A federal district court recently granted the United States’ Motion for Default Judgment against the quick-service burger restaurant franchise concept, Burgerim Group USA, Inc. and its owner (“Burgerim”). The Federal Trade Commission (“FTC”) filed a complaint against the defendants alleging they used misleading sales practices to sell more than 1,500 franchises in violation of the FTC Franchise Rule.  The complaint arose after several states, particularly California, Indiana, Maryland and Washington, filed cease and desist orders and barred Burgerim from offering and selling franchisees in their respective jurisdictions.

This was the first major civil enforcement action against a franchise system by the FTC in over ten years.  The court held that the FTC has proved its damages as defendants were paid $57,707,244 in franchise fees from 2015 through July 2019 and of that amount, the defendants only issued $9,230,555 in refunds.  The court also found the United States’ request for a $5,000 penalty per violation was reasonable as it was far below the amount authorized by the FTC’s Rule of Practice.  The court granting the United States request for consumer redress in the amount of $48,747,689 and a civil penalty of $7,750,000.  The court also found that a permanent injunction prohibiting the defendants from selling additional franchises was warranted and an appropriate sanction for their conduct.

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Unfortunately, this may do little to assuage the purchasers as the franchisor ceased operations and its founder is purported to have fled abroad. This is why prospective franchisees are urged to conduct thorough due diligence before signing any franchise agreements or paying any initial fees, especially with unproven and emerging brands.  Anyone seeking to purchase a franchise should, at a minimum:

  1. Hire a franchise attorney to review the FDD and identify any concerns, follow-up questions for the franchisor, or red flags particularly with respect to: (A) previous litigation or bankruptcy matters; (B) indications of inadequate administrative, training, and operational support evidenced by too few Item 2 staff biographies, limited pages in the operations manuals, and non-specific and insufficient training disclosures; (C) uneven growth patterns (including large spikes in sales without corresponding successful openings) and unexplained terminations and non-renewals; (D) additional financial assurance requirements imposed by state regulators evidencing weak financial statements; and (E) financial performance representations (earnings claims) in Item 19.
  2. Call and email both former and current franchisees listed as an exhibit to the FDD and interview these franchisees about their experiences with the system.  Ask probing questions such as whether (A) they opened within the time frame specified in Item 11; (B) they received adequate training and pre-opening and post-opening support; (C) the technology, brand fund and other fees paid provide sufficient return of value; and (D) most importantly, they are making money!
  3. Engage an accountant, trusted business or tax or financial advisor who can prepare pro-formas and work with you to determine break-even and whether purchasing a franchise makes financial sense.  

There are no guarantees in business, but with the right trusted advisors and sufficient due diligence, prospective franchisees can decrease the risk of investing in an untrustworthy franchise brand.

As expected, the North American Securities Administrators Association (NASAA) announced last week that it voted to adopt a “Statement of Policy Regarding the Use of Franchise Questionnaires and Acknowledgements” (NASAA Policy).   The NASAA Policy will require any franchisor using a franchise acknowledgement or questionnaire to: (1) revise its franchise disclosure document (FDD) to include a form non-waiver paragraph and (2) scrutinize and amend its form, where necessary, to comply with the new NASAA Policy prohibitions and mandates. The NASAA Policy is effective January 1, 2023.

Many franchise systems rely on the use of franchisee questionnaires or acknowledgment statements.  Franchisors believe they are a helpful tool and consider them useful for several purposes: (i) ensuring that new franchisees are onboarded in compliance with all applicable franchise sales laws, regulations, and best practices; (ii) reducing the risk of misunderstandings or claims by disgruntled franchisees in the future; and (iii) avoiding sales solicited by misrepresentations or fraud. 

There is no one uniform type of questionnaire/acknowledgement form, but most require a prospective franchisee to (i) confirm he or she did not receive financial performance representations, promise of profits, revenue, or costs incurred outside the FDD or any other statements or promises inconsistent or contrary to the information in the FDD; (ii) acknowledge that he or she had the opportunity to consult with an attorney and business advisor and ask questions; and (iii) represent that he or she has not signed any binding agreement with or paid any money to the franchisor during the statutory waiting period.

The new NASAA Policy outlines a long list of prohibited statements, including requiring that a prospective franchisee:

  • has read or understands the FDD or franchise agreement;
  • understands or comprehends the risks associated with the purchase of the franchise;
  • is qualified or suited to own and operate the franchise;
  • has relied solely on the FDD and not on any other information, representations, or  statements from other persons or sources;
  • has had the opportunity to or has/has not actually consulted with professional advisors or consultants or other franchisees; and
  • agrees or understands that the Franchisor is relying on the questionnaire/acknowledgement to ensure that the sale of the franchise was made in compliance with state and federal law or that no unauthorized, inaccurate, or misleading statements.

