Item 3: Litigation | Franchise Disclosure Documents

Item 3: Litigation

Item 3 calls for the disclosure of certain lawsuits involving the franchisor and other entities associated with the franchisor – i.e., predecessors, parents, and affiliates – in addition to certain lawsuits involving any person identified in Item 2. These are substantially similar to the disclosure requirements of the original Rule and the UFOC Guidelines. What is new, however, is the requirement that franchisors disclose suits that they initiate against franchisees, as explained below. In preparing an Item 3 disclosure, franchisors must consider two preliminary issues: (1) what types of litigation must be disclosed; and (2) whose litigation must be disclosed.

What Types of Litigation must Be Disclosed?

Under the amended Franchise Rule, certain suits falling into four broad categories must be disclosed in Item 3: pending lawsuits, lawsuits involving the franchise relationship, priorlawsuits, and current government injunctive or restrictive actions. These include arbitrations. Ordinarily, mediations need not be disclosed, unless the mediation results in the settlement of an ongoing lawsuit that must be disclosed in Item 3. It also includes material foreign litigation, even if the actions are in a foreign court or arbitration forum.

Pending Actions

Two types of pending lawsuits must be disclosed. The first type consists of any administrative, criminal, or material civil action that alleges a violation of a franchise, antitrust, or securities law, or that alleges fraud, unfair or deceptive practices, or comparable allegations. A “material” civil action is one that is likely to influence a prospective franchisee’s investment decision. Accordingly, a franchisor must disclose pending suits such as those filed by the Federal Trade Commission or United States Department of Justice against a franchisor for violations of the Franchise Rule (or other Commission trade regulation rules) or deceptive or unfair trade practices in violation of Section 5 of the FTC Act. It also includes state actions, such as those filed by a state Attorney General. Second, the franchisor must disclose whether it, any related entity identified in the chart below, or any person identified in Item 2 has been involved in any pending civil lawsuits, “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.” These factors must be weighed on a case-by-case basis to determine whether any particular civil action is material and therefore must be disclosed. For example, a civil suit by a supplier against a large franchise system with many franchisees may not be material even if the supplier were to prevail in the suit, if the amount of damages alleged would not have a materially adverse effect on the franchisor’s overall financial condition. On the other hand, a civil suit for toxic dumping or stock manipulation which, if successful, may give rise to a multi-million dollar civil penalty award may be material because of its likely impact on even a large franchise system’s financial condition.

Material Actions Involving the Franchise Relationship

The franchisor must disclose whether it, any related entity identified in the chart below, or any person identified in Item 2 has been a party to any material civil actions involving the franchise relationship in the last fiscal year. Material franchisor-initiated suits – those likely to influence a prospective franchisee’s investment decision – must be disclosed. All suits pertaining to the franchise relationship – even a small number of suits – are presumed to be material because they may shed light on problems in the franchise relationship or the likelihood that the franchisor will resort to litigation against a franchisee. One notable exception may involve isolated, non-traditional franchise sales. Where a franchisor sues a franchisee based upon a franchise agreement for a non-traditional outlet – such as an outlet in a hospital or in a military facility – the particulars of that agreement and any suit to enforce it are not necessarily material to the sale of traditional franchises under the franchisor’s standard franchise agreement.

Further, only suits filed over the course of the last fiscal year must be disclosed. Franchisors need only prepare this disclosure on an annual basis and disclose only those suits filed (not pending) during the previous fiscal year. Franchisors that begin franchising in the middle of their fiscal year, or that first initiate a lawsuit against a franchisee in the middle of their fiscal year, need only update their documents to disclose franchisorinitiated suits upon the close of their current fiscal year, as part of their annual update.

Only suits involving the “franchise relationship” must be disclosed. Such suits involve contractual obligations between the franchisor and franchisee, arising directly from the operation of the franchised business. The “franchise relationship” limitation specifically excludes actions involving third parties, such as suits by a franchisor against a supplier. It also excludes suits initiated by a franchisor against a franchisee for indemnification of tort liability. Franchisors disclosing franchisor-initiated litigation may utilize streamlined reporting. While franchisors reporting franchisor-initiated litigation may disclose full case citations and summaries, they may comply with the amended Rule, if they wish, by listing individual suits (by name with citation) under one common heading that serves as a summary. For example, the franchisor may list individual cases under common headings such as “royalty collection suits,” and “system standards.”

