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The offer and sale of franchises is regulated by the Federal Trade Commission. The FTC promulgated in its rulemaking capacity what has been referred to as the franchise rule in 1978. The FTC has recently amended the franchise rule on Jan. 22. The amendments change what franchisors are required to disclose in their Uniform Franchise Offering Circular (UFOC) and the timing requirements for making disclosure. The amended rule will go into effect on a voluntary basis on July 1 of this year. On July 1, 2008, the amended rule will become mandatory. This article summarizes the key changes to the rule, which are updated to address the computer age and issues that have occurred over the past 30 years. Excluded Transactions One of the key changes is clarification of what transactions are exempted from the franchise rule. The rule will not apply to franchisees making major initial investments more than $1 million (but excluding real estate and amounts that are franchisor-financed) that sign an acknowledgement; large franchisees (at least five years in business, with a net worth of at least $5 million); or “insider” franchise purchases involving owners or officers of the franchise system, or managers with at least two years management experience in the franchise system. The rule will apply only to franchised locations in the United States or its territories. “Business opportunities” (for example, advertised schemes to make money providing vending machines or display racks) will no longer be covered by the rule, but will be regulated by a separate rule. Disclosure Changes Another set of key changes is identifying who must make disclosures and when. In a significant change, the amended franchise rule eliminates the “first personal meeting” requirement. Now, franchisors must deliver the UFOC (or “franchise disclosure document”) 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 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. The final form of franchise agreement no longer has to be provided to a prospective franchisee five business days prior to 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 prior to 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 rule specifies what constitutes “delivery” to address uncertainties as to timing. The amended rule greatly simplifies the process for franchisors to provide electronic disclosure. Prior to 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 Web site, e-mail, or CD-ROM). The franchisee must 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 Web site. The rule also permits franchisors to state on the cover page the different ways that franchisees may receive a copy of the disclosure document, including electronically. Signatures can be handwritten or through the use of security codes, passwords, electronic signatures, and similar devices through which a person’s identity can be authenticated. Content Changes Content changes are mandated to increase transparency in the disclosures. 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. The amended rule significantly expands the required litigation disclosures to include all material lawsuits filed by or against a franchisor involving the franchise relationship; all material lawsuits involving a franchisor’s parent company that promises to back the franchisor financially or otherwise guarantees the franchisor’s performance; and all material lawsuits involving 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. 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. The amended rule has added disclosure of bankruptcy history of any parent company. Under the rule, a franchisor must disclose whether an officer of the franchisor owns an interest in any approved supplier. The amended 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. Under the amended 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, catalog sales, telemarketing or other direct marketing sales, to make sales within the franchisee’s territory either using the franchisor’s principal trademarks or trademarks different from the ones the franchisee is granted the right to use. The amended rule requires disclosure of a franchisor’s use of confidentiality clauses that prohibit or restrict existing or former franchisees from discussing their experience with prospective franchisees. 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. Presentation Formats The presentation of information of quantitative information will be changed. The table of data that 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 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 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 requirements currently include the inclusion of a reconciliation of the foreign statements to U.S. GAAP. Start-up franchises are not required to provide audited financials for their first partial or full fiscal year operating as a franchise. Annual updates to the disclosure document must be made within 120 days after the end of the franchisor’s fiscal year; formerly, the requirement was 90 days. Earnings claims, which explain to prospective franchisees how much other franchisees can make, are now referred to in the amended rule as “financial performance representations.” These 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 that must be included as to whether financial performance representations are made or not. Conclusion This long-overdue overhaul of the rule simplifies some of the legal issues in the offer and sale of franchises. The FTC staff intends to prepare a compliance guide by July 1 that focuses on the changes to the FTC rule. The staff is accepting suggestions for interpretive issues that should be included in the compliance guide. Nevertheless, FTC rule compliance remains the bailiwick of franchise specialty lawyers and a trap for the unwary. CRAIG R. TRACTENBERG is a founding partner of the Philadelphia office of Nixon Peabody. He is a former articles and topics editor for the Franchise Law Journal of the American Bar Association.Tractenberg can be reached by e-mail at [email protected].

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