Complying with the FTC Franchise Rule for the FDD - What You Need to Know

In the summer of 2008, the FTC enacted requirements that replaced the old UFOC with the FDD ( Franchise Disclosure Document). This webinar will educate you on the new terminology being used in the FDD, changes to the items in the document, new delivery requirements and much more.

Speakers:

Susan Grueneberg is a Partner in the law firm of Snell & Wilmer, in Los Angeles, California. Susan focuses on advising clients on franchise and distribution law, including FTC compliance. Ms Grueneberg is a Past Chair of the American Bar Association Forum on Franchising and serves as Chair of the Industry Advisory Committee to the North American Securities Administrators Association (NASAA) Franchise Project Group. She is a graduate of UCLA Law School. Contact her at sgrueneberg@swlaw.com.

David T. Azrin is a partner at the New York City law firm of Gallet Dreyer & Berkey LLP where he practices franchise law on behalf of franchisees and franchisors. Mr. Azrin is a graduate of Stanford University and the University of Michigan Law School. He is a member of the International Franchise Association and the American Bar Association Forum on Franchising. Contact him at dta@gdblaw.com.

For those of you who would prefer to read the official transcript, enjoy!

Jesse: Ladies and gentlemen, thank you for standing by, and welcome to the FranchiseHelp, Inc. Understanding the FDD for Franchisors Conference Call. During the participation, all participants will be in a listen only mode. Afterwards, we will conduct a question and answer session. If you have a question, please press the 1 followed by the 4 on your telephone. Your line will be briefly accessed from the conference to obtain the information. If at any time during the conference you need to reach an operator, please press star zero. As a reminder, this conference is being recorded Wednesday, May 7th, 2008.

I would now like to turn the conference over to Mary Tomzack, President of FranchiseHelp. Please go ahead, ma'am.

Mary: Thank you. Welcome, everyone, to our webinar. My name, as mentioned, is Mary Tomzack. I think I am in acquaintance with many of you. I'm the president and founder of FranchiseHelp.com.

Our topic today is one of utmost importance. It is what you need to know about complying with the new FTC Franchise Rule for franchise documents. It's really important, especially for those who have not yet converted from the UFOC format, which many of us know, to the FTC-mandated FDD, which stands for Franchise Disclosure Document.

You should have your new FDD approved and registration states before July 1st, 2008. So, please listen very closely and follow along with the PowerPoint presentation, which you can access either on the Web or in the reminder email that was sent to you. So please follow along with our speakers, as they refer to the slides. We're going to try to make our presentation of this sometimes complex subject as clear and simple as we possibly can.

Just a reminder that you may email your questions into us as they come to you. But in the interest of time, we may not be able to interrupt the presenters during the presentation. Instead, we will probably end up doing most of the questions, both the emailed ones and the ones which you will present on the telephone, at the end of the formal presentation.

Right now, I'd like to introduce our two presenters. We have Susan Grueneberg and David Azrin. Both Susan and David have their contact numbers on the slide, so please feel free at the end of the presentation, if your question doesn't get answered, to contact either Susan or David.

Susan Grueneberg is a partner in the law firm of Dreier Stein Kahan Browne Woods George LLP. Susan's way out there, on the West Coast, in Santa Monica, California. Susan practices in the area of franchise and distribution law.

And then we have David. He's in my part of the country. He's in New York City. David's a partner at the law firm of Gallet Dreyer & Berkey LLP. David practices franchise law on behalf of franchisees and franchisors.

So, between Susan and David, I'm sure you'll have many of your questions answered today in our webinar. So I think, Susan, you'll be starting first, and so, Susan, take it away.

Susan: Well, thank you, Mary.

First of all I'd like everyone to note that in the contact information on that initial page, there's a slight correction to the telephone number for me -- the area code is 310. So, if you want to jot that down, in case you have follow-up questions, feel free to call either David or myself afterwards.

Before David and I jump into the substance of the changes, I wanted to go through, preliminarily, some of the changes to terminology that you're going to experience, if you haven't already done so. The terms, Uniform Franchise Offerings Circulars, otherwise known as UFOCs or as some people refer to them, UFOCs, are now going to be referred to as Franchise Disclosure Documents or in some cases, FDDs.. Another term that's changing is Earnings Claims. They are now known as Financial Performance Representations. And then there are a number of terms that are going to become archaic and will disappear altogether, and those terms are things like First Personal Meeting and Five Business Day Rule, that gradually you will see used less and less.

And then let's turn to the major substantive changes in the FTC Rule. David, what do you think are the some of the changes franchisors should focus on?

David: Okay. Well, thanks, Susan. This is David Azrin, and before we jump right in, I wanted to thank Mary for putting this together. We do have a lot of ground to cover, so let's jump right in.

I'm going to slide number 5, and in case you're not on a computer and you're just looking at the hard copy, it's page 5. Is that coming up on your screen, Susan? There we go.

Susan: I just pulled it up for you.

David: Page 5. Okay. Thank you. I feel like John King from last night, from the primary race, going through the computer charts.

Susan and I both went through together, before today's seminar, and decided on what we thought were the most important things to talk about. There's some minor revisions that we're not going to address.

But hitting on the first topic that came up, it was in Item 3, relating to litigation. So, the big change here, in Item 3, is franchisor initiated lawsuits. So you still, under the new rule, have the same disclosures for pending suits against the franchisor, that are material to the system, or involving fraud or deceptive practices. You still have disclosure of cases that were decided adversely to the franchisor in the past 10 years.

But what you did not have before was suits that were brought by the franchisor against franchisees for, let's say, unpaid royalties or to enforce non-compete agreements. Those were not required to be disclosed before, and under the new rule, you are required to disclose those. Actions that were filed by the franchisor, against the franchisee, in the past year.

