David J. Kaufmann
David J. Kaufmann ()

In today’s column we address the issue of “pipeline” franchise sales—that is, sales of franchises to franchisees who received a now (or soon to be) superseded Franchise Disclosure Document (FDD) but who have not yet signed a binding agreement with, or paid any money to, the franchisor. Specifically, what steps must a franchisor take with respect to franchisees in the pipeline once the franchisor has issued a new successor FDD (such as happens every year at franchise registration renewal time).

We need to divide how to handle such “pipeline” franchise sales into two categories: those states featuring no franchise registration/disclosure laws of their own and in which, as a consequence, only the FTC Franchise Rule applies (the “FTC states”), on the one hand, and those states featuring franchise registration/disclosure laws, on the other hand.

Redisclosure in FTC States

In the FTC states, only the FTC Franchise Rule1 applies to the offer and sale of franchises. It states that no franchise may be offered or sold in the United States, its territories or possessions unless the prospective franchisee is first furnished with a detailed Franchise Disclosure Document containing virtually all of the information a prospective franchisee would find material in forming its investment decision (disclosure must be effected at least 14 days before any franchise agreement is signed or any money passes hands—it is typically accomplished very early on in the franchise sales process).

When the FTC revised its Franchise Rule in 2007, it incorporated in the revised rule a feature which is often overlooked by franchisors: the ability to close “pipeline” franchise sales without having to furnish the franchisor’s most recent Franchise Disclosure Document (after already having furnished a now superseded FDD). In other words, in the FTC states, once disclosure is made with any FDD, no redisclosure need be effected unless the franchisee requests it.

This feature of the revised FTC Franchise Rule is somewhat hidden in Section 436.9(f) thereof, which simply states that it is an unfair or deceptive act or practice for a franchisor to: “Fail to furnish a copy of the franchisor’s most recent disclosure document…to a prospective franchisee, upon reasonable request, before the prospective franchisee signs a franchise agreement.”

At first blush, this sounds like the FTC Franchise Rule actually mandates that franchisors redisclose “pipeline” franchisees with any new successor FDD that comes into existence. However, this is not at all what the FTC intended.

Instead, reference must be made to the Federal Trade Commission’s “Statement of Basis and Purpose” (SBP)2 which accompanied the commission’s 2007 revisions to its Franchise Rule. In the SBP, the FTC staff makes clear that the intent of the above-quoted provision of the FTC Franchise Rule is actually to permit franchisors to refrain from having to redisclose “pipeline” franchisees who had theretofore received an operative FDD. Specifically, Section III(G)(6) (“Furnishing Updated Disclosures”) of the FTC SBP states:

Section 436.9(f) [of the FTC Franchise Rule, as quoted above] prohibits the franchisor from failing to furnish a prospective franchisee who has received a basic disclosure document with updated disclosures, upon the prospect’s reasonable request…

Section 436.9(f) [of the FTC Franchise Rule, as quoted above] recognizes that the information contained in a disclosure document may become out-of-date by the time a prospect who relies on such information is ready to sign a franchise agreement. It prevents deception by enabling such prospective franchisees, if they wish, to get any updated disclosures prepared by the franchisor. At the same time, Section 436.9(f) imposes no continuous updating requirement on franchisors. Rather, it strikes the appropriate balance, preventing deception by enabling a prospective franchisee to gain access to the most current updated disclosures prepared by the franchisor, while imposing no new affirmative disclosure obligations on the franchisor.

Thus does the FTC Franchise Rule, and the FTC Statement of Basis and Purpose accompanying same, clearly contemplate that franchisors need not redisclose “pipeline” franchisees who had received a now-superseded Franchise Disclosure Document with that franchisor’s current FDD.

One major caveat: the foregoing does not apply with respect to changed financial performance representations. That is, Section 436.7(d) of the revised FTC Franchise Rule states: “When furnishing a disclosure document, the franchise seller shall notify the prospective franchisee of any material changes that the seller knows or should have known occurred in the information contained in any financial performance representation made in Item 19…”. Under this FTC Franchise Rule provision, while a franchisor is not required to redisclose “pipeline” franchisees with the latest copy of that franchisor’s Franchise Disclosure Document, the franchisor must nevertheless furnish to such “pipeline” franchisees updates to the prior FDD’s Item 19 financial performance representations.

Moreover, for a franchisor to be able to avail itself of the FTC Franchise Rule’s relief from having to redisclose “pipeline” franchisees (except, as noted, with respect to changed Item 19 financial performance representations), the transaction in question must be a pure “FTC state” transaction. That is, in the case of an individual franchisee, that individual must reside in a state featuring no franchise registration/disclosure law. In the case of a business entity franchisee, that entity’s principal place of business must similarly be situated in a state featuring no franchise registration/disclosure laws. In all instances, the subject franchised restaurants must not be situated in a state featuring a franchise registration/disclosure law.

Finally, and critically, any franchisor whose franchise agreement features a governing law provision citing the law of a state having a franchise registration/disclosure statute may never avail itself of the FTC Franchise Rule’s relief from “pipeline” redisclosure but must, as addressed immediately below, comply with that state’s statutory requirement to redisclose “pipeline” franchisees with the subject franchisor’s latest Franchise Disclosure Document.

