A Close Look at Pitfalls in the Franchise Disclosure Document

Chris Bjorklund: You’re listening to the AllBusiness podcast. I’m Chris Bjorklund. If you’re getting this through iTunes and RSS feed or an online streaming-media player, you can hear interviews with other experts at AllBusiness.com.

Bjorklund: If you’re going to buy a franchise, federal law requires that you receive a pre-sale disclosure document. We’ll be dissecting that document with our two experts, Julie Lusthaus, a franchisee attorney with Ian Binder and Dunn, and Warren Lewis, who chairs the franchising group at his law firm, Williams Moen. He typically represents franchisors. Warren, why is this industry regulated in this particular way?

Warren Lewis: The reason for the Franchise Disclosure Document is to give potential franchisees at least some information about the franchisor and the franchisor’s offering. The reason for the regulation and the reason for the Franchise Disclosure Document coming into effect is that back in the 1950s and 60s, there were no rules on disclosure. There were many promises made to prospective franchisees. There was money being paid and many people had high hopes of going into new businesses. But they found out later that many of the promises that were made to them were not true. So in the 1970s, some of the states began to implement or put into effect laws to regulate disclosures that had to be made to franchisees and then in 1979 the Federal Trade Commission implemented a rule and all of the rule and the laws require 23 items of disclosure to a prospective franchisee. Now over the past 30 or so years, there have been changes in the disclosure requirements. The states have changed their laws and just last year, the Federal Trade Commission changed its rule but basically, the disclosures have stayed the same over about the past 30 years. And the rule and the laws have contributed to a more responsible industry. The franchisors are required to provide certain information and if they do provide it, hopefully, they and the franchisee will make a better decision in terms of whether someone should become a franchisee.

Bjorklund: I would think the main thing is if you received one of these disclosure documents, is that you should read it. Julie, do most people read them?

Julie Lusthaus: Unfortunately, many people do not read them. They’re very large documents. The disclosure part of the document could be many pages. In addition, they include copies of all the agreements that franchisees will be expected to sign. Some of those agreements can be as much as 50 or 80 pages. There are financial statements which can be very lengthy. And they’re very intimidating documents. They are supposed to be written in plain English and while the disclosure document tends to be more clear, certainly the agreement can get very complicated.

Bjorklund: Tons of fine print. I mean, why should people be reading that?

Lusthaus: Well, I think it’s very important not to think of the fine print as fine print. It’s very important information that one would find in the footnotes. For instance, there is information provided about potential costs for starting up your business and some of the information provided in the main item is not necessarily going to be applicable to the franchisee. That information may include information about what your rent might be if you’re opening up a store, for instance. And that rent information may not apply to a franchisee located in a different geographical area from the franchisor. So it’s very important to not only read the document but to read all of the information in it to make sure that the information will apply to you.

Bjorklund: Aren’t most of the people buying franchises at least first-time franchisees? I mean, they’re novices.

Lusthaus: They are and that’s why it’s very important for them to seek professional assistance in reviewing the documents. It’s important that prospective franchisees find a franchise lawyer who can advise them about the information in the document and who can advise them about the franchise agreement, which is going to control the relationship between the franchisee and the franchisor.

Bjorklund: Now this document was in the news recently and it’s name was changed, as I understand it, from the uniform Franchise Offering Circular so people may read some things when they’re doing background research that refer to it that way but now it’s called the Franchise Disclosure Document. What are some of the disclosure requirements that have been changed, Warren?

Lewis: Yes, because you mentioned it, the name was changed from Uniform Franchise Offering Circular to Franchise Disclosure Document. The body of the document was not changed significantly. Under the old format, there were 23 disclosure items. Under the new format there are still 23 disclosure items. There are some changes but basically they’re the same item. The Franchise Disclosure Document is still required to include all of the franchise agreements and related agreements that will be signed by a prospective franchisee. It’s still required to include three years of financial statements and also to list all of the franchisees in the system as of the last fiscal year of the franchisor. So it’s basically the same document. Some of the differences are that the cover pages are very different. The receipt pages are different so you can tell them apart. But most of the information is the same or there is some clarification of information and some addition of some information.

