State of the States Report

Our objective with this column is to identify issues and best practices that will enable franchisors to more effectively address state registration/disclosure matters in connection with their franchise development efforts. The IFA 2009 Legal Symposium's "Ask the Regulators" session provided insight on a number of those fronts. During this session, state regulators identified several common mistakes franchisors make during the registration process, many related to the Revised FTC Rule. We discuss five of those common mistakes, with another five to be discussed next month.

1) First Personal Meeting. Under the Revised FTC Rule, franchisors no longer have to provide a franchise disclosure document (FDD) at the first personal meeting. The general rule now is that the franchisor must deliver the FDD to a prospect at least 14 calendar days before signing an agreement or paying any fee. Here is the catch. Certain states (Maryland, New York, and Rhode Island) have not modified their first personal meeting requirement. In those states, franchisors (or any franchise seller representing franchisors) still must comply with the first personal meeting requirement when delivering an FDD to a candidate. Franchisors therefore must adopt best practices to address the state variation, or risk getting caught in a violation that is otherwise avoidable with a little bit of compliance planning and execution.

2) Franchise Seller/Receipt Page. One issue that has dogged some franchisors is the Revised FTC Rule's requirement that the FDD receipt pages identify each "franchise seller" offering the franchise. "Franchise sellers" include sub-franchisors, third-party brokers, and franchisor representatives, employees, and agents who are involved in franchise sales activity. The FTC has issued two FAQs on this point. (All FAQs are available at www.ftc.gov/bcp/franchise/amended-rule-faqs.shtml)

The FTC responses to FAQs 12 and 23 clarify that not every person disclosed in Item 2 will be considered a franchise seller. Further, not every franchisor representative who meets a franchise candidate during the sales process (for example, discovery day) will be a franchise seller. The key is to identify those folks who have significant contacts with a candidate (contacts in which material representations are made about the franchise). Here again, it is important for a franchisor to have a definite process in place that defines how they determine who is a franchise seller and how they address the Item 23 receipt requirements.

3) Integration/Disclaimer Clauses. Franchisors absolutely cannot step over this critical issue. The Revised FTC Rule makes it unlawful for franchisors to disclaim or require a prospective franchisee to waive reliance on any FDD representation. It also is unlawful to make any claim or representation -- orally, visually, or in writing -- that contradicts the information required to be disclosed in the FDD. Accordingly, franchisors need to carefully review their "integration" clauses (those clauses that say some variation of "this agreement is the only agreement, and you can't rely on anything else") to make sure they comply with the Revised FTC Rule.

At least one state has indicated that they report to the FTC franchisors who violate this prohibition. Further, franchisors need to carefully review any closing checklist/acknowledgement questionnaire used in the sales process, as those documents may violate the Revised FTC Rule prohibition. Those documents also have come under attack in recent reported cases where franchisors have attempted to rely on them in defense of fraud/franchise law claims. It is not that the documents themselves are unlawful. Franchisors, however, must use care when they are drafting the specific language in the documents to ensure they are meeting appropriate and lawful objectives.

4) Item 20 Confidentiality Disclosures. The disclosure requirement regarding whether franchisees signed confidentiality clauses during the last three fiscal years is an example of a franchisor needing to respond affirmatively or negatively, rather than taking the position of not responding at all to the requirement if no franchisees have signed confidentiality clauses. If franchisees have indeed signed confidentially clauses, then specific language is included in Item 20. Not responding at all (i.e., silence), even if the answer is that no franchisees have signed these clauses, will result in a comment and further delay the registration process.

This procedural issue of responding positively or negatively to a "whether" instruction, rather than being silent, applies throughout the FDD. State examiners will not guess whether the answer is no such clauses have been signed or whether the franchisor forgot to include the disclosure. They simply will issue a comment letter on the point.

5) No Cross-References. A few states are commenting that a franchisor cannot respond to a specific disclosure requirement by cross-referencing to another FDD item. For example, if a franchisor's Item 11 trainers are also included in Item 2, some states will require that the franchisor disclose the individual's training program experience in Item 11, rather than cross-reference Item 2. This approach is not a complete prohibition against cross-references, but it is a reminder to franchisors to respond to the disclosure requirements in a manner that will help franchisee candidates understand the disclosure and its implications within the specific item, rather than flipping pages back and forth to piece together the disclosure information.

Some of these points are more critical than others, but they all are important as the failure to address these issues can not only cause delays in the state registration approval process (few things are more frustrating for the franchise development folks as lengthy delays in getting approved in a particular state), but also can result in disclosure violations alleged by franchisees or former franchisees. A franchisor's attitude toward its disclosure/registration obligations exemplifies its overall attitude regarding compliance. Those franchisors who pursue these matters seriously adopt compliance programs and then hold regular training programs and compliance seminars. On the other hand, those franchisors who simply give it their best shot or respond only if a state issues a comment letter will encounter breakdowns down the road.

NOTE: This article is provided for general informational purposes only and should not be considered or construed as legal advice or opinion concerning any specific circumstances or facts. You are encouraged to consult with your own franchise lawyer regarding any specific issue, situation, or legal question you may have.