Beyond the Binder: Item 3-Litigation
When you're evaluating a franchise opportunity, there’s more to due diligence than just reviewing the shiny marketing deck or sitting through a polished discovery day. The Franchise Disclosure Document (FDD) is where the real story begins and Item 3 might be one of the most important, yet overlooked, chapters.
What Is Item 3?
Item 3 of the FDD focuses on litigation. Specifically, it discloses material legal actions involving the franchisor, its affiliates, and key executives. The goal is to alert prospective franchisees to any lawsuits or legal proceedings that may impact the franchisor’s credibility, financial stability, or ethical conduct.
Under the Federal Trade Commission (FTC) Rule, the franchisor must disclose:
Pending lawsuits filed against the franchisor or its executives alleging violations of franchise, antitrust, or securities laws.
Material claims involving fraud, unfair practices, or violations of franchise agreements.
Completed lawsuits (within the past 10 years) that resulted in liability or settlements involving similar claims.
Bankruptcy history (although this is technically in Item 4, it often gets flagged in litigation-related reviews).
Why Does This Matter to You?
Because litigation is a window into how a franchisor really operates.
When you read Item 3, you’re not just looking for courtroom drama, you’re looking for patterns. Patterns of franchisee lawsuits, settlements with NDAs, repeated breaches of contract, or allegations of deceptive sales practices should all set off red flags.
Here's why this matters:
Legal History = Operational Risk
If multiple franchisees have sued over misrepresentation or failure to support, that’s not a coincidence, it’s a warning. Litigation can reveal system-wide issues that could impact your success.Ethics and Accountability
Legal actions against key executives, especially for fraud or franchise violations, speak volumes about leadership integrity. These are the people you’re going into business with. You deserve to know if they’ve betrayed trust before.Hidden Costs of Litigation
Even if the franchisor is currently winning legal battles, ongoing litigation drains resources: money, time, and focus. That could mean fewer dollars reinvested into the system or less support for you as a franchisee.Impact on Resale and Financing
A litigation-heavy franchise brand may scare off lenders, future buyers, and even customers. Your exit strategy could suffer from something entirely outside your control.
Real Due Diligence Tip:
Franchisors are required to disclose material litigation, but what counts as “material”? It’s any legal action that would influence a reasonable person’s decision to invest. That includes lawsuits alleging fraud, contract breaches, or violations of franchise law.
But here's the catch: franchisors often word disclosures vaguely or omit lawsuits they don’t consider material, especially if a case was settled or quietly dismissed. That’s why it’s up to you to investigate beyond the FDD. Search public court databases like PACER and state court records. Google the names of the franchisor and its executives. Check LinkedIn, local news archives, and franchise forums. Most importantly, talk to former franchisees. They’ve lived what the FDD may leave out.
I learned this lesson the hard way. In the 2017 FDD I received by email on October 13, 2017 from Mac and Cheese Franchise Operations, LLC, the franchisor of I Heart Mac and Cheese, there was no litigation disclosed. But years later and deep into litigation, I uncovered lawsuits from 2016 and early 2017 that absolutely should have been. Had I known about them at the time, I would have never signed their franchise agreement.
What were these lawsuits? Glad you ask. Click here for the backstory on my real-world example of what a failure to disclose material litigation looks like.
The FDD is supposed to inform, but it doesn't always tell the whole truth. That’s why real due diligence means doing your own homework, because what you don’t know can hurt you.
Bottom Line:
Item 3 isn’t just a list of lawsuits, it’s a map of where the landmines are buried. Any franchise brand can sell you a dream. But a brand that’s buried in litigation might hand you a nightmare. Real due diligence means looking beyond the binder, and it starts with asking the tough questions about what’s been disclosed, and what hasn’t. This is work that YOU, as the prospective franchisee, have to do. Your CPA and franchise attorney are not going to do this type of deep-dive investigation that is needed in order to protect your investment.
Franchise Reality Check: Because the FDD doesn't always tell the full story, and it’s your money on the line.
Stay Tuned: Part 4 – Item 4: Bankruptcy – What It Really Means When a Franchisor Has Filed is coming soon.
