In this first of a special 2-part series, a veteran franchise attorney looks at franchisee complaints that FDDs are too complicated to be understandable. Part 2, in the next issue of this newsletter, offers 10 tips on how to read an FDD critically.
No smart franchisor wants to sign up a new franchisee who has not read the franchise disclosure document (FDD). The FDD (franchising’s equivalent to a public company’s Form 10-K) is a government-mandated pre-sale disclosure document that franchisors must deliver to a prospective franchisee at least 14 days before the franchisee signs any binding agreement or pays any money to the franchisor, even a refundable deposit.
The FDD must contain the franchisor’s answers to 23 distinct categories (Items) of questions about the franchisor, the franchisor’s management, and the franchise program, as well as the franchisor’s audited financial statements and a complete copy of all contracts that a franchisee must sign.
Answering questions with brevity is not necessarily the best practice for franchisors. Most franchisors write their FDDs defensively to protect themselves against future claims by franchisees over business losses that they allege are due to FDD misstatements or omissions.
A prospect who is told by a franchisor or business broker that FDD delivery is a mere formality because everything they need to know about the franchise program can be found on the franchisor’s website or learned during a discovery day visit – should reject that franchise program and find a reputable one. There are a few thousand active franchise concepts in the U.S. across all industry sectors, including some run by Fortune 500 companies. Smart franchisors want franchise buyers to understand the deal they are getting into before signing a long-term contract allowing use of the franchisor’s most valuable asset, the franchise brand.
The franchisee’s lament
A September 2019 New York Law Journal article written by a highly regarded franchisee attorney and friend of mine describes franchising from the perspective of representing franchisee owners who have failed in business. These are franchisees who seek legal help to extricate themselves from an unsuccessful franchise investment after a few years of operation; they are losing money and, notwithstanding their contractual commitment to operate for a longer period, continuing in business makes no financial sense.
The classic franchise agreement, the article critiques, lacks an “out clause” allowing a franchisee to terminate the arrangement absent proof of the franchisor’s material breach, an observation that is unremarkable if only because it is entirely consistent with basic contract law. It also claims that franchise agreements give the franchisor too much control over basic aspects of the franchisee’s business, allowing the franchisor to dictate uniform standards for trade dress, operating protocols, authorized goods and services, hours of operation, and suppliers.
However, the fact a franchisor dictates these things is explainable by well-settled trademark law: a franchisor – as brand owner – must establish rules for all franchisees to follow to ensure that the licensed brand stands for the same thing in the minds of consumers who engage in transactions across branded outlets owned by different franchisees.
Omitted from the article is any mention of whether the franchisees who seek to escape from a franchise deal gone bad – a painful outcome that no one may trivialize – bothered to read the FDD or franchise contracts before signing them. Nor does the article mention if the franchisees engaged legal counsel to help them evaluate the franchise opportunity or conducted due diligence to validate the franchise program (e.g., interviewing existing franchisees) before leaping in.
Franchise agreements are, by necessity, incomplete contracts: they require mutual performance over a relatively long term, on average 10 years. As a result, they expressly vest franchisors with discretion to adjust the franchise program to keep the brand relevant as consumer preferences, technology, and competition inevitably change over the contract’s long term. This is not to say that all franchisors use their contract power benevolently or fairly; some do not. But, the fact that the franchise contract gives the franchisor control in the first place to dictate operating requirements and lacks an “out clause” for franchisees are risks that can readily be identified before buying a franchise by carefully reading the FDD, engaging counsel to read it, and interviewing existing and former franchisees whose contact information is in the FDD.
The Federal Trade Commission (FTC), which has administered a federal franchise sales law (the Franchise Rule) since 1979, requires franchisors to disclose on the very first page of the FDD in no-nonsense terms three basic warnings: 1) “Buying a franchise is a complex investment”; 2) “Read all of your contract carefully”; and 3) “Show your contract and this disclosure document to an advisor, like a lawyer or an accountant.”
Yet, despite these clear admonitions, research shows that most franchisees buying their first franchise neither read the FDD nor consult with a qualified franchise attorney before signing a franchise agreement. Instead, researchers say that most franchisees base their buying decision on “relatively shallow” less informative sources, such as statements in franchise advertisements, newspaper articles, or franchise prices.
It is textbook law that a party cannot evade the consequences of a contract that the party signed without reading. While people are free to sign legal documents without reading them, the documents are still binding. This truism applies to all contracts, not just franchise contracts. The principle is rooted in the “sanctity of contracts”, a doctrine that recognizes that contract-making benefits the general public and depends on parties being able to rely on their contracts being enforced as written. Courts advance this public policy by limiting their role to enforcing contracts and rarely creating, dissolving, or changing contracts.
