To control brand uniformity in the franchise system, many franchisors limit the suppliers from which a franchisee can purchase certain goods or services necessary to the establishment or operation of its franchise unit. Accordingly, if a franchisor requires franchisees to purchase or lease certain goods or services from the franchisor, its affiliates, or suppliers approved by the franchisor, Item 8 of the Franchise Disclosure Document (FDD) requires that the franchisor to disclose certain information pertaining to those “purchase obligations”. One of our attorneys could discuss what information pertaining to those purchase obligations that a franchisor must disclose, as well as the best practices for drafting such disclosures, under Item 8 of the FDD.
The information that a franchisor must disclose under Item 8 is codified under the Federal Trade Commission’s Amended Franchise Rule, 16 C.F.R. §436 (the “Amended Rule”); particularly, at § 436.5(h). In general, the Amended Rule requires a franchisor to disclose the restrictions on the franchisee to purchase or lease goods or services from sources of the franchisee’s choosing. Item 8 also must include how the franchisor or its officers may derive a benefit as result of those purchase obligations.
Under Item 8, a franchisor must disclose the franchisee’s obligations to purchase or lease goods or services in the establishment or operation of the franchised business that are “source-specific”. This means that the franchisee must purchase that good or service from the franchisor, its affiliates, or suppliers approved by the franchisor, or in accordance with the franchisor’s specifications. The purchase obligations that must be disclosed under Item 8 are strictly limited to those that are source specific.
Therefore, if a franchisee has absolute discretion in choosing the supplier from which they purchase a good or service, even if the franchisee has the option to purchase the good or service from the franchisor, that purchase obligation need not be disclosed under Item 8. Additionally, the franchisor does not need to disclose purchase obligations that are already provided to franchisees as part of the initial franchise fee under Item 5, such as initial training, or fees disclosed in Item 6.
The franchisor must first describe the source-specific good or service that a franchisee is required to purchase or lease, regardless of whether the purchase obligation is imposed under the terms of the franchise agreement or by the franchisor’s actual practice, such as requirements in the franchisor’s operating manual. For example, a franchisor must disclose purchase obligations for fixtures, equipment, inventory, computer hardware and software, real estate, or any other comparable item that is related to establishing or operating the franchised business.
For each purchase obligation, the franchisor must also provide the designated or approved suppliers from who the franchisee can purchase the particular good or service. The franchisor must disclose whether it or its affiliates are approved suppliers and must specifically state if they are the only approved suppliers. If the franchisor allows franchisees to purchase a particular good or service from alternative suppliers, the franchisor must disclose how the franchisor grants and revokes approval of alternative suppliers. This information should include:
Lastly, the franchisor must disclose whether it issues specifications and standards to franchisees, sub-franchisees, or approved suppliers, for the purchase of particular goods or services. If so, the franchisor must also describe how it issues and modifies those specifications.
In addition to stating the specific suppliers from or standards by which a franchisee must purchase a particular good or service, Item 8 also requires full transparency for any benefit that the franchisor or its officers could derive from the source-specific obligations.
The franchisor must disclose if any officers of the franchisor own an interest in a supplier for a particular purchase obligation. Here, an “officer” is any person within the franchisor’s business who has management or policy-making authority. An officer owns an “interest” in the supplier if he or she possesses any percentage of direct ownership from which the officer derives income or other financial benefits. However, if the interest is not “material” to a prospective franchisee’s decision to invest in the franchise system, the franchisor need not disclose it under Item 8 of the FDD. Whether an interest is “material” depends on the facts and circumstances surrounding each particular franchise, but as a general rule of thumb, the more direct an officer’s ownership interest is in a supplier, the more likely that that interest should be disclosed.
For example, an officer who owns a controlling interest in a supplier’s stock would more likely need to be disclosed than an officer who owns shares of a mutual fund or stock held in a blind trust. This is because in the latter example, the officer does not exercise control over the specific investment in the supplier. Ultimately, the franchisor need not disclose the identity of the officer or the extent of his or her interest in the supplier; the franchisor need only disclose the suppliers in which any of its officers have an interest.
