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Don’t Be a Victim of Franchise Fraud, aka, Churning -- Understanding Item 20

Part 2

By Mario Herman

Franchise candidates should know how to use the information in Item 20 of the Franchise Disclosure Document. Contacting former franchisees and obtaining information may be more difficult than appears.

Under Item 20, Franchisors are also required to provide the prospective franchisee with the contact information for all current franchisees, or for all franchisees in the state where they are offering to sell franchises if there are 100 or more franchises in the state, or for at least 100 franchisees in contiguous states and the next closest states. If a franchisor has fewer than 100 current franchisees, contact information must be provided for all of them.

Also under Item 20, Franchisors must provide the prospective franchisee with contact information for every franchisees who: 1) has had an outlet terminated, canceled, not renewed, or otherwise voluntarily or involuntarily ceased to do business under the franchise agreement during the most recently completed fiscal year; or 2) has not communicated with the franchisor within 10 weeks of the disclosure document issuance date.

One might think that contacting former franchisees would be quite useful, as they have no ongoing investment in the franchise business and might speak more openly. However, there are a few obstacles to gathering information from former franchisees. First, under Item 20, in order to protect the privacy of former franchisees, the Franchise Rule calls for the disclosure of only limited contact information: the name, city and state, and current business telephone number of a former franchisee. While the Franchise Rule provides that a franchisor should only use the “last known” telephone number if the current business telephone number is unknown, one has to question how many former franchisees keep their former franchisor updated with current contact information.

The second obstacle is what are known as “confidentially agreements” or “gag orders” between former franchisees and franchisors. Franchisors are required to disclose if franchisees have signed confidentiality agreements with the franchisor during the last three fiscal years that restrict a current or former franchisee from discussing his or her personal experience as a franchisee in the franchisor’s system. These confidentiality agreements typically arise as part of the resolution of a dispute between the franchisor and franchisee, and as such, might restrict a franchisee from disclosing relevant information about the franchise. The unfortunate result of these confidentiality agreements is that it allows franchise misrepresentation by preventing prospective new franchisees from learning potentially negative details about the franchise. All of which may result in the prospective franchisee unknowingly purchasing a franchise in a system that has a history of low or no profitability and high failure rates of franchisees. It should be further noted that current and ex-franchisees of systems have no duty under the law to disclose information about their businesses to prospective franchisees. By having former franchisees under a confidentiality agreement or gag order, franchisors that practice franchise fraud or franchise churning "inhibit prospective franchisees from learning the truth about the franchising opportunity as they conduct their due diligence investigation of a franchise offer." (Federal Register Franchise Rule, page 15505.)

While not foolproof, a careful review of Item 20 can disclose some red flags which might help to prevent you from falling victim to franchise fraud or churning. Is there a high turnover rate? What are the reasons for the turnover rate? Does the franchisor require confidentiality agreements of its current and/or former franchisees which would prevent you from getting relevant information as you conduct your pre-purchase due diligence? Again, before you purchase a franchise, you should seriously consider having an experienced franchise law attorney review this information with you, as well as reviewing the other disclosures in the FDD and the contents of the Franchise Agreement. Doing so may save you tens of thousands of dollars in the long run. The old saying, “penny smart, pound foolish,” is critical to remember when making such an important and financially significant investment.

Mr. Herman based in Washington, D.C., represents franchisees domestically and internationally negotiation, mediation, arbitration, and litigation.

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