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FRANCHISE EARNINGS CLAIMS – PART II

Written by: Peter Macrae Dillon

Article Overview: Franchise Earnings Information (Part 2) Part 1 of this article discussed how current Ontario and Alberta law makes it difficult to provide franchise prospects with information about how much they can expect to make in any given franchise. In Part 2 of this article, Peter Macrae Dillon discusses the advantages and disadvantages of including earnings information in a franchise disclosure document and how to prepare earnings information for inclusion in a disclosure document. Should we provide earnings information in our disclosure document?

FRANCHISE EARNINGS CLAIMS – PART II

Franchise Earnings Information (Part 2)

Part 1 of this article discussed how current Ontario and Alberta law makes it difficult to provide franchise prospects with information about how much they can expect to make in any given franchise. In Part 2 of this article, Peter Macrae Dillon discusses the advantages and disadvantages of including earnings information in a franchise disclosure document and how to prepare earnings information for inclusion in a disclosure document.
Should we provide earnings information in our disclosure document?

Recall from Part 1 of this article, that our working definition of “earnings information” is: 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. This working definition is adopted because of the absence of any workable definition within either the Alberta or Ontario Acts or Regulations concerning this very important subject. Note also that I prefer the expression earnings information to the more widely used earnings claim, since an earnings claim refers to a specific subcategory of earnings information; namely, historical information with respect to one or more franchised or company units. Recall also that a forecast is future oriented earnings information, and a projection is a forecast that contains one or more hypotheses. General purpose earnings information is general or system-wide in nature, whereas special purpose earnings information relates to a specific proposed site.

Background

One recent study in the U.S. suggested that only about 20 percent of franchisors currently provide earnings information in their US offering circulars. In only three industries, lodging, photo processing and printing, did a majority or close to a majority make such claims.
However, the experience of most people in the franchise industry in the U.S. suggests that a far higher percentage of franchisors and their salespeople actually make such statements or provide information to prospects that constitutes earnings information that is not prepared in accordance with federal or state law. That is, most U.S. franchisors are probably breaking the law.
Since the inception of its original Franchises Act in 1971, the provision of earnings information has been regulated in Alberta. As discussed in Part 1 of this article, Alberta’s Policy 4.3 provided detailed information on the format and content of earnings information being provided to franchise prospects in that province. Alberta also permitted a franchisor to provide special purpose (location-specific) earnings information if general-purpose information was included in the franchisor’s disclosure document. Virtually all of this regulatory framework was removed with Alberta’s new act in 1995, (including Policy 4.3). Alberta’s does continue to regulate the form and content of any such information being disclosed, and in a way that is closer to customary format of the North American Securities Administrators Association.

The situation in Ontario is, of course, very different. Until January 31, 2001, a franchisor could provide anything or nothing, without any restriction whatsoever other than the common law requirement that information not be fraudulent.

The post-January 1, 2001 requirement that earnings information -- if it is to be provided -- be given only in accordance with Ontario law, brings this issue front and center into the spotlight for Canadian franchisors. Ignoring this issue will certainly result in pain; the only question is how long will it take before you feel it.

Advantages of providing earnings information

The most commonly cited advantages of providing earnings information to prospective franchisees are the following:

• Prospects want information;

• Some prospects won’t buy without the information;

• Unscrupulous salespeople are given free rein to state whatever they want without franchisor-sanctioned information;

• Without franchisor-sanctioned earnings information, even good salespeople are forced to provide “cocktail napkin” earnings information in contravention of the law;

• Proper earnings information will assist a franchisor in containing a new franchisee’s expectations of performance;

• Providing general purpose earnings information in the offering circular allows a franchisor to provide special purpose earnings information to a specific franchisee (the status of this advantage is currently in doubt in Ontario and Alberta—see Part 1); and

• Properly worded warnings and disclaimers in franchisor-sanctioned earnings information may prove successful in avoiding liability to unsuccessful franchisees.

