How to Avoid the Franchise Surprise

In many states, the statutory definition of “franchise” has been, and could be, construed broadly to include relationships between brand owners and their trademark licensees, even though neither party intended to create a franchise relationship. Brand owners can only avoid the franchise surprise if they know the rules of the game.

States' Definitions

The majority of states have definitions largely resembling the FTC's franchise rules and require the presence of all three elements of the FTC's definition of a franchise: 1) use of a trademark; 2) a significant degree of control; and 3) payment of a fee by the franchisee. Twenty-seven states have statutory franchise definitions that are applied only in specific commercial contexts, including the regulation of motor vehicles (Alabama, Arizona, Georgia, Idaho, Iowa, Kansas, Kentucky, Louisiana, Maine, Massachusetts, Nebraska, Pennsylvania, South Carolina, Texas, Utah, and Wyoming), recreational vehicles (Maine and Utah), alcohol distributors (Montana, Nevada, New Mexico, North Carolina, Ohio, Tennessee, and Vermont), and petroleum products (Nevada, New Hampshire, and West Virginia). Two states (Alaska and Colorado) have no statutory franchise definition at all.

In the 23 remaining states where franchises are more broadly regulated, if any one statutory element is missing from the relationship, then it does not constitute a franchise. However, where a brand owner's/licensor's trademark license falls within the scope of the state franchise statute, the licensor could find itself unintentionally operating a franchise in violation of the state's franchise regulations.

Rules of the Game

To illustrate the rules of the “franchise” game for unsuspecting brand owners, we review the franchise law and its application in four states where a significant amount of trademark licensing and franchising occurs ' California, Illinois, New Jersey, and New York. California, Illinois, and New York are registration states. Further, California, Illinois, and New Jersey have franchise relationship laws, which govern when, and under what circumstances, a franchise may be terminated or not renewed. Generally, these state laws also address aspects of the franchise relationship, such as discriminatory treatment, fair dealing, the ability of franchisees to associate, and the minimum advance notice of franchise termination. Using these states as examples, brand owners should be able to navigate the franchise rules and, if desired, avoid the “franchise” tag when licensing their trademarks.

California

California has two general franchise laws: the California Franchise Relations Act, or “CFRA” (Cal. Bus. & Prof. Code ”20000-20043), and the California Franchise Investment Law, or “CFIL” (Cal. Corp. Code ”31000-31506). The CFRA applies to licensees who are domiciled in California or to brand owners who have operated a “franchised business” in California. Cal. Bus. & Prof. Code '20015. The CFIL applies to brand owners who are located in California and license their trademarks within or outside the state, or who are located outside of California and form a relationship with a trademark licensee within California. Cal. Corp. Code '31013.

The “franchise” elements under both California laws require the “use of a trademark,” the existence of a “marketing plan” prescribed in substantial part by the brand owner, and the licensee's payment of a “franchise fee.” Cal. Bus. & Prof. Code '2001; Cal. Corp. Code '31005. Exempted from the definition of “franchise fee” is the licensee's purchase of goods at bona fide wholesale price if no obligation is imposed to purchase a quantity of goods in excess of that which would reasonably be purchased, either as starting inventory or maintenance of inventory. Cal. Bus. & Prof. Code '2007; Cal. Corp. Code '31011. The CFRA requires franchisors to have good cause to terminate, not renew, or cancel a franchise, whereas the CFIL requires franchisors to make presale disclosures and register with a state agency before offering or selling franchises in the state. As in many other states, if the elements of the statute are met then a franchise may be deemed created, even if a contract expressly states otherwise. Gabana Gulf Distribution, Ltd. v. Gap Int'l Sales, Inc., No. C 06-02584, 2006 U.S. Dist. LEXIS 59799, *19-(20 (N.D. Cal. Aug. 14, 2006).

