Navigating Registration and Disclosure Requirements When a Franchisor Changes its Fiscal Year End

Vol. 15, No. 3

By

Briggs and Morgan, P.A.

I. Background

A franchisor’s fiscal year end is not an insignificant date. When that date changes, how are the franchisor’s registration and disclosure requirements impacted? Under the Federal Trade Commission’s amended Franchise Rule, 16 C.F.R. Part 436 (the “FTC Rule”), a franchisor is required to update its Franchise Disclosure Document (“FDD”) on an annual basis within 120 days after the franchisor’s fiscal year end. 16 C.F.R. § 436.7(a). Some registration states also require a franchisor to file a renewal or annual report within a certain period of time (typically within 90 to 120 days) following its fiscal year end. See, e.g., Minn. Stat. § 80C.08, Subd. 1. In any event, the fiscal year end will trigger the franchisor’s preparation of audited financial statements for the recently-completed fiscal year, as such audited financial statements will need to be included in the franchisor’s subsequent FDDs. While these requirements are rather straight forward in most circumstances, they can require some planning when a franchisor changes its fiscal year end. This article discusses how franchisors who change their fiscal year end may navigate registration and disclosure issues associated with such a change.

II. Implementation of Change in Fiscal Year End: Extended Year or Stub Year?

In a typical situation, a franchisor operates on a fiscal year based on either the calendar year or some other 12-month period. A franchisor that desires to change its fiscal year would first need to determine how it intends to implement such a change. Presumably, the franchisor would either elect to have a one-time extension of its current fiscal year to accommodate the change (and therefore have one fiscal year that extends for more than 12 months) or elect to have a one-time transitional fiscal year that has fewer than 12 months (a “stub year”).

For example, suppose a franchisor that currently operates on a fiscal year based on the calendar year desires to change to a fiscal year that runs from April 1 to March 31. In the first circumstance, the franchisor would elect to extend its current fiscal year an additional three months (to March 31) so that it would have a one-time, 15-month fiscal year, and then 12-month fiscal years thereafter (running from April 1 to March 31). In the second circumstance, the franchisor would elect to have a three-month transitional stub year running from January 1 to March 31, and then 12-month fiscal years thereafter (running from April 1 to March 31). Either can present challenges as to how the franchisor complies with applicable registration and disclosure requirements.

While existing FTC and state registration and disclosure requirements treat the fiscal year end as a pivotal date, neither state nor FTC requirements, nor the existing literature on franchise registration and disclosure compliance, offer much guidance on how to manage a change in a franchisor’s fiscal year end.

III. FTC Rule

Under the FTC Rule, a franchisor is required to prepare an updated FDD within 120 days after the close of its fiscal year. 16 C.F.R. § 436.7(a). As part of such updated FDD, the franchisor is required to include audited financial statements for the franchisor’s most recently-completed fiscal year (as well as certain prior fiscal years). 16 C.F.R. § 436.5(u).

A. Extended Year Under the FTC Rule

For the franchisor that elects to extend its fiscal year, compliance with the FTC Rule would not appear to be overly burdensome, as the franchisor could prepare its annual update within 120 days after the end of its extended fiscal year and include audited financial statements for the extended fiscal year as part of its update. Support for this approach can be found in an FTC Informal Staff Advisory Opinion addressing the issue under the original FTC Rule. Federal Trade Commission, Informal Staff Advisory Opinion 06-2. This Informal Staff Advisory Opinion also recommends that the franchisor include a clear caveat at the beginning of each use of the financial statements for the extended fiscal year noting that (i) such financial statements cover an extended period (instead of a 12-month period) because of a change in the franchisor’s fiscal year, and (ii) as a result, the financial statements for the extended period are not comparable to the other financial statements in the FDD. It is also worth noting that this Informal Staff Advisory Opinion specifically states that the approach outlined therein is based on the fact that the franchisor in such circumstance extended its fiscal year by three months, and that the FTC’s analysis may have been different if the franchisor had extended its fiscal year by more than three months.

