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 Inbal N. Zehavi, Adv.

On 22 January 2007 the Federal Trade Commission (FTC) approved an amended Franchise Rule. The amendments change what franchisors are required to disclose in their Uniform Franchise Offering Circulars (UFOCs) and the timing requirements for making disclosure. A final, official version of the amended Franchise Rule is expected to be published in the Federal Register shortly. The amended Franchise Rule goes into effect on a voluntary basis on 1 July 2007 while on 1 July 2008; the amended Franchise Rule will become mandatory. 

The new regulations change the scope of disclosure in Franchise Transactions. U.S companies get the advantage of limited disclosure while foreign companies, who whish to penetrate the U.S market, carry the burden of excessive disclosure obligations.

Disclosure of relevant information as provided for by the Franchise Rule enables investors to make informed decisions about franchise offerings. Such disclosure also minimizes the incidence of both fraud and divergent expectations concerning the franchise relationship. However, despite these pro-competitive effects, we are mindful that the compliance costs associated with excessive disclosure regulation can create barriers to entry by new and small franchising companies, generally the greatest source of marketplace innovation. While we are uncertain where the line between "just enough" and "too much" disclosure should be drawn, we nevertheless believe that it is incumbent upon policy makers reviewing new or additional disclosure obligations, to consider this issue carefully.

Applicability of the Rule to International Transactions

The international franchise market and the sales practices therein, are dramatically different from the U.S franchise market. In fact, many franchisors do not have a program for attracting prospective foreign franchisees. New franchisees may be individuals, companies or investment groups that approach franchisors about franchising possibilities abroad. Franchisors may enter into a wide range of business arrangements with these parties and grant international franchises pursuant to joint venture, area development and master franchise agreements. Even among agreements in the same category (e.g. area development agreements), there are materially different terms depending upon the nature and capability of the other party, the territory for which rights are granted, local laws, tax considerations and commercial customs.

Unlike the U.S market, negotiation of terms is the norm, not the exception. As a result, these highly-negotiated arrangements bear little resemblance to most domestic franchise offerings and are not amenable to "standardized" disclosure. The investors interested in international franchise relationships are typically sophisticated foreign nationals who have considerable capital and/or expertise regarding the market in which they will be developing the franchise system.

The UFOC and FTC Rule disclosure standards contemplate a U.S franchise sale occurring in a particular state. For example, Item 20 of the UFOC Guidelines refers to the number of franchise sales "in this state. . . ." Other disclosures about the franchise offering, including litigation and bankruptcy history, franchisor's and franchisee's obligations, royalty rates, initial investment, fees and trademarks, are U.S.-specific. For these reasons, much of the information in a U.S. franchisor's offering circular is of limited relevance to an international transaction and may be confusing, if not misleading, to local investors.  

We believe that a direct and substantial adverse effect on commerce of the U.S., either to a U.S. consumer or to competition in the U.S., has been or remains a jurisdictional requirement for action under the Act, including consumer protection actions under the Act. Accordingly, damage neither to foreign consumers nor to foreign franchisees, even if caused by U.S. franchisors unfair or deceptive acts, is within the ambit of the Act unless there is a significant impact on commerce in the U.S.  

Foreign countries in which franchise operations are located have a far greater nexus to the franchise sales transaction than the U.S.

These countries are capable of determining which laws are necessary to protect individuals and businesses within their borders. The disclosures required under the laws of that country, if any, are far more meaningful to local investors, whether foreign nationals or U.S. citizens, than those required under the FTC Rule or UFOC Guidelines. And, even in the absence of franchise-specific regulation, the business arrangement would be regulated by that country's commercial, competition, international trade and intellectual property laws.

The decision by the U.S. District Court for the Southern District of Florida in Nieman v. Dry Clean USA, Inc., No. 95-1390-CIV (S.D. Fla. Mar. 26, 1997), had to make the FTC clear on the fact that the amendment does not apply to foreign countries. Subsequently, if we look at it from the Israeli perspective, it imposes the burden of increasing Due Diligence significantly on the Israeli side in order to achieve maximum essential DISCLOSURE OF INFORMATION. In Nieman, the court held that a franchisor who accepted a non-refundable deposit before providing a disclosure document to an Argentinean citizen purchasing a franchise to be operated in Argentina, violated the Florida Unfair and Deceptive Trade Practices Act (known as the "Little FTC Act"), based on a violation of the FTC Rule's disclosure requirements. Clarification by the FTC that such international franchise sales are not within the scope of the Rule will prevent future mischief as a result of the Nieman decision.

