FTC Raises Monetary Thresholds for Three Exemptions to Franchise Disclosure Rule

This posting was written by John W. Arden.

The Federal Trade Commission is amending its franchise disclosure rule to raise the monetary thresholds used to determine whether a franchise sale is exempt from the rule, which requires presale disclosure information to prospective franchise purchasers.

The 2007 amendments to the franchise rule provide three exemptions based on a monetary threshold in 16 CFR Part 436 .8 (CCH Business Franchise Guide ¶6018).

These exemptions are for:

(1) Franchise sales in which the purchaser must make required initial payments of less than $540 (currently $500), §436.8(a) (1);

(2) Franchise sales in which the initial investment is at least $1,084,900 (currently, $1 million), excluding the cost of unimproved land and financing received from the franchisor or an affiliate, §436.8(a) (5) (i); and

(3) Franchise sales to large entities that have been in business for at least five years and have a net worth of at least $5,424,500 (currently $5 million), §436.8(a)(5)(ii).

The franchise rule requires the FTC to adjust the monetary thresholds every four years, based on the Consumer Price Index. The adjustments will take effect on July 1, 2012.

The Commission voted 5-0 to approve the Federal Register Notice on the adjustments. Further information on the franchise rule amendments appear here on the FTC website.

NASAA Project Group Seeks Public Comment on Multi-Unit Franchising

This posting was written by John W. Arden.

In connection with its work on a new commentary, the Franchise and Business Opportunities Project Group of the North American Securities Administration (NASAA) is seeking public comments on disclosure obligations under the FTC franchise rule and state franchise laws for the many forms of multi-unit franchising.

Multi-unit franchising includes arrangements such as area development or representation agreements, area or regional franchises, development agent agreements, subfranchises, and master franchises.

Parties involved in multi-unit franchising often have questions about disclosure obligations under the FTC rule and state laws, according to Dale E. Cantone, Deputy Commissioner of the Securities Division of the Maryland Attorney General’s Office and Chair of the Franchise and Business Opportunities Project Group.

Some multi-unit franchise issues have been addressed by the FTC in FAQs 9 and 13 (CCH Business Franchise Guide ¶6090), by NASAA in Sections 20.2, 20.3 and 20.4 of the Commentary on the 2008 Franchise Registration and Disclosure Guidelines (CCH Business Franchise Guide ¶5706), and by California in Release 18-F (CCH Business Franchise Guide ¶5050.49).

The NASAA project group intends to give expanded guidance on these and other issues and seeks comments on what should be addressed in the commentary.

Interested persons should submit issues, ambiguities, and problems as well as potential solutions. The group invites submission of any relevant cases, statutory provisions, regulations, papers, or other resources.

Comments should be sent by April 22, 2011. Persons comfortable with sharing ideas with attribution should send their comments directly to project group members Dale Cantone (dcantone@oag.state.md.us) and Theresa Leets (tleets@corp.ca.gov).

Those preferring to share ideas on a confidential basis should send comments to Warren Lewis of the Akerman law firm (warren.lewis@akerman.com), Ron Gardner of Dady & Gardner (rkgardner@dadygardner.com), or Chuck Modell of Larkin Hoffman (cmodell@larkinhoffman.com).

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.

UFOC Disclaimers Did Not Preclude Franchisee Reliance on Nondisclosure

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

The general language of the exculpatory clauses in a coffee shop franchisor’s Uniform Franchise Offering Circular (UFOC) did not preclude several prospective franchisees from reasonably relying on the franchisor’s nondisclosure of the financial losses of its parent company, a Colorado appellate court has decided.

A Colorado trial court’s judgment—dismissing the franchisees’ claim of fraudulent nondisclosure of the historic losses of the franchisor’s parent—was vacated.

Financial Losses of Parent Company

The losses were unlike the financial performance of the franchisor’s company stores, which the franchisor’s UFOC explained was not predictive of franchise results at a different location and under a different management, according to the appellate court. Rather, ongoing parent company losses could foreshadow its insolvency, which could destroy the value of the franchise, regardless of its location or management.

No clause in the UFOC either referred to information about the parent company’s financial condition or negated reasonable inferences that could be drawn from assumptions about this information.

