Within Item 3, franchisors must disclose certain types of lawsuits involving the franchisor, the franchisor’s affiliates, predecessors, and other individuals identified in Item 2.
For franchisors in the process of developing a Franchise Disclosure Document (FDD) or renewing their registration, determining the right information to disclose can be tricky.
Although the FDD is a large and complex legal document, its disclosures serve an important purpose in the franchise sales process. Each item provides prospective franchisees with information about the franchise they’re considering, allowing them to weigh any potential benefits and risks before making a purchase. Because Item 3 of the FDD provides franchisee candidates with important information about material legal disputes the franchisor is or has been involved in, the information it contains must be thorough and accurate.
In this article, we’ll explore the types of litigation that must be disclosed in Item 3 under the Federal Trade Commission’s amended Franchise Rule, as well as whose litigation must be disclosed, to help ensure that your FDD is legally compliant.
Types of Litigation to Disclose in Item 3
Under the amended Franchise Rule, specific types of lawsuits must be disclosed in Item 3 to provide prospective franchisees with enough information to fully understand the franchisor’s involvement in legal disputes. In addition to litigation, franchisors must also disclose arbitrations that fall into any of the required categories.
Pending Lawsuits and Other Material Civil Actions
According to the Franchise Rule, franchisors must disclose their involvement in any pending civil lawsuit “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,” including arbitration.
All current or pending criminal, administrative, or material civil lawsuits alleging a violation of antitrust, securities, or a franchise law, or otherwise alleging unfair or deceptive practices, fraud, or comparable accusations must be disclosed in Item 3.
Such disclosures include actions filed against the franchisor by federal agencies like the FTC or U.S. Department of Justice, as well as actions at the state level including those filed by a state Attorney General, as well as arbitration.
The FTC defines material civil actions as actions that are “likely to influence a prospective franchisee’s investment decision.”
Because determinations as to whether a pending action is material (and therefore must be disclosed in Item 3) are generally made on a case-by-case basis, it’s best to consult with an experienced franchise attorney regarding pending actions that should be included in Item 3.
Material Actions Involving the Franchise Relationship
Material actions involving the franchise relationship must be disclosed in Item 3 if the franchisor, its predecessors, affiliates, parents or any person identified in Item 2 has been a party to such litigation during the last fiscal year. This includes arbitration and material suits initiated by the franchisor.
The FTC defines franchise relationship lawsuits as those involving “contractual obligations between the franchisor and franchisee, arising directly from the operation of the franchised business.” This definition excludes suits involving third parties and suits “initiated by the franchisor against a franchisee for indemnification of tort liability.”
Because franchise relationship suits can highlight potential problems in the franchise system that prospective franchisees should be aware of, almost all litigation involving franchise relationships is considered material by the FTC and must be disclosed in Item 3. However, some exceptions exist involving isolated, non-traditional franchise sales. An experienced franchise attorney should be consulted before omitting any franchise relationship litigation in Item 3.
If the franchisor, its predecessors, affiliates, parents or any person identified in Item 2 has been involved in certain types of litigation within the 10 years prior to the FDD issuance date, those actions must be disclosed in Item 3.
This includes convictions or nolo contendere pleas to a felony charge, civil actions where the franchisor was found liable for alleged antitrust, securities, or franchise law violations, or alleged fraud, unfair or deceptive business practice or similar accusations, and arbitration.
Franchisor liability is determined by assessing whether the franchisor paid money or other consideration, was made unable to enforce its rights, took actions unfavorable to its business interests, or reduced indebtedness by the amount of an award as a result of an action.
Under the amended Franchise Rule, all material terms related to formal settlement agreements entered into after the franchisor commenced franchise sales must be disclosed in Item 3, even if the settlement was confidential. However, there are exceptions to this rule for new franchisors and others under specific conditions. When determining whether a settlement agreement should be disclosed in Item 3, franchisors should consult a franchise attorney.
Government Injunctive or Restrictive Actions
If the franchisor, its predecessors, affiliates, parents or any person identified in Item 2 is subject to a currently effective injunction, restrictive order or decree that has resulted from current or completed litigation brought against them by a government agency related to a violation of federal, state, or Canadian franchise, trade regulation, antitrust, securities, or trade practice law, or litigation that relates to the franchise, that litigation (including arbitration) must be disclosed in Item 3.
