F.T.C. Public Comment 114

As the franchise registration and disclosure laws reach their 25th birthday and beyond, we should expect that they will protect prospective franchisees with greater and greater precision. Like their older sibling, the securities laws, franchise laws recognize that certain franchisees need protection, whereas others do not.

FTC.jpg

U.S. Federal Trade Commission
October 29, 1997

Public Comment
Gary R. Duvall, Nadine C. Mandel, attorneys

Request for public comment on possible revisions to The Franchise Rule.

Comment #114

KNOWLEDGEABLE FRANCHISEE EXEMPTIONS:

LAW AND POLICY

by Gary R. Duvall and Nadine C. Mandel

I. INTRODUCTION

As the franchise registration and disclosure laws reach their 25th birthday and beyond, we should expect that they will protect prospective franchisees with greater and greater precision. Like their older sibling, the securities laws, franchise laws recognize that certain franchisees need protection, whereas others do not.(1)

Recent legislation adding sophisticated investor exemptions to the California franchise law reflects the thinking that protective laws are not necessary for all prospective franchisees. Continental Basketball Assn., Inc. v. Ellenstein Enterprises, Inc.(2) echoes that thought. In Continental Basketball Assn., the court was asked to find that a franchise agreement for the establishment of a professional basketball team was void because the franchisor did not comply with Indiana's franchise law. The court concluded the franchise agreement was not void as against public policy stating:

[T]here is absolutely no suggestion of unequal bargaining power; the franchisee…appears in all respects to have been a well-advised, sophisticated businessman who entered into the contract freely….While the integrity of offers and sales of franchises in Indiana is certainly an important public policy, we see little likelihood that refusal to enforce a professional sports franchise agreement
between highly sophisticated parties will further that policy. In short, a sports franchise agreement among highly sophisticated parties is so far from the typical franchise transaction which the Franchise Acts were designed to regulate that we can adhere to our strong presumption in favor of the enforceability of contracts without undermining the purposes of the Acts.

This Article discusses how franchise law distinguishes between franchise investors protected by the registration and disclosure laws, and those who are not - due to their wealth, knowledge or bargaining power. It then turns to the policy issues inherent in these distinctions. Finally, the authors propose a national uniform exemption for knowledgeable franchisees and experienced franchisors. Such a national uniform exemption would subsume within it much of the present overly-complex and underutilized patchwork of state and federal exemptions.

II. EXISTING LAW

In certain states, a franchisor can seek an exemption from registration requirements if it meets the definition of an experienced franchisor or if its prospective franchisees meet the definition of a sophisticated investor. This section of the Article addresses experienced franchisor, (3) sophisticated investor, and related exemptions, and the challenges inherent in using the exemptions.(4)

A. Experienced Franchisor Exemption.

Nine of the states that require franchise registration or notice filing - California, Indiana, Maryland, New York, North Dakota, Rhode Island, South Dakota, Washington and Wisconsin - have an experienced franchisor exemption.(5)

New York offers franchisors two alternative ways in which to qualify for the exemption. The state experienced-franchisor laws vary greatly. However, almost all contain both minimum net worth and experience requirements.(6)

There is no equivalent exemption in the Federal Trade Commission's (FTC's) Trade Regulation Rule: Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures (the FTC Rule).(7)

1. Net Worth. In most states, the franchisor must have a net worth of five million dollars as evidenced on its audited financial statements to meet the net worth requirement of the exemption.(8)

Most of the states also permit the franchisor to have a smaller net worth, usually one million dollars, so long as the person who owns eighty percent or more of the franchisor (its parent) meets the net worth requirement.(9)

In several states - California, Maryland, Rhode Island, South Dakota, and Wisconsin -it is necessary to provide the parent's guarantee for the performance of the franchisor's obligations if the franchisor wants to rely on the financial statements of the parent to obtain an exemption.

Many franchisors are the wholly-owned subsidiary of a company that has operated and often continues to operate the same type of business as the franchisees. Generally, the principal reason the parent forms the subsidiary franchisor corporation is to protect the assets of the operating company from claims by franchisees. If the parent must guarantee the franchisor, the parent puts its own assets at risk. Although some states interpret the "franchisor's obligations" under these exemptions to include only pre-opening obligations, most state laws are silent on this issue. The extent of the guarantor's liability if it agrees to the guarantee is unclear.

2. Experience. Experience requirements differ. Each state requires five years of experience, except for South Dakota which requires twenty-five years' experience and New York which does not require any experience. The type of five-year experience differs as well. The states define it in one or more of the following ways: (i) twenty-five franchisees operating the same type of business for five years; (ii) the franchisor conducting the same type of business as the franchisees for five years; (iii) twenty-five franchisees of the parent operating the same type of business for five years; (iv) the parent conducting the same type of business as the franchisees for five years; (v) twenty-five franchisees of the franchisor or parent operating the same type of business at twenty-five locations for five years; (vi) twenty-five franchisees conducting business for five years; and (vii) twenty-five franchisees conducting the same type of business at twenty-five locations in the state for five years.(10)

Part of the difficulty in meeting the experienced-franchisor exemption lies in this patchwork nature of the experience requirements. In addition, there are logical omissions from the exemption. For example, only California permits a combination of experience. In each of the other states (except New York), only one of the defined methods of experience qualifies. None of the states expressly allows the experience of an affiliate of the franchisor or the affiliate's franchisees to qualify.

It is common today that more than one of a group of affiliated companies may be a franchisor and that even unrelated companies may have interlocking directorates. Also common are organizational structures in which a sister entity, rather than a parent, operates the type of business the franchisees are conducting. If companies share officers or managerial employees, it clearly makes sense to extend the experience component to affiliates and their franchisees. Expanding the experience qualification to affiliates makes even more sense if we consider that many of the states allow the franchisor or its parent to meet the net worth requirement by a consolidated financial statement.

The experience requirements as currently crafted hamper the franchisor's ability to expand its system by area development and subfranchising. For example, in Rhode Island, South Dakota and Wisconsin, the twenty-five franchisees must have twenty-five different locations. If the franchisor wishes to sell a few franchisees the right to develop many locations, the franchisor may have less than twenty-five franchisees but they may have saturated the state with several hundred locations. Likewise, if the franchisor grants subfranchisors the right to sell subfranchises, the franchisor could not include any subfranchises in its franchisee count.

