as many as possible before buying. A small number of listed franchisees invites the franchisor to carefully pick the people who will relate the best stories of their franchise experiences. Preparation of the list should be very simple for franchisors to print out. FRANCHISEE ASSOCIATIONS Item 20 also requires certain trademark- specific franchisee associations to be disclosed [see §436.5 (t)(7) pages 132 & 56]. Association disclosure information might be more appropriate in Item 11 as part of the franchisor's obligations. Incorporation of a franchisee association may make good business sense, but why is being incorporated an essential prerequisite to the franchisor being required to disclose the existence of franchisee associations? There should be a definition of what a "trademark-specific franchisee association" is. RECEIPT PAGE In response to question 29. of the Request for Comments [p. 97], the Item 23 Receipt Page is an important reminder to the prospect that he or she is receiving the disclosure document. If no document is provided we would hope it would make the franchisee refuse to sign the receipt. From the standpoint of the franchisor, the Receipt is an extremely important document when a franchisee later alleges that disclosure was never effected. MISCELLANEOUS Please consider making a declaration in the FTC Franchise Rule that expresses the following thought:
States and franchisors should be assured in the FTC Franchise Rule that UFOC Guidelines, instructions and sample answers will survive the proposed FTC Rule to the extent that they do not conflict with the Rule and its instructions and examples. If the proposed franchise Rule becomes effective before a separate business opportunity rule is perfected, will the present FTC Rule continue to apply to business opportunities during the interim? [p. 8] Will any prior FTC interpretive guides continue to apply when the new Rule takes effect? You would also add further protection for franchisees in states that do not already have franchise laws providing for a private right of action, if you would grant such a right in the new Franchise Rule. The work done so far to revise the FTC Franchise Rule has been appropriately careful, deliberate and effective in gathering and considering as many diverse opinions as possible. Your employees are to be complimented for their extensive, professional labor. I appreciate your having provided this office the opportunity to comment on the proposed Rule. Sincerely, Robert Tingler RT/gcc |