Inserting Your Client’s Audit Into Their FDD? Stop. Read it.

12/01/2017 / Charles S. Modell

For those of us who draft and update Franchise Disclosure Documents (“FDDs”), franchise renewal season is upon us. If your practice is like mine, you will spend much of February, March and April, updating Franchise Disclosure Documents, and if you are lucky, a couple days before the filing is due, you will receive the audit. Many attorneys will then hand the audit to their staff to be included in the FDD, without ever reading it. That is a mistake!

It is important that you, as the franchisor’s attorney, review your client’s audited financial statements, hopefully before they are finalized. Failure to do so will often result in a mistake in the financial statements, or a mistake in the FDD, either of which can lead to significant liability for your client.

While it certainly helps to have knowledge
of accounting principles when reviewing the audit, many problems can be identified by simply reading the Notes that appear at the
end of the financial statements. This issue can best be explained by examples. Each of these
is a real life example taken from a presentation made by Ron Gardner and Eric Karp to state franchise examiners at a November 2015 NASAA Examiner Training.

  • The franchisor provides in Item 8 that franchisees are not required to buy supplies from any designated suppliers. The Notes to the financial statements state: “The supplier will pay [the franchisor] the sum of $650,000....

    In return, [the franchisor] agrees that each franchised store will purchase [the designated supplies] from supplier for its operations.”

  • Item 8 of the FDD states that the franchisor receives no payments from any supplier, but the Notes to the financial statements provide that in the last fiscal year, the franchisor received more than $500,000 in rebates from suppliers.

  • Item 11 of the FDD states that any contributions to the advertising fund that are not spent in the fiscal year in which they accrue will remain in the fund for use in future years. The Notes to the financial statements state: “The Company is required to expend on advertising all monies contributed by franchisees or return the excess to them on a prorated basis.”

    • The FDD discloses in Items 1 and 20 the number of franchise outlets open as of the end of the last fiscal year, while the Notes to financial statements contain the same disclosure, using a different number.

    In some cases, there is not a discrepancy between the FDD and the financial statements, but rather, the financial statements will purport to impose obligations upon the franchisor that were never anticipated by the attorney who prepared the franchise agreement - or by their client. In a draft of financial statements provided to me by a client, I found a Note stating that the franchisor held advertising contributions in trust for franchisees. The franchise agreement imposed no such obligation, and certainly no trust or fiduciary obligation was intended by the franchisor. That same set of financial statements also listed the services provided to franchisees by the franchisor, many of which were not listed either in the franchise agreement or in Item 11 of the FDD. Upon consultation with the client, I learned that at least one stated service was not routinely provided. If I had not reviewed the financial statements, I would never have learned of these mistakes – until a franchisee’s attorney brought them to my client’s attention, claiming reliance on the “representations” contained in the financial statements.

    If you do have knowledge of basic accounting principles, you should review the balance
    sheet to anticipate an impound or fee deferral requirement that might be imposed by state franchise examiners when there is a low or negative net worth or a low or negative “current

    ratio” (i.e., current assets to current liabilities). For franchisors that have debt to affiliates, these issues can often be avoided by restructuring the debt. When the debt is payable upon demand, that debt will be a short-term liability. If the affiliate will change the terms of the loan to one that is payable in a subsequent year, that debt will move from a short term liability to a long- term liability, thus improving the franchisor’s current ratio. If the affiliate will convert the debt to equity, both the current ratio and net worth will be improved.

    Whenever possible, you should try to review a draft of the financial statements and provide input to the accountants before they finalize the audit or issue their opinion on the statements. In my experience, trying to get the financial statements changed after they have been issued can be akin to trying to pass an Act of Congress when one party controls the House and the other controls the Senate! When it is not possible to review the financial statements before they are issued, and that is usually the case with public companies, it is still important that you review them before signing off on the

    FDD. Through that review, you may learn of errors in the information given to you by your client for inclusion in the FDD.

    Mistakes happen. It is immaterial whether a mistake was made by the auditors, by the client in providing information to you, or by you or your staff in compiling the FDD. What is important is that you review the audit to anticipate issues. By doing so, you have ability to help your client identify issues that may arise upon a prospective franchisee or state franchise examiner’s review of the financial statements, and address inconsistencies between the franchise agreement and/or the FDD. Addressing these issues will, at a minimum, save the embarrassment of having the client, or worse, a state franchise examiner, find an error. More importantly, reviewing the audit and correcting problems will avoid the potential liability that will arise if an error is first discovered two years later by a franchisee’s attorney who is poring through the FDD looking for potential claims against your client.