January 31, 2000
Mr. Donald S. Clark, Secretary
Re: 16 CFR Part 436
Dear Mr. Clark:
The following comments were prompted by one or more of the 27 comment letters previously filed with your office to suggest modifications to the proposed FTC Franchise Rule amendments.
States should not be foreclosed from having their own requirements, especially if they are not provided for in the FTC trade regulation. One of the most important areas is jurisdiction/venue/choice of law.
When franchisors designate their headquarters state as governing jurisdiction and choice of law in contradiction of another state's law, the door is open for any state or federal judge to decide that the signed contract should be given more weight than the expressed or implied intention of the state legislature.
If the FTC decides to deal with jurisdiction and choice of law issues, it should state that no franchisor can designate in its contract a state foreign to a franchisee as the venue or choice of law for legal disputes if the franchisee's state laws would be in conflict. For purposes of uniformity the franchisor could state in the contract where jurisdiction would be and what state law applies for each state within which sales activity is taking place. The other choices for the franchisor would be to say nothing about jurisdiction or choice of law, or to state that the law to be applied and jurisdiction for legal disputes shall be the state where the franchisee is located.
Dual federalism has served the public well. The states have been the laboratories for new ideas and in many areas the federal government has appropriately refused to preempt this relationship. The present merger of UFOC Guidelines and the FTC Franchise Trade Regulation is a good example.
If the FTC established a preemptive rule as to amendment requirements it should make it very clear that delivery of such material changes to prospective franchisees must be done immediately.
The FTC should also make a clear declaration that regardless of any specific preemptive rules, the states are free to establish or continue franchise registration and review systems.
A definition of Franchise Broker is necessary and different commentators have made good suggestions. The most common misunderstanding is with people who think of themselves not as brokers, but merely as persons making a referral and earning a referral fee. Any definition should make clear that, except for the franchisee making a referral within the same franchise system, anyone sending a prospect to the franchisor with the expectation of a fee should be considered a broker. Illinois has established new rules for brokers that take into account the
isolated transaction, which excuses registration and franchisor disclosure. A copy of the Illinois statute [815 ILCS 705 §§3(21) 5(3); 13]; and Rules [14 Ill. Admin. Code §200.116; 202b] are enclosed as to broker's responsibilities.
Several commentators want to increase the $500 threshold by hundreds or thousands of dollars regarding the definition of a franchise. The best solution is to leave this almost universal element of the franchise definition as-is. The reality is that a $500, up-front investment, is only the tip of the iceberg in virtually every franchise system. Royalties, equipment purchases, leases, inventory and myriad other payments and contractual obligations put most franchisees at great financial risk while having little or no direct experience to make life-changing decisions. To exempt franchises that do not have an initial fee, or ones that have what appears to be a modest fee of $1,000 or $2,500, would put too many "small" investors at risk. Franchisee exposure is typically much greater than the typical stock or bond purchaser, but regulation of corporations and stockbrokers is more comprehensive as to market investments than the regulation of franchises. Please do not eliminate substantial segments of franchising from regulation if to do so would have unsophisticated buyers at great risk.
Another commentator raised the issue of the franchise definition in §436.1 (g) including business relationships called a franchise by the parties, but which otherwise would fail the traditional definition. Case law verifies that a relationship will be a franchise if it fits the definition, even if the parties specify that it is not a franchise. However, there is no reason to thrust franchise responsibilities on persons who have in fact not created a franchise, although the "franchisee" might have a separate cause of action for misrepresentation.
Some of the comments filed raise important issues regarding territories. There should be a definition of "exclusive territory" and a warning legend in Item 23 that at least covers the various forms of franchisor controlled competition.
The new franchisee may not realize that an unclear territory definition in the contract would allow direct competition by the franchisor at non-traditional sites or through unanticipated means. For example: catalogs, web-sites, adding a product line in unrelated retail stores and competing brands owned by the franchisor can each diminish the sales in a franchisee's market area.
Comments regarding the "gag clause" disclosure proposal ranged from total opposition to outlawing confidentiality clauses, with some taking a middle ground, that justifiable trade secrets should be confidential, but the day-to-day relationship of franchisors and franchisees should never be silenced when a prospect asks for information. Please reconsider §436.1 (k) and the related provision in Item 20 to instead forbid confidentiality clauses that prevent franchisees from disclosing relationship issues to prospective franchisees.
The proposed rules could also list the subjects of confidentiality clauses that could properly be required of franchisees.
