Franchise Alert: Updating Disclosure Documents to Reflect System Changes During the Pandemic
By Sandra Gibbs on August 13, 2020
Franchise Alert Updating FDD
These are challenging times for businesses. Navigating intermittent and unpredictable government-mandated closures, keeping up with new health and safety risks and regulations, and finding new revenue sources in an uncertain environment have become standard features of doing business. Like other businesses, many franchise systems have responded to these challenges by making adjustments in the way they—and their franchisees—operate. As regulated businesses, however, franchisors carry the additional burden of ensuring that their disclosure documents are correct and up to date. Failure to do so can leave a franchisor exposed to claims of misrepresentation or fraud for years to come.
Updating requirements are found in both federal franchise law (the FTC Rule) and in most state laws that prescribe registration and disclosure requirements. In general, these laws require franchisors to amend or supplement their Franchise Disclosure Documents (FDDs) to reflect “material” changes and specify how frequently those updates need to be made (e.g., quarterly, “promptly,” within 30 days of the material change).
What is a “Material” Change?
The Federal Trade Commission’s Statement of Basis and Purpose behind the FTC Rule suggests that a change is “material” if it would affect a reasonable prospective franchisee’s decision to invest in the franchise system. Several state laws—including Hawaii, Illinois, Maryland, Minnesota, New York, and Wisconsin—provide more detailed definitions of materiality or examples of system changes that should be considered material. These can include the introduction of new products and services, the need for additional investment, the decrease in a certain number or percentage of units, a change in the franchisor’s management, and new litigation (or significant changes in the status of existing litigation).
Because the definition of “material” will be interpreted from the standpoint of the franchisee, the most prudent course for franchisors is to take a broad view of what might be considered material.
What Parts of the FDD May Need to be Amended?
Item 19 – Financial performance representations (“FPRs”) are treated as particularly sensitive under the FTC Rule; rather than wait for a quarterly update, the Rule requires franchisors to notify prospective franchisees of any material changes to their FPRs at the time of disclosure. And in response to the widespread economic disruption caused by the novel coronavirus pandemic in 2020, the Franchise Project Group of the North American Securities Administrators Association (“NASAA”) issued commentary in June advising franchisors that use of historical FPRs in a system whose franchisees have been negatively impacted could be deemed a misrepresentation under the FTC Rule. The State of Washington issued similar guidance and warned that unamended FDDs would meet with stricter scrutiny in the registration process.
In addition to drops in revenue, franchisors whose FPRs incorporate franchisee costs should consider whether higher supply costs or additional operating expenses render their FPRs outdated. For example, a system that has adopted substantially more rigorous cleaning procedures—perhaps including more frequent use of professional sanitizing or the purchase of new cleaning equipment—and experienced correspondingly higher costs may need to consider amending or supplementing their Item 19 disclosures.
Item 20 – Contraction in the number of units in a system is specifically identified by several states as a “material” change that must be reported in an amendment or supplement. One difficulty for franchisors is in determining how many closures are permanent and how many are only temporary; moreover, these numbers will change as shutdowns drag on, businesses run out of funds, or evictions become common.
Item 7, Item 8, Item 11 – Many systems are attempting to pivot to different revenue sources to make up for those that are not currently feasible due to the pandemic. Others are modifying their systems to offer products and services through different modes of commerce. Some of these system changes may last for some time, and new franchisees may need to be prepared to offer different products or services than are reflected in the current FDDs, and to incur additional expenses in opening or operating a unit. These types of system changes can create arguably material effects in multiple parts of the FDD.
Item 3 – With courthouses in many parts of the United States conducting only limited activities, most litigation has been stalled, but only temporarily. Once litigation activity resumes, franchisors will need to update their FDDs to reflect new lawsuits that meet the requirements of Item 3 disclosure or significant changes in the status of existing lawsuits.
Item 21 – Franchisors whose own financial condition has been battered by the business disruption may want to consider providing unaudited financials to minimize the risk of a claim that pre-pandemic financial statements conveyed a false picture of the franchisor’s condition.
What is the Next Step?
The attorneys at Mulcahy LLP can work with you to review the changes in your franchise system to determine if any may be deemed “material.” If needed, we can assist you in preparing updates to your FDD and filing amendments or supplements where appropriate.
This case report was prepared by Sandra Gibbs (firstname.lastname@example.org) of the Irvine law firm of Mulcahy LLP. Mulcahy LLP is a boutique litigation firm that provides legal services to franchisors, manufacturers and other companies in the areas of franchise, trademark trade secret, unfair competition, and distribution laws.