|December 22, 1999
RE: 16 CFR Part 436 - Franchise Rule Comment
Please include these comments for consideration as the Federal Trade Commission (the "FTC" or the "Commission") commences its rulemaking to amend its Trade Regulation Rule entitled "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures (the "Franchise Rule" or the "Rule")." The American Franchisee Association (AFA) is a national trade association of small business franchisees, representing 16,000 individuals who own over 30,000 franchised outlets in 65 different industries nationwide.
1. The Commission stated on page six of its Notice of proposed rulemaking that " the record does not support the Commission's ability to broaden the Rule to address substantive franchise relationship issues." The Commission further states on page six that " franchise relationships are matters of contract law that traditionally have been regulated at the state level. Indeed, several states, even those without franchise disclosure laws, have some type of franchise relationship law."
The implication of these statements is clear. First, the FTC will not and cannot address all of the issues current franchisee members of the American Franchisee Association (AFA) deem substantive. Therefore, the AFA will continue to seek legislative solutions to franchisee problems.
Second, the FTC seems to justify their limited jurisdiction over franchisor-franchisee relationship matters in part by using the cover of a variety of state disclosure and relationship franchise laws--what the AFA and others call a "patchwork quilt" of state franchise laws. A recent decision by the U.S. District Court for the Eastern District of New York (Paging Source of New York, Inc. v. Sprint Spectrum, L.P., E.D.N.Y., No. CV 99-7241, 11/19/99) shows just how useless that patchwork quilt is to current franchisees.
While the franchisee's business was based in New York, the franchise agreement contained a Missouri choice of law clause dictating that disputes between the parties arising from the agreement were to be resolved according to the laws of Missouri. The judge noted that the increased use of franchising as a marketing system "has led many state legislatures to adopt statutes to protect franchisees from abusive conduct, such as termination following substantial investment of money and time to develop a local market for the franchisor." However, the court held that since Missouri's franchise law does not cover non-Missouri franchisees like Paging Source, Sprint could in fact terminate the franchisee with 30 days' written notice, not 90 days' notice, as required under Missouri law--and without showing cause for the termination.
"There is no contention that such a result would be anathema to Missouri's (or New York's) common law of contracts," the judge wrote. Paging Source of New York v Sprint Spectrum clearly demonstrates that the patchwork quilt of Federal Rule and state laws does not protect the franchisee investor as was intended.
2. The Commission states on page 7 that " prospective franchisees could avoid harm by comparison shopping for a franchise system that offers more favorable terms and conditions ". The AFA does not believe that comparison-shopping is an alternative in most, if not all, of the industries that use franchising as a distribution method.
In a paper written by Eric Karp, Esq. Witmer, Karp, Warner & Thuotte LLP, Boston, MA and Dr. Frank Wadsworth, Indiana University Southeast, New Albany, IN entitled "Holding a Gun to Your Head: Marketplace Monopoly--How Pizza Franchisors Play the Game," (American Franchisee Association (AFA) 1999 Legal Symposium), the authors conducted a comparative analysis of the top eight pizza franchisors' franchise agreement contract terms. The authors stated, " for all the many details that differentiate the agreement offered by one franchisor from that offered by another, three themes exist throughout each sample contract and among them all that characterize the nature of the agreements being offered: unbridled discretion in the hands of the franchisor, unlimited calls on the franchisee's capital and asymmetry of the rights and obligations of the two parties."
The authors further state, "What the totality of the findings in this paper demonstrate is that, in fact, few alternatives exist If a franchisee wants to open a pizza store that will be recognized by the general public, it must contract with one of the top eight pizza franchisors and, among those eight there is little meaningful variation in the terms of the franchise agreements offered."
The fact that the FTC suggests that buyers of franchises look elsewhere for " more favorable terms and conditions " is not dealing with the reality of buying a franchise in today's take-it-or-leave-it marketplace of franchise contracts.
3. The Commission states on page 11 that it wants franchisors to " understand fully that the Rule covers the making of implied financial performance representations." This is not surprising. According to the Commission, of the franchise complaints that the FTC acted upon and cited by the General Accounting Office (GAO) in its July 1993 Report regarding the Enforcement of the Trade Regulation Rule on Franchising, 99% alleged false or unsubstantiated earnings claims.
However, the failure of the Commission to require franchisors to furnish prospective franchisees with a "financial performance representation" (a.k.a. an "earnings claim") remains a fatal flaw of the Rule. It is inherently misleading (by omission) not to disclose historical financial performance information when it exists.
Franchisors have had over twenty years to voluntarily provide earnings information and the vast majority has not done so. Why not? Because the market that buys franchises that are unprofitable runs out of money, goes out of business and wants nothing more than to leave their shameful franchise experience behind. Former franchisees are consumers who have suffered significant economic harm yet the Commission does not yet think a franchisor's failure to provide earnings information in these cases is necessarily deceptive or unfair.
No franchisor should be exempt from such disclosure. Start-up franchisors supposedly have a "proven" business system that they are offering to prospects. That proven business system should, obviously, have one or more operating prototypes. Start-up franchisors should not be exempt from supplying historical earnings information about one or more operating prototypes.
