Prepared Statement of Dale E. Cantone
Deputy Securities Commissioner and Chief of the Franchise
Business Opportunities Unit of the Office of the Maryland Attorney General, Securities Division
Subcommittee on Commerce, Trade, and Consumer Protection of the Committee on Energy and Commerce,
United States House of Representatives
June 25, 2002
A. The Franchise Disclosure Document
Federal and state franchise laws require presale disclosure of all material information necessary for a prospective franchisee to make an informed decision regarding the franchise being offered.
Fifteen states require registration of a franchise offering in addition to presale disclosure. Those states require franchisors to use the “Uniform Franchise Offering Circular Guidelines” to prepare their franchise disclosure documents. As a practical matter, most franchisors use a UFOC disclosure document in all 50 states.
The Franchise Rule is now 23 years old, and the disclosure document required under that Rule is not as relevant to prospective franchisees as the disclosure document required under the UFOC Guidelines.
The FTC is considering a proposal to revise the Franchise Rule by replacing its current franchise disclosure requirements with new disclosure requirements based in large part on the UFOC Guidelines, with some additional disclosures. NASAA supports this effort.
B. Federal-State Cooperation regarding “Business Opportunities”
The FTC should revise the Franchise Rule to distinguish “business opportunities” from “franchises” because those investments are clearly distinguishable. Currently, both types of investment opportunities are regulated under one rule–the Franchise Rule.
States and the FTC have cooperated in recent years on enforcement actions against fraudulent business opportunities. This cooperation has resulted in a number of law enforcement sweeps.
Many business opportunity sellers maintain an office in one state but sell their business opportunities to residents of another state. Federal-state cooperation is an important component in the fight against fraudulent business opportunities.
States and the FTC have communicated effectively regarding investigations and other issues involving fraudulent business opportunities through law enforcement summits, an electronic List Serve, and an on-line complaint database.
Chairman Stearns, Ranking Member Towns and Members of the Subcommittee: My name is Dale Cantone. I am the Deputy Securities Commissioner in the Office of the Maryland Attorney General. I also chair the Franchise and Business Opportunity Project Group of the North American Securities Administrators Association (“NASAA”). In the United States, NASAA is the national voice of the 50 state securities agencies responsible for investor protection and the efficient functioning of the capital markets at the grassroots level. Many of the agencies that administer and enforce state franchise and business opportunity laws are members of NASAA.
On behalf of NASAA, I appreciate the opportunity to appear before you today. Franchising continues to be a vibrant and popular business strategy in our economy. Oversight of franchising is an important consumer protection for hundreds of thousands of existing and prospective franchisees. It requires careful attention by both federal and state authorities. NASAA welcomes the subcommittee’s interest in this issue and looks forward to working with you and your staffs. My comments today will focus on two issues: state and federal franchise disclosure requirements; and state and federal cooperation on business opportunity enforcement initiatives.
Franchise Regulation: An Overview
Oversight of franchising at the state level is grounded in the traditional commitment of grassroots officials to protect consumers whenever possible before they part with their money; and in those cases where money is lost in a fraudulent deal, to marshal the enforcement resources to shut down the violator and seek restitution if possible.
California adopted the first state franchise statute in 1971. Today, 15 states1 have statutes that regulate the offering of franchises for sale. Eleven of these states2 operate under similar or uniform statutes that require registration with a state agency and delivery of disclosure documents to prospective franchisees prior to an offer and sale of a franchise.
Both state and federal franchise disclosure laws are intended to provide each prospective franchisee with the information necessary to make an intelligent decision regarding the franchise being offered. Further, state franchise laws bar the sale of franchises where such sales would lead to fraud or a likelihood that the franchisor’s promises would not be fulfilled.
At the federal level, the Federal Trade Commission (“FTC”) adopted its Franchise Rule3 in 1979. While the FTC’s Franchise Rule requires presale disclosure, there is no federal requirement that a franchisor register its disclosure document with the Commission, and no one at the federal level reviews the disclosure documents that a franchisor must provide to prospective franchisees. The Franchise Rule expressly preserves the right of states to adopt laws that are not inconsistent with the Franchise Rule if those laws provide protections that are equal to or greater than that provided by the Rule.