It would be reasonable to allow confidentiality as to prior agreements of a company that were not involved in franchising when the agreements were entered into.
CONTRACT INTEGRATION CLAUSES
One of the most difficult situations facing a franchisee and their counsel is the franchisee hearing a material representation that is relied upon, but only after meeting with a lawyer does the franchisee realize that the representation was meaningless because of the integration clause and contract law. Unlike the problem of oral statements, a franchisor should be held to the written representations in its UFOC unless a specific, negotiated change, would contradict something in the UFOC.
Comprehensive disclosure that gets the prospect through the door, should not be cast aside in the contract with an integration clause, the impact of which will be unknown to the franchise prospect when the contract is signed.
ITEM 20 LIST OF OUTLETS
The general consensus of commentators seems to be that Item 20 charts needed improvement, the proposed rule is an improvement, but some additional information is needed to make this disclosure more meaningful.
The problem that still needs to be solved is to identify high turnover at particular sites that may be unprofitable no matter who manages them, but the franchisor keeps selling the site or territory to new franchisees. Identifying the first or last event for the year at each site is totally inadequate.
One commentator made an excellent suggestion, which was to tie the list of former franchisees to the events indicated on the charts. This would be very helpful to prospective franchisees.
Separate charts to deal with what happened at various sites versus what happened to particular franchisees may resolve many of the problems with Item 20 data.
Inclusion of the parent company's financial statements should not be required unless that parent is a guarantor of the franchise system's financial obligations. If the FTC decides to require such financial statements from parent companies not acting as a guarantor, the rule should require a bold statement as to whether or not a parent is a guarantor for its subsidiary franchise system.
Identifying franchisee associations for prospective franchisees is an excellent idea. Several commentators want to diminish the degree of this disclosure, but in the process of trying to eliminate persons or groups representing few franchisees, the benefits of this disclosure may be totally lost.
While trying to design a workable association rule, please consider the mindset of most franchisees, which is an extreme fear of retaliation for belonging to an association not sponsored by the franchisor. Even in systems where this fear is unjustified, franchisees are still afraid to be identified with people or groups that may from time to time oppose policies of the franchisor. Setting a minimum percentage of franchisees to be a qualified association is virtually unworkable, but if this approach is used the threshold should be set very low. Five percent of a system's franchisees who are willing to be known as members of a franchisee association may be accompanied by 25% of the franchisees that are of like mind, but afraid to reveal their membership.
FINANCIAL PERFORMANCE REPRESENTATIONS
If a franchisor disseminates a previously published media statement containing information or quotes that could constitute earnings claims, the franchisor should be required to back up the claims upon request by a prospective franchisee or a regulatory agency. However, if the representations are accurate and supportable, the franchisor should be given the option of making a disclosure in Item 19. If the prospective franchisee could reasonably believe that a newspaper article provided by the franchisor presents reliable data, the franchisor should be responsible for material errors that influence a buyer's decision to be a franchisee.
There is no apparent need to require compliance with Generally Accepted Accounting Practices (GAAP) in Item 19 earnings claims. Disclosure in Item 19 should be encouraged, but GAAP requirements would further discourage disclosure.
However, with regard to GAAP requirements for Item 21 Financial Statements, foreign franchisors should continue to comply with GAAP. These franchisors could be allowed to use reconciliations and footnotes to restate or explain data that is absent under their accounting standards or that is in conflict with GAAP, but the basic requirement should remain. Reconciliation is most frequently necesssary when reporting goodwill, deferred taxes, pension costs, asset revaluation, net income and shareholders' equity.
Individuals, the S.E.C. and accountancy organizations throughout the world have compared the respective GAAP requirements of various countries and the general conclusion is that they wish complying with United States GAAP requirements could be made easier, but there is no need to rush into an international set of standards. Expecting franchisees, or even their accountants, to understand the nuances of multi-national accounting standards is not reasonable under the circumstances.
The January, 2000 edition of Business Finance includes the article "Worldwide Accounting Standards" The Ball Is In the SEC's Court (see copy attached). The article points out that although the Financial Accounting Standards Board (FASB) is making U.S. GAAP a little more like foreign standards, the standards developed by the International Accounting Standards Commission (IASC) are not likely to be accepted by the Securities and Exchange Commission (SEC), because they are not detailed enough and do not have the degree of credibility provided by U.S. GAAP.
This is not the time to attempt a dual set of accounting standards based upon the unproven concept that accepting foreign accounting standards will increase the number of foreign franchisors desiring to sell in the United States.