Legal Aspects of Franchise Law

Franchise law is simple and, at the same time, complex. The point is that there are both federal and state laws governing franchising. However, these laws are generally not uniform or consistent from state to state.

Basically, there are two general categories of laws regulating franchises:  (1) disclosure laws; and (2) registration laws.  There are also laws that govern the relationship between franchisors and franchisees and govern the grounds for terminating the relationship and/or renewing the relationship, as well as equal treatment of franchisees.

Disclosure laws regulate the following:

• the required pre-sale disclosures that a franchisor must provide to prospective franchisees;
• prohibited practices when franchising a business; and
• the mandatory cooling-off period before consummating a franchise sale.

Registration laws require:

• registration of the franchise;
• registration of persons that sell the franchise; and
• registration of advertising promoting the franchise.

Violation of franchise laws can result in governmental penalties, including fines, permanent bans on engaging in franchising, freezing of assets, money damages for victims, and even jail sentences. These governmental penalties can be assessed on the franchisor, and to its officers, directors, and managers who are involved in the formulation of the franchise or who direct or control the franchisor's activities. In certain cases, the violation of franchise laws can result in the cancellation of the franchise agreement and reimbursement of all fees paid to the franchisor.

The Federal Franchise Disclosure Law

The principal law governing what a franchisor must disclose to prospective franchisees is a federal law called the Federal Franchise Rule.  This rule provides that prior to offering or selling a franchise in any state, franchisors are required to provide to prospective franchisees a document setting forth certain disclosures about the franchise.  This document is referred to as the Franchise Disclosure Document (“FDD”). In certain states, franchisors are required to register the FDD with the state.  Federal law does not require registration of the FDD.

The following documentation is what is generally required to franchise a business:

1. Franchise Disclosure Document.- The franchisor and his or her lawyer must develop and prepare the FDD, which must contain and address the 23 different disclosure items mandated by the Federal Trade Commision ("FTC").
2. Operations Manual.- Just as important as the FDD is the Operations Manual for the franchise, which will be critical to the launch and operation of the franchise system. The Operations Manual is not a legal document and will not be disclosed to any governmental agency.  Moreover, it is a highly confidential document describing the details of the franchise system and how to operate the  business.  Nevertheless, the operations manual will be referred to in the FDD.
3. Financial Statements.- One of the fundamental aspects of franchising a business is the disclosure of financial statements of the company.  If the company is a startup and has only recently launched its operations and/or franchise system, then the financials will be very limited.  This is important because it should be kept in mind that at one point, the financial statements must be audited, although there is a short phase-in period that a startup franchisor is provided.

Requirements of the Franchise Disclosure Document

As discussed above, the FDD is a legal document that is provided to a prospective franchisee regarding the operation of a franchise.

The Basics of an FDD

Under federal franchise law, franchisors must provide prospective franchisees with any and all necessary information required for such prospective franchisee to make a well-informed decision as to whether or not to become a franchisee in the company.  This is done by providing the prospective franchisee with the FDD.

The FDD must be provided to the prospective franchisee no more than 14 days prior to signing the franchise agreement. The 14-day period begins when the prospective franchisee signs a receipt for having received the FDD. 

Information that Must be Included in the FDD

1. Business experience of the franchisor.
2. Litigation in which the franchisor is involved.
3. Bankruptcy filings involving the franchisor.
4. Initial fees to be paid by the prospective franchisee.
5. Other fees, such as annual or periodic fees to be paid by the franchisee.
6. Initial investment (including expenses) required to  launch the franchise.
7. Restriction on sources of products and services.
8. Franchisee's obligations when operating the franchise.
9. Financing agreements offered by the franchisor.
10. Franchisor's assistance, advertising, computer systems, and training that is offered to franchisees.
11. Territory to which the francisee is restricted.
12. Trademarks owned by the franchisor.
13. Patents, copyrights and proprietary information of the franchisor.
14. Obligation of the franchisee to participate in the actual operation of the franchise business.
15. Restrictions on what products and/or services the franchisee may sell.
16. Renewal, termination, transfer, and dispute resolution.
17. Public figures used in advertising and promotion and the compensation of the same.
18. Financial Performance of the franchisor and other franchisees.
19. Other Existing Franchisee OUtlets and performance of the same, as well as conctac information.
20. Audited Financial Statements  from the past three years.
21. Contracts that the franchisee will be required to sign.
22. Receipt for having received the FDD.

Registration Laws

The principal registration laws are state laws. While Federal Law provides an overriding franchise regulation framework, the following states require the registration of the franchisor’s FDD:

• California
• Hawaii
• Illinois
• Indiana
• Maryland
• Michigan
• Minnesota
• New York
• North Dakota
• Rhode Island
• Virginia
• Washington
• Wisconsin

In the foregoing states, franchisors must file and register their FDD prior to offering or selling a franchise.