Understanding Item 4 of the FDD

The Franchise Disclosure Document (FDD) is a critical form for a potential franchisee to read in its entirety. However, the FDD’s Item 4, where the brand’s bankruptcy history is listed, is particularly noteworthy. Item 4, Bankruptcy, is a section where any bankruptcy filings within the past decade by the franchise or any key executives are listed. Any legal matters are also noted. 

While the term “bankruptcy” often raises a red flag for many, it is important to note that bankruptcies are not necessarily always bad. If a brand has any bankruptcies listed on the Item 4 section of the FDD, a prospective franchisee needs to look into why the bankruptcies or legal matters were filed and ensure they are not part of a bigger issue within the franchise. 

Franchise Law specifies that this Item of the FDD must disclose the bankruptcy history of the franchisor’s predecessors, parents, affiliates and Item 2 individuals. This disclosure includes any bankruptcy in which an affiliate or a parent was involved during the 10-year reporting period immediately before the issuance date of the disclosure document. Additionally, the franchisor must disclose the bankruptcy history of all parents of the franchisor — not just a parent that the franchisor reports to or the highest parent in the chain of ownership.

If there is a history of bankruptcy on a franchisor’s Item 4, a potential franchisee should see the following: the name, address, and principal place of business of the debtor; the relationship of the debtor to the franchisor; and a summary of the bankruptcy proceeding including the original filing date, material facts, name of the bankruptcy court, case name and number, and the debtor’s discharge date, if applicable. If the brand has no bankruptcy information to include in the Item 4 of the FDD, the section should say “No bankruptcy is required to be disclosed in this Item.”

By understanding a brand’s past bankruptcy and legal information, a potential franchisee can better assess the franchisor’s financial stability, whether the company can deliver the support services it promises — and if they ultimately want to join the brand. 

There are a number of actions that comprise the “bankruptcy history” that a franchisor is required to disclose under Item 4. For instance, if an individual or entity above has filed as a debtor (or had filed against it) a petition under the United States Bankruptcy Code, this must be disclosed in Item 4 of the FDD.

Additionally, if an individual or entity above has obtained a discharge of its debts under the United States Bankruptcy Code, this information must be provided as well. Lastly, a franchise must disclose bankruptcy history if an individual or entity above has been a principal officer of a company or a general partner in a partnership that either:

• filed as a debtor (or had filed against it) a petition under the United States Bankruptcy Code; or
• obtained a discharge of its debts under the Bankruptcy Code; or
• within one year after, they held the position in the company.

Item 4 gives prospective franchisees insight into the financial stability of the franchisor and its associated individuals and entities. While full transparency and candor is best practice in drafting the FDD, just as in Item 3, a franchisor retains discretion to artfully craft the descriptions of the bankruptcy history it discloses.

Therefore, to minimize the negative connotations associated with such bankruptcy, a franchisor can provide a description of the context under which the bankruptcy was filed. Additionally, for bankruptcies filed by unrelated companies where an executive of the franchisor previously worked, the disclosure should identify the executive’s role with the other company and explain the executive’s role in the financial management of the company and the bankruptcy filing.

Doing so can alleviate the effect of the disclosure on the franchisee, and may assuage any concerns that the franchisee has about the financial status of the franchisor or its associated individuals and entities. Careful, artfully worded explanations of the context surrounding such bankruptcies can ultimately make a prospective franchisee more inclined to enter into a franchise agreement with the franchisor. As always, the best practice a franchisor can employ is to consult with its franchise attorney regarding the required disclosures under Item 4 of the FDD.