The long-awaited revision to the United States federal franchise regulation which requires presale disclosure throughout the country will become effective July 1, 2007, the Federal Trade Commission (“FTC”) January 23. The FTC Franchising Trade Regulation Rule (“FTC Rule”), initially adopted in 1979, has been under review since the early 1990s. Although the focus was upon making the disclosures and compliance burdens more relevant to changes in the U.S. market, franchisors from other countries which may have deferred U.S. franchising opportunities because of obstacles imposed by the FTC Rule will welcome the revised FTC Rule (“Amended Rule’) and the opportunities it presents. As of July 1, 2007, franchisors may comply either with the original Rule or the Amended Rule. After July 1, 2008, all U.S. franchise offerings must comply with the Amended Rule.

First Personal Meeting Disclosure Requirement Is Revoked
Franchisors will find that the Amended Rule makes testing American interest in their franchise offerings much easier. Under the current Rule, franchisors must deliver disclosure documents to a prospective franchisee at the “first personal meeting.” Under the Amended Rule, disclosures must be provided at least 14 calendar days before a prospective franchisee pays any money to the franchisor or its affiliate in connection with a franchise acquisition, or 14 calendar days before any agreement relating to the franchise purchase is signed.

The current Rule restricts franchisors from participating in trade shows in the U.S. or from talking seriously with prospective franchise partners, unless they have first compiled a disclosure document (“Uniform Franchise Offering Circular” or “UFOC”), prepared compliant audited financial statements and delivered them to prospective franchise partners at their first in-person meeting to discuss the possible relationship. UFOCs also must include copies of standard franchise agreements franchisees are expected to sign. Given the typical $20,000+ cost of developing these documents, many foreign franchisors have understandably devoted their foreign development budgets to places where a franchise “fishing license” could be acquired at a lower expense. The revised requirements of the Amended Rule will permit foreign companies evaluating franchising in the U.S. to delay preparing UFOCs and franchise agreements until they have found a serious candidate.

The elimination of the first personal meeting rule may also substantially facilitate a franchisor’s ability to comply with disclosure requirements. One of the most frustrating disclosure requirements for a foreign franchisor is the need to estimate the startup expenses a new franchisee will incur. A company with no U.S. operational experience usually only can compile the information through expensive market research. Once the information is included in a UFOC, it is always likely that the nature of the franchisee’s investment will change from what was disclosed, based on the terms of the franchise agreement negotiated. Under the Amended Rule, the parties can first determine whether they will expand through unit franchising, area development franchising or master franchising and then agree upon any modifications to the franchisor’s prototype business they want to make before the franchisor must place the information in a disclosure document. If the prospective franchisee and the franchisor work together on market studies, the cost of the market research may be less, and the estimates may be much more accurate.

Electronic Disclosure Is Approved
The Amended Rule specifically permits the use of electronic means, such as e-mail, website downloads, or compact discs, to deliver disclosure documents. This change can expedite and reduce the cost of the franchise recruitment process, especially when the franchisor’s headquarters are outside the U.S. No longer will franchisors need to bear the expense of international couriers or wait for international mail to be delivered to satisfy disclosure requirements.

Amended Franchise Rule Exemptions
Although the Amended Rule does not provide any specific exemptions for foreign franchisors, three new exemptions may provide a basis for many foreign-based franchisors to avoid the Amended Rule altogether. The Amended Rule exempts franchise offers made to “sophisticated investors” - those that have been in business for at least five years and have a net worth of at least $5 million USD. Only one member of an investor group needs to meet the requirement for the exemption to be applicable. Thus, prospective franchisees with established regional or national businesses may be granted franchises without the need for a disclosure document, audited financial statements or other documents usually required by the Amended Rule.

