Franchising Still Fraught With Pitfalls Despite New FTC Rule

Ever since Ray Kroc flipped his first hamburger and launched what eventually became the McDonald's restaurant chain, an untold number of small business owners have adopted the same franchising model, or bought into an existing franchise operation.

Today, thanks largely to the Internet, franchise opportunities have exploded in number; you can choose from more than 3,500 offerings. But it's still largely a "buyer beware" business, despite the involvement of government regulators, trade associations, more than 1,600 franchise attorneys, and thousands of franchise "consultants."

"It's incumbent upon the buyer to know what they're getting into, yet very few people understand what's happening and tons of lives have been ruined through bad investments," says Nick Bibby, who heads The Bibby Group, a franchise consulting firm in Shreveport, La., and also writes on the subject for AllBusiness.com.

The Federal Trade Commission (FTC) has regulated franchising since the late 1970s, when it set forth what's come to be known simply as the franchise rule. Central to the rule was the Uniform Franchise Offering Circular (UFOC), a document designed to help individuals conduct thorough due diligence before buying a franchise.

Last January, the agency released a revised rule after a decade of deliberation that is supposed to bring the circular up to date. Now called a Franchise Disclosure Document (FDD), it became effective in July. For now, franchisors can choose to follow either rule until the FDD becomes permanent next year. For all the effort, however, the FDD has drawn mixed reviews, at best, from franchisees.

While it addresses some problems, critics say it also creates new headaches. Worst of all, they add, the rule still fails to address several long-standing concerns. First and foremost: The army of brokers and consultants who offer to help guide franchisees and/or franchisors through the complicated process.

The International Franchise Association, the industry's largest trade group, which largely represents franchisors, offers a "Certified Franchise Executive" program. But brokers are unregulated and require no formal training. These days, the Internet is loaded with their advertisements, claiming to offer "free" consulting services. In fact, they are more than likely collecting a commission from the franchisor.

"When the system is built in such a way that the broker gets the money from the franchisor, you can't predict what's going to happen," says Dan Sniegowski, who launched the Web site Bluemaumau.org two years ago so franchisees could network and keep up with the latest industry developments.

Critics say this is one of the areas where the FTC has actually made it harder to conduct due diligence. Unlike the UFOC, the new rule no longer requires franchisors to disclose the brokers they use or their backgrounds, which previously had to include criminal convictions and the number of times they had been sued.

The FTC also chose to concentrate its enforcement efforts on pre-sale franchise disclosure issues, when most of the problems encountered by franchisees occur post-sale, according to Susan P. Kezios, president of the American Franchisee Association, a Chicago-based group that solely represents franchisees.

A case in point involved 12 Quiznos franchisees who sued the parent company for fraud. The sandwich store owners accused Quiznos of gouging them because they were required to buy food, supplies, and other services at high prices from approved vendors who paid kickbacks to Quiznos. To make matters worse, the franchise company ordered store owners to lower retail prices on their subs, crushing their margins.

But Wisconsin Federal District Court Judge William Griesbach ruled this week that the group's UFOC agreement clearly allowed Quiznos to charge markups and receive payments from vendors without restrictions. He dismissed the case. "They didn't understand all of the ramifications of the agreement. Then, they get two or three years down the road, and they get in trouble," says Sniegowski.

Today, there are more than 800,000 franchisees across the country, and entrepreneurs are making a good living as franchise operators. And, because franchises are usually based on proven concepts, they can involve less risk than starting a business from scratch. But the caveat still applies: Buyer beware.