The American Bar Association 31st Annual Forum on Franchising

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Notice -i- I. INTRODUCTION The Federal Trade Commission ( cFTC d) released its amendments to the FTC 9s Trade Regulation Rule entitled cDisclosure Requirements and Prohibitions Concerning Franchising d 1 (the cAmended FTC Rule d) in January 2007. The Amended FTC Rule disclosure format is, in most respects, an updated and enhanced version of the North American Securities Administrator Association 9s ( cNASAA d) Uniform Franchise Offering Circular ( cUFOC d) disclosure format. The Amended FTC Rule became effective on July 1, 2007, although the FTC permitted franchisors to continue to use the original FTC Rule, including NASAA 9s UFOC disclosure format, until July 1, 2008. As of July 1, 2008, all franchisors were required to comply with the Amended FTC Rule and have their franchise disclosure documents converted to the Amended FTC Rule disclosure format. Much has been written and discussed about the Amended FTC Rule since its release in January 2007, and, by the time of the annual Forum meeting, most franchise practitioners will have had experience preparing franchise disclosure documents ( cFDDs d) under the Amended FTC Rule and filing those FDDs in the franchise registration states. We have assumed for the purposes of this paper that the reader has a baseline knowledge of the requirements and prohibitions under the Amended FTC Rule. Therefore, this paper will not discuss in detail all of the revisions made to the original FTC Rule or the differences between the Amended FTC Rule and the UFOC Guidelines. 2 Instead, this paper focuses on disclosure issues under the Amended FTC Rule that may be unclear or are particularly problematic, other disclosure and compliance issues that may not be apparent on a superficial reading of the Amended FTC Rule, and any guidance or clarification that the FTC has provided to date. Where appropriate, this paper will also discuss NASAA and state responses to the Amended FTC Rule, including certain state comments received with respect to FDD filings and proposed responses. This paper was prepared well in advance of the annual Forum meeting. To the extent that there are clarifications made by the FTC, NASAA or the states or further developments between the completion of this paper and the Forum meeting, those issues will be discussed during the presentation of this paper. II. KEY DOCUMENTS/SOURCES The key documents and sources used in the preparation of this paper included the following: " The Amended FTC Rule (16 C.F.R. pt. 436). The Amended FTC Rule is available on the Internet from the GPO at http://ecfr.gpoaccess.gov/cgi/t/text/text- 1 16 C.F.R. pt. 436 (2008). The full text of the official version of the Amended FTC Rule is found in the Federal Register, Vol. 72, No. 61 at pages 15444 363 (March 30, 2007). 2 For an excellent discussion of key disclosure revisions under the Amended FTC Rule as compared to the UFOC Guidelines, see the paper entitled, Practical Disclosure Issues Under the Amended FTC Franchise Rule: The Final Word? , by John Baer, Shelley Harris-Horn, and Steve Toporoff, which was presented at the annual ABA Forum on Franchising meeting in October 2007. 2 idx?c=ecfr&sid=a4d5f9ffd8a3223b1a1af177ce1fca18&rgn=div5&view=text&node= 16:1.0.1.4.50&idno=16 . Consistent with the citation format in the Amended FTC Rule and the Statement of Basis and Purpose, we will cite only the Section number of 16 C.F.R. when citing the Amended FTC Rule in this paper (e.g. , § 436.2(a)). " The Amended FTC Rule Statement of Basis and Purpose (72 Fed. Reg. 15445- 15544 (March 30, 2007)) ( cStatement of Basis and Purpose d). The Statement of Basis and Purpose is available on the Internet at http://www.ftc.gov/os/2007/01/R511003FranchiseRuleFRNotice.pdf . " Franchise Rule Compliance Guide ( cCompliance Guide d). The Compliance Guide is available on the Internet at http://www.ftc.gov/bcp/franchise/franchise-rule- compliance-guide.pdf . " The FTC 9s Frequently Asked Questions, known as cAmended Franchise Rule FAQs d ( cFAQs d). The FAQs are available on the Internet at http://www.ftc.gov/bcp/franchise/amended-rate-faqss.shtml . FAQs are issued periodically, so the website noted above should be referred to. A copy of the current FAQs is attached to this paper as Appendix A . " FTC Staff Advisory Opinions (Bus. Franchise Guide (CCH) ¶¶ 6380 to 6533). The FTC Staff Advisory Opinions are available on the Internet at http://www.ftc.gov/bcp/franchise/netadopin.shtm . " State franchise registration and disclosure law statutes and regulations (Bus. Franchise Guide (CCH) ¶¶ 3000 to 3520, and ¶¶ 5050 to 5490). " 2008 NASAA Franchise Registration and Disclosure Guidelines ( cNASAA FDD Guidelines d). The NASAA FDD Guidelines are available on the Internet at http://www.nasaa.org/content/Files/2008UFOC.pdf . A copy of the NASAA FDD Guidelines is attached to this paper as Appendix B . III. ANALYSIS OF THE AMENDED FTC RULE, INCLUDING NASAA AND STATE RESPONSES AND INTERPRETIVE ISSUES A. Delivery Requirements 1. 7 Day Rule Under the original FTC Rule, franchisors were required to provide prospective franchisees with a final copy of the franchise and related agreements with all material blanks filled in at least five business days before the agreement was to be signed. That c5 business day rule d was eliminated in the Amended FTC Rule. However, under the Amended FTC Rule, if a franchisor unilaterally and materially alters the terms or conditions of the form franchise agreement or related agreements that are attached to the FDD, the franchisor must provide a copy of the revised agreement(s) to the prospective franchisee at least seven calendar days before the prospective franchisee signs the 3 agreement. 3 (Changes that result from negotiations initiated by the prospective franchisee do not trigger this seven day hold requirement.) At first glance a franchisor may not believe that the 7 day rule will apply to it very often since, after all, most changes to the form franchise agreement arise out of negotiations that the franchisee initiates. Additionally, the Statement of Basis and Purpose states that the 7 day rule will not be triggered when the franchisor completes cfill-in-the-blank d provisions, such as the name and address of the franchise and the date of the agreement. 4 However, the Statement of Basis and Purpose and FAQ #10 make clear that if csubstantive contractual details d, such as the geographic area of a protected territory, fees, and interest rates, are not disclosed in the FDD or its attachments, those terms must be inserted into the franchise agreement and the completed agreement must be provided to the prospective franchisee at least seven calendar days before the prospective franchisee signs. For example, if the form franchise agreement provides for territorial protection in a geographic area but there is a blank in the form franchise agreement for the protected territory to be filled in before the agreement is signed, the 7 day rule will apply. However, FAQ #10 states that if the protected territory has been previously disclosed, but the exact name or other circumstances are not known at the time of disclosure (e.g. , cWe grant territories based on the county in which your unit will be located. Your protected territory will be [county], [state] d), inserting specific information applicable to the prospective franchisee will not trigger the 7 day rule since information sufficient to enable the prospective franchisee to determine the geographic area that would be applicable to its franchise was disclosed as part of the FDD (in this example, the exact county and state). 