I. COMPLIANCE WITH FEDERAL AND STATE DISCLOSURE LAWS

A. THE FTC RULE
Under the Federal Trade Commission’s (“FTC”) Franchise Disclosure Rule¹, a franchisor must make certain disclosures to a prospective franchisee prior to the signing of a franchise agreement within a specified time period, otherwise, the franchisor’s conduct in connection with the advertising, offering, licensing, contracting, sale or other promotion of the franchised business will be considered an unfair and deceptive practice. Generally, the disclosures include material information a prospective franchisee needs in order to make an informed investment decision in circumstances where they might otherwise lack the resources, knowledge, or ability to obtain the information.

While the FTC Rule specifies what type of disclosures must be made, the FTC authorized the use of an alternative disclosure format known as the Uniform Franchise Offering Circular (“UFOC”)² enacted by the North American Securities Administrators Association (“NASAA”). The FTC format is less commonly used than the UFOC in part because the UFOC format can be readily used in registration states. In those states that require franchise offerings to be registered, their disclosure format requirements closely follow the UFOC Guidelines.

In furnishing the UFOC you must comply with the requirements of the FTC Rule, which preempts state law in this area. The FTC Rule requires you to deliver the UFOC to the prospect at the earlier of:

(1) the "first personal meeting" with the prospective franchisee; or

(2) at least 10 business days before:

   (a) the prospect signs any agreement; or

   (b) the receipt of any consideration from the prospect.

The first-face-to-face meeting occurs when the franchisor or its broker meets with the prospect for the purpose of discussing the sale or possible sale of the franchise, but generally does not include telephone calls or e-mail exchanges. Exhibiting at trade shows will generally not constitute a face-to-face meeting (and trigger disclosure obligations), if: (1) the discussions with trade show attendees are brief; (2) the are no substantive discussion of fees, territories, or other material terms; and (3) no earnings claims are made.

Upon delivery of the UFOC, the Company must obtain a signed and dated Receipt from the prospect. The last page of the UFOC must contain a complete set of the agreements to be executed (with all blanks filled in) at least 5 business days prior to execution. The FTC Rule defines “business day” to mean any date other than Saturday, Sunday or a national holiday.

The FTC Rule provides for three updating requirements. First, the information contained in the UFOC document must be current as of the close of the franchisor’s most recent fiscal year. After the close of the year, the franchisor must prepare a revised disclosure document within 90 days. Second, the franchisor must update its disclosures to reflect any material changes within a reasonable time after the close of each fiscal year quarter. A material change is generally "any fact, circumstance, or set of conditions which has a substantial likelihood of influencing a reasonable franchisee or a reasonable prospective franchisee in the making of a significant decision relating to a named franchised business or which has any significant financial impact on a franchisee or prospective franchisee."

Examples of a “material change” include: (1) changes in the franchisor’s management, corporate structure, address or interim financial statements; (2) changes to the offer itself; (3) closing or failing to renew a significant number of franchisees; and (4) the filing of material litigation or administrative proceedings.

Third, the FTC Rule contains specific updating requirements if a franchisor makes earnings representations. A franchisor must notify prospective franchisees of any material changes in the information contained in its attached earnings claim document prior to entering into the franchise relationship.

B. THE SINGLE TRADEMARK LICENSE EXCLUSION
The FTC Rules specifies four types of relationships which are not deemed to constitute franchises. One of these four is the single trademark license exclusion. Indeed, the FTC Rule specifically states that the term franchise shall not be deemed to include any continuing commercial relationship created solely by “an agreement between a licensor and a single licensee to license a trademark, tradename, service mark, advertising or other commercial symbol, where such license is the only one of its general nature and type to be granted by the licensor with respect to the trademark, service mark, advertising or other commercial symbol.” 16 C.F.R. §436.2(a)(4)(iv). With respect to the single trademark license exclusion, the FTC recognizes that it is often difficult to distinguish between trademark licensing and franchising, both of which involve the right to use a trademark. The essential difference involves a degree of control exercised by the franchisor and licensor.

