Franchisors should not mistakenly assume that a sale of an existing franchise business by the franchise owner is not subject to the registration and disclosure requirements of the franchise laws. When a franchisee is selling its franchise business, is the franchisor obligated to provide the prospective buyer with its current Franchise Disclosure Document? If the franchise business is in a franchise registration state, does the franchisor have to be registered to offer and sell franchises in that state for the franchisee sale/transfer to take place?
There is not an easy, quick answer to these questions. A review of the state franchise laws becomes necessary. Most, but not all of the state franchise statutes have an exemption for a sale of a franchise by the franchise owner. The statutes typically refer to it as an offer or sale of a franchise by a franchisee for the franchisee's own account if the franchisee's entire franchise is sold and if the sale is not effected by or through the franchisor. If there is a state exemption for a sale of a franchise by a franchisee, two questions have to be asked:
(1) What is the sale exempt from - the registration and disclosure requirements of the state law or only the state's registration requirements?
(2) When do the franchisor's actions result in the franchise being "effected by or through the franchisor"?
Most of the state franchise statutes only provide for an exemption from the state registration requirements. This means that the franchisor must still comply with the state's delivery requirements for the FDD and deliver the Franchise Disclosure Document to the prospective buyer. Only Hawaii, Illinois and Indiana specifically provide that the exemption for the sale of a franchise by the franchise owner is an exemption from both the state's registration requirements and the state's requirement that the franchisor deliver a Franchise Disclosure Document to the buyer.
When is a sale "effected by or through the franchisor"? The statutes generally specify what actions by the franchisor do not take the sale out of the exemption, rather than what actions by a franchisor will prevent it from relying on the exemption. Of course, if the franchisor is involved in helping the selling franchisee locate a prospective buyer and/or is involved in franchise sales and marketing efforts, the exemption will not apply. All of the statutes provide that a sale is not effected by or through a franchisor merely because a franchise has the right to approve or disapprove the sale. Some statutes provide further guidance and specify that the transaction will not be removed from the exemption if:
- The franchisor charges a transfer fee. In some cases the statute specifies that the transfer fee must be reasonable (Rhode Island, Virginia and Washington), and in Wisconsin, the franchisor can only charge a fee equal to the franchisor's reasonable and actual expenses.
- The franchisor requires a new franchisee to sign a franchise agreement; however, the franchise agreement must be "not materially different" from the selling franchisee's existing franchise agreement (Illinois and Rhode Island).
Some states provide additional triggers that remove a franchisee sale/transfer from the statutory exemption:
- There can be no interruption in the franchise operation and no material change in the franchise relationship (Hawaii)
- There can be no more than one exempt sale by a franchisee in a 12 month period (Minnesota) or the sale by the franchisee must be an isolated sale and not part of a plan of distribution of franchises (New York).
- The right to approve the buyer must be exercised in a reasonable manner (Washington).
In most cases, a franchise agreement will state that when a franchisee sells its franchise to a buyer, the franchisor has the right to require the buyer to sign the then-current franchise agreement (rather than assigning the selling franchisee's existing franchise agreement to the buyer). And in most cases, the franchisor will exercise that right and will want the buyer to sign its then-current franchise agreement, since the franchise agreement likely has been improved (since the version signed by the selling franchisee) to provide better protection for the franchisor and the franchise system in response to developments in the law, and to reflect changes and improvements in the franchise system, including product and service offerings and technology. And in some cases, the current franchise agreement may provide for higher or additional fees. As a practical matter, where there has been any substantive change in the franchise agreement since the selling franchisee signed its franchise agreement, a franchisor should work on the assumption that the changes mean that the current agreement differs materially from the existing franchisee's agreement and the exemption will not apply (unless a very careful analysis of the differences in the agreements and resulting impact on the franchisee is done).
Is disclosure required in a non-registration state under the Federal Trade Commission's amended Franchise Rule? The FTC Rule does not provide a specific exemption from the disclosure requirements in the situation where a franchisee is selling its franchise business. However, the Compliance Guide for the FTC Rule provides input, stating that a buyer of an existing franchise directly from the franchisee who owns it "without any significant contact with the franchisor" is not a prospective franchisee. Therefore, delivery of the Franchise Disclosure Document would not be required under the FTC Rule. The Compliance Guides goes on to state that even if the franchisor retains the right to approve or disapprove the sale of the existing unit, the transferee is not entitled to receive the FDD under the Rule "unless the franchisor plays some more significant role in the sale." Only one example of "some more significant role in the sale" is given in the Compliance Guide - the delivery of financial performance representations to the buyer. In that case, the franchisor is required to deliver the FDD. Further, the Compliance Guide is presented as advice and is not binding on the Federal Trade Commission.
The best practice for a franchisor is to provide a prospective buyer of a franchise business being sold by an existing franchisee a copy of the current Franchise Disclosure Document at least 14 days before the buyer purchases the franchise business. In franchise registration states, only 3 provide for an exemption from disclosure with the FDD and the franchisor should elect not deliver the FDD to the prospective buyer only if it meets the specific requirements of the exemption under the state law. In non-registration states, if a franchisor does not routinely provide the FDD to prospective buyers of existing franchises businesses, it runs the risk that any of its actions relating to the buyer other than approving the sale could later be deemed as playing "some more significant role in the sale."
If a franchise sale by an existing franchisee is happening in a franchise registration state where a franchisor is not registered, the franchisor should review with its franchise attorney the state franchise law's exemption for a franchise sale by an existing franchisee for its own account to determine if the franchisor and the franchisee sale/transfer can meet the exemption requirements or if the franchisor must obtain a franchise registration in that state before the sale/transfer takes place.