FDD Compliance - What You Need to Know
The familiar UFOC is now obsolete. This webinar will educate you on the new terminology, new format, changes in delivery requirements, and the items in the disclosure document most changed by the new rule.
Susan Grueneberg is a Partner in the law firm of Snell & Wilmer, in Los Angeles, California. Susan focuses on advising clients on franchise and distribution law, including FTC compliance. Ms Grueneberg is a Past Chair of the American Bar Association Forum on Franchising and serves as Chair of the Industry Advisory Committee to the North American Securities Administrators Association (NASAA) Franchise Project Group. She is a graduate of UCLA Law School. Contact her at firstname.lastname@example.org.
David T. Azrin is a partner at the New York City law firm of Gallet Dreyer & Berkey LLP where he practices franchise law on behalf of franchisees and franchisors. Mr. Azrin is a graduate of Stanford University and the University of Michigan Law School. He is a member of the International Franchise Association and the American Bar Association Forum on Franchising. Contact him email@example.com.
For those of you who would prefer to read the official transcript, enjoy!
Operator: Ladies and gentlemen, thank you for standing by. Welcome to the FranchiseHelp webinar. During the presentation, all participants will be in listen only mode. Afterwards, we will conduct a question and answer session. At that time, if you have a question, please press the one followed by the four on your telephone. If at any time during the conference you need to reach an operator, please press star zero. As a reminder, this conference is being recorded Thursday, June 26th, 2008.
It is now my pleasure to turn the conference over to Mary Tomzack. Please go ahead.
Mary: Thank you. Welcome to our webinar: What you need to know about complying with the changes to the FTC Franchise Rule. My name is Mary Tomzack. I'm the President of FranchiseHelp and FranchiseHelp.com.
I think many of you use our website, FranchiseHelp.com, and I'm sure many of you are also subscribers to our newsletter. But for those of you who are unfamiliar with us, FranchiseHelp.com is a portal site which provides services, products, and information for the entire franchise community.
Our technical partner today is ReadyTalk. They are the producer of this web conference. If you're interested in learning more about ReadyTalk, some of the information is on our first slide. I'll just add that they're a great company, and they're headquartered in Denver, Colorado.
First, I'm just going to take a few minutes to do a few housekeeping notes. One thing that we've added recently is on our home page of FranchiseHelp.com we have a link which gives the audio and the slide presentation for all of our webinars. So, that's a great convenience for you. You can go back to webinars which you weren't able to listen into, to attend to, and you'll get the audio portion and you'll be able to also download the slide presentation. This will include our presentation today. Most likely we'll have it up by the end of tomorrow if you'd like to see that or like to access that.
We will take questions all through the presentation, and we'll be using the chat button which all of you should see on the lower left-hand part of your screen. Please feel free when you have a question just to type it in, and we'll interrupt with it if it's a timely question. Otherwise, we might keep it to the end of the formal presentation. Then, we'll address it at that time.
So, there will be a few minutes, hopefully, at the end of the formal presentation to get most of your questions answered. The webinar today will last about one hour.
Our presenters today, we have two presenters, Susan Grueneberg. Susan is a partner in the law firm of Dreier Stein Kahan Browne Woods George LLP out there on the West Coast in Santa Monica, California. Susan practices in the area of franchise and distribution law. She graduated from UCLA Law School, and if you're looking at slide 2 now on your screen, you will see Susan's email and her phone number if you would like to contact her.
David is with me in the New York City area. David Azrin is a partner at the New York City law firm of Gallet Dreyer & Berkey LLP. David practices franchise law both on behalf of both franchisees and franchisors. David graduated from Stanford University and the University of Michigan Law School. At the end of his description, you will also find the contact information for David.
So, here we are June 26th. We're just about, I guess, four days away from the July 1st D-Day, and that's the day where it has been said that franchisors must convert the old, friendly uniform franchise offering circulars, the UFOCs, to the new format and transform these documents into the franchise disclosure documents or FDD.
We know this has been a little bit confusing to many franchisors. So, this webinar is designed to present the major changes from the old version, which I'm sure you're very familiar with, to what is now the new version. Surprisingly from the point of view and FranchiseHelp deals with a lot of franchisors, there's a great number of franchisors that haven't registered their new documents yet.
So, if you're one of them or if you're thinking about it, you might want to ask Susan and David if there will be any sort of a time reprieve, or what's going to happen with the authorities or possibly ways that you can speed up your revision process. I think if I were a franchisor right now and didn't have my document together, I think I'd be asking that question.
So, let's get on to the changes, and I would like to turn it over now to David Azrin. David?
David: Thank you, Mary. Thanks for organizing this, and welcome everybody. And good morning or good afternoon, depending on where you are, Susan, and everybody.
We have a lot of material to cover, and I'll just give a little bit of a disclaimer. We're not going to cover every single change from the prior UFOC guidelines to the new rule. We're not going to cover some of the more minor or esoteric issues. What we've tried to do is focus today on the issues that are really going to have a practical effect on franchising and the way that franchisors operate and sell franchises. So, that's what we're going to be focusing on, the more significant and practical issues.
