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FRANCHISE EARNINGS CLAIMS AN INTRODUCTION PART I

Written by: Peter Macrae Dillon

Article Overview: This article examines the topic of earnings claims contained within franchise disclose documents (offering circulars). It focuses on the particular problems of disclosing earnings information under Ontario law, but the content is of general application to most disclosure jurisdictions.

FRANCHISE EARNINGS CLAIMS AN INTRODUCTION PART I

A Primer on Franchise Earnings Information

The first question that most prospective franchisees will ask a franchisor is “how much money will I make?” Ontario (and, to lesser extent, Alberta) law makes responding to this question and the provision of historical financial information, earnings claims information or financial forecasts or projections extremely difficult -- if not impossible. In Part 1 of a 2 part article, Peter Macrae Dillon reviews the background to current Ontario and Alberta laws relating to the provision of franchise earnings information and identifies the gaping holes into which franchisors may be leaping, without guidance or assistance from the legislation. In the Part 2 of the article, Peter will discuss the advantages and disadvantages to including earnings information in a franchise disclosure document and how to prepare earnings information for inclusion in a disclosure document.
Disclosure of earnings information: an accident waiting to happen.

When I attend American Bar Association events, I’m always struck by how many litigators vs. corporate solicitors are present. Now I’m starting to understand why. Ontario’s franchise legislation -- especially in the area of earnings information -- is so severely flawed or otherwise devoid of guidance or assistance to those required to comply with the legislation, that non-compliance is likely to be the rule, not the exception. Non-compliance is likely to continue until enough of the people who signed disclosure documents have been found personally liable for damages to bring about either a change of behavior on the part of franchisors, or amendments to the legislation. To understand why I’m making these dire prognostications, a little bit of background is necessary.

What is Earnings Information?

Earnings information is a representation regarding franchise earnings capability made in connection with the sale of a franchise. I have chosen to refer to any and all financial information -- historical, projected or otherwise -- relating to a franchise as “earnings information”. American sources usually refer to this information as an “earnings claim”. I have chosen not to use the American term since, as a review of the definitions below will demonstrate, an earning claim is a specific, rather than a general, class of information. Under the former Alberta Act, earnings information was referred to as “estimated or projected franchise earnings”.
Since neither the Ontario nor the current Alberta Act nor Regulations contain any definitions whatsoever relating to this important subject, this paper looks to former Alberta legislation and current U.S. legislation for assistance. An amalgam of current Federal Trade Commission (“FTC”) and North American Securities Administrators Association (“NASAA”) definitions yields the following definition of earnings information: a representation or disclosure, whether oral, written or visual, by, or on behalf of, or at the direction of the franchisor, to: a prospective franchisee or in the media, that states, or from which one can easily ascertain, a specific level or range of actual or potential sales, costs, income or profit from franchised or nonfranchised units. Earnings information includes, but is not limited to, future oriented information that may take the form of a budget, forecast, projection, pro forma statement, or estimated costs or cash flows, or an historically-based earnings claim.

Statements like this would constitute earnings information that should be considered subject to the laws of Ontario and Alberta: “Earn a $10,000 profit”; “Earn enough money to buy a new Cadillac” (the statement suggests a specific level of income, sales or profits). “Sales puffery”, namely statements that do not suggest a specific level of potential sales, income, gross for net profit or cost data, would not constitute earnings information. Examples might be: “make big money”; “opportunity of a lifetime”; or “there’s money in them there hills”.

It is certainly worthwhile to set out the definition of various phrases associated with franchise earnings information, especially since there is considerable confusion about just what is meant by these terms -- and because neither Ontario nor Alberta’s Acts nor Regulations contains these definitions:

Forecast A forecast is defined in the CICA Accounting Recommendations handbook (the “Handbook”) as future oriented earnings information prepared using assumptions, all of which reflect the entity’s planned courses of action for the period covered given management’s judgment as to the most probable set of economic conditions.

Projection A projection in the Handbook as future oriented earnings information prepared using assumptions that reflect the entity’s planned courses of action for the period covered given management’s judgment as to the most probable set of economic conditions, together with one or more hypotheses, that are assumptions which are consistent with the purpose of the information, but are not necessarily the most probable in management’s judgment.

