When Ara Madenlian fled war-ravaged Lebanon in search of peace and prosperity in the United States, owning his own business was a big part of the dream. And, of all the opportunities he explored, operating an ice cream parlor seemed the most attractive.
Madenlian, his brother-in-law and two cousins spent about $450,000 on franchise fees and leases for several ice cream stores. But soon after handing over the money, they learned that the company they bought the franchises from had no right to sell them.
Madenlian learned an important and costly lesson: Buying a franchise can be risky business.
Risky or not, a new franchise opens every 17 minutes in the United States, and this explosive growth has spawned a debate between state and federal regulators over who should regulate the industry.
While buying a reputable franchise can provide even the most inexperienced person an opportunity to make more money than he ever dreamed of, buying a bad franchise can be a nightmare.
With that in mind, California has led the nation in requiring companies selling franchises to provide sweeping disclosures about every aspect of their business. The regulations, considered burdensome by some franchisers, are designed to combat franchise fraud.
Now, those California regulations are threatened. The staff of the Federal Trade Commission is seeking comments on a proposal that would have the federal government take over part or all regulations governing franchising.
The focus of the debate is who should oversee franchising--individual states or the FTC.
FTC staff members and one commissioner argue that there should be one set of regulations for companies selling franchises and that the FTC is the best agency to oversee the industry. Opponents say the FTC is a weak regulator compared to states such as California and is ill-equipped to do the job.
Leading the drive for uniform regulation is FTC Commissioner Terry Calvani, who says he is responding to complaints from companies who have to comply with dozens of different state regulations. “I kept hearing people say they feared we were moving toward a crazy-quilt kind of regulation,” he said in a recent interview. “We may be creating a (franchise) system where only wealthy or heavily capitalized people are able to take advantage of it.”
Calvani, who has prodded fellow FTC commissioners to consider preempting state laws, said his intention is to reduce the regulatory maze that poses an economic barrier to companies selling franchises. Consumers will still be protected, he said.
Depending on the public comments, Calvani said the FTC will draft new regulations, amend current regulations or do nothing.
The franchising debate is significant because the industry is exploding. According to the International Franchise Assn., about 35,000 new franchises or outlets are opening each year. Franchises employ an estimated 7.3 million Americans and each year create 300,000 new jobs, according to industry statistics.
Counting gasoline stations and automobile dealerships, franchised companies generated $640 billion in sales last year, according to the U.S. Department of Commerce. Business format franchises providing services such as mailing and printing services, contributed about $200 million of the total.
Currently, 15 state have laws stricter than the federal regulations on franchising. Most states with franchise laws require companies selling franchises to register a prospectus with state authorities. The material, including detailed disclosures about the parent company, must be approved before the company can begin selling franchises. State officials say they comb through the material and make sure every risk is outlined to protect naive investors from fraud.
The remaining 35 states rely on the less stringent federal regulations, which do not require any form of registration.
Attorneys for the California Department of Corporations, charged with enforcing the strictest franchise regulations in the country, say they oppose federal preemption.
“There is a tremendous amount of abuse,” said Alan Weinger, supervising counsel for the Department of Corporation’s enforcement division in Los Angeles. “The people need the protection of a local agency.”
Weinger and others said the federal government hasn’t the staff or funds to protect small investors from unscrupulous franchisers.
In recent years, Weinger said fraudulent franchisers have taken millions of dollars from naive investors, many of them immigrants anxious to cash in on the American dream.
He said cease and refrain orders like the one issued against the firm that sold Ara Madenlian the illegal franchises, are, unfortunately, common in California. In Madenlian’s case, the man who sold the franchise had no right to do so, state officials said.
After five years in court, the Madenlians won a settlement for some of the money they invested. But a bitter Madenlian says he is working seven days a week selling photographic equipment to recoup the loss of his life savings.
Between 1986 and the present, Weinger said the corporations department has handled 185 franchise cases and issued 46 administrative cease-and-refrain orders against companies involved in selling unregistered or unlicensed franchises.
In the same period, the department filed six civil injunctions and revoked, suspended or denied 11 franchiser registrations.
In contrast, the FTC has taken about 20 enforcement actions against franchisers in the past 10 years, according to a commission spokesman.
Craig Tergillus, the FTC’s franchise rule coordinator, said it is unfair to compare the state and federal statistics because the federal agency focuses on multimillion-dollar cases involving people across the country. And, he said, the FTC’s enforcement actions have resulted in the collection of about $20 million for wronged franchisees.
“It’s not as if franchising doesn’t have some priority here,” said Tergillus, who is coordinating public comment on the proposed changes. “The commission would be very concerned about reducing protection for consumers.”
