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Just over 40 years ago, franchising was barely a blip in the American economy and franchise law, as such, did not exist. Franchising’s compelling attractiveness-enabling companies large and small to establish local, regional, national and even international networks within a period of years rather than decades by neatly allocating between franchisor and franchisee the economic and operational burdens of doing so-propelled franchising to the forefront. Today, reports indicate that franchising companies and their franchisees account for $1 trillion in annual United States retail sales-an incredible 40% of all retail sales consummated in this country. Globalization soon followed. Approximately 500 American franchise networks now have a presence internationally, with McDonald’s alone now in 119 countries. As franchising exploded on the economic scene in the 1950s and 1960s, story after story appeared reporting the vast wealth being generated in the franchise arena. By the late 1960s and early 1970s, fraud was pervasive and even organized crime invaded the arena in a fierce fashion. It was to combat widespread franchise fraud that certain key states, followed by the federal government, in the 1970s enacted the first substantive body of franchise law-what are referred to as franchise disclosure laws. Franchise disclosure laws Fourteen states and the federal government feature franchise disclosure laws, pursuant to which no franchise may legally be offered or sold, no contract signed and no money paid unless the prospective franchisee first receives a comprehensive disclosure document. The federal mandate is to be found in the Federal Trade Commission (FTC) Franchise Rule, under which disclosure is mandated but no prereview or registration of the subject disclosure document is required. By contrast, all of the states (save Michigan) featuring franchise disclosure laws on their books-California, New York, Maryland, Virginia, Wisconsin, Illinois, Minnesota, Indiana, North Dakota, South Dakota, Michigan, Hawaii, Washington and Rhode Island-provide an elaborate registration protocol pursuant to which both the franchisor seeking to offer franchises, and the disclosure documents they intend to utilize to do so, are closely scrutinized before any franchise registration is forthcoming. Not only must a franchisor and its disclosure document secure registration from the franchise regulating states, but so too must that franchisor’s franchise advertising material and its franchise brokers (third parties engaged by the franchisor for the purpose of selling franchises). The disclosure document mandated by these laws must describe in detail the background and experience of the franchisor and its management team, the terms of the franchise and all required franchisee expenditures. This disclosure document must be given to prospective franchisees at the earlier of the “first personal meeting” held between the franchisor and its prospect or 10 business days before any contract is signed or consideration paid. While the states share no uniform franchise disclosure law or even a common definition of the term “franchise,” nevertheless-working together under the umbrella of the North American Securities Administrators Association (NASAA)-they developed a single disclosure document, the Uniform Franchise Offering Circular. The circular, when accompanied by certain addenda, will satisfy the requirements of all franchise registration states and will satisfy the FTC as well. Each state franchise disclosure law has unique “twists” and is administered by a varying agency. Since the jurisdictional scope, terms, provisions and disclosure requirements of each franchise disclosure statute vary, counsel must take extraordinary care to ascertain precisely which state laws apply to a franchisor engaging in multistate franchising activity. Critical to this analysis is how each state law defines the term “franchise.” Generally, all of these laws attempt to define the term “franchise” by reflecting franchising’s underlying economic paradigm. However, the franchise-regulating states have agreed upon no single, uniform definition, and thus the scope of coverage of each state statute must be carefully analyzed. The inadvertent franchisor Federal and state franchise laws define the terms “franchise” and “franchisor” so broadly as to embrace businesses, business relationships, licenses, distributorships and other distribution methods that seem to have nothing to do with traditional franchising. Of vital import is the fact that if the varying state and federal definitional elements of a “franchise” are extant in any business relationship, then the foregoing federal and state laws will apply to that relationship regardless of how it is denominated-whether it is actually called a franchise or, in the alternative, is termed a joint venture, distributorship, license or anything else. For good measure, the FTC Franchise Rule explicitly covers the reverse situation, that is, it embraces all relationships that are not actually franchises but are denominated as such. If a client’s business activities unwittingly bring it within the embrace of the foregoing state and federal franchise laws, and the attorney and the client are unaware of this fact, the client’s business is in dire jeopardy, as is the lawyer’s ability to defend any resulting malpractice claim. It has happened all too often since California enacted the first franchise law in 1971. Time and again over the past 30-plus years, a company that is not a “franchisor” in the traditional sense has discovered that its way of doing business, its methods of distributing products or services, or its grant of trademark or other “licenses” brings it within the extraordinarily broad jurisdictional scope of federal and state franchise laws. Unfortunately, this discovery usually takes place in the context of a government investigation or prosecution, sometimes accompanied by private lawsuits commenced by putative franchisees unhappy with the business relationship. Accordingly, it is vital that counsel to any business that either engages in licensing activity and/or distributes products or services through independent third parties conduct extraordinarily detailed analyses of the varying definitions of the term “franchise” to be found in the federal and state franchise laws referred to above, lest the client’s business activities unwittingly fall within the embrace of such laws, rendering the client subject to governmental attack, the plethora of criminal and civil penalties that apply to illegal franchising (as always, ignorance of the law is no excuse) and private rights of action commenced by self-styled “franchisees” unhappy with their business relationship with their clients. Liability for noncompliance Failing to comply with federal and state franchise disclosure statutes yields grave results. Any failure to register (where required), any fraudulent or unlawful activity engaged in, any intentional making of an untrue statement of a material fact, any act which would or does operate as a fraud or deceit and any attempt to compel franchisee waiver of any given statute’s protections are, under most of the aforementioned laws, declared fraudulent and unlawful practices. Each violation of the FTC Franchise Rule-that is, each franchise sold absent any disclosure document whatsoever or pursuant to a fraudulent or misleading