Exemptions Can Work For You

September 2008 Franchising World

By Susan Grueneberg

As the franchising industry recovers from the impact of adjusting to the new Federal Trade Commission’s Franchise Rule disclosure format, a topic that looms increasingly large on the horizon is the increase in the sheer number of franchise systems. States that regulate franchising are experiencing record increases in the number of new filings. And franchisors are waiting longer than ever for registrations to be effective.

How do exemptions help? Exemptions can allow a franchisor to avoid registration requirements in states, and in some cases, disclosure obligations. They free up state resources for oversight of new franchises and systems that may present a greater risk to prospective franchisees. But anyone who has taken the time to look into exemptions may easily be dissuaded by the patchwork quilt of different exemptions that exist federally and from state to state. Even the same type of exemption can have different conditions, depending on whether the franchise will be operated in California or Kalamazoo. Yet, the benefits can be worth exploring in many instances. Offered here is an analysis of the types of franchises and transactions that are more likely to qualify for exemption and the pitfalls to avoid in trying to take advantage of them.

Mature Franchise Systems
Franchisors with a significant net worth and with substantial experience can often qualify for a “blue chip” franchisor exemption. The net-worth requirement can vary from $5,000,000 to $20,000,000 and can often be satisfied with a lesser net worth if a parent of the franchisor has the requisite net worth. The experience component is usually met if the franchisor has been operating the business for five years or has at least 25 franchisees who have been operating for at least five years. Often this exemption must be claimed by a notice filing with the state and the payment of a filing fee.

The FTC, however, did not choose to provide for this type of exemption under its franchise rule. As a result, the franchisor will still have to comply with disclosure requirements to prospective franchisees unless another federal exemption applies. Many state exemptions retain a disclosure component as well. The ability to avoid the delays of the registration process still makes this an attractive option.

On the surface, it would seem that this path would be a desirable one for those companies that qualify. Yet, there are still dangers to claiming any exemption. The burden will be on the franchisor to prove that the exemption applies. A slight misstep such as a typographical error in a required notice filing can throw the exemption into doubt. Similarly, a transaction or corporate restructuring can unexpectedly and negatively affect the net worth of a company, resulting in disqualification and the need to register before continuing with franchise-sales activity.

Exploring New Markets
Another time to pause and reflect on exemptions is when a franchisor is poised to enter a new geographic area or market or when a franchisor is developing an extension of a core offering. Even if the franchise system is too small to qualify for the mature franchisor exemption, another exemption may be available in that market. Perhaps the franchisor is only willing to enter the market with the assistance of an experienced, successful franchisee or developer. The qualifications that make that franchisee attractive to the franchisor may also be those most likely to trigger exemption coverage. The state may exempt high-net worth and experienced franchisees. Or it may determine that existing franchisees of the franchisor do not need the same protections. Franchisees who are former employees of the franchisor itself may also be exempt.

Similarly, federal law provides for exemption from disclosure for franchisees who or transactions that meet certain conditions such as a high-initial-investment threshold. In some cases, state law will also provide exemption from both registration and disclosure.

Once again, however, it is essential to review every detail of the exemption being claimed and the policy the government agency has in enforcing it. For example, an exemption that applies if the franchise is substantially similar to a franchise already owned by the franchisee could be interpreted in several ways. It could apply to the offer and sale of a restaurant franchise to a franchisee who already owns one that operates under a different brand in the same market segment. At least one state, however, has interpreted this condition to mean that the franchisee must already have a franchise agreement in the same system as the one that is being acquired.

Conversion Franchises
Existing businesses operated by single owners may present a strategic opportunity for some franchise systems. There may be no national brand that unifies businesses in an industry. The advantages of converting these single operations into a system can provide opportunities to both the franchisor and the business owners who are joining the franchise system. The business owner anticipates a stronger name that will bring more customers and the possibility of operational innovation that can be accomplished in a larger setting. The franchisor gains franchisees who already know how to operate the business and do not need the level of assistance that an inexperienced franchisee may require.

This scenario can allow for exemption-based franchising if the franchisor limits prospective franchisees to those who have operated the business for some period of time, typically two years, and if a franchisor limits its activities to states like California that provide for an exemption for experienced franchisees.

Again, qualifying for the substance of the exemption may not be enough. If there is a requirement that a notice is filed to claim the exemption, and that is not done, the exemption may be lost.

Checklist of Triggers
What are the telltale characteristics of a franchisee or a franchise transaction that should trigger consideration of exemption availability? Following is a checklist of common factors:

• The prospective franchisee is a former executive or owner of the franchisor.
• Initial investment for the franchised business is more than $1 million.
• The franchisor only plans to grant one franchise in the state or territory.
• The prospective franchisee already operates franchises in the same system.
• The prospective franchisee or his owners have a high-net worth or income.
• The franchisee already operates a similar business and is adding a product or line of business.
• The franchisee is an airport concessionaire or convention-center operator, a national retail chain or other powerful, sophisticated company.

These are just some examples. The caveat is that not all of these scenarios will qualify for exemptions in all cases. If all else fails, and no exemption is available, franchisors should also consider checking on the possibility of approaching the state involved to see if the regulators will grant a discretionary exemption.

The urgency of having a more uniform playing field has not been lost on franchise regulators. With the advent of new exemptions available on a federal basis, franchise registration states are considering addressing the increase in franchise applications with more exemptions of systems that do not require the same level of scrutiny. While completely uniform exemptions are not yet a reality and may never be one, rational allocation of resources is still a goal that merits continued effort.

Susan Grueneberg is a partner with the law firm Dreier Stein Kahan Browne Woods George LLP in Santa Monica, Calif. and can be reached at sgrueneberg@dreierstein.com.