On July 12, 2024, The FTC and its Staff undertook four semi-permanent measures in support of franchisees. These actions were announced by the FTC in its July 12, 2024, press release (“Press Release”). This article discusses the first of these – the FTC’s Policy Statement on Franchisors’ Use of Contract Provisions, Including Non-Disparagement, Goodwill, and Confidentiality Clauses.
Introduction – The Four Actions Announced in the Press Release
The FTC’s Press Release initially states that the FTC was carrying out its current actions “to address a growing concern about unfair and deceptive practices by franchisors” and to “ensure that the franchise business model remains a ladder of opportunity to owning a business for honest small business owners.” Clearly, the FTC believes that the franchise industry was intended to be an effective method of creating a strong small business sector. Implicit in this view is that the franchise model, when run ‘fairly,’ can achieve and has achieved this societal goal. Second, and relatedly, the FTC also appears to believe that at present the franchise model is under attack through “unfair and deceptive practices” by franchisors. It has taken too many years for the FTC to arrive at this conclusion.
The first action identified by the FTC was a “Policy Statement” warning franchisors that contract provisions including non-disparagement clauses that prohibit franchisees’ communications with the government violate the law. The FTC appeared especially angered by such contracts in that they allegedly undercut the FTC’s investigatory functions to protect franchisees. In the Press Release, the FTC stated very clearly that “threats of retaliation against a franchisee for reporting potential law violations to the government are unlawful.” In addition to the views of FTC Staff, Chair Khan in the Press Release confirmed this strident position: “Today the Commission is making clear that contractual terms prohibiting franchisees from reporting potential law violations to the government are unfair, unenforceable and illegal.”
The second action announced by the FTC was “new guidance” explaining that franchisors cannot lawfully charge franchisees for fees that were not disclosed before execution of their franchise agreements. The FTC relied upon comments from franchisees responding to the pending RFI back in 2023. In particular, the FTC relied upon the comments of some franchisees reporting that “ever increasing payment processing and technology fees … make it difficult to make a living” and others identifying “undisclosed fees for training, marketing, property improvement, or any other product or service required by the franchisor.” Again, here, the FTC “makes clear” that it is illegal for “franchisors to impose undisclosed junk fees” and goes on to define the term “junk fees” as including “fees that raise costs and which may make the difference between a profitable franchise and an unsustainable one.”
The third action announced by the FTC was an Issue Spotlight, apparently summarizing the main concerns raised by franchisees (not franchisors) in response to the significant 2023 RFI regarding unfair franchise practices. The Issue Spotlight, according to the Press Release, “summarizes” the public concerns as submitted to the FTC in response to the 2023 RFI.
The fourth and last action by the FTC as announced in the Press Release is that the FTC has reopened the comment period for the 2023 RFI. Below I provide a short analysis of only the Policy Statement on the use of contract provisions including non-disparagement, goodwill, and confidentiality clauses. I will address the remaining FTC actions in subsequent articles.
Substance of the Policy Statement – Franchisors Must Cease Information Suppression Activities
The Policy Statement – although very welcome by franchisees — provides very little substance other than to articulate clearly that “[t]he FTC is concerned that franchisees are reluctant or unwilling to voluntarily discuss or file reports about their experiences with franchisors, even if the franchisees believe a law violation has occurred.” Essentially, the FTC relies considerably on the commonsense belief that it cannot perform its mission of helping franchisees if franchisees are “unwilling or unable to file reports and discuss their experiences.” However, there is neither guidance nor details provided by the FTC as to what specific types of contractual provisions would transcend the law. Indeed, in a footnote, the Policy Statement says that “[t]he Commission … will continue to analyze, on a case-by-case basis, whether contract provisions, such as confidentiality clauses, are unfair or deceptive under the FTC Act.”
The Policy Statement also notes that this issue of stultified reporting by franchisees to the government was tangentially raised in the 2023 RFI, specifically asking “whether non-disparagement, goodwill, and similar clauses inhibit franchisees from filing reports with regulators or from providing information to prospective franchisees or third parties about their experience with a franchise system.” According to the FTC, “some” of the commenters expressed concerns that such clauses “are likely to impede franchisees from speaking with the government.” And back in 2007, the FTC’s only action in this matter was to require a relatively useless ‘disclosure’ in FDDs indicating whether the franchisor ‘did’ or ‘did not’ use confidentiality clauses (a term which even after that rule-making process remains unclear).
