Tuesday, November 19, 2013

FDD Fundamentals: Item 4

Item 4 is a fairly straight forward disclosure requiring the franchisor and any of its related parties (affiliates, parents, predecessors and certain individuals) to disclose a bankruptcy, or similar foreign proceeding, within the last ten years. And while the disclosure appears simple, there are some interesting nuances with respect to each party’s disclosure.

With respect to the franchisor, if it has declared bankruptcy it may indicate an increased potential for a future bankruptcy, and may further indicate that in the past, the franchisor has had problems preforming under its contracts. This is particularly important to a franchisee because the relationship between a franchisee and a franchisor is primarily governed by the franchise agreement.

Parent Company
In addition to the requirement for the franchisor entity, the franchisor’s parent company or companies are required to disclose any bankruptcy. This is because under those bankruptcy proceedings the parent may be required to sell its assets, which, depending on the relationship between the franchisor and the parent, may include the franchise system. Under this scenario, the franchisee will not have input over who purchases the franchise system, and the sale could be to a party inexperienced in franchising or possibly even to a competitor. Despite the fact that the franchisee may not like the new owner, she would likely be bound to work with the new owner under the terms of the original franchise agreement, because most franchise agreements contain assignment provisions that require the franchisee to be bound to the terms of that agreement even if the franchisor sells, transfers, or assigns the franchise system to another party.

The franchisor’s affiliates also need to disclose bankruptcies. One reason for this requirement is to alert franchisees to the possibility that the affiliate may choose to divert funds from the franchise system to cover costs etc. of the affiliate’s bankruptcy. While not a common scenario, this diversion of funds may reduce the franchisor’s ability to provided services to the franchisee. For this reason, the definition of “affiliate” for purposes of Item 4 is more broad than the definition under Item 3, i.e., it includes all affiliates not just those who have sold franchises under the franchisors principle trademark.

The franchisor’s predecessors also must disclose any bankruptcy proceedings under Item 4. The primary purpose for this is to prevent the franchisor from reincorporating or reorganizing under a different name in an attempt to avoid disclosing previous bankruptcies. 

Lastly, any individual person affiliated with the franchisor who has significant management responsibility over the franchise system is required to disclose their relevant bankruptcies as well. Relevant bankruptcies include any personal bankruptcy as well as the bankruptcy of any entity that occurred within one year of her serving as a principle officer or general partner.

For the franchisee, these disclosures have important implications when deciding whether to buy into a particular franchise system. A franchisee should be very attentive of the bankruptcy disclosure section and should keep in mind how each party’s bankruptcy could affect both the franchisee’s investment in the franchise and her relationship with the franchisor. Before declaring bankruptcy or selecting the franchise management team, franchisors should be aware of these disclosure requirements. Additionally, franchisors need to be aware of the various entities and individuals who are required to make Item 4 disclosures. Finally, one common mistake is to assume that the ten-year disclosure requirement automatically ends ten years after the person or entity filed for bankruptcy. However, under the FTC Rule this is not necessarily the case; it is ten years from the date of disposition. 

Monday, November 4, 2013

FDD Fundamentals: Item 3

Item 3 of the FDD requires disclosure of the franchisor’s material legal disputes. Legal disputes include formal lawsuits, arbitrations, and settlement agreements (including some confidential settlement agreements). For the purpose of litigation disclosures, “franchisor” means the franchisor company, any of the individuals with significant management responsibility, affiliates, parents, and predecessors. Similar to Item 2, the policy concerns that gave rise to the original version of Item 3 were concerns with deception, fraud, and unfair commercial practices used in the sale of franchises by franchisors. In drafting the revised franchise rule, the FTC expanded the disclosures to include suits initiated by the franchisor. The purpose for this expansion was to reveal the nature and amount of legal disputes within a franchise system, and to indicate the overall franchise system performance.

This blog post will address the following: (1) who needs to disclose, (2) what needs to be disclosed, and (3) the two types of disclosure.

