When considering a franchise opportunity, one of the most important items, a prospective franchisee should review is the disclosed litigation between a franchisor and its franchisees. Presented in Item 3 of the Franchise Disclosure Document, this component of the due diligence process has been recommended by franchise attorneys and franchise industry professionals for countless years. There is little doubt that the amount and type of litigation a franchisor disclosed in their FDD can provide insight into the state and quality of franchise relations in a franchise system. However, what it doesn’t reveal is the amount of litigation that’s avoided due to a franchisor and franchisee amicably resolving their differences.
Under the amended FTC Franchise Rule, certain suits falling into four broad categories must be disclosed in Item 3: pending lawsuits, lawsuits involving the franchise relationship, prior lawsuits, and current government injunctive or restrictive actions. These include arbitrations. When analyzing franchise system litigation at FranchiseGrade.com, we compute an index that compares the amount of litigation to the number of franchisee outlets. This will address the fact that large systems are more apt to have more litigation cases than smaller systems and that any litigation must be disclosed for a period of ten years.
Analysis
An analysis of the FranchiseGrade.com database of 2,500 FDD’s indicated the following amount of litigation ranked by percent of franchise systems with disclosed cases. In spite of certain perceptions regarding franchise industry litigation, the data indicates that 92% of franchise systems disclose 0-3 litigation cases brought against franchisees, while 85% of systems disclose 0-3 cases brought against franchisors. In an ideal business world, there be no litigation, however, in reality considering the size and number of franchises in the U.S. these statistics portray a more positive relationship between franchisors and their franchisees than some might perceive to be the case. Although the measure of franchise relations consists of more than one variable this data provides an interesting overview of litigation between the parties.
The following table presents the percent of disclosed litigation by franchise systems by number of cases:
| Franchisor Litigation vs. Franchisee | Franchisee Litigation vs. Franchisor | |
|---|---|---|
| Cases Disclosed | Percent of Franchise Systems | Percent of Franchise Systems |
| 0 | 75% | 57% |
| 1-3 | 17% | 28% |
| 4-9 | 4% | 8.2% |
| 10-25 | 2.3% | 4.5% |
| 26 + | 1.7% | 2.3% |
| 92% of Franchisors had 3 or less lawsuits | 85% of Franchisees had 3 or less lawsuits |
It’s important that prospective franchisees include a review of disclosed litigation as an important component of their due diligence process. However, the above data reveals that a preponderance of franchise systems operate with little or no litigation. This should cause the outliers that disclose more litigation to receive added scrutiny.