The Policy Statement, although clearly an ominous shot at franchisor information suppression shenanigans, failed to provide guidance as to how clauses in franchise agreements (or agreed upon by the parties after signing) can be found wrongful. What legal formula is to be used? The public is left with the possibility that certain general provisions, such as non-disparagement clauses (e.g., “franchise shall not disparage the brand in any way”), confidentiality or non-disclosure clauses (e.g., “franchisee is prohibited from sharing any information about the franchise or experience”), and goodwill clauses (e.g., “franchisee shall not engage in any conduct that may tarnish the goodwill of the brand”) with no purpose to inhibit government reporting can “maybe” be found to be unlawful.
In the conclusion of the Policy Statement, the FTC states again that the “caselaw is clear that such clauses cannot operate to inhibit a franchisee from reporting potential law violations to the government.” However, shockingly, there is no discussion at all (here or earlier in the Policy Statement) regarding a test to determine whether any given clause “operates to inhibit the provision of relevant information.” Nor is there a healthy recognition that by failing to address the effect of direct information suppression on franchisees and potential franchisees, the ultimate goal of protecting franchisees cannot be achieved.
The Two Dissenting FTC Commissioners
Two FTC Commissioners dissented from the Policy Statement, including Andrew N. Ferguson and Melissa Holyoak. Commissioner Ferguson, even though he agreed that threats of retaliation against a franchisee for reporting potential law violations are unfair, and that federal cases have generally treated contracts as unenforceable to the extent they interfere with law enforcement investigations, assails the Policy Statement for ‘going too far.’ In essence, stated Ferguson, the Policy “is an attempt to announce de facto administrative rules through an ostensibly nonbinding Policy Statement.”
Commissioner Ferguson suggests that the Policy Statement bans the inclusion of non-disparagement, goodwill, or confidentiality clauses in franchise agreements that do not have an attendant disclaimer that the clause doesn’t cover reporting to the government. And, further, there is no guidance in the Policy Statement that including such a disclaimer would be sufficient to shield such a clause from being held unlawful. Commissioner Ferguson seems justifiably incredulous that under the Policy Statement it would be possible that the FTC Act is violated whenever a clause like “franchisee shall not disparage” is included. Commissioner Ferguson pointed out the obvious that “a clause is not void merely because it may be unenforceable in some hypothetical situations.”
Commissioner Ferguson suggested that if the FTC felt that it had the evidence, it should initiate a rulemaking proceeding to address this practice, including requiring disclosures on the limits of the non-disparagement clauses, or initiate enforcement cases against specific contract provisions. This issue should not have been addressed through a Policy Statement, according to Ferguson. “Indeed, using the Policy Statement as the ground for enforcement actions … turns this nonbinding policy statement into a type of informal law.” And most important according to Commissioner Ferguson, the Policy Statement process, not subject to the APA, denies franchisors of their due process rights, including notice, an opportunity for public comment, hearings, and ex ante judicial review. “Rulemaking by politically unaccountable technocrats, even with all of its attendant procedural safeguards, is not good for a democracy. Rules without rulemaking is even worse.”
The Dissenting Statement from Commissioner Melissa Holyoak was shorter but no less loud. Because the Policy Statement “attempts to effect a change in the law or, as here, overstates the law and confuses or burdens businesses, I will not support it.” While Commissioner Holyoak agrees that using non-disparagement, confidentiality, and goodwill clauses in franchisor-franchisee contracts should not impede law enforcement communications, “that does not mean that the inclusion of neutral provisions in a contract is unfair, in violation of Section 5 of the FTC Act.”
Commissioner Holyoak continues that the Policy Statement fails to meet its most important purpose: to provide guidance that reflects existing law since it “does not explain what franchisors looking to stay on the right side of the law should do.” As Commissioner Holyoak points out, must franchisors, to remain in compliance with the Policy Statement, call and email franchisees to tell them that no clauses in their franchise agreements will be enforced to prevent them from communicating with the FTC’s investigations activities, or should franchisors remove every non-disparagement, confidentiality, and goodwill clause from their contracts?
