John W. Fitzgerald
612 343-2937
john.fitzgerald@gpmlaw.com

VIA ELECTRONIC MAIL TO FRANPR@ftc.gov

FEDERAL TRADE COMMISSION
Room 159600
Pennsylvania Avenue N.W.
Washington D.C. 20580

Re: 16 C.F.R. Part 436—Franchise Rule Rebuttal Comments

Ladies and Gentlemen:

I write on behalf of the Franchise and Product Distribution Practice Group of Gray, Plant, Mooty, Mooty & Bennett, P.A., a law firm based in Minneapolis, Minnesota.  Members of our Franchise Group are actively involved in both the ABA Forum on Franchising and the International Franchise Association.  At Gray Plant Mooty, our Franchise Group represents more than 50 franchisors located throughout the United States and Canada.  These clients range from start-up franchisors to very seasoned franchise organizations that have developed successful worldwide franchise operations.  Our Franchise Group is committed to educating and enabling each of our clients to comply with applicable state, federal and international franchise laws, including the FTC Rule (the “Rule”).  Consequently, we are keenly interested in the recently proposed modifications to the Rule, as published in the Federal Trade Commission’s (the “Commission”) Notice of Proposed Rulemaking (“NPR”).  Having reviewed the numerous comments submitted to the Commission in response to the NPR, we offer several rebuttal comments for your consideration as you prepare a final draft of the Rule. 

Proposed Section 436.1—Definitions

Although we certainly agree that the Rule should apply to every offer or sale of a franchise as defined under the Rule, we do not endorse the broad view “that anyone who is involved in the offer or sale of a franchise is responsible to comply with the Rule.” [1]   Many individuals have such a remote or indirect relationship to actual franchise sales transactions that they should not be included within the scope of the Rule. [2]   Specifically, we are of the opinion that lead referral sources should not be included within the proposed Rule and recommend that the definition of “franchise seller” in proposed § 436.1(h) be altered to read as follows:

Franchise seller means a person that offers for sale, sells, or arranges for the sale of an interest in a franchise. It includes the franchisor and its employees, representatives, agents and third-party brokers.It does not include franchisees who sell only their own outlets or any person whose sole activity in connection with the sale of a franchise is to introduce the prospective franchisee to the franchisor, even if such person receives a commission when the sale occurs.

(Underlining indicates the proposed change.)  This change would eliminate the burdensome requirement otherwise imposed upon franchisors who utilize lead referral sources to manage and disclose detailed information on a host of individuals who have relatively little connection to the sale process and whose five-year employment histories, for example, are of no interest to prospective franchise buyers.  Third-party brokers who do more than introduce the prospective franchisee to the franchisor, however, are still expressly included in the definition of franchise seller.

Proposed Section 436.2—Furnishing and Preparing Disclosure Documents

With respect to section 436.2, our rebuttal comments are as follows:

• Scope (Proposed § 436.2, generally): We reject the view that “the Rule should apply if there is an offer or sale to a U.S. prospect by a U.S. franchisor even if the activity takes place outside the United States.” [3]   Rather, we strongly concur with the Commission’s decision to expressly limit the application of the Rule to the sale of franchises within the United States.  Such limitation will enable franchisors to compete in the international marketplace on an even playing field by allowing franchisors to establish international policies and compliance procedures that are uniquely and properly suited to the demands of the particular markets and cultures involved.  We also encourage the Commission to go one step further by clarifying the fact that the Rule has never, at any time, applied to international transactions.  Such clarification will “insure that existing international agreements are retroactively exempted from the FTC Rule.” [4]

• 4-Day Disclosure Period (Proposed § 436.2(a)(1)): We do not believe that “[t]he elimination of the first personal meeting disclosure trigger is a dangerous and unnecessary move that will increase the opportunities for fraud in the sales process.” [5]   Rather, we strongly concur with the Commission’s reasonable conclusion that the first personal meeting requirement has become obsolete in an era of electronic communication and commerce. [6]   Under the new Rule, franchisees will have two full weeks prior to signing any binding document, or paying any fee, in which to review the disclosure document.  That some franchisees may not elect to engage in a careful review process during the mandatory 14-day cooling-off period does not change the fact that the time frame is quite sufficient for reviewing a disclosure document, particularly with the assistance of experienced counsel. [7]   We simply cannot agree with the philosophy that “the power of. . . first glossy impressions” is sufficient to “disproportionately affect [a franchisee’s] ultimate decision.” [8]   As a final point in support of proposed § 436.2(a)(1), the Commission’s new language removes any ambiguity as to when disclosure to prospective franchisees is required – a valuable improvement from a compliance perspective.

