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Deadline Nears for NASAA’s ‘Reasonable Basis’ Rule in Giving FDD Earnings Claims

Under the Federal Trade Commission Franchise Rule and applicable state franchise laws, franchisors are prohibited from making a financial performance representation, formerly known as an earnings claim, in their franchise disclosure documents (FDD) unless they have a "reasonable basis" for the representation at the time it is made.

Now, with the adoption of the "Supplemental Commentary" issued by the North American Securities Administrators Association (NASAA) on May 8, 2017, regarding financial performance representations (FPR) in disclosure documents, "the effective date is the later of 180 days after the date of adoption by NASAA or 120 days after a franchisor's next fiscal year end, if the franchisor has an effective franchise disclosure document as of the date of adoption by NASAA," according to the official Commentary.

A Franchise Law Alert from Lewis Brisbois firm in Los Angeles affirms that the general rule is that FPRs must have a "reasonable basis" for making a financial performance representation at the time it is made. "The [NASAA] Commentary, as supplemented, is instructive as to what constitutes a 'reasonable basis' under various FPR situations. Notably, the Commentary will now require franchisors to present both 'medians' and 'averages,' as defined in the Commentary, when using either 'median' or 'average' in FPRs and to disclose the highest and lowest amounts in the 'median' and 'averages' to avoid presenting potentially misleading information."

The legal bulletin further explains that the Commentary addresses how to present company and affiliate-owned outlet financial information when the franchise system at issue also has franchisee-owned outlets. "In addition, the Commentary clarifies the proper use of forecasts and projections and outlines the prohibitions against including disclaimers and waivers when making FPR's, especially in relation to the 'Clear and Conspicuous Admonition.'

Attorneys Taylor Vernon and Leo A. Bautista said the NASAA Commentary is not the actual FPR compliance instructions, but it provides useful guidance to ensure compliance with the FPR requirements in the franchise disclosure document. They say, "State franchise regulators will begin using the Commentary when evaluating franchise renewals and registration, so it is advisable for franchisors to review their current FDD financial performance representations and have them vetted by their franchise counsel.

Franchise expert Rob Bond, who at one time published "How Much Can I Make?", a manual that compiled earnings claims presented by franchisors in their franchise disclosure documents, expresses the importance of FPRs in Item 19 of the franchise disclosure documents. In the preface of his book he states to potential buyers, "Your cheapest form of insurance is the time you put in investigating a business before you invest. Take full advantage of the tools available to you."

Bond feels all franchisors should be required to give prospects the financial information they need in determining what they can make when buying a franchise, at least after a franchise company has been in the business of franchising for two or three years. In a past interview Bond stated that "franchisors know what earnings franchisees make—after all, franchisees must pay royalties based on their sales performance." Bond said franchisors are also likely to know franchisees' average profits. Today, he sees about sixty percent of franchisors giving FPRs in franchise disclosure documents.

At last year's October ABA Forum on Franchising, Dale Cantone, Maryland Attorney General's Office and head of NASAA, presented with franchisee attorney Eric Karp and Gray Plant Mooty attorney Max Schott, II, the advanced drafting of the "FPR, A Reasonable Basis." They stated that at least half of franchisors now include FPRs in Item 19 of the FDDs, a significant rise over the past five years. They believe that competitive forces and a concern about the disclosure of unauthorized FPRs has led to the increase of FPRs. The presenters said although Item 19 does not dictate a form FPR and allows franchisors and their counsel the flexibility in crafting an FPR, one that fits the franchisor's business, the franchisor must have a "reasonable basis" and "written substantiation" for an FPR at the time it is made. The purpose of their ABA Forum paper was to help franchisor attorneys to draft FPRs that comply with federal and state law, including the NASAA's Commentary.

In conclusion, Cantone and his presenters stated that "the evolving regulatory guidance and case law surrounding FPRs can be boiled down to a continuing search for the still somewhat elusive definition of what constitutes a "reasonable basis." They leave attendees with this thought: "It is our hope and expectation that when issued, the final version of the FPR Commentary, will provide needed clarity and guidance for the benefit of those practitioners who draft FDDs, some safe harbors for the franchisors that they represent, additional valuable information to prospective franchisees to help them make a more knowing and intelligent decision about whether to invest, and a roadmap to those that represent prospective franchisees, and to those that evaluate potential claims on behalf of franchisees, to what is or is not proper in the preparation and presentation of an FPR."

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