Rupert M. Barkoff

For almost half a century, disclosure, and in some cases, registration, have been the primary method of preventing fraud in connection with the sale of franchises. And generally speaking, no one has seriously suggested that there are any other acceptable alternatives for reducing the likelihood of fraud in connection with the sale of franchises. The regulators of franchising will soon be conducting a review of the Federal Trade Commission's (FTC) Franchise Disclosure Rule under a mandate from the federal government that regulatory authorities review their regulations periodically to determine whether these regulations are still needed, and whether any changes to these regulations should be made.

History of Disclosure Requirement

Disclosure was no stranger as a means to prevent fraud when, in 1978, the FTC adopted it as the preferred means of reducing fraudulent franchise sales. Starting in 1970, a dozen or so states had enacted statutes dictating how a franchisor must disclose the details of its franchises before they may be sold to the public. In addition, almost all of these states required that the offering must be reviewed by these states' administrators, and if these officials found any deficiencies in the proposed offering, the franchisor had to modify its offering materials to correct these. Since their adoption, mostly during the 1970s, a few states have eliminated the registration requirement, but for the most part, these laws have not been materially amended since their enactment.

The FTC was a latecomer to the regulation party. With the adoption of the FTC's Disclosure Rule in 1978, the FTC has laid on top of the state statutes a requirement that a minimal level of disclosure with respect to franchise sales must be made in every state, regardless of whether that state had any franchise sales legislation governing franchise sales. To the extent a state's franchise sales law afforded less protection to prospective franchisees, these statutes were pre-empted.

The Franchise Disclosure Rule was adopted approximately seven years after it was first proposed, and was amended in 2007, after a lengthy commentary period intended to give state officials, franchisors and their legal counsel an opportunity to scrutinize and comment upon proposed changes. For the most part, the 2007 changes to the FTC were procedural, not substantive. The 2007 amendments included a requirement that certain information had to be provided about a franchise system's franchise association, if one existed. However, registration was still absent from the federal regulatory process, and financial performance information (formerly known as “earnings claims”) remained optional; and the tables in Item 20, dealing with franchise success and failure within the system, were clarified.

The amendments also resulted in changes as to formatting of the Franchise Disclosure Document (FDD), and the rules regarding filing requirements, which were worthwhile and brought the preparation and filing of franchise filings into the 21st century, technologically speaking. Literally thousands of hours were spent by franchise officials, lawyers and franchisors overseeing the 2007 changes. Never was the question raised of whether disclosure, in itself and by itself, is an effective way to regulate franchise sales.

Current Review

In 2012, the Franchise Law Institute, Inc. (FLI), a non-profit organization, was established (with the author of this article being the sole member) solely for the purpose of addressing the propriety and effectiveness of existing franchise sales regulation. In that year, the FLI held an invitation-only Colloquium (the Colloquium), attended by representatives of the franchisor and franchisee communities, franchise consultants, and one state regulator. There was clear consensus among the attendees that disclosure was a proper means of regulating franchise sales, but that the dual-level of federal and state franchise law was inefficient. The group also had mixed opinions as to whether registration at the state levels added much to the fraud reduction objective of regulation.

Several of the attendees suggested that once one state had reviewed a franchisor's offering, there was no need for further reviews of that same document. A substantial number of the attendees suggested that registration at the federal level would be a more efficient way to regulate franchise sales. The attendees also commented upon the sufficiency of the content of the required FDD, suggesting that more emphasis should be made on the required business disclosures, with perhaps less attention being placed on the legal aspects of the franchise relationships. No action was taken by the attendees at the Colloquium and no summary of the proceedings was ever published. That brings us to the starting point for the current review of the FTC Rule.

Recently, the North American Securities Administrator Association (NASAA) Task Force on Franchise and Business Opportunities (the Task Force), which oversees franchise sales regulation, released a proposal to change the state cover page of the FDD. The changes would increase the warnings of the risks of investing in a franchise. But it may have the opposite effect—longer documents may discourage prospects from reading the document. The fact that the Task Force is already trying to change the existing state cover page suggests that the review may not result in many significant changes, just like the 2007 review.

At least one author has suggested that the deficiencies in disclosure are that (1) many prospective franchisees never read the FDD; (2) if they did read it, they would not understand it; and (3) even if they avoided these problems, they will not be savvy enough to do the due diligence needed for them to make an intelligent investment decision. Will any changes to the FDD eliminate these failings?

Possible Considerations

So what are some of the things that NASAA might consider at this time?

(1) Do nothing. One strategy that the franchisor community might take is to encourage little or no changes unless there is demonstrative showing that the wheel is broken.

(2) Revamp the FDD in its entirety. This is not a likely scenario because the franchise community is now fairly comfortable with the FDD. What would be the justification for an entire rewrite?

(3) Federal review. Given the attitude of the current federal administration, it is unlikely that the government will step into deeper water. Federal review would require setting up another regulatory regime, again something not in line with current regulatory thinking. It would require more federal expenditures although it might eliminate some state expenditures. The regulators would benefit because in theory a lot of repetitive work by the regulator community would become unnecessary.

(4) Eliminate disclosure altogether. Such a proposal would receive a thumbs down from the franchisee community, unless it were accompanied with a plan that would still protect franchisee interests.

(5) Do as they do in Australia—require franchisees to get professional assistance. This is the way Australians purportedly assure that the franchisee will have someone covering his or her back. However, the requirement gives relatively little to improve the franchisee's position when purchasing a franchise. The Australian procedure can be waived. Moreover, what assurance will the franchisee have that the professional hired will have the skills to adequately advise a prospective franchisee. Would it now be necessary to set up a group to evaluate franchisee advisors? More red tape. California has already established a system under which lawyers can become certified franchisee advisors. It would be interesting to investigate whether certification improves the advice that franchisees receive.

After reviewing these alternatives, it seems that little can be done to improve franchising, particularly from the franchisees' perspective.

So we can predict that while considerable time may be spent in trying to steer franchising in the right direction (whatever that may be), it is likely when the next review is undertaken, franchise regulation will not look much different than the current regulatory scheme.

Rupert M. Barkoff is chair of the franchise team at Kilpatrick Townsend in Atlanta. He is a former Chair of the American Bar Association's Forum on Franchising, and currently serves as an adjunct professor at the University of Georgia School of Law.