2. State Issues Under the Amended FTC Rule, franchisors are required to provide prospective franchisees with a copy of the franchisor 9s current FDD at least fourteen calendar days cbefore the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale. d 5 Additionally the Amended FTC Rule eliminates the first personal meeting rule. These simplified delivery requirements are a welcome change from the more cumbersome delivery requirements under the original FTC Rule. However, some states have not yet amended their disclosure delivery requirements to reflect the requirements in the Amended FTC Rule. Iowa, Maine, Maryland, New York, Oklahoma, and Rhode Island still have a first personal meeting rule, so if a franchisor has a first personal meeting with a prospect in these 3 16 C.F.R. § 436.2(b). 4 See Statement of Basis and Purpose at 15471. 5 16 C.F.R. § 436.2(a). The Compliance Guide clarified that the execution of a pre-sale confidentiality agreement, under which the prospective franchisee agrees not to disclose the contents of the franchisor 9s operations manual in consideration for the franchisor permitting the prospective franchisee to review the manual prior to execution the franchise agreement, by itself, does not trigger the requirement to provide disclosure. See Compliance Guide, Item 11. 4 states, the franchisor must provide an FDD to the prospect at the first personal meeting that is held to discuss the sale or possible sale of a franchise. Additionally, Connecticut, Maryland, Michigan, New York, Oklahoma, Oregon, Rhode Island, and Washington (if the franchisor is not exempt from the Connecticut business opportunity law) have retained the ten business day disclosure holding period. 6 Therefore, in these states, a prospective franchisee must hold the FDD for a full ten business days before paying any consideration to the franchisor or its affiliate or signing an agreement related to the franchise. Franchisors must comply with both the Amended FTC Rule requirements (including the 7 day rule discussed above) and the state laws that have different disclosure delivery requirements in the states noted above. Section III.C. of the NASAA FDD Guidelines requires that franchisors add a statement to the Receipt pages of the FDD to reflect state laws that contain disclosure delivery requirements that differ from the Amended FTC Rule delivery requirements. Language similar to the following should be included in the FDD Acknowledgments of Receipt and should be updated if and when the laws of these states are brought into conformity with the Amended FTC Rule: Some state franchise laws require the franchisor to provide this disclosure document to you at the first personal meeting held to discuss the franchise sale or at least 10 business days before you sign a binding agreement with, or make a payment to, the franchisor or an affiliate in connection with the proposed franchise sale. 3. Requirement to Provide FDD cEarlier Upon Reasonable Request d It is an unfair or deceptive act or practice for a franchisor to fail to furnish a copy of the franchisor 9s FDD earlier in the sales process than required under Section 436.2 (i.e. , 14 calendar days before the prospective franchisee pays any money or signs an agreement) upon reasonable request by the franchisee. 7 Does this mean that the franchisor is required to provide an FDD to any person who asks for it at any time? The FTC has said cno. d This requirement applies only after the franchisor and prospective franchisee have commenced the franchise sales process. 8 Given the fact that most franchisors require prospects to complete a franchise application and meet certain minimum qualifications before proceeding with the sales process, a good rule of thumb is that prospective franchisees may request (and franchisors must provide) a copy of the FDD after the application is completed and the franchisor has determined that the prospective franchisee is qualified to move forward in the sales process or otherwise provides a positive response to the application. The Compliance Guide also makes clear that a franchisor is not permitted to charge any fee to a prospective franchisee in connection with its right to receive an FDD prior to the disclosure deadline. Another important question that is addressed partially by FAQ #14 is what a franchisor should do if a prospective franchisee creasonably requests d a copy of the FDD when the 6 The first personal meeting rule in Iowa, Maine, and Oklahoma and the 10 business day rule in Connecticut and Oklahoma are included in those states 9 business opportunity laws. 7 See 16 C.F.R. § 436.9(e). 8 See Compliance Guide at 21. 5 franchisor 9s FDD is no longer current, and the franchisor is in the process of updating its FDD or state registration applications are pending. FAQ #14 states that franchisors should provide the current FDD to prospects upon reasonable request even if an updated FDD is soon to be issued, but, in order to avoid possible misrepresentations, franchisors should advise the prospective franchisee that the franchisor is preparing a revised FDD which will be available to the prospect when it is issued or registered. The question that FAQ #14 does not directly answer is what a franchisor should do if a prospective franchisee makes a creasonable request d for a copy of the FDD for a franchise which would be covered by a state franchise registration law and the franchisor does not have an effective registration in that state. In some states (e.g. , California and New York) the franchisor may be able to continue to offer franchises while a renewal or amendment application is pending if certain requirements are met, but what should a franchisor do in other registration states that do not have such a provision or in registration states that have this type of provision but the franchisor has no application pending at the time of the request? Should the franchisor provide the FDD to the prospect in order to comply with the Amended FTC Rule, thereby potentially violating the state registration law? One may argue that requesting an FDD for a franchise in a state in which the franchisor is not effectively registered is not creasonable d and, therefore, the franchisor has no obligation to provide the FDD. Fortunately, in a recently issued FAQ (#24), the FTC provided some clarity on this issue by stating that, as a matter of policy, it would not recommend enforcement action when a material change amendment is pending if the franchisor can demonstrate that it: c(1) advised the prospective franchisee that it was revising its FDD to reflect a material change; and (2) delivered the revised FDD as soon as permitted by the applicable state law, but in any event at least 14 calendar days before the prospective franchisee signed a binding agreement with, or made a payment to the franchisor or an affiliate in connection with the proposed franchise sale. d 4. cPipeline d Re-disclosure The Amended FTC Rule does not require franchisors to provide an updated FDD to prospective franchisees that have already been disclosed before the prospective franchisee enters into the franchise agreement, even if an updated FDD (or quarterly updates) is available. Prospective