Next, let's go to slide number 6. Here, this issue centers on that disclosure, that I mentioned, of the cases that were decided adversely to the franchisor over the past 10 years, involving fraud, deceptive practices, and franchise law violations. Under the old UFOC rules, if it was a confidential settlement, where the franchisor did have to pay some kind of money, so in that sense, the rules said that, if there's a settlement where the franchisor had to pay something, then in that sense, it was decided adversely to the franchisor. The franchisor was held "liable," and therefore disclosure was required. And disclosure was required under the UFOC, even if it was a confidential settlement.

But under the FTC Rule, if any franchisor was traveling only under the FTC Rule of Disclosure format, they did not have to disclose it. Well, what's new is that the new rule clarifies that, going forward, everybody, for any settlements that are entered into after July 1, even if they're confidential, whether you were traveling under the UFOC or the FTC Rule, you have to disclose those new settlements.

Now, there's an exemption for the old settlements, if you were traveling under the FTC. But what's important is that, going forward, after July 1, all confidential settlements for everybody need to be disclosed.

And let me turn it back over to you, Susan, to talk about change in Item 8, regarding interested suppliers.

Susan: Great, thanks, David. Item 8 also has a brand new disclosure requirement. Recall, first of all, that Item 8 requires disclosure of restrictions on the sources of products and services. And this can include any number of things -- goods, services, supplies, fixtures, equipment, inventory, computer hardware or software, real estate, pretty much any kind of comparable item. And that kind of restriction could be that the franchisee must purchase or lease from a designated or approved supplier. But it could also mean that the product or service must meet certain specifications that are established by the franchisor.

So what is the new requirement? The new requirement, under the amended FTC Rule, is that a franchisor must disclose if an officer of the franchisor owns an interest in one of these suppliers. Now that seems pretty straightforward. If an officer owns an interest in the franchisor and the franchisor is an approved supplier, then disclosure is required.

But, what if one of the designated suppliers, in a restaurant franchise for example, is a major beverage supplier, like Coca-Cola or Pepsi? And what if an officer of the franchisor has a 401K investment in a mutual fund that owns shares of Coca-Cola? This would, technically, be an interest the supplier. And yet, it is hard to imagine that that is what the FTC had in mind in requiring this disclosure. While we are still waiting for clarification on this issue from the FTC, it is likely, I believe, that a materiality standard will apply to this requirement.

David, what about Item 19?

David: Great, thanks, Susan. So let's go to slide number 8. Here, we're going to talk about Financial Performance Representations, which is the new term for what used to be referred to as Earnings Claims, which Susan mentioned at the beginning, was one of the changes in the terminology. So what's new about Financial Performance Representations, what used to be called Earnings Claims? A couple of important things that we wanted to highlight, in terms of changes:

The first, which is referred to on slide number 8, is the change in what is the definition of an "Earnings Claim," or now referred to as a "Financial Performance Representation." And I'm going to stop using the words Earnings Claims, because that's no longer the correct term.

So what is a Financial Performance Representation? Under the old rule, that would have covered any information that was not disclosed, in the UFOC, regarding revenue or costs. So, if the franchisor did not elect to make a disclosure in the UFOC, in Item 19, regarding either revenues or costs, actual or projected, then they were not allowed to make any kind of additional or separate disclosures to franchisees.

What's changed is that the definition does not include cost information. So what that means is the franchisor, now, is only prohibited from making disclosures about revenue information that is not disclosed in the disclosure document. But they are not prohibited from making disclosures about cost information. So, even if the franchisor does not have a Financial Performance Representation, there's no prohibition on the franchisor from giving cost information directly to the franchisee, either actual or projected cost information. Cost information is no longer in the definition.

This is, obviously, an important change, because franchisees are always asking, it's one of their top questions, "How am I going to do? How much money am I going to make?" You can talk to them about cost of goods. This is even if you haven't made the disclosure in the disclosure document. You can talk to them about actual cost of goods and future cost of goods, but you can't talk about revenue information.

A tricky issue comes up here. Are you allowed to give percentages? For example, are you allowed to tell a franchisee, well, we think your costs will be x percent of your revenue? That's an open issue and, hopefully, the FTC is going to address that in the interpretive guides, which are expected. They have not directly addressed it in the "Frequently Asked Questions" yet. I would think that the answer would be no, because then it's easy to extrapolate what the person is saying is going to be the projected revenue. What if the franchisor says, "Well, the cost of this particular item is going to be this percentage of your cost"? I would say that that's probably allowed, but again, we need to wait for guidance from the FTC.

Next, let's go to slide number 9. We're still on the issue of Financial Performance Representations. Here, the FTC was trying to address a common misconception that's out there in the franchise community among some franchisors and more often with franchisees. There's a misconception out there that franchisors, as a general rule, are not allowed to say anything about revenues or how their other franchisees have done or how they might do. That's simply not the case. The rule, previously, and still today, provides that the franchisor is allowed to make those representations; but if they do, they have to include them in the disclosure document, and they have to have some reasonable basis and substantiation for those representations.

But the rule didn't prohibit franchisors from making representations, it was just that some franchisors elected not to. So what the new required statement is intended to address, is that if a franchisor elects not to make a Financial Performance Representation, and I'm just paraphrasing what the exact language is, but they must affirmatively state that the FTC does allow franchisors to provide such information, but that basically this franchisor has chosen not to. Now, we'll see if that affirmative statement provides a greater incentive now and more pressure on franchisors to go ahead and make a Financial Performance Representation.

There were some other minor clarifications which the new rule also provided, which I hadn't put up on the chart, but I'll just mention real briefly. The new rule clarifies that, if you are going to make a Financial Performance Representation, you are allowed to provide information about a subset, about franchisees that have been in existence for a certain period of time, or only non-company owned franchisees. You can provide that information about the subset, but you have to clearly state what information that you are providing.

The FTC clarified that the information for historical information that you're providing, if you're providing a Financial Performance Representation, that it does not have to be based on information that was prepared in accordance with GAAPs, so that franchisors are allowed to rely on the information that the franchisees have provided to them.

The new rule also clarifies that, if the franchisor is making a forecast, a future projection, that they do have to state all of the assumptions that they're making. And there is a new requirement that not only must the franchisor have a basis for the statement, but they are actually required to provide written substantiation for the forecast to the franchisee, if the franchisee requests. And that is something new.

