FTC Franchise Rule Review

The American Bar Association, 1995 Forum on Franchising

Orlando, Florida

Date:
By: 
Christine A. Varney, Former Commissioner

The views expressed are those of the Commissioner and do not necessarily reflect the views of the Federal Trade Commission or any other Commissioner or staff.

Thank you for inviting me to speak to you today. As you are very aware, the Commission is currently reviewing the Franchise Rule. I suspect that many of you submitted written comments and participated in the Public Workshop last month. This afternoon, I will discuss my view of the Rule and the developments from the Workshop. I will also highlight some of the Commission's recent enforcement actions in the franchising area, and share my thoughts on what areas may spark future Commission interest.

Franchising, as a means of distribution and as a form of business organization, continues to contribute greatly to our nation's economy. As of 1991, there were more than 542,000 franchising outlets in the United States generating approximately 758 billion dollars in sales. More than one-third of all retail transactions in the U.S. now take place at franchised outlets, and that figure continues to grow. This expansion has taken on a global dimension as U.S.-based franchisors have exported their business formats and know-how throughout the world.

Because the world of franchising is not only growing but also changing rapidly, pre-sale disclosure of all material terms and conditions of the franchise agreement " the heart of the Franchise Rule " is more important than ever. Competitive markets depend on informed purchasers. As we enter the information age, this fundamental tenet will shape the FTC's consumer protection and competition missions. We will continue to emphasize the important role that information disclosure plays in the marketplace.

This is particularly true in the franchise context. The Commission has historically directed its efforts toward ensuring that prospective franchisees have full and accurate information about a franchise before they invest. Franchisees who understand their rights and obligations before they purchase their franchise are, in our experience, far less likely to experience strained relationships with their franchisors. As we review the Franchise Rule, this emphasis continues to be appropriate, but we must also ask: whether the information required to be disclosed is accessible and meaningful; whether other information, such as earnings disclosures, should also be included; and whether, given our current understanding of the many differences between traditional franchises and business opportunity ventures, the Rule properly reflects that dichotomy.

Last month's FTC Workshop in Minneapolis provided an excellent forum to address these and other issues surrounding the Franchise Rule. As we at the Commission continue our efforts to streamline regulations and simplify procedures, we must seriously consider all options, including whether there is a need for the Franchise Rule at all. What are the quantifiable costs and benefits of the Rule, and are they justified? Commission staff are currently conducting a serious economic analysis to help us answer these questions. My understanding is that based on the written comments and the discussion at the Workshop, there is a continuing need for the Rule, but it clearly warrants certain changes.

It appears that a consensus was reached with respect to the desirability of having one national franchise disclosure standard. Although the Commission allows franchisors the option of complying with the Franchise Rule by means of the Uniform Franchise Offering Circular ("UFOC"), the opposite is not true that is, in the thirteen states that require franchise registration, the UFOC is the only permissible document (and not the FTC's Franchise Rule). The disclosures required by the UFOC, while similar to our Rule, are not identical in all respects. Accordingly, are considering replacing our current Rule with the more widely utilized UFOC.

Another area of consensus formed regarding the treatment of business opportunity ventures. In anticipation of the Rule review, the Commission recognized that the disclosure requirements might not be well suited to the sale of business opportunities and might impose unnecessary costs on both business opportunity sellers and buyers. For example, certain Rule disclosures

  • such as site selection and approval, initial training, and public figure involvement
  • are more important to franchise investors than business opportunity investors.

On the other hand, business opportunity investors may want certain information that the rule does not require, such as the seller's success rate in locating display racks and vending machines. The participants at the Workshop were almost unanimous in their position that the Rule should be changed so that business opportunities are treated separately from other types of franchises. Such a change would also provide greater consistency with the states, since business opportunities are regulated by the state attorney general, while franchises are regulated by the state securities commissioner.

On the subject of business opportunity ventures, I would also like to mention the joint federal and state enforcement effort " Project Telesweep " that was successfully prosecuted this past summer. In response to the growing epidemic of business opportunity scams preying on would-be entrepreneurs, the Commission, along with the Justice Department and state enforcement officials, launched a coordinated and aggressive campaign to attack these scams, which promise quick and easy money in vending machines, amusement games, pay telephones, and display racks. Estimates of losses due to these scams are conservatively estimated at 100 million dollars per year. While these scams are not new, the introduction of high-pressure telemarketing tactics previously used to tout travel and sweepstakes rip-offs have allowed business opportunity scams to grow dramatically. Project Telesweep resulted in coordinated legal action against more than 100 of these fraud artists, and was unique in its pro-active enforcement approach. Unlike the more typical Commission action which usually follows from consumer complaints, Project Telesweep involved the use of undercover investigators who attended trade shows and combed the classified ads of nationally circulated newspapers to uncover fraudulent and non-complying business opportunity sales. The results of Project Telesweep are extremely gratifying, and I expect the Commission will continue to actively participate in these types of joint efforts in the future, including both enforcement actions and consumer education activities.

Turning back to the Franchise Rule, one issue that, not surprisingly, did not yield a consensus is the subject of mandatory earnings disclosures. Over the past few years, there has been considerable discussion about whether the Franchise Rule should compel franchisors to disclose earnings information. While the current Franchise Rule does not compel franchisors to disclose such information, it does require that franchisors who choose to make earnings claims must provide substantiation in the form of an earnings disclosure document. Indeed, many of the Commission's recent enforcement actions, including many that were part of Project Telesweep, challenged the practice of making earnings claims without providing the required substantiation.

