Updates on Franchise Law
December 21, 2015
Financial Performance Representations (“FPR’s), or earnings claims, have been an integral part of franchise sales process well before the Federal Trade Commission (“FTC”) began its supervision of the franchise model. The original Federal Trade Commission franchise rule, known as the “Rule” and established in 1979, requires that certain disclosures be made to prospective franchisees before they can sign a franchise agreement. The Rule put rigid strictures on the presentation of earnings claims in the Franchise Disclosure Document (“FDD), such that, many franchisors, in order to avoid making improper disclosures, wrongly told their prospective franchisees that they were prohibited from making any pre-sale financial claims.
In response to this hesitancy the 2007 amendments to the Rule provided franchisors with greater flexibility in presenting financial performance representations, thus encouraging them to include FPR’s in their FDD. Armed with this increased flexibility franchisors tended to slice and dice financial information in ways that were limited only by their imagination.
At a recent round table discussion during the most recent International Franchise Association Legal Symposium questions were raised as to the overall effectiveness of the current use of FPR’s: Has the time come for the presentation of FPR’s to undergo reformation?
In a recent article appearing in Franchise Times, “Wrong Way to Present Item 19” Julie Bennett characterized the ubiquitous use of FPR’s by franchisors as a virtual arms race, “being fueled by lenders who want to know if new franchisees can generate enough revenue to pay back their loans; by prospective franchises who want to know if they make a profit; and by franchise salespersons who want to attract buyers and lenders to their concepts.” Quoting from a recently presented paper on the subject at the 2015 International Franchise Association Legal Symposium, she notes, “currently, the overarching mandate for an FPR is that a franchisor has a reasonable basis for information it presents.” With increased flexibility more franchisors are making more FPR’s with the greater possibility for more franchisee lawsuits claiming misleading financial information.
By coincidence, on October 1, 2015, shortly after the Franchise Times Article appeared, the North American Securities Administrators Association (“NASAA”) published for comment a suggested commentary on Financial Performance Representations (“FPR Commentary”) to answer frequently asked questions about how franchisors can make FPR’s under the federal and state franchise guidelines. It is clear from its comments, that NASAA believes that the Rule and current Franchise Rule Compliance Guidelines leave unanswered questions relating to the substance and format of presenting FPR’s.
The Franchise Rule Compliance Guidelines issued in 2008, after the 2007 amendments to the Rule, provided the franchise community a guide on the proper presentation of an FDD, including the rules for preparing proper FPR’s. For Item 19 disclosures the guidelines stress the importance that information included in earnings claims be predicated on a reasonable basis and based on written substantiation. Beyond these basic guides the franchisor was left with uncharted flexibility to create its own FPR’s tailored for its specific needs.
The guidelines provided limited commentary on what constituted a reasonable basis. For example:
If using one franchise in a system to support an FPR does not constitute a reasonable basis, does using 10 out of 100 franchises in a system satisfy the reasonable basis requirement?
Likewise, if a franchisor has no operating franchised units upon which to base an FPR, may it rely on the results of its company-owned units to represent gross sales or gross profits?
And, will the use of only corporate-owned units provide a reasonable basis upon which a prospective franchisee can rely when making its decision to buy a franchise opportunity?
These questions and others are what the suggested Commentary seeks to resolve.
The NAASA Franchise Project Group examined the existing guidelines and reached a consensus on the questions about the FPR’s that seemingly required clarification. The suggested guidelines are intended to supplement the 2008 guidelines and not replace them. The FPR Commentary is intended to address a number of questions raised by franchisor representatives and state franchise examiners about financial performance representations. The suggested commentary is divided into 5 principal sections: Use of Data from Company Owned Units, Use of Subsets, Use of Averages and Outliers, Use of Forecasts and Projections, and the Use of Disclaimers.
Use of Data from Company-Owned Outlets
When addressing the use of company-owned outlets in FPR’s the FPR Commentary focuses on the use of data from company-owned outlets when there are no franchised outlets in the franchise system. Under the current guidelines there are limited prohibitions against relying upon company owned units to make a FPR when there are no corresponding franchised outlets. In fact, in many cases, until a franchise system opens franchised units it has little else to provide its prospective franchisees other than the results of its company owned outlets.