So, let's get started. Both Susan and I, in terms of the format, are going to be alternating, discussing different issues. As Mary mentioned, feel free to send us chat messages or questions during our presentation. If it's a relevant question and time permits, then we'll either respond to you by email or on air, so to speak.
So, the first item we wanted to talk about had to do with Item 3, the litigation disclosures. And the big change here is that the new rule has added suits that are filed by the franchisor in the past year. So, under the prior rules in Item 3, the franchisor was required to disclose any pending suits that were against the franchisor that were material to the system or for breach of fiduciary duty, fraud, suits where they were held liable, felony convictions and injunctive relief.
All those things are the same. But what's new is under the previous rule, if they filed a suit, let's just say for collection of royalties, then that would not have been required to be disclosed. And what's new now is that suit against a franchisee, for let's say royalties or enforcement of a non-compete, does have to be disclosed.
The significance of this change, as a practical matter, it may give franchisors a little bit more pause before they do initiate actions because they are going to have to be disclosing all the suits that they filed in the past year.
In the recent Compliance Guide which the FTC has issued and also in the Frequently Asked Questions, they've provided some clarification on all of these issues. On this particular issue they've clarified that they're only talking about suits that were actually filed in the past fiscal year. So, when you do your disclosure at the beginning of the year, you're going to be including all of the suits that you as a franchisor filed during the past fiscal year.
Now, I'll turn it over to Susan to talk about Item Number 8.
Susan: Thank you, David. Item 8 also has a brand new disclosure requirement. Recall that Item 8 requires disclosure of restrictions on the sources of products and services, and this can include goods, services, supplies, fixtures, equipment, inventory, computer hardware or software, real estate, and similar items.
Now the restriction could be that the franchisee must purchase or lease from a designated or approved supplier. But it could also mean that the product or service must meet specifications that are established by the franchisor.
So, what is the new requirement? The new requirement under the FTC rule is that a franchisor must disclose if an officer owns an interest in one of these suppliers. It seems pretty straightforward. If an officer owns an interest in the franchisor, for example, and the franchisor is an approved supplier, then disclosure is required.
But what happens if one of the designated suppliers in a restaurant franchise, for example, is a major beverage supplier like Coca-Cola or Pepsi, and what if an officer of the franchisor has a profit-sharing plan or a 401K investment that happens to have invested in a mutual fund that owns shares of Coca-Cola? This would technically be an interest in the supplier.
Well, recently the FTC addressed this question in one of its FAQs posted on its website, which, by the way if you don't have access to, is an excellent source of additional information on the rule. And what the FTC said is that the key here is materiality, whether the ownership interest would be material to an investment decision by a prospective franchisee.
And it poses an example of an officer who owns shares of a diversified mutual fund that does not have a stated policy of concentrating its investments in a particular industry or line of business. The fact that the fund may acquire stock in a supplier does not trigger the Item 8 disclosure.
Also, the FAQ points out something that I think went unnoticed for a while, and that is when you do have one of these disclosure items, you don't have to disclose the particular officer involved. You only have to identify the supplier and state that an officer owns an interest in that supplier.
David, what can you tell us about Item 19?
David: Well, there's some important changes in 19. I'm going to talk about a couple of them. First, Item 19 has been renamed. So, it's no longer called Earnings Claims. We're going to be using a new term, Financial Performance Representations. So, now we have Financial Performance Representations instead of Earnings Claims, and we no longer call this disclosure document, UFOC. Now, it's referred to as a Franchise Disclosure Document.
With respect to Item 19, there's a couple important changes that are going to have a practical effect on franchising. The first issue is on slide 6 which is on your screen. Under the old rule, as everyone who is familiar with franchising is probably aware, the franchisors were not permitted to make any representations about either cost information or revenue information that was not disclosed in Item 19. The change is that this prohibition no longer applies to cost information. So, the prohibition now is only that you're prohibited from making representations about a specific level or range of actual or potential sales income, gross profits, or net profits. And so you'll see that does not include cost information.
So, what that means as a practical matter that even if, let's say, your franchisor and you're not going to make in Item 19 financial performance representation. So then, the rule still applies then that you're not allowed to make any representations about revenues or sales, either actual or projected. You're not going to be allowed to make those because you haven't provided a disclosure.
Under the new rule, even if you have not made any Item 19 disclosure, you are allowed to provide cost information to prospective franchisees. The prohibition no longer applies. Now, with that I would add that, of course, general fraud principles and misrepresentation principles are still going to apply. So, the cost information that you as a franchisor do provide, you need to make sure that it is not misleading or false.
You are allowed to provide either actual cost information or projected cost information in addition to the information you are already disclosing in Item 7. You can provide additional information even if you have not made an Item 19 financial performance representation disclosure.
Now, a question has come up and the Compliance Guide has tried to address this issue. Well, can you provide percentage information? Can you tell someone, well, your cost of goods should be 5% of your sales? And there was some uncertainty about that until the Compliance Guide has tried to clarify that, that any cost information that you provide, coupled with any additional sales or earnings figures from which somebody could calculate their average net profits is not allowed. So, based on that, I would say that you can't try to get around this rule by providing percentage figures.
