“WE’RE GOING PUBLIC”: CONSIDERATIONS AND TRAPS FOR PUBLIC
FRANCHISORS AND FRANCHISE SYSTEMS GOING PUBLIC
INTERNATIONAL FRANCHISE ASSOCIATION
48TH ANNUAL LEGAL SYMPOSIUM
MAY 2015
Chicago Marriott Downtown
Chicago, Illinois
Kara MacCullough
Greenberg Traurig, P.A.
Fort Lauderdale, FL
Sarah Yatchak
Buffalo Wild Wings, Inc.
Minneapolis, MN
Jordan Zucker
American Driveline Systems, Inc.
Horsham, PA
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TABLE OF CONTENTS
Page
I.
INTRODUCTION .................................................................................................. 1
II.
WHY GO PUBLIC? ............................................................................................... 1
III.
THE PROCESS FOR “GOING PUBLIC” – SECURITIES PRIMER ...................... 3
A.
B.
C.
IV.
Initial Public Offering .................................................................................. 5
Reverse Merger ......................................................................................... 5
A/B Exchange Offer ................................................................................... 7
CONSIDERATIONS FOR GOING PUBLIC .......................................................... 8
A.
B.
SEC and FTC Obligations.......................................................................... 8
Financial Statement Issues ........................................................................ 8
1.
2.
3.
C.
Communicating the Transaction – Recipients, Information and Timing
under Franchise and Securities Laws ...................................................... 13
1.
2.
3.
V.
FTC Rule and Timing of Disclosure .............................................. 14
Securities Act and Timing of Disclosure ........................................ 14
Practical Considerations for Franchise Company Going Public .... 15
ONGOING CONSIDERATIONS FOR PUBLIC FRANCHISORS........................ 16
A.
Disclosure Obligations For Public Franchisors ........................................ 17
1.
2.
3.
4.
B.
C.
D.
E.
Periodic Reporting Obligations Under the Exchange Act .............. 17
Duty to Correct and Update Under the Securities Laws ................ 19
Periodic Reporting Under the Franchise Laws .............................. 19
Practical Considerations ............................................................... 21
Evaluating Materiality Under the Two Regimes ....................................... 22
1.
2.
3.
Materiality Under the Franchise Laws ........................................... 22
Materiality Under the Securities Laws ........................................... 23
Practical Considerations ............................................................... 26
Communicating with Franchisees - Confidentiality Concerns .................. 26
Litigation Disclosures under the Two Regimes ........................................ 30
Financial Performance Representations .................................................. 33
1.
2.
3.
VI.
FTC Rule ......................................................................................... 9
Regulation S-X - Generally ........................................................... 10
Regulation S-X - Acquisitions ........................................................ 11
Disclosing Financial Performance Under the Franchise Laws ...... 33
Disclosing Financial Performance Under the Securities Laws ...... 33
Practical Considerations ............................................................... 35
CONCLUSION.................................................................................................... 36
i
148540v1
I.
INTRODUCTION
“We’re going public” – three words that upend the life of a General Counsel. The
reasons behind a desire to become a public company are varied. Some companies
pursue public debt or equity financing to fuel expansion of their franchise network,
others may want to access public equity to reduce outstanding debt or to appease
private equity sponsors’ need or desire for a liquidity event, or perhaps a private
company’s founders are looking to diversify their net worth. Whatever the reason, more
and more General Counsels are confronting the challenges imposed by those magic
words.
II.
WHY GO PUBLIC?
With multiples that can range from 10x to 15x, the public market has been
extremely attractive for franchisors. According to FRANdata, franchise-related public
companies experienced another strong year in 2014, with FRANdex 1 jumping 12.3%
and outperforming annual gains delivered by both the S&P 500 (+11.4%) and the
Russell 2000 (+3.5%). This growth was primarily driven by non‐food brands, which
segment of FRANdex gained 15.5% for the year, as compared to the food brands
segment that posted only 4.5% growth. After adjusting for component weights, the
lodging industry contained some of the biggest gainers in 2014, including Marriott
(MAR) and Hilton (HLT). During 2014 and the first quarter of 2015, these rewards
attracted numerous and diverse franchisors to the public market for the first time,
including but not limited to the $2.2 billion IPO of the ServiceMaster® brand’s parent
entity, $650 million IPO of the La Quinta® hotel chain, and others:


1
ServiceMaster Global Holdings, Inc. (NYSE:SERVE) – Franchisor of
residential and commercial protection and maintenance services,
completed its $610 million IPO at $17.00 per share in June 2014,
reflecting a $2.2 billion market capitalization. As of March 2, 2015,
SERVE was trading at $35.71 per share, with a market capitalization of
$4.8 billion.
La Quinta Holdings Inc. (NYSE:LQ) – Franchisor of the La Quinta® brand
hotels, completed its $650 million IPO in April 2014, shares were issued at
$17.00 per share, implying a market capitalization of $2.1 billion. As of
March 2, 2015, LQ was trading at $22.53 per share, with a market
capitalization of $3.0 billion.
FRANdex and FRANdex+M track the performance, based on market capitalization, of the largest 51 and 52 U.S.
publicly‐traded companies respectively, that use the business‐format franchising model and in which franchising
is material to the company’s financial performance and business operations. Collectively the companies in the
FRANdex index operate 123 franchise brands. All index levels are normalized to 1,000 at Q1 2006 for
comparison purposes and all remaining periods are adjusted accordingly. FRANdex+M includes the McDonald’s
Corporation. Since McDonald’s represents more than 25% of the overall market capitalization of publicly‐traded
franchise companies, it is excluded from FRANdex but included in FRANdex+M for comparative purposes.
1



Habit Restaurants Inc. (NASDAQ:HABT) – Franchisor of the fast casual
Habit Burger® Grill restaurant raised approximately $90 million in an IPO
in November 2014, reflecting a $148 million market capitalization. As of
March 2, 2015, HABT was trading at $32.11 per share, with a market
capitalization of $292.4 million.
The Joint Corp. – (NASDAQ:JYNT) – Franchisor of chiropractic clinics
raised more than $17 million in its November 2014 IPO, reflecting a $56.6
million market capitalization. As of March 2, 2015, JYNT was trading at
$8.16 per share, with a market capitalization of $85.1 million.
El Pollo Loco Holdings Inc. (NASDAQ:LOCO) – Franchisor of Mexican
chicken fast casual restaurant raised $107 million in its July 2014 IPO,
reflecting a $537.9 million market capitalization. As of March 2, 2015,
LOCO was trading at $24.62 per share, with a market capitalization of
$891.8 million.
At the moment, public capital markets are being accessed predominantly by
franchisors rather than franchisees. Typically an IPO is not considered the goal for a
franchisee’s investment. Many franchisees are smaller businesses for whom the
substantial cost of being public is too great or whose operations may not be sizable
enough to generate attention from institutional investors. From a valuation standpoint,
stock in publicly-traded franchisees tends to underperform stock in publicly-traded
franchisors as investors impose a discount because franchisee entities do not control
their brand and are thus beholden to their franchisor. Furthermore, franchisors do not
really like it when franchisees go public, in part because franchisees’ public filings have
a tendency to provide a level of granularity to the business that the franchisor may not
want to provide or the results of the franchisee may not be consistent with the results of
the network. Aside from franchisors’ misgivings, perhaps the biggest reason that large
multi-unit franchisees are not pursuing IPOs may be that they simply do not need to do
so. For the past several years, debt has been so cheap -- and private equity
investments so readily available -- that franchisees can raise plenty of private capital to
fund expansion without having to access public funding. However, if interest rates
increase materially, then the availability of inexpensive funding may diminish and large
multi-unit franchisees may need to access the public debt and equity markets to fund
their growth.
Notwithstanding the foregoing, there are a few multi-unit franchisees that are
public, many of which are in the food industry, including:



Arcos Dorados Holdings (NYSE:ARCO), owner and operator of over 1,800
McDonald’s franchise restaurants in Latin America;
Carrols Restaurant Group (NASDAQ:TAST), the largest Burger King franchisee;
Diversified Restaurant Holdings (NASDAQ:BAGR), owner and operator of 42
Buffalo Wild Wings franchise restaurants;
2


Meritage Hospitality Group (OTC:MHGU), owner and operator more than 120
Wendy’s and Twisted Rooster franchise restaurants; and
NPC (debt issuer), the largest franchisee of any restaurant concept in the United
States based on unit count, with 1,266 Pizza Hut franchise restaurants and 144
Wendy’s franchise restaurants.
THE PROCESS FOR “GOING PUBLIC” – SECURITIES PRIMER
III.
In the United States there are two principal federal statutes that govern the
actions of public companies. The first, the Securities Act of 1933, as amended (the
“Securities Act”)2, governs the offer and sale of securities sold in interstate commerce.
Specifically, Section 5 of the Securities Act prohibits the use of mail or other form of
interstate commerce for the offer or sale of a security without a registration statement in
effect, unless an exemption applies.3 The second statute, the Securities Exchange Act
of 1934, as amended (the “Exchange Act”), governs, among other things, the ongoing
periodic obligations of a “publicly reporting company”.4 Under Section 19 of the
Securities Act and Section 23(a)(1) of the Exchange Act, the Securities Exchange
Commission (the “SEC”) is the governmental authority empowered to make, amend and
rescind such rules and regulations as may be necessary to carry out the provisions of
the relevant title. As part of its rule-making authority, the SEC has adopted (1) a series
of registration statement forms, to register various offers and sales of securities under
the Securities Act5, and (2) a series of periodic disclosure forms to address the current,
quarterly, annual reports and proxy statements required to be filed by public
2
15 U.S.C. §77a et seq.
3
The Securities Act, and the rules promulgated thereunder, provides various exemptions from the registration
requirements. Specifically Section 3 of the Securities Act exempts specific types of securities from the provisions
of Section 5, such as government securities, securities issued by a savings and loan association, insurance
policies or annuity contracts and securities which are offered and sold only to persons of a single state or
territory. In addition, Section 4 of the Securities Act exempts specific transactions from the provisions of Section
5, such as transactions by any person other than an issuer, underwriter or dealer, transactions by an issuer not
involving any public offering, transactions involving offers or sales by an issuer solely to accredited investors or
transactions that are under a specific dollar amount. A discussion of the various private placements that a
private or public company may undertake, and the interaction of such actions with the franchise laws, is beyond
the scope of this paper.
4
The Exchange Act also regulates the securities exchanges and the over-the-counter markets operating in
interstate and foreign commerce.
5
The most common Securities Act registration statements used by issuers are as follows:

Form S-1 is the general registration statement form for the issuance and sale of securities if no other form
applies;

Form S-3 is an abbreviated registration statement form for the issuance and sale of securities for cash by
issuers that meet size, character and transaction type requirements or by selling shareholders if the issuer
meets certain size and character requirements;

Form S-4 is a registration statement form for the issuance and sale of securities in exchange for other
securities; and

