December 21, 1999
RE: 16 CFR Part 436 -- Franchise Rule Comment
I am an attorney whose practice is over 80 percent dedicated to franchising. I have represented exclusively franchisees in dispute resolution (litigation and arbitration) proceedings since 1981. Somewhat unique to the franchise bar, however, I also represent a number of small franchisors in their transactional work. In other words, I prepare franchise agreements, disclosure documents and related state registration and compliance documents. A significant part of my practice is advising prospective franchisors and prospective franchisees about the nature of the relationship they are contemplating creating or entering into. I am a member of the American Bar Association Forum on Franchising and serve as a member of the Franchise Advisory Committee to the Franchise Working Group of the North American Securities Administrators Association. I am an Affiliate Member of the American Franchisee Association and a founding member of the Franchisee Lawyers Association.
I will attempt to organize my comments by section and, along the way, address most of the general and specific questions posed by the Commission in the NPR.
Generally, the proposed definitions are an improvement over existing FTC definitions and over the UFOC definitions. I do have several suggestions for further refinement:
(d) Financial performance representations.
Use of the words "states or suggests" leaves out the possibility of providing fragments of information from which a prospective franchisee could readily estimate or calculate earnings expectations. I would suggest adding language such as "or from which a prospective franchisee could readily estimate or calculate" following the word "suggests".
The Commission has asked specifically for comment on whether the omission of "expenses" from this definition is well advised. I think not. Admittedly, this raises one of the central flaws in the Commission's proposed rule. In 18 years of talking with thousands of franchisees, I have never met a franchisee who did not receive financial performance information, either directly or indirectly, from the franchisor before entering into their first franchise agreement. Rational people simply do not make such investments without having some idea, from the seller of the opportunity, that they can reasonably expect to make more money than they are investing. If franchisors have (or reasonably should have) access to historic financial performance data from either company stores or franchised outlets, that information is critically material to every prospective franchisee as the Commission has defined that term in 436.1 (n). This is even more critical in the approximately 75% of all franchise offerings where the historic information would indicate that the prospective franchisee cannot expect the franchise system (much less the franchisee's business) to survive for the next five years.
Even though the failure to provide such material information to a prospective franchisee is or clearly should be a violation of the general section 5 requirement of full disclosure of material facts, the failure to mandate disclosure of available historic financial performance data will continue to make franchisors feel that they can avoid liability for hiding critical and material information from prospective franchisees--because the Rule, itself, says they do not have to provide it. It certainly is a violation of all of the applicable state anti-fraud laws (modeled after securities rule 10(b)(5)) to fail to disclose a material fact the disclosure of which is necessary, in light of other information given, in order to not mislead or work a fraud or deceit on the prospective investor. By declining to confront the industry and require disclosure of available material information regarding the historic financial performance of comparable businesses, the Commission will miss its greatest opportunity to require franchisors to make truly meaningful pre-sale disclosure to prospective franchisees.
The issue of leaving the reference to "expenses" out of the definition of "financial performance information" while requiring certain limited expense information in Items 6 and 7, brings the problem with the Commission's proposed methodology into clear focus. The Commission appears to acknowledge that the expense information provided in Items 6 and 7 does not bring with it all of the protections of such information if it were presented in Item 19. In fact, it can be deceptive, inter alia, by leading a prospective franchisee to believe that Items 6 and 7 overstate operating expenses because of the focus on the start-up period. However, because that is all of the expense information they officially have, they, inevitably, try to extrapolate information from those figures--often under the guiding hand of the franchise sales person.
In addition, because certain expense information is provided to prospects in Items 6 and 7, that opens the door under both the general section 5 requirement of full disclosure of material facts, under the state "anti fraud" laws, and under the common law fraud duty to speak doctrine (each of which embraces the concept that, if you open the door by providing some information, then you have a duty to speak all of the rest of the truth so as to not mislead the recipient of the information). By failing to require franchisors to disclose available historic financial performance data, the Commission is placing its implied approval on franchisors continuing their behavior of providing only the "favorable" portions of the information.
All of this is not to say that the Commission could not make allowance for those unique situations where the franchisor does not have reasonable ability to obtain financial performance information. Those are in two categories: (a) new start-up franchisors with no historic information; and (b) existing franchisors with very old contracts that may not permit them to obtain such information from their franchisees. The Commission could excuse either or both of those classes from the requirement, but require them to provide a prominent, bold faced, warning to the effect that:
The first two components of the definition are good. With regard to the third component, it needs some improvement. I recommend that the Commission revise the third element as follows:
Without this additional language, franchisors will expand an existing practice of establishing companies that do not meet the strict definition of "affiliate" (for example, owned by a spouse or other family member) and requiring, in practice if not by contract, that the franchisee deal with that company--often without any disclosure as to the connection. Failing to close this door leaves every "scam artist", as the Commission describes them, with a road map for avoiding any compliance with the Rule because the franchisee pays absolutely nothing to the franchisor or any "affiliate". It becomes irrelevant that the money ultimately benefits the same family or organization.