California courts have repeatedly noted that each element of the “franchise” statutory definition should be “construed liberally to broaden the group of investors protected by the law.” Kim v. Servosnax, Inc., 10 Cal. App. 4th 1346, 1356 (1992). Even so, the courts have been careful when examining whether amounts paid by a trademark licensee, either directly or indirectly, constitute franchise fees. For instance, a trademark licensee's expenses for telephone line fees and computer terminal costs were deemed not to be a franchise fee and “nothing more than ordinary business expenses and not an investment required by [the brand owner] for the right to operate a dealership.” Thueson v. U-Haul Intl., 144 Cal. App. 4th 664, 673, 676 (Calif. 1st Ct. App. 2006). Providing some guidance on the “franchise fee” determination, the court noted that the trademark licensee “made no required contribution of capital, made no unrecoverable investment in the [brand owner], was not required to purchase any inventory, and was not required to purchase services from [the brand owner] in order to become a dealer.” Id. at 676. Further, the licensee “placed none of his own funds, even the de minimis amounts required under [the statute], at risk in exchange for the dealership.” Id.

But, in a case considered to be an expansion of California franchise law, a franchise relationship was found between a manufacturer of record-keeping systems and office products and its commissioned sales agents. In Gentis v. Safeguard Business Systems, 60 Cal. App. 4th 1294, 1305 (Calif. 2d Ct. App. 1998), the manufacturer argued that it did not have a franchise because its sales agents did not offer, sell, or distribute goods or services under a marketing plan ' a required element of California's franchise laws. Nonetheless, the court found that the sales representatives were franchisees because, among other things, they solicited orders, demonstrated products, solved customer problems, installed the manufacturer's systems, maintained contact with existing customers, generated new business, and provided ongoing support to customers. Id. at 1305. Therefore, even though they could not enter into a contract and effectuate a sale, the sales agents' arrangements with the manufacturer were considered a franchise relationship.

An accidental franchise in California can be quite costly, i.e., liability for damages or even rescission, if the business relationship sours and the opposing party asserts the statutory franchise requirements to show non-compliance. Cal. Corp. Code '31300 provides that “any person who offers or sells a franchise in violation of Section 31101, 31110, 31119, 31200, or 31202 ' shall be liable to the franchisee or subfranchisor, who may sue for damages caused thereby, and if the violation is willful, the franchisee may also sue for rescission.” Cal. Corp. Code ' 31300. See Dollar Systems, Inc. v. Avcar Leasing System, Inc., 673 F. Supp. 1493, 1504 (D. Cal. 1987) (Franchise buyer was entitled to rescission of agreement and restitutionary damages totaling $715,250.91, plus attorney's fees, after franchise seller violated and was grossly negligent in its compliance with various state and federal investment laws.)

Illinois

The Illinois Franchise Disclosure Act of 1987 (“Disclosure Act”) applies to brand owners who are located in Illinois and license their trademarks within or outside the state, or are located outside of Illinois and form a relationship with a trademark licensee within Illinois. ' 815 ILCS 705/6. The elements of a “franchise” under the Disclosure Act are “use of a trademark,” a “marketing plan,” and payment of a “franchise fee” of $500 or more. '815 ILCS 705/3. The parties' subjective intent is not determinative ' if an agreement meets the criteria set forth in the franchise statute then a franchise relationship is created, even if a written agreement between a brand owner and authorized dealer specifically stated that it did not constitute a franchise agreement. Calderon v. Southwestern Bell Mobile Sys., 390 F. Supp. 2d 714, 720-21 (N.D. Ill. 2005). In Calderon, the dealer successfully alleged a franchise was granted because the three-part test was satisfied: 1) It was granted the right to sell the brand owner's products and services; 2) The dealer's operation was substantially associated with the brand owner's trademark; and 3) The dealer was required to pay the brand owner a $1000 fee for the right to sell the brand owner's products and services. Id.

