Advisory Opinion 95-4
This staff advisory opinion is issued in response to your request dated March 2, 1995, for our views concerning the obligation to disclose financial information under
section 436.1(a)(20) and the making of earnings claims under sections 436.1(b)-(e) of the Franchise Rule.
Your client incorporated in 1994 and intends to begin selling franchises later this year. To date, it has engaged in little business. Since the late 1980's, a predecessor corporation, however, has operated other businesses that are identical to that business being offered by the recently incorporated franchisor. This predecessor has engaged in considerable business which is reflected in unaudited financial statements. You now ask:
- Must the franchisor attach its own unaudited financial statements to its disclosure document, or may it attach the unaudited financial statements of its predecessor?
- May the franchisor disclose unaudited financial statements of the predecessor as supporting data for an earnings claim?
- May the franchisor disclose "abbreviated" earnings information from the predecessor -- something short of the predecessor's full unaudited financial statements -- as supporting data for an earnings claim?
We will first address the financial statement issue before turning to the earnings claims issue.
II. Required Financial Informatino Under Section 436(1)(a)(20)
Section 1(a)(20) of the Franchise Rule requires franchisors to disclose certain financial information: (1) a balance sheet for the franchisor for the most recent fiscal year, and (2) an income statement and statement of changes in the franchisor's financial position during the most recent three fiscal years. These statements must be examined in accordance with generally accepted auditing standards by an independent certified or licensed public accountant.
The Franchise Rule recognizes that start-up franchisors typically have no financial history with which to produce audited financial information. Accordingly, section 1(a)(20)(ii) sets out the manner in which a start-up franchisor may phase-in its financial statements:
Unaudited statements shall be used only to the extent that audited statements have not been made and provided that such statements are accompanied by a clear and conspicuous disclosure that they are unaudited. Statements shall be prepared on an audited basis as soon as practicable, but, at a minimum, financial statements for the first full fiscal year following the date on which the franchisor must first comply with this part shall contain a balance sheet opinion prepared by an independent certified or licensed public accountant, and financial statements for the following fiscal year shall be fully audited.
16 C.F.R. § 436.1(a)(20)(ii). See also Final Interpretive Guides to the Franchise Rule, 44 Fed. Reg. 49966, 49981 (August 25, 1979).
The Franchise Rule, however, does not permit franchisors to start the phase-in process by using the unaudited financial statements of a predecessor. Indeed, providing prospective franchisees with unaudited financial statements of a predecessor may be deceptive. We note that the operation of a franchise system is distinct from the operation of the underlying business. A franchise system involves the sale of franchises and the management of a franchise system, not just the sale of goods or services. Therefore, there may be little correlation between the predecessor's success at running the underlying business and the start-up franchisor's possible, but yet unproven, success at operating a franchise system. Thus, prospective franchisees must be able to obtain financial information that reflects the franchisor's own ability to operate a franchise system, even if that information is in the form of unaudited financial statements for a limited time.
On this point, the Rule's discussion of the relationship between an subsidiary and a parent is instructive. The Rule states that where:
a franchisor is a subsidiary of another corporation which is permitted under generally accepted accounting principles to prepare financial statements on a consolidated or combined statement basis, the above information may be submitted for the parent if (A) the corresponding unaudited financial statement of the franchisor are also provided, and (B) the parent absolutely and irrevocably has agreed to guarantee all obligation of the subsidiary.
16 C.F.R. § 436.1(20)(i).
Because franchisees are likely to place great weight on financial information in making their investment decision, they must be able to review the franchisor's own financial information, regardless of any additional financial statements provided. For these reasons, we conclude that the Franchise Rule does not permit a franchisor to attach to its disclosure document the unaudited financial statements of a predecessor in lieu of its own.
III. Earnings Claims Information
In your request, you ask if a start-up franchisor can use its predecessor's unaudited financial statement, in whole or in part, to substantiate its own earnings representations. Before addressing that question, we present a brief overview of earnings claims.
