December 29, 1999
Via E-Mail to firstname.lastname@example.org
Donald S. Clark, Secretary
RE: 16 CFR Part 436-Franchise Rule Comment
Dear Secretary Clark:
The North American Securities Administrators Association Franchise and Business Opportunity Project Group (the "Franchise Project Group" or the "Project Group") appreciates the opportunity to respond to the Federal Trade Commission's Request for Comments regarding its Notice of Proposed Rulemaking ("NPR") to amend the FTC's Trade Regulation Rule on Disclosure Requirements and Prohibitions concerning Franchising (the "FTC Franchise Rule").
The North American Securities Administrators Association ("NASAA" or "the Association") is the oldest international organization devoted to investor protection. NASAA is a voluntary association of state, provincial and territorial securities administrators from the United States, Canada, Mexico and Puerto Rico. Committees of NASAA develop model codes and guidelines for adoption by the Association. These uniform national models are made available for adoption by individual states. Members also participate in cooperative enforcement projects, information-sharing and training and education of state administrators.
Several NASAA members administer and enforce state franchise registration and disclosure laws. As a result, NASAA established a continuing project group, the Franchise Project Group, to address issues relating to franchises and business opportunities. The NASAA Project Group is the successor to the NASAA Franchise and Business Opportunity Committee. That Committee authored the current Uniform Franchise Offering Circular ("UFOC") Guidelines and previous versions of those guidelines. The Franchise Project Group studies and makes recommendations to NASAA about model acts and statements of policy that we believe will benefit investors of franchises and business opportunities and those industries as a whole. NASAA member agencies also participate in joint enforcement activities with the Federal Trade Commission to bring actions to halt unlawful practices by franchisors, sellers of business opportunities and promoters of fraudulent investment vehicles.
The following comments to specific issues presented in the Commission's NPR reflect the views of the Franchise Project Group and do not necessarily reflect the views of NASAA.
For ease of reference, the following comments of the Franchise Project Group are grouped under the same category headings as those the FTC has listed in Section H of the FTC's NPR, "Request for Comment."
"Financial Performance Representation" The Franchise Project Group believes that the FTC's proposed definition of "financial performance representation" under section 436.1(d) is clear and accurate as to the types of representations that should be addressed under the FTC Franchise Rule. The specific omission of "expense information" from the proposed definition could not reasonably be interpreted to allow franchisors to make "back door" financial performance representations in the form of expense information. In addition, based on the law enforcement experience of individual members of the Franchise Project Group, franchisors that make unlawful representations of financial performance generally make representations about earnings and rarely limit their representations to expense information alone.
"Franchise" The Franchise Project Group suggests that the elimination of what are commonly known as "business opportunities" from the definition of "franchise" under section 436.1(g) of the FTC Franchise Rule be effective only when a separate FTC Franchise Rule addressing business opportunities is adopted.
"Officer" The Franchise Project Group strongly supports the inclusion of "de facto officer" to the definition of "officer" under section 436.1(o). The law enforcement experience of some members of the Franchise Project Group reflects that franchisors and sellers of business opportunities have attempted to avoid litigation disclosures under the FTC Franchise Rule or comparable state disclosure laws by purposely not giving the title "officer" to individuals who, in fact, exercise significant management responsibility over a business.
The Project Group believes that the FTC Rule should be clear that both franchisors and individual owners of franchisors should be held liable for franchise law violations regardless of whether they knew or should have known of the violation. The FTC should consider including in the definition of "franchisor" shareholders of privately held corporations.
The Project Group agrees that the FTC's proposal to adopt a provision requiring franchisors to give disclosure documents to prospective franchisees at least 14 days before signing a binding agreement or paying a fee simplifies the timing obligations of franchisors. However, at the same time, this proposed new timing requirement creates uncertainty with regard to existing state laws that require franchisors to deliver disclosure documents earlier than a 14 day period; e.g., at the first personal meeting. Will those state requirements survive because they provide a disclosure obligation that is stricter than the proposed FTC Franchise Rule? The Franchise Project Group suggests that the FTC clarify that the FTC Franchise Rule does not affect any state law provisions requiring the delivery of a disclosure document sooner than the FTC's Rule.
