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Don’t Be a Victim of Franchise Fraud, aka, Churning -- Understanding Item
20
Part 2
By Mario Herman
Franchise candidates should know how to use the information in Item 20 of
the Franchise Disclosure Document. Contacting former franchisees and
obtaining information may be more difficult than appears.
Under
Item 20, Franchisors are also required to provide the prospective franchisee
with the contact information for all current franchisees, or for all
franchisees in the state where they are offering to sell franchises if there
are 100 or more franchises in the state, or for at least 100 franchisees in
contiguous states and the next closest states. If a franchisor has
fewer than 100 current franchisees, contact information must be provided for
all of them.
Also
under Item 20, Franchisors must provide the prospective franchisee with
contact information for every franchisees who: 1) has had an outlet
terminated, canceled, not renewed, or otherwise voluntarily or involuntarily
ceased to do business under the franchise agreement during the most recently
completed fiscal year; or 2) has not communicated with the franchisor within
10 weeks of the disclosure document issuance date.
One
might think that contacting former franchisees would be quite useful, as
they have no ongoing investment in the franchise business and might speak
more openly. However, there are a few obstacles to gathering
information from former franchisees. First, under Item 20, in order to
protect the privacy of former franchisees, the Franchise Rule calls for the
disclosure of only limited contact information: the name, city and state,
and current business telephone number of a former franchisee. While the
Franchise Rule provides that a franchisor should only use the “last known”
telephone number if the current business telephone number is unknown, one
has to question how many former franchisees keep their former franchisor
updated with current contact information.
The
second obstacle is what are known as “confidentially agreements” or “gag
orders” between former franchisees and franchisors. Franchisors are
required to disclose if franchisees have signed confidentiality agreements
with the franchisor during the last three fiscal years that restrict a
current or former franchisee from discussing his or her personal experience
as a franchisee in the franchisor’s system. These confidentiality agreements
typically arise as part of the resolution of a dispute between the
franchisor and franchisee, and as such, might restrict a franchisee from
disclosing relevant information about the franchise. The unfortunate
result of these confidentiality agreements is that it allows franchise
misrepresentation by preventing prospective new franchisees from learning
potentially negative details about the franchise. All of which may result
in the prospective franchisee unknowingly purchasing a franchise in a system
that has a history of low or no profitability and high failure rates of
franchisees. It should be further noted that current and
ex-franchisees of systems have no duty under the law to disclose information
about their businesses to prospective franchisees. By having former
franchisees under a confidentiality agreement or gag order, franchisors that
practice franchise fraud or franchise churning "inhibit prospective
franchisees from learning the truth about the franchising opportunity as
they conduct their due diligence investigation of a franchise offer."
(Federal Register Franchise Rule, page 15505.)
While
not foolproof, a careful review of Item 20 can disclose some red flags which
might help to prevent you from falling victim to franchise fraud or
churning. Is there a high turnover rate? What are the reasons
for the turnover rate? Does the franchisor require confidentiality
agreements of its current and/or former franchisees which would prevent you
from getting relevant information as you conduct your pre-purchase due
diligence? Again, before you purchase a franchise, you should
seriously consider having an experienced franchise law attorney review this
information with you, as well as reviewing the other disclosures in the FDD
and the contents of the Franchise Agreement. Doing so may save you
tens of thousands of dollars in the long run. The old saying, “penny
smart, pound foolish,” is critical to remember when making such an important
and financially significant investment.
Mr. Herman based in Washington, D.C., represents franchisees domestically
and internationally negotiation, mediation, arbitration, and litigation.
mherman@franchise-law.com
www.franchise-law.com
www.internationalfranchiselaw.com
202-686-2886 (ph)
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