Understanding The FDD
In August 2020, Harold L. Kestenbaum joined the radio show Pillars of Franchising with Ray Pillar, Owner of Molly Maid Aurora-Naperville, Fred McMurray, CEO of Westvyne, and co-host Elizabeth Denham, CEO of The Franchise Women to talk all things FDD. Below are some highlights from the discussion.
- The History of the FDD
- What is a FDD and Why is It Important
- Franchise Laws by State
- What Should a Franchisor Look Out for In An FDD?
- How Do You Present Information in an FDD Without Scaring Off Prospective Franchisees?
- How Long Does a Franchise Agreement Last?
- Does the FDD Need to Reveal Ongoing Legal Actions?
- What Can a Potential Franchisee Takeaway from a List of Current and Former Owners in the FDD?
- What’s The Best Advice for Making FDDs Franchisee-Friendly?
- Why Do You Need an Experienced Franchise Lawyer to Review an FDD?
- What Are the Red Flags to Look for in An FDD?
- Has COVID Caused Changes to the FDD?
- What Are The Penalties for Having a Non-Compliant FDD?
- Need Help With an FDD?
The History of The FDD
Harold Kestenbaum: For people out there who don’t know what it is. Well, I guess you can go back to 1971 when California was the first state to promulgate a franchise disclosure registration rule. They required franchisors to have a document. In those days it was called a uniform franchise offering circular, UFOC for short. And that document spelled out the three different areas that a franchisee needs to know about and a franchisor needs to disclose.
Fast forward to 1979, when the Federal Trade Commission passed the FTC rule, which basically copied the California law and made it a nationwide law that every company that wanted to franchise their business had to have this UFOC document. Now, unfortunately, today, we wish that back then they had a uniform filing system as they have for the Securities and Exchange Commission, where you file a prospectus there and you don’t have to worry about the rest of the country. The FTC didn’t do that. It left it to the states, like California, to pass their own state statutes.
Fred McMurray: Big mistake.
Harold Kestenbaum: Yeah well, exactly. I guess the good news is that not every state did that, and in fact, the last state to do that was my state, New York, in 1981. There are currently 15 states out of all of the states that require such a registration. There have been some rule changes, and then in 2008, they did a basic overhaul of the UFOC, changed the name, and now we call it a franchise disclosure document or FDD. It changed some of the content of the items but basically left 23 items in the document that a franchisor has to address in order to be compliant. So that’s the document that we now use, and that’s the document we’re talking about today, as opposed to back in the ’80s and ’90s, when it was called the UFOC. And that brings you up to date.
What is a FDD and Why is It Important
Elizabeth Denham: Since we just went over the history of it, if you will go over the process of how it is introduced in the process of a potential franchisee connecting with a franchisor. Where do they see it in the process, and what should they be looking for?
Harold Kestenbaum: Well, in 2008, I think the biggest change was when this has to be given to the franchisee. Prior to 2008, the franchisor had to distribute or give, at that time, the UFOC at the first personal meeting when they met the franchisee. Now, when the law was developed, we didn’t have the internet, we didn’t have electronic mail, we didn’t have e-disclosure, we didn’t have any of that stuff. So actually, the physical 300-page or 200-page document that the franchisor had to duplicate and actually mail it to a franchisee. You couldn’t send a PDF, you couldn’t do any of that stuff back in those days, so it became a very expensive process. But nevertheless, you had to do that.
Back then, when a franchisee got this big document, they had to go to the last page, and we call it the receipt page. They had to sign the receipt and send it back to the franchisor. At that point in time, the franchisee had 14, well, then it was 10 business days. Leave it at 14, 14 days to go over the document with his lawyer, read it, make changes or ask for changes, and do whatever it needed to do, before you could sign anything or pay a fee. You can call it a cooling off period, if you will. We call it a negotiating period. On the 15th day, theoretically, the franchisee and the franchisor could sign an agreement.
In 2008, they made it a lot easier. We have now what’s called e-disclosure. You don’t have to send the document through the mail. You don’t have to make copies of 300-page documents. All you have to do is send a PDF to the franchisee. They still have to print out the last page, the receipt page, and send it back, but there’s no longer a need for hard copies of anything. Everything is done electronically.
