Parsing the laws that regulate franchising

Part 2 of a 3 part series concerning franchising and what in-house counsel need to know

This is the second article in a three-part series (Part 1) focusing on what every corporate counsel should know about franchising. Part 2 provides an overview of the various laws that apply to franchise relationships that are intentionally or unintentionally created.

In 1970, California passed the Franchise Investment Law, the first law to regulate the offer and sale of franchises. The California Franchise Investment Law was followed by the passage of franchise laws in several states and the promulgation by the Federal Trade Commission (FTC) of its Rule on Franchising in 1979. There is little uniformity in these laws, which means that a patchwork of laws may need to be evaluated in connection with one transaction.

The franchise laws fall within three categories: franchise disclosure laws, franchise registration laws and relationship laws. The franchise disclosure laws regulate the pre-sale process, which includes requiring franchisors to provide presale disclosure. The franchise registration laws specify that the franchisor must comply with certain state registration requirements prior to commencing sales activities in the state. The relationship laws regulate the ongoing relationship between the franchisor and franchisee after the parties have signed an agreement that grants the franchise rights.

The FTC Rule is a franchise disclosure law that only mandates presale disclosure in connection with the offer and sale of franchises in the United States and its territories. The presale disclosures are provided in a franchise disclosure document (FDD), which is similar to a securities prospectus. The FDD must be provided to the prospect at least 14 calendar days before the prospect signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale. There are 23 sections of disclosures in the FDD and each section is referred to as an “item.” Each item contains required disclosures specified in the FTC Rule. The FTC Rule requires all information in the FDD to be current as of the franchisor's current fiscal year and annual updates must be completed within 120 days of the end of each fiscal year. During the course of each fiscal year, the FTC Rule requires franchisors to make quarterly updates to the FDD if there are material changes.

The FTC only preempts state franchise laws that are less restrictive. Therefore, conservative franchisors comply with both federal and state franchise laws unless the state law is clearly less restrictive. There are 15 states that have franchise disclosure laws that, like the requirements under the FTC, require the franchisor to provide a disclosure document to the prospect at least 14 calendar days before the prospect signs a binding agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale. However, there are a few state franchise laws that require the franchisor to provide the prospect with the disclosure document at the earlier of the first personal meeting or 10 business days before the prospect signs a binding agreement or pays any consideration. The form of disclosure document required under the various state franchise disclosure laws is similar to or the same as the FDD.

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Some of the states with franchise disclosure laws also have franchise registration laws in addition to their franchise disclosure laws. These franchise registration laws require the franchisor to register annually with the applicable state agency prior to offering or selling franchises. The state agency will generally be the securities commissioner, the corporations commissioner or the attorney general. The registration with the applicable state agency can range from filing an annual notice with the agency to submitting to a full annual review of the application and FDD to ensure compliance with the state's franchise laws. Some of the franchise registration laws also include requirements to register sales people and/or advertising materials. The franchise registration laws include obligations for the franchisors to update their FDD and renew their registrations annually and promptly update their FDD and amend their registrations in the event of a material change related to the franchisor or franchise offering.

19 states have relationship laws. Issues such as the permissible grounds for termination, the notice and cure periods required for termination, the permissible grounds for nonrenewal, and the notice period required for nonrenewal are regulated by the relationship laws. There are a few relationship laws that require a franchisor, under certain circumstances, to repurchase some or all the franchisee's equipment, inventory, supplies, furnishings, or other assets following the conclusion of the franchise relationship. In addition to franchise relationships, many of the relationship laws apply to a range of other distribution relationships.

The FTC Rule does not apply to franchises granted for a location outside the United States. However, state franchise laws may apply to sales of foreign franchises. Outside the United States, many countries have developed franchise laws modeled after the franchise laws in the United States. International franchise laws must be considered when offering or selling franchises  to be located or operated outside the United States or to foreign franchisees.

In addition to the franchise laws discussed above, there are a number of states with business opportunity laws. These laws are usually broad enough to include franchise relationships; however, they generally include an exemption for franchises that comply with the FTC Rule. A few include the additional requirement that the trademark being licensed be a registered trademark in order to qualify for the exemption for franchise relationships. The exemption is automatic in some states with business opportunity laws. However, there are states that require the franchisor to file a one-time filing, as well as others that require the franchisor to file an annual filing.

The next and final article in this series will focus on the consequences of failing to comply with the laws discussed in this article.

Contributing Author

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Gerald Wells

Gerald Wells advises his clients on franchising, licensing, distribution, mergers and acquisitions, and general corporate law. He counsels start-up and established franchisors, licensors and manufacturers...

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