December 21, 1999
Donald S. Clark, Secretary
Dear Mr. Clark:
Following are Hogan & Hartson's comments in response to the Notice of Proposed Rulemaking ("NPR") concerning Trade Regulation Rule on Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures ("the Franchise Rule" or "The Rule") published by the Federal Trade Commission's (the "FTC" or "Commission") in the Federal Register on October 22, 1999.
Hogan & Hartson's Franchise Practice
Hogan & Hartson is a firm of over 600 lawyers in ten cities and seven countries which was founded in 1904. Our Franchise Group, based in Washington, D.C., provides a full range of services to meet the legal needs of start-up and mature companies that offer goods and services through franchising and other distribution methods. The firm's franchise lawyers have practical experience in structuring a wide variety of domestic and international franchise arrangements and in counseling franchisors on sensitive franchise relations issues. Members of the group have handled franchise company merger and acquisition transactions, and related public and private financing, in the U.S. and throughout the world.
The Franchise Group has considerable experience in the interpretation and application of federal and state laws governing franchising. Franchise Group attorneys routinely assist franchisors in establishing cost-effective franchise sales compliance programs and in systematizing state registration of franchise offerings. We have created and obtained registration under all state franchise disclosure laws of a single, "multi-state" offering circular thereby eliminating for franchisors the compliance risks inherent in the maintenance of numerous state-specific documents.
Among the Franchise Group's members are nationally known trial lawyers specializing in the representation of franchisors in suits against franchisees to enforce contractual and intellectual property rights, as well as in the defense of claims brought by franchisees, including antitrust claims and class actions. The group's litigators also represent franchisors in suits with third parties that involve franchise-related issues. Members of the group have vast experience in negotiating with franchisee associations on critical issues and in the mediation and arbitration of domestic and international franchise disputes. We are also experienced in the representation of franchisors before Congress, the Federal Trade Commission and other federal and state governmental bodies.
Hogan & Hartson applauds the FTC's efforts at improving franchise regulation by updating disclosure requirements to reflect common industry practices and embracing modern communications technology. The FTC's efforts to consider the various interests in the franchise community, as reflected by the extensive explanations of the FTC's proposals in the NPR, lends considerable credibility to this effort.
Moreover, we support the FTC's proposed public policy of addressing the concerns about franchise practices raised by franchisee rights advocates through enhanced disclosure and having the competitive effects of disclosing those practices impose market place discipline on the franchise community. Hogan & Hartson believes the FTC has been prudent in avoiding being drawn into an approach of imposing government regulations on the terms of franchise relations - an approach we believe would stifle diversity and innovation in a method of distribution that has provided the U.S. economy with robust competition.
Overall, we believe that the approach to disclosure, and the specific disclosure requirements, proposed in the NPR is sound. The notion of essentially adopting the UFOC format for compliance with the FTC Rule is realistic, as it reflects common disclosure practices in the franchise community. It will also facilitate compliance to be able to use modern communications technology to meet the disclosure requirements.
We do have a number of comments on the NPR, which should not be interpreted to mean that we do not support the overall thrust of the FTC's efforts. We believe, however, that the FTC should clarify several points and should give further consideration to a number of areas where the proposal imposes excessive disclosure burdens on franchisors with, at most, only marginally useful information for prospective franchisees. As noted in our submission of April 30, 1997, we do not know exactly where the line should be drawn between "just enough" and "too much", but there are some areas where, in our view, the proposal is clearly "too much."
Furthermore, we encourage the FTC to remain active in monitoring common franchise practices and making further revisions, as appropriate, to the disclosure requirements and methods of communicating information as community practices and communications technology change. Perhaps an industry advisory group might be established to provide periodic advice and counsel.
Our comments are broken down into three main sections. First, we address several of the more significant conceptual issues. We then provide specific comments on the disclosure requirements. Finally, we respond to some of the 40 questions posed in the NPR, with cross references to other parts of this submission, where appropriate.
A. GENERAL COMMENTS
1. SCOPE OF COVERAGE
In general, Hogan & Hartson supports the retention of the existing exemptions included in the current Rule, as well as the addition of the proposed new exemptions, subject to the suggestions set forth below. We also believe, however, that the Proposed Rule should retain the specific exclusion of the four non-franchised relationships set forth in 16 C.F.R. § 436.2(4)(i)-(iv). Although the Commission states in its NPR that the franchise community is familiar enough with these exclusions, and that no confusion about them exists today, we believe that the franchise community is growing rapidly and new practitioners are likely to continue to benefit from the explicit exclusions. In our view, deletion of the specific exclusions is likely to create unnecessary uncertainty.
§ 436.9(a): Minimum Payment Exemption. We believe that the current minimum payment exemption of $500 should be increased to at least $1,000, recognizing that costs in general have increased substantially since the Rule initially was promulgated. We further believe that the amount of the minimum payment exemption should be increased periodically, perhaps every 4 years, (1)/ to reflect a reasonable rate of inflation. We also support the clarification that reasonable amounts of inventory purchased at bona fide wholesale prices for resale is not considered in determining whether the minimum payment has been made.
