The State of the States Report: Five Common FDD Mistakes, Part II

In our July column we identified five common mistakes franchisors make in their franchise development activities. These mistakes were discussed by state regulators as part of the IFA 2009 Legal Symposium's "Ask the Regulators" session. This column identifies a second group of five mistakes, each addressing specific FDD disclosure requirements. Our objective here is to identify issues or best practices that will enable franchisors to more effectively address state registration/disclosure matters in connection with their franchise development efforts.

1) Properly disclose "exclusivity" protection in Item 12. Many states are insisting that the franchisor specifically reference in Item 12 whether the franchisor grants the franchisee an exclusive territory. Franchisors will receive a comment letter from several states unless the term "exclusive" is specifically included in accordance with the Item 12 instructions. For example, if the franchisor does not grant the franchisee an exclusive territory, Item 12 requires the following disclosure: "You will not receive an exclusive territory. You may face competition from other franchisees, from other outlets that we own, or from other channels of distribution or competitive brands that we control."

The issue is that many franchisors prefer to not use the term "exclusive" when defining territorial rights, because when franchisees hear or read the term "exclusive" (regardless of the precise language used in the franchise agreement) they believe that franchisors selling products in their territory over the Internet or placing branded locations in sports stadiums or other captive market locations violate their exclusive rights. Rather than an "exclusive" territory, many franchisors will use terms like "protected" territory or "designated" territory and then further define what they mean with the use of those terms.

The bottom line for franchisors is to (i) adequately address in Item 12 the exclusive territory issue with specific reference to whether you grant an exclusive territory (that will satisfy the state examiner and meet your disclosure requirements); and (ii) clearly define what you mean by "exclusive" with specific reference to what rights the franchisee has regarding territory and brand protection, and also (absolutely do not miss this point) be very clear on what you and your affiliates may do now or in the future within and outside any franchisee's territory (even if the franchisee gets some form of "exclusivity"). Often, disputes ensue over territory issues simply because the FDD and franchise agreement were ambiguous in this area.

2) For Item 20 chart purposes, franchisees who have signed a franchise agreement but not yet opened are "franchisees," and then are "former franchisees" if they never open outlets. Some franchisors have franchisees at the outset sign multiple franchise agreements for future development and then, as a way to show significant growth in a short time, tout in their franchise sales materials how many franchises have been sold. Some of these franchisors, however, balk at including these franchisees in their Item 20 charts as terminated franchisees if the locations never open. This type of practice can be misleading to a prospective franchisee, and one of the clear purposes of the amended FTC Rule's Item 20 requirements is to clean up any misleading aspects of the Item 20 charts.

The FTC has issued a Frequently Asked Question (FAQ) on this point. Specifically, FAQ #19 requires a franchisee who has signed an agreement but not yet opened to be considered a current franchisee for the Item 20 charts, even if they do not yet have an open location/address. The NASAA Commentary on the 2008 Franchise Registration and Disclosure Guidelines states that these franchisees should be included only in Table 5 and the contact list of franchisees required by Item 20. Similarly, a former franchisee who never opened must be included in Item 20 as a former franchisee. (All FAQs are available at www.ftc.gov/bcp/franchise/amended-rule-faqs.shtml).

3) Make complete Item 11 disclosures regarding ad/marketing funds. Although perhaps a minor point, but still one that will draw a comment from state examiners, a franchisor must disclose (i) whether any ad/marketing fund is audited and when it is audited; and (ii) regardless of whether the fund is audited, whether the fund's financial statements are available for review. State examiners have noted that many franchisors will skip the "timing of the audit" disclosure or the availability disclosure noted in (ii) if the fund's statements are not audited.

4) Fully comply with the Item 21 financial statement requirements and be prepared for financial assurance conditions. Two points are worth noting regarding financial statements and the FDD Item 21 requirements. First, some franchisors have received qualified opinions on their audited financial statements because the statements do not comply with FIN 46R. (Don't worry franchise development folks, just ask your CFO or auditor about FIN 46R.) The issue is that financial statements with that qualification do not comply with U.S. GAAP, and states will deny registration. Registration denial is a significant issue. So, development folks, even if you do not understand FIN 46R, make sure the company is addressing this potential concern.

The second point is the increased scrutiny state examiners are applying to audited financial statements, and the state requirement that the franchisor comply with financial assurance requirements as a condition to registration. For example, if a franchisor has a negative net worth or negative working capital based on its most recent audited financial statements, many states will require the franchisor to (i) escrow initial fees; (ii) defer payment of those initial fees until opening; or (iii) obtain a surety bond to cover those fees. In some systems, that type of escrow or deferral can have a significant impact on the balance sheet and franchisor's cash flow, so franchisors must understand this requirement. One approach on this point is to determine if something can be done before fiscal year-end so the audited financial statements are healthier.

5) Do not include any extraneous language in response to FDD disclosure requirements. In one of the more potentially puzzling observations, the examiners noted that franchisors cannot include any extraneous language in response to the FDD disclosure requirements. This rule make complete sense to the extent a franchisor includes (i) extraneous "fluff" language in Item 2 regarding all the fabulous awards its CEO has received over the years; (ii) an explanation of the franchisor expenses covered by the initial franchise fee; or (iii) a description of ongoing support it may provide the franchisee even though it has no contractual obligation to do so.

What is troubling, however, is the apparent inflexibility in applying this standard. For example, Item 7 requires the "additional funds" disclosure for required expenses the franchisee will incur before operations begin and during the initial period of operations. Most franchisors typically include a period of three months for this disclosure.

Far too many franchisees assume that "additional funds" amount is a working capital amount, and all they will need before the business starts to cash flow. As a result, these franchisees can be undercapitalized and struggle from the very beginning. Recognizing that potential issue, some franchisors may elect to disclose that franchisees will need more than three months of additional funds for working capital. It is tough to argue against that type of disclosure, as its purpose is to assist the franchisee candidate in their due diligence and decision-making process on a fairly important issue: the initial investment and appropriate funding for that investment. The problem is that state examiners will require franchisors to remove that disclosure based on the "extraneous language" principle.

If you do get that type of state examiner comment regarding something that is critical to the candidate's decision-making process, do not stop at simply deleting the disclosure based on the state examiner comment. Be sure to consider whether the disclosure is appropriate somewhere else. For example, the warning that you may need more than three months of additional funds for working capital might be appropriate for a franchise application or financial statement form you ask the candidate to complete.

This article is provided for general informational purposes only and should not be considered or construed as legal advice or opinion concerning any specific circumstances or facts. You are encouraged to consult with your own franchise lawyer regarding any specific issue, situation, or legal question you may have.