Informal Staff Advisory Opinion 97-1

This staff advisory opinion is issued in response to your request for advice, dated November 5, 1996, on whether your client's rehabilitative services franchise qualifies for the fractional franchise exemption. 16 C.F.R. § 436.2(a)(3)(i).

I. INTRODUCTION

In your letter, you state that your client, a foreign company, has developed a system for providing rehabilitative services for back problems using specially created and patented equipment. Your client now wishes to license its system to a sophisticated group of health care providers in the United States. You state that potential licensees fall within two classes. The first class consists of health care entities, such as hospitals, medical centers or physical therapy clinics, that already offer physical therapy or rehabilitation services. These entities have been offering this kind of care for more than two years. The second class consists of health care entities that have been providing comprehensive health services for more than two years, but are not currently offering physical therapy or rehabilitation services. You now ask whether each of these classes of potential franchisees falls within the Franchise Rule's fractional franchise exemption.(1)

II. THE FRACTIONAL FRANCHISE EXEMPTION

The fractional franchise exemption, 16 C.F.R. § 436.2(a)(3), is available to a company offering a business relationship that meets each of the elements for Rule coverage if it can prove that the following two conditions are met: (1) the franchisee with whom it enters a relationship has been "in the business represented by the franchise more than 2 years;" and (2) the "sales arising from the relationship . . . represent no more than 20 percent of the sales in dollar volume of the franchisee." Id. at § 436.2(h).(2)

The Final Interpretive Guides to the Franchise Rule provide additional guidance. First, the Guides note that a "fractional franchise" relationship results when an established distributor adds a franchised product line to its existing line of goods or services. 44 Fed. Reg. 49965, 49968 (August 24, 1979). See also Statement of Basis and Purpose, 43 Fed. Reg. 59614, 59706-07 (December 21, 1978). Second, when interpreting the term "business represented by the franchise," the Guides state that: "[t]he required experience may be in the same business selling competitive goods, or in a business that would ordinarily be expected to sell the type of goods to be distributed under the franchise." 44 Fed. Reg. at 49968. Similarly, the Statement of Basis and Purpose states: "if the prospective franchisee is currently selling the type of goods or services which he will distribute under the new franchise . . . he will be 'in the business represented by the franchise.'" 43 Fed. Reg. at 59706, n.80. These conditions ensure that the prospective franchisee is familiar with the potential risks and benefits of entering into the franchise relationship. See 43 Fed. Reg. at 59707 (franchise will have "familiarity with the costs, profits, and potential problems of distributing similar goods.").

Finally, with respect to the twenty percent of sales limitation, the Guides state: "The Commission will expect the parties invoking this exemption to take into account in good faith the franchisee's anticipated sales for a period of at least 1 year after the franchisee begins selling the goods or products involved in the franchise." 44 Fed. Reg. at 49968. See also Statement of Basis and Purpose, 43 Fed. Reg. at 59707 and at n.84. In a previous advisory opinion, we made clear that a bald allegation that the parties anticipate that income will not exceed the threshold may be an insufficient basis to support a fractional franchise exemption claim. Rather, in determining whether a "good faith" basis exists to qualify for the exemption, we will consider whether both parties are capable of performing an analysis of historical and projected earnings, a market analysis, or otherwise demonstrating that the franchisee can derive eighty-percent of its income independent of the franchise relationship. See Advisory 96-2, Business Franchise Guide (CCH) ¶ 6477 at 9675 (May 20, 1996).(3)

III. THE FIRST CLASS OF PROSPECTIVE FRANCHISEES

In your letter, you note that the first class of franchisees already have offered physical therapy or rehabilitative services for more than two years and have the necessary experience and familiarity with the costs, profits, and potential problems of performing rehabilitative back services. Accordingly, the first prong of the exemption is satisfied.(4) You also state that the parties reasonably anticipate that the services arising from the license relationship will not exceed twenty percent of total sales volume. For support, you note that these potential franchisees are large health care providers, offering many different types of services to the public. Back rehabilitation, therefore, will constitute only a small portion of those services. More important, you note that your client knows from its European experience the range of revenue that back clinics can reasonably expect. Based upon your representations, we can reasonably conclude that your client has a good faith basis to believe that franchisees' sales will not exceed the threshold. Accordingly, the second prong is satisfied as well.