If a majority of franchisees sign franchise agreements without reading them, it is fair to say that, despite their efforts, franchise regulators and franchisee advocates have done a poor job in educating franchisees about the blunt consequences of blindly signing franchise contracts. When unsuccessful franchisees seek legal help for rescue from a deal gone bad, they learn the sobering lesson that the law strictly limits the circumstances in which a court will unwind a contract. If only these franchisees had sought the advice of experienced franchise counsel before buying the franchise.
The FDD readability problem
The FTC recently invited the public to comment on several proposed adjustments to the 41-year-old Franchise Rule. One proposal advanced by franchisee advocates would upend the longstanding pre-sale disclosure process. Proponents maintain that the FDD has grown so complicated and voluminous that it is “intimidating” to the average prospective franchisee, so much so that the FTC should no longer expect franchisees to read the FDD before buying a franchise. They urge the FTC to fix the “readability” problem by requiring franchisors to prepare and deliver a summary FDD containing just specific highlights, something short and straightforward enough that franchisees will read. Proponents of changing the pre-sale disclosure process also assert that prospective franchisees cannot afford and should not be expected to hire an attorney to digest the “big” FDD for them.
Franchising is a complex investment. It is the wrong business opportunity for someone unwilling to invest the time and resources to read the contracts or have them explained before signing them. I say this having written and reviewed hundreds of FDDs during my 40-year career as a franchise attorney representing mostly startup franchisors – but also having helped scores of prospective franchisees analyze the FDD and contracts to ensure that they appreciate what is expected of them, what they can expect from the franchisor, and to identify atypical contract provisions and red flags that could spell trouble ahead.
While I appreciate that parsing through long contracts written in legalese (the universal language of all contracts) is challenging for non-lawyers, it is difficult to understand why franchise buyers are apparently unwilling to invest in legal counsel. If franchise buyers find the “big” FDD and its many exhibits so confounding, why would they invest what often is their life savings in a binding agreement without hiring legal counsel to advise them about what they are getting into?
Furthermore, it is difficult to accept the affordability excuse for not hiring legal counsel. Compared to the amount of money that franchisees will invest to buy and start up a franchise business, the cost to hire an experienced franchise attorney to wade through the FDD and contracts is nominal. Once the franchisee signs on the dotted line, they will face far greater expenses opening and operating the franchise business – just to break even – than the up-front investment in good legal representation. Hiring an experienced franchise counsel before buying a franchise is the ounce of prevention hailed by Benjamin Franklin.
Debunking the readability problem
There are numerous articles written by franchise consultants offering different perspectives for how a franchise buyer should critically read the FDD or find the right franchise. Some of these articles are extraordinarily basic, written so simplistically that they leave the impression that selecting a franchise and digesting the legal documents are tasks that are easy to do. Add to this the fundamental attraction of franchising – being one’s own boss in control of one’s own destiny – and the sheer number of franchised businesses represented in the U.S. economy, and it may seem to a first-time franchise buyer that anyone can find financial success by investing in a franchise. Buying a franchise is a complex investment, and performing appropriate due diligence and engaging legal counsel before signing a franchise contract will not eliminate the risk embedded in every business investment, franchise or not.
It is important to debunk the notion that FDDs today are so complicated that franchisees may rightfully not read them. Anyone who buys a franchise will have to sign other contracts to get their franchised business open – leases, bank loans, supplier agreements, and more – for which the law does not provide a plain language, pre-signing disclosure like the FDD.
While the FDD’s plain-English disclosures cannot change the relational dynamics or level the playing field between franchise parties as a whole, the FDD does a good job of comprehensively explaining the parties’ mutual rights and duties in what may fairly be described as a lopsided power arrangement. Franchisees lose sight of the forest for the trees by blaming the FDD’s girth as a reason for signing franchise contracts without reading them. Proper due diligence of a complex investment is not something that can or should be abbreviated, condensed, or hastened.
Part 2, “Ten Tips for Reading an FDD,” will appear in the next issue.
Rochelle Spandorf is a partner with Davis Wright Tremaine and chairs the firm’s franchise practice. She is a nationally recognized business franchise and distribution attorney representing franchisors, manufacturers, licensors, suppliers, franchisees, and distributors in their domestic and international expansion and strategic development. She has the distinction of being the first woman to chair the ABA Forum on Franchising, the nation’s preeminent association of franchise attorneys, and is recognized by her peers as a Global Elite Thought Leader in franchise law. Contact her at [email protected] or 213-633-6898.