State Regulators Declare Registration Do's and Don'ts

Meanwhile, Leets put in a pitch for sustaining California's unique database of franchise registration documents, known as Cal-EASI. “California is in a severe budget crisis, and resources are limited. Cal-EASI is expensive to maintain because it requires an immense amount of scanning of paper documents,” she said. “There's no way of guaranteeing that Cal-EASI will be here forever. If you find it to be meaningful and helpful, now is the time to say something.”

Kevin Adler is associate editor of FBLA.

Attorneys seeking to obtain or renew franchise registration in state-registration states are always interested in how to get those state registrations quickly and with the least amount of back-and-forth with regulators. At the “Ask the Regulators” session at the IFA's 2010 Legal Symposium, representatives of three registration states offered suggestions about how to make the process run more smoothly.

Timothy O'Brien, chief examiner, Virginia Division of Securities & Retail Franchising, said that new franchise registrations were down about 25% in 2009, reflecting fallout from the economic downturn. “New franchise applications had been growing at 5% to 10% per year, but the 25% drop last year knocked us back to the levels we had seen in 2004,” he said. “Renewals were down about 6.5%. This year, we're seeing a small uptick from that level.”

Franchise regulators look to attorneys to uphold the integrity of the process and to treat the review of applications as more than processing paperwork, said Theresa Leets, senior corporations counsel, California Department of Corporations. “You are the coach [of the franchisor], and I'm the referee,” she said. “Teach your clients to play fair. Don't play 'fool the regulator.' I hate that game.”

All three regulators said that integration clauses continue to be a problematic area, though Dale Cantone, assistant attorney general, Maryland Attorney General's Office, said that he has seen “improvement” in the last few years. “I had noticed that franchisors filing after 2007 [when the new franchise disclosure rules came into effect] were still using the same, old integration clauses,” said Cantone. “But the FTC had made a point to say that franchisors could not use integration clauses to disclaim representations made outside of the contract. So we made the point that franchisors should revise the FDD to say that any representations made to the prospective franchise outside of the document do survive ' Franchisors fought us, but the FTC backed us up, and franchisors are now starting to come around.”

Leets added that franchisors should stop trying to modify the integration clause or do anything else to undermine its clarity. “Add it where it belongs, and don't change it,” she said.

Just as the integration clause language is very specific, so are the requirements for other parts of the FDD. When franchisors deviate from those requirements, even in seemingly trivial ways, their applications will need to be revised. Leets provided a common example that delays approval: providing information about the last five years of work history for franchise executives and officers in Item 2.

O'Brien noted another problem that occurs when the experience of instructors for franchisee training is cited in Item 11. For some franchises, executives are trainers, so they are listed in Item 2. Then, in Item 11, the FDD merely refers to the executive's professional information in Item 2. “But we require information specific to training in Item 11 that is not required in Item 2, so the reference does not necessarily meet the disclosure requirement,” he said. “Either make the disclosure in Item 2 that will also satisfy Item 11, or else make the separate disclosure.”

Discrepancies of any type raise red flags, and so do registration documents that appear to ignore prior instructions from regulators, said Cantone. Specifically, he mentioned that he often finds “there's something that was in the FDD one year at our insistence, and then it's wiped out in the registration document the next year. It's very frustrating, and it delays registration,” he said.

Some disclosures can be damaging to a franchisor, such as those in Item 3, but they still must be made. “The disclosures here may involve felonies committed by company officers. If I see a pattern of violations in Item 3, I have to ask if this application should be accepted,” Leets said. “We have, and the franchise has, a fiduciary duty to the public. Can a franchise uphold that duty and the implied faith and fair dealing if its officers have a history of moral turpitude?”

A High Standard

While franchise attorneys argue ' and Leets agrees ' that purchasing a franchise carries with it a certain level of “buyer beware,” Leets said that she nonetheless holds applicants to a high standard. “I care about protecting consumers. I look at all four corners of an application ' but I expect the attorney to look beyond the application at the fitness of the franchisor to operate and the possibility that the franchisor might make the industry look bad,” she said.

Similarly, a franchisor might not want to list contact information for each of its active, terminated, and canceled franchises in Item 20, but Cantone stressed the significance of that section of the document. “If it's not right, the whole disclosure is questionable. It's only effective if the information is accurate,” he said. And while franchise examiners cannot easily determine if an Item 20 filing is incomplete, Cantone will investigate when complaints are filed by franchise prospects who say they were unable to contact franchisees listed in Item 20.

Leets added that franchisors should present Item 20 listings in a way that is easy for franchisee prospects to search. Franchisors should provide listings on a state-by-state basis, and then, in larger systems, alphabetically by city within each state, she suggested.

O'Brien focused on financial and accounting issues that have arisen in the last few years, some of which are related to the financial challenges that franchises are facing during the recession. For example, last year he saw an increase in “going concern” opinions from auditors and accountants in financial statements that accompanied franchise applications. “If 'going concern' language is in the report of an auditor, Virginia will not register the franchise,” he said, though he added that he was not sure that every state had the same policy.

In general, O'Brien recommended that franchisors list more risk factors than they have done in the past. “This reflects the economic downturn. We've started to take a closer look at balance sheets, the solidity of the assets on the balance sheet, and other financial factors,” he said.

Nonetheless, franchisors that have financial blemishes might be able to earn Virginia registration by making some accommodations. For example, they could defer franchisees' payments for a franchise unit until that franchise is operating, or they could put a franchisee's payments in escrow, O'Brien said.

Franchisors that wish to present combined financial statements instead of consolidated statements also will have to complete additional steps to earn registration in Virginia. “Combined financial statements are permitted by Generally Accepted Accounting Principles. But when we see combined financial statements, the assets and liabilities of a parent company and its subsidiaries are lumped together, and we cannot tell if the assets of a particular company or subsidiary are available to support franchisees,” he said. “In those situations, we will ask for guarantees of performance for each of the subsidiaries. Most franchisors haven't had difficulty doing that, but it takes extra time, so knowing in advance that we will expect the guarantees might help them get through registration the first time.”

Electronic Databases

Finally, Cantone gave an update on the North American Securities Administrators Association's (“NASAA”) efforts to develop an electronic database that would facilitate online state franchise registrations. The NASAA work group, which he heads, is hoping to meet in the fall to continue its several-year study of the issue, he said. “It's one of the tasks we really would like to accomplish,” he said. “The benefits would be immense ' allowing franchisors to file electronically and in creating a centralized, electronic state-registration database.”

Meanwhile, Leets put in a pitch for sustaining California's unique database of franchise registration documents, known as Cal-EASI. “California is in a severe budget crisis, and resources are limited. Cal-EASI is expensive to maintain because it requires an immense amount of scanning of paper documents,” she said. “There's no way of guaranteeing that Cal-EASI will be here forever. If you find it to be meaningful and helpful, now is the time to say something.”

Kevin Adler is associate editor of FBLA.