A potential pitfall for brand owners is that even if a franchise is not created at the inception of the parties' relationship, it can become a franchise if the relationship later satisfies the requirements of the statute. This happened in To-Am Equipment Co. v. Mitsubishi Caterpillar Forklift America, Inc., 152 F.3d 658, 659-60 (7th Cir. 1998) where a tractor manufacturer/distributor relationship became a franchise when the distributor's incremental payments for sales manuals over the course of eight years exceeded Illinois' $500 statutory threshold. The penalty for the manufacturer's violation of the Illinois franchise law? An award of $1.5 million to the terminated distributor. Id. Strikingly, the court noted that it understood the manufacturer's concern that dealerships in Illinois are “too easily categorized as statutory franchisees,” however, “that is a concern appropriately raised to either the Illinois legislature or Illinois Attorney General, not to this court.” Id. In Bly & Sons, Inc. v. Ethan Allen Interiors, Inc., No. 05-668, 2006 U.S. Dist. LEXIS 62629 (D. Ill. 2006), the terminated licensee convinced the court that a franchise existed under 815 Ill. Comp. Stat. 705/3(1) because a contribution to an advertising fund was an indirect franchise fee. The court agreed and awarded limited costs and attorney fees to the licensee under the Illinois Franchise Disclosure Act due to wrongful termination. Id.

New Jersey

Brand owners who license their trademarks to distributors or other licensees maintaining a place of business in New Jersey should be aware of New Jersey's Franchise Practices Act (“NJFPA”). If a licensee is located in New Jersey, courts will apply the NJFPA to cover the brand owner/licensee relationship even where the application of New Jersey law supersedes the contractually agreed-upon choice-of-law clauses selecting the law of another state. Instructional Sys. v. Computer Curriculum Corp., 130 N.J. 324, 341-46, 367 (N.J. 1992). Also, where New Jersey law governs an agreement encompassing a multi-state territory, the NJFPA has an extraterritorial reach over franchise activities in those states other than New Jersey, which are covered by the agreement. Instructional Sys. v. Computer Curriculum Corp., 35 F.3d 813, 825 (3rd Cir. 1994).

New Jersey's unique statutory “franchise” definition does not require a “franchise fee,” but it does require a “license to use a trademark,” a “community of interest,” and gross sales of products between the franchisor and the franchisee exceeding $35,000 for the 12 months preceding the institution of suit pursuant to the Act, with not more than 20% of the licensee's gross sales intended to be derived from such franchise. It also requires that the franchisee's business be in New Jersey. N.J. Stat. ' 56:10-3 ' 56:10-4. Clearly, brand owners can avoid the NJFPA in several ways, the simplest of which could be not to have more than $35,000 of sales per year with licensees, i.e., let others deal directly with the licensees.

Brand owners can easily circumvent the “license to use a trademark” element of the NJFPA. This element has been applied narrowly, perhaps in recognition of the fact that the law was not intended to encompass brand owners. In New Jersey, “merely selling goods or distributing materials bearing the manufacturer's name or trademark does not constitute a 'license to use a trademark'” within the meaning of the NJFPA. Atlantic City Coin & Slot Serv. Co. v. IGT, 14 F. Supp. 2d 644 (D.N.J. 1998) (citation omitted); see also Cassidy Podell Lynch, Inc. v. Syndergeneral Corp., 944 F.2d 1131 (3rd Cir. 1991) (holding that “if a manufacturer merely furnishes advertising materials to a distributor, and allows the distributor to place its name alongside the manufacture's name on such materials, a license is not created”). Therefore, even where an agreement between a brand owner and its trademark licensee may technically fall within the definition of a “franchise,” New Jersey courts have found an exemption for straightforward trademark licenses.

Notwithstanding the court's exemption for straightforward trademark licenses, brand owners must be careful to avoid creating the impression in the mind of consumers that there is connection between the brand owner and the licensee, such that the brand owner “vouches for” the activity of the trademark licensee. Atlantic City Coin & Slot Serv. Co., 14 F. Supp. 2d 644. This type of relationship will bring a brand owner within the ambit of the NJFPA.

For example, a relationship was deemed a “franchise” when, through advertising and signage, the distributor used the manufacturer's trade name “in such a manner to create a reasonable belief on part of the consuming public that there is a connection between them” such that the manufacturer vouches for the distributor's activities. Cooper Distributing v. Amana Refrigeration, No. 91-5237, 1992 U.S. Dist. LEXIS 17918, at *8,*10 (D.N.J. Jan. 23, 1992) (Evidence confirmed that consumers believed that the manufacturer and distributor were affiliated, i.e., the distributor was designated as an authorized warranty repair center, it was required to maintain advertisements in the Yellow Pages proclaiming itself as such, it was required to maintain signs bearing the manufacturer's trade name, and it drove trucks with decals provided by the manufacturer.) Accordingly, while brand owners can and should control and monitor the branded products/services provided by their licensees, they should not interfere too much with the licensee's actual business operation to create the false impression that the brand owner and licensee are affiliated in any other way. Brand owners must ensure that their trademark licensees do not present themselves to the public in a way that could create the appearance of an affiliation between the parties.

