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Calls grow for tighter franchise regulations

As stories of problems at franchise brands mount, advocates and some regulators call for more enforcement at the federal level.
Burgerim
Photo courtesy of Jon Springer

Earlier this month, Rohit Chopra took to Twitter to urge regulators to take more aggressive actions to stop “exploitive practices by major chains” such as Subway.

“Regulators must stop unfair, deceptive, and discriminatory practices that target franchisees and their employees,” he began. “If not, many small businesses won’t survive.”

Chopra’s comments were notable for one big reason: He happens to be one of five commissioners of the Federal Trade Commission, the agency that regulates the franchise business model. And the FTC has started a formal process to update its “Franchise Rule,” the list of regulations that franchises such as McDonald’s and Subway have used to become global behemoths. The agency is asking for comments and plans to hold a workshop to start this process.

And Chopra’s comment is hardly unique. There appears to be a growing sentiment to give the FTC more teeth in regulating the franchise business amid a growing number of instances of major problems in the franchise sector. Many of the people behind this sentiment include some folks with the power to do something about it.

U.S. Rep. Jan Schakowsky, an Illinois Democrat, along with Reps. Mary Gay Scanlon (D-Pa.) and Pramila Jayapal (D-Wa.) this week wrote a letter to FTC Chairman Joseph Simons urging the agency to be more deliberate in investigating bad franchise practices. They called franchising “underinvestigated” and says it “deserves careful scrutiny.”

“Numerous complaints have been filed by franchisees of Dickey’s, Subway, 7-Eleven and Burgerim, alleging unfair and deceptive practices by the franchisors,” they wrote in a letter that also featured concerns about third-party delivery.

Schakowsky chairs the Consumer Protection and Commerce Subcommittee, which oversees the FTC.

The comments raise the prospects of potentially significant changes in the way that franchises are regulated at the federal level, and could push the FTC into a more direct enforcement role that it has only sparingly taken over the past couple of decades.

Among those saying that the agency needs to increase its enforcement of franchises is the International Franchise Association (IFA), a franchising trade group that has traditionally pushed back against more franchise regulations.

“We think there are opportunities to improve the rule,” Matt Haller, senior vice president of government relations and public affairs for the IFA, “to give the FTC more teeth to go after bad actors.”

That's a significant change from a year ago, when the IFA said in a comment  that it “strongly endorses continuation of the [franchise] rule in its current form.”

Franchise regulations, but little enforcement

The franchise rule requires franchises to disclose information to prospective franchisees on their offering and the background of the company. That information is compiled in what is known as a franchise disclosure document (FDD), typically a book-length tome that is complex and difficult to read.

Franchises are required to give that document to prospective operators, because it includes information such as initial investment, details on current and former franchisees, background of corporate officers and, sometimes, earnings claims.

But the FTC rarely polices the document, leaving enforcement up to a small number of states with specific franchise statutes, along with a large number of attorneys who specialize in franchise law.

“There have been some FTC investigations over the years but they are incredibly rare,” said Caroline Bundy Fichter, a franchise attorney out of Washington State. “It falls to people like us to do it, and I can only do it in states that have strong franchise statutes if the franchisee has the money to hire an attorney, which doesn’t always happen if they’ve lost their investment.”

The result, many advocates say, is a series of abuses by franchisors that are looking to sell franchises quickly to anyone with enough cash to pay for them—without ensuring that the franchisees can meet the long-term demands of operating a franchise.

Arguably the most egregious example in recent years was Burgerim, revealed in an extensive Restaurant Business investigation in January. The fast-casual chain, which in late 2018 was considered one of the hottest concepts in the country, operated a boiler room in which it sold franchises to hundreds of people, frequently skirting or outright violating franchise regulations in the process. The vast majority of them weren’t even able to open a restaurant because they couldn’t get financing or approval for a lease.

Most of those who could open a restaurant ran into massive cost overruns and lost money once they opened. The company’s founder, an Israeli national, fled the country in November, one month after Burgerim stopped paying employees. Last December the company sent an email to employees saying it planned to file for bankruptcy, something it never did. Operators have been left without an operable franchisor since.

The result of that collapse was enormous: Hundreds of people out tens of thousands of dollars for a franchise fee, plus dozens of operators who ended up in bankruptcy or lost everything when the restaurant they were able to open was forced to close because it lost too much money. One person we spoke with in January ended up homeless to fund a restaurant that never was able to open.

“Burgerim happens, and nothing as far as we know has been done about it,” said Keith Miller, a franchisee advocate and Subway operator. “People argue that [franchising is] heavily regulated. But if the regulations aren’t enforced, is it really?”

“We think there are opportunities to improve the rule to give the FTC more teeth to go after bad actors.” —Matt Haller, International Franchise Association

Selling on emotion

Burgerim isn’t the only example. “I don’t think Burgerim is that unusual,” Fichter said. She noted, for instance, that she recently reviewed the FDD for a child care concept operated by a person whose previous child care concept was shut down over repeated disclosure violations.

