NASAA Announces Y2K Disclosure Requirement

By Lane Fisher and Cheryl L. Mullin

The much debated issue of whether or not a franchisor should or needs to incorporate a Y2K statement is now over. On March 17, 1999, the Franchise and Business Opportunities Project Group of the North American Securities Administrators Association ("NASAA") finally issued a statement announcing that franchisors would be required to disclose potential Year 2000 computer problems. In its short release, NASAA stated that franchisors "must disclose potential Y2K problems under the Uniform Franchise Offering Circular Guidelines [using] the disclosure format adopted by the 14 [registration] states." While some franchisors have already elected to make voluntary Y2K disclosure and/or address the issue in their audited financial statements, it is now clear that a disclosure must also be contained within the franchisor's offering circular.

Pursuant to NASAA's statement, each franchisor will be required to include information about the franchisor's preparedness for addressing potential Y2K problems and its potential impact on prospective franchisees who are contractually required to maintain and update a computer system under the franchise agreement. Additionally, if franchisors anticipate that their franchisees will encounter Y2K related problems with suppliers, landlords, financial institutions or other third parties, NASAA recommends that such information also be disclosed.

The NASAA release parallels a letter issued on December 30, 1998 by the Rhode Island Securities Division (the "Division"). Until Rhode Island issued its letter late last year, NASAA and state agencies were silent on the issue. The Division was the first franchise-related state agency to recognize Y2K as " a material fact requiring disclosure under the Rhode Island Franchise Investment Act." Instead of interpreting existing disclosure requirements to include Y2K related information, however, the Division imposed Y2K specific disclosure requirements similar to those mandated by the SEC. In transactions subject to the Rhode Island Act, franchisors must now disclose their "awareness, assessment, renovation, validation/testing and implementation: of Y2K programs, including the possible effect on existing or prospective franchisees." Until the release by NASAA, some franchisors believed the Rhode Island disclosure requirement to be overly extensive. However, practitioners must now concede and incorporate an appropriate Y2K disclosure.

NASAA's release has taken the guess work out of whether or not a disclosure statement should be incorporated in a franchisor's offering circular. The question regarding the length and scope of the specific information to be disclosed, however, will depend upon various factors including the type of business being franchised, the extent to which the business relies on its internal computer system to maintain operations and the extent to which it relies upon equipment, or product or services provided by third parties, which may be affected by Y2K issues. Also, a more detailed disclosure will be necessary if proprietary technology mandated by the franchisor and used by the franchisees is a component of a franchise system. If, on the other hand, the franchisee uses off the shelf products, a more limited disclosure, which is purely cautionary in nature, would be appropriate. Franchisors who have issued a Y2K readiness disclosure should also consider incorporating a summarized version of such disclosure.

NASAA's release concluded by noting that franchisors who fail to adequately disclose material Y2K information will be at risk for private litigation as well as law enforcement action.

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