Brand owners also need to be aware of the “community of interest” franchise element of the NJFPA, which focuses on whether there is a “disparity in bargaining power between the licensor and licensee” and reviews factors such as a licensor's control over the licensee, the licensee's economic dependence on the licensor, and the presence of a franchise-specific investment by the licensee. Id.

In one New Jersey case, the community-of-interest element was used to find a franchise where, though the distributor at all times operated under its own name and did not adhere to any structural or procedural scheme and never paid a license fee, the distributor had the right to use the producer's name, trademark, and logo in its advertising, exhibits, trade shows, public relations materials, and manuals, and the duty to use its best efforts to promote the producer's products, which had the effect of appearing to consumers that the two entities were related. Instructional Sys. v. Computer Curriculum Corp., 130 N.J. at 351-55. Further, a community of interest was found where the distributor made “franchise-specific investments” ' such as purchasing copyrighted computer software ' and the distributor had developed goodwill and contacts, none of which could be used if the relationship with the brand owner ended. Id. at 366.

The Instructional Sys. v. Computer Curriculum Corp. case is also significant because the United States Court of Appeals for the Third Circuit has held that the NJFPA could have extraterritorial reach to franchise activities in states other than New Jersey where an agreement encompasses a multi-state territory. 35 F. 3d at 825 (holding “[w]hile a contract which covers multiple states may raise a difficult choice-of-law question, once that question is resolved there is nothing untoward about applying one state's law to the entire contract, even if it requires applying that state's law to activities outside the state”). The court noted that since the parties contemplated that the franchisee maintain a place of business in New Jersey and bound themselves to a multi-state distribution agreement, this agreement operated to project the New Jersey law outside of New Jersey's borders to cover the parties conduct in the other states, as well. Id.

New York

New York's statutory “franchise” definition is considered among the broadest in the country. No New York cases were found in which a court converted a trademark license into a franchise. Nonetheless, under New York's franchise statute it would seem that such a conversion could occur under a variety of circumstances.

While most jurisdictions require both a “marketing plan” (or “community of interest”) and use of a trademark or other commercial symbol, New York requires only one or the other to exist, plus the payment of a “franchise fee” in order for a “franchise” relationship to exist. N.Y. Gen. Bus. Law '681. New York's franchise law applies to brand owners who are located in New York and license their trademarks within or outside the state, or are located outside of New York and form a relationship with a trademark licensee within New York.

New York's franchise law also includes exceptions for certain types of payments from the statutory definition of “franchise fee,” such as payment for products at the bona fide wholesale price, payment of a fee not exceeding $500 annually where the licensee receives sales material of equal or greater value than its payment; and the purchase of sales demonstration equipment and materials furnished at cost for use in making sales and not for resale. N.Y. Gen. Bus. Law '681(7)(a). Payments for ordinary business expenses and to unaffiliated third parties do not constitute “franchise fees.” In re The Matterhorn Group, Inc., v. SMH Inc., Nos. 97-B-41274, 97-B-41277, 97-B-41275, 97-B-41278, 97-B-41276, 2000 WL 1174215, at *9 (Bankr. S.D.N.Y. Aug. 17, 2000).

The above statutory carve-outs are intended to protect brand owners from the franchise surprise. But, New York's case law is not as clear-cut regarding the types of payments that may constitute a “franchise fee.” Recent New York cases focus on the existence of hidden franchise fees ' payments by the trademark licensee which are the equivalent of a franchise fee. For example, the existence of a “franchise fee” has been found where the distributor was required to pay either a one-time fee or a monthly payment over a four-year period, notwithstanding the fact that the fee was characterized as a “lease” rather than a “franchise fee.” Zito v. Leasecomm Corp., No. 02 Civ. 8074, 2003 U.S. Dist. LEXIS 17236, at *80-*81 (S.D.N.Y. Sept. 30, 2003). Further, where a licensee alleged that it paid a $31,000 fee to distribute a brand owner's product and was also required to spend money on marketing the product (and did spend tens of thousands of dollars) for the benefit of the brand owner, the court found this to be adequate allegation of a franchise fee. Cal Distributor, Inc. v. Cadbury Schweppes Americas Beverages, Inc., No. 06 Civ. 0496, 2007 U.S. Dist. Lexis 854, at *19 (S.D.N.Y. Jan. 5, 2007).

