The Most Important Items in an FDD: Item 3 - Previous Litigation

When prospective franchisees are researching their next business opportunity, the Franchise Disclosure Document (FDD) can be their best friend. Every FDD contains 23 categories that are designed to break down a brand’s franchise concept. While every section is significant, there are some that are considered to be “more essential” than others.

One of those sections—Item 3—highlights a brand’s litigation history. This is not one that prospective candidates want to ignore. By highlighting the legal battles that a brand is facing or has faced in recent history, aspiring owners have the opportunity to foresee any potential problems that could arise with a concept down the road. 

“Item 3 is an incredibly important look into how a franchise is conducting itself legally,” said Brian Knuth, VP of Development at franchise sales solution Raintree*. “However, it’s important for potential franchisees to take context into consideration when examining a brand’s legal history.”

Nancy Lanard, Senior Partner at Lanard and Associates, P.C., noted how important it is that candidates look at this section carefully and understand the type of parties with whom they will be dealing. “For example, no one wants to buy a franchise from a person who was convicted of a felony related to perpetrating fraud or deceptive trade practice,” said Lanard. “Wouldn’t that be a sign that perhaps that party was going to act in the same way they did in the past? If a governmental action is disclosed, the prospective franchisee knows that the franchisor, a related party or one of the key people listed in Item 2 with whom the prospect will be dealing, has been enjoined or ordered to cease and desist by a relevant governmental agency.”

According to Lanard, under federal law, a franchisor must disclose litigation (including arbitration) that falls into four broad categories: pending lawsuits, lawsuits involving the franchise relationship, prior lawsuits or current government injunctive or restrictive actions.

While Item 3 allows prospective franchisees to explore a brand’s legal past, it’s up to them to differentiate baseless allegations from possible red flags. Sometimes litigation may be unavoidable. Still, a would-be franchisee should look into a brand’s history to see if there are any worrying patterns in the company’s legal history.

“Nothing should be taken for granted within the Item 3,” said Lanard. “Since the type of litigation that must be disclosed is going to be relevant to a prospective franchisee, it should all be taken as a significant part of the decision. As part of the validation, a prospective franchisee should always speak with franchisees in the system to learn their perspective on the litigation, along with all other aspects of the system. The prospect should always call from the list that is in the exhibits to the FDD and not just the franchisees that the franchisor recommends that the prospect contact. Calling from the list in the FDD ensures independent answers that the franchisor has not hand-picked to help sell the franchise to the prospect.”

Also, Item 3 of FDDs are designed to provide an overview of a brand’s litigation history—they don’t serve as a comprehensive list detailing every case that’s ever been made by or against a concept. That’s why when going through the due diligence process, candidates should use Item 3 as a starting point to dig deeper into a brand’s full legal presence.

“At the end of the day, if a brand has been around long enough it will probably have dealt with some litigation,” said Knuth. “Item 3 is meant to give franchisees a simple heads up about the type of litigation involved with a specific brand, the rest is up to the prospective owner.”