FDD Fundamentals: Item 2

To begin it is valuable to review some of Item 2’s relevant background; the original rule making commission found that some individuals offering franchises were misleading consumers regarding important facts about the franchise business. For example, how long the business had been operating and the experience of the parties managing the franchise. The FTC concluded that these types of misrepresentations could mislead reasonable consumers, causing them to believe that the franchise offering was a more secure investment than it actually was. Accordingly, they added a rule requiring franchisors to disclose information about their business including names and addresses for the franchise business, any parent companies, and any sellers. Additionally, they had to provide background information for any sellers, officers, and directors.

As the FTC enforced the franchise regulations, it became apparent that franchisors were still misleading consumers by misrepresenting relevant information about the business. Specifically, the franchisors would leave out information about their predecessors (entities or individuals who had previously owned or operated the franchise). Alternatively, franchisors would give the people managing the sales or services titles other than officer or director to avoid disclosing their unappealing backgrounds in the FDD. Consequently, the FTC amended the rule to require franchisors to disclose information about its predecessors and about any party with significant management responsibilities.

It is important to understand that Item 2 contains only work experience for the prior five years. Franchisors are not allowed to place information inside of Item 2 that is considered extraneous or unrelated.

            The Franchisee’s Perspective for Item 2:

There are a few red flags to look for in Item 2 of the FDD. First, if there are predecessors then the franchisee will want to research what happened to them. Did they go bankrupt, suffer significant legal problems, or did they sell the system to investors? If the conditions of the sale were concerning, and if the management is the same then you may want to reconsider franchising with that particular franchisor. Second, you will want to research the individuals who are managing the system. If they lack experience or they have a history of business mismanagement or failure you may want to reconsider franchising with them, because those traits are likely to permeate the entire franchise system. Finally, these red flags can be mitigated or exacerbated depending on the level of franchisor involvement. If the system is complicated, or you are unfamiliar with the underlying business, then these red flags are even more important. If you are inexperienced you will likely need significant help, at least at first, from the individuals managing the franchise.

            The Franchisor’s Perspective:

There are a few concerns that a franchisor should keep in mind when drafting Item 2. First, the FDD is not supposed to contain extraneous information. While you may want to include information about awards or accolades your management staff has received or a particularly impressive work position from more than five years ago, don’t. Registration states may require you to delete this information before they will accept it, and you can share this information with your perspective franchisees in other ways. Second, the exact definition of “management responsibility” is not explicitly defined in the Franchise rule leaving franchisors often to question whether an individual has management responsibility. However, some additional insight can be gained from an examination of the original rule (UFOC), and the commentary preceding the amendment to the franchise rule.

The old rule generally provided that an officer was an individual who had significant management responsibilities for marketing or servicing franchises. The old rule was amended because franchisors were giving these responsibilities to individuals who were not given the title or name of officer or director. To combat this naming problem, the FTC amended the rule to include any individual with significant management responsibilities. The amended rule was not changed to cover additional or different activities, but to cover individuals acting like officers (managing services or sales to franchisees). Ultimately, the rule of thumb for a franchisor is that any individual who actively controls the marketing or servicing of franchisees should be included in Item 2.

Finally, it is important to remember not to include individuals in Item 2 who do not have significant management responsibility. In other words, it may be misleading to include a notable individual who might attract franchisees, but who does not actually participate in the management of the franchise. For example, if Warren Buffet had a small interest in the franchisor, but exercised no control over the franchisors marketing or services it would likely be misleading to include his name in Item 2, and could result in a lawsuit.

Item 2 is an important part of the FDD, and while it may seem strait forward at first blush, there are important nuances that both franchisors and franchisees should both be aware of.  

FDD Fundamentals: Item 1

Generally, Item 1 is all about the franchisor. The information includes all of the franchisor’s affiliates and related companies, e.g., companies that own it, companies it owns, companies owned by the principles of the franchisor, and companies that are partially owned by a principle of the franchisor that provide goods or services to franchisees.

The Franchisee’s Perspective:

Item 1 performs two functions: first, it requires the franchisor to disclose true information about itself and the second follows from that if the information is misleading, then the franchisee could sue for damages or recession of the franchise agreement. Item 1 requires that the franchisor disclose information in three general categories. First, it must disclose information about itself. This includes the franchisor’s name, business address, and its business experience. It is important to note that “franchisor” here includes any predecessor (person who previously owned the franchise and sold it to the current franchisor) or affiliate (an associated business entity controlled by, controlling, or in common control with the franchisor) of the franchisor. Second, it must provide the name and address of its non-affiliate parent entities (for example a holding or shell company) and its agent for service of process. Third, it must describe the business opportunity it offers. This description includes a general description of the market and competition for the products or services offered and any laws or regulations that are specific to the franchise business industry.

