On August 1, 2009, the FTC began enforcing its so called “Red Flag Rules,” which requires certain businesses, including franchisors, to develop effective programs to identify the warning signs of identity thief.

Franchisors that regularly extend “credit” to their franchisees or arrange financing are subject to the rule. A franchisee may be regarded as a creditor if it defers payments from its franchisees or extents credit or if a franchisor bills a franchisee after providing goods or services. The other way a franchisor would fall under the rule is if it suspects that it may be subject to risk of identity thief. With such broad coverage, most national and regional franchise systems would appear to be subject to this new rule.

If a franchise system is subject to the rule, then it is responsible to develop and put an effective identity theft program into place. The program must be approved by the corporate board of directors or senior management. Failure to comply could result in a franchisor being fined civil penalties.

Although burdensome on franchisors, hopefully this new rule will help curb identity thief, a growing international concern. For more information about the Red Flag Rules, the FTC has published a free plain-language handbook, Fighting Fraud with the Red Flags Rule: A How-To Guide for Business. For a free copy of the guidebook, or for more information about compliance, visit the FTC’s website.

Postscript: With news today of Federal prosecutors charging a Miami man of trying to gain access to 130 million credit and debit card accounts, mostly though hacking into retail networks, it’s difficult to argue against the logic of the Red Flag Rule, despite the obvious burden it places on certain business and franchise enterprises.

The new FTC Franchise Rule that went into effect last summer continues to confuse franchisors and franchisees alike. Here is a link to the final rule: Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities; Final Rule. I think reading the disclosure requirements and prohibitions first hand is better than my summarizing here.

In order to help consumers and franchisors understand the new rule and its application, the FTC has now posted its Compliance Guild on the FTC website. In addition, recent FAQ’s interpreting the amended Rule are also available, as well as links to other information about the amended Franchise Rule.

Too often prospective franchisees merely skim through the technical detail found in a uniform franchise offering circular (UFOC), preferring instead to rely on the pitch of the franchise sales person. It’s important, however, for those considering the purchase of a franchise to familiarize themselves with the rules in order to understand the mechanics of the UFOC, and why each item is in the document. Even a basic understanding of the federal rules, and their application, will give franchise purchasers greater insight into the business strategies and intentions of franchisors in their dealings with franchisees. I found the FAQ’s well written and consumer-friendly. With an understanding of the FTC Franchise Rule, you will be a better consumer of legal services, and a more informed investor in a franchise system.

This week a California court upheld a distant venue arbitration clause against a California franchisee Smith v. The Paul Green School of Rock Music LLC, CV 08-00888 (C.D. Ca May 5, 2008). The clause forces the franchisee to arbitrate its dispute in Pennsylvania. In 2006, the 9^th Circuit Court of Appeals held that such clauses could be challenged as unconscionable Nagrampa v. MailCoups, Inc., No 03-15955 (9^th Cir. Dec. 4, 2006). Common sense dictates that the practice of demanding franchisees, usually independent business owners with little in the way of liquid assets, at least by the time of default, to travel across the country, pay for room, board, and retain counsel, to defend or bring actions against cash rich franchise organizations, is unconscionable. It is a boiler plate provision in nearly, if not all, franchise agreements. And for some reason, it is a provision that most franchisees blow right over when reading a franchise disclosure document and draft franchise agreement. In Smith, the California Central District Court upheld the distant venue clause on a technicality (the Pennsylvania “choice of law” provision) rendering the Nagrampa unconscionably decision unenforceable. Franchisors and their counsel are delighted.

The Federal Trade Commission issued an updated Franchise Rule today. The update amends the Franchise Rule originally promulgated in 1978. The purpose of the amendments is to harmonize state and federal disclosure rules. A further goal of the new rules is to account for changes in the marketing of franchises and to address certain franchise-relationship complaints of franchisees aired during the amendment proceedings. The amended rules also acknowledge the substantial difference between a “business format” and a “business opportunity” franchise and separates the requirements for each. The new rules have phased-in effective dates. On July 1, 2007 franchisors have the option to follow the new rules or the applicable existing rules. After July 1, 2008 franchisors will be required to follow the amended rule. An overview of the amendment will be outlined in future posts.

An accepted means of gaining entry into the world of business during the past thirty years has been through the purchase of a franchise. Simply put, franchising is a means of distributing goods or services employing a franchisor’s trademark(s) in compliance with a system of operation established by the franchisor. The franchisee is responsible for payment of a fee in exchange for the right to sell or furnish the goods or service in compliance with the franchisor’s system and use the franchisor’s trademark(s). The two principal forms of franchises are product distribution and business format franchises. The product distribution franchise model includes automobile, tire and gasoline distribution-franchises. The business format franchise model includes restaurant, copy-center and hotel chains operating nationally and internationally.

In a business format franchise, the franchisor generally provides the franchisee with an entire business concept including “operating manuals” explaining in detail important criteria such as site selection, details of branding the business location and products, pre-opening and operating procedures and strict guidelines on how the business is to solicit, interact and respond to its customers. The franchisee is expected to comply with every detail of the franchise agreement. Penalties for failure to comply with the terms of the agreement can be draconian.

Franchising has provided many individuals, investors and operating companies with a proven means of successful entry into many diverse businesses. Franchising as a business model has also been subject to a great deal of abuse by unscrupulous and inexperienced business people resulting in much litigation and imposition of federal and statutory laws designed to protect prospective franchisees and franchisors.

The Federal Trade Commission defines a “franchise” as a “continuing commercial relationship created by any arrangement” where (1) the franchisee sells goods or services that are associated with the franchisor’s trademark or must meet the franchisor’s quality standards, (2) the franchisor exercises significant control over, or gives the franchisee significant assistance in, the franchisee’s method of operation, and (3) the franchisee, as a condition of obtaining or commencing operation, is required to make payments aggregating more than $500 within six months of commencing such operation.

The Revised Code of Washington (“RCW”) defines a “franchise” as: (a) an agreement, expressed or implied, oral or written, by which: (i) a person is granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan prescribed or suggested in substantial part by the grantor or its affiliate; (ii) the operation of the business is substantially associated with a trademark, service mark, trade name, advertising, or other commercial symbol designating, owned by, or licensed by the grantor or its affiliate; and (iii) the person pays, agrees to pay, or is required to pay, directly or indirectly, a franchise fee. (RCW 19.100.010(4))

Franchisors wishing to sell franchises in Washington State must first register their offerings with the Washington State Department of Financial Institutions unless the offering qualifies for one of the exemptions contained in RCW 19.100.030.

In future posts I will furnish more detail on the definition of a franchise; discuss alternatives to franchising and what constitutes inadvertent franchising; examine common myths and abusive franchise practices and current legal trends in franchising as well.