COVID 19 undoubtedly impacted your business. Franchise systems in a wide array of industries experienced temporary closures, forced innovation in the delivery of goods and services, and altered unit economics. Some of these changes may qualify as “material” changed under state and federal law and will need to be accounted for in an amendment to the 2020 FDD. The federal and state requirements are outlined below and will help you to determine if and when you need to amend your FDD because of COVID-19.
If a “material” change has occurred within a fiscal quarter, then within a reasonable time after the close of that quarter, the FDD should be amended. The FTC’s primary guidance for determining materiality is considering the prospective franchisee’s perspective and what would likely impact his or her investment decision. Significant changes to the features of your system that continue beyond May 2020, like alterations to supplier relationships, goods and services offered, or the number of open outlets, may be material. If a material change occurred in the second quarter ending June 30, 2020, an amendment should be prepared and filed by the end of July 2020.
Most states that require registration of the FDD generally require the franchisor to amend more frequently than quarterly. These states are California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, Virginia, Washington, and Wisconsin. If you determine that the change is material, you should immediately contact an attorney so that the amendment can be filed promptly.
Some state law definitions of materiality track the federal definition and focus on what would likely influence a reasonable prospective franchisee in deciding whether to purchase the franchise. Other states provide specific examples of events that constitute a material change. These are a helpful guide to determining what is a material change under both federal and state law:
- The permanent closing or termination of more than 2 franchisees in a state in a 3-month period
- The permanent closing or termination of more than 5% of your total franchisees in a 3-month period
- The transfer of ownership of more than 5% of your franchisees in a 3-month period
- Change in ownership of the franchisor
- A significant addition of a product or service that franchisees offer
- Changes to the initial franchise fee or royalty fees
- Significant changes to management personnel of the franchisor
- Certain kinds of new litigation
- A decrease in the franchisor’s net income or net worth of more than 5% in a six-month period
- Significant changes to the items that franchisees purchase from the franchisor
- Changes to the franchise agreement or other agreements disclosed in the FDD
The examples from this list that are most relevant in the COVID-19 pandemic environment are franchisee ownership changes, franchisee closures, franchisor net income and net worth, and the goods and services offered by franchisees. Franchisors should review their outlets and system carefully to determine if changes made during the peak of business closures will linger through 2020.
These examples, of course, are not exhaustive. Any change that gives a franchisor pause should be reviewed carefully to see if they fit the legal definition of “material.”
Item 19 of the FDD contains your financial performance representations (“FPR”). If the franchisor no longer has a “reasonable basis” and “written substantiation” for the FPR, the FPR cannot be disclosed and the franchisor must make an update to reflect the material changes. Many franchisors disclosed financial data from a historical period before March 2020 and the impact of COVID-19. However, since FPRs using historical data are still used by prospective franchisees to draw inferences about their possible performance, material changes must be represented in an amendment.
The North American Securities Administrators Association (NASAA) released guidance on June 10, 2020 that referenced two scenarios that require an updated Item 19:
- Outlets disclosed in the FPR have experienced material changes in financial performance
- Non-temporary alterations to the business model to adapt to customers’ needs in a post-pandemic world
The first scenario is very significant because it applies broadly to many
franchise systems that experienced closures and reductions in gross sales in the second quarter of 2020. This is a departure from the commentaries by some state regulators and the consensus of the legal community during the first months of the pandemic.
Nevertheless, the changes in your franchise system due to COVID-19 need to be evaluated on a case-by-case basis. The team at Manning Fulton & Skinner can help you determine what changes are material and how to amend to account for the impact of COVID-19.