“Before he became a franchisor he was a stockbroker,” Fichter said. “He can’t do it anymore because he was fined by the SEC.”

Much of the problem, advocates argue, is the way franchises are bought and sold. Franchises are usually sold based on emotion, in which franchise sales representatives lure prospective operators with promises that they can “be their own boss.”

The prospects fall for this because they are overconfident in their ability to operate, which can lead to abuses as companies sell unproven concepts very quickly, which can lead to disaster. “Franchisees deserve some of the blame,” Miller said. “They get all hyped up and ready to go and excited to start based on emotions, not business thinking.”

Yet, he said, “You’ve heard this 1,000 times: Be your own boss, proven business model, no experience necessary. But when they fail they don’t know what they’re doing and should never have been a franchisee. Most of the bad franchisors will approve anybody who has a check for the fee and wants to do it.”

Some believe the system needs to be modernized to ensure that prospective operators can more easily access the information in the FDD. It’s difficult to find the documents. People frequently have to go to the franchisor to get them. A few states, including Wisconsin, Minnesota and California, will let people download the documents, but the franchises must be registered in those states.

Simplifying the document itself may also help. But, said Haller, “You can’t require somebody to read something they don’t want to read. Simplifying the process is easier said than done.” He urged operators to hire attorneys before they buy into a franchise.

 

“You’ve heard this 1,000 times: Be your own boss, proven business model, no experience necessary. But when they fail they don’t know what they’re doing and should never have been a franchisee. Most of the bad franchisors will approve anybody who has a check for the fee and wants to do it.” —Keith Miller, franchisee advocate

The franchise relationship

A number of problems in franchises happen long after operators have opened stores and started operating.

Quiznos in the early 2000s was one of the hottest, fastest-growing chains in the U.S. It signed up franchisees by the dozens, and they opened restaurants everywhere, becoming a major threat to Subway, so much so that the larger chain added toasters in all of its locations in a bid to compete.

Franchisees began complaining about their cost for food long before the chain peaked at close to 5,000 U.S. locations in 2006. Operators began closing units after their sales fell during the Great Recession, and the company was unable to take steps to help them as it was loaded with $800 million in debt, the result of a 2006 leveraged buyout and a 2008 refinancing.

Quiznos finished 2019 with fewer than 300 U.S. locations, making it one of the biggest franchise collapses in history. All of those closures were franchisees who, at best, simply walked away from their units.

When a small-scale franchisee closes, the personal impact can be awful: If the operator received a loan backed by the U.S. Small Business Administration, that loan is backed by the borrower’s home, meaning that many people lose their homes when their franchise fails.

To advocates, such stories point to further problems with the way franchises are regulated in the U.S.

“There is no relationship aspect to the FTC rule,” Fichter said. “It governs only the first three months of the 10-year franchise relationship. And the rule is so broadly written to give so much discretion to franchisors that they can do anything for those 10 years.”

Some would like to see requirements, for instance, that franchises disclose more about the people behind the companies.

Since the last time the franchise rule was rewritten in 2007, private equity has taken a bigger role in the franchise business. Many of these companies have deep track records that are not required to be disclosed as part of the FDD, even though those track records are quite relevant to the operation of the franchise.

“If they only disclose information about the franchise entity and they have two or three holding companies that are actually the majority owner and are active, it can be hard to know who is calling the shots,” Fichter said.

 

“There is no relationship aspect to the FTC rule. It governs only the first three months of the 10-year franchise relationship. And the rule is so broadly written to give so much discretion to franchisors that they can do anything for those 10 years.” —Caroline Bundy Fichter, franchising attorney

Long process

Haller said the IFA has asked to be part of the upcoming workshop on the franchise rule, building off comments it made last year. Haller said that the trade group has “put together a task force that represents all parts of franchising” to help it shape the views that come out of the workshop.

“It’s too early to say what we may or may not support,” Haller said.

Miller, for his part, said that the only way to get more significant changes in the franchise rule is for franchisees to speak up more loudly this time around, to get their voices heard. If not, he said, “what you’ll have is the people who represent the sellers of franchises saying that the current rule is wonderful and great, yet we know it’s not because all we have to do is look at Burgerim.”

The process of changing the franchise rule will not be a short one in either case. The FTC required nine years to change the franchise rule the last time it took the subject on, meaning two additional presidential elections could pass after this one before the new rule is finally updated.

Most hope it doesn’t take that long. They believe the problems that have arisen in a number of franchise companies in recent years are painting the entire business model in a bad light.

“We know that is not emblematic of the vast majority of franchisor-franchisee relationships,” Haller said. “That’s why having regulations in place that actually have teeth and allow bad actors that can be eradicated and be held accountable. Also, that’s a way to hold people accountable who do mislead potential investors in our business model.”

Said Miller: “Franchising isn’t a bad model. It’s a good model. But people can take advantage of it.”

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