Franchising World, April 2007

Despite the Amended Rule, foreign franchise systems still will need to consult with U.S. franchise counsel about the laws which may be applicable to the transactions they are contemplating.

By Carl E. Zwisler

According to a report on international franchising sponsored by the IFA Educational Foundation, featured in the August 2006 issue of Franchising World, more than one half of the U.S. based franchise companies responding to a recent survey said that they were seeking franchises in other countries.  Eighty percent of those respondents said they were planning to franchise internationally during the next three years (2007-2009). 

During the 2006 International Franchise Expo, the program noted that 90 exhibitors were seeking foreign franchise partners.  These franchise companies and hundreds of franchise systems from other countries are likely to be big beneficiaries of the Amended Federal Trade Commission Franchising Rule, referred herein as the Amended Rule, which franchise firms may follow as of July 1, 2007 and which they must follow as of July 1, 2008.

U.S. franchise systems are applauding the Federal Trade Commission’s decision not to apply the Amended Rule to foreign franchises.  Under the Amended Rule, if a franchise is granted for a location outside the United States, even if prospective franchisees live in the United States, no FTC disclosures are required.  Although the FTC Rule’s application to foreign franchise sales has been in doubt for years, especially since a 1999 decision of the Eleventh U.S. Circuit Court of Appeals in Nieman v. Dryclean USA Franchise Co. Inc., which held that the FTC had no authority to regulate franchise sales in other countries, the FTC itself had previously confirmed that it agreed with that conclusion.

Unfortunately for U.S. franchise companies, the Amended Rule does not preempt states from regulating franchise sales made by their resident franchise companies to prospective franchisees in other countries.  Thus, U.S. franchise firms still must evaluate whether franchise and business opportunity sales laws in their states require registration and disclosure to prospective foreign franchisees, regardless of the foreign location franchise exclusion from the Amended Rule.  Of 15 states with franchise registration or disclosure laws, only the Virginia franchise law does not require disclosures to be made to its citizens if they buy a franchise for a foreign location. 

Franchise laws in California, Hawaii, Indiana, Maryland, Michigan and Wisconsin do not apply to sales of franchises for foreign locations, unless a prospective franchisee for the franchise is domiciled in the states.  In Minnesota and Rhode Island, an international sale by a resident franchise company will not be subject to the state’s disclosure requirements if the prospective franchisee is not present in the state before a franchise agreement is signed.  In the other registration states, the act of “offering” a franchise for sale, or of “accepting” an offer in the state appears to be all that is required to impose disclosure obligations.

U.S. franchise firms planning to rely upon the foreign franchise location exclusion also will need to determine whether business opportunity laws in their states or in states where their prospective franchisees reside will require disclosure for foreign franchise locations not covered by the Amended Rule.

The greatest growth in franchising over the past decade has been outside the United States.  After examining the 2006 Asia-Pacific Franchise Guide and reviewing national franchise association Web sites, it is obvious that franchising is increasing in popularity throughout the world.  Despite their ever-increasing number, it is surprising that very few foreign franchise systems have extended their franchising programs to the United States.

One of the major reasons foreign franchise companies have avoided the U.S. market has been the substantial cost of testing the market imposed by the FTC Rule.  To place these costs in perspective, the FTC Rule has required foreign franchises to invest an amount which equals the cost of an expensive engagement right to have the privilege of a “blind date” with an American prospective franchisee.  The Amended Rule will substantially reduce those costs. 

Advantages of the Amended Rule for foreign franchises include: 
•   Elimination of the “first personal meeting” disclosure requirement,
•   Elimination of a duty to provide a completed copy of a franchise agreement to a prospective franchisee five business days before it may be executed,
•   Exemptions from any form of compliance for transactions involving franchisees making large investments, franchises granted to experienced high-net worth companies, and franchises granted to managers and owners of franchisors,
•   Relaxation of the obligation for all disclosure documents to include financial statements of franchisors which are prepared according to U.S. accounting standards, and
•   The ability to make disclosure electronically, e.g. via e-mail or Internet download. 

While these same changes also apply to U.S. based franchise systems, their impact will disproportionately benefit foreign franchise companies.

