Franchise Disclosure Pitfalls for Rapidly Expanding Retail Brands

Like most growing businesses, franchisors typically do not allocate significant resources to legal compliance until they have to (systems founded in franchise registration states have to from the start). A “nice-to-have” problem of rapid system expansion is having to retain counsel to navigate federal and state franchise laws. Whatever causes the focus on franchise law compliance— expansion into a registration state, negotiations with an experienced multi-unit owner, or potential claims from a dissatisfied franchisee—doing so is a necessary investment in the long-term strength of the brand. Here are five common pitfalls that even experienced franchise teams can fall into by overlooking disclosure requirements in the pursuit of growth.

Pitfall 1: Treating a Franchise as “Just a License”

As a retail brand adds units, it may be tempting to use a loosely structured “license” model as a quick path to growth. “We don’t have to comply with franchise law if we aren’t selling franchises,” the thinking goes. But in the words of Lee Corso, “not so fast, my friend!” Under the Federal Trade Commission’s (FTC) Franchise Rule (16 C.F.R. § 436.1), a franchise exists when the owner of a trademark: (1) sells the right to operate a business associated with the mark, (2) has or can exert control over the buyer’s method of operation of that business, and (3) makes the sale conditional on payment of a fee.  A brand that meets these three elements falls into the “accidental franchise” pitfall, regardless of whether it labels itself as a franchise, whether it calls the required payment a franchise fee, or whether the trademark was federally registered; and applicable state law may have a broader definition, making it easier to fall into the trap. Falling into the accidental franchise pitfall can severely affect the system.  It can lead to an enforcement action by the FTC (an admittedly rare occurrence), an enforcement action by a state government, or civil claims from one or several franchisees that could call every single agreement into question. In short, the brand can implode just as it shifted into high gear.

Pitfall 2: Moving Too Fast to Sign or Collect Money

Interest from a strong prospect can create pressure to quickly lock in the deal. That is where mistakes often happen. The FTC Franchise Rule requires a franchisor to provide its current franchise disclosure document, or “FDD,” at least 14 calendar days before the prospect signs a binding agreement or pays the franchisor or an affiliate. If the franchisor later makes a unilateral, material change to the form agreement attached to the FDD, it must wait another seven days before signing the franchisee. A deposit, reservation payment, or side agreement may trigger problems even if the main franchise agreement has not been signed. The practical fix is simple: Use one controlled sales process that tracks the correct FDD, delivery date, applicable state approval, and earliest permissible signing and payment dates.

Pitfall 3: Letting the FDD Fall Behind the Business

Fast-growing brands change quickly. Executives join or leave. Fees increase. Technology, suppliers, and build-out standards change. Stores open, close, or transfer. The brand may add training, modify its opening support, or enter new sales channels. The brand can be sold or re-organized. Those changes can make portions of the FDD inaccurate before the next annual update. The FTC rule requires an annual update within 120 days after fiscal year-end and quarterly revisions within a reasonable time after each quarter to reflect material changes. State amendment rules may require action sooner. The better practice is to identify the business events that require legal review and make reporting them in the FDD part of the company’s standard processes.

Retail concepts add another layer of risk because costs and operations can vary significantly by location. The initial investment estimate may no longer be reliable if newer stores require larger spaces, more expensive tenant improvements, additional technology, or more working capital. Supplier, rebate, and purchasing disclosures must match current arrangements. Promised training, opening assistance, and marketing support must reflect what the brand can actually deliver as the system expands. Territory provisions should also account for e-commerce, delivery, nontraditional locations, and company-owned stores. If the FDD describes yesterday’s model, prospects may be making decisions based on inaccurate information.

Pitfall 4: Making Earnings Claims That Are Not in Item 19

As a brand expands rapidly, more prospects enter the sales pipeline and more people may be involved in selling the opportunity. That increases the risk that someone will make an unauthorized earnings claim while trying to answer the question every prospect asks: “How much money will I make?”

Every agent for the brand, be it founder or broker on commission, should understand this cardinal rule of franchising: If a franchisor chooses to make financial performance representations, it must do so in Item 19 of the FDD, and those claims must have a reasonable basis and written substantiation. This applies not only to formal presentations, but also to emails, texts, webinars, and even casual conversations. Statements about actual or potential sales, income, or profits, if made at all, must match what is represented in Item 19 of the FDD. All brands should have a deliberate process for approving all earnings-related materials and thoroughly train everyone involved in the franchise sales process.

Pitfall 5: Ignoring State Laws

Compliance with the FTC rule does not necessarily clear a brand to sell franchises nationwide. Some states require registration or filing before an offer or sale, and regulators in those states may require state-specific changes to the FDD or franchise agreement. Advertising, franchise seller, and broker requirements may also apply. Additionally, many states that don’t require registration have business opportunity laws or other statutes that require attention. A national website or digital campaign can reach prospects in a regulated state before the development team intends to enter that market. Before pursuing a lead, the brand should confirm where the prospect is located, where the franchise will operate, and whether additional filings or disclosures are necessary. From a business perspective, the compliance costs of expansion into certain states may not be worth it.

The Bottom Line

Franchise disclosure compliance should grow with the brand. Everyone working for or with the franchisor should know who is responsible for making FDD updates, determining what changes must be reported, and approving a prospective sale. These controls do not have to slow expansion, but brand owners must deliberately put the right strategies, systems, and accountability in place to keep disclosure missteps from derailing growth.

Retail brands considering franchise expansion, or reassessing the compliance infrastructure supporting an existing franchise system, may contact Tanya Nebo at tnebo@clarkhill.com or Bin Minter at bminter@clarkhill.com with questions or for assistance.

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