B. Stub Year Under the FTC Rule

If the franchisor alternatively elects to use a transitional stub year to implement the change in its fiscal year, compliance with the FTC Rule may prove to be a little more burdensome. In the example described above, the franchisor would have a normal December 31 fiscal year end, as well as another fiscal year end on March 31 (or whatever other date marks the end of its transitional stub year). The franchisor would presumably be required to update its FDD within 120 days following the close of its normal fiscal year (including audited financial statements), and also within 120 days following the close of its transitional stub year (including another set of audited financial statements). In addition to the time and expense associated with preparing two annual updates in a relatively short period of time, this approach would require the franchisor to incur the additional costs of performing two audits within such time frame (which may be significant). As an alternative to preparing two annual updates (and two sets of audited financial statements) within this period of time, the franchisor could presumably wait until the end of its transitional stub year to prepare a one-time update (as well as a one-time audit of its financial statements for its normal December 31 fiscal year and its transitional stub year), but the franchisor presumably would need to refrain from making offers during the period beginning on the date that is 120 days after the end of its normal December 31 fiscal year and continuing until it has such update and audited financial statements prepared – an option that would likely be impractical for many franchisors.

If the franchisor elects to use a transitional stub year to implement a change in its fiscal year, the franchisor would also need to consider whether the stub year financial statements constitute financial statements for a separate fiscal year for purposes of determining which prior financial statements to include in the franchisor’s updated FDD. From the franchisor’s perspective, the stub year would be treated as a separate fiscal year (even though it is less than 12 months). A technical interpretation of the requirements under the FTC Rule would appear to indicate that the financial statements for the stub year would be treated as financial statements for a separate fiscal year – but such interpretation would result in the FDD including financial statements that cover a shorter period of time than if all financial statements related to 12-month periods. Similar considerations may arise with respect to the franchisor’s Item 19 and Item 20 disclosures, as the existence of a stub year could potentially skew the data reported therein. At the very least, a franchisor would presumably want to adequately disclose the fact that the data for the stub year is based on data for a shorter period (rather than a 12-month period). Another approach a franchisor may consider is adding appropriate information regarding the stub year to its FDD without deleting any information from any prior year (i.e., providing more information than perhaps is technically required), but this approach is arguably at odds with the FTC Rule’s express prohibition against disclosing “any materials or information other than those required or permitted by [the FTC Rule] or by state law.” 16 C.F.R. § 436.6(d).

IV. Registration States

A. Registration States With Renewals or Annual Reports Based on Fiscal Year End

A number of registration states (including, California, Hawaii, Illinois, Minnesota, New York, Rhode Island and South Dakota) require a franchisor’s renewal or annual report to be filed within a certain period of time after the end of the franchisor’s fiscal year (generally 90 to 120 days). For example, Minnesota requires a franchisor to file an annual report 120 days after its fiscal year end. Minn. Stat. § 80C.08, Subd. 1. As part of such renewal or annual update, the franchisor would need to include financial statements for the franchisor’s most recently-completed fiscal year (as well as certain prior years). See., e.g., Minn. Admin R. 2860.2500. But none of these registration states addresses directly in its law or regulations exactly how a franchisor is to manage disclosure compliance in connection with a change in the franchisor’s fiscal year.

     1. Extended Year in Fiscal Year End Renewal States

For the franchisor that desires to change its fiscal year through an extension of its current fiscal year, a state franchise administrator for one of these states has indicated that the franchisor may simply send a letter to the state franchise administrator notifying the state of the change, and the state franchise administrator would thereafter extend the franchisor’s current registration until the end of the extended fiscal year (after which the franchisor could prepare the necessary annual report, including audited financial statements for the extended fiscal year). However, the state administrators for some other states have indicated that the franchisor should still file a renewal within the time frame that such franchisor would ordinarily have been required to submit its renewal but for the change in its fiscal year end, and include unaudited financial statements as of the date that the franchisor’s fiscal year would have ended but for the extension (as the franchisor would presumably not have new audited financial statements prepared due to such extension). Upon receipt of the renewal, at least one of these state franchise administrators indicated that the state would extend a franchisor’s registration for another full term. Under similar circumstances, other administrators indicated that the state would extend the franchisor’s registration only for a certain period of time (e.g., either for a period ending 90 days after the date in which the franchisor would have been required to submit its renewal (but for the extension of its fiscal year) or for a period ending 120 days after the end of the franchisor’s extended fiscal year), at which time the franchisor would be required to submit a new renewal, including audited financial statements for the extended fiscal year.

     2. Stub Year in Fiscal Year End Renewal States

If the franchisor elects to use a transitional stub year to change its fiscal year end, the franchisor may encounter different issues in these states. In these states, the franchisor would technically be required to submit its renewal or annual report within the applicable period of time following the close of its normal (or previous) fiscal year (including audited financial statements), and also within the applicable period of time following the close of its transitional stub year (including another set of audited financial statements). This approach would require the franchisor to incur the additional costs of performing two audits within this time frame (which, again, may be significant).