On the other hand, a “franchise fee” was not found where a trademark licensee was “required to bear the cost of designing, constructing, opening and operating its Swatch stores as a condition to the right to sell Swatch products” and “part of the wholesale price it paid for inventory was to be allocated to Swatch 'coop' advertising, and if not used, retained by [the brand owner].” In re The Matterhorn Group, Inc., v. SMH Inc., 2000 WL 1174215, at *9. Since the costs of construction and other costs incurred by the trademark licensee were not paid directly to the brand owner, the court held that these expenses did not constitute a hidden franchise fee.

It is difficult to reconcile this holding with that in Cal Distributor, finding adequate allegations regarding the existence of a franchise fee, since in both cases the trademark licensees spent money on marketing. The only distinction was that the licensee in Cal Distributor paid money directly to the brand owner. This is a distinction without a difference when one considers that both payments technically satisfy the statutory definition of “franchise fee” as payments for the right to distribute the goods. N.Y. Gen. Bus. Law '681(7).

The penalties prescribed under the New York statute are perhaps the most far-reaching of any state, in that any person who offers or sells a “franchise” in violation of the statutory regime “is liable to the person purchasing the franchise for damages and, if such violation is willful and material, for rescission, with interest at 6% per year from the date of purchase, and reasonable attorney fees and court costs.” N.Y. Gen. Bus. Law '691. Even more serious for an accidental franchisor, liability under this provision may be extended beyond the corporate organization to the individuals involved in the transaction. Vysovsky v. Glassman, No. 01 Civ. 2531, 2007 U.S. Dist. LEXIS 79725 (S.D.N.Y. Oct. 23, 2007) (denying defendants' motion for summary judgment and finding a genuine issue of material fact as to the individual and collective liability of franchisors under the statute, noting that this provision “effectively dissolves the corporate veil by making corporate officers and directors jointly and severally liable under the FSA if they materially aid[] in the act [or] transaction constituting the violation”).

Conclusion

The state franchise statutes and case law raise many unanswered questions for brand owners. Can a brand owner circumvent the statutes merely by requiring a trademark licensee to make all payments for advertising to a third party? Would this still qualify if any of the unused payments revert back to the brand owner as part of the required royalty payment? Are “design fees” or other one-time fees considered “franchise fees” if they are over $500 and paid directly to the brand owner? Accordingly, brand owners should proceed with caution when entering into trademark licenses that fall under the franchise laws.

Marc Lieberstein is a partner in the New York office of Day Pitney and a member of the firm's Trademark, Copyright, Advertising & Internet Group, specializing in intellectual property litigation and licensing. Rebecca L. Griffith is an associate in that office and group. Lex Paulson, an associate in the group, and in the Stamford, CT, office, provided assistance with this article.

In many states, the statutory definition of “franchise” has been, and could be, construed broadly to include relationships between brand owners and their trademark licensees, even though neither party intended to create a franchise relationship. Brand owners can only avoid the franchise surprise if they know the rules of the game.

States' Definitions

The majority of states have definitions largely resembling the FTC's franchise rules and require the presence of all three elements of the FTC's definition of a franchise: 1) use of a trademark; 2) a significant degree of control; and 3) payment of a fee by the franchisee. Twenty-seven states have statutory franchise definitions that are applied only in specific commercial contexts, including the regulation of motor vehicles (Alabama, Arizona, Georgia, Idaho, Iowa, Kansas, Kentucky, Louisiana, Maine, Massachusetts, Nebraska, Pennsylvania, South Carolina, Texas, Utah, and Wyoming), recreational vehicles (Maine and Utah), alcohol distributors (Montana, Nevada, New Mexico, North Carolina, Ohio, Tennessee, and Vermont), and petroleum products (Nevada, New Hampshire, and West Virginia). Two states (Alaska and Colorado) have no statutory franchise definition at all.

