Do Franchise Laws Really Protect Your Franchise Investment?
Franchise investors tend to look for ways they are protected by franchise investment laws. I have always thought, however, that protection is too strong a word to use when talking about the ways that the law regulates the offer and sale of a franchise. While franchise laws do some things very well, don’t expect that they will insulate investors from risk or protect investors from the harsh realities of the commercial marketplace.
At their best, franchise laws knock the sharp edges off the rougher parts of the franchise marketplace -- but that’s it. Investors in franchise concepts should never think that they are magically protected by some warranty or money-back guarantee. Indeed, the best protection for a franchise investor is to understand the franchise laws well enough to know the limitations of their “protections.”
Let’s look at those aspects of the franchise investment laws that truly assist the investor (the “Hits”) and the places where the laws fall a little short (the “Misses”).
Federal Law Hits: Franchise investment laws are very effective at delivering information about a franchise program. Since 1979, federal law has required franchisors to deliver a complete Franchise Disclosure Document (FDD), as prescribed by regulations, to the investor a few weeks before closing on the transaction. This is a huge improvement over the days before disclosure rules were put in place. Now a prospective franchisee receives a complete set of disclosure information about a franchise and about the franchisor -- before putting money on the table.
Federal Law Misses: There are one or two small ‘‘Misses’’ in the FTC’s franchise rules: First, the FDD is restricted to the information prescribed by the regulations -- it is not open-ended and cannot be substantially tailored to the particular franchise being offered. That fact of franchising life is important to know. The franchisor is simply following a cookbook of franchise regulations when creating an FDD, and is generally not free to include more information -- even if the franchisor thinks this information pertains to their program. Of course, franchise lawyers will tell you that franchisors should provide only the information that is “material” to the offering, so there is a tension between the information that’s included and what’s excluded.
A second “Miss” is the approach to what are now called “Financial Performance Representations” and what used to be called “Earnings Claims.” Without going into too much detail, franchisors have a choice as to whether to include information about the financial performance of their franchised stores. I think a good argument can be made that this is some of the most important information a prospective investor can possibly receive, and yet most franchisors simply leave it out, inviting prospects to talk to current franchisees if they have financial performance questions.
Finally, it is not a “Miss” as such, but investors need to know that the Federal Trade Commission does not see the FDDs issued by a franchisor. They are not filed, not reviewed, and they are not made publicly available by the agency. Franchisors comply with the federal franchise laws simply by developing and delivering a complete disclosure document to the investor.
State Law Hits: Some states began regulating franchise sales well before the FTC got involved in franchise regulation -- California adopted its law in 1971 -- and state regulations go considerably further than the FTC’s hands-off-the-marketplace, disclosure-only approach. More than a dozen states (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin) require franchisors to register on an annual basis and will actually review the disclosure documentation. These “franchise registration states” create a private right of action for a franchisee against a franchisor who violates the rules, and state authorities have powerful tools for investigating and prosecuting problems in the franchise arena. The “Hit” benefit: The franchise registration states keep a lot of bad actors out of the marketplace (at least in their states).
State Law Misses: Less than 30 percent of the states are among the “franchise registration states,” although these states cover nearly half of the U.S. population. So the availability of these protections will depend on where you happen to be. Another “Miss” is that the states make the documents publicly available, but -- with only one exception -- do not make them easily available online.
The exception: California. You can find all of the available California-registered FDDs at the CalEasi website. While this may not be a direct protection for investors, it does make a stunning amount of investor information available.
The franchise laws are pretty good at putting a lot of information in an investor’s lap, and in some states they screen out some outfits that have no business being in franchising, but on the whole, franchise investors have to realize that the legal devices regulating the franchise marketplace have severe limitations, and -- as with so many other parts of our financial lives -- franchise investors have no alternative but to take care of themselves.
Andrew Caffey is one of the nation’s leading franchise legal specialists and he represents franchisors across the United States. Caffey served as General Counsel of the International Franchise Association, a member of the Governing Committee of the ABA Forum on Franchising, and Chair of the ABA Forum on Franchising. He also is a member of the bar in Maryland and the District of Columbia, and a member of the Panel of Neutrals of the American Arbitration Association. Caffey has appeared on numerous franchise programs and is a frequent speaker and author on subjects of franchise and business opportunity regulation.