Per the FTC Franchise Rule Compliance Guide, the FTC considers an injunction, restrictive order or decree “currently effective” for disclosure purposes unless its terms have expired or the action was rescinded or vacated by a court or the agency by which the action was brought against the franchisor.
While the actions listed above are standard disclosures to include in Item 3, there are some less common situations where other types of litigation might also need to be disclosed.
Although it’s typically unnecessary to disclose mediations in Item 3, mediations must be disclosed if they result in the settlement of an ongoing lawsuit.
Material foreign litigation must be disclosed in Item 3, even if such actions occurred in arbitration or a foreign court.
Whose Litigation to Disclose in Item 3
Because the Franchise Rule’s disclosure requirements vary depending on the individuals or entities involved in litigation, franchisors need to understand whose litigation must be disclosed in Item 3 of the FDD to comply with the law.
A franchisor’s involvement in litigation must be disclosed in Item 3 for actions that fall into every category mandated by the amended Franchise Rule, including pending lawsuits and other material civil actions, franchise relationship actions, prior actions, and government injunctions, decrees and orders.
Any time a franchisor or its predecessors is involved in any of the categories of litigation required to be disclosed in Item 3, those actions must be disclosed. This includes pending lawsuits and other material civil actions, franchise relationship actions, prior actions, and government injunctions, decrees and orders.
Under the amended Franchise Rule, if a predecessor is no longer affiliated with the franchisor, the franchisor must still make a good faith effort to acquire up-to-date information about the predecessor’s current and prior litigation. If a franchisor is unable to attain the information, they must include a note in Item 3 explaining those circumstances.
In connection with Item 1, predecessor litigation must only be disclosed in Item 3 for predecessors affiliated with the franchisor in the last 10 years.
According to the Franchise Rule, affiliate litigation related to pending lawsuits and other material civil actions, as well as franchise relationship actions or prior actions, must be disclosed in Item 3 if the affiliate promises to “back the franchisor financially or otherwise guarantees the franchisor’s performance, or sells franchises under the franchisor’s principal trademark.”
Generally, the FTC defines financial backing and performance guarantees as promises made by the affiliate to “ensure the franchisor’s post-sale performance either by providing needed funds to the franchisor or by fulfilling the franchisor’s post-sale obligations on behalf of the franchisor.”
Currently effective government injunctions, decrees and orders related to affiliates must also be disclosed if affiliates have guaranteed the franchisor’s performance or offered or sold franchises in any line of business during the last 10 years.
Similar to affiliates, the Franchise Rule states that parent litigation related to pending lawsuits and other material civil actions, franchise relationship actions and prior actions must be disclosed in Item 3 if the parent has promised “to back the franchisor financially or otherwise guarantees the franchisor’s performance.” Parent litigation related to government Injunctions, decrees and orders must be disclosed if the parent guarantees the franchisor’s performance.
Named Parties from Item 2
Actions where individuals listed in Item 2 of the FDD (including the franchisor entity’s directors, trustees, general partners, principal officers, and persons with management responsibilities) are named parties to a suit must be disclosed in Item 3.
Litigation Information in Item 3
Litigation disclosures in Item 3 must contain specific information about each action. These details include the title of the action, its case number or citation, its initial filing date, any named parties to the action, the forum of the action (for example, a court), the opposing party’s relationship to the franchisor, a summary of the litigation including its legal and factual nature, any relief sought or acquired as a result of the action, and the litigation’s resulting conclusions.
Items 13 and 14 Litigation Disclosures
Several items of the FDD require the disclosure of certain types of litigation. Depending on the franchisor’s circumstances, this can sometimes result in the same actions being disclosed in multiple items. For example, Items 13 and 14 require the disclosure of certain litigation related to trademark and intellectual property. If a legal action that meets the disclosure requirements for Items 13 or 14 also meets the disclosure requirements for Item 3, it must be disclosed under each item regardless of whether it has been disclosed elsewhere in the FDD.
Material Changes and Updates
Although franchisors are required to receive an audit and renew their FDD registration annually, certain items of the FDD may need to be updated more frequently. This includes Item 3, which should be updated within a reasonable period of time whenever a material change in the franchisor’s litigation status would require such an update.
Franchisors may make updates regarding material changes to Item 3 either quarterly, annually, or more frequently depending on the disclosure’s specific requirements. Because the definition of a “material change” and the requirements for updating the FDD can vary by state, franchisors should consult an experienced franchise attorney about any changes to their litigation status to determine whether it should be included in Item 3.