In the 23 remaining states where franchises are more broadly regulated, if any one statutory element is missing from the relationship, then it does not constitute a franchise. However, where a brand owner's/licensor's trademark license falls within the scope of the state franchise statute, the licensor could find itself unintentionally operating a franchise in violation of the state's franchise regulations.

Rules of the Game

To illustrate the rules of the “franchise” game for unsuspecting brand owners, we review the franchise law and its application in four states where a significant amount of trademark licensing and franchising occurs ' California, Illinois, New Jersey, and New York. California, Illinois, and New York are registration states. Further, California, Illinois, and New Jersey have franchise relationship laws, which govern when, and under what circumstances, a franchise may be terminated or not renewed. Generally, these state laws also address aspects of the franchise relationship, such as discriminatory treatment, fair dealing, the ability of franchisees to associate, and the minimum advance notice of franchise termination. Using these states as examples, brand owners should be able to navigate the franchise rules and, if desired, avoid the “franchise” tag when licensing their trademarks.

California

California has two general franchise laws: the California Franchise Relations Act, or “CFRA” (Cal. Bus. & Prof. Code ”20000-20043), and the California Franchise Investment Law, or “CFIL” (Cal. Corp. Code ”31000-31506). The CFRA applies to licensees who are domiciled in California or to brand owners who have operated a “franchised business” in California. Cal. Bus. & Prof. Code '20015. The CFIL applies to brand owners who are located in California and license their trademarks within or outside the state, or who are located outside of California and form a relationship with a trademark licensee within California. Cal. Corp. Code '31013.

The “franchise” elements under both California laws require the “use of a trademark,” the existence of a “marketing plan” prescribed in substantial part by the brand owner, and the licensee's payment of a “franchise fee.” Cal. Bus. & Prof. Code '2001; Cal. Corp. Code '31005. Exempted from the definition of “franchise fee” is the licensee's purchase of goods at bona fide wholesale price if no obligation is imposed to purchase a quantity of goods in excess of that which would reasonably be purchased, either as starting inventory or maintenance of inventory. Cal. Bus. & Prof. Code '2007; Cal. Corp. Code '31011. The CFRA requires franchisors to have good cause to terminate, not renew, or cancel a franchise, whereas the CFIL requires franchisors to make presale disclosures and register with a state agency before offering or selling franchises in the state. As in many other states, if the elements of the statute are met then a franchise may be deemed created, even if a contract expressly states otherwise. Gabana Gulf Distribution, Ltd. v. Gap Int'l Sales, Inc., No. C 06-02584, 2006 U.S. Dist. LEXIS 59799, *19-(20 (N.D. Cal. Aug. 14, 2006).

California courts have repeatedly noted that each element of the “franchise” statutory definition should be “construed liberally to broaden the group of investors protected by the law.” Kim v. Servosnax, Inc. , 10 Cal. App. 4th 1346, 1356 (1992). Even so, the courts have been careful when examining whether amounts paid by a trademark licensee, either directly or indirectly, constitute franchise fees. For instance, a trademark licensee's expenses for telephone line fees and computer terminal costs were deemed not to be a franchise fee and “nothing more than ordinary business expenses and not an investment required by [the brand owner] for the right to operate a dealership.” Thueson v. U-Haul Intl. , 144 Cal. App. 4th 664, 673, 676 (Calif. 1st Ct. App. 2006). Providing some guidance on the “franchise fee” determination, the court noted that the trademark licensee “made no required contribution of capital, made no unrecoverable investment in the [brand owner], was not required to purchase any inventory, and was not required to purchase services from [the brand owner] in order to become a dealer.” Id. at 676. Further, the licensee “placed none of his own funds, even the de minimis amounts required under [the statute], at risk in exchange for the dealership.” Id.

