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Posted on Feb 02, 2011

Franchise Disclosure Documents For Dummies – Part 1

To begin my new weekly column for FranchiseHelp.com I will be writing a series of articles covering some basics and need-to-know information for each of the twenty-three Items of the Franchise Disclosure Document (“FDD”). I will try to be as non-technical as possible, and will try to provide insight and information that is useful for both franchisors and prospective franchisees. Nine weeks from now, you may have a slightly better understanding of the core elements of the FDD.

By way of introduction, the FDD is the disclosure document mandated by the Federal Trade Commission for the substantial majority of all franchise offerings in the United States.

Item 1 – The Franchisor, and Any Parents, Predecessors and Affiliates

In Item 1, the franchisor must disclose all of its predecessor, parent and affiliate entities that are relevant to the franchise offering. This includes, among others, all parents and affiliates that will provide post-sale services or product sales to franchisees. The idea here is to provide prospective franchisees with all information that may potentially be considered important in their decision whether or not to pursue the franchise.
Item 1 also includes:

  • Summary of the franchise offering
  • The franchisor’s franchising history
  • General description of the market for franchised outlets’ products or services
  • Identification of franchisees’ competitors in general terms
  • Overview of laws and regulations applicable to the specific industry in which franchisees will operate.

These disclosures are critical from the franchisor’s perspective, as they allow the franchisor to introduce its offering to franchisees while at the same time exposing the risks—and shifting the burden of those risks to a certain extent—to prospective franchisees. From a franchisee’s perspective, these disclosures are important for much the same reasons.

Item 2 – Business Experience

In Item 2, franchisors are required to provide 5-year work histories for their officers directors, and franchise personnel.
Item 2 also must:

  • Adhere strictly to the disclosure requirements. Franchisors must not embellish with board and other advisory positions that fall outside the scope of permissible Item 2 disclosures.
  • Provide disclosures for all individuals “who will have management responsibility relating to the sale or operation of franchises offered by this document.”

For prospective franchisees, Item 2 provides insight into the key players’ history with the franchise system and in franchising generally.
Prospective franchisees should look for:

  • Owners and officers experienced in franchising
  • Owners and officers experienced in the franchised business
  • Sufficient personnel to adequately manage and adminster the franchise system

While franchisors with only a few units or with models that do not require a lot of franchisor involvement may not need much in the way of staff, larger systems generally require a dedicated team of knowledgeable personnel to oversee and administer the franchise network.

Item 3 – Litigation

In Item 3 franchisors must disclose all court proceedings involving the franchisor, its parents and affiliates, and any individuals identified in Item 2. Franchisors need to be sure to address all of the required disclosures carefully, and franchisors with a history of litigation should make sure to update Item 3 regularly to delete references to cases predating the 10-year disclosure requirement.

Prospective franchisees should examine all pending and resolved litigation disclosed in Item 3.
Questions for prospective franchisees to answer when evaluating a franchisor’s litigation history:

  • Is the franchisor a defendant in any pending litigation where it faces substantial liability that could bankrupt the company?
  • Does Item 3 demonstrate a pattern of litigating disputes with franchisees?
  • Has the franchisor been involved in any publicized litigation that may harm its reputation?

Getting to the bottom of these types of questions can provide valuable insight during the due diligence process for franchisees.

Item 4 – Bankruptcy

Item 4 is similar (though not identical) in its scope and coverage to Item 3, except that it focuses on bankruptcy filings rather than litigation. As in Item 3, franchisors need to make sure to address all of the required disclosures (including obtaining bankruptcy histories for all individuals identified in Item 2). Prospective franchisees should consider these disclosures carefully when evaluating the viability and long-term prospects of the franchise system.

There is a lot more to cover! Next week's post, Franchise Disclosure Document for Dummies - Part 2, will focus on the fee and investment disclosures in Items 5, 6 and 7 of the FDD.

Jeff Fabian is the owner of Fabian, LLC, a boutique intellectual property and business law firm serving new and established franchisors and prospective franchisees. Visit www.fabianlegal.com for more information, or contact the firm directly at 410.908.0883 or jeff@fabianlegal.com. You can also follow Jeff on Twitter @jsfabian.

This article is provided for informational purposes only, and does not constitute legal advice. Always consult an attorney before taking any action that may affect your legal rights or liabilities.

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