Under the FPR Commentary a franchisor would be prohibited from making gross or net profit representations based on company-owned units when there are no operational franchised units. Conversely a franchisor can make gross sales representations of its company-owned units if it has no operating franchisees. Why the difference between the two? According to the Commentary, “gross sales is not comparable to an FPR that combines gross sales and costs. There are fewer potential material differences between gross sales of company-owned outlets and those of franchised outlets.”
The proposed supplemental guidelines seek to limit the use of merging data between company owned and franchised outlets. In response to the question of, “if a franchisor makes an FPR that includes data from both franchised and company-owned outlets, can the franchisor merge the data from both types of outlets in the FPR?” According to the FPR Commentary, if the franchisor seeks to include data from both franchised outlets and company-owned outlets, the franchisor must disclose the data from company-owned outlets and franchised outlets separately. There is an exception to this general rule, which is limited to the situation where a franchisor has a very small number of total franchisees in the system and the results of those franchisees are not materially different from the franchisor. In that situation the franchisor may merge that data. What the FPR Commentary is attempting to do is to reduce any seeming confusion or ambiguity that may result from the mixing of franchise and company-owned unit information.
Use of Subsets
One of the more creative ways that franchisors make FPR’s is through the use of subsets, which under the current guidelines is permitted if the subset of outlets shares a particular set of characteristics. The question that the FPR Commentary seeks to clarify is “whether there are any general limitations on a franchisor’s ability to make an FPR based on a subset of outlets?” The general limitations placed on the use of subsets are that they must have a reasonable basis, be accurate, and not misleading.
The FPR Commentary then addresses specific subsets that focus on the best performing outlets, small number of company owned outlets and franchised outlets, and geographic subsets. With respect to Best Performing Outlets, a franchisor may not make an FPR based solely on the performance of a subset of its best performing outlets, because the Franchise Project Group believes that use of such data on its own would be misleading and has no reasonable basis.
Likewise, the FPR Commentary presumes that a franchisor with fewer than 10 substantially similar company-owned outlets and franchise outlets that have been operational for at least one full year will include too few outlets in which to base an FPR solely on a subset of those outlets.
With respect to geographic subsets the use of this subset will require the franchisor to describe why and how that geographic subset was selected. Moreover, the franchisor cannot present a geographic subset if the information for that subset is misleading.
Averages and Outliers
With respect to using averages, the franchisor will be required to publish the median results as well as the mean - or average results. The reason behind this requirement is that there is a concern that outliers – abnormally high results – may skew the average thus rendering the representation misleading.
The FPR Commentary permits the exclusion of company-owned or franchised units that opened and closed during the first year of operation, provided that in its Item 19 the Franchisor discloses the number of the outlets that opened and closed during its first year of operation.
With respect to outliers the Commentary finds that the use of units that show atypical results that are not representative of other company-owned or franchise outlets would not have a reasonable basis and therefore should not be used in representing franchise or company-owned averages.
Forecasts and Projections
The FPR Commentary requires that projections must be supported by historical results and cannot be based on hypothetical situations. Moreover, the historical data must be based on a reasonable sample of the historic results of the brand being offered. In other words, if the franchisor licenses different brands in its umbrella of franchise systems, it must use the results from the particular franchise system that it is selling to a prospective franchisee.
Under the FPR Commentary, a franchisor will be limited to the required admonitions contained in the original guidelines and the Rule. With this proposed requirement, NASAA wishes to eliminate a franchisor disclaiming responsibility for its FPR.
When the FPR Commentary was published NASAA requested comments by November 2, 2015. In a recent communication from Dale Canton from the Office of the Attorney General for the State of Maryland, and a member of the NASAA drafting committee, he reported that there were approximately 13 public comments to the proposed FPR Commentary, which are currently being considered. As a result of these comments NASAA may further amend the Commentary. If the modifications are substantive it may call for another round of comments, thus delaying finalization of an FPR Commentary.
As a result of this delay the Commentary will not be ready to implement for the 2016 FDD renewal season. However, it is clear from his comments that it is more than likely we will see a reformation of the current guidelines addressing the disclosure of FPR’s.
Ted Pearce is the co-chair of the firm's Franchise Practice Group. He focuses his efforts on transactional matters affecting both the franchisor and the franchisee.