Registration/Disclosure Laws

In marked contrast to the FTC Franchise Rule, in those 15 states featuring franchise registration/disclosure laws—California; Maryland; Virginia; Wisconsin; Illinois; Minnesota; Indiana; New York; North Dakota; South Dakota; Michigan; Hawaii; Oregon; Washington; and, Rhode Island—there exists no parallel “no need to redisclose pipeline franchisees” provision as that found in the FTC Franchise Rule. Instead, these states mandate that no franchise sales be effected prior to redisclosure with the franchisor’s latest Franchise Disclosure Document (with a few exceptions, as noted below) following FDD amendment. Accordingly, in franchise sales transactions where one or more state franchise registration/disclosure laws may or will be implicated—such as where the franchisee is domiciled in such a state, will operate its business in such a state or has its principal place of business in such a state—franchisors must redisclose “pipeline” franchisees, and observe the required 14 calendar day waiting period, to comply with the provisions of those states’ franchise registration/disclosure laws mandating dissemination of a franchisor’s latest FDD and deeming superseded FDDs entirely stale, inoperative and in fact misleading (as the information set forth therein is no longer correct).

In fact, certain states featuring franchise registration/disclosure laws specifically address activity that may take place during the period when a Franchise Disclosure Document is being amended/renewed. By way of example only, in New York a franchisor is actually permitted to sell a franchise using an outdated FDD while it is in the midst of registering its amended FDD—but only if that franchisor (i) holds any monies received in escrow, (ii) rediscloses to its franchisee with the newly registered, amended FDD, and (iii) permits that franchisee to rescind the franchise sales transaction after 14 calendar days have elapsed following such redisclosure (those 14 days not including the day that redisclosure was effected).

California, by contrast, statutorily expressly forbids any franchise sales activity during a period of FDD amendment. Instead, California only permits franchisors to offer franchises for sale during the amendment period and requires that franchisors taking advantage of this opportunity redisclose to the subject franchisees the newly registered amended FDD redlined so that the franchisee can see all changes which were effected.

Recommendation

Synthesizing the foregoing, we believe that while the FTC Franchise Rule clearly relieves franchisors from having to redisclose “pipeline” franchisees with said franchisor’s latest amended Franchise Disclosure Documents, nevertheless many franchisors should elect not to universally take advantage of this FTC Franchise Rule permissive authority except when exigent circumstances exist (such as if franchisee financing is about to lapse).

First, as noted earlier, the transaction in question must be determined to be a pure “FTC state” transaction in which the subject individual franchisees reside in states featuring no state franchise registration/disclosure laws; a business entity franchisee must have its principal place of business in such a state; and, in either event, the subject franchised units must likewise all be in states featuring no franchise registration/disclosure laws. The administrative burden of having to determine that, in fact, the transaction in question involves only “FTC states” featuring no franchise registration/disclosure laws of their own and the possibility of getting any of the facts wrong renders it even less inviting to follow the FTC Franchise Rule’s permission to close “pipeline” franchise transactions without effecting redisclosure. Where do the franchisees reside? Where will the franchised units be situated? What is the principal place of business of an entity franchisee? Get the answers to any of these questions wrong, or fail to ask the questions in the first place, and a franchisor not redisclosing “pipeline” franchisees may find itself engaging in violative conduct under state franchise registration/disclosure laws.

Second, the need even under the FTC Franchise Rule to redisclose “pipeline” franchisees with the franchisor’s latest Item 19 financial performance representation updates mitigates the utility of the rule’s “no redisclosure necessary” feature. Even if the latest Item 19 financial performance representation information is only slightly different from that featured in the prior Franchise Disclosure Document (now being amended) given to “pipeline” franchisees, a significant risk exists that such franchisees will later claim that, in fact, the financial performance representation variations were “material,” which could lead to expensive litigation even in those circumstances where the franchisor prevails.

Third, notwithstanding the ability of a franchisor under the revised FTC Franchise Rule not to redisclose “pipeline” franchisees (except with respect to financial performance representations), nevertheless many franchisors elect to redisclose anyway as a defensive measure to guard against future litigation claims of misrepresentation, omission or common law fraud. Indeed, the Franchise Disclosure Document is most often introduced in litigation as Exhibit “1″ to ward off such claims. But, to be effective in achieving this goal (instead of clouding the issue), the FDD in question must be the franchisor’s latest FDD.

All of which leads us to suggest that franchisors not avail themselves of the FTC Franchise Rule’s authority to close franchise transactions with “pipeline” franchisees absent redisclosure of same with the franchisor’s latest Franchise Disclosure Document, even in pure “FTC states” where doing so is explicitly permitted under the FTC Franchise Rule, other than when exigent circumstances compel doing so.

David J. Kaufmann is senior partner at Kaufmann Gildin & Robbins. He wrote the New York Franchise Act while serving as special deputy attorney general of New York.

Endnotes:

1. 16 CFR Part 436.

2. 72 Fed. Reg. 15444 (March 30, 2007).