Monday, December 20, 1999
E-Mail and Federal Express
This letter is in response to the Commission's request for comments with respect to proposed amendments to its Trade Regulation Rule entitled "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures" (the "Franchise Rule" or the "Rule.") As suggested in the notice of proposed rulemaking, these comments are being submitted via e-mail, by this letter and through the accompanying computer disk.
Our comments are relatively few in number, it being our belief that most of the proposed changes to the Rule would be substantial improvements over its existing formulation. We would like to congratulate the Commission and its staff on the proposal.
To assist in understanding our comments, we've organized them under separate headings.
Definition of "Franchise" - 436.1 (g)
The current Statement of Basis and Purpose (43 FR at 59699-70) provides that a business relationship will be deemed a franchise if it offered or represented as having the characteristics of a franchise, irrespective of whether or not the relationship independently meets the actual (now revised, simplified and improved) definition of a franchise.
In our opinion, this is a mistake, raising the form of a description of a business relationship to a level which would control over the actual substance of the relationship.
While a misrepresentation of a relationship as a "franchise" may itself be misleading and an unfair trade practice (although we are unaware of that being a current problem in the industry or of any evidence on the record of a widespread practice in this regard), the appropriate remedy for any such mischaracterization would seem to be prosecution or civil remedies for any such unfair practice on its own merits, rather than automatically bringing into effect the requirements of the Rule merely because the parties may have (perhaps ignorantly and even innocently) mislabeled their relationship.
This is particularly important since in the presentation of many business relationships one or more legally unsophisticated parties may say something like "Yes, this business is like a franchise" when, in fact, one or more of the legal elements of a franchise may be missing or a relevant exemption exists. To impose the requirements of the Rule merely because one or more of the parties (mistakenly) believed a relationship to be a franchise would be analogous to treating a hockey stick as a golf club, merely because someone called it that, even though we all know that they are quite different.
We're also impelled to raise questions of symmetry and definitional precedence. For example, if one party's mischaracterization of the relationship as a "franchise" leads to application of the Rule, would both parties' good faith belief that the relationship is not a franchise remove the relationship from application of the Rule? If not, why not, since the question of the parties' understandings and expectations seems to be analogous in both situations? Wouldn't the more clear approach, and the one leading to greater certainty and predictability of result, be to simply rely on the express definition under the Rule, rather than one or more parties' misunderstanding of, or vague remarks concerning, their relationship?
In addition, a system in which characterization of a relationship as a franchise leads to the legal result of it being a franchise, irrespective of whether or not it meets the definitional requirements or qualifies for some exemption, poses the risk of unintentional inconsistencies with the definitions under most state laws (which the revised Rule definition generally tracks.)
Given that uniformity between state and federal disclosure regimens is generally to be desired, to have a situation in which a relationship might not meet state definitions, and therefore not require disclosure, and yet have the same relationship trigger federal disclosure requirements merely because of a mistaken characterization, seems unwise and a classic "trap for the unwary."
We believe that (1) merely referring to a business relationship as a franchise when it is not one is not a serious problem in the industry, (2) if such a reference is an actionable misrepresentation and someone is harmed by it, normal principles of contract or anti-fraud law are adequate to deal with the problem and (3) imposition of the Rule's requirements in such a situation is an inappropriate and unnecessary remedy, with probably unintended consequences.
All in all, the intellectually conservative course would seem to be to bring within the Rule's ambit only those relationships which actually meet the applicable definition (and which fail to qualify for any exemption), rather than leaving application of the Rule to the vagaries of comments by persons having no legal understanding of (or even contemplating) the actual definitional requirements for a franchise. Therefore, we would suggest that the Rule specifically provide that the parties' characterization of a relationship being, or not being, a franchise will have no impact whether or not the relationship is deemed a franchise.
Disclosure Delivery - 436.2 (a) (1)
We agree with the proposal to abandon the "first personal meeting" trigger for providing the disclosure document and to substitute a simple 14 day requirement (and a related 5 day contract review period), each of which provide greater certainty and remove the need for questions of close interpretation as to the purpose or circumstances of a first meeting.
We would only suggest that, either in the Rule or accompanying official guidance, an example be given of how these rules would operate, so as to resolve any question as to whether or not the day on which the documents are delivered, or the day on which they are signed, may be counted for purposes of compliance with the Rule.
As we understand it, the following example would suffice:
Disclosure of Franchisor-Initiated Lawsuits - 436.5 (c)
The Commission proposes to require disclosure of lawsuits by the Franchisor against its Franchisees. While we can understand the basis for such possible disclosure, we believe that a percentage or other "floor" should be implemented in connection with any such requirement.
The statement, in the Notice of Proposed Rulemaking, that "(i)n many instances, however, franchisees do not have the financial resources to hire an attorney to initiate a suit or pursue a counterclaim" is quite surprising. This statement is made without any empirical or other evidence on the record to support it and our experience, and that of our clients, is precisely the opposite.
Given the ability of Franchisees to obtain representation on a contingency basis, and the reality of Franchisees almost always filing counterclaims when they are sued, such an assertion seems to be, at best, highly doubtful. In real life, few if any Franchisees would fail to file an action against the Franchisor for what they or they counsel may feel is a valid claim, particularly where the Franchisor has sued the Franchisee. In such a situation, an Item 3 disclosure will generally be triggered as a result of the Franchisee's counterclaim, which typically alleges the types of claims covered by Item 3. Thus, in the vast majority of situations in which the Franchisor sues the Franchisee, the Franchisee will file a counterclaim, triggering the Item 3 disclosure as to the entire litigation and making the proposed change to the rule unnecessary.
