Right way, wrong way to present Item 19
Franchisors are adding Item 19s, also known as financial performance representations or FPRs, to their franchise disclosure documents in record numbers. But the quality varies dramatically, ranging from highly explicit to vague and confusing.
While some franchise experts think any type of earnings claim is better than nothing, others predict that misleading FPRs are inviting future lawsuits. One such lawsuit, filed by franchisees against Papa Murphy’s Pizza, is now pending.
When Dale Cantone started overseeing franchise registration for the Maryland attorney general’s office about two decades ago, only about 10 percent of franchisors in that state included Item 19s in their FDDs. Today the number is 57 percent, Cantone said on a panel discussion called “Walking the FPR Tightrope” at the International Franchise Association’s Legal Symposium last spring.
Source Book Publications in Oakland, California, publisher of the “How Much Can I Make?” guides, says 67 percent of the franchisors in their database provide Item 19s. Research firm FranchiseGrade.com in London, Ontario, reports that FPR inclusion varies by franchise category, with 77 percent of lodging franchisors providing one and only 16 percent of real estate franchises; 48 to 58 percent of franchisors in all other categories have Item 19s.
“It almost seems there is an arms race when it comes to making financial performance representations,” said Ted Pearce, special counsel to Nexsen Pruet in Charlotte, North Carolina, in an email interview after the legal forum. The race is fueled by lenders who want to know if new franchisees can generate enough revenue to pay back their loans; by prospective franchisees who want to know if they can make a profit; and by franchise salespeople who want to attract buyers and lenders to their concepts.
Just having an FPR has become so important that some compilers of “top franchise” lists won’t even consider a system without one. FRANdata President Edith Wisemann said when her research company published its list of “Best and Worst Franchises” this summer, “brands were only able to be considered for our ‘best’ ranking if they had an Item 19. Then the quality of that Item 19 went into our overall evaluation.”
“The problem,” said Rupert Barkoff, chairman of the franchise team at Kilpatrick, Townsend & Stockton in Atlanta, “is that franchisors can say anything as long as they can substantiate it. Over the years, I watched some franchisors try to manipulate their numbers to present them in the best light.”
We can thank the Federal Trade Commission for that leeway. According to a paper presented at the IFA Legal Symposium in May, when the FTC amended its original franchise rule in 2007, it encouraged franchisors to include Item 19s in their disclosure documents, but provided little concrete guidance on what they should include. “The overarching mandate for an FPR is that a franchisor must have a reasonable basis for the information it presents,” the paper says.
“There are so many ways to slice and dice the data to make franchise opportunities look more appealing,” said Pearce. The easiest data to include in Item 19s is gross franchisee revenue, because almost every franchisor uses that information to calculate its royalty assessments. The majority of FDDs examined for this article included that information, often separated into thirds or quartiles, with average gross revenue calculated for the top, middle and lowest earning franchisees.
Item 19s are optional and until recently, franchisors whose gross revenue numbers fell short of their competitors chose not to include one; today many of them disclose some other slice of data instead. But some industry insiders, like Eric Stites, CEO of Franchise Business Review in Portsmouth, New Hampshire, argue Item 19s that provide gross revenue without also including franchisees’ average expenses can be just as misleading. “You hand someone an Item 19 that includes average gross sales of $1.6 million a year and they’ll get excited. You should also tell them what it costs to run that franchise.”
Stites’ market research firm measures franchisee satisfaction. He said franchisees in systems with FPRs that include broad expense-related data are 28 percent more satisfied than franchisees in systems that have only gross revenue in their Item 19s, or no Item 19s at all. “An Item 19 that gives a good, balanced perspective of what it will cost to run a franchise sets very realistic expectations,” Stites said. “Franchisors that fudge the numbers in their FPRs are dooming their franchisees to dissatisfaction and underperformance.”
Papa Murphy’s dispute
They may also be inviting future lawsuits. New York attorney Richard Rosen said, “When franchisees are not successful or, even worse, when they fail, they will look for a reason why. Inaccurate or incomplete FPR disclosure is often on their radar.”
Until recently, Item 19 lawsuits had been rare and had usually involved single franchisees. But in April 2014, 28 current and former franchisees of Papa Murphy’s Pizza filed a lawsuit against their Vancouver, Washington, franchisor claiming the Item 19s in the disclosure documents were misleading. The take-and- bake pizza company reached confidential settlements with several of the franchisees, but early this year, Caroline Fichter, of the Bundy Law Firm in Kirkland, Washington, filed an amended complaint for 19 remaining franchisees. The complaint states that all plaintiffs opened stores in the South and Southeast United States while relying on Papa Murphy’s Item 19 and its disclosures of average unit sales.
“As early as 2002, Papa Murphy’s International knew that a store’s age and location were crucial factors in its success and that new stores in the south and southeast would experience much lower sales,” the complaint reads.
Fichter added in an interview, “Some of the franchisees spent all their savings, lost their houses and marriages and still never came close to ‘average’ sales numbers.” If Papa Murphy’s had included geographic subsets in its Item 19s, Fichter said, these franchisees would have seen that stores in the Pacific Northwest near company headquarters achieved much higher sales than those in far away locations, and never would have purchased their franchises.
In a response filed in March by Miller Nash Graham & Dunn in Vancouver, Washington, and Faegre Baker Daniels in Minneapolis, the publicly traded Papa Murphy’s denied all the allegations. When asked for a comment, Papa Murphy’s sent the following: “At all times, we are diligent to ensure that we are providing the necessary information and following the required process as directed by the FTC for the FDD. It is of the utmost importance to us that potential franchisees have access to this information, which could be helpful in making decisions about whether to invest in a Papa Murphy’s franchise.”
When asked if Papa Murphy’s had changed its FDD over the years, they replied: “Each year, the FDD is updated with the most recent past year’s data that is available. At times, when we did not have sufficient system data available to us, and including such information was optional under FTC rules, we chose to not incorporate any data. Over the years, the categories of information we have included in Item 19 have changed as the data available to us has increased.”
Some attorneys, including Justin Klein of Marks & Klein in Red Bank, New Jersey, do not expect more Item 19 lawsuits. “The disclosure laws are there not only to provide information to prospective franchisees, but, and perhaps more significantly, to protect franchisors from lawsuits like this. It’s simple. Give as much information as possible and this way, everyone is in the best place to succeed and avoid litigation,” he said via email.
But others, like Susan Grueneberg of Snell & Wilmer in Los Angeles, and a member of the IFA Legal Symposium panel, do anticipate more lawsuits “because there are just more franchisors including information in Item 19s.”