The exemption provisions are silent about whether the same twenty-five franchisees must conduct the same type of franchise during the entire experience period, or whether merely an aggregate total of twenty-five franchisees must be in operation during the period. If the former is the case, presumably no transferee franchisee who purchases within the time period can be included in the count. Franchisors also may be required to exclude from the count new franchisees who take the place of terminated or expired franchisees.

It is unclear whether the states are trying to protect franchisees from franchisors inexperienced in being a franchisor, franchisors inexperienced in the general industry of the franchised business, or franchisors inexperienced in the specific franchised business. For example, if a chicken fast-food restaurant franchisor is exempt under the experienced-franchisor exemption and decides to franchise a hamburger fast-food restaurant which may also sell chicken, the second franchise may not qualify for exemption because it is not the "same" business. If the same franchisor instead franchises a hair salon business, the second franchise also might not qualify for exemption. If the franchisor has been licensing dealerships or distributorships in the past and decides to convert its system to a franchise, it is likely the franchisor will not meet the experience requirement because it does not have twenty-five "franchisees." Yet, if the franchisor or its parent operated during the requisite time period the same type of business as the franchisees will but neither has ever franchised, the franchisor meets the experience requirement.

There has been a debate aired recently in the Franchise Law Journal about the applicability of the experienced-franchisor exemption after a formerly-exempt franchisor is acquired - either by acquisition of assets or stock or by merger (and, if by merger, whether or not the franchisor is the surviving entity).(11)

The debate briefly concerns whether general corporate law and the state exemption laws on their face control the applicability of the experienced-franchisor exemption or whether state administrators may, in their discretion, impose other prerequisites on the maintenance of the exemption, such as a requirement that the same management personnel remain following the acquisition. Although this Article voices no opinion on the debate for fear of setting off another spate of articles on the topic, the debate further illustrates the difficulty in using the exemption.

Only Washington requires a minimum initial investment as part of its experienced-franchisor exemption. By requiring that franchisees invest at least one hundred thousand dollars, the State eliminates from possible exemption the franchisors that require a smaller start-up cost. In addition, if a franchisor sells franchises to both conversion and nonconversion prospects, a prospect who can convert for less than one hundred thousand dollars could spoil the exemption for the franchisor even though nonconversion franchisees have a greater than one hundred thousand dollar initial investment.

3. Effect. Franchisors who qualify for the exemption are exempt from registration under state law, but they are not normally exempt from providing disclosure to prospects or from notifying the state that they are claiming an exemption. Each of the exemption states specifically requires an exempt franchisor to provide disclosure to prospective franchisees.(12)

Unless also exempt under federal law, franchisors must provide the full disclosure the FTC requires despite the limited disclosure the state allows.

There is some question as to how the format of the new Uniform Franchise Offering Circular (UFOC) Guidelines affects state-required disclosures for an exempt franchisor. For example, several states, including Indiana, require that exempt franchisors prepare a statement of the conditions under which the franchisor may terminate, refuse to renew, or repurchase the franchise. Item 17 of the UFOC Guidelines now presents information in chart form and may not fulfill this requirement adequately. Also, the negative disclosure suggested in Item 10 of the new UFOC Guidelines does not comply with the requirement of some state exemption laws to provide a statement of any past or present practice or of any intent of the franchisor to transfer to a third party any note, contract, or other obligation of the franchisee in whole or in part. Must the exempt franchisor provide an addendum to its UFOC offering circular or revise the disclosure portion of its offering circular to comply with these disclosure vestiges from the previous guidelines? If the franchisor registered, the registration review process may answer
these questions partially, but not necessarily so the exempt offering.

Though the franchisor may be exempt from registration, the state may require the franchisor to:
(i) file notification of the exemption with the state annually, (ii) pay an exemption fee, (iii) complete a notice of exemption form, (iv) submit a consent to service of process, (v) submit either the franchisor's offering circular or all the agreements the prospect will sign, (vi) submit the parent's financial statements, and (vii) provide evidence that the franchisor meets the requirements to obtain the exemption initially and periodically. Many states retain the right to require additional information from the franchisor to approve the exemption.(13)

If these approval requirements are in place, approval of the exemption may be as time-consuming as approval of a non-exempt franchise application.

While the experienced-franchisor exemption can be a frustrating journey for the franchisor, there are many reasons why a franchisor may wish to use it. The principal reasons are time and cost savings. Many of the state laws permit the exemption without requiring state review of the franchisor's offering circular. The review of a registered offering circular in the state may be more time-consuming than an exemption filing. This time-saving would occur when the franchisor first begins offering franchises in the state, at the time of renewal or annual updating of the offering circular, and at the time the franchisor amends its offering circular to indicate a material change.(14)

Decreased state involvement with the offering circular may translate into decreased legal expenses as well.

B. Sophisticated Investor and Related Exemptions.

There are various exemptions for sales to franchisees less in need of protection, including sales to: (i) an existing franchisee, (ii) an existing franchisee seeking to renew, and (iii) an investor who meets either (a) initial investment criteria, (b) net worth or income and experience or knowledge criteria, or (c) business experience (fractional franchise) criteria. Each of these three exemptions is somewhat limited in scope. The exemption may or may not affect registration as well as disclosure.

In the first two types of sophisticated-investor exemption, it is the franchisor's second sale of a franchise to the investor which is exempt. In all likelihood, the franchisor registered with a state to make the first sale to that investor. Indeed, the franchisor currently may be registered with the state because the franchisor is offering and selling first-time franchises to others. It is also possible for a franchisor to use the third type of sophisticated-investor exemption on a sporadic basis, unless the franchisor offers and sells franchises only to prospects who meet the criteria of the exemption.