A full list of prohibited provisions can be found here.

The NASAA Policy also requires that any franchisor using a questionnaire or acknowledgment to provide the following in its FDD:

No statement, questionnaire, or acknowledgment signed or agreed to by a  franchisee in connection with the commencement of the franchise relationship  shall have the effect of (i) waiving any claims under any applicable state franchise law, including fraud in the inducement, or (ii) disclaiming reliance on any statement made by any franchisor, franchise seller, or other person acting on behalf of the franchisor. This provision supersedes any other term of any document executed in connection with the franchise.

The NASAA Policy is not a change in federal or state law. However, we expect, consistent with past NASAA policies, that most state franchise examiners, will implement and follow the NASAA Policy when reviewing franchise applications.  Franchise systems may reevaluate the utility of these questionnaires and acknowledgements after revising to eliminate the long list of prohibited provisions.  

We will likely know more after the ABA Forum on Franchising Annual Meeting in San Diego this fall as the NASAA Policy is expected to be addressed at the workshop lead by a panel of state franchise examiners.  Stay tuned for more information on this issue as it becomes available.

Recently, I moderated a panel for an International Franchise Association webinar called “From Venture Capital to Private Equity: Franchise Investment Trends and Terms”.  I was fortunate to have fantastic panelists: Satya Ponnuru (General Partner of NewSpring Franchise), Vanessa Yakobson (CEO of Blo Blow Dry Bar), Bernard Markey (Navigator Partners) and Ed Teixeira (Franchise Grade).  I wanted to share some of the takeaways of that panel.

First, to differentiate, the panel covered everything from early stage growth equity investments (venture capital) to later stage private equity buyouts – a lot to fit into one hour!  Both venture capital and private equity have grown exponentially in the last few years – the first half of 2021 approximating the first 2/3 of 2020 in private equity funding according to the Pitchbook Q2 2021 US PE Breakdown report.  And interest in the franchise sector has grown at all stages.

One of the main takeaways was the emphasis all panelists placed on a healthy relationship between the franchisor and the franchisee.  Clearly, a franchise system will not be a strong business unless the financial metrics are solid at the franchisee level – if the franchisees are not making money, the system will ultimately fail.  But also general communication between the franchisor and franchisee and satisfaction with that relationship was an important aspect of strong franchise business.

Second is making sure that the partnership between the founders and others involved in the franchise system and the investors is solid and that goals are aligned between the two.  They will be working together, hopefully for a long time, so it is important to take time to be confident of the relationship.

Third, for a franchise system to make strong efforts to keep your books and records in order.  If you don’t have someone on your team that is in charge of legal, compliance and/or the financial end of the business, that needs to be added.  Everything from the basics of making sure receipts and franchise agreements are properly signed to gathering solid data on your franchisee businesses should be undertaken from the beginning.

And all seemed to agree that, except in rare circumstances, a solid Item 19 Financial Performance Representation is important.  A lack of an Item 19 was viewed as a warning sign.

Of course, pointers relating to the due diligence process and the negotiation of the transaction were covered, but it is important to keep these high-level tips in mind as well.

With most non-essential businesses closed across the country, it is easy to forget we are two weeks away from the April 30th Franchise Disclosure Document (FDD) update deadline for franchisors with a calendar fiscal year end.   Some franchise systems are delaying the preparation and issuance of an updated 2020 FDD and corresponding state renewal registrations. However, we found most of our clients are updating their FDD consistent with past practice and filed renewals in those states requiring registration.

One of the trickiest issues to address this year is the inclusion of Item 19 Financial Performance Representations (FPRs). On one hand, the financial data used to prepare the FPRs is based on past performance in 2019 and prior years. Therefore, compiling Item 19 FPRs consistent with past practice and in compliance with the FTC Franchise Rule and NASAA guidance, should be business as usual. On the other hand, the COVID-19 pandemic is likely to impact unit operations in the coming months, maybe years.  Some hospitality and food based concepts may never fully recover. Should any franchise system include a FPR in its 2020-2021 FDD?  We discovered one state regulator already weighing in on the issue by providing the following comment to a renewal filing:

In Item 19, we note that the Franchisor presents a financial performance representation based on the past performance of outlets prior to the COVID-19 pandemic. We further note that to slow the spread of COVID-19, many businesses have been closed or are operating on a limited basis this year. These events may significantly impact the potential performance of the franchised business. In your response letter, please explain why the Franchisor believes that it is reasonable and not misleading to present a financial performance representation based solely on results from a period prior to the COVID-19 pandemic.

