12 Degrees of Separation – FTC Reveals Substance of Rule Comments.
By: Lane Fisher and Max Staplin, Fisher Zucker
The current iteration of the Federal Trade Commission’s (FTC) Franchise Rule took effect in 2007, and we’ve seen a number of recent indicators that the next version may be coming sooner rather than later. The North American Securities Administrators Association (NASAA) has been active over the past 17 years by publishing commentaries on important topics like multi-unit franchise offerings, Item 19 financial performance representations, and franchisee questionnaires/compliance certifications, but the underlying statute regulating the franchise industry has remain unchanged.
In 2023, the FTC solicited comments regarding franchise agreements and the business practices of franchisors through a Request for Information (RFI), and over 5,000 comments were submitted (of which roughly 2,200 were publicly posted). Earlier this month, the FTC published three separate documents that specifically relate to franchising and a clear intent to clamp down on certain practices.
First, the FTC issued staff guidance regarding fees imposed on franchisees that were not included in the franchise disclosure document (FDD) — Staff Guidance on the Unlawfulness of Undisclosed Fees Imposed on Franchisees (ftc.gov). We wrote an article on this subject several months ago in response to a similar statement issued by the State of Washington (See article).
Second, the FTC issued a Policy Statement on a franchisor’s use of certain non-disparagement, goodwill, and confidentiality clauses — Policy Statement of the Federal Trade Commission on Franchisors’ Use of Contract Provisions, Including Non-Disparagement, Goodwill, and Confidentiality Clauses (ftc.gov). While noteworthy, the title of this statement makes it sound more far-reaching than the underlying statements. The statement expressed a concern about broad contractual language (such as “franchisee shall not disparage the brand in any way” and “franchisee shall not engage in any conduct that may tarnish the goodwill of the brand”), but the real focus is making sure that this language would not prohibit a franchisee from reporting potential violations to the government or be construed as a threat of retaliation for such reporting activities.
Third, the FTC published an “Issue Spotlight” that summarized the top 12 primary concerns stemming from the comments received in response to the 2023 RFI. Given the increasing possibility of imminent changes to the FTC Franchise Rule, it doesn’t take too much of a leap to draw the conclusion that these types of concerns will be the impetus for some of the more noteworthy changes in the next version of the statute. In fact, the FTC noted that 15% of the comments they received specifically called for changes to the Franchise Rule. Here is a short overview of the 12 spotlighted issues:
1. Unilateral Changes to Operating Manuals
Most franchise agreements provide franchisors with the right to effectuate system changes through their operations manuals, so long as the changes don’t contradict the terms of the underlying agreement. This is important for franchisors who have a clear need to revise processes and well as product and service offerings, update vendor lists, and change brand standards as the system grows and evolves. However, the #1 concern raised to the FTC was the fact that franchisors can unilaterally update the operations manual to impose new fees and “effectively turn the operations manual into a de facto franchise agreement.”
2. Franchisor Misrepresentation
As pre-sale representations form the basis for most franchisee lawsuits, it’s unsurprising that many comments focused on claims made during the sales process. Some of the cited topics were financial performance and marketing and training assistance.
3. Fees and Royalties
While some of the comments seem to boil down to a general claim that fees are too high, the concept of specifically setting rules about what can be charged seems both anti-competitive and overreaching if implemented at the federal level, especially if the fees are properly disclosed. Instead, the more likely focus in this area will be fees that aren’t disclosed in the FDD or fees that can be changed during the term of the franchise agreement.
4. Supplier Restrictions
Franchisees expressed a concern about short lists of approved suppliers, coupled with the fact that franchisors may receive rebates from those suppliers. On the other side of this, the FTC Issue Statement also cited to other comments making the point that supplier restrictions are necessary for brand uniformity and that franchisors are required to disclose the revenue they receive from these relationships in the FDD.
5. Retaliation
The comments on this topic were likely the impetus for the Policy Statement described above, and related to concerns that reporting franchisor practices could lead to default notices or termination. Retaliation for making a valid complaint to a governmental authority is not a practice that anyone in the industry would encourage, but the other side of this is the need to prevent public complaints, generally over the Internet, that won’t or can’t be evaluated for accuracy and will harm an entire brand. Ultimately, it seems like the solution here may be a carveout from the non-disparagement/goodwill clauses noted above for making a statement to the relevant authority so that it can properly investigate.
6. Non-Competition Covenants
Comments on both sides of this topic raised valid points. Non-competition clauses limit the ability of a franchisee to open a similar business after they leave the system. However, non-competition clauses have also been widely (and legitimately) used with respect to sale of businesses generally and protect against the very realistic possibility of providing training and proprietary information to franchisees, only to see them leave the system and immediately start competing with other franchisees.
7. Franchise Renewal
Several comments were received regarding the common practice of franchisees being required to sign the then-current form of franchise agreement upon renewal or leave the system entirely. While the frustration with signing a more onerous contract is understandable, the practical reality is that franchise systems (and the contracts that govern them) need to evolve, and that renewal franchise agreements are the same contract that every new franchisee is signing, thus inherently limiting the potential for abuse as an overly unfair contract would inhibit new franchise sales.
8. Refusal to Negotiate Contract Terms
Many comments expressed frustration that many franchise systems present their franchise agreements to new prospects on a ‘take-it-or-leave-it’ basis. However, these comments ignored the fact that forcing a franchisor to negotiate introduces the possibility of discrimination and that a uniform set of terms contributes to the overall system health. Franchisees are free to not sign a contract they don’t like and/or seek another franchise opportunity with different terms, and therefore we think that we’re more likely to see a focus on mid-term changes (see #1 above) rather than this topic in the future.
9. FDD Disclosures
Comment about what currently is (and isn’t) disclosed in the FDD are perhaps the most on-point when it comes to speculating as to what we’ll see in the next version of the FTC Franchise Rule. Unsurprisingly, complaints about Items 6 (fees), 7 (estimated initial investment), and 19 (financial performance representations) were cited in the FTC’s Issue Statement, and we will not be surprised to see more specific guidance regarding these disclosures moving forward.
10. Private Equity Takeovers
Many commenters raised concerns about private equity’s increased involvement in the franchising industry, stemming from private equity’s reliance on debt and the pressure for system growth that often comes with a private equity takeover.
11. Marketing Strategy/Marketing Fund
While acknowledging the mandatory disclosure items regarding a franchisor’s use of a systemwide marketing or brand fund, many comments seemed to question the actual benefits that such a fund provides. To us, the underlying value of a successful national brand strategy is self-apparent, but we would not be surprised if additional disclosures regarding the use of such funds is mandated in the future.
12. Liquidated Damages
Finally, commenters raised concerns about provisions in franchise agreements that award lost future royalty fees when a franchisee unilaterally closes its business during the middle of the contract term. On the other hand, the grant of a franchise comes with a corresponding obligation to operate the business for the entire initial contract term, and courts will generally only enforce these provisions if they are reasonably related to the actual damages incurred.
Tagged in: Articles, Featured Articles