This staff advisory opinion is issued in response to your request for advice concerning the applicability of the Franchise Rule, 16 C.F.R. Part 436, to the sale of multiple franchises to an existing franchisee.
In your letter, you correctly note that the Franchise Rule requires franchisors and franchise brokers to furnish a disclosure document to a prospective franchisee prior to the sale of a franchise. You also note that disclosure is required when a franchisor sells a new franchise to an existing franchisee under terms and conditions that are materially different from the original franchise agreement. You now ask whether the Franchise Rule requires a franchisor to provide disclosures to an existing franchisee in the following scenario.
A franchisor and a franchisee enter into a franchise agreement. Under their agreement, the franchisee does not have the right or obligation to establish additional outlets, and the agreement does not provide for future development. Over a period of years, however, the parties execute addenda to their existing franchise agreement permitting the franchisee to establish additional outlets. You state that these additional outlets will operate under the terms of the original franchise agreement.(1) You ask whether the sale of additional outlets under these facts would constitute a material change of the original franchise agreement thereby compelling additional disclosure under the Rule.
Your request for advice essentially raises three issues: (1) when must a franchisor provide disclosure to an existing franchisee; (2) when does modifying an existing franchise agreement through an addendum constitute a material change; and (3) whether each and every subsequent addendum constitutes a material change from the original franchise agreement. We will address each of these issues below.
II. DISCLOSURE TO AN EXISTING FRANCHISEE
As stated above, your letter raises the issue whether a franchisor must provide a disclosure document to an existing franchisee who purchases an additional outlet. We start our analysis by noting the definition of "sale of a franchise" contained in the Rule:
The term sale of a franchise includes a contract or agreement whereby a person obtains a franchise or interest in a franchise for value by purchase, license, or otherwise. This term shall not be deemed to include the renewal or extension of an existing franchise where there is no interruption in the operation of the franchised business by the franchisee, unless the new contracts or agreements contain material changes from those in effect between the franchisor and franchisee prior thereto.
16 C.F.R. Section 436.2(k).
In the Statement of Basis and Purpose to the Franchise Rule, the Commission discussed expansion of outlets by an existing franchisee as follows:
Comment was also received on . . . whether there would be an exception for franchise sales where there is already an existing franchise relationship between the parties. The Commission, however, finds that such an exclusion is inadvisable in view of the fact that subsequent franchise purchases may be at terms different than those at which the franchisee has previously purchased his or her franchise(s), and since other material changes concerning the franchisor may have occurred without the knowledge of the franchisee.
Statement of Basis and Purpose, 43 Fed. Reg. 59614, 59718 (December 21, 1978).
In the same vein, the Commission stated in the Final Interpretive Guides to the Franchise Rule:
Franchisees who exercise a right under their franchise agreement to establish new outlets for themselves . . . need not be furnished with the disclosures required for prospective franchisees unless the new relationship is under terms and conditions materially different from their present agreement. In interpreting whether disclosure is required in such circumstances, the Commission will employ a flexible standard based upon the extent to which the disclosure will materially assist the franchisees in making an informed decision.
Final Interpretive Guides, 44 Fed. Reg. 49966, 49969 (August 24, 1979).
It is clear that a franchisor must provide a disclosure document to an existing franchisee if that franchisee is purchasing new outlets under terms and conditions that are materially different from those of the original franchise agreement. Thus, disclosure would be required if the new franchise, for example, was for a shorter or longer term; if the franchisee was obligated to pay different costs or royalty payments; or if the franchisee was subject to new territory, product, or source restrictions. Similarly, disclosure would be required if material changes have occurred in the franchisor's business, such as new litigation or a bankruptcy filing. Disclosure would also be required if there had been a material change since the signing of a previous addendum concerning either the franchisor's business or the terms and conditions under which a new outlet would operate.
III. AN ADDENDUM PERMITTING EXPANSION MAY NOT CONSTITUTE A MATERIAL CHANGE
Assuming no additional change in terms, conditions, company policy, or business operations, it does not appear that expansion alone, under the facts presented, would constitute a material change. From your description of events, we can reasonably infer that each addendum the parties sign modifies their original agreement narrowly: rather than changing company policy to permit expansion generally, the franchisor appears to grant the franchisee the limited right to open a specific outlet or outlets only. If the franchisee subsequently wishes to expand again, the franchisor apparently must execute yet another addendum granting the franchisee the right to open that additional outlet, and so on. By signing the addendum, the franchisee has no assurance, and cannot reasonably believe, that the franchisor has now adopted a pro-expansion policy. Under these circumstances, we conclude that the franchisor's limited grant of approval to open an additional outlet alone does not constitute a material change in the original franchise agreement.
IV. A PATTERN OF SUBSEQUENT ADDENDA MAY BE CONSTRUED AS ABANDONMENT OF ORIGINAL CONTRACT
The question remains, however, whether the franchisor has, in effect, adopted a pro-expansion policy by repeatedly amending the original contract to permit the franchisee to expand. Clearly, a franchisor and a franchisee can formally agree to modify their contract to adopt a pro-expansion policy, where no such right previously existed. For some reason, the franchisor in the scenario you present does not wish to grant expansion rights generally, but apparently wishes to approve any additional outlets through multiple addenda to the franchise agreement. At some point, however, the franchisor's willingness to grant exceptions might be construed as a material change in its policy regarding expansion. Indeed, there may be no practice difference between signing a one-time modification of an agreement to permit expansion generally and the signing of multiple addenda over time to permit expansion in a piecemeal fashion.
At this time, we are not prepared to determine when a franchisor's practice of permitting expansion through multiple exceptions might be deemed a constructive change in the franchisor's policy regarding expansion. As noted above, in determining whether disclosure is required, the Commission will employ a flexible standard based upon the extent to which the disclosure will materially assist the franchisees in making an informed decision. Even if the franchisor has constructively adopted a pro-expansion policy by permitting multiple addenda to its original contract, disclosure would not likely materially assist the existing franchisee in deciding whether to purchase an additional outlet. At most, disclosure would inform the franchisee that the company has changed its policy from one permitting expansion through a piecemeal exception approach to a broader grant of expansion rights. While this change may be material to prospective franchisees and existing franchisee who have not sought to expand, it does not appear to be material to the existing franchisee who has already negotiated with the franchisor for additional outlets.
A material change in a franchisor's expansion policy occurs when a franchisor either formally abandons a no-expansion policy, or formally adopts an expansion policy when its franchise agreement is silent on the subject. In such circumstances, the franchisor must provide disclosures to prospective franchisees and existing franchisees seeking to purchase additional outlets. Arguably, the franchisor may also be deemed to have constructively adopted a pro- expansion policy by permiting existing franchisees to expand repeatedly through multiple addenda to the original franchise agreement. Although constructive adoption of a pro-expansion policy may be a material change to prospective franchisees and existing franchisees who have never sought to expand, it does not appear to be material to an existing franchisee who has already negotiated with the franchisor for additional outlets. While disclosure may be desirable to such an existing franchisee, under such circumstances it does not appear to be required.
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.
Franchise Rule Staff
Date: December 8, 1997
1. You add that the original franchise agreement requires the payment of ongoing royalty fees and it is expected that these fees will exceed $500 for each additional outlet during the first six months of operation.