So, we'll see whether these new requirements either cause more franchisors to provide these representations or discourage them.

I'll turn it over to you, Susan.

Susan: Well, that's a very interesting comment, David. A couple of years ago, I heard an informal estimate by some of the state franchise examiners that the number or percentage of franchisors registering in their states that were actually making "Earnings Claims" at that point in time was about 35%.

David: Right, that's about a figure that I've heard.

Susan: Yeah, so it's going to be very interesting to see whether the new required language actually encourages the use of financial performance information.

David: Yeah.

Susan: One other thing to pause and point out, at this point in time, is that that there are a couple of sources for information on interpretation of the amendments to the FTC Rule. And one of them, David mentioned just a few minutes ago -- the Compliance Guides that the FTC will issue any day now. We've been hearing that for a while. But they will be extremely helpful in interpreting the requirements, as are a section on the FTC's website, which is FTC.gov, in which they have FAQs, Frequently Asked Questions and Answers, about the new rules. So those are a couple of sources to keep in mind as you have questions in interpreting the FTC Rule and in converting your disclosure documents.

David: That's right, Susan, and yeah, right now the only source for guidance is those answers to the Frequently Asked Questions. So we don't have the detailed guides and samples that we had under the old UFOC Guidelines. We don't have those yet for the new rule. I know that the FTC and NASAA are working together to try to issue guidelines and instructions that will be consistent.

Susan: Right. Well, one of the other . . . yes?

Mary: I'm sorry, Susan, I think we have a question that was emailed that maybe we can take right now, because it's relating to the Financial Performance. It was emailed by Jason Kilo [SP], and the question is: "To clarify, can franchisors now disclose, verbally or in writing, cost per goods, cost per lead. In our business that is important. Cost per sale? All of this would be on a franchisee's business, or of a group of franchisees in a particular market. Without disclosing this in Item 19?" So, I guess he's looking at, you know, what's going to be in writing in the document, as opposed to what you can do verbally. So, do the verbal representations have to coincide with the new written representations?

David: That's a great question, and just to clarify. Costs per goods is no longer in the definition of a Financial Performance Representation. So the prohibition about not disclosing anything that's not disclosed in your disclosure document just doesn't apply. So the new rule is only concerned about representations about revenue. That means, the short answer to your question is yes.

The franchisor, whether or not they've made a Financial Performance Representation, let's assume that you've chosen not to, you are allowed to disclose cost information to the franchisees. You can do it verbally or in writing. And the prohibition no longer applies. Now, of course, the general laws concerning deceptive practices, intentionally providing false information, that kind of thing, obviously would still apply. So, the careful franchisor still needs to be careful about the information that you are providing. But the short answer is yes, even if you have not made any disclosure in Item 19, you can go ahead and give, verbally and in writing, cost information, and that would include cost of goods. And if in your business, it's cost per lead, same applies.

Susan: I would just . . .

Mary: Thank you, David. And Jason, if . . .

David: Do you want to add something to that, Susan?

Susan: Yes, I did.

David: Go ahead.

Susan: I would just add the caveat, of what David mentioned before, that if you're giving pure cost information, that's fine. But if you start getting into percentages -- the cost of labor is x percent of your total costs or against some revenue number -- that's when you're going to get into the, probably, very dark gray area of crossing the line and actually making what you're saying a Financial Performance Representation, that is required to go into Item 19.

David: That's a good point.

Mary: Okay. Thank you, Susan.

Susan: Sure.

David: All right. And, Susan, do you want to talk about franchisee associations?

Susan: Sure. This opens up the whole world of Item 20, where we do see a lot of the changes that were made in the amendments to the rule. And the title itself is now, "Outlets and Franchisee Information."

The first topic we wanted to cover was that of franchisee associations. Obviously, no disclosure was required not under the UFOC Guidelines or the old FTC Rule format of this. But this is potentially one of the most important changes. The change is that contact information about certain franchisee associations is now required in Item 20.

Now, there are two types of franchisee associations that are covered. The first type you often see referred to as "franchisee councils" or "advisory councils." And these are associations that have been created or are sponsored or are endorsed by the franchisor itself. So the contact information for a designated person in that franchisee association is included.

More controversial is the other type of independent association. Now, in order for an independent franchisee association to be required to be included in Item 20, there are a number of conditions that have to be met. The first is that the franchisee association has to request inclusion. And that request must be sent to the franchisor within 60 days after the franchisor's fiscal year end. The reason, obviously, is that during that period of time, the franchisor is typically updating its disclosure documents, and to have a last minute request come in and be required to change those documents would not be reasonable. But there is also an additional requirement of the franchisee association, and that is that it must be organized under state law. It must a corporation or other type of entity.

Now, while it may take a few years for independent franchisee associations to actually become aware of this new disclosure opportunity, once they do, I think that their influence over franchise systems is likely to increase. Because most diligent prospective franchisees will likely check with the franchisee association contact, as part of their due diligence, a franchisor may be wise to vet changes to the franchise that it's planning to offer with the franchisee association, before making those changes. And thus, the influence of those independent franchisee associations may grow.

There are a number of other major changes like this to Item 20. David, what else is new?

David: Just on that last point, Susan. So, on franchisee associations, even if the association was created without the franchisor's blessing, or even without their approval, the franchisor still might be required to disclose that in their disclosure document, disclose that and the contact information for that association.

Susan: Absolutely. And as we know, in some cases, franchisors have been involved in disputes with franchisee associations. So it's a very important new requirement.

David: Sure. It might increase their influence, as you mentioned. The other change that we wanted to talk about in Item 20 under the "Outlets and Franchisee Information," this is a new disclosure that was intended to address an abuse that the FTC said that they have some evidence of. I've never come across this practice, but apparently, some franchisors were requiring franchisees, as part of a settlement, possibly of a dispute, or possibly some other situation, to enter into an agreement that said that not only are they not allowed to disclose the trade secrets of the system, but they're just not allowed to talk to anybody about their experience with the franchisor. Sort of like a gag order, or a do not talk agreement.