Concluding that the Policy Statement fails to provide useful guidance about the state of the law or predictable enforcement criteria, Commissioner Holyoak asserted that the Policy Statement “casts a pall over the use of non-disclosure, non-disparagement, confidentiality and goodwill clauses in franchisor-franchisee contracts, in a manner that is unlikely to help franchisors comply with the law while potentially impeding franchisors’ ability to protect their brands and intellectual property.”
Conclusion – More Meaningful Work Must be Accomplished by Franchisees During this Narrow Window of Opportunity
What is troublesome about the Policy Statement is that its procedural defects seemed knowable, almost a priori. The three majority Commissioners’ refusal to modify the Policy Statement even after reading and evaluating the reasoning of the two dissenting Commissioners is surprising, given that the FTC appears to have finally decided to recognize and do something about the massive market failures in franchising markets.
And what remains now after the Policy Statement? In the short term, franchisors are understandably concerned about the general and non-descript types of clauses identified in the Policy Statement. Some of their existing formulations in current franchise and other agreements for the relevant clauses (goodwill, confidentiality, non-disparagement clauses) are legitimate attempts to protect their goodwill, while of course many others are merely disguised punishment mechanisms to punish franchisees who share information about unlawful franchisor behavior. To avoid erring on the wrong side, some franchisors will likely ‘overprotect’ and make sincere efforts to avoid chilling franchisee reporting. However, some of these good faith efforts will fail because there are no clear guidelines for compliance in the Policy Statement. Indeed, some franchisors will succumb to the facial ambiguity and simply continue to operate as they had previously until they are ‘caught.’ Franchisees will suffer. On the other hand, in the short run, some franchisees will have misguided lawyers running into court to challenge every clause that looks like a goodwill clause. Franchisees will suffer.
The costs associated with all of the above problems are real transaction costs. Transaction costs frequently hinder and destroy what in their absence would be very efficient and productive markets. Although transaction costs are not always avoidable or reasonably manageable, they are in this case. They could have been significantly mitigated by more sophisticated legal and economic analysis and more succinct writing in the Policy Statement.
Moreover, the transaction costs problem created by the Policy Statement is further exacerbated by the historical failure of the FTC Rule (and the FTC) to reasonably cure the severe information market failures that have dogged the franchise industry forever. The FDD in its current incarnation cannot realistically be viewed as an effective or meaningful effort to truly cure this historical theoretical riddle. The marginal changes contemplated for the FTC Franchise Rule cannot cure the extant modern market failures that permeate franchise markets: cognitive failures, transaction costs failures, unchecked and rampant opportunism, and holdup problems due to asymmetric penalties and investment. The most important issue that was ignored in the Policy Statement is that franchisees are uniformly prevented by franchisors from relating the terrible (or very good) performance of or experiences with franchisors to other franchisees and prospective franchisees in their franchise systems.
As the FTC noted in the Policy Statement: “No benefits flow from the suppression of truthful information to the government.” However, it missed the much more important point: “No benefits flow from the suppression of truthful information to anyone, especially potential franchisees.”
Regardless, the FTC should be commended for its very active efforts to investigate unfair and deceptive franchisor practices. However, it seems to me, an attorney representing only franchisees, the over 2,000 comments submitted already for the 2023 RFI on franchising conduct do not appear to capture the problems afflicting the franchising industry fully and adequately; comments submitted from lawyers who simultaneously represent both franchisees and franchisors in conflict will not do the job. Nor will snippets of horror expressed by angry current and former franchisees turn the tide.
Franchisee associations need to take advantage of this rare opportunity to submit additional comments during the now-expanded investigation period. Funding to these associations from hybrid sources should not be the governing principle as to what is ultimately submitted. The failure of franchisee associations to both recognize that this is a ‘once in a lifetime’ opportunity, and to arrange for and submit stellar analysis of the open questions on both an academic and practical level, would be a tremendous disservice to themselves and their franchisee members.