Bjorklund: Julie, what impact have the changes had on buyers?

Lusthaus: There’s generally not going to be a huge impact to the franchisees. I will say that to the extent more information is provided to them, that is only a good thing. There are certain new information that they will now receive in the disclosure document such as information about when the franchisor has commenced litigation against franchisees, additionally there will be information about independent franchisee associations, and all of this information is helpful to the prospective franchisee who wants to conduct their due diligence and learn about the franchisor before buying into the system.

Bjorklund: I think it’s important to remind our listeners that Warren, you primarily represent franchisors?

Lewis: That’s correct.

Bjorklund: And Julie, you primarily represent franchisees.

Lusthaus: That is correct.

Bjorklund: So I think it’s very valuable to have both of your perspectives as we continue to talk about the disclosure document. Again, what can--go ahead, Warren?

Lewis: Should I give you my perspective on the new information?

Bjorklund: Yes.

Lewis: I mean, as Julie mentioned, there is some new information and it should be very helpful to franchisees. As Julie mentioned, it’s the lawsuits brought by the franchisors against franchisees. Also in item eight of the Franchise Disclosure Document, there is a new requirement that any supplier in which an officer owns an interest has to be disclosed to the franchisee. That was something that was not required in the past. In item 19 in addition where the franchisor is permitted to make earnings claims or what are now called financial performance representations to franchisees talking to them about sales and costs and profits, there is a new disclosure required by the Federal Trade Commission where if the franchisor chooses not to make any of those types of representation, it is required to include a statement that the rule the FCC will permit those types of representation and it has decided not to make any of those representations. This may end up encouraging more franchisors to make sales, cost, and profit information available to franchisees. Also in item 20, there is more information about changes in the system, closings, openings, terminations, that type of thing; a more extensive disclosure and also there is a requirement that the franchisor disclose whether it requires franchisees on confidentiality clauses, where they’re prohibited from talking with prospective franchisees so that the franchisee knows that some people may be prohibited from talking with them. Those are new pieces of information. In addition, the disclosure document clarifies points that it didn’t clarify before. For example, it clearly now explains what the meaning of an exclusive territory is. That was not something that was required in the past. It clarifies the meaning of renewal in franchising because renewal in franchising basically means that at the time that it’s time to renew, you may be required to sign a new franchise agreement. Some franchisees don’t understand that and the new disclosures hopefully help them to understand that. And then finally, there is a clear explanation of what consequences are if a franchisor doesn’t have these federal trademarks.

Bjorklund: So let’s get back to the disclosure document. What are some of the many things that you can learn from the document itself, Julie?

Lusthaus: Well, the document contains 23 items of information that the Federal Trade Commission has determined are important items of information for prospective franchisees. And generally the information is provided to the franchisee to inform them about the franchisor, the franchisor’s history, the franchisee’s investment costs, ongoing fees, and the obligations of the parties in their franchise relationship. It is also significant that their prospective franchisee is provided with copies of all the agreements that is going to be required to sign in order to buy the franchise. This would include not only the franchise agreement but if a guarantee is required, if there’s a non-competition agreement that it will be asked to sign, sometimes there is a lease if the franchisee is going to lease the premises from the franchisor, and the benefit to this is the franchisee will have an opportunity to review the agreement and hopefully to obtain professional advice with respect to the agreement, and the investment and the franchise that they are potentially buying into. The FDC will also include financial statements of the franchisor and this is important information for the franchisee to review to get an idea of the financial situation of the franchisor. It’s very good to review this with a professional accountant and this would enable the franchisee to determine whether or not you make the investment in the franchise.

Bjorklund: All the contracts are there for the buyer to sign?

Lusthaus: Yes, that is correct. Any contract that the franchisee is going to be asked to sign must be included. There may be agreements that the franchisor generally asks the franchisees to sign that a particular franchisee may not be required to sign but any agreement that the franchisee may be asked to sign will be provided along with the 23 items of disclosure.

