What IS The Policy On Operating Expenses?
As many of you may be aware, an increasing number of franchisees are reporting issues regarding chargebacks to Operating Expenses. It appears that SEI has been changing its policies and procedures regarding allowable Operating Expenses in ways that are contrary to the specific terms of the Franchise Agreement. SEI has also been applying a much more restrictive approach to this issue than in the past.
The term “Operating Expenses” is defined in Exhibit F to the Franchise Agreement, which is found at page F-53. The definition includes ten enumerated categories of expenses or credits that are necessarily permitted to be charged against the Open Account. Those categories are as follows: 1) payroll; 2) payroll taxes (including unemployment, workers compensation, payroll, insurance, and social security contributions); 3) Inventory Variation; 4) Cash Variation; 5) maintenance, repairs, replacements, laundry, expense, and janitorial services; 6) telephone; 7) store supplies, including grocery bags another store-use items; 8) government fees and taxes; 9) bad merchandise caused by you or your employees; and 10) Advertising Fees and other advertising.
In addition to the 10 enumerated categories, there is a catchall, which allows other miscellaneous expenditures that SEI, in its reasonable judgment and regardless of the classification of such expenses by the Internal Revenue Service, allows as permitted Operating Expenses. To our knowledge, SEI has never published a list of miscellaneous Operating Expenses.
The permitted Operating Expenses feed into the Item 19 Financial Performance Representation included within the Franchise Disclosure Document (FDD) issued by SEI to all prospective franchisees, whether those becoming franchisees for the first time, or renewing franchisees. The FDD is required by the Federal Trade Commission Franchise Rule, which says that SEI, or any franchisor for that matter, at the time of sale can provide profit and loss statements reflecting the historical financial performance information of current franchisees. This information must have a reasonable basis and must be accurate and not misleading.
In the definition section of the Franchise Agreement, SEI reserves the right to disallow expenses which would be permitted by the IRS or generally accepted accounting principles, creating a misleading and distorted picture of the financial results of the operation of the franchised businesses. To put it another way, if the Item 19 profit and loss statement does not include expenses that every franchisee can expect to have, it will overstate profit.
We have been informed by a number of franchisees that expenses they incur in the normal course of operating their stores, which in many cases had been previously allowed, are now being disallowed or charged back. Some examples are as follows:
• Outside landscaping and general maintenance—this expense is clearly permitted under the Franchise Agreement, as it constitutes maintenance and repair;
• Snowplowing—this is also a normal and customary expense, and is absolutely required for customer safety and access to the store;
• Interest on lines of credit used at times, to make contributions to the Open Account in order to maintain the Minimum Net Worth—one of the permitted expenses is “interest” and the disallowance of that expense is contrary to the terms of the franchise agreement;
• Property taxes on inventory, furniture, fixtures, and/or equipment;
• Travel expenses between stores owned by the same franchisee, as well as travel expenses to FOA meetings and other gatherings—these expenses are clearly normal and customary expenses which any prospective franchisee would expect to incur in the operation of a business;
• Group health insurance—this is clearly a payroll related expense, and given the healthcare mandate, is an expense that many franchisees can no longer avoid;
• Group life insurance—this is also clearly a payroll related expense, and a more than reasonable benefit to be provided to employees; and
• Telephone lines for the store—this is one of the enumerated categories of permitted Operating Expenses, and there is no justification for a chargeback.
One of the more disturbing parts of this trend is that franchisees have not been treated uniformly with respect to what expenses or credits are permitted to be part of Operating Expenses. SEI has an obligation to apply its standards in this area in a uniform, nondiscriminatory and reasonable manner. It also appears that the personnel assigned to determine whether or not Operating Expenses should be allowed are not trained properly or in a consistent way.
In addition, when a franchisee opens an accounting case on a disputed expense, unreasonable delays have been encountered in resolving these matters. In some situations, franchisees have been required to file amended tax returns based on the results.
We are also concerned that this recent campaign of excessive and unreasonable chargebacks is being done with an eye on the Item 19 Financial Performance Representations that are being prepared and distributed by SEI. Every dollar of Operating Expense that SEI can keep off the income statement is a dollar of profit that can be presented to the next prospective franchisee. Moreover, to the extent that SEI disallows expenses that are properly characterized as Operating Expenses under the Franchise Agreement, or which are unreasonably disallowed, notwithstanding the fact that they are normal and customary expenses as defined in the Internal Revenue Code, it is creating an artificial, inflated and misleading presentation of franchisee profitability.
The concerns in this area may well be related to our previously stated objections to the new GEA form. While SEI has recently announced plans to withdraw and reevaluate the form, the most recent version consisted of 448 separate standards and 6,500 words which would have had a substantial impact on the profitability of franchised locations. Requirements that a franchisee open registers, so the line does not exceed one employee to one customer, that guests at the grill or hot foods area be greeted within 15 seconds, and that service begin within 60 seconds, will add materially to the staffing requirements of the location. This increase in payroll and related costs would have depressed profits. It is entirely possible that the drive to reduce other Operating Expenses is an attempt to offset the inevitable increase in Operating Expenses that would have resulted from the GEA form. While SEI is in the process of reevaluating the GEA form, our concerns in this area remain, and we will await the outcome of this process.
Our requests to SEI include the following:
1) Allow all credits and expenses to be charged as Operating Expenses to the extent expressly permitted in the Franchise Agreement;
2) Publish a list of Miscellaneous Expenses;
3) Redefine payroll expenses to include all customary benefits provided to employees, including health, dental, disability and life insurance;
4) Allow as Operating Expenses all ordinary and necessary expenses incurred while operating the franchise business, to the full extent permitted under the Internal Revenue Code and generally accepted accounting principles;
5) Provide adequate training to all personnel charged with reviewing Operating Expenses; and
6) Pledge to apply these standards regarding operating expenses in a uniform, nondiscriminatory and fair and reasonable manner.
We will keep you informed of our efforts to introduce fairness, balance and uniformity in the treatment of Operating Expenses.