New Year, New FDD: Federal FDD Updating Requirements
The Federal Trade Commission Franchise Rule requires that franchisors update their franchise disclosure document (the “FDD”) after the close of each fiscal year. These annual updates must be prepared within 120 days after a franchisor’s fiscal year ends. After the 120-day period, a franchisor can only use the updated FDD.
There are many cosmetic changes and optional updates that a franchisor can make such as increased royalties, different marketing requirements, and deadlines for opening among other things. However, there are certain things that must be updated, and many of them are obvious. Below, I’ll briefly walk through the FDD Items to highlight important required updates.
Item 1 contains a description of the franchise and what products or services it offers. If the franchise system undergoes a significant change in the products or services it offers, that must be updated. If Chick-Fil-A were to start selling cheeseburgers, you bet their Item 1 would be updated to reflect that.
Item 2 lists the franchisor’s key management. If any of these people change roles, leave, or are replaced, those changes must be reflected. Also, the past five years’ employment history must be listed for each of these individuals. As another year passes, older information should be removed. This is an easy comment for state examiners to make when they review FDDs for state registration, and simply updating this information can save time and prevent blackout dates.
Item 3 lists litigation relevant to the franchisor, related entities, and its management. To list the types of litigation that must be disclosed would require an entire article on its own. The rule of thumb is to list every legal action (mediation, arbitration, or litigation) against the franchisor, its affiliates, and its directors and persons with management responsibility. If a franchisor has initiated any lawsuits or been sued in the past year, those actions generally must be disclosed in Item 3. However, there are several exceptions to that rule. It’s best to talk to a franchise attorney to determine whether a particular pending or past legal action must be disclosed.
Item 4 similarly lists bankruptcy action related to the franchisor, related entities, and its management. New bankruptcy filings must be disclosed while some bankruptcy proceedings may fall off due to their age.
Item 5 explains the initial fees. Any change in the initial fees must be updated. While less common, franchisors are required to disclose whether these fees are uniformly imposed. For example, if a franchisor sells a franchise for a reduced initial franchise fee or gives it away to a desirable franchisee, that must be disclosed. This often occurs with multi-unit deals where the franchisor cuts the franchisee a break due to the volume of units the franchisee is committing to develop.
Item 6 lists other fees such as royalties, advertising, training, and renewal and transfer fees among other things. If these are changed, they must be updated in the current year’s issued FDD. Even if the remarks such as the payable party, due date, or other payment terms change, those must be updated.
Item 7 details the franchisee’s estimated initial investment. The numbers must be updated if they change. As emerging franchisors grow, they usually determine more accurate numbers for Item 7 as their franchisees develop their units. For instance, if a franchisor’s Item 7 lists “equipment” at $40,000 but most of the franchisees are able to get their equipment for half of that, the franchisor could update that line item to “$20,000 – $40,000.” Emerging franchisors should also pay close attention to their franchisees’ breakeven points as they open their respective locations. If franchisees aren’t making money for the first few months, the franchisor should update “Additional funds – 3 months” to a greater amount of money so that prospective franchisees have a better idea of what reserves they should have prior to buying into that particular franchise.
Item 8 explains the restrictions on sources of products and services. The most important required updates for Item 8 involve (1) the franchisor’s revenue from sales to franchisees and (2) rebates the franchisor received from vendors over the past year. Failure to update or disclose these numbers can lead to huge lawsuits against franchisors.
Item 9 is a table that lists the franchisee’s obligations. Updating this item is mainly for a franchisor’s attorney. If the franchise agreement shifts around and sections change, they have to be updated. Otherwise, no real updates here.
Item 10 discusses whether the franchisor offers any direct or indirect financing. Most franchisors don’t offer financing, so this item usually contains a “affirmative negative statement” as the examiners call it. However, if a franchisor allows a franchisee to pay their initial franchise fee by executing a promissory note, that’s considered financing. Other alternative arrangements can constitute financing as well. If a franchisor has done anything out of the ordinary with collecting a franchisee’s initial franchise fee, they may be required to update their Item 10 disclosure.
Item 11 details the franchisor’s assistance as well as advertising, computer systems and training requirements. This item requires the franchisor to disclose the table of contents of its operating manual. The table of contents is usually included as an exhibit to the FDD, and it must be updated if the table, itself, is updated in the past year. The franchisor’s marketing or “brand fund” is explained in Item 11 as well. The franchisor must update the percentages of the marketing fund’s income that were spent on production and administrative expenses. That’s one detail that state examiners like to get hung up on. Also, if the franchisor’s training program changes, that must be updated.
