On June 10, 2020, the North American Securities Administrators Association (“NASAA”) promulgated new commentary regarding the inclusion of historical financial performance representations (“FPR”) in Item 19 of franchise disclosure documents (“FDDs”), given the impacts of the COVID-19 pandemic on retail businesses. Due to state and municipal government orders, many businesses were required to shut their doors to customers for the better part of March through June. As a result, revenue for these businesses declined significantly during the second quarter of 2020.
As required by the FTC Franchise Rule and applicable state franchise laws, many franchisors updated their FDDs in the spring of this year, and those FDDs included information from the franchisor’s prior fiscal year, which, in most cases, ended on December 31, 2019. Many franchisors included a financial performance representation in Item 19 of their FDDs based on revenue data for franchisee and/or company-owned outlets from fiscal year 2019, which predated the COVID-19 pandemic.
In response to inquiries from state franchise regulators seeking guidance on whether franchisors can make historical financial performance representations in 2020 due to the impacts of the shutdown orders that resulted from the COVID-19 pandemic, NASAA has provided this guidance.
Franchisors are obligated to update all material disclosures, including historical financial performance representations, to disclose material changes.
Under federal and state laws, franchisors have long had an affirmative obligation to amend the FDD mid-year to reflect material changes, including material changes in FPRs. Although, in most FDDs the historical FPR data from 2019 accurately reflects the revenue achieved in the prior fiscal year, NASAA is requiring franchisors to update that data for the first half of 2020, to include additional financial performance information in Item 19, or to delete the Item 19 disclosures altogether.
Failure to update Item 19 may be considered deceptive, misleading or fraudulent.
State and federal franchise laws make it illegal for franchisors to make untrue statements of a material fact or to omit material facts that make a statement not misleading. The materiality of a fact is viewed from the perspective of a reasonable prospective franchisee. NASAA is now conflating the obligation to update for material changes and the anti-fraud obligation with the Item 19 regulations on disclosing historical FPRs, to suggest that a failure to amend a historical FPR could be misleading.
Certain factors should be weighed to determine if historical financial performance representations should be updated.
- Whether the franchised business has been significantly impacted by the COVID-19 pandemic;
- The type of data the franchisor includes in the FPR;
- The reasonable inferences a prospective franchisee can draw from the FPR;
- When the franchisor estimates a prospective franchisee can expect to open for business after entering into a franchise agreement;
- Whether and how the franchisor adapts the franchised business to account for current market conditions resulting from the COVID-19 pandemic; and
- Whether and how the franchisor adapts the franchised business to account for future market conditions resulting from the COVID-19 pandemic.
If outlets represented in an FPR have experienced material changes in financial performance, the franchisor may no longer make a historical FPR that is not updated to reflect those changes.
Non-monetary impacts may also require updates to financial performance representations.
As a result of the COVID-19 pandemic, some franchise systems have changed or will change how they deliver goods and services to the public. Some changes may be temporary; however, franchisors may alter their business models permanently to adapt to new consumer demands and attitudes in a post-COVID-19 world. Once a franchisor concludes that it will make changes to its franchise system or business model that will materially impact a historical FPR, the franchisor no longer may include a historical FPR that is not updated to reflect those changes and their impact on the FPR.
Franchisors whose outlets have been affected by the COVID-19 pandemic and resulting shutdowns are likely acutely aware of the impact those closures have had on the revenues of each outlet.
Franchisors should review their Item 19 disclosures and compare those FPRs against their system’s financial realities in 2020. If the COVID-19 pandemic has impacted the performance of the system’s outlets in such a way that those historical FPRs may appear misleading, changes to the FPR or deletion of the entire FPR may be appropriate.
If you are unsure what changes you may need to make to your FDD or if you need to make changes, please contact Lynne Hanson, Co-Chair of the Franchise and Distribution Group.
A version of this article was originally published in Franchise Update.