1. Sale to Existing Franchisee. Seven states - California, Hawaii, Maryland, New York, Rhode Island, Washington and Wisconsin - permit an exemption from registration for a franchisor offering or selling an additional franchise to an existing franchisee.(15)

Michigan also grants an exemption from filing notice with the State and in some circumstances from the duty to provide disclosure to the prospect.(16)

Oregon provides for exemption from the franchisor's duty to disclose if the franchisor gave an offering circular to the franchisee for the previous sale and there has been no material adverse change in the information required to be disclosed.(17)

The laws vary in breadth. There is no similar exemption from FTC Rule disclosure, however, requiring disclosure even if registration is not required.(18)

Hawaii's provision is the broadest and permits the exemption if the franchisor is offering or selling any additional franchise to an existing franchisee. Presumably, the franchisor could offer a fast-food restaurant franchise to an existing franchisee in its automotive repair franchise system. Many of the state exemptions require that the additional franchise be "substantially similar" to a franchise the buyer already owns but the laws do not define these words.

Several state laws impose a time restriction. California permits the offer, sale or other transfer of an additional franchise to an existing franchisee of the franchisor or to an entity (one or more of whose officers, directors, managing agents or owners with at least a twenty-five percent interest is an existing franchisee of the franchisor) if for at least twenty-four months the franchisee, or the qualifying person, has been engaged in a business offering products or services substantially similar to those to be offered by the franchise being sold or otherwise transferred. Michigan and New York require that the franchisee actively have operated the existing franchise for at least the eighteen months preceding the offer and that the franchisee purchase the additional franchise for operation and not resale. In addition, in New York, the franchisor must report the sale to the State on a special form within fifteen days of the sale. Both Rhode Island and Washington require two years of operation at the time of the offer or sale of the substantially-similar, additional franchise.

The obvious logic of these laws is that the franchisee has a working history with the franchisor and likely does not need the type of protection the registration and disclosure laws provide.(19)

2. Renewal of Existing Franchise. California, Hawaii, Illinois, Indiana, Maryland, New York, North Dakota, Rhode Island, and Wisconsin offer an exemption from registration for franchisors who are renewing or extending an existing franchise.(20)

Michigan also exempts the franchisor from filing a notice with the State and Oregon exempts the franchisor from disclosure requirements.(21)

In actuality, neither California, Indiana, New York, North Dakota, Oregon nor Wisconsin provides for a renewal "exemption." Instead, each of these states excludes these renewals from the definition of "offer" or "sale." Several state exclusions clearly cover by definition "offers" and "offers to sell" renewal franchises. However, it is not clear that these same definitions include the actual sale of the renewal franchise. A franchisor may end up in the position of not having to register to offer the renewal franchise but having to register before closing the sale of the renewal franchise.

Illinois, Indiana, Maryland, New York, North Dakota and Wisconsin limit the exemption to renewals of an existing franchise if there is no interruption in the operation of the franchised business. Hawaii, Michigan and Rhode Island additionally restrict the renewal or extension exemption to instances where there is no material change in the franchise relationship.(22)

None of the latter states defines "franchise relationship." Since most franchisors revise their franchise agreement over the years, it is unclear whether changes, material or otherwise, in the agreement constitute a material change in the relationship. It is possible, for example, that a change in management over the years constitutes a material change in the franchise relationship.

Oregon's exclusion for renewal franchises is the narrowest. Oregon exempts the franchisor from the requirement to disclose for a sale or offer to sell a renewal franchise if there is: (i) no interruption in the operation of the franchise relationship, (ii) no material change adverse to the franchisee in the franchise relationship, and (iii) no material change adverse to the franchisee in the disclosure information previously furnished to the franchisee. Presumably, this latter requirement only rarely can be met.

Similar restrictions apply under federal law to the franchisor's ability to forgo providing disclosure to existing franchisees at the time of renewal.(23)

The FTC Rule excludes from the definition of "sale of a franchise" the renewal or extension of an existing franchise if there is no interruption in the franchisee's operation of the franchised business, unless the new agreements contain material changes from those in effect between the franchisor and franchisee. Since the FTC Rule limits the restrictions to material changes in the existing and renewal agreements, it gives more guidance than the state laws on when the renewal exemption may be applicable.

3. Sophisticated and Other Special Franchisees. This section of the Article represents a hodgepodge of exemptions - both on the federal and state levels.

Each of the six states with a sophisticated franchisee exemption - California, Indiana, Maryland, Rhode Island, Washington and Wisconsin - defines the exemption criteria in a completely different way!(24)

The Washington provision simply provides a long list of investors for whom the franchisor's registration is not required either due to the type of business the investor conducts (e.g., insurance company or employee benefit plan), the assets, net worth, or income of the investor (e.g., net worth over one million dollars), or the investor's relationship to the franchisor (e.g., an executive officer of the franchisor). Many of the registration states include an exemption for sales to certain businesses such as banks, trust companies, investment companies, insurance companies and other institutional prospects.

Maryland tacks onto the sophisticated franchisee exemption a number of franchisor obligations such as (i) filing a notice, a copy of the offering circular and a consent to service of process with the State, (ii) paying a fee, and (iii) undertaking to supply the State with additional requested information. Nonetheless, Maryland equates the sophistication of the investor not with any characteristic of the investor but only with a characteristic of the franchise -an initial investment of at least seven hundred fifty thousand dollars.(25)

California has two exemptions, each of which requires the owner of at least fifty percent of the franchisee to have certain experience. In one exemption, the owner must have within the seven
years before the franchise sale twenty-four months' responsibility in the financial and operational
aspects of a business offering products or services substantially similar to those the franchised business offers. In the second exemption, the owner must have twenty-four months' experience within sixty days before the franchise sale as an officer, director, managing agent, or at least a twenty-five percent owner in the franchisor. The franchisor cannot control the franchisee's owners under either exemption.

Island and Wisconsin, on the other hand, provide net worth and income restrictions and require that the investor (or a representative in Wisconsin) have knowledge and experience to the merits and risks. Wisconsin further restricts the knowledge and experience to the type of business operated under the franchise while Rhode Island restricts the knowledge and experience to financial and business matters.

