Information Disclosure in Franchising

 

 

 

Information Disclosure in Franchising

 

Abstract

 

Franchise businesses go beyond license agreements which simply allow the usage of licenses such as business marks in that the franchisor is able to provide suitable training, support, and control to the franchisee regarding its specific profit-making activity. As such, the franchisor has to be involved in managing the franchisee’s store and must have the ability to provide necessary support to franchisees in order to bolster marketing. However, more often than not, franchisors lacking this ability intercept franchise fees by inviting prospective franchisees who are relatively ignorant regarding the franchising business. As long as it is impossible for franchisees to access sufficient information, franchisees risk losing their investment to franchisors who intend to abuse their position.

 

This research focuses on how Korea’s Fair Transactions in Franchise Business Act provides necessary measures to protect prospective franchisees before agreeing on the franchise agreement and gives suggestions as to how the act and the accompanying decree can be revised in the future. First, the necessity for information disclosure is covered along with the explanation on possible contents that are to be disclosed. Second, upon the basis that information disclosure is essential the United States’ rule devised by the Fair Trade Commission is analyzed as a model regulation on franchising. Third, Korea’s Fair Transactions in Franchise Business Act and its enforcement decree is introduced and the provisions related to information disclosure in franchising are mainly examined.

 

. Introduction

 

Franchise businesses go beyond license agreements which simply allow the usage of licenses such as business marks in that the franchiser is able to provide suitable training, support, and control to the franchisee regarding its specific profit-making activity. However, the franchisor’s active involvement in managing the franchisee’s store has continuously accumulated harmful consequences in the distribution market. While the franchisor is supposed to have the ability to provide necessary support in terms of prestige, authentic trade secrets and business know-how to franchisees in order to bolster their sales, in reality, some franchisors have intercepted franchise fees by inviting prospective franchisees without holding up their end of the bargain. Such situations occur due to the prospective franchisee’s relative ignorance regarding the franchising business – the impossibility of attaining sufficient information.

Currently, the Fair Transactions in Franchise Business Act provides legal protection for franchisees entering into franchise business by preventing rip-offs by franchisors in Korea. Several provisions in the act and its presidential decree intend to offer better protection for prospective franchisees by stipulating about the franchisor’s information disclosure statements. The enactment of the legislation was majorly affected by the United States’ franchise rule devised by the Fair Trade Commission. Given the circumstances, it is crucial to analyze the regulative measures in the United States regarding information disclosure. Besides, the United States in the 1950s and 1960s saw the advent of modern franchising and the phenomenon led to the recognition of how important information disclosure could be for potential franchisees.

This research focuses on how Korea’s Fair Transactions in Franchise Business Act provides necessary measures to protect prospective franchisees before agreeing on the franchise agreement and gives suggestions as to how the act and the accompanying decree can be revised in the future. To do so, the necessity for information disclosure is addressed, along with the explanation on possible contents that are to be disclosed. Upon the basis that information disclosure is essential the United States’ rule devised by the Fair Trade Commission is analyzed as a model regulation on franchising.

 

 

. Necessity for Information Disclosure

 

The franchisor must provide the potential franchisee with necessary information regarding the franchise business in order to enable the franchisee to conclude the contract with full knowledge of the relevant facts. The obligation to provide such pre-contractual information is important because franchise contracts are often concluded over a long period and performance under the contract frequently implies investment in the form of franchise fee for the franchisee. Moreover, the franchisee has to make big investments without having any other possibility of obtaining qualified information from an outside source.

 

  1. Information Subject to Disclosure

 

Adequate information which is sufficient to enable the other party to decide on a reasonably informed basis whether or not to enter into a contract is subject to disclosure. In other words, the information must be correct, complete and transparent for the benefit of the potential franchisee. Depending on the circumstances, the types of information which must be given may include information regarding the franchisor’s company and experience, intellectual property rights which are involved, methods of franchising, market conditions, terms of the franchising agreement, etc. Domestic legislation or rules generally stipulate what information is subject to disclosure in detailed provisions.

 

  1. Contents of the Information

 

1) Franchisor’s Company and Experience

The information in the franchisor’s company and experience category encompasses the particulars that identify the franchisor and essential facts regarding the experience of the franchisor in its specific field of business.

2) Intellectual Property Rights

The franchisor is to disclose evidence that the franchisor is the rightful owner or a valid licensee for the use of the trademark and distinctive signs that represent the franchisor. Such information is necessary to determine the scope of rights over intellectual property should the potential franchisee agree to become a party to the franchising agreement.

3) Franchising Methods

The information about the method of franchising includes a general explanation of the system of business the franchisor is currently engaged in. The characteristics of the ‘know-how’, the assistance to be provided by the franchisor, and an estimate of the investments and expenses necessary for conducting a typical business are common examples of franchising methods. Of all the methods to disclose, know-how is indispensable to the franchisee for the use, sale or resale of products under the franchise agreement.

