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"Stating
Your Claim"
by Gerald A. Cook, Esq.
The franchise
offering circular can be a franchisor's best friend or worst enemy.
Carefully considered and well-written statements in the circular
can help close franchise sales now and prevent costly litigation
later.
A franchise
offering circular is the basic disclosure document required as
part of offering franchises for sale. The Federal Trade Commission
Trade Regulation Rule on Franchising (the "FTC Rule")
requires that an offering circular be presented to every prospective
franchisee. The FTC Rule of course applies in all 50 states. Several
states known as "registration states" require in addition,
that the circular be pre-approved before a franchisor is permitted
to offer franchises in the state. A number of additional states
require a certification that the franchisor uses a circular that
complies with the FTC Rule before franchises can be offered in
those states.
The twenty-three "items" of required disclosure in the
offering circular range from the boilerplate to the tedious to
hidden opportunities to augment the sale of franchises. One of
the most interesting items and one that needs to be carefully
crafted is Item 19, the "earnings claim." A properly
crafted earnings claim can help franchise sales. A poorly presented
earnings claim can be lethal in any litigation.
A franchise candidate often asks the question, "How much
money can I make in this business?" The answer that can be
given legally is completely dependent on how Item 19 of the offering
circular is designed.
Unless a written
statement of the operational results of the business known as
the "earnings claim" is included in the offering circular,
federal law prohibits any meaningful response to this question.
On the other hand, the FTC Rule permits the franchisor to make
a "claim" about the earnings of the business units.
If an earnings claim is made, the FTC Rule affords franchisors
great flexibility in the type of earnings claim they may wish
to make. There is no specific format; there are only general guidelines.
One option
that is always available to the franchisor is to make no claim
at all. If no earnings claim is made, the FTC Rule requires a
"negative disclosure." The negative disclosure consists
of standardized language that clearly alerts the prospect that
the franchisor is making no representations whatsoever about the
performance of the business being considered. Therefore, if the
franchisor has chosen to make no earnings claim in Item 19, the
proper answer to the prospect's question will necessarily be the
equivalent of "No comment." This is so because any advertising
and representations about the performance of the business made
to a prospective franchisee must be consistent with the statements
in Item 19. Because there is no claim stated, the no comment answer
also extends to the performance of any company-operated units
the franchisor may have. There is an exception to this rule where
the prospect is interested in buying an existing unit. However,
this exception will of course not be available in the more typical
situation where the prospect is interested in developing a new
location.
Usually, the
only alternative in this situation is to refer the prospect to
other franchisees in the system. Of course, this leaves the ultimate
answer to the question to happenstance. In addition, a new franchisor
may not have this alternative available. Many offering circulars
use the "no claim" alternative. While it can be said
that making no claim may be the safest and easiest legal alternative,
in many cases it may not be the best business alternative. Making
no claim may be particularly inappropriate for new franchisors
who usually have a proven history of operating their own very
successful business model.
The FTC Rule
broadly defines an "earnings claim" as any information
given to a prospective franchisee or information given for general
dissemination from which a specific level or range of potential
or actual sales, costs, income and profits from franchised or
nonfranchised units may be easily ascertained.
Under this
definition, if the salesman answers, "You can make good money,"
he has not made an earnings claim. However, if the salesman truthfully
answers, "I think you can recoup your investment in six months,"
he has made an earnings claim. This answer is an earnings claim
for many reasons. If for no other reason, Item 7 of the offering
circular will inform the prospect of the range of the amount of
the initial investment required. Therefore, the statement clearly
implies a specific profit to be made after six months of operation,
a profit number or range the prospect can easily ascertain. If
the franchisor has chosen to make no earnings claim in Item 19
of the offering circular, the answer is also a violation of federal
law.
Every business closely monitors sales, profits, gross margins
and other indicia of performance. With the advent of POS systems,
many franchisors are now in a position where they can monitor
most of those results for franchised units as well. Consequently,
there is usually much information available on which to base an
earnings claim. Since the FTC Rule about stating an earnings claim
is flexible, the claim can be made from any one of a number of
viewpoints. It can even be as simple as gross sales.
However, responsibility
for the accuracy and reasonable basis of the claim lies with the
franchisor. The franchisor is in the best position to know the
financial performance of the business, certainly at least of its
company operated units.
Therefore, if an earnings claim is made, it must be carefully
considered and clearly state the factual basis and material assumptions
for the claim. In addition, the general rule requires that the
company must have a reasonable basis for making the claim at the
time it is made. The data used to construct the claim must be
reliable. This does not mean that the data must necessarily be
audited. However, the statement of the earnings claim must clearly
inform the prospective franchisee about the source of the data
used. This data must be made available to the prospective franchisee
upon request.
The earnings
claim must also clearly state all the material assumptions underlying
the claim. What these material assumptions may be will be specific
to any particular business and situation.
The FTC Rule
also requires a conspicuous disclaimer to the effect that financial
results for the new franchise units are likely to vary from the
claim. However, using the required disclaimer is not a panacea
if there are material errors or omissions in the factual basis
or assumptions of the statement. There is no boilerplate language
that will work in all circumstances to prevent a poorly-worded
or poorly-considered claim from being misleading.
Let's take
an example. A company operates a chain of twenty stores and would
like to expand through franchising. Four of these stores generated
profits in excess of $500,000 in the last fiscal year. Twelve
of these stores generated profits between $50,000 and $120,000
in the last fiscal year. Four of these stores were in poor locations
and lost money. Those four stores were closed during the last
year. The company would like to tell prospective franchisees that
the average company operated store made a profit of $190,000.
This statement is true if we disregard the four unprofitable stores
that were closed. Therefore, the statement is true for all stores
open and operating at the close of the last fiscal year. However,
if we include the closed stores, the average profit made was $146,000.
If we disregard the four "homerun" stores and the stores
that were closed, the average company store made a profit of $74,000.
Assuming the data is accurate, does the franchisor here have a
reasonable basis to claim that its average store generated profits
of $190,000 last year? Or, is the reasonable claim $146,000? Or,
should the claim be that the average store made a profit of $74,000?
If the best claim can be legally made, the franchise salesman
can now answer a prospect as follows: "I can't predict how
you would do with your store, but our average company store made
$190,000 last year."
Any of these
"claims" may be acceptable depending upon how the statement
of the earning claim is drafted and presented. Even the $190,000
claim may work. It depends on how accurately and clearly the information
in the earnings claim describes the factual basis and assumptions
behind the presentation.
If this hypothetical disclosure is not crafted carefully and correctly,
the earnings claim can be a potential liability. However, if the
claim is made correctly in Item 19, it becomes a useful tool to
answer the inevitable question by the prospective franchisee.
The answer may also now very well include the information the
prospect needs to decide to invest in the franchise.
Gerald
A. Cook is Of Counsel to the law firm of DKW Law Group, PC. His
practice includes representing franchise owners and other business
owners in complex business and commercial matters, including franchising,
distribution and licensing transactions. Mr. Cook received his
B.A. from Temple University and his J.D. from the University of
Pittsburgh School of Law.
DKW Law
Group tailors its legal services to meet the needs of its middle
market clients. Through the firm's ancillary services groups -
DKW Capital Markets, Renaissance Partners, FiCap Strategic Partners,
DKW Value Recovery and Concord Health Partners - clients also
receive the investment banking, turnaround management and business
consulting services they need to position their businesses for
the future.
Copyright
2002 by DKW Law Group, PC. All rights reserved.
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