The FTC has issued two informal staff advisory opinions with respect to the single trademark license exclusion. In 2000, the FTC issued Opinion 00-3, where it considered two factors: (1) the degree of control of the licensee; and (2) the number of licensees. The FTC found that the level of control which would disqualify one from availing itself of the single trademark license exclusion was inherently fact sensitive and not subject to any bright line test. However, in analyzing the second prong of their analysis, the FTC determined that in order to take advantage of the single trademark exclusion, the licensor must offer the licensee an exclusive license to use the marks. Moreover, the FTC found that if the totality of the circumstances suggest that the licensor intends to offer, or reserves the right to offer, more than a single exclusive license, than the exclusion will not apply. For this reason, the FTC also indicated that they would expect a grant of an exclusive right to use the licensor’s mark to be on a national basis, and where a licensor establishes regional or statewide exclusive licenses, the FTC can reasonably conclude that the licensor is reserving the right to offer multiple licenses in the future.

However, in 2002, the FTC issued Opinion 02-1 where it apparently adopted a more practical and common sense approach with respect to the single trademark license exclusion. In Opinion 02-1, a licensor sought to issue a second license to an entity it had previously granted a prior trademark license. Without reference to Opinion 00-3, the FTC found that the first grant of a license fell squarely within the FTC Rule’s single trademark exclusion, despite not being national in scope. The FTC stated in Opinion 02-1 that “although we repeatedly have stated that exclusion and exemptions from the FTC Rule will be narrowly construed, we can find no principle basis for extinguishing between a one time license and multiple licenses to the same licensee”. The FTC now found that the single trademark license exclusion focuses on the relationship between the licensor and the licensee, not on the number of outlets the licensee may ultimately open. In effect, the FTC found that the series of license agreements to the same entity merely permit what the parties could have arranged initially through a one time, broader license agreement covering multiple units. In short, the FTC found that in order to take advantage of the single license exclusion, it must find either a one time multiple use license agreement, or a series of substantially identical licenses, granted to the same licensee. The opinion makes no mention of the license having to be national in scope from the outset. Indeed, the possibility of multiple similar licenses would imply that there is no such requirement.

Accordingly, if the licensor, at the time it issues the single trademark license, has no intention of granting additional licenses to third parties, it may avail its of the single trademark license exclusion subject to the control requirement. However, if the licensor has plans to license a trademark to others, the single trademark license exclusion would not be applicable. Similarly, if the licensor desired to issue additional licenses to its existing sole licensee, these licenses must be substantially similar to the first license in order to be covered by the single trademark license exclusion.

C. STATE REGISTRATION / DISCLOSURE LAWS
Many states have franchise laws which may apply to an offer or sale of a franchise³. A state franchise law is potentially applicable whenever: (a) the prospective franchisee is a resident of or domiciled in the state; (b) the franchised business is to be located or to operate within the state; (c) the offer to sell originates in the state; or (d) the offer was directed to, or accepted from, the state.

Currently 12 states require annual pre-sale registration of a franchisor’s UFOC. Those states are California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin (the “Registration States”). Michigan and Indiana require a Notice of Intent (to sell franchises) to be filed and Michigan also requires state-specific language to be included in an addendum to the offering circular (although the actual addendum need not be filed or registered). In addition to these states’ franchise laws, it is necessary to register or file exemption notices under the business opportunity laws of Florida, Kentucky, Nebraska, Texas and Utah.

Although the UFOC attempts to provide a common format to permit franchisors to comply with state franchise disclosure laws, the registration states have adopted laws or regulations that require certain variations to the uniform format. State variations required in registration states result from both published statutes and regulations as well as local practice. These state specific changes are contained in a state specific amendment to the UFOC and franchise agreement.

In response to a franchise registration application, state examiners review the UFOC submitted for registration and generate comment letters which identify “deficiencies” which must be satisfied prior to registration.

Franchisors must exercise caution during the registration renewal process. In certain registration states, if the renewal application is not approved before the previously approved document expires, a franchisor may be required to cease all offer and sales activity in such states until the renewal application is approved. See Appendix “B” for more information regarding permissible sales activity during the renewal process.

In 2000, NASAA announced a Coordinated Review Project, in which an initial registration application can be submitted to a single state examiner for review on behalf of all of the registration states. Originally all of the registration states participated in the Coordinated Review program except California. On February 19, 2004, California announced that it would now participate in the coordinated review program. Therefore, once the UFOC has been approved and registered by the examining state, it is approved and registered for all of the registration states. The Coordinated Review program is only available for initial franchise registrations and not renewals.

Further, NASAA is considering the electronic submission of state registration applications. NASAA has also proposed to exempt Internet “offers” from state registration requirements if the franchisor: (1) uses cautionary language; (2) does not target anyone in the state; and (3) does not make a sale in the state until registered.

