Although most franchisors have only recently completed their franchise renewals for 2020, and a few may still even be waiting on state approvals, the North American Securities Administrators Association (“NASAA”) has issued “Guidance” to franchise examiners, franchisors, and franchise practitioners, suggesting that many franchisors may need to immediately update the financial performance representations (“FPRs”) in Item 19 of their 2020 Franchise Disclosure Document (“FDD”).
While the key points will be summarized below, you can find the entire press release here.
Material Changes to FPRs
The FTC Franchise Rule has always provided that if there are material adverse changes in the financial results of franchisees, or company-owned outlets, from those disclosed in Item 19, franchisors are required to immediately amend Item 19 to disclose the new information. (State disclosure laws have similar requirements, though the timing for disclosure ranges from “immediately” to “within 30 days,” depending on the state.) The question on the minds of everyone in franchising today is whether declines in operations caused by COVID-19 necessitate an amendment, or even deletion of the Item 19 disclosure from the FDD. The Guidance basically answers, “it depends.”
Factors Requiring an Updated FPR
The Guidance tells us that an FPR disclosing historically accurate data may still contain an omission of material fact, or an untrue statement of material fact, if material changes have occurred to that FPR by the time it is provided to a prospective franchisee. The Guidance now gives us 6 factors to consider in making the analysis as to whether the FPR needs to be updated, though these factors are not intended to be all-inclusive. The factors, and an analysis of them, follows:
1. “Whether the franchise business has been significantly impacted by the COVID-19 pandemic.” If the business has not been adversely impacted by the pandemic, then no update is needed. If there has been an adverse impact, then the other factors must be considered.
2. “The type of data the franchisor includes in the FPR.” This factor is important in a number of contexts. For example, if the franchisor has made significant changes in the premises of its businesses, or in its method of operation, but sales following these changes are closely tracking pre-COVID-19 sales, then an FPR showing only sales results would not have to be amended, while an FPR showing costs and net profit may need to be amended to show the adverse changes in net profit. (In both situations, consider whether changes in Item 7 pertaining to the cost of starting the business or working capital needs have changed.) There are also franchisors that focus on sales to independent businesses that are converting to the franchise system, and many of these systems provide information other than gross sales and expenses, which allow prospects to compare their existing results for the period in question to the results they might have achieved as a franchised outlet. This is another example where the type of data presented might suggest that no amendment is required.
3. “The reasonable inferences a prospective franchisee can draw from the FPR.” While all franchisors include in their Item 19 disclosure a required statement that the results shown are historic results and there is no assurance a franchisee will do as well, a prospective franchisee will nevertheless be able to draw inferences about its business from the FPR. Are the reasonable inferences a prospective franchisee might draw from the information presented consistent with what is happening today, or will be happening when the franchisee opens for business?
4. “When the franchisor estimates a prospective franchisee can expect to open for business after entering into a franchise agreement.” If the business is such that any downturn in the numbers is likely to be reversed by the time the franchisee would open for business, then no amendment may be needed to the FPR. The converse is also true. Thus, it is more likely that a system in which the franchisee will be open for business in the next couple months will need to amend its FPR than a system that projects it will be another year before franchisees open.
5-6. “Whether and how the franchisor adapts the franchised business to account for current market conditions resulting from the COVID-19 pandemic.”
“Whether and how the franchisor adapts the franchised business to account for future market conditions resulting from the COVID-19 pandemic.”
While these are not the same factors, one accounting for temporary changes, and one accounting for permanent changes, they are related. We have already discussed changes in operation that may only affect operating costs. However, these points also go to the question of how franchisees will operate in the future. Let’s start with an easy example. If the franchisor’s business was the operation of a buffet-style restaurant, and it must convert permanently to a different format, the results achieved from the operation of the buffet-style restaurant would no longer be relevant to the business to be operated by future franchisees and the franchisor would no longer have a reasonable basis for including the prior information in its FDD. On the other hand, if changes only need to be made temporarily, then depending on the magnitude of the changes, and the results, it may not be necessary to make any changes in the FPR, or it may be necessary to only amend the FDD to provide more recent information concerning results in recent months. (And, in both cases, consider again whether the changes affect the Item 7 disclosure of the cost of getting started.)
As the Guidance tells us, it is impossible for NASAA, or for any franchise attorney, to provide specific guidance to all franchisors about the making of a historic FPR in 2020 and beyond. As NASAA stated:
Each franchise system is unique, and the determination of whether a franchisor has a reasonable basis to make an FPR is based on the specific facts and circumstances related to the franchise offering.
We would suggest, however, that it is best to consider this question today, immediately, rather than waiting, because waiting has risks. First, if you wait until the end of the year, and then provide updated disclosures for the 2021 FDD that are materially different than you included in the 2020 FDD, you may be asked by state examiners to explain why you did not previously amend the FDD. Those types of questions often result in the imposition of sanctions that will have to be disclosed for at least 10 years in Item 3 of your FDD. If that were not enough, you can also expect that lawyers representing disgruntled franchisees in the next several years will be looking at any franchise sales made subsequent to issuance of this Guidance and asking whether the franchisee was misled by the information contained in Item 19 of the FDD.