A Step in the Right Direction: NASAA Releases New Item 19 Commentary
Last week, the North American Securities Administrators Association (“NASAA”) published a notice of request for public commentary regarding financial performance representations, or “FPRs”, that a franchisor discloses in Item 19 of its FDD. The commentary aims to create a set of guidelines that will control how franchisors are permitted to disclose financial results in its Item 19, by prohibiting certain types of FPRs and requiring additional support or information in conjunction with specific types of disclosures. Overall, NASAA wants to create additional rules for Item 19 that will restrict a franchisor’s ability to determine how it presents financial data in its FDD.
The importance of this notice should not be understated, as the final adopted version will be implemented by the franchise registration states. Franchisors that fail to comply will not only struggle to register their FDD in the tougher states, but will also expose themselves to potential across-the-board liability for selling a franchise with a non-compliant Item 19.
NASAA first published a request for public commentary in October 2015, and received 13 responses, including one from Fisher Zucker. In light of the comments received from Fisher Zucker and other concerned members of the franchise community, it appears that NASAA has revised its 2015 guidelines and is now soliciting another round of comments before finalizing its official position. We applaud this measured approach, in light of the issues we raised in response to NASAA’s first draft, as well as the significant effects that the final version will have on the franchise disclosure and sales process.
The substance of the Item 19 commentary remains largely similar to the 2015 version. The NASAA commentary includes general information about defining certain types of metrics (e.g., gross sales and net profits), as well as the use of averages and medians, future projections, and disclaimers in Item 19. However, the most controversial sections remain NASAA’s position regarding the use of (1) company-owned outlets, and (2) subsets of outlets.
Overall, NASAA’s proposed guidelines have improved from the 2015 version, including the specific adoption of two recommendations submitted by Fisher Zucker. Both of these two changes minimize the harm to new franchisors that was a major problem with the 2015 version.
First, NASAA removed the prohibition against presenting gross profit/net profit FPRs of company-owned outlets if a franchisor does not have any operational franchise outlets. This puts new franchisors on a level playing field with developed franchisors, though it is important to note that any franchisor who wishes to discloseonly the gross profits or net profits of company-owned outlets must still include a supplemental disclosure the reflect the material differences between company-owned and franchised locations.
Second, NASAA clarified that, while franchisors with fewer than 10 outlets are prohibited from presenting a subset of those outlets, franchisors with more than 10 outlets may disclose a subset of less than 10 outlets in Item 19. This prevents a distorted reading of the NASAA commentary, and justifiably permits franchisors to highlight a smaller subset of outlets that may share a particular characteristic (e.g., outlets in a certain geographic area, or all drive-thru locations) that is material to prospective franchisees.
While the 2016 draft represents movement in the right direction, the NASAA commentary still contains restrictions that will limit franchisors’ ability to provide crucial financial performance information, which is often the most important data that a franchisee needs to evaluate a potential franchise. Franchisors showing company-owned data to illustrate gross profit or net profit must still adjust their disclosures to incorporate “reasonably expected” differences between company-owned and franchised locations, which requires franchisors to undertake the significant risk of making a speculative future projection. Additionally, franchisors with fewer than 10 outlets are prohibited from presenting data from a subset of those outlets, which harms new franchisors that may have a legitimate reason to only show a certain number of their existing locations.
Public responses are due by October 13, 2016, and Fisher Zucker plans to once again submit our comments in hopes of generating further positive change.
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