franchisees may, however, request an updated FDD before they sign franchise agreements, and the franchisor must provide any update upon such request if available. Notwithstanding the Amended FTC Rule 9s lack of a cpipeline d re-disclosure requirement, franchisors must consider whether applicable state law requires such re-disclosure. Further, even in non-registration states, the cbest practice d is to re-disclose prospects in the pipeline before the franchise agreement is signed. Doing so may help avoid claims of misrepresentation, 9 particularly if there has been a material change to the FDD since the prospect was originally disclosed. B. Form and Formatting It is critical that FDDs be prepared specifically as required in the Amended FTC Rule, and the disclosures should appear in the exact order set forth in the Amended FTC Rule. For 9 See Video Update, Inc. v. Guenther , 741 F. Supp. 172, 174 (D. Minn. 1990) (franchisee was disclosed with 1984 UFOC; while waiting for required pre-sale disclosure period, franchisor was notified that 1985 UFOC had been registered in Illinois, but franchisor did not re-disclose prospective franchisee before signing the franchise agreement). 6 example, the titles and subtitles of each Item and the column headings and cProvision d descriptions in the Item 17 chart must be exactly as they appear in the Amended FTC Rule. Any variation in the wording will likely draw a comment and requirement to modify the particular language from a state examiner. We discuss some specific examples of comments made by state examiners in this regard in Section III.F. of this paper. Additionally, Section IV.A.12 of the NASAA FDD Guidelines requires that the FDD must be clearly readable and be in at least 11 point type. Tables in the FDD and ancillary documents attached to the FDD may be in type smaller than 11 point. However, any tables or ancillary documents that are in smaller type must still be clearly readable. Section II.B. of the NASAA FDD Guidelines requires that initial, renewal, and amendment filings must be submitted both in paper copy and in PDF format on a CD-ROM, and the cover letter transmitting application documents must contain a representation that the paper copies of the documents are identical to the document contained on the CD-ROM. Finally, any blackline documents submitted in connection with a franchise filing must not contain cmargin balloons d and must not show changes in color. C. Exemptions 1. New Exemptions The Amended FTC Rule contains three new exemptions. 10 The first is the clarge investment d exemption, which exempts franchise offers and sales where the initial investment is at least $1 million, excluding the cost of unimproved land and any financing provided by the franchisor or its affiliate. At least one investor (or owner of an entity franchisee) must invest $1 million or more in order to qualify for the exemption (in other words, 5 investors investing $200,000 each would not qualify for the exemption). In order to determine whether the $1 million threshold is met, the franchisor may consider all amounts that it anticipates will be paid as contemplated in Item 7 prior to opening and during the three-month period following opening. Additionally, if the prospective franchisee is purchasing multiple units as part of the proposed transaction, the franchisor may aggregate the initial investment that the franchisee will make during the Item 7 initial investment period for all of the units in determining whether the threshold is met. The FTC has also stated that conversion franchises and transfers may qualify for the large investment exemption. With respect to a conversion franchisee (i.e. , a business owner who has already invested in and opened a business but wants to convert its business to the franchisor 9s brand), the franchisor may consider the franchisee 9s previous investment in the business in determining whether the threshold is met, even though these amounts were not paid to the franchisor. The logic applicable to a transfer is the same as with a conversion franchisee. If the proposed transferee is investing at or above the $1 million threshold when it purchases an existing franchised outlet, the fact that the money is being paid to someone other than the franchisee will not preclude the franchisor from qualifying under the exemption. 11 10 16 C.F.R. § 436.8(a)(5) 3(6). 11 Compliance Guide at 11. 7 Importantly, in order to qualify for the large investment exemption, franchisors must obtain a signed acknowledgement from the franchisee which states that the investment in the franchise satisfies the $1 million threshold. The acknowledgement must be in plain English and cclear and conspicuous d and contain the following prescribed statement: The franchise sale is for more than $1 million 3 excluding the cost of unimproved land and any financing received from the franchisor or an affiliate 3 and thus is exempt from the Federal Trade Commission 9s Franchise Rule disclosure requirements, pursuant to 16 C.F.R. 436.8(a)(5)(i). It is the franchisor 9s burden to prove that the exemption is applicable and that the acknowledgement is received and signed by the prospective franchisee so it is critical that the franchisor obtain the signed acknowledgment and retain it in the franchisor 9s permanent files to avoid future claims that the franchisor failed to comply with the Amended FTC Rule. The second new exemption is the clarge franchisee d exemption. The offer and sale of a franchise to a prospective franchisee that has a net worth of at least $5 million and has been in business for at least 5 years is exempt from the Amended FTC Rule. The Amended FTC Rule does not specify any particular methodology for determining how net worth is to be determined, but franchisors wishing to rely on this exemption should obtain a recent balance sheet to confirm net worth. The balance sheet should either be audited or certified by an appropriate officer of the entity that it is true and correct. With respect to the business experience component, the Statement of Basis and Purpose provides that any business experience of the franchisor or its affiliates or parents may be counted toward the 5 year threshold (i.e. , the business experience need not be in franchising or the business that is the subject of the franchise). The franchisor may aggregate the business experience and net worth of the franchisee 9s parents or affiliates in determining whether the large franchise exemption applies. It is important to note with respect to the large investment and large franchisee exemptions that the FTC built in the ability to adjust the $1 million and $5 million thresholds every four years based on inflation. The third and final new exemption is the cinsiders d exemption. This exemption applies to an officer, director, general partner, or manager of the franchisor who: (i) seeks to purchase at least a 50% interest in the franchise; and (ii) has at least 2 years 9 experience with the franchisor as an officer, director, general partner, or manager. That association must be current or within sixty days of the proposed purchase. Similarly, the exemption applies to an owner of the franchisor if: (i) the owner seeks to purchase at least a 50% interest in the franchise; and (ii) the owner currently has, or has had within sixty days prior to the sale of the franchise, at least a 25% ownership interest in the franchisor for at least two years. The