Informal Staff Advisory Opinion 05-5

This staff advisory opinion addresses two issues under the Franchise Rule: (1) the disclosure of audited financial statements; and (2) the disclosure of parent information.

I. BACKGROUND

According to your letter, your client (“Client”), a corporation, is wholly owned by a private corporation (“Parent”). In turn, Parent is wholly owned by a private holding company (“Holding Parent 1”), which in turn is wholly owned by a second private holding company (“Holding Parent 2 ”). Client currently has no audited financial statements; however, Parent, Holding Parent 1, and Holding Parent 2 each has audited financial statements.

Client has entered into an asset purchase agreement with a limited liability company (“Predecessor”). Predecessor had offered franchises in compliance with the Franchise Rule, but has no audited financial statements because it ceased offering franchises before the Franchise Rule would require audited statements. Under the asset purchase agreement, Predecessor sold its franchise-related assets and assigned its existing franchise contracts to Client, but retained all liabilities and obligations arising under its franchise contracts prior to the date of the agreement. Client assumed approximately 8% of the Predecessor’s total debt. Predecessor, which remains in existence, now operates solely as a real estate holding company.

According to your letter, Client now wishes to operate under Predecessor’s former trade name and offer the franchises previously offered by Predecessor. You now asks a series of questions concerning audited financial statements and parent information. First, you inquire whether Client must disclose financial information other than its own unaudited financial statements. If so, must Client:

  1. disclose Predecessor’s unaudited financial statements?
  2. disclose Parent’s audited financial statements?
  3. disclose Holding Parent 1’s audited financial statements?
  4. disclose Holding Parent 2’s audited financial statements?

Second, you ask whether Client must disclose background information (e.g., name, address, business experience) of the Parent, Holding Parent 1, and/or Holding Parent 2.

II. AUDITED FINANCIAL STATEMENTS

The Franchise Rule requires franchisors to attach to its disclosure document audited financial statements. Specifically, franchisors must include:

A balance sheet (statement of financial position) for the franchisor for the most recent fiscal year, and an income statement (statement of results of operations) and statement of changes in financial position for the most recent three fiscal years. Such statements are required to have been examined in accordance with generally accepted auditing standards by an independent certified or licensed public accountant.

16 C.F.R. § 436.1(a)(20)(i).

The Rule sets forth two exceptions to the audited financial statement requirement. First, there is a conditional exception permitting a franchisor to use the audited financials of its parent. Specifically:

where a franchisor is a subsidiary of another corporation which is permitted under generally accepted accounting principles to prepare financial statements on a consolidated or combined statement basis, [audited financial information] may be submitted for the parent if (A) the corresponding unaudited financial statements of the franchisor are also provided, and (B) the parent absolutely and irrevocably has agreed to guarantee all obligations of the [franchisor] subsidiary.

16 C.F.R. § 436.1(a)(20)(i).

Second, there is an exception for start-up franchise systems from the general requirement that all financial statements be audited. On this point, the Franchise Rule provides as follows:

Unaudited statements shall be used only to the extent that audited statements have not been made, and provided that such statements are accompanied by a clear and conspicuous disclosure that they are unaudited. Statements shall be prepared on an audited basis as soon as practicable, but, at a minimum, financial statements for the first full fiscal year following the date on which the franchisor must first comply with this part shall contain a balance sheet opinion prepared by an independent public accountant, and financial statements for the following fiscal year shall be fully audited.

16 C.F.R. § 436.1(a)(20)(ii).

As noted in the Interpretive Guides to the Franchise Rule, the exception for start-up franchisors may result in franchisors having three fiscal years to phase in audited financial statements. For example, if a franchisor begins to sell franchises – and thus first begins to comply with the Rule – in fiscal year 2005, then the franchisor may use unaudited financials during 2005, as well as 2006 (its first full fiscal year selling franchises). In fiscal year 2007 – the year after the franchisor has completed one fiscal year selling franchises – it must provide a balance sheet opinion. Thereafter, starting with fiscal year 2008, the franchisor must prepare fully audited financial statements. See Interpretive Guides, 44 Fed. Reg. at 49,966, 49,981 (Aug. 24, 1979).

In your letter, you ask whether Client must include the audited financial statements of Parent, or one of the two Holding Parents. You also ask whether Client must include the unaudited financial statements of Predecessor. We begin our analysis by noting that the Franchise Rule does not specifically require any franchisor to include financials of third-parties, including the financial statements of related companies. Accordingly, the Rule does not require Client to include the financial statements of its Parent, Holding Parent 1, or Holding Parent 2. That said, Client may wish to take advantage of the exception for Parents, which, under the facts presented, would permit franchisor to include the audited financials of Parent, Holding Parent 1, or Holding Parent 2, provided the conditions noted above are satisfied: (1) the franchisor includes its own unaudited financials in the disclosure document and (2) the parent “absolutely and irrevocably agrees to guarantee all obligations of” Client.