Finally, the great untruth that franchise salespeople have been allowed to perpetrate over the years is the following statement in one form or another--"the federal government prohibits us from giving you information regarding the financial performance of [name of our] franchises." There is no federal Rule or state law that prohibits franchisors from disclosing earnings information. In the interests of full and complete disclosure, therefore, a franchisor's salesperson should be required to state; "Financial performance information is a voluntary disclosure. Our chain, [name of franchise system], has volunteered NOT to disclose that information."
1. Proposed section 436.1(k)("Gag Clause"). The use of gag clauses becomes a
disclosure issue because franchisors do not put in their disclosure documents statements like the following: "Upon expiration / termination / non-renewal of your franchise we may [will] require that you sign a confidentiality statement agreeing not to talk about your experience in the [name of] franchise system, whether positive or negative, with anyone outside of the [name of] franchise system including the public, the media or the government."
Certain franchisor attorneys claim that their law firms do not use gag rules. They further claim that the disclosure of franchisees under gag clauses will cause enormous administrative problems for their clients. We don't follow their logic. If these law firms don't use gag rules then it follows there will be no administrative problems for their clients.
AFA members came forward and identified for the Commission a variety of examples of themselves and other outgoing franchisees being forced to sign their franchisors' gag clauses. Several franchisees who put their comments on the record for the Commission stated that their chains use gag clauses 100% of the time for franchisees who wish to sell or transfer their franchise. These gag clauses typically release the franchisor from legal liability and bar the franchisee (under threat of legal action) from making any oral or written statements about the franchise system or their experience with the franchised business. The purpose of such clauses is to shut down any negative public comment about the franchise system.
Not surprisingly, none of the AFA franchisees who came forward and put their comments on the record for the Commission had a problem with signing confidentiality agreements created to protect a franchisor's trade secrets and other proprietary information. However, none of these franchisees saw disclosure of the use of gag clauses as a condition of a franchisee's exiting the system in the offering circular / prospectus that they received from the franchisor, either.
2. Proposed section 436.3: The Cover Page. The cover page language that
deputizes prospective franchisees to rout out the flaws / errors in the offering circulars they have received is ludicrous. First-time franchisees are often not experienced businesspeople. In fact, they acquire franchises precisely because they realize they lack experience in operating a business. They are consumers of the American dream of entrepreneurship. They have bought into the dream of owning their own business and are willing to invest large sums of money to learn. They are not told that they are, in fact, not purchasing a business. They are not told that they are, in fact, leasing the rights to sell goods or services under the franchisor's tradename, that this arrangement will expire at some point in the future and they will have to start from ground zero with the franchisor to continue to "lease" the business from them.
The AFA recommends the Commission include the following statement on the offering circular's cover page: "You will not own your own business. You will lease the rights to sell [company's name] goods [services] to the public under the [company's name] tradename and trademarks. This agreement will expire and you will have no rights to continue in operation upon expiration."
Finally, to strengthen the consumer education message the FTC Rule gives and clarify the cover page's consumer education message, we propose replacing the current Rule language ("If possible, show ") with a stronger "Show your contract and this disclosure document to an attorney, preferably one who practices franchise law. Show the disclosure document, in particular the sections regarding your financial obligations and the franchisor's financial statements, to an accountant."
3. Proposed section 436.5(c): Item 3 (Litigation). The AFA is in agreement with the Commission that broader litigation disclosures are warranted to alert prospective franchisees to potential problems in the franchise relationship. The AFA believes that franchisor-initiated litigation is material to prospective franchisees because it identifies a problem or patterns of problems in the franchise relationship as well as the extent to which the franchisor is inclined to use litigation to resolve disputes.
The notion that an expanded Item 3 would "bulk up" disclosure documents causes the AFA great concern. Are there that many franchisor-initiated lawsuits that their inclusion in disclosure documents would cause an increase in compliance costs? What are franchisors doing (or not doing) which results in so many lawsuits that by sheer numbers their inclusion would increase the bulk of their disclosure documents?
If franchisor advocates are concerned about a "bulked up" disclosure document then why would limiting the scope of disclosure, by providing that a franchisor would not have to make this disclosure unless it had sued a certain percentage of its franchisees, help the situation?
The Commission has a choice--to save franchisors a few pennies on a slightly larger offering circular or to save a franchisee from investing hundreds of thousands of dollars in a franchise that he / she might not had invested in if he / she would have known about all of the franchisor-initiated lawsuits against its own franchisees.
4. Proposed section 436.5(h): Item 8 (Restrictions on Sources of Products and Services). It is insufficient disclosure to merely inform a potential franchisee that they can or cannot source products from suppliers not affiliated with the franchisor. Full and complete disclosure requires franchisees be told what really happens when they bring a product / item to be approved under the franchisor's approval process. The following examples should be disclosed to the prospective franchisee in Item 8: "We have been known to take up to one year or more to approve a non-franchisor-affiliated vendor;" or "We have been known to change the specifications for [specific product] during the approval process. This has caused delays of between [number of days / weeks / months / years] to [number of days / weeks / months / years]."