Form S-8 is a registration statement form for the issuance and sale of securities to employees.
3
companies6. To facilitate consistent disclosure, the SEC has adopted an integrated
disclosure framework. Consequently both the Securities Act forms and most of the
Exchange Act forms will generally refer to a specific item in Regulation S-K (which
provides guidance of the scope of all legal disclosure requirements) or Regulation S-X
(which provides guidance of the scope of all financial disclosure requirements), rather
than explain the disclosure requirements directly in the form.
In addition to federal legislation, the offer and sale of securities is also subject to
applicable state securities laws, often referred to as “blue sky” laws. This dual system
of federal-state regulation has existed since the Securities Act was adopted. In 1996,
this dual system was drastically amended by the National Securities Markets
Improvement Act of 1996 (“NSMIA”)7. NSMIA preempted state regulation for a broad
list of “covered securities”. Included within the definition of “covered securities” were all
“nationally traded securities8.” Offerings of securities that are not “covered securities”
continue to be subject to a dual system of federal-state regulation, including registration
and review.9
This paper will first evaluate the methods a franchisor may take to become a
public company and the tensions that may arise for such franchisor under the franchise
laws as it follows the “going public” process. The paper will then provide an overview of
the ongoing disclosure obligations that a company, once public, must comply with under
the Exchange Act and the special challenges that a franchisor may face in complying
with both its Exchange Act obligations and its franchise law obligations.
There are three classic ways in which a private company can make the transition
to a public one, and each involves careful consideration and a series of well thought out
steps.
6
The most common Exchange Act forms used by issuers are the following: (i) Current Report on Form 8-K for the
reporting of specific items, typically within four business days, (ii) Quarterly Report on Form 10-Q for the report of
financial and other information for each of the first, second and third fiscal quarters, (iii) Annual Report on Form
10-K for the report of the business, risks, financial and other information for the fiscal year and (iv) Schedule 14A
for the proxy statement or other soliciting materials used in connection with a meeting of shareholders.
7
National Securities Markets Improvement Act of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (October 11, 1996).
8
Section 18(b)(1) of the Securities Act defines a “nationally traded security” as a security that is:
“(A) listed or authorized for listing, on the New York Stock Exchange or the American Stock Exchange, or listed
on the National Market System of the Nasdaq Stock Market (or any successor to such entities);
(B) listed, or authorized for listing, on a national securities exchange (or tier or segment thereof) that has listing
standards that the Commission determines by rule (on its own initiative or on the basis of a petition) are
substantially similar to securities described in subparagraph (A); or
(C) a security of the same issuer that is equal in seniority or that is a senior security to a security described in
subparagraph (A) or (B).”
9
The scope of the various state statutes is extremely complex and varied and beyond the scope of this article.
For purposes of this article, the discussion assumes that the company is an issuer of “covered securities.”
4
A.
Initial Public Offering
An initial public offering, or IPO, has historically referred to the first time a
company offers its shares of stock to the general public. In a traditional IPO, a company
registers the offering by filing a registration statement on Form S-1 (a “Form S-1”) with
the SEC.10 All registration statements, including a Form S-1, have two parts: (1) part I,
which is the prospectus that will be delivered to potential investors; and (2) part II, which
includes additional information provided only to the SEC. The prospectus serves two
important functions. First, it serves as a selling document to make investing in the
company appealing. Second, it serves as a disclosure document to make complete and
accurate disclosure of all material information about the company and the offering,
including the associated risks. Once an initial Form S-1 has been filed with the SEC, the
SEC will send a response letter to the company containing comments, questions and
requests for additional information, which the company typically receives within 30 days
of the filing. The company then will file an amended registration statement with
modifications, as necessary, and send a letter to the SEC responding to its comments.
The process can take three to four months, or longer, as the company revises its
disclosures to meet the requests of the SEC. Once a company has “cleared comments”
and the SEC has declared the company’s registration statement effective, the company
is free to market its equity to institutional and retail investors. Its investment bankers will
then take the company on a “road show” where management will have a series of
meetings with brokers, analysts and institutional investors. Once the bankers have
gathered sufficient interest in the offering, they will put together the order book and
provide preliminary pricing. The company will then have the registration “declared
effective” and will execute the underwriting agreement, whereby they agree to sell the
shares at the agreed upon terms. Upon closing, the company will typically list its shares
on the NASDAQ Stock Market LLC (“NASDAQ”), New York Stock Exchange LLC
(“NYSE”) or NYSE MKT (“NYSE Amex”).11
B.
Reverse Merger
Many smaller private companies seek to access the public market by foregoing
the traditional IPO route and instead opting to merge with an existing public company.
This IPO alternative is known as a reverse merger. Reverse mergers typically are used
as a method of going public by smaller companies or foreign companies that, because
10
Under the JOBS Act, emerging growth companies (“EGCs”) are permitted to file a Draft Registration Statement
with the SEC on a confidential basis. The company then goes through the comment and respond process
outside of public scrutiny. EGCs are required to file a definitive registration statement publicly 21 days prior to
the first use of the preliminary prospectus.
11
The NYSE, NASDAQ, and NYSE-MKT are three of the most commonly used national securities exchanges,
although there are also regional stock exchanges. The decision regarding which stock exchange to list on is
usually a hotly discussed issue and will depend, among other things, on the size of the offering, the revenues of
the company, the estimated number of record holders, the exchange which lists the company’s competitors, the
number of market makers that the company expects to have and the perceived value that the board and
management believe will come from being listed on that specific exchange. NYSE and NASDAQ are both
considered to be aimed at companies with significant capitalization while NYSE-MKT is focused on being the
exchange for small-cap companies.
5
of their size, might not be able to attract the attention of underwriters who could take
them through the traditional IPO process.
In a reverse merger transaction, a private company merges with an existing
public “shell company” (a public reporting company with few or no operations or
operating assets), and by doing so becomes public. A reverse merger can be
structured either through the exchange of shares or through the merger of the private
company into a subsidiary of the public shell company. Whichever way it is structured,
the private company’s shareholders acquire a controlling interest in the voting power
and outstanding shares of the public shell company, its management typically takes
over the board of directors and management of the public shell company, and the postmerger public company’s assets and business operations are mainly, if not completely,
those of the formerly private operating company.
Reverse mergers are typically structured so that the public shell company
shareholders are not required to approve the transaction, thereby reducing the
interaction with the SEC prior to effecting the merger. If the transaction requires a
change in the majority of the members of the board of directors, the public shell
company must prepare and file a Schedule 14f-112 with the SEC at least 10 days before
closing the transaction and must mail this document to all stockholders of the public
shell company. Once the reverse merger closes, the public shell company is required
to report, within four business days, the reverse merger in a Form 8-K. This “super”
Form 8-K is a comprehensive disclosure document that includes all the information that
would be included in a Form 10 for the combined company and looks very much like the
Form S-1 that a company would have filed in connection with an IPO. Unlike an
offering, however, the disclosure is filed under the Exchange Act on Form 8-K, which is
not required to be reviewed by the SEC and is effective upon filing. As a result of this
expedited timeframe, a reverse merger can generally be completed in a much shorter
time period than a traditional IPO.
One important difference between a traditional IPO and a reverse merger is the
absence of new capital. While an IPO typically results in new funds being infused into
the company, a reverse merger will only result in the company assuming the obligations
and costs of being a publicly-reporting company, but without the initial infusion of
cash.13 Another significant difference is the stock exchange on which the company will
12
A Schedule 14f-1 is an information statement that looks much like a proxy statement for a public company’s
annual meeting of stockholders. It includes information about the nominees for the board of directors, disclosure
regarding executive and director compensation of the private company (prior to the consummation of the reverse
merger) and the company’s ownership both before and after the transaction. While the SEC has the authority to
review and comment upon this document, typically the SEC does not review this document. Consequently,
unlike a registration statement on Form S-1, this process does not usually delay the consummation of the
transaction.
13
In connection with some reverse mergers, the shell company actually has a significant amount of cash and
therefore, upon closing, the combined company will benefit from the cash as well as the large shareholder base.
However, these transactions tend to look more like a traditional IPO, with investment bankers involved and a
proxy statement, which is subject to prior review and comment by the SEC, being delivered to the public
company shareholders.
6
be listed. Public shell companies are generally listed on the OTC Bulletin Board14,
rather than on NASDAQ, NYSE or NYSE Amex. Commencing in 2011, it has become
much more difficult for public shell companies to “uplist” their shares onto one of the
exchanges after consummation of the reverse merger. In response to significant
investor protection and regulatory concerns that arose in connection with reverse
merger companies, many of which operate primarily outside of the United States, the
exchanges have imposed a one-year waiting period, minimum price requirements and
timely filing of all Exchange Act required filings during the one-year period, before being
eligible to list.15
Despite these concerns, reverse mergers are often still viewed as the quickest
way to obtain other appealing benefits of a public company. These include the ability to
offer meaningful stock options to employees, the use of liquid shares to purchase other
companies, and the credibility and public access to information that a registrant may
need to attract key customers and suppliers. In addition, many companies believe that
because the company will have access to the public markets, raising capital in the
future through public or private offerings will be quicker and less burdensome.
C.
A/B Exchange Offer
The third method for becoming a public company is through an A/B Exchange
Offer. In this type of transaction, the private company does a private offering of its debt
securities to qualified institutional buyers (or “QIBs”) pursuant to Rule 144A. This Rule
144A offering has several similarities with a traditional IPO, including that: (1) the notes
are sold by way of an offering memorandum that contains almost the same type and
scope of disclosure as would be required in a registration statement on Form S-1; and
(2) investment bankers are engaged to underwrite the transaction and are actively
involved in the preparation of the offering memorandum and the subsequent sale of the
notes on the road show.
Unlike an IPO, the disclosure document is not provided to the SEC for its review
and comment prior to the offering. Instead, the private company agrees to register a
14
The OTC Bulletin Board (the “OTCBB”) is an interdealer quotation system that is used by subscribing brokers to
reflect market making interest in OTCBB-eligible securities. Unlike a stock exchange, companies do not apply to
be listed on the OTCBB and there are no ongoing quantitative and qualitative requirements for an issuer to be
listed on the OTCBB, other than that the issuer continue to be current with its Exchange Act obligations.
15
Under stock exchange rules adopted in 2011, a reverse merger company will be eligible to list on an Exchange if
it has:

concluded a “seasoning period” by trading for at least one year in the U.S. over-the-counter market or on
another regulated U.S. or foreign exchange following the filing of the Form 8-K including all relevant
information regarding the combined company;

maintained a closing stock price of $4 (or, in the case of the NYSE Amex, either $3 or $2, depending on the
applicable listing standard) per share or higher for a sustained period of time, but in no event for less than 30
of the most recent 60 trading days prior to the filing of the initial listing application and prior to listing; and

