With most non-essential businesses closed across the country, it is easy to forget we are two weeks away from the April 30th Franchise Disclosure Document (FDD) update deadline for franchisors with a calendar fiscal year end. Some franchise systems are delaying the preparation and issuance of an updated 2020 FDD and corresponding state renewal registrations. However, we found most of our clients are updating their FDD consistent with past practice and filed renewals in those states requiring registration.
One of the trickiest issues to address this year is the inclusion of Item 19 Financial Performance Representations (FPRs). On one hand, the financial data used to prepare the FPRs is based on past performance in 2019 and prior years. Therefore, compiling Item 19 FPRs consistent with past practice and in compliance with the FTC Franchise Rule and NASAA guidance, should be business as usual. On the other hand, the COVID-19 pandemic is likely to impact unit operations in the coming months, maybe years. Some hospitality and food based concepts may never fully recover. Should any franchise system include a FPR in its 2020-2021 FDD? We discovered one state regulator already weighing in on the issue by providing the following comment to a renewal filing:
In Item 19, we note that the Franchisor presents a financial performance representation based on the past performance of outlets prior to the COVID-19 pandemic. We further note that to slow the spread of COVID-19, many businesses have been closed or are operating on a limited basis this year. These events may significantly impact the potential performance of the franchised business. In your response letter, please explain why the Franchisor believes that it is reasonable and not misleading to present a financial performance representation based solely on results from a period prior to the COVID-19 pandemic.
This comment raises a lot of questions. We recommend a franchise system base its approach to FPRs this year on all pertinent factors applicable to that particular system. For example:
- What industry does the franchise system operate? Is it likely that the system can revert to pre-COVID-19 performance levels? If it is a childcare or healthcare based concept, then consumers will likely have a need to resume patronizing the franchised units. However, non-critical entertainment concepts where people socially gather in close quarters may not recover as quickly.
- How long does it take from signing the franchise agreement to opening? If the average time from signing to opening is over 12 months, then it is possible that COVID-19’s impact on the economy when the franchise commences operations may be less severe.
- What is consumer profile patronizing the units? Will these consumers have discretionary income in a post-COVID 19 economy?
However, it is impossible to predict the future and know how people are going to react once society resumes. Will people rush to resort hotels for respite? Can most afford to do so? Franchisors need to make the most logical decision based on the information they have now.
It may be reasonable to include a statement that addresses the issue without slipping into prohibited disclaimer territory. For example, a statement like “the financial data was compiled prior to the time of the COVID-19 pandemic and the temporary local and state governmental restrictions on operations” may be appropriate. This reminds the prospective franchisees of the origin of the data without renouncing the performance representations. Based on our experience with state regulators, language beyond this factual statement (for example, stating that the franchisor is unable to predict how COVID-19 may impact future unit performance) is unlikely to pass regulator scrutiny.
However, a blanket conclusion that all FPRs based on accurate data from 2019 are unreasonable or misleading in the COVID-19 pandemic era is problematic. My view is that (in most cases) a lot of value remains in providing FPRs to prospective franchisees. If FPRs are made in good faith and in compliance with the FTC Rule and NASAA Guidelines, then this historical data is more useful than hurtful for a franchisee. Further, it may help in reigning in a sales broker or agent who may have a tendency to make unlawful or misleading earning statements without proper Item 19 FPRs. A complete prohibition on inclusion of FPRs does not benefit these franchisees or provide them with the information to make an informed decision. Hopefully, state regulators will craft a uniform approach to this issue to avoid potential conflicting comments and requests.