4) Structure and Extent of Franchise Business

The organization of the franchise and the total number of establishments can only be provided accurately by the franchisors. Information about market conditions that describes the franchisor’s field of business activity in terms of the state of competition, demand and price development is also within this category.

5) Terms of the Franchise Agreement

It is fair to give potential franchisees an opportunity to know what the contract entails because unlike franchisors whose goal is to expand their business, franchisees take on a heavy financial burden by their investment in the franchise business. The terms include the rights and obligations of the respective parties, fees to be paid by the franchisee, contract duration, etc.

 

 

. Regulative Measures in the United States

 

The United States’ Federal Trade Commission originally enacted the FTC Franchise and Business Opportunity Disclosure Rule which has been in effect nationwide since the late 1970s as the nation’s sole federal franchise regulation. However, on January 22, 2007, the Federal Trade Commission approved a comprehensively revised FTC Franchise Rule (16 CFR Part 436) fundamentally transforming the rule for the first time since its adoption.[1] As mentioned above, Part 436 of the Code of Federal Regulations is about disclosure requirements and prohibitions concerning franchising. Subpart C of the rule lists the contents of a disclosure document in 23 items.

 

  1. Revised Rule’s Disclosure Requirements

 

1) Franchisor’s Company and Experience

Items 1 through 4 require the franchisor to state about itself and its associates in terms of business activities and other factors that might affect the business financially. Under Item 1, the name and principal business address of the franchisor, any parents, predecessors and affiliates is to be disclosed along with many other details about business organization and operation. Item 2 requires the franchisor to disclose individuals who will have management responsibility. Items 3 and 4 are respectively titled as Litigation and Bankruptcy to ensure that franchisors disclose such facts regarding the persons mentioned in item 1.

2) Intellectual Property Rights

Under item 13, each principal trademark to be licensed to the franchisee has to be disclosed. In a similar respect, item 14 requires the disclosure of patents, copyrights and proprietary information that are material to the franchise.

3) Franchising Methods

In accordance with item 5, initial fees and any conditions under which these fees are refundable have to be disclosed. All other fees that the franchisee must pay to the franchisor or its affiliates are also to be disclosed in the tabular form provided in item 6. Estimated initial investment is subject to disclosure under item 7 table. Item 8 stipulates the disclosure of restrictions on sources of product and services. Such limitations are to be disclosed since they are to become the franchisee’s obligation. Item 9 provides a tabular form for the purpose of listing the franchisee’s obligation. The terms of each financing arrangement that the franchisor offers to the franchisee is one of franchising methods that has to be disclosed beforehand in accordance with item 10. Franchisor’s assistance, advertising, computer systems and training provided by item 11 are also subject to disclosure. Disclosure of the involvement of public figures is also necessary under item 18 since public figures may affect the business.

4) Structure and Extent of Franchise Business

The franchisor has to disclose whether the franchise is for a specific location or a location to be approved by the franchisor pursuant to item 12 that stipulates about territory. Item 19 and 20 respectively requires the disclosure of financial performance representations and outlets and franchisee information. In terms of item 20, the franchisor has to disclose the total number of franchised and company-owned outlets for each of the franchisor’s last three fiscal years.[2]

5) Terms of the Franchise Agreement

As franchise agreement between the franchisor and the franchisee is a contract, it is natural to disclose information about the rights and obligations of the respective parties before the contract is established. In particular, the table included in item 9 provides a detailed and categorized list about the franchisee’s obligation that the franchisee should know before agreeing to contract terms. Item 15’s obligation to participate in the actual operation of the franchise business and item 16’s restrictions on what the franchisee may sell is one of the franchisee’s obligations as well. Item 17 which deals with renewal, termination, transfer and dispute resolution, requires the disclosure of a table that cross-references each enumerated franchise relationship item with the applicable provision in the franchise or related agreement.[3]

6) Other Required Documents

Items 21 through 23 require that the franchisor attach financial statements, contracts and acknowledgment of receipt of the disclosure document in order to preserve evidence that the franchisor followed the rule.

 

  1. Analysis

The revised FTC Franchise Rule’s requirements are rather extensive but cover most of necessary contents a potential franchisee should know before entering into a franchise agreement with the franchisor. The rule reflects a commitment by the FTC to evolve the federal regulation of franchising in the United States to take into account the massive transformation of that critical component of the American economy over the past three decades and the changes in society, demographics, economics and technology since the original FTC Franchise Rule was first promulgated in 1978.[4] The explanation following 23 items to include in the disclosure document is very detailed and to the point. Moreover, the tables act as a ready-made form and checklist for the franchisee and because of this factor it is highly commendable for its user-friendliness.

