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Franchise Lawsuits: What Do They Really Mean?

A franchisor must disclose legal actions in their UFOC, but is that necessarily cause for concern?

All franchisors are required to provide prospective franchisees with a substantial disclosure document, called the Uniform Franchise Offering Circular (UFOC), which contains a wealth of information concerning many aspects of the franchise company. One of the document's items is a history of any material lawsuits or other litigation that either the company or its executives have been involved in.

Prospective franchisees often have a number of questions about these disclosures. Are they relevant and material? Should you be worried about these disclosures? What can you discern about the franchise company by reviewing these disclosures? To answer these questions, you need to understand the reality behind most legal conflicts in the franchise industry.

The franchise agreement contract is carefully drawn up by the franchise company attorneys and governs the relationship between the parties. Franchisees often do not use the same care to make sure they completely understand the requirements of the contract as the franchisor did during the drafting process. This can lead to confusion and future conflict.

When litigation is instigated by the franchisor, it is almost always because of the failure of the franchisee to meet the obligations contained in the contract. These obligations are usually spelled out pretty clearly. The most common areas of "default" on the part of a franchisee are not paying fees when due or not meeting the terms of a development schedule.

When litigation is instigated by franchisees, it is almost always because the franchisees are not happy with their franchise business anymore. This could mean they don't like the franchisor, they don't like the business or they are financially failing in the business. In fact, it is often all of the above.

The challenge franchisees have in litigation is that most franchisors are very careful to make sure they meet all their obligations under the terms of the contract and there is typically no contractual obligation to make sure the franchisee is happy or financially successful. Therefore, most franchisee litigation alleges that the franchisor violated the rules pertaining to the initial sales process, since prevailing on this point is one of the few strategies that would allow the franchisee to obtain a right of rescission to undo the contract they signed with the franchisor.

When evaluating litigation disclosed in the UFOC, there are some clear deductions you can make about the franchisor. This is typically the case regardless of the allegations contained in the specific disclosures. The most important of these are:

  • If you take the total number of franchisees in the system and divide by the number of litigations listed for the past year (or for each of the past two years), you'll have an idea of the percentage of franchisees who end up in litigation with the franchisor each year. As a general rule, you want this percentage to be very small, regardless of who instigated the litigation or what was alleged to have taken place. Remember, these are your future odds we're talking about.
  • If the total percentage is significantly less than 1 percent (for example, if they have about one litigation event per year with 500 franchisees), you probably don't have much to worry about. These things happen in business occasionally, but if you're a reasonable person, these odds suggest it probably won't happen to you.
  • If the percentage is greater than 4 to 5 percent, my advice is to run away from this franchise as fast as you can. You don't even need to know what the specific problem is, since this percentage tells you there is a significant problem somewhere in this system.
  • If there is a percentage of system litigation in the past two years is in the 1 to 3 percent range, look at the cases to see who's instigating it. Don't worry about what is being alleged at this point; just see who started it for clues about where to do more research.

If the litigation is predominately instigated by franchisees, you need to research the financial performance of this franchisee business very carefully, since this is a red flag that something is wrong in terms of the moneymaking potential of the business. Franchisees who are making good money don't usually file lots of lawsuits against the franchisor-if they're unhappy, they can probably just sell their profitable business and move on to something else.

If it is predominately instigated by the franchisor, this is an indication that they may be litigious and prone to solving problems by calling in the lawyers. Though some would argue there's nothing wrong with this approach, I would personally just send them a copy of How to Win Friends and Influence People and go find another opportunity with people whose values were closer to mine.

It is not uncommon for franchise companies that have been around for a while to have some litigation disclosures, but anything greater than a small amount should raise questions in your mind about either the financial performance of the opportunity or the values of the people behind it. The best advice is to steer clear of any franchise with excessive litigation if it's important to you personally to avoid such events in the future.

Though the above analysis ignores the substance of the allegations contained in the disclosure, if a company passes the tests mentioned above, you still need to look at the specifics of the litigation history. Ask the franchisor for their explanation of whatever happened and try to contact the franchisees to get their side of the story. Even if it is a fairly rare event, this research may give you information that is relevant to your decision about whether this franchise is the right one for you.

Jeff Elgin has almost 20 years of experience franchising, both as a franchisee and a senior franchise company executive. He's currently the CEO of FranChoice Inc., a company that provides free consulting to consumers looking for a franchise that best meets their needs.

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