Also exempt are franchises requiring investments exceeding $1 million USD, excluding the cost of unimproved land and any financing provided by the franchisor. In calculating the investment, franchisors may include the expenses and fees associated with establishing franchised outlets under multi-unit franchise agreements, such as area development agreements and master franchise agreements. Prospective franchisees who agree to convert existing business operations to a franchise also may include the value of their business assets in the calculation of the amount they are investing in a franchise. Foreign companies which decide to enter the U.S. market using master franchise or area development programs may frequently find that they can avail themselves of this exemption.

Finally, franchises sold to officers, owners or managers of a franchisor which have been employed by the franchisor for at least two years before purchasing the franchise will be exempt. This will allow a company-owned prototype franchise or a joint venture formed to enter the U.S. market to be sold as a franchise after two years to an employee without the need for FTC disclosures. It would also permit a franchisor to avoid the Rule by selling a franchise to a U.S. entity “which is at least 50 percent owned by a person who, within sixty days of the purchase of the franchise, has been, for at least two years, an officer, director, general partner, individual with management responsibility for the offer and sale of the franchisor’s franchises or the administrator of the franchised network.” In addition, the exemption applies to a person who has owned at least a 25 percent interest in the franchisor for a two year period, ending no later than 60 days before the franchise sale. This should facilitate franchise sales where a member of a franchisor’s management or ownership team will take a 50 percent “ownership interest” in a U.S. franchisee. The Amended Rule would not prohibit the other owners from having voting control over the franchisee entity, nor from investing a majority of the capital need to acquire the franchise and launch the franchised business.

Financial Audit Requirement Changes
One of the principal roadblocks for some foreign franchisors is the FTC’s audit requirement. Disclosure documents must include audited financial statements of the franchisor and audits must be performed in accordance with U.S. Generally Accepted Auditing Standards (“GAAS”). The Amended Rule relaxes this requirement somewhat, and allows foreign companies to use statements prepared under their country’s Generally Accepted Accounting Principles (“GAAP”), so long as the statements also satisfy criteria published by the U.S. Securities and Exchange Commission (“SEC”) for the use of foreign financial statements in U.S. securities offerings. Whether franchisors can find accounting firms willing and able to modify existing statements to meet the SEC criteria in a cost-effective way is an open question.

The Amended Rule permits companies which are “new to franchising,” which have not previously had “an audit” to phase in to the audit requirements. Rather than being required to provide three years of balance sheets, profit and loss statements, and cash flow statements, “start up franchisors” only are required to prepare audited statements after the end of the first fiscal year in which they begin franchising. New franchisors must include in their disclosures unaudited statements which have been prepared in accordance with U.S. GAAP. It is not clear whether a company which has only offered franchises outside the U.S. will be considered a “start up franchisor” or “new to franchising.” It is also unclear whether a company that has had audited financial statements prepared under its home country’s GAAP will qualify for the audit requirement phase in. Those issues should be resolved when the FTC releases its Compliance Guides before the Amended Rule becomes effective.

Foreign franchisors will need to carefully consider how they structure the entity that will offer franchises in the U.S. The audited financial statements of a franchisor’s parent company must be included in the disclosure document if the parent company commits to perform the franchisor’s post-sale obligations to franchisees or if the parent guarantees obligations of the franchisor subsidiary. In the past, some foreign franchisors have set up new companies to grant franchises in the U.S. in order to minimize tax liability, exposure to claims from U.S. franchisees or audit costs. Under the Amended Rule, establishing a new entity to be the franchisor for the U.S. could result in the parent company having to provide its financial statements, unless it clearly arranges for the franchisor entity to perform services for U.S. franchisees. Parent company guarantees are sometimes required by state franchise examiners as a condition of registering franchisor subsidiaries that are perceived to have weak financial statements.

Negotiating Franchise Terms Is Easier
Under the current Rule, a prospective franchisee must have a completed copy of the franchise agreement and all agreements related to the franchise purchase in its hands for five business days before he can sign them. If the parties change terms of the standard agreement – especially if the changes benefited the franchisor – the five business day waiting requirement is renewed. Business people who often travel far to close deals and who are accustomed to negotiating changes in deal terms up to the time an agreement is signed have found the process to be thoroughly frustrating. Under the Amended Rule, unless the franchisor unilaterally changes the form of agreement which is included with the disclosure document, and requests the prospective franchisee to sign that changed version, the parties do not need to wait to conclude a deal – assuming they already have complied with the 14 day pre-sale disclosure requirement.

