waivers; the ability to approve suppliers; real estate controls; territories
that are not too large and the right to require execution of the current
form franchise agreement on transfer or renewal.
Failure to maintain proper records can also be a red flag. Does
the franchisor have good systems in place or are they in disarray? Are
proper records and fully executed copies of documents maintained
(i.e., franchise agreements, acknowledgements of receipt, franchisee
questionnaires, personal guarantees)?
There are numerous legal items that affect nearly all franchised
businesses, including joint employer issues, vicarious liability of a franchisor for acts or omissions of its franchisees, data privacy and cyber-security, protection of intellectual property, state tax laws, gift cards
and escheat issues, ongoing compliance with franchise disclosure,
registration, relationship laws and monitoring franchisees’ maintenance
of appropriate insurance. Lenders should be aware of all of these.
Acquiring a Competitor
If the loan proceeds are being used by the franchisor to acquire a
competing brand, the due diligence should address both brands.
Counsel must ensure the currently owned brands’ franchise agreements do not create any encroachment, territorial or intellectual property rights issues, such as the sharing of confidentiality and proprietary
information and internal resources bet ween brands. The lender should
also determine if the acquiring company could face successor liability
for liabilities of the acquired company. Although the intricacies of
acquiring a competing brand are beyond the scope of this article,
special attention is warranted when a franchisor acquires a competitor.
Legal due diligence is often conducted by special legal counsel
with expertise in franchise matters. Part of the lender’s underwriting
analysis should include due diligence with respect to business and
accounting issues. Legal due diligence is constrained by financial and
time considerations and is, therefore, selective. Every relevant document cannot possibly be reviewed and there are inherent limitations
to the scope of the investigation. The focus should be on trends and
patterns of non-compliance, dissatisfaction or areas that limit the franchisor’s growth. The lender’s legal due diligence will not be as comprehensive as that undertaken by a company acquiring or merging with a
franchisor. Of course, no franchise system is perfect.
The existence of red flags must be evaluated in light of the size of
the loan and an assessment of the risk that any of the significant red
flags will come to fruition. The main question is: Has the legal due
diligence raised concerns that would cause lender’s counsel to recommend against granting the loan? abfj
LEONARD D. VINES is an officer in the Franchise & Distribution industry
group at Greensfelder, Hemker & Gale, P.C. (St. Louis).
BEATA KRAKUS is an officer with Greensfelder in Chicago. She works
with clients throughout the U.S. and across the globe preparing franchise
programs and assisting in managing distribution networks.
and advertising-fund contributions? Is there any group activity, such
as the formation of a franchisee association, indicating franchisees are
banding together to develop strength in numbers? Independent franchisee associations can be a signal of widespread discontent because
they are often formed by groups of disgruntled franchisees who share
common grievances and seek significant system-wide changes.
As with any business, performance and profitability are subject
to many variables, such as the vicissitudes of economic and industry
conditions, competition, changes in consumer preferences and the
ability of the system to adapt to them, customer retention and the availability of suitable locations and financing.
The lender’s due diligence should include a general internet search
for newspaper articles and postings about the franchise. Websites
bluemaumau.org and unhappyfranchisee.com, which might uncover any
public franchisee complaints, are valuable resources. Other warning
signs of franchisee dissatisfaction include the franchisor indiscriminately approving unqualified franchisees and saturating the market.
Franchise Documents & Legal Compliance
Franchise due diligence must include determining whether the franchisor has complied with the unique franchise registration and disclosure laws. Although lender’s counsel will not be able to independently
verify much of the factual information contained in the franchise
disclosure document (FDD), counsel will review the format, disclosures and related documents to determine if they substantially comply
with the Federal Trade Commission (FTC) Franchise Rule and the
FDD disclosure guidelines. The lender’s counsel’s comfort level will be
enhanced if the franchisor has used knowledgeable and experienced
franchise law firms.
The FDD is one of the most important documents for review
and contains valuable information about the system. One of its key
sections is Item 3, concerning litigation and arbitration. It is not,
however, an exhaustive source and should not be relied on exclusively.
For example, additional information about threatened litigation and
mediations should be included in disclosure schedules to the credit
agreement. A large claim or a pattern of similar types of litigation are
obvious red flags.
Item 4, which includes bankruptcy of the franchisor and its key
management, could also be a cause for concern. Although the franchisor is not obligated to provide financial performance representations to prospective franchisees, if it does provide such information it
must be included in Item 19 of the FDD. A careful review of that item
is critical. One of the most important sections of the FDD is Item 20,
which specifies the number of franchised and company-owned outlets,
transfers to new owners, anticipated future sales, terminations and
the number of franchises that have been “sold but not open.” A large
number of terminations, transfers and sold-but-not-open franchises
raises a red flag indicating a possible unhealthy system.
In 14 states, franchisors are required to register their FDDs prior
to selling franchises, and they must update them annually to continue
to do so. A lender’s counsel will want to verify that the franchisor has
properly registered in those states where its sales are subject to registration. Some states will impose financial assurance requirements
on those franchisors the regulator believes lack sufficient finances to
perform their obligations to franchisees.
Counsel will also review the form franchise agreements to determine if they are well drafted and include provisions that are important
to maintaining, growing and adapting to the future, such as the right
of the franchisor to transfer and to approve assignments, non-compete
and confidentiality agreements; the ability to modify the system and
to require the franchisees to update and remodel; the ability to change
trademarks; broad rights reserved to the franchisor; class action
If the loan proceeds are being used by the franchisor to
acquire a competing brand, the due diligence should address
both brands. Counsel must ensure the currently owned brands’
franchise agreements do not create any encroachment,
territorial or intellectual property rights issues, such as the
sharing of confidentiality and proprietary information and
internal resources between brands.