Last week the attorneys at Huck Bouma attended (virtually) the International Franchise Association’s Legal Symposium. The breakout session on Item 19 in 2020 and the state regulator session reinforced how proactive franchisors need to be this year. Due to the COVID-19 pandemic, you need to continually be reviewing Item 19 information and other information in your FDD to determine if the information is no longer accurate or could now be misleading to a prospective franchisee looking to buy your franchise now.
In light of the impact COVID-19 has had or continues to have on so many businesses, franchisors need to regularly review the information in their FDD to determine if material changes have occurred which would result in the need to amend the FDD during the registration year. Of particular concern is whether the financial performance representations presented in Item 19 based on data from 2019 and earlier years continue to have the required reasonable basis in 2020 or whether an update is needed due to changes in the financial performance of your franchise system since March.
In June 2020 the North American Securities Administrators Association (the organization of state franchise regulators) issued a specific commentary warning that franchisors need to be carefully reviewing Item 19 financial performance representations (“FPRs”) during the COVID-19 pandemic to see if the FPRs continues to have a reasonable basis for franchisees looking to purchase the franchise now. If the FPRs no longer have a reasonable basis due to changes in the performance of franchised units in 2020, the FDD must be promptly amended.
Some states, Maryland and Washington in particular, have gotten very aggressive in reviewing pending applications, including requiring franchisors to submit 2020 data to them to demonstrate that their 2019 data still has a reasonable basis. Not only is the requirement to amend the FDD an obligation under state franchise law, but it is a requirement under the federal franchise law as well. The FTC Franchise Rule has always required that franchisors promptly provide updated Item 19 FPRs to prospective franchisees when material changes occur and quarterly updates for other material changes.
Besides financial data in Item 19, changes in other FDD disclosures may be necessary if the existing disclosures in the FDD are no longer accurate or complete. Other areas where changes may have taken place include:
- if the franchise model of doing business has been changed in order to continue to conduct business during the pandemic, especially if some of these changes may become a permanent part of the system.
- if there have been a material number of franchise unit closings so that updates need to be made to the Item 20 tables.
- if there are additional expenses to open a new franchise related to safety precautions or modifications in doing business due to the pandemic.
- if there has been a negative change in the franchisor’s financial condition.
Failure to review Item 19 data and other FDD disclosures and to make necessary updates exposes a franchisor to state franchise law violations and federal franchise law violations. If not discovered now by a state franchise regulator, state regulators may raise questions next year when you renew your registrations with a revised FDD (if you do not amend this year) and may determine that you should have amended during 2020. Fines could be imposed and offers of rescission to franchisees sold in 2020 could be required.
In addition, franchisors also have exposure to franchisees who purchase the franchise during 2020. If these franchisees are not successful in the next year or two, they may be looking for the basis for a claim against you. Failure to provide current information and data showing the impact of COVID-19 on your franchise businesses can be the basis for fraud and misrepresentation as well as state franchise law violations.
Once you review the data, if you determine that financial performance of your franchisees in 2020 is materially different than what you currently present in Item 19 of the FDD, what do you do?
- One option is to add updated 2020 information or a comparison of 2019 and 2020 data so that prospective franchisees can see the impact of COVID-19 on your franchise system. We are currently working on this type of comparative data for a couple of clients based on requirements in state comment letters.
- Along with revised data, explanations about how the franchised businesses have been impacted (i.e., business closures for a certain period of time, modifications or limitations on services and products sold) can be included.
- Another option is to remove all Item 19 FPRs. Of course, doing so can present challenges for franchise sales because you would be prohibited from discussing financial data with prospective franchisees.
All of these options require amending the FDD and filing amendment applications in the state where you are registered.
As you complete your reviews of the FDD disclosures throughout the year, contact us to discuss whether an amendment is required for compliance with franchise laws. If so, we can discuss what new data and information should be presented.