Catch 22. Area 51. Apollo 13. Form 1040. And Item 19 of the Franchise Disclosure Document. These shorthand references all have significance well beyond the clause, the area, and the mission they represent. In the franchise community, Item 19 has been the white-hot focus of franchise disclosure since the original Uniform Franchise Offering Circular was introduced in the 1970s, and it has come to represent so much more than other sections of the document.
Item 19 is the portion of the franchise disclosure document that once regulated “Earnings Claims” under the UFOC, and now under the FDD regulates what are more grandly known as “Financial Performance Representations.” Item 19 is the answer to one of the first questions–and one of the most legally dangerous questions–asked by a potential franchisee: “How much money can I make?”
As defined in the Amended FTC Rule, a Financial Performance Representation is “any representation … to a prospective franchisee … that states … a specific level or range of actual or potential sales, income, gross profits, or net profits …” Got that? There’s more to this definition if you are a franchise seller, but this is the heart of it.
What does Item 19 contain?
Item 19 covers any statement that would inform the reader about the financial performance of existing franchised units or about how a particular franchise might perform in the future. It does not, however, discuss the actual performance of an existing business that is to be sold as a franchise.
Under FTC rules, no information about the financial performance of a franchise that meets the definition of a Financial Performance Representation can be given to franchisees unless it is listed in Item 19. Franchisors have complete freedom to select the type of Item 19 disclosure that makes sense for their businesses. Hotel systems may want to include occupancy rates; restaurants may include gross sales figures and key percentages reflecting food costs or labor costs; car washes may want to include daily car counts and average ticket numbers. Some franchisors include complete profit and loss statements; others include simple presentations of average gross sales figures. Some retail systems include a table showing the gross sales of every unit in the system without identifying their locations in the disclosure document.
What should you look for in Item 19?
While an Item 19 disclosure may be industry-specific, the more information on a franchise system’s financial performance, the better for the investor. With more information in hand, you are in a far better position to do your own financial planning. For instance, if you are considering buying a hotel chain franchise with a powerful central reservation system, you will need to know what percentage of total reservations are centrally provided for the typical hotel unit. This information It will help you calculate your break-even point and estimate the money you will need to spend on local advertising and promotion. If you know that the average restaurant in a particular system grossed $1.3 million in 2007, it will be enormously useful to you. It may be even more useful to know what the numbers look like since the 2008 recession hit, so ask the franchisor for recent data or gather your own by asking other franchisees in the market how their businesses are performing this year.
Legal requirements of Item 19
Even though franchisors have freedom to develop the information they include in Item 19, it all must follow a few legal standards. The Amended FTC Rule makes it unlawful for any franchise seller to make a financial performance representation that is not true or not substantiated when it is made. Information in Item 19 must have a reasonable basis, the disclosure must reveal the bases and assumptions underlying the representation, and the franchisor must have written substantiation for the representation at the time it is made. There are also affirmative statements that must accompany the representation, such as the admonition that the prospective franchisee’s actual earnings may differ. Item 19 information has some heavy legal sanctions behind it; in that sense, it is as reliable as any information appearing in the FDD. But even though there are serious sanctions behind any incomplete or misleading information, franchisors have been known to be wrong or misleading, so it never hurts to talk to existing franchisees to see how their businesses have performed and what they think of the Item 19 information being published by the franchisor.
Origins of Item 19
Why did Item 19 come to be? Buried deep in franchising’s DNA are broken strands of pure hucksterism. In its earliest days, just as McDonald’s started its financial rocket ship ride for early investors, franchises were sold on sales adrenaline, hyperventilating excitement, and investor dreams of grabbing the next McDonald’s on the launch pad. And a lot of people got taken.
The answer offered by state and federal regulators was the pre-sale franchise disclosure document. By laying out all of the basic terms of the franchise offering, in writing, well before the sale, the thinking went, investors will be armed with information and can make wiser, or at least informed, decisions. And with that came the Item 19 instruction that strikes most businesspeople outside of franchising as counterintuitive: “No more claims of million- dollar revenues. Not only that, you cannot reveal any aspect of the financial performance of your franchise system unless it is in Item 19 of the disclosure document.” Truth, as they say, is no defense if you violate this command.
The fundamental rules of Item 19 became the single most important part of any franchise sale, and a ticket to pain for franchisors that did not grasp its prohibitions. Plaintiff’s attorneys representing franchisees delight in this aspect of franchise regulation. One prominent franchisee litigator has said he is happy to see no representations in Item 19, because he knows that in all likelihood the franchisor has broken the no-performance-representation rule somewhere along the way to the sale, and all he has to do is find it in discovery. And when he finds that performance statement scrawled on the back of a cocktail napkin, it becomes a smoking gun in the court case.
Most businesspeople talk in terms of performance, which can be dangerous in a franchise sale if they are representing the franchisor and they don’t understand the discipline necessary in order to sell a franchise in compliance with Item 19. For franchisors, complying with the proscriptions of Item 19 is complicated and nearly impossible if they do not strictly control the sales process, carefully train all franchise sellers representing the franchisor, and instruct everyone who might have occasion to talk to a prospective franchisee to refer all inquiries to an authorized franchise seller and not to say anything that might come back to haunt the company.
No financial information in Item 19?
What does it mean if you read through an FDD and in Item 19 all you find is the requisite boilerplate, and no financial performance representations? It simply means that the franchisor has chosen not to provide that information as part of the franchise sale, as it is allowed to do. In my experience working with franchisors, the company would probably refrain from providing this information for one of three reasons. 1) The performance picture is one the company would rather not reveal — either because the figures are so low, or because financial performance varies widely among franchisees. 2) The franchisor’s advisors think that including a statement will increase its exposure to litigation from new franchisees if those franchisees’ financial performance does not measure up. 3) Some franchisors with programs that charge flat monthly fees simply do not gather from their franchisees the information they would need to put together a reasonable financial performance representation.
Studies of FDDs conclude that between 25 percent and 30 percent of all franchisors include some form of financial performance representation in Item 19, perhaps a surprisingly low figure given the importance of the information in a franchise sale.
In any case, if there is no Item 19 disclosure, the franchisor answers the prospect’s inevitable question about financial performance by urging him or her to talk to existing franchisees about performance. (For detailed discussion of this point, read The Most Valuable Information in the Franchise Disclosure Document.) If the franchise program is new and there are few or no franchisees that have been operating for any significant period of time, the franchisor has a dilemma. Prospects should certainly feel free to talk with the franchisor about its Item 19 decisions. Ask why no Item 19 information is included, listen carefully to the answer, and point out the disclosures provided by direct competitors.
Item 19 is the outsized focus of every franchise disclosure document. It provides a clear avenue for delivering performance information and is deserving of close attention by both parties to the franchise transaction. Franchisors that include financial performance representations in their Item 19 deserve credit for providing important information the franchisee needs to make a smart decision.
Andrew Caffey is one of the nation’s leading franchise legal specialists and he represents franchisors across the United States. Caffey served as General Counsel of the International Franchise Association, a member of the Governing Committee of the ABA Forum on Franchising, and Chair of the ABA Forum on Franchising. He also is a member of the bar in Maryland and the District of Columbia, and a member of the Panel of Neutrals of the American Arbitration Association. Caffey has appeared on numerous franchise programs and is a frequent speaker and author on subjects of franchise and business opportunity regulation.