(h) Franchise seller
Use of the term "franchise seller" is an improvement, making it clear that anyone who is involved in the offer or sale of a franchise is responsible to comply with the Rule. The exclusion relating to franchisees who sell their own outlets is, however, a serious problem as written. Although I could articulate policy reasons for just eliminating the exclusion--based upon the need of every prospective franchisee to receive truthful information regardless of who they buy from--I think it is important to narrow the exclusion to deal with what, I believe, the Commission is trying to cover. That is, individual franchisees who are selling all of their interest in the franchise and who have no other relationship with the franchisor and who are doing it as an isolated transaction. The problem is the practice conducted routinely, by at least several large national franchisors, of setting up what are, in fact, subfranchisors who are obligated to open a certain number of outlets in their territory and then turn around and sell them (on the theory that each is a "franchisee" who is selling "only their own outlet"). They take the position that each sale is an isolated sale even though, over time, they may sell dozens--all without complying with the disclosure and applicable registration requirements. I propose language such as: "It does not include franchisees, who are not otherwise franchise sellers or affiliated with or under any other contractual relationship with the franchisor who sell their complete interest in all of their own outlets." It is important to not give scam artists an easy avenue to circumvent the Rule--by simply setting up their defacto subfranchisors to "sell their own outlets"--and to do it repeatedly, without disclosure.
(k) Gag clause
I applaud the Commission's proposal to require disclosure of the fact of gag clauses. The definition of "gag clause" appears to me to adequately address the issue, although the Commission needs to leave open the possibility that such a new term may need further adjustment a few years down the road. The problem with the definition, again, is the exclusion in the last sentence. All a franchisor would have to do is force each franchisee who signs a gag clause to sign language in which they agree that the gag clause, itself, is "other proprietary information" and they would feel some comfort in not making disclosure as required. There may be some policy justification for keeping disclosures short by not disclosing agreements that merely protect trademarks or proprietary information, but the proposed language would allow non-disclosure of any gag-order (even if it contained otherwise required disclosures) if you just add a paragraph that purports to protect "trademarks or other proprietary information." The better approach would be to exclude confidentiality agreements that "only" or "merely" protect such proprietary information and then specifically state that gag clauses, themselves, can never be proprietary information.
The provisions relating to the "internet" have a number of problems. I will try to deal with some here and some later in addressing the substantive provisions (Section 436.7). Initially, I would call the Commission's attention to the fact that the only defined term in this area is "internet", yet, when you reach Section 436.7, the principal operative term (although not used consistently) is "electronic communication". Acknowledging that this is a rapidly evolving area of technology and law, and accepting the fact that the word "internet" has a certain cache in the 1990s, I recommend trying to avoid using that word--instead using the term "electronic communication". I would define "electronic communication" broadly to include:
The italicized portion should be all the definition needed--because of how broad and all inclusive it is. However, I think that, in the interest of clarity, it is wise to continue to use the additional descriptive or exemplary language for a few years--until the industry gains experience with just how broad the proposed definition is.
If you, thus, more broadly define the concept of "electronic communication", you probably have included most, if not all, of the foreseeable future developments in communications technology. I am concerned, for example, that the Commission's proposed definition may not encompass either personal communications devices (such as the Palm Pilot) or so-called "internet ready" cellular telephones, each of which may develop the capacity to transmit or receive sufficient amounts of data at such efficiency levels that they are competitive with the devices that are included in the Commission's proposed definition. Keep in mind that, with evolving technologies and our propensity for re-naming things when there is even a slight change, the term "internet" may become as obsolete within five years as the term "floppy disk". I recommend that the Commission focus the definition, as I have proposed, on the functionality of the communication of "written" information as the Commission has proposed to define that word.
I like the Commission's approach to defining "officer". One suggestion that has worked well in the Washington law: Instead of creating room to argue forever over whether a person has "significant management responsibility . . .whose title does not reflect the nature of the position", which appears to virtually require proof of fraud, I suggest simply replacing that awkward language with the simple concept that an officer includes any "person in act of control of" the relevant functions of the entity.
(u) Required payment
One of the most effective sales techniques is to persuade a prospective buyer or investor to make some commitment of time or money to someone--anyone--in connection with the proposed transaction. Having made that preliminary tangible commitment, the prospect is much more likely to proceed with the deal than had he or she not "committed". In franchising, it has become common to use the "takeaway close" to entice prospects to travel to the franchisor's headquarters as a condition precedent to receiving the disclosure document. Likewise, we see instances of franchisors requiring a franchisee to contract with or pay for demographic or real estate services with technically "unaffiliated" entities as a condition precedent to being "approved" as a franchisee. Having thus invested several hundred to several thousand dollars and substantial time in pursuing the franchise opportunity, the prospect is "hooked". He or she knows that, if they back out now, they lose their sunk investment. It changes the dynamics of the negotiation in a material way.
To address the problem of requiring payments to third parties, I suggest modifying the definition of "required payment" to include, after the word "affiliate", the words:
(v) Sale of a Franchise
This definition reveals the second most material flaw in the Commission's proposed rule. As the Commission has acknowledged repeatedly, there is no agreement on what the term "renew" means in franchising. There seems, however, to be a general acknowledgment that it means something different to the lay person who is the prospective franchisee than it does to lawyers for the franchisors. The prospective franchisees that I talk with (and most people who have been franchisees for less than a full term) understand the word "renew" to mean that they will be able to continue, uninterrupted, in their business for a reasonable number of terms with no material adverse changes in the agreements governing the relationship--such as territory, goods and services offered, capital expenditures, and required fees. Ordinary people are shocked to learn that "renewal" in a franchise document tends to mean that they get to decide, after three to ten years, whether to sign a brand new and materially different and adverse form of contract or to lose substantially all of the value of their investment and years of labor--because they cannot continue in the industry after termination or non-renewal. In my experience, most prospective franchisees do not and would not invest in a franchise if they knew the truth about how franchisors define that one word. That becomes a very material fact that every franchisor should be required to clearly disclose.
