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This is the tenth in a series of articles for prospective franchisees that discuss the components of a franchise disclosure document. Unlike almost all other articles about what you will learn in a franchise disclosure document, however, this series will focus on what you may not learn. This focus is intended to help you both refine and expand your due diligence efforts.

The disclosure of a lot of lawsuits in a franchise disclosure document (FDD) can tell you quite a bit about a franchise. On the other hand, the disclosure of little or no litigation may not tell you very much about the level of disputes between the franchisor and franchisee. In either case, a prospective franchisee’s due diligence should focus on digging beneath the Item 3 (Litigation) disclosures in the FDD to fully understand the nature of disputes and the level of litigation within a franchise system.
 
What you will learn.
 
Item 3 requires the franchisor to disclose certain lawsuits involving the franchisor and other entities and individuals associated with the franchisor. Specifically, the franchisor must disclose whether the franchisor, its predecessor and specified affiliates and individuals:
  • Have pending against them administrative, criminal or material civil actions alleging a violation of franchise, antitrust or securities law or alleging fraud, unfair or deceptive practices or comparable allegations
  • Have pending against them any non-routine civil actions that are material in the context of
    • The number of franchisees and
    • The size, nature or financial condition of the franchise system or its business operations
  • In the last fiscal year, were a party to any newly filed material civil action involving contractual obligations between the franchisor and franchisee – including franchisor-initiated litigation – directly relating to the operation of the franchised business (such as royalty payments and training obligations) or, in other words, involving the “franchise relationship”
  • In the last10-years, have been
    • Convicted of or pleaded to nolo contendere to a felony charge
    • Held liable in a civil action involving an alleged violation of a franchise, antitrust or securities law or involving allegations of fraud, unfair or deceptive practices or comparable allegations
  • Are subject to a currently effective injunctive or restrictive order or decree resulting from a pending or concluded action brought by the government and relating to the franchise or to a Federal, State or Canadian franchise, securities, antitrust, trade regulation or trade practice law.
The specified affiliates and individuals include:
  • A parent or affiliate who induces franchise sales by promising financial backing for the franchisor or otherwise guarantees the franchisor’s performance or
  • An affiliate who offers franchises under the franchisor’s principal trademark
  • The franchisor’s directors, trustees, general partners, principal officers and any other individuals who have management responsibility relating to the sale or operation of franchises offered by the FDD
  • With respect to the injunctions or restrictive orders or decrees described above,
    • A parent or affiliate who guarantees the franchisor’s performance
    • An affiliate who has offered or sold franchises in any line of business within the last 10 years
    • The individuals with management responsibility described above.
The franchisor must disclose certain identifying facts about the actions, a summary of the legal and factual nature of each claim in the action, the relief sought or obtained and any conclusions of law or fact. In addition, the franchisor must state:
  • For prior actions, the status of the action
  • For past actions, the date when the judgment was entered and any damages or settlement terms (including those for confidential settlements)
  • For injunctive or restrictive orders or decrees, the nature, terms and conditions
  • For convictions or pleas, the date of the conviction and the sentence or penalty imposed.
One of the most significant changes to the Federal regulation that govern franchises (the Franchise Rule) when it was amended in 2007 was the requirement for franchisors to disclose franchisor-initiated litigation. The change was made because the Federal Trade Commission (FTC) believes that franchisor-initiated litigation is “material information that prospective franchisees need in order to assess a critical aspect of the franchise relationship – the nature of disputes and the level of litigation within a franchise system.”
 
For franchisor-initiated lawsuits not involving a franchisee counterclaim, franchisors may list individual lawsuits under a single common heading such as “royalty collection suits.”
 
What you will not learn.
 
According to the Amended Franchise Rule’s FAQs, franchisor-initiated litigation disclosure is not cumulative; pending suits filed by the franchisor against a franchisee more than a fiscal year ago need not be included in Item 3 disclosure. That is, according to FAQ #5, franchisors must disclose the suits it filed against franchisees in the last fiscal year only. The FTC believes that “this ‘snapshot’ in time is sufficient to reveal the franchisor’s practice of initiating litigation, as well as to reveal the types of franchise relationship problems that typically arise in the franchise system.” So, while franchisors may disclose older franchisor-initiated litigation (and many do), they need not.
 