What also changed was that there’s no longer a first personal meeting, because the drafters realized that that doesn’t happen anymore. Everything is done virtually. We didn’t have Zoom then, but you’d still do it on the phone. You don’t fly to the franchisor’s headquarters and sit there. So now you don’t have to give out the document unless the franchisee requests it, and the document doesn’t have to be given out until 14 days prior to signing or paying a fee. So now the franchisors can talk to franchisees on the phone. They could even see them face to face even, if they wanted to, and still not have to give them the document until the franchisee says, “Okay, I’m ready to go.” Then the franchisor electronically sends the document and you got the 14-day waiting period. That hasn’t changed.
So that’s basically the steps that are involved. These days, there’s a California website that if a franchisee really wants the document, they don’t even have to talk to the franchisor. They can go get it for free on the California website. And there are other registration states that have similar websites where you can do that. If the franchisor says, “Well, I’m not going to give you the document until I know you’re real, so let’s sit and talk about it,” if a franchisee wants to get around that, they can certainly do that. It’s not that difficult. The internet and the software that’s out there, and states are spending money to do that. Does that answer your question?
Franchise Laws by State
Fred McMurray: So if I file in Wisconsin and Minnesota and California, is it the same FDD, or do the states tweak how the FDD is so that there’s various different variations?
Harold Kestenbaum: That’s a good question, and that also changed in 2008. Before 2008, some states wanted their own FDD and you had to make changes for that state, and it became very cumbersome and some franchisors had multiple FDDs for different states. It became very expensive and very burdensome. So in 2008 when they amended the rule, now the states say okay, let’s use one document, but if you come into our state, a registration state like California, you have to do an addendum that picks up the California nuances to the California state law. All of the registration states allow you to do an addendum for their particular state and have one document. Made it a lot easier, less cumbersome, and franchisors appreciated that very much.
Fred McMurray: All right, so one follow-up question on the addendum. Are there any gotchas in the addendum besides… I know California’s a crazy place.
Harold Kestenbaum: Well, yeah. Some of the states, and I’ll use California, unfortunately, as an example. For example, in California, and this is the only state where you have this problem, every franchise agreement that I’ve ever seen in 43 years, they all have what we call a covenant not to compete. That means the franchisee can’t go out and do the same business under a different name, either while he’s a franchisee or for a period of time after he leaves the system. It protects the system from poaching and competition. Well, California is the only state that prohibits that provision, so in California, if you terminate a franchisee, they can go across the street or they could stay in the same location, and instead of being Arby’s they could be Joe’s Roast Beef House and get away with it. That’s in the California addendum.
And certain states have their own little quirky sections in their statute that you put in the addendum, which I can tell you, and we had this discussion offline before we started, 99.9% of the franchisees who even read the document never get that far, because the addendums are at the end. So they probably never even see what they say, and maybe they have a lawyer who’s getting paid enough money to read the whole damn thing, but other than that they’ll never know on each state addendum. And that’s the fact.
What Should a Franchisor Look Out for In An FDD?
Ray Pillar: Okay. Well, sort of based on the title of the show today, what items, I’m sure there’s several, in the FDD that a franchisor can tweak and cheat and not possibly say the right thing, that a prospective franchisor should look out for?
Harold Kestenbaum: Well, I don’t like to use the word “cheat.” The purpose of the FDD is full disclosure, and if you leave out things that are required, you open yourself up to a potential lawsuit, because the franchisee, if they fail, they’ll find a lawyer who will see, oh wait a minute, you left this out. So for example, in item 8, if you have rebates that you get from suppliers and you don’t put in that amount and what percentage that is of your total revenue, that’s a problem and you’re going to get nailed. First of all, if you go into a registration state, they’re going to pick that up right away.
The good news about the registration states is they serve as sort of a backstop, where if you leave things out, whether intentionally or unintentionally, you’re going to get a comment letter from those states, saying, “Oh, by the way, you left this out. You got to put it in or else you’re not going to get registered.” For the sneaky franchisors, I don’t like to use that word but I’ll use it, who think they [inaudible 00:17:27], yeah, if they’re only in non-registration states, they probably will be able to duck around the law until there’s a lawsuit. Then they’re going to be in trouble. But if they go into a registration state, they’re never going to be able to get away with that, because these state examiners, they go to the extreme.
