III. EARNINGS CLAIMS

An earnings claim is defined as "any information from which a specific level or range of actual or potential sales, costs, income or profit from franchised or non-franchised units may be easily ascertained." UFOC Guidelines, Item 19. If a franchisor makes an earnings claim, in any form, it must be disclosed in Item 19 of the UFOC and it must meet the detailed disclosure requirements contained in the UFOC guidelines.

Pursuant to the FTC Rule, an earnings claim must have a reasonable basis to support the accuracy of the claim, the documents to substantiate the claim must be in the franchisor's possession and the claim must be geographically relevant to the prospective location. The FTC Rule requires, in "immediate conjunction with any earnings claim, the disclosure of the number and percentage of the outlets which the franchisor or broker knows to have made at least the same results as those presented in the claim." Franchisee and company owned outlets must be reported separately. Finally, all earnings claims must include the following warning in any projection or forecast:

These figures are only estimates; there is no assurance you will do as well. If you rely upon our figures, you must accept the risk of not doing as well.

With regard to the "reasonable basis" of an earnings claim, the American Institute of Certified Public Accountants ("AICPA") publications, which define the "reasonable basis" necessary to support accounting claims, suggest by analogy that the following considerations are relevant:

• The quality of the information.



• Whether the claims are based on the best information available.



• Whether the claims represent the single most probable result.



• The existence of reasonable support for any assumptions.



• Whether the claims are prepared by qualified personnel.



• The accuracy of previous forecasts or projections.

For earnings claims based on past performance, the underlying data must be capable of independent examination and verification and must reasonably support the claim. A franchisor's earnings claim has no reasonable basis if: (1) the results are achieved by a small minority of franchisees; (2) earnings are due to a non-recurring condition; or (3) franchisees use inconsistent methods for reporting earnings.

Substantiating data, including market studies, statistical analysis, franchisee profit and loss statements (although it need not identify particular franchisees) must be prepared in accordance with GAAP, and other information which the franchisor relied upon in making any earnings claims must be available to franchisees for inspection.

Earnings claims must also be relevant to the geographic market in which the prospect will be located. The experience of outlets in the same geographic market area is likely to be predictive of the prospect's experience and therefore geographically relevant. Additionally, an earnings claim based on outlets located outside the prospect's geographic market may also be geographically relevant so long as the regions share similar market conditions such as: demographics, climate, real estate conditions and location (i.e. free standing v. shopping center locations). Certainly the more similar market conditions the different regions share, the more likely the earnings claim is to be geographically relevant. An earnings claim should also disclose the different factors between the regions.

Although the subject of much debate, currently franchisors are permitted to include earnings information in their UFOC. However, if a franchisor actually makes any earnings claim it must be included in Item 19 of the UFOC in the detail required by the UFOC guidelines. The franchisor must disclose the factual basis of the claim, which includes those significant matters upon which it expects a franchisee's future results to depend, such as economic or market conditions, which are basic to a franchisee's operation and other matters affecting the franchisee's sales and costs. In addition, when a franchisor chooses to make an earnings representation, it must also make the following minimum disclosures:

1. the material assumptions underlying the preparation and presentation of the earnings claim;



2. a concise summary of the basis for the claim including a statement of whether the claim is based upon actual experience of franchised units and, if so, the percentage of franchised outlets in operation for the period covered by the earnings claim that have actually attained or surpassed the stated results;



3. a conspicuous admonition that a new franchisee's individual financial results are likely to differ from the results stated in the earnings claim; and



4. a statement that the franchisor will provide substantiation of the data used in preparing the earnings claim to the prospective franchisee upon reasonable request.

Earnings claims include any statement of: (1) average unit revenues, income or expenses; (2) average costs of goods, labor or occupancy; (3) differences in revenues, income or expenses based on location, market or type of unit; (4) potential return on investment; (5) average annual "break even"; and (6) pro forma franchisee financial statements⁸. Thus, making such claims in an advertising brochure, a slide presentation, a verbal sales presentation, on the back of an envelope, or in any other manner is unlawful unless the franchisor makes the required disclosures in Item 19 of the UFOC.

