The New Franchise Disclosure Document (FDD) Regulations Settle in on Franchising Andrew Caffey, a leading franchise legal expert, updates you on the changes in the Franchise Disclosure Document and the impact it's having on the industry.
Chris Bjorklund: You’re listening to an Allbusiness podcast. I’m Chris Bjorklund. If you’re buying a franchise, chances are you’ve heard about the franchise disclosure document. Disclosure rules have changed recently so we’ve asked a leading franchise attorney to join us to give us an update on the impact of those changes. Andy Caffey is chair of the American Bar Association Forum on Franchising and a former general counsel for the International Franchise Association. Andy, we’ve read about the new disclosure document and that it became mandatory about a year ago. We’ve been using it for about a year and it replaced that old uniform franchise offering circular known as the UFOC and it’s now called the franchise disclosure document or FDD, I guess that’s what we’ll be referring to it as today. This new document was a long time in coming, Andy wasn’t it?
Andrew Caffey: Oh hi, Chris, yes it was. Believe it or not, the FDD has been in the works at the Federal Trade Commission since October of 1999 so many years of consideration went into this set of changes and the FTC did an admirable job, I thought, of drawing comment from all corners of the franchise community, not just franchisors and their lawyers but franchisees, their representatives, their associations, and individual players in the franchise community. The FTC held a series of hearings, gathered all the information and then finally, nine years into the process, they issued a new FDD.
Bjorklund: Well public policy takes a long time to hash out especially when there’s so many competing interests.
Caffey: Well, that’s right and it’s important to hear from all sides in the community like a franchise community which is generally, there are two basic sides, franchisors and franchisees and the Commission did a good job of listening to everyone. As it did, the first time the rule went into effect in the late 1970s but I think with this round of changes, it was probably the most thoughtful and mature approach to this regulation and I think it shows with the results of the FDD that we’re using and what it’s meant for everyone.
Bjorklund: Well, this leads me, of course, to my next question which is whether the new format has been a good development for franchising both for the franchisors and the franchisees.
Caffey: Well, I think it has been a good development. The new FDD follows in the footsteps of the old UFOC and I think it’s important to understand what we didn’t see with this new approach to franchise regulation. We didn’t see a more intrusive form of regulation. You know, the UFOC has been in place, it’s been used for 30 years and by UFOC, I don’t mean just the format but the whole approach to regulation. The UFOC is delivered in a pre-sale setting and there is much of the responsibility for disclosure, all of it really is left to franchisors. There is not a federal or even a state agency that has inserted itself into the franchise relationship to determine whether a particular offer is fair or equitable. It is a more sort of arm’s length regulation of the marketplace. The decision was made originally by the Federal Trade Commission that what the franchise marketplace needed was an informed investor. We needed better information in the hands of decision makers so that when someone decides to buy a franchise, he or she has all of the material information on hand that is important in making the decision to buy or not buy a franchise and the FDD that became mandatory last year has continued that tradition and as I say, I think it’s the absence of more intrusive regulation that has indicated the health of franchising and I think one of the reasons that the FDD is as welcome as it is.
Bjorklund: What about the changes? Do they favor one side or the other? I mean, you would know.
Caffey: Well, I would say that arguably there are changes to the disclosure format and the rules surrounding it that benefit both franchisors and franchisees. I think that franchisors benefit because there are more clarifications in the guidelines that have been provided by the Federal Trade Commission and by the states. The FTC has dropped an awkward requirement of its delivery timing and that is the first personal meeting rule has been dropped. Electronic disclosure is one of the biggest changes in the FDD but the Federal Trade Commission has wholeheartedly embraced the idea that franchisors can deliver disclosure to franchisees electronically but they are leaving to franchisees the option of selecting the form of disclosure that they want to receive so that if a prospective franchisee doesn’t have a computer and is handed a CD-ROM with a copy of a disclosure document, that prospect can say, “Wait a minute, I can’t read this. I’d like a paper copy, please.” And I think the franchisors will deliver that. I’ve found that while we’re on this point of electronic disclosure, several of my clients have mentioned that they have found resistance in the marketplace to electronic disclosure. A lot of people do want to receive a paper document and so many franchisors are staying with paper and delivering a paper FDD because that’s what a lot of people want to receive. It is wisely, I think, the FTC has left flexibility for franchisors to consider how, what format the disclosure is going to take and they put power in the hands of prospective franchisees to say, “I want another form. I want another format that I can read, that I’m comfortable with.”
