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Guide to Franchise Broker and Seller Franchise and FDD Compliance

Franchise Broker and Seller Compliance Guide

Franchise Broker and Seller Compliance

  1. The legal role of brokers in the franchise sales process
  2. Broker registration requirements
  3. FDD disclosure and compliance obligations
  4. Liability for franchise violations

If you are a franchisor, franchise broker, consultant, or industry professional and you have questions about franchise brokers and sellers, their legal role in the franchise sales process, broker registration requirements, and franchisor FDD disclosure and compliance obligations when dealing with franchise brokers and sellers, then this guide will help.

Who is a Franchise Broker?

A franchise broker is an individual or organization that operates as an independent contractor that is engaged in the business of promoting, offering, or arranging for the sale of a franchise. Franchise brokers consult with prospective franchisees about franchise opportunities that may be of interest to the prospect and assist in promoting and facilitating franchise sales transactions between the franchisee prospect and a franchisor.

Franchise brokers are not employees of the franchisor but are independent contractor agents of the franchisor and are compensated by the franchisor, typically, through a contingent commission calculated as a percentage of the initial franchise fee paid by the franchisee prospect. Within the franchise industry, franchise brokers are also sometimes referred to as franchise consultants and, commonly, franchise brokers are members of umbrella trade and professional associations such as IFPG, Franchise Brokers Association, and FranNet.

Franchise Brokers vs Franchise Consultants

Is there a difference between franchise brokers and franchise consultants? It all depends on how the intermediary (whether he or she is referred to as a broker or consultant) is compensated for recommending a franchise.

Typically, a "consultant" is hired by a franchisee prospect and is paid by the franchisee to consult and advise him or her on available franchise opportunities that are vetted and, in the consultants opinion, a good fit. In such instance the consultant is not compensated by the franchisor. On the other hand, a "broker" is paid a contingent fee by the franchisor for placing or referring a franchisee candidate who, in turn, buys a franchise.

Although there is a distinction between the terms franchise broker and franchise consultant, in practice, the distinction has been blurred and the terms franchise broker and franchise consultant are used interchangeably. For legal and transparency reasons while we recommend use of the term "broker," context is important and ultimately, no matter the terminology - broker or consultant, its critical that brokers and consultants properly communicate with franchisee candidates as to the nature of their relationship, how the broker/consultant is compensated, and the limited intermediary role of the broker/consultant to introduce the franchisee prospect to franchise brands.

Who is a Franchise Seller?

The term franchise seller is a legal term that is specifically defined by federal and state franchise regulations. The term franchise seller is a broad term and while the definition of a franchise seller includes franchise brokers who are independent contractors, it goes beyond brokers and includes all individuals and businesses engaged in offering, selling, or arranging for the sale of a franchise. This means that the term franchise seller not only includes franchise brokers but, also, franchisors, the franchisor's employees, and subfranchisors.

The Federal Franchise Rule defines a franchise seller, as follows:

Franchise seller means a person that offers for sale, sells, or arranges for the sale of a franchise. It includes the franchisor and the franchisor's employees, representatives, agents, subfranchisors, and third-party brokers who are involved in franchise sales activities. It does not include existing franchisees who sell only their own outlet and are otherwise not engaged in franchise sales or on behalf of the franchisor.

Franchise brokers fall within the definition of franchise sellers and are therefore franchise sellers under all applicable federal and state regulation. However, not all franchise sellers are franchise brokers, i.e., the term franchise seller includes franchisors and their internal employees who are directly employed by the franchisor and are, therefore, not brokers.

What are the FDD Disclosure Obligations Involving Franchise Sellers and Franchise Brokers

A franchisor's obligation to disclose its FDD is triggered, in part, by discussions between a franchise seller (which includes franchise brokers) and a prospective franchisee. The FTC Compliance Guide defines a "prospective franchisee" as "any person...who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship." Under the Federal Rule a franchisor is required to disclose its FDD to a prospective franchisee "at least 14 calendar days before the prospective franchisee signs a binding franchise agreement with, or makes any payment to, the franchisor or an affiliate in connection with the proposed franchise sale." However, a franchisor must provide a prospective franchisee with a copy of its FDD earlier than the 14 day period if requested by the prospective franchisee.

Within the FDD itself, Franchisors are required to disclose franchise sellers, including franchise brokers. The method of disclosure varies and is summarized, as follows:

(a) Franchisor Disclosure of Franchise Sellers - But Not Brokers - in FDD Item 2 - Franchise sellers who are directly employed by the franchisor (i.e., such as franchise sales directors) must be disclosed as a part of the franchisors management team in FDD Item 2.

(b) Franchisor Disclosure of Franchise Sellers - Including Brokers - in the FDD Receipt Page - Franchise sellers, including franchise brokers engaged in a particular franchise sale, should be disclosed on the FDD receipt page disclosed and signed by the prospective franchisee. The FDD Receipt page, in particular requires disclosure of the franchise sellers and and the franchise broker for each specific franchise sales transaction. In practice this means that as to particular franchise sales transactions, the FDD Receipt page should be modified or supplemented to identify the involved franchise sellers (including franchise brokers) involved in the sale.

(c) Franchisor Inclusion of Broker Disclaimer on FDD State Cover Page (Amended and No Longer Required but Instructive for evaluating Franchise Broker Disclosures) - Under NASAA's Old and No Longer Active Franchise Registration and Disclosure Guidelines, franchisors that used the services of a franchise broker or referral source were previously required to include the following broker disclaimer at the bottom of the FDD State Cover Page following the risk factors:

We use the services of one or more FRANCHISE BROKERS or referral sources to assist us in selling our franchise. A franchise broker or referral source represents us, not you. We pay this person a fee for selling our franchise or referring you to us. You should be sure to do your own investigation of the franchise.

Under the new NASAA Franchise Registration and Disclosure Guidelines this broker disclaimer is no longer required. However for franchise brokers, the prior disclaimer is instructive as to the type of disclaimers that should be considered when working with franchisee candidates and advising those candidates as to how you, as a franchise broker, are compensated and that, ultimately, you work for the franchisor. If approached properly as an act of transparency and open communication this type of disclosure could become a win-win for the relationship between broker and candidate.

(d) Franchisor Filing of Franchise Seller Disclosure Form - Within almost all franchise registration states, franchisors are required to register and file a "Franchise Seller Disclosure Form" for each franchise seller (including franchisor employees and independent brokers) that will be soliciting, offering, or selling franchises for the franchisor within the particular state.

The Franchise Seller Disclosure Form is attached as Exhibit D as a part of the NASAA Uniform Franchise Registration Application. As stated in the instructions to the NASAA form, the Franchise Seller Disclosure Form should be completed for:

...each person who may be engaged in soliciting or offering or selling the franchises for the Franchisor submitting the [FDD registration] Application. [The] form should be submitted for the franchisor's own employees, for employees of its parents or affiliates, and for any independent third party (e.g., broker) who may be providing sales services on its behalf in each [state]...

Submission and filing of a Franchise Seller Disclosure form for each franchise seller is an on-going process and requires updates as franchise sellers are added and removed.

(e) Franchise Broker State Registration - In certain states, specifically, New York and Washington, franchise brokers are required to register with the state as a franchise broker. The following links are to the New York Franchise Broker Registration Form and to the Washington State Franchise Broker Registration Form.

Franchise Seller and Broker Liability for Franchise Violations

Franchise sellers, including franchise brokers, are charged with certain obligations and potential liabilities under the federal and state franchise laws. The most common and important example of potential franchise seller liability under the Federal Franchise Rule relates to issues involving Item 19 financial performance representations and earnings claims where compliance obligations are not only imposed on the franchisor but, also, all franchise sellers. As an example and as stated in the FTC compliance guide: the time of furnishing a disclosure document, any franchise seller (including any broker) must notify a prospective franchisee if the seller knows of any material changes relating to a financial performance representation. This obligation arises even if a disclosure document is furnished at a time that falls between quarterly updates. For example, a franchisor may prepare an annual update to its disclosure document that contains an Item 19 financial performance representation. A franchise broker may then furnish the disclosure document to a prospective franchisee on June 1... If the broker knows of a material change in information underlying the Item 19 representation...the broker must notify the the prospective franchisee of the fact when furnishing the disclosure document...

The franchise rules that prohibit financial performance representations that are not true or that are not substantiated at the time they are made, not only applies to franchisors, but also to "franchise sellers." As an example, the FTC Compliance Guide states:

...individual franchise sellers - such as brokers - may not be liable for failing to furnish disclosure or for improperly preparing the contents of a disclosure document. Under the amended [Franchise] Rule, only the franchisor and any subfranchisor are responsible for that. Nevertheless, any seller can be held liable for the seller's own violation of the amended Rules provisions that prohibit:

  • making any financial performance representations unless the franchise seller has a reasonable basis and written substantiation for the representation at the time the representation is made;
  • failing to include in any financial performance representation a clear and conspicuous admonition that a new franchisee's individual financial results may differ from the results stated in the financial performance representation; or
  • making any financial performance representation that is not included in Item 19 of the franchisor's disclosure document.

Beyond financial performance representations, franchise sellers, including franchise brokers, must be aware that even basic and common sense franchise obligations - such as the prohibition against providing contradictory information - applies to them and not just the franchisor. As stated in the FTC Compliance Guide:

Prohibition Against Contradictory Information

The amended Rule prohibits a franchise seller from making any statement that contradicts the information disclosed in the franchisor's disclosure document...Prohibited contradictory statements include those made orally, visually, or in writing. For example, a franchise broker would be in violation of the amended [Franchise] Rule if it stated that the franchisor has never been sued by a franchisee, when, in fact, the franchisor has been sued and has disclosed the information in Item 3. Of course, franchise sellers are always free to disseminate additional truthful non-contradictory information to a prospective franchisee...

Contractual and Fiduciary Obligations and Recommended Steps for Franchise Brokers

As a practical matter franchise sellers and, in particular, franchise brokers need to consider basic legal obligations that govern all commercial and business relationships. Franchise brokers serve an intermediary role between the prospective franchisee and the franchisor and, in this role, it is important that franchise brokers avoid actions that could be misconstrued as constituting actions of fraud, misrepresentation, breach of contract and, even, breach of a fiduciary duty to the prospective franchisee. Legal exposure issues arise when a prospective franchisee is either not informed or misinformed about the relationship between the franchise broker and the franchisor.

At a most basic level it is important that, as a franchise broker, in all of your communications with prospective franchisees that you:

  1. Work to avoid a potential misunderstanding as to the nature of the relationship between you (as the franchise broker), your franchisee candidates, and ultimately the franchisor that pays you a commission.
  2. Focus on transparent relationships between you and the franchisee candidates that you assist and consider implementing a use of a disclosure advising your candidates as to the nature of your services and how you are compensated.
  3. Always conduct your actions as an intermediary and not as an advocate - you role should be to make introductions and to leave sales activities to the franchisor.
  4. Avoid all actions that would create the impression that you are a fiduciary of the prospective franchisee, i.e., avoid all actions and statements where you create the appearance that you are in a position of trust with the prospective franchisee and you are personally advising and counseling the prospective franchisee.
  5. Rely on the new Q&A advisories that are now a mandatory part of the FDD state cover pages as published under the new NASAA Franchise Registration and Disclosure Guidelines. This is especially the case for answering questions like "how much can I earn," "how much will I need to invest," and "is the franchise system stable".
  6. Remember that if you are aware of any inconsistency contained in the franchisors FDD that you have a duty to disclose.
  7. Never misrepresent or misstate the disclosures contained in a franchisor's FDD; (e) never make any financial performance representations other then referring a prospect to a Franchisors Item 19.
  8. Never make statements or representations that conflict with the franchisor's FDD disclosures.
  9. Be aware of terminology and the statements, promises, and representations that you make to franchisee candidates.
  10. Once a candidate is matched with a franchise opportunity, the candidate should be advised to take the next steps in the due diligence process in investigating and evaluating the opportunity. This diligence process should include validation with existing franchisees, and independent counseling and advice with the candidate's franchise lawyer.

When evaluating and mitigating franchise broker compliance and liability issues there are no clear cut answers and in the current climate where lawyers are starting to challenge and sue brokers involved in certain failed franchise relationships, its important to maintain clarity as to the relationship between franchise brokers and their candidates. This clarity starts with educating candidates about the nature of your services, the method of your compensation, and that the nature of relationship is for the broker to introduce candidates to potential franchise opportunities that the candidate may be interested in.

Developing and using a franchise broker / franchise consultant candidate disclosure, can be beneficial in many ways and can help address many issues of concern.

Also consider purchasing Errors and Omissions insurance. Annual premiums are relatively inexpensive and range from $1,000 to $3,000. Be aware that these policies will contain exclusions including excluded coverage for claims related to claims that the broker or consultant made promises or representations as to future franchisee earnings. Nevertheless these policies are valuable.

If you are a franchisor or a franchise broker and would like additional information about laws and rules involving franchise sellers and franchise brokers, call us at (718) 979-8688 or click the button below.