New Legal Developments Affecting Franchise Sales Effective January 1, 2023

1. Acknowledgments and Questionnaires in the Franchise Sales Process

Background: About a year ago, the North American Securities Administrators Association ("NASAA"), an unofficial association of state regulators who work together to adopt uniform securities and franchise regulatory policies across the United States, asked the public to comment about a proposal that it was considering to outlaw a long-standing franchise sales practice requiring prospective franchisees to sign a questionnaire or acknowledgment ("Closing Acknowledgment") either before or when they signed a franchise agreement indicating, among other things, if they had read and understood the Franchise Disclosure Document (FDD) and contracts or had received financial performance information different from what the franchisor disclosed in Item 19 of its FDD. According to NASAA, franchisors "routinely" use Closing Acknowledgments to insulate themselves from potential liability by franchisees who later allege fraud or misrepresentations during the franchise sales process. The FTC had held a public workshop on the same topic in late 2020, but has yet to do anything further. Perhaps impatient with the FTC's lack of movement, a few weeks ago, NASAA adopted its proposal nearly verbatim, despite numerous comments about the benefits of using Closing Acknowledgments in selling franchises, including to police rogue franchise brokers. NASAA's new policy, effective on January 1, 2023, takes an extremely hard stance against the continued use of Closing Acknowledgments by identifying 11 prohibited questions that franchisors may not ask. You can read the final version of NASAA's policy here.

What does this mean for a franchisor? NASAA is not a legislative body, so it has no authority to render the use of Closing Acknowledgments illegal or to void a franchisee's answers to prohibited questions. However, California, one of fourteen "registration states" regulating franchise sales, has already amended its franchise sales law effective January 1, 2023, to make it illegal to use a franchisee's answers to a Closing Acknowledgment as a waiver of statutory rights (see below). We at DWT believe other registration states will follow suit. We also believe that franchisors risk exposure to an unfair trade practice claim if they try to use a franchisee's answers to prohibited questions in a manner that offends NASAA's policy. From a practical perspective, given the significant discretion that registration states vest in their franchise agency to approve or reject a registration application, we do not believe a franchisor will succeed in registering an FDD that includes a Closing Acknowledgment with prohibited questions. Federal and state franchise sales laws require that a franchisor attach a copy of all contracts that a franchisee must sign to buy a franchise to its FDD, so, if a franchisor requires a franchisee to sign a Closing Acknowledgment, they must include the Closing Acknowledgment form with their registration application. At DWT, we are evaluating if it is possible or practical to redesign the Closing Acknowledgment form so that it (i) remains useful as a statement by a franchisee as to their due diligence in deciding to buy a franchise; and (ii) will be accepted by registration states. Franchisors across the U.S. are struggling with this issue now; some intend to discontinue using a Closing Acknowledgment altogether since NASAA's policy severely limits what a franchisor may ask a franchisee. For franchisors needing to update their FDD, we can guide you through our recommendations for how to handle this in 2023.

2. Changes to California's Franchise Laws

California Franchise Investment Law (regulating franchise sales) ("CFIL")

1. California's franchise regulatory authority may deny or revoke a franchise registration if the franchisor's business methods are or would be illegal outside of California where they are performed. This change expands California's franchise agency's enforcement authority. However, it does not appear to give a non-California franchisee a civil claim against a California franchisor for violating the CFIL based on activity outside of California.
2. The CFIL adds a new provision that establishes standards, processes, and timelines for the transfer of an existing franchise to a new franchisee. These changes bring the CFIL in line with provisions in California's other franchise law, the California Franchise Relations Act, which regulate post-sale relationship issues. California's franchise agency may condition registration on a franchisor rewriting its transfer provisions if it provides less than the minimum requirements. The minimum requirements include (i) forbidding a franchisor from withholding consent to a transfer in its sole discretion, i.e., without having a valid business reason; (ii) requiring franchisors to respond in writing to a transfer request within 60 days after receiving the franchisee's request and supporting documents about the transferee and transfer; and (iii) if the transfer request is disapproved, requiring franchisors to notify the prospective transferee of its reasons. Subpart (iii) sets up the possibility that not only the selling franchisee, but the rejected buyer, might have separate and independent claims challenging the fairness of the rejection. The new law does not affect a franchisor's right to exercise a right of first refusal or limit a franchisor's right to establish conditions for transfer in a franchise agreement.
3. The new law prohibits a franchisor from refusing to sell a franchise or provide financial assistance to a prospective franchisee based on age, ancestry, color, disability, national origin, race, religion, sex, or sexual orientation. However, it allows "affirmative action" programs that make franchises available to persons lacking the capital, training, business experience, or other qualifications that the franchisor ordinarily requires of franchisees.
4. The new law voids any provision in a writing that asks the franchisee to disclaim or deny (i) representations made by the franchisor or its personnel or agents to a prospective franchisee, (ii) reliance by a franchisee on any representations made by the franchisor or its personnel or agents, and (iii) reliance by a franchisee on the FDD and any exhibits to the FDD. This new prohibition puts teeth into the new NASAA policy discussed above.

California Franchise Relations Act (post-sale relationship matters)

1. Pre-amendment, a franchisor could offset any amounts that it owed to the franchisee against amounts the franchisee owed to the franchisor. For example, many franchise agreements require upon termination that a franchisor repurchase salable inventory or physical assets at their book value. After January 1, 2023, a franchisor may only offset amounts owed if (i) the franchisee agrees to the amount; or (ii) the franchisor has received a final judgment establishing the amount owed by the franchisee.
2. It is unlawful for a franchisor to modify a franchise agreement or require a general release in exchange for assistance related to a declared state or federal emergency.

For more information about NASAA's latest policy or franchise sales or post-sale relationship issues or disputes, please contact Shelley Spandorf or Tanja Hens.

Shelley Spandorf – rochellespandorf@dwt.com – 213-633-6898

Tanja Hens – tanjahens@dwt.com – 503-778-5432