Regulatory Compliance

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Change is inevitable in a franchise system, and disclosure then becomes a concern. Disclosure may be a business issue for the existing franchisees, but it becomes a legal issue in the offer and sale of franchises. The question is whether the information would be considered by a hypothetical purchaser of a franchise as significant. Case law is sparse, but certain registration states, such as New York, provide examples of material change requiring disclosure.

Examples of material business changes that must be disclosed are closures or buybacks of five percent or more of the franchises in one year, change of control, management, corporate name, state of incorporation, and commencement of any new product, service, or model line increasing the investment or risk of the franchisee, and discontinuing or modifying the marketing plan of system where the total sales affected could be 20% or more of the franchisor’s business. Material financial changes or defaults will also require disclosure.

Often the timing of the disclosure is problematic because some states require immediate disclosure. In the case of a merger discussion, no disclosure is required until definitive or binding contracts are signed. A non-binding letter of intent does not normally trigger a disclosure obligation. Some material changes must be disclosed immediately and some not for 45 days.

Best practices suggest ceasing new sales until counsel has had an opportunity to review the material change and the steps for disclosure are agreed upon. Even in regulated states, protocols are in place to allow sales during the change process and allow disclosure and sale with subsequent disclosures to occur when necessary.

On Fox’s Immigration View blog, my partner Alka Bahal provides a detailed exploration of the I-9 inspection process, in the wake of a recent surge in I-9 audits carried out by the U.S. Immigration and Customs Enforcement (ICE) agency. All employers in the United States are required to have a Form I-9 on file for all employees to verify their identity and authorization to work in the United States.

We invite you to read Alka’s information-packed post addressing concerns facing employers:

Employers Beware: ICE Is Ramping Up I-9 Audits to Record Levels

The North American Securities Administrators Association, Inc. (“NASAA”) is proposing to revise the instructions in the NASAA Franchise Registration and Disclosure Guidelines (the “Guidelines”) that outline policies and procedures regarding the preparation of a franchise disclosure document (“FDD”). Specifically, NASAA has set forth a proposal for public comment that replaces the “State Cover Page”  to the FDD with three separate pages titled “How to Use this Franchise Disclosure Document”, “What You Need to Know About Franchising, Generally”, and “Special Risks to Consider about This Franchise.”

Currently, the Guidelines require that the State Cover Page include certain standard “risk factors” about the franchised business being offered under the FDD, including dispute resolution procedures, governing law, and personal guaranty requirements. Additionally, registration state examiners may, in their discretion, mandate that additional information be included as additional risk factors, such as the franchisor’s financial condition and operating history. In putting this information on the second page of the FDD, NASAA and the state examiners hope to put prospective franchisees on alert of certain factors that are likely important in their decision-making process.

The first new page, “How to Use this Franchise Disclosure Document”, would require a franchisor to disclose, in table format, certain questions a prospect might have and the corresponding Item in the FDD where that information is contained. Similarly to Item 17 of the FDD that provides a summary of certain provisions in the Franchise Agreement, this page would provide prospects with a roadmap to the FDD. NASAA has noted that many prospects find the FDD overwhelming and this page would hopefully alleviate some of these concerns. However, we are concerned that some of the questions seem to put preconceived notions in a prospect’s head about disclosures contained in the FDD.

The second new page, “What You Need to Know About Franchising, Generally”, outlines certain “general” risks a prospect should be aware before entering into a franchise relationship. These additional risks include discussions on personal liability, additional investment requirements, operating and supplier restrictions, and renewal procedures. A franchisor would need to make these disclosures even if a particular factor was inapplicable to the underlying franchise offering. This seems to be counterintuitive and may only cause additional confusion for prospects and the franchisors that have to answer these questions.

The final new page, “Special Risks to Consider about This Franchise”, replaces the current “State Cover Page” and would, again, allow state examiners to require that certain additional risk factors applicable to the specific franchised business be included in the FDD.

Overall, while we believe the NASAA’s intentions are in the right place, these three pages could very well create more confusion due to the use of leading questions on the first page and disclosure of generalized risks without context on the second page. If approved in its current form, franchisors should be prepared to answer many questions about the information on these first two pages. Public comments on this proposal are due on July 13, 2018, so it is important to propose revisions if you have concerns, as we do! We will continue to watch and report on this development with interest.

