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.

Franchisor

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.

Affiliates

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.

Predecessors

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. 

Individuals.

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. 

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. 

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. 

Effective Communication with Franchisees

Creating effective communication strategies with franchisees is a vital part of franchise systems of all sizes. Today there are more communication tools than ever before and many are literally in sitting your back pocket, your purse or wherever you keep your smart phone. It is important to remember that when a franchisee succeeds, the franchise brand and system succeeds, and communication is a tool to that success.

A franchise relationship is like any long-term relationship. In order to succeed, both sides need to be willing to listen and to work together. Effective communication builds support and buy-in of new ideas and concepts. It also gives the franchisee a reason to share their ideas and thoughts. Remember, some of the most successful concepts, advertisements and services have originated from a franchisee. As a franchisor, you don’t want to lose out on taking the next big thing system-wide simply because you did not have an effective communication system in place.

If you are a franchisor, ask yourself these five questions to find out if your communication needs some reworking:

1. How often do you communicate with your franchisees? Once a week? Every month? Only at the annual conference? The more often you communicate, the more your franchisees will see and come to believe that you are truly invested in their success. The franchisee has invested their own money and time and they want to know that the franchisor is as invested as they are.

2. Is your communication in the same format each time? Are you a one-trick-pony communicator? If so, switch it up. There are a multitude of technologies available to you from webinars to surveys to conference calls. Don’t just send out emails. Invite groups of franchisees to participate in a web conference;

3. When was the last time you sat face to face with a group of franchisees and just listened to what they had to say? Often, as a franchise system grows, those at the top stop spending time with their franchisees and stop hearing what they have to say. Just because the system is expanding it does not mean that everything is going well and that franchisees are happy. And even if they are happy, it is still a good idea to sit down every once in a while.

4. Are your franchisees able to openly communicate with one another? You should encourage your franchisees to share their success stories and best practices with one another.

5. Do you know if your franchisees understand the mission and vision of the company? If the last time you shared your vision of the company with franchisees was at initial training, it might be time to get your franchisees excited again. Help your franchisee to become your cheerleaders. They are out there every day and working with the public. If they know the mission and vision and are excited about it, the public will be able to feel it.

Taking a page out of the Dunkin’ Brands CEO’s playbook, franchisors need to remember that franchisees are their customers. Just as good customer service is vital for the success of a franchisee’s business, good customer service from the franchisor helps the franchisor’s business thrive.

Reader Topics

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Second, in an effort to make sure that our blog addresses not only the most current topics in franchise and business law, but to make sure we are addressing those topics and subjects relevant to our readers, we are asking for your help. What would you like to read? Is there a topic that you would like us to address or to provide more information on? Simply comment to this post or send an email to either kmartin@toolaw.com or christiant@toolaw.com. We will select a few topics and make them the subject of upcoming blog posts.

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