There are three ways to deal with the issue: First, the Commission could prohibit use of the word "renew" and its derivatives in favor of "plain English" that explained the franchisee's rights and obligations at the end of the term; Second, the Commission could define the term "renew" and its derivatives to mean "the continuation of the franchise relationship with no interruption under terms and conditions that do not differ materially from the previous agreement" and prohibit any other usage; or Third, the Commission could require a clear and precise disclosure (such as the mandatory language at the beginning of Item 11) regarding the post-term rights. Any approach would work. However, because of the Commission's reluctance to touch contract terms and because of the wide range of usages of the "renew" words from state to state, the best approach would be to require more clear disclosure of the real post term rights of the parties.
To that end, I propose a separate (apart from the table) section at the beginning of Item 17 that would require language such as the following unless it was specifically inapplicable:
436.2 The Obligation To Furnish Documents.
This section of the proposed Rule raises a number of questions.
First, this section should contain a reminder of the obligation of the franchisor to update the Disclosure Document, if applicable, as of the time of the Sale.
Second, subparagraph (a) (1) should be modified as follows:
This language deals with the sales technique discussed above whereby the franchisor requires the prospective franchisee to travel to the franchisor's home office before the franchisor will provide a copy of the Disclosure Document or other information the individual needs to make a decision. Another version is the requirement that the prospective franchisee hire a demographer, business advisor or real estate advisor before they can be further considered and receive the Disclosure Document. The purpose, of course, is to induce or require the prospective franchisee to make some investment in pursuing the particular franchise opportunity, thus causing the person to feel that they have wasted their money if they do not go through with the deal. It also permits the franchise sellers to "corner" the prospective franchisee, wine and dine them in a distant city, free from distractions such as advisors and family members, and convince them, subtly or otherwise that their financial future will be much brighter if they can just "qualify" as a franchisee of the system. As the limousine drops them off at the airport for the return flight, they receive the Disclosure Document with an admonition that they can use it to induce sleep on the flight home. No one tells them that will be their one and only ride in a limousine.
This also would further the goal of the Commission of providing meaningful disclosure before the prospective franchisee makes an investment decision. When cash is flowing from a prospective investor's pocket at the direction of the franchisor or franchise seller, it matters not that it is flowing to some third party. It is still a required investment of resources as a condition of obtaining the perceived valuable franchise rights.
Third, the elimination of the "first meeting" requirement, although done for good reasons, creates a potential problem in light of the sales techniques used by franchise sellers. It is well known that the first communication people receive regarding a subject is the most likely to persuade them. In law school, we called it the rule of primacy. In marketing schools, they use other terms. The Bible acknowledged it in saying that "if you train up a child in the way he should go, when he is old he will not depart from it." In life, it means that, if our first contact with an investment opportunity is a ride in a limousine or a five color brochure touting the wealth and success of the franchisor and its franchisees, those things will disproportionately affect our ultimate decision.
Understanding that the Commission can never fully counter the power of those first glossy impressions, I recommend that the Commission replace the previous first meeting rule with a rule requiring that the franchisor provide a summary disclosure document to the prospective franchisee as the first pages of the first "written" communication from the franchisor to the prospective franchisee. It should be, literally, the first three pages of that first written communication--on top of everything, including any "cover letter". It should be a paper document unless it is included in the same medium as the balance of the first written communication (meaning, for example, that it is the opening screen upon inserting a CD or other disk in a computer or other reading device or the first screen of an internet home page.) There are two practical ways of accomplishing this: (1) the Commission could slightly modify the summary disclosure statement required with electronically communicated disclosure documents; or (2) the Commission could develop a different model. I would suggest the Commission consider something like the following language:
The balance of the summary document would be a copy of the table of contents from the Franchise Disclosure Document and two copies of the required receipt.
436.5 Disclosure Items
I applaud the Commission's decision to adopt the general UFOC format. It contributes to uniformity and understandability. The following comments address, without differentiation, both weaknesses in the UFOC guidelines and weaknesses created by changes the Commission has proposed.
(a) Item 1 - Franchisor and related persons
(7) The Commission would require disclosure of the "prior" business experience of the franchisor and then requires specific information regarding any franchises in other lines of business. Although I think it is implicit in the general requirement of subparagraph (7), the Commission should make it clear that the franchisor must disclose all of the business activities of itself, its parent, predecessors, and affiliates. You should really add "officers" to that mix--because "sweetheart deals" with companies owned by officers are ripe for abuse. In other words, do the officers' companies have the ability to compete with the franchisees? Are the officers' companies designated vendors? Keep in mind that a company owned by an officer and his spouse who are not majority shareholders of the franchisor probably is not within the definition of an "affiliate". Failing to close that informational gap will give the scam artists a road map for taking unfair advantage of franchisees.
