Jenkens & Gilchrist
a p r o f e s s i o n a l c o r p o r a t i o n
1919 Pennsylvania Avenue, NW
LOS ANGELES, CALIFORNIA
SAN ANTONIO, TEXAS
Carl E. Zwisler
December 22, 1999
Mr. Donald S. Clark
Re: 16 CFR Part 436-Franchise Rule Comment
Dear Mr. Clark:
We write in
response to the Notice of Proposed Rulemaking ("NOPR") issued
We commend the Commission and its Staff for
the work that has gone into the revision and for the many very positive
changes that the Proposed Rule ("Proposal") reflects. In
the interest of time we have not commented on most of the changes which
are positive. Rather, we have focused on a limited number of
issues which are of general concern to the franchisors we
represent. We also have attached to these comments an analysis of
the Proposal which, among other things, identifies drafting issues and
other problems in the Rule which are not specifically addressed in these
Jenkens & Gilchrist is a law firm with approximately 450 lawyers operating from offices in California, Illinois, Texas and Washington, DC. Lawyers from our firm regularly represent clients in virtually all forms of business endeavor, while our franchising and distribution law practice group acts almost exclusively on behalf of clients who are involved in franchising and independent distribution. We represent franchisor clients in virtually every industry and provide advice and dispute resolution services to them in all facets of their domestic and international franchising operations.
We salute the FTC Staff for its diligence in
listening to all available viewpoints and
Before addressing comments about specific sections of the Proposal, we observe that the Proposal would modify the Uniform Franchise Offering Circular ("UFOC") which has been developed and modified by the North American Securities Administrators Association ("NASAA"). While we wholeheartedly embrace some of those changes including the Commission's proposal not to mandate earnings claims in disclosure documents we urge the FTC Staff to continue to coordinate with NASAA to avoid the application of conflicting or cumbersome disclosure standards which could result if NASAA or individual state franchise laws regulators disagreeing with the modifications proposed by the FTC.
Additionally, we note that over the last twenty years, both the Rule and the UFOC have been interpreted through advisory opinions, court decisions, UFOC Guidelines, FTC Compliance Guidelines and Commentaries by NASAA on the UFOC. We urge that the interpretations of disclosure requirements contained in that body of law be incorporated into the language of the Franchise Rule to provide clarity to the franchising community and to avoid confusion about whether prior interpretations apply to new disclosure standards.
(1) We agree that the Rule only should apply to franchise locations to be established in the United States, but not to its possessions and territories. In the vast majority of international transactions, the Rule's standards are almost impossible to meet. In some cases, they may overlap or conflict with franchise sales laws of other countries. Information needed to compile disclosures for remote territories often is difficult to obtain for franchisors who have not previously done business there.
(2) The Rule only should apply to franchises requiring a total investment (including franchise fees, real estate, furniture, fixtures, equipment and inventory supplies) of less than $1.5 million where:
The owners of the franchise or the owners of the franchisee entity have
The franchise is expected to account for more than 75% of the gross
c. The franchised business or the premises from which it operates is not subject to the Petroleum Marketing Practices Act ("PMPA"); and
The entity which is acquiring the franchise or entities which directly
Our proposal would incorporate the large investment and sophisticated investor exemptions theoretically proposed by the FTC. It would also split up the Fractional Franchise Definition and expressly exempt affiliation franchises involving businesses which already have been operating for two years, as well as many co-branding arrangements.
Also, our proposal would clarify that
relationships that are governed by the PMPA which are presently exempt
from the disclosure requirements, would not be brought back into the
disclosure requirements of the Rule because a service station franchisee
operates a convenience store from the premises or sells branded
sandwich or bagel products from the service station premises. The
(3) We support a large investment
exclusion, as well as a sophisticated investor
The sophisticated investor exemption must
apply to the franchise entity, regardless of form of organization (i.e.,
it should not be limited only to corporations), and it should be based
upon a consolidated net worth standard so that the net worth of those
owning or controlling the entity may be taken into consideration.
E.g., if a multinational corporation establishes a limited partnership,
LLC or new corporation to acquire property and operate a franchised
business, the disclosure requirements should not apply, regardless of
the fact that the new entity itself has neither $5 million
The requirement that the $5 million net worth be coupled with a five-year business history is also unnecessary. Any entity or group of entities with a $5 million or more net worth should, by definition, be deemed to have the requisite sophistication to satisfy the exclusion or exemption. Because new business ventures regularly involve the establishment of new business entities, prospective franchisees are rarely likely to possess the five-year business experience requirement. To satisfy any business experience (or net worth) requirement, one must look to the experience of the owners, affiliates and predecessors of the franchisee.
