Business Law Notes
Spring 2008 Edition
The Federal Trade Commission’s Franchise Rule is probably the single most important legal pronouncement affecting franchising. A major rewrite of the Rule became effective on a voluntary basis on July 1, 2007 and becomes mandatory nationwide on July 1, 2008. One of the pro-franchisor innovations of the new Rule is the creation of a class of “sophisticated investors.” If you are a sophisticated investor, to a large extent you are on your own as far as the FTC is concerned.
The new Rule considers any prospective franchisee to be a “sophisticated investor” if the initial investment (excluding purchase of raw land and funds obtained from the franchisor) is $1 million or more. If your total expenses in the start-up phase (at least three months) are likely to be $1 million or more, you will find that you are exempted from the pre-contract disclosure protections of the FTC Franchise Rule. The estimated costs of opening two or more units will be aggregated, making it more likely that you will be considered a sophisticated investor. Also, regardless of the amount of the initial investment, investors who have been in business for five years and have a net worth of $5 million or more are considered sophisticated and able to protect themselves.
If the FTC considers you to be a sophisticated investor, it is essential that you act like one – conduct a thorough due diligence review of the franchise opportunity, including the following:
- Insist on receiving a Uniform Franchise Offering Circular (UFOC) even though it may not be a technical requirement that you receive one.
- Exercise even greater care than you normally would. Rights available to most franchisees arising from the initial sale of the franchise may not be available to you, substantially limiting your claims and defenses in the future.
- Document your requests for information and the franchisor’s responses and keep them with your permanent records. These documents could be critical if you ever have a dispute with the franchisor.
- Expect brokers or salesmen to coax you into estimating that your initial investment (including bank loans) will exceed $1 million and ask you to sign an acknowledgment to that effect. If you are borderline or do not expect your investment to exceed that amount, do not sign the acknowledgment.
- Thoroughly examine the financial feasibility of the franchise, including interviewing other franchisees, past and present, and obtaining the advice of a competent accountant or other business advisor.
- Have the franchise agreement reviewed by competent legal counsel before you sign. The typical franchise agreement today is a mine field for the unwary franchisee.
- Try to negotiate a better deal, especially relief from any overreaching contract terms. After all, if you are willing to invest over $1 million in the franchisor’s system, the franchisor should be willing to grant you at least a few concessions.
NOTE: A number of commentors on the proposed Rule, including the author, strongly urged the FTC to focus on the capabilities of the investor, rather than the size of the investment.
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