By David Cahn & Jeffrey Fabian
The relationships involved in two- and three-tiered, multi-unit franchise expansion models raise difficult compliance questions under the Federal Trade Commission (FTC) Franchise Rule (“FTC Rule”) and the various state franchise registration and disclosure laws. Failure to properly disclose all parties involved in the franchise sales process, including intermediate parties, can lead to civil liability, fines and cancellation of franchise agreements.
Franchisees involved in multi-unit expansion typically fall into one of three classes. “Area Developers” are typically a franchisee who is granted the right to open more than one franchise in a defined territory in accordance with a development schedule, as a “multi-unit developer.” Area Developers of this type do not have any franchise disclosure obligations. “Master franchisees,” also known as “Sub-franchisors,” recruit and enter into franchise agreements directly, and pay fees to the franchisor out of the amounts they collect from their franchisees; these parties must issue an FDD and register as franchisors in states that require such filings. The third category, “Area Representatives” or “Development Agents,” are sub-contractors of franchisors, acting as sales agents and performing some post-sale obligations on the franchisor’s behalf in a defined geographic area in exchange for a percentage of franchise fees paid by franchisees in the assigned area. The disclosure and registration obligations concerning Area Developers have created uncertainty in the law.
A recent case still pending in the Washington State court system demonstrates the complexities and obscurity surrounding the registration and disclosure obligations of franchisees involved in a franchisor’s multi-unit expansion efforts. Pinchin v. Nick-N-Willy’s Franchise Pizza Company, LLC involves a franchisee’s claim for rescission of its franchise agreement based upon the franchisor’s failure to disclose its relationship with an area representative who “played a role” in recruiting the franchisee into the Nick-N-Willy’s system. The franchisor’s FDD did not reference the area representative, and the area representative did not prepare his own FDD. The court determined that the area representative was required to be disclosed in the franchisor’s FDD and to independently register as a “subfranchisor” with the Washington Securities Division. As a result, the court awarded the franchisee “rescission” of the franchise agreement, meaning that it was released from all obligations in the agreement (including the covenant not to compete) and granted the right to obtain a refund of all amounts paid to the franchisor, and possibly additional damages to compensate for its losses due to pursuing the franchise. The case is still pending solely for a determination of the franchisee’s monetary damages award.
Under the FTC Rule only true “Sub-franchisors” who enter into agreements with franchisees must prepare their own FDDs. It appears that the area representative relationship in Nick-N-Willy’s is not a subfranchise under the FTC Rule, but the court determined that the area representative was obligated to register as a franchisor under Washington law.
According to Dale Cantone, chair of the Franchise and Business Opportunities Committee of the North American Securities Administrators Association (“NASAA”) and Deputy Securities Commissioner in Maryland, that committee is studying the issue of the disclosure and registration duties of Area Representatives and hopes to provide additional guidance to the states in the near future. Such guidance would be helpful in clarifying an uncertain area of franchise sales law.
In the meantime, however, the Nick-N-Willy’s case is a warning shot directed at franchisors and area representatives who fail to disclose their relationship to prospective franchisees. In states like Washington where the definition of a “subfranchisor” is arguably broader than the definition under the FTC Rule, area representatives may face registration obligations. Franchisors and their development agents in the field should carefully consider whether the area representative’s information should be included in various portions of the Franchisor’s FDD used in the area representative’s state, since such disclosures may be required by the FTC Rule.