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1.1 What is the legal definition of a franchise?
The U.S. Federal Trade Commission (“FTC”) promulgated 16 C.F.R. Part 436 (the “FTC Franchise Rule”) to regulate the offer and sale of franchises throughout the United States. Under the FTC Franchise Rule, a commercial business arrangement or relationship will be deemed to be a “franchise” if the terms of the contract (whether oral or written) satisfy the following three definitional elements:
(i) the franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;
(ii)the franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provides significant assistance in the franchisee’s method of operation; and
(iii)as a condition of obtaining or commencing operation of the franchise, the franchisee will make a required payment or commit to make a required payment to the franchisor or its affiliate. According to the FTC’s Compliance Guide, the required payment must be a minimum of at least $500 during the first six months of operations.
At the state level, there is no uniform legal definition of a “franchise”. Each state defines “franchise” differently. For example, California, Illinois, Indiana, Iowa, Maryland, Michigan, North Dakota, Oregon, Rhode Island, Virginia, Washington, and Wisconsin, a business arrangement is a “franchise”, if, under the terms of the agreement:
(i)a franchisee is granted the right to offer, sell, or distribute goods or services, under a marketing plan or system prescribed or suggested in substantial part by a franchisor;
(ii)the operation of the franchisee’s business pursuant to such plan or system is substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor or its affiliate; and
(iii)the person granted the right to engage in such business is required to pay to the franchisor or an affiliate of the franchisor, directly or indirectly, a franchise fee of $500 or more.
In essence, the above states’ laws mirror the FTC Franchise Rule. A second group of states vary from the model by identifying a “community of interest” as an element rather than a “marketing plan” (e.g., Hawaii, Minnesota, Mississippi, Nebraska and South Dakota follow this model).
A “community of interest” means a continuing financial interest between the franchisor and franchisee in the operation of the franchise business.
A third group of states, including Connecticut, Missouri, New York and New Jersey, use “two-pronged” definitions of a “franchise” (contrast this with the “three-pronged” federal definition). For example, New Jersey law provides that a business arrangement qualifies as a “franchise” if:
(i) there is a written agreement in which one person grants another a licence to use a trade name, trademark, service mark, or related characteristic; and
(ii)there is a community of interest in the marketing of the goods and services being offered.
New York adopts a “two-pronged” approach in its own unique way. The first prong contains one of two elements: a New York franchisee either operates under a marketing plan or is granted the use of a trademark. In either case, the franchisee always pays a franchise fee (the “second prong”).
1.2 What laws regulate the offer and sale of franchises?
The federal FTC Franchise Rule imposes a pre-sale disclosure requirement that applies to all states, obligating franchisors to furnish prospective franchisees with the material terms of the franchise relationship prior to consummating the sale of a franchise. Franchisors disclose this material information in a prescribed format commonly referred to as a Franchise Disclosure Document (“FDD”). In addition, at the state level, 15 states have registration and/or disclosure requirements that must be met before a franchise can be offered and sold in that state. Only 11 of these states require that: (i) a state agency review the FDD; and (ii) the franchisor register its franchise programme with the state. In “registration states”, the franchisor and/or the disclosure document must be registered and approved by the appropriate state agency before the franchisor can commence any franchise sales activities in that state. Twenty-five states have business opportunity laws which extend the disclosure protections afforded to franchisees to consumers that purchase business opportunities, including franchises. Under these laws, sellers are obligated to prepare and disclose certain information to prospective buyers prior to the consummation of a sale. Typically, the information required to be disclosed by sellers under business opportunity laws is less extensive than what is required to be disclosed under the FTC Franchise Rule or state franchise laws. Thus, many franchisors tend to be “exempt” or “excluded” from business opportunity laws provided that they are in compliance with the FTC Franchise Rule and provide prospective franchisees with an FDD. Obtaining the exemption or exclusion may require some act of the franchisor (e.g., Florida, Kentucky, Nebraska, Texas and Utah require the filing of a notice with the state to qualify for an exemption).
1.3 If a franchisor is proposing to appoint only one franchisee/licensee in your jurisdiction, will this person be treated as a “franchisee” for purposes of any franchise disclosure or registration laws?
Business format franchising is the primary method by which franchisors elect to expand their brand in different domestic consumer markets. However, it is not the preferred method of franchising for U.S.-based franchisors looking to establish their presence internationally. Franchisors seeking global expansion of their brand will typically partner with a single franchisee/licensee (“master franchisee”) to develop, market and operate units under the franchisor’s brand within a specified geographic region. This form of expansion is more commonly referred to as master franchising. Under this form of expansion, a master franchisee/sub-franchisor is treated as a franchisee for the purposes of franchise disclosure and registration laws. The master franchisee/sub-franchisor is making a substantial investment in the franchisor’s system and it is therefore afforded the same franchise disclosure and registration protections as if it was a “typical” franchisee.
