As a prospective franchisee, reviewing the terms of a franchisor’s Franchise Disclosure Document (FDD) is a critical early step in the due diligence process. When reviewing the FDD, it is important to review all of the 23 “Items” – not just the ones dealing with fees and the estimated initial investment.
Among the more “legal” sections of the FDD that prospective franchisees frequently overlook is Item 3: Litigation. But, whether the franchisor provides a “negative disclosure” or details multiple ongoing pending lawsuits, Item 3 can often provide valuable insights into the risks of choosing a particular franchise opportunity.
Potential Takeaways from the Item 3 of the FDD
1. An Item 3 “Negative Disclosure”
If a franchisor does not have any litigation history that is subject to disclosure under the Federal Trade Commission’s (FTC) Franchise Rule, it must simply state in Item 3, “No litigation is required to be disclosed in this disclosure document.” While this is generally what you want to see as a prospective franchisee, it is important to note that not all types of lawsuits are subject to disclosure in Item 3 under the FTC Franchise Rule. For example, lawsuits that do not need to be disclosed in Item 3 include:
- Criminal actions that do not involve allegations of fraud; violations of franchise, antitrust or securities laws, or other “comparable allegations;”
- Civil lawsuits that are considered “ordinary routine litigation incidental to the business;” and,
- Bankruptcy proceedings subject to disclosure in Item 4.
2. Litigation Against Franchisees
Under the FTC Franchise Rule, franchisors are required to disclose, “any material civil action involving the franchise relationship in the last fiscal year.” The rule goes on to state that:
“For purposes of this section, ‘franchise relationship’ means contractual obligations between the franchisor and franchisee directly relating to the operation of the franchised business (such as royalty payment and training obligations). It does not include . . . or indemnification for tort liability.”
There are numerous factors that are relevant to prospective franchisees’ assessment of franchisor-initiated litigation disclosures in Item 3. For example, franchisors are only required to disclose lawsuits from their most-recent fiscal year. Additionally, not all forms of franchisor-initiated litigation are subject to disclosure. For these reasons (among others), it is important to have the Franchise Disclosure Document reviewed by an attorney who has extensive experience representing new and existing franchisees.
3. Litigation Impacting the Franchisor’s Trademark or Financial Stability
In Item 3, franchisors must also disclose various form of third-party litigation. While some third-party lawsuits will not be particularly relevant to prospective franchisees, lawsuits that have the potential to threaten the franchisor’s trademark rights or its ongoing financial stability are worthy of careful consideration.
Discuss Your Franchise Opportunity With National Franchise Attorney Jeffrey M. Goldstein
Jeffrey M. Goldstein is a franchise attorney who has over 30 years of experience representing new and existing franchisees in due diligence, contract negotiations and litigation. To discuss your franchise opportunity with Mr. Goldstein, please call (202) 293-3947 or inquire online about a flat-fee franchise business review.