“Earnings Claims” Regulation – Public Comments Help Prevent Unfair Restrictions

October 13th, 2016

Takeaway: Demonstrating our value to early stage franchisors, WTP public comments help eliminate proposed regulations that would have prevented new franchisors from providing profit information.

Generally speaking, the most important type of information that a franchisor can provide to prospective franchisees concerns the profits earned by businesses operating under their brand.  This type of information, as well as information on gross revenues, is called a Financial Performance Representation (“FPR”) or “earnings claim” under the laws governing franchise sales in the United States.  Unfortunately, while the FTC Franchise Rule requires certain disclosures to prospective franchisees (through provision of a Franchise Disclosure Document or “FDD”), and requires that any FPR that a franchisor provides be included in Item 19 of the FDD, it does not provide substantive guidance on what can and cannot be provided in an FPR.  Instead, it simply requires that there be a “reasonable basis” for providing that information to prospective franchisees.

While the FTC does not require filing and approval of the FDD prior to selling franchises, several U.S. states require that the FDD be reviewed and approved before a franchise is sold in that state (a process called “registration”).  Among the most prominent registration states are California, Illinois, New York, Maryland and Virginia.  Those states’ review of FDDs are informed and guided by policy statements issued by the North American Securities Administrators Association (“NASAA”), of which each state’s franchise regulatory authority is a member.  Since 2015 NASAA has been considering issuance of a Financial Performance Representations Commentary.

The original proposed FPR Commentary, issued for public comment on October 1, 2015, contained many useful provisions.  However, proposed Section 19.7 would have drastically interfered with new franchisors’ ability to provide truthful, factual information to prospects.  It read:

19.7 Item 19 — FPR Disclosing Gross Profit or Net Profit of Company-Owned Outlets When Franchisor Has No Operational Franchises.

QUESTION: If a franchisor has no operational franchises, can the franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?

ANSWER: No. A franchisor with no operational franchises cannot make an FPR disclosing gross profit or net profit based on company-owned outlet data alone.

The proposed commentary’s reason for this blanket ban was a concern that franchisees are likely to incur higher operating costs than company-owned locations, and without operating franchisees the new franchisor would not have a way to know if its costs were lower (or higher) than franchisees would experience. Therefore, to provide net profit information to prospective franchisees based solely on the company-owned data would be misleading.

This proposed commentary, if enacted, would have severely limited the ability for the many early stage franchisors that we represent to compete in recruiting franchisees – which is already tough enough for a start-up! Moreover, while it is appropriate for the commentary to highlight issues that franchisors need to consider when deciding whether its FPR has a “reasonable basis” and is not materially misleading, an outright ban under all circumstances deprives prospective franchisees of information they wish to know.

Accordingly, on October 27, 2015 we submitted our public comments objecting to proposed Section 19.7 on those bases.  With our client’s approval, our comment included an early stage franchisor’s net profit FPR, redacted to remove the name of the franchisor and its principal owners.  The numerical presentation was accompanied by a paragraph explaining why revenues and expenses increased over a period of years, and also warning about the franchisor principals’ level of experience in the industry and therefore why its business performance probably would exceed that of new franchisees.  The public servant who leads the NASAA Franchise Project Group told the author that the example was “particularly helpful.”

On September 14, 2016, after lengthy internal deliberations among the project group members, NASAA issued a revised version of the proposed FPR Commentary for public comment.  While not specifically addressing comments received, what is notable is that former Section 19.7 no longer exists.  Instead, no distinction is made between franchisors with or without operating franchises, and rather new Section 19.10 reads in part as follows:

19.10 Item 19 — Gross Profit or Net Profit FPR Based on Company-Owned Outlets Alone

QUESTION: Can a franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?

ANSWER: Yes. A franchisor can make an FPR disclosing gross profit or net profit based on company-owned data alone if it has a reasonable basis to make the FPR and includes the following information: (a) gross sales data from operational franchise outlets, when the franchisor has operational franchise outlets; (b) actual costs incurred by company-owned outlets; and (c) supplemental disclosure or adjustments to reflect all actual and reasonably expected material financial and operational differences between company-owned outlets and operational franchise outlets. These differences consist of fees and other expenditures required by the franchise agreement, disclosed in the Franchise Disclosure Document, or that are otherwise known or reasonably should have been known by the franchisor.

The remainder of the answer explains the need to adjust the presentation to disclose franchise royalties and other fees that a company-owned outlet does not pay, and also to adjust the costs of goods sold upward if the company-owned locations receive more favorable pricing from suppliers than franchisees will experience. The latter is a tricky issue and new franchisors either will need to be very careful to make sure that actual franchisee pricing is the same, or increase the costs of goods sold by a specific percentage in the presentation and explain the basis for the increase in footnotes.

Nevertheless, this is a major win for new and early stage franchisors, since they are likely to retain the freedom to provide prospects the information that they desire and to compete in franchise sales. It was our pleasure to be able to influence this regulatory outcome in favor of companies that want to use franchising to grow their brand and create entrepreneurial opportunities in the U.S.A.