Franchisors must deliver state-specific disclosure documents (that is registered offering circulars along with the state specific addendum) to franchise prospects in that state. Several states have disclosure obligations that are greater than those required by the FTC Rule, such as Illinois, which requires that the UFOC be delivered at least 14 calendar days before: (a) the prospect signs any agreement; or (b) the receipt of any consideration from the prospect.

D. STATE BUSINESS OPPORTUNITY LAWS
Franchisors must be aware of the possible application of business opportunity laws, which, although not directly intended to regulate franchising, could encompass the offer and sale of a franchise. Twenty-five states regulate the sale of business opportunities.⁴

The term “Business Opportunity” is defined nearly identically in all of those states. For example, Illinois defines a “Business Opportunity” as a contract or agreement, between a seller and purchaser, express or implied, orally or in writing wherein it is agreed that the seller or a person recommended by the seller shall provide to the purchaser any product, equipment, supplies or services enabling the purchaser to start a business when the purchaser is required to make a payment to the seller or a person recommended by the seller of more than $500 and the seller represents directly or indirectly, orally or in writing, that:

1. The Seller or a person recommended by the Seller will provide or assist the purchaser in finding locations for the use or operation of vending machines, racks, display cases or other similar devices on premises neither owned nor leased by the purchaser or seller;

2. The Seller or a person recommended by the Seller will provide or assist the purchaser in finding outlets or accounts for the purchaser’s products or services;

3. The Seller or a person specified by the Seller will purchase any or all products made, produced, fabricated, grown, bred or modified by the purchaser;

4. The Seller guarantees that the Purchaser will derive income from the business which exceeds the price paid to the Seller;

5. The Seller will refund all or part of the price paid to the Seller or repurchase any of the products, equipment or supplies provided by the Seller or a person recommended by the Seller if the Purchaser is dissatisfied with the business; or

6. The Seller will provide a marketing plan, provided that this law shall not apply to the sale of the marketing plan made in conjunction with the licensing of a federally registered trademark or federally registered service mark.

Ill. Rev. stat. 5-5.10.(a).
Many business opportunity laws contain statutory exemptions for businesses which comply with federal or state franchise disclosure requirements, or for those businesses being offered in conjunction with a registered⁵ trademark or service mark, so long as the franchisor does not offer a money back guarantee. If you do not qualify for a valid exemption, a violation of state business opportunities laws may result in civil and criminal penalties. See Appendix “C” for more details regarding business opportunity laws.

E. REGISTRATION OF FRANCHISE SALESMEN AND BROKERS
As part of the registration package, when required, the franchisor’s salesman must submit completed Salesman Disclosure Forms which are submitted with the registration application in those states which require registration of the franchise offering circular. All third parties who assist in the sale of franchises, including potentially all franchise brokers, franchise lead referral networks and business consultants may have disclosure obligations under state law. Illinois and Washington require separate registrations for franchise brokers and Illinois even has criminal penalties for franchise sales violations.

The FTC Rule defines a franchise broker as:

Any person other than a franchisor or a franchisee who sells, offers for sale, or arranges for the sale of a franchise.

16 CFR Part 436, § 436.2(j). The UFOC guidelines, define a franchise broker as:

Any person engaged in the business of representing a franchisor or subfranchisor in offering for sale or selling a franchise, except anyone whose identity and business experience is otherwise required to be disclosed at Item 2 in the body of the offering circular.

UFOC Instructions. In addition, the states of Washington and Illinois have similarly defined franchise brokers as:

Any person engaged in the business of representing a franchisor in offering for sale or selling a franchise and is not a franchisor or an officer, director or employee of a franchisor with respect to such franchise.

Ill Rev. Stat. Ch. 85-551 § 3(21).

A person who directly or indirectly engages in the business of the offer or sale of franchises. The term does not include a franchisor, subfranchisor, or their officers, directors, or employees.

Wash. Rev. Code § 19.100.010(11).

Franchise Brokers must be disclosed in Item 2 of a franchisor’s UFOC and any material litigation or bankruptcy relating to a franchise broker must be disclosed in Items 3 and 4 of the UFOC. Further, franchise brokers must register annually in the states of Illinois and Washington.