The franchise registration laws that 15 states have adopted are designed to provide greater protections to prospective franchisees and prevent fraud in the sale of franchise offerings. Eleven states require that franchise disclosure documents be filed and reviewed by trained state personnel, called franchise examiners. Through their efforts, state examiners can better discover proposals that are fraudulent or unlawful, and thereby protect state consumers before they have parted with their money.
Although all states do not require registration of franchise offerings, few franchisors sell in non-registration states only. Thus, franchise reviews conducted by so-called “registration states” have improved the standard of disclosure generally in the franchise market.
In recent years, some have questioned the need for any state to perform reviews of offering circulars. Yet the registration and review function is an important part of the franchise regulatory scheme. Although large franchisors typically retain experienced lawyers to draft franchise disclosure documents, even large franchisors sometimes fail to disclose all of the information required by the disclosure guidelines. In addition, some large franchisors target unsophisticated franchisees. The franchise review process can better inform the unsophisticated franchisee about risks the franchisee may not fully appreciate. The states’ ability to require financially undercapitalized franchisors to escrow franchise fees also benefits prospective franchisees. State examiners may identify specific “risk factors” that a franchisor must disclose on the cover of state disclosure documents. These risk factors highlight special concerns that a franchisee should consider before investing in a franchise.
In addition, not all franchisors are well established or experienced in preparing offering circulars. States routinely receive franchise registration applications from start-up and smaller franchise systems. Some of these applications are prepared without benefit of legal counsel. Some do not even begin to approach substantial compliance with the state guidelines. For these franchisors and, more important, for their prospective franchisees, the review function conveys a critical benefit.
State agencies that require filing of franchise disclosure documents also serve as an important repository of information for prospective franchisees to compare documents from various franchisors. In many instances, this information is crucial to the process undertaken by investors to evaluate franchise deals. Many franchisors do not deliver copies of their disclosure documents to the public upon request.
The states have a broad assortment of enforcement tools available under their franchise laws that allow them to move swiftly and decisively against violators. States may issue orders prohibiting violations of the law, as well as orders denying, suspending and revoking registration and exemption of franchises. In addition, states have injunctive and criminal referral authority.
Franchisees in registration states benefit tremendously from the private right of action granted under state law. In contrast, private parties cannot enforce violations of the FTC Rule; only the FTC has that authority. A private right of action allows consumers to sue for damages when they sustain losses due to franchise law violations. The experience of state regulators is that private remedies serve as a necessary supplement to governmental regulation and enforcement efforts in providing a deterrence to abuse. Without private remedies, injured franchisees can be protected only through governmental action. The absence of a private remedy places a greater premium and demand on the already strained resources of the regulatory agencies and frequently means that fewer injured franchisees can be “made whole” than would be the case if a private right of action was explicitly authorized in the law.
The Role of NASAA
An important goal of NASAA is the promotion of efficient and uniform state laws. In the franchise regulation area, it is NASAA’s intention to move forward and continue the serious efforts the Association has undertaken to promote uniformity of state law, provide enhanced training and educational opportunities for state franchise personnel, seek ever more cooperative relationships with the Federal Trade Commission, and solicit the advice and input of franchisors and franchisees.
To further the goal of state uniformity, NASAA authored and encouraged adoption of the UFOC Guidelines. NASAA sponsors regular franchise training programs and educational seminars for state franchise examiners. NASAA also regularly proposes uniform statements of policy on many franchise related issues. These statements of policy are model laws and regulations that are made available for states to adopt in accordance with their laws. NASAA recently implemented a new Internet “List Serve” by which state examiners and enforcement personnel can contact each other to discuss issues of common concern and seek effective solutions to matters involving franchise reviews and potential enforcement actions.
Two years ago, NASAA developed and launched a new program of coordinated franchise review, which has been adopted by all of the franchise registration states except California. Coordinated franchise is a voluntary program open to franchisors that allows them to file a franchise registration in multiple states at the same time. Coordinated review eliminates conflicting comments by state examiners and results in a single, uniform franchise offering circular that is made effective on the same date in multiple jurisdictions.
The Uniform Franchise Offering Circular Guidelines
NASAA authored the Uniform Franchise Offering Circular (“UFOC”) Guidelines after holding public hearings and extensive discussion with members of the franchisor and franchisee communities, academics, and the FTC. On April 25, 1993, NASAA unanimously adopted the UFOC Guidelines as the recommended format for franchise disclosure documents at the state level. Within two years, the new Guidelines were adopted by each of the state franchise regulatory authorities that require registration of franchise offerings. On December 30, 1993, the FTC approved the use of the UFOC as an alternative to the FTC’s disclosure requirements.