First Personal Meeting Disclosure Requirement Is Revoked
Under the current rule, franchise companies must deliver disclosure documents to a prospective franchisee at the “first personal meeting.”  Under the Amended Rule, disclosures must be provided at least 14 calendar days before a prospective franchisee pays any money to the franchise system or its affiliate in connection with a franchise acquisition, or at least 14 calendar days before any agreement relating to the franchise purchase is signed.

The current rule restricts franchise firms from participating in trade shows in the United States or from talking seriously with prospective franchise partners, unless they have first compiled a disclosure document (Uniform Franchise Offering Circular), prepared three years of compliant-audited financial statements and delivered them to prospective franchise partners no later than at their first in-person meeting to discuss a possible franchise relationship.  UFOCs also must include copies of standard franchise agreements franchisees are expected to sign.  Given the typical legal, accounting and market research cost of preparing these documents, many foreign franchise systems have understandably deferred considering franchising in the United States and expanded into other markets with lower market research costs.  The Amended Rule allows companies evaluating franchising in the United States to delay preparing UFOCs and franchise agreements until they have found a serious candidate.

The 14-day disclosure standard may also reduce a franchise system’s costs of complying with disclosure requirements.  One of the most challenging disclosure requirements for a foreign company is the need to estimate the start-up expenses a new franchisee will incur in the United States.  A company with no U.S. operational experience usually only can meet this requirement through expensive market research.  Under the Amended Rule, a franchise company and a prospective franchisee can first determine whether they will expand through unit franchising, area development franchising or master franchising, and then they can agree upon any modifications to the franchise system’s prototype business they want to make in the United States before the franchise company must place the information in a disclosure document.  If the prospective franchisee and the franchise company work together on market studies using the prospective franchisee’s knowledge of his market, the cost of the market research may be less, and the estimates may be much more accurate.

Electronic Disclosure Is Approved
The Amended Rule specifically permits the use of electronic means, such as e-mail, Web site downloads, compact discs or other electronic methods to deliver disclosure documents.  No longer will franchise systems need to bear the expense of copying thick documents and the expense of international courier services. 

Amended Franchise Rule Exemptions
Three new exemptions to the rule may enable many foreign-based franchise companies to avoid the franchise disclosure process altogether.  The Amended Rule exempts franchise offers made to “sophisticated investors,” companies that have been in business for at least five years and have a net worth of at least $5 million.  Only one member of an investor group needs to meet the requirement for the exemption to be applicable.  Thus, franchises may be granted to companies with established regional or national businesses without the need for a disclosure document, audited financial statements or other documents usually required by the Amended Rule.

Also exempt are franchises requiring investments exceeding $1 million, excluding the cost of investments in unimproved land and any financing provided by the franchise organization.  In calculating the investment, franchise companies may include the expenses and fees associated with establishing franchised outlets under multi-unit franchise agreements, such as area development agreements and master franchise agreements.  Multi-unit franchising programs are the norm in international franchising and are therefore likely to satisfy the $1 million investment threshold in many retail and hospitality franchise offerings.  Prospective franchisees who agree to convert existing business operations to a franchise also may include the value of their business assets in the calculation of the amount they are investing in a franchise.

Finally, franchises sold to officers, owners or managers of a franchise system which have been employed by the franchise company for at least two years before purchasing the franchise will be exempt.  This will allow a joint venture formed to enter the U.S. market to be sold as a franchise if one of the franchise company’s management staff owns a 50 percent interest in the venture without the need for FTC disclosures.  An entity “which is at least 50 percent owned by a person who, within 60 days of the purchase of the franchise, has been, for at least two years, an officer, director, general partner, individual with management responsibility for the offer and sale of the franchise system’s franchises or the administrator of the franchised network” qualifies for the disclosure exemption.  The same exemption applies to a person who has owned at least a 25 percent interest in the franchise system for a two-year period, ending no later than 60 days before the franchise sale.  Thus, if a member of a franchise firm’s management or ownership team could acquire a 50 percent “ownership interest” in a U.S. franchisee, and operate it as a prototype unit in the United States, the exemption would be available.  The Amended Rule does not prohibit the other owners from having voting control over the franchisee entity, nor from investing a majority of the capital need to acquire the franchise and launch the franchised business.