critical issue that franchisors must understand with respect to these new csophisticated franchisee d exemptions is that, although they may facilitate streamlined franchise transactions in certain circumstances in which the exemption qualifications are met, the franchise registration states have not yet adopted these exemptions. Exemptions under state registration laws vary significantly from state to state, and, although some registration states have exemptions which overlap with the new Amended FTC Rule exemptions, there is no 8 common thread in terms of exemptions provided for in the state franchise registration laws and the Amended FTC Rule. 12 Therefore, the benefit of the new Amended FTC Rule exemptions will likely only be realized in transactions that meet the exemption qualifications in the non- registration states, at least until (and if) the registration states adopt similar exemptions. Given the above, franchisors that generally offer franchises in both registration and non-registration states will need to prepare and maintain an FDD which meets the requirements of the Amended FTC Rule. 2. Exemptions Under the Original FTC Rule The Amended FTC Rule retains each of the exemptions in the original FTC Rule, including the minimum payments exemption, the fractional franchise exemption, the leased departments exemption, and the oral agreements exemption. With respect to the minimum payments exemption (which essentially provides that franchise sales are exempt if the franchisee is not required to pay $500 or more to the franchisor or its affiliates before or during the first six months of the franchisee 9s operations), there was a minor (but potentially significant) wording change in the Amended FTC Rule that lead some commentators to question whether franchisors could require franchisees to sign a nonnegotiable promissory note for amounts accrued during the first six months of the relationship to be paid following the expiration of such six month period. 13 Nonnegotiable promissory notes were commonly used by franchisors wishing to take advantage of the minimum payments exemption, and this practice was approved by the FTC in a 1979 Staff Advisory Opinion. 14 The FTC clarified the issue in the Compliance Guide by stating the c[a] commitment entered into during the first six months that requires a payment later than six months after commencing operation (such as a promissory note or that portion of lease payments made after six months) is not counted toward the $500 minimum. d 15 D. Definitions The Amended FTC Rule contains a useful definitions section at Section 436.1. It is critical that franchisors and their counsel are familiar with the defined terms under the Amended FTC Rule and refer to the definitions section often because there are a number of new defined terms, and some of the defined terms carried over from the original FTC Rule were modified. 12 When analyzing the potential applicability of state exemptions, it is important to remember that some exemptions from state franchise registration laws may be exemptions from registration only, in which case, the franchisor may still be required to provide disclosure in compliance with the state registration law. 13 The original FTC Rule stated that franchise sales are exempt if cthe total payments . . . made during a period from any time before to within 6 months after commencing operation of the franchisee 9s business, is less than $500. d The Amended FTC Rule states that franchise sales are exempt if cthe total required payments, or commitments to make a required payment , to the franchisor or an affiliate that are made any time from before to within six months after commencing operations of the franchisee 9s business is less than $500. d (emphasis added) The language under the Amended FTC Rule could be read to say that commitments to pay (e.g. , promissory notes signed) during the first six months would count toward the $500, even if the commitment required the franchisee to pay after the six month period expired. 14 See Bus. Franchise Guide (CCH) ¶ 6382. 15 Compliance Guide at 7. 9 We will not discuss every defined term in this section, but we will highlight certain critical definitions and issues raised by certain of the defined terms. We will discuss certain of these terms in more detail in Section III.F. of this paper. 1. Confidentiality clause Item 20 of the Amended FTC Rule requires that franchisors disclose the existence of confidentiality clauses. 16 The term is narrowly defined to include agreements or provisions that directly or indirectly restrict a current or former franchisee from discussing with a prospective franchisee the franchisee 9s experience as a franchisee in the franchise system. The Amended FTC Rule makes clear that confidentiality clauses do not include provisions that protect the franchisor 9s trademark or proprietary information like those that are typically found in franchise agreements or franchise termination agreements. 17 2. Financial performance representation The term cfinancial performance representation d replaces the term cearnings claim d in the original FTC Rule. 18 The definition of financial performance representation is essentially the same as the definition of earnings claim under the original FTC Rule, with one exception. Under the Amended FTC Rule, cost information is not included in the definition of financial performance representation. Therefore, with one important caveat, cost information can be provided to prospective franchisees without including that information in Item 19. Interestingly, the FTC has taken the position that cost information provided outside of Item 19 as a percentage may only be provided as a percentage of total costs and not as a percentage of revenues (see further discussion infra). 3. Franchise seller cFranchise seller d is a new defined term under the Amended FTC Rule and is broader than the term cfranchisor. d Franchise seller means ca person that offers for sale, sells, or arranges for the sale of a franchise d and includes not only the franchisor but also employees, agents, and contractors of the franchisor, including brokers, area representatives, and subfranchisors. 19 The franchise seller(s) that sold a particular franchise is required to be listed in the Item 23 Receipt page as further discussed in Section III.F (13) below, and, importantly, the prohibitions under the Amended FTC Rule apply to franchise sellers. 20 4. Franchisor The definition of franchisor includes any person who grants a franchise and participates in the franchise relationship, and it includes subfranchisors. 21 The Amended FTC Rule requires 16 See 16 C.F.R. § 436.5(t)(7). 17 See id. § 436.1(c). 18 See id. § 436.1(e). 19 Id. § 436.1(j). 20 See id. §§ 436.9, 436.5(w)(2). 21 See id. § 436.1(k). 10 all required information about the cfranchisor, d including subfranchisors that cfunction[] as a franchisor by engaging in both pre-sale activities and post-sale performance d, be included in the FDD. 22 One issue that was raised with respect to this definition is whether area representatives (also known as area directors or development agents) are csubfranchisors d since they are typically involved in the franchise sales process and provide certain post-sale services to franchisees in their respective areas. The FTC clarified in FAQ #9 that an area representative or other development agent (regardless of the nomenclature) is not a subfranchisor, even if the area representative performs post-sale obligations on behalf of a franchisor unless the area representative is a party to the franchise agreement (or to another agreement involved in the outlet franchise). 