In addition, under FAQ #16, the FTC distinguishes between “financial backing” and “guaranteeing” the franchisor’s performance. As described above, franchisors are required to disclose injunctions and restrictive orders and decrees only in cases in which the parent or affiliate “guarantees” the franchisor’s performance. “Financial backing” refers “to promises that a parent may make to ensure that the franchise system is and remains on stable financial footing” such as “promises to infuse the franchisor with cash or other assets or to extend credit, if needed, to pay debts to third parties on behalf of the franchisor.” “Guaranteeing performance,” on the other hand, means “promises made between the franchisor’s parent and the franchisor for the benefit of franchisees or from the franchisor’s parent directly to the franchisees.”
 
So, even though the FTC has stated that a government injunction or comparable order may be an indicator of fraud or other unlawful conduct, it makes what may be an unnecessary distinction between legal and equitable (injunctive) actions: if a parent or affiliate only provides “financial backing” for the franchisor – even if that financial backing induces franchise sales – the franchisor is not required to disclose whether that parent or affiliate is subject to any injunctive actions.
 
Item 3 also allows franchisors to omit disclosure of settled litigation where the settlement is favorable or is otherwise neutral to the franchisor. The text of Item 3 is not a model of clarity on this point, but the Franchise Rule’s Statement of Basis and Purpose makes clear that the FTC does not consider material any settlements that are favorable or neutral to the franchisor. So, if a franchisor is in the habit of exacting favorable settlements against franchisees, you may not learn about the full extent of a franchisor’s penchant for suing franchisees through Item 3. Nevertheless, some franchisors, mindful that State franchise authorities might take a different view and wary of gumming up the State franchise registration process, may disclose all settlements – favorable, neutral or unfavorable.
 
The franchisor-initiated litigation requiring disclosure under Item 3 also does not include litigation involving affiliates and third-party suppliers. Accordingly, if a franchisor sues a supplier of franchisee goods and services over, for example, issues related to the quality or efficiency of supply, you will not learn about it in the FDD because the FTC does not believe that it bears on the “quality of the franchisor-franchisee relationship.”
 
In addition, franchisors are allowed to report franchisor-initiated litigation annually, not quarterly. This means that franchisor-initiated litigation is not captured by the Franchise Rule’s quarterly updating requirements.
 
Finally, the disclosure of cases in which the franchisor and other entities and individuals associated with the franchisor is limited to “material civil actions.” A “material civil action” is one likely to influence a prospective franchisee’s investment decision. This is not too much of a concern because the FTC guidance takes a fairly broad view of what is considered material, stating that “any franchisor-initiated litigation that goes to the quality of the franchise relationship being offered for sale is likely to be material” and only specifically providing some wiggle room in the definition of material for “ ‘nontraditional outlets’ operating a unique franchise agreement – such as the operation of an outlet on a military base.”
 

The following summary table for Item 3 is provided in the FTC’s Franchise Rule Compliance Guide:

 
 
Pending Lawsuits; Other Material Civil Actions
Franchise Relationship Actions
Prior Actions
Govern-ment Injunctions, Decrees, Orders
Franchisor
Must Disclose
Must Disclose
Must Disclose
Must Disclose
Predecessor
Must Disclose
Must Disclose
Must Disclose
Must Disclose
Affiliate

Must disclose if affiliate promises to back the franchisor financially or otherwise guarantees the franchisor’s performance or sells franchises under the franchisor’s principal trademark

Must disclose if affiliate promises to back the franchisor financially or otherwise guarantees the franchisor’s performance, or sells franchises under the franchisor’s principal trademark

Must disclose if affiliate promises to back the franchisor financially or otherwise guarantees the franchisor’s performance or sells franchises under the franchisor’s principal trademark

Must disclose if the affiliate guarantees the franchisor’s performance, or if the affiliate has offered or sold franchises in any line of business within the last 10 years.

Parent

Must disclose if the parent promises to back the franchisor financially or otherwise guarantees the franchisor’s performance

Must disclose if the parent promises to back the franchisor financially or otherwise guarantees the franchisor’s performance

Must disclose if the parent promises to back the franchisor financially or otherwise guarantees the franchisor’s performance

Must disclose if the parent guarantees the franchisor’s performance

Directors, trustees, general partners, principal officers and persons with manage-ment responsibil-ity relating to the sale or operation of the franchise offered

Must disclose if named as a party

Must disclose if named as a party

Must disclose if named as a party

Must disclose if named as a party

 
 

Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.

This article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own franchise attorney concerning your own situation and any specific legal questions you may have.
 
© 2012 Mike Sheehan. All rights reserved.