How Many FDDs Do I Need? New Rules on Disclosing Multi-Unit Franchising Arrangements
On September 16, 2014, the North American Securities Administrators Association (“NASAA”) adopted the Multi-Unit Commentary (the “Commentary”) that provides guidance on how multi-unit franchise arrangements are to be disclosed in Franchise Disclosure Documents (“FDDs”). Multi-unit franchise arrangements are known by a myriad of names—including area development, subfranchising, and area representation—but the new guidance is crystal clear: if you are a franchisor with multi-unit franchise arrangements, you will have additional work to do in your next franchise renewal cycle, and may actually have to create multiple versions of your FDD and filings in the registration states.
The typical franchise relationship is between a franchisor and a franchisee, where the franchisor grants one franchise to a single franchisee. The Commentary discusses the disclosure requirements for three types of “multi-unit” franchising arrangements: “area development arrangements,” “subfranchise arrangements,” and “area representation arrangements.” NASAA adopted the Commentary to clarify uncertainties regarding disclosure requirements in multi-unit franchising.
Existing franchisors with fiscal years ending on December 31, 2014 must comply with the new Commentary with their next franchise renewal. For new franchisors, the Commentary will not be effective until mid-March 2015, but franchisors should expect state regulators to rely on the Commentary immediately as they review new filings.
Types of Multi-Unit Franchising Arrangements
The Commentary sets forth different disclosure requirements depending on the multi-unit franchising arrangement used (irrespective of the terminology used), each of which are summarized below:
- Area Development: In an area development arrangement, the “area developer” is granted, for consideration paid to the franchisor, the right to open and operate more than one unit franchise, generally within a specific geographic territory, but not the right to grant unit franchises to third parties. Most area development arrangements involve an area development agreement granting this right and specifying the number of units to be developed pursuant to a development schedule, with a separate unit franchise agreement for each unit opened. Some franchise systems refer to area developers as area franchisees or regional developers.
- Subfranchise: In a subfranchise arrangement, the “subfranchisor” is granted, for consideration paid to the franchisor, the right to further grant unit franchises to third parties, generally within a specific geographic territory. Most subfranchise arrangements involve a master franchise agreement (between the franchisor and subfranchisor, which may be referred to as a master franchisee) and unit franchise agreements between the subfranchisor and each unit franchisee (which may be referred to as subfranchisees). Typically, the subfranchisor provides certain services—including pre-opening and training services—to the unit franchisees in lieu of the franchisor, in exchange for part of the fees payable by the unit franchisees under the franchise agreements.
- Area Representation: In an area representative arrangement, the “area representative” is granted, for consideration paid to the franchisor, the right to solicit or recruit third parties to enter into unit franchise agreements with the franchisor, and/or to provide certain services to third parties entering into unit franchise agreements with the franchisor. Unlike the subfranchise model, the area representative is not a party to the unit franchise agreements, but the area representative typically receives a part of the fees payable by the unit franchisees under the franchise agreements.
While Franchisors are not required to use those terms in their legal documents, state regulators may be able to more quickly review FDDs with those terms. Further, some state laws define the above relationships differently than the Commentary, in which case the state law governs. Summarized below are the disclosure obligations under the Commentary for the above multi-unit franchise arrangements:
An area developer is essentially a unit franchisee, but with the right to develop more than one unit franchise within a specific area. Therefore, the relationship with an area developer is very similar to that with a unit franchisee. The Commentary confirms that a franchisor may offer area development franchises in the same FDD as it offers unit franchises.
However, the Commentary clarifies certain disclosures required in the FDD for area developers. For example, depending on the set up, Item 1 of the FDD must disclose which form of franchise agreement the area developer will sign for units developed in subsequent years. Items 11 and 12 of the FDD must disclose, if applicable, that the franchisor will determine or approve the location of future units to be opened by the area developer and any territories for those units (if the specific locations are not already set forth in the area development agreement), and that its then-current standards for sites and territories will apply. Any cross-default provision in the area development agreement or in the unit franchise agreement (which provides that any termination of the area development agreement could also result in termination of that area developer’s unit franchise agreement(s), or vice versa) must be disclosed in Item 17 of the FDD. And the Commentary clarifies some confusion as to Item 20 disclosures—i.e., if and when units opened by area developers may be included in the Item 20 charts.