Well, let's go to the next slide which is the next important change in Item 19, which is the FTC has tried to clarify the law regarding Item 19 disclosures. In the past, there was a misconception among some franchisors and prospective franchisees that franchisors are just simply not allowed to make any statements to franchisees about either cost or revenue, projected profits.
So, when a prospective franchisee would ask a franchisor, "How much money can I make?" which is the first question that they ask, and then the franchisor would say, "Well, by law, I'm not allowed to tell you." Well, that wasn't exactly correct, because the law was that a franchisor was allowed to provide that information, but they just had to put it in writing and put it in Item 19, in the disclosure document, and make sure that there was a substantial basis for it.
So, there's a new required, mandatory disclosure statement that's required in everybody's Item 19 that tries to clarify this issue for everybody. And essentially this disclosure says that the FTC does allow franchisors to provide financial performance information. And then, if a franchisor is not going to provide a disclosure in Item 19, then the franchisor has to affirmatively state in Item 19 that, basically, we have chosen not to, so that it's clear to everybody that, again, the FTC does allow it if it's in Item 19, but the franchisor has just chosen not to.
We'll see the idea here is that this might encourage franchisors to possibly go ahead and make the disclosure if all the franchisees are getting this statement that says, well, they can provide it to me, but they've chosen not to. Possibly that might encourage more franchisors to do that.
The new rule also provided some more guidance to franchisors who do choose to make a financial performance representation. They have provided more guidance to franchisors who choose to make the financial performance representation. There are certain required disclosures if you do choose to make that representation and some guidance on how you should prepare it and how you should disclose it, but those are technical issues. The important change is this new mandatory disclosure.
And with that, we'll move to the next slide, Item 20, and Susan will talk about the important changes to that item.
Susan: Thank you, David. There are actually a number of changes to Item 20, but the first one that I wanted to talk about, I think, has the potential of having the greatest impact on franchising of all of the changes under the amendments to the rule.
Item 20, which provides information to a prospective franchisee on the franchise system itself, has been overhauled and pretty much reorganized. One of the new requirements is that contact information about certain franchisee associations is now required to be included. Let's go through the types of franchisee associations that have to be disclosed in this item.
The first type is one that is created, sponsored, or endorsed by the franchisor. The other type of association for which contact information must be included is an independent association that requests inclusion. Now, that request must be sent within 60 days after a franchisor's fiscal year end. And there is an additional requirement that the franchisee association itself must be organized under state law, for example, as a corporation or other entity.
Now, it may take a few years for independent franchisee associations to become aware of this new disclosure opportunity. But once they do, their influence over franchise systems is likely to increase exponentially. Because most diligent prospective franchisees will check with the franchisee association contact as part of their due diligence in researching the franchise system, a franchisor may be wise to vet changes to the franchise offered with the franchisee association before making those changes. And thus, the influence of independent franchisee associations may grow.
David, what else has changed in Item 20?
David: Thanks, Susan. There's another change in Item 20 that we did want to talk about. I'll put up that slide. This has to do with a concern of the FTC's that they wanted to make sure that the prospective franchisees are getting as much information as possible. And, of course, a big source of information for prospective franchisees is being able to talk to existing or former franchisees.
So, the FTC was concerned that there was a practice by some franchisors where, either as a result of a dispute that had arisen with that franchisee, the franchisor as part of a settlement agreement had required or asked the former franchisee to enter into a confidentiality agreement that not only prohibited them from talking about trade secrets or confidential information but just prohibited them from talking in general about their experience as a franchisee. So, there was a concern over at the FTC then that prospective franchisees were going to former franchisees and asking them for information, and the former franchisees would just respond and say, "I can't talk to you."
Now, the FTC decided that they were not going to prohibit these types of agreements. They are still permitted. There is no prohibition against them. But what the FTC has done is they've said to the franchisors in Item 20, "If you are going to ask or require former franchisees to enter into this type of agreement, then you're going to have to disclose that fact to prospective franchisees in your disclosure document, and you're going to have to make an affirmative statement that we have entered into confidentiality agreements with franchisees that may prohibit them from talking to you."
The idea here is, as a policy matter, that this might discourage franchisors from entering into those types of agreements, or at least it would let prospective franchisees know why it is that these former franchisees aren't talking to them.
Now, there's a wrinkle to this rule. Let's say that if a franchisor has only entered into one such agreement in the past three years, then the FTC was concerned that it might give an incorrect impression if the franchisor has to state, "We've entered into these types of agreements in the past three years." It might give the impression they've entered into a lot of them. So, the franchisor, at their option, is allowed to provide a clarification as to exactly how many they have entered into and even what the circumstances were. So, they could say, "Yes, we have entered into this type of agreement in the past three years. It was only one instance and it was the result of these circumstances."
And next, let's go to Item 21. And we're going to talk a little bit about financial statements. There are two important changes with respect to financial statements in Item 21 that we wanted to highlight.