As part of its ongoing Rule Review, the FTC is currently considering a proposal to replace the franchise disclosure requirements4 under the Franchise Rule with updated disclosure requirements based in large part on the UFOC Guidelines, with some additional disclosures. NASAA supports the FTC’s efforts to modify the Franchise Rule in this way.
The UFOC is the only franchise disclosure document that franchisors may use in the 15 states that register franchise offerings. The UFOC Guidelines are, in fact, a revision of several earlier versions of the Guidelines, versions of which have been in effect since 1975. The UFOC Guidelines reflect an effort on the part of NASAA to produce a more readable and relevant disclosure document for franchisees, and one that does not unduly burden franchisors. It is a disclosure document that was based on the experiences of many individuals in the franchise community as to what constitutes “material” information about a franchise offering.
NASAA asserts that the UFOC is a superior disclosure document than the current disclosure document required under the Franchise Rule. The UFOC requires disclosure of information that franchisees need to know in order to make an informed investment decision in the present business environment. For example, the UFOC requires disclosure of required computer hardware and software (UFOC Guidelines, Item 8 A), including whether the franchisor will have independent access to the stored data (UFOC Guidelines, UFOC Guidelines, Item 11, Instruction 11 iii c). The UFOC Guidelines require extensive disclosure about a franchisor’s use of advertising dollars and advertising programs (UFOC Item 11). There is extensive disclosure about protected territory, or the lack of one, and the franchisor’s ability to establish alternative channels of distribution in a protected territory (UFOC Item 12). The UFOC is intended to be written in “plain English” (UFOC Instruction 150) and features a readable cover page that emphasizes the most important aspects of the disclosures in the document.
There would be a significant advantage to franchisors if the FTC were to adopt a new Franchise Rule based on the UFOC model. Many franchisors, especially those that offer franchises in multiple jurisdictions, have experience with preparing an offering circular based on the UFOC Guidelines. The Guidelines are intended to produce a single disclosure document that may be used in multiple states. In addition, many of the questions of interpretation that inevitably accompany any new guideline or regulation have been answered. The UFOC Guidelines have been the subject of numerous programs and seminars open to franchisors and franchisees. In 1994 and 1998, NASAA published Commentaries to the UFOC designed to discuss and clarify issues of interpretation.
As part of the FTC’s recent Franchise Rule Review, the FTC has sought input from NASAA and a variety of other sources representing both franchisors and franchisees. In addition, the FTC has sought to work with NASAA and the franchise review states to ensure that the new disclosure document to be required under the Franchise Rule provides enhanced and commonsense disclosures for franchisees. As a result, the FTC has identified several disclosure items not currently required under the UFOC Guidelines that the FTC may seek to require under the revised Franchise Rule, for example, new disclosures related to a franchisor’s parent and franchisor initiated litigation.
The disclosure document that the FTC has proposed under its Rule Review is a significant improvement over the existing format. Adoption of a federal franchise disclosure document consistent with the current proposal would benefit prospective franchisees in every state, especially those who reside in the 35 states that do not currently require a disclosure document to be prepared under the UFOC Guidelines. NASAA and the franchise review states look forward to continuing to work with the FTC as it seeks to finalize the new Franchise Rule.
Distinguishing Between Disclosures for Business Opportunities and for Franchises
One of the other proposals in the FTC’s Franchise Rule Review is to include a specific definition of “business opportunity” that distinguishes it from a “franchise.” NASAA applauds this effort. This distinction is necessary in order to avoid the current confusion caused by the FTC’s attempts to regulate two distinct types of business enterprises under one rule. Typical “business opportunities” include distributorships involving vending machine, greeting card display racks, and medical billing software.
Currently, 24 states regulate the offer and sale of “business opportunities.” Many states require registration of business opportunity sellers as well as presale disclosure to prospective buyers. In general, states require business opportunity sellers to provide a disclosure document that, in most cases, is simpler and more abbreviated than the type of disclosure document required for franchise offerings.