The state sophisticated franchisee exemption provisions raise questions for the unsuspecting franchisor. For example, must the sophisticated franchisee be the corporate franchisee or can the sophistication be imputed to the franchisee's officers, shareholders, management or directors? To the extent that state law is silent on the issue, must the investor be sophisticated in business generally, in franchising generally, in the particular industry of the franchise, or in the particular franchise? Should the amount of money the investor has equate with sophistication in business? Since the experience and knowledge criteria may be subjective, will the franchisor be held liable down the road if its judgment was not accurate? Perhaps the people who may be the most sophisticated investors - people who have worked for the franchisor or managed a franchised unit or a company-owned unit - are not considered sophisticated under any franchise law, except that of Rhode Island or Washington.(26)

The FTC Rule's "fractional franchise," "leased department," and "single trademark" exemptions are somewhat analogous to state sophisticated-franchisee exemptions. Under the FTC Rule, a franchisor need not provide disclosure to a person if the relationship qualifies for one of these or other delineated exemptions or exclusions.(27)

The FTC Rule defines a fractional franchise as any relationship in which the franchisee, or any of its current directors or executive officers, has been in the type of business represented by the franchise relationship for more than two years and the parties anticipate, or should anticipate, at the time the agreement establishing the franchise relationship is reached, that the sales from the relationship will represent no more than 20 percent of the sales in dollar volume of the franchisee. The 20 percent cap is very limiting. Illinois, Indiana, Michigan, Minnesota and Virginia also have a fractional franchise exemption.(28)

Under the FTC Rule, a leased department is characterized as an arrangement in which a retailer independently sells its own goods or services from premises leased from a larger retailer in the
larger retailer's store. The federal exemption applies only if there are no restrictions about the
persons from whom the retailer must or may purchase goods or services. Illinois, Minnesota, Rhode Island, South Dakota and Virginia also exempt leased departments to varying degrees.(29)

Many states and the FTC Rule also have exemptions for franchisee resales "not effected by or through the franchisor."(30)

The policy for this exemption is that the burden on the franchisor is too great in light of the availability of information about the operating franchised business purchased directly from the selling franchisee.(31)

Several of the states further restrict the exemption. The states also differ about whether they permit exemption from registration or disclosure or both. In Indiana, Rhode Island and Washington, affiliates of the franchisor cannot be the "franchisee" that sells its franchise. Several states, such as Hawaii and Michigan, limit the sale to an isolated sale, i.e., a sale that is not a part of a plan of distribution of franchises. South Dakota limits these sales by prohibiting the seller from making more than one sale during any twelve consecutive months. New York law defeats the purpose of the exemption by requiring the franchisee to provide the prospect a copy of the franchisor's offering circular currently registered with the State. North Dakota's law is the most onerous. The franchisee (not the franchisor) must obtain written approval from the State before transferring the franchise!

Other isolated sales also are exempt under certain state registration laws. Minnesota, New York and Washington exempt varying numbers of offers or sales under varying circumstances.(32)

Each of the three states imposes additional restrictions on isolated offers and sales.

The FTC Rule's exclusion for unique licenses(33)

(also known as single trademark licenses) is similar to the state isolated sales exemptions discussed in the preceding paragraph. The federal exemption is not limited to an offer or sale to a single licensee. Rather, the exemption generally occurs when the parties have a one-on-one agreement. The exemption applies if a licensor licenses a trademark, trade name, service mark, advertising or other commercial symbol and the license is the only one of its general nature and type that the licensor grants.

C. Discretionary Exemptions.

Ten states - California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island and Wisconsin - allow the director, commissioner or other state administrator to grant a discretionary exemption to franchisors.(34)

These exemptions generally provide that the administrator may award an exemption if registration is not necessary in the public interest or for protection of prospects.

As the name implies, the exemption is discretionary and therefore subjective. Some states attempt to shed more light on the subject. For example, the Illinois administrator may grant a discretionary exemption if registration is not necessary in the public interest or for the protection of a class of franchisees or due to the investment or due to the limited character of the offering. Hawaii's administrator may exempt any transaction, person, firm, corporation or industry and will consider if the disclosed information would be material in determining whether the prospective franchise has a reasonable chance of success and if the exemption is in the public interest.(35)

The discretionary exemption can be useful in situations where the franchisor does not qualify for an experienced-franchisor exemption or a sophisticated-investor exemption due to some quirk in the law or the absence of the exemption in the state. The discretionary exemption is also helpful when the franchisor sells franchises in an industry which should be exempt due to the method of doing business in that industry or the large initial investment of the franchisee. For example, the hotel industry is generally one which supports only sophisticated investors and could be a good candidate for a discretionary exemption.

State administrators generally do not issue discretionary exemptions quickly. Franchisors usually must apply in writing for the exemption and submit a fee to the state.(36)

The franchisor could wait weeks or months to obtain the exemption.

D. Federal "Discretionary" Exemption.

As described above, the FTC Rule permits a franchisor not to provide disclosure to prospects if the relationship between the parties is exempt or excluded from the disclosure requirements as defined in the FTC Rule.(37)

However, federal laws permit a franchisor to either petition the FTC or to seek an informal staff advisory opinion from the FTC if the franchisor believes the FTC Rule should not apply to the franchisor.

The FTC may prescribe rules which define with specificity acts or practices which are unfair or deceptive acts or practices in or affecting commerce.(38)

One of those rules is the FTC Rule.(39)

Any person to whom the FTC Rule applies may petition the FTC for an exemption from the FTC Rule.(40)

If, on its own motion or on the basis of a petition, the FTC finds that the application of a rule to any person or class of persons is not necessary to prevent the unfair or deceptive act or practice to which the rule relates, the FTC may exempt the person or class from all or part of the rule. Section 553 of 5 U.S.C. applies to the action.(41)

Franchisors may petition the FTC for an exemption from the FTC Rule requirements if they believe that they, or the type of franchise they offer and sell, or the type of investors they seek, should not be under the aegis of the FTC Rule. Obtaining an exemption in this manner may be time-consuming and costly and is unlikely to be practical for a single franchisor.