And so the FTC wasn't comfortable with these agreements. It didn't prohibit them, but it does provide that a franchisor who has entered into that type of agreement, within the last three years, has to affirmatively state, "We have entered into this type of agreement. We're prohibiting franchisees from talking about their experience with the system, and because of that some franchisees may not be able to talk to you at all."

Now, the FTC did allow that in a situation, let's say, where a franchisor has a large system and they've entered into one such agreement with somebody, that it might sound bad for them to state that we have entered into these types of agreements. People might interpret that that was a widespread practice. So, the rule allows the franchisor, if they want, and they think that just the general disclosure sounds bad, that they can provide a clarification that, "No, we've only done this on one occasion," and they can describe the circumstances of that one particular occasion. So, we'll see, again, if this affirmative disclosure has the FTC's intended effect, which was apparently to discourage these types of agreements.

And next, in Item 20. The big thing, I guess, in Item 20 is the charts, and I'm going to turn that one over to Susan.

Susan: Thank you, David. Yes, indeed, this looks like a very daunting requirement. The good news is, when you actually sort through the information, much of the information that is required in these five charts has already been required in the three charts that were set forth in the UFOC Guidelines. It's just set forth in a clearer matter. Item 20 has always required charts that provide information about the franchise system, at least since the mid-'90s. But new Item 20 increases the number, and we've listed some of them here.

Basically, the first chart is a systemwide outlet summary that includes information, kind of a snapshot at the end of the past three years, about changes to the total number of franchisor or franchisor-affiliate-owned outlets, and to the number of franchisee-owned outlets. And so, it's a pretty simple chart.

The second chart focuses on transfers to third parties by franchisees during the past three years. It captures that information separately, so it doesn't get buried in another chart.

And then, the third chart basically provides a lot of information about franchise outlets and their status for the last three years, and looks a little bit like one of the charts in the old UFOC Guidelines.

Fourth, there is a chart for company-owned outlet status, or in some cases, where a franchisor's operating arm is a sister entity or another related entity, that would be for the affiliate-owned outlet status.

And then, finally, the fifth chart, again, a familiar one, is projected openings of both franchisor-owned, and franchisee outlets during the ensuing year.

So basically, we're recycling the information into a clearer presentation. These changes to Item 20 also address a problem that had developed over the years, and it was known as the "double-counting problem." And this would come up if there were different events of a single franchise outlet during a year. Say, for example, a franchisee falls into default, and the franchisor assumes control of the business. And then, to resolve the situation, the franchisee is allowed to transfer the outlet. This could have been reported as a number of different kinds of events in the previous chart. And since different franchisors addressed it in different ways, there could be a lot confusion. The new requirement is that only the last event that occurred during the year need be reported, for purposes of that chart.

Now, footnotes have always been a way to explain information that is confusing in Item 20, and to the extent that you have done that before, it's probably going to be a good idea to continue that practice.

Another factor that makes the information in Item 20 charts more valuable is that the FTC has more clearly defined some of the terms, such as termination, reacquisition by franchisor, and non-renewal. All of those are now set forth in definitions that are in Item 20.

One interesting issue that's come up with Item 20, because of the proliferation of charts, is what is required in a sub-franchise situation. Now, recall that a sub-franchise situation occurs when a franchisor grants the rights to a franchisee to, basically, enter into franchise agreements with sub-franchisees, usually in a defined geographic territory.

So typically, a sub-franchisor receives the right from a franchisor to engage in both pre-sale and post-sale performance in a territory, and itself enters into contracts with franchisees to conduct a franchise business. So, the question becomes, "Wait a minute, what charts does this sub-franchisor have to include in its Item 20?" Because, if you're working with a sub-franchise system, you know that there's information about the franchisor that has to be included in that franchise disclosure document, along with relevant information about the sub-franchisor.

Again, this is an area where we're awaiting clarification on. But let me break down the three possibilities. The one that's clearly required is a set of charts on the sub-franchisor's own franchisees. The other possibilities are, "Do you need to include charts that reflect all of the franchised outlets in the system, no matter where they are, no matter who the sub-franchisor is?" If the answer is yes, and, by the way, it used to be yes under the old UFOC Guidelines Item 20, then you have another five charts. Finally, there's a third category. Is information about sub-franchisors, themselves, required to be captured in a set of five charts?

I will tell you, from experience, that if you try to capture all three of those sets of information, you will have an Item 20 that is 30 to 40 pages long. And so, I believe that the clarification on this will be that the sub- franchisor's own units will need to be disclosed. And, for the moment, I think sub-franchisors would be wise to at least include data about the systemwide numbers in a separate set of charts.

And then, finally, before we leave this fascinating area of charts, I wanted to talk a little bit about the information that's required. If you look at the charts, they are all using the term "outlet." And some franchise systems don't have outlets. They're mobile franchises, like dog groomers or transportation providers, that are, just that, mobile. They're service providers, like physical trainers that come to your home or your gym to work out with you. They're web-based businesses that may not have brick-and-mortar addresses. These are just some examples of franchises, in which a franchisee does not operate an outlet.

Now, of course, it would be absurd to say that these franchises aren't required to include any information about franchisees. So, even if franchisees operate no outlets, they must be listed in the Item 20 charts, and the best practice would be to base that on their business address.

David: Great, okay. Thanks for verifying that. That sounds like we need some additional clarification from the FTC, especially with respect to the sub- franchises.

Let's jump into financial statements. We're looking at slide number 13, in case you're looking at the hard copy. This is Item 21, relating to financial statements. And there are three important changes, with respect to the financial statements, that need to be provided with the disclosure document.

First, on slide 13, let's talk about the circumstances under which the franchisor has to include the parent company's financials. This is often important because a franchisor is a separate subsidiary unit of a much larger company, and that much larger company may not have audited financial statements or may not want to provide those to franchisees for whatever reason.

