A "reasonable basis" for FPRs: what to expect this renewal season from state franchise examiners in light of the proposed NASAA FPR Commentary

by DLA Piper

DLA Piper

Last fall, the North American Securities Administrators Association Inc. (NASAA) issued a notice of request seeking public comment on an updated proposed financial performance representations (or FPR) Commentary. The Federal Trade Commission's Amended Franchise Rule, 16 CFR Parts 436 and 437, permits a franchisor to disclose financial results in Item 19 of a franchise disclosure document (FDD) as long as the franchisor has "a reasonable basis" for the representation. The FTC Rule does not define what constitutes a "reasonable basis," and the FPR Commentary purports to provide more clarity by creating a set of guidelines that will govern the disclosure of financial results in Item 19 (including prohibiting certain disclosures) and what support or factual information franchisors must provide when making specific types of FPRs. Ultimately, the proposed FPR Commentary seeks to address various questions raised by franchisors, their representatives, and state franchise examiners regarding FPRs.

The FPR Commentary has not yet been formally approved by NASAA (which could occur at its Spring Conference in May 2017, or at its Annual Conference in September 2017), and thus will not likely be final and formally effective until the 2018 franchise registration and renewal period. It could still be modified from its current version. But some state franchise examiners have indicated that they plan on using the FPR Commentary as guidance when reviewing FPRs during the 2017 renewal period. (Indeed, because the FPR Commentary purports to clarify the "reasonable basis" requirement in the FTC Rule, it provides the examiners wide latitude to issue comments based on what they believe a "reasonable basis" entails.)

We therefore recommend that franchisors take a look at their FPRs this year to ensure that they comply with the FPR Commentary as currently written and consider the following modifications where necessary:

  • Medians/averages. Wherever franchisors provide an average or mean of numbers in the FPR (such as sales or number of years the outlets in the FPR were open), they must include the median figure for the information and vice versa. The theory behind this requirement is that the existence of outliers may skew both an average and a median.
  • High/low figures. In addition, where average and median figures are provided, franchisors must disclose the high and low figures in the sample set. For example, if a franchisor provides average monthly sales information in its FPR, the franchisor would need to add the highest and lowest monthly outlet sales in the sample set.
  • Subsets. Many franchisors disclose FPRs for subsets of outlets, often the best performing outlets (e.g., top 10 percent, top 20 percent). The FPR Commentary provides that a franchisor may not separately disclose the best performing outlets without also disclosing a subset of the corresponding lowest performers (e.g., bottom 10 percent, bottom 20 percent). Additionally, a franchisor may not base a subset on fewer than 10 outlets.
  • Gross sales based on company-owned outlets. The FPR Commentary states that if a franchisor has operational franchised outlets, it cannot make a gross sales FPR based on company-owned data alone. However, if the franchisor has no operational franchised outlets, the franchisor can make a gross sales FPR based solely on company-owned outlet data.
  • Gross/net profit based on company-owned outlets. Whether or not a franchisor has operational franchised outlets, a franchisor can make an FPR disclosing gross or net profit based solely on company-owned data. However, when using this company-owned data, franchisors must account for material financial and operational differences between company-owned outlets and operational franchised outlets in their FPRs. Wherever franchisees are likely to incur additional or higher costs, those costs must be described or added to the company-owned outlet P&Ls. Examples of these costs include imputed royalties, advertising fund contributions or other fees paid by franchisees if these fees are not otherwise paid by company-owned outlets or paid at a different rate than franchisees and other costs which franchisees incur which are not incurred in a company-owned outlet. The FPR Commentary states that this additional information must be presented in the same format as the rest of the FPR. In the past, franchisors have provided this information often in footnotes to the FPR. The FPR Commentary rules out the use of footnotes and states that if the FPR is provided in tabular format, this additional information must be included within or added to the end of the table.
  • Omission of outlets that have closed. Franchisors should clarify any sample sets, including by listing the number of outlets that are excluded from the sample set because they closed during the reporting period. Under a typical FPR, a franchisor may define the sample set as follows: (i) there were X outlets at year end; (ii) Y outlets were removed from the sample for the following reasons; and (iii) the sample set is X minus Y outlets. However, when clarifying that a franchisor can exclude from the sample set outlets that closed during the reporting period, the FPR Commentary provides that the franchisor must disclose: (1) the number of company-owned and/or franchised outlets that closed during the time period; and (2) the number of excluded outlets that closed during the same time period after being open less than 12 months.
  • Merging data. The FPR Commentary permits a franchisor to merge company-owned and franchised data in a single table but only if the franchisor also discloses the data from the company-owned and the franchised outlets separately. The only exception to this requirement is when the franchisor has a very small number of franchisees (less than 10) that the identity of the franchisees would be discernible. In such case, the data may be presented in the merged format only as long as the franchisor can represent that there is no material difference between the company-owned and franchised data.
  • Admonitions. The FPR Commentary requires the specifics of the form and substance of admonitions that franchisors may use in their FPRs. The admonition must be presented in a separate paragraph from the rest of the FPR and must be in bold type but may not be in capital letters, underlined or in larger type than the rest of the FPR. The form and substance of the admonition must be as follows (with modifications provided only to define the scope of the information provided):

"Some outlets have earned this amount. Your individual results may differ. There is no assurance that you'll earn as much."

If a franchisor chooses not to follow the FPR Commentary this renewal season and receives a comment from a state examiner who is following the proposed FPR Commentary, the franchisor must consider FTC Rule FAQ #38. In FAQ #38, the FTC addressed the question of what a franchisor must do if required by a state to modify an FPR and whether the unaltered FPR could still be delivered to prospective franchisees in other states. The FTC concluded that a failure to make any resulting changes to the FPR in all other states raises significant concerns about whether the FPR meets the requirements of the FTC Rule.

Therefore, if a franchisor chooses not to incorporate the language of the FPR Commentary during this renewal cycle and receives a comment from a state examiner requiring inclusion of additional/modified information in Item 19, the logic of FAQ #38 might be asserted to require that that franchisor incur the costs and burden of having to amend franchise registrations in all states in which the franchisor is registered based on these comments.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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