Earnings claim An earnings claim is defined in the Handbook as information prepared with reference to actual results of franchised or company units, which may refer to a summary or average number of operating units past performance or some other historical basis. Note that, in common parlance, “earnings claims” is the phrase generally applied to the entire class of “earnings information” or “estimated or projected franchise earnings”, of which earnings claims technically forms only a part.

General purpose The Handbook defines general purpose estimated or projected franchise earnings as forecasts, projections or earnings claims prepared for external users before a specific franchisee and franchise site have been determined.

Special purpose Special purpose estimated or projected franchise earnings are defined as forecasts, projections or earnings claims prepared for external users with whom the entity is negotiating or dealing directly. This refers to information circulated after a specific franchisee has been identified and negotiations are proceeding on a franchise sale for a particular location or area.

The Ontario Act and Regulations

There is currently no case law anywhere in Ontario on the subject of franchise earnings information. The regulations, which contain the restrictions regarding earnings information, were not, strictly speaking, part of the public deliberation that preceded the introduction of the legislation. The regulations were never circulated for public review or comment prior to their being brought into force. In Ontario, we have no means to apply for administrative rulings, nor is there any form of interpretive or administrative guide that accompanies the Act or regulations.
The disclosure obligations under the Act apply to franchise agreements entered into after January 31st, 2001, as well as the renewal or extension of franchise agreements entered into before that date (we recommend that no reliance ever be placed on the exemption contained in subsection 5(7) of the Act). The Act applies only to franchises located (partly or wholly) within Ontario (without reference to the residence of the franchisee). A disclosure document must be given to the prospective franchisee no less than 14 days before the earlier of: a. the signing of a franchise agreement or any other agreement relating to the franchise; and b. the payment of any consideration by or on behalf of the prospect relating to the franchise. A disclosure document may be given personally or by registered mail (note the absence of any allowance for delivery by courier; it is anticipated that this oversight will be corrected by way of regulatory amendment). A disclosure document must contain: a. all material facts, including those prescribed; b. financial statements (unless exempt); c. copies of all agreements relating to the franchise to be signed by the prospect; d. prescribed statements; e. prescribed information. All information in a disclosure document must be accurate, clear and concise.

If something “material” occurs between the time the disclosure document is given to a prospect, and the signing of any agreement relating to the franchise or payment of any money, then a written statement of the material change must be given to the prospect as soon as practicable after the change has occurred and before the prospect signs any agreement relating to the franchise or pays any money.

If the franchisor fails to provide a disclosure document or statement of material change within the proper time, or if the contents of the disclosure document do not meet the requirements of the Act, then the franchisee may rescind the agreement no later than 60 days after receiving the disclosure document. If the franchisor never delivers a disclosure document, then the franchisee may rescind the agreement at any time within two years after entering into the agreement. Rescission means that franchisee is to be made whole (refund all monies paid to the franchisor, repurchase inventory, supplies and equipment, and compensate for any losses).

If the franchisee suffers a loss because of a misrepresentation in the disclosure document or statement of material change, or as a result of the franchisor’s failure to comply with the disclosure requirements of the Act, then the franchisee can sue the franchisor, the franchisor’s agent, the franchisor’s broker, the franchisor’s associate, and every person who signed the disclosure document. Recall that a franchisee cannot waive any of the rights granted to him by the Act, and any attempt to do so is void.

Neither the Ontario Act nor its Regulations contain any definitions, guidelines or policies relative to earnings information. Reg. Sec. 6.2 states as follows: “If an estimate of annual operating costs for the franchise is provided, a statement specifying the basis for the estimate, the assumptions underlying the estimate and a location where information is available for inspection that substantiates the estimate.” Reg. Sec. 6.3 states as follows: “If an earnings projection for the franchise is provided, a statement specifying the reasonable basis for the estimate, the assumptions underlying the estimate and a location where information is available for inspection that substantiates the estimate.”

If you are in any way normal, you should be entirely confused by what you just read. The wording used is very different from anything else in Canada, the United States, or the World. There is no explanation as to what it means, and there’s no one to ask (worst still, lawyers and judges who don’t know anything about this area of law are about to get their hands on this). The best we can do is take a look at the state of the law elsewhere, and come back and speculate as to what is meant by the Ontario regulations.

