The Anatomy of an Effective Franchise Sales Compliance Program

An effective franchise sales compliance program enables the franchise organization to operate free from the impending threat of litigation or other disruptions that can result from a failure to properly manage the sales process.

By Richard Morey, CFE and Ann Hurwitz, CFE

In our previous article, “The Case for Legal Compliance: Fran-Guard Update,” Franchising World (March 2016), examining the value of franchise sales compliance, we made the business case for a robust franchise sales compliance program. Compliance with the franchise sales laws requires clear and complete pre-sale disclosure of the franchise opportunity, which allows franchise companies to manage expectations and select franchisees that are a good fit for the franchise system. When franchisees’ talents and aptitude are aligned with the attributes of the franchise system and franchisees enter the system with realistic expectations, the result is happier, more successful franchisees and a stronger franchise system.

In this article we explore the elements of an effective franchise sales compliance program:

Designate an independent, authoritative compliance officer

The franchise compliance officer is responsible for guiding the franchise organization on matters of compliance. For larger franchise companies, the compliance officer might be an in-house lawyer or paralegal, whose primary focus includes compliance. In smaller franchise companies, the compliance officer might have a number of different roles within the company. Any compliance officer should ideally have the following characteristics:

Access to outside counsel. A compliance officer should have a good understanding of the franchise sales laws, but need not know all the nuances of those laws. However, he should have access to outside counsel who does. To maximize efficiencies, the compliance officer should be the only person in the company who contacts outside counsel on day-to-day compliance issues.
The right approach to risk analysis. A compliance officer who consistently says “no” often will become marginalized. Worse yet, the development team might avoid the compliance officer altogether. A good compliance officer will work with the development team to achieve development goals while minimizing risk and ensuring compliance with the disclosure laws.
Support of senior management. Even with a solution-oriented approach, sometimes the right answer is to abandon the franchise sale in view of the risk. That is when the compliance officer most needs management support. If the leadership team consistently overrules the compliance officer, the organization will soon understand that sales always trump compliance, rendering the compliance program meaningless.

Ensure that there is a clear understanding of the franchise sales laws

For a compliance program to be effective, the franchise company’s personnel should have a basic understanding of the franchise sales laws. Clearly, the level of understanding that an organization’s compliance officer must have will differ from that of the development team or the operations team. But within the context of an employee’s position, the rules should be understood.

Most franchise professionals understand that federal law requires delivery of a franchise disclosure document to prospective franchisees a certain period of time before any binding agreements are signed or any money is paid. Experienced franchise personnel also know that the disclosure document must be registered in certain states before offering or selling franchises in those states, and that both federal and state laws regulate the types of financial performance information that can be disclosed. But the nuances of compliance are not always clear.

There are a number of programs, including those offered at the IFA Annual Convention and IFA Legal Symposium that can help educate franchise professionals about franchise sales compliance. At those programs, company personnel also can interact with representatives of other franchise companies to share best practices for compliance. Franchisors who fail to comply with the franchise laws reflect poorly on other franchisors and on the franchise model generally. Helping other franchisors to comply with the franchise laws is in everyone’s best interests.

Implement sales procedures that promote compliance

Understanding the franchise laws is only one step. Franchisors must develop procedures that promote compliance with those laws. Most large franchise companies have procedures covering when and how to update the disclosure document; assigning responsibility for ensuring that state registrations are maintained; determining which state law(s) apply to a transaction; governing delivery of the disclosure document and confirming that the required waiting periods have passed; and ensuring that all franchise agreements have been properly signed. These procedures should be evaluated periodically for efficiency and effectiveness.

In smaller franchise companies, franchise sales compliance procedures may be less well developed. Some organizations may handle compliance on an ad-hoc basis, especially if they are only granting a few franchises each year. But standard checklists and processes are important to be sure that no compliance issues fall through the cracks. Franchisors that only grant a few franchises each year cannot afford to have one of them result in a lawsuit because of a compliance violation.

Establish processes for early identification of potential violations

Procedures that promote compliance with the franchise sales laws are fundamental to an effective compliance program. Equally important are processes for identifying and reporting potential violations. Situations outside the norm will inevitably arise. Potential violations should be identified and addressed as early as possible to minimize legal and business risks.

Many franchise companies use a franchise sales compliance questionnaire to identify sales violations. This questionnaire asks each prospective franchisee a series of questions designed to identify possible infractions. Used prior to closing, this tool can help companies spot potential violations while there is still time to take corrective action.

Once a potential violation is identified, it must be communicated to the appropriate decision makers. Employees who report a potential violation should not be penalized. Senior management should make it clear that closing a “bad” sale is not in the organization’s long term best interests. There are often ways to close a franchise sale legally and on time even if an aspect of the sale falls outside the standard norms. But opportunities to correct a problem before closing are missed if employees are not encouraged to identify possible violations and communicate them to the appropriate decision maker.

Design strategies for correcting violations

Ideally, a well-designed franchise sales compliance program will help identify and correct most potential violations before the sale is closed. However, some mistakes will inevitably be missed. In those cases, it is important to address the situation as soon as possible after the sale has closed. The passage of time will only exacerbate the situation and limit the organization’s available options for corrective action.

Correcting franchise sales violations is not simple, nor is it inexpensive. Deciding how to deal with the violation often requires senior management and the organization’s professional advisors to assess the magnitude of the violation, its potential impact, and the available options for correcting the violation. It is by far preferable to deal with a violation proactively, when there is time to develop a strategy to minimize the organizational risk. Latent violations that are exposed unexpectedly are infinitely worse. That type of situation often occurs at a critical juncture, such as during the diligence process associated with a strategic transaction, when the franchisor is introducing a new program, or when the franchisor attempts to enforce its franchise agreement.

The goal of an effective franchise sales compliance program is to enable the franchise organization to operate free from the impending threat of litigation or other disruptions that can result from a failure to properly manage the sales process.

Richard Morey, CFE, is a partner at DLA Piper in its Chicago office. Ann Hurwitz, CFE, is a partner of Baker & McKenzie in its Dallas office. Find them at fransocial.franchise.org