Why Franchises Should Oppose Mandatory Financial Performance Representations

By: Earsa Jackson

The Federal Trade Commission (“FTC”) promulgated the FTC Franchise Rule (“Rule”) in 1978 with the principle objective of ensuring prospective franchisees throughout the United States received relevant and material information about a particular franchise program before making an investment decision in a particular franchise system. This information is detailed in a franchisor-offered Franchise Disclosure Document (“FDD”) which includes 23 disclosure sections about the franchisor, the franchise opportunity being licensed to the prospective franchisee, the fees charged by the franchisor, the legal relationship between the franchisor and the franchisee, and other information about the franchise offering. 

While franchisors and franchisees alike have enjoyed the clear disclosure requirements of the Franchise Rule for over 30 years, some advocates have urged that franchisors also disclose the financial statistics of their franchisees in the form of a Financial Performance Representation (“FPR”). Historically, disclosure of an FPR under “Item 19” of the FDD, has been a voluntary decision for franchise brands. Yet, in April 2021, Nevada Senator Catherine Cortez Masto sought to change that by introducing a bill called the “Small Business Administration (SBA) Franchise Loan Transparency Act (S. 1120), to require franchisors to provide: 1) The average and median first-year revenue for all franchise locations for each of the preceding three years; and 2) The average and median revenues for all locations of the franchise for each of the preceding three years of operation.

The FTC Has Rejected Proposals to Mandate FPRs

Similar proposals have consistently been opposed by stakeholders in the franchise community, including the FTC, which already has twice concluded—once in connection with its 1978 Statement of Basis and Purpose (“SBP”) for the original 1978 Rule and again in its 2007 SBP for the amended Rule—that financial performance representations (formerly “earnings claims”) should be voluntary and not mandatory. The FTC revealed the following:

false or misleading financial performance claims are the most common allegation in Commission franchise law enforcement actions. However, there is no assurance that mandating performance claims will in fact reduce the level of false claims. Given that many different industries are affected by part 436, what makes a financial performance disclosure reasonable, complete, and accurate is quite varied. Thus, the Commission will not mandate a particular set of financial performance disclosures.”[1]

Ordinary Market Forces Propel Voluntary Disclosure of FPRs

The FTC also noted that at the time “approximately 20% or more of franchisors choose to make financial performance disclosures.” [2] Persuaded by the record before it, the FTC concluded, “prospective franchisees can find franchise systems that voluntarily disclose such information. If prospective franchisees were to seek out such franchise systems, or demand the disclosure of such information from franchisors, ordinary market forces might compel an increasing number of franchisors to disclose earnings information voluntarily, without a federal government mandate.”[3]

This argument in favor of “ordinary market forces” many years ago was not misplaced and to this day militates in favor of retaining the voluntary nature of FPRs. According to industry research firm, FRANdata, franchisors have increasingly began providing information in their systems’ financial performance disclosures, with 66% of all franchisors disclosing revenue information in their Item 19 in 2017.[4] Ordinary market forces have indeed propelled this result. 

FPR Data from Regionally Located or Emerging Franchise Brands May Mislead Prospective Franchisees 

It is impossible to create a one-size-fits-all FPR disclosure format that accounts for the reasonableness, relevance, and reliability of data for the broad array of business sectors using franchising as a method of distributing products and services and for the numerous different types of franchise systems operating within each sector. In 2017, there were about 3,800 franchise brands operating in over 200 business sectors in the U.S.[5] Likewise, FRANdata estimates that more than 300 new franchise brands enter the market each year.[6]

Consider that many emerging franchise brands are those with little to no operating locations (less than 100). This list could also include regionally located brands seeking to open locations in new states where none currently exist and foreign franchise brands looking to enter the U.S. market. Emerging franchise brands make up an overwhelming majority of the franchise community, and they would not be able to collect and provide meaningful financial data to prospective franchisees. Given the lack of franchise locations, either in number or in the new region that the brand hopes to market, adequate financial data likely could not be collected.