timely filed all required periodic financial reports with the SEC or other regulatory authority (e.g., Forms 10Q, 10-K or 20-F), including at least one annual report containing audited financial statements for a full fiscal
year commencing after filing the information described above.
7
new series of notes, with identical terms at some time post-closing, and to offer to
exchange those registered notes for the privately placed notes. The exchange of these
notes are filed with the SEC on a registration statement on Form S-4 and will be subject
to the same review and comment process as the Form S-1. Once this process is
complete, the company will exchange the notes and will become a “publicly reporting
company.” The company’s equity will not yet be registered or listed on an exchange, so
it will not be able to use its equity as liquidity with the same ease. However, a company
will use the A/B Exchange process for going public if its management only seeks to
access the public debt markets or if they are looking to become an experienced
“seasoned issuer” without the market pressure on their equity.
IV.
CONSIDERATIONS FOR GOING PUBLIC
A.
SEC and FTC Obligations
As the franchise business model reduces many of the upfront costs of expansion,
franchisors typically go public to pay down debt, acquire a second brand, realize a profit
or provide liquidity for their founders, private equity owners, and/or stock incentivized
employees. While the current stock market is attractive for franchise IPOs, there are a
multitude of issues that a company considering an initial public offering must evaluate.
Unanticipated lawsuits, supply chain complications or integrating new officers and
directors might lead the company to postpone the offering. Navigating the regulatory
conflicts between the Securities Act requirements and the Federal Trade Commission’s
Franchise Rule (“FTC Rule”) can be another source of unexpected delay.
As a preliminary matter, a transaction’s timing and structure will invoke, or be
subject to, certain regulatory requirements imposed by the SEC and the FTC, including
the preparation and presentation of financial statements, the additional financial
information that will be included in the prospectus, and the development of a description
of the company. Company management must ensure that: (1) its regulatory documents
to be released include other necessary information about the franchisor, its operating
activities, and those of the franchise network; and (2) harmony exists between
overlapping information contained (or to be contained) in the Registration Statement
and the Franchise Disclosure Document (“FDD”). Thereafter, the franchisor or its
parent must determine how best to communicate information about the “go public” event
to various audiences impacted by the transaction, including the financier community of
prospective investors, existing franchisees of the brand, and prospective future
franchisees (albeit possibly to varying degrees of information flow depending upon the
regulatory protections afforded to each audience). This section and those that follow
address such issues surrounding an IPO or acquisition by a public entity within the
purview of both securities laws and franchise laws.
B.
Financial Statement Issues
In connection with any public offering of equity or debt, one of the first
considerations that management teams address is what financial statements must be
included in the registration statement. When a franchisor is involved, management is
8
well-served to devote heightened attention to which entity’s statements will be required
to be included in the registration statement by SEC regulations (whether the
franchisor’s, a newly created/acquiring parent’s, or perhaps both) and which additional
financial statements or information may be needed to comply with Section 11
requirements.16
1.
FTC Rule
As a precursor to evaluating the financial statements and other financial
information that will be included in the prospectus, management should be mindful that
the FTC Rule and state franchise laws will require inclusion of the franchisor’s audited
financial statements in the FDD. The financials must be current within one hundred
twenty (120) days after the end of the franchisor’s most recently-completed fiscal year.17
While many franchisors commonly operate on a calendar fiscal year, not all do; thus,
the necessary preparation of financial statements for a securities offering might be a
viable reason to change the fiscal year measuring dates for the franchisor entity going
forward.
As an alternative to disclosing the franchisor’s financial statements, the financial
statements of any affiliate (including a parent) of the franchisor that guarantees or
otherwise commits to perform all of the franchisor’s obligations to franchisees may be
included in the FDD in lieu of the franchisor’s financials.18 Hence, even if the public
offering will market shares of a franchisor’s parent entity, management will still have to
produce and release audited, GAAP-compliant statements of the franchisor subsidiary
for FDD purposes, or the public parent will necessarily assume full and direct liability for
the franchisor’s actions and performance of its franchise obligations. Further, even
where a franchisor’s statements must be disclosed in the FDD because no affiliate will
backstop or assure the franchisor’s overall performance, a parent company’s financial
statements still may have to be added into the FDD along with the franchisor’s where
the parent will provide, on the franchisor’s behalf, any post-sale good or service to
franchisees “that is so essential to the franchise… that the franchised business cannot
be conducted without it.”19 For example, it is common in the hospitality industry for hotel
franchisors under a corporate umbrella brand to rely on an affiliate within the corporate
family to provide mandatory “shared or centralized” services (such as billing or
reservation services, food & beverage services, loyalty programs, and so on) directly to
all hotels in the chain, including franchised properties operated by independent third
party franchisees. Thus, subject to the franchise laws, management possibly will be
16
See Infra, at note 50.
17
Although it varies by registration state, newer statements are requirement, whether audited or unaudited.
18
FTC Rule instruction (u) on Item 21. FTC Amended Franchise Rule FAQs #4.D and 21.
19
FTC Amended Franchise Rule FAQ #30: “It is staff’s view that, even in the absence of an express commitment
in the franchise agreement for the franchisor’s parent to provide a good or service that is so essential to the
franchise that the franchised business cannot be conducted without it, this obligation is implicit in the contractual
obligations of the parties. Accordingly, disclosure of the parent’s financial statements in Item 21 is required in
these circumstances.”
9
faced with having to prepare, and make available in the public realm, audited financial
statements for more than one entity involved in a franchise-related “go public” event,
and should analyze such potential exposure when deciding how to structure the event.
2.
Regulation S-X - Generally
Regulation S-X,20 promulgated by the SEC, provides the regulatory framework
for evaluating which financial statements must be included in the registration statement
and the number of years that will be required. Traditionally, Item 3-02 of Regulation S-X
has required companies that register a securities offering with the SEC to include three
years of audited financial statements.21 However, the adoption of the Jumpstart Our
Business Startups Act (“JOBS Act”) in 201222 reduced this requirement to two years for
any company that qualifies as an “emerging growth company” in connection with its
initial offering of equity securities.23 While the name might imply limited applicability, the
JOBS Act actually defines an “emerging growth company” as any issuer24 with “total
annual gross revenues” of less than $1 billion during its most recently completed fiscal
year, calculated in accordance with GAAP or the International Financial Reporting
Standards (“IFRS”). Consequently, approximately 80% of all IPO issuers since the
enactment of the JOBS Act have qualified as “emerging growth companies”. An
interesting issue arises, however, for franchisors who are going public as the FTC Rule
and state franchise laws require that the franchisor’s FDD include three prior years’ of
audited financial statements. If the entity that is going public is the same entity that is
included in the franchisor’s FDD, or if it is a parent entity with minimal assets or income
to differentiate it from the operating company’s financial results, then three years of
audited financial statements are already available and securities counsel and the
accountants must determine whether (1) the omission of the additional year of financial
information could be deemed to be material,25 and (2) they are comfortable with some
20
17 CFR Part 210.
21
17 CFR Part 210.3-02
22
Jumpstart Our Business Startups Act, Pub. L No. 112-106, 126 Stat. 306 (2012).
23
While the JOBS Act amendment to Securities Act Section 7(a)(2)(A) that permits the filing of only two years of
audited financial statements is limited to the registration statement for the emerging growth company’s initial
public offering of common equity securities, the SEC, in Question 12 of its “Jumpstart Our Business Startups Act
Frequently Asked Questions”, has indicated that it will not object if, in other registration statements, an emerging
growth company does not present audited financial statements for any period prior to the earliest audited period
presented in connection with its initial public offering of common equity securities.
24
If the financial statements for the most recent year included in the registration statement are those of the
predecessor of the issuer, the predecessor’s revenues should be used when determining if the issuer meets the
definition of an emerging growth company.
25
As discussed infra at note 50, Section 11(a) of the Securities Act makes the issuer, the directors of the issuer,
persons named, by their consent, in the registration statement as about to become directors of the issuer, every
person who signs the registration statement, every expert (e.g., accountant, engineer, appraiser, etc.) who is
named by consent as having certified or prepared any part of the registration statement (but solely with respect
to that part certified or prepared) and every underwriter of the relevant security liable for any untrue statement of
material fact in a registration statement or any omission of any material fact required to be stated in a registration
statement or necessary to make statements therein not misleading, to any person acquiring the relevant security
unless the purchaser knew of such untruth or omission at the time of the acquisition.
10
potential investors (those that have access to the FDD) having different information than
those that are making a decision solely on the information contained in the prospectus.
In addition to the audited financial statements of the issuer, two other financial
statement requirements may impact franchisors that have been actively acquiring units
or refranchising company units: (1) Rule 3-05 of Regulation S-X, which addresses the
financial statement requirements of a significant business - recently acquired or whose
acquisition is probable; and (2) Rule 11-01 of Regulation S-X, which addresses the pro
forma financial information that is required when a significant business has been
acquired or disposed, or such transaction is probable. The term “probable” is
interpreted to mean more likely than not. While the SEC’s staff (“Staff”) has taken the
general view that an acquisition becomes probable upon the signing of a letter of intent,
“probability” must be evaluated on the facts and circumstances of the particular situation
and may vary based upon the customary practice for an industry or situation.
3.
Regulation S-X - Acquisitions
Rule 3-05 of Regulation S-X requires that issuers provide audited financial
statements for any (i) business26 or (ii) variable interest entity27 that is consolidated in
the issuer’s financial statements that was acquired since the date of the last audited
balance sheet if the acquired business exceeds 20%, 40% or 50% of any of the
following three tests:



Asset Test – comparing registrant’s share of acquired business’s total assets
to the registrant’s consolidated total assets.
Investment Test – comparing the total GAAP purchase price of the acquired
business to the registrant’s consolidated total assets.
Income Test – comparing the acquired business income from continuing
operations before income taxes, extraordinary items and cumulative effect of
a change in accounting principle to registrant’s consolidated business income
from continuing operations before income taxes and extraordinary items.
The required presentation period of the financial statements varies based on the
level of significance. Typically, (i) for acquired businesses that exceed the 20%
26
In “NOTE to SECTION 2010.2” of the Division of Corporate Finance – Financial Reporting Manual” (the “FRM”)
the Staff of the SEC (the “Staff”) stated that the staff’s analysis of whether an acquisition constitutes the
acquisition of a business, rather than of assets, focuses primarily on whether the nature of the revenue producing
activity previously associated with the acquired assets will remain generally the same after the acquisition. New
carrying values of assets, or changes in financing, management, operating procedures, or other aspects of the
business are not unusual following a business acquisition. To the extent that registrants have succeeded to a
revenue producing activity by merger or acquisition, with at least one of the other factors listed above remaining
after the acquisition, the Staff encourages registrants to obtain concurrence from the staff in advance of a filing if
they intend to omit financial statements related to the assets and activity.
27
Topic 2005.8 of the FRM states that an acquisition or disposition by a variable interest entity that is consolidated
in the registrant’s financial statements pursuant to ASC 810 is subject to the … S-X reporting requirements even
if the consolidated variable interest entity does not meet the S-X 1-02(n) definition of “majority-owned subsidiary.”
11
threshold, one year of audited financial statements are required; (ii) for acquired
businesses that exceed the 40% threshold, two years of audited financial statements
are required; and (iii) for acquired businesses that exceed the 50% threshold, three
years of audited financial statements are required. For first time registrants involving
businesses built by the aggregation of discrete businesses that remain substantially
intact after acquisition (i.e., industry roll-ups), SEC guidance allows first-time issuers to
consider the significance of businesses recently acquired or to be acquired based on
the pro forma financial statements for the issuer’s most recently completed fiscal year. 28
Each of these tests has relatively complicated interpretations so it will be important to
get the company’s accounting group and its external auditors to focus on these
obligations as soon as possible.
As noted earlier, the SEC defines “business” very broadly, so while a transaction
may be structured as an asset purchase agreement, the Staff may still take the position
that a “business” was acquired. Franchisees or franchisors (depending on who is the
registrant) that are acquiring multiple outlets, may face challenges in preparing financial
statements that reflect the results of operations, statement of cash flows and statement
of equity of the individual outlets for the required presentation period. If the registrant
acquires or succeeds to substantially all of the entity’s key operating assets, then full
audited financial statements of the acquired entity are presumed to be necessary, with
the elimination of specified assets and liabilities not acquired or assumed by the
registrant being depicted in pro forma financial statements that demonstrate the effects
of the acquisition. However, if the registrant acquires or succeeds to less than
substantially all of the entity’s key operating assets, then in lieu of providing complete
“audited financial statements” a registrant can approach the SEC about the ability to
provide either “carve-out” financials29 or audited statements of assets acquired and
liabilities assumed and statements of revenues and direct expenses30 (abbreviated
financial statements). In this case, the registrant should submit a request to substitute
such abbreviated financial statements —or carve-out financial statements—in place of
28
Staff Accounting Bulletin 80.
29
Section 2065.3 of the FRM provides guidance that “carve-out” financial statements may be appropriate when the
acquired business represents a discrete activity of the selling entity for which assets and liabilities are specifically
identifiable and a reasonable basis exists to allocate items that are not specifically identifiable to the acquired
business, such as debt and indirect expenses not directly involved in the revenue producing activity. Carve-out
financial statements should reflect all assets and liabilities of the acquired business even if they are not
acquired/assumed as part of the acquisition.
30
Sections 2065.4 through Section 2065.12 of the FRM provide guidance when abbreviated financial statements
may be appropriate and confirm that (i) the included statement of assets acquired and liabilities assumed as of
the end of each period required to be provided under S-X 3-05 on the basis of seller’s historical GAAP carrying
value and (ii) the included statement of revenues and direct expenses exclude only those costs not directly
involved in the revenue producing activity, such as corporate overhead, interest and taxes. All costs directly
associated with producing revenues reflected in the statement, including, but not limited to all related costs of
sales and other selling, general and administrative, distribution, marketing, and research and development costs,
must be included in the statement.
12
full financial statements, to the Division of Corporate Finance’s Office of Chief
Accountant (CF-OCA) prior to filing.31
Rule 11-01 of Regulation S-X requires issuers to provide pro forma financial
information when: (1) a significant business has been acquired during the most recent
fiscal year or interim period for which a balance sheet is required or since the most
recently provided balance sheet date, (2) a significant business acquisition is probable,
or (3) the disposition of a significant business has occurred or is probable and is not
fully reflected in the financial statements of the issuer included in the filing. For
purposes of Rule 11-01, a business’s significance is evaluated based the same three
tests (described earlier) that are used for historical target financial statements, and the
business will be deemed significant if it exceeds 20% percent in the case of acquisitions
or 10% in the case of dispositions. For franchisors that have had significant
refranchising activity, it is important to determine if the units being divested meet the
definition of a “business” – and if so, to keep in mind the need to prepare pro forma
financial statements to comply with applicable SEC disclosure requirements.
C.
Communicating the Transaction – Recipients, Information and
Timing under Franchise and Securities Laws
Securities and franchise laws share a common goal—protecting investors from
undue harm. The main goal of federal securities laws is to protect investors by
providing them will full disclosure about the securities that are being offered or which
they hold. Similarly, the FTC Rule is designed to protect potential franchisees by
providing them with information essential to an assessment of the franchise opportunity
and helping to prevent serious economic harm caused by a franchisor’s omission of
material disclosures. It goes without saying that a public offering—a major event in the
life of a company—is material and will need to be disclosed in accordance with
applicable SEC, FTC and state law requirements. In addition to disclosing the
transaction in any securities filings, the franchisor also will need to communicate
information about the transaction to prospective franchisee purchasers as part of, or
supplemental to previously-provided representations made in, the franchisor’s FDD, and
possibly even to existing franchisees to the extent that their ongoing operations will be
impacted. In the context of the franchise laws and securities laws, key questions arise
about the type of information that is “material” for purposes of disclosure to potential
investors, and when that information becomes “material” such that it must be
announced publicly. These questions are not easily answered under the franchise or
securities laws.
31
Letters requesting a waiver or accommodation relating to certain financial reporting requirements should be
submitted to CF-OCA via [email protected]. Please see the SEC website for guidance on how to submit
these type of waiver requests - https://www.sec.gov/divisions/corpfin/cflegalregpolicy.htm
13
1.
FTC Rule and Timing of Disclosure
While the FTC Rule falls short of defining “materiality”,32 regulatory guidance
issued along with the federal franchise legislation cross-references other FTC
rulemaking on deceptive trade practices to indicate that any representation or omission
is “material” where the underlying information would be likely to impact a reasonable
prospective franchisee’s purchase decision.33 This guidance reflects a prior definition of
“materiality” that had been written into the older iteration of the FTC Rule, and is
similarly included in certain state franchise laws, to calibrate the barometer of
“materiality” with the likelihood that an objective investor would consider a piece of
information (or an omission thereof) as a decision-making variable before purchasing.
Further, other FTC guidance has indicated that the subject matter of every disclosure
instruction covered by the FTC Rule is “material,” even if some such changed
information about the franchise offering may only require updating in the following year’s
FDD rather than via an interim amendment to the current FDD. Thus, the significance
of the new information to be shared, and the juncture at which that information becomes
influential on the investment decision, are difficult factual questions to be addressed on
a case-by-case basis.
By all accounts, a franchisor going public is material information that must be
disclosed to a prospective franchisee. But at what point during the process is this
disclosed? When management signs an engagement letter with its independent
auditors to handle an intended IPO, when the company files a confidential Draft
Registration Statement (a “DRS”) with the SEC, or when the company engages in “test
the waters” meetings with potential investors? No foolproof agency direction exists on
this question, except to revert back to the materiality barometer in context of the
reasonable investor, while relevant case law has suggested that omission of information
about a change in franchisor’s ownership could be deemed fraudulent or deceptive,
depending upon the prospective investor’s sophistication, level of reliance on
discussions with franchisor, and other situational characteristics.34
2.
Securities Act and Timing of Disclosure
The Securities Act contains detailed restrictions on the types of promotional and
sales activities in which an issuer can engage prior to the initial public offering, based on
three time periods: (1) the pre-filing period before the registration statement is filed; (2)
the quiet period before the SEC declares the registration statement effective; and (3)
the post-effective period after the registration statement is effective but before the
buying and selling of the security begins. In the pre-filing period, companies need to
avoid “conditioning” the market for the companies’ securities, a violation known as “gun
32
For the definition of “materiality” in the predecessor franchise rule, see 16 C.F.R. § 436.2(n) (2006).
33
72 Fed. Reg. 15,455 (Mar. 30, 2007). FTC staff cites Section 5 of the FTC Act on deceptive practices.
34
Century Pac., Inc. v. Hilton Hotels Corp., 528 F. Supp. 2d 206, 236 (S.D.N.Y. 2007) (granting summary judgment
for defendants on fraud claim involving sale of Red Lion brand after hotel franchisor told franchisee pre-sale that
it was not planning to sell the chain), aff’d, 354 F. App’x 496, 499 (2d. Cir. 2009).
14
jumping.” Because gun jumping restrictions apply to all forms of communications, and
intent is not required, statements in speeches, press releases and even Twitter tweets
must be carefully considered to avoid being construed as attempting to generate
demand for an upcoming offering. Jumping the gun may result in the SEC delaying a
proposed public offering.
As a result, many companies severely restrict
communications to the market during the pre-filing period.
3.
Practical Considerations for Franchise Company Going Public
These conflicting rules can create timing issues between the FTC Rule
requirements and the Securities Act’s pre-IPO requirements. The post-disclosure
waiting period following FDD receipt by a prospective franchisee prevents a franchisor
from signing franchise-related agreements or receiving money in consideration for the
franchise for 14 days. This waiting period could extend into the limitation periods
imposed by the SEC and prevent (or delay) a franchise sale to the extent a franchisor is
wary of violating the FTC Rule (for lack of material disclosure) or common law (for fraud
or misrepresentation). The FDD must be updated each quarter, and any financial