The first has to do with a situation where a company has formed a subsidiary corporation to do its franchising, and this is a fairly common situation, a common practice. Under the prior rules where a company would form a subsidiary, then it was not required that the subsidiary who's selling the franchises, as a general rule, the subsidiary was not required to provide the audited financial statements of the parent company. So, a company that wants to do franchising could form a subsidiary, and then that subsidiary would do the franchising. And then, that subsidiary that's doing the franchising, that's offering the franchises, would only have to provide the audited financial statements of the subsidiary corporation.
Well, the FTC had some concern about this, and they added a new requirement in Item 21 that if as part of the franchise agreement or in the disclosure document or in some other written agreement that the parent company has, and here's the key terminology, committed to perform post-sale obligations for the franchisor, then in that circumstance, when the subsidiary is going to sell the franchises and in their documents it says, for example, that the parent company is going to be providing all these services to you, then, in that circumstance, the subsidiary corporation is going to have to attach and provide the audited financial statements of the parent company.
Now, after the FTC enacted this requirement, there was some pushback from the franchisor community, and the franchisors have asked for a clarification of the rule. And the FTC has provided some clarification of the rule in their answers to these frequently asked questions which Susan mentioned are on the website.
Essentially, what they've done is the FTC has narrowed the scope of this requirement. So, they clarified that if the franchisor is merely just an approved supplier and the franchisor is not obligating the franchisees to buy only from the franchisor, but the franchisor is just an approved supplier, then, in that circumstance, that's not going to trigger the requirement to attach and provide the parent company's audited financial statements..
They've also clarified that if the parent company is just providing what they refer to as back office or administrative assistance to the subsidiary franchisor, that's not going to trigger the requirement to provide the parent company's audited financial statements. And they've also clarified that because the new rule uses the word "obligations" plural that if the parent company is only providing what they refer to as an isolated service, so a single service, then that also is not going to trigger the requirement to provide and attach the parent company's audited financial statements.
So, this is obviously a new wrinkle that is only going to be significant to the franchisor systems where there is a parent company involved that does not have audited financial statements.
Let's go to the next slide which is also on Item 21. This is a new and important change that is going to affect startup franchisors. So, under the old rules even a startup franchisor under the federal regulations was required to prepare and provide and attach an audited financial statement right from the get-go. So, if it's a new company and they just put $50,000 in the bank, they've got to have a CPA go right off the bat, before they sell their first franchise, they've got to prepared an audited financial statement that's basically just going to show $50,000 in the bank.
Under the new rule, if a company is brand new to franchising and they don't have audited financial statements, they can do a phase in. So, during the first year, they're not required to have a CPA do that audited financial statement. For the first year they can get away with just attaching an unaudited financial statement. But then after the first year, then they do need to bring in the accountant and pay for the accountant to do an audited financial statement and slowly phase it in.
Now, it's important to note that not all of the registration states have adopted this. In some registration states, for example in New York, you still do have the requirement for a startup franchise or to have an audited financial statement right from the get-go.
And next, we're going to move to some issues concerning the receipts and the changes in the delivery requirements, which is a real important change that's going to have a practical effect on the sale of franchises for a lot of different reasons. I'm going to turn it over to Susan to cover these new rules.
Mary: Okay. And David and Susan, if I can just interrupt here because we've been getting some questions coming in. So, if we can just take a little look backward for either David or Susan, we have a question from Lisa which goes back to Item 20 again. And I don't want to lose this train of thought.
Lisa had a question about Item 20 as to how it applies to development agreements as opposed to, I guess, a unit franchise agreement. And how do you deal with development agreements in the tables, those famous tables in Item 20? David or Susan, can one of you address that, please?
David: Go ahead, Susan. You can take it.
Susan: That's an excellent question. If I could also add to it, there are questions similar to this that apply if you have a sub-franchise situation or if you have franchises which are not traditional outlets. Item 20 is outlet information. The name has even been changed to Outlet and Franchisee Information.
So, if you have a developer who has the obligation to open a number of outlets pursuant to franchise agreements, the disclosure would be outlet based for purposes of the charts. For purposes of the lists, you would also, for example, if you had a developer who had signed a number of franchise agreements but had not opened all of those outlets, you would indicate that on a list with as much information as you had about the outlets at that point in time. It might even just be city and state. And that's been clarified both in the Compliance Guide and in other materials.
Incidentally, the Compliance Guide to which we've been referring is a living document that may be updated from time to time. So, hopefully we'll continue to have continuing input from the FTC on issues like this and on its website with the FAQs.
Mary: Okay. Thank you very much. Another question and honestly, it's from Tom, and, Tom, I'm not quite getting this, but I'm sure Susan or David will understand a little bit better. The question being, "Does the franchisor of a regional franchisor," which to me would be a sub-franchisee but, maybe, I'm wrong there, "still have to supply financials?"
David: The answer's yes. The rule has not changed. The change in the rule with regard to the parent has not changed. It has not changed that rule.
Mary: So, the franchisor of a regional franchisor would have to supply financials. The answer is yes?
David: Yes. Right. Right.
Mary: Okay. Thank you very much.