The rights and obligations of subfranchisors differ significantly from those of a unit franchisee. For instance, the fee structure is completely different, the territories for a subfranchisor are larger, and supplier relationships may differ. Because many of the disclosures in an offering of a subfranchise are different from an offering of a unit franchise, the franchisor must offer and sell subfranchise rights using an FDD separate from the one used in the offer and sale of unit franchises. This means that the franchisor must obtain two separate franchise registrations—one for its unit franchise offering and one for its subfranchise offering.
A subfranchisor must prepare its own FDD and register in many states before offering and selling franchises in those states. The registration requirements for a subfranchisor are similar to that of a franchisor. A subfranchisor must usually file an FDD meeting the registration requirements of the state(s) in which it has the right to sell franchises, ancillary filing materials required by the state, audited financials of the subfranchisor and franchisor, and auditor’s consents as to both sets of financial statements.
Likewise, a subfranchisor must amend its FDD if material changes occur at the franchisor level. Both FDDs will require some cross-disclosures. For instance, Item 1 of the FDD offering unit franchises must disclose that the franchisor offers subfranchises as a separate line of business from the offer of unit franchises. Items 3 and 4 of the subfranchisor’s FDD must disclose litigation information and bankruptcy information, respectively, of both the franchisor and subfranchisor. Item 20 of the subfranchisor’s FDD requires outlet information for the whole system. And the franchisor’s audited financial statements must be included in the subfranchisor’s FDD. Thus, it is imperative that the subfranchisor work closely with the franchisor in the preparation of the subfranchisor’s FDD (including each renewal and amendment). Further, to the extent possible a subfranchisor should align its fiscal year end with the franchisor’s so that the parties renew their offerings at approximately the same time. This should allow the subfranchisor to obtain needed information from the franchisor (and vice versa) in an efficient manner, and alleviates the need for the subfranchisor to amend when the franchisor renews at another time. The Commentary clarifies that a subfranchisor’s obligation to renew its franchise offering is tied to its fiscal year end, not the franchisor’s fiscal year end.
Many franchisors currently offer and sell unit and area representative franchises through the same FDD. However, the Commentary requires that a franchisor offering area representative franchises must do so from an FDD separate from the one it is using to offer unit franchises, as the two offerings are materially different. Although several sections of the FDDs (such as Items 1-4, 13, 14, and 21) will be nearly identical for both offerings, there are significant differences (including, contracts, costs and fees, supplier relationships, and services and obligations) in the information to be disclosed in almost all of the other Items.
Franchisors that offer multi-unit franchises must comply with the Commentary in their next renewal. This will require information gathering that should begin soon for those with a calendar year end. For franchisors that offer subfranchise or area representative arrangements, they should be aware that they must separate their subfranchise and area representation arrangements from their offerings of unit franchises, if they don’t already. This may significantly increase the burden and filing fees for franchisors and their subfranchisors and area representatives, but as the Commentary notes, separate FDDs will alleviate confusion between the different offerings for state regulators and subfranchisors, area representatives, and unit franchisees.
For our franchise clients that offer multi-unit franchises, we will be sending specific information on updating their FDD(s) about 90 days in advance of their next renewal. If you are a franchisor that offers multi-unit franchises and do not work with us, you should contact your attorney regarding the Commentary.
Note: Chuck Modell was a member of the NASAA task force that worked on the Commentary. Chuck also authored NASAA Adopts Multi-Unit Commentary, published in The Franchise Lawyer, Fall 2014, regarding the new disclosure rules for multi-unit franchising.