The Amended Rule requires use of a single disclosure format, modeled after the UFOC format, which was first developed by state franchise law regulators in the mid 1970s. A UFOC must provide disclosure of 22 categories of information about the franchisor, the franchises being offered and certain franchise agreement terms. Specific disclosures describe the franchisor’s history, its officers and directors, litigation and bankruptcy experience, franchise fees, initial franchise investment costs, restrictions on franchisee purchases, franchisor sponsored financing, franchisor duties to franchisees, same brand competition restrictions, trademark and patent rights and financial performance representations. UFOCs must include contact information for current and former franchisees, audited financial statements and all form agreements franchisees typically are required to sign. Although the FTC has approved the use of the UFOC to satisfy federal disclosure requirements, it also has permitted use of a disclosure format published in the Rule. The new disclosure format will effectively replace the current UFOC format, although additional disclosures may be required by state laws.

State Regulations Remain in Place
The Amended Rule applies to all franchises offered for sale for locations in the U.S. However, franchise sales laws in fourteen states also regulate offers and sales of franchises to their residents and sometimes to non-residents if franchised locations will be established in those states. Under the Amended Rule, the state regulators may impose higher standards of disclosure than the Amended FTC Rule prescribes. At a minimum, these states will require that franchisors either “register” their franchises under their laws or submit applications for exemptions from the laws, if the franchisors qualify. Some franchise registration laws exempt franchise transactions which are similar to the Amended Rule’s exemptions. Additionally, franchisors lacking a U.S. trademark registration also may be required to comply with filing and disclosure requirements of “Business Opportunity Sales Laws” (Biz Opp) which exist in 25 states. Compliance with Biz Opp laws usually involves filing a brief disclosure statement (which is much less detailed than a UFOC) and the payment of a filing fee, which rarely exceeds $100. Without detailing specific requirements and exemptions of state franchise and business opportunity laws, the FTC Rule is the only law which specifically regulates the sale of franchises in 18 states, plus Washington, D.C. and Puerto Rico.

Franchise Sales from the U.S. to Other Countries Are Not Covered by Amended Rule
The Amended Rule also impacts international franchising for U.S.-based franchisors. The Amended Rule only applies to sales of franchises to be located in the U.S. Although several state franchise registration laws may arguably apply to the sale of franchises for foreign countries, the FTC’s confirmation that it will not assert jurisdiction over such sales resolves a longstanding question and reduces liability U.S.-based franchisors may have for complying with franchise laws in both the U.S. and in the countries where they are selling franchises.

The Amended Rule contains many other changes, most of which have met with the approval of the franchising community. The Amended Rule may be accessed at www.ftc.gov.

By: Carl E. Zwisler
Haynes and Boone, LLP

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Carl E. Zwisler is a franchise lawyer in the Washington, D.C. office of Haynes and Boone, LLP. Carl was a former general counsel for the International Franchise Association, and participated in the development of both the initial FTC Rule and the Amended Rule. When the FTC Rule was issued in 1979, he edited and co-authored The FTC Franchising Rule, the IFA Compliance Kit. His analysis of the first version of the Amended Rule was published in the Commerce Clearing House Business Franchise Guide in 2000. In the report issued with the Amended Rule, the FTC cited his comments on the proposal more than 100 times. He also has authored Master Franchising: Selecting, Negotiating and Operating a Master Franchise, published by Commerce Clearing House in 1999, and Franchising Basics: The Official IFA Course, available at www.franchise.org. He regularly represents franchisors entering the U.S. market, and U.S. franchisors which are franchising abroad. [email protected]
www.haynesboone.com