5. Parent The Amended FTC Rule adds and expands disclosure requirements with respect to cparents d of the franchisor in Items 1, 3, 4, and 21. We discuss each of the substantive disclosure requirements with respect to parents of the franchisor in Section III.F., but we note here that the definition of parent in the Amended FTC Rule is limited to an entity or entities that control the franchisor either directly or through one or more subsidiaries. 23 6. Signature Franchisors are required to have the prospective franchisee 9s csignature d on the Item 23 Receipt page to evidence that disclosure was properly provided. The term csignature d is broadly defined under the Amended FTC Rule as any caffirmative step to authenticate [one 9s] identity d and includes handwritten signatures as well as a person 9s use of electronic signatures, passwords, etc. 24 7. Written or in writing Franchisors are required to provide prospective franchisees with a cwritten d FDD. The terms cwritten d and cin writing d are broadly defined as any cdocument or information in printed form or in any form capable of being preserved in tangible form and read d and includes word processed hard copies of documents as well as electronic versions of documents stored on CD-ROM, sent by e-mail, or posted on the Internet. 25 E. FTC and State Cover Pages 1. FTC Cover Page The cover page required under Section 436.6 of the Amended FTC Rule (the cFTC Rule Cover Page d) must be the first page of the FDD. It should be set out in the order set forth in 22 See id . §§ 436.6(f), 436.5(u)(1)(v). 23 See id. § 436.1(m). 24 See id. § 436.1(u). 25 See id. § 436.1(w). 11 Section 436.3, and must include each of the required statements in Section 436.3(e), word for word with no variation. If the franchisor intends to provide disclosure electronically, it may (but is not required to) include the statement set forth in Section 436.3(f) which advises the prospective franchisee that the FDD is available in another format. We have highlighted a few important points regarding the FTC Cover Page and related matters below: As noted above, the FTC Cover Page should be set forth in the exact order as the requirements appear in Section 436.3. Several state franchise examiners have gone so far as to require that the franchisor 9s logo be placed directly under the franchisor 9s name and contact information (in the order set forth in the Amended FTC Rule) as opposed to the upper left-hand corner of the FTC cover page, which was the common place in which the logo appeared in UFOCs prepared under the original UFOC Guidelines. Section 436.3(e)(1) requires that the total initial investment range from Item 7 and the total amount that must be paid to the franchisor or its affiliate from Item 5 must appear on the FTC Cover Page. Examiners in certain states have required that the disclosure be made in one sentence and that specific disclosure of the Item 5 amounts should only list the total of all amounts described under Item 5 (i.e. , it should not list each amount described in Item 5 separately) and if there are any cost items that are not included in the Item 7 or Item 5 disclosures, franchisors should not note this on the FTC Cover Page, but, instead, include a statement to that effect in Items 7 and/or 5. The FTC has made clear that including on the FTC Cover Page the optional disclosure regarding alternative formats discussed above will not satisfy the pre-disclosure notice requirement regarding the format(s) in which the FDD is available, and that such pre-disclosure notice must be provided before giving the FDD to a prospective franchisee (e.g. , in the franchise application, in a letter or other communication, or on the franchise opportunity web pages on the franchisor 9s website). A sample pre-disclosure notice regarding alternative formats in letter format is attached as Appendix C. Some state examiners have expressed confusion regarding the issuance date that must be included on the FTC Cover Page. In some cases examiners have requested that the issuance date be deleted, reasoning that the FDD does not become effective in the registration state until the state approves the application and provides a notice of effectiveness, and, therefore the inclusion of the issuance date is cconfusing. d Clearly, the issuance date on the FTC Cover Page should not be removed since it is required to be included by the Amended FTC Rule and it relates to issuance in the non-registration states. However, the NASAA FDD Guidelines clarify this issue and indicate that franchisors may include a state effective date summary page (similar to the Uniform UFOC Addendum Page used in many UFOCs prepared under the original UFOC Guidelines) that lists the applicable registration state effective dates following the cover pages. In order to avoid confusion by the reader and the state examiners regarding the FDD issuance date, if the FDD contains a state effective date summary page, the following language should be included under or adjacent to the FDD issuance date appearing on the FTC Cover Page and on the State Cover Page: cSee the following state effective date summary page for state effective dates. d 12 2. State Cover Page The NASAA FDD Guidelines require that a cover page ( cState Cover Page d) be included as part of the FDD immediately following the FTC Cover Page. 26 Among other things, the State Cover Page requires a statement highlighting the fact that some franchise agreements require that franchisees meet certain conditions in order to renew the franchise after the initial term and certain crisk factors d relating to dispute resolution procedures, jurisdiction, and governing law provided for under the franchise agreement. As with the FTC cover page, the language required to be included on the State Cover Page should be presented exactly as it appears (including capitalization format), and in the order set forth, in the NASAA FDD Guidelines. In addition to the standard risk factors required by the NASAA FDD Guidelines, state franchise examiners may require that additional franchise system-specific risk factors be added to the State Cover Page. If they do, those additional risk factors should be added following the standard risk factors. Under the Amended FTC Rule, brokers are no longer required to be disclosed in Item 2. However, the NASAA FDD Guidelines require that the following legend be included on the State Cover Page if the franchisor engages third-party franchise brokers to offer the franchise: We use the services of one or more FRANCHISE BROKERS or referral sources to assist us in selling our franchise. A franchise broker or referral source represents us, not you. We pay this person a fee for selling our franchise or referring you to us. You should be sure to do your own investigation of the franchise. Not only must a franchisor include this legend on its State Cover Page when it engages the services of typical third-party franchise brokers, but this language should also be included on the State Cover Page if the franchisor has area representative/development agent relationships under which the area representative/development agent engages in franchise sales activities. F. Disclosure Items 1. Item 1 (§ 436.5(a)) 3 The