• Five-Day Contract Review Period (Proposed § 436.2(a)(2)): We oppose “raising [the contract review period] to seven days.” [9]   We believe the Commission’s shift to a slightly shorter review period is proper.  Five business days, is a sufficient period for franchisees to review completed franchise agreements.  The Commission’s modification of the “five-day rule” accounts for the fact that once a final agreement is drafted, both parties – including the franchisee – want to move forward with the proposed deal as quickly as is reasonably possible.  In fact, we would recommend an exception be crafted to state that even the five-day period is eliminated in those situations where the franchisee is represented by counsel.

Proposed Section 436.3—The Cover Page

While we agree with the Commission’s rejection of the UFOC’s risk factor disclosure requirement, we are nonetheless concerned that the new Rule still allows states to impose such a requirement. [10]   While franchisors generally must prepare and attach state-related addenda to offering circulars used within states that have promulgated express franchise laws, the Commission’s proposed § 436.3 results in something more burdensome.  Franchisors remain exposed to the obligation to prepare distinct cover pages for each state that may impose such a requirement.  Such requirements by individual states will derail the positive, efficient trend toward use of a single, multi-state UFOC by franchisors.  Instead, the Commission should require states to conform to the Commission’s cover page format in an effort to simplify compliance by franchisors.  Should a state feel that a particular additional disclosure is necessary, such concern could be satisfied in a state-specific addendum.  This is true for the body of the offering circular as well.  In short, the Rule should require each state to precisely adopt the terms of the FTC-modified UFOC disclosure document and cover page, while allowing states to provide for the attachment of clearly enumerated addenda to the end of the disclosure document.  While respecting individual state autonomy, this preemptive step will enhance the ease, and therefore the likelihood, of compliance for franchisors.

Proposed Section 436.5—The Required Disclosure Items

Although we support the Commission’s decision to adopt the UFOC disclosure model, we offer the following rebuttal comments regarding the Commission’s version of the UFOC Guidelines:

• Item 1: We object to the view “that the franchisor must disclose all of the business activities of itself, its parent, predecessors, and affiliates. . .[and officers].” [11]   With respect to predecessors, we recommend that such disclosure be limited to information regarding a franchisor’s immediate predecessor.  In an era of constant mergers, consolidations, acquisitions, and other fundamental structural changes, it does not make sense to require franchisors to provide a 10-year predecessor history – or a detailed history of every officers’ business dealings for that matter – which history will often have no bearing on the currently proposed sale.  This type of disclosure should be eliminated, or at the very least significantly limited to the immediate predecessor, in order to ensure that: (1) the offering circular is a streamlined, user-friendly resource that contains only that information which is truly useful to a prospective franchisee (information concerning the business activities of a predecessor, other than an immediate predecessor, likely serves no useful purpose); and (2) the compliance costs associated with preparing the offering circular are justified by the benefits derived from the document.  

• Item 3 (Proposed §436.5(c)):  We do not believe “that franchisor-initiated litigation is material to prospective franchisees because it identifies a problem or patterns of problems in the franchise relationship as well as the extent to which the franchisor is inclined to use litigation to resolve disputes.” [12]   At present, franchisors already disclose in Item 20 the number of units cancelled or terminated, not renewed, or that have otherwise left the system and in Item 3 all suits with claims made by franchisees against the franchisor.  These numbers and suits should already provide prospective franchisees with a general picture of the franchise relationship between a franchisor and its franchisees.  Yet, the Rule change will require disclosure of information that is very susceptible to misinterpretation. [13]   Franchisor–initiated suits may actually be required to fulfill the franchisor’s obligation to protect the integrity of the system for the benefit of all franchisees by enforcing system standards and by collecting fees.

