The Franchise Disclosure Document: Puzzling or Just a Puzzle?
by Stephanie L. Russ and Kelly G. Dion
Drafting a Franchise Disclosure Document (FDD) is much like assembling a jigsaw puzzle. Each puzzle piece represents an element of the franchise program. When assembled, the viewer sees and understands the big picture—the franchise model as a whole.
The FDD is arranged in 23 chapters—called Items—which are designed to provide prospective franchisees detailed information about the franchised business so that they can make an informed decision about whether or not to purchase a franchise. The FDD includes the franchisor’s audited financial statements and a copy of all agreements that a franchisee must sign.
Federal law prescribes the content and format of the FDD, and requires delivery of the FDD at least 14 calendar days (or sooner in the sales process if requested) before a prospective franchisee signs a binding agreement or pays any consideration in connection with the franchise. Additionally, 15 states have franchise investment laws, some of which require additional disclosures to potential franchisees who live in, or will operate the franchise in, their states. Drafting with these franchise-specific statutes in mind is important because state sales and relationships laws may override provisions of the franchise agreement, as described below.
While buyers become franchisees for various reasons, they usually ask the following two questions: What is the cost of my investment? And how much can I make? To help avoid litigation, franchisors must be cautious as to the information contained in Item 7 and Item 19.
Item 7 of the FDD is a table that contains a list of items representing the potential franchisee’s total estimated initial investment. The goal of Item 7 is to provide potential franchisees with material information regarding the expenses that are likely to occur in the start-up phase of the franchise so that potential franchisees can determine if they have the financial resources to start the business and support it during its initial phase.
It is critical that Item 7 is accurate. Numbers are easy to compare and fairly easy to compile. If a franchisor underestimates initial investment costs, it may expose itself to misrepresentation and other fraud-based claims.
With regard to potential earnings, federal law permits, but does not require, franchisors to disclose in the FDD any earnings information. Dissemination of any kind of historical or projected earnings information is considered a “financial performance representation,” and if made, must be contained in Item 19 of the FDD.
Franchisors electing not to make a financial performance representation in the FDD are prohibited from providing any earnings or profit information to prospective franchisees. It is currently estimated that 30-40 percent of all franchisors make a financial performance representation in their FDD. This means that the majority of franchise companies are legally barred from providing prospective franchisees with any revenues or profit information helpful to preparing a rate of return analysis, a business plan for financing purposes or an initial operating budget.
While the information contained in the FDD is important to educate prospective franchisees, the franchise agreement is the key piece of the puzzle that defines the parties’ relationship. The FDD must be prepared in “Plain English,” but the franchise agreement is often lengthy and complex, and terms of the franchise agreement are neither dictated by law nor reviewed or approved by any government agency. However, federal law prohibits the use of merger and integration clauses to disclaim a franchisee’s reliance on representations contained in the FDD, and state franchise sales and relationship laws may override certain key franchise agreement provisions, such as those dealing with termination and nonrenewal. State franchise laws also affect the enforceability of a franchise agreement’s forum selection clause.
For this reason, many franchisors elect to resolve franchisee disputes via arbitration pursuant to the Federal Arbitration Act. If electing arbitration, drafters should be familiar with arbitration procedures and federal law. Arbitration provisions should be written carefully and with knowledge of the Federal Arbitration Act and relevant case law.
A well-drafted FDD helps prospective franchisees make an informed business decision by allowing them to see the “whole picture” of their potential investment. The federal and state regulatory schemes contribute to the process by providing the framework to which the different pieces of the franchise model fit together. Finally, the franchise agreement is the centerpiece that defines the contractual relationship between the parties overall. Together, these pieces can create a sound business system for both franchisor and franchisee.
Stephanie Russ and Kelly Dion are attorneys at Mullin Law, PC. Ms. Russ handles franchise regulatory and commercial matters, and she is the past Chair of the DBA Franchise and Distribution Section. Mrs. Dion focuses her practice on franchise and commercial litigation. They can be reached at email@example.com and firstname.lastname@example.org, respectively.