Franchisor, and any Parents, Predecessors, and Affiliates The only significant difference between Item 1 of the Amended FTC Rule and Item 1 of the original UFOC Guidelines is that under the Amended FTC Rule, franchisors are now required to disclose the name and principal business address of any cparents. d Questions have been raised about what parent is required to be disclosed if the franchisor has multiple parents. For example, is the franchisor only required to disclose its cultimate parent d or must it disclose all of its parents? FAQ #16 addresses these issues. For the purposes of Item 1, a parent is required to be disclosed only if it directly or indirectly controls the franchisor (i.e. , it cshape[s] the franchisor 9s policies or control[s] franchise sales or operations d). A parent company that owns the franchisor but does not exert such control over the franchisor does not qualify as a cparent d for the 26 NASAA FDD Guidelines, Section III.B. 13 purposes of Item 1, and, therefore, need not be disclosed in Item 1. Importantly, the Amended FTC Rule intentionally uses the plural cparents d in Section 436.5(a). Therefore, if the franchisor has more than one parent that controls the franchisor, all of those parents should be disclosed. The determination of which parent(s) should be disclosed in Item 1 will, obviously, be made based on the particular structure and circumstances of each franchise system. The determination regarding whether a parent controls the franchisor (particularly the determination of whether some indirect control is being exerted) may not always be clear-cut. However, in most cases, it is better for franchisors to err on the side of disclosure, particularly given the relative innocuousness of the Item 1 parent disclosure requirement. Another potential Item 1 issue relates to the inclusion of a list of defined terms in Item 1. Some franchisors have traditionally included a list of defined terms used throughout their disclosure document in Item 1 in an effort to make the defined terms easier to locate and the document more readable as a whole. The Amended FTC Rule does not prohibit the inclusion of a list of defined terms, but at least one state (Maryland) has taken the position that Item 1 should not contain such a list. Given the fact that registration states (including Maryland) often suggest ways to make FDDs more cuser-friendly, d Maryland 9s reasoning for requiring the deletion of lists of defined terms is not entirely clear. However, until such time that Maryland changes its position on this issue, franchisors that employ this drafting technique and file in Maryland should expect a comment from the state requiring that the list of defined terms be deleted and that the definitions be scattered throughout the FDD. 2. Item 2 (§ 436.5(b)) 3 Business Experience The information required to be disclosed in Item 2 is almost identical to the information disclosed under the original UFOC Guidelines with two exceptions: brokers are no longer required to be disclosed, and, importantly, the individuals required to be disclosed in Item 2 are no longer limited to officer, directors, and employees of the franchisor. The Statement of Basis and Purpose states that individuals with management responsibility for the sale or operation of the franchise must be disclosed regardless of that individual 9s employer. 27 Therefore, employees of an affiliate of the franchisor that have management responsibility for the franchise must be disclosed in Item 2. The determination of whether an individual has cmanagement responsibility d is fact-specific, but, again franchisors should err on the side of disclosing an individual if the question is close. Additionally, although franchise brokers are no longer required to be disclosed in Item 2 under the Amended Rule, certain types of brokers that have management responsibility relating to the franchise (e.g. , area representatives/development agents) may need to be disclosed in Item 2. 3. Item 3 (§ 436.5(c)) 3 Litigation The Item 3 disclosure requirements in the original UFOC Guidelines have been expanded in two material respects in the Amended FTC Rule. First, litigation for certain parents of the franchisor must be disclosed. Pending and past litigation to which a parent of the franchisor has been a party must be disclosed if that parent cinduces franchise sales by 27 Statement of Basis and Purpose at 15467. 14 promising to back the franchisor financially or otherwise guarantees the franchisor 9s performance d (injunctions or restrictive orders or decrees resulting from pending or concluded public agency actions to which a parent is subject are also required to be disclosed, but only with respect to parents that guarantee the franchisor 9s performance). 28 The determination of whether parent company litigation must be disclosed is critical, particularly in franchise systems that have a large parent company or a parent that is a public company that may have significant amounts of litigation that fall into the categories of discloseable litigation. In determining whether litigation of a parent is required to be disclosed, it is important to first analyze whether a particular parent of the franchisor falls within the general definition of cparent d under the Amended FTC Rule. Remember, the entity must directly or indirectly control the franchisor in order to fall within the Amended FTC Rule 9s definition of a parent. The next step in the analysis is to determine whether the parent cfinancially backs d the franchisor or guarantees the obligations of the franchisor. The Amended FTC Rule does not define what cfinancial backing d means, but FAQ #16 and the Compliance Guide provide some guidance. FAQ #16 states that financial backing in the context of Item 3 means cpromises that a parent may make to ensure that the franchise system is and remains on stable financial footing. d If the parent promises to provide the franchisor with cash or extend credit or pay debts on behalf of the franchisor, if needed, those promises may be deemed financial backing. Where there is a formal commitment to provide financial backing, this analysis should be straightforward. Situations in which there is an informal arrangement under which the parent provides a financial backstop or in which there may be de facto financial backing (i.e. , the parent bears a disproportionate share of overhead) may be more difficult to analyze. However, if a franchisor merely associates itself with a large, strong parent company (e.g. , Best Value Hotels, an American Hotels company (where Best Value Hotels is the franchisor and American Hotels is the parent)) without more, the parent should not be deemed to be financially backing the franchisor. FAQ #16 also clarifies that cguaranteeing performance d refers to cpromises made between the franchisor 9s parent and the franchisor for the benefit of franchisees or from the franchisor 9s parent directly to the franchisees. d The most common situation in which this occurs is where the parent agrees to meet the obligations of the franchisor under the franchise agreement if the franchisor is unable to perform its obligations. If the franchisor has no parent or affiliate that guarantees its obligations or provides financial backing, it should consider including a disclaimer similar to the following in its franchise agreement: Franchisee acknowledges that it is relying solely on ABC Franchise Company, LLC, and not on any affiliated entities or parent companies related to ABC Franchise Company, LLC, with regard to Franchisor 9s financial and other obligations under this Agreement, and no employee or other person speaking on behalf 28 Consistent with the original UFOC Guidelines, litigation involving certain non-parent affiliates must also be disclosed, including litigation of affiliates that financially back the franchisor or guarantee the franchisor 9s performance or non-parent affiliates that offer franchises under the franchisor 9s principal trademark. See 16 C.F.R. § 436.5(c)(1). 