This comment raises a lot of questions.  We recommend a franchise system base its approach to FPRs this year on all pertinent factors applicable to that particular system. For example:

  • What industry does the franchise system operate?  Is it likely that the system can revert to pre-COVID-19 performance levels? If it is a childcare or healthcare based concept, then consumers will likely have a need to resume patronizing the franchised units. However, non-critical entertainment concepts where people socially gather in close quarters may not recover as quickly.
  • How long does it take from signing the franchise agreement to opening? If the average time from signing to opening is over 12 months, then it is possible that COVID-19’s impact on the economy when the franchise commences operations may be less severe.
  • What is consumer profile patronizing the units? Will these consumers have discretionary income in a post-COVID 19 economy?

However, it is impossible to predict the future and know how people are going to react once society resumes. Will people rush to resort hotels for respite? Can most afford to do so? Franchisors need to make the most logical decision based on the information they have now.

It may be reasonable to include a statement that addresses the issue without slipping into prohibited disclaimer territory. For example, a statement like “the financial data was compiled prior to the time of the COVID-19 pandemic and the temporary local and state governmental restrictions on operations” may be appropriate. This reminds the prospective franchisees of the origin of the data without renouncing the performance representations. Based on our experience with state regulators, language beyond this factual statement (for example, stating that the franchisor is unable to predict how COVID-19 may impact future unit performance) is unlikely to pass regulator scrutiny.

However, a blanket conclusion that all FPRs based on accurate data from 2019 are unreasonable or misleading in the COVID-19 pandemic era is problematic. My view is that (in most cases) a lot of value remains in providing FPRs to prospective franchisees. If FPRs are made in good faith and in compliance with the FTC Rule and NASAA Guidelines, then this historical data is more useful than hurtful for a franchisee. Further, it may help in reigning in a sales broker or agent who may have a tendency to make unlawful or misleading earning statements without proper Item 19 FPRs. A complete prohibition on inclusion of FPRs does not benefit these franchisees or provide them with the information to make an informed decision. Hopefully, state regulators will craft a uniform approach to this issue to avoid potential conflicting comments and requests.

Mark Siebert, CEO of the well-known franchising consulting firm iFranchise Group, authored a very interesting article in a recent issue of Franchise Times magazine about “influencers” in franchise sales. As a corporate and regulatory transactional franchise attorney, I represent both franchisors (in the sale) and franchisees, multi-unit owners and area developers (in the purchase) of franchise units. Helping a start-up franchise system navigate the sale of one of its first units is exciting as is providing the legal guidance to a prospective franchisee in deciding whether to decide a franchise unit.

77420569 – influencer marketing concept in business

I can educate a franchisee on the legal implications on signing on the dotted line and provide best practices to a franchisor on the offer and sale of a franchise unit in compliance with the FTC Rule and state law. However, as Siebert explains, franchise systems must be aware of the local “influencers” that drive the sale – that is the spouses, family members, business advisors, friends, bankers/lenders and accountants that drive the sale.   This is where Siebert recommends that franchise systems involve these influencers in the evaluation process to ensure that a sale doesn’t get derailed. According to Siebert “educate them on the offer. Involve them in the conversation. Invite their objections and explore their fears and concerns. Get them on the phone, share your marketing materials, invite them to discovery day. By involving them in the process, you communicate their importance to you and demonstrate your commitment to transparency.”

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To “win” over the business influencers, Siebert recommends having accurate and complete financial performance representations in Item 19 of the franchise disclosure document and providing third-party validation necessary to make the influencers comfortable with the offering.   I echo Siebert’s advice. I recommend to all of my franchise clients that they have strong Item 19 FPRs and solid relationships with their franchisees to ensure positive word of mouth.   I can provide the best and most comprehensive analysis of the legal terms of the franchise and other agreements and point out red flags and cautionary items in the FDD, but only current franchisees will be able to provide the needed first-hand validation and knowledgeable about the brand and its culture.  Often that is just as important to a prospect when making a decision.  To read the entire article click here.

Fox Rothschild recently gave a presentation at the International Franchise Expo in New York City on the “Top Ten Provisions to ‘Never’ Negotiate in a Franchise Agreement.” A summary of this presentation is being presented in four separate blog posts.  The first post focused on the central theme of franchise negotiation from the perspective of the franchisor and franchisee.

