A company considering franchising may see exemptions as an ideal way to avoid burdensome registration and disclosure requirements and streamline their path to market. Indeed, exemptions reduce time, avoid the process of gathering copious amounts of information, and bypass regulatory approvals.
On the other hand, validating exemptions requires its own due diligence, and exposes the franchisor to risks that the conventional disclosure route would mitigate or eliminate. Consequently, franchisors should consider exemptions a potentially valuable tool, but should be wary of relying on them widely, and should have a clear-eyed view of their pros and cons.
Franchising Regulations & Franchise Disclosure Documents
Franchising in the United States is regulated at both the federal and state levels. Federal law requires franchisors to disclose to potential franchisees a franchise disclosure document (FDD), with a prescribed body of content. Laws in fourteen states further require the registration and (in most cases) approval of that FDD before offering franchises in that state. FDDs are lengthy, often running several hundred pages when paired with the required exhibits and attachments. They require a broad range of information, including biographies of key personnel, details on litigation involving the company, requirements and restrictions on sourcing products and services, detailed breakdowns of fees and costs, lists of other franchisees in the system, and audited financial statements. Although franchise companies typically outsource the preparation and registration of FDDs to law firms, the process can be time-consuming and costly.
Exemptions from Franchise Registration and Disclosure Requirements
Both federal and state laws contain a number of exemptions from registration and disclosure requirements. The details of those exemptions vary, but common themes are: more sophisticated franchisees (based on net worth and experience), the size of the initial investment by the franchisee, insiders coming from within the franchise company, franchisees who will embed the franchise business within a larger unrelated business (thereby reducing the risk of business loss, known as a fractional franchise), and an isolated franchise relationship. Where applicable, those exemptions allow the franchisor to avoid the federal disclosure requirement, the state registration requirements, and (sometimes) the state disclosure requirements.
In most instances, exemptions are self-executing. In other words, a franchisor need not get a regulator’s approval or confirmation that the exemption applies – the franchisor simply relies on the exemption in the course of offering and selling the franchise. However, if the franchisor has claimed that exemption incorrectly, then the franchisor has effectively sold an unregistered franchise, in violation of any applicable registration and disclosure rules. In that case, the potential consequences include liability to the franchisee for monetary damages, the franchisee’s right to rescind the franchise (and get back its investment), regulatory fines, restrictions on offering additional franchises, and even criminal liability.
Costs and Risks of Franchise Exemptions
At a glance, a franchisor’s use of exemptions to avoid registration and disclosure requirements may seem ideal. Exempt franchising allows new franchisors to enter the market quickly or when a specific opportunity arises. It reduces or eliminates the cost and administrative effort of preparing and filing an FDD and audited financials. It allows the franchisor to keep confidential more information about its corporate enterprise and its franchise system. And it creates more flexibility in the form and structure of its franchise agreements, which can be more specifically tailored to an individual franchise arrangement.
But franchisors should weigh the costs and risks of relying on exemptions:
- Validating the Exemption: The franchisor will need to validate that the exemption applies. In many cases, exemptions are based on external factors, like the franchisee’s net worth, its revenue from other lines of business, or its experience in similar industries. And since franchise disclosure laws are solely for the benefit of franchisees, the risk of getting that analysis wrong falls entirely on the franchisor.
- Documenting the Exemption: If there’s a dispute about whether an exemption applied, it will typically arise many months, if not years, after the franchise sale occurs. To defend itself, the franchisor will need to be able to produce the financial statements, communications, or other information that the franchisor relied on when claiming the exemption. If documents are stuffed in a random file or messages are buried in an email folder (or have been deleted through regular processes) and cannot be reproduced, the franchisor will be exposed to the legal risks of having sold an unregistered and undisclosed franchise.
- Patchwork State Laws: Although federal exemptions apply uniformly, state exemptions are a patchwork, and even the same conceptual exemption (e.g., fractional franchise) will have nuances from one state to the next. That still requires a degree of legal analysis, and awareness of which states’ exemptions are in play. Also, in some instances, even if the franchise offering is exempt from registration requirements, the franchisor still must disclose an FDD to the franchisee, which largely negates the value of the exemption. And certain states require notice filings when a franchisor intends to rely on an exemption in that state, so an exemption does not completely alleviate the franchisor’s administrative burden.
- Ambiguities in the Law: Exemptions often feel like they were created as an afterthought in franchise statutes and regulations, and don’t address many real-world considerations. Does a franchisor need to validate the franchisee’s financial condition with audited or GAAP-compliant financial statements? How closely do two entities need to be related for one to rely on the exemption qualifications of the other? How should a franchisor calculate the fractional math when the intent is open multiple units on a staggered schedule? Exemptions and associated commentary don’t answer these questions definitively, further exposing franchisors to the legal risks of having sold an unregistered and undisclosed franchise. That risk remains even when the franchisor attempts to make a good-faith interpretation of legislative or regulatory intent.
- Uninformed Franchisees: For better or for worse, an FDD contains a significant amount of information about the franchise system, including the costs of establishing a franchise unit. One of the best ways to mitigate risk in a franchise system is for franchisees to know what they are getting into, and a well-prepared FDD helps enable that. In the absence of an FDD, a franchisee may be left with marketing materials, scattershot presentations, conversations with cherry-picked existing franchisees, or representations from the franchisor’s sales team. That can be a recipe for expectations that are unrealistic and impossible to satisfy.
- Missed Opportunities: The reality is, a franchisor that relies on exemptions as a go-to-market strategy will almost certainly leave good opportunities on the table, since not every franchisee and not every situation will fit into an exempt category.
In short, exemptions from registration and disclosure can be a valuable tool for franchisors to seize specific opportunities or to dip a toe into franchising. But exemptions come with their own burdens, hassles, and pitfalls, and it is the rare U.S. franchise system that can go to market based solely on them.
Moving Forward with Franchise Exemptions
If you are a franchisor navigating the world of franchise disclosure documents and exemptions, or if you are a franchisee and curious about how exemptions could impact the sale or acquisition of your franchise, Miller Nash can help. Visit our franchise team page to learn more.
This article is provided for informational purposes only—it does not constitute legal advice and does not create an attorney-client relationship between the firm and the reader. Readers should consult legal counsel before taking action relating to the subject matter of this article.