§ 436.9(b): Fractional Franchise Exemption. Hogan & Hartson supports the retention of the "fractional franchise exemption." We believe, however, that the experience requirement should not be limited to two years of experience in the same type of business, but should be expanded to include experience in a similar or complementary type of business. In our experience, business enterprises seek to expand existing product lines or services by offering complementary products or services, rather than more of the same. The additional products and services generally are related in some way, however, and the franchisee is likely to have some familiarity with the new products/services such that compliance with the Rule's disclosure requirements is not warranted. In fact, the Interpretive Guides (2)/ state that "[t]he required experience may be in the same business selling competitive goods, or in a business that would ordinarily be expected to sell the type of goods to be distributed under the franchise." We believe, therefore, that the experience requirement under the fractional franchise exemption should be expanded to include complementary businesses.
§ 436.9(e)(1) Large Investment Exemption. We support the addition of this exemption, but suggest that the Commission: (a) reduce the minimum threshold below $1.5 million, (b) state in the Rule that the threshold includes the total projected investment in multiple-unit transactions (as explained in the notes to the NPR), and (c) include the fair market value of an existing facility as part of the investment, so as to include an existing facility that is being converted to the franchise system.
§ 436.9(e)(2): Sophisticated Investor Exemption. We support the addition of the sophisticated investor exemption. We believe, however, that the requirement that a prospective franchisee be a corporation with a net worth of at least $5 million effectively limits the exemption to a small number of publicly traded companies. Many successful private companies do not seek to accumulate equity, but instead to maximize cash flow to their owners. Thus, such a high net worth requirement would prevent the exemption of many sophisticated investors. Second, there is no rational basis for limiting the exemption to business enterprises organized in a corporate form and excluding limited and general partnerships, limited liability companies and sole proprietorships. Third, the exemption, limited to the entity actually signing the franchise agreement as franchisee, would eliminate the exemption's application to project-specific companies that are formed in order to limit liability for the franchisee's entire business enterprise. (3)/ Fourth, we believe that the $5 million net worth requirement is too high. (4)/
We believe, therefore, that § 436.9(e)(2) should be broadened to require that "the franchisee or its principal owners have been in business for at least five years and individually or collectively have a net worth of at least $1 million." In this way, we believe the exemption would be more widely available, but still would be limited to investors with substantial resources and sophistication, thereby making the Rule's protections unnecessary.
2. SUBFRANCHISE AND CO-BRANDING DISCLOSURES
We believe that the FTC should provide greater flexibility regarding franchise disclosure in the context of subfranchising and co-branding. As proposed, the Rule merely states that subfranchisors should disclose the required information about the franchisor and, to the extent applicable, the subfranchisor.
Subfranchising can take many different forms, including structures whereby the subfranchisor signs the unit franchise agreements with the subfranchisees, as well as structures whereby the franchisor itself enters into the unit franchise agreements with subfranchisees, but delegates many support functions to the subfranchisor. In the former example, the proposed requirement may lead to disclosure about the franchisor in a subfranchise offering that is irrelevant and, in some circumstances, could be misleading to prospective franchisees. (5)/ Moreover, the proposed Rule does not address co-branding at all, a concept which can also have many different structural variations.
We believe that the Proposed Rule should state that, in the context of subfranchising and co-branding, required information should be included about the franchisor and subfranchisor, and the anchor franchisor and host franchisor, respectively, to the extent applicable. This will provide the necessary flexibility to prepare disclosure documents that are relevant to the particular structure, while providing prospective franchisees with all material information.
3. PREEMPTION OF STATE LAW
We ask that the FTC further elucidate the relationship between the proposed rule and state law and to what extent the Rule is intended to preempt inconsistent state law. The statement in Section 436.11 (c) that " [a] law is not inconsistent with this Rule if it affords prospective franchisees equal or greater protection, such as registration of disclosure documents or more extensive disclosure ...." is helpful, but should be expanded to give more guidance to the community on matters that are likely to occur but not addressed.
The FTC should clarify that preemption should relate to an entire disclosure format, otherwise the community will be left without guidance as to potentially conflicting Federal and state law. (6)/ Presumably, it is not the intention of the FTC that franchisors be required to determine to what extent specific disclosures of the Rule and any future revisions to the UFOC provide more disclosure and then create a disclosure document that is a blend of those required by Federal law and state law.
Another area where the FTC should provide further guidance is the potentially conflicting requirements on updating disclosures mandated by Federal and state law and the unwarranted burden of multiple updating dates. These issues are addressed in the current Rule, and we encourage the Commission to continue its current updating requirements, as articulated in Section I.D.1. of the Interpretive Guides. (7)/
We ask the Commission to give the franchise community further guidance with respect to the issue of conflicting state law where only some states having franchise registration or disclosure requirements. For example, if in the future NASAA were to provide more extensive disclosure requirements in its UFOC format for implementation in the states that regulate franchise sales, what effect would that have on franchisors' Federal disclosure obligations in non-regulated states, as to which the new UFOC disclosures would be inapplicable? We urge the Commission to add a statement to the effect that if a state law imposes greater disclosures, then franchisors' compliance with such law shall be deemed compliance with the FTC Rule. Otherwise, franchisors with national offerings will be subject to two different disclosure formats.
