How Many FDDs Do I Need? New Rules on Disclosing Multi-Unit Franchising Arrangements

11/12/2014 / Chuck Modell and Sawan Patel

On September 16, 2014, the North American Securities Administrators Association (“NASAA”) adopted ‎the Multi-Unit Commentary (the “Commentary”) that provides guidance on how multi-unit franchise ‎arrangements are to be disclosed in Franchise Disclosure Documents (“FDDs”). Multi-unit franchise ‎arrangements are known by a myriad of names—including area development, subfranchising, and area ‎representation—but the new guidance is crystal clear: if you are a franchisor with multi-unit franchise ‎arrangements, you will have additional work to do in your next franchise renewal cycle, and may actually ‎have to create multiple versions of your FDD and filings in the registration states.  ‎

The typical franchise relationship is between a franchisor and a franchisee, where the franchisor grants ‎one franchise to a single franchisee. The Commentary discusses the disclosure requirements for three ‎types of “multi-unit” franchising arrangements: “area development arrangements,” “subfranchise ‎arrangements,” and “area representation arrangements.” NASAA adopted the Commentary to clarify ‎uncertainties regarding disclosure requirements in multi-unit franchising.  ‎

Existing franchisors with fiscal years ending on December 31, 2014 must comply with the new ‎Commentary with their next franchise renewal. For new franchisors, the Commentary will not be effective ‎until mid-March 2015, but franchisors should expect state regulators to rely on the Commentary ‎immediately as they review new filings.  ‎

Types of Multi-Unit Franchising Arrangements

The Commentary sets forth different disclosure requirements depending on the multi-unit franchising ‎arrangement used (irrespective of the terminology used), each of which are summarized below:‎
  • Area Development: In an area development arrangement, the “area developer” is granted, for ‎consideration paid to the franchisor, the right to open and operate more than one unit franchise, ‎generally within a specific geographic territory, but not the right to grant unit franchises to third ‎parties. Most area development arrangements involve an area development agreement granting ‎this right and specifying the number of units to be developed pursuant to a development ‎schedule, with a separate unit franchise agreement for each unit opened. Some franchise ‎systems refer to area developers as area franchisees or regional developers. ‎
  • Subfranchise: In a subfranchise arrangement, the “subfranchisor” is granted, for consideration ‎paid to the franchisor, the right to further grant unit franchises to third parties, generally within a ‎specific geographic territory. Most subfranchise arrangements involve a master franchise ‎agreement (between the franchisor and subfranchisor, which may be referred to as a master ‎franchisee) and unit franchise agreements between the subfranchisor and each unit franchisee ‎‎(which may be referred to as subfranchisees). Typically, the subfranchisor provides certain ‎services—including pre-opening and training services—to the unit franchisees in lieu of the ‎franchisor, in exchange for part of the fees payable by the unit franchisees under the franchise ‎agreements. ‎
  • Area Representation: In an area representative arrangement, the “area representative” is granted, ‎for consideration paid to the franchisor, the right to solicit or recruit third parties to enter into unit ‎franchise agreements with the franchisor, and/or to provide certain services to third parties ‎entering into unit franchise agreements with the franchisor. Unlike the subfranchise model, the ‎area representative is not a party to the unit franchise agreements, but the area representative ‎typically receives a part of the fees payable by the unit franchisees under the franchise ‎agreements.‎
While Franchisors are not required to use those terms in their legal documents, state regulators may be ‎able to more quickly review FDDs with those terms. Further, some state laws define the above ‎relationships differently than the Commentary, in which case the state law governs. Summarized below ‎are the disclosure obligations under the Commentary for the above multi-unit franchise arrangements: ‎

Area Development

An area developer is essentially a unit franchisee, but with the right to develop more than one unit ‎franchise within a specific area. Therefore, the relationship with an area developer is very similar to that ‎with a unit franchisee. The Commentary confirms that a franchisor may offer area development ‎franchises in the same FDD as it offers unit franchises. ‎

However, the Commentary clarifies certain disclosures required in the FDD for area developers. For ‎example, depending on the set up, Item 1 of the FDD must disclose which form of franchise agreement ‎the area developer will sign for units developed in subsequent years. Items 11 and 12 of the FDD must ‎disclose, if applicable, that the franchisor will determine or approve the location of future units to be ‎opened by the area developer and any territories for those units (if the specific locations are not already ‎set forth in the area development agreement), and that its then-current standards for sites and territories ‎will apply. Any cross-default provision in the area development agreement or in the unit franchise ‎agreement (which provides that any termination of the area development agreement could also result in ‎termination of that area developer’s unit franchise agreement(s), or vice versa) must be disclosed in Item ‎‎17 of the FDD. And the Commentary clarifies some confusion as to Item 20 disclosures—i.e., if and ‎when units opened by area developers may be included in the Item 20 charts.   ‎