This installment highlights a few practice pointers that can save time and money during the negotiation process and protect the confidentiality of your negotiations.  Installments three and four will examine the top ten things never to negotiate in in detail, including typical franchisee requests, franchisor counter-arguments, and common compromises.

When negotiating a franchise agreement, the franchisee should provide a memorandum of the terms he or she proposes to revise.  This can take many forms, from a formal letter of intent to an informal email.  The level of detail will vary, but at a minimum it should cover all of the franchisee’s requests and be thorough enough for the parties to begin negotiations and understand what they are agreeing to.  This process focuses the parties on the most impactful terms and identifies potential deal breakers early in the process, saving time and money.

Copyright: / 123RF Stock Photo

Once the negotiated terms are established, we suggest that they should preferably be included in an addendum to the franchise agreement, which will be attached to the franchisor’s standard form of franchise agreement.  We strongly encourage you to avoid revising the standard franchise agreement.  There are a few reasons for this.  First, it is generally easier and faster to draft and negotiate an addendum rather than redline the entire franchise agreement.  Second, sticking to an addendum will keep revisions focused and precise.  The franchisee’s attorney is likely to make more changes if he or she has the opportunity to redline the entire franchise agreement. Finally, when you need to review the negotiated terms of multiple franchise agreements, short addendums will be easier to review than redlined franchise agreements.

Finally, be sure to protect the confidentiality of your negotiations – but don’t go overboard.  Franchisees will talk to each other, which can be both good and bad.  You want your star franchisees to speak with new and prospective franchisees.  They’re in a great position to give advice that will boost performance, and to be a cheerleader for your system.  However, avoid permitting them to share negotiated terms, which can hurt morale and give new franchisees unreasonable expectations. For example, original or early franchisees may have obtain concessions that were appropriate for a startup system may no longer be appropriate at later stages of the brand’s development.  Moreover, you must be sure to understand the franchise laws of the states where you are offering franchises, which may require you to disclose negotiated terms in certain cases as briefly mentioned in our first post.  Also, as you probably know, disclosures and representations respecting financial performance are fraught with danger and should never be made by franchisees.

Your addendum should include a confidentiality provision that balances these considerations.  The negotiated terms, and the fact that you negotiated your franchise agreement, should be protected from disclosure.  After all, those are private terms between two business partners.  However, franchisors shouldn’t be so specific as to prevent franchisees from communicating in ways that benefit all members of the system.

In the next installment, we’ll launch into the first 5 of our top 10 provisions to “never” negotiate:

1.       Signing the “then-current” franchise agreement

2.       Reservation of Rights

3.       Right of First Refusal

4.       Marketing Fund

5.       Renewal

As we head into Tuesday night’s State of the Union Address, our thoughts at Fox Rothschild return to last year at the ABA Forum on Franchising Annual Meeting in Palm Desert, California.  One of the most interesting seminars was entitled “What’s New and What’s Next: The New Administration and Beyond.” In addition to reviewing updates on joint employer issues, SBA lending rules and changes to accounting rules, the session provided an interesting update on whether the FTC Franchise Rule will succumb to the Trump administration’s mandated review of all regulations.

70035381 – president holding shredded federal regulations isolated on white.

The short answer (drumroll please) is probably not, at least not anytime soon. The Federal Trade Commission was scheduled to review its 66 rules and regulations (including the FTC Franchise Rule) to determine whether they should be modified, expanded or repealed in 2018. However, the FTC decided it will not proceed with the review. Further, the administration clarified that the FTC is not subject to the Executive Order requiring that two regulations be discarded for every new regulation.   For now, it appears there may not be any immediate changes to the FTC Rule.

However, the NASAA’s Franchise Project Group chaired by Dale Cantone, Maryland Deputy Attorney General, is forging ahead with a number of initiatives. According to the session presenters, such projects include:

  1. Working with state franchise regulators to implement the new FPR Commentary [PDF];
  2. Revising the NASAA state cover page;
  3. Revising the 2008 Franchise Registration and Disclosure Guidelines [PDF];
  4. Making Risk Factors requirements uniform among states; and
  5. Developing one electronic filing system for all states to use.

Although, there may be little action on the federal level, it appears that the NASAA Franchise Project Group will continue to make strides to eliminate conflicting applications of franchise disclosures among the states and work towards standardization.  An action plan that all franchise regulatory attorneys likely endorse.