Bjorklund: Warren, you have something to add?

Lewis: Yes, Chris. You had mentioned earlier about the fine print in the Franchise Disclosure Document. When I hear the words fine print, I think of the print on, for example, a credit card, a statement, the one on the back of one that has fine print, or maybe the terms of use on an internet site, that is really fine print. I’m probably--most of us never read that because we’re dealing, we’re not investing a significant amount of money into that relationship. If we don’t like the company we’re dealing with, we could go somewhere else. There really is no fine print in a Franchise Disclosure Document. There may be larger print and smaller print but anyone who is thinking about investing 50 or 100 or half-a-million dollars into a business and then thinking about running that business for 10 or 20 years, even if you receive a document with 100 or 300 pages, you shouldn’t consider any information in there to be fine print. Even maybe the smaller print may be the footnotes in the audited financial statements of the franchisor, you may say that’s fine print, but you could read those and develop a much better understanding of what you’re getting into. You might understand the liabilities of the company or the plans of the company, where it’s planning to expand, the problems it has had in the past. So none of it is really fine print and really anyone who doesn’t read it because they think it’s fine print is really not doing due diligence of the type that they should be doing.

Bjorklund: I’m going to insert a question here that some of the listeners might be thinking about and that is, how long do I have to review this document? Is there some kind of quick turnaround?

Lusthaus: Well, essentially, you have as long as you want to take to review the document and at a minimum, you have 14 days before paying any money to the franchisor or signing any agreement to review the document. That is, that the franchisor must give you that time to review the document and cannot require you to sign an agreement, cannot allow you to sign the agreement or pay any money during those 14 days. In addition, when you are inquiring of the franchisor about the business, you can ask for the disclosure document at any time and the franchisor is required to provide it to you. And you can take as long as you need to, to review the document. Unfortunately, sometimes salesmen are aggressive and tell a prospective franchisee, “Oh you know, we have somebody else who wants that territory, you better decide soon, you need to sign the agreement, you got to get it back.” And these tactics can be effective and cause franchisees to think that they don’t have a lot of time to sign the document. But in fact they can take as long as they need to and have at least 14 days.

Bjorklund: Now, we obviously can’t dissect all the items in this short podcast. But let’s hone in on some of the most important ones, both from the franchisee and franchisor point of view. So Julie, we’ll start with you. Where is there the most potential for conflict and misunderstandings and even worse, deception?

Lusthaus: Well I would say that item seven, which refers to the initial investment is a very important item for franchisees. People want to know, how much money is going to cost me to open my franchise? And this item will include disclosure about expenses such as training fees, real property expenses, real estate, whether it’s going to be purchased or leased, opening inventory costs, equipment costs, and this is the kind of information that franchisees often want to know at the beginning. The problem is, however that, sometimes the information included in item seven is not going to be applicable to a particular franchisee and it’s really important as Warren said before, that franchisees review the footnotes to this item. There are times when the franchisor will indicate rent, for instance, that should be expected for a particular unit and that rent rate just may not apply to a franchisee located in a different geographical area. Or simply, the information may be out of date in situations where franchisees have filed claims for fraud relating to item 7, information when the expenses were listed were based on information that the franchisor has obtained years prior to the disclosure. Of course, the franchisor should and some do conduct due diligence when providing the information but it’s important for the franchisees to be clear that the information provided is not necessarily going to be exactly accurate for their situation.

Bjorklund: Warren, do you want to comment on item seven?

Lewis: Yes, item seven isn’t the initial investment, the thing that from a franchisor’s standpoint, you need to give a range of costs in item seven. These are the initial investment numbers because if you are a franchisor that’s franchising nationally, you’re going to have variances across the country, urban, suburban settings, north, south, east, west. So they’re going to be a lot of variables so generally when you look at item seven, there’s going to be a range. For example, rental rates might range tremendously from $20 a square foot to $60 a square foot. Hopefully, that would be explained in item seven but then as a prospective franchisee you have to determine where you stand in that range. So you can’t just assume that you’re going to be in the low end of the range. You have to look at the upper end of the range.