15 of, or otherwise representing, ABC Franchise Company, LLC, has made any statement or promise to the effect that any affiliated entities or parent companies guarantee Franchisor 9s performance or financially back Franchisor. Such a disclaimer would not relieve the franchisor of the requirement to disclose litigation of a parent or affiliate if the parent or affiliate, in fact, guarantees its obligations or provides financial backing, but it could be helpful to show that the franchisee should not have relied on any statement to the contrary if an issue ever arises in this respect. The second significant additional disclosure obligation under Item 2 of the Amended FTC Rule is the requirement to include a disclosure of material litigation initiated by the franchisor against franchisees involving the franchise relationship. The critical points with respect to the new franchisor-initiated action disclosure are: (a) this disclosure may be made in summary fashion (i.e. , the individual suits can be listed under common headings (e.g. , croyalty suits d or csuits to enforce standards compliance d) without providing a full description of the action) and (b) the disclosure is to include only actions filed in the franchisor 9s most recently completed fiscal year and is not required to be updated during the year. One caveat: if a franchisee that is the subject of an action that was initiated by the franchisor files a counterclaim against the franchisor that is otherwise required to be disclosed in Item 3, that action is essentially converted from a franchisor-initiated action for which summary disclosure was appropriate to an action which must be fully-disclosed as if it were initially filed by the franchisee. Litigation involving individuals listed in Item 2 must be disclosed. This is not a change from the original UFOC Guidelines requirements, but, as discussed above, the list of individuals who must be disclosed in Item 2 has been broadened to include non-employees with management responsibility for the franchise. Therefore, additional litigation may need to be added to Item 3 if individuals with discloseable litigation have been added to Item 2. Finally, although not specifically contemplated in the Amended FTC Rule, litigation in foreign jurisdictions should be disclosed. Although the Commentary to the original UFOC Guidelines does not apply to the Amended FTC Rule, that Commentary states that Item 3 is not limited to litigation filed in the United States. 29 Since the Amended FTC Rule generally tracks the UFOC Guidelines, it is reasonable to assume that the FTC adopted this position, and it is prudent to include foreign litigation. 4. Item 4 (§ 436.5(d)) 3 Bankruptcy Under the original UFOC Guidelines, disclosure of parent bankruptcies was not required. However, under the Amended FTC Rule, parent bankruptcies are required to be disclosed. Importantly, there is no qualification, as in Item 3, regarding the parents for which bankruptcies must be disclosed, and, therefore, bankruptcies of all parents of the franchisor must be disclosed in Item 4. Although the general definition of parent in Section 436.1 applies in Item 4, franchisors should carefully consider the issue of whether a parent controls the franchisor in this context. Excluding bankruptcies of a parent on the basis of a determination that the parent does not 29 UFOC Guidelines Commentary, 1994 Issue #12, Bus. Franchise Guide (CCH) ¶ 5790. 16 control the franchisor could present a risk. Although arguments may be made to the contrary, a disgruntled franchisee could argue that any parent has at least an indirect ability to control the franchisor, and that a bankruptcy, even of a remote parent, was material to its determination to purchase the franchise and that the exclusion of the bankruptcy disclosure was a material violation of the Amended FTC Rule. As noted previously, when considering whether to disclose parent bankruptcies, it 9s likely better to disclose if the issue of control is unclear. Finally, franchisors must remember that under the Amended FTC Rule, bankruptcies filed in foreign jurisdictions must be disclosed. 5. Item 7 (§ 436.5(g) 3 Estimated Initial Investment Item 7 remains essentially the same as the Item 7 in the original UFOC Guidelines. However, we note one technical formatting issue that has drawn comments from numerous state examiners and one more substantive point. First, state examiners have been particularly keen to point out that the title of Item 7, cEstimated Initial Investment d and the title of the Item 7 chart, cYour Estimated Initial Investment, d must appear adjacent to each other in Item 7. Although the appearance is somewhat awkward, the following format must be followed: Item 7 Estimated Initial Investment YOUR ESTIMATED INITIAL INVESTMENT [Item 7 Chart] Additionally, the Compliance Guide addresses the issue of the effect of sales of company-owned units on the Item 7 estimates. The price paid by a franchisee in purchasing a company-owned outlet need not generally be reflected in Item 7. However, if the investment made by a franchisee that purchased a company-owned outlet in the prior year exceeds the high end of the Item 7 initial investment range, a footnote should be included in Item 7 which states the highest amount invested by a franchisee that purchased a company-owned outlet. 6. Item 8 (§ 436.5(h)) 3 Restrictions on Sources of Products and Services Item 8 of the Amended FTC Rule essentially tracks Item 8 of the original UFOC Guidelines. However, if an officer of the franchisor owns an interest in any supplier of the franchise system from which franchisees are required to purchase products or services, that fact and the name of the supplier must now be disclosed in Item 8. It is important to note that there is no requirement to disclose the name of the officer or the level of ownership 4only the fact that an officer owns an interest in the supplier and the name of the supplier are required to be disclosed. This disclosure requirement applies to any supplier from which franchisees are required to make purchases, including entities affiliated with the franchisor and publicly-traded companies. However, it generally would not be triggered by ownership of units in diversified mutual funds that might hold investments in a supplier. The FTC responded to the question of whether the Amended FTC Rule requires disclosure regarding ownership of de minimis interests in a supplier by an officer of the 17 franchisor in FAQ #18. The FTC confirmed in that FAQ that de minimis ownership interests would not be material in a franchisee 9s decision to invest in the franchise, and, therefore, would not be discloseable. However, the FTC refused to state a threshold level of ownership, above which would be considered material. The FTC suggested that the more cdirect d the ownership is, the more likely that the interest would be material, and the more cindirect and attenuated d the ownership is, the more likely that the interest would be immaterial. Consistent with the original UFOC Guidelines, Item 8 requires the disclosure of certain payments by system suppliers to affiliates of the franchisor. The Compliance Guide indicates that payments made by suppliers to a franchisor-administered advertising fund or a trademark- specific franchisee association or other third-parties controlled by the franchisor or its affiliate must be disclosed in Item 8. However, payments made to independent third parties, including independent advertising cooperatives, need not be disclosed. The FTC has not addressed whether payments made to independent advertising cooperatives in which the franchisor participates and has voting rights would need to be disclosed, but as long as the franchisor does not have voting control of the cooperative, payments to such a cooperative should not be required to be disclosed. 