Last week we blogged about the top franchisee missteps and mistakes when purchasing a franchise; this week, we thought we would focus on franchisor missteps and mistakes when selling franchises. Generally these arise in two categories: 1) misrepresentations in the disclosure documents provided to prospective franchisees; and 2) failure to know and follow the procedural requirements during the sales process.
1. Misrepresentations. All franchisors must give a prospective franchisee a franchise disclosure document (FDD) prior to entering into a franchise sale. The FDD has 23 sections and hundreds of specific issues that must be disclosed to the prospective franchisee prior to entering into a franchise agreement. Just providing an FDD is not enough – it must be materially correct and not misleading. The consequences for inaccurate information can be severe. Some of the areas that are regularly inaccurately disclosed include the following:
a. Supplier rebates. Supplier rebates not only pertains to actual rebates that the franchisor may receive from suppliers due to franchisee purchases, but also applies to any other benefit that the franchisor receives from the supplier due to the franchisee purchases.
b. Territorial rights and restrictions. Often the FDD will not accurately define the territorial rights of the franchisee and will fail to correctly disclose the franchisor’s reservations. If this is not clear and a dispute arises in the future, the franchisor may be more vulnerable to a lawsuit by the franchisee.
c. Start up costs. The franchisor is required to provide the prospective franchisee with an accurate estimation of the startup costs for opening a franchise. Often this information is inaccurately reported in order to show a lower cost investment to help entice franchisees to purchase the franchise. However, this can be very dangerous for the franchisor. This is one of the easiest ways for a franchisee to show inaccuracy in the FDD provided by the franchisor.
2. Procedural Requirements. Under the FTC Franchise Rule, there are very specific rules related to providing disclosures, waiting periods and restrictions on what franchisors can tell a franchise prior to completing a franchise sale. If your franchise sellers do not follow the rules for franchise sales, the franchise sale may be illegal and lead to serious consequences, such as rescission of the franchise agreement by the franchisee. Some of the common mistakes include:
a. Receipt page. Failing to collect a signed receipt page after sending the disclosure document to a prospective franchisee. Under the FTC Franchise Rule, the franchisor must keep a copy of all receipts for 3 years, whether or not the prospective franchisee purchases the franchise or not. This is the best defense to show that the FDD was provided and show that the waiting period was met. Too often the franchisor does not have this document when a problem arises with a franchisee.
b. Waiting period. Not waiting the full 14 day period before collecting money or signing a binding agreement. Under the rule, the franchisor must send the FDD and give the prospective franchisee a full 14 days to review the documents.
c. Earnings claims. Providing financial performance representations also known as earnings claims, either verbal or written, outside the FDD. Under the rule, the franchisor may provide numbers on historic or projected earnings ONLY within Item 19 of the FDD. There are certain disclosures and cautions that the franchisor must also provide with this information. Often sales staff will give out numbers that can be construed as financial performance representations. Even if these are accurate numbers, the rule only allows this information to be provided if it is in the FDD with the required cautions and warnings.
d. State registrations. Some states require that the franchisor register its FDD with the state prior to selling (or even offering to sell) franchises in the state. Too often sales staff will offer a franchise or sell a franchise to a person who is in a registration state or plans to open the franchise in a registration state, without knowing if the franchisor’s FDD has been registered. This sort of action can create a rescission action for any contract entered into and it can also trigger fines and fees from the registration state. If the action is in blatant violation of the law, it may cause the state to disallow any further franchise sales in the state by the franchisor.
All of these issues can be avoided by ensuring that you provide accurate information to the attorney preparing your disclosure documents, regularly update your FDD for any material changes to the franchise system, and train your franchise sellers to understand the rules required to sell franchises.