Bjorklund: Let’s take a look at another item, item 19, how much money can I make?

Lusthaus: Well, you know Chris, that’s exactly the question that franchisees want to know. They want to go into a franchise and they want to know exactly how much money they’re going to make. Item 19 is the item that franchisors may use in order to provide certain earnings information to franchisees although the franchisor is not required to do so. Earnings information would include representations that state generally or by implication a specific level or range of actual or potential sales or income that the franchisee may earn from their business. It’s very important that franchisees don’t rely on this information as fact and assume that they will be able to earn the revenue that may be described in this item. Additionally they should be aware of information provided to them by salespeople whom, you know, it’s that scenario where the sales person says to you, “I’m not supposed to give you this information but you’re going to make a million dollars in that location” or “You can make a million dollars,” or “By next year, you should have a second store.” Information provided outside of the UFOC or the FTD is not authorized and should not be relied on by franchisees.

Bjorklund: Warren, do you see conflict in this item 19 too?

Lewis: Well, I have a little different take as a franchisor lawyer working on these representations. If there is a representation in item 19, it’s very likely that it is truthful because the franchisor is required to follow certain procedures in preparing the representation and they are required to give you the basis for it, any qualifications, and if it’s not truthful, they expose themselves to significant penalty under state and even federal law. So for those franchisors who choose to make representations in item 19, as a prospective franchisee, I would feel very fortunate to receive that information because you want to know as much as possible about how much you will earn as the franchisee. The more common practice is that franchisors do not include information in item 19 because they are concerned that if they give that type of information there will be too much reliance on it. Or perhaps, they don’t have that great an earnings history so maybe they don’t want to give it in item 19. You don’t really know. If it says in item 19 they’re not giving you that information, it’s up to you then to try to figure out how much you’re going to earn. You may be able to work with an accountant or someone familiar with the business to get some idea of costs and profit and revenue. You should certainly contact as many franchisees already in the system as possible and see if any of them are willing to give you their P&Ls, their profit and loss statements so that you could get some feel for how much they’re earning. But the burden then, if there’s nothing in the item 19, it’s totally on you to figure out how much you’re going to earn.

Bjorklund: So more due diligence.

Lewis: Due diligence, yes. You need to know what you’re looking for not only looking at the legal provisions in the disclosure document but also, you’re going to have to do your own due diligence on the business itself.

Bjorklund: Julie, let’s move on to item 20, what can you tell us about that from the franchisee point of view?

Lusthaus: Well item 20 gives information about franchisees in the system and who have left the system and this is very valuable information for the franchisees to have. As Warren indicated, they should definitely be contacting as many of the people listed in item 20 as they can. You can’t get too much information about the franchise system or the franchisor or the business and competition. And these are the people that are out there doing it so this is very important information. Franchisees should be very persistent about trying to contact these other franchisees and they should know that, you know, they still need to, as Warren said, conduct their own due diligence. A franchisee who is quite successful, you know, that success may be attributable to causes that relate solely to that franchisee situation. A franchisee who is not doing well may not want to disclose that and I may be very difficult to reach some of the franchisees because they’re small business operators and they’re running their businesses. Nonetheless, we highly recommend that prospective franchisees speak with existing and former franchisees about the system.

Bjorklund: If possible, in person.

Lusthaus: Absolutely! There’s nothing better than seeing the franchise in operation.

Bjorklund: What about franchisee associations, what do you need to know about that?

Lusthaus: Franchisee associations, there’s actually two different kinds of associations. One is a franchise council that has been started by the franchisor and that is different from an independent franchisee association. The new FTD rule is going to require franchisors to disclose information about independent franchisee organizations and this is good information for prospects to have. They should be contacting associations and finding out about the system and franchisor in that regard as well.