Moreover, expanding Item 3 will further add to the already burdensome task of franchisor compliance, [14] and will similarly complicate the already lengthy offering circular – which is intended to provide a clear and concise picture of the franchise.  It seems overburdensome to stop the selling process, amend the UFOC and redisclose all prospects just for one franchisor–initiated lawsuit with no counterclaim and, indeed, to do the same the next month or the next quarter if additional suits are started.

 

In light of the costs and time involved in complying with an expanded Item 3, we recommend that the Commission follow the traditional Item 3 format.  In the event that the Commission expands Item 3 as proposed, we strongly encourage the Commission to also implement the intended limitations related to such expansion (i.e., requiring merely pending and material franchisor-initiated litigation related to the franchise relationship) and to consider some threshold figure or limitation before the disclosure obligation would be triggered. [15]

• Item 4 (Proposed § 436.5(d)): We differ with those individuals supporting disclosure of bankruptcy information for a franchisor’s predecessors and affiliates. [16]   As in other areas of the proposed Rule in which the Commission has expanded the breadth of disclosure requirements to include parties not previously covered, we simply do not believe that the marginal benefit provided by such a requirement are justified in light of the costs of compliance.

• Item 12 (Proposed § 436.5(l)): We oppose the requirement to disclose “plans to operate businesses under a different trademark” whether such plans relate to the franchisor or affiliate, or to franchise sellers or officers. [17]   By forcing franchisors to disclose this information, or business development plans in general, the Commission creates numerous problems.  First, in response to the Commission’s inquiry on the matter, current development plans are proprietary information that, if disclosed, can jeopardize a franchisor’s legitimate business plans by alerting competitors to the franchisor’s strategic pursuits.  Second, although perhaps less obvious, prospective franchisees may actually rely on a franchisor’s disclosure of development plans that may ultimately fail to materialize, based on the franchisor’s sound business discretion.  Prospective franchisees may also view such development plans, in unique circumstances, as positive indicia of growth and strength of the franchisor; thus, when the franchisor alters course, the franchisee may claim fraudulent inducement by the franchisor.  The inverse is also true.  A franchisor may, in good faith, create a new development program subsequent to the time of initial disclosure.  In light of proposed Item 12, franchisees might try to attack such actions, even though grounded on sound business rationale, claiming that the franchisor should have known of such plans at the time of disclosure.  In sum, the problem with proposed Item 12’s forced disclosure of development plans is that while a franchisor cannot always know with certainty what business strategy it will follow at some time down the road – perhaps even in the near future – the rule may nevertheless create such an expectation in the minds of individual franchisees.

• Item 19 (Proposed § 436.5(s)): We reject the view that “the failure of the Commission to require franchisors to furnish prospective franchisees with [an earnings claim] remains a fatal flaw to the Rule.” [18]   There is nothing “inherently misleading” about a franchisor’s silence with respect to financial performance of franchise. [19]   Of course, where a franchisor intentionally leads a prospect to draw certain conclusions from the franchisor’s silence, the franchisor may be misleading the prospect; however, such misconduct is already prohibited under proposed § 436.1(d)’s broad definition of “financial performance representation.”  Simply because a franchisee may independently reach an unjustified conclusion in the face of a franchisor’s silence on the question of financial performance, does not mean the Commission should incorporate mandatory earnings claims into Item 19.  In response to the assertion that franchisors unreasonably expect franchisees to buy a business without at least three years of financial statements to review, [20] we believe the commenter distorts the effect of the Rule.  Under Item 21, franchisors are required to disclose certain financial statements regarding the franchisor’s financial performance.  But, to force franchisors to go one step further and to somehow estimate a level of prior franchisee financial performance on which the prospect can reply is both improper and irresponsible.  Many franchisors simply do not have the data to support such a disclosure. [21]   Moreover, the Commission is wise to respect the discretion of many franchisors that recognize their disclosure of general information may mislead an individual who is going to be operating under unique circumstances.  In sum, we strongly agree with the Commission’s view “that financial performance disclosures should remain voluntary and that ordinary market forces are sufficient to provide an incentive for franchise systems to make performance information available to prospective franchisees.” [22]     

• Item 20 (Proposed § 436.5(t)): We do not agree with one commenter’s suggestion that franchisors should disclose information regarding 500 franchisees. [23]   In fact, we encourage the Commission to require disclosure of less than 100 franchisees.  This is yet another simple way to streamline the UFOC, without significantly jeopardizing the quality of the disclosure provided.  As a practical matter, if the prospective franchisee desires a larger “contact” pool, the prospect can request additional contact information from the franchisor.  For obvious practical reasons, it will be in the franchisor’s best interest to comply with such a request.  In the alternative, the Commission might also consider mandating additional franchisee disclosure upon request, provided that such disclosure need not exceed a total of 100 franchisees.