In general, the Franchise Project Group believes that the proposed disclosure format contained in the FTC's Franchise Rule is a significant improvement over the existing Franchise Rule. We applaud the FTC's adoption of many of the provisions contained in the UFOC Guidelines, and we believe that, except as noted below, most of the additions and modifications the FTC has made to the UFOC are both beneficial to prospective franchisees and reasonable for franchisors to implement.
The Franchise Project Group notes that, to the extent possible, the FTC should issue interpretive guides at the same time the new FTC Franchise Rule is adopted and that those interpretive guides include sample answers similar to those found in the UFOC Guidelines. The Franchise Project Group believes that the sample answers contained in the UFOC Guidelines have been a valuable resource for understanding how the disclosure requirements should be interpreted.
The Project Group's comments to specific provisions in the NPR follow:
§ 436.4 "Table of Contents" Note that Item 6 of the Table of Contents is labeled "Other Fees" yet the text of Item 6 is labeled "Recurring or Occasional Fees." The Franchise Project Group believes that "Other Fees" is the more appropriate title for this category of disclosure. In any event, the designations should be consistent throughout the proposal.
§436.5(c) "Franchisor Initiated Litigation" The Project Group believes that the FTC's proposal to include additional information about franchisor initiated litigation fills a significant void in the UFOC Guidelines. The Franchise Project Group suggests that if the FTC seeks to limit the scope of this new disclosure at all, its proposed 5% threshold would be an appropriate limitation, i.e., a franchisor should report all litigation against franchisees when that franchisor commences any civil action against 5% or more of its franchisees in a year. In contrast, the mere listing of the number of such actions is insufficient to inform a prospective franchisee of this potentially material information.
§436.5(f) "Recurring or Occasional Fees" The FTC should consider closing a gap in the UFOC Guidelines by requiring disclosure of required fees paid directly to third parties, e.g., local advertising requirements, yellow page advertising expenses, costs of attending training and conventions, fees for obtaining audited financial statements and mandatory store updates or remodeling. These fees are not required to be disclosed in UFOC Item 6 and may reflect a material ongoing expense for franchisees.
§436.5(o) "Obligation to Participate in the Actual Operation of the Franchise" The FTC should consider expanding the disclosure under this heading to include operating hours and the method used by franchisors to notify franchisees of changes in required operating hours.
§436.5(s) "Financial Performance Disclosure" The Franchise Project Group believes that proposed section 436.5(s), "financial performance disclosure," may discourage franchisors who choose to make lawful financial performance disclosures from doing so. The Project Group continues to believe that financial performance information is among the most important disclosures in a franchise relationship. As the FTC is not inclined to mandate disclosure of financial performance information, the proposed Franchise Rule should be crafted to encourage franchisors to voluntarily make these disclosures in greater numbers.
Footnote 13 to the FTC Franchise Rule requires that historical financial performance data used as part of this disclosure "must be prepared according to U. S. generally accepted accounting principles ("GAAP")." This requirement goes well beyond what is currently required under the UFOC Guidelines.
Based on the experience of states that register franchise offerings, many franchisors that currently include historic financial performance data in UFOC Item 19 may not prepare them according to GAAP. In some instances, a franchisor's historic financial performance data presented may be accurate and material, yet may not be presented according to GAAP. In many other instances, the franchisor may not be aware whether the data presented is according to GAAP. This requirement likely would discourage franchisors that have a factual basis for making financial performance disclosures from doing so. In addition, this requirement likely would increase costs to franchisors who do choose to make historical financial performance disclosures by requiring them to obtain an accountant's opinion as to whether their data is presented according to GAAP.