1.4 Are there any registration requirements relating to the franchise system?
The FTC Franchise Rule does not require franchisors to register their FDDs with a federal administrative or governmental agency. It only imposes a pre-sale disclosure requirement on franchisors. However, as noted in the response to question 1.2 above, there are 15 states that require a franchisor to either: (i) register their FDD; or (ii) file a notice of intent with the appropriate regulatory authority prior to any offer or sale of a franchise or multi-unit development rights within the state.
1.5 Are there mandatory pre-sale disclosure obligations?
Any violation of the pre-sale disclosure requirement imposed by the FTC Franchise Rule is a violation of the FTC Act, and grants the FTC the right to sue franchisors in federal court and to seek any or all of the following remedies: (i) civil penalties of up to $11,000 per violation; (ii) injunctive relief with respect to violations of the FTC Franchise Rule, including barring franchise sales in the United States; and (iii) restitution, rescission, or damages on behalf of the affected franchisees. While the FTC can bring an action against franchisors who violate the FTC Franchise Rule, no such private right of action is granted to aggrieved franchisees. Although franchisees do not have a private right of action under federal law, state franchise disclosure laws permit an aggrieved franchisee to bring an action against the franchisor for violations of state registration and disclosure laws. These claims most commonly include actions for rescission of the franchise agreement and/or actions for actual damages (including reasonable attorneys’ fees and expenses).
With respect to pre-sale disclosure requirements, franchisors may look to the Franchise Registration and Disclosure Guidelines (the “Guidelines”) promulgated by the North American Securities Administrators Association, Inc. (“NASAA”) as a resource (along with other NASAA publications). NASAA is a voluntary association with a membership consisting of 67 state and territorial securities administrators in the 50 U.S. states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada and Mexico. NASAA facilitates multi-state enforcement actions, information sharing and education (including the publication of new materials). The Guidelines provide an item-by-item breakdown of the information required to be disclosed in FDDs.
On May 19, 2019, NASAA adopted three new cover pages which were to be incorporated into FDDs beginning on January 1, 2020. These new pages include: “How to Use this Franchise Disclosure Document”, “What You Need to Know About Franchising” and “Special Risks to Consider about This Franchise”. The NASAA website provides instructions for use of the new cover pages ((Hyperlink) ).
1.6 Do pre-sale disclosure obligations apply to sales to sub-franchisees? Who is required to make the necessary disclosures?
The FTC Franchise Rule imposes a pre-sale disclosure requirement on franchisors selling franchises using the business format method of franchising, but no such pre-sale disclosure requirement applies to sub-franchisees. While the FTC Franchise Rule does not directly address master franchising, NASAA has adopted a Multi-Unit Commentary that provides franchisors with practical guidance concerning their disclosure obligations with respect to certain multi-unit franchising arrangements, including master franchising. Under the NASAA guidelines, franchisors are required to prepare a separate FDD (from the FDD the franchisor uses) for offering and selling sub-franchise rights to prospective master franchisees/sub-franchisors. This pre-sale disclosure requirement is not only imposed on franchisors offering and selling sub-franchise rights to prospective franchisees and multi-unit developers, it is also imposed upon master franchisee/sub-franchisors who “step-into” the franchisor’s shoes and engage in franchise sales activities and provide training and support to sub-franchisees. Therefore, under the NASAA guidelines, master franchisees/sub-franchisors are responsible for preparing and providing their own FDD in connection with their offer and sale of sub-franchises and, where applicable, complying with state registration requirements.
1.7 Is the format of disclosures prescribed by law or other regulation, and how often must disclosures be updated? Is there an obligation to make continuing disclosure to existing franchisees?
Under the FTC Franchise Rule, franchisors are obligated to furnish prospective franchisees and multi-unit developers with certain material information through the prescribed format of an FDD. The purpose of the FDD is to provide prospective franchisees and multi-unit developers with the information they need to make an informed decision about investing in the franchisor’s franchise system. The FDDs, which are the most essential component of the pre-sale due diligence process, are uniform in structure and are comprised of 23 categories (“Items”) (which are laid out in the FTC Franchise Rule) of detailed information and accompanying exhibits regarding, among other things: (i) the history of the franchisor (and any parent or affiliate), including any history of bankruptcy or litigation; (ii) the business experience of the franchisor’s principals; (iii) the recurring or occasional fees associated with operating the franchised business; (iv) an estimate of the initial investment in order to commence operations; (v) the products (and sources for those products) that the franchisor wants the franchisee to use and/or purchase in connection with the operation of the franchised business; (vi) any direct or indirect financing (along with the terms of such financing) being offered by the franchisor; (vii) a list of all of the franchisor’s word marks, service marks, trademarks, slogans, designs, and patents that will be used in connection with the operation of the franchised business; (viii) the territory in which the franchisee will operate, along with any rights retained by the franchisor to operate or cause a third party to operate in such territory; (ix) the exit strategies available to the franchisee and franchisor; (x) a description of how disputes are resolved; and (xi) the franchisor’s financial performance, etc.