The Current Alberta Act and Regulations

As of now, there is no case law on the subject of earnings information in Alberta. There is no means to apply for administrative rulings, nor is there any form of interpretive or administrative guide that accompanies the Act or regulations. Alberta used to be an active member of NASAA’s franchise division. As a result, its new Act closely reflects NASAA-approved earnings information wording—but without NASAA’s definitions, guidelines policies and policies.

Alberta Reg. Sch. 1, Sec. 16 states as follows: “If information is given or is to be given, by or on behalf of the franchisor or its associate, to a prospective franchisee from which a specific level or range of actual or potential sales, costs, income or profit from franchisee outlets or franchisor outlets can be easily ascertained, the information must: a) have a reasonable basis at the time it is made; b) include the material assumptions underlying its preparation and presentation, whether it is based on actual results of existing outlets and the percentage of outlets that meet or exceed each range of results, and c) indicate the place where substantiating information is available for inspection by the franchisee. If information is given in respect of franchisor outlets, the franchisor must state that the information may differ in respect of a franchise outlet.”

This definition is the same as the one used by NASAA for preparation of a Uniform Franchise Offering Circular (“UFOC”, being the form of franchise disclosure document accepted in all 15 U.S. registration states and approved for use elsewhere in the United States by the FTC). It appears that Alberta will permit the giving of earnings information to prospective franchisees as part of or separately from the franchisor’s Alberta disclosure document, before, at the same time or subsequent to the giving of the disclosure document, and the information may be historical earnings information of the specific site, an earnings claim of the system generally, or projected or forecast earnings of the system or of a specific site, provided that the requirements of section 16 of the Regulation are met. This conclusion is based on the following: there is no statement requiring the earnings information form part of the disclosure document (in fact, section 16 clearly envisages the provision of earnings information under separate cover through use of the words “or is to be given”); there is no requirement under the Alberta Act, as there is in Ontario, that the disclosure document “... be one document, delivered... as one document at one time.”; and, the Alberta Act requires only that “a disclosure document must comply with the requirements of the regulations”, while Ontario requires that a “disclosure document shall contain all material facts, including material facts as prescribed” (i.e. a form of mandated all-inclusiveness).

Former Alberta Policy 4.3

When Alberta became the first jurisdiction in Canada to introduce franchise legislation in 1971, it followed the pattern established by California and most other U.S. jurisdictions; namely, it adopted securities-type legislation with prospective-type disclosure. The Alberta Securities Commission administered the Act. As a long-standing member of NASAA, Alberta has always endeavored to adhere to the letter and spirit of NASAA policy and practice, including allowing use of a disclosure document prepared in accordance with the UFOC guidelines to be used in Alberta. Ontario’s law not only omits any express right to do so: it also creates structural impediments to use of a UFOC, despite the fact that Ontario too is a member of NASAA. The ASC did what securities commissions do: they created policies. In particular, the ASC promulgated Policy 4.3 in 1990 on the subject of Estimated or Projected Franchise Earnings. Although with the proclamation of Alberta’s new franchise law in 1995 the Policy no longer has any force or effect, it still constitutes the only legislative or administrative guidance in Canada on the subject, and I therefore set out substantial portions of the Policy below.

Definitions: the Policy contained definitions of key phrases referred to above (which definitions are taken from the CICA Handbook) such as “Forecast”, “Projection”, “Earnings claim”, “General Purpose” and “Special purpose”.

Option: the Policy provided franchisors with the (clear) option to use or not to use estimated or projected earnings in connection with the offer of a franchise
Negative statement: if no estimated or projected earnings were made, the offering document had to contain the following language: “[Name of franchisor] does not furnish or authorize its salespersons to furnish any oral or written information concerning the actual or potential sales, costs, income or profits of [name of franchise system]. Actual results vary from unit to unit and [Franchisor’s name] cannot estimate the results of a particular franchisee.

Use of general purpose estimated or projected earnings: if general purpose estimated or projected earnings were made in connection with the offer of a franchise, they must be included in full in the offering document, and contain all disclosures required by the policy
Use of special purpose estimated or projected earnings: special purpose projected or estimated earnings could be used only when the following conditions had been met:

• General purpose estimated or projected earnings information had been included in the offering document

• prescribed wording accompanied the special purpose information

• Prescribed wording regarding the franchisor’s intention to distribute special purpose information was included in the offering document, and

• An amendment to the offering document was filed with the ASC for each franchise sale in which special purpose earnings information was provided

Advertising: Advertising of earnings information was restricted to information contained in the offering document prepared in accordance with Policy 4.3.

