Franchising Legal Requirements and Best Practices

by Noel Bagwell
for Executive Legal Professionals, PLLC

August 26, 2014

Addressing Legal Risk Requires Team-building

For the entrepreneur or business considering franchising their successful business, one of the biggest hurdles to overcome is meeting the franchising legal requirements. Doing the things the government requires as well as the things that are necessary in order to maintain industry standards are a part of meeting franchising legal requirements. Beyond that, however, the wise business decision-maker will think long-term, and consider whether the contracts they use might be challenged in Court.

An average small business earning $1 million per year spends $20,000 on lawsuits each year.1 By using well-drafted contracts and other preventive legal services, a business can significantly reduce the risk of having to defend a lawsuit. You will need a business attorney. When it comes to legal issues cutting corners and DIY solutions are ineffective and inefficient, and, in the long run, often lead to greater costs than benefits.

Understanding the Minimum Franchising Legal Requirements

Where to Find the Rules

The Federal Trade Commission (FTC) promulgates rules, codified in the Code of Federal Regulations (C.F.R.), governing the federal disclosure requirements and prohibitions concerning franchising. These requirements and prohibitions are published in Title 16 of the C.F.R., Part 436 (16 C.F.R. 436). Section 436.2 (§436.2) covers the obligation a franchisor has to furnish disclosure documents to potential franchisees. Failing to meet the requirements of 16 C.F.R. 436.2, according to its own terms, is “an unfair or deceptive act or practice in violation of Section 5 of the Federal Trade Commission Act” (Title 15 of the United States Code Annotated, Section 45; 15 U.S.C.A. § 45). The FTC’s Bureau of Consumer Protection also has a somewhat helpful FAQ for helping interested parties understand the Amended Franchise Rule.

Penalties for Violating the Rules

Title 15 of the United States Code Annotated, Section 45, Subsection “(m)” provides:

“(1)(a) The Commission may commence a civil action to recover a civil penalty in a district court of the United States against any person, partnership, or corporation which violates any rule under this subchapter respecting unfair or deceptive acts or practices (other than an interpretive rule or a rule violation of which the Commission has provided is not an unfair or deceptive act or practice in violation of subsection (a)(1) of this section) with actual knowledge or knowledge fairly implied on the basis of objective circumstances that such act is unfair or deceptive and is prohibited by such rule. In such action, such person, partnership, or corporation shall be liable for a civil penalty of not more than $10,000 for each violation.” (emphasis added)

Clearly, these are very serious federal rules with stiff penalties. Also, if you haven’t noticed by now, they’re not the easiest rules to read, much less to follow. Having a business attorney to help you navigate through these regulations is strongly advised. Also, keep in mind that the registration states’ regulations are actually more stringent than the federal regulations on franchises.

The Big Three

There are three major requirements imposed by 16 C.F.R. §436. These are:

(a) The franchisor must provide to a prospective franchisee a copy of the franchisor’s current disclosure document at least 14 calendar days before the prospective franchisee signs any contract or makes any payments to the franchisor (or any affiliate of the franchisor) in connection with the proposed sale of a franchise;

(b) The franchisor may not “unilaterally and materially” alter the terms and conditions of the basic franchise agreement or any related agreements attached to the disclosure document without furnishing to the prospective franchisee a copy of each revised agreement at least 7 calendar days before the prospective franchisee signs the revised agreement. “Changes to an agreement that arise out of negotiations initiated by the prospective franchisee do not trigger this seven calendar-day period.” 16 C.F.R. 436.2(b).; and

(c) The required documents are considered furnished by the required date if “(1) a copy of the document was hand-delivered, faxed, emailed, or otherwise delivered to the prospective franchisee by the required date; (2) directions for accessing the document on the Internet were provided to the prospective franchisee by the required date; or (3) a paper or tangible electronic copy (for example, computer disk or CD-ROM) was sent to the address specified by the prospective franchisee by first-class United States mail at least three calendar days before the required date.” 16 C.F.R. 436.2(c).

RELATED ARTICLE:  Letters of Interest

The Franchise Disclosure Document

There are many, many things that must go into an acceptable Franchise Disclosure Document (FDD). In fact, “

[t]here are 23 categories of information that must be provided by the franchisor to the prospective franchisee at least 10 business days prior to the execution of the franchise agreement.”2 They are all listed on this page, if you’d like to read through the list. Some states in the U.S. have more stringent requirements than those imposed by the FTC. So, meeting the FTC’s minimal requirements will not be adequate for meeting these states’ requirements. In order to do that, franchisors most commonly use the FDD format prepared and adopted by the North American Securities Administrators Association (NASAA).3

Again, preparing this document correctly is crucial, and failure to prepare and provide it correctly could have severe civil penalties. Cutting corners and trying to do it yourself is ill-advised. You should contact a business attorney–and probably an accountant, too–to ensure this document is correctly prepared and provided to potential franchisees.

Other Franchising Legal Requirements

There are many other legal requirements with which both franchisors and franchisees must comply, and they vary from state to state in the U.S. (and from country to country). If you are serious about succeeding in your franchising business, having a good accountant and a good business attorney on your team really is not optional. If you forego hiring an attorney and an accountant, and try to DIY your franchise company, you will fail spectacularly. Not only will you fail, you will most likely do things that will put you at extremely high risk of being sued, which is ironic, because then you will have to hire a lawyer to defend you in the lawsuit, when you could have just hired a lawyer to prevent it in the first place. Hire a lawyer early-on, or hire a lawyer when you get sued. Either way, you’re going to have to hire a lawyer. Personally, as the National Center for Preventive Law Aspect of Practice Leader for Start-ups and Small Businesses, I’d prefer to see you avoid the lawsuit.

Achieving Excellence

More than just about anything else, break-downs in communication cause problems with franchises–all businesses, really. From the beginning of their interactions with each other, franchisors and franchisees need to be honest and forthright about what their expectations are, and what outcomes they desire. Having unrealistic expectations can cause conflict; therefore, clearly communicating what your expectations are, and listening to the other party’s feedback about your expectations can reduce the likelihood your expectations will be unreasonable. In your communication, also ensure you are responding in a timely fashion and with as much transparency as reasonably possible. Doing so will foster trust, the foundation of all healthy relationships.

Do your due diligence. Both franchisees and franchisors are well-served by spending resources early in their relationship to help determine both that a business owner who wants to franchise their business is prepared to do so, and that a prospective franchisee interested in buying a franchise unit is qualified (or, after being trained by the franchisor, can become qualified) to operate the business. Do not try to figure it out as you go! When forming and structuring and organizing a franchise company, don’t try to bootstrap and DIY the business; if you do, you will fail. You will need to invest in the start-up phase of your business, but, with effort and patience, that investment can reap huge dividends. Franchisees also need to ensure they know what to expect and have done their homework about the franchising industry and the specific businesses in which they’re interested. This due diligence should be done well in advance to minimize both surprises and unreasonable expectations.

Finally, stay focused on what your ultimate goal is. How long do you want to run this business? Are you planning to sell it when it hits a certain threshold? In short, what is your exit strategy? Have one. Stay focused on it. Make sure everything you do brings you closer to it.


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