New Laws Could Curb SBA Guaranteed Lending to Franchisees

On March 16, 2022, the U.S. Senate Small Business Committee held a hearing on the Small Business Administration’s future on guaranteeing lenders’ loans to franchisees under S.1120, the Small Business Administration Franchise Loan Transparency Act, and S.2162, the SBA Franchise Loan Default Disclosure Act. Each bill was proposed by Senator Catherine Cortez-Masto (D-NV).

In April 2021, almost a year prior to the date of the hearing, Senator Masto issued an 87-page report, “Strategies to Improve the Franchise Model: Preventing Unfair and Deceptive Franchise Practices” (Report) which “highlights four areas where franchise complaints are most problematic, including:

1. Unfair and deceptive contracts that give nearly all control to the franchise corporation;
2. A lack of honesty and transparency in the financial disclosure documents;
3. Costly kickbacks and overpriced goods; and
4. Fees charged for limited or no actual benefit” and concluded that these characteristics “are the hallmarks of a franchise model that operates to strip small business owners of their wealth.”

The Report’s recommendations included enabling the Small Business Administration (SBA) to require franchisors to provide actual historic revenue data and store closing information to franchise candidates before providing a government guaranteed loan to a franchisee, to publish loan performance information for franchisors by brand and to refuse to guarantee any loan to a franchise candidate if the franchisor had high levels of defaults on SBA government guaranteed loans. S.1120 and S.2162 are follow-up bills addressing both of these subjects.

S.2162 would require the SBA to publish each quarter publicly accessible loan default rates by franchise brands during the preceding 10 years.

Under S.1120, a franchisor, excluding franchisors in the lodging industry, whose franchise qualified for guaranteed lending from the SBA would be required, at a minimum, to disclose to franchise candidates in its Franchise Disclosure Document (FDD) the following information for each of the three years preceding the issuance date of the FDD: 

• The average and median revenues for all franchises granted by the franchisor, in accordance with the Financial Performance Representation Commentary adopted by the North American Securities Administrators Association (NASAA) in May 2017; and

• The total number of franchises granted by the franchisor that, during the first year of operation, either ceased operations or were transferred to a new franchisee.

S.1120 would forbid a franchisor from disclosing to a franchise candidate or a current franchisee, either directly or indirectly, any financial information that conflicted with the revenue information in an FDD.  However, if the purchase included one or more franchised businesses that were in operation on the date the FDD was issued, the franchisor could disclose the revenue information as of the date the FDD was issued for those businesses.

If passed by Congress, the practical effect of S.1120 would be significant. The federal Franchise Rule (16 C.F.R. § 436) currently permits franchisors to include Financial Performance Representations in an Item 19 disclosure in their FDD, but does not require franchisors to do so.

Franchisors that choose to include Financial Performance Representations in an Item 19 disclosure in their FDD determine the type of Item 19 disclosures to make. Choices include historical gross revenue of company-owned and franchised units, average and median annual unit revenues, gross revenue with expense information or gross revenue, expense information, gross and/or net profit information or no information at all.

Under S.1120, franchisors that look to the SBA to guarantee loans of start-up money for their franchise candidates would have to provide three years of the information discussed above. Franchisors should assume that the mandatory disclosure of Financial Performance Representations will be inevitable and begin to gather the data required to provide compliant Financial Performance Representations in the future.

Barry Kurtz is a Certified Specialist in Franchise & Distribution Law, by the State Bar of California Board of Legal Specialization.