Not only will they pick that up, but they’ll also tell you, “Oh, by the way, there should have been a comma there. You got to put a comma in. Oh, there’s a spelling mistake.” And you’ll get comment letters that are both substantive, like in your example, or absurd, which is, “Oh, there’s a grammatical error” or “There’s a typo that you have to switch and change.” So that’s what you get with the states.
Ray Pillar: That means there’s at least one person in each state that’s actually reading the FDD.
Harold Kestenbaum: Oh, yeah. Each state has their own group of examiners, and they do read them. No question. Which is the other problem. It takes weeks to get registered in most of these states, because the examiners are so backed up and they have so little help, because there’s no funding, that in the State of Maryland now, it could take three months to get registered. It could take six months, and that’s a real negative, and that’s a real problem. I have clients who refuse to go into registration states for that reason. They’d rather give up a sale than have to sit there and wait six months for an approval. Yeah, that’s right, Fred. Six months.
How Do You Present Information in an FDD Without Scaring Off Prospective Franchisees?
Elizabeth Denham: In the spirit of full disclosure, there are requirements to show franchisee failures or statistical things like that. How do you present that information as the franchisor without scaring off prospective franchisees?
Harold Kestenbaum: Well, except if you’re a startup, if you’re a big system, it’s in item 20 in their charts. They’re all done via charts, and there’s exhibits to the charts that who left the system in 2019, and you have to give the name and address and phone number, so the prospect could call them and ask why did you leave the system? And that’s every year. What we didn’t talk about is, every year that document has to be updated, and every year you have to have audited financial statements for the prior fiscal year or calendar year-end. The franchisors, and that’s their job, not mine, have to provide me and my staff and my team with the information about who left the system, who came into the system, et cetera, for that year. That’s my wife’s phone. Sorry about that.
That’s done every year, so that’s how you find out. That’s item 20. Those charts go back three years. They don’t do back forever, it’s only the prior three years. So it would be ’17, ’18, and ’19 for purposes of our discussion today.
How Long Does a Franchise Agreement Last?
Fred McMurray: Okay, wait a second. Run that past me again. You said that they have to update it every year?
Harold Kestenbaum: Every year, that’s correct, if they’re going to continue selling franchises, if they’re not out of business.
Fred McMurray: So in California, Wisconsin, and Minnesota at least, I should see a FDD every year?
Harold Kestenbaum: If they’re registered. Look, keep in mind, if some franchisor says you know what, I haven’t sold any in Minnesota in 10 years, I’m never going to sell one, they’re not going to renew and they’re going to just say I’m not renewing. So you’d get the older FDDs, but you wouldn’t get a current one if they don’t register.
Fred McMurray: Okay. If they have current franchisees in the state, they have to be registered, yes?
Harold Kestenbaum: Well, they should, yes.
Fred McMurray: I guess what I’m saying is that by your example, if they hadn’t sold a franchise in 10 years but they still had a franchisee in that state over that period-
Harold Kestenbaum: You know what? That’s a good question, and the answer is, if you have a franchisee in a state, you don’t need a current FDD, because if you’re not selling anymore, you only have the one franchisee. The disclosure document is not for the guys who are in the system already, it’s the new people who are buying into the system. If you’re not selling in a particular state and you have somebody there for 10 years, if he wants a second unit, that’s an exemption in most states, because he’s an existing franchisee. He just signs the same franchise agreement. So you don’t have to re-register in that particular state.
But the reality is, franchisors will register anyway, because if there’s one in a state, there may be one coming down the pike, and they don’t want to, “Oh, by the way, ooh, we didn’t register in Minnesota again. We have to do that now. When is it going to be done?” You get ahead of the curve and say okay, if you have a franchisee in Minnesota, there may be one. A buddy of his may want one. So yeah, we’ll refile.
Does the FDD Need to Reveal Ongoing Legal Actions?
Ray Pillar: I guess my question to Harold is, to what depths does the franchisor have to go, and in what timeframe do they have to mention all the legal actions that are taking place with that franchise?
Harold Kestenbaum: Good question. That would be item 3. Not every litigation that a franchisor is involved with has to be disclosed. Some companies don’t realize that. So for example, if the franchisor has a landlord-tenant action, that’s not disclosable. If the franchisor is sued for negligence, somebody slips and falls in front of the company-owned restaurant, that’s not disclosable. What is disclosable are lawsuits brought by franchisees against the franchisor or counterclaims brought by a franchisee against a franchisor. Typically, it would be fraud, breach of contract.
