The Rules Have Changed for Franchise Brokers and Franchisors

Part 1: Fewer FTC Disclosure Requirements Promote Changes in Broker Business

WASHINGTON, D.C. (Blue MauMau) - The Federal Trade Commission once stated, "the public record clearly indicates that franchisees who purchase franchises from franchise brokers or promoters need protection as much as those who purchase from the franchisor itself." But in spite of that observation, the FTC seems to be more lenient towards third-party brokers in revising its Franchise Rule last January. The Commission previously had not cut any slack for this industry in its regulations of disclosure documents, known as the Uniform Franchise Offering Circular, clearly identifying them as brokers. It defined brokers as "anyone who either offers or sells a franchise directly to a prospective franchisee, or otherwise arranges for the sale of a franchise." Franchisors were required to list brokers in the documents with their business background and history, the same as company officials and sales employees. The information had to include material or criminal civil actions regarding violations of franchise, securities and antitrust law, as well as fraud and unfair or deceptive practices and felony convictions.

When the FTC amended its original Franchise Rule this year, which became effective July 1, 2007, it included two major changes in franchisor disclosure documents regarding brokers. First, the FTC, with the help of North American Securities Administrators, NASAA (pdf file) ), officially renamed the broker as the "franchise seller," and second, it relaxed the requirements for broker disclosure. One explanation given at the International Franchise Association Legal Symposium on Broker Liability this year was that the revisions will better reconcile state law with the FTC's Franchise Rule, and will cut costs for franchisors and franchisees by reducing disclosure. Franchisors will no longer have to disclose the names of the brokers they use in the franchise disclosure document item 2, nor will they have to divulge broker litigation in item 3 or bankruptcies in item 4. Franchisors will be required to list "franchise sellers" on the receipt page for the revised Uniform Franchise Offering Circular.

Some of the changes that were made reflect a relaxation of the very rules that have been seen as unnecessarily burdensome to franchisors. Because there are usually pages of brokers listed in the UFOC, which some feel no prospect reads, omitting that section will relieve franchisors of keeping the list updated and accurate. It will also help alleviate liability. One example given at the legal symposium was a court decision made in a lawsuit where a franchisee sued a franchise broker for alleged violations of state law and unfair and deceptive trade practices. He was asking for the return of the purchase price of the franchise, but was instead awarded three times the original amount. In appeal, the district court's ruling was affirmed.

Even though the regulations will be less of a burden to franchisors, FTC is requiring some new language in the franchise disclosure document. Franchisors must clearly state on its cover page, according to NASAA Interim Guidelines, the following statement:

We use the services of one or more FRANCHISE BROKERS or referral sources to assist us in selling our franchise. A franchise broker or referral source represents us, not you. We pay this person a fee for selling our franchise or referring you to us. You should be sure to do your own investigation of the franchise.

And on its Exhibit 1 Definition page it gives the following description:

Franchise seller means a person that offers for sale, sells, or arranges for the sale of a franchise. It includes the franchisor and the franchisor’s employees, representatives, agents, subfranchisors, and third-party brokers who are involved in franchise sales activities. It does not include existing franchisees who sell only their own outlet and who are otherwise not engaged in franchise sales on behalf of the franchisor.

Although the FTC had addressed franchise brokers federally, only five states directly defined rules for franchise brokers — Illinois, New York, Hawaii, Washington and Virginia. But that too has changed. Illinois and Washington are the only two states that will now require state regulation.

Brokers Revamp Old Business Model, As Will Franchisors

Franchise brokers, no doubt, are as pleased with the recent revisions in the Franchise Rule as are franchisors. For years they have tried to distance themselves from the controversial "broker" label by coming up with new ways to describe the services they provide in finding franchisee prospects for franchisors. Among them are consultants, coaches, lead generators, advisors and referral networks. The word "broker" seems to have a negative connotation for a variety of reasons, one being that they are paid a commission by the franchisor, which is sometimes negotiated on a case-by-case basis. Another is that brokers have limited franchisor clients, restricting the number of businesses prospects can choose from. And one more concern is that referrals may be biased because some brokers receive larger commissions from the big franchisors, causing them to push would-be franchisees in their direction.

But there have been other problems associated with franchise brokers, namely that of false advertising and giving illegal earnings claims to prospective franchisees. Some broker websites are constantly making claims of expected earnings which cannot be substantiated in disclosure documents. They also give outdated statistics regarding the success rate of franchised businesses compared to those that are independent. These misleading and illegal marketing tactics seem to go unchallenged year after year.

Broker Competition Becomes More Fierce

As franchisors prepare for the amended FTC Rule, mandatory on July 1, 2008, the pool of prospective franchisees seems to be dwindling due to lower unemployment, a good economy and growing competition. Low employment, according to some franchise insiders, keeps people in their jobs, while a good economy allows franchisors to expand their businesses, requiring more prospects. The broker business is already fiercely competitive and now with the relaxation of regulation it may grow. Some franchise consultants who used to detest the idea of brokers are now changing their tune and adding a referral network, another term for brokers, to their services.

The franchise community is now seeing a change in the way some brokerage firms are expanding and improving their businesses. Some are using the usual techniques of giving bonuses to their broker consultants or even offering stock in their company. Others are considering franchising their own brokerage business, in spite of one well-known broker being knee-deep in litigation with his own franchisees. Others are being more creative by considering bringing their "franchise sellers" in-house instead of trying to manage independent outside consultants.

But at the same time, franchisors are also becoming more innovative and questioning if using franchise brokers is cost-effective. Speakers at this year's IFA Legal Symposium stated that despite the abundance of franchise brokers, there is a surprising amount of debate as to the actual usefulness of the services they provide. They state, "It is often just as effective and much less expensive for a franchisor to have an in-house sales team." Speakers also revealed that some franchisors use both, along with regional developers, which only adds to the confusion as to who brought the prospect in.