The Franchise Rule sets out three scenarios for the making of earnings representations. First, a franchisor can make representations to prospective franchisees about their level of potential sales, income, gross or net profits. 16 C.F.R. § 436.1(b). Second, a franchisor can make representations to a prospective franchisee about the sales, income, gross or net profits of existing outlets in the franchisor's system. Id. at § 436.1(c). Finally, a franchisor can make representations for general dissemination about specific levels of sales, income, gross or net profits, either actual or potential, of existing or prospective outlets. Id. at § 436.1(e). In each scenario, the Franchise Rule sets out certain substantiation requirements. Among other things, a franchisor who makes earnings claims must have in its possession a reasonable basis for such claims at the time they are made. Id. at §§ 436.1(b)(1)-(2); (c)(1)-(2), e(1). In addition, a franchisor must disclose the bases and assumptions upon which its earnings claims are made. Id. at §§ 436.1(b)(3), (c)(3), and (e)(2).
The Franchise Rule does not prohibit start-up franchisors from making earnings representations. Obviously, a start-up franchisor cannot make earnings representations about existing franchisees in its system. Rather, earnings representations of a start-up company most likely will take the form of income, sales, or gross or net income projections. In order to make such projections, however, a start-up franchisor must satisfy the same requirements as an experienced franchisor, including possessing a reasonable basis for such projections and disclosing the bases and assumptions upon which such projections are made.
In order to prevent misleading earnings claims, the Rule provides that a start-up franchisor must make additional disclosures. Sections 436.1(b)(5)(ii) and (c)(6)(ii), for example, require a start-up franchisor to disclose if it does not have prior franchising experience. In the Statement of Basis and Purpose accompanying the Rule, the Commission stated: "In light of the Commission's decision to allow forecasts to be made in the absence of prior franchising experience, this disclosure is necessary to alert the prospective franchisee that the forecast is not based on the experience of the particular franchisor in franchising the particular product or service being considered." 43 Fed. Reg. 59613, 59694 (December 21, 1978). With respect to general media claims, sections (e)((5)(v) and (vi) require a disclosure whether the franchisor lacks prior franchising experience or has not been in business long enough to have actual business data.
While the Franchise Rule permits start-up franchisors to make earnings representations, it contains no specific guidance on what information might constitute a "reasonable basis." Rather, as with all earnings claims, the Commission will determine "reasonableness" on a case-by-case basis. The Statement of Basis and Purpose provides the following factors the Commission will consider in determining what constitutes a "reasonable basis":
[t]he question of what constitute a reasonable basis is essentially a factual issue which will be affected by the interplay of overlapping considerations such as (1) the type and specificity of the claims made . . . ; (2) the type of product . . . ; (3) the possible consequences of a false claim . . . ; (4) the degree of reliance by consumers on the claims; (5) the type, and accessibility of evidence adequate to form a reasonable basis for making the particular claims.
43 Fed. Reg. at 59686.
The Commission also set forth the following policy considerations:
Because of the importance of such forecasts and the serious economic injury which can result from reliance on inadequate forecasts, however, the rule requires such forecasts to be prepared with a high standard of care. A forecast must be based on facts in the franchisor's possession which provide a reasonable basis for the conclusion that the forecasted outcome is highly probable to be realized.
Id. at 59687.
Thus, at the very least, any financial information that is used to substantiate a start-up franchisor's earnings projections should be prepared according to generally accepted accounting principles. Audited financial statements are preferred. See Id. at 59688-89. However, it is impossible for us to determine whether unaudited financial information of a predecessor would constitute a "reasonable basis" for a start-up franchisor's earnings claims absent more detailed information about the nature of the earnings claims made, the nature of the predecessor's business operations, and the predecessor's financial history.
For these reasons, we conclude that a franchisor may not substitute the unaudited financial statements of a predecessor for its own when phasing-in financial information under Section 436.1(20) of the Franchise Rule. With respect to what constitutes a "reasonable basis" for a start-up franchisor's earnings representations, we conclude that financial information of a predecessor is relevant, especially when prepared in accordance with generally accepted accounting principles. Whether such information alone is sufficient to support an earnings projection, however, can only be determined in light of the totality of the circumstances on a case-by-case basis. Finally, we note that any start-up franchisor who wishes to make earnings representations, though, must make full disclosure about its lack of independent franchise experience, as noted above.
Please be advised that our opinion is based on all the information furnished in your request. Please be advised further that the views expressed in this letter are those of the FTC staff. They have not been reviewed, approved, or adopted by the Commission, and they are not binding upon the Commission. However, they do reflect the opinions of the staff members charged with enforcement of the Franchise Rule.
Date: April 4, 1995
Franchise Rule Staff