This change in the rule addresses the situation where the franchisor is a subsidiary of a parent company, and the franchise agreement provides that the parent company is supposed to fulfill a number of the franchisor's obligations. The FTC felt that, in that circumstance, the potential franchisee really should have financial information about the parent company, because they're the ones that are going to be fulfilling a lot of the franchisor's obligations. So, that's the new rule. The key language here is "if the parent company commits to perform post-sale obligations for the franchisor."

Now, after promulgation of this rule, a number of franchisors have made a number of objections to this rule, because there are many situations, and I've heard it's particularly prevalent in the hotel industry but I'm sure in other industries, where the parent company is providing a lot of the services or fulfilling a lot of the obligations of the franchisor entity. And that it would just be either totally burdensome or difficult for that parent company, now, to go and do audited financial statements and to include those.

So, the FTC has, in a way, sort of backed off the rule by providing clarifications and exceptions in their answers to the Frequently Asked Questions. And we'll probably get some more guidance on this new requirement also in the interpretive guides. But already, just in a few months after the promulgation of the rule, we already have some pretty important exceptions to the rule that's just been enacted.

The first is they have clarified that, well, if the parent company is just really acting as a supplier, so the parent isn't really fulfilling the obligation of the franchisor, because it's really an obligation, and they're just acting as a supplier and the franchisee could get the supplies from anybody. Now, maybe, the parent company is the only approved supplier, but still, they're just acting as a supplier, and where the franchisor is itself not obligated to provide those goods, the FTC has clarified that well, then the rule probably doesn't apply to that situation. So, if the franchisor is a supplier, even though they may be the only approved supplier, then that does not trigger the requirement to include the parent's financial statements.

Exception number two is, people came back and said, "Well, the parent company is helping us with the back office kind of stuff, with processing and paperwork. Now is that a fulfillment of the franchisor's obligations?" The FTC said, "No, probably not. If it's just back office, internal services provided to the franchisor to assist it in fulfilling its obligations, that doesn't trigger the parent financial statement disclosure requirement."

And third, still some franchisors were upset with the rule, and some franchisors said, "Well, the parent company is just providing one service. And it's not really a big deal, but they're just doing one thing." And so the FTC came back and said, "Well, the rule does say 'obligations', plural. That the parent company commits to perform post-sale obligations, plural." So, the FTC said, "If it is an 'isolated' obligation that the parent company is performing, then it will not trigger the disclosure of the parent company's financial statements." So that's where that stands.

Let's talk about two other important changes in the financial statements. Going to slide 14. And this is talking about startup franchisors. Quickly, we'll go over this.

Previously, startup franchisors basically had to have their audited financial statements done right away. So that means it's a new company, and they just have to have an accountant go out there and do an audit. The company may have no other assets other than $50,000 in the bank. They still had to prepare an audited financial statement and attach it to the disclosure document.

The new rule says that there's a phase-in for startup franchisors. It has to be a true startup franchisor. If it is, then they start selling franchises, they can get away with just an unaudited opening balance sheet. Now, it has to be presented in a format similar to GAAP, but the bottom line is that the startup franchisor doesn't have to go out and get an accountant to do a full- blown audit the first year. After they complete their first year, then they have to get their audit done for that first year's performance, and then start attaching the audited financial statements after the first year. But just to start, day one, they don't have to have an audit.

Now, the tricky part here is, and this addresses one of the questions that I saw that somebody submitted as a chat in the chat box, was the problem that not all of the registration states have adopted these new rules. And so there are still many registration states that do require audited financial statements from the get-go. In different states, it may be just that they need to change the regulations. In some states, it may even require a change in the statute. But the bottom line is, for non-registration states, a startup franchisor can get away with an unaudited opening balance sheet. For registration states, the startup franchisor still needs to check their state rules to see if they have adopted a similar exemption.

Next, we'll go to slide 15. Still on the topic of financial statements. This change was intended to address an objection by foreign companies who wanted to come and do franchising in the US. And there were two important hurdles or obstacles. And I've had this situation come up, where foreign companies contacted me and they wanted to do franchising in the US. And they said, "We're planning on meeting with a potential franchisee, or master franchisee for a particular state. Can we do it?" Well, I told them there are two problems. First is, there was a first personal meeting requirement, which Susan is going to address later, but that's required at the first meeting they had to give a disclosure document. And second problem was that they had to attach audited financial statements.

So, this rule change in Item 21 financial statements addresses the issue of foreign companies. And the problem is that, you may not be aware, but the US auditing standards are probably the strictest in the world, and they are stricter than in most other countries. So that most other companies in other countries, companies that are even publicly traded in their own country and they have financial statements that meet the audit requirements of their country, don't satisfy the audit requirements for the US.

So what this new rule says is that a foreign company that has audited financial statements that are audited in their own country, that meet their own country's rules, can have an accountant who, even if it's a foreign accountant, if they have been registered and they're authorized to file SEC filings in the US, then that accountant can do what's called a "reconciliation" to reconcile their financial statements that are prepared in accordance with the foreign requirements, and can reconcile them to the US GAAP requirements. If those conditions are met, then they can attach the financial statements that were, at least initially, prepared by the foreign accountant in accordance with the foreign accounting rules.

Next probably one of biggest changes, as a practical matter, are all of the various changes in the delivery requirements. And I'm going to turn this over to Susan.

Susan: Thank you. But before we do that, let's not forget Item 23, the receipt, where a little time bomb has been buried for us here. In the old form of receipt, you were required to disclose contact information for a sub- franchisor if you had one, or for franchise brokers. Practically speaking, this was not too much of an issue. The sub-franchisor, clearly, you could indicate there. The franchise broker, if you had a number of them, they were usually attached as an exhibit to the then-called "offering circular," and you could refer to that exhibit.

What the new requirement is, is that contact information for a franchise seller or sellers, dealing with that particular prospective franchisee, has to be included in the receipt. Now the definition of a franchise seller under the amended FTC Rule is actually quite broad. It refers to someone who offers for sale or arranges for the sale of a franchise. This can include brokers, sub- franchisors, the franchisor itself, individuals who may be the franchisor's employees, representatives, or agents. But the person whose information is required to be included in the receipt reflects a more narrow definition. It should be the specific individual or individuals who are dealing with the prospective franchisee.

The purpose behind this new requirement is twofold. One is, obviously, to allow the prospective franchisee an opportunity to follow up with an individual with questions that he or she might have. And the other is for law enforcement purposes. In another words, this would be a first step for a regulator or other investigator to identify someone who might have been responsible for furnishing the disclosure document to that prospective franchisee.

In some situations, it's going to be easy to identify who this person is, especially with startup systems or fairly small to medium size systems. But as a franchise system grows, the person may be different, depending on the different prospective franchisee. Now the franchise seller could be the person who helped the prospective franchisee fill out the application for the franchise, or a person with whom the prospect has ongoing conversations. But there may be situations in which you don't know who the franchise seller is when the document is actually being delivered.

The FTC has given us some examples of how you could still comply in that kind of situation. One example would be that the franchisor would then request that the franchisee write in the name and contact information of the individual that they ultimately end up dealing with and then to send that copy back to the franchisor. Now, the franchisor will have already signed the receipt, evidencing the date that the disclosure document was received, but would send a copy of that receipt back. The FTC has said this will not affect the actual count of the required days during which the prospective franchisee must have the franchise disclosure document before they could sign the agreement.

Another method is for the franchisor to identify who the franchise seller ultimately is and attach a copy of the business card of the person, who ends up becoming the franchise seller, and sending that back to the franchisee.

Now there clearly are a number of ways you could comply with this. Other things I've seen are a couple of people listed with little blank lines there so you could check off the one who was actually dealing with this particular prospect. I've also seen franchisors who've registered their documents in blank, so they can fill them in later, during the course of the year. The problem with all of this, if you don't have a specific person listed there, is that it becomes another open item in your franchise compliance checklist, before a prospective franchisee is becoming part of the system, because you want to make sure that this requirement hasn't fallen through the cracks and never been addressed in the ongoing negotiations.

And with that, we would like to take a few minutes to talk about changes in the whole delivery requirements, as these have been rather significant. First of all, I'm going to cover an explanation of when these delivery requirements come into play. They only will affect your system when you have converted to the new format. Before you convert, you are going to be still be subject to the first personal meeting requirements, the 10 business day requirement, the 5 business day rule, and we'll go through the replacements for each of those, sequentially.

Once you do convert, you will have a requirement to deliver format information. This is before you provide the franchise disclosure document. This is a brand new requirement, and one that may not have gotten the publicity that it requires for people to incorporate this into their compliance system. Basically, before delivering the disclosure document, the franchisor has to indicate to the franchisee information about the format or formats in which the franchise disclosure document is available -- paper, posted on the Web, CD-ROM, or PDF. This communication also has to include the prerequisites for a particular format and the conditions for viewing the document in a particular format.

All of this can really be done in any number of ways. You can actually include this information in your advertising materials. You can send an email or letter to the prospective franchisee. You can leave a phone message. You can even have an oral conversation. But you really should do it in manner that you will have later evidence that you've complied with this requirement. Say, for example, the disclosure document is only available on CD-ROM. In that event, the franchisor would also disclose the format the document was in and whether any specific applications or equipment would be necessary in order to view it.

Now, let's move on . . .

Mary: Susan, if I can just interject here.

Susan: Yes.

Mary: Since we've gone through the 23 items, I just don't want to run out of time before we address an early question that we had from Lee Roberge [SP] about Item 7. So if either Susan, you or David, can just let us know? Were there any changes made to Item 7, which is the item regarding initial investment?

David: Short answer is no.

Mary: Okay. That was easy.

Susan: There are some technical changes to the title, to the chart. But David's right, no substantive changes.

Mary: Okay. Thank you.

Susan: Sure. Let's go back to the delivery requirements, and we're on slide 18, the obligation to furnish the disclosure document.

Now, franchisors have long been familiar with that tricky process of calculating the time where they have to provide the disclosure document. It was the earlier of, (A) the first personal meeting to discuss the possible purchase of a franchise, or (B) 10 business days before signing the agreement or receiving any consideration from the prospective franchisee. Well, the FTC has determined that that first personal meeting trigger really has become obsolete in light of the age of electronic communications and the way franchisors and prospects do business nowadays.

Similarly, everyone had trouble calculating the 10 business days, and that challenge is more than met when you have a 14-calendar day disclosure requirement, which is the new requirement. Just straight 14 calendar days. It's a lot clearer. Therefore, once you convert to the new format, these new delivery requirements apply, and the only obligation to furnish that disclosure document, except for one we'll talk about a little bit later, is that you deliver it 14 calendar days before you sign the agreement or accept any consideration.

So what happened to that five business day rule, the obligation to deliver the completed agreement or agreements? It used to be that you had to do that 5 business days before signing them, and that could run contemporaneously with the 10 business days. But it was still a significant hold-up, especially to prospective franchisees who, on the one hand, may want to negotiate, on the other hand, don't want to delay entering into the agreement. This requirement is now eliminated. There's no general requirement to replace it.

However, and, as usual, it's a big however, a franchisor does have to deliver a revised agreement seven calendar days before signing, if the franchisor makes a material and unilateral change. What does this mean? Well, for one thing, because the five business day rule was really an impediment to a franchisee's ability to negotiate, especially if say, for example, the franchisee had to sign a lease or fund financing. This frees up the franchisor and franchisee to negotiate, have multiple drafts of the franchise agreement, without worrying about the prospect having the documents for five business days before they could be signed.

Logically, though, it does make sense that if a franchisor, absent a negotiation, is making a unilateral change, that the document should be recirculated to the prospective franchisee. But the devil's in the details. What if there are fill in the blank provisions in the franchise agreement? There could be all kinds of things that have to be completed. Say, for example, and most typically, the territory that a franchisee is going to be granted. The FTC has given us some guidance in one of these FAQs, where they say that you can have a situation where inserting a description of a territory does not trigger this seven calendar day requirement, but it's a pretty onerous standard.

