Navigating the Gray Areas: Systems and Best Practices for Legal Compliance
Properly designed systems and processes can help ensure compliance and provide guidance for navigating problematic compliance issues that frequently arise.
By Richard Morey, CFE, and Ann Hurwitz, CFE
The franchise disclosure document is at the heart of franchise compliance. Each fiscal year the FDD must be updated. In some franchise companies, it is “legal’s job” to manage the updating process, but while the legal/compliance department clearly has a significant role, it is critical to involve the entire organization. Representatives from all areas, including finance, real estate/construction, and operations, as well as the franchise development team, should review the FDD each year. Even if team members do not provide many comments, there is a benefit to having them understand the disclosures. This is particularly true for the franchise development team, so that their statements in the sales process are consistent with the document. The development team is also best positioned to comment on the clarity of the FDD disclosures based on their discussions with prospective franchisees.
Once the FDD is updated, the franchisor should have a system in place for tracking the disclosure process. Many franchisors are now using third party technology providers to manage disclosure document delivery and other aspects of the disclosure process. These providers automate the disclosure process and can track when prospects first access the FDD and sign (electronically) its receipt. They also can help prove that the prospective franchisee was able to store, download, print or otherwise maintain the FDD for future reference, as required by the Federal Trade Commission’s franchise rule. Of course, it remains important for the franchisor to manage the state registration and exemption process by ensuring that the provider has the correct disclosure document for each state (if the franchisor uses multiple FDDs) and that the appropriate registrations or exemptions are in place before a prospective franchisee gains access to the franchise disclosure document.
Many franchisors, including some who disclose electronically, still collect manually-signed FDD receipts, and they need to carefully monitor the dates and signatures on the receipts. It is common for a prospective franchisee to sign and date the receipt when he sends the receipt to the franchisor, instead of when he actually received the FDD. If the prospect signs and dates the FDD receipt at the same time he signs and dates franchise agreement, then it could appear to be a disclosure violation, even if the document was delivered weeks earlier. If the franchisor has proof (such as a delivery receipt or an email) indicating when the FDD was actually delivered, the franchisor can ask the prospect to sign a new FDD receipt reflecting the actual delivery date. This way the franchisor can correct the mistaken appearance of a disclosure violation.
Another practice to help ensure legal compliance is to make a financial performance representation in the FDD. An FPR is a representation that states, expressly or by implication, actual or potential sales, income or profits. Franchisors may make FPRs only if they have a reasonable basis for making them, have written substantiation for the representations at the time they are made, and include the FPRs in Item 19 of the disclosure document. Whether the franchisor has a reasonable basis to make an FPR, and what information should be disclosed, is a complex question that requires significant planning. FPRs are becoming more common, however, in part because prospective franchisees are demanding this information. Providing a well-prepared financial performance representation in the FDD can be an important part of a franchisor’s compliance program because it can diminish (and hopefully eliminate) the development team’s desire to provide financial information outside of the FDD in violation of the franchise laws. Unauthorized FPRs often are not the result of unscrupulous behavior, but rather the result of a well-intentioned franchise seller responding to requests from prospects. Providing a financial representation in the disclosure document is the best way to minimize the compliance issues associated with unlawful FPRs provided outside the FDD.
Franchisors also can implement procedures to minimize compliance issues in FDD amendments. Franchisors must amend the disclosure document if there is a material change to the information in the FDD. Involving the compliance administrator in periodic meetings to discuss the franchisor’s financial condition, development plans and other strategies can ensure that potentially material changes are identified early. Also, while many franchise disclosure document amendments are triggered by external changes, such as the filing of a lawsuit, amendments for other reasons (e.g., new programs that impact fees or initial investment levels) are voluntary and their timing can be controlled. Franchisors can coordinate these voluntary amendments with their development pipelines to ensure that the sales process continues while prospective franchisees are given the most accurate information about potential changes.
Detecting Compliance Problems
Even franchisors that have solid compliance programs will encounter occasional lapses. An important part of any compliance program is implementing procedures designed to detect, and if possible correct, issues before they become violations.
One critical element of the compliance program is a final compliance check before each franchise agreement is signed. A compliance administrator should have a checklist designed to confirm that the basic disclosure processes were followed. The checklist covers items such as state registration/exemption status, timing of FDD delivery, correct dates on disclosure document receipts, proper identification of franchise sellers, proper signing of agreements (including any state-specific amendments or riders), and proper formation and ownership of business entity franchisees. This final check should be done before the franchisor signs the franchise agreement, as some of these compliance issues can be corrected before the signing but not after.
Many franchisors also utilize a franchisee compliance questionnaire. This is a document that franchisees complete before signing the franchise agreement to uncover any compliance-related issues. These questionnaires might ask the franchisee to confirm that there were no unanswered questions about the franchise opportunity and no unauthorized financial performance representations provided. Given the FTC’s franchise rule’s prohibition on disclaiming or requiring a franchisee to waive reliance on any representation in the FDD, as well as the state franchise laws’ prohibitions on waivers of compliance with those laws, a franchisor could face significant challenges in relying on these compliance questionnaires to override actual violations of the law. However, when used properly, the questionnaires can help franchisors detect and correct issues before the franchise agreement is signed.
Richard Morey, CFE, is a partner at DLA Piper in its Chicago office. Ann Hurwitz, CFE, is a partner at Baker & McKenzie in its Dallas office.