information must be updated before each FDD is delivered. But at certain times before
an IPO, the Securities Act limits the information a company may release. During the
quiet period, a company may not make any announcements that might reasonably be
expected to affect an investor’s analysis of the company. Frequently, franchisors are
approached during the quiet period because of the publicity an IPO announcement
brings to the company.
A franchisor considering going public should strategically time its decision to
avoid the FDD’s updating times and minimize the quiet period. Filing under the JOBS
Act’s confidential filing process is a method to minimize the amount of publically
available information about the franchise and prevent possible conflicts with the FDD. A
well-constructed communication plan with franchisees is necessary to ensure the
company does not accidentally violate the FTC Rule or the securities laws. Even so,
navigating between the two regimes is complicated because the FDD must be updated
periodically for material changes, and if a franchisor chooses to disclose financial
performance, as many do, then each FDD must be updated with any material changes
to the financial performance representations.
Fortunately, strong nondisclosure
agreements with potential franchisees might alleviate some risk.
Once management deems the transaction as material to a reasonable
prospective franchisee purchaser, the franchisor then should address various steps to
inform interested or affected parties about the changes to its operations and franchise
program.
First, the franchisor should strongly contemplate suspending all selling activities
under its current FDD, because the information contained therein is incomplete or
inaccurate with respect to at least some or all of the following: the franchisor’s
ownership status and history, organizational formation, updated financial structure, and
potential changes in network operations.
15
Next, the franchisor should start the process of amending its FDD, or preparing a
supplemental disclosure that corrects or adds to existing disclosures contained in its
current FDD, as necessary, in each jurisdiction where its FDD remains effective
(including submitting post-effective amendment paperwork in franchise registration
states). While no current state franchise laws mention the concept of providing a
disclosure “supplement” to an FDD, the FTC Rule explicitly permits franchisors to
disclose any material changes within a reasonable period of time after the close of each
fiscal quarter by way of an addendum or supplement to the FDD. 35 The topic of FDD
amendment practice is discussed separately in Section V below.
Besides initiating supplemental disclosures or amendment, some franchisors
may also choose to distribute press releases or informational notices to pipeline
prospects and to existing franchisees in order to ensure that these audiences have
general knowledge and awareness of the anticipated transaction. By delivering possibly
material news in such an informal and supplementary manner, a franchisor can lay the
foundation for a colorable defense against possible future allegations of fraud or
misrepresentation for failure to disclose the transaction. In such cases, the simple act
of disseminating information about the transaction to prospective and existing
franchisees can help to diffuse substantially the level of future risk (or claimed damages
incurred by) franchisees seeking to allege fraud, omission, or misrepresentation claims
against the franchisor. Also, this “informal” method of providing notice of the material
transaction may be especially helpful in dealing with pipeline prospects who are well
advanced in the sales process at the time a potential transaction is ripening toward
“materiality” in order to trigger the franchisor’s disclosure obligations.
Finally, and as alluded to above, since information about a public offering often is
highly confidential, any mention of a material event to prospective franchisees should be
well coordinated and properly sequenced in conjunction with other regulatory reporting
obligations and internal procedures. Communications to existing franchisees or
prospective purchasers should occur no earlier than the securities-related filings, and
should otherwise be implemented in tandem with other investor-facing communications,
inter-company or inter-departmental advisories, executives’ updates to company owners
or lenders, and operational personnel who may have support responsibilities to existing
franchisees.
The following section explores the complexities of disseminating
confidential information in greater detail.
V.
ONGOING CONSIDERATIONS FOR PUBLIC FRANCHISORS
Whether a private company goes public by way of a traditional IPO, a reverse
merger or an A/B Exchange, the net result is that the company is now subject to the ongoing reporting obligations of the Exchange Act. For franchisors that are also subject to
federal and state franchise laws, this can bring complications.
35
75 72 Fed. Reg. 15566 (Mar. 30, 2007).
16
A.
Disclosure Obligations For Public Franchisors
While the focus of the Securities Act discussed above is to allow investors
access to basic facts about a company before an offering of securities, the focus of the
Exchange Act is to allow investors periodic access to information about the company’s
ongoing performance. Like the Exchange Act, the FTC Rule is designed to require
uniform and complete disclosure documents for prospective franchisees. Both regimes
were formed in the wake of abusive sales practices: the securities laws passed in the
wake of the depression, and the FTC Rule was enacted in the aftermath of abusive
franchise sales practices in the 1960s. The regulatory approach under both regimens is
similar because securities lawyers had considerable influence over the creation of
franchise laws at the state and federal levels. The regimes rely on accurate disclosure
of information to inform investors and potential purchasers.
Under the federal securities laws, an issuer has no general obligation to disclose
material information as it arises absent additional circumstances.36 For companies that
are not offering their securities under the Securities Act, the duty to provide disclosure
for a public company arises from four sources: (1) the ongoing disclosure obligations set
forth in Section 12(b) and 12(g) of the Exchange Act for companies that are listed on an
stock exchange or that have completed a public offering, (2) an affirmative duty to
disclose material information when a company “insider” (including the company itself)
possesses material, nonpublic information that may affect the value of the company’s
securities and the insider intends to trade on that information, (3) pursuant to Regulation
Fair Disclosure, to the extent that the issuer intends to disclose, or has disclosed,
material non-public information to a member of the professional investment community
or a shareholder37 and (4) a duty to correct any materially inaccurate, incomplete or
misleading disclosure it may have previously made, commonly referred to as a “duty to
correct”.
1.
Periodic Reporting Obligations Under the Exchange Act
As discussed above, Section 12 of the Exchange Act prescribes a series of
periodic reports that are required to be filed by public companies. The forms most
commonly used by public companies are the following:
Form 8-K - A Current Report on Form 8-K (a “Form 8-K”) is an event-based
report that generally must be filed with the SEC within 4 business days after a
reportable event occurs, although certain reportable events are subject to a safe harbor
and may be included in the next periodic filing. In 2004, the SEC dramatically expanded
the scope of the items that require reporting. There are currently 21 distinct categories
of items that are required to be reported by all public companies on a Form 8-K38.
36
“Silence, absent a duty to disclose, is not misleading under Rule 10b-5.” Basic, Inc. v. Levinson, 485 U.S. 224,
239 n. 17 (1988). See also Chiarella v. United States, 445 U.S. 222, 235 (1980) (‘‘When an allegation of fraud is
based upon nondisclosure, there can be no fraud absent a duty to speak. We hold that a duty to disclose under
§10(b) does not arise from the mere possession of nonpublic market information.”).
37
See GARY M. BROWN, SODERQUIST ON THE SECURITIES LAWS § 12:7, at 12-31 to 12-35 (5th ed. 2006).
38
In addition, there are 6 additional items that are only reportable by issuers of asset-backed securities.
17
These include (1) entry into, or termination of, a material agreement, (2) completion of
acquisition or disposition of assets, (3) creation of, or triggering events that accelerate, a
direct financial obligation or off-balance sheet arrangement, (4) material impairments,
(5) sales of unregistered securities, (6) changes in accountants or non-reliance on
previously issued financial statements, (7) and change in director or named executive
officers or any new compensation arrangement or award provided to a named executive
officer (8) amendment to the company’s organizational documents or its code of ethics
(or a waiver of a provision of the code of ethics), (9) the results of the annual meeting,
and (10) any other “material information” that the issuer believes its need to report in
order to comply with its other disclosure obligations. In addition, the SEC included two
additional items, Item 2.02 (Results of Operations and Financial Condition) and Item
7.01 (Regulation FD Disclosure) which are permitted to be “furnished” rather than “filed,”
and therefore subject to lesser liability.
Form 10-Q – A Quarterly Report on Form 10-Q (a “Form 10-Q”) is a periodic
report required to be filed by public companies to report their results for their first,
second and third fiscal quarters. Form 10-Qs are due 40 days after the quarter-end for
large accelerated39 and accelerated filers and 45 days after quarter-end for all other
issuers. The Form 10-Q is required to contain (i) unaudited financial statements
prepared in accordance with GAAP, (ii) a Management Discussion and Analysis
(“MD&A”), which provides management’s explanation of material changes in revenue,
expense and liquidity items for the quarter as compared to the prior year period as well
as estimates regarding known trends, and (iii) an update of other material events that
have occurred during the quarter (e.g., any new risks that have arisen during the
quarter, the commencement of significant litigation)
Form 10-K – An Annual Report on Form 10-K (a “Form 10-K”) is a periodic report
required to be filed by public companies to provide an annual update regarding the
company and its financial results. Form 10-Ks are due 60 days after the year-end for
large accelerated filers, 75 days after year-end for accelerated filers and 90 days after
year-end for all other filers. The Form 10-K is required to contain, among other things,
(i) audited financial statements, (ii) a MD&A analyzing the results year over year, (iii) a
narrative discussion of the business, the risks associated with the business, properties
and legal proceedings, (iv) an overview of the market performance of the stock, (v) an
overview of the company’s corporate governance practices, (vi) information regarding
its directors and executive officers and the compensation paid to such persons during
the prior year and (vii) a description of transactions between the company and
management or principal stockholders.40 The required information is substantially
39
Pursuant to Rule 12b-2 of the Exchange Act, an issuer who has been subject to the reporting requirements of the
Exchange Act for more than one year and has filed at least one annual report will be an “accelerated filer” if it
had an aggregate worldwide market value of voting and non-voting common equity held by non-affiliates of at
least $75 million but less than $700 million and a “large accelerated filer” if it had an aggregate worldwide market
value of voting and non-voting common equity held by non-affiliates of $700 million or more, in each case as of
the last business day of the issuer’s most recently completed second fiscal quarter.
40
The disclosure regarding the Company’s corporate governance, directors and officers, director and executive
compensation and the Compensation Discussion and Analysis are permitted to be included in the company’s
18
similar to the information required to be contained in the Form S-1 to register the
company’s securities under the Securities Act.
2.
Duty to Correct and Update Under the Securities Laws
While the federal securities laws do not impose a general duty to continuously
update prior communications on a subject upon the discovery or development of new
material facts, an issuer does have a duty to correct when a public company makes a
historical statement, believing it to be true at the time made, but subsequently discovers
that statement to have been materially incorrect, misleading or incomplete. Upon
discovering the statement’s inaccuracy the company has an obligation to correct the
statement within a reasonable time. Determination of a reasonable time depends upon
the particular facts and circumstances surrounding the disclosure.
It is important to note that a duty to correct only arises if the inaccurate statement
made by a company was material. Courts are more likely to consider disclosures
relating to a matter material when a company, itself, places importance on that matter.