UFOC Guidelines  

In its Staff Report of 25 August 2004, the FTC Staff recommended a variety of changes to the Franchise Rule, including abandoning the FTC format and adopting the UFOC disclosure format with modifications. The final, amended Franchise Rule is similar, but not identical to, the proposed Franchise Rule discussed in the 2004 Staff Report.

Which transactions are covered?

Exemptions

•   The Franchise Rule will not apply to (1) franchisees making major initial investments of more than $1 million (but excluding real estate and amounts that are franchisor-financed) and who sign an acknowledgement; (2) large franchisees (at least five years in business, with a net worth of at least $5 million); or (3) "insider" franchise purchases involving owners or officers of the franchise system, or managers with at least two years management experience in the franchise system.

Business opportunities excluded

•     "Business opportunities" (for example, advertised schemes to make money providing vending machines or display racks) will no longer be covered by the Franchise Rule. Instead, they will be regulated by a separate rule, which the FTC also approved on January 22. We will address these changes in a separate Franchise Law Alert.

Who makes and receives disclosure/When should disclosures be made?

No "first personal meeting" requirement

•   In a significant change, the amended Franchise Rule eliminates the "first personal meeting" requirement. Now, franchisors must deliver the UFOC at least 14 calendar days before the franchisee signs a contract with the franchisor or pays any money to the franchisor. Previously, the requirement was delivery of UFOCs to the prospective franchisee at the earlier of the "first personal meeting" or 10 business days before receipt of money or execution of any franchise-related agreements.

Separate furnishing of completed franchise agreement no longer required

•     Significantly, the final form of franchise agreement no longer has to be provided to a prospective franchisee five business days before signing the agreement. However, a final copy of the franchise agreement must be disclosed to the prospective franchisee if the franchisor unilaterally makes material changes to the form agreement that is included in the disclosure document. The time for such disclosure is seven calendar days before execution of the agreement, instead of five business days. Negotiated changes initiated by the franchisee do not trigger the seven-calendar-day period.

•    The amended Franchise Rule defines what constitutes "delivery" to address uncertainties in respect of the above stated timing.

Electronic delivery/Execution

•      The amended Franchise Rule greatly simplifies the process for franchisors to provide electronic disclosure.

Delivery

•      Before delivery, the franchisor must advise the franchisee of the different formats in which the disclosure document is made available, including any prerequisites for obtaining the disclosure document in a particular format and any conditions necessary for viewing the disclosure document in a particular format.

•    The disclosure document and agreements can be delivered electronically (via the franchisor's website, e-mail, or CD-ROM). The franchisee should be able to store, download, print, or otherwise maintain the documents. Navigation tools, such as scroll bars, internal links, and search features, are permitted. No audio, video, pop-up screens or external links are allowed.

•      The cover page of the disclosure document must include the franchisor's e-mail address and website. The Franchise Rule also permits franchisors to state on the cover page the different ways whereby the franchisees may receive a copy of the disclosure document, including electronically.

Execution

•     Signatures may be handwritten or through use of security codes, passwords, electronic signatures, and similar devices through which a person's identity can be authenticated.

Changes to the content of the disclosure document

Related companies

•      The disclosure document must identify direct and indirect parent companies, and may be required to provide litigation and bankruptcy disclosure regarding parent companies, as described below.

Business experience

•     In a significant simplification, brokers must no longer be identified in the Franchise Disclosure Document.

Litigation

•     The amended Franchise Rule significantly expands the required litigation disclosures, to include: (1) all material lawsuits involving the franchise relationship in the last fiscal year, filed by or against (a) a franchisor, (b) a franchisor's parent company which promises to back the franchisor financially or otherwise guarantees the franchisor's performance, or (c) a franchisor's affiliate that either offers franchises under the franchisor's principal trademark or promises to back the franchisor financially or otherwise guarantees the franchisor's performance; and (2) certain pending and past litigation against such parent or affiliate.

•   The disclosures described above are significantly broader than the current Franchise Rule, which does not require disclosure of lawsuits initiated by the franchisor and limits the disclosure of lawsuits against the franchisor to those that allege a violation of a franchise, antitrust, or securities law; fraud; unfair or deceptive practices; or comparable allegations.