Almost every year at the IFA Annual Legal Symposium in Washington D.C., a panel of distinguished franchise attorneys and state regulators will discuss best practices in drafting a franchise disclosure document in compliance with the FTC Franchise Rule.   This year was no different and the workshop “Thorny FDD Disclosure Issues” offered a number of best practices and tips to help draft an FDD that is compliant with federal rule and state law and will breeze through the state registration process:

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  1. Item 2 (Business Experience). Franchise systems often have a difficult time determining what officers to disclosure. The panelists reminded attendees that when making this decision, the franchisor should ask themselves whether “an individual’s involvement in either sales or operations is such that a franchisee would rely on his or her expertise, formulation of policy, or control of the system.”
  2. Item 3 (Litigation). Remember that the FTC Rule requires that all material terms to a settlement must be disclosed regardless of whether the settlement agreement is confidential. Legal counsel should remind franchise system clients of this fact so they are not surprised when state regulators demand the information be included in Item 3.
  3. Item 6 (Other Fees). Remember to distinguish between negotiated discounts in initial fees verses other fees. Item 5 requires disclosure of discounted initial fees during the last fiscal year but Item 6 does not require the disclosure of discounted royalty deals.
  4. Item 8 (Restrictions on Sources of Products and Services). Item 8 requires franchisors to disclose the precise basis by which a franchisor receives consideration for required purchases or leases made by the franchisees. State regulators interpret this as a requirement to specify a percentage or flat fee amount per item. For example, “franchisor receives a rebates of $300 for each oven purchased.”

With such resources as the FTC Compliance Guide, FTC Frequently Asked Questions and NASAA Disclosure Guidelines, it would seem like there should be nothing up for debate when it comes to FDD drafting.   After attending this workshop, however, it is clear that there are always new tips to learn.

 

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Each year the ABA Forum on Franchising Annual Meeting offers a regulatory roundup on state disclosure and registration issues consisting of a panel of franchise examiners from some of the most difficult registration states. This past year in Palm Desert regulators from California, Maryland and Washington offered their tips, tactics and recommendations for preparing and registering franchise disclosure documents compliant with federal and state law.   Some of the most interesting takeaways to keep in mind while you prepare your FDD include:

  1. Item 3. For any litigation matter that must be disclosed in Item 3 of the FDD make sure you include all pertinent facts even if the franchisor entered into a settlement agreement with the franchisee where the parties promise confidentiality. The franchisor must disclose the settlement terms regardless of any nondisclosure agreement.
  2. Item 5. Do not forget the 14 day rule requires that no money be paid or any agreements be signed until 14 calendar days pass. California regulator, Theresa Leets, panned the surprising number of FDDs that include territory deposit agreements, option agreements or other agreements requiring the payment of a fee that is not disclosed in Item 5 of the FDD and is collected even before an FDD is distributed.   Make it clear in Item 5 when you require any payment and make sure it does not run afoul of the 14 day rule or you will get comments from state regulators.
  3. Item 10. Be mindful of indirect financing to franchisees by affiliates if you are registered in California. Although franchisors are exempt from California’s Finance Lender Law when offering direct financing to franchisees, the same exemption does not apply to affiliates.
  4. Item 13. Be sure to include a description of all intercompany license agreements In Item 13.
  5. Item 21. Conduct due diligence on your accountant. Maryland Deputy Commissioner, Dale Cantone, reminds franchisors that just because someone has a shingle, you cannot assume he or she is licensed to perform audits. During the past year eager newly hired regulators in Maryland took it upon themselves to check the license status of franchisor’s financial statement auditors and found many were unlicensed. This causes huge issues for franchisors. Use a licensed certified public accountant.

Even seasoned practitioners and franchise systems can face pitfalls when registering with states so hopefully these tips should help speed that process along!

Michelle Webster, a franchise financial legal examiner with the State of Washington Department of Financial Institutions, took a few minutes at the start of the ABA Forum on Franchising’s Annual Meeting seminar on disclosures to discuss the registration of franchise brokers in Washington. The main takeaway? If you sell franchises in Washington, then there is a good chance you need to register.

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Third parties selling franchises on behalf of a franchisor must register as franchise brokers. The Washington Franchise Investment Practice Act prohibits a franchise broker from offering or selling franchises in Washington unless the seller is registered separately with the Washington Securities Division.    Franchisors, subfranchisors and their respective officers, managers, members, directors and employees are excluded from the broker registration requirements.   However, Ms. Webster reminded attendees that employees of an affiliate “no matter now integrated the franchisor and its affiliated companies may be.”  She explained the common example of where a franchise system offers multiple brands operated under separate legal entities, then employees of an affiliate, subsidiary or parent of the franchisor must be registered with the Washington Securities Division as a broker for all of the brands where the seller is not employed.

Remember that if you, as a franchisor, engage franchise brokers in the State of Washington, then make sure they are separately registered or else you will receive a comment letter.  The Revised Washington Code declares it unlawful for any franchisor, subfranchisor, or franchisee to employ a franchise broker unless the franchise broker is registered.  Therefore, it is important to make sure that anyone selling on behalf of your franchise system is registered or exemption.  The initial application fee is $50 and there is a $25 annual renewal fee.  The standard form can be accessed here [PDF] or you can apply online here.

International franchisors inbound into the U.S. face a complex set of business decisions and legal regulations.  Even seemingly simple tasks–like properly executing a franchise registration application–can become a time-consuming and expensive endeavor (especially where the franchisor does not have an authorized signatory in the U.S.).  Knowing how and when to request waivers can save time and money.