disclosure document-is punishable by a fine of $11,000. On the state level, state disclosure laws confer upon franchise administrators extraordinarily broad powers to investigate franchise sales fraud and, if they do uncover fraud, to institute both criminal and civil proceedings seeking (without limitation) restitution, rescission, damages, injunctions, fines and court-ordered receiverships. As well, many state franchise administrators possess “stop order” powers, the ability to suspend ex parte a franchisor’s franchise registration, and thus its ability legally to offer and sell franchises, should the administrator believe that fraudulent or illegal activity is being engaged in. Finally, most state franchise disclosure laws confer upon franchisees a private right of action for, respectively, rescission, damages and attorney fees. Critically, under most state franchise disclosure statutes, both criminal and civil liability for violations inures not only to the subject franchisor but also to that franchisor’s officers, directors and senior management personnel who knew (or should have known) of the improper conduct, such liability being “joint and several.” Both the FTC Franchise Rule and virtually all of the state franchise disclosure laws contain a series of exemptions from their coverage. The key federal exemption applies to a “fractional franchise” (where a franchisee, or one of its directors or executive officers, has been in the type of business represented by the franchise for more than two years and the parties anticipate that the gross revenues attributable to the franchise will represent no more than 20% of the total gross revenues of the business received in the franchise). The most common exemptions from state franchise disclosure law registration requirements pertain to large franchisors (those featuring a certain net worth and, in certain states, a certain number of franchisees that have been operational for a specified period of time). Some states afford exemptions when the franchisees at issue are deemed “sophisticated franchisees” (under statutory tests that vary from jurisdiction to jurisdiction). Almost all states exempt the isolated sale of a franchise effected by a franchisee for his/her/its own account. More and more states are adopting the FTC’s “fractional franchise” exemption. And the sale of an additional franchise to an existing franchisee is exempt under the FTC Franchise Rule and many state franchise laws, but only when the new franchise is granted on terms not materially different from the franchisee’s existing agreement. Counsel must beware-even if an exemption from registration and/or disclosure is available under state franchise disclosure statutes, the FTC Franchise Rule still will usually require disclosure nevertheless. Once a franchisor has secured its required franchise registrations under state franchise laws, it must update its disclosure document at least annually to incorporate all material changes to the information contained therein (including the franchisor’s latest set of audited financial statements). Under virtually all state franchise laws, the franchisor similarly must amend its disclosure document whenever there is a “material change” to any of the facts set forth. Under either scenario (annual amendment or “material change” amendment), the subject franchisor must cease offering and selling franchises until the required registrations are forthcoming (but under the FTC rule, covering nonfranchise regulating states, the disclosure document can be changed and immediately used since no registration requirement pertains). International regulation The United States was not alone in enacting franchise legislation to regulate the burgeoning franchise arena. Counsel should be aware that the following foreign jurisdictions regulate franchising in various ways: Australia, Canada, China, France, Indonesia, Italy, Japan, Malaysia, Mexico, Romania, Russia, South Korea and Spain. Further, practitioners counseling franchisors doing business in Europe must become thoroughly familiar with articles 85 and 86 of the Treaty of Rome (addressing European Union competition law, antitrust requirements and prohibitions). Eighteen states, two territories and the District of Columbia have enacted what are referred to as “franchise relationship” statutes. They are: Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, South Dakota, Virginia, Washington, Wisconsin, the U.S. Virgin Islands and Puerto Rico. Generally, these state franchise relationship laws govern when, and under what circumstances, a franchisor may terminate or refuse to renew an extant franchise. These laws also variously address such aspects of the franchise relationship as fair dealing, discriminatory treatment, market protection, encroachment, the ability of franchisees to associate and the minimum advance notice of franchise termination, expiration or nonrenewal that must be given to franchisees. The provisions of state franchise relationship laws governing when, and under what circumstances, a franchisor may terminate an extant franchise agreement or refuse to renew a franchise supersede, by law, the termination and renewal provisions set forth in any given franchise agreement. Each state statute varies from the others in material ways. There are thus no uniform standards governing when a franchisor can terminate or fail to renew a franchise. The way franchises are offered and the way franchising is regulated will soon undergo dramatic change. The Federal Trade Commission is about to revise entirely its FTC Franchise Rule for the first time since its promulgation in 1979, following years of study and public comment conducted under the leadership of the FTC’s Eileen Harrington and Steven Toporoff. Gone will be the days when disclosure documents had to be handed out in “hard copy.” Instead, franchisors will be free to effect disclosure through electronic means-through the franchisor’s Web site, e-mail, CD-ROMs or otherwise. Also due to be scrapped is a requirement that the franchisor give its disclosure document to a prospective franchisee at their “first personal meeting.” The only disclosure timing requirement that will pertain is that the prospective franchisee have his/her/its disclosure document in hand 14 calendar days before signing any contract or paying any money to the franchisor. Also, it appears that the FTC will exempt from rule coverage transactions between franchisors and sophisticated franchisees. On the state level, the administrators who serve on the NASAA Franchise Project Group (Dale Cantone of Maryland, Joseph Punturo of New York, Steven Maxey of Virginia, Timothy Le Bas of California, Martin Cordell of Washington and Brian Stern of Rhode Island), working in close cooperation with the FTC, are striving soon to clear the way for franchise disclosure to be effected exclusively through electronic communications. And if you want to see the future right now, look to California. Under the leadership of California Corporations Commissioner Demetrios Boutris and Deputy Commissioner Timothy Le Bas, California is making available on its Department of Corporations’ Web site virtually all franchise filings effected in California. David J. Kaufmann is a senior partner at New York’s Kaufmann, Feiner, Yamin, Gildin & Robbins. He wrote the New York Franchise Act and is franchising columnist for The New York Law Journal.

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