Bjorklund: Good to have flexibility built in.
Caffey: It is and let me mention that for franchisees, this FDD is overall is easier to read and I think easier to understand than the old UFOC. Like the UFOC, the FDD has to be written in plain English so it is accessible to the average person who’s going to be reading it and the FDD has a wider scope of the people that it is providing disclosure about. There are a wider scope of the people that are executives with the franchisor or are otherwise involved in the franchise sale that are going to be included in an FDD that under the old rules would not have been included in the UFOC. So this is the sort of change that I think is not going to be immediately evident to a prospective franchisee reading an FDD but it is an improvement to the format. I think it does benefit franchisees. The new FDD closed a few loopholes in the format so that franchisors have to provide disclosure about say their parent companies when the parents are financially backing the franchisor entity. So that in the FDD, there is less of a form over substance and the FTC has made it clear to franchisors in its regulations that it wants substantive disclosure and doesn’t want the form of these guidelines to overcome what is important and material to a prospective franchisee so franchisors are delivering more disclosure about more people. The statistical information about the franchise system that appears in item 20 of the FDD was a complete redesign over the UFOC. We now have a set of five tables to statistically lay out the number of franchisees that have been opened or closed or terminated over the last three years in a very easy-to-read format and that is probably the most obvious difference if you put these two documents side by side. Look at item 20 and you’d see that there is a new set of tables that are very easy to read and understand and tell you instantly what has been going on in the franchise system as a whole over the last three years. There is one last thing I would mention that I think is a benefit to franchisees and that is there is a new category of litigation that now must be disclosed by franchisors and that category is enforcement actions that have been filed against franchisees so that if a franchisor files a lawsuit against say a terminated franchisee to enforce the post term requirements of the franchise agreement, under the old UFOC, that doesn’t have to be disclosed because there were no counterclaims brought by the franchisee and that was the trigger that required litigation disclosure. Now that we have this new category, you will see in item 3 of the disclosure document a mention of enforcement cases brought in the past fiscal year against franchisees so a lot of these changes are technical and they’re not going to be obvious to the reader but there are some distinct advantages for franchisees. I think there are a few for franchisors as well but particularly they will benefit franchisees.
Bjorklund: Now, does the FTC review the facts as stated by the franchisor in the FDD? How do I know the company’s telling me the truth?
Caffey: Well, in fact, there is no government agency that reviews the FDD to determine whether it is a good deal or whether the information being provided is truthful. There are certainly serious legal consequences to a franchisor if it is determined that it is not being truthful in its disclosures but you don’t know as prospective franchisee upfront whether a particular statement is true or not. The Federal Trade Commission requires that these disclosure documents be delivered to prospective franchisees in a timely fashion but the Federal Trade Commission never sees this disclosure document. In fact, even the registration states that we’ll about in a minute, I hope, will see these disclosure documents but certainly don’t make a determination whether the information provided is truthful. As I say, there are serious legal consequences if a franchisor is caught offbase in some fashion or is misleading in some fashion and a lot of the state investment laws put power in the hands of franchisees who perhaps have been misled to bring a private action and of course, state officials can bring enforcement actions against franchisors so there is very heavy legal weight behind the creation of an FDD but it is important to remember that no government agency has vetted this information. It is generated exclusively by the franchisor without review by a government agency.
Bjorklund: I think that’s an important point and also, we’re talking here about being an informed investor so that maybe you can also get some legal advise as you review this document yourself. Most people, I think, may not be able to fully review it on their own.