While some franchise brands may be able to collect and provide “accurate” data, it may be either be statistically insignificant or misleading to prospective franchisees when accounting for the territory size, population, and needs of the local economy (of the newly market location) as compared to the averages of the current franchise businesses operating under the brand. Consider the following example:

XYZ Burger is a fast-food franchise located in Dallas, Texas that specializes in “Southern-Style” burgers and barbeque sandwiches. The brand currently has 25 franchisee-operated locations (all in Texas) and hopes to expand the franchise into California and Arizona. XYZ Burger has collected accurate financial performance data from all of its Texas locations, and provides it accordingly to John, a prospective franchisee in San Diego, California. After reviewing the average and median revenue for all XYZ Burger locations, John decides an investment into the brand would present a great entrepreneurial opportunity for him and his family in San Diego.

Unfortunately, after John’s first year of operating under a five-year agreement with XYZ Burger, his location in San Diego is performing significantly below the average and median revenue data offered in the brand’s FPR. This trend continues into his third year, until John is unable to sustain his operations and ends up closing the location. John believes his revenue expectations were due to misleading information contained within XYZ Burger’s FPR. He contends that the brand engaged in a fraudulent business practice and sues XYZ Burger for making false financial representations. XYZ Burger contends the financial performance data provided to John three years earlier was an accurate representation of the system. The two parties are locked in costly litigation.

The above example relays that while FPR data may be accurate, the low number of franchisees operating in an emerging or regional franchise may make the data statistically insignificant or misleading to prospective franchisees. While XYZ Burger may have performed well in Texas, as a “Southern-Style” restaurant, the FPR data may not correlate with the market expectations and local economy for a prospective franchisee in San Diego, California, especially given that virtually all of the data was aggregated from Texas-based locations. While this certainly resulted in a financial disaster for the prospective franchisee, it also opened the emerging franchise to liability for making a misleading financial representation. In order to avoid this result, XYZ Burger would need to make an inordinate number of disclaimers to qualify the financial performance data in avoiding misleading financial expectations to prospective franchisees. Disclaiming such data after its provision would render mandatory FPR disclosures virtually meaningless.

Concluding the Case Against Mandating FPRs

While the FTC Franchise Rule’s primary purpose is to offer transparency to a franchisor-franchisee relationship before it begins, prospective franchisees need an honest and clear understanding of the franchise system under consideration for investment. While more disclosure of information appears positive for purposes of transparency, it may run counterproductive to the Rule’s purpose if it misleads prospective franchisees with false expectations about their own future performance in a brand.

It would be imprudent to mandate a one-size-fits-all type of disclosure that is rife with complexities and complications when that type of disclosure already has become increasingly normal in franchising—allowing prospective franchisees to comparison-shop—due to self-regulatory market practices. Doing so would accomplish nothing more than to harm smaller franchise brands that are unable to provide such data without risk of litigation and harming the reputation of the brand.

As the SBA Franchise Loan Transparency Act intends to deter “bad actors” from making fraudulent financial statements to prospective franchisees, the legislation would do no more than mislead the very franchisees it seeks to protect and open up innocent actors to needless liability. As the FTC has correctly rejected similar proposals to mandate FPRs, its well-reasoned arguments still ring true today, that FPRs should remain voluntary.

  • Earsa Jackson is a Member of the law firm of Clark Hill PLC, and she is the Leader for Clark Hill’s Franchise & Licensing group.   She is also a Certified Franchise Executive. Earsa structures franchises and assists franchisors with on-going transactional and regulatory needs. Earsa also handles litigation matters in the following areas: business and commercial, False Claims Act, business torts, franchise and licensing, trademark infringement, misappropriation of trade secrets, and contract disputes. Earsa has written and spoken extensively on franchise issues.  She also serves on the Board of the International Franchise Association.   

The views expressed are those of the author and not necessarily of Clark Hill PLC.

 

[1] Disclosure Requirements and Prohibitions Concerning Franchising, 16 CFR Parts 436 and 437 (2007), at 15498.   

[2] Id. at 15498.

[3] Id.

[4] FRANdata 2017 Financial Performance Representation Study, April 2017, at 4.

[5] FRANdata, Franchise Industry Study, 2017, at 1.

[6] FRANdata, An Examination of New Franchise Concepts, 2017, at 3.