The Federal Trade Commission (FTC) published a notice requesting comments on its trade regulation rule government the disclosure requirements associated with the sale of franchises as part of its periodic review of rules. This series of columns features excerpts from the U.S. Small Business Administration Office of Advocacy’s response to that request.
Most new enterprises, especially if they are seeking financing, must have business plans which specify cash flow and income. Since the largest portion of revenue for franchisors generally is royalty payments, a new franchisor would have a good estimate of the total royalty payments expected and the number of units to be established during the year. As a result, these franchisors have an excellent idea of projected earnings, probably on a per unit basis.
The FTC could require franchisors to disclose their estimated projected earnings per unit to the franchisee. Again, the franchisor would have to alert the franchisee that these are only estimates and might not represent actual earnings by franchisees. Furthermore, franchisors should disclose to franchisees that the FTC maintains disclosure documents on systems in the same industry and advise them to examine those as a comparison.
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Existing enterprises have a track record for their operations and probably have that broken down on a per unit basis. This historical information, if disclosed in a manner identical to that for historical franchisee information, could prove a useful substitute for actual franchisee experience. However, company operations may take advantage of scale economies not available to individual franchisees. Thus, the experience in franchisor-operated units, while instructive, is far less helpful than historical franchisee data.
Jere W. Glover is the Chief Counsel for Advocacy at the U.S. Small Business Administration Office for Advocacy. His response to the FTC’s request for comments was prepared in conjunction with Barry Pineles, Assistant Chief Counsel.
Should the FTC decide to permit utilization of company-owned stores for new franchisors, a disclaimer must alert the franchisee that the potential earnings may be different, and the franchisee should take into account such factors as royalty fees and differences in operating costs.
New franchisors should provide potential franchisees with information on earnings even if it does not have the credibility of historical franchisee data. Any of the aforementioned proxies for historical earnings claims of franchisees would provide prospective purchasers with some guidance concerning earnings. And in the opinion of the Office of Advocacy, some information is better than none at all.
Franchisors who provide earnings disclosure through one of the proxies already discussed should be obligated to disclose earnings information in the format recommended by the Office of Advocacy as soon as that is feasible. Franchisors should be prepared to disclose historically-derived earnings claims at the commencement of the second full year of operation for any franchisee. Franchisors must be prepared to provide franchisees with a note of caution that the results are still too new to be of great accuracy.
The Commission seeks comment on whether small franchisors should be exempt from the earnings disclosure requirements. The FTC is concerned that the collection of information and its analysis may pose an undue burden on small business. As these comments have already discussed, small franchisors, however that number is determined, should be able to provide meaningful disclosure of earnings.
The only potential problem for small franchisors is to provide that information on a geographically relevant basis. As a general proposition, small franchisors will not have geographically historical information. Nor are such franchisors likely to have as much information on sites with similar conditions as a large franchisor. Therefore, the geographic information that small franchisors can provide prospective franchisees will be more speculative than large franchisors. As a result, the Office of Advocacy does not believe that small franchisors should be required to disclose geographic relevant information if it is not available. However, to the extent that a small franchisor has historical data from franchisees for a particular geographic region, that information should be made available as part of the earnings disclosure.
Franchisees must consider such factors as royalty fees and operating costs.
The White House Conference on Small Business supported enactment of H.R. 1717, a bill introduced by Representative LaFalce to promote greater fairness and equity in franchise relationships, particularly in the post-disclosure phase of the relationship. The bill would achieve this objective by modifying the existing legal status of the relationship between franchisors and franchisees.
Among other things, the bill would restrict franchisors from terminating franchisees without good cause, would prohibit franchisor-owned stores from encroaching on the territory of franchisees and would require successors to the franchisor to assume the obligations of the franchisor. Each of these areas has been the subject of heated debate, litigation, and, in some cases, state statutory solutions.
The Office of Advocacy believes that an administrative solution to the disputes between franchisors and franchisees should be attempted before legislation is enacted. The FTC’s review of the disclosure requirement might be an opportune time for the Commission to explore other aspects of the franchisor/franchisee relationship.
FTC HAS THE POWER
The Commission determined that the failure to provide the disclosure, as outlined in Part 436 of its rules, was an unfair and deceptive trade practice. The Office of Advocacy believes that the Commission has the power to consider other aspects of the franchisor/franchisee relationship to be unfair or deceptive trade practices and write appropriate regulations if needed to prevent such unfair and deceptive trade practices.
The FTC should not be dissuaded from investigating the utility of writing trade regulation rules for other aspects of the franchise relationship simply because they are covered by state law. The courts that have addressed the issue have found that the Commission has the authority to draft trade regulation rules that otherwise would be left to the states to address. Therefore, the commission has the authority to draft rules which historically have been the subject of state regulation, as long as the rules meet the specificity standard of Section 18.
The Office of Advocacy, however, does not believe that the Commission should conduct conventional rule-making. Rather, it should use a negotiated rule-making process in which the franchisors and franchisees are brought together to find a common solution to their post-disclosure problems.
Failure to produce disclosure is an unfair and deceptive trade practice.
The Office of Advocacy recognizes that a substantial amount of animosity exists between franchisors and franchisees but notes that the Environmental Protection Agency, for example, has used negotiated rule-making in which environmental groups and industry have agreed on appropriate solutions. If these groups can find common ground, franchisors and franchisees, under the aegis of the FTC, should be able to do the same. After all, and unlike environmental groups and industry, franchisors and franchisees do have one thing in common—the desire to make money. Even if the negotiated rule-making falls through, it would provide a sound record, as opposed to anecdotal information, upon which Congress could consider legislative changes.