FTC Business Opportunity Rule Proposal
by L. Andrew Clark & Rachel E. Edwards

Introduction
On April 12, 2006, the Federal Trade Commission ("FTC") issued a notice of proposed rulemaking to promulgate a new "Business Opportunity Rule."  This proposal has significant implications for a wide variety of distribution and marketing arrangements.  The proposal is published at 71 Federal Register 19053.  

Currently, "business opportunities" are covered by the FTC's "Franchising and Business Opportunity Ventures" rule.  That rule requires that covered businesses make certain "pre-sale" disclosures to prospective franchise or business opportunity purchasers.  Its purpose is to protect prospective purchasers from fraud and misrepresentation.  The FTC is now proposing to cover "business opportunity" relationships under a separate provision—the proposed new Business Opportunity Rule.  (For convenience, the current "Franchise and Business Opportunity Ventures Rule" will be referred to in this memorandum as the "Current Rule," and the proposed Business Opportunity Rule will be referred to as the "Proposed Rule.")
 
The FTC has requested comments on the Proposed Rule.  In order to be considered, comments must be received by the FTC by July 17, 2006.¹

The Proposed Rule's scope of coverage is very broad.  The Proposed Rule would cover many distribution and marketing arrangements that are not covered by the Current Rule.  Indeed, the FTC states that "the scope of coverage of the Proposed Rule is much broader than . . . " that of the Current Rule.

The Proposed Rule's disclosure requirements, on the other hand, are less extensive than the disclosure requirements under the Current Rule.  However, the Proposed Rule's disclosure requirements are not insubstantial, and the compliance burden imposed by the Proposed Rule would not be insignificant. 

Coverage
The FTC believes that the Current Rule's coverage is too narrow, and that some fraudulent and abusive programs are escaping coverage under the Current Rule.  For example, the FTC's proposal references programs involving "rack displays," "pyramid marketing" and "work-at-home" schemes that are not covered by the Current Rule but that are, in the FTC's view, "permeated with fraud."  Consequently, the Proposed Rule casts a much wider net than the Current Rule. 

Unfortunately, the Proposed Rule would also cover many legitimate distribution and marketing arrangements that have not had histories of fraudulent or abusive practices. 

The Proposed Rule would apply to "the offer for sale, sale, or promotion of a business opportunity. . . ."  "Business Opportunity," in turn, is defined as:

. . . a commercial arrangement in which:
(1) The seller solicits a prospective purchaser to enter into a new business;
(2) The prospective purchaser makes a payment or provides other consideration to the seller, directly or indirectly through a third party; and
(3) The seller, expressly or by implication, orally or in writing, either:
(i) Makes an earnings claim; or
(ii)Represents that the seller or one or more designated persons will provide the purchaser with business assistance.

This is a broad definition, and the FTC's commentary that accompanies the Proposed Rule emphasizes the definition's expansive nature.  For example:

• The term "new business" in item (1) of the definition includes a "a new line or type of business."  Thus, if an existing business acquires a new product line, that new product line could be deemed a "business opportunity" under the Proposed Rule.
• The Proposed Rule, unlike the Current Rule, does not include an exemption for payments made for inventory at a bona fide wholesale price.  Consequently, such payments would satisfy item (2) of the definition, and therefore could subject the recipient of the payments to coverage under the Proposed Rule.²
• "Earnings claim" (item (3)(i) of the definition) is interpreted very broadly:  "any oral, written, or visual representation to a prospective purchaser that conveys, expressly or by implication, a specific level or range of actual or potential sales, or gross or net income or profits." 
• "Business assistance" (item (3)(ii) of the definition) is likewise given a broad interpretation:  "the offer of material advice, information or support to a prospective purchaser in connection with the establishment or operation of a new business."

It would appear that many, if not most, distributorships and dealerships would meet the definition of "business opportunity" and therefore be covered by the Proposed Rule.³   In many cases, the distributorship or dealership does constitute a "new business" (or a "new line or type of business" for the dealer or distributor).  In addition, presumably the distributor or dealer will make payments to the "seller" (i.e., the supplier).  Thus, items (1) and (2) of the definition would be satisfied.

If items (1) and (2) of the definition are satisfied, the Proposed Rule would apply if the "seller" (supplier) "expressly or by implication, orally or in writing," either makes an earnings claim or represents that business assistance will be provided.  As discussed above, "earnings claims" and "business assistance" are interpreted very broadly under the Proposed Rule.  As a practical matter, many companies will find it difficult to appoint a distributor or dealer without making some type of earnings claim or representing that business assistance will be provided, and thereby triggering application of the Proposed Rule.   

Disclosure Requirements
Under the Proposed Rule, the "seller" (i.e., the supplier) must make certain written disclosures to a "prospective purchaser" (i.e., the prospective distributor or dealer).  The disclosures must be made at least seven days before the earlier of the time that the "prospective purchaser":  (i) signs a contract or (ii) makes a payment (or provides other consideration) in connection with the business opportunity.

The Proposed Rule specifies a form disclosure document, which is attached to this memorandum as Appendix A.  If any earnings claims are made, a supplemental "earnings claim statement" must be attached to the disclosure document.  The Proposed Rule includes extensive requirements regarding earnings claims.

Another key item in the disclosure document involves "Legal Actions."  This item requires the "seller" (supplier) to check "yes" or "no" with respect to whether:

The seller, its key personnel, or its representatives involved in the sale of business opportunities have been the subject of a civil or criminal action involving misrepresentation, fraud, securities law violation, or unfair or deceptive practices within the past 10 years.

