Special Report #104
©COPYRIGHT 2003 FGS – ALL RIGHTS RESERVED

SELLING FRANCHISES WITHOUT GETTING INTO TROUBLE
-Federal and State Disclosure Laws-

The disclosure laws that we face in this country are laws that arise from two sources, both federally and on the state level. On the Federal level, the Trade Commissions Trade Regulation Rule on Franchising requires the furnishing of disclosure documents. On the state level, there are a number of states that require registration prior to the disclosure of documents. Between the Federal and State Laws there are several ways to ensure that franchises are sold legally and successfully.

Disclosure is the furnishing of a prospectus, an offering circular, or disclosure documents to a prospective franchisee. Disclosure documents are given to the prospective franchisee to provide information on what it is they are purchasing and to tell them upfront, in layman terms, exactly what they’re getting into.

The FTC (Federal Trade Commission) requires that the Franchisor, or person that is representing the franchise, give the prospective franchisee a disclosure document upon discussion of a franchise, with exception to tradeshow circumstances in which one would encounter many interested individuals at a time. Further discussions outside of a tradeshow, however, require disclosure. It is a good idea to provide each interested party an offering. (Example: two brothers, who wish to be partners, should receive two offerings, one for each brother). In the case of an interested corporation, only one circular is required to be given to an officer of that corporation. If you are uncertain as to when to distribute disclosures, the best rule of thumb is, “When in doubt, give them out”.

Uniform Franchise Offering Circulars (UFOC’s) assist individuals in making an informed decision when purchasing a franchise, but also acts as an insurance document in the case of the Franchisor. All Offering Circulars are to follow guidelines provided by NASAA (The North American Security Administrators Association). There are 23 items that are to be followed, broken down into four main categories; Information about the Franchisor, information about the franchise program, financial statements, and information about franchise agreements (all agreements must be provided). It is important that the UFOC be put together with great care and to keep it updated with current information, so the franchise is not misrepresented. Changes to the UFOC are exceptionally important when material changes occur. The definition of “material” in this case is the substantial likelihood of influencing the reasonable franchisee or reasonable prospective franchisee to make a significant decision. Therefore, the best way to determine when a UFOC needs to be updated is to ask your self, “Would someone/anyone be upset about not knowing the information at hand?” If the answer to the question is yes, the information should be added to the Offering Circular. Examples of changes that should be added to a UFOC are pieces of litigation, major financial situations, or a change in franchise officers. Also, the Franchisor is obligated by law to issue an updated UFOC to a prospective franchisee if any changes have been made between the time they have received the initial UFOC and the time of signing. (There are state laws regarding the changes of Offering Circulars as well).

The disclosure document must be furnished to the prospective franchisee at the first personal meeting (generally a face to face meeting) or ten-business days prior to purchase of the franchise. This ten-day rule allows for the prospective franchisee to research what they are getting into so that they may proceed rationally. A five-day rule also exists in which a contract must exist five days before it is signed, allowing time for review. If revisions are made, you must allow five more days. Each time there is a revision, the wait is extended by five days until the contract is complete and then it may be signed. It is important to keep all proper documentation before signing of the agreement to be certain that you are following the five and ten day rules, thus avoiding violations. It is important to have the signed receipts of Offering Circulars (though not required by state) for proof of disclosure.

It is also a good idea to provide a Compliance Certification at the signing of an agreement. The Compliance Certification is a document that specifies what official documents (i.e. Offering Circulars, contract, etc.) has been provided to the potential franchisee and when they were provided. It may also specify that no inconsistency (difference(s) in stated facts vs. written facts) has been noted, and earning claims have not been provided. This document should be signed by the prospective franchisee at the time of the signing of the agreement for protection of the Franchisor. These precautionary measures assure that any fraudulent claims, by the franchisee, in the future would be difficult to prove.