Franchise brokers are required to meet the FTC Rule’s disclosure obligations. Under the FTC Rule, franchisors and franchise brokers are obligated to furnish disclosures at the earlier of the “time for making disclosures” or the “first personal meeting”. The “time for making disclosures” means 10 business days before the prospect signs a binding agreement or pays a fee in connection with the franchise sale. 16 CFR § 436.2(g). The term “first personal meeting”, in turn, is defined as “a face-to-face” meeting between a franchisor or franchise broker and a prospective franchisee which is held for the purpose of discussing the sale or possible sale of a franchise. 16 CFR § 436.2(o).

In Opinion 99-6, the FTC concluded that “a face-to-face meeting in which any independent consultant or other sales agent of the franchisor pre-screens prospects for the possible sale of a franchise” constitutes a “first personal meeting” under the FTC Rule and thus requires the franchise broker to provide the prospect with the required disclosures.

FTC Opinion 99-7 clarified Opinion 99-6 and held that “where a broker personally meets with a prospect and solicits information from a consumer and takes the next step of suggesting one or more franchise systems that match the consumer’s interests or qualifications, the parties are engaging in a “first face-to-face” meeting for the purpose of arranging for the possible sale of a franchise.”

F. ADVERTISING
All advertising used to promote franchise sales, including promotional material given to prospective franchisees to influence their investment decision, must be filed with state authorities in 9 states before they can be used in those states.⁶

Franchise advertising includes: (1) franchisee recruitment advertising; (2) any oral communication contained in recorded telephone messages, radio or television advertising or similar communication, made in connection with an offer of a franchise or to induce the purchase of a franchise; and (3) any printed communication including newspaper, brochures, electronic sales presentations, reproduced magazine articles, form solicitation letters and other writings. Typically, all internet advertising must also be filed with the appropriate state authority. Refer to Appendix “D” for more information regarding advertising filing requirements.

G. ENFORCEMENT AND PENALTIES
A failure to comply with the disclosure obligations contained in the FTC Rule is a violation of §5 of the Federal Trade Commission Act, 15 U.S.C. §45, and punishable by a fine of $11,000 for each violation as well as additional liability for any injury to a consumer as a result of the FTC Rule violation.

Similarly, a failure to comply with the disclosure obligations of any registration state may result in administrative actions resulting in civil and criminal penalties and may result in stop orders preventing the franchisor from selling in the state. Further, the failure to comply with the disclosure obligations under state law may subject the franchisor, its officers, directors, employees, salespersons and sales brokers to criminal sanctions as well as franchisee lawsuits for recission of the franchise agreement, attorneys fees and treble damages.

Finally, such administrative actions or lawsuits must be disclosed by the franchisor in the UFOC for the next 10-years.

H. PROPOSED CHANGES TO THE FTC RULE
The FTC has been engaged since 1995 in a public review of the FTC Rule. This review included numerous public workshops and forums intended to provide each of the parties with an opportunity to suggest improvements to further revise the FTC Rule. On or about October 15, 1999, the FTC released a 150 page Notice of Proposed Rulemaking (“NPR”) outlining sweeping changes to the FTC Rule. Comments on the proposed changes were received on December 22, 1999 and rebuttal comments on January 31, 2000. This summary is not intended to be exhaustive of all the proposed changes, but rather seeks to highlight the most meaningful changes.

The NPR contains new: (1) definitions; (2) disclosures; (3) exemptions; (4) prohibitions; and (5) instructions. As in the past, the FTC is a disclosure rule and is not intended to otherwise regulate the franchise relationship.⁷

The new NPR permits a franchisor to transmit offering circulars (complying with the NPR’s changes) electronically (through the Internet, CD rom, disk or any other electronic means), at a franchisee’s option after a franchisor discloses the format of the electronic transmission and operating system necessary to view it. The NPR still requires franchisors to obtain a non-electronic acknowledgment of receipt, renamed a Notice and Receipt, containing a cover page, table of contents and receipt identifying the franchisor’s e-mail address and principal URL. The notice is designed to advise franchisees that the diskette/e-mail/website contains important information, similar to the FTC cover sheets which currently accompany disclosure documents. The offering circular must be self-contained in a single document (i.e., no links to other documents) and must look like a traditional document containing no electronic graphic or similar promotional material. The NPR clarifies that the parties may negotiate terms of the franchise agreement and execute a negotiated agreement.

