Before You Start Selling Franchises -- A Legal Checklist for New Franchisors

When a lawyer completes an offering circular for a new client, he should provide the client with a summary of the laws that regulate the sale of a franchise.  The letter would not be a comprehensive statement of the law, but a reference tool the franchisor can retain and distribute to those involved in the sales process.  Let’s explore the contents of that letter and see how they can be guides to new franchisors as well as their attorneys.

 

 Contents of the Compliance Letter

 

The Registration and Disclosure Laws

 

The letter should list all of the franchise registration states, and those in which the franchisor is registered.  It should also remind the franchisor that various state business opportunity laws (and in Nebraska, the Seller Assisted Marketing Plan Law) can also apply to the sale of the franchise.  The letter should list the states having these laws, and those in which the franchisor can sell franchises.  However, the decision that the franchisor can sell franchises in a business opportunity state frequently depends upon certain assumptions, such as the franchisor not offering to refund money to unhappy franchisees. 

 

These assumptions should be included in the letter so that the franchisor does not unwittingly run afoul of these laws.

 

The letter should remind the franchisor of the federal rule requiring a copy of the offering circular be given to a prospective franchisee at the first face-to-face meeting at which the sale of the franchise is discussed, and at least 10 business days before any money is paid by the franchisee, or the franchisee signs any contract.  The letter should explain what type of meetings count as a first meeting (probably not a trade show encounter, but likely a one-on-one follow-up meeting), how to count business days (Saturdays, Sundays and federal holidays are excluded even if the franchisor works on those days), and any state law nuances (such as the current Illinois law, which requires the document be held for 14 calendar days before signing).  The franchisor should be reminded to obtain signed and dated acknowledgments from prospective franchisees, confirming receipt of the offering circular.  Further, if there are any changes to the agreements, or if material blank spaces appear in the agreements, the prospective franchisee must have the final contract in his hands at least five business days before paying any money or signing any agreement.

 

Updating the Offering Circular

 

During the year, the franchisor will make changes in its system, and experience changes in its company.  The initial compliance letter should remind the franchisor about the state and federal requirements to update the offering circular as material changes occur.  The concept of materiality should be explained, since some of the laws require amendments when information changes that the franchisor itself may not consider material.  The letter should also contain a reminder of the requirements to annually update the document, including the federal requirements that mandate a new document within 90 days following the close of each fiscal year, and the state requirements that may be tied to the anniversary date of the initial registration.

 

Advertising

 

It is not unusual that after franchisors begin selling franchises, they develop brochures and advertisements they want to use in the sale of the franchise.  The compliance letter should remind the client that all these items are advertisements, and must be filed in a number of states before they are used.  There are also state pronouncements, some by statute and some by regulatory fiat, barring certain statements in advertising, like references to "success," or a "safe investment," and prohibiting "blind ads" and earnings claims.  New York and Minnesota also require additional information be included on the face of the advertising.

 

If you are a new franchisor and have not received a letter from your attorney summarizing the laws related to the sale of franchises, you should talk to your attorney about preparing one; many franchise attorneys do so as part of the work they do in initially preparing the UFOC, and readying their client to sell franchises.

 

Earnings Claims

As the franchisor begins making sales, questions will inevitably surface about earnings potential for the franchise.  Franchisors should be provided a summary of the rules related to earnings claims, beginning with the fact that a "claim" includes not only a statement of projected earnings, but also a statement of the actual results of particular units, and system averages.  The compliance letter should explain the difference between "puffing" and "earnings claims," as described in the commentary to the FTC Franchise Rule.

 

If no earnings claim has been included in the offering circular, the letter should explain the strict prohibitions against any type of response to an inquiry regarding income possibilities, and the exception for the sale of an existing unit.  However, even when the offering circular contains earnings claims, franchisors need to understand the limits on providing additional information.

 

Other Matters

 

The letter should also remind the franchisor of the difficulties it will encounter if it negotiates each franchise agreement.  Apart from operational challenges, there are laws prohibiting discrimination among franchisees, and the California law requiring franchisors to file notices of negotiated changes.  However, the Virginia law specifically mandating franchisee-initiated negotiations should also be disclosed.

 

The franchise registration and disclosure laws are not the only laws that govern a franchise relationship.  While it is not practical for one letter to describe every law that may apply to the sales process, franchisors do need to understand the laws concerning misrepresentation, fraud and breach of contract, in order to avoid unwittingly causing problems through innocuous statements, or mere "guesswork" on the part of a sales person.  Franchisors should also be advised of the many practices that the various state laws consider to be "unfair practices" in the sale of a franchise.

 

A good compliance letter should also discuss provisions of the agreement that were placed in the agreement to protect the franchisor, and the importance of following up on those provisions.  For example, a typical franchise agreement includes requirements that the franchisee obtain insurance naming the franchisor as an additional insured, and that the franchisee identify itself on the premises as an independent licensee.  These provisions can help the franchisor avoid incurring significant liability for the actions of franchisees, but unless the provisions are understood, they are not likely to be followed.  Similarly, information should be provided regarding trademark laws and antitrust principles that were addressed in preparing the franchise agreement.

 

The Bottom Line

 

A well-drafted compliance letter serves a number of purposes.  It protects the attorney against a franchisor who claims it was never told the various legal requirements that govern its conduct.  More importantly, it provides the franchisor a simple, but important reminder of actions that need to be taken to avoid significant liability.  It also gives the franchisor a mini-training program to give to its employees who may not have been involved in the preparation of the franchise agreement and may not understand the importance of information previously imparted to the franchisor. 

 

This article originally appeared in the May-June, 2002 issue of Franchising World Magazine, a publication of the International Franchise Association www.franchise.org.  It is reprinted here with permission of the publisher.