Franchise Laws – What You Don’t Know Can Hurt You

With the greater percentage of this country’s gross national product each year coming from sales of goods and services in franchise systems, recognizing when a business plan or distribution system falls within the definition of a franchise, under federal or state laws is important.  It is also important to understand the risks to businesses, and the individual principals of those businesses, for failure to comply with these laws.  Although many entrepreneurs dislike the cost of effective compliance with franchise laws, most successful franchisors realize that franchising is an excellent way to finance expansion of their business and that non-compliance with the franchise laws provides a potential for exceedingly greater costs.  Compliance with all applicable laws is not difficult if handled properly from the beginning.

What is a Franchise?

 Although there are numerous legal interpretations of what business relationships constitute a franchise, there are three basic elements of a franchise under both federal and state laws. The definition of a franchise under federal law, which is under the jurisdiction of the Federal Trade Commission (the “FTC”), is found in the FTC Rule (16 CFR Part 436), which was initially adopted in 1979, and substantially overhauled in January 2007.  That definition contains the following three elements, all of which must be present to have a franchise: (1) use of another’s trademark, (2) substantial control or assistance by another; and (3) a required payment of $500.00 or more within six (6) months after commencing operation of the franchisee’s business (which can include payment for goods or services).  Interpretation of each of these elements has been very broad, even extending the definition of a franchise to some business relationships more commonly referred to as distributorships.  Therefore, many companies legally subject to franchise laws are not even aware of their compliance obligations.

Compliance Under the Law

The FTC Rule requires that certain disclosures be made by franchisors or their agents to prospective franchisees at least fourteen calendar days prior to receipt of a franchise fee or the signing of a franchise agreement and again when modifying existing agreements.  These disclosures must be in a prescribed disclosure document form, the Franchise Disclosure Document or FDD (previously called the Franchise Disclosure Statement or Uniform Franchise Offering Circular or UFOC). The FDD is similar to a securities offering prospectus and in it the franchisor must disclose detailed information about its principals and business.  In twelve states, the disclosure document must be registered with a franchise administrator after their review.  These states each require slightly different disclosures, some more important than others to a particular franchisor.  Texas does not require registration of the franchise offering.

Penalties for Non-Compliance

For each violation of the FTC Rule, the FTC may recover civil penalties up to $10,000 per day for each violation of the FTC Rule plus rescission or reformation of contracts, a refund of money, and payment of damages to individuals.  The statute provides no excuse for ignorant or unintentional violations.  Although the FTC is more likely to bring an action against a franchisor who fails to make proper disclosures and misrepresents the franchise, there have been several cases where the only apparent violations of the FTC Rule were a failure to provide the required disclosure documents. 

Under most state laws, a franchisee can bring a civil action against a franchisor.  Often such laws allow a franchisee to rescind a franchise agreement, obtain a refund of monies paid to the franchisor and, in some cases, obtain punitive or multiple damages for intentional misrepresentations or wrongdoings.  In Texas, actions can be brought under the Deceptive Trade Practices-Consumer Protection Act and can result in multiple damages to a non-compliant franchisor.

A franchisor who fails to comply with disclosure and registration requirements is also subject to criminal sanctions.  Under most states this would be a felony, and these states will usually apply such sanctions to any violation of the state’s franchise law, no matter how egregious.  In addition, under most of the criminal statutes, it is only necessary to show that the franchisor intentionally offered or sold a franchise knowing that it was not registered, not that it intended to break the law.

Personal Liability

 Under both federal and state law, there may be personal liability for individuals acting on behalf of the franchisor as well as individual control persons of the franchisor.  The FTC will invariably target for punishment the individuals responsible for a violation along with the franchisor.  In addition, the FTC can assert individual responsibility on persons who control a corporate franchisor and have knowledge of its fraudulent practices. 

Under many state laws, there are specific provisions which allow the state or a franchisee to hold certain individuals responsible for all damages awarded to franchisees under the statute.  Often the laws apply to any person who violates the statute, which would include the corporate franchisor and any control person as well as the agent who made the misrepresentations or directed the non-compliance.

Conclusion

Even the best of franchise systems will ultimately have a franchisee who for one reason or another becomes disenchanted with the business.  Failure by the franchisor to initially comply with all franchise disclosure laws will allow such a franchisee to have a much greater chance of success in a legal action against the franchisor.  In addition, such a success might provide encouragement for other franchisees who are marginally dissatisfied and might not otherwise bring an action.  With exposure to the franchisor for non-compliance with franchise laws potentially so large and the strong likelihood that corporate officers and directors will be personally liable and/or exposed to jail terms, a prudent franchisor will be certain that the business receives the expert advice necessary to insure full compliance with the law.