The NPR modifies the existing 5- business day rule, within which a franchisee must obtain a final version of his proposed franchise agreement with all of the blanks filled in, to 5 calendar days with a 3-day extension for mailing. The NPR eliminates the “first personal meeting” trigger in favor of a 14-day prior to sale trigger for disclosure requirement.

The Rule makes clear that there is no application in international transactions.

Some of the more sweeping disclosure changes are found in the initial sections of the offering circular. The Rule essentially replaces the FTC Rule format with the UFOC disclosure format which must contain certain additional information including the following:

1. In addition to predecessor disclosures, the NPR requires disclosure on any parent company. In a system which owns multiple other systems, (i.e., Cendant), the NPR would require a description of the parent company, and potentially expand the litigation and bankruptcy history relating to individuals who are officers or directors of the parent.

2. The current litigation disclosure would be modified to require a franchisor to disclose actions initiated against a franchisee involving the franchise relationship. There is no 7 or 10 year historical carryover, rather the Rule requires only disclosure of pending actions.

3. Under the current Rule, in the Item 20 chart, franchisors usually include multiple entries for single franchise units. The NPR makes clear that the necessary disclosure is the first in time with no double counting.

4. The new NPR requires a franchisor to identify any franchisees subject to a confidentiality agreement, presumably to advise prospects that certain franchisees have signed contracts restricting their ability to discuss the relationship. Franchisors can express this measure either in terms of the number or percent of franchisees under a confidentiality order and must explain the circumstance surrounding such orders.

5. The NPR requires disclosure of trademark specific franchisee associations, but only those which are separately incorporated and officially recognized by the franchisees.

6. The NPR voids integration clauses which seek to disclaim a franchisee’s reliance on information contained in the disclosure document (as distinguished from information contained in the franchise agreement) reflecting the FTC policy that franchisees must be permitted to rely on information contained in the offering circular.

7. The information contained in an offering circular will be required to be updated quarterly, but updates may be sent under a separate cover to franchisees who have already been disclosed. The NPR retains the plain English requirement and does not provide to franchisees a private right of action under the FTC Rule as modified.

8. There are no mandatory earnings claims, although state regulators seem eager to impose such a requirement.

9. There is an exemption from compliance for sophisticated franchisees for investments exceeding $1.5 million.

I. ELECTRONIC DISCLOSURE
The 1999 Notice of Proposed Rulemaking purports to revise the current FTC Rule by expressly permitting the use of electronic disclosure upon satisfaction of enumerated guidelines. The proposed Rule is predicted to take effect in 2004.

Currently, Franchise.com and several other companies provide electronic disclosure services. These companies followed the federal guidelines contained in the 1999 FTC Notice of Proposed Rulemaking and has expressly received the necessary FTC approval to provide such services.

Proponents of electronic disclosure claim that the system would reduce the cost and expense associated with disclosure, including production, mailing and staffing costs.

Sales personnel can provide substantive information to a qualified prospect faster, or while on the telephone, which in turn, can accelerate a closing. Sales compliance officers would receive an electronic receipt as soon as the prospect receives the electronic transmission, simplifying regulatory compliance procedures. Electronic archives also reduce a franchisor’s hard costs for copying, binding, storage, postage and overruns.

Opponents of electronic disclosure claim that the system would not be beneficial in that it would lead to uniformed investment decisions and fraudulent behavior. They fear that franchise prospects may experience difficulty in accessing the information due to inherent electronic complications. In addition, recipients may not thoroughly review the UFOC because it is in electronic form.

Despite the proliferation of technology in all aspects of our personal and professional lives, the franchise community is only slowly embracing electronic disclosure.

Footnotes:

¹ 16 CFR Part 436.1, et seq.

² As used in this Manual, the term UFOC is used interchangeably with the terms offering circular and disclosure document, and is intended to mean your UFOC and all its contents.

³ See Appendix "A" for more information regarding franchise registration, disclosure and relationship laws.

⁴ These business opportunity states are: Alabama, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia and Washington.

⁵ Certain states require a federally registered trademark while others except offers in conjunction with a state registered trademark.

⁶ These states are: California, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota and Washington.

⁷ Legislation intended to regulate the franchise relationship was introduced at the end of the 105th Congress in 1999 by Representative Howard Coble and reintroduced at the 106th Congress. No action has been taken since. The "Coble Bill" is similar to the prior proposed franchise relationship regulation which had been introduced by Representative John LeFalce every year since 1990.