The franchisor must also disclose whether the franchisor or any of its affiliates may receive revenue or other material benefits from any purchases or leases from the franchisor, its affiliates, or a third-party supplier. For example, some franchisors receive special deals or volume discounts from suppliers that benefit company-owned outlets, but not franchised outlets. This is a material benefit that a franchisor would be required to disclose under Item 8. However, if the special deals or volume discounts are offered by the supplier to all buyers, including franchisees, the franchisor need not disclose it.
Here, “supplier” means any third party in the manufacturing and distribution chain who may make payments to the franchisor or any of its affiliates when their goods or services are sold to franchisees. While the franchisor is not required to identify the specific third party who may make such payments, if the franchisor or its affiliate derives revenue or some other benefit from a supplier, the franchisor must describe the precise basis by which that revenue or benefit may be derived, by providing:
The figure for the franchisor’s total revenue should be taken from the franchisor’s statement of operations, or profit and loss statement, from its most recent annual audited financial statement, which is required under Item 21 of the FDD. In the event that audited statements are not yet required for the franchisor, say, if a start-up franchisor is phasing in audited financials as permitted under the Amended Rule, or if the entity deriving the revenue is an affiliate, the franchisor may disclose its total revenue from other sources of information used in computing revenues. In this situation, the franchisor must identify those alternative sources.
Also, if a designated supplier makes payments to the franchisor from franchisee purchases, Item 8 must disclose the basis for the payment as either a percentage or a flat dollar figure. For purposes of this disclosure, a “payment” includes the sale of similar goods or services to the franchisor at a lower price than to franchisees. The franchisor must state the percentage or flat dollar figure in the aggregate not based on each individual supplier. Therefore, if Company A makes payments of 1% of all purchases to the franchisor ($1000), and Company B makes payments of 5% of all purchases to the franchisor ($5000), the franchisor must disclose that it receives payments from its designated suppliers as 1%-5% or $1,000-$5,000.
In addition to the restrictions for purchase obligations and the benefits received as a result of those obligations, the franchisor must also disclose a few additional items of information. Under Item 8 of the franchise disclosure document, the franchisor must provide an estimate of the proportion of the franchisee’s source-specific purchases and leases to all non-source-specific purchases and leases of goods and services in establishing and operating the franchised businesses. The franchisor must also disclose the existence of purchasing or distribution cooperatives. If a franchisee is required to participate in a purchasing or distribution cooperative, then the franchisor must identify the cooperative. If there is a cooperative that the franchisee is not required to participate in, but may voluntarily do so, the franchisor need not identify the cooperative, but should disclose that one or more of these cooperatives exist.
The franchisor must also state whether the franchisor negotiates purchase arrangements or price terms with designated suppliers for the benefit of franchisees. The franchisor must disclose whether it engages in this practice but is not required disclose the specific price terms negotiated. Lastly, the franchisor must disclose whether the franchisor provides material benefits to a franchisee based on a franchisee’s purchase of particular products or services or use of particular suppliers. Common examples of a material benefit that franchisor’s provide include renewal of the franchise agreement or the granting of additional franchises.
The source restrictions for purchase obligations control the look and feel of franchised businesses. For new franchisors, Item 8 should be drafted carefully to give the franchisor flexibility to receive rebates or other benefits, or to designate alternative suppliers, in the future. As the need for supplies grows, a new franchisor may find it beneficial to create affiliates to supply franchisees. Additionally, as the franchise system expands into new territories, it may be necessary to engage new architects, contractors, or suppliers. All of these hypothetical scenarios should be considered, whether by a new or established franchisor, when drafting the source-specific purchase obligations for Item 8 of the franchise disclosure document.
In addition to disclosing all that is required in Item 8, it is important to note that the Amended Rule permits franchisors to disclose the reasons for any purchase obligation. If a franchisor elects to do so, it should describe the reasons for a particular purchase obligation in a way that emphasizes the vital role that the restriction plays in protecting the franchise system.
For one, the restrictions ensure uniformity and promote quality, but they also protect the prospective franchisee’s potential investment. Painting the reason for the restriction on suppliers in a light that emphasizes these points is a wonderful way to assuage any concerns the franchisee may have about the disclosed purchase obligations. Consulting with a franchise attorney could ensure that the information required under Item 8 is properly disclosed and painted in a light most favorable to the franchisor.