Typically, what you have, say, for example in Item 12 of the franchise disclosure document, is a description of how that territory will be determined. Maybe it's population based. Maybe it's county based. But the actual determination of what goes into the franchise agreement is often left until later. The FTC says, if you say in your disclosure document, "We define our territories by counties, and your county is Orange County, California," that will do it. You don't need to re-disclose. But, if you don't go to that extent, and you don't negotiate the territory description with the prospective franchisee, then you're going to have to get the completed documents seven days before you sign them.

Mary: Susan, again, if I can just interject. A question that came in, while we're on this topic of delivery requirements.

Susan: Yes.

Mary: If a state law requires a more stringent delivery requirement, are these preempted by the FTC Rule?

David: That's a great question.

Susan: Excellent question. We would have answered it two slides from now. The answer is no. No, the state laws that still have, on their books, the requirement of a first personal meeting delivery or 10 business day requirement, those state laws are still in effect and must be complied with. Hopefully, over the next year or so, all of those states will convert to the FTC Rule delivery requirements, but until they do, they are not preempted. Excellent question.

Mary: Okay. Thank you very much.

Susan: Sure. Now, a few minutes ago, I had mentioned the fact that earlier delivery of the disclosure document may be required. This earlier than the 14 calendar days. Well, there was no similar requirement before, when you had that first personal meeting trigger. But now, under the new rule, you must deliver the disclosure document earlier if a prospective franchisee reasonably requests it.

Now, does this mean that if someone contacts you, you must give them a disclosure document? No, the FTC has stated in the Statement of Basis and Purpose, that a prospective franchisee is generally one that's already filled out an application form and has already been told that they qualify for the franchise. It's someone with whom you're in ongoing discussions. That is meant to make this not so onerous of a requirement.

Another interesting question is, what is a reasonable request? Well, that's pretty much a case by case basis, according to the FTC. If a prospect shows up at a hotel, where the franchisor's officer is staying, and asks for a copy of the disclosure document, that's obviously not a reasonable request. One type of situation that comes to mind is, what if you have a legitimate prospective franchisee requesting a copy of the disclosure document, because they have to do something like decide whether to come out to discovery day, or enter into a lease for a location, or somehow make a major decision regarding this franchise, and they haven't seen a disclosure document yet.

But, you, franchisor are in the midst of updating your disclosure document, filing an amendment, or filing a renewal. And the disclosure document that you have available is outdated. The FTC has said you still have to give that to the prospective franchisee, if it's a reasonable request, and that the best practice would be to tell them that you're in the course of updating your document and that you will provide that to them when it's effective, but that you still need to give that prospective franchisee that document.

Now we've moved up to states that do have these earlier delivery requirements in a place, as our questioner just asked about. And slide number 21 lists them. They are Maryland, Michigan, New York, Oregon, Rhode Island, Washington, and Wisconsin. And you will see, as they become effective, that the new NASAA franchise forms and requirements for registration include a couple of paragraphs in the receipt page that describe these requirements, so that your receipt page can be uniform in all of the states.

Finally, I wanted to talk a little bit about electronic disclosure. This is the one area of the new rule that you could take advantage of on July 1st, 2007, even if you did not convert to the new disclosure format. The FTC Rule now makes clear that electronic disclosure is permitted. The delivery requirements can be satisfied by posting a disclosure document on the Internet or sending an electronic copy or CD-ROM to a prospective franchisee. And there is an optional paragraph you can include in your cover page if your documents are available in multiple formats.

There is a requirement for earlier disclosure about format information that we covered earlier. And that would definitely need to be complied with in any instance, but especially when you have electronic disclosure and certain requirements for formatting.

Now, what are the requirements if the franchise disclosure document is delivered electronically? Well, it must be a single document, and it must be in a format that the franchisee can download or store, print, and basically maintain for its records. It can't include anything like audio, video, pop- ups, animation, or external links, any of the things that might make it more user-friendly. But, as a compromise, the FTC does permit the document to include scroll bars and internal links and search features, which can also be quite helpful. If a company wants to go to an electronic disclosure format protocol, it is advisable to set up a system to administer this protocol, so that you can document access to the disclosure document and make sure you have evidence of receipt of the document.

Now, as we are drawing to an end, David, I understand there are going to be number of new exemptions under the amended rule.

David: Yes, there are. And basically, let's go to slide 23, what the FTC has done is they have federalized two or three of the exemptions that, not all, but many of the state registration states had. So, let's talk about specifically what we're talking about. Under the old UFOC Guidelines, there were certain exceptions for, let's say fractional franchise, single trademark license. Those are still retained.

But, in some of these state registration states, they had additional exemptions for, let's say, large franchisors and also for sales to large or sophisticated franchisees. So under the old rules, if it was a large franchisor or it was a franchisor that was selling to a large franchisee, because the federal law did not have those exemptions, that franchisor was still required to provide disclosure under the federal law. Even though they weren't required to register in the registration states that have those exemptions, they were still required to provide disclosure. So, let's say, Burger King or McDonald's in California might not have been required to register, but they were still required to disclose, because the federal disclosure law did not have those exemptions.

What the new rule has done is taken some of those common state exemptions and federalize them, so that now, if a franchisor falls within one of these new federal exemptions, they don't have to provide disclosure at all. And the new federal exemptions are for large and also sophisticated franchisees. That is, specifically, if a franchisor is selling to a franchisee where the initial investment is more than a million dollars, not including vacant land, or the franchisor is selling to a franchisee that has a net worth of $5 million and has been in the business, or a similar business, for at least 5 years, then no disclosure is required to those franchisees. There's also exemptions for insider sales.

