Franchise 101: COVID-19 vs. Item 19; and Recruitment Reprimand

FRANCHISOR 101: COVID-19 vs. Item 19

Item 19 of the Franchise Disclosure Document (FDD) can provide information on how a prospective franchisee may perform financially. Historical financial performance representations (FPRs) may be made if the franchisor has a reasonable basis for them and they are not misleading.

On June 17, 2020, the North American Securities Administration Association (NASAA) posted a commentary regarding a new issue in FPRs. The commentary addressed concerns that FPRs which are based on past performance (historic FPRs) may not accurately represent a franchise system’s current position in light of the COVID-19 pandemic. Regulators in some states are echoing this concern in state-specific releases (such as in Washington) and comment letters responding to applications to register FDDs.

NASAA states that “if outlets represented in an FPR have experienced material changes in financial performance,” franchisors may not make historical FPRs unless they are updated to reflect those changes. Franchisors must update Item 19 even if the current disclosures are purely historical and there has been no change in historical information.   

Many franchisors who recently renewed or are now in the process of renewing their FDDs for 2020 will need to evaluate, with franchise counsel, whether a “material change” occurred in their historic FPRs. NASAA lists factors for franchisors to consider before continuing to use historic FPRs, such as:

• Whether the franchise business has been significantly impacted by the COVID-19 pandemic;
• The type of data the franchisor includes in the FPR;
• Reasonable inferences a prospective franchisee can draw from the FPR;
• When a prospective franchisee can expect to open for business after entering into a franchise agreement;
• Whether and how the franchisor adapts the franchise business to account for current market conditions resulting from the COVID-19 pandemic; and
• Whether and how the franchisor adapts the franchise business to account for future market conditions resulting from the COVID-19 pandemic.

The pandemic has affected franchise systems in different ways in different industries, also varying by location, business model and other factors. Many franchises suffered financially, while others are thriving. Franchisors with historic FPRs in their FDDs may need to pause offering and making franchise sales until they confer with franchise counsel on whether to amend the FDD to include updated FPR data or remove historic FPRs from the FDD for 2020, and potentially beyond, and file amendments in registration states where the FDD is already registered.

FRANCHISEE 101: Recruitment Reprimand

A Massachusetts state court ruled that real estate franchisor, Re/Max of New England (Franchisor), breached its franchise agreements, the implied covenant of good faith and fair dealing and violated Massachusetts’ consumer protection law in its dealings with its franchisee, Leading Edge (Franchisee).

The Franchisee had six different franchise agreements with the Franchisor and operated nine Re/Max offices. Each franchise agreement had a five-year term, with staggered terminations dates, and in-term and post-term noncompete clauses. In the later part of the terms of the franchise agreements, the parties began arguing over renewal terms, largely over staggered termination dates and non-compete provisions. During the time between these negotiations and termination of the franchise agreements, the Franchisor sought to recruit the Franchisee’s sales agents from both existing and expired Re/Max locations. The Franchisor also tried to get other franchisees to recruit the sales agents even though four of the Franchisee’s locations were still under contract. The Franchisee sued the Franchisor for breach of contract, breach of the implied covenant of good faith and fair dealing, and unfair or deceptive acts or practices in violation of Massachusetts’ unfair business practices statute.

The Franchisee pointed to the franchise agreements’ stated policy that prohibited and penalized franchisees for predatory recruitment of other franchisees in the system. The Franchisor argued this policy was between franchisees only and did not apply to the Franchisor. The court disagreed. The Franchisor’s predatory recruitment actions were a material breach of contract. In addition, the Franchisor’s behavior breached the implied covenant of good faith and fair dealing since the Franchisor attempted to recruit the Franchisee’s sales agents while the Franchisee was still performing under valid franchise agreements.

Despite ruling in favor for the Franchisee on these claims, the court limited damages to losses suffered due to the Franchisor’s solicitation of sales agents (none of whom broke their contracts with the Franchisee and left). The court declined a request for $128,826 in costs incurred for the Franchisee’s expedited de-identification and subsequent rebranding of its Re/Max locations, finding that the Franchisee would incur these costs at some point when the franchise agreements ended. However, the court awarded $22,565 for a premium the Franchisee paid for expedited de-identification and rebranding services. The Franchisor was also ordered to pay the Franchisee’s attorney’s fees.

Franchisees whose agreements have staggered terms often try to get the durations aligned so that all expire at or around the same time. Otherwise, they can face unique challenges in negotiating renewals. Franchisees who cannot reach mutually agreeable renewal terms for expiring franchise agreements may be stuck in a system with a franchisor who is wary or suspicious that a franchisee trying to compete post-term. This could hurt the parties’ relationship. Franchisees should seek advice from franchise counsel before, during and after renewal negotiations.