• Item 20 and Gag Clauses (Proposed § 436.5(t)(6)): While we do not oppose the general disclosure of the use of certain confidentiality agreements, as proposed by the Commission, we would strongly oppose a requirement of “disclosure of [specific] franchisees under gag clauses.” [24]   Individual franchisees and franchisors must be free to define the terms of their contractual relationship, with the fewest possible governmental intrusions.  As a matter of policy, the Commission should favor a regulation model that allows franchisors and franchisees to create settlement agreements that are in the best interests of both parties.  By requiring disclosure of particular instances of “gag clause” usage, the Commission would actually injure existing franchisees by weakening one of the valuable bargaining chips franchisees, of their own volition, may offer during settlement proceedings.  Therefore, we recommend that the Commission implement, without heeding expansion proposals submitted by certain commenters, [25] its currently proposed confidentiality agreement provision. [26]   However, in reaching this conclusion, we add one critical qualification – the Commission’s use of the term “gag clause” is inappropriate.  Obviously, the word “gag” has plainly negative connotations in the English language.  Using such a label for legitimately negotiated confidentiality agreements unjustifiably raises prospective franchisees’ suspicions of their potential business partners.  The Commission should simply refer to such agreements as “confidential settlement agreements” or some other similarly accurate term.

Proposed Section 436.6—Instructions for Preparing Disclosure Documents

In the Commission’s NPR at pages 60-61, the Commission indicates that because the instructions clearly allow franchisors to attach state-specific information to their particular offering circular, compliance costs and burdens will be reduced “because franchisors need not generate disclosure documents tailored for each state.”  While we wholly endorse the end that the Commission is striving to achieve, we simply note that under the proposed Rule, states might choose – by statute – to mandate alterations in disclosure requirements within the body of the document itself.  As long as such state-mandated modifications are more protective than the proposed Rule, the Commission would apparently allow state enforcement of such provisions.  Although this possibility may occur only in isolated circumstances (i.e., only one or two jurisdictions), the possibility nevertheless exists, leaving franchisors potentially exposed to otherwise unnecessary compliance burdens.  We believe this problem can be easily solved.  We recommend that the Commission expressly state, within the Rule, that the federal UFOC format will control and that any state-imposed modifications must be in the form of clearly defined and clearly itemized requests for attachments and/or addenda. [27]

Proposed Section 436.7—Instructions for Electronic Disclosure Documents

Consistent with many comments directed to the Commission, we applaud the Commission’s acceptance of electronic disclosure methods.  However, unlike some who have commented, we do not believe that it is necessary for a franchisor “to furnish the prospect with a summary-type document which contains the cover sheet, table of contents, receipt and described summary,” [28] as required by proposed § 436.7(b).  This requirement poses an unjustified increase in the compliance burden already resting upon franchisors and effectively eliminates some of the efficiency of electronic disclosure. [29]   As a practical matter, under the proposed Rule, if a prospect wants a hard copy of the entire circular, the franchisee can request such a copy and the franchisor must provide it.  Although we recognize the Commission’s concern with balancing bargaining power in a franchise relationship, we oppose a disclosure model which assumes that franchisees are incapable of choosing – and then being held accountable for – a  particular disclosure format.  In response to the suggestion that a prospective franchisee will not appreciate the importance of an electronically distributed document, we believe this concern overlooks a fundamental and momentous shift in the nation’s mode of commerce.  Furthermore, the Commission can effectively address this concern by publishing its own notices or warnings at its web site, to which the franchisee will now be directed pursuant to the proposed cover page modifications. [30]

Proposed Section 436.8—Material Changes

We have no rebuttal comment with respect to this section.