Fortunately, state administrators in some of these states have indicated a willingness to work with a franchisor who desires to avoid the costs of going through two audits within a short period of time. At least one such state franchise administrator has indicated that a franchisor may simply send a letter to the state franchise administrator notifying them of the circumstances, and the state franchise administrator would thereafter extend the franchisor’s current registration until 120 days after the end of the transitional stub year (after which the franchisor could prepare the necessary annual report, including audited financial statements for the normal fiscal year and the transitional stub year). State franchise administrators in some of the other states indicated that the franchisor could file a renewal or annual update within the applicable period of time after the end of the franchisor’s normal fiscal year and include unaudited financial statements as of the end of its transitional stub year. At least one of these state franchise administrators indicated that upon receipt of the renewal or annual update they would extend the franchisor’s registration only for the period ending 120 days after the end of the franchisor’s transitional stub year (at which time the franchisor would be required to submit another renewal, including audited financial statements for the franchisor’s normal fiscal year and the transitional stub year). Other state franchise administrators indicated that the franchisor’s registration would be extended for another full term, and that the franchisor could submit (but did not necessarily require them to submit) an early renewal after the franchisor has audited financial statements available for the franchisor’s normal fiscal year and the transitional stub year.

B. Registration States With Renewals or Annual Reports Based on Effective Date of Previous Filing

A number of registration states (including Indiana, Maryland, Michigan, North Dakota, Virginia, Washington and Wisconsin) provide that a franchisor’s registration is effective for a specific period of time (typically a year), and require the franchisor to submit a renewal at some point before the expiration of the franchisor’s registration (typically on its “expiration date” or “anniversary date”). For example, Indiana provides that a registration is effective for a period of one year and requires a franchisor to file a renewal no later than the expiration of its registration. Ind. Code §§ 23-2-2.5-17 and 23-2-2.5-18. As part of such renewal, the franchisor would need to include financial statements for the franchisor’s most recently-completed fiscal year (as well as certain prior years). See., e.g., Ind. Code §§ 23-2-2.5-13 and 23-2-2.5-19. But none of these registration states addresses directly in its law or regulations exactly how a franchisor is to manage disclosure compliance in connection with a change in the franchisor’s fiscal year.

     1. Extended Year in States Where Renewal Date Depends on Effective Date of Previous Filing

If a franchisor desires to change its fiscal year through an extension of its current fiscal year, such a change presumably would not pose any significant burdens on the franchisor in the event the franchisor is able to have audited financial statements for its prior fiscal years prepared by the time it is required to submit such renewal. But if a franchisor effects a change in its fiscal year through an extension of its current fiscal year, it is possible that the renewal date could fall either before the end of the franchisor’s newly-extended fiscal year or within a short time thereafter.

In this circumstance, the franchisor presumably would not have audited financial statements prepared for its extended fiscal year by the renewal date (either because the extended fiscal year has not yet ended or because the extended fiscal year ended too soon before the date when the renewal is due). State franchise administrators in these states have generally indicated that the franchisor could (i) file either a renewal or an amendment with an explanatory cover letter before its renewal date and include unaudited financial statements as of the date that the franchisor’s fiscal year would have ended but for the extension of its fiscal year, and (ii) submit an early renewal or an amendment when the franchisor has received audited financial statements for its extended fiscal year (usually within 120 days after the end of such extended fiscal year). While the filing of an early renewal or amendment when the franchisor has received audited financial statements for its extended fiscal year may not necessarily be required by all such states, at least one of these states has indicated that such an amendment or renewal would be required.

     2. Stub Year in States Where Renewal Date Depends on Effective Date of Previous Filing

For a franchisor that effects a change in its fiscal year through the use of a transitional stub year, such a change presumably would not pose any significant burdens on the franchisor in the event the franchisor is able to have audited financial statements for its prior fiscal years prepared by the time it is required to submit such renewal. But it is possible that the renewal date could fall shortly after the end of the franchisor’s transitional stub year. In this circumstance, the franchisor presumably would not have audited financial statements prepared for the recently-ended transitional stub year by the renewal date, and may also not have audited financial statements prepared for the franchisor’s most recently-completed normal (or previous) fiscal year by its renewal date (particularly if the franchisor is concerned about incurring the additional costs associated with preparing two sets of audited financial statements within a short period of time).

State franchise administrators in these states have generally indicated that the franchisor could (i) file either a renewal or an amendment before its renewal date and include unaudited financial statements as of the date of the franchisor’s most recently-completed normal (or previous) fiscal year, and (ii) submit an early renewal or amendment when the franchisor has received audited financial statements for its normal (or previous) fiscal year and its transitional stub year. However, a state franchise administrator in at least one of these states has indicated that the state would be willing to consider simply extending the franchisor’s renewal date upon being notified of the franchisor’s circumstances.

