Sometimes, the disclosures in an annual audit and registration-renewal of a franchisor’s Franchise Disclosure Document (FDD) are not the only disclosures a franchisor is required to make in a given fiscal year.  In addition to these, the Federal Trade Commission (FTC) also requires that a franchisor update its FDD when there is a “material change” to the franchisor or the franchise system itself. While a number of states have this requirement, they vary as to what changes are considered material and how such changes should be disclosed. Our seasoned attorneys could explain what changes are material in relation to a franchisor’s FDD, and whether it should be updated to reflect certain changes.

What is a “Material Change”?

“Material change” is defined in full by the FTC under 16 C.F.R. § 436.7(b), and it is any change to the franchisor or in the franchise itself that is likely to have a significant financial impact on, or which is likely to influence the decision-making process of, a franchisee or prospective franchisee. Whether a change is material, such that it requires a franchisor to update its FDD to reflect that change, is largely dependent upon the circumstances of each change. Some changes that are more likely than not to be considered material include:

  • The addition or removal of upper-level personnel to the franchise system; particularly, those disclosed in Item 2 of the FDD;
  • The filing of a lawsuit by or against individuals listed in Item 2 of the FDD; or the franchisor entity itself; as well as developments in litigation previously disclosed in Item 3;
  • Significant changes in unit development costs or working capital requirements;
  • A cancellation, termination, or other form of franchise unit closure;
  • Events changing the validity of any financial performance representations previously disclosed in the FDD; particularly, Item 19; and
  • Adverse changes in the franchisor’s financial statements.

If these changes occur in the early years of the franchise, they are more likely to be considered material. For example, a common material change for start-up franchisors occurs if there is a significant decrease in the number of franchisees because, as most start-up franchisors have a small number of franchisees, even a small decrease is likely to be significant.

When Should Material Changes Result in Updating a FDD?

If any of these material changes to the franchisor or the franchise system occur, unlike most state FDD obligations, the FTC requires only that a franchisor disclose and update these changes at the close of each quarter of the franchisor’s fiscal year. However, there is one exception to this rule, which is that material changes relating to Item 19 financial performance representations must be disclosed when they occur.

For all other material changes, at the close of each quarter, the FTC requires that a franchisor prepare an attachment to its FDD reflecting the material change and requires that that attachment be included with any FDD given to a prospective franchisee.  Of course, a franchisor is not required to prepare an attachment at the close of a quarter where no material changes occur.

Seek Help When Updating Franchise Disclosure Documents

Any development that might make a prospective franchisee change its mind about purchasing the franchise, or that significantly affects the accuracy of costs or expenditures included in the FDD, is likely to constitute a material change that the franchisor is required to disclose in a quarterly update to the FDD. It is important to note that the FTC’s disclosure requirements for material changes is minimal; each state is free to define “material change” broader than the FTC and to impose more stringent reporting requirements.

Issuing questionnaires to personnel and preparing interim unaudited financial statements on a quarterly basis are prudent practices by which a franchisor can ensure that material changes to the franchisor, the franchise system, or any of the information in its FDD are documented and disclosed on a timely basis. While a franchisor may not be able to determine whether a certain change is of such materiality that it requires disclosure in a quarterly update of its Franchise Disclosure Documents, having a system in place to record any such changes in the franchise system is important to understand. Providing a franchise attorney with this information is a prudent way to ensure that necessary updates to the FDD are made.

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