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Monday, October 21, 2013

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.