You’ve probably heard the phrase, “COVID ruined everything” more than once. And unfortunately, we’re here to tell you the same likely applies for Item 19 financial performance representations (FPRs).
Any operating results presented in Item 19 must have a reasonable basis and cannot be misleading. If COVID has caused (1) a drop in revenue, (2) temporary or permanent store closures or (3) changes to the business model/operations, then presenting 2019 or earlier financial data may no longer have a reasonable basis and might be misleading. This means the FPR will most likely be rejected by franchise state examiners and may result in franchisee litigation in the future.
Drop in Revenue
Issue: If franchisees’ revenue during periods impacted by COVID is lower, it may be misleading to show only the results from operations when revenue wasn’t impacted by COVID.
Solution: Include operating results during period impacted by COVID. The registration states have universally approved including data that compares monthly revenues prior to 2020 to periods impacted by COVID. This data should cover time periods impacted by COVID and should include the same reporting group that is used for any data already presented. This disclosure allows prospective franchisees to make their own judgements about how the pandemic may impact operating results.
Temporary/Permanent Closures
Issue: If franchised businesses temporarily closed during the pandemic or went out of business, it may be misleading to show only the results from a period when franchised businesses were operating full-time or before they permanently closed.
Solution: Include closure data in the Item 19. In addition to including a year-over-year comparison (see above), the Item 19 should be updated with information on temporary and permanent closures. This information can be included in an introduction or footnote and should provide details on when franchised businesses closed and re-opened—or when they closed permanently—and the number of franchised businesses affected. Any financial data should include the operating results of the franchised businesses that temporarily or permanently closed (i.e. revenue would be reduced or equal to $0 for those franchised businesses).
Changes to Operations
Issue: If franchised businesses had a shift in their business model or operations (e.g. a dine-in only concept that begins offering delivery or adds drive-thru), it may be misleading to show only results from a period before operations changed.
Solution: Re-draft or remove Item 19. If changes to operations are significant enough, then there is likely no reasonable basis for including results prior to the pandemic (e.g. you can’t use operating results from franchised businesses that don’t operate a business that is “substantially similar” to the franchise being sold). If the changes are minor, then at a minimum these changes to operations should be described in the Item 19.
Cautionary Note for Using Different Item 19s
Keep in mind that if a franchisor revises or removes an FPR in one state, it’s risky to keep using the existing FPR in other states. The Federal Trade Commission suggests that any Item 19 changes made to comply with one state’s requirements must also be reflected in every other state (https://www.ftc.gov/tips-advice/business-center/guidance/amended-franchise-rule-faqs#38). For this reason, we generally recommend franchisors always use the same Item 19 in all states.
Be sure to see our blog on FPRs at https://drummlaw.com/blog/financial-performance-representation/.