4. DISCLOSURES BEYOND THE REQUIREMENTS OF THE PROPOSED RULE
Inherent tension exists within the Proposed Rule on the extent of franchisors' disclosure obligations. On the one hand, the Commission correctly observes that franchise disclosure is done in the context of prospective franchisees' own due diligence. (8)/ Unlike a passive investment in the equity or debt securities of a business, franchises are opportunities to invest in one's own business in coordination with the business of the franchisor and other franchisees of that system. There is much a prospective franchisee can and should do on its own in gathering and analyzing information in order to make an informed decision about its own business, and the franchisors' disclosures are only part of that entire information mix. The FTC's statement in Section 436.6(c) that franchisors should "not include any materials or information other than that required by this Rule or by State law not preempted by this Rule..." is consistent with that approach. Yet in other sections of the Rule, the FTC appears to signal that franchisors are required to include additional material information with their disclosure documents. For example, Section 436.8 (c) states that information must be updated with respect to "any other known material change in the franchisor, the franchise business, or the franchise agreement ..."(emphasis added), thereby suggesting that information beyond what the Proposed Rule requires should also be included. (9)/ Likewise, Section 436.11(a) states that "... franchisors may have other obligations to disclose material information to prospective franchisees under section 5 of the Federal Trade Commission Act."
These statements leave the franchise community without clear guidance on what is expected and may lead to unfair, after the fact, findings that a franchisor did not disclose a particular item of information not required by the Proposed Rule but that is deemed material in hindsight, including information to which the franchisee may have had equal access. Furthermore, imposing an undefined general obligation to disclose all material information in the disclosure document is likely to lead to significantly greater costs in complying with the Rule (10)/ and will cause barriers to entry in the field of franchising. Again, franchise investments are unlike securities investments, and franchisors simply cannot know all that is material to the individual investment decisions of each and every franchisee.
5. NEGOTIATED SALES
Hogan & Hartson believes that the proviso in Section 436.10(e) of the Proposed Rule misses the point about negotiated franchise sales. It suggests that a franchisee could legitimately rely on disclosures of contractual provisions in the disclosure document as to which he negotiated changes for his own benefit and charge the franchisor with having incorrectly disclosed the terms of the agreement; and that the only way for franchisors to avoid liability would be a waiver of reliance on the disclosure document. This defies common sense and lacks legal support. (11)/ Section 436.10(e) then provides franchisors with a "safe harbor" that is cumbersome and not particularly meaningful. The franchisor is to disclose (where? in the disclosure document, or perhaps elsewhere? and what if the negotiated provisions are not required to have been disclosed in the first place?) to the franchisee the very changes that the franchisee has asked for, and then have the franchisee initial the changes in the agreement. Emphasizing to the franchisee the changes that he has requested suggests that franchisees don't understand the effect of their own requested changes and is unduly paternalistic.
We don't believe that there is a "problem" with negotiated changes that needs to be solved; we believe the proposed solution is both meaningless and cumbersome. (12)/
6. DISCLOSURE FOR RENEWALS AND MATERIAL MODIFICATIONS OF EXISTING FRANCHISE AGREEMENTS
Hogan & Hartson believes that the Commission should exclude renewal and amended franchises from the disclosure obligations and adopt the approach of many of the state franchise registration and disclosure laws that disclosure is only required if there is an interruption in the operation of the franchise business. (See, e.g., Illinois, Indiana, Maryland, New York, North Dakota and Wisconsin).
Disclosures in the UFOC are focused on the initial investment decision to be made by a prospective franchisee. The format has evolved away from regurgitating the terms of the franchise agreement to covering more information about the history and practices of the franchisor that are outside of the terms of the agreement. In fact, the items that deal with contractual provisions, such as Items 9 and 17, simply reference the sections in the agreement and at most contain a summary description of the applicable provisions. Consequently, the UFOC is not focused on the terms of the agreement and repeatedly encourages a prospective franchisee to read the agreement itself rather than relying on contractual descriptions in the UFOC.
Material modifications to existing franchise agreements typically involve one of two situations. First, the revised agreements may be the result of a settlement of litigation or other disputes with franchisees, whereby the franchisor is making concessions to franchisees. Second, changes may also be initiated by management of the franchise company and almost always involve franchisee input through independent franchisee associations or franchisee advisory councils.