Disadvantages of providing earnings information

The most commonly cited disadvantages of providing earnings information to prospective franchisees are the following:

• preparation of earnings information is expensive and time-consuming;

• earnings information must be updated every year (or more frequently in the event of any material change);

• franchisees who do not match the performance touted in the earnings information will scrutinize the document and may pursue the franchisor for misrepresentation

• the franchisor may not have the necessary raw data upon which to make a reliable claim;

• use of earnings claims may invite people to imply other, unintended claims (projections or forecasts);

• the earnings information may create a negative picture of the franchise opportunity; and
• availability of this information to competitors.

Availability of data

A franchisor considering providing earnings information to prospective franchisees needs to consider whether it has the data available upon which to compile an earnings estimate. Some franchisors don’t have the contractual right to require franchisees to provide the necessary earnings and expense information. Even where earnings information is provided, it may be highly distorted by the tax, accounting and operational decisions of each individual franchisee, raising issues as to the reliability of the information.

If the franchisor has corporate locations, it will of course have access to all of the necessary data. If an earnings estimate is provided on the basis of corporate owned locations alone, that fact must be made abundantly clear, and assumptions as to how franchised performance would be expected to differ must be included.

Is the data misleading?

Earnings information is misleading if it does not present a true picture of what do the prospective franchisee can expect. For instance, data collected from a region in which the franchisor has strong brand recognition will have little application in a distant market in which the franchisor’s brand is unknown. Similarly, data collected from units operating in small towns and cities may have little application to locations in the GTA.
Preparation of earnings information

Upfront issues

A detailed review of the preparation of earnings information to be included in a disclosure document is beyond the scope of this paper. A franchisor will need to:

• decide what kind of information is to be provided (forecast/projection or earnings claim);

• carefully compile information (making assessments as to the reliability of the data, seeking additional data or verifying data where necessary);

• select a format for communicating the earnings information (probably the most technical aspect of the exercise); and

• include conspicuous cautionary language and disclaimers.

The standard for preparation of earnings information

Although with the proclamation of Alberta’s new franchise law in 1995 Alberta Policy 4.3 no longer has any force or effect, it still constitutes the only legislative or administrative guidance in Canada on the subject of earnings information, and I therefore set out substantial portions of the Policy below as they relate to the form and content of earnings information.

Forecasts and projections were to be prepared in accordance with CICA Accounting Recommendations, reviewed in accordance with CICA Audit Recommendations, and accompanied by an auditor’s report.
An earnings claims was to be prepared in accordance with the format set out in the Policy, and was required to disclose the following:

• Title: The basis on which the statement was prepared, and the source of the data was required to be clearly identified in a descriptive statement (example: “statement of actual operating results of the five most profitable franchised outlets”).

• Factual Basis: The factual basis or foundation of the statement was to be disclosed in detail. In most cases, this would consist of a combination of actual and estimated results.

Disclosure would include material assumptions and key factors upon which the claim was based as well as information as to the attainability of the earnings claim. This would include reference to the number of units currently attaining the results claimed and a warning that results of a specific franchise might vary from those claimed.

• Material assumptions: The statement was to disclose material assumptions as to economic or market conditions other than matters of common knowledge underlying the earnings claim. Market conditions would include a description of features of the proposed entity such as whether the entity is franchised or company-owned or operated, as well as features relating to location, capacity and period of operation.

• Key factors: The statement was to identify the key factors significant to the franchisee’s achieving the actual results disclosed. Key factors would include factors basic to the entity’s operation, such as sales, production, service and the financing activities, information as to capital, expenditure and location requirements, breakeven sales, and the sales compositions in terms of product mix and related profit margins.

• Substantiation: The statement was to indicate the percentage of outlets that have achieved or surpassed the results and the period covered by those results claimed in the statement. Where company-owned or operated outlets formed the basis for the statement, details of any adjustments necessary to make the claim relevant to franchised outlets was to be provided.