Now, what the FTC did not do is they did not adopt a federal large franchisor exemption. So you still have this situation where a large franchisor does not have an exemption under the federal disclosure law, so it still has to provide disclosure. But certain registration states, for example New York and California, do have large franchisor exemptions. It's basically if there's a net worth of more than $5million, you still have to provide a short form disclosure, but you don't have the more detailed disclosure and registration requirements. So, unfortunately, this is a situation where the states are still not uniform with the federal law. And each particular situation will have to be looked at individually.

But if you are a franchisor that is only selling to large or sophisticated franchisees, and that's the only people you're selling to, then, arguably, you don't have to provide a disclosure document at all anymore, unless you're in a state registration state that does not have a similar exemption. So you're still going to need to look closely at each situation.

We're just about out of time. Hopefully, we'll have a little bit of extra time to take some additional questions. We have been trying to answer some questions that have been submitted through the chat box.

But last, we just wanted to emphasize the deadline. Slide 24, July 1, so we're less than two months away. What this means is any sales going forward after July 1, it's no longer optional. You have to comply with these new disclosure requirements and provide all of this additional information that we've talked about. The delivery requirements will now apply, unless, of course, if the registration state still has more strict delivery requirements. But July 1, everybody has to be providing the additional disclosures that are required in the rules.

Now, if you have already registered in a registration state under the old requirements, and you haven't yet registered in compliance with the new rule requirements, my understanding is that the state registration states are not requiring you to submit, after July 1, a new registration in compliance with the new rule. But of course, you're going to be having to provide the disclosure document in compliance with the new rule after July 1.

So, even though you don't have to be re-register it, you have to prepare it in any case, and you have to be giving it out in any case. So that's the most important thing to keep in mind is that you have to start giving out the disclosure document that complies with the new rules after July 1.

Mary: David, if I may ask a question that I'm sure is on other people's minds. As a franchisor, if you are non-compliant as of the July 1st date, is it your understanding that there will be any penalties or you'll have to stop doing business in certain states, or anything like that? Those are some of the ideas that I've seen batted around.

David: Well, as I said, everywhere in the country, you have to start giving out the disclosure document. So the only tricky issue is, let's say, if you registered at the end of the year in New York or California, and when you registered, you registered under the old UFOC Guidelines. Then as of July 1, do you have to file a new registration? You should check with each registration state, but my understanding is that the registration states are not requiring that. But you have to be giving out the disclosure document that does comply with the rules in any case.

Susan: And I don't think you can give out a disclosure document in a registration state that is different from the one that is registered. So, in effect, because all of those state laws will be preempted to the extent they are not more restrictive than the FTC Rule's format, then effectively from a practical point of view, if you haven't filed an amendment in a registration state to register that franchise disclosure document, you are dead in the water there.

David: Right, so you couldn't. Yeah, I haven't had that situation come up, because with all of my clients, we've gone ahead and already registered and complied with the new rules. But that makes sense.

Mary: Okay. Thank you. Yes, because I have seen the word penalties, and I was just wondering what that entailed -- penalties if you are in non- compliance by that time. Okay. I think we've covered everything. We're ready to take at least a few call-inquestions. If you'd like to have a question for David or Susan,just press 1-4, and the operator will put through your question.

Jesse: Thank you. Ladies and gentlemen, if you'd like to register aquestion, please press the 1 followed by the 4 on yourtelephone. You will hear a three- tone prompt to acknowledge yourrequest. Your line will be briefly accessed from the conferenceto obtain the information. If the question has been answered andyou would like to withdraw your registration, please press the 1 followed by the 0. If you are using a speaker phone, please liftyour handset before entering your request.

Susan: Mary, while we're waiting for the calls, are there any otherchat questions that we need to address?

Mary: Yes, there is a question that just came in from Cheryl, and thequestion is, "Do franchisors have to file and get approval fromthe registration states for the quarterly updates, which arerequired to be made to the FDD?"

Susan: Well, I'll just jump in. Typically, you have requirements ofthe state registration laws that actually require an amendmentif there's a material change, much more frequently thanquarterly. Some say "promptly," some say "immediately," some say"within 30 days." So, from the perspective of the registrationstates, if you have a material change, you will be making that likely long before the quarterly updates that are required byFTC Rule.

Mary: And I guess that hasn't changed very much.

Susan: No.

Mary: That was always in effect. Is that correct?

Susan: Correct.

David: So, Susan, what are the requirements for the quarterly updatesunder the new rule, if you could clarify that for everybody?

Susan: Oh, sure. The FTC Rule has updating requirements in it that aresimilar to what were there before. I think that the onlydifference is that the annual one is a longer period of timethan previously required. But, again, if you look at the oldinterpretive guides, to the extent that the rule doesn't changein a certain regard, they're still effective too. So there is an interplay when you have a registration state updatingrequirement and a federal updating requirement that will vary,depending on whether you're using the disclosure document in aregistration state or in a non-registration state.So, bottom line, if you're in an absolutely no registrationstates, then you would look at the quarterly updatingrequirements and the annual updating requirement of the FTCRule. But, because the registration states are more restrictive,you would look at them in registration state situations.

David: Right. So the new rule doesn't require you to just update ifthere haven't been any significant or material changes. Only ifthere is material change, then will you need to update.

Susan: Or provide the updated information.

David: Right. And, if you're in a registration state, the registrationstate is likely going to require you to do that as soon as thechange happens, and not wait till the end of the quarter?

Susan: Correct. Or within a certain period of time that is sooner thanthat quarterly update.

David: Right.

Susan: Yeah. And I don't believe that's a change.

David: Right.

Mary: Okay. Jesse, do we have any audio questions coming in?

Jesse: There are no audio questions at this time.

Mary: Okay. Then, hopefully that means that all of the questions have been answered, and I want to thank everyone for joining us today.And, hopefully, we've made a good start at helping you understand the new FTC Franchise Rule. And please remember thatyou may contact Susan and David. You will find their contactnumbers in one of the beginning slides. Thank you very much.

David: Thank you, Mary. Thank you, Susan.

Susan: Thank you, David. Thank you, Mary.

Jesse: Ladies and gentlemen, that does conclude the conference callfor today. We thank you for your participation and ask that youplease disconnect your lines.