Are Changes to the Federal Trade Commission’s Franchise Rule in Our Future?

Are Changes to the Federal Trade Commission’s Franchise Rule in Our Future?

Spoiler alert—probably not, at least not in the near term.

Franchising as a method of product and service distribution has been wildly successful, constituting an ever-growing percentage of business activity, both in the United States and worldwide.  2021 and the post-pandemic economic environment are likely to see even more accelerated growth as disillusioned former employees seek more control over their financial security by purchasing franchises and owning their own businesses.

While the public health crisis we have experienced has meant disaster for some concepts, for others it has spurred creativity and innovation. Many of the adaptations that have surfaced such as ghost kitchens and increased online marketing, are likely here to stay. But there is still a long road to recovery ahead.

In the midst of this, there have been signals that the legal regulation of franchising may be changing. Nationally, franchisors are required to provide prospective franchisees with pre-sale disclosure and observe a cooling off period before signing a Franchise Agreement or accepting any consideration. 

This is mandated by the Federal Trade Commission’s Franchise Rule. Periodically, the FTC reviews the rules it promulgates to determine if there is still a need for the rule and if any changes should be made. That process started again in 2019 for the Franchise Rule, more formally known as Disclosure Requirements and Prohibitions Concerning Franchising, when the FTC requested comments on whether the Rule was still necessary, whether it should be modified, the cost of compliance and whether technological or economic changes made changes necessary.   

Almost universally, the responses were positive about the continuing need for the FTC Franchise Rule. It is hard to find any stakeholder who thinks it should be abolished. In fact, many are happy with the Franchise Rule the way it is and feel that it still serves its intended purpose.

In November 2020, the FTC held a virtual public workshop on some areas of change that have been proposed by some parties. The three-and-a-half hour workshop addressed topics such as financial performance representations; disclaimers, waivers and questionnaires; and the pros and cons of the current Franchise Disclosure Document format. Following are some of the issues discussed:

Financial Performance Representations

  • Should financial performance representations be mandatory?

Pre-pandemic, the percentage of franchise programs making financial performance representations was on the increase. On the one hand, it seems like this is the most important type of information a prospective should want, so why should it be optional? On the other hand, how do you exclude certain programs where disclosing this information could actually be misleading or where the franchisor does not have ready access to meaningful financial data? 

  • What, if anything, has changed since the last time the FTC looked at this issue?

The FTC previously conducted a formal review of the FTC Franchise Rule from 1995 to 2007. At the time, the FTC concluded that record did not reflect benefits to prospective franchisees that would outweigh the cost to franchisors. Actually, not that much has changed in terms of the factors that motivate franchisors to provide this disclosure. If anything, market forces encouraged this disclosure. Still, the thought lingers—disclosure of litigation and bankruptcy history is mandated. Why should the most important information be optional?

  • Financial performance representations must have a reasonable basis. What does that mean exactly?

There is no easy definition of what “reasonable basis” means because it can vary depending on a large number of factors. Luckily, in recent years, the North American Securities Administrators Association has provided us with a number of Commentaries, one of which specifically addressed financial performance representations. The Commentary issued in 2017 provides guidance on what information can be presented and how to present it.

Disclaimers, Waivers and Questionnaires

  • How do disclaimers and waivers affect franchisees?

According to regulators, disclaimers of the information presented in the Franchise Disclosure Document make it difficult for a franchisee to rely on that information in making an informed decision about a franchise. Waivers jeopardize franchisees’ ability to seek recourse if the information is not correct. From a franchisor’s perspective, disclaimers and waivers protect against unjustified claims by franchisees who may want to blame the franchisor for financial difficulties. 

What is the current state of the law on this? The FTC Franchise Rule does not permit the franchisor from disclaiming the information presented in the Disclosure Document. A franchisor is not allowed to add any disclosure not required by the FTC Franchise Rule itself (or that may be required by a state authority). So adding extraneous disclaimers and waivers is not permitted.

  • What are franchise questionnaires and how do they work?

Some franchisors attach a questionnaire to be completed by a franchisee buying a franchise.  These questionnaires typically document whether the franchisee received a Franchise Disclosure Document on a timely basis and whether the franchisee received any financial performance representations outside of the four corners of the Disclosure Document. There is no legal requirement for such a questionnaire to be completed and the format and questions vary widely.

Franchisors argue that these questionnaires are an important part of the compliance process and make sure that no violations of the legal requirement occurred in the offer and sale of the franchise. The counter argument is that a franchisee who might answer the questions in a way that indicated that there was a violation is told that if he or she completes it that way, they won’t be awarded a franchise.

Pros and Cons of Current Disclosure Format

  • Do franchisees read Franchise Disclosure Documents?

Franchise Disclosure Documents have become long and complex. The requirement is that they be written in plain English, but relying on lawyers to write in plain English is an iffy proposition.  The concern is that prospective franchisees do not read these documents and often do not consult with an advisor such as a lawyer or accountant to advise them on the purchase.

  • Should there be a summary of the Franchise Disclosure Document?

Some franchisee representatives have been lobbying for a summary document of the most important information in the Franchise Disclosure Document. Beginning in 2020, franchisors have had to include a series of Cover Sheets that highlight some of the most important topics to a prospective franchisee and alert the prospect where to find them. Stay tuned to see if this trend continues.

Bottom line, the public workshop and comment period are a preliminary step the FTC has taken to determine if a rulemaking is necessary and desirable. The last rule review lasted for 12 years.  Even if the determination to proceed is made, we know from past experience that this would be a long and winding road.

 

By Susan Grueneberg, attorney at Cozen O'Connor

Susan has been working with franchisors and multi-unit franchisees in industries ranging from food and beverage to transportation, fitness, senior care, health care, pet services, real estate, children’s activities, automotive care and construction for the past 30 years. She assists franchisors in setting up franchise systems and expanding them nationally and internationally. To learn more, you can reach Susan at 213-892-7996 or sgrueneberg@cozen.com.