It is January and that means we are already counting down the days until the deadlines for updating your franchise disclosure document (FDD) and filing state franchise renewals are here.    Many franchisors’ fiscal year ended on December 31st.   The FTC gives a franchisor 120 days to update its franchise disclosure document (FDD) but some state deadlines many come much sooner.   Franchisors should already be gathering the information needed to update their FDD and file state renewal applications (if applicable).  Below are some quick tips franchisors should follow to ensure they meet the deadlines:

  1. Begin compiling the additional information needed to update your FDD in an organized and complete manner. This includes changes to executive personnel, disclosure of new litigation, updated financial performance representations under Item 19, and current franchise sales data for the 2016 year. If your outside or in-house counsel does not provide you with a renewal questionnaire or list of needed information to easily compile this data, then request they do so.

    Copyright: vician / 123RF Stock Photo
    Copyright: vician / 123RF Stock Photo
  2. Make sure that the outside or in-house counsel responsible for overseeing the final updates or filing state renewals are provided with accurate draft documents and other information with ample time to review, revise, comment, and finalize. Seasoned franchise counsel should have a streamlined system in place for handling updates and renewals. The starting place to this process, however, is getting accurate information from the franchisor.
  3. Pay extra close attention to states that recommend or require a renewal registration be filed in advance of the expiration date, such as California [pdf] and Rhode Island.
  4. Keep in contact with your accountants or finance division and remind them that the audited financials must be completed before April 30th. Many delays in updating an FDD will be the result of auditors not having adequate time to prepare the financials. For franchisors filing state registration renewals the deadline for the audit may be sooner. Some states require that renewal registration applications be filed days or weeks in advance of the 120 day deadline as stated above.  If you are filing state renewal registrations make sure you get your Consents of Accountant forms returned with the financials.

Failing to update or file renewal registrations on time can impede a franchisor’s ability to offer and sell. Therefore, it is important to get a head start on the process to give all parties involved adequate lead time.

Many franchisors’ fiscal year ended on December 31st.   The FTC gives a franchisor 120 days to update its franchise disclosure document (FDD) but some state deadlines many come much sooner.   Franchisors should already be gathering the information needed to update their FDD and file state renewal applications (if applicable).  Below are some quick tips franchisors should follow to ensure they meet the deadlines:

Copyright: iqoncept / 123RF Stock Photo
Copyright: iqoncept / 123RF Stock Photo

  1. Keep in contact with your accountants or finance division and remind them that the audited financials must be completed before April 30th. Many delays in updating an FDD will be the result of auditors not having adequate time to prepare the financials. For franchisors filing state registration renewals the deadline for the audit may be sooner. Some states require that renewal registration applications be filed days or weeks in advance of the 120 day deadline. If you are filing state renewal registrations make sure you get your Consents of Accountant forms returned with the financials.
  2. Begin compiling the additional information needed to update your FDD in an organized and complete manner. This includes changes to executive personnel, disclosure of new litigation, updated financial performance representations under Item 19, and current franchise sales data for the 2015 year. If your outside or in-house counsel does not provide you with a renewal questionnaire or list of needed information to easily compile this data, then request they do so.
  3. Make sure that the outside or in-house counsel responsible for overseeing the final updates or filing state renewals are provided with accurate draft documents and other information with ample time to review, revise, comment, and finalize. Seasoned franchise counsel should have a streamlined system in place for handling updates and renewals. The starting place to this process, however, is getting accurate information from the franchisor.

Failing to update or file renewal registrations on time can impede a franchisor’s ability to offer and sell. Therefore, it is important to get a head start on the process to give all parties involved adequate lead time.

Copyright: stuartphoto / 123RF Stock Photo
Copyright: stuartphoto / 123RF Stock Photo

Last week the NASAA Franchise and Business Opportunity Project Group released for public comment a Notice of Request for Comments Regarding A Proposed Franchise Commentary on Financial Performance Representations.  The FPR Commentary includes proposed answers to frequently asked questions about how franchisors can make a Financial Performance Representation (“FPR” and sometimes also referred to as an earnings claim) in a Franchise Disclosure Document.  FPR’s found in Item 19 of the FDD are one of the more difficult sections of an FDD to draft and often receive scrutiny from state regulators.   The public comment period runs from October 1 through November 2, 2015.  Once the comment period closes, NASAA will post comments received on its website.

Topics addressed include the use of disclaimers, the presentation of gross and net sales and profit figures, the presentation of data of company-owned versus franchised outlets, the use of subsets and projections, among others.  On first read, it provides useful clarification addressing the  standard of what constitutes a “reasonable basis” for making an FPR under federal and state franchise disclosure guidelines.

The Notice and Proposed FPR Commentary can be found here.