Making Item 19 Franchise Disclosures In a Post-COVID World
FDD’s Item 19 & The Potential Challenges Franchisors Face After The Pandemic
Item 19 in a Franchise Disclosure Document (“FDD”) is the place for a franchisor to make a Financial Performance Representation (“FPR”) about the franchise it is offering for business. Making an FPR is optional, but not surprisingly, a study recently showed that franchisors that choose to make an FPR sell more franchises than those who choose to forego making an FPR. This makes sense when we remember that a franchisor is prohibited by law from making financial representations to potential franchisees that are not contained in or consistent with financial representations contained in the FDD. In other words, a franchisor who chooses not to include FPR disclosures in the FDD is prohibited from making any financial representations to potential franchisees, preventing the franchisor from answering the potential franchisee’s all-important question, “how much money can I make?”
The Impact Of COVID-19 In Financial Performance Representations
Pre-COVID, Item 19 disclosures could already be somewhat complex, with federal and state regulations requiring careful disclosure to ensure that the FPRs being made could reliably be used by a potential franchisee in projecting anticipated earnings. Franchisors who decide to make FPRs were and are required to provide information based on economic and operational conditions similar to those likely to face a new franchisee. With that in mind, and in light of the recent COVID-19 pandemic, making Item 19 disclosures has become an entirely new challenge.
In 2020, while the COVID-19 pandemic was in full swing in the United States, the North American Securities Administrators Association (“NASAA”), an association of state security administrators responsible for issuing guidelines relating to franchising in the United States (among other things) released new information about FPRs in a post-pandemic environment. The new NASAA guidelines recognize that while the “long-term impact of the COVID-19 pandemic is unknown,” it is recognized at this point that the “COVID-19 pandemic’s impact on franchise systems appears to be unprecedented.”
Because of COVID-19’s significant impact, NASAA reminds franchisors in its new guidelines that “a franchisor is permitted to make a historical FPR if the franchisor has a reasonable basis and written substantiation for the representation, and the franchisor discloses the material bases for the representation,” and that it is “unlawful . . . for a franchisor, in connection with the offer or sale of a franchise, to make an untrue statement of material fact or to omit to state a material fact that would make a statement not misleading.”
In light of the foregoing, most franchise regulators are requiring that franchisors carefully explain FPRs based entirely on pre-COVID-19 performance. Although some franchise models have been more obviously impacted by the pandemic than others (i.e., restaurants, gyms), nearly every franchise model has been impacted by COVID-19 in some way or another. Consequently, franchisors seeking to use pre-COVID-19 data to make FPRs are now being required to explain why it is reasonable to characterize that data as comparable to economic data that potential franchisees will face in a post-COVID-19 economy.
In fact, franchisors with existing Item 19 FPRs whose business models have been impacted to such an extent that the pre-COVID-19 disclosures no longer portray the franchise’s finances accurately are required to amend their FPRs to account for the change. In short, federal and state law both require that Item 19 FPRs paint an accurate picture for potential franchisees of the franchise model’s economic situation. If COVID-19 was a significant factor in the finances of the franchise model, that information needs to be disclosed.
Additionally, regulators will not allow this obligation to be satisfied merely through qualifying language by the franchisor. Statements in Item 19 to the effect that the FPRs are “not representative of what prospective franchisees can expect as a consequence of COVID-19 . . . or otherwise suggest that prospective franchisees should not rely on the disclosure” are prohibited. Franchisors are required to make FPRs that potential franchisees can actually rely on, or none at all.
Legal Standard For Making An Item 19 FPR
At the end of the day, it’s safe to assume that franchisors wanting to make FPRs will need to include 2020 economic data reflecting the impacts, if any, of COVID-19 on the franchise’s finances. Some franchisors who have been negatively impacted in a substantial way by the pandemic may rightfully be hesitant to disclose significant losses to potential franchisees. However, even franchisors with less-than-ideal economic data in 2020 may still be able to impress potential franchisees with data representing strong financial performance relative to competitors in the same industry, or otherwise demonstrating above-average performance in the face of the pandemic. Knowledgeable franchisees are aware, after all, that 2020 financials are not going to be the franchise model’s gold standard.
Complying with the requirements of Item 19 FPRs is crucial for franchisors who wish to make financial representations of any kind to potential franchisees. Franchisors who choose not to make an FPR in Item 19, but who make financial representations outside of the FDD, or inconsistent with those contained in the FDD, can face serious liability, including civil, administrative, and criminal penalties, as well as personal liability of the franchisor’s management. Assuming the franchise survives such penalties, the franchisor will be required to disclose FPR violations for 10 or more years, making the sale of future franchises substantially more difficult.
Seek The Help Of An Experienced Franchise Attorney In Scottsdale, AZ
The best way to make sure your FPRs conform to the standards of franchise regulators is to seek the help of an experienced Scottsdale franchise attorney. At Denton Peterson Dunn, our attorneys have been helping franchisors draft franchise documents and successfully register their franchise models for decades. Our team has the knowledge and skills necessary to make sure that your franchise model has the legal footing necessary to get you moving towards success from day one. If you have questions about your franchise, or starting up a franchise model, contact Denton Peterson Dunn today to see how an experienced legal team can be an invaluable asset to your franchise.
For more information view (1) Anya Nowakowski, Financial Performance Representation: Market Demand Pushing Higher Levels of Transparency, 14 (IFA Education and Research Foundation, 2017). (2) Disclosing Financial Performance Representations in the Time of COVID-19, NASAA (June 17, 2020). (3) (citing FTC Franchise Rule, 16 CFR Part 436.5(s)).