Monday, February 28, 2011

Nondisclosure of Affiliate's Rebates to Franchisor Did Not Violate FTC Franchise Rule

This posting was written by Pete Reap, Editor of CCH Business Franchise Guide.

A franchisor of cleaning service businesses did not violate the FTC Franchise Rule—and therefore, did not fraudulently induce a franchisee to enter into an agreement—by failing to disclose in the Uniform Franchise Offering Circular (UFOC) provided to the prospective franchisee the "rebates" or "kickbacks" paid by an affiliate mailing services company to the franchisor, a federal district court in Baltimore has decided.

It was undisputed that, at the time of the franchisee’s decision to enter into an agreement with the franchisor, the North American Securities Administrators Association’s Uniform Franchise Offering Circular Guidelines—1993 (CCH Business Franchise Guide ¶5750) governed the contents of the UFOC used by the franchisor.

Disclosing Basis of Revenue

The relevant disclosure provision of those Guidelines was Item 8, which in part mandated a franchisor to disclose: "Whether, and if so, the precise basis by which the franchisor or its affiliates will or may derive revenue or other material consideration as a result of required purchases or leases."

The franchisee alleged that the affiliate made payments to the franchisor and that those payments constituted "rebates" or "kickbacks" that should have been disclosed in the UFOC, the court noted.

Assuming that the affiliate made payments to the franchisor, their disclosure was not required by Item 8. Instead, the franchisor was required to disclose whether its affiliate "will or may derive revenue" from required purchases, the court determined.

Required Purchase of Mail Services

The franchisor did, in fact, disclose that franchisees were required to purchase mail advertising services from its affiliate and also disclosed the cost of those services. The obvious implication of that disclosure was that the franchisor’s affiliate would derive revenue from those franchisee purchases, the court reasoned. No further disclosure was necessary.

Such an interpretation was consistent with the court’s finding that the franchisor’s disclosure documents drew a distinction between the affiliate, whom franchisees were required to purchase advertising services, and approved suppliers, from whom franchisees could purchase goods and services.

Amount of Payment Disclosed

What the affiliate did with the money it received from the franchisees for advertising services was immaterial, according to the court. What was material was how much the franchisees would have to pay the affiliate for advertising services. The franchisee here was fully informed of that.

The court’s conclusion was buttressed by the FTC’s Statement of Basis and Purpose—1979 (CCH Business Franchise Guide ¶6300) to the then-current version of its Franchise Rule. In that document, the FTC made a clear distinction between "affiliated persons" and "suppliers," thereby exposing the fallacy of the franchisee’s theory that the affiliate should be treated the same as an unaffiliated supplier.

The February 11 decision in Cleaning Authority, Inc. v. Neubert, will appear in CCH Business Franchise Guide.

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