FINANCIAL PERFORMANCE REPRESENTATIONS – AVOIDING THE LITIGATION TRAP
Category : Newsletter
Just as Franchisors began to get comfortable foregoing the use of an “Earnings Claims” in their disclosure document, the rules of the game changed and a new name for Item 19 appeared – “Financial Performance Representation” (FPR) and with the new name, the information required changed, making it easier for franchise companies to make financial representations to prospective franchisees when selling their franchise. For the prospective franchisee, financial performance information is critical in the decision making process. Often the first question asked by a prospective franchisee is “how much money can I make.” But even though the FTC made it easier for Franchisors to use an FPR there still exist a steady stream of litigation from hungry plaintiff attorneys waiting for the neophyte or the overzealous Franchisor to make unsubstantiated, exaggerated, fraudulent or technically illegal FPRs. For the prudent Franchisor who desires to build the franchise company on a solid foundation, the question is – how do you incorporate FPRs into the sales process without encountering the snare of a hungry plaintiff’s lawyer.
First know the most common pitfalls leading to litigation. One of the most common Franchisor pitfalls is the use of data gathered too far in the past and which is no longer relevant or applicable to current market conditions and may not provide a reasonable basis for the FPR representation. This is particularly true in a tight economy. Today consumers are keeping a close eye on their spending habits. Franchisor’s that rely on consumer spending for non essential products and services are especially vulnerable to lawsuits from the use of outdated or no longer relevant information.
Another area in which Franchisors must proceed with caution is their use of cost data coupled with a percentage of sales. Although the Amended FTC Rule excludes cost information by itself from the definition of financial performance, Franchisors must not present cost or expense data as a percentage of sales. Presenting a prospect with cost data, coupled with sales or earnings figures which enable a prospective franchisee to calculate average net profits falls squarely within the definition of a financial performance representation.
Second – The Amended FTC Rule broadly defines financial performance representation to include any representation, whether oral, written or visual, that states expressly or by implication a specific level or range of actual or potential sales, income, gross profits or net profits. Therefore Franchisors are required to make an Item 19 FPR disclosure for cost of goods sold if expressed as a percentage of sales, assisting in the preparation of an FPR statement, or providing a prospective franchisee with a pro forma, or any representation regarding occupancy rates or transaction volumes. As a Franchisor you must be cognizant that FPR representations include not only what is contained in Item 19 of the FDD, but also information stated in your brochures, advertising materials, website, verbal representations made by you or your franchise sellers as well as, your assistance to prospective franchisees in preparing a pro forma, or reviewing a business plan.
Franchisors that fail to consult with franchise counsel regularly may also be caught in the disclosure trap where they provide an unaudited financial statement to a prospective franchisee and the statement breaks down revenue into royalty revenue or advertising fees. In cases where a franchisee’s fees are calculated as a percentage of gross revenue, a prospective franchisee can “do the math” to ascertain potential revenue.
The stage is set! There is no doubt that prospective franchisees want financial performance information as part of their due diligence and therefore those franchisors that provide it are ahead of the rest that don’t. But the Franchisor that fails to review all aspects of its sales process with franchise counsel may find itself in the jaws of a hungry plaintiff’s lawyer.