Thus, as the franchisee, this item is very important. You can be reasonably confident in this information because there are potentially significant repercussions for the franchisor if it is misleading. However, it is important to remember that the FDD should not be your only source of information about the franchisor. You should use the FDD as a starting point for additional research. Additionally, there are several red flags to watch for in Item 1. First, if the information regarding the franchisor’s business is very vague or overly general as this could indicate that the franchisor lacks a real understanding of what it is offering, or that the franchisor believes the franchise would not be appealing if the details were fully spelled out and disclosed. Second, you will want to look at the predecessors, parents, affiliates and business experience of the franchisor. You will want to investigate the circumstances surrounding any potential transfer of the franchise business and you will want to look into management of the franchise to see their business histories. If the franchisor has a checkered business past, you may want to reconsider purchasing a franchise from them. It is important to remember that while you are legally considered an independent business owner, the franchisor will exercise significant control over your business and you will want to be sure that you trust them, and can work well with them.

Third, if you decide to consider purchasing a franchise you should compare the information in the FDD with the other information the franchisor gives you. If there appears to be conflicts between the information in the FDD with what the franchisor is telling you, this is a red flag. Finally, if franchise business is subject to significant governmental regulation, you will want to be aware how this may increase the cost to operate the franchise business and increase the potential liability for the franchise business. For example, some franchises offering business opportunities in the health care industry are subject to significant regulations including regulations on storing and sharing patient information, doctor self-referral laws, licensing requirements, employment requirements, and fee sharing.

The Franchisor’s Perspective:

            For franchisors, it is important to remember that the FDD can serve two important functions. It protects the franchisor from liability should a franchisee try to sue the franchisor and it also conveys information about your franchise business. If you comply with the regulations and make appropriate disclosures then it can protect the franchisor from future liability, but if your disclosures are not sufficient or you do not comply with state and federal regulations then it can result in significant liability down the road.

The franchisor needs to balance two interests: the need to provide sufficient, accurate information such that a franchisee cannot claim he was materially misled, and the interest to present an attractive franchise offering. However, it is important to remember that although the FDD does convey information about your franchise to prospective franchisees, its primary purpose is not advertisement but disclosure. Individuals who are looking at your FDD are already interested in your business concept, and (despite what was recommended above) the fact of the matter is that most franchisees who receive your FDD will not read the entire thing, and even if they do, it is unlikely to change their mind. Accordingly, the most important thing is to make sure the information in the FDD is correct and that no information required by federal or state law is omitted.

            Therefore, comparing the franchisor and franchisee perspective of Item 1 gives additional insight into how each party can use Item 1. On the one hand, the franchisee can see that while the information is likely correct, it may not be very detailed and the franchisee should use the information in Item 1 as jumping off point for additional research. On the other hand, the franchisor should keep in mind that although the FDD conveys information about your business to prospective franchisees, its primary function is disclosure. It is important to be careful to include only true information and not leave out any required information. 

Fundamentals of the Franchise Disclosure Document

At the start of every franchise relationship, the prospective franchisee is given the Franchise Disclosure Document ("FDD") which discloses all the requirements in the pending franchise relationship. Often this document is difficult to navigate for both the franchisor and the franchisee. Over the course of the next several weeks, we will break down each item in the FDD and give a summary of what can be expected and what is required within the FDD.

The FDD came about due to the federal government's concern about fraud and corruption in the franchise industry. Accordingly, since 1979, the Federal Trade Commission requires all franchisors to provide a disclosure document to all prospective franchisees. In July 2007, the FTC updated their requirements and renamed the requirements as the FDD. The general purpose of the FDD is to require franchisors to disclose information the federal government believes will reduce fraud and assist franchisees’ in making informed decisions about whether to invest in a particular franchise. The FDD is broken down into 23 Items. Each item addresses a specific topic. With respect to each topic, there are two important perspectives to consider: first is the franchisee’s perspective and second the franchisor’s perspective. Each upcoming post on the FDD will take a brief look at each of the 23 Items from each of these perspectives.

We look forward to sharing our understanding and perspective on the FDD.