But, in a case considered to be an expansion of California franchise law, a franchise relationship was found between a manufacturer of record-keeping systems and office products and its commissioned sales agents. In Gentis v. Safeguard Business Systems , 60 Cal. App. 4th 1294, 1305 (Calif. 2d Ct. App. 1998), the manufacturer argued that it did not have a franchise because its sales agents did not offer, sell, or distribute goods or services under a marketing plan ' a required element of California's franchise laws. Nonetheless, the court found that the sales representatives were franchisees because, among other things, they solicited orders, demonstrated products, solved customer problems, installed the manufacturer's systems, maintained contact with existing customers, generated new business, and provided ongoing support to customers. Id. at 1305. Therefore, even though they could not enter into a contract and effectuate a sale, the sales agents' arrangements with the manufacturer were considered a franchise relationship.

An accidental franchise in California can be quite costly, i.e., liability for damages or even rescission, if the business relationship sours and the opposing party asserts the statutory franchise requirements to show non-compliance. Cal. Corp. Code '31300 provides that “any person who offers or sells a franchise in violation of Section 31101, 31110, 31119, 31200, or 31202 ' shall be liable to the franchisee or subfranchisor, who may sue for damages caused thereby, and if the violation is willful, the franchisee may also sue for rescission.” Cal. Corp. Code ' 31300. See Dollar Systems, Inc. v. Avcar Leasing System, Inc. , 673 F. Supp. 1493, 1504 (D. Cal. 1987) (Franchise buyer was entitled to rescission of agreement and restitutionary damages totaling $715,250.91, plus attorney's fees, after franchise seller violated and was grossly negligent in its compliance with various state and federal investment laws.)

Illinois

The Illinois Franchise Disclosure Act of 1987 (“Disclosure Act”) applies to brand owners who are located in Illinois and license their trademarks within or outside the state, or are located outside of Illinois and form a relationship with a trademark licensee within Illinois. ' 815 ILCS 705/6. The elements of a “franchise” under the Disclosure Act are “use of a trademark,” a “marketing plan,” and payment of a “franchise fee” of $500 or more. '815 ILCS 705/3. The parties' subjective intent is not determinative ' if an agreement meets the criteria set forth in the franchise statute then a franchise relationship is created, even if a written agreement between a brand owner and authorized dealer specifically stated that it did not constitute a franchise agreement. Calderon v. Southwestern Bell Mobile Sys. , 390 F. Supp. 2d 714, 720-21 (N.D. Ill. 2005). In Calderon, the dealer successfully alleged a franchise was granted because the three-part test was satisfied: 1) It was granted the right to sell the brand owner's products and services; 2) The dealer's operation was substantially associated with the brand owner's trademark; and 3) The dealer was required to pay the brand owner a $1000 fee for the right to sell the brand owner's products and services. Id.

A potential pitfall for brand owners is that even if a franchise is not created at the inception of the parties' relationship, it can become a franchise if the relationship later satisfies the requirements of the statute. This happened in To-Am Equipment Co. v. Mitsubishi Caterpillar Forklift America, Inc. , 152 F.3d 658, 659-60 (7th Cir. 1998) where a tractor manufacturer/distributor relationship became a franchise when the distributor's incremental payments for sales manuals over the course of eight years exceeded Illinois' $500 statutory threshold. The penalty for the manufacturer's violation of the Illinois franchise law? An award of $1.5 million to the terminated distributor. Id. Strikingly, the court noted that it understood the manufacturer's concern that dealerships in Illinois are “too easily categorized as statutory franchisees,” however, “that is a concern appropriately raised to either the Illinois legislature or Illinois Attorney General, not to this court.” Id. In Bly & Sons, Inc. v. Ethan Allen Interiors, Inc., No. 05-668, 2006 U.S. Dist. LEXIS 62629 (D. Ill. 2006), the terminated licensee convinced the court that a franchise existed under 815 Ill. Comp. Stat. 705/3(1) because a contribution to an advertising fund was an indirect franchise fee. The court agreed and awarded limited costs and attorney fees to the licensee under the Illinois Franchise Disclosure Act due to wrongful termination. Id.

