Federal franchise law imposes many requirements on franchisors that are intended to protect prospective franchisees from fraud and deception in connection with the offer and sale of franchises. Once the prospective franchisee buys a franchise, however, almost all federal protections disappear. Federal franchise law does not regulate the substantive terms of a franchise relationship. It’s primarily a disclosure law and only requires franchisors to disclose certain material information to prospective franchisees. The theory underlying this approach to regulation is that informed investors can adequately determine for themselves whether a specific franchise offer is the real deal or a real dud or something in between.
At the federal level, the primary source of franchise law is the Federal Trade Commission’s Franchise Rule, a comprehensive regulation originally adopted in 1978 and last significantly changed in 2007.
The Franchise Rule governs franchises by imposing pre-sale disclosure requirements and prohibitions on franchisors. The disclosure requirements are detailed in the specific rules for the contents of the franchise disclosure document (FDD), which a franchisor must furnish to a prospective franchisee within a specified time period and in a specified manner. The prohibitions include things like:
- making claims that contradict the information required to be disclosed in the FDD;
- making misrepresentations about who purchased or operated the franchise or who can make an independent and reliable report about the franchise or the experiences of any current or former franchisees; and
- providing earnings claims that lack a reasonable basis and written substantiation.
The Franchise Rule also provides for exemptions from these requirements and prohibitions based on, for example, the size of the franchisee’s initial investment or whether the franchisee is a well-established entity with a minimum net worth.
Importantly, the Franchise Rule does not regulate the post-sale franchise relationship. Issues such as covenants not to compete, encroachment of franchisee territories and the franchisor acting without “good cause” are simply not regulated at the federal level. To be sure, the Franchise Rule requires certain pre-sale disclosures that bear on the franchise relationship, but it is really not intended to address any issues that arise after a franchise is sold. Certain state franchise laws partly fill this gap but they only help if you live in or operate your franchise in the state imposing the law. Even then, the degree of help varies. Minnesota, for example, places limits on the franchisor’s termination rights and imposes a “good cause” requirement on a franchisor’s failure to renew a franchise. On the other hand, the California Franchise Relations Act covers a range of post-sale issue, including terminations (only for “good cause”), survivors’ rights, renewal (180 days’ notice), the content and delivery of termination and renewal notices, franchisor offers to repurchase inventory upon termination or failure to renew, arbitration and venue of disputes.
In addition, the Franchise Rule does not impose any broad anti-fraud requirements. Under Federal securities laws, section 10b-5 provides a general anti-fraud remedy under certain circumstances for any material misstatements or omissions in connection with the purchase or sale of a security. There is no similar provision in the Franchise Rule, although under Section 5 of the Federal Trade Commission Act, which prohibits “unfair or deceptive acts or practices in or affecting commerce,” franchisors may have additional obligations to provide material information to prospective franchisees outside of the pre-sale disclosure requirements. Nevertheless, the specific disclosure requirements of the Franchise Rule only pertain to the 23 items or categories of information prescribed by the FDD. In other words, if certain information is not plainly spelled out in the 23 items, it falls outside of the scope of the Franchise Rule and its omission may not be noncompliant – even if that information might have been very significant to a prospective franchisee.
Moreover, there is no “private right of action” under the FTC Act or the Franchise Rule. That’s a lawyer’s way of saying that a franchisee cannot sue a franchisor for any claims involving federal franchise disclosure law violations or fraud. Some states step into the breach with “Little FTC” Acts that prohibit unfair or deceptive acts or practices and often provide for a private right of action. Again, state laws generally only help if you reside in or operate your franchise in the state. Of course, a franchisee who thinks he was hoodwinked can always sue based on his franchise agreement but must do so under state law and, generally, must limit the claims to what’s in the franchise agreement and not what’s included in or omitted from the FDD. A notable exception is a claim that the prospective franchisee was fraudulently induced into signing the franchise agreement.
Finally, the FTC does not review FDDs. Some of the 14 “registration states” review and comment on the FDD, but if you’re living or operating in one of the other 36 states and your franchisor does not operate in a registration state, chances are that no regulator ever took a peek at your FDD. That means that your FDD might have been pieced together without the rigor and diligence that the prospect of a regulator’s review might otherwise command.
All of these limitations can be overcome or at least mitigated if you take some essential steps: prepare and conduct a comprehensive due diligence investigation, including franchisee validation and Internet searches on the franchise and its principals; carefully read both the FDD and the franchise agreement; hire a certified public accountant to review the financial disclosures; and, most importantly, engage a qualified franchise attorney.
Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.
This article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own franchise attorney concerning your own situation and any specific legal questions you may have.