Still, attorneys and others representing franchisees say they are concerned about what would happen if the weaker federal regulations preempted the stronger state laws.
“Everyone acknowledges the FTC rules are weaker than most of the state laws,” said Timothy Fine, a San Francisco attorney specializing in franchise law. “If this goes through, the stronger state laws would be nullified.”
One California regulation in jeopardy requires smaller, less financially stable franchise companies to deposit funds from new franchisees in an escrow account. The money remains in escrow until the franchisee is satisfied that the company has kept its promises. Fine said this rule and others have “literally saved millions of dollars for small business people.”
He argues that the extra protection provided by state requirements is necessary because the “number of franchisers that have gone into bankruptcy is staggering.” One of the most recent cases involved the bankruptcy filing by Pioneer Take Out Corp., the chicken restaurant operator.
Harold Brown, a Boston franchise attorney and author of several books on franchising, takes a dim view of FTC enforcement actions.
“The FTC is a gelding,” said Brown. “It has diminished its staff by 40% in the past eight years and devoted itself to inattention to the plight of the franchisee . . . “
Brown contends that in every fraud case so far, the FTC’s actions were “too little and too late.”
“In all but one case, they were against companies whose telephones were already disconnected,” said Brown.
Brown said he also discounts the franchisers’ complaints that the regulations are a financial burden.
“When franchisers say they have to spend tens of thousands of dollars to comply with state regulations, what they are really saying is that if they stink or have a bad record the state authorities won’t let them slip through the net,” he said.
But franchise industry consultants agree with Calvani in saying the different state registration requirements pose a burden. “They are dealing with 15 different people playing God in different ways,” said Ed Kushell, president of the Franchise Consulting Group in Century City. “I’m not out to take anything away from the states, I’m just saying the regulations should be uniform.”
Although the North American Securities Administrators’ Assn., which represents state officials charged with enforcing securities laws, has developed a uniform code of franchise regulations, there are still differences from state to state.
Meanwhile, the industry’s major trade association is trying to remain neutral in the battle.
“It’s turf warfare between the federal and state agencies, not between us and the state agencies,” said Bill Cherkasky, president of the Washington-based International Franchise Assn., which represents 765 franchisers.
“But, I wouldn’t mind if they (the states) all got together,” he said. “For goodness’ sake, it would be nice to deal with one law.”
Since New York and California have the most restrictive state regulations, franchisers say if they receive approval in those states it is very easy to sell franchises in all the others. California passed the nation’s first law requiring registration of franchises in 1970. The federal government enacted its laws in 1979.
“We welcome all those rules and regulations, we feel very good about the rules,” said Esther Muller, director of franchising for Mail Boxes Coast to Coast Inc., which has about 1,000 franchises nationwide. “It legitimizes us and gives us credibility.”
Muller said her company supports state regulation because “people need to be protected” from many unscrupulous companies.
She said she also supports upgrading the qualifications of people who sell franchises. “There should be tests like those for real estate brokers.”
Lewis Rudnick, counsel to the International Franchise Assn., said he doesn’t think that the state registration statutes have much of an impact on fraud.
“By and large, the crooks are going to ignore statutes of this kind--they always have and they always will,” Rudnick said, adding, however, that he doesn’t favor total federal preemption.
Besides the possible preemption of state laws, the other key issue being explored by the FTC is how to untangle the rules dictating how franchisers disclose information on potential earnings.
Calvani and franchise industry leaders said the regulations are so complex in many states that franchisers often refuse to provide any official information at all on such things as how much money a franchisee could expect to earn.
Instead, the dollar estimates are passed around under the table or scribbled on cocktail napkins, he said, and weaken rather than strengthen consumer protections.
“I can’t stress to you how ridiculous it is that in the name of disclosure you are going to make it impossible to provide the one piece of information they (the franchisee) needs,” said Calvani. “It’s hard to believe that it’s a choice of either screwing the franchisees or violating state or federal law.”
Calvani said if you can’t provide the information people want the most, it’s “just dumb.”
“Do you believe that anyone has ever bought a franchise and not talked about earnings?” Calvani asked.
Entrepreneur magazine ranks the top 500 franchisers in the nation annually, using a formula that includes years in business, start-up cost and growth rate. Here are the top 10 in California.
No. of Franchises
1. Chem-Dry Carpet 2,000
Cleaning Cameron Park Irvine
2. Century 21 7,000 3.Jazzercise 4,000
4. Taco Bell 1,126
5. Baskin-Robbins 3,392
6. Coverall 897
7. PIP Printing 1,164
8. ComputerLand 800
9. Mail Boxes Etc. 606
10. Denny’s 190