Lewis: In terms of item 20, there are two kinds of information about franchisees and former franchisees in the system. First, you have a complete list of all franchisees in the system as of the end of the franchisor’s last fiscal yearend. So you would have a minimal of a 100 franchisees, their names, addresses and telephone numbers so you are able to contact those franchisees. Those franchisees cannot be selected by the franchisor; they have to include all franchisees. So if there are 20 franchisees in your state, all 20 franchisees must be listed. They cannot pick and choose. For large franchise systems, if they have for example, 3,000 franchisees, you wouldn’t have a list of 3,000 but you might have a list of 100 or more of those franchisees. In a small franchise system, you’re going to give a list of all franchisees. The other thing that you’re going to receive is if any franchisee left the system in the previous year, if they were terminated, if they closed their businesses, or if they just by agreement stopped operating their businesses, you’re going to get their names, addresses, and telephone numbers. So you will be able to contact people who might be more willing to talk to you because they’re no longer in the system and might be very open with you about issues that they saw with the system or why they have left the system.

Bjorklund: We have time for one more item that I wanted to focus in on and that’s the audited financial statements. Julie?

Lusthaus: The audited financial statements provide financial information about the franchisor. Now it will also include information about the franchisor’s parent, if the parent has agreed to perform the franchisor’s post sale obligations. This information is very important. It should be reviewed with an accountant, preferably one with experience in franchising. Alternatively, it should be reviewed with an accountant who has experience in the industry of the franchise business.

Bjorklund: Warren, what about the footnotes? There is narrative there. Is that important to review?

Lewis: When I look at a disclosure document, one of the first things I look at is the footnotes in the audited financial statements. Those footnotes were written by an accountant and the accountant in order to perform an audit has to do a certain amount of due diligence. So in the footnotes, the accountant has to include any qualifying information or any material information that someone should have when they read the financials. So sometimes, it will talk about lawsuits in the footnote, liabilities that the company may have, difficulties it may be experiencing. So these are rules of the accountants and they’re not the franchise disclosure rules so the information is presented differently than in the rest of the document and it can give you just another angle at understanding the franchise company. So that’s very important to look at footnotes in financial studies.

Bjorklund: Warren, how important is it to know about a franchise’s litigation history or complaint history and is that difficult information to find?

Lewis: Well, it is not difficult information to find. As a franchisor, you’re required in item three of the disclosure document to include all relevant litigation that you’ve been involved in for the past 10 years and you’re also required to report any outstanding orders that might be against you such as a state order or some type of an injunction that might be against you. And when I say relevant, I mean any type of litigation that might indicate fraudulent activities, misrepresentations, violations of any franchise laws or securities laws. So it’s required to be there. If there is no litigation disclosed then you should be very comfortable that the franchisor has not been in litigation for the past 10 years and has a fairly good relationship. That should give you some sense that they have a fairly good relationship with their franchisees. If there is significant litigation in item three, it might mean that it’s a large franchise system that may have more litigation than a small franchise system or it may indicate that there are some issues that you really should delve into in terms of relationship issues between the franchisor and the franchisee or perhaps the value of a business system that you’re buying into. The litigation gives the names of the parties. It gives the court where the litigation has occurred. So you can go to get the information on the litigation or you can contact the parties to see what the issues were.

Bjorklund: Prospective franchisees probably can use the internet to dig up information when they’re doing due diligence on a franchise opportunity. What are some of the sources there?

Lusthaus: Well that’s exactly right, Chris and while the disclosure document provides information to prospective franchisees that is quite valuable, it is important for the franchisees to conduct their own due diligence and to gather as much possible information about the franchise system and the franchisor as possible. The website is a perfect tool for gaining additional information. There are certain websites that have lots of news about the franchise industry. It is also important as we previously indicated that franchisees contact current and former franchisees to find out about the system. They’re considering investing hundreds of thousands of dollars in the business and they can’t have too much information about the opportunity.

Bjorklund: What about the FTC and the Better Business Bureau, can they be helpful Warren?

