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Required Franchise Disclosures-Litigation
By Mario Herman
The litigation section in the Franchise Disclosure Document
known as Item 3 can provide a good deal of information regarding the
franchisor. Understanding this important section is an important part of
your franchise evaluation process.
Pursuant to the Federal Franchise Rule, 16 C.F.R. 436.5(c),
franchisors are required to disclose to prospective franchisees information
regarding the litigation history of the franchisor and certain related
persons and entities.
As to whom must disclosure be made? Disclosure must be made as to
the franchisor; a predecessor, a parent or affiliate who induces franchise
sales by promising to back the franchisor financially or otherwise
guarantees the franchisor’s performance; an affiliate who offers franchises
under the franchisor’s principal trademark; and the franchisor’s directors,
trustees, general partners, principal officers, and any other individuals
who will have management responsibility relating to the sale or operation of
franchises offered by the disclosure document.
What must be disclosed?
1. Pending Actions. The franchisor must disclose
whether any of the persons/entities listed above have any actions pending
against them, including: (1) an administrative, criminal, or material civil
action alleging a violation of a franchise, antitrust, or securities law, or
alleging fraud, unfair or deceptive practices, or comparable allegations;
and, (2) civil actions, other than ordinary routine litigation incidental to
the business, which are material in the context of the number of franchisees
and the size, nature, or financial condition of the franchise system or its
business operations.
2. Actions in the Last Fiscal Year. The franchisor
must also disclose whether any person/entity listed above was a party to any
material civil action involving the franchise relationship in the last
fiscal year. For purposes of this section, ‘‘franchise relationship’’ means
contractual obligations between the franchisor and franchisee directly
relating to the operationof the franchised business (such as royalty payment
and training obligations). It does not include actions involving
suppliers or other third parties, or indemnification for tort liability.
3. Previous 10 Years. The franchisor must also
disclose whether any person/entity listed above has in the 10-year period
immediately before the disclosure document’s issuance date has/have: (1)
been convicted of or pleaded nolocontendere to a felony charge; and, (2)
been held liable in a civil action involving an alleged violation of a
franchise, antitrust, or securities law, or involving allegations of fraud,
unfair or deceptive practices, or comparable allegations. ‘‘Held liable’’
means that, as a result of claims or counterclaims, the person must pay
money or other consideration, must reduce an indebtedness by the amount of
an award, cannot enforce its rights, or must take action adverse to its
interests.
4. Injunctive – Restrictive Orders. The franchisor
must also disclose whether the franchisor, a predecessor, a parent or
affiliate who guarantees the franchisor’s performance, an affiliate who has
offered or sold franchises in any line of business within the last 10 years,
or any other person identified in § 436.5(b) of this part is subject to a
currently effective injunctive or restrictive order or decree resulting from
a pending or concluded action brought by a public agency and relating to the
franchise or to a Federal, State, or Canadian franchise, securities,
antitrust, trade regulation, or trade practice law.
As to each of these matters, the franchisor must disclose the following
information regarding such actions: the title, case number or citation, the
initial filing date, the names of the parties, the forum, and the
relationship of the opposing party to the franchisor (for example,
competitor, supplier, lessor, franchisee, former franchisee, or class of
franchisees). The franchisor must also summarize the legal and factual
nature of each claim in the action, the relief sought or obtained, and any
conclusions of law or fact, and state the status of any pending action, and
the date when judgment was entered and any damages or settlement terms of
any prior action. For injunctive or restrictive orders, the franchisor
must state the nature, terms, and conditions of the order or decree.
Regarding convictions or pleas, the franchisor must set forth the crime or
violation, the date of conviction, and the sentence or penalty imposed. For
any other franchisor-initiated suit which is a material civil action
involving the franchise relationship in the last fiscal year the franchisor
may comply with the disclosure requirements by listing individual suits
under one common heading that will serve as the case summary (for example,
‘‘royalty collection suits’’).
Why Are These Disclosures Important to Review Carefully
A careful review of this section will let you know who you’re dealing
with. It will be important to review this section for both the
franchisor’s history of initiating litigation against its current or former
franchisees, i.e., if the franchisor or its representative is telling you it
never enforces its covenant not to compete but there are pending or prior
litigations listed involving such matters that would certainly be a red
flag. It can also give you valuable information regarding the
character of the franchisor and associated persons/entities. For
instance, are there any fraud or misrepresentation actions past or pending?
An experienced franchise law attorney can also review this section in
context with the remainder of the franchise disclosure document, i.e, Item
20, which requires disclosure on outlets and franchisee information and
attrition rate, and Item 1, which requires disclosure regarding the
franchisor, and any parents, predecessors and affiliates, as well as Item 2,
which requires disclosure of the business experience of the franchisor’s
directors, trustees, general partners, principal officers, and any other
individuals who will have management responsibility relating to the sale or
operation of franchises offered, and finally, Item 4, which requires
disclosure of bankruptcy related issues of such persons/entities.
Mr. Herman, licensed in Washington, D.C., represents franchisees
domestically and internationally in negotiation, mediation, arbitration, and
litigation with their franchisors.
mherman@franchise-law.com
www.franchise-law.com
www.internationalfranchiselaw.com
202-686-2886 (ph)
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