(b) Item 2 - Business Experience
After the word "parent" in the first sentence, you should add the words "or affiliate" to require disclosures regarding the officers of any affiliates who may have management responsibility. In some situations these could be very key people. It could be important to know whether they have adverse bankruptcy information or adverse litigation history--both of which get triggered by an Item 2 disclosure. Without the added language, someone who wanted to hide a personal history that was less than exemplary could have that person separately employed as an officer of an affiliate and then cause the affiliate to perform the services for the company under contract. No disclosures would be triggered about the individuals in that scenario.
(c) Item 3 - Litigation
I hope I have just missed it, but I cannot find any requirement that franchisors disclose arbitration and other binding alternative dispute resolution process decisions. This is one of the most important changes that NASAA made in the UFOC Guidelines in recent years. It is one that the Commission should include. The vast majority of franchise agreements contain mandatory arbitration or binding ADR clauses. If the franchisor does not have to disclose such decisions (unless there is a "settlement"), it would keep prospective franchisees from obtaining virtually all of the valuable "litigation" information. Keep in mind that, although it may defy logic, franchisors have a long history of not regarding arbitration as even similar to "litigation" and thus triggering a disclosure obligation. The Commission needs to take away any possibility that anyone might misunderstand.
The Commission asked for comment on the disclosure of "pending" litigation commenced by the franchisor. In my experience, this is potentially very important information for a prospective franchisee. I recommend eliminating the word "pending" and require disclosure of all franchise relationship suits commenced by the franchisor or an affiliate during at least the last three years. Such information is very material to a prospective franchisee. It tells the prospect whether the franchisor polices the system and enforces uniformity and other rules, including payment of fees; it tells whether the franchisor has a practice of suing (or demanding ADR with) franchisees over minor infractions; it tells more about the relationship between the franchisor and its franchisees than the prospect may be able to glean from any other source. I suspect that few franchisors would face much of a burden--because few file large numbers of cases. However, for those franchisors that do manage and control by litigation, it would be beneficial for the prospect to know of that tendency before making the investment. Just giving the "pending" cases is like giving only one month of financial statements. It does not permit the prospect to see and evaluate trends and developments.
Even without the specific rule, I suspect that such litigation would be material information and required by Section 5 of the Act as well as by the state anti-fraud acts and the common law fraud duty to speak doctrine. I urge the Commission to require the disclosure. I do not believe that a threshold number of cases before an obligation to disclose arises contributes anything. It invites abuse (deferring commencing the next case until one of the "pending" cases is resolved) and deprives the prospective franchisee of an important look inside the franchise relationship that he or she is considering becoming a part of.
(d) Item 4 - Bankruptcy
Sub-paragraph (1) needs one clarification. After the word "offers" in the first sentence, the Commission should add the words "or has offered". Without this, so long as the affiliate does not at the moment offer franchises under the principal trademark, there would be no obligation to disclose a bankruptcy of the affiliate. I have already discussed the potential, if not the reality, of the use of affiliates to perform many of the franchisor's obligations and duties under the franchise agreement. If the affiliate is involved, the affiliate should be required to disclose its bankruptcy history.
(e) Item 5 - Initial Franchise Fee
In addition to the disclosures the Commission would require in Item 5, I recommend disclosure of any contractual formulas for determining the initial fee. Historic fee ranges and factors may provide some information, but, particularly with a start-up franchisor, there is a tendency to reduce initial fees in the early stages to entice people to sign up. It is important to have that disclosed, and the proposed rule does it. However, it is equally or more important to have disclosure of any contractual formulas that will result in this prospect paying a different initial fee than the historic information would suggest.
In the last sentence of Item 5, the Commission has left a gap that could result in abuse. It only defines the initial fee in terms of cash actually currently paid. It should include any amounts that the franchisee becomes obligated to pay before entering into the franchise. For example, if the entire initial franchise fee is deferred into a promissory note, that does not change the fact that it is an "initial fee".
(f) Item 6 - Estimated Initial Investment
This is the third area of the proposed Rule that I regard as critically flawed. It permits franchise sales to occur without assuring that the prospective franchisee is fully informed about the nature and extent of the investment required. My criticism is not based upon the world as it should be, where everyone understands basic legal and business concepts, but upon the world as it is--where most people take a mass of information such as contained in the Franchise Disclosure Document at its face value without the skills and experience to analyze behind what is given.
Specifically, the Commission has exacerbated a problem that I have perceived with the UFOC Guidelines. It invites the franchisor to focus the prospective franchisee's attention on the monthly installments of large, ongoing obligations, without honestly exposing the true extent of the prospect's total investment obligation. In the vast majority of the franchise cases we see, the franchisee's ongoing legal obligations to third parties far exceed the franchisee's ongoing legal obligations to the franchisor. However, the franchisee cannot obtain the franchise without incurring the third-party obligations. These third party obligations include real property leases, equipment and fixture leases, and bank loans (often for operating capital and franchise fees as well as for tenant improvements). Item 7 (which, of course, transfers the bottom line numbers to the cover page) permits a franchisor to disclose only that portion of the long term obligations that must be paid during the initial phase--which is, historically interpreted by the industry as being three months. Thus, a lease obligation totalling nearly $1 Million over a ten year term would show up as a $24,000 item for the three month period. Almost always franchisees are required to personally guaranty these large third party obligations. If the business fails, the franchisee not only loses the $25,000 to $50,000 paid for the franchise, but he or she gets to face bankruptcy over a judgment for the balance of the amount of the third party obligations.
