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Under Item 3 of the Franchise Disclosure Document (FDD), a franchisor is required to disclose certain current and past lawsuits, or “actions,” that the franchisor or its predecessors, affiliates, parents, or individuals disclosed in Item 2 were involved in or subject to. Our knowledgeable attorneys could discuss whose and what types of lawsuits a franchisor must disclose, the nuances that may arise when identifying those lawsuits, and the best practices a franchisor can employ in fulfilling the disclosure requirements under Item 3.
The required disclosures under Item 3 are codified at 26 C.F.R. § 436.5(c) and are essentially classified into four categories: pending actions; material civil actions in the last fiscal year; prior actions; and injunctive or administrative orders. Our attorneys could determine what types of lawsuits fall within each of these categories and whether it should be disclosed, depending on whether the franchisor or a predecessor, affiliate, parent, or Item 2 individual was involved in the lawsuit. A lawyer could also identify what information pertaining to the lawsuit a franchisor should include under Item 3.
There are two main types of pending actions that a franchisor should disclose under Item 3. The first is any pending criminal, administrative, or civil action involving a violation of a franchise, antitrust, or securities law, or that alleges fraud, unfair or deceptive practices, or similar allegations. The second is any pending material civil action that is not routine or incidental to the franchisor’s business. Whether or not these non-routine civil actions are “material” largely depend on the number of franchisees and the size, nature, or financial condition of the franchise system or its business operations. However, generally, a pending civil action is material if its disclosure would likely influence the decision making of a prospective franchisee. Lawsuits falling within either of these two categories must be disclosed under Item 3 of the FDD if brought against:
Additionally, if a lawsuit is brought against an affiliate of the franchisor, this action must be disclosed as well. It is important to note that this affiliate must either induce franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor’s performance or offers franchises under the franchisor’s principal trademark.
A franchisor must disclose material civil actions filed in the last fiscal year that involved the franchise relationship. A material civil action involves the “franchise relationship” if it concerns contractual obligations between the franchisor and the franchisee and arises directly from the operation of the business, such as royalty payment and training obligations. A franchisor need not disclose civil actions with third parties arising from the franchised business, such as a suit against a vendor, or disputes brought by the franchisor against a franchisee for indemnification of tort liability. Further, a franchisor does not need to disclose a franchisor-franchisee legal dispute based on a franchise agreement for a non-traditional outlet, provided that the particulars of that agreement and any action to enforce it are not likely to influence the sale of traditional franchises under the franchisor’s standard franchise agreement. A franchisor must disclose the lawsuits falling under this category under Item 3 if any of the following were party to it:
It is important to note that a franchisor only needs to disclose these types of lawsuits involving an affiliate if it either induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor’s performance or offers franchises under the franchisor’s principal trademark.
A franchisor must disclose two types of prior actions if they occurred within the previous ten years of the franchisor’s filing of its FDD. The first includes felony convictions or pleas of nolo contendre to a felony charge. The second includes civil actions in which the franchisor or entity related to the franchisor was held liable for violation of a franchise, antitrust, or securities law, or involving allegations of fraud, unfair or deceptive practices, or comparable allegations.
Under this type of prior action, it must be disclosed only if the individual or entity was “held liable,” meaning that as a result of the court’s judgement, the individual or entity was required to pay money or other consideration; was required to reduce an indebtedness by the amount of an award; was restricted from enforcing its rights; or was required to take action adverse to its interest.
If a person is not required to pay a material amount or its rights are not materially restricted, no disclosure is required. If either of these actions occurred within the last ten years, and involved the franchisor, predecessors of the franchisor, or Item 2 individuals it must be disclosed under Item 3.
Lawsuits involving parents of the franchisor must be disclosed if this party induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor’s performance. If an affiliate is named as a formal party to the dispute, these lawsuits must be included in Item 3 as long as this party either induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor’s performance; or offers franchises under the franchisor’s principal trademark.
