F.T.C. Public Comment 4

Any investor is absolutely entitled to a reasonably authentic evaluation of the purchase, particularly the anticipated gross sales, gross profit, net profit, and time to reach the break-even level. Without such data, it is impossible for the buyer to project net profit (or its equivalent in wages), return on his investment, and ultimate capital value.

FTC.jpg

U.S. Federal Trade Commission
March 10, 1997

F.T.C. Public Comment
Harold Brown, attorney

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

Comment #4

March 10, 1997

Secretary
Federal Trade Commission
Room 159
6th St. & Pennsylvania Ave., NW
Washington, DC 20580

Attention Staff Contact: Steven Toporoff or Myra Howard

Re: 16 C.F.R. Part 436 FTC File No. 954402

Gentlemen:

This letter is in response to your request for public comment on possible revisions of the Franchise Rule.

Briefly, we have been intimately involved in franchise matters for close to thirty years. Attached is a copy of our extended biography that may be helpful in your considering our comments.

Notably, we were quite active in the proceedings that led to your adoption of the Rule in 1978, as
indicated in your Statement of Basis and Purpose.

Our comments address each of the following issues that are being considered:

A. Rule Revision Partially Based on Adoption of the Revised UFOC

1. I strongly urge the FTC to consider such revisions of its current rule.

2. My analysis of the Revised UFOC is contained in Chapter 3 of my book "Franchising: Realities and Remedies" (Law Journ. Sem. Press Rev. Ed. 1996), 161 pages.

3. My analysis of the FTC Franchise Rule is contained in the same book at pp. 1-52.

4. These reviews demonstrate that the Revised UFOC provides considerable improvement over the FTC Rule adopted almost 15 years earlier in 1978.

5. Conformity will provide perceived benefits to prospective franchisees and, indirectly, to all existing franchisees. The latter will occur partly because of the franchisor's need for as much uniformity as possible, both for managerial needs and to avoid claims of possible discrimination against existing franchisees due to improved treatment by the franchisor. The latter disparity will arise as a result of the impact of sunshine disclosure in the revised UFOC and simply as a matter of fairness to those existing franchisees who built the goodwill of the franchisor's system.

6. Conformity with the Revised UFOC will markedly help to reduce the cost of franchisor compliance by new, as well as established, franchisors.

7. My writing (see above) contains detailed criticism of certain portions of the Revised UFOC. These can be addressed by the FTC with probable benefit for both federal and state disclosure regulation.

8. As discussed below, I strongly favor compulsory disclosure of earnings data. That can be accomplished only by substantive directive. The FTC should also seriously consider the adoption
of certain other substantive regulations including without limitation:

a. The duty of good faith and fair dealing both in drafting the franchise agreement and in the franchisor's conduct in dealing with the franchises. It is wrong to allow franchisors to exclude this responsibility by drafting devices.

b. Protection of the value of the franchisee's capital asset, the franchised business, through use of he good cause standard for termination, renewal, transfer of ownership, and relocation.

c. Restriction on unreasonable encroachment.

d. Removal of restriction on purchases of goods and services where the prescription of standards and specifications would be enough.

e. Removal of restrictions on joinder and participation in the affairs of a trade association of franchisees or dealers within or without the franchise system.

f. Restriction on all post-term non-competition covenants except for the protection of genuine trade secrets.

g. Restriction on franchisor's unreasonable use of advertising funds, including choice of agency, content, placement, and cost.

h. Prohibition of all direct and indirect "kick-backs" from third party vendors for goods and services.

i. Prohibition of contract provisions and conduct in which the franchisee must surrender constitutional and other rights, particularly procedural matters like ubiquitous demands for general releases; distant choice of law; surrender of all or a major part of procedural protection such as time limits through statutes of limitation; Due Process and other limitations; and waiver of trial and other Rule safeguards.

j. In order to prevent confusion and eternal delays in adoption, conduct separate hearings on these substantive conduct rules.