UFOC disclosures are irrelevant in the context of material modifications. (13)/ There typically is no investment decision to be made. (14)/ Franchisees have an existing relationship with the franchisor and are fully familiar with the franchisor, its management and its practices. What is changing under these circumstances is the agreement, which the UFOC doesn't really deal with. Thus, to impose the costs and burdens of preparing UFOCs on a franchisor where there is little, if any, relevant information for existing franchisees is not good public policy. An offer to exchange different forms of agreement or add an addendum to existing franchise agreements does not establish a new franchise relationship - that relationship already exists and will continue regardless of the decision the franchisee makes.
The same rationale exists with respect to renewals. There is no investment decision the renewing franchisee is making. His decision relates to whether to continue a relationship, with which he should be intimately familiar at that point, under the terms of a new form of franchise agreement. The UFOC does little to help him understand the terms of that agreement.
Accordingly, we urge the Commission to revise the definition of a sale of a franchise to state: "It does not include modifying, extending or revising an existing franchise agreement where there is no interruption in the franchisee's operation of the business."
We believe the FTC in the NPR may have unintentionally increased disclosure requirements in connection with transfers. Under the current FTC Rule, a disclosure document need not be delivered to the transferee of an existing franchise if the franchisor's role in the transaction is to approve or disapprove the purchaser. See Bus. Fran. Guide ¶ 6220. Yet, the proposed Rule in the NPR defines a "sale of a franchise" broadly to include any transfer and then exempts in the definition of "franchise seller" the franchisee who sells the franchise, but not the franchisor. In other words, in any transfer of a franchise (regardless of the franchisor's role), the transferring franchisee has no obligation to provide the disclosure document, but the franchisor always does.
Again, we believe this is unintentional. If not unintentional, there is no rational basis for imposing a disclosure obligation on franchisors under these circumstances, and the proposal goes beyond current practice both under federal and state law. We would suggest that the Commission deal with this issue in the definition of "sale of franchise" to provide that the phrase does not encompass the transfer of a franchise by an existing franchisee where the prospective franchisee has no significant contact with the franchisor. Actions of the franchisor in connection with approving or disapproving the purchaser should not be deemed to be significant contact.
8. DISCLOSURES ABOUT PARENT COMPANIES
One of the major areas in which the FTC is seeking to expand disclosure beyond what is currently required under the UFOC guidelines is information about parent companies of franchisors. Item 1 would require information about parent companies that is similar to the information required of franchisors, regardless whether the parent company sells franchises or conducts business with franchisees, so as to fall within the definition of an "affiliate" for purposes of Item 1. Item 2 requires disclosure of management personnel of a parent "who will have management responsibility relating to the offered franchises" and which could include executive officers whose function for the parent company is to oversee the operations of a number of operating subsidiaries, including the franchisor. Item 3 requires identical litigation history disclosure for parent companies as for the franchisor itself. Item 4 requires identical bankruptcy history. Item 21 requires "separate financial statements for a company controlling 80% or more of a franchisor", i.e., a parent company, and also requires that such financial statements be prepared in accordance with U.S. accounting principles.
By adding these requirements, the Commission is creating a significant disincentive for the acquisition of franchise companies by other businesses. This is likely to result in the dimunition of the value of franchise companies. The additional disclosures are, at best, of marginal relevance to franchisees and may be misleading. For example, attaching parent company financial statements under circumstances where the parent company is not guaranteeing the financial performance of the franchisor may mislead the prospective franchisee into believing that the financial strength of the parent company stands behind the franchisor.
Aside from the fact that a "parent" is undefined, (15)/ the information in Item 1 required about parent companies that are not otherwise "affiliates" is not particularly meaningful to a prospective franchisee. Additionally, having to disclose all concluded litigation, of whatever nature, of a parent company during its last 10 years in Item 3 will result in much irrelevant information being inserted in that item. Finally, the requirement to attach parent company financial statements to the UFOC will likely cause concern to parent companies that the legal liability risks inherent in operating a franchise system will pierce through the corporate veil of the franchisor into the assets of the parent company. It is only in the context that the parent company agrees to guarantee the obligations of the franchisor, that the parent company's financial statements should be included.
Additionally, the requirement that financial statements conform to U.S. GAAP is problematic. Some major U.S. franchisors, including Burger King, Dunkin' Donuts, Baskin Robbins, Meineke and Canteen, are owned by foreign companies. Unless these companies have their shares or ADR's publicly traded in the U.S., they would have no reason to conform their certified statements to U.S. accounting standards. For companies located in many foreign countries, including Germany, a requirement to convert to U.S. accounting standards would be enormously expensive. Accordingly, we believe Item 21 should require that financial statements should conform to U.S. GAAP or otherwise to the generally accepted accounting principles established in the country of the company's domicile.
9. FINANCIAL PERFORMANCE REPRESENTATIONS
Hogan & Hartson concurs with the FTC that requiring franchisors to provide financial performance information is impractical. We believe that the approach reflected in the proposed Rule, being an improved version of Item 19 of the UFOC, is likely to provide marketplace driven disclosure of relevant financial performance information and is generally sound.