A franchisor may seek an informal staff advisory opinion by submitting a request to the FTC.(42)

The request must include all the information that the franchisor and the FTC believe necessary for the FTC to formulate a response. The FTC assumes the supplied information is accurate. After the FTC reaches its opinion, it provides a written response to the franchisor. The response is also published in the Business Franchise Guide (CCH). The informal staff advisory opinion is generally less time-consuming and costly than a petition to the FTC for exemption.(43)

III.POLICY UNDERLYING EXEMPTIONS

It is surprisingly difficult to obtain consensus concerning the purpose of federal and state franchise registration and disclosure laws. For example, while the Statement of Basis and Purpose of the FTC Rule(44)

summarizes extensive testimony about abuses visited by franchisors on unsuspecting franchisees, the International Franchise Association continues to assert that abuses are rare and the need for legislation unconvincing.(45)

The FTC and Congress continue to study both proposals that would radically increase and other proposals that would radically reduce franchise regulation.(46)

The FTC Statement of Basis and Purpose recites many examples of alleged instances of abuse by franchisors of ill-informed or unsophisticated franchisees. The FTC took the position in promulgating the FTC Rule that franchisors generally have greater bargaining power than franchisees. This greater bargaining power was found to be due to both greater financial resources and also to greater knowledge.(47)

As seen above, however, the FTC also realized that in certain circumstances, franchisors did not have greater bargaining power than franchisees. The result was promulgation of a variety of exclusions and exemptions. In discussing the reason for one of these exemptions, the fractional franchise exemption, for example, the FTC stated:

The franchisee's prior experience and his relative lack of dependence on the sales of the franchised goods substantially reduce the franchisee's reliance on the franchisor … .(48)

Unfortunately, however, these FTC exemptions did not completely succeed in restricting the scope of the franchise laws only to those franchisees in need of protection due to disparity in bargaining power. There are three reasons for this failure of the present FTC exemption regime, in our opinion:

1. the exemptions fail to address directly the issues of disparity in bargaining power, lack of information, or lack of financial resources;

2. the exemptions do not coordinate or provide a rational scheme. For example, a "leased department" may also be a "fractional franchise" and may also be a "single trademark license"; and

3. the states have not always followed the FTC lead and have crafted their own patchwork quilt of exemptions, as discussed above.

At the state level, the inconsistencies are even more disconcerting. As seen from the discussion above, there are literally dozens of types of exemptions and subtypes of exemptions, with inconsistent provisions. As a result, in our opinion, the exemptions are underutilized and inadequate for the job. For example, the authors' telephone polls to Illinois and New York indicate that less than twenty franchisors have an exempt status in each state while over five hundred have registered. The diversity in numbers may reflect the type of exemptions permitted in the states or the ease with which the franchisor can obtain an exemption.(49)

There does not appear to be any logical justification for this inconsistency. The preambles and legislative history related to many state franchise laws discuss problems that are similar from state to state. The franchise industry is clearly national in scope, having as its roots the mobility of the American population and the desire for consistent, quality standards at the franchisee level.

Great strides have been made recently to make state registration and disclosure requirements more uniform. For example, a new uniform franchise offering circular has been adopted. Greater cooperation of state franchise administrators has virtually eliminated the need for state-specific disclosures in the body of the offering circular. Now, franchisors typically can make these disclosures by state addenda. Finally, state administrators recognize the reality that many, if not most franchisors, intend to market their franchises in multiple states.(50)

Unfortunately, however, there has been no similar progress made regarding uniformity in exemptions. The National Conference of Commissioners on Uniform State Laws (NCCUSL) has proposed a uniform notice filing and disclosure statute, with uniform national exemptions.(51)

NCCUSL is responsible for many successful uniformity projects, including the Uniform Commercial Code, and has a remarkable record in convincing states to adopt its proposals. But unfortunately this proposal has not been favorably received by any state legislature to date. The North American Securities Administrators Association (NASAA) also promulgated a Model Franchise Investment Act in 1990, with proposed uniform national exemptions.(52)

No state has adopted this Act.

We also may seek guidance from the securities laws. The trend for the last decade in the securities laws is to increase the scope and uniformity of exemptions. These exemptions are analogous to those which exist in the franchise laws, but are much more consistent nationally than those found in the franchise laws. For example, Regulation D of the federal securities laws includes an exemption from all registration and disclosure for sales of securities aggregating under one million dollars to "accredited investors."(53)

Accredited investors include certain types of institutional investors, as well as natural persons with net worth exceeding one million dollars or individual income in excess of two hundred thousand dollars. Accredited investors also includes any director, executive officer, or general partner of the issuer. An issuer offering or selling securities in reliance on Rule 504 of Regulation D need only file with the Securities and Exchange Commission (SEC) five copies of a notice on Form D no later than fifteen days after the first sale of securities.

We do not believe that it is accidental that the NCCUSL and NASAA proposals for uniform exemptions more closely resemble the securities laws than either the present FTC Rule or any state franchise statute. The focus of these securities exemptions is on the knowledge and bargaining position of the investor, and the investor's ability to withstand a loss of its investment.

IV.TOWARD AN IDEAL NATIONAL UNIFORM
EXEMPTION FOR KNOWLEDGEABLE INVESTORS

We think it inevitable that the FTC and the states will evolve to broader and more uniform exemptions for investors who do not suffer from a lack of bargaining power vis-a-vis their franchisor. In the interests of adding to that process, we propose here language of a uniform national exemption scheme. We focus on exemptions for sophisticated franchisees and do not mean by omitting a proposal for other exemptions to suggest that we would favor the repeal of existing exemptions. But, in fact, many of the myriad exemptions which now apply in various jurisdictions may be rendered superfluous if a uniform standard were adopted.

