Franchisee Insight: Learning from Franchisor Litigation (or Lack Thereof)

When performing their due diligence and investigating new franchise opportunities, one of the key areas of inquiry for prospective franchisees should be the franchisor’s litigation history. Assuming the franchisor has been in business for some time (this, of course, is not always the case, as new and innovative franchise offerings are introduced on a regular basis), the franchisor’s litigation history, or lack thereof, can provide valuable insight into both its culture and financial wellbeing.

As a starting point, prospective franchisees should turn to Item 3 of the Franchise Disclosure Document (“FDD”). In Item 3, franchisors are required to disclose a variety of litigation-related matters — both pending and resolved — and must meet specific mandated disclosure requirements with respect to each matter disclosed.

The Item 3 disclosure requirements are complex compared to other items of the FDD, but they can generally be summarized as follows. In Item 3, franchisors must disclose:

• Pending actions alleging the franchisor’s violation of franchise, antitrust or securities laws, or alleging fraud or deceptive trade practices, and 10 years’ worth of history of similar claims.
• Other pending actions that are pertinent to the franchise system generally, and 10 years’ worth of history of similar claims.
• Any actions within the past year involving contractual relations between the franchisor and any franchisee.

Notably, these disclosure requirements apply not only to the franchisor, but also to its parents and affiliates and any individuals identified in Item 2 of the FDD.

If the franchisor does not have any litigation disclosures in Item 3 of the FDD, this generally is a good sign, especially for well-established franchisors with large systems who you would expect to have some sort of litigation history. For new franchisors, however, this “negative” disclosure may be less meaningful.

When a franchisor discloses pending or resolved litigation in Item 3, prospective franchisees should follow up on these disclosures with a series of questions directed toward the franchisor’s representatives. Specifically, depending on the nature of the litigation, prospective franchisees should seek to learn:

• How the costs of litigation are impacting (or will impact) the franchisor’s daily operations.
• Whether a negative result in a suit against the franchisor would cause financial ruin.
• What it generally takes before the franchisor decides to file suit against a franchisee.
• What the franchisor is doing to avoid similar disputes in the future.

By investigating these issues, prospective franchisees can learn a lot about their would-be franchisor. For example, if the franchisor has sued ten franchisees in the last twelve months to collect past-due royalties, (i) this may suggest that franchisees are struggling within the system, and (ii) it may also suggest that the franchisor puts more emphasis on collecting than seeing its franchisees succeed. Similarly, if the franchisor has repeatedly been sued by its vendors, this may suggest (i) a lack of financial health, or (ii) deficiencies in management and/or a propensity for getting into trouble. In addition, if the franchisor is facing the possibility of a multi-million dollar judgment in a fraud case or other civil action, this may put the entire franchise system in jeopardy. These are three rather extreme examples, but they provide insight into how litigation disclosures can be used to build an understanding of the franchisor’s business model and system health as a whole.

Importantly, even if the franchisor has not disclosed any litigation in Item 3, prospective franchisees should still inquire as to the current status of any pending or possible claims. New disputes may have arisen since the date the FDD was issued, or the franchisor may be involved in certain disputes that are not required to be disclosed in the FDD. Additionally, the limited mandatory Item 3 disclosures simply may not tell the whole story of how things came to be.

Jeff Fabian is the owner of Fabian, LLC, a boutique intellectual property and business law firm serving new and established franchisors and franchisees. 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.