Recognizing that no one can provide complete protection against such calamitous results, the Commission can try to assure some semblance of full disclosure. I also recognize that it may be difficult to make a general rule that will apply to all franchisees in a system. However, the one result the Commission should not accept any longer is the failure to disclose this little understood risk. I recommend that, unless the franchisor is willing and able to hold the franchisee harmless from such mandatory third party obligations, that there be a clear and unambiguous disclosure regarding the total amount of such liabilities the franchisor expects the franchisee to incur. If the franchisor has an arrangement for such third party obligations that they terminate or transfer in the event of termination or non-renewal of the franchise, the franchisor could also disclose that fact. The Commission could probably deal with this by adding a column to the Item 7 table or by adding a mandatory paragraph just ahead of the table in Item 7. The franchisor could use a range of totals to account for the fact that no two leases will be identical. In any event, the total of such third party obligations should be carried over onto the cover page and disclosed immediately following the range of "initial investment".
It is only when a prospective franchisee fully understands that such third party obligations do not end just because the franchise ends that the prospect can make a fully informed decision. This is critically material information to every prospective franchisee and information that is often essentially unavailable to them at the time they are making their decision. Until after it is too late, they generally assume that, like a residential rental agreement, they can get out of the balance of the obligation by just giving the property back to the leasing company. They need to understand that those payments continue to come due and can be accelerated if they close the business or move it or miss a couple of payments. They need full disclosure regarding the true total amount of the obligations they must undertake.
The same consideration should apply to minimum royalties if imposed by the contract. Either the franchisor should state unequivocally that royalties and similar fees terminate upon expiration or termination for any reason or there should be full disclosure as to the minimum amount over the term of the agreement. That total number should drop to the bottom line and be picked up on the cover page.
(h) Item 8 - Restrictions on Sources
Subparagraph (7) should require the franchisor to disclose the dollar amount of such kickbacks during some stated period--I would suggest at least the previous year, although there might be great benefit to a three year trend. Words like "only 1%" may not alert the prospect to the reality that it amounts to hundreds of thousands of dollars over a year of individual small transactions.
Subparagraph (8) should require the franchisor to disclose whether participation in cooperatives is mandatory and the terms of such mandatory participation. Otherwise, it is possible to structure a cooperative so that the franchisor or one of its officers has effective control and can use the cooperative to extract extra money from the franchisee that no one disclosed. This is true of advertising cooperatives and can be true of purchasing or distribution cooperatives. If participation is mandatory (whether by contract or by practical necessity) the potential exists for overcharging for goods or services, or for use of profits for things that benefit the franchisor or a select group of franchisees, but not all of the participants. We need further disclosure.
(j) Item 10 - Financing
In subparagraph (1)(ii), it is important to not only disclose relationships between the franchisor and the lender, but also relationships between the lender and any officer or franchise seller. That should include not only "affiliate" relationships, but any other business relationships, including being a shareholder, officer, director or independent contractor of the other entity. We often find out very late that there is such a relationship with a preferred lender and find only a trail to suggest that money is being transferred in ways that don't appear to have business justification--unless you consider the relationship. The franchisee needs to know about such relationships--before he signs up with a recommended lender. This same comment applies throughout Item 10, and specifically in subparagraph (4) and (4)(ii).
(k) Item 11 - Franchisor's Assistance
Item 11 is a major improvement by the Commission. The Commission solicited comment on the question of whether the required disclosures regarding cash registers and computers was unduly burdensome to new franchisors. In my opinion it is simply part of the risk that any company needs to accept if it elects to use franchising as its way of using other peoples money to expand its distribution system for goods and services. From the consumer's point of view (read that prospective franchisee), it is important to know what computer gear they will have to purchase and something about the maintenance and upkeep costs. I do not see it as being inconsistent with the proposed Rule if a new franchisor simply confessed that it has not selected a computer system yet, but intends to in the future and that the uncertainty creates an issue the prospective franchisee should consider. The franchisor might go on to articulate some guidelines it will follow in selecting a system--for example, franchisee input, non-proprietary operating systems, security concerns, remote access, and similar matters. A franchisor might even place a monetary cap on the cost of the system to the franchisee. Thus, even without knowing what precise hardware and software he or she would be required to invest in, the franchisee learned a lot--most importantly that the franchisor is not yet computerized, in itself placing the franchisee at a disadvantage in many, if not most, industries. With full disclosure, even of the absence of information, the franchisee can make an informed decision.
(l) Item 12 - Territory
Paragraph (3) of Item 12 needs to be clarified to require disclosure of operation of or plans to operate businesses under a different trademark by "officers" and "franchise sellers" as well as by the franchisor or affiliate. Likewise, subparagraph (3)(vii) should clarify that the disclosure of the address of the similar operating business should extend to "officer", "franchise seller" and "affiliate", in addition to the franchisor. It is much more likely that such persons will be involved in such competitive activities than that the franchisor entity itself would be involved. The prospective franchisee needs to know.
(m) Item 13 - Trademarks
In addition to disclosing any pending material trademark litigation, the item should require disclosing (perhaps by reference to Item 3 to avoid duplication) all material adverse trademark litigation during the last ten years. Keep in mind that many franchisors will argue that some trademark litigation is not the type and character of litigation that they must disclose in Item 3. Lets close the loop and require disclosure of any material adverse trademark litigation outcomes, including settlements and arbitration awards.
(q) Item 17 - Renewal, etc.