Caffey: Well, there are two professional advisors that are important in the franchise situation. One is a lawyer who can help you understand the franchise agreement because the franchise agreement, of course, is part of an FDD but it does not have to be written in plain English. It can be the most dense legalese possible and can be very hard to understand and it is, in fact, the operative legal document between a franchisor and a franchisee. So number one, it is really helpful to have a lawyer go through the FDD and especially the franchise agreement with you; and the second professional who is essential, I think, is a good accountant, who can help a prospective franchisee understand the investment. Now there is some information on FDD that can be used by an accountant and that is there is information in item 5 about the initial fees that are going to be paid by the prospect, item 6 all the other fees of the franchise system have to be laid out and then item 7 is key. That provides an estimate of the total investment that the franchisee is going to be asked to make from soup to nuts and those three items 5, 6, and 7 can be taken by a good accountant and it could be very useful in putting together the business plan and the financial projections for this particular franchise that an investor wants to buy.
Bjorklund: You touched on earlier these franchise registration states. You said there’s 14 of them. What about any changes going on there?
Caffey: Well, first of all, can I just mention quickly what the 14 states are so that our listeners know what we’re talking about and if they’re located in one of these states, it’s going to be important for them to know that. The 14 franchise registration states are California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin. Now those 14 states require franchisors to go one step further than the Federal Trade Commission does. Not only must the franchisor have a disclosure document but they have to register that disclosure document with the state officials in these 14 states. A franchisor has to register its offering and every year, update and renew that offering if it wants to continue offering franchisees. So this is a very important part of the world of franchising for a franchisor. It has to make that it is in full compliance with the requirements of these 14 states and they can be quite demanding. Now the 14 states, the good news for franchisors is that the 14 registration states have very quickly adopted the new FDD format so that the disclosure format is the same across the country and it is accepted by all of the states. This is news and a great development that simply didn’t apply with the old UFOC. So now we have all of the registration states accepting the FDD format and the other big change from the registration states is that they have started to require franchisors when we submit to the states to not only submit a paper copy of the FDD but an electronic copy on disk and there are a copy of states now, Rhode Island and Indiana that want disks only and tell franchisors not to submit paper. There is one other state, Wisconsin has announced that sometime later this year, it will put in place a fully electronic submission system for franchisors. This is less important to franchisees, of course, but for franchisors, this is very big news. In my law practice, we represent franchisors. We used to…the whole force used to go down with the paper that would be generated just for the filing among the states and now the amount of paper has been reduced to a fraction of what it was. The states are modernizing their systems so that they can receive electronic filing and I think over the next few years, we’re going to see more and more states take this direction. The advent of the new FDD has been a little bumpy among the states and now that we’ve been through the spring 2009 renewal, it’s not quite as bumpy as it was with the 2008 renewal but this is the first renewal after use of the FDD became mandatory. The states have been scrambling, of course, we’re in a recession. The states have been very hit hard by this recession and a lot of the franchise offices that we found are understaffed and they simply don’t have the budget to have the people involved with processing the applications and a lot of franchisors I know are frustrated because they’re hung up in states where they may have 2 or 3 months where they can’t offer franchises. They’ve done everything they can. They’re simply waiting for the state to approve an annual renewal and prospective franchisees will hear this and become very frustrated. I’m getting a lot of feedback from my clients of the frustrations they have in states where they’re having trouble renewing. So, it’s just something to be aware of if you’re a prospective franchisee that in some states, there is a real difficulty in getting the annual renewal completed so that an offer can be made. A lot of prospects who were interested in investment are being told, “Well, you have to wait. It may take a few more weeks.”
Bjorklund: You know, I’ve read Andy that all an investor needs to do to receive the FDD from a franchisor is just ask for one. Is that correct?
