As an attorney who represents franchisors, a significant part of my practice is drafting franchise agreements and franchise disclosure documents. Once these documents are completed, I also help franchisors comply with state laws by filing and maintaining their registrations in the various states that have franchise registration laws.
As a result, much of my time (particularly during the first half of the year) is spent dealing with franchise regulators in various states.
During my years of practice, I have seen a number of common mistakes made by both start-up and established franchisors in their Franchise Disclosure Documents ("FDDs"). Many of these mistakes, which can cause delays in a franchisor's ability to obtain registration, are easily avoided. Make them, and state regulators will refuse to register your franchise offering - sending you a comment letter requiring you to correct your errors before issuing a registration permit. Avoid them, and your time to obtaining registration may be cut down by weeks, or even months.
The Disclosure Requirement
A common FDD mistake is failure to list all "Other Fees" in Item 6. Item 6, entitled "Other Fees," is where a franchisor must disclose all fees, other than initial fees, that are paid to or imposed by the franchisor. Specifically, in Item 6 a franchisor is directed to disclose "all other fees that the franchisee must pay to the franchisor or its affiliates, or that the franchisor or its affiliates impose or collect in whole or in part for a third party." The franchise company must list the type of the fee, state the amount (either a fixed amount or a formula used to determine that amount), state the due date, and make any remarks, definitions, or caveats regarding the fee.
Many franchisors do not follow instructions and fail to list all "other fees" in Item 6. These mistakes typically come in two varieties.
1. Common Mistake #1: Failure to List All "Other Fees" Paid to the Franchisor or its Affiliates
The first type of mistake is that the franchisor or its counsel fails to list all of the fees that could be charged during the life of the franchise according to the franchise agreement. In these situations, the franchisor may list only the more "obvious" fees like the royalty fee, advertising fund fee, technology fee, and the like - the fees that are typically identified in a section of the franchise agreement devoted specifically to listing fees.
The problem with this approach is that often, a number of other possible payments are hidden within other section of the franchise agreement, and these amounts clearly fall within the definition of "other fees" in Item 6.
There can be a multitude of fees charged that may be hiding in the franchise agreement but need to be disclosed in Item 6. Some examples:
- The franchisor charges a "relocation fee" in the event that the franchisee wants to relocate the franchised business.
- The franchisor charges a mark-up fee if the franchisor is required to obtain insurance for the franchisee, because the franchisee failed to purchase insurance on its own.
- If the franchisor conducts an audit of the franchised business that shows the franchisee has understated its gross revenue to the franchisor, the franchisor charges the franchisee for the cost of the audit (in addition to the other rights that it retains under those circumstances).
- The franchisor charges a fee for the franchisee to send a replacement manager to attend the franchisor's initial training program.
- The franchise agreement has a liquidated damages provision that requires the franchisee to pay a set amount if the franchise agreement is terminated early due to the franchisee's material uncured breach of the contract.
- The franchisor requires the franchisee to pay for or reimburse the franchisor for the cost of advertising, marketing or promotional materials provided by the franchisor.
This is only a partial list of the types of fees that can fall under the category of "other fees." I have seen many FDDs where franchisors will clearly charge these fees, but fail to list or disclose them in Item 6.
2. Common Mistake #2: Failure to List All Initial Fees Imposed and Collected by the Franchisor
The second type of common mistake is the franchisor lists only fees paid by the franchisee directly to the franchisor, but ignores the fees that are imposed and collected by the franchisor. The instructions for Item 6 clearly call for these fees to be disclosed, too.
Some examples of fees that might be imposed and collected by a franchisor:
- The franchisor uses a third-party company to conduct "mystery shop" visits, but pays the third-party directly and bills the franchisee as a pass-through cost.
- The franchisor has a centralized toll-free phone number for the system, and charges the franchisee its pro rata share of the cost of the number.
- The franchisor requires the franchisee to use a third-party software, the third party charges a license fee for that use, and the franchisor pays the fee on the franchisee's behalf and then bills the franchisee for the cost of the fee.
Again, these are just some examples of the types of fees that might be "imposed and collected" by the franchisor.
3. Common Mistake #3: Over-listing Fees in Item 6
The final type of mistake is not as problematic as mistakes #1 and #2, but a franchisor should strive to avoid it anyway. Many times, a franchisor will list too many fees in Item 6, and include fees that are not called for by the FDD Guidelines. A franchisor should avoid listing these fees because they clutter and unnecessarily lengthen the FDD. Moreover, both the Federal Trade Commission and the various states that regulate franchise companies admonish franchisors to not include information in the FDD that the Franchise Rule or state law do not specifically call for.
Some of these over-disclosed fees that I have seen listed in Item 6 of franchisors' FDDs include:
- The franchisee's required local advertising spend, which need not be included in Item 6 unless the amount will or could be paid to the franchisor or its affiliates.
- The franchisee's rent payment obligation under its lease, which does not need to be disclosed in Item 6 unless the franchisor leases space directly to the franchisee.
- The franchisee's expected employee salaries.
Again, the listing above is only a partial one - I have seen many different fees included in Item 6 of franchisor FDDs when they clearly did not have to be listed there.
Avoid making these common mistakes in Item 6 of your own FDD, and you will have an easier time of getting registered in the registration states. You may also avoid liability due to claims by franchisees that you did not comply with disclosure laws by failing to disclose fees as required by law.