Please see my comments above regarding the need for better disclosure regarding renewal. This is one of the principal areas of problems in franchisor/franchisee relationships. Although the Commission may not have the authority to regulate the terms of franchise relationships, the Commission certainly has the power to require clear and unambiguous disclosures regarding the rights of the parties upon expiration of the initial term of the franchise agreement. The Commission should not let anyone take advantage of what everyone seems to agree is a lack of clarity of definition of the words "renew" and "extend" within the franchise industry to avoid their duty of full disclosure. The Commission can permit franchisors to define the terms however they please, but should require franchisors to clearly and prominently advise the franchisee of what those definitions are--in a way that focuses their attention on the importance of the issues involved.
(r) Item 18 - Public Figures
Because I see very little modern use of public figures to sell franchises, I would simply ask why this information has not moved to somewhere within either Item 8 or another Item. It would make more sense to elevate the renewal issue, the gag order issue, and the integration clause issue, and, perhaps even the arbitration clause issue to full Item status and move the public figure information elsewhere. In virtually every case, it calls undue attention to a practice that few franchisors use--for reasons relating to the cost of paying public figures for their endorsements and insuring them against claims by investor victims. This is space that could be put to much better use. The Commission should take the lead by examining whether the issues I have identified could be better presented in the available space and whether they are more deserving of the prominent focus.
(s) Item 19 - Financial Performance Representations
Although I have, at the beginning of these comments, gone on record as opposing the current proposed approach to Financial Performance Representations, I will make a few comments on the language as proposed.
Subparagraph (1), clause (2) leaves the gate wide open to abuse by using the word "possible" to describe "performance". The only supplemental information a franchisor should give is "actual" data relating to the site in question. There is no reason to open the door to guessing and speculation about how good the location could "possibly" be or become. Such information is predictably unreliable and subjective. The Commission should require franchisors to stick to "just the facts".
If the Commission elects to proceed without mandating financial performance information where such information is or reasonably should be available (please refer to my comments near the beginning of this letter) then, at the least, the Commission should require some advisory legend to clearly and prominently advise the prospective franchisee investor of the importance of such information. I would suggest something like:
(t) Item 20 - Outlets
I strongly support the Commission's approach to disclosing the existence of gag clauses. This gives franchisees valuable information. It invites them to ask every current and former franchisee they speak with whether they are subject to such a clause. The very existence of such clauses usually red flags the franchisor as having something to hide. In most cases, the franchisor can still unilaterally waive the clause so that its current and former franchisees are free to speak.
The Commission should use a similar approach to require disclosure of whether the franchisor has any mechanism in place to financially or otherwise reward franchisees who refer prospective franchisees or who give glowing reports regarding the franchise system resulting in the prospect becoming a franchisee. For franchisees who are barely able to feed their families, any reward is too tempting. Even in established systems, it is not unusual to find $50 to $1000 "rewards", however characterized, for referring or hooking a franchisee. Many franchisors have policies that promise additional outlets or other favorable treatment to franchisees who are "with the program" and make referrals. All of these practices, although, perhaps short of pure "shilling" should be exposed through disclosure.
In subparagraph (1)(vii), the Commission should delete the words "to exercise its right" in the last sentence. The words add nothing to the meaning of the Item and leave some impression that the Commission is endorsing the position that franchisors have some objective "right" to not renew franchisees. That is a matter of contract and should be left to the contract instead of imbuing one party with a regulatory-endorsed "right".
Except for these limited comments, I will leave further critique of Item 20 to others more qualified and anticipate that Mr. Eric Karp will provide some thoughtful analysis in this area, which he has studied extensively. I would only comment that the proposed format, while apparently solving some of the major defects of the prior rule and UFOC Guideline, still throws at the prospective franchisee an eye-boggling mass of numbers that may not be easy for a lay person to understand the importance of. Item 20 contains incredibly important information and I hope that brighter minds can come up with a method of presentation that better accomplishes full disclosure without so intimidating the uninitiated that they miss the point entirely. I find that most of my clients miss the point. Please don't give up, but go with the best you can do now and the entire industry should keep working on this one.
(u) Item 21 - Financial Statements
Subparagraph (1)(ii) could use some fine tuning. It is fine to permit use of the affiliate's financials statements if the affiliate guarantees all of the duties and obligations of the franchisor in writing and for the entire term of the franchise, including any renewals or extensions. In addition, it is critical that the franchisor include a copy of the written guarantee in the Disclosure Document. Otherwise, as written, a franchisor could say that there is a guarantee, but later defend that it was only as to the "opening" duties and expired 30 days after each sale as to each franchisee. You could not prove to the contrary because there is no duty to attach a copy of the document--or that the guarantee even be in writing. As written, the sub-paragraph would be a handbook for scam artists in how to defraud prospective franchisees.
I am concerned about the phase-in requirement for audited financial statements. Several of the states require audited statements from the beginning either by rule or in practice as a condition of registration. It is not a terribly onerous requirement for a company or person who is selling franchises for substantial sums of money and insisting that its franchisees invest substantial sums in the business. In reality, according to the Small Business Administration, only about 25% of franchisors even survive to five years. If we excuse audited financial statements for the first two years, for all practical purposes, even more investors will risk losing everything. Without audited financial statements for the franchisor and without legitimized and "on the table" financial performance information, the prospective franchisee is lacking the two most critical pieces of information about the prospective franchisor--while sitting for hours studying the glossy brochure and the snappy web site, each of which cost more than an audit for a small company. Prospective franchisees need all the information they can get to evaluate the financial strength of their franchisor--they need more than a ride in a rented limousine and an expensive dinner on which to base their decision. Audited financial statements, from the beginning, give that.