However, one major problem with proposed Item 19 is the statement in footnote 293 that "...historical information must be prepared according to U.S. generally accepted accounting principles." This is an unduly burdensome requirement that creates a strong disincentive to provide financial performance information. For franchisors to be assured that financial information from their franchisees complies with GAAP, existing franchisees are likely to have to prepare and submit to their franchisors annual audited financial statements. This goes far beyond what the UFOC guidelines have ever required, even historically under the original 1977 version promulgated by the Midwest Securities Commissioners Association (NASAA's predecessor), when the purpose of Item XIX was to discourage earnings claims. (Under the old UFOC version, a franchisor only had to disclose whether or not the information was prepared in accordance with GAAP.) We strongly urge the Commission to delete this requirement altogether, but if it is believed that GAAP statements are preferable, the requirement should be that franchisors disclose whether or not the historical data was prepared according to GAAP, as under the old UFOC rules.
We also believe that the statement in footnote 295 that financial performance representations would not have a reasonable basis under certain circumstances is unduly restrictive. Circumstances very well may exist where, for instance, a franchisor could overcome inconsistent franchisee financial reporting and prepare a reliable financial performance representation. The burden of the reasonableness of such a representation lies with the franchisor, and the FTC should permit a franchisor to judge what information it is willing to rely on. We urge the Commission to clarify that financial performance representations "may not" have a reasonable basis under the described circumstances, rather than precluding them altogether.
We urge the Commission to give further consideration to the breadth of the proscription against generally disseminated financial performance information in Section 436.10 (d) in light of other legitimate reasons franchisors might have to make such information publicly available. In particular, many publicly traded companies publicize on their Web sites the financial information which is filed with the SEC to keep investors informed about the company and its financial performance. These financial disclosures often include financial measures of the health of the company, such as average store sales and various operating margins that are analyzed in detail, information which might constitute financial performance representations under the proposed Rule. Thus, if the Web site with such information also provides information for prospective franchisees, Section 436.10(d) might very well be implicated in that it may be viewed as having been disseminated to franchisees.
We believe the Commission should provide limits on what is deemed to be a generally disseminated financial performance representation. For example, the proposed Rule might exempt from regulation all information filed with the SEC or similar regulators of securities markets. This type of information has a high degree of reliability, given the serious implications for filing false or inaccurate information. In this manner, publicly traded franchisors would not need to update their Item 19 disclosures on a quarterly basis, as they file their 10Q's and make their financial performance publicly known. This issue not only arises in the context of corporate Web sites, but could even arise in connection with attaching the very same financial statements to the UFOC as required by Item 21.
B. SPECIFIC COMMENTS ON DISCLOSURE REQUIREMENTS
(i) Franchisee: We believe that the wording "an interest in a franchise" could encompass stockholders and other investors of the franchisee. By including the owners of a franchisee entity in the definition of "franchisee," the franchisor may be required to deliver a disclosure document to each of them. This is clearly unwarranted and would be absurd with franchisees that are publicly traded corporations. We suggest that the term franchisee be defined as "any person who is granted a franchise." The vague and undefined phrase "an interest in a franchise" is also contained in the definition of franchise seller and franchisor, and lends unnecessary uncertainty about the scope of coverage of the Rule and should be deleted.
(ii) Gag clause: Because the words used to define this concept, i.e., "gag clause," inappropriately suggests that they are illegitimate, we believe that this term should be defined as "Confidentiality agreements." Moreover, we believe that the definition should be limited to restrictions from discussing matters "with prospective franchisees." Some franchisors prohibit franchisees from tarnishing the reputation of the franchise system by publicizing disparaging or inaccurate comments over the Internet or otherwise. Such restrictions could be limited so that they would not preclude the franchisee from honestly responding to requests for their opinions from prospective franchisees.
(iii) Predecessor: We believe this definition is too broad by including companies which own the trademark, but license it to the franchisor. For example, a franchisor might become involved in a trademark or trade secret dispute with an unrelated third party and a settlement that might involve cross licensing. The other party would then be viewed as a "predecessor." We suggest that the Commission apply the definition of "Predecessor" from the UFOC Guidelines.
Item 1: The Franchisor, Its Parents, Predecessors and Affiliates:
As noted above, the FTC should consider eliminating disclosure requirements regarding "parents" of franchisors.
Information about a "parent" is not relevant to franchisees unless the parent will be involved in franchise business or otherwise has a relationship with franchisees. The definition of "affiliate" in subitem (1) is broad enough to encompass entities with these ties to the franchisor or franchisee.
Subitem (2) should be changed to a five-year disclosure period both for reasons of consistency and to reduce compliance costs. Item 2 establishes a five-year business experience disclosure period for those with management responsibility for the franchise. Extending the five-year limit to subitem (2) will reduce compliance costs without eliminating any useful information. Five years is an ample period of time for a prospective franchisee to determine if a system has merely changed its name to escape bad press or a bad reputation.
