In late 2020, the Federal Trade Commission held a virtual public workshop. The workshop addressed whether the utility of the FTC Franchise Rule (“Disclosure Requirements and Prohibitions Concerning Franchising,” 16 CFR Part 436) could be enhanced. The workshop was part of a systematic review of all FTC regulations and portends potential revisions to the FTC Franchise Rule.
Parts of the workshop focused on three issues: 1) franchisors’ financial performance representations; 2) franchisors’ use of disclaimers; and 3) the format and contents of the Franchise Disclosure Documents (the “FDD’s”) required by the FTC Franchise Rule.
This post will address the first issue, franchisors’ financial performance representations. Franchisors are supposed to provide these representations in Item 19 of the FDD. If the franchisor elects not to make financial performance representations, it does not have to make them. However, if the franchisor does make them, it must usually do so in the manner required by the FTC Franchise Rule in Item 19 of its FDD.
The FTC is considering making financial performance representations mandatory.
Arguments in Favor of Mandatory Financial Performance Representations
About 2/3 of franchisors currently include financial performance representations in their Franchise Disclosure Documents. Franchise regulators argue that financial performance representations are one of the most important pieces of information franchisors can give prospective franchisees, and that the cost to franchisors of providing financial performance representations is offset by the benefit to franchisees.
I routinely discuss with franchisor clients the desirability of providing financial performance representations. My point is, “Assume a prospect DOESN’T ask, ‘how much can I make?’ Would you want a franchisee like that in your system?”
I wouldn’t want a franchisee like that in my system. I want prospects whose FIRST question is “how much can I make?”
Arguments Against Mandatory Financial Performance Representations
Other commentators at the workshop argued against mandatory financial performance representations. They argued that:
Sometimes this is a valid point. As one example, in some systems, franchisees may pay a flat fee royalty (e.g., $1,750 per outlet per month) instead of a royalty that is based on a percentage of revenues. Franchisees may not be required to report their earnings to the franchisor. On the other hand, this could be cured by requiring franchisors to collect revenue reports from franchisees.
Commentators argued that, in other instances, franchisees may underreport revenues. This is not usually a valid objection. Underreporting would harm franchisors who have every incentive to show maximum revenues, to enhance: (i) their own income; and (ii) favorable presentations to prospective franchisees. Almost every franchisor I have worked with has an audit procedure to verify franchisees’ claims. If franchisors are accepting underreporting, they may exercise their audit rights and verify the figures their franchisees are reporting.
Other commentators at the workshop argued that many franchise systems are young and do not have a reliable performance history. This is not a valid excuse. The FTC Franchise Rule has almost always allowed franchisors, whether new or experienced, to generate financial performance representations based on projections.
Once again, this is not a valid excuse. No rational franchisor would expand into the U.S. without determining the likelihood of profitability; i.e., without preparing pro formae estimates of profitability. As before, the FTC Franchise Rule has almost always allowed franchisors, whether domestic or international, to generate financial performance representations based on projections. Those projections give franchisors, including international franchisors, bases for Item 19 disclosures.
For the sake of argument, let’s assume that prospective franchisees may get financial performance information from other sources. That information is probably not presented in user-friendly form in a single place, like the FDD. It probably does not come with legal liability if it is fraudulent or incorrect.
In short, objections to including financial performance representations may be sincere and well-meaning, but they are not dispositive.
The FTC is near-certain to revisit the issue of financial performance representations. This blog will keep you updated on the progress of the FTC’s efforts. For answers to your legal questions and help with your case, contact us online or call our office.