(4) The proposal to make use of merger and integration clauses a violation of the Rule must be abandoned.
The complaint about merger and integration
clauses is that they may deny franchisee-plaintiffs a remedy when
franchisees litigate against franchisors. The FTC is the only
entity authorized to bring a claim for violation of the Franchise
Rule. The FTC is not a party to franchise agreements, is not bound
by merger and integration clauses, and is not deprived of a remedy
because of merger and integration clauses. To focus on private
remedies when the FTC has not been authorized by Congress to provide
them is inappropriate. The proposed prohibition is intended to
prohibit franchisors from escaping liability for misrepresentations or
omissions in disclosure
After information about the franchisor, the
franchised business and the franchise agreement is delivered to a
prospective franchisee in a disclosure document, time passes and
negotiations often occur. The disclosure document admonishes the
prospective franchisee to seek advice and to read the documents
carefully. At least two weeks pass between the date of disclosure
and the date a franchise agreement may be signed. Sometimes months
pass. During the interim, information contained in the original
offering circular may have changed, new policies may have been adopted,
and terms of franchise agreements, leases, financing arrangements, and
licensing agreements may be negotiated by the parties. If the
number of franchises in the vicinity of the proposed franchised location
has changed, or if expenses associated with a new franchised location
differ from that disclosed, or if the franchisor has just decided to
change computer system requirements, and the
If financial performance representations ("FPRs") in a disclosure document would not apply to a particular franchise, or if the franchisor provides a supplemental FPR to a prospective franchisee pursuant to Item 19, the franchisor could not disclaim liability for what is in the disclosure document. That surely is not intended by the Proposal, but it seems to be the result of the prohibition. Contract negotiations often result in a rewriting of portions of one or more agreements. The franchisor has to be able to rely upon the final documents as a manifestation of the intent of the parties, not some general disclosure of standard terms which may be inapplicable.
One of the more frequent claims in disputes is that oral or written earnings claims were provided the franchisee who were not included in the franchise offering circular. Franchisors regularly disclaim the reliability of those claims. If a prospective franchisee has obtained unauthorized earnings information, whether from a "rogue salesman," a franchise broker, a franchisee or sources on the Internet, unless franchisors bring to the attention of the franchisee that such information is unauthorized and may not be relied upon, franchisees needlessly risk litigation unless they use some form of integration clause. The Proposal does not prohibit such waivers, and we agree that it should not.
Regardless of whether a separate five-day
cooling-off period is required for completed contract terms, there is no
reasonable basis for concluding that failing to initial changes which a
prospective franchisee has negotiated to a franchise agreement (or other
agreements related to it) is an unfair or deceptive act or
practice. Virtually all changes to franchise agreements are
initiated by franchisees, not by franchisors, and their interest in
seeing that the changes are included in the final
(5) Timing Requirements. The
adoption of a 14-calendar day pre-sale disclosure
If the FTC elects to retain the proposed requirement, it should clarify that it does not apply to all other agreements executed as a part of the franchise transaction.
(6) The revision of the earnings claims standard is generally favorable. In particular, we support the FTC's proposal not to mandate FPRs. We also agree that elimination of cost statements from the definition of FPRs is a positive step. The proposal to adopt standards allowing sub-groups of units to be used as the basis for FPRs is laudable, especially when franchisors are frequently adopting new business strategies which may result in different FPRs depending upon whether the old or new format is offered to the franchisees.
Still, the Proposal contains several
problems. First, the required admonition about
The admonition to the prospective franchisee to notify the FTC and an appropriate state agency of an unauthorized earnings claim seems a bit excessive.
The most troubling part of the Proposal
results from the developing use of web sites which contain both
franchise information and, especially in the case of public companies,
financial information about the company, as well as links to trade dress
and articles which may also contain financial information about
franchisors, franchisees or their unit's sales or profitability.
The most rational approach to the topic would be to make franchisors
liable for the information which is contained in their disclosure
documents, and that franchisors be given the opportunity to disclaim
The Commission should drop the requirement
that historical data must be prepared according to United States
Generally Accepted Accounting Principles ("GAAP").