7. Item 11 (§ 436.5(k)) 3 Franchisor 9s Assistance, Computer Systems, and Training Item 11 of the Amended FTC Rule differs significantly in several respects from Item 11 of the original UFOC Guidelines. There are no particularly cthorny d new disclosure issues in Item 11, but there are some general guidelines that should be kept in mind when drafting Item 11. First, the order of the disclosures in Item 11 has changed. Item 11 should be presented in the order set forth in Section 436.5(k). Second, the detailed computer system disclosures that were required by the original UFOC Guidelines are no longer required. All that is required with respect to computer systems is a non-technical description of the required systems generally and the types of data to be generated or stored in the systems. Additionally, the cost of the systems; any obligation of the franchisor, its affiliate, or a third-party to maintain, upgrade or repair the systems; any requirement for the franchisee to upgrade the system; and the annual cost of optional or required maintenance, upgrading or support contracts must be disclosed in Item 11. Finally, the headings of the training chart have been revised so that the location of training must be included in the chart, and the materials used in training are no longer in the chart but are now required to be disclosed in narrative format. 8. Item 12 (§ 436.5(l)) 3 Territory Item 12 includes a new requirement to include the following statement if the franchisor does not grant an exclusive territory: You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control. 18 Some commentators have questioned whether this disclaimer is required in any circumstance in which the franchisor does not grant complete exclusivity, which would be almost every franchisor that grants territorial protection since most franchisors that grant territorial protection reserve some rights in the franchisee 9s protected area, including the right to offer products and services that are the subject of the franchise through alternative distribution channels or under different brands. The FTC clarified in a recent FAQ (#25) that a typical reservation of rights provision which permits the franchisor cto make sales in the territory through alternative channels of distribution or competitive brands d does not trigger the requirement to include the statement. The statement is only required in circumstances where the franchisor does not commit to refrain from establishing ccompany-owned or franchised outlet[s] selling the same or similar goods or services under the same or similar trademarks or service marks. d Otherwise, the statement should not be included in Item 12. Although most franchisors fully described in their UFOCs the reserved rights provisions contained in their franchise agreements, Item 12 now specifically requires the disclosure of rights in the protected territory that the franchisor reserves both with respect to the distribution of products and services under the franchisor 9s principal trademark and other trademarks through other channels of distribution, including the Internet, catalog sales, telemarketing, or other direct marketing. It is important to specifically address whether the franchisor reserves rights to engage in distribution through these alternative channels, whether or not the franchisor grants any territorial protection. 9. Item 17 (§ 436.5(q)) 3 Renewal, Termination, Transfer, and Dispute Resolution Item 17 now requires franchisors to disclose the terms under which a franchise agreement will be renewed, with a particular emphasis on whether the terms of the agreement 3 after renewal 3 might be cmaterially different d from those in the original form of agreement. 30 In adopting this requirement, 31 the FTC observed that: Especially in an age of new technologies and changes in franchise marketing, renewal contracts may be significantly different from original contracts that franchisees signed 10 to 20 years ago. A renewing franchisee, for example, may reasonably wish to see Item 20 closure rates for franchises operating under the new franchise agreement. Accordingly, the Commission concludes that where the franchise agreement contains terms and conditions materially different from the original agreement, the renewing franchisee needs advance disclosures in order to make an informed renewal decision. 32 More recently, the Commission 9s staff and the NASAA FDD Disclosure Guidelines 33 provided sample disclosures for Item 17 of the FDD that dispense with the paragraph of 30 See, e.g. , Test Services, Inc. v. The Princeton Review, Inc. , Bus. Franchise Guide (CCH) ¶ 13,450 (D. Colo. 2005) (upholding requirement that franchisee execute franchisor 9s then-current form of franchise agreement as a condition to franchisee 9s exercise of option to renew initial term of franchise agreement). 31 16 C.F.R. § 436.5(q)(3). 32 Statement of Basis and Purpose at 15467, 15496. 33 NASAA FDD Guidelines, Section VII. 19 citations to state relationship laws 3 which had been a staple of UFOCs since that language was inserted in the sample answers to the 1993 UFOC Guidelines (but not required under the Guidelines themselves). 10. Item 19 (§ 436.5(s)) 3 Financial Performance Representations Mandatory language . The FTC has specified in Section 436.5(s) certain language that must appear in Item 19. These include: First , a mandatory statement explaining that the FTC Rule allows a franchisor to provide a financial performance representation. Second , if a franchisor does not make a financial performance representation, there is a mandatory paragraph to add to explain that fact. Third , if a franchisor makes a financial performance representation, it must make a required statement regarding the availability of written substantiation for the financial performance representation, such as the following: 34 We will make available to you, upon reasonable request, written substantiation for the financial performance representation in this Item 19. Fourth , if a franchisor makes a financial performance representation, it must also include a cclear and conspicuous d statement that a new franchisee 9s results may differ from those stated in the financial performance representation, such as the following: A new franchisee 9s individual financial results may differ from the results stated in the financial performance representation provided in this It

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