Another consideration is that, with many franchisors being insolvent from the beginning (and most achieving insolvency within five years), requiring audited financial statements gives the franchisee who relied upon the audit a possible remedy they might not have otherwise. Although there have been few, if any, cases yet, there is no doubt that the auditor has liability to the franchisee if the auditor did not follow proper procedures and provide the appropriate warnings--including notes to the effect that the company may not be solvent or may be reliant upon selling more franchises for its economic survival. The credibility of an auditor's report, driven by fear of liability, can give prospective franchisees critical cautionary notes.
436.6 - Instructions for Preparing Documents
This section is good, with one proviso: In subparagraph (d), the word "should" following the word "subfranchisors" should read "shall". The requirement should be mandatory, not advisory--which is what "should" suggests.
In addition, concerning subparagraph (d), this appears to be the only use of the word "subfranchisor" or its derivatives in the proposed Rule. I think this should read "franchise sellers" Alternatively, the Commission should add a definition of the term "subfranchisor" and explain what it is limited to in this context.
436.7 Instructions for Electronic Disclosure Documents
Please refer again to my comments near the beginning of this letter suggesting a different defined term "electronic communication" instead of limiting the concept to the "internet". By adopting that nomenclature and using it consistently throughout this section, the Commission could greatly improve the ability of franchisors to understand and comply with the requirements and increase the availability of written documents to prospective franchisees in electronic form. My proposed changes are too extensive to justify using revision marks. Here is my proposed re-write:
I have made a number of modifications from the NPR version of Section 436.7, including clarifying the use of terminology for consistency. In addition, I have made a number of substantive suggestions:
(a) I recommend that franchisees have the right to receive a paper document up until the later of the expiration of the initial franchise term or the termination of the franchise relationship. This imposes very little burden on the franchisor who simply needs to maintain an electronic archive and be prepared, upon request, to print out a copy and send it to a franchisee. Franchisors will need to retain copies for business and litigation defense purposes anyway. It adds very little burden to ask them to print it out one time upon request. The cost of storing an electronic communication document is often less than the cost of storing a large paper document.
(b) No substantive changes.
(c) I have added the requirement that the electronic communication document be capable of being permanently stored by the franchisee. The Commission should not leave open the possibility that the franchise seller or franchisor might cause a bug or virus to destroy the record on the franchisee's computer or make it inaccessible the day after the sale.
(d) I added the reference to "exhibits" to make it clear that the electronic communication version of the Franchise Disclosure Document must be complete--not just the first 23 items. It must contain everything from the cover page through the financial statements, copies of contracts, lists of franchisees, lists of state regulators and registered agents, state specific addenda, and the receipt. Although I have not drafted language to deal with the issue, the Commission needs to consider whether any "supplemental" disclosures required by Section 5 of the Act should be included in the same place--or how to otherwise assure prospective franchisees of access to such required additional information.
(e) I added a new paragraph (e) to make it clear that the electronic communication version of the Franchise Disclosure Document cannot be buried in the franchisor's web site or other electronic communication medium through which a prospective franchisee must navigate to reach the first page of the Franchise Disclosure Document. This is to prevent franchisors from making a prospective franchisee wade through any amount of advertising or marketing material that puffs about the franchise before they can reach the rather sterile-appearing Franchise Disclosure Document. It should be the same as the current prohibition against putting extraneous advertising material on the cover or within the Franchise Disclosure Document. My concern is that it will become the last page the visitor to the site reaches after entering and reading through a colorful and animated presentation of all of the benefits of the franchise. The Commission needs to make sure that we don't find a "button" on the last page of the franchisor's advertising materials that says "push here for legal information about this franchise". A far better solution would be to require that the electronic communication media used or the internet URL used contain nothing but the Franchise Disclosure Document.
(f) This and subsequent paragraphs are re-lettered. In paragraph (f), I have added a prohibition of any external links.
(g) I have modified this to require that the Franchise Disclosure Document remain available in the same electronic communication medium at least until the time of the sale. I have proposed narrowing the excuse of technological failures, replacing upon the franchisor the obligation to assure that, notwithstanding such failures, the prospective franchisee actually received the Franchise Disclosure Document (in any form) in the time frame required by the Rule. Finally, I added language to clarify that, notwithstanding the franchisor's right to update an electronic communication version of the Franchise Disclosure Document, the franchisor continues to have the notification duties contained in the subsequent section relating to advising the franchisee of the updates before the time of sale.
(h) For the same reasons as in (a), above, I recommend that the duty to provide the Commission with a copy not be terminated merely by the passage of time. I have suggested a minimum period of three years, or any longer period that the franchisor retains a copy for any purpose.
All of these recommended changes are for the purpose of trying to assure that franchisors have the ability to use electronic communication to disseminate the Franchise Disclosure Document while assuring that the prospective franchisee receives access to the functional equivalent of a paper Franchise Disclosure Document in all respects--including for archival purposes. The language I propose separates the franchisor's advertising material from the Franchise Disclosure Document. It gives the industry the ability to use the new technologies while assuring full disclosure and that documents will be available for legitimate archival purposes, including litigation or other dispute resolution proceedings.