Who Needs to Disclose
First, the franchisor, its affiliates, its predecessors, parents, or individuals working for the franchisor with significant management responsibility are the parties who need to disclose material legal actions. Parent companies need to disclose their litigation history only when they guarantee the franchisor’s performance or have post-sale obligations. Any affiliate that falls into one of the following three categories will need to make some litigation disclosures. Any affiliate who: (1) guarantees the franchisors performance; (2) offers franchises for sale under the franchisor’s principle trademark; or (3) under certain circumstances, affiliates who have sold franchises in any line of business within the last ten years. Importantly, these different subclasses of affiliates have slightly different disclosure requirements (discussed below).

What Must Be Disclosed
Second, the Franchisor et al. must disclose three types of legal action and some regulatory actions.

       a)  Pending legal actions, these parties must disclose pending criminal, regulatory, or civil actions involving illegal or deceptive conduct or unfair trade practices.

           b) They must disclose any past convictions, no contest, or guilty pleas within the last ten years resulting from criminal, regulatory, or civil actions alleging illegal, deceptive, or unfair actions or practices.

        c) They must disclose material civil actions involving any franchise relationship. Additionally, they must disclose currently effective injunctive or restrictive orders brought by a public agency that involve violations of securities, franchise, or trade practices.

However, as mentioned above, the third class of affiliate, those who have offered or sold a franchise in any line of business, are required to disclose any injunction or restrictive order brought by a public agency. Conversely, franchisors et al., do not need to disclose suits not directly related to the operation of the franchise business. For example, suits only involving suppliers, other third parties, or suits for tort indemnification do not need to be disclosed. These types of lawsuits do not need to be disclosed because, according to the FTC, they are not indicative of the franchise system’s overall performance.

Additionally, under the amended Franchise rule of 2007, franchisors must disclose confidential settlement agreements. However, there are exceptions to this disclosure requirement. First, the franchisor need not disclose any settlement that has a neutral or favorable outcome for the franchisor. These types of disclosures are not required because they would not be deemed “material” under the FTC’s interpretation of Item 3. Second, the Franchisor need not disclose any settlements entered into before it started selling franchises. One reason for this exclusion is that these parties would not have considered franchising during these negotiations, and consequently, it would be unfair to make the party disclose those settlements for franchise disclosure purposes. Finally, any franchisor who operated under the franchise rule – Not the UFOC – need not disclose any settlements it entered into before the new franchise rule became effective on July 1, 2007. One reason for this exclusion is that disclosure of these types of settlements was not previously required.

Two Types of Disclosure
It is important to note that Item 3 permits two classes of disclosure. The first requires quarterly disclosures. Legal actions are material civil actions involving the franchise relationship. Specifically, they typically involve the contractual obligations between franchisee and franchisor that relate to the operations of the franchise business. The second type of Item-3 disclosure requires only annual updates, e.g., franchisor initiated suits. However, a franchisor initiated suit can be moved into the quarterly disclosure group if a franchisee asserts a counterclaim related to the contractual obligations of the franchisor to help operate the franchise business.

Item 3 of the FDD is meant to help the franchisee understand how the franchise system is performing and how often lawsuits occur within the franchise system. However, as the franchisee, it is important to keep in mind the exceptions to the disclosure rule. As with all large investments, it may be important for the franchisee to preform additional research if there has been a recent change to the franchisor’s principle trademark, or if the franchisor has been selling franchises for some time. One way to obtain additional information is to contact former and current franchisees and ask for information regarding the franchise system’s performance and culture.

From the franchisor’s perspective, there are a few important things to remember. First, be sure to disclose all required information involving lawsuits and settlements. Second, understand your business organization, specifically which entities have been involved in settlements or lawsuits that need to be disclosed and whether those entities or individuals fall into a class that needs to disclose. Third, moving forward, you should attempt to prevent problems before they arise. Attempt to avoid situations where a lawsuit or unfavorable settlement is likely to occur. For example, be engaged in your franchisee’s success. Keep in touch with them, and do your best to help them be successful. Successful franchisees are less likely to sue their franchisors. However, if a problem does arise, before immediately initiating a lawsuit, attempt a resolution outside of the courts, and utilize competent legal counsel.