Information about franchisees' performance is almost always based upon
information provided by franchisees which may not be in a form which
satisfies GAAP standards. Moreover, it is unclear that information
used in the lodging industry concerning revenue per available room,
average occupancy, or average daily
(7) The definition of "prospective franchisee" should be revised if our recommendation about earnings claims is not substantially revised. Someone "surfing the Internet" who "approaches" the franchisor's web site could cause a franchisee to be liable for a violation of Section 436.10(d), if the franchisor has not placed prescribed disclaimers with financial information found there or if the precise information found on the web is not contained in Item 19 of its disclosure document.
(8) The requirement to provide paper
documents simultaneously with the electronic delivery of disclosure
documents is impossible as it relates to Internet disclosures. The
Proposal imposes the disclosure obligations on the franchise sellers,
but it should not restrict the evidence they may use to demonstrate
their compliance with the requirement. We cannot imagine any
reason for a franchisor to be found in violation of the FTC Act when the
appropriate information has been
(9) The "officer" definition creates more problems than it solves. Its intent is to expand the group of individuals about whom disclosures must be made in Items 2, 3 and 4.
"Officer" is defined as "any individual with significant
b. The "officer" definition further confuses issues by including in its enumeration of officers "financial ... officers." Depending upon the nature of the franchise, even the CFO may not have any responsibility for marketing franchises and may not have significant responsibility for "servicing" franchises.
Whether officers of franchisors' parents have "significant management responsibility for marketing and/or servicing franchises" raises many additional questions. If a parent's CEO, COO or CFO has significant influence over whether franchisors' officers keep their jobs, is that "management responsibility?" If so, is it related to marketing and servicing franchises?
The "officer" definition is not
restricted by an individual's title. Any "individual with
The term would also frustrate the application of the fractional franchise exemption (as it relates to "franchisee" officers) and may unwittingly expand the exemption in Section 436.9(f) for franchises purchased by "officers" of a franchisor. Use of the term "de facto officers" would principally add to the bulk of the disclosures, the cost of preparing them, make the document less user friendly and provide no material benefit to prospective franchisees in 999 of 1,000 cases.
The current disclosure requirements are adequate, especially when they are evaluated in the context of all of the other disclosures required by the Rule, e.g., litigation, financial statements, list of franchises, affiliates, purchase requirements, persons responsible for training and audited financial statements.
(10) The "predecessor" definition should not be extended beyond the current definition. The Proposal would require disclosures in Items 1, 3 and 4 about entities which license any trademarks or trade secrets used in the "franchise operation" (sic). The term is not limited to principal trademarks, but even if it were so limited, it is not clear why, for example, disclosure of information about the licensor of "Popeye's" trademark is relevant or desirable to the prospective purchasers of a Popeye's franchise.
Moreover, franchisors are increasingly employing technology licensed to them for use in the franchise system. The technology may include trade secrets. Requiring disclosure of additional information about licensors of trade secrets and their litigation and bankruptcy history in a franchisor's disclosure document would be intrusive and unwarranted. This expansion of the definition would create tremendous additional work and potential liability for franchisors without providing any material corresponding benefit to prospective franchisees.
Comments on Disclosure Items
(11) Item 1. Reference to "parent" should be deleted. It is undefined and unneeded and for some franchisors it would impose major administrative burdens.
(12) Item 2. If the Commission does not agree with our recommendation relating to the "officer" definition, Item 2 should be modified to eliminate conflicts with that definition.
"Franchise broker" is a term that is not defined. The Rule should clarify that franchise brokers only are individuals who are not employed by franchisors or subfranchisors and companies who are compensated pursuant to a written agreement for qualifying prospective franchisees and actively participating in the sales process. Franchisees who are given some consideration for referring prospective franchisees to the franchisor should not be considered franchise brokers. Nor should trade show promoters, owners of web sites which provide information about franchisors and links to them, the mass media or other persons who are paid for referrals but who do not spend more than an hour with a prospective franchisee, or engage in substantive discussions with a prospective franchisee about terms of a franchise agreement.
As an alternative to requiring broker disclosures about the entities we have just described, it would be appropriate for the franchisor to disclose that it does compensate such persons for leads or referrals which are made to the franchisor, but that no representations which such persons make are binding on the franchisor or will govern a franchisee's rights or duties under a franchise agreement.
The Rule also should provide clarification as to what disclosures are required of corporate franchise brokers and network franchise brokers. Requiring detailed information about every corporate employee of a broker, as well as every franchisee in a broker network and each of their employees who might be involved in a franchise sale is extremely cumbersome, and of little use to prospective franchisees.