Earnings claims (any statement that states/suggests a specific level/range of sales, income, or profits) are unlawful. To quote earnings that may not be reached by every individual is misrepresentation, and results in penalties quite often. Examples of illegal earnings claims are, “The average franchisee will bring in $2,000.00 a week”, “You could have $500,000.00 in the bank within five years”, or “Tell me what range you’d like to fall in and I will tell you if it is realistic”. There are alternatives to making earnings claims. When selling an existing unit, the interested individual can request to see the financials of the existing franchisee. Another alternative is to provide the interested individual with validation names of existing franchisees so that the individual may speak with them regarding financials.

Misrepresentation of a franchise an important aspect one must focus on when presenting a franchise. There are three forms of Misrepresentation; the first is misstating a fact. The second is omitting to state a fact (leaving out important information). The third is presenting facts that are technically true, but leave a false impression. The third form is most often the case. The issue is not what the Franchisor says but what the individual thinks that the Franchisor is saying. It is important to state facts clearly.

There are three penalties for violating FTC rules. The first is an Injunction for future violations. The second is a Civil Penalty that could result in fines up to $11,000.00 per incident. The third is Consumer Redress, losses sustained by the customer due to a violation. Consumer Redress can exist in two forms; the first as a claim by the prospective franchisee regarding monetary losses. The second by the FTC, a Disgorgement, which states that the Franchisor has gained profits unjustifiably or by unlawful means. It is important to follow all laws, both Federal and State, because it is required that all violations be documented in the franchises Offering Circulars for ten years from the date of occurrence. It is also important for the Franchisor to know whom they are hiring, including who is representing and selling their franchises on their behalf, because all litigation situations of the officers must be stated in the Offering Circular as well.

Disclosure laws that fall under the state (i.e. Registration States) regulate the relationship between Franchisors and Franchisees and protect prospective franchisees in their territories. There are currently sixteen registration states (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, Nebraska, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin). These are the states that require registration and authorization to sell franchises within their territory. State registration territories also require that brokers/consultants (this includes tradeshow promoters) be registered as “brokers” to represent franchises within those areas. There are many laws that exist within these states, some having more laws than others, and some following laws to a higher degree than others. It is important to know the laws of each registration state, if you do not, you should contact the state administration department(s).

Registration is the first step in which one must take to franchise in registration states, yet it is a continuing effort to remain franchising in registration states. Renewal of registration is required, yet it is different through out the states. It is important to know when renewal is due and to renew before registration expires to avoid a lapse period (the time between registration expiration and renewal). It is illegal to sell franchises in a lapse period.

There are several states that require that Franchisors submit their advertising materials to be viewed and authorized for usage. Submission of materials includes point-of-sale literature (such as brochures) or national publication (such as television, radio, newspaper ads, etc.). State administrators are looking to see that earnings claims are not in use, as well as other smaller items that may be unlawful. It is also important to note that when providing franchise information to prospective franchisees, both physical brochures and information by website, you provide a statement as to which states are available and which are not available in regards to your franchise. By stating which states are and are not available, you avoid unlawful advertising laws that fall under the state (primarily so in regards to regulation states).

State laws regarding UFOC’s are identical to those of Federal laws; however, state registration territories govern such laws with a fine-tooth comb. It is important to make certain all aspects pertaining to the contents of an offering circular follow all guidelines provided by NASAA, contain no unlawful earnings claims, and contain all litigation that pertains to the franchise and it’s associates (including independent franchise sales people). The state makes certain that disclosure is made at the correct time, to the correct number of people, and that five and ten day rules are followed in regards to the signing of a franchise. The state also makes certain that all updates to a UFOC follow with the distribution of those UFOC’s to prospective franchisees. Overall, the state makes certain that the franchise has not misrepresented itself in any way, shape, or form.

Because of the ambiguity that exists in Federal and State laws, no one can comply with 100% of the rules 100% of the time. Yet it is important to follow Federal and State laws to the best of your ability to ensure that franchises are sold legally and successfully.