Notary public working on a document with stamp and padsFranchise registration applications must be signed by the franchisor’s authorized representative. In addition, some of the signatures must be notarized.  Generally speaking, satisfying this requirement requires having the signature notarized at a U.S. embassy or obtaining an apostille. U.S. embassies will have policies regarding scheduling appointments, what documents to bring, and how to prepare documents to be notarized. In addition, notarial services can be significantly more expensive at the embassy than stateside. Finally, embassy representatives are not used to seeing standard franchise applications and disclosure documents, which can cause confusion and delays.

Alternatively, the franchisor can obtain an apostille, a specialized certificate that verifies that a document is legitimate and authentic. Apostilles are only effective between countries that are parties to the Hague Apostille Convention (which is many). First, the franchisor must translate the documents into the local language so they can be notarized under local law. Then the franchisor must obtain an apostille, which ensures the documents and signature are accepted by the U.S. examiner.

Unfortunately, both options can be costly and time-consuming. Therefore, inbound international franchisors and their counsel should inquire whether the U.S. examiner will grant a waiver if obtaining an apostille or notarization will create a financial hardship and undue delay. Examiners understand there are specific difficulties to international franchising and may waive the notary requirement or permit the signatory to obtain notarization when he or she is next in the U.S.  Franchisors or counsel should contact examiners to determine how to properly make the request.  Some examiners will accept requests made in a cover letter to the application or in a preliminary email exchange.

International franchising inbound to the U.S. can be very complex. Obtaining a waiver of the notarization requirement is one less headache, which allows franchisors and their counsel to focus on the substantive issues.

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Maybe you are an international company with a successful brand that sold a master franchise or area representative right in California without knowing the robust state franchise registration laws. Maybe you are an up-and-coming pizza joint operating in Los Angeles that decide to sell a business associate the right to operate a location under you brand with your recipes in exchange for a fee without considering if it was a “franchise.”

You did not mean to violate the California Franchise Investment Act but it turns out you did. What can you do? Is there any way to “fix” your violation? The answer is yes. Although, California has a very robust and stringent state registration and disclosure process, it also provides a fair remedy for curing these non-compliance issues. The state wants to encourage self-reporting and rewards a franchisor’s attempt to do so by offering a process to bring finality to an illegal sale.

If you or your franchise system client sold a franchise in California without pre-registering with the California Department of Business Oversight, then you will need to prepare a Notice of Violation.   Instructions on preparing a compliant Notice of Violation can be found here. This is a separate application than the general application for registering the franchise offering.   Once approved, you will submit the Notice of Violation to the franchisee.  The Notice of Violation will describe to the franchisee the nature of the violation and the franchisee’s rights under the law.   However, delivery of the Notice of Violation will also start a 90 day statute of limitations clock running shortening the statute of limitation of 4 years from the illegal act or 1 year from when the franchisee discovers the violation.

In most cases, this is a much better option for a franchise system rather than waiting to see if a franchisee becomes disgruntled and reports the system to the California regulators.

Fox Rothschild LLP has deployed a new mobile app to assist companies, including franchisors, as they rush to comply with the European Union’s General Data Protection Regulation (GDPR) – a complex set of new data privacy rules with major implications for businesses.  The app – GDPR Check – helps businesses catalog their data management practices and policies to determine necessary steps to comply with GDPR when it takes effect in May.

“The pending implementation of GDPR will impact all companies that process or control the personal data of any EU citizen,” said Mark G. McCreary, chief privacy officer at Fox Rothschild and co-creator of GDPR Check.  “Every business, regardless of where it is headquartered, will be responsible for complying with these sweeping new data privacy rules when collecting or processing Personal Data,” said Daniel L. Farris, co-chair of the Fox’s Technology Group and co-creator of GDPR Check.

Even if a business does not collect personal data from EU citizens, the GDPR requirements apply to that business if it provides services to another business that must comply with GDPR.  Failure to comply with the regulations can result in fines of up to €20 million (approx. US$24.7 million) or 4 percent of global annual revenue in the prior year.

GDPR Check maps an organization’s data management practices in 17 areas that are key to determining compliance, including:

  • Types of data collected
  • Privacy policies (external and internal)
  • Consent
  • Data retention
  • Breach readiness

The app produces a report for each key area that a company can share with its attorneys and compliance team.

GDPR is intended to protect the rights of EU citizens to control the use of their personal data, including customer data such as birthdates, mailing addresses, IP addresses, product purchases and payment information, as well as supplier data, employee data and “sensitive data” such as health information, race, and sexual orientation.

This is the second app Fox Rothschild has launched in the data privacy space. The firm also maintains Data Breach 411, which provides easy access to applicable state statutes and breach notification rules to enable in-house counsel and compliance professionals, in the midst of a data breach crisis, to quickly identify controlling law and relevant guidance.

GDPR Check is available for free download in the Apple App Store and Google Play stores.

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.

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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.