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Federal regulators examine franchise rules amid debate on their effectiveness

As the Federal Trade Commission begins what could be a long process to change its franchise regulations, considerable differences exist in what changes should be made.
Photo courtesy of Christina Gandolfo

Earlier this month, the Federal Trade Commission kicked off what could be a long process to change its franchise rule, the set of regulations required of any company that sells a franchise.

How much it should change will be a matter of considerable debate, with critics suggesting that the rules do a poor job keeping bad franchises from preying on unsuspecting investors, while others say the system has generally worked well in the decade since the rule was last changed.

“The current FDD has functioned effectively over the last decade,” U.S. Rep. Kevin Hern, a Republican from Oklahoma and a McDonald’s franchisee, said in opening a workshop on the rule. He referred to the franchise disclosure document, or FDD. “I would encourage small changes.”

The FTC’s franchise rule is a complex set of regulations all franchises must follow. It is a disclosure rule, requiring franchisors to provide a massive set of information on a franchise company to any prospective franchisees. In theory, franchisees read that document, which all franchises must file, so they can understand the franchise they’re buying.  

But there is almost no enforcement of violations of disclosure rules, which enable franchises to sell poorly working concepts to unsuspecting investors with little fear of punishment. The disclosure rule, for instance, did not prevent the fast-casual concept Burgerim to convince several hundred investors in just a couple of years to send in at least $10,000 apiece for a concept that was almost unworkable.

“Not all franchisors out there are McDonald’s or are the big names we hear in franchising all the time that have very sophisticated, qualified counsel,” said Howard Bundy, a partner with the Kirkland, Wash.-based Bundy Law Firm. “The franchisors that I see are much less sophisticated, much less experienced and frankly much less honest. They don’t care as much about being sure their franchisees understand.

“What they care about is if a franchisee can fog a mirror and sign a check. That’s what they’re looking for because they’re trying to hit the bottom line.”

“The reason someone buys a franchise is the brand is supposedly tested and proven as a business model. For franchisors that can’t show data that the model is proven, I would ask why they’re franchising in the first place.” - Keith Miller, franchise advocate.

Financial performance representations

One big question is whether franchises should be required to disclose a concept’s potential financials. At the moment, franchises aren’t required to disclose any revenue or earnings numbers, though approximately two-thirds of them do. That is the most important piece of information on a franchise.

That still leaves a number of franchisees “without the disclosure item that is certainly what franchisees desire most,” said Dale Cantone, assistant attorney general for the state of Maryland. That “allows a franchisor in a failing system to simply choose not to disclose their financial performance representations.”

Keith Miller, a Subway franchisee and franchise advocate, argues that franchisees will try to get that information, anyway, and some systems will outright skirt the rules by providing numbers during the sale process—either directly or in more subtle manners. These numbers can often be misleading, as sales representatives are eager to make a sale.

Burgerim sales representatives, for instance, frequently provided revenue information to prospective franchisees. A financial requirement would at least provide the data in a legal document that are audited and can be referenced by a franchisee.

“The reason someone buys a franchise is the brand is supposedly tested and proven as a business model,” Miller said. “For franchisors that can’t show data that the model is proven, I would ask why they’re franchising in the first place.”

Others argue that franchisors that don’t provide financial data are not hiding anything—they may be a strong enough brand that they don’t need to, or they’re an emerging concept without enough data to provide in the document. They may also be an international concept where the information is not necessarily relevant.

And it costs money to prepare such data, which might be tough for smaller franchisors. And ultimately franchisees have a choice. “The information is there,” said Sandy Wall, attorney with the law firm DLA Piper. “The prospective franchisee has the choice to proceed or not to proceed.”

Indeed, franchisees are probably better off walking away from brands that don’t provide financial data. According to a 2016 study by the franchise site FranchiseGrade.com, franchise systems that provided financial data grew by 13.8% on average. Those that didn’t declined by .02%.

“The franchise relationship is a very different creature. We have to recognize the power and information balance favors the franchisor.” -Theresa Leets, assistant chief counsel at the California Department of Financial Protection and Innovation.

Are there really problems?

Carl Zwisler, another franchise attorney, argued that most franchisees understand their franchise system when they get into it, based on surveys, and suggested that there are relatively few complaints about franchise disclosure.

He cited a 2015 FranchiseGrade study that said 72% of franchisees had a “clear understanding” of their FDD, and 82% read through the document. Three quarters said they consulted with an attorney or a consultant.

(In that same survey, 32% of franchisees were either dissatisfied or very dissatisfied with their franchise and 64% would not recommend their system to friends or family.)

Zwisler also noted that there were only 42 legal cases alleging disclosure violations over the past three years, even as tens of thousands of franchises opened. “I’m sure there are disputes,” Zwisler said. “It doesn’t seem like there are a tidal wave by any means.”

But others argue that the document is too immense and intimidating. “My office is in business with hundreds of clients because people were overwhelmed by the FDD,” said Ron Gardner, attorney with the law firm Dady & Gardner. “Shorten it, make it more succinct.”

And others say that many franchisors will include provisions in the agreements saying they are not responsible for information franchisees find outside of the FDD. This can often be used as a defense when franchisees file a lawsuit after sales representatives tell them their business could make so much in revenue and earnings that turns out to be false.

“These clauses are a problem,” said Brandon Moore, a former franchisee of a dental company called Dental Fix Rx. “They give any person in the sales process license to stretch the truth to make a sale. The franchisee goes to their business plan and constructs a proforma based on what they heard. When the franchisee realizes the opportunity wasn’t necessarily the way it was described, it’s too late.”

And others argue that the information balance is weighted heavily toward the franchisor, who may or may not provide all of it. “The franchise relationship is a very different creature,” said Theresa Leets, assistant chief counsel of the securities regulation unit at the California Department of Financial Protection and Innovation’s legal division. “We have to recognize the power and information balance favors the franchisor.”

Perhaps the biggest problem, said Miller, is the profit motive. It can be easier to profit off of the sale of a franchise than it is to profit off the operator’s long-term success.

“Far too many people profit from the sale of a franchise,” Miller said. “Far too few profit from the success of that sale.”

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