Earnings claims in the general media include: (1) claims in advertising (radio, television, newspapers, etc.); (2) claims in speeches; and (3) claims in press releases. While some earnings claims are not obvious and can result in franchisors making advertisement claims, others, such as the following examples, are often obvious and easily avoided:

• Earn a $10,000 profit, or up to $25,000 in annual income.



• Earn gross sales in excess of $250,000.



• Earn enough money to buy a new Porsche.



• Earn an 100% return on investment in the 1st year of operation.

Earnings information contained in published articles in national business magazines are generally not earnings claims, however, subsequent use of the article in a franchisor's promotional package for franchise sales is an earnings claim and must comply with Item 19.

Even a franchise salesman's comments on an analysis of sales potential, projected profits and financial performance which the prospect has prepared on his own can be an earnings claim.

The FTC Rule contains a specific exemption which permits a franchisor to provide a prospect of a company owned unit with access to that unit's books and records. The prospect must be a genuine candidate for the specific location in order to qualify for the exemption and it is a good idea to include certain additional disclosures and disclaimers based on the known limitations of any financial information pro-rated, including the extent to which such information is based on information provided in whole, or in part from information obtained from third parties.

Interestingly, information provided to a prospect's bank at the prospect's request, including any pro forma or other financial information in connection with a business loan application, is not an earnings claim, but a franchisor would be wise to obtain a confidentiality agreement from the bank preventing the bank from making any subsequent disclosure of such information to the franchisee borrower. The FTC Rule has been strictly defined to require a direct communication between the franchisor and prospective franchisee.

Earnings Claims Made in Electronic Marketing
Recently, the FTC issued informal staff advisory Opinion 04-2 with respect to earnings claims and electronic marketing. Specifically, the FTC addressed for the first time the application of the FTC Rule's general media earnings claims provisions to new marketing techniques such as pop-up screens and banner advertisements on websites and commercial bulk emails. Specifically, FTC Opinion 04-2 addressed whether the making of an earnings claim in advertising materials on a website or in electronically distributed materials (such as bulk emails) trigger the FTC Rule's general media earnings claims disclosures, or whether the FTC Rule's earnings claims regulations could be satisfied by subsequent delivery of a UFOC that includes information supporting the earnings claim.

With respect to general forms of electronic media advertisement, such as static ads, pop-up screens and banner ads, the FTC had no trouble finding that such advertisements would be governed by the broad definition of general media within the FTC Rule. However, with respect to emails containing earnings information, the FTC found that the primary factor is whether an email earnings claim is considered a "point-of-sale" representation.

In the Statement of Basis and Purpose for the FTC Rule, the FTC recognizes the distinction between direct earnings representations made in "point-of-sale" materials and indirect earnings representations made in the general media, where "slightly different treatment is warranted".

The FTC found that where a franchisor emails an earnings claims to a potential buyer, the email message constituted a direct point-of-sale representation. For example, where a perspective franchisee submits an online application with a franchisor, it is reasonable to conclude that the perspective franchisee solicits email messages from the franchisor in response to advance the franchise sale. If the franchisor were then to send the prospect information containing an earnings claim, such a direct communication would be deemed a point-of-sale claim and the franchisor must subsequently follow the emailed claim with a complete and accurate UFOC containing a detailed Item 19 in the time frame required by the FTC Rule.

On the other hand, the FTC found that unsolicited bulk email messages sent to the public are a form of general media advertising. Under the FTC Rule, a general media advertisement is widely disseminated with the intent of creating an interest in the franchisor, possibly leading to franchise sales. This contrasts with "point-of-sale" materials, which are designed to advance a franchise sale between an interested buyer and seller. This distinction holds true even if an advertisement is sent to a specific consumer's email address. For example, the FTC found it is clear from the Statement of Basis and Purpose that a franchise advertisement in a magazine or a newspaper would constitute a general media claim, even thought the magazine or newspaper may be sent to the addresses of individual subscribers. The mere fact that a message is sent to specific individuals alone does not mean that those individual recipients are buyers who have expressed interest in a franchise offer. Accordingly, the FTC found that unsolicited electronic advertisements containing an earnings claim would be deemed a general media claim if widely disseminated, even if sent to specific individuals' addresses.