436.8 Instructions for Updating Disclosures
All of the updating provisions are adequate except that, I propose the Rule require that the notice described in paragraph (c) be "written" as that term is defined by the Rule. Without a writing, the Commission and all parties will be left with only memories of franchise sellers who are long gone as to whether the franchisee was informed.
Paragraph (a) should be modified to provide that the $500 threshold includes both amounts the franchisee actually pays, but also any amounts that the franchisee, during that first six months, agrees to pay in the future--either by contract or by practical necessity.
Subparagraph (e)(1) should be clarified by adding after "acknowledgment" and before "verifying" the words: "stating the basis for the exemption from the Rule and providing the CFR citation to the Rule and ".
Both of the exemptions in paragraph (e) should be limited so that they apply only if the franchisee corporation's owners and officers and directors do not have to sign personal guarantees. Alternatively, there should be a prominent written warning to the prospective franchisee regarding the effect of personal guarantees. If the Commission decides to not adopt either of these limitations, then I recommend that the commission adopt a net worth threshold of $50 million instead of $5 million, more accurately indicating the level at which franchisees are likely to be sophisticated enough and have enough resources to make their decision independently without benefit of a Franchise Disclosure Document. $5 million of net worth is still a very small company in the U.S. economy. That is a small enough net worth to not be indicative of the level of sophistication that would indicate no need for mandatory disclosures. Regardless of the net worth threshold adopted by the Commission, it should require any franchisor who has a Franchise Disclosure Document for other (lower net worth) franchisees to provide a copy to all prospective franchisees regardless of net worth.
The Commission should modify subparagraph (f) to require that the officer, etc. be "bona fide". It is already too tempting for franchisors to put every prospective franchisee on their board of directors (without voting privileges of course) for a few days or weeks before the sale and remove them shortly thereafter. It is better to deal with the issue up front and require that the exemption is available only if the people are bona fide in the designated positions.
436.10 Additional Prohibitions
In subparagraph (b), it makes sense, in consistency, to limit the documents to written documents as defined in the Rule by inserting the word "written" before "document" at the end of the sentence.
Financial Performance Information. In subparagraph (d), the Commission should make appropriate modifications to integrate the term "electronic communication" consistently with the other recommendations I have made.
Integration Clauses. In subparagraph (e), one category of written representation is missing. That is "written" marketing materials originating from the franchisor. It is patently unfair to permit any franchisor to disclaim any representation or statement made in any of the written materials it originates, whether or not the information is also in the Franchise Disclosure Document. This still permits disclaimer of third party claims and verbal claims, which offends a sense of justice itself. At a bare minimum, if a franchisor originates a written document, the franchisor should not be able to require a franchisee to waive any claims based upon representations contained in that document--without having to go through the additional hoop of proving that the representation was somehow inconsistent with the Franchise Disclosure Document.
Arbitration/ADR Clauses. The Commission does not address this issue in the NPR. I believe it is a critical issue to deal with. Prospective franchisees and the general public fail to understand that the courts have expanded the reach of the arbitration mechanism to permit terrible abuse by franchisors and other users of such clauses. In effect, arbitration clauses prevent the "weaker" party from being able to have disputes resolved in court. ADR clauses that must be complied with as a precondition to arbitration (such as "face-to-face meetings" and non-binding mediation) prevent the "weaker" party from even being able to reach an arbitration forum. It has become common for franchisors to turn arbitration clauses into Trojan Horses laden with waivers of statutory and other legal rights. The clauses impose expenses and burdens on the franchisee (such as multiple trips to the franchisor's home office as a condition precedent to arbitration) that franchisors probably could not otherwise impose. The federal courts generally uphold every term contained in an arbitration clause even if it would otherwise be unlawful. My preferred solution would be for the Commission to simply announce that it is a violation of Section 5 of the Act for any franchisor to insert any term in an arbitration or dispute resolution clause except a naked agreement to arbitrate disputes and the appointment of or procedure for selecting a bona fide neutral organization to administer the arbitration proceeding. All of those other terms should be outside the arbitration clause and subject to the laws that otherwise govern the contract.
Alternatively, the Commission should require full disclosure, in plain English, of the effect of each legal term included within the arbitration clause. In our culture, which loves to hate everyone else's lawyer, we have elevated arbitration on such a pedestal that most consumers believe it is up there with motherhood and apple pie. Prospective franchisee investors need to understand how to identify an abusive arbitration clause and how to understand its true effect on their long term relationship with their franchisor. It literally means, in most cases, that the franchisor wins all disputes by default because the franchisee cannot afford the process.
436.11 Other Laws
One element is missing. It should be expressly a violation of the Rule to represent to any person, for any purpose, that the Commission has reviewed or approved the form or content of any document.
In light of the complexity of many of the issues before the Commission and the novelty of some of the proposals both from the Commission and contained herein--including, specifically the definitions and handling of electronic communication of Franchise Disclosure Documents, I think it would be useful to provide affected parties and their representatives to examine and air the issues in a series of informal workshops. Although there may be other reasons for formal hearings, I view the greater informality of a workshop as being more conducive to obtaining meaningful input from the consumers the Commission seeks to protect--franchisees and prospective franchisees. I urge such a procedure.
Howard E. Bundy