Our proposal, which we acknowledge borrows heavily from the Model Franchise Investment Act and the Uniform Franchise and Business Opportunities Act, both discussed above, is as follows:

An offer or sale of a franchise is exempt from all registration and disclosure rules if it is:

1. To (i) a current or former (within 7 years) officer, director, partner, general manager, principal or affiliate of the franchisor (or of an affiliate of the franchisor) for that person's(54) own account; or (ii) a current or former (within 7 years) employee of the franchisor (or of an affiliate of the franchisor) with managerial, training, or sales responsibility with respect to franchises for that person's own account;

2. To a person who has had (directly or through one or more affiliates, employees or agents, or employees or agents of any affiliate) two or more years of experience (within the past seven years) in managerial positions in a business similar to the franchised business;

3. To an "Accredited Investor" as defined in Regulation D of the U.S. securities laws promulgated by the SEC, as it existed on January 1, 1996;(55)

4. To a person who (i) intends to invest more than two hundred fifty thousand dollars in the franchised business and (ii) has such knowledge and experience in financial and business matters that the person is capable of evaluating, either alone or together with legal counsel, the merits and risks of the franchise;

5. To a person who is a member of a bona fide cooperative.

6. To an existing franchisee of an additional franchise that is substantially the same as the franchise that the franchisee has operated for at least two years at the time of the offer or sale;

7. By a franchisee who is not an affiliate of the franchisor for the franchisee's own account if the franchisee's entire franchise is sold and the sale is not effected by or through the franchisor;

8. By the franchisor of a franchise agreement containing negotiated changes to a previously-delivered franchise agreement, if those negotiations were either proposed by the prospective franchisee or are in the aggregate beneficial to the prospective franchisee;

9. By a franchisor in a situation that the franchise administrator of this jurisdiction by rule, order for informal no-action or advisory letter exempts, because registration or disclosure is not necessary or appropriate in the public interest or for the protection of prospective franchisees. The administrator will respond to requests for this no-action letter within 15 business days of the request, and will make all previously issued no-action letters available to the public upon reasonable request and payment of reasonable costs.

The foregoing exemptions would be to both registration and disclosure. The only filings that would be necessary to claim and retain the exemption would be an initial and annual filings. The initial filing would be made no later than fifteen days after the first sale of an exempt franchise, which would be a notice filing only, without a copy of offering documents, sufficient to identify the exemption claimed. Thereafter a similar notice would be required to be filed annually, again simply identifying the exemption claimed and the party claiming it. Filing fees would be appropriate to the minimal costs involved in processing these notices.

There should be additional exemptions focusing on the experience of the franchisor or seller of the franchise. These exemptions would be from registration, but not from disclosure. The policy reason is that experienced franchisors, after having sold their initial franchises under the supervision of a registration process, could be trusted to maintain full disclosure without annual merit review. Only an initial and annual notice filing would be required. The exemptions from registration, but not disclosure, would be:

1. The offer or sale of a franchise by a franchisor with a five million dollar net worth (or where a franchisor's affiliate that guarantees the franchisor's obligations to its franchisees has a five million dollar net worth), and with (i) at least twenty-five franchisees (or "company" outlets in the same industry) at the time the initial and each annual exemption notice is filed, or (ii) with at least five franchisees, all of whom have been in business for at least two years;

2. The offer or sale of a franchise that is an "isolated sale," defined as a sale (i) by a franchisor who has sold no more than one franchise in this jurisdiction within the preceding twelve months, and (ii) who does not publish an advertisement for that franchise, and (iii) the buyer is represented in the transaction by legal counsel independent of the franchisor;

3. The offer of a franchise pursuant to an offering circular that has been submitted to a regulator for amendment or renewal of an existing registration, if before the sale the franchisor: (i) obtains the regulator's approval of the amendment or renewal and (ii) provides the newly-approved offering circular to the prospective franchisee for the applicable ten business day period.

Until the adoption of a sensible, uniform national exemption scheme, franchisors in the U.S. must face the ongoing reality of significant compliance costs, even if bargaining power rests with the franchisee, not the franchisor. As the court in Continental Basketball Assn. found, this is not what the drafters of franchise legislation would have intended.

Mr. Duvall is a shareholder and co-chair of the Franchise Team at Graham & Dunn in Seattle, Washington. Ms. Mandel is of counsel to Graham & Dunn.

Endnotes

1. . See infra notes 53 and 55 and accompanying text (discussing securities).

2. . Bus. Franchise Guide (CCH) 10,961 at 28,365 (Ind. Sup. Ct., June 26, 1996). The case also raised issues under Indiana's relationship law. Although the Article does not directly address exemptions from franchise relationship legislation, certain of the policy issues are similar.

3. The term "experienced franchisor" is somewhat of a misnomer. Most states that grant this exemption
permit either the franchisor or its parent to be experienced. Experience may be in the form of (i) actual
operation of the same type of business as franchisees will operate or (ii) franchising the operation of the same type of business. New York does not require experience yet permits this type of exemption. See discussion.

4. The authors do not include a discussion of specific industry exemptions such as those for wholesale
distributors of petroleum products, motor or recreational vehicles, farm machinery, or cable franchises.

5. Cal. Corp. Code § 31101; Ind. Code § 2-2.5-3; Md. Regs. Code tit. 02, § 02.02.08.10(D); N.Y. Gen. Bus. Law §§ 684.2 and 684.3(a); N.D. Cent. Code § 51-19-04.1; R.I. Gen. Laws § 19-28.1-6(a); S.D. Codified Laws § 37-5A-12; Wash. Rev. Code § 19.100.030(4); Wis. Admin. Code § SEC 32.05(1)(c), and Wis. Franchise Bulletins No. 2, located in Bus. Franchise Guide (CCH) 5490.56 (June 22, 1994). Note that Wisconsin's recent conversion from a registration review state to a notice state before sale may affect a franchisor's ability to obtain any type of exemption.

6. New York, alone, does not include an experience component in either of its two experienced-franchisor exemptions, but does require certain disclosures about the franchisor's affiliates in one of its alternatives.

7. 16 C.F.R. §§ 436 et seq. (effective October 21, 1979), Bus. Franchise Guide (CCH) 6080.

8. Some states permit the franchisor to use consolidated financial statements. North Dakota, Rhode Island, and South Dakota require a minimum net worth of ten million dollars. One of New York's alternatives demands at least a fifteen million dollar net worth.

9. Rhode Island, South Dakota, and Wisconsin accept the parent's net worth alone if the parent guarantees the franchisor's performance. In one of its alternative provisions, New York requires the franchisor to have a three million dollar net worth.

