Understanding Franchise Law
Understanding the legal requirements and obligations associated with franchising is of critical importance for both franchisors and franchisees. The franchise disclosure document (FDD) outlines important information about the franchisor, the franchise system, its owners, and other important details necessary to make an informed selection . Laws governing franchising are set up to protect the franchisee and provide it with a certain amount of information that it can rely upon when deciding whether or not a franchisor will be a good fit for their business. Franchisors, when presented with a complete application packet and/or application fee, must take each application seriously and have each applicant evaluated fairly without bias towards minority groups. Franchise laws, however, often vary from state to state, so due diligence is vital.
Franchise Law: State versus Federal
While some states regulate franchises, the Federal Trade Commission (FTC) is the only federal agency that regulates franchises. The FTC enforces the Federal Trade Commission Act, which contains provisions that require franchisors to furnish potential franchisees with a Franchise Disclosure Document (FDD). An FDD contains information necessary for a prospective franchisee to make an informed investment decision. In addition to the FDD, the FTC Rules also require the franchisor to make financial disclosures, make certain disclosure about earnings claims, allow an opportunity to meet other franchisees, and register disclosures. One important note is that the FTC has no authority to regulate any relationship between a franchisor and franchisee.
Some states like Hawaii, California, New Jersey, New York, and Texas have registration and filing requirements for the business and ownership document provided to the prospective franchisee. Other states like Maryland and Virginia have other requirements. Compliance with federal law does not mean compliance with state law. Particularly non-legal professionals rely too heavily on compliance with the FTC rules as the only regulatory issue. Federal law may apply to all 50 states, but compliance with federal law alone is not enough.
State Registration and Disclosure Laws
There are some states that require that the franchisor file its franchise offering documents with the state, and possibly other documentation, before the franchisor can offer or sell a franchise in that state. There are currently 13 registration states: California, Hawaii, Illinois, Indiana, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, and Washington. These states are generally referred to as "registration states" or "state registration states." Franchisors or their counsel often inquire about why these states require this. There are a few different reasons. Both Hawaii and California require that the franchisor’s offering circular be on file with the state, and the documents filed must be kept current. The purpose of the registration requirements is usually to protect consumers by preventing misrepresentation or fraud by wayward or fly-by-night franchisors. In these states, there is either a state agency with enforcement authority, such as the California Department of Business Oversight or the Hawaii Office of Consumer Protection, or a private right of action for damages and attorney’s fees (i.e., civil damages or losses caused by the acts or omissions of a person who sells or offers to sell a franchise).
Under North Dakota law, a franchisor must also register with the state. The purpose is to resist attempts to establish Minnesota-type franchise laws while maintaining the franchise relationship’s stability. Illinois, New York, the District of Columbia, and a few other states have laws that provide that the failure to register or make a required franchise disclosure document filing constitutes a criminal violation, as opposed to a civil violation.
The Importance of FDD Compliance
A critical element of franchise law is the Franchise Disclosure Document (FDD). The FDD includes 23 standard disclosures about the franchise business, the franchisor, and the franchisor’s officers, affiliates, and directors, which the franchisor must provide to potential franchise buyers practicing in accordance with state and federal law. Importantly, unlike a company’s vision or marketing strategy, the contents of the FDD, if accurate, should not change regardless of where states the franchisee and franchisor reside, which raises the standard to which franchisees are held when entering into agreements with franchisors.
The FDD includes a variety of information designed to protect both the potential buyer and the seller, including, but not limited to the franchise’s background, litigation history, contact information for prior franchisees by state, estimated initial investment, estimated initial fees, and the litigation history of the franchisor and its affiliates. While the FDD is an important tool for consumers to review prior to purchase, because the FDD does cover a broad range of information, it should always be reviewed in consultation with a franchise attorney at the time of purchase.
Franchise Law: Key States
Several states present particularly unique and sometimes strict laws or rules governing franchise relationships. For example, the state of California imposes several requirements that enjoy no follow on other states. If franchisors have units or intend to sell units in California, then they are well advised to familiarize themselves with the following requirements:
- Attachment of Franchise Disclosure Statute to Franchise Agreement: California state law requires that the California Franchise Investment Law be included as an attachment to every Franchise Agreement with a California Franchisee. Cal Corp Code § 20035.
- Thirty-Day Revocation Period: California state law provides that a franchisee has 30 days to rescind its Franchise Agreement without obligation if it proves that the franchisor violated the California Franchise Investment Law. Cal Code Regs § 310.1613.
- California Franchise Tax Board Registration: when registering the FDD in California, franchisors must also register with the California Secretary of State’s Franchise Tax Board. Cal Code Regs § 310.1603. This registration must be renewed with any amendment/update of the FDD .
- California Franchise Tax Board Disclosure: the California Franchise Tax Board requires companies to disclose additional information on their cover pages if the entity is doing business in California as defined by the California Franchise Tax Board. Cal Code Regs § 315.1603.