David: So, the amended rule requires the disclosure of financial information of any sub-franchisor. That's right.
Mary: Okay. Thank you, David.
Mary: And Susan, do you want to go ahead then with the Item 23?
Susan: Yes, I'd be happy to. The receipt actually contains one of the new requirements -- contact information for the franchise seller or sellers involved with the transaction. Previously, under the UFOC guidelines, if a sub-franchisor, a franchisor broker was involved with the franchise system, that disclosure was included in the receipt. But now, every receipt must have disclosure of a franchise seller.
And the definition of a franchise seller under the FTC rule is quite broad. It refers to someone who offers for sale or arranges for the sale of a franchise. It includes sub-franchisors and brokers as well as the franchisor and individuals who may be the franchisor's employees, representatives, agents.
The person whose information has to be included in this receipt, however, reflects a more narrow definition of franchise seller. It should be the specific individual or individuals with whom the prospective franchisee has had significant contact. And the purpose of this disclosure is twofold. One is to allow the prospective franchisee an opportunity to follow up with an individual with questions that he or she may have. And the other purpose is for law enforcement purposes.
It would be a first step in identifying someone who might have been responsible for furnishing the disclosure document to a particular franchisee. In some situations, it's going to be easy to identify who this person is, but as franchise systems grow the person may be different, depending on who the prospective franchisee is, what geographic region they are located in, or what their particular interests are.
Now, a franchise seller is someone who offers for sale or arranges for the sale of a franchise. The franchise seller could be the person who helped the prospective franchisee fill out an application or the person with whom the prospect has ongoing conversations. But, what happens if a franchisor invites a prospect to come to headquarters for a discovery day? In that case, there may be more people who become franchise sellers for purposes of completing that prospective franchisee's receipt. They will include anyone who makes a material representation about the franchise. A FAQ that came out yesterday on the subject also advised franchisors to plan for this in structuring their discovery day visits.
Now, what happens if the parties don't know who the franchise seller is when the disclosure document is given? Well, the FTC has also provided some guidance on how to address that type of situation. One example of compliance is to request that the franchisee write in the name and contact information for the franchise seller with whom he or she ends up dealing and then to return the receipt to the franchisor.
Another method would be for the franchisor to attach the business card of the person who ends up becoming the franchise seller and attach it to a previously signed receipt and send a copy to the franchisee.
Interestingly enough, the FTC has stressed that none of this will affect the 14 day disclosure period. So, the function of a receipt becomes quite different now since conceivably all of the franchise sellers won't be listed in the receipt until possibly the time at which the franchise agreement is signed. And so, it functions much less as an information conduit and more as a record of the persons with whom the franchisee prospect had contact.
David: So, Susan, if I may interrupt?
David: Let's say the franchisor gives the disclosure document early in the process to the franchisee, and then after that the franchisee meets with additional people, maybe goes to discovery day or talks to additional people who are involved in telling them about what's going to be involved in being a franchisee. Now, the franchisee had already signed the receipt and given it back when they first got the disclosure document. So, what is the franchisor, as a practical matter, what are they supposed to do then when they're about to sign the agreement, and they know that franchisee has, subsequent to giving the receipt, met with two or three different people about the sale?
Susan: Well, I think one of the things that franchisors should incorporate into their compliance process is at the closing have a review of the receipt and add those additional names at that point, if they haven't been added previously.
David: So, they would meet with the franchisee or talk with the franchisee and just add them together on the receipt together as one way of doing it.
Susan: That's one way of doing it. It doesn't have to be a physical face to face meeting. It could be done any number of ways, but it's certainly something that could easily fall through the cracks, especially since many systems are registering their receipts with this information item blank to be filled in later.
Mary: Now, if I might add, this is Mary. From the grapevine, we're hearing that this particular item is causing lots of problems. For example, there are many franchisors who use broker organizations, and besides the names of everybody who is maybe coming in contact with a potential buyer, sometimes they're adding another layer to it. In the beginning having sort of a telemarketing unit, calling to qualify a lead and then maybe giving some basic information. So, we see this escalating in that, just how many names are you going to have to end up writing down at the end.
David: I think based on . . .
Susan: I'm sorry. Go ahead, David.
David: I'm sorry. Based on the FTC's answer to that frequently asked question, which Susan mentioned, it looks like the FTC is really concerned that there's some record of the names of the people that, as Susan mentioned, the franchisee met with. So, the idea is before the person signs that there's going to be some kind of list of the people that they met with, and the FTC has emphasized it's not just people who they talk with on a casual basis, like somebody who drove them to the airport. It has to be somebody who had a significant contact with them is the words that the FTC has used, a significant contact in connection with the sale of the franchise.
Mary: Okay. We have a few more questions, Susan and David. I can see where this is causing considerable problems. Karen asks, "Are the franchise consultants, are they listed in this category?"
Susan: Well, again . . .
Mary: It may be they're not directly involved, but maybe . . . I take it that's what she's talking about as a consultant.