The trial court made no finding that the franchisees had been discouraged from relying on inferences concerning parent company financial information. The only finding was that franchisees had been told that financial information about the parent would not be provided.

Neither of the disclaimers cited by the trial court disclaimed reliance on undisclosed information. Thus, the trial court’s paraphrasing of the disclaimers as “[franchisees] acknowledged that they were not relying on any other information at the time they entered into their Franchise Agreements” was overbroad, the appellate court held.

FTC Franchise Rule

The Federal Trade Commission franchise rule did not preempt Colorado common law, which allegedly required the franchisor to disclose that the parent company had been, or was, unprofitable. The appellate court rejected the franchisor’s contention that, because the parent company was not a guarantor, the franchise rule prohibited the disclosure of financial information about the parent.

The plain language of Section 436.1(a)(20) of the 1979 franchise rule would not preclude a general comment, such as “The franchisor is the wholly owned subsidiary of _________, which has not shown a profit during its _____ years of operation,” according to the court. The section did not preempt common law alleged to require disclosure of the parent financial information.

The franchise rule sought to protect franchisees from unfair or deceptive practices and, as mentioned in the FTC commentary for the 2007 rule, disclosures did not “create a safe harbor for franchisors engaging in otherwise unlawful conduct.”

Preemption of State Law

The FTC addresses preemption in Section 436.10(b), explaining:

“The FTC does not intend to preempt the franchise practices laws of any state or local government, except to the extent of any inconsistency with part 436. A law is not inconsistent with part 436 if it affords prospective franchisees equal or greater protection, such as registration of disclosure documents or more extensive disclosures.”

Because of the reference to “franchise practices laws,” there could be no preemption of common law claims, the court held. In any event, the reference to “inconsistency” limited the court’s inquiry to direct conflict, not express or field preemption.

There was no inconsistency between the prohibition against disclosing a parent’s financial statements absent a guarantee and merely informing prospective franchisees that the franchisor’s parent has been, or is, unprofitable.

The decision—Colorado Coffee Bean LLC v. Peaberry Coffee Inc.—will appear at CCH Business Franchise Guide ¶14,325.

License Agreement Was Not “Franchise” Under FTC Rule

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

An agreement that permitted a dealer to produce, sell, and install a licensor’s patented and trademarked gutters in a limited territory was not a "franchise" under the meaning of the FTC franchise disclosure rule, a federal district court in Florence, South Carolina, has ruled.

Thus, the dealer could not proceed with its claim that the licensor violated the South Carolina "little FTC Act" by failing to provide it with a disclosure statement as required by the FTC rule.

The licensor notified the dealer in 2001 that it was terminating their agreement and requested the payment of accrued royalties and the return of a gutter-fabricating machine, as required by the agreement. When the dealer failed to comply, the licensor filed the instant suit, seeking injunctive relief and asserting other claims.

Subsequently, the dealer asserted various counterclaims—including one brought under the South Carolina “little FTC Act”—and continued to use the fabricating machine without paying royalties during the eight years the suit has been pending in both state and federal court.

Caption of Agreement

The actual contract was captioned as a license agreement and had been described by both a South Carolina appellate court and the South Carolina Supreme Court as a license agreement. However, that was not determinative of whether a franchise agreement existed.

As noted by the dealer, an FTC staff advisory opinion provided that "[w]hether a business relationship constitutes a franchise, is not dependent upon what the parties call the relationship …[r]ather, a relationship is covered by the Franchise Rule if it satisfies the definitional elements of a franchise set forth in the Franchise Rule" (FTC Informal Staff Advisory Op. 98-4, 1998, CCH Business Franchise Guide ¶6493).

“Franchise” Definition

In determining whether a commercial relationship constitutes a franchise for purposes of the FTC rule, courts have looked to see (1) whether the relationship involved the distribution of goods or services associated with a franchisor’s trademark or trade name; (2) whether the franchisor had authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and (3) whether the franchisor must pay at least $500 within six months after the franchise business began.

The first prong of the analysis was not in dispute, as the agreement involved the sale or distribution of goods associated with the licensor’s trademark. However, as to the second prong, the controls or assistance had to be related to the franchisee’s entire method of operation, not merely its method of selling a specific product or products which represented a small part of the franchisee’s business, according to the court.