One of the Items that prospective franchisees and multi-unit developers usually deem to be amongst the most vital in analysing the franchise opportunity is financial performance information concerning existing franchised and company-owned units. These will include past or projected revenues or sales, gross income, and net income or profits. Franchisors are not required by federal or state law to provide prospective franchisees with this information, but if they choose to do so, they may provide the information in Item 19 of the FDD; provided that there is a reasonable basis for the information and such information is properly disclosed. Improper financial performance representations can (and have, in many instances) give rise to a governmental or private cause of action under federal, state and/or common law (although there is no private right of action under the FTC Franchise Rule). NASAA provides commentary (adopted May 2017) on certain aspects of the financial performance representations which may be disclosed under Item 19.
The FTC Franchise Rule requires new annual information (including updated audited financial information) to be made within 120 days of the end of each fiscal year. In addition, at the end of each fiscal quarter, a franchisor must prepare and include in Item 22 an attachment reflecting any “material” changes to its FDD (e.g., bankruptcy filings or pending litigation filed against the franchisor).
In addition to the federal requirement to update an FDD, certain states require the franchisor to update the FDD and submit amendment filings (e.g., in New York, California, Maryland, Michigan, North Dakota and Rhode island, a franchisor must “promptly” update its FDD and file an amendment with the state agency whenever there is a material change to the disclosed information).
Due to the Coronavirus pandemic, various registration states have devised ways of accommodating franchisors impacted by the lockdowns who might otherwise fall out of compliance as a result. For example, several states have begun encouraging online filing of renewals and registrations (e.g., California and Hawaii). Other states have opted to extend registration renewal filing deadlines to allow additional time for franchisors to make their submissions. (E.g., New York extended its filing deadline an additional 90 days from April 30 to July 30, 2020
1.8 What are the consequences of not complying with mandatory pre-sale disclosure obligations?
A myriad of federal and state regulatory frameworks each have their own varied repercussions for non-compliance. Under federal law, violations of the FTC Franchise Rule are deemed “unfair or deceptive acts or practices” in violation of Section 5 of the FTC Act. The FTC can initiate enforcement actions against franchisors, and the FTC may exercise broad investigatory powers in doing so, including the ability to investigate, take testimony, examine witnesses, issue civil investigatory demands (“CIDs”), and issue subpoenas, with the additional ability to enforce their powers in federal court (see e.g. 15 USC 46, 49, 57, and 16 CFR Section 2.5). If a violation is found, the FTC may seek to have an administrative enforcement proceeding in front of an administrative law judge (“ALJ”), and any decision of the ALJ is enforceable in federal court. Remedies may include preliminary and permanent injunctive relief, including potentially barring a franchisor from conducting business or engaging in certain conduct (15 USC Section 56(b)), civil penalties, restitution of aggrieved parties, and other equitable relief. However, such enforcement actions by the FTC are relatively uncommon in the franchise context.
Many individual states have their own regulatory enforcement scheme, typically enforced through a state’s Attorney General’s office, depending upon the state-specific franchise consumer protection law. While remedies differ by state, these state statutes can allow state regulators to impose fines, obtain preliminary and permanent injunctive relief (again, including potentially barring a franchisor from conducting business within the state), and relief for aggrieved parties, such as damages, restitution, or rescission. Some state violations are even punishable as crimes.
Violations may also subject a franchisor (or inadvertent franchisor) to liability from franchisees. Notably, the FTC Act does not provide for a private right of action. However, as discussed herein, many states have “Little FTC Acts”, which do provide for private rights of action for pre-sale disclosure obligations. Such claims typically allege that a franchisor’s failure to provide a compliant FDD before entering into a franchise business relationship violated the federal FTC Rule, which in turn violated the particular state’s “Little FTC Act”, which does allow a private right of action. Notably, many of these state-specific consumer protection acts grant significantly augmented damages, including in some cases, multiples of damages, punitive damages, and attorney fee-shifting.
