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.