What franchisors need to know about developing in registration states and how it affects their FDD.
While the majority of U.S. states do not have laws that regulate franchise sales, there are a handful that require franchisors to file their Franchise Disclosure Documents on a yearly basis. In some of these states, registering an FDD makes brands eligible to sell franchises in that state immediately, while others require a review process to ensure a brand’s FDD complies with the state’s law.
There are 13 registration states in the U.S.: California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, Virginia, Washington and Wisconsin. Filing is required in a handful of others.
“When a franchisor files its FDD with a registration state, they wait for a response, which comes in the form of either a registration notice, signifying a green light, or a comment letter, a red light,” explained franchise lawyer Alexander Tuneski, Of Counsel at DLA Piper LLP. “Comment letters identify deficiencies that need to be addressed and remedied before the franchise is registered and can begin doing business in the state.”
The timeframe for this process can range from anywhere between three weeks and three months, Tuneski continued, depending on the state. Also depending on the state is the amount of comments you will receive, he said. In some, franchisors aren’t likely to receive any comments at all, while in others, they’ll almost definitely receive comments, it’s just a question of how many. This is why, Tuneksi stressed, diligence is key when preparing an FDD for submission to registration states.
Franchise lawyer Evan Goldman, a partner at A.Y Strauss, agreed, saying, “I think it’s vital for brands to understand that registration obligations are in addition to, and not in lieu of, the Federal Trade Commission’s Franchise Rule and other registration states’ franchise rules should you intend to sell franchises there, too. I have some clients who say, for instance, ‘State X only requires this, so let’s do that.’ And I have to caution them that, while State X requires one thing, the FTC has additional requirements. And, more importantly, States Y and Z, where you also want to sell franchises, require even more.”
As far as how they advise brands to approach marketing and development in these states, both lawyers emphasized the importance of a long-term development plan in order for franchisors to best navigate the complexities of registration states.
“Brands must consider their long-term goals before drafting their initial FDD and look at registration as a long-term plan, as opposed to a short-term one,” Goldman said. “This creates a more cohesive FDD and will set franchisors up for more success. With the right counsel who knows the laws and is intimately involved with the brand being developed, you can avoid some of the pitfalls of registration states’ disclosure, marketing and development obligations.”
Tuneski agreed, explaining that having a strategy as far as where you intend to sell and where you are realistically going to be adding locations in the next year is imperative.
“Lots of franchisors don’t want to worry about whether they can sell in a state, so they register in all of them because they don't want to have a situation where they have a lead and are unable to develop near them,” Tuneksi said. “But if they know they’re only going to operate regionally for the time being, there’s no reason for the added expense of registering in states outside of that range. The opposite is true if their strategy is to develop wherever the next best prospect is located. Then, it’s worth it to consider registering in all states because they can lose a viable prospect in the time it takes to register.”
Understanding registration states is crucial for all franchisors, Tuneski and Goldman continued, because breaking the rules in these states by going too far down the path with a prospective franchise owner before being registered opens them up to potentially serious liability. States have the right to enforce non-compliance in a number of ways, the lawyers said.
“Consequences vary based on what the franchisor has done,” Tuneski said. “Regulators are typically willing to work with the franchisor to fix the mistake and get them on the right track. If franchisors are cooperative, there's leniency. If they’re not, however, and the error is egregious, states can penalize brands in a number of ways.”
Some violations result in multi-thousand dollar fines, while others bar individuals from selling franchises in certain states for a number of years, Goldman added.
“What franchisors should know is that it’s better to be honest and forthright with the states, as opposed to trying to hide their (usually accidental) misdeed,” he said. “Although states may not let you off scot-free if you violate their franchise laws, they will be significantly more lenient and forgiving if you are candid and, even better, if you self-report an accidental violation.”
By understanding all of the complexities of registration states early on in the FDD drafting process, franchisors give themselves the best chance of finalizing the document with as few hiccups as possible.