However, the FTC found that a more difficult question arose concerning the sending of email messages to those who have previously expressed some interest in franchising. The FTC believed that a logical distinction existed between those who have previously expressed interest in a specific franchisor and those who have expressed general interest in the subject of franchising. The FTC believes that where a member of the public has contacted a franchisor to receive information about that specific franchisor, than that individual has taken the initial step towards becoming a buyer. Under these circumstances, future correspondence from the franchisor to that individual consumer, is akin to the "point-of-sale" model described above. If however, the consumer has contacted a third party who expressed interest in receiving franchise information generally, than the contact between that consumer and any specific franchisor is too attenuated to be considered a "point-of-sale" contact. The FTC saw no difference between sending email messages to the public who happened to express some interest in an area of franchising and sending advertisements in franchise related magazines or newspapers to subscribers. Accordingly, email messages sent to those who express an general interest in franchise would be deemed to be general media claims.

Referring Prospects to Franchisees for Earnings Information
In the ordinary course, a prospect will contact existing franchisees to perform due diligence on the business and its unit economics. In systems without Item 19 earnings claims, sales people typically refer existing franchisees to prospects for the purpose of discussing, among other things, earnings information. Ordinarily, earnings representations which are made by existing franchisees fall outside of the scope of the FTC Rule because the FTC Rule has been interpreted to apply only to representations made by the franchisor or its agents.

Where a franchisor's level of involvement with a referred franchisee is significant, there is a risk that the referred franchisee will be deemed an agent of the franchisor thereby triggering the requirements of the FTC Rule regarding earnings claims. In deciding this issue, courts scrutinize the: (i) nature of the relationship between the franchisor and the referred franchisee; (ii) payment of consideration to the referred franchisee; and (iii) franchisor's level of involvement in setting up, participating in and following up on the interview with the prospect.

Even if a franchisor has an Item 19 Earnings claim, it is still exposed. Earnings claims only represent an estimate of potential earnings and not a guarantee that a particular franchisee will attain the stated results at a particular location. Therefore, if a referred franchisee comments on how a prospect can expect to perform, or reviews prospect prepared projections even if the representations are consistent with the Item 19 disclosure, there is a risk that the franchisor may have violated the FTC Rule if the referred franchisee is determined to be the franchisor's agent.

To avoid any potential liability, a franchisor should refer franchisees at all ends of the performance spectrum, including some who have recently opened in similar size units in areas sharing similar demographics. Identifying only the "stars" of the system will no doubt create unreasonable expectations about initial financial performance. As an additional safegaurd, prospects should be encouraged to contact other random franchisees in order to confirm or refute the information obtained from the referred franchisees.

Additionally, the practice of providing franchisee referrals with substantial direct or indirect financial benefits is considered material in a fact-finders' determination that a referred franchisee is the franchisor's agent. Because the ramifications of such an agency relationship are significant, compensation for franchisee referrals or for favorable franchise prospect interviews should be avoided. Most significantly, franchisors should refrain from providing administrative assistance to the referred franchisees in communicating with prospects about earnings information.

The New FTC Rule
The NPR sets forth proposals that would significantly affect an earnings claim disclosure under the FTC Rule format and changes the name of the disclosure item from "earnings claims" to "financial performance disclosures." The FTC would adopt the approach taken under the UFOC format permitting franchisors to provide financial performance information within the body of the main disclosure document, thus eliminating the need for a separate earnings claim disclosure document.

Most significantly, the new rule alters the requirements needed for financial performance representations. Currently, a franchisor can only make an earnings claim if it is geographically relevant to the unit being offered. Additionally, the franchisor must disclose the number and percentage of franchised outlets that actually attained or exceeded the stated results, which effectively precludes a franchisor from making an earnings claim unless it has complete information concerning all of the franchisees in the system. The new rule would permit franchisors to provide financial performance information to prospective franchisees for all or a subgroup of company-owned and/or franchised outlets if the franchisors disclose the number and percentage of outlets that attained or surpassed the stated results based on the number of outlets in the subset rather than the number of outlets in the entire franchise system, along with the characteristics of the measured subset that may differ from the offered unit. Additionally the new rule would require that the historical data be prepared in accordance with generally accepted accounting principles, which is not required under the current rule.

Footnotes: