NASAA Proposes Four Exemptions for State Registrations

The North American Securities Administrators Association (“NASAA”) has proposed four exemptions to state registration and disclosure requirements, representing a welcome effort to standardize exemptions at the state level. The proposed exemptions were circulated for public review on July 1, and the comment period ended on Aug. 1. The proposal can be found at www.nasaa.org/issues___answers/regulatory_activity/14627.cfm.

Fifteen states have some form of registration requirement beyond the federal disclosure requirements overseen by the Federal Trade Commission (“FTC”). After the proposed state exemption rules are finalized, each state would decide whether or not to adopt the rules, or to modify the exemptions developed by NASAA.

“We have not had uniform exemptions at the state level, so this is a good idea,” said Christopher Wallace, attorney with Nixon Peabody LLP (Washington, DC).

Analyzing the four categories of proposed exemptions, Wallace commented on the benefits and some of the areas in which franchisors would possibly suggest adjustments.

Fractional-Franchise Exemption

The fractional-franchise exemption would apply when “the franchisee, any of the franchisee's current directors or officers, or any current directors or officers of an affiliate, has more than two years of experience in the same type of business; and the parties have a reasonable basis to anticipate that the sales arising from the relationship will not exceed 20% of the franchisee's total dollar volume in sales during the first year of operation.” Definitions of “same type of business” and “reasonable basis” for sales expectations are further spelled out in the proposal.

The fractional exemption would apply for both franchise registration and disclosure, and Wallace said that “the basic requirements are the same as federal law.” He added, however, that Section D of the exemption for fractional franchises is a break from existing statutes in that it allows a state franchise administrator to request documentation from a franchisor or franchisee about anticipated future earnings, “and this aspect could be burdensome.”

Experienced-Franchisor Exemption

The first thing that Wallace noted about the experienced-franchisor exemption is that it applies only to registration requirements, not disclosure. “Obviously, it would be more helpful to franchisors if it applied to both,” he said.

The exemption would apply when the franchisor's shareholders, members, and/or partners have equity of $10 million, or an 80% owner of the franchisor can demonstrate $1 million of equity and $10 million of corporate equity (as shown through audited financial statements). Also, the 80% owner must “absolutely and unconditionally guarantee to assume the duties and obligations of the franchisor under the franchise agreement.”

Currently, states do offer this exemption, but they have different thresholds for net equity. Several registration states with large numbers of franchisors, such as Illinois and New York, have a $5-million threshold for the franchisor's parent, so the proposal would represent a higher standard. Virginia's exemption is $15 million for an 80% owner.

The experienced franchisor or 80% owner would have to demonstrate some longevity. It would have to show that it had at least 25 franchisees operating for two years each during the five-year period immediately preceding the franchise offer or sale ' which Wallace characterized as common requirements for exemptions today.

However, the proposal also contains a requirement that could potentially trip up a franchisor: the prohibition of having any officers or affiliates of the franchisor who have been convicted of or pleaded nolo contendere to a felony charge or faced federal felony or state securities penalties. “Essentially, this is saying that anything that would have to be disclosed in an FDD Item 3 would make the franchisor not eligible under the experienced franchisor exemption. I am not aware of any state that has this restriction now,” said Wallace. “I'm not sure I see the purpose of this prohibition because the franchise buyer would still receive a franchise disclosure document with the information in Item 3. It would simply be a factor that the franchisee would consider in making his decision about buying the franchise.”

Sophisticated Purchaser Exemption

As with the experienced franchisor exemption, the sophisticated purchaser exemption applies only to registration, not disclosure. Four categories of sophisticated purchasers are potentially included:

1. “Existing franchisees” who have owned at least 50% of one of the franchise units in another state for at least two years.
2. “Franchisor insiders” who are or were officers or at least 25% owners in the franchisor, are buying at least a 50% share in the franchise, and will operate the franchise (not resell it).
3. “Accredited investors,” also known as high-net-worth investors. They are defined as having $3 million in liquid wealth, annual income of $500,000 or more, a trust with $5 million in assets, or a business entity with partners' equity of at least $5 million.
4. Franchisees making investments of at least $2 million, and for whom that investment does not represent more than 20% of their net worth.

While the language of the exemption in this section implies that it is valid for both the purchase of a new franchise and a renewal, Wallace said that “it would be helpful to have clarity that it also applies to renewals, which are commonly exempted today under state registration laws in these situations.”

The other provision that raised Wallace's attention is the $2 million threshold, which is twice the level of $1 million in the FTC Rule and in most states (and some states, such as Maryland, have even lower thresholds). Furthermore, the language of the proposed state exemption seems not to make a provision for a multi-unit agreement in which the prospective franchisee would commit to spending $2 million, but not on a single unit. The federal Franchise Rule does allow the exemption when multi-unit investments will reach $1 million.

Discretionary Exemption

As the name implies, the proposed rule would give state administrators discretion to waive state registration requirements based on other information presented by a franchisor that pertained to its specific situation ' discretionary waivers that are occasionally granted today.

Kevin Adler is associate editor of LJN's Franchising Business & Law Alert. He can be contacted at [email protected].

The North American Securities Administrators Association (“NASAA”) has proposed four exemptions to state registration and disclosure requirements, representing a welcome effort to standardize exemptions at the state level. The proposed exemptions were circulated for public review on July 1, and the comment period ended on Aug. 1. The proposal can be found at www.nasaa.org/issues___answers/regulatory_activity/14627.cfm.

Fifteen states have some form of registration requirement beyond the federal disclosure requirements overseen by the Federal Trade Commission (“FTC”). After the proposed state exemption rules are finalized, each state would decide whether or not to adopt the rules, or to modify the exemptions developed by NASAA.

“We have not had uniform exemptions at the state level, so this is a good idea,” said Christopher Wallace, attorney with Nixon Peabody LLP (Washington, DC).

Analyzing the four categories of proposed exemptions, Wallace commented on the benefits and some of the areas in which franchisors would possibly suggest adjustments.

Fractional-Franchise Exemption

The fractional-franchise exemption would apply when “the franchisee, any of the franchisee's current directors or officers, or any current directors or officers of an affiliate, has more than two years of experience in the same type of business; and the parties have a reasonable basis to anticipate that the sales arising from the relationship will not exceed 20% of the franchisee's total dollar volume in sales during the first year of operation.” Definitions of “same type of business” and “reasonable basis” for sales expectations are further spelled out in the proposal.

The fractional exemption would apply for both franchise registration and disclosure, and Wallace said that “the basic requirements are the same as federal law.” He added, however, that Section D of the exemption for fractional franchises is a break from existing statutes in that it allows a state franchise administrator to request documentation from a franchisor or franchisee about anticipated future earnings, “and this aspect could be burdensome.”

Experienced-Franchisor Exemption

The first thing that Wallace noted about the experienced-franchisor exemption is that it applies only to registration requirements, not disclosure. “Obviously, it would be more helpful to franchisors if it applied to both,” he said.

The exemption would apply when the franchisor's shareholders, members, and/or partners have equity of $10 million, or an 80% owner of the franchisor can demonstrate $1 million of equity and $10 million of corporate equity (as shown through audited financial statements). Also, the 80% owner must “absolutely and unconditionally guarantee to assume the duties and obligations of the franchisor under the franchise agreement.”

Currently, states do offer this exemption, but they have different thresholds for net equity. Several registration states with large numbers of franchisors, such as Illinois and New York, have a $5-million threshold for the franchisor's parent, so the proposal would represent a higher standard. Virginia's exemption is $15 million for an 80% owner.

The experienced franchisor or 80% owner would have to demonstrate some longevity. It would have to show that it had at least 25 franchisees operating for two years each during the five-year period immediately preceding the franchise offer or sale ' which Wallace characterized as common requirements for exemptions today.

However, the proposal also contains a requirement that could potentially trip up a franchisor: the prohibition of having any officers or affiliates of the franchisor who have been convicted of or pleaded nolo contendere to a felony charge or faced federal felony or state securities penalties. “Essentially, this is saying that anything that would have to be disclosed in an FDD Item 3 would make the franchisor not eligible under the experienced franchisor exemption. I am not aware of any state that has this restriction now,” said Wallace. “I'm not sure I see the purpose of this prohibition because the franchise buyer would still receive a franchise disclosure document with the information in Item 3. It would simply be a factor that the franchisee would consider in making his decision about buying the franchise.”

Sophisticated Purchaser Exemption

As with the experienced franchisor exemption, the sophisticated purchaser exemption applies only to registration, not disclosure. Four categories of sophisticated purchasers are potentially included:

1. “Existing franchisees” who have owned at least 50% of one of the franchise units in another state for at least two years.
2. “Franchisor insiders” who are or were officers or at least 25% owners in the franchisor, are buying at least a 50% share in the franchise, and will operate the franchise (not resell it).
3. “Accredited investors,” also known as high-net-worth investors. They are defined as having $3 million in liquid wealth, annual income of $500,000 or more, a trust with $5 million in assets, or a business entity with partners' equity of at least $5 million.
4. Franchisees making investments of at least $2 million, and for whom that investment does not represent more than 20% of their net worth.

While the language of the exemption in this section implies that it is valid for both the purchase of a new franchise and a renewal, Wallace said that “it would be helpful to have clarity that it also applies to renewals, which are commonly exempted today under state registration laws in these situations.”

The other provision that raised Wallace's attention is the $2 million threshold, which is twice the level of $1 million in the FTC Rule and in most states (and some states, such as Maryland, have even lower thresholds). Furthermore, the language of the proposed state exemption seems not to make a provision for a multi-unit agreement in which the prospective franchisee would commit to spending $2 million, but not on a single unit. The federal Franchise Rule does allow the exemption when multi-unit investments will reach $1 million.

Discretionary Exemption

As the name implies, the proposed rule would give state administrators discretion to waive state registration requirements based on other information presented by a franchisor that pertained to its specific situation ' discretionary waivers that are occasionally granted today.

Kevin Adler is associate editor of LJN's Franchising Business & Law Alert. He can be contacted at [email protected].