Harold Kestenbaum: The state brings a regulatory action against a franchisor for selling a franchise without being registered, for example, that would get disclosed. Arbitrations where a franchisee brings an arbitration against a franchisor for fraud or breach of contract, that would be disclosed. States like to see that litigation in the document for at least seven years. A couple of states say 10 years, but if you’re in a registration state and the state doesn’t say 10, it’s seven. And if the case is settled and the franchisor wins or doesn’t have to pay anything or has no liability, you can take the case out. But if it’s a settlement and the franchisor has to fork over money, that settlement stays in for the same amount of time.
Ray Pillar: Oh, wow. So that’s highly enlightening.
Harold Kestenbaum: Yeah. Look, let’s use the big boys. Subway has an exhibit with 32 pages of lawsuits. The bigger you are, the more franchisee lawsuits that you’re going to have. And the little ones have very few. Now, if the little ones have a lot, then that’s a red flag that anybody wants to take a look at. The big ones, they have 35,000 franchisees, you’re going to have lawsuits. That’s just the way of the world. Same with McDonald’s. But if you’re a new franchisor, you have five units and you have five lawsuits, then you got to scratch your head if you’re a buyer.
Ray Pillar: Yeah, but also the type of lawsuit that’s going on is very revealing as well, especially if you see a lot of the same type of lawsuit.
Harold Kestenbaum: Sure. Yeah, it does. You’re right. Look, the franchisee lawsuits run the gamut from you told me I would make a million dollars and it’s not in your document and I made $2, or the franchisor doesn’t perform under the agreement that he will do this or that, and the franchisee is now complaining. Look, my advice to my clients is, try to settle it before it gets to the litigation stage. Sometimes it’s worth it just to get rid of the franchisee. A friend of mine who owns an 800 or 900 chain franchise company has a philosophy. If a franchisee’s not happy, find a buyer and get him out of the system. He’s been very successful over the years doing that, and they have no litigation. Look, it’s not always the franchisor’s fault. If you have a bad franchisee, that happens, so get with a sale and get rid of them.
Elizabeth Denham: Is there a threshold? Clearly, the size of the franchisor matters, in terms of looking at numbers of litigations that they’re involved in, but as you get larger and larger, and I think Ray’s point was good about what kinds of litigation are going on, if they’re not adhering to the agreement, if it’s a contract violation or whatever, but when do you start to question, especially on the larger scales? There are certain numbers of lawsuits, and anybody in business knows this, that are normal. So when do you start to worry if you’re someone looking into a larger-scale franchise?
Harold Kestenbaum: Well, if you’re looking to buy a franchise on the scale of a McDonald’s or a Subway or Burger King or a system like that, you have to expect that there’s going to be lawsuits, because there’s so many franchisees.
Elizabeth Denham: And they’ve been around forever.
Harold Kestenbaum: Right, right. It’s the smaller systems where they multiple litigations that you have to start to scratch your head in finding out, why is this? What’s going on here? The big ones, you assume. When you’re a franchisee attorney and they want to buy one of those franchises from one of the big chains, you basically say, “Look, this is what it is. It’s the cost of doing business.” And the franchisors know that and they deal with it.
Fred McMurray: My question is this. What about corporate employee lawsuits? The first thing that pops into my head is sexual harassment lawsuits.
Harold Kestenbaum: No, that’s not disclosable. Well, for example, McDonald’s just, they fired their CEO because, yeah. If the CEO sues McDonald’s, that’s not disclosable. It’s between an employee and McDonald’s. There’s no franchisee involved. So it doesn’t matter. You could have 100 of those and they wouldn’t be disclosable.
Ray Pillar: Which makes sense. It doesn’t really affect the potential buyer.
Harold Kestenbaum: No, that’s right. It has no effect on the franchisees whatsoever.
Fred McMurray: Wow. In my head, I would think that would seem to indicate mismanagement at the executive level, and that’s not disclosable. So any lawsuit has to be between the franchisee and the franchisor to be disclosable? Assuming the franchisor lost.
What Can a Potential Franchisee Takeaway from a List of Current and Former Owners in the FDD?
Ray Pillar: Well, I think my next favorite item is the list of current owners of franchises and former owners. What can a potential buyer get out of that list?
