The 2008 Amended Franchise Rule:
Most Hotel Deals Now Exempt from Federal Regulation of Franchising
The FTC’s Recent Reduction of the Scope of Federal Regulation
By Cecelia L. Fanelli, Esq.
and
Jonathan D. Twombly, Esq.
Cecelia L. Fanelli (cfanelli@stroock.com, 212.806.6158), is a Partner in the Hospitality Industry Practice Group of Stroock & Stroock & Lavan LLP, which Ms. Fanelli heads, and Jonathan D. Twombly, an Associate in Stroock’s Hospitality Industry Practice Group. The Group represents industry leaders from across the hospitality spectrum – from owners, investors, managers and lenders to franchisors and franchisees – and has extensive experience in negotiating hotel franchise and management agreements. Ms. Fanelli speaks and writes extensively on matters relating to the hospitality industry and has been a guest faculty lecturer at the Cornell Hotel School on a variety of franchising topics.
On July 1, 2008, the amended Franchise Rule 1 (the “Amended Rule”) promulgated by the Federal Trade Commission (“FTC”) became mandatory and replaced the original Franchise Rule (the “Original Rule”), which had been in effect since 1979. The Amended Rule contains several exemptions for franchisees that are deemed “sophisticated” and presumably are able to obtain adequate disclosure regarding prospective franchise opportunities without the mandatory disclosures required by the Original Rule. Large franchisors, including some hotel franchisors, actively encouraged the FTC to adopt these amendments. 2
The “Fractional Franchise Exemption” Could Exempt Many Multiple-Property Owners from the Amended Rule
In the Amended Rule, the FTC revised the “Fractional Franchise Exemption” 3 to better reflect long-standing policies developed in applying the Original Rule. This exemption generally arises when “an existing business seeks to expand its product line through a franchise.”4 A fractional franchise exists when both of the following criteria are met at the beginning of the franchisor-franchisee relationship:
- The franchisee, any of its current directors or officers, or any of
the current directors or officers of the franchisee’s parent or affiliate
company, has more than two years’ experience in the same business; and
- The parties reasonably anticipate that the franchise will account for 20 percent or less of the franchisee’s total sales during the first year of operation. 5
Many hotel owners with multiple existing properties potentially could satisfy these criteria. For example, most sizeable hotel owners have at least one director or officer who meets the requirement of two years’ experience in the industry. Moreover, few new franchises offered to such an owner are likely to contribute 20 percent of the owner’s sales in their first year of operation. 6 Thus, this exemption potentially could exclude a significant percentage of hotel franchises from the application of the Franchise Rule.
The “Sophisticated Investor Exemptions” Exempt Large Franchisees and Large Franchise Investments from the Amended Rule
The Amended Rule also contains two new “sophisticated investor exemptions” that could have a significant effect on the rule’s applicability to hotel franchising transactions: the “Large Franchisee Exemption” and the “Large Franchise Investment Exemption.” Franchisors “enthusiastically supported” the creation of these exemptions during the review and comment process for the Amended Rule. 7
According to franchisors, “…franchising today often involves heavily-negotiated, multi-million dollar deals between franchisors and highly sophisticated individuals and corporate franchisees with highly competent counsel.” Because of their sophistication, “[i]n the course of such deals, prospective franchisees often demand and receive material information from the franchisor that equals or exceeds the disclosures required by the Rule.” 8 Franchisors “asserted that such business arrangements are not the kind of franchise sales that the Commission originally intended to cover.” 9 The FTC agreed and included these exemptions, among others, in the Amended Rule.
The Large Franchisee Exemption: Five Years in Business or a $5,000,000 Net Worth
The FTC regards the Large Franchisee Exemption 10 as “a logical extension” of the Fractional Franchise Exemption. 11 Whereas the Fractional Franchise Exemption focuses “on persons who wish to expand their existing product line” and requires experience in the field of the franchised business or a closely related field, the Large Franchisee Exemption posits that some business entities may be sophisticated enough not to need the protections of the Franchise Rule, even if they lack experience in the franchise’s particular field. This exemption applies wherever a prospective franchisee (a) has been in any business for at least five years and (b) has a net worth of at least $5 million. 12 During the review and comment period, at least one hotel franchisor commented that for tax or liability reasons, many individual hotels are owned by a special purpose entity (“SPE”) that does not satisfy the criteria of the exemption but have affiliates that do satisfy them. In response to this comment, the FTC determined that “the prior experience and net worth of the franchisee’s affiliates and parents” could be considered “when determining whether the franchisee qualifies as a ‘large franchisee.’” 13
Although the Large Franchisee Exemption probably does not exempt, for example, the personal trainer who wants to operate a fitness franchise, this exemption is likely to have a significant impact on the hotel industry. A substantial percentage of the individuals and entities with the financial resources to buy or build a hotel are likely to satisfy the exemption’s requirements of five years’ experience in any business and a net worth of $5 million. Moreover, because many new entrants to the hotel industry satisfy these criteria, they will be considered “sophisticated” for purposes of the Amended Rule even though they lack experience in the hotel business. The underlying premise for this change is that new entrants with this level of business experience and assets will hire “highly competent counsel” and that these sophisticated businesspersons ask for and obtains greater disclosures than mandated by the Rule. It is clear that under the new Rule, exempt entities should carefully monitor the disclosure issue, and the “highly competent counsel” that they hire should be specifically competent in hotel franchise matters, and not, for example, simply experienced in the non-hotel business in which the franchisee may operate or have operated.