Subfranchise

The rights and obligations of subfranchisors differ significantly from those of a unit franchisee. For ‎instance, the fee structure is completely different, the territories for a subfranchisor are larger, and ‎supplier relationships may differ. Because many of the disclosures in an offering of a subfranchise are ‎different from an offering of a ‎unit franchise, the franchisor must offer and sell subfranchise rights using ‎an FDD separate from ‎the one used in the offer and sale of unit franchises.‎ ‎This means that the ‎franchisor must ‎obtain two separate franchise registrations—one for its unit franchise offering and one ‎for ‎its subfranchise offering‎.  ‎

A subfranchisor ‎must prepare its own FDD and register in many states before offering and selling ‎franchises in those states. The registration requirements for a subfranchisor are similar to that of a ‎franchisor. A ‎subfranchisor must usually file an FDD meeting the registration requirements of the ‎state(s) in which it has the right to sell franchises, ancillary filing materials required by the state,‎ ‎audited ‎financials of the subfranchisor and franchisor, and auditor’s ‎consents as to both sets of financial ‎statements.  ‎

Likewise, a subfranchisor must amend its FDD if material changes occur at the franchisor level. Both ‎FDDs will require some cross-disclosures. For instance, Item 1 of the FDD offering unit franchises must ‎disclose that the franchisor offers subfranchises as a separate line of business from the offer of unit ‎franchises. Items 3 and 4 of the subfranchisor’s FDD must disclose litigation information and ‎bankruptcy information, respectively, of both the franchisor and subfranchisor. Item 20 of the ‎subfranchisor’s FDD requires outlet information for the whole system. And the franchisor’s audited ‎financial statements must be included in the subfranchisor’s FDD. Thus, it is imperative that the ‎subfranchisor work closely with the franchisor in the preparation of the subfranchisor’s FDD (including ‎each renewal and amendment). Further, to the extent possible a subfranchisor ‎should align its fiscal year ‎end with the franchisor’s so that the parties renew their offerings at approximately the same time. This ‎should allow the ‎subfranchisor to obtain needed information from the franchisor (and vice versa) in an ‎efficient manner, and alleviates the need for the subfranchisor to amend when the franchisor renews at ‎another time. The Commentary ‎clarifies that a subfranchisor’s obligation to renew its franchise offering ‎is tied to its fiscal year ‎end, not the franchisor’s fiscal year end.  ‎

Area Representation

Many franchisors currently offer and sell unit and area representative franchises through ‎the same FDD. However, the Commentary requires that a franchisor offering area representative ‎franchises must do so ‎from an FDD separate from the one it is using to offer unit franchises, as ‎the two offerings are materially ‎different. Although several sections of the FDDs (such as Items 1-4, 13, 14, and 21) will be nearly ‎identical for both offerings, there are significant differences (including, contracts, costs and fees, ‎supplier relationships, and services and obligations) in the information to be disclosed in almost all of ‎the other Items.‎

Conclusion

Franchisors that offer multi-unit franchises must comply with the Commentary in their next renewal. This ‎will require information gathering that should begin soon for those with a calendar year end. For ‎franchisors that offer subfranchise or area representative arrangements, they should be aware that they ‎must separate their subfranchise and area representation arrangements from their offerings of unit ‎franchises, if they don’t already. This may significantly increase the burden and filing fees for ‎franchisors and their subfranchisors and area representatives, but as the Commentary notes, separate ‎FDDs will alleviate confusion between the different offerings for state regulators and subfranchisors, ‎area representatives, and unit franchisees.‎

For our franchise clients that offer multi-unit franchises, we will be sending specific information on ‎updating their FDD(s) about 90 days in advance of their next renewal. If you are a franchisor that offers ‎multi-unit franchises and do not work with us, you should contact your attorney regarding the ‎Commentary.‎

Note: Chuck Modell was a member of the NASAA task force that worked on the Commentary.‎ Chuck also ‎authored NASAA Adopts Multi-Unit Commentary, published in The Franchise Lawyer, Fall 2014, regarding ‎the new disclosure rules for multi-unit franchising.‎