In subitem (7), the Commission should consider adding a footnote following "its parent, predecessors, and affiliates," that would read: "For parents, predecessors, and affiliates, disclosures should cover only the 5-year period immediately before the close of the franchisor's most recent fiscal year." Such a footnote is important for several reasons. First, this footnote will promote consistency between business experience disclosures in subitem (7) and Item 2. There is no reason to require more extensive disclosures regarding parents, predecessors, and affiliates than for people with actual management responsibility. Second, there is likely to be much irrelevant information if there is no time limit on disclosures related to parents and affiliates. Finally, it may be both costly and difficult, if not impossible, for the parent or an affiliate to obtain this information which provides little or no benefit to the franchisee.
Item 2: Business Experience:
We recommend that the Commission clarify this item by rephrasing the first sentence as follows: "Disclose the position and name of the directors, trustees, general partners, and officers of the franchisor and the subfranchisor [footnote], if applicable, who will have management responsibility relating to the offered franchises." [Text of footnote: A franchisor need only provide disclosures with respect to the subfranchisor(s) that will provide services to the prospective franchisee. At the franchisor's discretion, it may include disclosures with respect to other subfranchisors, as well.]
This phrasing clarifies that a franchisor should disclose the names and positions of all persons with management responsibility. The reference to disclosures about officers of "any parent" should be deleted because it is both redundant and confusing. The definition of "officer" in the definitional section of the proposed rule includes "de facto officers," i.e., those with significant management responsibility for the marketing and/or servicing of franchises.
The suggested footnote would clarify the information about officers of subfranchisors that needs to be disclosed. Franchisors should only be required to furnish information about subfranchisors that will provide services to the prospective franchisee. For example, a prospective franchisee in the United States would not need to know information about subfranchisors located in foreign countries.
However, where a franchisor has multiple domestic subfranchisors and wants to create one UFOC for all prospective franchisees, it should be allowed to include information on all its domestic subfranchisors. By permitting such a practice, franchisors will be able to reduce compliance costs by creating one comprehensive UFOC, rather than creating a different UFOC for each subfranchisor.
Item 3: Litigation:
As noted above, we are concerned that the additional disclosures about parent company litigation required in this Item will be burdensome without providing meaningful information to prospective franchisees.
We firmly believe that the addition of Item 3(1)(ii), all material actions "involving the franchise relationship", would add a very burdensome requirement of listing all relevant details of garden variety litigation, including collection actions against franchisees. For large franchise organizations in particular, this is likely to result in a significant number of lawsuit disclosures that shed no light on franchisor illegal activities. We strongly urge the Commission to delete this requirement. In the alternative, the Commission should consider permitting a franchisor to summarize generally the number and nature of other actions "involving the franchise relationship."
We also suggest that Section (iii)(B) and (iii)(C) be combined to read in accordance with the UFOC Guidelines. Otherwise, there is no limitation to disclosing concluded litigation that is material, i.e., all litigation in which there is an adverse judgment on any claim would have to be disclosed, regardless of the nature of the claim. For individuals, this might include, for example, divorce and child custody matters that are completely irrelevant to a prospective franchisee.
Furthermore, we suggest (1) that the term "ordinary routine litigation" be defined in accordance with the current NASAA guidelines for Item 3; and (2) the word "material" be substituted for "significant" in (1)(i)(B).
Item 4: Bankruptcy:
As noted above, we suggest that the Commission delete the parent company's bankruptcy disclosure.
Item 7: Estimated Initial Investment:
The phrase "during the initial phase of the franchise" is defined in the discussion to mean the franchisee's operational costs "until they break even." We are concerned that this definition is tantamount to a mandatory financial performance representation, creating unnecessary liability for the franchisor. We suggest that the Commission discuss the initial phase in the same manner as NASAA, i.e., a reasonable initial period of time, but without reference to seeking a break-even point.
Item 10: Financing:
The Commission should clarify that disclosure of leases under this Item should relate to "finance leases," a well-established term in commercial law.
Item 18: Public Figures:
This Item seldom, if ever, is applicable, and we suggest that it be deleted.
Item 19: Financial Performance Representations:
Our comments are on page 11.
Item 20: Outlets and Franchise Information:
Hogan & Hartson supports the Commission's efforts to address the "double counting" problem with existing Item 20 of the UFOC. However, in attempting to eliminate double counting, we believe that the Commission has created other problems that will lead to distortions in this information.
First, by seeking to create "symmetry" in the chart, i.e. having an exact number of outlets at the beginning of the fiscal year and at the end of the fiscal year (which presumably then should be the same number of outlets for the beginning of the following fiscal year), the Commission has overlooked a major category. This is the number of new outlets opened or acquired by franchisees in the fiscal year.
Second, the Commission has equated an outlet transfer in Column 6 with an outlet closing by requiring that Column 9 be the sum of Columns 4 through 8. That number would be incorrect because a transfer of a franchise does not result in the closure of an outlet. The problem arises from mixing what is occurring to a franchise relationship with what is occurring to an outlet.
There are also other problems inherent in this proposal. For example, within one fiscal year, it is possible that an outlet is transferred from one franchisee to another, with the second franchisee having his franchise terminated (and the outlet closed) during the same fiscal year.