The Large Franchise Investment Exemption: a $1,000,000 Investment Threshold
The Amended Rule also includes the Large Franchise Investment Exemption, 14 which applies to certain high net worth individuals and families that seek hotel franchises, whether or not they are experienced in the hotel industry. 15 This exempts from the Amended Rule “franchise sales where the prospective franchisee makes an initial investment totaling at least $1 million, excluding the cost of unimproved land,” in the period up to and including the first three months after opening. 16 Despite objections that $1 million was too low a threshold for exemption from the rule, the FTC settled on that amount because, in its view, “investment level is one indicium of sophistication,” and “individuals investing $1 million or more are sufficiently sophisticated that they do not need the Rule’s protections.” 17 Such investors, the FTC reasoned, “will demand and obtain material information with which to make an investment decision regardless of the application of the Rule,” such that “the case for federal intervention” into the transaction “is not compelling.” 18Nevertheless, the Amended Rule requires a franchisor seeking to apply this exemption to a franchise transaction to obtain from the prospective franchisee a written acknowledgment that the initial investment in the franchise exceeds $1 million. 19
The $1 million initial investment required to qualify for the Large Franchise Investment Exemption need not be made to the franchisor; it also can include payments to third parties, such as an investment of “$1 million to purchase a building” or up-front payments for “equipment or other assets.” 20 In addition, a person converting an existing business into a franchise also qualifies for the exemption if his investment in the existing business meets the $1 million threshold. Indeed, the FTC reasoned, “a strong argument can be made that a conversion franchisee is even more sophisticated than a new franchisee, having worked in the business for a period of time.” Similarly, an individual who spent $1 million to purchase an existing franchise operation “would qualify for the large investment exemption in a transfer” of the franchise. 21
The Large Franchise Investment Exemption has generated relatively little
comment, presumably because it will not affect most franchisees who are
smaller entrepreneurs. But it is likely to have a large impact in the
hotel industry, causing many individual hotel investors to be exempted
from the Amended Rule. Few hotels in sizeable markets cost less than $1
million to purchase or build, and the cost of bringing even a relatively
small hotel into compliance with a franchise’s brand standards could easily
push an owner’s initial investment above the $1 million threshold. Indeed,
the FTC specifically contemplated that this exemption would “offer tangible
benefits” to franchisors in “franchise systems, such as lodging, where
the typical franchise investment is likely to exceed the large investment
exemption’s monetary threshold. Accordingly, the large investment exemption
will provide regulatory relief in at least those instances.” 22
1 Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities, 16 C.F.R. § 436.
2 See Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities; Final Rule, 72 Fed. Reg. 15,459, 15,522-15,529 (March 20, 2007) (codified at 16 C.F.R. §§ 436.8 (a) (5) and (a) (6)).
3 See Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities; Final Rule, 72 Fed. Reg. 15,459, 15,522-15,529 (March 20, 2007) (codified at 16 C.F.R. §§ 436.8 (a) (5) and (a) (6)).
4 72 Fed. Reg. 15,458.
5 Franchise Rule Compliance Guide at 8-9; 72 Fed. Reg. 15, 458.
6 It is not clear whether a special purpose entity (“SPE”) formed for the purpose of owning the new hotel franchise would meet the second prong of the Fractional Franchise Exemption. However, it seems likely that the FTC would take the position that the total sales of all affiliated hotel businesses would be taken into account. For example, the FTC has stated that the experience of directors, officers or managers of affiliated entities would satisfy the “experience” prong of the exemption. 72 Fed. Reg. 15,459. With respect to the Large Franchisee Exemption, the assets of the SPE’s parents and affiliates can be aggregated in order to satisfy the exemption. 72 Fed. Reg. 15,528. Because the FTC considers the Large Franchisee Exemption to be “a logical extension of the original Rule’s fractional franchise exemption,” arguably it should apply these two exemptions consistently.
7 72 Fed. Reg. 15,522.
8 Id.
9 Id.
10 16 C.F.R. § 436.8(a) (5) (i).
11 72 Fed. Reg. 15,527.
12 Id. (discussing 16 C.F.R. § 436.8(a) (5) (ii)).
13 72 Fed. Reg. 15,528.
14 16 C.F.R. § 436.8(a) (5) (i). In a publication entitled Amended Franchise Rule FAQ’s, available at http://www.ftc.gov/bcp/franchise/amended-rule-faqs.shtml, the FTC makes clear that this exemption applies to individuals and not “entities.” See FAQ 3 therein.
15 Married couples are considered as a single individual under this exemption because their assets are generally commingled. Franchise Rule Compliance Guide at 12. Investment groups that include at least one individual who invests at the $1 million level also fall within this exemption. Id.; 72 Fed. Reg. 15,526.
16 72 Fed. Reg. 15, 522; Franchise Rule Compliance Guide at 48-49.
17 72 Fed. Reg. 15,523, 15,525.
18 72 Fed. Reg. 15,523.
19 16 C.F.R. § 436.8(a) (5) (i).
20 72 Fed. Reg. 15,525.
21 72 Fed. Reg. 15,527.
22 72 Fed. Reg. 15,523
