Researching Your Franchisor: Looking at the Item 3 “Litigation” Disclosure in a Franchise Disclosure
Are you a prospective franchisee researching a franchisor? Are you wondering whether it’s safe to invest thousands of your own dollars and to commit the next years of your life to a franchise business model? If so, one of the things you absolutely need to know is what kinds of lawsuits your franchisor has been involved in, and how those cases have turned out.
In the Franchise Disclosure Document (FDD) given to you before purchasing a franchise, there are 23 sections.
Those lawsuits are contained in Section 3, which is titled “Litigation,” of your 23-part Franchise Disclosure Document (FDD). Under the FTC Franchise Rule, it is mandatory that your franchisor provide this disclosure, which I’ll call the FDD Litigation Disclosure. Section 3 of the FTC Franchise Rule is often overlooked because the FDD could be hundreds of pages long. And once you read it, you still need to make sense of it. Let us help.
There are a number of categories of litigation that must be disclosed in the Item 3 FDD Litigation Disclosure, as follows.
Pending Cases Involving Franchisor Unfair Business Practices. A pending case is one that is still going on. Pending cases that must be disclosed are those that allege “violation of a franchise, antitrust, or securities law, or alleging fraud, unfair or deceptive practices, or comparable allegations.” These only need to be allegations – they don’t need to be proven yet. Also, it need not actually be in court – they may be “administrative” cases brought by, a state or federal board with supervisory powers.
“Material” Pending Cases Against Franchisor. The franchisor must disclose any other cases that would be “material” to the potential franchisee when making up their mind about whether to buy the franchise. This includes cases involving the number of franchisees, or the “size, nature, or financial condition of the franchise system.” This means that even if the case isn’t for unfair business practices, it could still have to be reported.
Cases with Franchisees. Any lawsuits with franchisees within the last fiscal year have to be disclosed. This doesn’t include cases with vendors or suppliers.
Franchisor’s Felony Convictions in Past 10 Years. Any case where the franchisor, its affiliates, officers, directors, or mangers was convicted of any felony, or pleaded nolo contender (no contest).
Cases Where Franchisor Held Liable in Past 10 Years. This is a key one – it includes settlements, not just cases that went to trial. The FTC says a franchisor was “held liable” where they had to pay money, reduce an obligation someone owed to them, or took any other action it wouldn’t have normally done.
The question all these disclosures invite is what about those cases needs to be disclosed, exactly? The Item 3 FDD Litigation Disclosure requires the following categories of information:
Title of the lawsuit or case,
Name of court,
Date the case was filed,
Names of all parties to the case,
and Relationship to the opposing party (e.g., franchisee, supplier, competitor).
If you are reviewing an FDD, you can look at it to see how a real one of these looks.
If you aren’t reviewing a FDD, here is a sample Item 3 FDD Litigation Disclosure from a McDonald’s Franchise Disclosure Document.
As you can see, it’s by no means comprehensive, but gives the general idea of what the litigation was about.
You should probably review any of your franchisor’s litigation with an attorney to see what, if any, relationship the cases might have to your prospective franchise. The franchise relationship can be lucrative, but you should go into it with your eyes open.
DYE CULIK PC is a franchise law firm that represents franchisees – never franchisors. We help entrepreneurs like you to assess risk, avoid pitfalls, and succeed. We make your business, our business.
If you would like to discuss a franchise or any other business-related matter with us, email us or call us at 980-999-3557.