Item 12 of the Franchise Disclosure Document (FDD) informs prospective franchisees of three important aspects of running the franchised business: the location of the franchised business and associated territory; the franchisee’s and franchisor’s rights relating to the associated territory; and, if applicable, the franchisor’s present or future plans to operate a competing franchise system offering similar goods or services. Our dedicated team of attorneys could help a franchisor draft this Item in the FDD.
The FDD disclosure requirements are codified under the Federal Trade Commission’s Amended Franchise Rule, 16 C.F.R. §436.5 (the “FTC Rule”), and the disclosure requirements for Item 12 are codified at § 436.5(l). Under Item 12, franchisors must first disclose whether the franchise opportunity will be sold for a specific location, or a location to be approved by the franchisor. Franchisors must also disclose whether the franchise agreement grants franchisees a specific territory and, if so, what methodology was used to determine the territory and how it is defined under the franchise agreement. If the territory is undefined in the franchise agreement, franchisors must nonetheless include a minimum size of the territory, which is typically described using a radius, zip code(s), or description of an area encompassing a certain population.
If the franchise agreement grants franchisees a specific territory, franchisors must further disclose any conditions the franchisee must meet to obtain or retain that territory. For example, it is common for franchise agreements to set forth the conditions under which a franchisor will approve the relocation of the franchised business or the franchisee’s establishment of additional franchised outlets. Franchisors must also disclose any of the franchisee options, rights of first refusal, or similar rights to acquire additional franchises, as set forth in the franchise agreement.
If the franchise agreement grants franchisees a specific territory, then franchisors must also indicate whether it is an “exclusive territory.” As provided by the FTC, a franchisor may state that a territory is exclusive only if the franchisor contractually “promises not to establish either a company-owned or franchised outlet selling the same or similar goods or services under the same or similar trademarks or service marks” within the geographic area or territory granted to a franchisee. A territory is non-exclusive if the franchise agreement reserves rights to the franchisor to open company-owned or franchised outlets selling the same goods or services under the same trademarks or service marks within a franchisee’s territory. This is the case regardless of whether the outlets are established at non-traditional venues or captive market locations, such as airports, stadiums, hospitals, parks, campuses, and the like. Non-traditional franchises that by their very nature do not grant a geographic territory, such as internet-based franchises, are also considered non-exclusive. Thus, if a franchisor reserves the right to sell through such non-traditional venues, it must disclose that the territory is non-exclusive.
If a territory is non-exclusive, franchisors must provide the following disclaimer, word-for-word, under Item 12:
“You will not receive an exclusive territory. You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control.”
However, franchisors are not required to provide this disclaimer based solely on a provision in the franchise agreement reserving to them the right to offer competitive brands or use alternative channels of distribution, as the disclosures relating to such competition are provided in detail later in Item 12. If a territory is exclusive, franchisors must state so and disclose whether the exclusivity is conditioned on any contingencies of the franchisee’s performance, such as achieving a certain sales volume or degree of market penetration, the circumstances under which the franchisee’s territory may be altered, and the franchisor’s rights in the event these circumstances occur or a franchisee fails to meet its conditions for territorial exclusivity. A franchisor must also disclose any other circumstances that permit the franchisor to modify the franchisee’s territorial rights, as well as the effect of such modifications on the franchisee’s rights.
Regardless of whether the territory is exclusive or non-exclusive, the FTC Rule also requires disclosure of the franchisor’s and franchisee’s restrictions related to the territory and set forth in the franchise agreement. Specifically, the FTC Rule requires disclosure of the franchisor’s restrictions on soliciting or accepting orders from consumers inside the franchisee’s territory, as well as the franchisee’s restrictions on soliciting or accepting orders from consumers outside the franchisee’s territory.
The FTC Rule provides the following non-exhaustive list of franchisor restrictions that, in addition to those set forth in the franchise agreement, should be included under Item 12:
The FTC Rule also requires franchisors to disclose whether, and to what extent, a franchisee may solicit sales outside of their specific territory, including through other channels of distribution, such as the Internet, catalog sales, telemarketing, or other forms of direct marketing.
There is an additional disclosure requirement under Item 12 for franchisors with present or future plans to operate a competing franchise system offering similar goods or services. If a franchisor or its affiliate operates or franchises a business under a different trademark, or plans to do so in the future, and that business sells or will sell goods or services similar to those that the franchisee will offer, then a franchisor must also disclose:
If the principal business address of the franchisor’s similar operating business is the same as the franchisor’s principal business address stated under Item 1, then the franchisor must also disclose whether it maintains (or plans to maintain) physically separate offices and training facilities for the similar competing business.
Item 12 is a critical consideration for prospective franchisees, as most eagerly want as much territory as possible and to secure their investment. Because of its potential to dissuade prospective franchisees from entering into a franchise agreement, the keys to successfully drafting the Item 12 disclosures are clarity and accuracy. It is best practice for franchisors to avoid using terms of art or legal jargon in Item 12, as those who are new to franchising may find it difficult to understand what rights have been granted and what rights have been reserved. In addition, while the FTC Rule generally encourages the use of footnotes in other Items of the FDD, they should not be included in Item 12. Franchisors should strive to make Item 12 of the franchise disclosure document as clear as possible for a prospective franchisee, and consulting with a seasoned franchise attorney is the best way to ensure that goal is met.