More importantly, for large systems, normal collection activities, which sometimes result in suits at the justice or small claims court level, would result in lengthy disclosures of a substantial (in number, but not in percentage) amount of lawsuits. A system with, say, 3,000 franchises outstanding, may have 10 or 15 collection suits in process at any time.
We believe that if the Commission remains committed to mandating disclosures of Franchisor-initiated lawsuits, such disclosures be required only when (1) the number of Franchisees currently being sued exceeds 15% of the number of franchises outstanding and (2) the Franchisor has initiated the suit, not counting instances in which the Franchisee initiated the suit and the Franchisor merely responded with a counterclaim, since the later situation does not relate in any way to a supposedly overly-aggressive Franchisor.
This later requirement (of the Franchisor initiating the suit against the Franchisee) seems appropriate since the Commission's concern seems to be with Franchisors that have a practice of suing their Franchisees, not merely defending themselves from Franchisee-initiated lawsuits. In addition, unless this later condition is included, some suits by Franchisees which do not meet Item 3 requirements (e.g. for simple non-performance or for interpretation of a contractual provision) and to which a Franchisor responded by making a counterclaim for past due royalties, would be required to be disclosed even though no Item 3 type litigation was involved and the Franchisor had not demonstrated an "aggressive" approach to dealing with its Franchisees.
Estimated Initial Investment - 436.5 (g)
Significant problems are raised by the Rule's requirement (mirroring that of UFOC Item 7) for disclosure of additional funds required before operations begin, to the extent that such disclosure requires an estimate of working capital.
As noted in the Notice of Proposed Rulemaking, the intention is to make a disclosure of working capital requirements, not merely additional funds needed to begin operations or, as is commonly said in franchising, "turn the key in the door."
However, no meaningful working capital disclosure can be made without an estimate of the cash flow of the franchised business. (Obviously, some businesses may be in positive cash flow from the day they begin operations; others may never reach positive cash flow and will require endless infusions of capital to remain in operation.)
As an accounting matter, no estimate of working capital can be made without entering into certain assumptions as to the costs of operation (some of which are generally fixed, such as base rent, and others of which will vary based on revenues, such as materials, percentage rent, royalties, etc.) and projected revenues.
To take a simple example, assume three businesses, each of which have fixed costs of $20,000 per month and no variable costs (an admittedly unrealistic scenario: nearly all businesses have variable costs but this assumption makes the example easier to understand.)
Each of these hypothetical businesses has significantly different working capital requirements (in the case of A, working capital requirements are, as a practical matter, zero, and in the case of C they are unlimited, at least as long as the business remains in operation.)
Even if we assume that business B is average or typical for the franchise system involved, the calculation of working capital requirements necessarily involves assumptions as to fixed costs, variable costs (which, in turn, involve assumptions as to unit or other volume) and revenues. (You may wish to confirm this analysis with your staff accountants.)
What's critical to understand is that it is impossible to provide a meaningful estimate of working capital requirements without making assumptions as to total revenues (and related costs), which is functionally equivalent to a representation as to financial performance. By definition, an estimate of working capital requires knowledge or assumptions as to revenues.
Since such a representation is otherwise forbidden unless made in accordance with Item 19 (or a relevant exemption is available), a "disclosure" of working capital requirements is, from an intellectual standpoint, a "back door" method of providing representations as to financial performance.
We suggest that, in order to avoid this result, Item 7 expressly exclude (and, perhaps, forbid) a requirement to disclose estimated working capital or other funds needed "during the initial phase" unless there has been related compliance with Item 19.
Financial Performance Representations - 436.5 (s)
While the Commission's proposed requirements with respect to disclosure of financial performance of operating units is a major step forward and deserves support, the omission of certain language which should be required in Item 19, together with the lack of a provision clearly allowing the Franchisor to provide additional information and warnings, raises the possibility of continued abuses in this area.
In the Advance Notice of Proposed Rulemaking, the Commission suggested draft language warning prospective Franchisees to not rely on information regarding sales, income or profits where written substantiation is not provided. That language has been omitted in the most recent draft, without any explanation, other than a reference to one commentator's concern that such language might serve as a disclaimer of liability.
Given the Commission's perception that the making of false or unsubstantiated earnings claims is a widespread and significant problem in franchising, the omission of a "do not rely" warning creates substantial risks for prospective Franchisees. Given the almost universal agreement among franchise practitioners that undocumented earnings claims are generally unreliable and the source of inappropriate expectations by prospective Franchisees, it seems prudent, for the protection of prospective Franchisees, to include express language making it clear what all practitioners, whether representing Franchisors or Franchisees, seem to agree on: unsubstantiated earnings claims are not reliable and should not be relied on. It seems clear that that is the message that all prospective Franchisees should receive.
It is certainly true that "do not rely" language may be used as a defense by a Franchisor, just as a "Wet Floor" sign may be used by a retailer as a defense in a slip and fall lawsuit. However, the overriding goal, in each instance, should not be to preserve a potential plaintiff's cause of action, but to prevent the injury or loss in the first place.
We suggest that language such as the following be required in Item 19, whether or not a Franchisor makes a formal Item 19 disclosure of financial performance:
Any financial performance information (or projections) which is not contained in this disclosure document is unreliable and you shouldn't rely on it. Past results are no guarantee as to future results. While some units have reported the results shown in this disclosure document, there's no guarantee you'll do as well.
We would also suggest two other minor changes:
We very much appreciate the opportunity to submit these comments and suggestions and hope that they will be helpful in preparing an update to the Rule.
If you have any questions or we can be of assistance in any other way, please do not hesitate to contact us at our toll-free number or by e-mail.
David E. Holmes