10. See also Wis. Admin. Code § SEC 31.01(1) which permits commingling of company- and
franchisee-owned businesses for the count of twenty-five. Wisconsin did not update its regulations at the time it revised its franchise statute. The statutory reference in this regulation no longer exists and it is unlikely this regulation applies to Wis. Admin. Code § SEC 32.05(c)(3).

11. See Kaufmann, Mergers, Acquisitions & LBOs: Beware the Disappearing 'Experienced Franchisor'
Exemption from Registration, 11 Franchise L.J. 63 (1992); Rudnick & Miller, The 'Experienced Franchisor' Exemption from Registration is Quite Durable, Even When the Exempt Franchisor is Acquired, 12 Franchise L.J. 71 (1993); Kaufmann, The 'Experienced Franchisor' Exemption from Registration – Proceed with Great Caution, 12 Franchise L.J. 107 (1993); Rudnick & Miller, and Kaufmann, Letters to the Editor, 13 Franchise L.J. 106 (1994).

12. In some cases, the required disclosure is less than the disclosure required under the UFOC Guidelines (see infra note 50) and the FTC Rule, 16 C.F.R. §§ 436 et seq.

13. See, e.g., MD. Regs. Code tit. 02 § 02.02.08.10.D.

14. Franchisors may not experience any time saving in states that review offering circulars submitted as part of an exemption application.

15. Cal. Corp. Code § 31106 (effective January 1, 1997); Haw. Rev. Stat. § 482E-4(a)(6) (there is actually some confusion about whether the exemption is from disclosure only or also registration of the franchise with the State); Md. Code Ann., Bus. Reg. § 14-214(b); N.Y. Gen. Bus. Law § 684.3(d); R.I. Gen. Laws § 19-28.1-6(e); Wash. Rev. Code § 19.100.030(6); Wis. Admin. Code § SEC 32.05(1)(f).

16. Mich. Comp. Laws §§ 445.1506(1)(g) and 445.1506(2).

17. Or. Admin. R. §§ 441-325-030(3) and 441-325-050.

18.Oregon exempts the franchisor from providing disclosure to prospects under any circumstance if the
franchisor is exempt under federal law. Or. Admin. R. § 441-325-030(1).

19. Rhode Island and Washington permit an exemption for the offer and sale of a franchise to a person who has been an officer, director, partner, or affiliate of the franchisor. R.I. Gen. Laws § 19-28.1-6(c); Wash. Admin. Code § 460-80-108(4).

20. Cal. Corp. Code § 31018(c); Haw. Rev. Stat. § 482E-4(a)(5) (there is some confusion about whether this provision applies only to disclosure or to registration exemption as well); Ill. Comp. Stat. ch. 815, § 705/7; Ind. Code § 2-2.5-1(g); Md. Code Ann., Bus. Reg. § 14-203(c); N.Y. Gen. Bus. Law § 681.11; N.D. Cent. Code § 51-19-02.14.a(2); R.I. Gen. Laws § 19-28.1-6(f); Wis. Stat. § 553.03(8r) and § 553.03(11).

21. Mich. Comp. Laws § 445.1506(1)(e); Or. Rev. Stat. § 60.005(8) and Or. Admin. R. § 441-325-030(2).

22. California's exclusion of renewal franchises from the offer and sale definition additionally contains the proviso that a material modification of an existing franchise, whether on renewal or not, is a sale. The recent revisions to Cal. Corp. Code § 31125 exempt certain material modifications from the registration and disclosure requirements.

23. 16 C.F.R. § 436.2(k).

24. Cal. Corp. Code § 31106 (effective January 1, 1997); Ind. Admin. Order 84-0097 AO, (1984) - the Indiana exemption is actually an isolated sale exemption which requires the purchaser, investor or franchisee to be a sophisticated investor who has had the benefit of legal counsel or other experts regarding the proposed transaction and the application for exemption from registration; Md. Regs. Code tit. 02 § 02.02.08.10.E; R.I. Gen. Laws § 19-28.1-6(d); Wash. Rev. Code § 19.100.030(5) and Wash. Admin. Code § 460-80-108; Wis. Stat. § 553.235. Minnesota requires additional registration and disclosure requirements if the franchisee makes an initial, unfinanced investment in excess of two hundred thousand dollars. Minn. R. §§ 2860.8100-8300.

25. This requirement could eliminate nearly all conversion franchisees.

26. R.I. Gen. Laws § 19-28.1-6(c); Wash. Admin. Code § 460-80-108.

27. The FTC Rule contains a number of other exemptions and exclusions including minimal investments, purely oral agreements, employer-employee relationships, general business partnership relationships, relationships among members in a retailer-owned cooperative, and testing or certification service relationships. See 16 C.F.R. §§ 436.2(a)(3) and (4) for a definition of the various exemptions and exclusions. Some of these other exemptions and exclusions are discussed elsewhere in this Article.

28. 16 C.F.R. § 436.2(h); Ill. Comp. Stat. ch. 815, § 705/3(1)(ii); Ind. Code § 2-2.5-1(a); Mich. Comp. Laws § 445.1506(1)(h); Minn. Stat. §§ 80C.01.18 and 80C.03(f); Va. Code § 13.1-559.B.

29. 16 C.F.R. § 436.2(a)(3)(ii); Ill. Comp. Stat. ch. 815, § 705/3(1)(i); Minn. Stat. § 80C.01.4(e); R.I. Gen. Laws § 19-28.1-6(i); S.D. Codified Laws § 37-5A-2; Va. Code § 13.1-559.B.

30. See, e.g., Cal. Corp. Code § 31102; Haw. Rev. Stat. § 482E-4(a)(7); Ill. Comp. Stat. ch. 815, § 705/7; Ind. Code § 2-2.5-4; Md. Code Ann., Bus. Reg. § 14-214(c); Mich. Comp. Laws § 445.1506(1)(i); Minn. Stat. § 80C.03(a); N.Y. Gen. Bus. Law § 684.5; N.D. Cent. Code § 51-19-04.2; Or. Admin. R. §§ 441-325-030(4) and 441-325-040; R.I. Gen. Laws § 19-28.1-6(b); S.D. Codified Laws § 37-5A-13; Wash. Rev. Code § 19.100.030; Wis. Stat. § 553.23; 16 C.F.R. § 436.2(k).

