The Federal Trade Commission recently issued a policy statement regarding the franchise industry. The FTC is charged with protecting franchisees from unfair methods of competition and unfair and deceptive practices. The policy statement from the commission addresses restrictions on the ability to report and collect information about potential law violations. The FTC staff also issued guidance about the charging of fees not disclosed when a franchisee purchases a franchise. The response to these statements are mixed.

Policy Statement Pertaining to Communications Regarding Potential Law Violations

The FTC is concerned that franchisors suppress the ability of franchisees to voluntarily discuss or file reports about their experiences with franchisors, even if the franchisees believe a law violation has occurred. The policy statement was issued to express the FTC’s “view that provisions included in franchise agreements or other contractual documents between franchisors and franchisees may not restrict franchisees’ communications with the commission or any other or federal law enforcer or regulator about potential law violations.”

Franchisees have reported to the FTC that they are dissuaded or contractually prohibited from communicating complaints. The FTC considers franchisee reports and voluntary interviews a critical part of FTC investigations. Without franchisee feedback, the FTC’s “ability to protect franchisees is weakened and the competitive and consumer protection benefits that flow from the franchise business model are undermined.”

One of the ways the FTC gathers information about the industry is through its public requests for information in connection with its rulemaking. The FTC solicits comments on its website, and often the comments are anonymous. A few commenters complain that they have been threatened by their franchisor for talking. Others point to confidentiality clauses and non-disparagement clauses as chilling frank discussion with the FTC. Additionally, complaints arose regarding clauses which prohibit impairing good will as these are broad enough to inhibit communications.

The policy statement provides:

“These provisions may take the form of nondisparagement clauses (‘franchisee shall not disparage the brand in any way’), confidentiality or nondisclosure clauses (‘franchisee is prohibited from sharing any information about the franchise or their experience’), goodwill clauses (‘franchisee shall not engage in any conduct that may tarnish the goodwill of the brand’), and similar clauses. They are sometimes included in franchise agreements or may be entered into post-sale, including at termination of the relationship. Generally, case law establishes that clauses that impair or prohibit free communication about potential law violations with an administrative agency acting within its statutory mandate are void and unenforceable.”

The policy statement concludes that any contractual provision which impedes communication and frustrates the goals of the FTC will be considered to be an unfair practice and unenforceable. Moreover, any threats of retaliation will be considered an unfair practice, and the FTC takes its statutory mandate seriously to enforce the law. Of the five FTC commissioners, the two Republicans dissented from the policy statement. They expressed concern that the contractual provisions, used routinely in contracts and transactions, would be unfairly scrutinized even though the provisions have commercial benefit. Let’s see how this can work in the real world.

Suppose a franchisee sues its franchisor and uncovers a fundamental violation of the FTC disclosure rules. The franchise disclosure document (FDD) the franchisor gave 100 franchisees contained the same material misstatement which if presented to a court, might likely allow rescission to all 100 franchisees. But this franchisee settles its case with the franchisor with a payment over time, such that if the franchisor is subjected to mass claims, this franchisee cannot recover its settlement. Naturally, the franchisor required a confidentiality provision, and the franchisee accepted those terms. Can the franchisee report the material violation of the FTC disclosure rules notwithstanding the confidentiality clause? Under the FTC policy, the violation can be legally reported with attribution or anonymously, however, this would work against the personal interests of the franchisee who settled and expects a payments over time. This is the reality of the franchise world today.

FTC Staff Guidance Regarding Undisclosed Fees

The guidance reflects the views of the staff of the FTC and is not binding on the commission. The staff has recognized the practice of franchisors charging fees not originally disclosed in the FDD. These fees are implemented during the term of the franchise relationship to the franchisee. The typical reasons for implementing new costs could be new or additional cost of supplying support to the franchisee, new products or services, or simply greed.

The guidance provides:

“The Franchise Rule requires franchisors to disclose in the FDD certain fees. If a franchisor fails to disclose those fees in the FDD, such failure is a violation of the Franchise Rule and Section 5 of the FTC Act. Furthermore, if a franchisor imposes or collects a new fee, through its operating manual or otherwise, that was not disclosed in the FDD and included in the franchise agreement, the franchisor may be engaging in an unfair act or practice in violation of Section 5 of the FTC Act.”

The guidance further gives an example in the consumer setting where the unilateral increase of annual cost of a long term extermination contract was held to be an unfair practice by a court. The Guidance was immediately criticized by the International Franchise Association (IFA), which stated that such short sighted statements could suppress innovation in the franchise industry.

The reality is that any franchise brand evolves based on among other things, consumer preferences, availability of products and services, competition and innovation. Franchise counsel attempts to build in flexibility to the franchise agreements and disclosures so that the franchisee is fairly apprised of the risks of increasing operating costs, but franchisors cannot be clairvoyant. Who knew 20 years ago that the cost of technology and the need to be competitive would increase technology costs to the franchisee by system-wide improvements in point of sale systems, reservation systems, online ordering, and web hosting. Some systems morphed to meet competition by offering additional or alternative products, and such products require a capital investment by the franchisee. Freezing franchise systems to their past cost disclosures would prevent meeting competition, cause existing locations to look like museums, and ultimately create anachronistic and failing businesses. Franchisees do not want additional costs, but have no choice sometimes to remain competitive to “up their game.”

Abusive cost impositions by a franchisor which are not disclosed in the FDD are actionable under common law theories, such as violation of the covenant of good faith and fair dealing, or a claim of lack or failure of adequate consideration. Some states provide statutory rights to franchisees to contest unreasonable performances, which could include increased cost impositions. There may be a place of FTC enforcement of an abusive cost increases across a franchise system, but commercial reality is that a franchisor that imposes unreasonable costs to its franchisees is simply taxing the franchisees out of business. The market will probably tamp costs down more that the this FTC Staff Guidance.

Conclusion

The FTC in an important element in market regulation of the franchise industry. These recent statements show the difficulty in achieving the proper balance between governmental regulation and industry realities.

Reprinted with permission from the July 19, 2024 issue of The Legal Intelligencer© 2024 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.