Harold Kestenbaum: Well, let’s take the list of former owners. You only have to go back for the last calendar year. In other words, if you have 10 franchisees who left the system, we’ll use 2019, then you have to list each one of them and their name and address and their current phone number. The purpose of that is so that if prospects, they go to that list, they can call each one and find out why they left the system. Were you unhappy? Did the franchisor not do what they were supposed to do, or whatever? You’re not required to go back beyond one year, so if the number of franchisees who left the system in 2019 in zero, it doesn’t matter than 500 left in 2018. You don’t have to disclose that. That’ll come up in the charts, because you go back three years on the charts. It wouldn’t come out on that list of one year.
Ray Pillar: So the numbers would show that in the prior year, they lost a lot of franchisees.
What’s The Best Advice for Making FDDs Franchisee-Friendly?
Elizabeth Denham: In terms of marketability and the use of the FDD as a tool for that, what advice would you give to franchisors, especially newer ones, in terms of making it franchisee-friendly, not getting too complex, that kind of thing?
Harold Kestenbaum: Well, that was another thing that the 2008 amendment… Prior to 2008, they were very legalistic and very cumbersome. Only lawyers would be able to decipher what it meant. So in 2008, the FTC said it’s got to be in plain English. And the states follow that. The registration states will call you out if you use “therefore” and “heretofore” and legalistic words that lawyers tend to use. To say that the FDD is a marketing tool, I think exaggerates a little bit. It’s in there. There’s nothing marketing about it. Nobody’s going to read that and say, “Oh wow, do I want to buy this franchise.” No, it’s basically black and white. You get the 23 items. You answer the questions. You can embellish a little bit, but not much. It’s not going to win any Peabody Awards for marketing genius, I’ll tell you that right now.
Elizabeth Denham: No, but if it’s clean, if you’re low on lawsuits, if you’re low on people who are leaving, that kind of thing, that is something that you can brag about.
Why Do You Need an Experienced Franchise Lawyer to Review an FDD?
Harold Kestenbaum: I’ll tell you what I do see. I see companies that come to me who say, “I’m not happy with my lawyer.” And what I see frequently is I see a document that is not only poorly written but non-compliant. The franchisor doesn’t know any better until he sends it to me or somebody in my firm. We say, “Wait a minute, this is ridiculous. Whoever did this?” And I can tell you right now that there are consulting companies out there who think they can write FDDs, and they’re practicing law without a license. And they try to do it, and they do an awfully bad job. So yeah, I see clients that had somebody else write it who did a very, very unprofessional and terrible job.
Fred McMurray: Like they used a Google Docs template or a Microsoft Word template?
Harold Kestenbaum: Yeah. No, that’s what they do. Yeah, believe it or not, they do that. In the franchise bar, there are franchise lawyers and there are franchise dabblers. There’s the lawyer who says, “Oh yeah, I’ve done FDDs before.” Yeah, one. So that makes him a franchise lawyer in his mind. And then you get the law firms that do it exclusively, like our firm and other firms out there that just do franchising or have a group. Like DLA Piper, which has 3,000 lawyers, but they have a franchise practice group that’s got, last I heard was 250 lawyers in the franchise practice group. That’s the size of many law firms.
And then there are the boutique firms like my firm, where we are, I don’t know, seven lawyers and six paralegals, and all we do is franchising, but we’re not dabblers. But then you get these lawyers who think they know anything or try to allege that they know anything, they’re horrible and the product is terrible. And the client paid a fee, and now what am I supposed to do? You got to redo it. That’s another fee. That doesn’t make them very happy.
What Are the Red Flags to Look for in An FDD?
Fred McMurray: One of our listeners asked a question. He said, “What are things to look for that may project the impression that a FDD is poorly written?” In other words, what are the red flags that will indicate that a FDD is poorly written?
Harold Kestenbaum: That’s an interesting question, because from a prospective franchisee’s point of view if they’ve never seen one, they don’t know what’s good or bad. They’ll take a document and read it and think it’s good when it’s really not, but unless they’ve seen others that are more professionally done and well written, they’re not going to know the distinction between a piece of garbage and one that’s well done. Unless they have a franchisee attorney who’s looked at 20, 30, 40, 50 franchise disclosure documents for franchisees, and they’ll tell them immediately that this is a piece of garbage.
