Franchise Relationships That Are Exempt From The Federal Franchise Rule
Not every franchise offering requires disclosure of a Franchise Disclosure Document (“FDD”). Under the Federal Franchise Rule, the following franchise transactions are exempt from the disclosure of an FDD:
- Minimum Payment Exemption;
- Fractional Franchise Exemption;
- Large Franchise Investment Exemption;
- Large Franchisee Exemption;
- Insider Transaction Exemption;
- General Partnership Exemption;
- Single Trademark License Exemption;
- Oral Franchise Agreement Exemption;
- Leased Department Business Exemption; and
- Petroleum Marketing Practices Act Exemption.
Application of a franchise exemption must be carefully evaluated with your franchise lawyer. Any determination as to whether or not your franchise transaction is exempt must also involve an evaluation of state-specific franchise laws, as certain states do not recognize many of the federal exemptions.
Minimum Payment Exemption
Franchise transactions “where the total of the required payments, or commitments to make a required payment, to the franchisor or an affiliate that are made at any time before to within six months after commencing operations of the franchisee’s business is less than $500” are exempt. Commencement of franchisee operations is determined by the date that the franchisee first makes its goods or services available to the public.
Fractional Franchise Exemption
This exemption applies to franchise transactions where (a) the franchisee possesses not less than two years of experience in the industry of the franchised business, and (b) franchisor and franchisee have a reasonable basis to believe that the franchised business – when combined with the existing business of the franchisee – will generate revenue that do not exceed 20% of the franchisee’s total dollar volume in sales in the first year in operation. Not every state recognizes the fractional franchise exemption. Before relying on a fractional franchise exemption, there must be a careful legal analysis of the opportunity being sold and how it relates to the franchisee’s existing business.
Large Franchise Investment Exemption
This exemption applies to franchise transactions where the franchisee’s initial investment is $1 million dollars or greater. The basis for this exemption rests on the assumption that a franchisee making a large franchise investment will be more sophisticated and is less likely to require protections afforded by FDD disclosure. The determination of what counts toward a franchisee’s “initial investment” (a) includes those start-up costs and expenses that are typically disclosed in FDD Item 7 (“Estimated Initial Investment”), (b) excludes costs associated with unimproved land, (c) excludes funds obtained through franchisor financing or financing through an affiliate of franchisor, and (d) includes expenses paid by franchisee through the opening of the franchised outlet and through the three-month initial period thereafter. If the franchisee is a corporate entity or an investor group with more than one individual investor, for the large franchise investment exemption to be effective at least one investor by himself or herself must have expended and met the minimum $1 million threshold.
To invoke the large franchise investment exemption, the franchisor must obtain from the prospective franchisee a signed acknowledgment that contains the following statement:
The franchise sale is for more than $1 million – excluding the cost of unimproved land and any financing received from the franchisor or an affiliate – and thus is exempt from the Federal Trade Commission’s Franchise Rule Disclosure requirements, pursuant to 16 C.F.R. Section 436.8(a)(5)(i).
Large Franchisee Exemption
This exemption applies to franchise transactions with large franchisees where the franchisee (a) possesses a net worth of at least $5 million, and (b) the franchisee has been in business for at least five years. Net worth is determined by the franchisee’s balance sheet, and when determining the net worth and historical business experience of the franchisee, the franchisor may consider the prior experience and net worth of the prospective franchisee’s parent and affiliates. Unlike the fractional franchise exemption, the franchisee’s prior business experience does not need to be related to the franchised business.
Insider Transaction Exemption
This exemption applies to franchise sales to officers, directors, general partners, managers, and owners (collectively, “Insiders”) of a franchisor. To qualify, the Insider must (a) seek to purchase at least a 50% ownership interest in the franchise being offered for sale, (b) must have at least two years of experience with the franchisor as an officer, director, general partner, or manager, and (c) be currently associated with the franchisor or have been associated with the franchisor within 60 days of the franchise sale.
General Partnership Exemption
As a general rule, bona fide relationships among general partners are excluded from the Federal Franchise Rule. The substance and nature of the partnership is important, and in general, a bona fide partnership requires proportionate allocation of liability exposure and risk.
Single Trademark License Exemption
Traditional trademark licenses where a single licensee is granted the right to use a trademark are, typically, exempt. This exemption applies to basic trademark licenses on a one-to-one basis and without the indicia of a franchise relationship.
Oral Franchise Agreement Exemption
This exemption applies to franchise agreements that are oral only and where there is no written documentation evidencing the material terms of the franchise relationship.
Leased Department Business Exemption
This exemption applies, typically, in retail settings where an independent retailer sells its own goods and services from a premises leased from a larger retailer and in the larger retailer’s store, provided that the independent retailer is not required to purchase goods or services from the larger retailer or from suppliers designated by the larger retailer.
Petroleum Marketing Practices Act Exemption
This exemption applies to gasoline stations and other businesses that are governed by the Petroleum Marketing Practices Act.
Caution: These “exemptions” are to the Federal Franchise Rule and do not apply to franchise disclosure and registration requirements enacted and required by the Franchise Registration States and other states that have enacted franchise relationship laws. Although an exemption may apply under the Federal Franchise Rule, state law (i.e., the state where your business is located, the state where your prospective franchisee resides, and/or the state where the franchised outlet may be located) – especially in the Franchise Registration States – may nevertheless require FDD disclosure and registration. So, before relying on an exemption, you must carefully review with your franchise lawyer (a) whether or not the federal exemption applies, and (b) whether or not state law nevertheless requires FDD disclosure.
For example, although in the Federal Franchise Rule the FTC recognizes a large franchisee exemption, this exemption is not recognized by many franchise registration states. Of the registration states, only California, Rhode Island, and Washington recognize a form of exemption for large franchisees; and in certain instances, the exemption is from FDD “registration” but not FDD “Disclosure.” State franchise laws must be carefully evaluated.
To learn more about exemptions to the Federal Franchise Rule and whether or not your franchise transaction is exempt, give us a call at (718) 979-8688 or contact us.
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