• Warning re: likelihood of attaining earnings claim: The statement was to provide a warning in a prescribed form as to the likelihood of the franchisee attaining the results contained in the earnings claim.

We don’t provide earnings information – what can we do?

After studying the current Ontario legislation and regulations, and reviewing them in the context of current and past Alberta and U.S. franchise laws on the subject, I have concluded that Ontario law does not permit the provision of general or specific earnings information by a franchisor other than as part of a disclosure document prepared in accordance with Ontario’s franchise disclosure law (see Part 1). That being the case, how does a franchisor who does not wish to provide earnings information as part of its disclosure document inform prospects as to the earnings potential of the business in which the prospect is about to invest?

Prepare an individualized disclosure document

Remember, all of the information recited above concerning definitions and rules does not currently exist in Ontario. For instance, in the United States and under the previous Alberta law, site specific information could be presented to an identified prospect only if general earnings information was contained in the disclosure document available to all prospects (and in most cases registered with the provincial or state regulatory body). As a result, there appears to be no reason why earnings information under either section 6.2 or 6.3 of the regulation could not be prepared for and inserted into a disclosure document (delivered as one document at one time) to a single prospect. This information could be non site-specific (prepared on the basis of system-wide results) or could be site-specific (either historical earnings data from an existing location, or a forecast or projection relative to an identified new location).

Refer prospects to existing franchises

In order to satisfy a prospect’s natural craving for earnings information, a franchisor may refer the prospect to existing franchises. Of course, the individual franchisee may or may not provide such information, and may or may not paint a positive picture of the system. Some care must be taken not to present a biased picture; for instance, by supplying only the names of the four most successful franchisees in the region, instead of a list of all eight franchisees in random order.

Use industry publications

Some industries publish trade journals containing information concerning sales, profits and costs of businesses in that industry (which may or may not include the franchisor). In the U.S., the Federal Trade Commission has taken the position that, if the franchisor provides the article—or even makes the prospect aware of its existence-- the article forms part of the franchisor’s disclosure and therefore must satisfy all of the enumerated requirements. No such guideline or restriction is evident in Ontario and how a court would handle this issue is anyone’s guess.

Provide discrete pieces of information

Individual pieces of information that do not, when taken together, constitute either an estimate of annual operating costs or a projection, may be provided to a prospect. Examples might include information about rental rates or hourly wages.

Provide information to a third party

In Alberta and the U.S., only information given to a prospective franchisee is regulated. Ontario – knowingly or unwittingly – has not included this provision, which has the potential to restrict the ability of a franchisor to provide earnings information to the prospect’s bank or lender. Although a court may decide otherwise, I think the general approach of the Ontario Act does permit the provision of such information to persons other than the prospect. Of course, if the intent of the franchisor is to indirectly circumvent the law, then liability will almost certainly ensue. The franchisor must also take great care in the preparation of the financial information provided to a financial institution or lender, lest they incur liability to that lender as a result of reliance placed by the lender on negligently prepared information.

Provide “assistance only” to the prospect

A franchisor who provides a blank pro forma worksheet to assist a franchise in identifying the categories of anticipated revenues or expenses – as opposed to suggesting those revenues and expenses, will not contravene the law in Alberta or Ontario. Diligence is required to ensure that this practice is not abused by salespeople who subsequently provide or suggest numbers for completion of the worksheet.

Conclusion

This paper has considered some of the advantages and disadvantages of providing earnings information in the context of the disclosure to be provided to franchise prospects in accordance with the franchise statutes of Alberta and Ontario. The paper also relies heavily upon a former Alberta Policy to suggest the form and content of earnings information for use in a franchisor’s disclosure document. The paper once again sets out the lack of clarity and guidance in Canada relative to the subject of -- in terms of statutory definitions, regulatory or administrative guidelines or caselaw on the subject. Perhaps in no other subject area relative to franchise disclosure do franchisors, franchisees, lawyers, accountants and the courts have as much to learn.

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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