Item 19 Disclosures Must Now Comply With New Law

01/30/2018 / Chuck S. Modell

The North American Securities Administrators Association (NASAA) Commentary on financial performance representations (FPR), which we have been writing about for the last year, is now the law. As a result, if your fiscal year ended Dec. 31, 2017, you must comply with the new law when you prepare the annual update to your franchise disclosure document (FDD) and file your renewal applications with the franchise registration states. This article will highlight provisions we found needed updating in many of the FDDs we have reviewed.

Define Gross Revenues
When you discuss revenues, you need to include in Item 19 a definition of the terms you use. For example, if you discuss total revenues, you must clarify whether the revenues include items such as sales taxes, refunds, discounts and returns. If you charge a royalty based on a percentage of revenues, ideally, you will tie the term to the definition you have for revenues in your franchise agreement, and you need to clarify if that is not the case.

Additional Disclosures Needed When Using Averages
Whenever you disclose average gross revenues, you will now need to show the high and low revenue among the outlets used in computing the average. Note that this applies only to revenues. However, for all averages, you must also show a median. Thus, if you talk about average costs of goods sold or of other expenses, you will now be required to also calculate and disclose a median to accompany each average.

If you exclude outlets from a disclosure of averages, you must explain why the outlets were excluded (and it cannot be simply to show better numbers). Many franchisors exclude outlets that were not open for the entire period covered by the FPR. That is permissible, but you will now need to disclose how many outlets were excluded because they closed during the period covered by the FPR. In addition, if any outlets opened and closed during the period, you must disclose how many of these existed.

Using Company-Owned Information
The biggest benefit of the law is that it confirms it is permissible to use information from company-owned outlets – so long as the results are not significantly different from franchise outlets. However, you need to point out all the differences between the two. If you have a disclosure that combines company-owned outlets with franchise outlets, you must also separately show the results for the company-owned outlets and for the franchise outlets. If you show costs and/or net profits, you must not only explain what costs were different for company-owned outlets, but you must show the effect on the numbers of including these additional costs. For example, if company-owned outlets do not pay royalties, you must not only explain that royalties were not an expense item for the company outlets, but you must also show how the profits would have been reduced if the company outlets had paid the royalty required of franchisees.

Using Subsets
Some franchise consultants, including some lawyers, have been very aggressive in using subsets of outlets to paint a rosy picture of the system. If you have been preparing subsets that are based solely on best performing outlets, those disclosures are now prohibited by the law (and many take the position they always have been improper as not having a “reasonable basis” under the law). The exception is that you can show the results of the best performing outlets, such as results from the top 10 percent, if you give the same information for the corresponding low percentage, or in this example, the lowest 10 percent. Otherwise, a subset should be based on operating differences, like all units having certain operating characteristics. Subsets based on geography and/or time-in-operation are also permitted.

If you use projections, they must be based on historical data from the system, and not on mere speculation (such as, “we have never had anyone who did this, but if you had revenues of $2 million a year, here is how much you would make”). The concept is that any numbers you show should be capable of being achieved by franchisees. There are no guarantees, and certainly there will be limitations on some franchisees based on location, size and other factors, but the numbers shown in Item 19 should not be numbers that have not, or could not, be achieved by franchisees in the system.

Those who made extensive use of disclaimers will find that the registration states will now be more adamant about allowing you to only state: “Some outlets have earned this amount. Your individual results may differ. There is no assurance that you’ll earn as much.” Note also that this required language must be in its own paragraph, and in bold face, but not capital letters.

Hopefully, these points will give you an initial checklist for reviewing your current FDD for compliance with the new FPR law. If you are responsible for preparing the FPR for your company, you should have a copy of the law in front of you, and check it against the disclosures, as the foregoing points only cover some of the more common issues.