 

 

. Regulative Measures in Korea

 

Fair Transactions in Franchise Business Act and its enforcement decree applies to parties entering into the franchise business. The act was first enforced in the year 2002 and subsequently amended to comply with current franchise business practices. The legislation intends to ensure the mutually complementary and balanced growth of franchisors and franchisees on an equal footing.[5] The accompanying presidential decree enumerates what should be included in the information disclosure statements.

 

  1. Franchisor’s Obligation

In accordance with the Fair Transactions in Franchise Business Act, the franchisor has a duty to provide its prospective franchisees with an information disclosure statement.[6] The aforementioned information disclosure statement must be registered with the Fair Trade Commission pursuant to article 6-2 of the Act. In addition, franchisors are prohibited from providing false or exaggerated information to its prospective franchisees or franchisees.[7] Article 9 also provides that information about past profits or expected future profits of a prospective franchisee or a franchisee including sales, profits, gross profit, and net income has to be provided in writing.

 

  1. Information Disclosure Statement

The term “information disclosure statement” means a document that contains matters specified by the enforcement decree of Fair Transactions in Franchise Business Act.[8] The items to be included are referred to as “matters prescribed by presidential decree” in article 4 of the enforcement decree and means matters to be mentioned in the franchise disclosure statement.

Table 1 is attached to the enforcement decree to list the matters the franchisor ought to mention in the franchise disclosure statement and the contents are as follows: 1) general status of a franchisor, 2) current status of the franchise business of a franchisor (including matters concerning sales of its franchisees), 3) fact that a franchisor or any of its executives has ever violated this Act or the Monopoly Regulation and Fair Trade Act, has ever been rendered a final judgment against the franchisor or its executives in a civil lawsuit or a civil compromise in connection with a crime of acquiring or taking another’s property by fraud, embezzlement, or misappropriation, or has ever been sentenced to criminal punishment for the commission of a crime of acquiring or taking another’s property by fraud, embezzlement, or misappropriation, 4) charges of franchisees, 5) conditions of and limitations on business activities, 6) detailed procedures for the commencement of franchise business and the duration required for the commencement of business, 7) assistance to be provided by franchisors in terms of business activities and management, 8) explanations on education and training.

 

 

. Conclusion

 

The franchisor must provide the potential franchisee with necessary information regarding the franchise business in order to enable the franchisee to conclude the contract with full knowledge of the relevant facts. As such, it is highly important for the prospective franchisee to know adequate information about the franchisor’s company and experience, relevant intellectual property rights, franchising method, etc.

The United States provides an excellent rule that encompasses what the franchisor must disclose. Considering the circumstances, it is only natural that the United States has superior regulation. McDonald’s, Pizza Hut, Burger King, Holiday Inn, Baskin-Robbins, Kentucky Fried Chicken all geared up and franchised out during the 1950’s and 60’s in the United States and the popularity, growth and economic rewards of franchising led to the need for its regulation as criminal franchise enterprises began selling non-existent franchises.[9] Revision of the FTC rule in the year 2007 only improved it to become more detailed and clear in meaning. Moreover, the tables included in the list of disclosure items are categorical and prevent the potential franchisee from omitting crucially relevant information prior to the contract.

Korea’s Fair Transactions in Franchise Business Act is parallel to the United State’s rule in stipulating the franchisor’s duty to disclose the factors that are specified in the accompanying decree. Nevertheless, the provisions in the act intended to protect prospective franchisees as disadvantaged parties to the franchise agreement are rather vague and generic. The fact that the franchisor’s duty regarding information disclosure statements is uniformly regulated under the chapter entitled “Fair Transactions in Franchise Business” represents such obscurity. To make matters worse, detailed contents are all delegated to the presidential decree and it is usually up to potential franchisees to look these up and assert their rights. Thus, revising the lists in the decree to resemble the United State’s disclosure rule for the purpose of achieving user-friendliness is strongly recommended.

[1] David J. Kaufmann and David W. Oppenheim, FTC Disclosure Rules for Franchising and Business Opportunities, 2007, at 9

[2] Subpart C section 436.5(t) of FTC Franchise Rule

[3] Subpart C section 436.5(q) of FTC Franchise Rule

[4] David J. Kaufmann and David W. Oppenheim, FTC Disclosure Rules for Franchising and Business Opportunities, 2007, at 51

[5] Article 1 of Fair Transactions in Franchise Business Act

[6] Article 7 of Fair Transactions in Franchise Business Act

[7] Article 9 of Fair Transactions in Franchise Business Act

[8] Subparagraph 10 of Article 2 of Fair Transactions in Franchise Business Act

[9] David J. Kaufmann and David W. Oppenheim, FTC Disclosure Rules for Franchising and Business Opportunities, 2007, at11

 

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Posted in Autumn 2014.