For example, if a company has a pattern of supplementing its projections with
subsequent public disclosures, courts will take such pattern into consideration when
determining materiality sufficient to impose a duty to correct.
3.
Periodic Reporting Under the Franchise Laws
The FDD forms the basis of an ongoing relationship between the franchisor and
the prospective franchisee. Not surprisingly, more information about the potential
franchisor/franchisee relationship must be disclosed than the securities laws require.
Even though both legal regimes developed in a similar fashion (first by state laws and
then federal preemptive laws), securities lawyers typically do not need to refer to state
laws for large public companies, because NSMIA, as discussed earlier, preempts state
legislation for “covered securities.”41 For franchisors, both federal and state laws may
apply to a single transaction and national franchisors will often file FDDs in multiple
states. The nature of the transaction, where franchisees are expected to contribute
substantial effort to running their franchise, also drives many of the additional FDD
requirements, such as territorial exclusivity plans, training plans, advertising
contributions, cost recovery fees, and transfer restrictions.
A franchisor may not include superfluous information in its FDD. The FTC Rule
and state counterpart legislation are clear that only the specific items of disclosure can
be detailed in an FDD. Determining if a particular piece of information is required to be
included in a securities filing, the FDD, or both, is the subject of the next section.
Franchisors have a continuing obligation to ensure that their disclosure
documents are up to date. Similar to the securities laws, the FTC Rule imposes three
proxy statement, rather than its Form 10-K, provided that the proxy statement is filed within 120 days of the fiscal
year-end.
41
See infra notes 7, 8 and 9.
19
basic periodic updating requirements: (1) annual updates; (2) quarterly updates; and (3)
notification of changes in financial performance information.42
As periodic updates to the FDD are governed by state and federal legislation,
public company franchisors can face challenges in coordinating the timing of such filings
with their securities law counterparts. Within 120 days after the fiscal year-end, a
franchisor must update its FDD to ensure that it is current (and file renewals subject to
approval in certain registration states), in order to continue to offer and sell franchises.43
By comparison, as discussed above, the Form 10-K is due either 60, 75 or 90 days after
the fiscal year-end. However, for franchisors that may be registering or renewing an
FDD after 120 days past its fiscal year-end, certain state franchise registration laws (for
example, Hawaii, Maryland, Minnesota, and Virginia) require franchisors to also include
unaudited financial statements of the franchisor (or its substituted parent or affiliate)
current within 90 to 120 days before the FDD’s issuance date. This requirement could
prove problematic for a publicly traded franchisor, or its public parent, that can only
issue financial statements in connection with its 10-Q or 10-K filings. The subsequent
quarterly filing may not yet be prepared or due for release. Further, some public
companies may not be permitted to issue unaudited statements at all due to internal
company policies (in which case substantial costs of a new audit would be
unavoidable).
As a result, coordination and timing are critical between a public
franchisor’s annual FDD renewal filings and its securities reporting calendar to ensure
that franchise offering activities can continue seamlessly, and cost-effectively, in the
franchisor’s normal course of business.
With respect to the timing and need for quarterly updates, federal and state
franchise laws lack perfect alignment on amendment instructions and timing. Whereas
the FTC Rule instructs a franchisor to update its FDD on a quarterly basis within a
reasonable time after each fiscal quarter ends,44 state franchise laws vary on specified
timing for amending a franchisor’s registration. By way of example, Virginia mandates
that an FDD be amended “within 30 days after a material change,” but Maryland and
California specify that an FDD be amended “promptly” in the wake of a material
change.45 Besides the absence of a clear nationwide timing metric for when to amend
an FDD after a material change, the FTC seemingly blurs amendment compliance
issues further by noting that some—but not all—material changes will necessitate
quarterly (rather than annual) updating. “Material changes include such events as the
recent filing of a bankruptcy petition or the filing against the franchisor of a legal action
that may have a negative effect on its financial condition,” but “several of the disclosure
requirements. . . require only annual updating,” such as Item 3 franchisor-initiated
litigation, and Item 20 network statistics and trademark-specific association information
(provided, of course, that such events do not alter the company’s financial position or
42
Franchise Rule 16 C.F.R. Part 436 Compliance Guide.
43
Id.
44
72 Fed. Reg. 15,566 (Mar. 30, 2007).
45
79 CAL. CORP. CODE § 31123;) MD. CODE REGS. § 02.02.08.06(A)(1); 21 VA. ADMIN. CODE § 5-110-40(A).
20
ongoing operations enough to rise to the level of affecting a prospective franchisee’s
purchase decision regarding the franchise investment).46
Absent a common deadline by which to amend an FDD under federal and state
franchise laws, franchisors often follow the practice of making material changes to its
existing FDD within thirty (30) days after the end of the franchisor’s fiscal quarter (i.e.,
akin to the federal standard). Notwithstanding this approach, where the information
forming the basis of a material change is so significant—for example, a sale of the
franchisor entity to a public company, or a public offering of shares in a heretofore
private franchisor entity—that the franchisor’s failure to convey such information to a
prospective franchise owner might constitute a damaging omission or fraudulent
misrepresentation by the franchisor, then the franchisor should not wait a month or
more to amend its FDD. Instead, the franchisor is best served to immediately amend its
FDD to reflect the material event, and in the meantime cease franchise sales activities
until the FDD is properly amended (and registered in certain states, as applicable).
Finally, it is worth noting again that: (1) the FTC Rule allows a franchisor to disclose any
material changes on a quarterly basis (plus 30 days after quarter close) via an
addendum or supplement to the FDD, although no state franchise laws mention
supplemental disclosure as a means of amending the FDD;47 and (2) an informal notice
from a franchisor containing materially changed information, like a press release, letter
campaign, or email blast, can be an expedient mechanism to diffuse potential fraud or
misrepresentation claims from prospective franchisee investors, although it is necessary
to align with securities counsel on whether the underlying facts of any situation warrant
this approach.
Further, the fact that the FTC Rule does not permit any franchisor-based
exemptions (e.g. size or experience-based exemptions) from a franchisor’s duty to
disclose—but only certain transaction-based (or prospect-focused) exemptions from
disclosure—illustrates the importance of a prospect receiving particular information in a
timely manner in connection with making a franchise investment decision. Finally, even
where an exemption from registration or notice may exist under an individual state’s
franchise law, disclosure of an FDD to the prospect is frequently required – again
pointing to the importance of prospective franchisees being informed of required
information.
4.
Practical Considerations
With respect to periodic filings, securities counsel and franchise counsel of a
public franchisor will need to take care to manage both the scope and timing of the
disclosures. In preparation of both the FDD and the Form 10-K, public franchisors
should have internal procedures in place to ensure there are no inconsistencies
between the two filings. However, not all information contained in the Form 10-K will
necessarily be deemed “material” for an FDD, and vice versa. 48 The timing of the
46
FEDERAL TRADE COMMISSION, FRANCHISE RULE COMPLIANCE GUIDE 126 (2008).
47
75 72 Fed. Reg. 15566 (Mar. 30, 2007).
48
See infra Section V.B.
21
disclosures also must be coordinated based on the fact that the annual update to the
FDD will not be due until 30 to 60 days after the Form 10-K is due49, while the quarterly
updates to the FDD may likely be filed 10 to 15 days prior to the date the Form 10-Q is
due. Franchise counsel will want to avoid material information being released in the
Form 10-K that has not yet been included in the FDD which could subject a franchisor to
claims from a new franchisee that an FDD used during the intervening period was not
complete. Meanwhile, securities counsel will want to confirm that there is no information
being disclosed in the annual update to the FDD that should have been included the
Form 10-K or that, upon disclosure, would trigger either a Form 8-K filing requirement or
a Regulation FD violation. With respect to quarterly updates, the concerns would be
reversed.
When it comes to updates and disclosure necessitated by material
developments, either expected or unexpected, it is important that securities counsel
keep franchise counsel aware of anticipated disclosure. As a result of the significant
liability under the federal securities laws imposed on companies and on individual
director and officers, the analysis of what is required to be disclosed in the securities
arena tends to be an on-going discussion with counsel and management. Determining
whether any Form 8-K disclosure or any other securities disclosure will trigger a need to
immediately update the FDD, and stop selling until the update and new registrations are
completed, is an important step that should be part of every public company’s
disclosure checklist.
B.
Evaluating Materiality Under the Two Regimes
As discussed above, “materiality” is the touchstone concept against which both
securities-related and franchise-related disclosure obligations are measured when
deciding whether, and when, to communicate new information that might influence a
reasonable person’s purchase decision.
1.
Materiality Under the Franchise Laws
Within the context of the franchise laws, even if the franchisor might not deem
new information as “material,” the FTC Rule allows any prospective franchise owner to
regard every statement in a franchisor’s FDD as material. According to interpretive
materials issued by the FTC Staff, Section 436.9(h) of the FTC Rule reflects the FTC
Staff’s viewpoint that every disclosure required by the FTC Rule is material to a
prospective franchise owner’s investment decision.”
It therefore follows that any change to the information presented within an FDD
could be material, and should be appropriately updated in compliance with applicable
federal and state laws. Such considerations can extend beyond the realm of the
franchisor’s daily business activities, including changed circumstances within the
franchisor’s corporate family. For instance, in the context of Item 1 alone, a franchisor
49
See discussion supra Section V.A.1. “Periodic Filings under the Securities Laws”. The due date of a Form 10-K
is based on the market capitalization of the public company.
22
subsidiary positioned within a publicly-traded conglomerate may need to constantly
monitor and update background information on “affiliates” that offer other franchises or
that supply or service the franchisor’s franchisees, and “parent” companies that may
assert control or direction over the franchisor’s policies. Similarly, Item 12 requires
disclosure about possible territorial conflicts with other affiliated franchise brands, while
Items 3 and 4 implicate certain types of disputes or bankruptcy proceedings that have
involved named personnel (from Item 2) or affiliates (from Item 1) within the prior tenyear period.
In a consolidated public company, ongoing franchise disclosure obligations can
be extremely challenging to satisfy at all times, as the franchisor entity may not readily
be aware of changes in business activities and circumstances of these attenuated
entities, persons, or related brands. This may also be true of sophisticated financing or
acquisition/divestment activities undertaken by a consolidated public company, which
could be deemed “material” to prospective franchise owners and/or to current franchise
owners in some situations if the change in financial variables (net worth, explanatory
notes to statements, etc.) might have a “material impact” on the financial position of the
public company, or the subsidiary franchisor.
2.
Materiality Under the Securities Laws
If a franchisor is a public company, it not only has to make disclosures under the
materiality standards of the franchise laws, but also has to make relevant disclosures
under the federal securities law materiality standards. The federal securities laws
provide two similar statutory regimes under which materiality is evaluated, under the
Securities Act in connection with disclosure made in registration statements and
prospectuses and under the Exchange Act in connection with any offer or sale of
securities.

