New franchise rule: More disclosure, same high risks

(FORTUNE Small Business) -- If Beth Tomei had only known.

In November 2004, the Walnut Creek, Calif., fitness club owner signed a franchise agreement with the Butterfly Life women's fitness company in hopes of cashing in on the company's Curves-like business circuit training plan. Soon, however, she realized all was not right: she learned that 12 of the company's 16 California franchises were failing or had failed, she says; that the start-up costs would be close to twice those claimed in the company's franchise prospectus; and that the oral profitability claims she'd been given were mostly wishful thinking.

Today, down $450,000 in savings and home equity, she is part of a group of franchisees involved in a class arbitration claim against Butterfly Life.

"If they had been required to disclose more and do it more clearly, I think a lot of heartache could have been saved and would be saved for future franchisees," Tomei said. A Butterfly Life representative did not return calls for comment.

It seems that Tomei may get her wish. Since 1995, the Federal Trade Commission (FTC) has been studying ways to update the Franchise Rule - the regulations governing the sale of franchises to aspiring business owners - to make it more consistent with state regulations. On July 1, the fruit of 13 years of internal meetings, public workshops and industry comment becomes real when the new and improved Franchise Rule goes into effect.

But while Tomei and other franchisees and franchisee advocates applaud the changes, many say the new rule falls short of being the far-reaching revision needed to protect prospective franchisees from the abuses reported in an FSB cover story two years ago, "Risk/Reward." Instead they, echo Susan Kezios, the president of the American Franchise Association franchisee group, who wrote in a recent industry trade publication article: "The FTC labored a dozen years to revise its Franchise Rule - only to give birth to a mouse."

The new rule and its creation myth take up 133 pages in the Federal Register - its basic purpose is to define the information that franchisors must disclose in the document they provide prospective franchisees, currently known as the Uniform Franchise Offering Circular, or UFOC (California's Department of Corporations website collects a number of these, though not for the biggest franchisors; industry data firm FRANdata also sells them).

The new rules requires that franchisors provide additional information about subjects like franchisor-initiated lawsuits against franchisees; contact information for former franchisees who have left the franchise in the last year; franchise turnover; the dangers of buying non-exclusive territories; the franchisor's use of confidentiality clauses that stop current or former franchisees from talking about their experience with prospective franchisees; and contact information for independent franchisee groups.

This additional disclosure is good news for prospective franchisees, as it should help them make better decisions as they weigh an investment that can run from under $50,000 to more than $1.5 million.

"There are some very significant changes. By and large, more information for a franchisee is better. And they're getting more," said Michael Einbinder, a co-founder of New York law firm Einbinder & Dunn, which represents both franchisors and franchisees. "When I advise franchisee clients, if I see that a franchisor sued 35 franchisees last year, I worry because it means that they're trigger happy or they have a high failure rate."

Chris Schmitz, who owns or co-owns three Meineke Car Care Centers in Northern Virginia, agrees.

"I don't see how more information could ever be bad for franchisors," he said. "You want people who are confident that they're making a good investment. If you have nothing to hide, the more information that gets out, the better."

But what rankles some franchisees and their advocates is the omission of two big requests: the mandatory disclosure of earnings claims - projections of what a franchisee will make - and the franchisee's right to sue the franchisor if he feels that the company violated the FTC rule (known as a "private right to action").

"They should be required to make earnings claims," said ex-Butterfly Life franchisee Tomei. "Then there's no chance to have something on a cocktail napkin or said in a seminar; the franchisor would have to back them up. It would close the opportunity for false the claims that are rampant in the business."

Bob Purvin, the CEO of the San Diego-based American Association of Franchisees & Dealers franchisee group, concurs.

"The lack of a private right of action and the lack of required performance data are pretty devastating," he said. "The first questions a prospective franchisee ask are, 'How much will I make?' and 'If you lie, can I bring legal action?' The original rule didn't provide those, and the new one still doesn't."

Of course, complaining is easy. As FTC staff attorney Craig Tregillus explains it, income projections would be impossible for young franchisors without a long history to make, and would have to be defined differently for each industry, from restaurants to rug cleaning. At the same time, he says, it would take an act of Congress - not of the FTC - to create a private right of action.

"Our only authority at the FTC is to do rulemaking within the FTC act," Tregillus said. "The courts have held that there is no private right of action under the act."

In the end, what this means is that while the new rule will give prospective franchisees access to more and clearer data, it likely won't improve their odds.

"We have this wonderful fiction that franchisees should make these investments and franchisors can say, 'We don't provide any guidance.' They expect prospective franchisees, many of whom invest their life savings, mortgage their homes, and withdraw from 401(k)s, to make the investments without this information," said Eric Karp, a Boston franchise lawyer who teaches MBA courses in franchising at Babson College. "If financial disclosure information were given, I think the failure rate would go down."

That rate is hard to pinpoint, but in a 1994 study based on Census Bureau data on 20,000 new businesses, Wayne State University professor Timothy Bates found that 38% of franchise units failed over a four-year period, compared to 32% of independent startups. Today, Bates says he has seen no fundamental change in the failure rates he documented in the 1990s.

For former franchisee Tomei, the FTC's changes are good - just a few years too late.

"Had there been proper disclosure when I was looking at purchasing, there's no way I would have walked down this path," she said.