Finally, franchisors who refuse to allow franchisees to source products from suppliers not affiliated with the franchisor should be required to disclose the following: "Requiring you to purchase solely from approved vendors leaves the determination of your gross margin arbitrarily in [our hands] / the hands of the franchisor."
5. Proposed section 436.5(k): Item 11 (Franchisor's Assistance, Advertising, Computer Systems and Training). The Commission should require franchisors to disclose the extent to which franchisors can withhold operating and other forms of assistance to its franchisees. We suggest language similar to the following: "Your franchisor, regardless of what it has told you, reserves the right to receive your [number] percentage royalty [gross margin] payment while providing you with absolutely no franchise services."
6. Proposed section 436.5(q): Item 17 (Renewal, Termination, Transfer and
Dispute Resolution). The Commission states on page 41 that "renewal appears to be a term of art that is well understood in franchising circles." Prospective franchisees are not familiar with the "artful" ways of those in franchising circles. Therefore, the term "renewal" is a misnomer to a prospective franchisee. He or she asks the franchisor's sales representative, "what happens at the end of my [number of years] contract?" The sales representative typically answers with a variation of "don't worry, we'll renew you." Prospective franchisees are told if they are not in default, they will most likely get to sign the then-current contract--another "artful" term of those in franchising circles.
Most franchisees find that when it is time to renew, they are not renewing or extending their current franchise agreement, but are presented with a wholly new agreement, often with materially different financial and operational terms. These "renewal" contracts are presented on a take it or leave it basis and are under various pressures to sign--particularly when the old agreement contains a post-termination covenant not to compete. Renewal means, "press hard, there's three copies." There is no negotiation. There is no equal bargaining power. This is truly holding a gun to the head of the renewing franchisee.
"Re-franchise," "re-license" or "re-write" may be a more accurate description of what actually happens at the end of the initial contract term. Or, in the interests of full and complete disclosure, the franchisor can state in the offering circular, "You do not own your own business. Your are leasing the rights to sell our goods / services to the public under our trade name. At the end of your initial [number of years] term, your current contract will expire [terminate]. You will have the choice of signing a new contract with us at the time of expiration [termination]. The new contract will be written by us with no input from you and will] contain materially different financial and operational terms."
Also, in the interests of full and complete disclosure, the Commission should consider having franchisors insert the following language with regard to franchise transfers: "You cannot transfer this agreement without your franchisor's approval. Your franchisor has the right to be completely unreasonable in denying your request for a transfer." This more accurately portrays the reality of what occurs for the majority of franchisees who try to transfer their franchises.
7. Franchisee Association Issue. The American Franchisee Association (AFA) fully
supports the Commission in its proposal to include the name of the independent franchisee association(s) affiliated with the chain, the contact person's name, address and telephone, facsimile and e-mail numbers provided the independent franchisee association makes its existence known to the franchisor no less than annually for inclusion in the franchise system's offering circular. The franchisee association can notify the franchisor no less than 90 days prior to the close of the franchisor's fiscal year of the name of the independent association(s), the contact person, etc. in order to be included in the most current version of the franchisor's offering circular / prospectus.
The AFA, however, does not believe that the franchisee association should have to ask the franchisor to be included in the offering circular / prospectus. The franchisee association should merely have to notify the franchisor of their pertinent information to be included in the prospectus. Having to "ask" the franchisor implies that the franchisor can refuse the request.
8. Proposed section 436.10(e): Disclaimers. The AFA fully supports the FTC's proposal that franchisors can no longer disclaim liability for, or cause franchisees to waive their reliance on, statements made in the franchisors' disclosure documents. The integrity of a franchisor's disclosure document is critical to prospective franchisees. The prevalent use of integration clauses to disclaim liability for required disclosures undermines the very purpose of the Rule, which is to prevent fraud and misrepresentation in the pre-sales process by ensuring prospective franchisees have complete and truthful information from which to make sound investment decisions.
If disclosure under the current scheme of Federal Rule and patchwork quilt of state law was all that was needed to right the informational imbalance between franchisees and their franchisors, then the American Franchisee Association (AFA) would never have come into existence.
If disclosure of material information to prospective franchisees is based on the theory that an informed consumer will then be equipped to determine whether a franchise deal is in his or her best interest, then the Commission must take all steps necessary to ensure that lay people can understand what they are getting into. This means that franchisors must use plain English (not use their "artful" franchise terms) and come clean with the public that franchisees do not, in fact, own their own businesses. Franchisees are leasing the rights to sell goods or services under the franchisor's trade name and trademarks.
If disclosure is ever to be considered adequate to "regulate" franchising, then when called upon to do so by Congress, Commission staff must go on the record in favor of providing a private right of action under the FTC Rule.
It is the experience of AFA member franchisees after they sign their contracts with franchisors that tells us that the current scheme of pre-sale disclosure is wholly inadequate in protecting their interests. Only with the establishment by law of federal standards of conduct for both franchisors and franchisees to abide by after the sale will there be the necessary balance to ensure that franchising is a safe vehicle for consumer investment.
Susan P. Kezios