IV. THE SECOND CLASS OF PROSPECTIVE FRANCHISEES

The second class of franchisees -- hospitals and full-service health care entities -- currently do not offer rehabilitative services. Nonetheless, you contend that these entities "would ordinarily be expected to sell the type of goods [back rehabilitation services] which will be distributed." For support, you cite statistics from the American Hospital Association, showing that the vast majority -- 4,626 out of 5,789 reporting hospitals (79.9%) -- had existing physical therapy units and 3,081 hospitals (53.2%) had existing rehabilitation outpatient services. You contend that this data "strongly suggest that all hospitals and other full-service health care entities could 'ordinarily be expected to' offer back rehabilitation services, and thus are 'in the type of business represented by the franchise," as contemplated by the fractional franchise exemption. Finally, you state that revenues from back rehabilitation services, as discussed above, are likely to constitute an extremely small percentage of these entities' gross revenues.

For the following reasons, we cannot conclude that this second class of franchisees qualifies for the fractional franchise exemption. As an initial matter, it is important to note that Commission staff ordinarily cannot intuit what the reasonable expectations and experiences of franchisees might be, especially in complex industries such as the health care industry. Therefore, credible statistical support of the type you have provided is particularly useful in assisting us to analyze the potential application of the fractional franchise exemption.

It is quite clear from the statistics you cite that a significant number of hospitals offer physical therapy or rehabilitation services, and, as noted in our discussion above, we can readily conclude that those hospitals may qualify for the fractional franchise exemption. It is also reasonable to assume that the remaining hospitals will have some general familiarity with basic rehabilitation services. In the absence of any additional information, however, we are not prepared to make the leap necessary to conclude that an entity with no prior experience in rehabilitation services is ordinarily expected to know about very specific rehabilitation services, namely back rehabilitation and related equipment.

At the same time, we are mindful that this second class of franchisees are sophisticated investors who can understand the potential risks and benefits inherent in purchasing your client's equipment. As a class, hospitals are not likely to be coerced into purchasing equipment or service programs, or agreeing to terms that they do not accept. Nonetheless, we must emphasize that the fractional franchise exemption is not the equivalent of a sophisticated investor exemption to the Rule. Rather, the exemption is available only in those instances where franchisees are sophisticated precisely because of their actual experience with the particular goods or services, or similar goods or services, being offered through the franchise arrangement.

We take no position on whether the second class of franchisees might qualify for a broad statutory exemption from the Rule. If your client believes that hospitals and similar facilities may qualify for such an exemption because of their general sophistication in the field of health care, the proper course of action is to file a petition with the Commission for a statutory exemption under Section 18(g) of the FTC Act, 15 U.S.C § 18(g).

Please be advised that our opinion is based on all the information furnished in your request. This opinion applies only to your client and to the extent that actual company practices conform to the material submitted for review. Please be advised further that the views expressed in this letter are those of the FTC staff. They have not been reviewed, approved, or adopted by the Commission, and they are not binding upon the Commission. However, they do reflect the opinions of the staff members charged with enforcement of the Franchise Rule.

Date: February 7, 1997
Franchise Rule Staff

1. For purposes of this Advisory Opinion, we will assume that your client's proposed business arrangement constitutes a franchise under the Franchise Rule.

2. In a previous advisory opinion, we explained that the fractional franchise exemption may apply to the performance of services. Advisory 93-5, Business Franchise Guide (CCH) ¶ 6449 (April 2, 1993).

3. See also Advisory 95-2, Business Franchise Guide (CCH) ¶ 6467 at 9653 (February 14, 1995)(requestor submitted no evidence from which we could draw any inference about sales levels).

4. See Advisory 94-4, Business Franchise Guide (CCH) ¶ 64660 (May 12, 1994).