Item 12 explains how the franchisee’s territory is determined. If the franchisor’s process for defining or determining territories changes, that must obviously be updated. Restrictions on sales outside of a franchisee’s territory must be updated as well if changed.
Item 13 lists the trademarks involved with the franchise system. Many emerging franchisors for their franchise while their trademark application is still in publication status. In that case, the trademark has a serial number, and they must disclose that the application is still pending. If the U.S. Patent and Trademark Office grants registration for one of the franchisor’s trademarks, that must be updated. Additionally, the franchisor is required to disclose any known infringements of its marks. For instance, if the franchisor has a holdover franchisee that is continuing to use the system marks, that must be disclosed whether the franchisor is seeking formal legal action or otherwise.
Item 14 similarly lists the franchisor’s patents, copyrights and proprietary information. Most franchises don’t involve patents, so this is usually a boilerplate item. However, any changes that occur in the status of a franchisor’s patents must be disclosed. The rule of thumb for Items 13 and 14 is to update these items to reflect any changes in the status or exposure of the intellectual property used in the franchise system.
Item 15 simply explains the franchisee’s obligation to participate in the operation of the franchise business. This usually doesn’t change. However, if a franchise goes from an owner-operator model to an absentee-owner model, that change must be updated. If requirements for managers of the franchisee’s business change, those must be included as well.
Item 16 briefly describes restrictions on what the franchisee must sell. This is where general requirements are listed such as whether the franchisee must only buy product from the franchisor or whether the franchisee can sell products in addition to the franchisor’s offerings. The real details on actual products, services and suppliers are included in the operations manual. It’s more common for changes to take place in the operations manual as opposed to Item 16.
Item 17 is a table listing important provisions of the franchise agreement and other related agreements. If the franchisor changes key things like the franchise term, renewal rights and terms, causes for default, transfer conditions or non-competition rules, these must be updated in the Item 17 table as well as in the franchise agreement.
Item 18 is used to disclose any public figures involved in the franchise system’s sales process. For instance, if the franchisor uses a celebrity spokesperson, their compensation and some other details must be disclosed. If this information changes, it must be updated.
Item 19 is where the franchisor makes financial performance representations. This is the most hotly litigated section of the FDD regardless of the required disclaimers. Franchisors that choose to make financial performance representations absolutely must update the numbers in this section. They may choose to disclose a particular unit’s profit and loss statement, or they may want to include average revenues for all of their stores. There are very specific rules for what can and cannot be included in Item 19. Regardless, updating this numbers each year is very important.
Item 20 is a set of five tables that show the franchise system’s outlet statistics. These numbers are easy to update if the franchisor’s operations team or manager keeps track of this information throughout the year. It is important to list a franchised outlet’s last status. For example, if the franchisor sold a franchise in January, then re-acquired it in March, and then sold it to another franchisee in November all in the same year, then this particular outlet would be listed under “Outlets Opened” in Table 3, and not under “Reacquired by Franchisor.” Item 20 also requires the franchisor to disclose contact information for all franchisees if the franchisor has fewer than 100 franchisees. If the franchisor has over 100 franchisees, there are rules for which franchisees must be listed. However, its best practices and easiest administratively, to simply list all franchisees. This information must be updated annually and is most often included as an exhibit to the FDD.
Item 21 required the franchisor to disclose its audited financials for the past three years. For emerging franchisors, there is a “phase-in” rule that eases this requirement in part while they get to the three-year mark. Sometimes, franchisors are required to disclose audited financials for their parent company or any subfranchisors. In any case, most franchisors have an annual audit performed in January or February for the past fiscal year, assuming their fiscal year ends on December 31. This allows their auditors plenty of time to complete the audit so that the franchisor can file its state renewals before the 120-day deadline. If no other changes occur in the entire franchise system, and if the franchisor makes no other changes in its FDD or franchise agreement, the franchisor must still update its FDD to include audited financials for the previous year.
Item 22 lists all contracts, primarily the franchise agreement and its exhibits, related to the franchise offering. This includes, lease riders, financing agreements, purchase agreements, and more. If any agreements are removed, replaced or added, they must be listed in Item 22.
Item 23 itself doesn’t change. It states that there are two receipt pages at the end of the FDD that must be signed upon the franchisee’s disclosure with the FDD. In the receipt pages themselves, the effective date, salespeople, and any of the franchisor’s contact information must be updated.
Aside from this item-by-item walkthrough of required annual updates, the franchisor may choose to update just about anything in their franchise offering. Franchise agreements offer a great amount of flexibility. The FDD simply has to line up with the franchise agreement to accurately reflect its terms. Regardless, January and February are the time to make updates. If a franchisor fails to stay on top of the update process, they could face issues selling their franchise that year or, even worse, they could open themselves up to significant liability.