Disclosure Issues of Litigation in the Franchise Disclosure Document

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 franchisesales 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 offeredby 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.

1. 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.

1. 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.

1. 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, thefranchisor 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 with whom you are getting into bed, so to speak.  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.