FRANCHISOR 101: COVID-19 vs. Item 19

Lewitt HackmanItem 19 of the Franchise Disclosure Document (FDD) can provide information on how a prospective franchisee may perform financially. Historical financial performance representations (FPRs) may be made if the franchisor has a reasonable basis for them and they are not misleading.

On June 17, 2020, the North American Securities Administration Association (NASAA) posted a commentary regarding a new issue in FPRs. The commentary addressed concerns that FPRs which are based on past performance (historic FPRs) may not accurately represent a franchise system’s current position in light of the COVID-19 pandemic. Regulators in some states are echoing this concern in state-specific releases (such as in Washington) and comment letters responding to applications to register FDDs.

NASAA states that “if outlets represented in an FPR have experienced material changes in financial performance,” franchisors may not make historical FPRs unless they are updated to reflect those changes. Franchisors must update Item 19 even if the current disclosures are purely historical and there has been no change in historical information.

Many franchisors who recently renewed or are now in the process of renewing their FDDs for 2020 will need to evaluate, with franchise counsel, whether a “material change” occurred in their historic FPRs. NASAA lists factors for franchisors to consider before continuing to use historic FPRs, such as:

  • Whether the franchise business has been significantly impacted by the COVID-19 pandemic;
  • The type of data the franchisor includes in the FPR;
  • Reasonable inferences a prospective franchisee can draw from the FPR;
  • When a prospective franchisee can expect to open for business after entering into a franchise agreement;
  • Whether and how the franchisor adapts the franchise business to account for current market conditions resulting from the COVID-19 pandemic; and
  • Whether and how the franchisor adapts the franchise business to account for future market conditions resulting from the COVID-19 pandemic.

The pandemic has affected franchise systems in different ways in different industries, also varying by location, business model and other factors. Many franchises suffered financially, while others are thriving. Franchisors with historic FPRs in their FDDs may need to pause offering and making franchise sales until they confer with franchise counsel on whether to amend the FDD to include updated FPR data or remove historic FPRs from the FDD for 2020, and potentially beyond, and file amendments in registration states where the FDD is already registered.

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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