Finally, the company owned outlet chart should not only list outlets opened and closed but also outlets acquired or sold in order for the total in column no. 5 to be accurate.
We urge the Commission to reconsider what information be imparted by the charts of Item 20 and limit it to what is most important to prospective franchisees. Requiring comprehensive charts just for the sake of symmetry is not good public policy. We understand NASAA is studying the double counting problem of Item 20. We believe it would be fruitful for the Commission to review the matter with NASAA.
List of Former Franchisees
While we believe that valuable information can be obtained by prospective franchisees from existing and former franchisees who have left the system, the requirement to include as former franchisees those who have "not communicated with the franchisor within 10 weeks of the disclosure document issuance date" is impractical for most franchisors. Franchisors have great difficulty obtaining this information.
We question the necessity of disclosing the extent of use of "gag clauses." We do not believe there is sufficient empirical evidence of widespread use of these clauses so as to warrant disclosure.
If the Commission decides to retain this disclosure requirement, we believe that the scope of disclosures about gag clauses contained in proposed Item 20 goes beyond what would be relevant to a prospective franchisee. Item 20 requires disclosure of all current franchisees as well as former franchisees who have left the system in the last fiscal year. It would seem most relevant to a prospective franchisee to know the extent of the use of gag clauses within that group of franchisees and former franchisees. The fact that two or three years prior thereto franchisees or former franchisees may have been subject to gag clauses would appear to be irrelevant to the prospective franchisee. Trends in gag clauses may be of interest to the Commission, but the primary interest of prospective franchisees is likely to be the extent to which they will receive open and candid responses from the people identified pursuant to Item 20 of the UFOC.
Hogan & Hartson does not believe the Commission has struck the right balance with respect to disclosure of franchisee associations. The Commission appears to believe that the only concern a franchisor would have is potential liability for not having complete disclosure in its Item 20 with respect to nascent organizations. We firmly believe that franchisors' concerns go much farther than that. If franchisors are required to disclose in their UFOCs every incorporated association (the cost of incorporating is perhaps $200 to $500) that notifies the franchisor, it is likely that franchisee rights advocates will incorporate an association to promote their anti-franchisor agenda to prospective franchisees. We believe it inappropriate that franchisors should be required to assist in such efforts.
We strongly urge the Commission to delete paragraph 7(ii) from Item 20. However, if the Commission desires to have disclosure beyond those organizations that are currently supported and recognized by the franchisor, we suggest that any such organization be able to satisfactorily demonstrate to the franchisor that it has the support of at least a significant plurality of franchisees (for example, 30%) before the franchisor is required to disclose its presence in the UFOC.
Item 21: Financial Statements:
As mentioned above, proposed Item 21 creates some significant problems for franchisors. First, the requirement that the financial statements be prepared in accordance with United States generally accepted accounting principles is problematic for foreign companies. We urge the Commission to amend this requirement to state that the financial statements shall conform to generally accepted US accounting principles or the generally accepted accounting principles of the country of the entity's domicile.
Second, rather than mandating that in all instances the financial statements of a franchisor and "any subfranchisor or comparable entity" be included, we suggest that the Commission provide flexibility and require only the financial statements of the entity with whom the franchisee will have a contractual relationship. To include the financial statements of others is potentially misleading. Third, as noted above, the requirement that a parent company financial statements be attached is a significant impediment to franchisors and potentially misleading to prospective franchisees.
Item 23: Receipt:
We have some concern regarding the second paragraph of the disclosure contained on the receipt page. The proposed disclosure refers to "a binding agreement." We suggest that the words "with the franchisor or any of its affiliates" be added because the franchisor cannot control whether a prospective franchisee proceeds to commit with independent third parties (e.g. lessor of real estate) before expiration of the cooling off period.
Given the three page disclosure proposed by the Commission in connection with electronic transfer of the UFOC, we also suggest adding language to the Receipt acknowledging the receipt of the electronic version of the UFOC and, in such event, the three page "Summary" document.
Finally, we do not believe compliance with the delivery requirements will be enhanced by requiring that the receipt be returned at least 5 days before the agreement is signed, as required by paragraph (2). This will simply add more paperwork for those franchisors who seek to diligently comply with the Rule and is easily circumvented for those who don't. If the FTC is concerned that receipts are being backdated, why wouldn't the acknowledgment of the return of the receipt also be backdated? Accordingly, we suggest that paragraph (2) be deleted.
Delivery of UFOC
Proposed § 436.2 should be revised to parallel the recommended changes to proposed Item 23. As discussed in the comments on proposed Item 23, the disclosure document should be provided before signing a binding agreement with the franchisor or an affiliate, not before the signing of any binding agreement.
Proposed § 436.3(g)(1) should also be revised to parallel the recommended changes to proposed Item 23.