Lewis: Those are not particularly good sources of information. If a company is being investigated by the Federal Trade Commission, that is confidential information. They keep that as investigators, they don’t want you to know who they are investigating. So if you call the FTC and even if they are investigating a franchise company, they’re not going to let you know that. Now, if there is an outstanding order against that company or consent decree with that company, that is something that you could get off the website of the Federal Trade Commission. In terms of Better Business Bureau, I would not view that as a good source of information. They’re really not going to know about the franchise company. You might call the Better Business Bureau but it’s highly unlikely that you could get any information about the franchisor itself from the Better Business Bureau. I think a better source is the internet such as on websites such as those mentioned by Julie.

Bjorklund: How often does the Franchise Disclosure Document have to be updated anyway?

Lewis: Franchisors are regulated by the Federal Trade Commission rule and also by state laws. Under both the FTC rule and the state laws, the franchisor at least has to update the disclosure document annually and also needs to update the document whenever any material change occurs. So in terms of an annual update, under the FTC rule, the franchisor has to update the disclosure document either 90 or 120 days after its fiscal year end. So for example, if you are being disclosed as a prospective franchisee in the middle of 2008, the document that you receive should include information for 2007 because the document should have been updated sometime in the spring of 2008. Also, if a material change occurs, the franchisor needs to amend the document before they continue offering and selling franchises. So if a franchisor for example is sued by a franchisee or wants to change its fees, these would be material changes and would require the franchisor to update the document before continuing to offering to sell franchises.

Bjorklund: If a franchisor doesn’t give me this particular disclosure document that’s required by law, what should I do? Head for the hills?

Lusthaus: I think, Chris, that’s not a bad idea. And there are two reasons for it. One is the franchisor is required by law to provide you with the disclosure document and you want to be very careful about investing in a business opportunity with a franchisor that is in violation of the law. If they’re going to violate this law, who knows what other laws they may be willing to break? Additionally, the disclosure document contains a lot of information that’s very helpful in deciding whether to invest in the opportunity and in ascertaining information about the franchise business. So if you’re not provided with that information, it’s going to be very difficult to gather information about the investment opportunity.

Bjorklund: Warren, your thoughts on that?

Lewis: Any company that goes into franchising understands that it has to have a disclosure document so legitimate franchisors all have Franchise Disclosure Documents and if they’re actively offering and selling franchises, that document should be registered in various states. So if a company doesn’t have a document, it’s possible for example, that they may not be a franchise. It may be some other type of opportunity that’s being offered to you and they may say it’s a license or something other than a franchise. If it involves, however, of the use of their trademark, the use of their business system and you’re going to be paying them fees, it’s likely that it is a franchise and that you should be protected under the law. Therefore, if you run into that type of company, you should be very, very careful as Julie mentioned and maybe that it is a good opportunity for you, it may be that it isn’t a franchise, but if it looks like a franchise to you and the company doesn’t have a disclosure document, it may be that they don’t understand their obligations under the law in which you should be concerned, or they’re ignoring their obligations under the law and you should be concerned there also. You need the information in that disclosure document in order to make an informed decision about whether to become a franchisee.

Bjorklund: Any last thoughts, Julie, that you’d like to pass on to prospective franchisees?

Lusthaus: I would urge them to obtain the disclosure document from any franchisor they are interested in investing with and to review them to make sure that they understand them, to retain professional assistance in understanding them, both with lawyers and accountants. It’s very important that they understand the business opportunity before they invest hundreds of thousands of dollars in that.

Bjorklund: Warren, from the franchisor perspective, any last thoughts?

Lewis: Yes, from a franchisor perspective, we are in a period of transition. The disclosure document format is changing and the rules for using the document are changing. So any franchise company needs to be very aware that the rules are changing and they need to change their disclosure document and the procedures for selling franchises as a result of the amendment of the Federal Trade Commission rule in 2007, which takes effect completely on July 1, 2008.

Bjorklund: Thank you so much for joining today on the AllBusiness podcast.

Lusthaus: Thank you, Chris.

Lewis: Thank you, Chris.

Bjorklund: Our guests, Julie Lusthaus and Warren Lewis are both legal experts in the field of franchising. Check out our podcast library for other shows about the different aspects of franchising. And send your feedback and suggestions for future guests to podcasts@allbusiness.com. I’m Chris Bjorklund, thank you for listening.