Conclusions Regarding Ontario

So how does one comply with the Ontario Act and Regulations? First, how do we deal with one of the most frequent issues faced by franchisors; namely, how to provide a prospect with historical earnings data for an identified location? The answer in the U.S. is clear: earnings information limited solely to the actual operating results of a specific unit being offered for sale need not comply with UFOC Item 19 if it is given only to potential purchasers of that unit and is accompanied by the name and last known address of each owner of the unit during the prior three years. I also concluded that the wording of Alberta Reg. Sch. 1, Sec. 16 permits site-specific historical earnings information to be provided separate and apart from the main disclosure document (provided the content and format of the information otherwise comply with the requirements of that section). In Ontario, however, no such express exemption exists.

Furthermore, we have the express requirements of section 5(3) that “a disclosure document must be one document, delivered... as one document at one time” and of section 5(4) that the disclosure document must contain all prescribed material facts and “other information and copies of documents as prescribed”, both of which expressly prohibit the provision of information separate and apart from the disclosure document itself. Some franchisors are taking to the position that site-specific historical earnings data qualifies as information that can be provided to a prospect pursuant to section 5(5) of the Act. This approach is suspect, since the definition of “material change” contained in section 1 anticipates only changes in the franchisor or the franchise system, which changes would have an adverse effect on the price of the franchise or the decision to acquire the franchise. Since historical earnings data does not constitute new information, does not relate to the franchisor, and may not be adverse, it simply may not fit under this category of disclosure. It appears that the only certain manner to provide historical earnings data to a franchise prospect is to incorporate it into the disclosure document provided to the prospect in accordance with section 5 of the Act and subject to the content and format requirements of section 6.2 and/or section 6.3 of the Regulations. Clearly, this is not a practical alternative for most franchisors and the legislation should be amended to permit subsequent disclosure of this site-specific historical earnings data along the lines permitted under UFOC Item 19. Sections 6.2 and 6.3 of the Ontario Regulations are themselves an enigma. Why the traditional (i.e. UFOC and Alberta) definition of estimated or projected franchise earnings was broken into two sections is the first puzzle. The second puzzle is why several portions of the traditional definition were omitted. Section 6.2 deals only with annual operating costs, while section 6.3 deals only with earnings projections. Projections mentioned, but forecasts (so clearly dealt with in the CICA Handbook and Alberta Policy 4.3) are not. Annual operating costs are mentioned, but income and profits are not. Projections are included, but “actuals” are not. The sections are so badly worded that the best advice may be to simply ignore them. The recommended format and procedure for the preparation of earnings information disclosure set out in Part 2 of this paper relies exclusively on the well proven Alberta and UFOC formats, for which we have not only a body of U.S. case law, but existing U.S. guidelines and interpretations, and previous Alberta regulations that I suggest provide considerable and worthwhile guidance on the subject.

This paper has demonstrated some of the considerable shortcomings of the current Ontario Act and Regulations as they relate to the disclosure of franchise earnings information. Franchisors and their counsel should anticipate that the absence of a legislated definition will likely result in the widest possible definition of what constitutes earnings information being arrived at by the courts. Judicial scrutinizing of franchisors’ advertising and media content should also be anticipated. Many future claims for rescission or damages will likely be based on alleged noncompliance with the earnings information requirements. In the matter of earnings information, 9/10ths of the danger lies submerged underwater. What might appear superficially straightforward is sublimely metaphysical. These are the halcyon days of litigators.

More information. For more information on franchising in Canada, the United States and internationally, please contact Peter Macrae Dillon, head of Siskinds Franchise Law Group. Peter is the author of the annotated Ontario Franchise Disclosure Act and the annotated Alberta Franchises Act and over 30 other publications on the subjects of franchising, licensing and distribution. He is licensed in Ontario and New York. Peter can be contacted at 800-816-9596 ext. 389 or by email at peter.dillon@siskinds.com. The information contained in this note is for general reference only, and should not be relied upon as constituting legal advice.

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