Proposed Section 436.9—Exemptions

We disagree with the suggestion that proposed § 436.9(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 the last six months, agrees to pay in the future – either by contract or practical necessity.” [31]   The proposed modification would eliminate the bright-line character of the Rule without offering justifiable gains.  Where a franchisee pays less than $500 to the franchisor over a six-month span, or greater, it is safe to assume that the relationship is not of the type which the Rule is designed to regulate.  In fact, the Commission should consider raising the amount specified to $1000 or higher.

We strongly favor the Commission’s inclusion of the sophisticated investor exemptions to the Rule and we believe that proposed § 436.9(e) is “reasonably tailored to its stated objectives” and not “antithetical to the purposes of the Rule.” [32]   The sophisticated investor exemptions, including the large investor exemption, recognize the fact that the spirit of the Rule is to provide full disclosure sufficient to place the prospective franchisee on an even playing field with the franchisor.  Where the playing field is already level, which is undoubtedly the case in the vast majority of transactions involving more than $1.5 Million, no such need exists.  This is particularly true in light of the proposed large investment exemption’s exclusion from the threshold amount of any amounts received from the franchisor or an affiliate. [33]   Even where a franchisor is already required to produce a disclosure document because less than 100 percent of its franchisees qualify under the sophisticated investor exemptions, compliance burdens are nevertheless eased by reducing the number of individuals to whom disclosure must be made and subsequently tracked. [34]   In discussing various new exemptions created under the proposed Rule, one commenter asks, “if the document already exists why should the [prospect] not receive it?” [35]   This question, while certainly reasonable, ignores the fact that the Rule’s disclosure requirements are accompanied by waiting periods [36] —time periods which may unnecessarily delay the consummation of business transactions between informed and experienced parties.  And, in response to the concern that prospective franchisees planning to invest more than $1.5 Million may not prevail “in their efforts at due diligence. . . without the aid of mandatory disclosure requirements,” we note that such prospects are free to leave unattractive or uncertain business ventures at the table. 

As a final related point, we believe there is some risk that exempted franchisors would not be aware that they are subject to the Rule prohibitions set forth in proposed section 436.10.  The Commission may want to consider making an express reference to section 436.10 within the introductory sentence of 436.9.

Proposed Section 436.10—Additional Prohibitions

We strongly oppose any suggestion that integration clauses should be banned under the Rule. [37]   Integration clauses have become an important part of this nation’s common law fabric, and for good reason.  These contractual provisions provide a clear indication to a court or any other third party that the contracting parties have reached a meeting of the minds regarding their respective obligations in a contractual relationship, and that these commitments have been intentionally merged into a single document. 

Prior to executing a franchise agreement, a prospect will likely speak with franchisor representatives, past and present franchisees of the system (and perhaps outside the system), business professionals, and financial and legal advisors.  Furthermore, the prospect will review various documents in addition to the franchise agreement, including the UFOC.  In light of the vast amount of information provided to the prospective franchisee during the negotiation process, it is critical that the parties obtain a clear  measure of certainty and predictability as to which terms and conditions will actually govern the eventual franchise relationship.  A carefully and succinctly drafted integration clause can provide this sense of certainty to all of the parties involved – including the franchisee.

Unfortunately, proposed § 436.10(e) will likely foreclose, as a practical matter, the use of integration clauses by franchisors. [38]   For, if it chooses to do so under the proposed Rule, the Commission could construe any generally worded integration clause as a disclaimer – in violation of § 5 of the FTC Act – of representations made in an offering circular.  Consequently, notwithstanding the Commission’s acknowledgment of the “useful purpose” served by integration clauses and the Commission’s related desire not to impose an outright ban on such clauses, [39] franchisors will be chilled, by the language of the proposed Rule, from using these legitimate contractual provisions. 

Additional Sections

We have no further rebuttal comments with respect to the Commission’s proposed changes to the Rule.

If we can provide any further clarification to the above-outlined recommendations, please feel free to contact us at your convenience.  Thank you for your attention and consideration of these important matters.

Very truly yours,

John W. Fitzgerald
GRAY, PLANT, MOOTY, MOOTY & BENNETT, P.A.

JWF/mav

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