Susan: Well, consultants sometimes act as franchise sellers as well, and you would go back to the same analysis. Did the person, did the individual, it has to be an individual, have significant contact with their material information about the franchise conveyed to the prospect by the consultant? If that's the case, then yes, they would need to be included. What you don't want to do is go back to the bad old days where you had lists of hundreds of brokers that would get attached to the UFOC.
Mary: Yes, I remember that.
Susan: That's something that the FTC does not intend to have happen.
Mary: Okay. Thank you. One last question and then we'll move along. Nancy asks, "Is it acceptable to refer to Item 2 instead of listing each person involved in the sale on the actual receipt?"
Susan: Well, that's a good question. First of all, you have to include contact information on how to reach those people, and I would err on the side of listing their names again in the receipt as opposed to referring to Item 2. But there's no clear guidance on that. If you were to refer to Item 2 and then also list contact information, arguably you've complied, but I would put the name in.
Mary: All right. Thank you, Susan. Then, perhaps, we can move along now.
Susan: David and I are now going to move into some other areas of the amended rule. First of all, I'm going to talk about changes in the delivery requirements. These only apply when a franchisor converts to the new format, but that's going to be required in just a few days. So, we are, for all intents and purposes, dealing with the new requirements now.
This is a good segue from the receipt in our discussion of best practices and franchise sales compliance, too, because this first requirement is brand new and is one that may not have gotten all of the publicity it actually requires.
Before a franchisor delivers the disclosure document, the franchisor has to indicate, in some manner to a prospective franchisee, information about the format or the formats in which the document is available. And this communication also has to include prerequisites for a particular format and conditions for reviewing the document in a particular format.
All of this really can be done in any number of ways. It can be included in advertising materials. It can be in an oral conversation. It can be sent by email or by letter or through a telephone message. This requirement was intended to be very flexible. Now, obviously, it would be preferable to use the method of communication that you can confirm was actually sent and received.
For example, perhaps a disclosure document is only available on CD-ROM. In this event, you would want to disclose what format the document was in and whether any specific applications or equipment would be necessary in order to view the disclosure.
Well, next let's talk about the obligation to furnish the disclosure document itself. Franchisors have long been familiar with the tricky process of calculating the time at which they must provide a disclosure document. Previously, it was the earlier of the first personal meeting to discuss the possible purchase of a franchise or 10business days before signing the agreement or receiving any consideration from the prospect.
The FTC has determined that that first personal meeting trigger really had become obsolete because of electronic communications and the way franchisors and prospects do business. Similarly, calculating 10 business days was often a challenge, and a 14 calendar day disclosure requirement is clearer.
Therefore, once a franchisor converts to the new disclosure format, these new delivery requirements will apply, including the obligation to furnish that disclosure document 14 calendar days before signing an agreement or accepting consideration. One caveat, as we'll see later though, not all states have changed over to this timing requirement.
Mary: Susan, just a quick question. It came in from Lisa, and other franchisors may have this question. Do franchisors have to include information about available formats if the only format is a hard copy?
Susan: Yes. This requirement applies no matter what format your disclosure document is in.
Mary: Okay. Thank you. Another . . .
Susan: The disclosure would be quite simple at that point, however.
Mary: Thank you. And another quick question on this same topic. Are there states, and if so, which states aren't following the 14 day rule? I think there are a few. I mean is it too many to talk about?
Susan: Oh, we'll cover that on a slide in just a couple of minutes.
Mary: Oh, okay. That's coming up then.
Susan: Then your questioner will have a written record of it, too.
Mary: All right.
Susan: Now, let's look at the obligations to deliver the completed agreement. The changes to the rule mean that some long used terminology is going to be relegated to the history books, and one of these is the term the "five business day rule."
As you no doubt recall, copies of the completed agreements to be signed with everything except the signature and date had to be presented to the prospective franchisees five business days before signing the documents. This requirement is now eliminated, and there is no general requirement to replace it. However, and as usual it's a big however, a franchisor does have to deliver revised agreements seven calendar days before signing if the franchisor makes a material and unilateral change.
Now, what does that mean? Well, for one thing it makes life easier for the prospective franchisee. The five business day rule was really an impediment to a franchisee's ability to negotiate, especially if the franchisee needed to close on a certain day. The elimination of the requirement frees up the franchisor and franchisee to negotiate, have multiple drafts of the franchise agreement or an addendum without worrying about the prospect of having the documents for five business days before they could be signed.
Logically, it does make sense, however, that if a franchisor is making a unilateral change that the document should be recirculated, but the devil is in the details. What if there are fill in the blank provisions in the franchise agreement? There could be all kinds of things that are franchisee specific.
If there are territorial boundaries, for example, they're likely not to have been inserted into the document before it was delivered to the prospective franchisee. One example that the FTC has given to us on this subject of inserting the description of territorial boundaries is that they say that that would be a material unilateral change unless the disclosure document said something like the following: "You will receive a territory consisting of one or more counties. Your county is Orange County, California."
Now, most franchisor's sales compliance processes are not set up to deliver documents that are specifically focused on the individual franchise being granted. Therefore, unless they change, it will be difficult for many franchisors to avoid the seven day rule unless the change results from a negotiation with the prospective franchisee.
