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What is "The Franchise Rule" and what should I know about franchising?

Oct 12 2017 Staff
In short, it is: 16 Code of Federal Regulation (CFR) Parts 436 and 437

More specifically, the Franchise Rule gives prospective purchasers of franchises the material information they need in order to weigh the risks and benefits of such an investment. The Rule, primarily enforced by the Federal Trade Commission ("FTC") at the federal level, requires franchisors to provide all potential franchisees with a disclosure document (commonly known as the "FDD") containing 23 specific items of information about the offered franchise, its officers, and other franchisees.

History and Overview
The FTC is the Federal agency that governs the manner in which a franchise is offered for sale in the United States and which, in 1978, defined what a franchise is and adopted disclosure requirements and rules for offering franchises. Those FTC requirements are generally referred to as the “Franchise Rule”.

The Franchise Rule was significantly amended in 2007.

Prior to the amendment, the FTC also accepted as adequate disclosure a franchisor’s compliance with the disclosure guidelines that had been established by the North American Securities Administrators Association (NASAA). Under the old NASAA requirements franchisors also made disclosure under a document then called the Uniform Franchise Offering Circular (“UFOC”) that was substantially similar to what the FTC’s disclosure required. When the Franchise Rule changed in 2007, much of what was included in the UFOC was adopted for the new FTC disclosure document called the Franchise Disclosure Document (FDD).

While most states have adopted the amended Franchise Rule, in some states the rules are still different, including but not limited to filing requirements, the definition of what is a franchise, and some states also have relationship laws that govern the conduct between the franchisor and franchisee and different from the Federal Rule allow a franchisee to sue the franchisor for violation of The Rule (the private right of action).

Definition of a Franchise under the Franchise Rule
Under the Franchise Rule, the FTC defines a “franchise” in Section 436.1(h) as follows:

A “Franchise means any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:​

(1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;

(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a requirement payment or commits to make a required payment to the franchisor or its affiliate.”​​​

Under a Business Format Franchise, the type of franchising most identifiable to the average person, the franchise relationship generally includes the entire business format and not simply the franchisor’s trade name, products and services. Under a Business Format Franchise the franchise system generally provides operating manuals, training, brand standards, quality control, a marketing strategy, etc.

Pre-Sale Disclosure and the Franchise Disclosure Document
The Franchise Rule requires that franchisors provide the presale disclosure document (the “FDD”) to prospective franchisees necessary for them to make an informed decision prior to entering into a franchise relationship. According to the FTC, the Franchise Rule is “designed to enable potential franchisees to protect themselves before investing by providing them with information essential to an assessment of the potential risks and benefits, to meaningful comparisons with other investments, and to further investigation of the franchise opportunity.”

*Of course, as with any such large regulation, there are significant additional and/or alternative conditions and aspects to these requirements at the federal and state level, but I am going to gloss over them here because they are a bit too technical for this type of article.

Franchise Compliance Calendar
Franchisors are required to provide the FDD to prospective franchisees at least fourteen days prior to them signing the franchise agreement, and the franchisee is entitled to receive the completed Franchise Agreement at least seven days prior to signing it.

"Plain English" Required
The Franchise Rule requires that the disclosure portion of the FDD be written in “Plain English” and not in legalese and provide the potential franchisee with specified categories of information about the franchisor and the franchise offering including information about the franchisor’s business, the terms of the relationship and the rights and obligations of the license sufficient for prospective franchisees to make an informed decision before entering into a franchise relationship. While some of the states require that franchisors file or register their FDD with the state before offering franchises, no such requirement exists under the Federal Rule.

23 Items of Disclosure
Under the Franchise Rule there are twenty-three specified areas of disclosure (called Items in franchise parlance) together with a written receipt. These 23 Items are:

  1. The Franchisor and any Parents, Predecessors, and Affiliates
  2. Business Experience
  3. Litigation
  4. Bankruptcy
  5. Initial Fees
  6. Other Fees
  7. Estimated Initial Investment
  8. Restrictions on Sources of Products and Services
  9. Franchisee’s Obligations
  10. Financing
  11. Franchisor’s Assistance, Advertising, Computer Systems, and Training
  12. Territory
  13. Trademarks
  14. Patents, Copyrights, and Proprietary Information
  15. Obligation to Participate in the Actual Operation of the Franchise Business
  16. Restrictions on What the Franchisee May Sell
  17. Renewal, Termination, Transfer, and Dispute Resolution
  18. Public Figures
  19. Financial Performance Representations
  20. Outlets and Franchisee Information
  21. Financial Statements
  22. Contracts
  23. Receipts

Qualified Counsel is Essential
For franchisors, developing a Franchise Disclosure Document should be completed by qualified franchise lawyers and only after significant strategic and other business planning.

For prospective franchisees, it is important that when reviewing an FDD that you understand what it includes and also what is not included. You should consult with a qualified franchisee lawyer in evaluating any franchisor and to ensure you understand the franchisor’s offering and the franchise agreement.

**For more information check out the FTC Compliance Guide or give us a call.

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