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.