There's also a brand new requirement because the new disclosure delivery requirements left the FTC concerned with the prospective franchisee, who was going to incur expenses or make decisions without ever having seen the franchise disclosure document. Hence, this new requirement, one that requires the franchisor to deliver the document earlier than required upon a reasonable request by a prospective franchisee.
Now, this does not mean that just anyone can call up and require the franchisor to deliver a disclosure document. A prospective franchisee, who can make this request, is someone who has moved through the sales process and is in discussions with the franchisor. The FTC has pointed out that the type of person who would be a prospective franchisee is someone who would have, for example, submitted a franchise application and who has been notified that he or she qualifies to purchase the franchise.
But what happens if the franchisor at the time this request is received is in the process of preparing its annual update or is awaiting registration of an amendment or renewal registration in one or more of the states? Well, the FTC's response is that the franchisor must continue to provide prospects with its most current documents, but it counsels that the franchisor would be well advised to inform the prospect that it is preparing revisions to the disclosure and to make that document available when it's issued or registered.
And now, we've reached the slide that outlines which of the states still have earlier delivery requirements. And this is important because a franchisor cannot nationally change its franchise sales compliance practices until these differences have been either accounted for or the states have changed their rule.
A handful of states still require the 10 business day disclosure period, and a few more actually retain a first personal meeting requirement. Hopefully, at some point in time all of these states will make the transition to the 14 calendar day rule so that national franchisors can develop a consistent practice.
And finally, briefly let's talk about electronic disclosure. This is actually one provision of the rule that went into effect and could be available to franchisors immediately on July 1st, 2007, without the need to convert from the UFOC Guidelines format.
It's now clear electronic disclosures are permitted. The delivery requirements can be satisfied by posting the disclosure document on the Internet or sending an electronic copy or a CD-ROM to a prospective franchisee. The cover page has a paragraph that must be included if there are multiple formats in which the disclosure document is available. And there's also that earlier rule about format information that we covered.
Now, what are the requirements if the franchise disclosure document is delivered electronically? It's very important. It must be a single document, and it must be in a format that the franchisee can download, store, print, and basically can maintain for its records. It cannot include audio, video, pop- ups, animation, external links, anything of that sort. As a compromise, the FTC does permit the document to include scroll bars and internal links and search features which can be very helpful.
It's advisable for franchisors who want to use this format to set up a protocol for how they are going to document access to the disclosure document and evidence of receipt of that document.
David, I understand there are going to be a number of new exemptions available next week.
David: Yeah, they are. Thanks, Susan. And that was real helpful on the delivery requirements.
Susan: Thank you.
David: Let's see, exemptions. The big change here on the exemptions is that the FTC has added on a national level, there's now a new exemption essentially for large franchisees. There's a large investment exemption and a large franchisee exemption. So, the FTC under the new rule has kept the old exemptions that were applied on the national level, for example, the fractional franchise, the single trademark license. And they have added though a new exemption for large franchisees.
This is significant because there are many states that also have large franchisee exemptions. So, at a national level, if a transaction qualifies and a franchisee qualifies for this exemption on a national level, he won't have to provide the disclosure requirement. And if you're in a registration state that has a large franchisee exemption, then you may qualify there.
Now, it gets a little bit trickier because there are some registration states that still do not have a large franchisee exemption, for example, New York. So in that situation, even though on a national level you would not qualify, you would still have to register and provide the disclosure in that state, for example, in New York.
Also significant is what the FTC did not do. Many states have large franchisor exemptions. So, for the larger systems, they're not required. For example, if California has a large franchisor and New York has a large franchisor, exemptions are not required to register there, but there is no large franchisor exemption at the national level. So, for that issue, the large systems will still have to provide the disclosure document even though they might not have to register at the state level.
Now, let's talk about the specifics. How do you qualify for this exemption? There are two types of large franchisee exemptions. The first is what the FTC refers to as the large investment exemption. This is for a franchisee who is investing more, whose "initial" investment is more than a million dollars, and that does not include if they have to purchase some vacant land.
Now, there was some ambiguity. What do you mean by initial investment? Are you talking about where they have to pay a franchise fee that is more than a million dollars? The FTC has said, "No. What we're talking about is what is the franchisee's startup costs, in other words, the costs that would normally have to be listed in Item 7?" So, we're talking about costs for opening and even the costs for the first three months.
If the franchisee's costs for the opening and for the first three months are going to total more than a million dollars, then they would qualify for this exemption and the disclosure document would not be required. And this is going to apply even if, let's say, a person's buying multiple units at the same time if altogether their initial investment for multiple units is a million dollars, they will qualify.
And it applies to an existing business that's converting to a franchise. If they can show that they put in more than a million dollars to start up their business, then they convert to a franchise, it may still qualify for that exemption.
The other large franchisee exemption that we now have on a national level is the large franchisee who has a net worth of at least $5 million and has at least 5 years business experience. The business experience doesn't have to necessarily be in franchising or even in that same line business, just that they have 5 years of business experience and a net worth of $5 million.
