Franchise Alchemy

COVID-19 is About More than Item 19 Franchise Disclosures

On June 10, 2020, the Franchise Project Group of the North American Securities Administrators Association, Inc. (NASAA) issued guidance to assist state franchise examiners when they review Financial Performance Representations (FPRs) in Item 19 of the Franchise Disclosure Document (FDD) during the COVID-19 pandemic. FPRs provide prospective franchisees with at least partial answers to the perennial question, “How much can I make?”

Franchisors are not required to make FPRs in their FDDs, and many franchisors do not include them. But franchisors recognize that FPRs can help sell franchises, and the numbers of franchise companies making these representations in Item 19 has increased steadily in recent years.

The most common type of FPR is historical data from franchisees or from the franchisor’s company-owned outlets. But historical data can be misleading when the world has changed.

As the pandemic continues, any franchise system that has experienced outlet closures or serious reductions in sales may need to either remove the FPRs from their FDDs or amend them to reflect the negative effects of the pandemic on their business.

Three state franchise regulators suggested on August 13, 2020, at the Franchise Law Virtual Summit of the International Franchise Association (IFA) that Item 19 FDD revisions might take the form, for example, of a table comparing monthly 2019 sales to the same months in 2020. Or the franchisor may disclose the numbers of outlets that have closed permanently or temporarily as a result of the pandemic, or whether outlets have modified their operations. Many franchised restaurants, for example, have launched takeout and delivery programs in response to the pandemic or have expanded existing takeout and delivery programs.

But COVID-19 is about more than Item 19 disclosures. Regardless of whether a franchisor makes Item 19 disclosures, franchisors may need to reflect the effects of the pandemic in other sections of the FDD. Based on my own experience with recent franchise filings, I can tell you that franchise examiners might raise these points:

  • In Item 1, under Laws and Regulations, please mention how COVID-19 government orders to shut-down has impacted the franchisor’s business model.
  • In Item 11, please explain how COVID-19 has impacted the time of opening.
  • In Item 11, please explain how COVID-19 has impacted the in-person training program.
  • In Item 20, Table 5, please clarify whether the numbers of projected outlets are still accurate. If the estimate has changed, please update Table 5 to reflect any adjustments made due to the COVID-19 pandemic.

If a reasonable prospective franchisee would consider Covid-19 related information significant in deciding whether to purchase the franchise, then the franchisor would have a legal obligation to amend the FDD to add the appropriate disclosures.

Franchisors will need to keep these points in mind at least until a vaccine is authorized and widely available and the public generally feels secure enough to venture into restaurants, hotels and retail stores.

Franchisors that need to modify their FDDs in response to the pandemic are the lucky ones. The unfortunate fact is that a number of franchised businesses have been forced to close down entirely during this pandemic, and some companies planning to franchise their businesses have postponed or cancelled the launch of their franchise programs, if they are surviving at all. The state regulators noted at the recent IFA Franchise Law Virtual Summit that the number of franchise applications filed from January through June 2020 declined from the same period in 2019 by 17% in California, 12% in Maryland and 12% in Washington. Hopefully, 2021 will see an upturn in these numbers.