C. ANSWERS TO FTC'S QUESTIONS ON SPECIFIC PROPOSED CHANGES
In the interest of keeping our comments as brief as possible, we have provided cross-references to our General Comments or our Specific Comments on Disclosure Requirements where we have already addressed the substance of a particular question. On a number of specific questions, we have no comment at this time and therefore do not reference the question.
Please see our Specific Comments on Item 7, supra, page 16.
Please see our Specific Comments on the definition of "Gag clause," supra, page 13, and our Specific Comments on Item 20, supra, pages 17-18.
Please see our Specific Comments on the definition of "Predecessor," supra, page 13, and our Specific Comments on Item 1, supra, pages 13-14.
Please see our Specific Comments on Item 3, supra, pages 15-16.
In response to FTC question 14, a franchisor should only be required to disclose the specifications of any mandatory computer system to the extent known or available. Start-up franchisors may not have identified software systems before they start franchising. If such specifications are not known or available, we suggest that the franchisor should be permitted to disclose that and satisfy the requirements of Item 11.
In response to FTC question 16, Item 12 should not require franchisors to disclose their current development plans. Most franchisors legitimately consider those plans to contain proprietary information that would place them at a competitive disadvantage if they were to be made publicly available. Also, franchisors need flexibility to adapt their development plans in response to market factors. Disclosure of development plans could lead to possible claims by franchisees who anticipated greater or lesser franchise development in a particular area.
Please see our General Comments on Financial Performance Representations, supra, page 11.
Please see our Specific Comments on Item 20, supra, pages 20-21.
Please see our General Comments on Scope of Coverage, Minimum Payment Exemption, supra, page 3.
Please see our General Comments on Scope of Coverage, Large Investment Exemption, supra, page 4.
Please see our General Comments on Scope of Coverage, Sophisticated Investor Exemption, supra, pages 4-5.
Please see our General Comments on Scope of Coverage, Minimum Payment Exemption, supra, page 3.
In response to FTC question 40, the Commission should not revise the Rule to add a requirement that franchisors state in their disclosure documents the name, business address, and telephone number of the primary individuals who were responsible for preparing the disclosure document. Such a requirement would increase the risk that franchisors' counsel be named in lawsuits regarding the disclosure documents. This is likely to significantly increase the cost of complying with the Rule, as counsel may deem it necessary to independently verify all information contained in the UFOC in order to avoid potential liability. By increasing the already significant cost of compliance, the FTC would be creating significant barriers to entry in the field of franchising.
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We appreciate the Commission's consideration of our comments. We may submit rebuttal comments and appreciate the opportunity to participate in any conferences to further discuss the NPR.
HOGAN & HARTSON, LLP
Erik B. Wulff
1. Such period of review also is suggested by the Commission in connection with the thresholds established for the sophisticated investor exemption, § 436.9(e)(1).
2. § I.A.3.a., Interpretive Guides to Franchise and Business Opportunity Ventures Trade Regulation Rule, 44 Fed. Reg. 49,966 (Aug. 24, 1979).
3. In our experience, large multi-unit franchisees seldom, if ever, acquire additional franchise concepts through their existing entities, but instead establish project-specific companies.
4. The Commission might compare its proposed exemption with the Regulation D exemption under the Federal Securities Act of 1933, and in particular the definition of an "accredited investor."
5. For example, subfranchisors would be required to include in their offering circulars their own financial statements as well as those of the franchisor. This may mislead prospective franchisees to believe that the franchisor stands behind the subfranchisor financially.
6. For example, NASAA has now for some time been considering the possibility of mandating financial performance information in Item 19 of the UFOC. Yet, the Rule in other areas has expanded on the disclosure requirements of the UFOC. If NASAA mandates financial performance disclosures in the UFOC, it would then contain more extensive disclosures in one area but less disclosure in others.
7. Bus. Fran. Guide (CCH) ¶ 6227.
8. See, e.g., NPR Section B. "The Continuing Need for the Franchise Rule" at page 6.
9. Language such as "any other known material change to the information contained in the disclosure document" would provide a clearer basis of the information that needs updating and would be more consistent with state franchise laws.
10. As a point of comparison, the legal fees for the issuer in connection with a public stock offering typically are at least several hundred thousand dollars, approximately tenfold of the typical cost of preparing a UFOC.
11. This should be distinguished from the potential technical problem of negotiated sales under state franchise registration and disclosure laws where offering a franchise on terms different from those registered with the applicable state authorities might be viewed as a violation.
12. The issue of disclosure to the franchisee who negotiates the change is distinguishable from the issue of whether negotiations generally or on specific topics should be disclosed to subsequent franchisees.
13. California, the only state that regulates material modifications, requires a disclosure document that compares the agreement provisions that are being changed.
14. At most, there may be requirements for remodeling or upgrading business premises.
15. Presumably, it would include a corporation that owns all of the capital stock of the franchisor, but it is unclear whether it also includes a corporation that owns some or a majority of that stock, whether it would include an individual that owns the franchisor's stock, whether it is limited to the immediate parent, or includes an intermediate parent or the ultimate parent or all of the above.