Section 11(a) of the Securities Act50 creates civil liability in connection with
statements contained in a registration statement upon its effectiveness,51
while Section 12(a)(2) of the Securities Act creates civil liability in
connection with statements contained in a prospectus or in an oral
communication in connection with an offer or sale of a security. 52 In each
case, if the document contains “an untrue statement of a material fact or
omit[s] to state a material fact required to be stated therein or necessary to
make the statements therein not misleading.”53
50
15 U.S.C.A. § 77k(a).
51
For large accelerated and accelerated issuers that are able to utilize the shelf registration statement provisions of
Securities Act rules, Rule 430B(f) provides that the deemed effective date under Section 11 of the Securities Act
for the part of the registration statement relating to such offering is the earlier of the date any prospectus
supplement for such offering is first used or the date and time of the first contract of sale of securities in such
offering to which any such prospectus supplement relates. See SEC Release No. 33-8591, p. 205-206.
52
15 U.S.C.A. § 77l(a)(2).
53
15 U.S.C.A. § 77k(a).
23

Section 10(b) of the Exchange Act is a general anti-fraud provision
applicable to the purchase and sale of any security, 54 while Rule 10b-5
promulgated thereunder imposes liability if a company makes, among
other things, “any untrue statement of a material fact or to omit[s] to state
a material fact necessary in order to make the statements made, in the
light of the circumstances under which they were made, not misleading.”55
In each of these regulatory regimes, the determination of whether there is liability
is based on whether the fact, either misstated or omitted, was “material.” Determining
materiality under the securities laws can be difficult due to an intentional lack of bright
line rules and guidance from the SEC and federal courts. The courts view a materiality
determination as fact and context-specific, and consequently have been unwilling to
adopt any rigid formula or bright lined test under the theory that any such formula or test
that views a single fact or occurrence as dispositive in a materiality finding must
necessarily be over-inclusive or under-inclusive.56
Two key U.S. Supreme Court cases, TSC Industries v. Northway, Inc.57 and
Basic, Inc. v. Levinson,58 together set the standard for the current materiality test under
the securities laws, which is an objective one59. The Supreme Court has ruled that
materiality exists if there is a “substantial likelihood that a fact would have been viewed
by the reasonable investor as having significantly altered the ‘total mix’ of information
made available.” The standard does not require that there be a substantial likelihood
that the misstated or omitted facts actually lead to an investor changing an investment
or voting decision. Rather, it merely requires that there be a substantial likelihood that
proper disclosure of the misstated or omitted fact would have had actual significance in
the deliberations of a reasonable investor.
In addition to the obligations to include within disclosure documents “all material
facts”, Item 303 of Regulation S-K, which provides for the disclosure of Management’s
Discussion and Analysis of the period over period financial results, requires public
disclosure of “any known trends or uncertainties that have had or that the registrant
reasonably expects will have a material favorable or unfavorable impact on net sales or
revenues or income from continuing operations.” Most practitioners view this as an
54
Section 10(b) of the Exchange Act makes it unlawful to “use or employ, in connection with the purchase or sale
of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and
regulations as the Commission may prescribe.” 15 U.S.C.A. § 78j(b).
55
17 C.F.R. § 240.10b-5(2). Rule 10b-5 also includes broader anti-fraud provisions in subsection (1) and (3) which
makes it unlawful for any person: (1) “[t]o employ any device, scheme, or artifice to defraud”;…or “[t]o engage in
any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in
connection with the purchase or sale of any security.” However the application of these provisions is beyond the
scope of this article.
56
Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1312 (2011).
57
TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). TSC Industries adopted materiality test in the
context of Section 11 of the Securities Act.
58
Basic, Inc. v. Levinson, 485 U.S. 224, 232 (1988). Basic expressly adopted the materiality test of TSC Industries
for claims made under Section 10(b) of the Exchange Act and Rule 10b-5.
59
Akerman v. Oryx Commc’ns, Inc., 609 F. Supp. 363, 367 (S.D.N.Y. 1984).
24
extension of the obligation to not “omit a material fact” that would make those
statements, in this case the discussion of historical financial results, not misleading.
The SEC has provided practitioners limited guidance to assist them in making
materiality assessments in connection with a company’s disclosure obligations. Staff
Accounting Bulletin 99 – Materiality (“SAB 99”), issued in 1999, provides a quantitative
and qualitative framework to evaluate materiality in the context of financial statements
misstatements60. The bulletin begins by acknowledging the “rule of thumb” that a
misstatement below a five percent threshold may provide the basis for a preliminary
assumption that the misstatement is immaterial.61 SAB 99 then identifies a nonexhaustive list of qualitative factors that could render even a misstatement below five
percent material. 62 Finally, SAB 99 notes that market reaction to the disclosure of the
misstatement may “provide guidance” as to whether an item should be deemed material
and that when management or an auditor expects that a known misstatement may
result in a significant positive or negative market reaction, that expectation should be
taken into account when considering whether a misstatement is material.63 In 2000, as
part of its Regulation Fair Disclosure adopting release,64 the SEC referred to TSC
Industries and Basic, for direction to practitioners in evaluating materiality. In addition,
the release provided a non-exhaustive list of information and events that are likely to be
considered material, including (i) earnings information; (ii) mergers, acquisitions, joint
ventures or tender offers; (iii) acquisitions or dispositions of company assets; (iv) new
products or discoveries; (v) developments regarding customers or suppliers (such as
the acquisition or loss of a contract); (vi) changes in control or management; (vii)
changes in a company’s auditors or receipt of notice that the company may no longer
rely on an audit report; (viii) events regarding a company’s securities, such as: defaults
on senior securities, a call of securities for redemption, repurchase plans, stock splits or
changes in dividends; (ix) changes to the rights of shareholders; (x) the public or private
sale of securities; and (xi) bankruptcies and receiverships.65
In making a materiality determination for contingent or speculative events, the
probability that the event will occur must be balanced with the significance of the event
to the company. This balancing requires consideration of specific facts.
60
64 Fed.Reg. 45150 (Aug. 12, 1999).
61
Id. at 45151.
62
Qualitative considerations for determining materiality cited by SAB 99, included whether the item (1) is capable of
precise measurement or is based on an estimate (and the degree of imprecision inherent in the estimate); (2)
affects the trend in earnings or other key items; (3) is consequential to meeting analysts’ consensus
expectations; (4) changes results from positive to negative; (5) is significant to a segment; (6) is consequential to
compliance with regulatory requirements or loan or other contractual requirements; (7) affects compensation; (8)
is intentionally wrong or misleading, or conceals unlawful transactions; or (9) prompts significant market reaction.
Id at 45152.
63
Id.
64
Release Nos. 33-7881, 17 CFR Parts 240, 243, and 249.
65
Id.
25
3.
Practical Considerations
In evaluating materiality under the two regulatory regimes, publicly traded
franchisors should focus on two areas of potential concern. The first is the categories of
information that are required to be included in the FDD and that are included within the
itemized information required to be disclosed, if material, by the rules and regulations
adopted by the SEC under the Securities Act and the Exchange Act. With respect to
these categories of information it is important that each of the franchise and securities
counsel of a publicly traded franchisor coordinate to ensure that disclosure is consistent.
This is not to indicate that the disclosure will be a mere “copy and paste” from one
document to another. In fact, there may be reasons why a specific fact would be
relevant to a potential franchisee, but not to investors in the public company. 66 For
example, requirements to remodel a specific restaurant at certain intervals and the
costs associated with such remodeling is clearly material to a franchisee, but may not
be material to an equity investor in the public company as it would not be the public
company’s capital commitment. However, to the extent that the public company has
advised investors that it believes that the reimaging of its franchise system is one of the
future drivers of growth, then revisions to the remodeling timing or costs that are
included in a FDD could be deemed to be material to the public company investors.
The second area of potential concern is the additional information that will tend to
be disclosed under the securities laws due to its principles-based approach to
disclosure. At first glance materiality under the franchise laws may be viewed as more
prescriptive than that of the federal securities laws. The FTC Rule sets forth the
categories of information that will be deemed to be material, but does not on its face
require an analysis of additional factors that might be relevant to prospective
franchisees. By comparison, the securities laws set out a framework of what types of
information might be deemed material but leaves it to the company and its advisors to
determine what information a reasonable investor might deem relevant in making an
investment decision. However, the reality is that both sets of laws seek to protect
investors and avoid “fraud” claims.67
Consequently, franchise lawyers should
continually review the periodic SEC filings, the earnings releases and transcripts and
other investor presentations to determine if information being provided to investors
belongs in the FDD. For example, a discussion in the MD&A of known trends regarding
supply costs or statements by management of future strategy to reduce marketing
expenses by moving to a new advertiser may be deemed relevant to a potential
franchisee, although not technically required to be disclosed by the FDD.
C.
Communicating with Franchisees - Confidentiality Concerns
Preserving the integrity of confidential information is a paramount concern to
public company franchisors given the real dangers that may arise under the SEC
66
See infra Section V.D. The disclosure of legal proceedings is one of these areas.
67
There is potential liability for material omissions under the anti-fraud provisions commonly found in the franchise
registration and disclosure laws, as well as under common law fraud, negligent misrepresentation and similar
theories.
26
regulations for selective disclosure and the very real need to share certain information
with their franchisees. On the one hand, the SEC holds public companies accountable
for ensuring that all investors, including potential investors, have access to the same
material information about the company and its performance at the same time. This
ensures that everyone is on the same playing field with respect to their investment (or
divestment) decisions, and helps to prevent instances of insider trading—a serious
offense that can lead to criminal prosecution, heavy fines and prison for both the “tipper”
and the party that acts on the tip. While every public company has a healthy paranoia
about preserving the integrity of confidential information (often internally disclosing
material non-public information very selectively only to senior executives and others on
a “need to know” basis), complexities abound when the public company is a franchisor.
Franchisors are in the unique position of fueling unit growth through third parties
by exploiting the use of these third parties’ capital and effort. The franchised business
model thus creates an efficient tool for growth, provided that franchisors engage with
their franchisees robustly about key matters related to the development and operation of
their units. Franchisors also work closely with franchisees to maintain a competitive
edge in the marketplace, often by sharing insights and analytics related to brand health,
network-wide performance and sharing strategies for moving forward in a way that will
help maintain or enhance competitive advantages against industry rivals. Through
these varied conversations, franchisors sometimes find themselves in the position of
sharing confidential information with franchisees that is not otherwise made available to
the public.
In response to the SEC’s increasing concern over the practice of selective
disclosure by public companies of important non-public information which gave select
investors an informational advantage, the SEC adopted Regulation Fair Disclosure
(“Regulation FD”). Regulation FD prohibits a public company from disclosing material,
non-public information to its shareholders or market professionals (such as analysts)
“under circumstances in which it is reasonably foreseeable that the person will purchase
or sell the [company’s] securities on the basis of the information,” unless it discloses
the same information to the public. Public disclosure is required to be made
simultaneously in the event of an intentional disclosure and promptly (no later than 24hours or the next trading day) in the case of an inadvertent disclosure. This public
disclosure is typically made through a Form 8-K filed or furnished with the SEC, though
it may be made through other methods reasonably designed to effect broad, nonexclusive distribution to the public.68
68
The Regulation FD adopting release provided guidance that acceptable methods of public disclosure for
purposes of Regulation FD would include press releases distributed through a widely circulated news or wire
service, or announcements made through press conferences or conference calls that interested members of the
public may attend or listen to either in person, by telephonic transmission, or by other electronic transmission
(including use of the Internet), provided that the public had been given adequate notice of the conference or call
and the means for accessing it. More recently, the SEC had begun to provide guidance under what
circumstances disclosure by way of posting on the company’s website or through other social media distribution
channels may be deemed to be “public disclosure.”
27
However, Regulation FD was not intended to capture all communications a public
company has with its stakeholders. For example, it does not apply to ordinary-course
business communications of the public company with its suppliers, customers or
employees. In addition, disclosure of material, non-public information is exempt from
Regulation FD if made to a person who “expressly agrees to maintain the disclosed
information in confidence.” Although these confidentiality agreements are not required
to also have the counterparty confirm that it will not trade upon such information, many
companies include this restriction as the SEC has stated that if a recipient of material
nonpublic information subject to such a confidentiality agreement trades or advises
others to trade, he or she could face insider trading liability”. 69 Technically, to the extent
franchisees have entered into confidentiality agreements with their franchisor,
communications with franchisees should be exempt from Regulation FD. However,
practically, franchisors may not want to put their franchisees in the tenuous position of
deciding which information that they received may be shared with their employees or
financial sponsors and which information is “material” and therefore would subject them
to civil or criminal sanctions for insider trading. Additional concerns arise in connection
with broad based franchisee communications, via mailings, webcasts or conferences.
First, to the extent that covered persons are part of the audience for such
communications, it could result in a Regulation FD breach. Second, to the extent the
information leaked and an analyst became aware of it, company officers would be in a
very difficult position of either not responding to questions on the topic or of prematurely
disclosing the information. As a result of these concerns, many public franchisors
decide to limit all broad-based franchisee communications to information that is either
public or non-material70 from a securities law standpoint.
The truth is that there is no magic statement or approach to striking the right
balance between needing to share certain confidential, non-public information with
franchisees and complying with the SEC’s prohibition on sharing material, non-public
information. That’s the rub, and it’s very real -- especially when franchisees also own
shares in the public company franchisor. Public company franchisors thus are wise to
have a healthy paranoia about the kinds of information to be shared with franchisees
and why it must be shared. Assessing how important the information is to continued
strong franchised operations may be instructive in assessing whether, or when, the
franchisor chooses to share that information. For example, the franchisor may decide
that it is best to withhold certain acquisition information from franchisees until the
franchisor is ready to make its requisite disclosure to the SEC. In that case,
contemporaneously with or shortly after the requisite filing, the franchisor might choose
to provide its franchisees with separate, special notice of the new information by way of
an alert bulletin or a video message from the CEO announcing the change (and
affirming the importance of ensuring that the franchisees have knowledge of the
information).
69
See Question 101.05 of the “Compliance and Disclosure Interpretations – Regulation FD” issued by the Division
of Corporation Finance of the SEC:
70
See supra Section V.B. “Evaluating Materiality Under Two Regimes” for a discussion of the factors that a public
franchisor may take into consideration in deciding whether information is material.
28
Another sensitive communication and franchisee relationship issue arises when a
public franchisor must determine precisely when a potential significant transaction
should be deemed material, and thereby trigger disclosure. Should a potential
acquisition or sale be disclosed at the time the franchisor, its parent, or its affiliate signs
a preliminary agreement (for example, a non-disclosure agreement (“NDA”),
memorandum of understanding (“MOU”), initial term sheet or letter of intent (“LOI”)), or
should the franchisor postpone disclosing the anticipated deal until after the parties sign
a definitive and binding agreement? Franchise companies often face such questions
without clear regulatory guidance. As a practical matter, many franchise companies
have adopted a practice of not disclosing a potential material event (or planned event),
such as sales, acquisitions, or financing transactions by the franchisor or its corporate
affiliates, until a definitive agreement is signed.71 The rationale is that before the signing
of a definitive agreement, non-binding negotiations (or non-binding documentation such
as an LOI or MOU) between the parties are not conclusive that the parties will enter into
a definitive agreement. Moreover, the transaction may be confidential, which is a
particularly sensitive issue for publicly-traded franchise companies that would need to
coordinate any public disclosure of a material event with their securities-related filings,
investor-facing communications, and various company departments and personnel that
have reporting responsibilities to shareholders and financiers (as well as operational
support responsibilities to franchisees). Upon signing a definitive agreement, however,
the level of expected certainty that the transaction will consummate is such that a
franchisor should strongly assess the probability that the information could be “material”
to prospective franchise owners.
Franchisors also should educate their franchisees about the public company
sensitivities that impact how and what the franchisor is able to share with its
franchisees. That approach will create a better understanding among the franchisee
base as to why the franchisor is unable to disclose certain information until immediately
before, or even contemporaneously with or after, the requisite SEC disclosure notice.
While these considerations are of paramount importance when franchisees own shares
in the public company franchisor, they are still important where the franchisee does not
own shares in the public company because even the franchisee’s innocent mention of
confidential information to a third party could result in an indirect tip. This is especially
important in today’s environment where analysts aggressively target franchisees of
public companies in an effort to elicit information that is not otherwise available.
Accordingly, uneducated franchisees could pose a risk to themselves and the franchisor
if they do not have a proper awareness of the issues at play.
71
The Form 8-K adopting release affirmatively rejected the proposal that a Form 8-K would be triggered by the
execution of a non-binding agreement or a letter of intent. Instead the release confirmed that only the execution
of a "material definitive agreement" which provide for obligations that are material to and enforceable against or
by a company are required to be disclosed pursuant to Item 1.01. However, the release continues to reiterate
that there may be other instances under the securities laws in which a company would be required to disclose
non-binding agreements, notwithstanding the absence of a Form 8-K requirement.
29
D.
Litigation Disclosures under the Two Regimes
Both the SEC and FTC require disclosure of “material” litigation in their
respective underlying offering documents, but each takes a different approach with
respect to defining the type of litigation that is “material” and also in defining the parties
to whom the disclosure obligation applies and when litigation must be disclosed.
Item 103 of Regulation S-K requires issuers to include in any registration
statement and any annual or quarterly report a brief description of the following:






any material pending legal proceedings, other than ordinary routine litigation
incidental to the business, to which the issuer or any of its subsidiaries is a
party or of which any of their property is the subject;
any material legal proceedings known to be contemplated by governmental
authorities
any material bankruptcy, receivership, or similar proceeding with respect to
the issuer or any of its significant subsidiaries
any material proceedings to which any director, officer or affiliate of the
registrant, any owner of record or beneficially of more than five percent of any
class of voting securities of the registrant, is a party adverse to the registrant
or any of its subsidiaries or has a material interest adverse to the registrant or
any of its subsidiaries;
material administrative or judicial proceedings arising under any Federal,
State or local provisions that have been enacted or adopted regulating the
discharge of materials into the environment or primary for the purpose of
protecting the environment; and
any material pending legal proceeding which involves a cyber incident.72
Item 103 specifically excludes disclosure in the following scenarios:


If the business ordinarily results in actions for negligence or other claims,
no such action or claim need be described unless it departs from the
normal kind of such actions; and
For any proceeding that involves primarily a claim for damages if the
amount involved, exclusive of interest and costs, does not exceed 10
percent of the current assets of the registrant and its subsidiaries on a
consolidated basis.73
72
Division of Corporation Finance Disclosure Guidance: Topic No. 2 – Cybersecurity (Oct. 13, 2011).
73
However, if any proceeding presents in large degree the same legal and factual issues as other proceedings
pending or known to be contemplated, the amount involved in such other proceedings shall be included in
computing such percentage.
30
The determination of which legal proceedings are “material” can be challenging,
particularly for types of proceedings that are not expressly addressed in Regulation S-K.
Typical issues that trigger a materiality assessment under the securities laws include
the potential impact on the company’s earnings, potential major loss of business
including loss of a sizable contract, and potential loss of a major customer. Courts and
the SEC look at two factors to determine whether a pending or threatened legal
proceeding is material to a reasonable investor: (1) the probability of incurring losses in
such a proceeding and (2) the anticipated magnitude of those losses. Courts consider
both factors and balance them to determine materiality. This materiality test arises from
Basic, Inc. v. Levinson (U.S. Sup. Ct. 1988), in which the Supreme Court held that, in
the case of speculative or contingent events (pending or threatened legal proceedings
are by nature speculative or contingent events), materiality “will depend at any given
time upon a balancing of both the indicated probability that the event will occur and the
anticipated magnitude of the event in light of the totality of the company activity.”
Consequently, in evaluating which legal proceedings must be evaluated the issuer must
first evaluate the probability and magnitude of the litigation itself. 74 Even if the legal
proceeding is deemed to meet this “materiality” threshold, companies do not need to
disclose proceedings that occur in the “ordinary” course of running their business
(unless it is an otherwise specified type of proceeding – such as an environmental
proceeding).
By comparison, the FTC Rule is much broader and sets forth several types of
material litigation that must be disclosed. Specifically:
-
-
-
-
74
Pending administrative, criminal or material civil actions alleging a violation of a
franchise, antitrust or securities law, or alleging fraud, unfair or deceptive
practices or comparable allegations.
Concluded actions involving the above-mentioned types of claims in which the
defendant was “held liable,” which is defined as having to “pay money or other
consideration, . . . reduce an indebtedness by the amount of an award, cannot
enforce it rights, or . . . take action adverse to its interests.”
A felony charge in which the defendant has been convicted or pleaded nolo
contendere.
A currently effective injunctive or restrictive order or decree resulting from a
pending or concluded action brought by a public agency and relating to the
franchise or to a Federal, State, or Canadian franchise, securities, antitrust, trade
regulation or trade practices law.
Any material civil action involving the franchise relationship in the past fiscal year,
defined with reference to contractual obligations between the franchisor and
franchisee that directly relate to the operation of the franchised business. Such
actions include lawsuits to recover unpaid royalty payments and advertising fees,
lawsuits for unfulfilled training obligations or failure to purchase required products
See also In re Bank of America AIG Disclosure Sec. Litig., C.A. No. 11 Civ. 6678 (JGK) (S.D.N.Y. Nov. 1, 2013)
in which the Court held that no disclosure was required under the securities laws, of a pending claim of “at least
$10 billion” was required since the imminence and amount of AIG’s suit were insufficiently certain.
31
and services, and others that relate to the franchise relationship. Exempted from
this “franchise relationship” disclosure requirement are actions involving suppliers
or other third parties, or indemnification for tort liability.75
The scope of disclosure under the FTC Rule extends not only to pending and
concluded actions in which the franchisor is named a defendant, but also to actions that
involve other entities and individuals associated with the franchisor.
Specifically,
litigation disclosure obligations also apply to the franchisor’s predecessor, parent, any
affiliate who induces franchise sales by promising to back the franchisor financially or
otherwise guarantees the franchisor’s performance, any affiliate that offers franchises
under the franchisor’s principal trademark, and any person identified in Item 2 of the
FDD.76
“Materiality,” for purposes of the FTC Rule’s Item 3 disclosure, is defined with
reference to civil actions, other than ordinary routine litigation incidental to the business,
which are material in the context of the number of franchisees and the size, nature, or
financial condition of the franchise system or its business operations.77 In short, the
types of litigation that must be disclosed under the FTC Rule are aimed at preventing
deception and untoward sales practices, by ensuring that prospective franchisees have
all material information to make an informed decision about whether to sign a franchise
agreement with a particular franchisor. Accordingly, the best practice recommendation
when confronted with a disclosable litigation matter is for the franchisor to cease all
franchise sales activities and amend its FDD to include the requisite disclosure prior to
redisclosing the candidate and resuming offer and sale discussions.
As discussed above, the federal securities laws do not impose a general
obligation to disclose material information as it arises, including any legal proceedings,
absent additional circumstances. With respect to legal proceedings, the Exchange Act
only requires disclosure of material legal proceedings in the issuer’s quarterly or annual
report. There is no item disclosure requirement under Form 8-K that would require
immediate disclosure of a material development in a material legal proceeding.
Consequently, unless the company is under some other legal obligation to speak, or
voluntarily speaks and therefore is required to be fulsome, the federal securities laws
only require updating legal proceedings disclosure quarterly in the Form 10-Q and the
Form 10-K.
For publicly reporting franchisors, the issue may arise that the FTC Rule will
potentially require disclosure before that which would be required by the securities
rules. In such cases, the issuer will need to evaluate whether may need to proactively
and voluntarily provide more information to investors, via a voluntary Form 8-K or other
public disclosure.
75
Federal Trade Commission, Franchise Rule, 16 CFR § 436.5(c)(1-2) (2007).
76
Id.
77
Id. at § 436.5(c)(i)(B).
32
E.
Financial Performance Representations
Every investor in every business venture wants a solid return on investment,
whether that investor is a potential franchisee or an investor in a public company.
Accordingly, and as alluded to earlier in this paper, both the SEC and FTC have
adopted strict rules governing how and when a public company franchisor may share
financial performance information with potential investors.
1.
Disclosing Financial Performance Under the Franchise Laws
Under the FTC Rule, if a franchisor elects to include a financial performance
representation for a collection of units, it must adhere to several firm requirements,
including:
(1)
(2)
(3)
The franchisor must have a reasonable basis and written
substantiation for any performance representation included in
the FDD;
The representation must relate to performance of the franchise
system’s existing outlets or a subset of the those outlets that
share certain characteristics (e.g., geographic location, type of
location, and so on); and
The franchisor must include detail surrounding the number of
outlets in the data set, including the actual low and high
performance metrics and the number and percent of outlets
that actually attained or surpassed the stated result.
Franchisors often use average historical sales data in their FDDs, although some
franchisors also provide detail on average costs and other financial indicators (e.g.,
labor metrics, royalty and advertising fee deductions) to arrive at a net sales amount.
FTC guidance also is clear that a franchisor with a substantial sample of franchised
outlets cannot exclude franchised outlet results from Item 19. In fact, while a franchisor
may include corporate-owned outlet performance in its Item 19 statement, it may not do
so to the exclusion of relevant franchised outlet data.
2.
Disclosing Financial Performance Under the Securities Laws
Franchisors who make a financial performance representation in the FDD will
also need to evaluate (1) whether the financial information in the FDD complies, or
needs to comply, with the requirements of Regulation G78 which governs the
presentation of non-GAAP financial measures, (2) whether such information needs to
be disclosed in accordance with Regulation FD prior to its inclusion in the FDD and (3)
78
17 CFR PARTS 228, 229, 244 and 249. Adopting Release No. 33-8176 - Conditions for Use of Non-GAAP
Financial Measures.
33
whether such information is required to be included in the company’s securities filings
for purposes of complying with Section 11 and Rule 10b-5.79
From a securities law standpoint, financial information disclosed by a public
company is classified into one of four categories: (1) financial statement data taken
directly from the financial statements and calculated in accordance with GAAP (“GAAP
financial measures”)80, (2) financial data that does not modify the GAAP comparable
measure,81 (3) measures of operating performance or statistical results (“operating
metrics”)82, and (4) non-GAAP financial measures. Regulation G defines a non-GAAP
financial measure as “a numerical measure of a registrant’s historical or future financial
performance, financial position or cash flows that (i) excludes amounts, or is subject to
adjustments that have the effect of excluding amounts, that are included in the most
directly comparable measure calculated and presented in accordance with GAAP in the
statement of income, balance sheet or statement of cash flows (or equivalent
statements) of the issuer; or (2) includes amounts, or is subject to adjustments that
have the effect of including amounts, that are excluded from the most directly
comparable measure so calculated and presented.”83 For public companies, the most
common types of non-GAAP financial measures include EBITDA. Non-GAAP financial
measures can often be identified by the phrase “Adjusted” in front of the financial or
“excluding the impact of…” after the financial measure. To the extent that any entity
that is required to file reports pursuant to Sections 13(a) or 15(d) of the Exchange Act,
or a person acting on its behalf, discloses publicly or releases publicly any material
information that includes a non-GAAP financial measure, then such disclosure must
79
See discussion supra Section V.B.2. “Materiality Under the Securities Laws” on the evaluation as to whether
such information is required to be included in a periodic filing or a registration statement will depend on the
analysis as to whether such information is a “material fact” or if the omission of such information would make the
information contained in such document misleading.
80
Included within the scope of this category are measures of profit or loss and total assets for each segment
required to be disclosed in accordance with GAAP in the company’s segment footnote to its consolidated
financial statements. For many public franchisors, segment profitability is measured on the basis of EBITDA or
Operating Revenue by regional segment or by brand.
81
In accordance with Regulation G, this would include the following types of information: (i) disclosure of amounts
of expected indebtedness, including contracted and anticipated amounts; (ii) disclosure of amounts of
repayments that have been planned or decided upon but not yet made; (iii) disclosure of estimated revenues or
expenses of a new product line, so long as such amounts were estimated in the same manner as would be
computed under GAAP.
82
Regulation G sets forth a non-exclusive list of the types of operating metrics that would not covered by the
regulation and that, therefore, may be disclosed without complying with the specific guidance set forth in the
regulation. These include: (1) operating and other statistical measures (such as unit sales, numbers of
employees, numbers of subscribers, or numbers of advertisers); and (2) ratios or statistical measures that are
calculated using exclusively one or both of: financial measures calculated in accordance with GAAP; and
operating measures or other measures that are not non-GAAP financial measures. For public franchisors,
common operating metrics are Average Restaurant Sales per unit, same store sales growth, and franchise
system sales.
83
Id.
34
include (1) the most directly comparable GAAP financial measure, (2) a reconciliation of
such non-GAAP financial measure to the most directly comparable GAAP measure.84
3.
Practical Considerations
As discussed above, in order to comply with both the securities laws and the
franchise laws, a public franchisor should ensure that its franchise counsel and
securities counsel collaborate closely on these issues to avoid potential landmines.
The first analysis that counsel will need to determine is whether the financial
results in the FDD will be deemed to be the financial results of the public company. If
the public company has multiple brands and subsidiaries and the financial data in the
FDD is of only one subsidiary of the public company and is tied solely to the subsidiary’s
results, then it would likely not be the results of the public company. However, to the
extent that financial information is of the public company or the public company has only
one subsidiary and the results of the two entities are substantially similar, then the
disclosure in the FDD could be deemed to the financial information of the public
company.
 If the financial information is deemed to be that of the public
company, then the company would need to decide if the
inclusion of such information in the FDD would be deemed to
be “disclosing publicly or releasing publicly” such information.
While franchisees often sign a non-disclosure agreement
(“NDA”), typically franchisors do not require potential
franchisees to sign a NDA before receiving the FDD and the
FDD is often made publicly available.85 In either of these cases,
if any of the financial information in the FDD was a non-GAAP
financial measure, the FDD would need to comply with
Regulation G and include the reconciliation to the most directly
comparable GAAP metric.
The second analysis that the counsel will need to determine is whether the
financial results in the FDD is “material information” regarding the public company as a
whole. For example, would the reader of such information be able to extrapolate results
such that he or she would have additional “non-public information” about the historical
or future financial or operational results of the public company as a whole? As with
most analysis on franchise and securities issues, the recommended approach will differ
84
In addition, to the extent that such non-GAAP financial information is included in a document that will be filed
with, or furnished to, the SEC, Regulation G sets forth additional requirements, including (i) presenting the
directly comparable GAAP financial measure with equal or greater prominence and (ii) disclosing the reasons
why the company’s management believes that the presentation of the non-GAAP financial measure provides
useful information to investors regarding the registrant’s financial conditions and results of operations.
85
National franchisors have to file their FDDs with certain ‘registration’ states that don’t have exemptions from
agency filing/review (such as Minnesota) and therefore the information in the FDD may be deemed to be
“disclosed publicly” even if the individual recipient signed a NDA before receiving the FDD.
35
based on factors unique to each public company franchisor and franchise system. To
illustrate this point, a franchisor with 1,000 company-owned units and 1,000 franchised
units is may not run afoul of Regulation FD or Rule 10b-5 by including in its FDD a
financial performance representation that discloses the historical, system-wide average
unit sales for the 1,000 franchised units. Under that scenario, the sample size could be
deemed to be too small to extrapolate the historical or future performance of the entire
system. However, the analysis very likely would change if the franchisor in that
scenario had a materially smaller number of company-owned units— say 50—as
compared to the 1,000 franchised units detailed in the FDD. The analysis could also
change if the franchisor had announced that it was in the process of a refranchising
initiative and that, consequently, a reasonable investor could deem it material to
understand the historical financial results of the franchised units in predicting the future
results of the whole system.
 If the information is deemed to be “material”, then the
information must be disclosed in a Regulation FD manner86
prior to the delivery of the FDD to any potential franchisee of
the filings of the FDD with any governmental entity that makes
the FDD publicly available.
VI.
CONCLUSION
Franchise and securities practitioners face a series of landmines when a client
indicates a desire to go public, both with respect to the initial planning and analysis as
well as the many ongoing considerations that must be taken into account at every turn.
While the potential rewards for public company franchisors are great, a rigorous
approach to the issues that arise is a necessary precursor to achieving a successful
public offering and franchise. Developing and maintaining a healthy awareness of the
various issues, and then consulting with counsel versed in navigating such matters, will
help alleviate the additional disclosure burdens and information restrictions that attach
to public companies.
86
As discussed above, Regulation FD deems information to be public if it was included in a registration statement
or periodic filing filed or furnished with the SEC or if it was made on or at a Regulation FD compliance
conference call or a presentation. See supra Section V.C., for a discussion of Regulation FD.
36