Most business opportunity ventures are clearly distinguishable from a franchise. Business opportunities generally require much smaller investments than the fees required to purchase a franchise and unlike franchisors, business opportunity sellers provide very little, if any, assistance and training and exert little control over business opportunity purchasers. The contracts are simpler and impose fewer restrictions on buyers. In addition, business opportunity buyers generally do not operate under the sellers’ tradename, trademark, or service mark. The creation of a separate definition of a business opportunity under the Franchise Rule would recognize these differences.
A separate definition for business opportunities also would improve state and federal enforcement efforts. Prospective business opportunity buyers have expressed their concern and confusion over the type of investment being purchased. For example, a business opportunity under state law might be considered a franchise under the Franchise Rule. Adopting a clear and distinct definition of a business opportunity would enable prospective buyers to determine what rules apply to their investments. This revision also would benefit state and federal enforcement efforts by clearly defining the type of investment opportunity being investigated.
Federal and State Cooperation on Business Opportunity Enforcement Actions
On June 20, 2002, the FTC, Department of Justice (“DOJ”) and 17 states announced “Project Busted Opportunity,” a coordinated attack on business opportunity and work-at-home fraud. The initiative included a consumer education campaign and a law enforcement sting targeting hucksters who use deceptive earnings claims and paid “shills” to promote their scams or otherwise violate consumer protection laws. Seventy-seven operations were caught in the sting.
The 17 state law enforcement agencies participating in Project Busted Opportunity announced a total of 48 actions against business opportunity sellers. Those actions include lawsuits, cease and desist orders, consent agreements, and fines. The FTC and DOJ each brought 11 cases in federal court.
Project Busted Opportunity is but the latest in a series of federal/state enforcement sweeps regarding business opportunity fraud. Since 1995, the FTC has organized at least six federal/state coordinated sweeps aimed primarily at business opportunities.5
From about 1995 until 2001, the FTC and NASAA have jointly sponsored annual law enforcement summits dealing with business opportunities, franchises and pyramid schemes. These summits presented an opportunity for state and federal law enforcement officials to communicate with each other and coordinate law enforcement issues. At the summits, state and federal law enforcement personnel had the opportunity to meet and discuss current and anticipated enforcement actions, upcoming sweeps, industry trends, investigative techniques, and consumer education. Last year, the FTC did not hold an annual law enforcement summit on franchises or business opportunities. NASAA hopes that, in the future, the FTC will join us again in co-sponsoring these important events.
FTC staff also regularly communicates with state enforcement personnel through regular conference calls, an FTC sponsored business opportunity List Serve, and Consumer Sentinel. Consumer Sentinel is an on-line complaint database repository available to approximately 250 law enforcement agencies around the U.S., Canada and beyond. The Consumer Sentinel database is a valuable resource, and has proven itself to be an especially effective tool in the fight against business opportunity fraud.
There is no doubt that communication between federal and state officials on business opportunity issues is critical. In many cases, business opportunity con artists maintain their offices in one state but avoid selling to consumers in that state, in an effort to avoid detection and prosecution by state law enforcement officials. In those instances, it is critical for states to work with each other and federal officials to make sure that the business opportunity con artists are identified, caught and brought to justice.
NASAA and state business opportunity enforcement officials look forward to continued opportunities to work with the FTC and each other to take effective action against con artists who commit business opportunity fraud. We hope to continue and expand interagency opportunities to work together on both enforcement matters and consumer education.
Mr. Chairman and members of the Subcommittee, NASAA appreciates your interest in franchising and the role of the states in safeguarding the interests of franchisees. It should be apparent that the current system of state franchise regulation is a vital component of the entire regulatory scheme in this area. Clearly, oversight of franchise and business opportunity offerings is an important consumer protection for the hundreds of thousands of people who invest in these operations. We look forward to a continuation of federal and state cooperation on franchising and business opportunity issues.
1California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin.
2California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia and Washington. In addition, Oregon requires disclosure prior to the sale of franchises, but does not have a registration or filing process. Indiana, Michigan, and Wisconsin require disclosure and the filing of a “notice of franchise offering.”
3Trade Rule 436, “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities Ventures” (16 CFR, Ch.1, Part 436).
4Described at 16 CFR §436 (a) (1) through (20).
5See United States General Accounting Office, Federal Trade Commission Enforcement of the Franchise Rule: Report to Congressional Requesters; Table 7, p. 66 (July 2001).
June 25, 2002