(13) Item 3. The current franchise litigation disclosures are adequate. The objective of Item 3 is to disclose claims of wrongdoing by franchisors. That is adequately covered in the existing requirements. Requiring disclosure of franchisor-initiated lawsuits against franchisees which are not followed by counterclaims should not be disclosed in Item 3. Such a requirement would create disincentive for franchisors to enforce their agreements, would clutter the document with useless information, cause sales to stop in states which require sales to stop until amendments are filed and approved, and provide marginal, if any, benefit to prospective franchisees. Franchisees already identified in disclosure documents may be called. Terminations and the identity of terminated franchisees must be disclosed. Disclosure of franchise advisory council or franchisee association leaders would be required. Virtually any material information that could possibly come out of franchisor-initiated litigation disclosures would surface through these other Rule requirements, if not through financial statements.
We find the existing requirement to disclose all material settlement terms to be intrusive and often counter-productive to the process of settling claims. The objective of the disclosure is to provide information to the prospective franchise buyer that will help him make an intelligent decision about whether to buy the franchise. It is not to provide him with a basis for litigation or for negotiating settlements of claims. If franchisors purchase franchised businesses from franchisees to settle litigation, disclosure of the fact or the nature of the resolution should be adequate. The dollar terms involved are private and seem immaterial to a decision about whether to buy a franchise.
Settlement terms are not offered to franchisees at the time they acquire their franchises. It would be a mistake for a prospective franchisee reading about a claim that was resolved eight years earlier, or even one year earlier, to believe that if he should ever have a claim that the settlement terms would at all be relevant to terms of a settlement in his case. The only real beneficiaries of these disclosures are persons who already are franchisees or their lawyers who are looking for evidence for use in current claims. They do not satisfy the express objective of the Rule.
(14) Item 4. Bankruptcy disclosures should not be required of the (undefined) parent, predecessors which include trademark and trade secret licensors, or outside directors of franchisors. There is no legitimate reason for imposing these additional burdens on franchisors.
Moreover, the dates which trigger the current disclosure requirements are inconsistent. If disclosures are required, it would seem that ten years from the date of the filing of a petition would be the appropriate beginning date. We are aware of one case in which an officer was involved with a company when a petition was filed in 1986, and the bankruptcy proceeding is still pending. Were it settled this month (December 1999), disclosure of that event would be required for a total of 23 years!
(15) Item 7. We applaud the addition of language which defines "initial phase" as "your estimated initial investment for the first _____ months." This provides clarity for franchisors and prospective franchisees.
(16) Item 9. Although its language is ambiguous, we would endorse clarification that the disclosures required by Item 9 apply only to franchise agreements, and not to licenses, leases, subleases, guarantees, security agreements, loan documents, software agreement, etc. The time required to compile and maintain accurate disclosures for this item can be extensive, but the benefits to prospective franchisees seem insignificant.
(17) Item 11. We suggest the Commission reevaluate the benefits of extensive disclosures about computer hardware and software in Item 11. The information required is extensive, not easy to compile, and is subject to frequent change. It is not clear why most of the disclosures required about computer hardware and software and point of sale systems are material to a prospective franchisee's decision to buy a franchise, especially considering that disclosures about computer requirements, and related expenses may be found in Items 5, 7 and 8.
(18) Item 12. Item 12 has been rewritten to minimize references to exclusive territories and focus more on a "market area." The references to "minimum area granted" assumes that the franchise is related to a market area. A franchisor who grants rights for a location and agrees not to establish another similar outlet within a certain radius of the location may not be granting "an area" and should not be forced to disclose that one is being granted.
Item 12 contains many references to "defined territories." What are franchisors who do not grant "defined territories" or any "territories" supposed to disclose? Disclosures about establishing "franchisor-owned outlets or another channel of distribution selling or leasing similar products ... within the defined area ..." may be intended to disclose the right to sell, among other things, through the Internet, through direct marketing, through national accounts, through mail order, all of which may be accomplished without establishing a presence within a defined area.
The precautionary language for franchisors not granting an exclusive territory is too limiting. Besides disclosing that other "franchisee or franchisor-owned outlets may compete with your location," a proper admonition also should disclose possible establishment of licensed, co-branded, mail order, Internet and all other forms of distribution. Otherwise, the language may mislead prospective franchisees who rely upon it to their detriment.
The requirement that franchisors or affiliates disclose "present plans to operate or franchise a business under a different trademark [which] business sells goods or services similar to those offered by the franchisee ..." raises problems for many franchisors. They may have plans to operate or franchise such a business, but may not yet have decided upon trade names or trademarks, or how they will resolve conflicts, if any, between the two businesses regarding territory, customers or franchisor support, other than those contained in dispute resolution clauses in the franchise agreement. "If known" or "if applicable" are words that should precede the disclosure requirements.
