A colleague recently asked me this question:
"You've stated that defects in the FDD or disclosure process can sometimes be used by unhappy franchisees to exit their franchise systems, even if a significant amount of time has passed. What are the most common defects in the FDD or disclosure process that can be used in this way?"
This scenario is a focus of my practice and I've handled dozens of these situations for both franchisees and franchisors.
The question has two parts, which will be discussed in separate articles.
Part 1. What are some common significant disclosure violations?
Here are eight common disclosure violations which I regard as significant:
1. Failure to disclose sufficiently in advance of signing or taking payment (e.g., handing out the FDD at "Discovery Day" and then signing the contract without waiting the necessary 14-day period). In this scenario, the Receipts are typically not signed and dated, or they are signed later and backdated.
2. Making defective financial performance representations. Franchisors want to put their financial data in the best possible light, and sometimes they cherry pick data in violation of FTC guidelines.
3. Providing different or "updated" financial performance information after the FDD, but before contract signing, either verbally or in writing. Many franchisors decline to provide an Item 19 financial performance representation at all. That's the safest course legally for a franchisor, but it makes it hard to sell franchises. What do you tell a proposed franchise buyer when his bank asks him to prepare a budget for his loan application? If you give him some projections, that becomes an unlawful financial performance representation.
4. Failing to provide an updated FDD after the previous document expires. The documents have to be updated within 120 days after the end of a year.
5. Providing an updated FDD which does not include updated financial statements. The financial statement requirements can be confusing, but they are a fertile area to check for disclosure violations. Sometimes the footnotes contain information that conflicts with the disclosures in the FDD text.
6. Providing a parent company's financial statement in the FDD in lieu of franchisor financials, without also providing a guarantee of performance by the parent company.
7. Failing to address ownership of key trademarks by entities other than the franchisor. Check the trademark registrations to see if the trademark owner is the same as the franchisor. Often the business owner starts a new entity to operate the franchise, and sometimes the trademark will be shared between the franchised units and the preexisting company units. Is there an Agreement between the trademark owner and the franchise entity addressing this shared ownership? How is this relationship described in the FDD?
8. Failing to update a prior FDD before signing, where a material change requiring an updated version has occurred since FDD preparation.
If this material is relevant to YOUR situation,
please give me, Stan Dub, a call at: 216-991-4480
What Joe and I see a lot is franchisors who have an Item19, but then make earnings claims which are not consistent with their Item 19.
It's as if having the Item 19 allows them to say anything they want about the profitability of their franchise.
Yes, that's covered in Item #3, above. It makes for a clearcut violation. I have a case pending in federal court now with those facts.