Under Item 2 of the Franchise Disclosure Document (FDD), a franchisor is required to disclose the names and positions of certain individuals comprising the franchisor’s management team, as well as their prior business experience. These disclosures provide prospective franchisees with a general landscape of the franchisor’s executive decision-making apparatus. Our experienced attorney could describe what individuals should be disclosed, what information concerning their prior business experience should be disclosed, and what the best practices when drafting its required disclosures under Item 2.
The disclosures required under Item 2 of the FDD are set forth in 16 C.F.R. § 436.5(b). Under Item 2, there are five categories of individuals that a franchisor must disclose:
Generally, the first four of these categories (i.e., directors, trustees, general partners, and principal officers) are easily identifiable by the franchisor. These positions in the franchise system are not arbitrarily awarded and, by operation of the franchise system, most franchisors have first-hand contact with these individuals. The main point of confusion for most franchisors under Item 2 is identifying individuals that have management responsibility over the sale or operation of the franchise units.
It is important to note at the outset that the formal title held by an individual within the franchise business is inconclusive of whether that individual falls within the fifth category of “management responsibility” individuals. However, certain position titles, such as “Sales Manager” or “Operations Manager,” are more likely than not a good indicator that disclosure of that individual under Item 2 is required. Yet, even individuals without the words “manager,” “sales,” or “operations” in their formal title, but who nonetheless exercise some managerial authority over the sale or operation of franchise units, may still need to be disclosed. For these individuals, disclosure under Item 2 is required if their involvement in the sale or operation of franchise units is of such a degree that a reasonable prospective franchisee, in deciding whether to purchase or operate a franchise unit, would rely on their expertise, formulation of policy, or control of the franchise system.
Another consideration that is sometimes overlooked is that Item 2 deals only with individuals—not entities. Thus, in a limited liability company, where “members” can be both entities and individuals, only those members that are individuals and fall within one of the five categories stated above are required to be disclosed. It is also important to note that an individual with management responsibility need not be an employee of the franchisor. It is for that reason that independent contractors and employees of unaffiliated third parties must be disclosed under Item 2 if they also constitute “management responsibility” individuals.
For any individual falling within one of the five categories of individuals stated above, a franchisor must disclose that individuals name and current position. A franchisor must also disclose that individual’s previous employers and principal positions held with those employers for the last five years. For each principal position within the last five years, a franchisor should disclose the start and end date of that individual’s position, as well as the location where that position was held.
Franchisors should employ due diligence in identifying and disclosing the necessary individuals under Item 2 of the FDD. Some franchisors, typically those with a smaller management system, will over-disclose individuals in their Item 2 to give the appearance of a robust franchise system. This is highly discouraged. For one reason, it is potentially misleading; for another reason, a franchisor must make subsequent litigation and bankruptcy disclosures for any individual disclosed in Item 2, in Items 3 and 4, respectively. However, if a franchisor is uncertain whether a particular individual meets the disclosure requirements, unless the list of persons to disclose in Item 2 threatens to become distractingly long, it is best practice to be safe and include this person.
It is also important that a franchisor only disclose prior business experience of Item 2 individuals within the required five-year window. Some franchisors are inclined to provide business experience outside of this time frame, most times to assure prospective franchisees meet the qualifications of the franchisor’s management system. However, this approach is highly discouraged, as many state examiners have required that business experience disclosed on Item 2 persons outside of the five-year window be removed from the FDD. Therefore, including information on Item 2 persons that predate this time frame may delay the FDD registration process; ultimately hurting, rather than helping, the franchisor.
In the event a franchisor is uncertain whether a particular individual falls within one of the five categories of individuals required to be disclosed under Item 2, or how much information about that individual a franchisor should disclose, it is always the best practice to consult an experienced franchise attorney.