Bankruptcy

•     The amended Franchise Rule has added disclosure of bankruptcy history of any parent company.

Restrictions on suppliers

•     Under the amended Franchise Rule, a franchisor must disclose whether an officer of the franchisor owns an interest in any approved supplier.

Computer systems

•    The amended Franchise Rule requires less-detailed disclosure regarding a franchisor's computer requirements. A franchisor is no longer required to identify each and every required piece of hardware and software by brand, type, and principal function, or to identify compatible equivalents and whether they have been approved by the franchisor.

Territory

•      Under the amended Franchise Rule, a franchisor must disclose whether the franchisor or an affiliate has used, or has the right to use, other channels of distribution, such as the Internet, catalogue sales, telemarketing, or other direct marketing sales, to make sales within the franchisee's territory, using either the franchisor's principal trademarks or trademarks differing from the ones which the franchisee is granted the right to use.

Confidentiality clauses and agreements

•      The amended Franchise Rule requires disclosure of a franchisor's use of confidentiality clauses which prohibit or restrict existing or former franchisees from discussing their experience with prospective franchisees.

Franchisee associations

•   Franchisee associations must be disclosed in the disclosure document if they are sponsored, created, or endorsed by the franchisor or if they are incorporated or otherwise organized under state law and request to be included within 60 days of the close of the franchisor's fiscal year-end.

Summary of outlets

•      In a significant set of changes which will affect all franchisors, the table of data shows how many franchises in each of the last three years were terminated, sold, or transferred has been changed to avoid the "double-counting" problem. The definitions of each category have been expanded to avoid any overlap, and Item 20 will now have five separate tables, including a separate table for transfers.

•      One of the new tables requires a breakdown of how many company-owned outlets opened, closed, were acquired from franchisees, or were sold to franchisees during the franchisor's last three fiscal years.

•      Significantly, under the amended Franchise Rule if a franchisor is selling a previously franchised outlet that is currently under the franchisor's control, the franchisor must provide the prospective franchisee with a supplemental disclosure that lists the name, address, and phone number of each previous owner of the outlet during the last five years, the reason for each change in ownership, and certain additional information.

Financial statements

•     Financial statements may be prepared in accordance with non-United States GAAP (Generally Accepted Accounting Principles), but only as now permitted by the Securities and Exchange Commission (SEC). SEC requirements currently include a reconciliation of the foreign statements to U.S. GAAP.

•       Start-up franchises are not required to provide audited financial reports for their first partial or full fiscal year operating as a franchise.

Annual renewal

•     Annual updates to the disclosure document must be made within 120 days from the end of the franchisor's fiscal year; formerly, the requirement was 90 days.

Financial performance representations ("Earnings claims")

•       Earnings claims, which are referred to in the amended Franchise Rule as "financial performance representations," must be made in Item 19 of the disclosure document itself, not in a separate document attached to the disclosure document.

•       The amended Franchise Rule eliminates the requirement that any historical financial performance claims must be based upon GAAP.

•    There is new required "preamble" language which must be included as to whether financial performance representations are made.

Conclusion/Open issues

•      The amended Franchise Rule constitutes a long-overdue, major overhaul of the original 1978 Franchise Rule.  It provides practical solutions to long-standing problems, inconsistencies, and inefficiencies which existed in the original Franchise Rule.

•     By adopting the UFOC disclosure format (with some changes), the FTC becomes the governing body that will now have authority to interpret the new UFOC guidelines.

•      The amended Franchise Rule does not become effective until 1 July 2007 and will be mandatory from 1 July 2008, providing sufficient time for franchisors to become informed and revise their disclosure documents. 

•     The FTC Staff intends to prepare a Compliance Guide by 1 July 2007 which focuses on the changes to the FTC Rule. The Staff is accepting suggestions for interpretive issues which should be included in the Compliance Guide.

•      The amended Franchise Rule raises a variety of issues - for example, how exactly will the states adopt the amended Franchise Rule and when will they implement it? Will all the states implement the amended Franchise Rule, or will there be differences in the individual states?

•       One of the most frequently asked questions on the Israeli aspect involves the depth of Dew Diligence, required to take place on behalf of the Israeli party. An Israeli potential franchisee does not have the right to receive the same information as an American Franchisor would.