Franchise Disclosure Document – Financial Performance Representations

Business Performance

Financial Performance Representations

The amended Rule prohibits financial performance representations that are not true or are not substantiated at the time they are made. It is important to note that these prohibitions cover not only the franchisor, but any “franchise seller.” The amended Rule defines the term “franchise seller” as follows:

A person that offers for sale, sells, or arranges for the sale of a franchise. It includes the franchisor and the franchisor’s employees, representatives, agents, subfranchisors, and third-party brokers who are involved in franchise sales activities. It does not include existing franchisees who sell only their own outlet and who are otherwise not engaged in franchise sales on behalf of the franchisor.

Accordingly, individual franchise sellers – such as brokers – may not be liable for failing to furnish disclosure or for improperly preparing the contents of a disclosure document. Under the amended Rule, only the franchisor and any subfranchisor are responsible for that. Nevertheless, any seller can be held liable for the seller’s own violation of the amended Rule’s provisions that prohibit:

  • making any financial performance representations unless the franchise seller has a reasonable basis and written substantiation for the representation at the time the representation is made;
  • failing to include in any financial performance representation a clear and conspicuous admonition that a new franchisee’s individual financial results may differ from the results stated in the financial performance representation; or
  • making any financial performance representation that is not included in Item 19 of the franchisor’s disclosure document.

What Constitutes a “Financial Performance Representation”?

The amended Rule defines the term “financial performance representation” as follows:

any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables.

Typically, a financial performance representation explicitly states or specifies a particular level or range of actual or potential earnings. It includes statements such as “earn a $10,000 profit,” “sales volume of $250,000,” or “earn up to $25,000 per year income.”

Financial performance representations also include implied representations that suggest – or from which a prospective franchisee easily can infer – a specific level or range of income, sales, or profits. These include statements such as “earn enough money to buy a new Porsche,” and “100% return on investment within the first year of operation.” Mere puffery does not fall within the ambit of the amended Rule’s definition. Examples of what may be considered puffery, defending on the full context, include such statements as “make big money,” “this business is a real cash cow,” or “opportunity of a lifetime.”

Does Cost Information Constitute a Financial Performance Representation?

The presentation of cost or expense data alone is not a financial performance representation. Accordingly, the disclosure of fees, required purchases, and expenses reported in Items 5 through 7 ordinarily will not constitute a financial performance claim that would have to be disclosed in Item 19. Nevertheless, a presentation of cost data, coupled with additional sales or earnings figures, from which prospective franchisees could readily calculate average net profits, is a financial performance representation, and does trigger the Item 19 disclosure obligation.

General Media Representations

Financial performance representations include representations made in the general media, where they are likely to attract members of the public interested in purchasing a franchise system.

The term “general media” is to be read broadly to include all forms of advertising, including radio, television, magazines, newspapers, and billboards. It also includes electronic advertisements such as those placed on a franchisor’s website or on a web site operated by a broker or some other third party. Electronic advertisements include both static advertisements, as well as pop-up screen and banner advertisements.

Unsolicited bulk email sent to the public – sometimes referred to as “spam” – is also a form of general media advertising since these messages are widely disseminated to create interest in the franchisor, possibly leading to franchise sales. This is true even if the messages are sent to members of the public who have expressed an interest in receiving franchise information. There is no material difference between sending email messages to members of the public who happen to have expressed some interest in the area of franchising and including financial performance representations in advertisements in franchise-related magazines or newspapers distributed to subscribers. In both scenarios, the financial performance message contained in the ad constitutes a general media claim and triggers the Rule’s disclosure and substantiation requirements.

Do Statements in Speeches and Press Releases Constitute “General Media Representations”?

Ordinarily, company statements in speeches, press releases, and the like will not be considered “general media representations,” unless they are specifically directed at members of the public interested in purchasing a franchise. For example, financial performance information appearing in a franchisor’s press release or in the investors section of the franchisor’s website ordinarily would not be deemed a general media representation because such information is not necessarily directed at, or intended for, potential franchisees. The mere fact that those interested in purchasing a franchise can find such information in a newspaper or online does not make it a general media claim. However, where a franchisor utilizes financial performance information disseminated, or intended to be disseminated, to the public generally in its franchise promotional materials (e.g., in a brochure or franchisee section of a website), and includes in its franchise promotional materials a reference to general financial information on its website, or otherwise repeats the general financial information to lure potential franchisees (such as in a face-to-face meeting with an audience of prospective purchasers), such information will be deemed general media financial performance representations.

What about Statements in SEC filings – Do They Constitute General Media Representations?

Publicly filed financial performance information submitted to the Securities and Exchange Commission (e.g., 10-Qs and 10-Ks) are not considered general media representations. In enforcing the amended Rule, the Commission adheres to its historical policy of excluding from general media representations any communications to financial journals or the trade press undertaken in connection with bona fide news stories. Financial performance information provided directly to lenders in connection with arranging financing for prospective franchisees also does not constitute a general media representation.

Specific Requirements Applicable to General Media Claims

Financial performance representations made in the general media are subject to the requirements that apply to all financial performance representations, i.e., that they be truthful and reasonable backed by substantiating written information the franchisor possesses when the representations are made. In addition, general media financial performance representations must state:

  • the number and percentage of outlets from which supporting data for the representation were gathered that actually attained or surpassed the represented level of financial performance;
  • the time period when the performance results were achieved; and
  • a clear and conspicuous admonition that a new franchisee’s results may differ from the represented performance.

Relationship Between General Media Financial Performance Representations and Item 19 Disclosures

The amended Rule requires that a franchise seller making a financial performance representation in the general media ensure that a full disclosure of the financial performance representation – including the material bases and assumptions – appears in Item 19 of the franchisor’s disclosure document. A franchisor running an advertisement containing financial performance information at the very least must furnish any prospective franchisees with the required Item 19 disclosures while the advertisement is running. If a franchisor stops running the advertisement and makes no additional financial performance representations in the general media, it nonetheless must continue to disclose information required by Item 19 for a reasonable period of time thereafter. A reasonable period of time is not less than six months.

If a franchisor replaces one advertisement containing a financial performance representation with a new one containing updated financial information, the amended Rule requires that the updated information – not the information used in the initial version of the advertisement – be included in the franchisor’s Item 19 disclosures. Updated information is clearly more material to a prospective franchisee than older, perhaps stale, and possibly misleading information. Finally, where a franchisor runs multiple advertisements containing different types of financial performance claims, the franchisor must disclose and provide information for each type of claim in Item 19 of its disclosure document.

This article is part of a series of articles on starting a franchise in Minnesota.
CREDIT: The content of this post has been copied or adopted from the Federal Trade Commission’s Franchise Rule Compliance Guide.