Revisiting the Preparation and Use of Your Item 19
Savvy franchisors opportunistically structure their Item 19s and franchise sales presentations to maximize the impact of the information provided.
March and April are typically when franchisors whose fiscal year ends Dec. 31 begin the annual process of updating their franchise disclosure documents for use during the upcoming annual period. Critical in that process is updating FDD Item 19 – the financial performance representation.
Keeping Tabs on Item 19
A franchisor wishing to provide historical or projected financial performance information directly to prospective franchisees may do so (with limited exceptions) only within Item 19 and, in preparing it, must follow strict reasonableness, relevance and substantiation mandates. Compliance does not end though with the FPR’s initial FDD appearance. A franchisor must constantly review and assess its Item 19. While the Federal Trade Commission’s franchise disclosure rule permits a franchisor to reflect “material” FDD changes calendar-quarterly, franchisors have heightened updating requirements with Item 19. The FTC Rule requires a franchisor to notify prospective franchisees − when actually furnishing the FDD − of material changes that it “knows or should have known occurred” in the FPR information.
The “change” to which the FTC Rule refers is not the discovery that Item 19 was originally prepared inaccurately. It is the recognition that the real-world financial performance of franchise and or company-owned outlets since the Item 19 issued is materially different (i.e., worse) than the performance Item 19 reflects. Using an Item 19 containing numbers − though wholly accurate, truthful and representative when originally prepared − no longer materially resembling actual system performance would be misleading.
The annual FDD updating process is when a franchisor customarily scrutinizes its FPR and assesses options. No set rules dictate what information a franchisor must include in its FPR or the manner of presenting that information. Franchisors have latitude regarding information (e.g., top line sales versus bottom line profits) and the presentation form (e.g., charts, graphs or prose) if the representations are truthful and reasonable.
A franchisor evaluates the accuracy, reasonableness and recentness of the FPR numbers. Should all system outlets open as of year-end be included? Is it better to limit Item 19 to certain subsets of outlets sharing particular characteristics (geography or type and age of location)? Is the sample size relevant? Are the reported numbers reliable? Must outlet differences be highlighted? Are there reporting issues?
Include Franchisor- and Affiliate-Owned Outlet Performance?
Should a franchisor include financial performance information for company-owned and or affiliate-owned operations (“Controlled Outlets”)? Context and reasonableness are important criteria. A franchisor’s FPR undeniably may include information about franchisor-owned outlets. What about affiliate-owned outlets?
Item 19 rules should not differ for affiliate-owned outlets. Whether an outlet is “franchisor-owned” or “affiliate-owned” is a fortuity of ownership with no substantive relevance. An operating business launching a franchise program typically forms a sister entity as “franchisor” to bifurcate and shield the entities’ respective assets and liabilities. The operating business’ performance is no less reliable just because it is a sister to the franchisor.
Including Controlled Outlets in Item 19 ultimately hinges on whether franchise outlets also exist.
- Absent representative franchise outlets, a franchisor may base its FPR on Controlled Outlets if they are adequately representative of prospective franchise outlets.
- If there are representative franchise outlets, a franchisor may not exclude those franchise outlets from its FPR in favor of only Controlled Outlets, even if the latter also are representative of prospective franchise outlets. However, including representative franchise outlets should not concomitantly exclude Controlled Outlets that otherwise are representative. To minimize potential resistance by franchise registration states, a franchisor should segregate franchise outlet performance and Controlled Outlet performance within the FPR (in addition to providing system-wide outlet performance).
- Franchisors typically may present the operating cost (and net profit) experience of Controlled Outlets if the franchisor does not have reliable and or representative franchisee cost (or profit) information and the Controlled Outlet information has a reasonable basis and is representative of actual or possible system performance.
- If a franchisor has reliable and representative franchisee cost (and profit) information, it should not exclude that information from the FPR in favor of only Controlled Outlet information, even if the latter also is representative of prospective franchise outlet performance. However, including representative franchise outlets should not concomitantly exclude Controlled Outlets that otherwise are representative.
While Item 19 requires a “clear and conspicuous admonition” that a new franchisee’s individual financial results may differ from those stated in the FPR, it does not prescribe the disclaimer’s wording. That has resulted in myriad caveats, carve-outs and exculpatory and no-reliance language in Item 19s that, to some, undermine the integrity, reliability, and reasonableness of the Item 19 because they essentially instruct the prospective franchisee that the FPR, supposedly “representative” of potential system performance, may not be so considered.
To combat this practice, North American Securities Administrators Association’s Disclosure Rules Commentary directs franchisors to use a specific “one-size-fits-all” admonition for historical FPRs: “Some [outlets] have [sold] [earned] this amount. Your individual results may differ. There is no assurance that you’ll [sell] [earn] as much.” Franchisors may not include additional disclaimer or no-reliance language. Of course, NASAA’s proffered language really does not “fit” all FPRs that franchisors make. Only one other disclaimer is permitted at the end of Item 19, but it does not impact Item 19’s actual numbers.
A Media Circus?
Most franchisors refrain from promoting their system’s financial performance through “general media” (e.g., the Internet, television, radio, magazines, newspapers and email blasts). However, franchisors with properly-prepared Item 19s should consider embracing such media. Be mindful that the FTC Rule regulates general media claims, including certain minimum information and disclaimers in the actual “advertisement.” One might be surprised how many franchisors with general media claims fail to comply with the FTC Rule’s mandate. Pragmatically, the cryptic and fleeting messages emitted by today’s social media appear to foreclose full compliance.
Item 19 as Step One in Two-Step Process
Franchisors increasingly use Item 19 as a doorway to potential information proliferation. The disclosure rules for decades have allowed “supplemental financial performance representations” if a franchisor has an Item 19. A “Supplemental FPR” is financial performance information, provided separate and apart from the FDD, pertaining to a particular “location” or “variation.” What does this mean? A Supplemental FPR enables a franchisor to “slice and dice” and adapt its Item 19 to a particular situation.
For example, a franchisor whose Item 19 discloses system-wide franchise outlet average gross sales may give a prospective franchisee interested in a particular city the actual or average gross sales of all franchise outlets in that city. Or the franchisor may disclose gross sales of all franchise outlets operating at a certain type of location (kiosk, end-cap space, free-standing, etc.) if the prospective franchisee is interested only in that type of location. A franchisor has significant discretion in preparing a Supplemental FPR (subject to several conditions) and may use it proactively in the franchise sales process. However, it is commonly understood that a Supplemental FPR may not present financial information constituting a different species from the base Item 19, i.e., it may not provide franchisee net profits if the Item 19 addresses only gross sales.
An ever-growing percentage of franchisors make FPRs. Savvy franchisors opportunistically structure their Item 19s and franchise sales presentations to maximize the impact of the information provided.
Stuart Hershman is a partner in the Chicago office of law firm DLA Piper LLP (US). Find him at fransocial.franchise.org.