C. Treatment of Stub Year for Other Purposes

As further discussed above with respect to the FTC Rule, if a franchisor elects to use a transitional stub year to implement a change in its fiscal year, the franchisor also will need to consider whether the stub year financial statements constitute financial statements for a separate fiscal year for purposes of determining which prior financial statements to include in the franchisor’s updated FDD. The franchisor may also need to similarly consider the impacts to the franchisor’s Item 19 and Item 20 disclosures.

D. Is the Availability of New Audited Financials a “Material Event”?

Even if a state franchise administrator permits a franchisor to renew its registration using unaudited financial statements and does not specifically require the franchisor to submit an amendment or renewal within a certain period of time after the end of the franchisor’s extended fiscal year or transitional stub year, it would presumably be advisable for the franchisor to do this so that the franchisor’s FDD includes the franchisor’s most recently-available audited financial statements. Availability of new audited financial statements arguably is a “material event” in and of itself that warrants amending a state registration. This also would be consistent with the approach discussed in the FTC Informal Staff Advisory Opinion mentioned above in certain situations (e.g., where the franchisor has elected to extend its current fiscal year in a registration state that requires a renewal or annual report to be submitted within a certain period of time after the end of the franchisor’s fiscal year end).

E. State Approaches and Consistency with FTC Rule

While a franchisor that elects to change its fiscal year end may be able to keep its registration in these states effective by complying with the approaches outlined above, such approaches may not necessarily be completely in accordance with what is required under the FTC Rule. For example, if a franchisor elects to use a stub year to implement a change in its fiscal year, and a state franchise administrator permits the franchisor to simply extend its registration by sending a letter to the state explaining the circumstances, the franchisor may find itself in a situation where it is offering franchises in such state at a time when the franchisor’s registration in that state is still effective, but the franchisor’s FDD is not technically compliant with the FTC Rule (because such FDD has not been updated to include more recent financial statements within 120 days from the date of its normal fiscal year end).

The FTC Rule only preempts franchise laws of a state to the extent a state law is inconsistent with the FTC Rule. 16 C.F.R. § 436.10(b). While a state law will not be deemed to be inconsistent with the FTC Rule to the extent “it affords prospective franchisees equal or greater protection,” Id., a registration state’s decision to continue a franchisor’s registration without including audited financial statements for the franchisor’s most recently-completed fiscal year could be deemed to provide franchisees lesser protection than what the FTC Rule provides. The FTC addressed this issue under the old FTC Rule in the FTC Informal Staff Advisory Opinion discussed above, and stated that the FTC will generally presume the “‘sufficiency, adequacy and accuracy of the document’” where “a franchisor has a currently registered disclosure document in a state,” but that the FTC ultimately “‘retains the right to determine whether the UFOC requirements . . . have been met.’” Federal Trade Commission, Informal Staff Advisory Opinion 06-2 (citing 43 Fed. Reg. at 49970-971). Perhaps the most useful guidance on this issue, however, is found in FAQ 31 of the FTC’s Amended Franchise Rule FAQ’s, where the FTC states that it does “not interpret the amended [FTC] Rule as requiring a franchisor with an FDD validly registered in a state to suspend sales in that state after the [FTC’s 120-day] update deadline pending either completion of the registration of its updated FDD in that state, or expiration of the existing registration.” While the guidance provided by the FTC appears to minimize much of the concern regarding this issue, a franchisor should nevertheless be cognizant of it.

V. Conclusion

A franchisor that is considering changing its fiscal year must be proactive and strategic in considering the implications such change may have with respect to its registration and disclosure requirements. While such a change is certainly not impossible to implement, it will likely take careful consideration to navigate, as well as some coordination with the various states in which the franchisor is active. Each circumstance will likely be different – and this article is not necessarily intended to cover every possible circumstance or issue that might arise in connection with such a change. But it can be of some benefit to franchisors and their attorneys who are faced with navigating these issues in the future. It is also important to note that any references to the guidance provided by the various state franchise administrators regarding these issues are based upon the specific factual information that they were provided when posed with such questions, and do not reflect any official guidance or policy position of the applicable state franchise administrators. In addition, not all of the registration states were contacted with respect to these issues. For these reasons, this article does not reference any specific states or state examiners. Any franchisor that is considering changing its fiscal year end will certainly want to discuss well in advance the implementation of such change with the appropriate state franchise administrators and their franchise attorneys.

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