Prior Actions

The franchisor must disclose whether it, any related entity identified in the chart below, or any person identified in Item 2 has been involved in certain types of legal actions within 10 years before the issuance date of the disclosure document. Specifically, any convictions or nolo contendere pleas to a felony charge must be disclosed, as well as civil actions in which the franchisor was held liable involving alleged violations of “a franchise, antitrust, or securities law, or involving allegations of fraud, unfair or deceptive practices, or comparable allegations.” For purposes of this disclosure, a party is “held liable” if that party 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.

Accordingly, dismissals, including a dismissal concluding an adversarial proceeding, need not be disclosed. If a formal settlement agreement must be disclosed, then all material terms of the settlement must be disclosed, whether or not the agreement is confidential. However, franchisors need not disclose the terms of any confidential settlements entered into before the franchisor commenced franchise sales. In addition, any franchisor that has historically used only the original Franchise Rule format set out at 16 C.F.R. Part 436, or which is new to franchising, need not disclose confidential settlements entered into prior to the effective date of the amended Rule.

Injunctive Actions

The franchisor must disclose whether it, any related entity identified in the chart below, or any person identified in Item 2 is subject to a currently effective injunctive or restrictive order or decree resulting from a pending or concluded action brought by a governmental agency – such as the FTC, SEC, or state Attorney General – under a federal, state, or Canadian franchise, securities, antitrust, trade regulation, or trade practice law, or that otherwise relates to the franchise. An injunctive or restrictive order or decree is “currently effective” unless it has (1) been vacated or rescinded by a court or by the issuing agency, or (2) expired by its own terms. If the named parties have fully complied with an order requiring a specific course of action – such as registering its disclosure document – then the order is no longer “currently effective.” However, a party cannot fully comply with an order to act or to refrain from acting (for example, to comply with the amended Franchise Rule) until the order expires by its own terms. Most, if not all, Federal Trade Commission injunctive orders 11 As noted above in connection with Item 1, this disclosure pertains only to predecessors of the franchisor over the last 10 years.

Whose Litigation must Be Disclosed?

Item 3 calls for different disclosures depending upon the entity involved in the suit. Whenever a franchisor or predecessor has been involved in one of the four categories of litigation covered in Item 3, that suit must be disclosed.11 If a franchisor’s predecessor is no longer affiliated with the franchisor, the franchisor must make a good faith effort to obtain updates about the predecessor’s prior and current litigation. If unable to do so, the franchisor can note that fact in Item 3.

In contrast, a parent’s litigation must be disclosed only if the parent promises “to back the franchisor financially or otherwise guarantees the franchisor’s performance.” Generally, this means that parent litigation must be disclosed when the parent promises 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. In contrast, affiliate litigation must be disclosed if the affiliate offers franchises under the franchisor’s principal trademark, or if the affiliate promises “to back the franchisor financially or otherwise guarantees the franchisor’s performance.” A franchisor must also disclose currently effective injunctions, decrees, and orders resulting from government legal actions against an affiliate if the affiliate “has offered or sold franchises in any line of business within the last 10 years.”

The following chart summarizes the disclosure obligations of franchisor-related entities:

Must disclose if affiliate promises to back the franchisor financially or otherwise guarantees the franchisor’s performance, or sells franchises under the franchisor’s principal trademark

Must disclose if affiliate promises to back the franchisor financially or otherwise guarantees the franchisor’s performance, or sells franchises under the franchisor’s principal trademark

Must disclose if affiliate promises to back the franchisor financially or otherwise guarantees the franchisor’s performance, or sells franchises under the franchisor’s principal trademark

Must disclose if affiliate guarantees the franchisor’s performance, or if the affiliate has offered or sold franchises in any line of business within the last 10 years

Must disclose if the parent promises to back the franchisor financially or otherwise guarantees the franchisor’s performance

Must disclose if the parent promises to back the franchisor financially or otherwise guarantees the franchisor’s performance

Must disclose if the parent promises to back the franchisor financially or otherwise guarantees the franchisor’s performance

Must disclose if the parent guarantees the franchisor’s performance

Must disclose if named as a party

Must disclose if named as a party

Must disclose if named as a party

Must disclose if
named as a party