Proposed section 436 (t) (Item 20-Outlets and Franchisee Information) The Franchise Project Group has sought to remedy the "double counting" problem identified in the FTC's NPR within the context of the existing UFOC Guidelines. After much effort, the Project Group recognized that UFOC Item 20 should be revised in its entirety. The Project Group, along with members of its Industry Advisory Committee, has prepared and debated several alternatives to the current UFOC Item 20 in the hopes of proposing a new Item to the UFOC. Because the FTC Rule's disclosure requirements, once adopted, will replace the UFOC Guidelines, the Project Group offers its version of a new Item 20 for the FTC's consideration.
The Franchise Project Group believes that the FTC's proposed section 436 (t) does resolve several problems found in UFOC Item 20. The Project Group suggests, however, that the proposal does not achieve the goals asserted in the Rule Review and that the Franchise Outlet Summary Chart, as presented, may be unduly complicated.
The Project Group believes that the proposed adoption of a "first in time" approach to multiple reportable events is flawed. Instead, the Franchise Project Group suggests that when a franchise outlet experiences multiple events that should be reported under Item 20, the last event to occur should be reported, not the first. In almost all cases, the last event to occur is the most significant to the affected outlet. If, for example, a franchisor sends a notice of termination to a franchisee, but the franchisor later agrees to repurchase the outlet for consideration, the franchisor should report that outlet as a reacquisition. The franchisee who sold the outlet, and prospective franchisees reviewing the outlet's history, would surely consider the last event as the most significant.
Within this framework the Franchise Project Group proposes that Item 20 should contain four tables: one to indicate a system-wide snapshot of franchise outlets; one to indicate outlet transfers; one to summarize franchise outlets; and one to summarize company owned outlets.
Except where specifically noted otherwise, the terms contained in the tables set forth below may be defined as the same terms are defined in the FTC's Franchise Rule.
Table No. 1
Table No. 1 reflects the status of the franchisor's system as of the beginning and end of each year. This table summarizes the most material data from the other charts and presents it in a simple, "snapshot" presentation.
The number of outlets listed in this chart are included for illustration.
Table No. 1
Table No. 2
Table No. 2 reflects transfers of franchised outlets. The Project Group believes that transfers should be reported separately from terminations and non-renewals. Transfers do not affect the total number of outlets in a franchise system, yet the number of transfers in a franchise system may be valuable information. While some transfers are problematic for franchisees or prompted from disputes, many other transfers simply reflect a desire on the part of the franchisee to cease operating a franchise or to pursue other opportunities.
Table No. 2
Table No. 3
Table No. 3 tracks the a franchisor's turnover rate of franchised outlets. The "last in time" approach resolves the double counting problem and requires reporting of the event most significant for purposes of assessing accurate and verifiable turnover.
For purposes of Table No. 3, the columns entitled "Outlets at Start of Year"and "Outlets at End of Year" would contain the same information as is contained in Table No. 1.
The term "Outlets Opened" would include both new outlets opened as well as outlets that a franchisee purchased from the franchisor to be operated as a franchised outlet.
The term "Ceased Operation Other Reasons" would include outlets that ceased to operate because of the franchisee's decision not to renew and outlets that ceased to operate because the franchisee terminated its franchise agreement on its own initiative.
Table No. 3
Table No 4
Table No. 4 is the summary for turnover of company-owned outlets. Column 4 should be the same as Column 6 in Table 3. Column 5 should include both actual closures and instances when an outlet ceases to operate under the franchisor's trademark. The data in Columns 2 and 7 should be the same as the data reported in Table No 1.
Table No. 4
Finally, with regard to the Item 20 disclosure of franchisees that have been terminated, canceled, not renewed or otherwise voluntarily or involuntarily ceased to do business under their franchisee agreement, the Franchise Project Group suggests that the FTC consider requiring franchisors to list the reason why each franchisee on this list terminated, canceled, did not renew or ceased to do business. This information is clearly material. In some cases, prospective franchisees may not be able to contact the franchisees named in this list. In some cases, those franchisees may be unwilling or unable to provide this information to prospective franchisees.