(19) Item 20. The proposal to require
disclosures about practices of entering into
The proposal to require disclosures about "trademark-specific" franchisee associations that are associated with the franchisor if they have been "created, supported or recognized" by the franchisor, or incorporated, is ambiguous. It should either be clarified or eliminated. The Commission would be better to define the type of entity which should be disclosed. Its characteristics should be that it is comprised of a substantial number of franchisees of a particular franchisor which at least twice annually communicates or meets with the franchisor for the purpose of addressing issues arising from the franchise relationship. To qualify for inclusion in the disclosure, the leader of the association should provide a written notice to the franchisor no later than 30 days after the close of the franchisor's fiscal year end identifying the association, its mission, its form of organization and the number of franchisees and franchise units which are dues paying members or are otherwise accredited members of the organization. If some franchisees are not dues paying members, standards used for accreditation should be enclosed in the notice.
Inclusion in the disclosure should not be dependent upon the form of the organization. Nor should amendments to this item be required more than once annually. The contact person for the association to be disclosed should be a current owner of a franchise, not an association executive or lawyer for the association.
(20) Item 21. We object to the proposal that consolidated financial statements of affiliates of a franchisor which has its own audited financial statements be included in disclosure packages. The increased cost and potential liability of other affiliates is unwarranted. The information has only marginal relevance to prospective franchisees and may create the impression that prospective franchisees may rely upon the financial strength of the franchisor's affiliates.
(21) Answers to Selected Questions Posed in the Notice. The numbering sequence is that used in the Notice itself.
Question 17. The term "renewal" is potentially misleading, unless it applies to a renewal of the relationship rather than a renewal of the contract. Even then, the relationship is not renewed. Rather it is extended, but typically on different terms.
Question 18. Eliminating the specific geographic relevance of earnings claims disclosure should have no impact, because the materiality standard remains. If geography is material to the earnings claims disclosure, then it should be included, regardless of a change in the language of the requirement.
Question 19. Any additional requirements or restrictions imposed upon making FPRs will in all likelihood further reduce their use.
Question 23. A first in time approach to disclosing changes of ownership in Item 20 is a satisfactory one. However, the example suggested is inappropriate. If a franchise has not been terminated before it is transferred, a previous notice of termination should be irrelevant to how it is characterized in the chart. A substantial number of transfers result in the issuance of a new franchise, but the most relevant aspect of the transaction is that the ownership has been assumed by a new entity. The fact that the identity of the former franchise owner will be contained in the offering circular for one year should provide adequate opportunity for prospective franchisees to evaluate the nature of those ownership changes.
Question 24. An order of priority approach is not helpful.
Question 26. The required disclosure about "gag clauses" is offensive in the way that it is labeled. Despite the FTC's interest in full disclosure, our laws also recognize a right to privacy. It is unclear how a statement about confidentiality agreements in a disclosure document will in any way help a prospective franchisee to evaluate the information that is disclosed by a present or former franchisee. If such a person refuses to provide information explaining that he has executed a confidentiality agreement, the prospect will learn about the agreement at that time.
The proposed disclosure appears to be borne out of an obsession with forcing every conceivable bit of information about a franchise relationship to be disclosed to prospects. Yet, the Rule itself already requires disclosures about litigation, bankruptcy, terminations, transfers, etc. which individually and collectively should adequately alert prospective franchisees to issues that may be important to them. If efforts at obtaining additional information are unsuccessful because of confidentiality agreements, a reasonable prospective franchisee should be able to take that fact into its evaluation of whether to buy the franchise. Any additional disclosure about "gag clauses" is not helpful. The proposed disclosure deserves the same fate as other "risk factor" disclosures.
Question 33. To the extent that the transactions which are exempt from disclosure are still subject to other requirements of the Rule, clarification is appropriate.
Question 34. With inflation, it would
seem that at least a $5,000 minimum threshold
Question 40. Identifying in the offering circular the individuals who are primarily responsible for preparing the disclosure document may provide marginal benefit to a franchise lawyer representing a franchisee who reviews the document, but contributes nothing to the objective of providing information necessary to help the prospect make a rational business decision. It is unlikely to have any effect on the value of the advice given to franchisor-clients by their lawyers.
We appreciate the Commission's consideration of our comments and look forward to working with the Commission in the development of a Final Rule which will benefit the entire franchising community.
Very truly yours,
Carl E. Zwisler