Caffey: Well, that is partly correct and it is partly correct because the franchisor is obligated to deliver an FDD when it’s reasonably requested and there’s the trap, the word “reasonably”. And the FTC has made it clear in fairness to franchisors that they need not deliver a disclosure document to everyone who requests an FDD but they are required to deliver an FDD to a prospective franchisee where there has been substantial discussion about the purchase of a franchise or if a prospect has been through the qualifying process that many franchisors will impose. And if there have been substantial discussions about the purchase of a franchise at some point of reasonableness, I suppose the franchisor has an obligation to deliver an FDD on request. So to someone who’s looking at a franchise investment, I would say, be aware of that. If you’re going through the qualification process, by all means request the FDD. In fact, there is new information that not a lot of franchisors are in step with compliance. This is one of the little fine points of the new FDD rule where franchisors are required to deliver information on their websites and on their application materials advising prospective franchisees when they can expect to receive a disclosure document. So I don’t see a lot of companies complying with that but that will come, I think, as franchisors now are designing and tweaking and adjusting their compliance programs and their lawyers are reminding them that they need to put some statements in their application brochures, on their application forms, and on their websites to tell a prospect when he or she can expect to receive an FDD.
Bjorklund: I would think the early you disclose that, the less…the fewer problems you’re going to have with that down the line.
Caffey: Well, yes that’s true. This is part of one of the largest changes that has affected franchisors and that is the rule surrounding the timing of when a disclosure document must be delivered, the one with the old UFOC rule, it was 10 business days or at the first personal meeting for the purpose of discussing a sale of a franchise. Now there were lots of questions and problems with determining how we count business days and when we start counting them. Do we count the day that the document is actually delivered to a prospective franchisee? We didn’t know. We had to make sort of our own reasonable judgments as lawyers looking at these rules and advising franchisor clients. Now, the FTC has scrapped the whole idea of a first personal meeting rule and has also changed the 10-business day requirement now saying a franchisor must deliver an FDD at least 14 calendar days before a binding contract is signed or a prospective franchisee pays money to the franchisor. Now, I think that’s a good change. The FTC has also clarified how we should count, we being franchisors and their lawyers, how to count those 14 calendar days. We don’t count the day of delivery and the day of actually signing a franchise agreement, for instance. So we need 16 days. So there’s the full 14 calendar days to review an FDD and that’s a fair and reasonable approach. The timing requirements are confused somewhat now because there are a handful of states that have older rules on their books. Maryland and New York and Rhode Island, for instance, still have a first personal meeting requirement that is required by state law. So if you’re a prospective franchisee in my home state of Maryland, then that first personal meeting is going to be the time when I receive a disclosure document. I think Maryland is considering changing its rules but it hasn’t happened yet and I don’t know if there are efforts under way in New York and Rhode Island. Michigan, Oregon, and Washington also have on their books a measure of 10 business days rather than calendar days so there’s some technicalities that franchisors at least must be aware and you can overcome these technicalities by giving a disclosure document at an early point in discussion so that there is a generous time for a prospective franchisee to review it. But what I have found in advising franchisors is that there is a slow process by which these new rules are understood. We’ve lived with the UFOC under the old rules for nearly 30 years and it’s taking an immense education effort, I think for franchisors to understand and comply with the new rules.
Bjorklund: You sure know your stuff, Andy. Before we wrap up here, one last question and that is changes on the horizon. Are you making any predictions there with your looking out into the future?
Caffey: Well I think the number one change that we can anticipate, it’s at the top of the list and that is that electronic disclosure and the use of electronic documents and electronic submission among the franchise registration states over the next two or three years is going to become universal and I think that’s a great development. I’m delighted to see it. I think we’ve all benefited from our facility with generating documents and these documents will be 150 to 180 pages long by copying them onto disks for delivery or merely posting disclosure on a website so that it’s available to our prospect and I think we will see down the road a lot of progress in this area and in a few years, we will start to associate these big fat paper documents with the old UFOC and maybe the prior century. I think we are finally and it was frustrating waiting for the FTC to go through this nine-year review process. We all had computers. We could have generated documents but now we have an FTC that has fully embraced this direction and I think it’s going to spell an important part of the future of franchising.
Bjorklund: Andy Caffey, thanks for talking to us today. I really appreciate it.
Caffey: It’s a pleasure, Chris. Thank you.
Bjorklund: Andy Caffey is a franchise attorney practicing in Maryland and a blogger for Allbusiness. To find out more about other aspects of franchising, go to our franchise center at Allbusiness.com. I’m Chris Bjorklund, thanks for listening.
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