This disclosure requirement would include any such action brought against any "affiliate or prior business of the seller, and any of the seller's officers, directors, sales managers, or any individual who occupies a position or performs a function similar to an officer, director, or sales manager of the seller."

Further, actions must be disclosed even if the seller (or affiliate, officer, etc.) prevailed in the action.  For example, assume that five years ago a disgruntled distributor sued the seller (or affiliate, officer, etc.) and alleged fraud or deceptive business practices.  Even if the defendant prevailed in the lawsuit and the court found that the allegations had no merit, in the "Legal Actions" section the "yes" box must be checked, and the case name, case number, etc. must be provided.

In that situation—in which the seller is required to disclose a prior legal action that was eventually dismissed—presumably the seller would want to include in the disclosure document an explanation of the relevant circumstances.  In particular, presumably the seller would like to explain in the disclosure document that the allegations were found to be without merit.  Unfortunately, under the Proposed Rule apparently the seller can't do that.  Under the Proposed Rule the seller may not:  "include in any disclosure document or earnings claim statement any materials or information other than what is explicitly required or permitted by [the Proposed Rule]."

The Proposed Rule also requires disclosures regarding any "cancellation or refund policy" and any cancellation or refund requests received during the past two years.

In addition, the seller must provide a list of "prior purchasers as references."  The Proposed Rule requires disclosure of "at least the 10 prior purchasers nearest to the prospective purchaser's location."  Alternatively, the seller can furnish a list of all purchasers. 

The seller must update the disclosure statement at least quarterly.

Additional Provisions
The Proposed Rule also:

• prohibits various specified misrepresentations and sales practices,
• imposes record retention requirements, and
• states that it does not preempt state laws that give "prospective purchasers equal or greater protection" than is provided under the Proposed Rule.

Conclusion
The FTC's goal of deterring fraud in business opportunity transactions is laudable.  However, the Proposed Rule's coverage is so broad that it would cover many legitimate distribution and marketing arrangements that would not, up until now, have been considered a "business opportunity."

The FTC justifies this sweeping coverage on the grounds that the Proposed Rule's disclosure requirements are less extensive than those of the Current Rule.  The FTC, however, may be underestimating the compliance burdens and effects associated with the Proposed Rule.

Companies that do business with dealers or distributors, or with other parties who could be deemed a "purchaser" under the Proposed Rule, should consider filing comments with the FTC on the Proposed Rule.  Possible topics for such comments could include the need for an exemption for business arrangements that are not subject to the types of abuses at which the Proposed Rule is aimed, and suggestions for reducing the compliance burden under the Proposed Rule.

If you have additional questions about this article, please do not hesitate to contact either Drew Clark:423-757-0245 / dclark@cbslawfirm.com, or Rachel Edwards: 423-757 0215 / redwards@cbslawfirm.com.

  

¹Originally, the comment period was to expire on June 16.  The expiration date was subsequently extended to July 17.  71 Fed. Reg. 31124.

²The Proposed Rule, and the FTC's commentary on the Proposed Rule, often speak in terms of the "sale" of a business opportunity.  The product supplier is referred to as the "seller" of the business opportunity, and the distributor or dealer is referred to as the "purchaser" of the business opportunity.  These references are somewhat misleading, however, because the Proposed Rule can apply even if no payment is made for the right to enter into the business.  As noted, payments made for inventory can satisfy the "payment or consideration" element of the definition.

³The Proposed Rule does, however, exempt most franchise arrangements.  Proposed Rule Sec. 437.7.

  
 Appendix A--Model Document
BUSINESS OPPORTUNITY DISCLOSURES

Seller: [Name]-----------[Address]------------------------------
[Phone]----------------Salesperson:----------------- Date:--------
 
The following information can help you in deciding whether to buy a
business opportunity. Note, however, that no governmental agency has
verified the information. To learn more about business
opportunities, call the FTC at 1-877-FTC-HELP (877-382-4357) or
visit the FTC's website at ftc.gov/bizopps/. Also, check with your
state's Attorney General.

---------------------------------------------------------------

Yes   No (Either the "YES" or "NO" box must be checked for the
following three disclosures)
 
[]        []  EARNINGS: the seller or its representatives states or implies a specific level of sales, income, or profit you can make or that current or former purchasers have earned. If so, the information must be set forth in an "Earnings Claims Statement" attached to this page. Read this statement carefully. You may wish to show this information to an advisor or accountant.
 
[]        []  LEGAL ACTIONS: The seller, its key personnel, or its representatives involved in the sale of business opportunities have been the subject of a civil or criminal action involving misrepresentation, fraud, securities law violation, or unfair or deceptive practices within the past 10 years. If so, the seller must attach a list of all such legal actions.
 
[]        []  CANCELLATION OR REFUND POLICY: The seller offers a
cancellation or refund policy. If so, the seller must attach a statement describing its policy.
 
CANCELLATION OR REFUND REQUESTS: In the past two years, the seller sold the same type of business opportunity to----purchasers, and, of those,----purchasers asked to cancel their purchase or requested a refund.
 
REFERENCES: The seller must provide you with contact information for at least 10 of its purchasers located nearest to you (or, if there are fewer than 10, all purchasers). You may wish to contact them to verify the seller's claims. If you buy a business opportunity from the seller, your contact information can be disclosed in the future to other buyers.
 
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