A franchisor must disclose any currently effective injunctive or administrative order resulting from a pending or prior action brought by a governmental agency, such as the FTC, SEC, or a state Attorney General. The action may be under a federal, state, or Canadian franchise, securities, antitrust, trade regulation, or trade practice law, or law that otherwise relates to the franchise. A franchisor does not need to disclose any court order that has expired or has been vacated or rescinded by the court or issuing agency. Additionally, a franchisor does not need to disclose court orders that it has complied with. However, a court order is not technically “complied with” until the order expires by its own terms. Therefore, as most FTC injunctive orders do not contain an expiration date, they will likely need to be disclosed. If any of the following parties are subject to a currently effective injunctive or administrative order, it must be disclosed under Item 3:
Once a franchisor identifies that a certain lawsuit must be included and involves an individual or entity that requires its disclosure, it must include the following information for each:
However, a franchisor need not provide the information in the last bullet for franchisor-initiated suits filed within the last fiscal year. Rather, if a franchisor has multiple suits filed that are common in nature, such as to collect royalties or enforce system standards, the franchisor may simply include the other information required above under a common heading, such as such as “royalty collection suits,” and “system standards.”
Additionally, depending on the nature of the legal dispute, a franchisor must also include:
Lastly, if any civil action discussed in Item 3 of the FDD resulted in a settlement agreement, then all material terms of that agreement must be disclosed. If, however, the settlement agreement was deemed confidential, the material terms must be disclosed only if the settlement occurred after the Franchisor began selling franchise units. In addition, any franchisor that has historically used only the original Franchise Rule does not need to disclose confidential settlements entered prior to the effective date of the amended Rule.
Lawsuits involving parents or affiliates are generally disclosed only if the parent or affiliate financially-backs or guarantees performance of the franchisor. “Financial backing” refers to promises made to ensure that the franchise system is and remains on stable financial footing, such as when a parent or affiliate promises to infuse the franchisor with cash or other assets, to extend credit, or pay debts to third parties. “Guaranteeing performance” refers to any promise made between the franchisor and its parent or affiliate for the benefit of franchisees, or any promise made by its parent or affiliate directly to franchisees. This generally arises when a parent or affiliate promises to perform the franchisor’s obligations to franchisees, as outlined in the franchise agreement, if the franchisor is unable to do so.
All categories of lawsuits involving a predecessor of the franchisor must be disclosed under Item 3 of the franchise disclosure document. However, if the predecessor is no longer affiliated with the franchisor, then this party must only make reasonable efforts to obtain updates on the status of the predecessor’s lawsuits. If unable to obtain such information, the franchisor may omit it, but must make a clear indication of its inability to obtain such information under Item 3.
Items 13 and 14 also require disclosure of certain lawsuits pertaining to trademarks and patent infringements. However, if lawsuits that are required to be disclosed under Items 13 and 14 also fall within lawsuits that are required to be disclosed under Item 3, they must be disclosed under Item 3 as well.
It is best practice for a franchisor to obtain continuous updates on the status of new and pending lawsuits falling within those provided in Item 3. At the outset of compiling the necessary information for an Item 3 disclosure, a franchisor should address the following questions:
In the rare occurrence that a franchisor has no prior or pending lawsuits to report, it should not leave Item 3 blank; instead, the franchisor should state “No litigation is required to be disclosed in this Item.” It is best practice to organize the disclosures in Item 3 by category. A franchisor could organize this information by type of lawsuit, or a similarly clear group of headings, such as: “Concluded Litigation,” “Pending Litigation,” and “Litigation Filed by Franchisor in Last Fiscal Year.”
It is also best practice to summarize the lawsuits disclosed under Item 3 of the franchise disclosure document in a light favorable to the franchisor. However, this is not a license to overuse descriptors with compelling imagery, such as “vigorously” prosecuting or defending a claim. A franchisor should also be careful not to include too much “legal jargon.” While the use of plain English is preferable in the FDD, if the use of a legal term is unavoidable, an accompanying explanation of the legal term’s meaning is recommended. Ultimately, by describing the litigation in a clear and transparent fashion, franchisees will have a better understanding of how any litigation may impact their investment and the franchise system as a whole.