Fred McMurray: Okay. So I guess the first answer is, have your franchise attorney, and it should be somebody that… In other words, there’s a couple of attorneys I know that I’ve used in various things in past, for intellectual property disputes, something like that. But you’re saying if I’m buying a franchise, I should come to a franchise attorney.
Harold Kestenbaum: Yes, because look, when you’re a franchisee looking for a lawyer, you don’t hire your brother-in-law who’s a matrimonial lawyer to look at an FDD, or a negligence lawyer. You check around, you go to the bar association, and you find out what law firms do franchisee work. And there are a bunch. There are some firms that just specialize in that. And there are firms that do both. We don’t, but there are firms that’ll do franchisee and franchisor work.
Has COVID Caused Changes to the FDD?
Ray Pillar: Well, in this day and age we have to ask the question, and basically it is, since March, have you seen any lawsuits or changes in the FDD because of COVID?
Harold Kestenbaum: Well, we can do a whole new show on how the COVID has impacted franchising, but there are states, particularly Washington and California, that… We didn’t get into each item of the FDD, because we’re running out of time, but there’s an item 19 in the FDD. And that’s a very important item if you’re not a startup and if you have existing franchisees. Franchise lawyers have the option of putting in sales and P&Ls and all kinds of stuff regarding the operations of franchisees and company-owned units in item 19. States are saying you’ve now got to put a disclosure in there that 2020, your numbers may not be what they were in 2019 or before, as a result of the coronavirus, and you have to disclose that so the franchisee has it.
Now look, everybody and their mother will know that that’s probably going to be the case anyway. How many, except for a few industries, are the numbers going to be as good as they were in 2019? I could give you a few, but not many. There is a disclosure, and most of my clients, even if they’re not in those two states, should put in a disclaimer that the numbers in 2020 won’t reflect what they were in the years before, because of COVID-19.
In terms of the franchise industry in general, look, they’re hurting. Franchisees are going left and right. In New York City alone, I have a client that lost every single franchisee that they had in the city. They just shut down, and they’re not going to reopen. They’re in the personal care business. That’s an industry that got hit as hard as any, and the same with gyms. They are getting hammered.
Now, on the flip side, I have food clients that are doing better than they did last year, because they’re doing takeout and delivery, and nobody’s cooking. And people are running out of things to cook, like my wife, so you get a delivery or pick it up at the curbside. So there are companies that are doing pretty well in the pandemic. Not all, though.
What Are The Penalties for Having a Non-Compliant FDD?
Elizabeth Denham: All right. Well, Harold, let me ask you this, in terms of reiterating the importance of a good franchise attorney. What are the penalties for noncompliance, having a non-compliant FDD as a franchisor?
Harold Kestenbaum: Okay. Unfortunately, on the one hand, the FTC doesn’t do anything, and complaining to the FTC is a waste of time if you’re a franchisee. The states, however, are very diligent in going after franchisors who sell franchises before they’re registered, who are non-compliant, and it can get expensive. New York State, as an example, I’ve had clients penalized $20,000 and $25,000 because they didn’t listen to me and they actually sold franchises before we got the approval. So clearly, the states are very diligent and will hammer people, franchisors, if they don’t comply or if they do something that’s noncompliant and the state finds out about it. So yeah, the states are very active in that respect.
Now, if you’re a franchisor that avoids all of the registration states, you’re never going to have a problem, because there’s no watchdog. As much as I hate the registration process, it kind of puts a rein on franchisors getting carried away and doing things that they shouldn’t do.
Fred McMurray: Before we go down the rabbit hole, the only question I’d ask is, why hasn’t the FTC or Congress said you know what, we’ll have one repository for all of them and simplify it?
Harold Kestenbaum: Yeah. Well, we’d like that, and most franchise lawyers have advocated for that, but the federal government doesn’t want to get involved. That’s why they’ve deferred to the states to do that. I would love it. Every client I have would love the same thing. File in Washington like they do the prospectus when you go public, and then you file a form in each state letting them know that you’re doing it, the blue sky laws, and that’s all you do. And then you can sell franchises without having to wait six months or three months or whatever it is.
Need Help With an FDD?
The experienced franchise attorneys at Spadea Lignana can help with drafting and reviewing franchise disclosure documents. Learn more about our FDD services.