B. Change the Applicability of the Rule to Business Opportunities

1. I am opposed to this if it means repeal; it is probable that a separate rule may be preferable.

2. Any change may create problems in several states like Connecticut, that already have Business Opportunity Laws which are broad enough to include product and service franchises. They grant a safe harbour exemption if there is presentation of an approved Pre-Sale Disclosure Prospectus. (See citation of such statutes in Appendix B(2) of "Franchising: Realities and Remedies," Law Journal Sem. Press, Rev. Ed. 1996, at p. B2).

3. The current requirement is very difficult for a putative violator in rack or vending machine sales etc. It therefore provides an additional state remedy under little FTC Acts, and is particularly useful where there is no Business Opportunity Law.

C. Applicability of Rule to Trade Show Operators

1. In view of several decided FTC cases, it is unnecessary to argue for the serious need of such regulation.

2. In addition to the direct operators, attention should be given to advertising, seminars, and other adjuncts that knowingly combine to deceive and defraud prospective franchisees.

D. Earnings Disclosure Mandate

1. I strongly support such a mandate.

2. Any investor is absolutely entitled to a reasonably authentic evaluation of the purchase, particularly the anticipated gross sales, gross profit, net profit, and time to reach the break-even level. Without such data, it is impossible for the buyer to project net profit (or its equivalent in wages), return on his investment, and ultimate capital value. Such principles are inherent in section 5(a) of the Act, as well as in numerous individual FTC cases, and should not be excluded from one of the most central and repetitive examples of its need.

3. The triggering device has inevitably led to gross violations because most franchise investors will not buy the franchise, invest large sums in the business, and devote a life-time of effort to an unknown bargain. There have therefore been endless variations of supposedly "indirect" franchisor representations of profitability, combined with the partially false statement in the prospectus that no profitability data has been conveyed. The deception has ranged from the proverbial notation on a napkin or envelope, to prearranged referrals to "typical" franchisees, to use of "company store" figures with plain implications of comparability, and to the required preparation of a "business plan" by the prospective franchisee and its "review" and "oral adjustment" by franchisor or personnel. It is time for the FTC to face reality and remove this unfair blemish of its own creation.

4. The current "triggering device" was probably a compromise on one of the principal issues that stalled the adoption of the Franchise Rule for over eight years from 1971 to 1979. Two decades of experience should now preclude the continuation of this untenable concession.

E. Marketing of Franchises, Especially Through International Sales and Through the Internet

1. The saturation of many local "capital" markets has been offset by a dramatic surge in the sale of franchises throughout the world. A very high percentage of those sales have been to area sub-franchisors who operate their own "company-owned" outlets and sell franchises to third parties.

2. There is a dramatic impact of such overseas sales upon the domestics family of franchisees. This occurs through discriminatory withdrawal of franchisor support within the United States; a large potential for foreign litigation against franchisors emanating from the unregulated sale of foreign franchises; petty distinctions involving the sale of such franchises to a United States resident for total use outside that territory as compared with sales to an entirely foreign entity; and to justified complaints against "products" (i.e. franchises) devised, made, managed, and sold in the United States.

3. Franchisors may seek to evade such regulation by creating and operating through independent entities entirely separated from the United States. Such problems should be addressed, but their
challenge should not control the major problem. The FTC undoubtedly has jurisdiction to regulate all conduct "in or directly related" to marketing factors within the United States.

4. The marketing use of the Internet is simply an extension of the FTC's jurisdiction over both domestic and foreign sales. One of the severe problems may involve the identification of the parties who improperly create the Internet material.

F. Miscellaneous Comments

1. The FTC should seriously review the adequacy of sec. 11A of the Revised UFOC which only requires a table that identifies each obligation of the franchisor together with the paragraphs of the
franchise agreement that spell out its terms. Such non-disclosure of about twenty important items, appears to offend the basic purpose of the disclosure statement, namely, to provide the prospective franchisee with a reliably complete description of what is being purchased. Contractual terms are wholly within the franchisor's discretion, but this provision obviously fails to give any reliable hint of the content of virtually every capital item. Because of that vacuum, the "disclosure" document can also mislead the prospective franchisee into believing that a governmental agency has prescribed the presentation of all of the important factors relevant to the purchase of the business, including the important "capital" matters.