Many franchisee advocates claim that obtaining earnings information is not only critical to an informed investment decision, but is often the single most important piece of information that a prospective franchisee needs before making an informed purchasing decision. On the other hand, franchisors may be reluctant to make formal earnings disclosures because revealing earnings information may subject franchisors to liability if franchisees fail to achieve the level of disclosed earnings. In addition, generating earnings information may be costly in terms of both dollars and management time.

As an agency committed to promoting the free flow of accurate and non- misleading information in the marketplace, mandating earnings disclosures raises particularly difficult issues. In addition to compliance costs and burdens, we are most concerned that any type of earnings disclosure neither mislead nor deceive prospective franchisees. For example, disclosure of gross sales figures may be misleading absent accompanying information about franchisees' costs. At the same time, franchisees' profit and loss statements, or ranges of profits and losses, may present a more accurate picture of franchisees' earnings; however, franchisors have generally not collected such information and it may even be proprietary information. Further, franchisors may find it difficult to comply with a single profit and loss disclosure requirement due to a lack of uniform accounting practices across franchise systems. In addition, until we obtain some hard data on this specific issue, we are unable to assess whether the benefits such disclosures could provide to prospective franchisees outweigh the costs to franchisors of requiring profit and loss disclosures.

Some commenters have suggested that one way to address this problem without mandating earnings claims is to require a disclosure that makes it clear to prospective franchisees to pay particular attention to any earnings claim, and that if no claims are made it is because the franchisor chose not to, thereby putting a stop to franchisors who " falsely" tell prospective franchisees that the government "prohibits" them from making earnings claims. As we continue our comprehensive review of the Rule, and consider the range of reasonable options, we will carefully be weighing the costs and benefits associated with each suggested approach.

Let me now turn to a recent Commission action that I believe is significant in several respects. Last month, the Commission accepted a proposed settlement with Blenheim Expositions, Inc., a company that produces a variety of franchise trade shows and expositions. At issue was the company's use of a Gallup Poll featuring franchise success and earnings rates in its advertisements promoting the International Franchise Expo. According to our complaint, the cited advertisements falsely stated that the Gallup poll showed that franchisees earn an average of pre-tax income of more than $124,000 and enjoy a 94 percent success rate.

In 1992, the International Franchise Association reported the results of a Gallup poll of 994 current franchise owners who were asked to report their estimated annual gross income before taxes as a franchise owner, and Gallup calculated the average of such incomes to be $124,900. No former franchise owners were contacted and the poll included reported results from a disproportionate number of multiple franchise locations. In addition, the poll did not ask franchisees to report their "average income," "pre-tax income," or "pre-tax profits" -- the terms used by Blenheim in the advertisements promoting the shows. The complaint alleges that by using such statements as "According to a recent Gallup poll, 94% of franchise owners are successful, averaging $124,290 in pre-tax profits," Blenheim represented that it had substantiation for its claims " which it did not " and that the actual results of the Gallup poll did not support the claims made in advertisements promoting the Expo.

The proposed consent agreement, announced for public comment on September 27, would prohibit Blenheim from misrepresenting the sales, income, or profits prospective franchise owners have earned or can or will earn; or the chances of success or success rates of franchise owners unless it possesses substantiation to support the claims. Further, in connection with the advertising, promotion or marketing of any franchise show, Blenheim would be prohibited from misrepresenting the validity, results, contents, conclusions, or interpretations of any survey, test, poll, or study. In addition, for the next five years Blenheim would be required to distribute a copy of the FTC's consumer education publication entitled "A Consumer's Guide to Buying a Franchise" to as many as 500 people attending each show the company promotes.

I believe this case raises a larger issue than simply the need to make truthful and substantiated claims in the franchise context. Over the years, claims regarding franchise success rates have been common. There is a widely held perception -- that is only now being challenged -- that franchisees have a much greater chance to succeed than a similarly-situated entrepreneur who launches a new independent business. Yet, reliable and independent data on success and failure rates are in short supply. One study by economist Timothy Bates concludes that franchises were less profitable and more likely to fail than other independent small businesses. Using 1987 as a baseline and tracking these companies through 1991, Bates found that 34.9% of franchises had gone out of business, while only 28.0% of non-franchised businesses had. While it seems intuitive that statistics that do not include surveying unsuccessful as well as successful franchisees cannot provide a complete story, numbers alone also cannot provide a full picture; there are simply too many variables among the many types of franchises. I suspect that unsubstantiated success and failure claims will properly continue to receive increased scrutiny; it truly is in everyone's best interest not to tout overly optimistic success claims.

The Blenheim case is also noteworthy for the remedy obtained. Blenheim must pay for the reproduction and distribute our Franchise brochure. Requiring parties to distribute consumer education materials can prove a very effective way to heighten overall consumer knowledge. This is particularly appropriate where a party's course of conduct has contributed to widespread consumer misinformation. Look for other Commission consumer protection cases that utilize innovative remedies, with an eye to increased consumer education.

In conclusion, let me say again that we are undertaking a serious and thorough review of our Franchise Rule. We are seeking to streamline and tighten the Rule, but at the same time insure that the Rule gives franchisees meaningful information without an undue burden on the providers of that information, the franchisors. It is my understanding from staff that in the several areas where a consensus was reached, changes to the Rule will be conducted through a negotiated rulemaking proceeding, which I strongly endorse. Although our recently completed Telemarketing Rulemaking was not formally a negotiated rulemaking (pursuant to the Telemarketing Act, we used notice and comment procedures), the open process that we used there yielded the type of positive and workable results that a RegNeg can achieve. As this review moves forward, I urge your continued participation; working together, we can reach an appropriate and balanced approach to franchising in the 21st Century.