Financial Audit Requirement Changes
A major expense for some foreign franchise companies is the FTC’s audit requirement.  Under the current rule, disclosure documents must include the franchise system’s audited financial statements, and audits must be performed in accordance with U.S. Generally Accepted Auditing Standards.  The Amended Rule relaxes this requirement somewhat, and allows foreign companies to use statements prepared under their country’s Generally Accepted Accounting Principles, so long as the statements also satisfy criteria published by the U.S. Securities and Exchange Commission for the use of foreign financial statements in U.S. securities offerings.  Whether franchise companies can find accounting firms willing and able to modify existing statements to meet the SEC criteria in a cost-effective way is an open question.

Foreign franchise companies will need to carefully consider how they structure the entity that will offer franchises in the United States.  The audited financial statements of a franchise firm’s parent company must be included in the disclosure document if the parent company commits to perform the franchise system’s post-sale obligations to franchisees, or if the parent guarantees obligations of the franchise firm subsidiary.  In the past, some franchise companies have set up new companies to grant franchises in the United States to minimize tax liability, exposure to claims from U.S. franchisees or audit costs.  Under the Amended Rule, establishing a new entity to be the franchise firm for the United States could result in the parent company having to provide its financial statements, unless it clearly arranges for the franchise company entity to perform services for U.S. franchisees.  Parent company guarantees are sometimes required by state franchise examiners as a condition of registering franchise company subsidiaries, and are required by the Amended Rule if the franchise system does not have its own audited financial statements and relies upon its parent’s audited consolidated statements.

Negotiating Franchise Terms Is Easier
Under the current rule, a prospective franchisee must have a completed copy of the franchise agreement and all agreements related to the franchise purchase in its hands for five business days before he can sign them.  Although domestic unit franchise agreements often are not negotiated, international franchises usually are negotiated, especially if they are multi-unit agreements.  If a negotiation of terms of the standard agreement benefits the franchise system under the current rule, the five business day waiting requirement is renewed.  Executives who often travel far to close deals and who are accustomed to negotiating changes in deal terms up to the time an agreement is signed have found the old process to be thoroughly frustrating. Under the Amended Rule, unless a franchise company unilaterally changes the form of agreement which is included with the disclosure document, and requests the prospective franchisee to sign that changed version, the parties do not need to wait to sign the agreement after negotiations are concluded.

State Regulations Remain in Place
The Amended Rule applies to all franchises offered for locations in the United States and its territories.  However, franchise sales laws in 15 states also regulate offers and sales of franchises by their residents to their residents, and sometimes to non-residents if franchised locations will be established in those states.  Under the Amended Rule, the states may impose higher standards of disclosure than the Amended FTC Rule prescribes.  At a minimum, 14 of these states require that franchise systems either “register” their franchises under their laws or submit applications for exemptions from the laws, even if the franchise companies qualify for exemptions under the Amended Rule.  Additionally, franchise firms lacking a U.S. trademark registration also may be required to comply with filing and disclosure requirements of “Business Opportunity Sales Laws,” which exist in 26 states.  Compliance with “Biz Opp” laws usually involves filing a brief disclosure statement (which is much less detailed than a UFOC) and the payment of a filing fee, which rarely exceeds $100.  The FTC Rule is the only law which specifically regulates the sale of franchises in 18 states, plus Washington, D.C. and Puerto Rico.  Thus, despite the Amended Rule, foreign franchise systems still will need to consult with U.S. franchise counsel about the laws which may be applicable to the transactions they are contemplating.

The FTC is to be commended for the changes it has made.  Franchise companies will continue to hope that state regulators will rely upon the record and analysis compiled by the FTC over the past dozen years and follow the FTC’s lead in facilitating the introduction of new franchise concepts into their states’ economies, and the growth of international franchise networks by their resident franchisors.

Carl E. Zwisler is a franchise lawyer in the Washington, D.C. office of Haynes and Boone, LLP.  He can be reached at carl.zwisler@haynesboone.com.