3. A Brief History of Franchising
Back in the mists of ancient time (when a Quarter Pounder with Cheese® meant nothing and Colonel Sander’s parents were still in diapers), it’s said that franchising was born. Although some have suggested it started in England with the Crown granting exclusive territories to tax collectors for the collection of the 13th century equivalent of GST, for us in the modern world, common wisdom seems to agree that it started with the Singer Sewing Corporation (sewing machines) in the United States. Singer licensed retail stores to sell their sewing machines and sewing supplies in the 19th century. This evolved over the 20th century, and other businesses adopted the model; chief among them being soft drink bottling companies and gas stations.
For those of you who might recall the 1960s and 1970s as being the salad days of rock and roll, free love, and funny cigarettes, it was also the heyday of franchising. The United States became the grand central station of franchising activity; so much so that franchising became the subject of government legislation and regulation. (Around this time, the Alberta government also got involved with franchising legislation and regulation.)
The government did not get involved in the regulation of franchises because it needed the money, or because it wanted to take over the McDonald’s corporation and run it like the US defense department. Although McDonald’s and some other well-known brands were working rather nicely, thank you very much, the state legislators got involved because many other concepts were not running as well. Some consumers (in this case, those voters who were acquiring the franchises) lost their shirts (and their houses) as a result of getting into franchises in which the franchisor wasn’t capitalized enough, or misrepresentations were made by franchisors or their salespeople to get the consumers into the deal. Complaints were made to politicians and the government reacted.
Laws were enacted that treated the sale of a franchise like a “securities” offering, which required franchisors to make disclosure of material facts to franchisees and to give them some time (i.e., 14 days) to do their due diligence and think about the deal before they signed on. In short, the politicians got involved because a few bad operators caused them to get involved. (Government doesn’t tend to get involved unless events force it to or people are pressuring it to.)
4. US Disclosure Agreements and Regulations
Since the 1970s, US-based franchisors have been subject to a witches’ brew of state and federal laws governing the sale and operation of franchises to franchisees. Currently, US-based franchisors are subject to either the Federal Trade Commission Rule on franchising or a regulatory review in select states. The Federal Trade Commission Rule on franchising requires disclosure of all material facts to prospective franchisees through the use of a disclosure document (sometimes referred to as a Uniform Franchise Offering Circular [UFOC]). This is now called a Franchise Disclosure Document (FDD) in the United States. Franchisors can also be subject to regulatory review in approximately 15 US states that currently have legislation specifically regulating franchisors. As of the date of writing, those states are California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin (although some registration requirements differ markedly in these states).
In these registration states, unless the franchisor obtains or otherwise qualifies for an exemption from the authorities, a document similar to a securities prospectus must be prepared by the franchisor’s lawyers, and must usually be filed with and approved by the state regulatory authority together with the franchisor’s franchise agreement, sublease, trade-mark license agreement, general security agreement, and other agreements that normally comprise the package to be signed by the franchisee.
In most cases, the franchisor’s audited or reviewed financial statements must also form part of the disclosure package, which is in and of itself an expensive undertaking. But the state authorities don’t just “rubber stamp” a franchisor just because the franchisor has submitted the documentation to the regulators. The state regulatory authorities read and review the material and may reject the franchisor altogether, or impose conditions on the franchisor’s ability to trade in franchises in that state. This could mean that the franchisor is required to hold a portion of collected initial franchise fees in escrow for a period of time or it may mean capitalization requirements and other conditions.
As you might appreciate, the preparation of these documents by hordes of well-paid attorneys, the vetting process with state regulatory agencies, and the tangled web of rules under which franchisors are required to lawfully “sell” their franchises is extremely complicated, very specialized, and lawyer intensive. It costs a lot of money to start a franchise in the US. Franchising south of the border is not for the faint of heart or those who live in abject fear of large legal bills.
5. Are US-based franchisors required to give Canadian franchisees disclosure documents?
US-based franchisors do not always give and are not always required to give disclosure documents to prospective Canadian franchisees. As a prospective Canadian franchisee, you might not be provided with this information even if you ask for it.
It’s possible this material could be on the public record and a great deal of information can be learned about a US-based franchisor from its FDD. Accordingly, if you have been approached by a US-based franchisor, but have not been provided with a copy of its FDD, you should ask for it. If the US franchisor refuses to give you a copy of its FDD (your heightened sense of suspicion having now been justifiably aroused), you might well wonder why, given that it is normally a publicly obtainable document and you can probably get a copy of it from the private company FRANdata (www.frandata.com) or from FranchiseHelp (www.franchisehelp.com).
The following list outlines the types of “material facts” that would be useful for you to know in advance of making your decision to buy into the concept:
• Bankruptcy and previous convictions of principals
• Outstanding litigation against or by franchisees
• Net worth of the franchisor
• Expected range of a franchisee’s initial investment costs
• Product and service restrictions
• Number of units that have ceased doing business (i.e., failed) in the previous 12-month period
• Names and addresses of existing franchisees
• What the standard form of franchise agreement looks like
• Other facts that the franchisor’s lawyers have deemed to be material and therefore must be disclosed
• Litigation against the franchisor and its directors and officers
A good reason why you might not be given a copy of the disclosure document is because it’s irrelevant to you and has little or no bearing on the franchisor with whom you would be contracting, such as in circumstances in which a prospective Canadian franchisee is not contracting directly with the American franchisor (which is subject to US regulation), but with a Canadian subsidiary or master franchisee (which may not be subject to US regulation). In other words, this information could be very valuable to you if you were negotiating and contracting directly with the US-based franchisor that is the subject of the disclosure document.
Quite often, the American-based franchisor has “master franchised” or otherwise licensed its rights to franchise all of Canada (or certain Canadian provinces) to someone else; normally an unrelated Canadian company with different directors, officers, and shareholders than the US franchisor and with a totally different corporate history. (See Chapter 3 for more information on master franchising.) Or perhaps the US franchisor has created a Canadian subsidiary to franchise in Canada, and this subsidiary company is not bound by US laws. In that case, all the information you have obtained on the franchisor isn’t