2. The FTC should provide clear, express, and extended disclosure directions regarding the sale of sub-franchises where the buyer is granted the right to sell franchises in its own name or as an
agent of the franchisor. Those agreements may or may not require the buyer to open and maintain certain outlets of its own. Protection of the ultimate franchise buyer is the primary goal of the Rule, but it is equally applicable to the sub-franchisor as a purchaser-consumer. Further, the sufficiency of pre-sale disclosures to the sub-franchisor will provide the actual structure into which the ultimate buyer is entering and can be the most controlling factor of its existence.

3. Similar extended attention should be given to the sale of development territories in which the franchisee agrees to open a specified number of franchise units within a prescribed period. Such
deals are often offered to a new or existing franchise on the basis of supposed protection against encroachment. In fact, unless the complex financial and marketing factors are fully disclosed, the
buyer may be agreeing to a certain failure. The latter will occur where there has been inadequate investigation and disclosure of the capacity of the territory to sustain the number of prescribed
outlets within the prescribed time periods. Financially, such an undertaking by a franchisee may require millions of dollars, as compared with the already heavy onus of close to one million dollars for a single outlet. Such capital cannot realistically be obtained from net-tax dollars produced by the existing units. As for the franchisor, it cannot lose since its income is often obtained from the capital sale, the purchase of operating products, and from a royalty on gross sales regardless of the absence of net profits. In case of franchisee failure, the franchisor can recapture all of the units without any payment for equity and then operate or re-sell the complex to another buyer.

4. The disclosure of existing and projected sales of new franchises should be modified. They should also cover sales of sub-franchises and development territories, with disclosure of their failure rates and identification of past and present such franchisees as possible references for the prospective buyer of such a package.

5. Some attention should be given to the continued protection of existing franchisees. The statutory restrictions on the FTC's rule-making powers do not apply to enforcement through individual cases. A few cases in each category will have an equal or greater effect on the general franchise industry. Many substantive and procedural subjects fall within this category. To mention a few abuses, it would address contractual selection of venue and of applicable law; contractual demand of a general release for every conceivable event, even including a recommended transfer to the franchisee's new corporation; one-sided demands for arbitration; waiver of Due Process rights like excessively brief time bars, right to jury trial, confession of judgment, surrender of right to consolidate claims; and false arguments of alleged boycott where franchisees seek to negotiate jointly with their franchisor on "non-competitive" factors outside the antitrust laws.

6. It is also time for the FTC to apply sec. 5(a) to bad faith (i.e. the absence of good faith), reckless disregard for certain risks, stringing along, and similar wrongs where they are involved in franchise relationships. There is, of course, a logical extension of this effort to requiring a showing of good cause for any termination, non-renewal, rejection of transfer, rejection of relocation, rejection of right to mortgage the business, and other capital matters.

Overall Comment

Many states have discovered that pre-sale disclosure is necessary, but that it does not provide the fundamental protection to which a prospective franchisee is entitled. The FTC should not take the
position that alterations of the disclosure rule can ratify all demands against unfair or deceptive acts and practices. Before adoption of the Franchise Rule, the FTC entered many of the areas adumbrated in this submission. It is time that the Commission begin to address such issues through its activities in individual cases.

Sincerely,

Harold Brown

HB/ap

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


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Risks: F.T.C. Public Comments, Encroachment (too many outlets in area), Gouging on rent and equipment, Must buy only through franchisor (tied buying), Gouging on supplies, Advertising fund put into general franchisor's coffers, Secret kickbacks and rebates, Misrepresentations, United States, 19970310 Comment 4

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