What happens to a franchisor who continues to sell franchises even though its state registration has lapsed?
Registration of a franchise disclosure document (“FDD”) generally expires in registration states either 120 days after a franchisor’s fiscal year or one year after the date of registration.
Franchise sales in violation of the New York Franchise Sales Act expose franchisors to significant monetary penalties. In our experience, state examiners, such as the New York Attorney General’s office, are willing to impose lesser penalties on a franchisor if the franchisor voluntarily brings the matter to the examiner’s attention. For that reason alone, we highly recommend that a franchisor facing such a situation voluntarily bring the matter to an examiner’s attention. Otherwise, that franchisor may face stiffer penalties in the future, including but not limited to that state’s refusal to register the franchisor’s FDD and the imposition of higher monetary fines. Franchisors should remember that Item 20 of the FDD discloses the number of franchise sales for the three previous fiscal years. If the Item 20 disclosures indicate that new franchises were sold during a fiscal year in which registration of the franchisor’s FDD lapsed for a period of time, an examiner may rightfully ask the franchisor to provide the dates those franchises were sold and may require the franchisor to provide an affidavit attesting that no franchise sales took place during the period of time when registration of the FDD had lapsed. Franchisors that fail to provide a state examiner with accurate information or fail to disclose accurate Item 20 information have committed additional violations, which may only compound the problem later and result in considerable penalties. Accordingly, it makes sense to bring this matter to an examiner’s attention before submitting a copy of the new FDD for registration.
In our experience, once a franchisor advises an examiner of the issue, the franchisor can expect to be asked to submit an affidavit providing information concerning the dates of each franchise sale, the initial franchise fee collected from each franchisee and any mitigating factors for such sales along with a copy of each franchise agreement entered into after registration of the FDD lapsed. With the proper support, certain mitigating factors may help the franchisor convince the state examiner to reduce the proposed penalty. In New York, the Attorney General’s office will then review the information and it will prepare an Assurance of Discontinuance to be signed by the franchisor and its principal in lieu of initiating an investigation into the franchisor’s conduct. The Assurance of Discontinuance will impose a penalty on the franchisor and it will also require the franchisor to offer rescission to all franchisees that purchased their franchises after registration of the FDD lapsed. While the imposition of a penalty and the requirement that the franchisor offer rescission may be a steep price to pay, failing to bring this matter to a state examiner’s attention may yield an even more substantial penalty.