§436.5(u) "Financial Statements" The FTC should consider requiring franchisors to include a copy of an auditor's consent form along with the franchisor's financial statements, when audited financial statements are required. The instructions to this provisions should likewise require the franchisor to include the date of its financial statements . In addition, the FTC Rule should require that those financial statements be prepared within 90 days of the issuance date.
In addition, the Project Group suggests that the term "start up franchise systems" is unclear and should be defined. If a major corporation that has been in business for many years and then begins to franchise, that corporation should not enjoy the same exemption from disclosing audited financial statements as a new company that just organized as a true "start up franchise systems" (see also Item 21(2)(iv)(A), relating to a specific disclosure that a "franchisor has not been in business three years or more"). The Project Group suggests that franchisors that have been in any type of business for three years or more, not just the business of selling franchises, should be required to provide audited financial statements.
The Project Group notes that the FTC proposes to require that financial performance disclosures be prepared according to GAAP. There is no similar requirement that a franchisor's unaudited financial statements to be included in the disclosure document must be prepared according to GAAP. The Project Group suggests that because financial statements are required of all franchisors, those statements should be prepared according to GAAP. Because the FTC does not mandate disclosure of mandatory financial performance information (and because that disclosure is very different from a financial statement), Item 19 information should not be required to be prepared according to GAAP.
"Receipt" The FTC should clarify that the acknowledgment of receipt page should be placed as the last two pages of the franchisor's disclosure documents. The States that review franchise offerings have noted many instances where this page was buried in the middle of the disclosure document.
Based on the Project Group's informal survey of states that register franchise offerings, states generally do not object to a franchisor's offering a franchise disclosure document in an electronic form, so long as the franchisee retains the choice of an electronic or paper disclosure. The Project Group continues to study recommendations regarding issues related to electronic disclosures and possible electronic registrations. The Project Group believes that the technology surrounding the Internet is so fast moving that a specific policy must be susceptible to frequent updating.
§436.9(e)(1) "Sophisticated Franchisor Exemption" The Franchise Project Group suggests that the FTC's proposed $1.5 Million threshold for establishing a new sophisticated franchisor exemption may not be sufficient to exempt the types of sophisticated franchisors the FTC intents to exempt. The Project Group believes that even "unsophisticated investors" as that term is discussed in the NPR, may have access to $1.5 Million to invest in a franchise. The Project Group suggests that the more appropriate threshold for unsophisticated investors is at least $3 Million.
"Integration Clauses" and "Waiver Provisions" The Franchise Project Group believes that integration clauses and waiver provisions in franchise agreements and disclosure documents have served as mechanisms for franchisors to avoid liability for disclosure violations. The Project Group supports proposed Section 436.10 (e), which would prohibit franchisors from disclaiming any statements made that conflict with the franchisor's disclosure document or franchise agreement. Based on the law enforcement experience of franchise registration states, the vast majority of franchise agreements contain some type of waiver or integration provision purporting to insulate franchisors from liability for oral and other representations that conflict with the required disclosure document or franchise agreement.
A survey of reported and unreported decisions should reflect that franchisors have been successful in using contractual integration clauses and waiver provisions to defend, at the earliest stages of litigation, many lawsuits brought by franchisees alleging disclosure violations. See, e.g., Motor City Bagels, LLC v. The American Bagel Company, 50 F. Supp. 2d 460, 474 (D. Md. 1999) (granting franchisor's motion for summary judgment on fraud count relating to alleged misrepresentations of average store sales; based on integration clause in franchise agreement, franchisee's reliance on the oral claim was unreasonable as a matter of law).
The Franchise Project Group believes that the FTC's approach to bar franchisors from using these protections is necessary and appropriate considering the fundamental purposes of state and federal franchise disclosure laws. In the experience of the Project Group, waiver provisions serve an appropriate purpose under the existing regulatory scheme only when used to settle an ongoing dispute between a franchisor and franchisee.
The NASAA Franchise and Business Opportunity Franchise Project Group appreciates the opportunity to comment on these issues.
NASAA FRANCHISE AND BUSINESS OPPORTUNITY PROJECT GROUP
Dale E. Cantone, Chair (MD)