The state of Illinois provides another unique and difficult requirement for franchisors. Illinois state law allows a private lawsuit for "fraudulent franchise sales," which is defined as "a sale of a franchise that employs one or more fraudulent devices, makes one or more fraudulent misrepresentations or materially impairs the rights of the franchisee or the benefits of the franchise." 815 ILCS 705/8. A plaintiff only must show that the franchisor made a withholding or omission that materially impairs or deprives the franchisee of the rights or benefits of selling the franchised goods or services to recover for fraudulent franchise sales. Moreover, damages for fraudulently sold franchises in Illinois may be significant. The statute specifies that a plaintiff may recover "either the rescission remedy or actual damages sustained…if the franchisor’s conduct was willful or reckless, but only to the extent necessary to compensate the injured franchisee; or a civil penalty of $5,000 for each violation, if the franchisor did not act in a willful or reckless manner." 815 ILCS 705/9.
Franchise Law: Common Legal Issues
Franchise law is complex given that it varies from state to state. Unfortunately, many franchisors are not familiar with the specific requirements of each state in which they operate. As a result, they can run afoul of a state’s franchising laws, opening up the company to liability and potentially serious legal problems. For example, some states may require a franchisor to register its disclosure documents with the state before offering or selling franchises in that state. If the franchisor fails to do so, the franchisee may not have to follow the agreed upon letter of intent and may be able to get out of the franchise agreement. In addition, if a franchisor fails to register, it may be liable for damages in an amount equal to the loss or damage incurred or a purchase price of the franchisee’s franchise (whichever is greater). Some jurisdictions have fines in the hundreds of thousands of dollars. Some states also have "relationship laws," passed to provide statutory protection to franchisees. These provisions are designed to balance the negotiating power between a franchisor and franchisee and prevent franchisors from abusing their powers. For example, under New York law, a franchisor may not unilaterally terminate a franchise agreement or refuse to renew the agreement without cause. Under other states’ laws, a franchisor may be required to sell its business to the franchisee upon termination. Franchisors should be aware of the specific provisions in these laws so that they can prevent and avoid the potential for liability under them. In conclusion, to successfully navigate franchising in the United States, you need to have a strong understand of the rules, regulations and legal concerns in each state in which you plan to operate. Enlisting the help of a knowledgeable attorney is a great way to ensure you stay above board and avoid unintended consequences.
Franchise Law: Recent Changes
Although the majority of states did not make waves with significant franchise law reform in 2016, we cannot overlook the continuing trend in Illinois to take steps to protect franchisees from unlawful franchisor actions. Changes in Michigan and California also drew interest from the franchise community. New York, Kentucky and other states continue to be the focus of regulatory changes and decisions.
In February 2016, the Illinois Secretary of State issued The Advisory Opinion on Franchise Relationship Laws in Illinois Divided Franchisee Relationships for Practitioners. The Advisory Opinion office interprets the Illinois Business Opportunity Act ("IL BOST") and the Franchise Disclosure Act ("IL FDD") in tandem. Some of the multiple requirements imposed on franchisors may conflict. The Advisory Opinion’s purpose is to streamline the harmonization of the IL BOST and IL FDD. Franchisors should bear the cautionary statement of the Advisory Opinion in mind: While the Attorney General’s Office has stated that a disclosure document must comply with the provisions of both the BOST and the FDD, the AG’s Office has expressed that it will not enforce any provisions that are in conflict because of their adoption. Franchisors’ compliance efforts must ensure that disclosures do not create more obligations than are required or create a violation of another statute. The Advisory Opinion’s interpretation should give franchisors a comfort level when drafting their franchise offerings.
Starting September 5, 2016, new amendments to the Michigan Franchise Investment Law ("MFIL") allow franchisors to charge franchise fees at any time. Franchisors can now defer all or part of the franchise fee (not to exceed 15% of the franchise fee) to be paid no later than twelve months after the date of the franchise agreement. The franchisee must also pay the franchisor an interest charge computed from the payment due date. The amendment allows greater flexibility for franchisors to accept and place a franchisee.
California also amended its Franchise Investment Law ("Franchise Act") by expanding the definition of "franchise" to include affiliations, memberships and paying fees for an association with a group of businesses. The Franchise Act will also apply to parties that offer or sell franchises with the knowledge that the person will offer or sell franchises in California. Without the requirement to have a physical presence in California, franchisors and their business affiliates will need to determine whether they meet the new definition of "franchise" and whether they now need to register under the Franchise Act.
Franchise Law: Get Help
Given the diverse and complex nature of franchise laws, seeking legal advice from franchise attorneys and other professionals is strongly advised. Experienced attorneys can provide invaluable assistance to franchisees, franchisors, and other stakeholders in navigating these regulations and ensuring compliance.
Consulting an attorney with expertise in franchise law can help you understand your responsibilities, rights, and obligations under state and federal regulations. Legal experts can also help you keep up to date on any changes to the rules or requirements in each state you intend to operate in to avoid potential lawsuits, non-compliance and expensive fines.
In addition to attorneys , there are a variety of resources and organizations available to help keep up to date on franchise laws in every state across the country. The American Bar Association’s Forum on Franchising provides a list of at least one franchise attorney in each state. The directory also includes helpful information on starting a franchise business.
Many organizations, such as the International Franchise Association (IFA), the Franchise Disclosure Document (FDD) Consultant Network, and the Franchise Registration and Disclosure Law Library are available for franchisees, franchisors, and professionals providing services to the franchise industry to share information and resources. Both state and national franchise associations, such as the California & Hawaii Franchise Forum and the Michigan Franchise Group, also provide a wealth of information.