A more difficult question arises with respect to Predecessor. We first note that the Franchise Rule contains no express requirement that a successor-franchisor include financial statements of a predecessor. Indeed, presentation of a predecessor’s financials may be irrelevant to a prospective investor of a successor-franchisor or, worse, misleading. It is the financial health of the successor-franchisor, not a predecessor, that is material to a prospective franchisee.

As described in your letter, Predecessor has sold its assets and has assigned its existing franchise contracts to Client, while retaining all liabilities and obligations arising under franchise contracts prior to the date of their agreement. Under these circumstances, we conclude that Client is financially separate and distinct from Predecessor and, therefore, Client should not attach Predecessor’s financials to its disclosure document.

Our conclusion, however, is based upon the specific facts presented in your inquiry. Depending upon the facts, which can only be determined on a case-by-case basis, it is possible that the Commission may conclude that the relationship between a predecessor and successor-franchisor is so close as to warrant attributing the financials of the predecessor to the successor. This is particularly true in the case of an asset sale designed to circumvent the Rule’s financial statement disclosure requirements. For example, a franchisor cannot prolong the phase-in of audited financials indefinitely by continually spinning-off successor corporations every two years. In circumstances where it appears, based upon all of the facts taken together, that a franchisor is intentionally attempting to avoid audited financial disclosures or otherwise fraudulently taking advantage of the phase-in of audited financial statements, we will deem the successor-franchisor as stepping into the shoes of the predecessor, affording both a single phase-in. If a predecessor is in the second year of the phase-in, an attempt to avoid audited financials by spinning off a successor will result in the successor having only one additional year to phase-in audited financials. If the franchisor attempts to spin-off yet another successor, we will deem the phase-in exhausted and the successor-franchisor must prepare audited financials before selling franchises.

III. PARENT INFORMATION

You also ask whether Client must disclose background information of Parent, Holding Parent 1, and/or Holding Parent 2. The answer to this question depends entirely on whether Client intends to comply with the Franchise Rule by complying with the Uniform Franchise Offering Circular (“UFOC”) Guidelines. In general, the UFOC Guidelines do not require the disclosure of parent information. An exception exists, however, if the relationship between the Parent or Holding Parent is one of an affiliate.

If Client intends to furnish prospects with an FTC-format disclosure document, then Client must disclose certain information regarding its parents. Specifically, parent disclosures are found in 436.1(a)(1)(i) (“official name and address and principal place of business of the franchisor, and of the parent firm or holding company of the franchisor”); 436.1(a)(3) (“business experience of the franchisor and the franchisor’s parent firm (if any) . . .”); 436.1(a)(4) (litigation disclosures by reference to 436.1(a)(3)); and 436.1(a)(5) (bankruptcy disclosures by reference to 436.1(a)(3)). In addition, audited financials of a parent may be included, as described above.

The question remains, however, how far up the chain a franchisor must go when preparing parent disclosures. For example, must Client disclose parent information for each and every parent or holding company in the ownership chain, including Parent, Holding Parent 1, and Holding Parent 2? We note that the Franchise Rule does not specifically define the term “parent.” However, the Interpretive Guides to the Rule makes clear that a parent “controls the franchisor directly or indirectly through one or more intermediaries.” 44 Fed. Reg. at 49,972. At the very least, therefore, any franchisor using the FTC-format disclosure document must disclose all parents and holding companies that would have control over the business operations of the franchisor. This would include any parent or holding company that guarantees the franchisor’s performance.

Further guidance on this issue can be gleaned from the Statement of Basis and Purpose accompanying the Franchise Rule. In its discussion of the background disclosures, the Commission first noted that it requires parent disclosures, although the UFOC Guidelines do not. In that regard, the Commission stated that full disclosure of the franchisor’s identity is material because the absence of such information “(1) misleads the franchisee as to the parties with whom he or she is dealing and (2) could readily result in economic injury to the franchisee because of his or her inability to make a rationale decision as to whether to enter into the franchise relationship.” 43 Fed Reg. at 59,639. Accordingly, to the extent that any parent or holding company, or series of such companies, each exercises management control over the franchisor, or its ownership interest may impact upon the franchisor and ultimately its franchisees, then its background becomes material and must be disclosed.

Accordingly, we conclude that Client should disclose background information for Parent, Holding Parent 1 and Holding Parent 2. To the extent that any of these entities may manage or otherwise control Client, then its background is material to prospective franchisees. Further, because Client is an asset of Parent, Holding Parent 1, and Holding Parent 2, its financial future may be at risk – as well as that of its franchisees – should any of the Parents become unable to fulfill its obligations or file for bankruptcy.

Please be advised that our opinion is based on all the information furnished in your request. This opinion applies only to your company and to the extent that actual company practices conform to the material submitted for review. Please be advised further that the views expressed in this letter are those of the FTC staff. They have not been reviewed, approved, or adopted by the Commission, and they are not binding upon the Commission. However, they do reflect the opinions of the staff members charged with enforcement of the Franchise Rule.

Franchise Rule Staff: October 25, 2005