Control Over Method of Operation

The dealer pointed to numerous terms from the agreement—including limitations on territory, limitations on the ability to sell the product through lumberyards and home centers, and accounting and sales reporting requirements—as evidence that the licensor exercised a great deal of control over the dealer’s method of operation. However, it was readily apparent from the terms of the agreement that these limitations only restricted the dealer’s operations with respect to the gutter product line, the court determined.

It was not disputed that the sale and installation of those gutters was but one of multiple products and services provided by the dealer. Thus, the level of control exerted by the licensor over the dealer’s method of operation was not significant for purposes of the FTC franchise rule, the court held.

Franchise Fee

There was no evidence that any franchise fee was paid to the licensor by the dealer as required by the third prong of the analysis, the court determined. Although the dealer paid the licensor a sum of money at the inception of the business relationship, that payment was made in exchange for the purchase of the gutter-fabricating machine. It was not in the form of a franchise fee as required by the rule. Thus, the agreement was not a franchise as a matter of law.

Therefore, the dealer was denied partial summary judgment on its "little FTC Act" counterclaim. Even if the business relationship between the parties was a franchise, the dealer still would be required to establish that the failure to comply with the FTC franchise rule constituted a per se violation of the Act, an issue on which the dealer failed to provide persuasive authority, the court noted.

The decision is Englert, Inc. v. LeafGuard USA, Inc., CCH Business Franchise Guide ¶14,297.

Focus on Franchising

This posting was written by John W. Arden.

News and notes on franchising and distribution topics:

 The Franchise and Business Opportunity Project Group of the North American Securities Administrators Association (NASAA) has proposed that states amend their franchise disclosure laws to change the delivery rules for franchise disclosure documents. The group proposes that states (1) eliminate the requirement that franchisors provide a disclosure document at the “first personal meeting” with prospective franchisees and (2) revise statutory provisions requiring disclosure within “10 business dates” to require delivery “14 calendar days” prior to the signing of an agreement or payment of money. The proposal follows the franchise delivery requirements of the new FTC franchise disclosure rule, which was adopted in 2007. The NASAA project group has solicited internal and public comment on this proposal. The comment period, which began on July 29, extends through August 18, 2009. Further information on the proposal and the procedure for filing written comments appears here at the NASAA website.

 U.S. franchisors faced with a sluggish domestic economy are discovering “willing investors and growth opportunities overseas,” according to an article published August 11 in the Wall Street Journal. The article—by reporter Richard Gibson—says that the overseas push is fueled in large part by saturation of the U.S. market. However, in this challenging economy, the ability of overseas master franchisees to bankroll franchise operations has become even more important, as domestic franchisees find it more difficult to obtain bank loans to finance their businesses. The numbers are compelling. McDonald’s Corp. has opened 286 foreign units this year, compared with only 53 U.S. units. Subway has opened 1,432 units abroad and only about 1,230 here at home. Meanwhile, Curves International Inc. has experienced double-digit growth abroad, particularly in Brazil, Central Europe, and Eastern Europe. Japan is now its biggest overseas market, with 744 locations. It opened its first unit in China in May. Text of the story (“U.S. Franchises Find Opportunity to Grow Abroad”) appears here on the Wall Street Journal online.

 The New York State Department of Taxation and Finance is creating an automatic 90-day extension process for franchisors required by a new law to report gross sales of each franchisee within the state, sales by the franchisor to the franchisee, and any franchisee income reported to the franchisor, according to Troy Flanagan of the International Franchise Association. New legislation, effective on April 7, 2009, requires franchisors to file annual information returns with the State Department of Taxation and Finance on or before March 20. That return must cover the four quarterly sales tax periods immediately preceding. The law provides that the first returns must be filed on or before September 20, 2009, and cover the period of March 1, 2009 through August 1, 2009. Returns filed on or before March 20, 2010, must cover the period from September 1, 2009 through February 28, 2010. Prior to the initial September 20, 2009, deadline, the Department will post on its website instructions to request an automatic 90-day extension to December 20, 2009. All future annual deadlines will be given a similar treatment, according to Flanagan. Further information on the reporting requirement appears here at the Department website.