31. See infra note 44, Statement of Basis and Purpose of FTC Rule, at 6352. Michigan, New York, and Oregon require either offering circular disclosure or access to the franchisee's books and records.

32. Minn. Stat. § 80C.03(e) and Minn. R. § 2860.0200 - no more than one sale in any twelve months; N.Y. Gen. Bus. Law § 684.3(c) - no more than two persons and only if the franchisor is domiciled in New York; Wash. Rev. Code § 19.100.030(4)(b(ii) - no more than three franchises located in Washington and none elsewhere.

33. 16 C.F.R. § 436.2(a)(4)(iv).

34. Cal. Corp. Code § 31100; Haw. Rev. Stat. § 482E-4(b); Ill. Comp. Stat. ch. 815, 705/9 and Ill. Gen. R. & Reg. 14.A.II §§ 200.200 and 200.201; Ind. Code § 2-2.5-5; Md. Code Ann., Bus. Reg. § 14-214(b)(3) and Md. Regs. Code tit. 02 § 02.02.08.10.G; Minn. Stat. § 80C.03(g) (this exemption may apply on a specific transaction basis only); N.Y. Gen. Bus. Law § 684.1; N.D. Cent. Code § 51-19-04.3; R.I. Gen. Laws § 19-28.1-6(j); and, Wis. Stat. § 553.25. (In a November 1996 telephone conversation, the Wisconsin franchise administrator
expressed doubt that the State would grant a discretionary exemption due to the State no longer reviewing
offering circulars.) South Dakota's law appears to exempt only certain disclosure, not registration. The
director may provide that information need not be included by any class of franchisors if he finds the
information is inappropriate to the class and that disclosure adequate for protection of prospects is
otherwise included in the offering circular. S.D. Codified Laws § 37-5A-31.

35. As with the other Hawaii exemptions, it is not clear whether the exemption is only from disclosure or also
registration.

36. See Ill. Gen. R. & Reg. 14.A.II § 200.201 for an example of the in-depth information the franchisor must
submit to the State to obtain a discretionary exemption order.

37. The franchisor may still be required to provide disclosure and to register its franchise offering circular
under certain state laws.

38. 15 U.S.C. § 57a(a)(1)(B).

39. 16 C.F.R. §§ 436 et seq.

40. 15 U.S.C. § 57a(g)(1). See Garner, Franch. & Distr. Law & Prac. § 5:20 (1990).

41. 15 U.S.C. § 57a(g)(2).

42. See generally, FTC Interpretations, Bus. Franchise Guide (CCH) 6380.

43. See section III of this Article for the discussion regarding a federal exemption for sophisticated
investors.

44. Statement of Basis and Purpose of FTC Rule, 43 Fed. Reg. at 59,621-59,733 (Dec. 21, 1978), Bus.
Franchise Guide (CCH) 6310-6314.

45. See, e.g., Franchise Legal Digest (IFA) No. 1, at 1 (Winter 1994).

46. Id.

47. Statement of Basis and Purpose, supra note 44, Bus. Franchise Guide (CCH) 6309, at 9230 and at 9214
notes 27-31.

48. Id., 6350, p.9359.

49. In fact, we counted over one hundred exemptions that exist in the twelve registration states and
Michigan, Oregon and Wisconsin! While some of these exemptions are similar from state to state, very few
are identical.

50. Uniform Franchise Offering Circular Guidelines, April 25, 1993, by North American Securities
Administrators Assn., Bus. Franchise Guide (CCH), 5900. See also State Specific Project, Bus. Franchise
Guide (CCH), 5826, 1989.

51. Uniform Franchise and Business Opportunities Act, Bus. Franchise Guide (CCH) 3600 (Aug. 7, 1987).
The proposed uniform exemptions are as follows:

1. A sale by a franchisor who has sold no more than three franchises, without general
advertisement, and the buyer is represented by independent counsel.

2. A sale to a franchisee that has experience in the line of business in which the franchise will
be operated and the franchise will be a fractional franchise.

3. An offer to an officer, director, partner, principal, or affiliate of the franchisor, and the offer
is not pursuant to a public offering.

4. A sale approved by a bankruptcy court.

5. A sale to a government agency.

6. A sale by a franchisee not effected by or through the franchisor.

52. Model Franchise Investment Act, Bus. Franchise Guide (CCH) 3700 (Aug. 30, 1990). The exemptions
from registration contained in that Act include:

1. Large franchisor exemption.

2. Franchisee resale exemption.

3. Offer or sale of a franchise to a person who has been for at least two years an officer,
director, partner or affiliate of the franchisor.

4. Offer to a wealthy and sophisticated investor.

5. Offer of a second franchise to an existing franchisee.

6. Renewal of a franchise.

7. De minimis fee exemption.

8. Offers by certain institutional franchisees.

9. Offers which occur during the pendency of renewal and amendment registrations.

10. Offer to a department or division of a retail establishment.

11. A discretionary exemption.

53. 17 C.F.R. § 230.51, Regulation D, Rule 501, which provides in part:

(a) Accredited Investor. Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:

(1) Any bank as defined in Section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in Section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to Section 1 of the Securities Exchange Act of 1934; any insurance company as defined in Section 2(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in
Section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under Section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a State, its political subdivisions, or any agency or instrumentality of a State or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in Section 3(21) of such Act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited
investors;

(2) Any private business development company as defined in Section 202(a)(22) of the Investment Advisers Act of 1940;

(3) Any organization described in Section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

(4) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;

(5) Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000;

(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

(7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and

(8) Any entity in which all of the equity owners are accredited investors.

54. The terms "person" and "affiliate" would be defined similarly to the way they are currently defined in existing franchise and securities laws, and would include individuals and entities.

55. See supra note 53.

For Review, see FTC “Table of Commenters”
http://www.ftc.gov/bcp/franchise/comments/tabcomm.htm


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