The FTC has also adopted an insider exemption which is something new, but again they have not adopted the large franchisor exemption. So, large systems are not going to have that, even though they might qualify for that at the state level.
I see we're just about out of time. So, I'll just finish up with the last slide which is just to emphasize the deadline for compliance next Tuesday, July 1. The FTC just issued an answer to a frequently asked question. Well, what if we provided a disclosure document under the old rule before July 1, and now the person wants to sign, let's say, July 15th?
What the FTC has said is that you are not required to provide them with the new disclosure document format as long as you had provided them with the old format before July 1, unless they ask for it. So, let's say you provided them last month with the old format document, and then July 10. they say, "You know, do you happen to have a new format document?" And then, you would be required to provide it, and then they would sign after that.
But if they don't ask for it and you provided it beforehand, then you're not required to provide the new document before they sign. Be that as it may, whatever documents you give out after July 1, they have to be in the new format. That's starting next week.
With that, I'll turn it back over to Mary.
Mary: Thank you. Thank you, David, and excellent from both you and Susan. I think you've covered a lot of ground today. I think we can allow for a few call-in questions if there's anything that we haven't delved into yet. Otherwise, you're still able to send in your chat questions.
Phil, are you there, the operator?
Operator: Yes. Ladies and gentlemen, if you would like to register a question, please press the one followed by the four on your telephone. You'll hear three tone prompts acknowledge your request. If your question has been answered and you'd like to withdraw your registration, please press zero one followed by the three. If you're using a speaker phone, please lift your handset before entering your request. One moment please for the first question.
Susan: While we're waiting for that, I noted that we had another chat question about the pre-delivery requirement about formats. And the question was whether or not the information on the cover page can satisfy that requirement. And the answer to that is no. You need to make this disclosure before you deliver the FDD, before you actually hand out the disclosure document to someone or transmit it electronically.
Mary: Okay. Thank you. And another while we're waiting for call-in questions, but I think most people prefer chat nowadays. So, we do have a question from Greg, a big question, and hopefully you can attack this question, David and Susan. Can you recommend any good resources that cover the best practices in eDisclosure?
David: I know that some of my clients use a company called IFX to help with online services, providing operations manuals online and also providing the disclosure documents online. I've heard good feedback about them. So, that's a name that comes to mind.
Mary: Yes. I know of them, too, David, and they're very active in franchising. So, they would probably be a good source.
Susan: Another source might be to go to the IFA website at franchise.org and look in their supplier listing for companies that specialize in eDisclosure.
Mary: That is a good suggestion. I don't think there are too many of them. I know that Nancy Ghanem's old company, Franchise.com, which I don't know if they're still involved in that, but if any of you know Nancy Ghanem who was the previous owner of Franchise.com, this will also be listed some place in the IFA companies. Nancy was very involved in that. In fact, she would probably be a good source of information.
Susan: And if you're looking for the legal aspects of it, you can find a couple of new books. I think the IFA has one and the ABA. There's a chapter in the new ABA book written by Joel Buckberg and Mary Beth Trice that covers eDisclosure.
Mary: Okay. One of our participants tells me that Nancy's new company, which just sort of escaped me, is FranServices. So, that's a company you can look up. They do have the UFOCplus.com if that's sort of what you're looking for. But other than that, it's not a subject that's widely covered. If anyone comes up with any ideas, please just email me and we'll pass it on.
Susan: It sounds like an opportunity for someone.
Mary: Absolutely. Do we have any more questions? Is anyone calling anything, Phil?
Operator: We have no questions from the phone lines.
Mary: Okay. So, I think since we've already run over a little bit, I'll just thank everyone for participating, for listening. I hope you had at least most of your questions answered. And thank you very much to our great presenters, Susan and David. Thank you for really making things a lot clearer for all of us.
David: Thank you, Mary.
Mary: I'm sure David and Susan would be happy to answer additional questions. You have their contact numbers, and you can give us a call or an email at FranchiseHelp as well. Again, thank you very much.
Susan: Thank you.
Operator: Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation. Please disconnect your lines.
5 Tips for Finding the Right Franchise
So you’ve decided that a franchise is the right path for you? Now comes the exciting part—choosing among hundreds of franchise opportunities. Here are questions to ask yourself to help narrow the field:
5 Ways to Evaluate Your Franchise Options
A great way to go and figure out whether or not the franchise you’re thinking about is the right one for you is to just go into a location and take a look around. Watch how things run. Talk to some of the employees or the customers. Figure out what day to day operations are like. If you have a big problem with the day to day business for any reason then it probably isn’t the right franchise for you. But if you go there and think that the business is great then it’s probably a good fit.
The first point I made ties into this, but you need to make sure you’ve done your research before you go ahead and sign a franchising agreement. And that doesn’t just mean from a financial perspective. There are so many other aspects in running a franchise that you need to understand before you get started. Most of this information can be found in the Franchise Disclosure Documents. Some of the most important things you should take a look at would be any legal issues the franchisor might have and the churn rate of franchises. Both of those could potentially be pretty significant red flags that might make you want to reconsider whether or not you want to open that franchise.