In addition, there are currently 15 states (see question 1.2, above), which provide for state-specific registration or disclosure obligations, and 25 states have business opportunity laws, which must be complied with. Each of these state statutes has its own applicable remedies, and many not only provide regulators with enforcement powers, but also permit damaged parties to maintain private rights of action. Again, these state-specific statutes have different remedies, and may often include augmented damages, fee-shifting, costs, and additional remedies such as rescission. Some state statutes also impose individual liability on officers, directors, control persons, or principals of franchisors engaging in prohibited activity.
Additionally, even where a technical right of action may not be available to an aggrieved party based upon disclosure requirements alone, it should not be lost on franchisors that the presence of disclosure violations can lead to a greater risk of liability for common law claims, including fraud and misrepresentation, or even for violations of the implied covenant of good faith and fair dealing. In large part, an FDD (with its many protective disclosures and disclaimers) is a protective document for a franchisor, and franchisors are well advised to take care to show that a prospective franchisee properly received a compliant FDD.
Finally, in the COVID-19 pandemic, franchisors should be particularly mindful of the need to update their disclosures, as both federal and state law may require franchisors to provide interim disclosures or amendments if circumstances have materially changed due to the pandemic, particularly if they result in adverse changes. Material changes in the franchised system’s operations may be forced by governmental mandates (e.g. prohibiting “in person” interaction with customers), or material changes to financial conditions or disclosures may be triggered by significant changes in revenues, or closures of units. These types of adverse changes may require a franchisor to amend, and redisclose the amendment to an FDD to prospective franchisees (or even recently-disclosed franchisees). The failure to do so may result in a violation that could entail the risk of substantial civil liability (see e.g. NY’s Franchise Regulations Section 200.5(b) (amendments to franchise offering prospectus) (“material change”)).
1.9 Are there any other requirements that must be met before a franchise may be offered or sold?
Although franchisors must ensure that they strictly adhere to the aforementioned franchise disclosure and registration laws, there are other business and legal elements that the franchisor must address prior to engaging in franchise sales activities.
Trademark and Assumed Business Name Registration. As noted in the response to question 1.1 above, in order for a business arrangement to qualify as a franchise, the franchisee must operate its franchised business under the franchisor’s trademark. Therefore, franchisors should look to register all trademarks, service marks, trade names, logos, domain names, or other commercial symbols that will be used in connection with the franchise system, prior to offering and selling franchises. Additionally, franchisors should register any assumed business names under which they operate with the proper administrative agency, prior to offering and selling franchises, in order to protect their rights to use that particular assumed name.
Advertising Materials Related to the Sale of Franchises. Certain registration states, like New York, require that franchisors file any materials that advertise the sale of franchises (such as brochures and websites) prior to the advertisement’s first publication in that state.
Registration of Franchise Brokers and Sellers. Certain states require franchisors to register their franchise sellers with the appropriate regulatory agency before that person is permitted to sell franchises or multi-unit development rights in that state. In these states, franchisors must file a Franchise Seller Disclosure Form for each franchise seller, which includes the seller’s name, business address and phone number, his or her employer, title, five-year employment history and information about certain relevant litigation and bankruptcy matters. In instances where a franchisor elects to use a franchise sales broker, two states (New York and Washington) require franchisors to file a separate registration form that provides the state with more detailed information about the broker. These states additionally require the broker to have a licence from the state prior to engaging in franchise sales activities in the state. A Franchise Seller Disclosure Form and/or Franchise Broker Registration Form must be submitted with each initial registration application, annual renewal application and any post-amendments to a franchisor’s FDD.
1.10 Is membership of any national franchise association mandatory or commercially advisable?
No. While membership in a national franchise association is not mandatory, it is advisable. Many franchisors, individual franchisees and businesses that service the franchising industry are members of the International Franchise Association (“IFA”), which is the largest and oldest global franchising organisation. The IFA provides its members with a wealth of valuable information (including, but not limited to, the latest legal developments affecting the franchising industry, networking platforms and franchise opportunity information) relating to the franchising industry. For information about the IFA, visit their website at: (Hyperlink) . In addition to holding membership in the IFA, many franchisees and franchisee associations are members of the American Association of Franchisees and Dealers (the “AAFD”). The AAFD has promulgated a code of Fair Franchising Standards which sets forth the AAFD’s view of requirements for a more “level playing field” between franchisors and franchisees. Visit (Hyperlink) for more information about the AAFD.
1.11 Does membership of a national franchise association impose any additional obligations on franchisors?
The IFA has a Code of Ethics that can be found at (Hyperlink) . While it does not have the force or effect of law, this Code of Ethics provides IFA’s members with a framework for the manner in which they are to act in their franchise relationships.
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1.12 Is there a requirement for franchise documents or disclosure documents to be translated into the local language?
No. Federal and state law only require that the FDD be written in “plain English”.