New Jersey

Brand owners who license their trademarks to distributors or other licensees maintaining a place of business in New Jersey should be aware of New Jersey's Franchise Practices Act (“NJFPA”). If a licensee is located in New Jersey, courts will apply the NJFPA to cover the brand owner/licensee relationship even where the application of New Jersey law supersedes the contractually agreed-upon choice-of-law clauses selecting the law of another state. Instructional Sys. v. Computer Curriculum Corp. , 130 N.J. 324, 341-46, 367 (N.J. 1992). Also, where New Jersey law governs an agreement encompassing a multi-state territory, the NJFPA has an extraterritorial reach over franchise activities in those states other than New Jersey, which are covered by the agreement. Instructional Sys. v. Computer Curriculum Corp. , 35 F.3d 813, 825 (3rd Cir. 1994).

New Jersey's unique statutory “franchise” definition does not require a “franchise fee,” but it does require a “license to use a trademark,” a “community of interest,” and gross sales of products between the franchisor and the franchisee exceeding $35,000 for the 12 months preceding the institution of suit pursuant to the Act, with not more than 20% of the licensee's gross sales intended to be derived from such franchise. It also requires that the franchisee's business be in New Jersey. N.J. Stat. ' 56:10-3 ' 56:10-4. Clearly, brand owners can avoid the NJFPA in several ways, the simplest of which could be not to have more than $35,000 of sales per year with licensees, i.e., let others deal directly with the licensees.

Brand owners can easily circumvent the “license to use a trademark” element of the NJFPA. This element has been applied narrowly, perhaps in recognition of the fact that the law was not intended to encompass brand owners. In New Jersey, “merely selling goods or distributing materials bearing the manufacturer's name or trademark does not constitute a 'license to use a trademark'” within the meaning of the NJFPA. Atlantic City Coin & Slot Serv. Co. v. IGT , 14 F. Supp. 2d 644 (D.N.J. 1998) (citation omitted); see also Cassidy Podell Lynch, Inc. v. Syndergeneral Corp. , 944 F.2d 1131 (3rd Cir. 1991) (holding that “if a manufacturer merely furnishes advertising materials to a distributor, and allows the distributor to place its name alongside the manufacture's name on such materials, a license is not created”). Therefore, even where an agreement between a brand owner and its trademark licensee may technically fall within the definition of a “franchise,” New Jersey courts have found an exemption for straightforward trademark licenses.

Notwithstanding the court's exemption for straightforward trademark licenses, brand owners must be careful to avoid creating the impression in the mind of consumers that there is connection between the brand owner and the licensee, such that the brand owner “vouches for” the activity of the trademark licensee. Atlantic City Coin & Slot Serv. Co., 14 F. Supp. 2d 644. This type of relationship will bring a brand owner within the ambit of the NJFPA.

For example, a relationship was deemed a “franchise” when, through advertising and signage, the distributor used the manufacturer's trade name “in such a manner to create a reasonable belief on part of the consuming public that there is a connection between them” such that the manufacturer vouches for the distributor's activities. Cooper Distributing v. Amana Refrigeration, No. 91-5237, 1992 U.S. Dist. LEXIS 17918, at *8,*10 (D.N.J. Jan. 23, 1992) (Evidence confirmed that consumers believed that the manufacturer and distributor were affiliated, i.e., the distributor was designated as an authorized warranty repair center, it was required to maintain advertisements in the Yellow Pages proclaiming itself as such, it was required to maintain signs bearing the manufacturer's trade name, and it drove trucks with decals provided by the manufacturer.) Accordingly, while brand owners can and should control and monitor the branded products/services provided by their licensees, they should not interfere too much with the licensee's actual business operation to create the false impression that the brand owner and licensee are affiliated in any other way. Brand owners must ensure that their trademark licensees do not present themselves to the public in a way that could create the appearance of an affiliation between the parties.

Brand owners also need to be aware of the “community of interest” franchise element of the NJFPA, which focuses on whether there is a “disparity in bargaining power between the licensor and licensee” and reviews factors such as a licensor's control over the licensee, the licensee's economic dependence on the licensor, and the presence of a franchise-specific investment by the licensee. Id.

In one New Jersey case, the community-of-interest element was used to find a franchise where, though the distributor at all times operated under its own name and did not adhere to any structural or procedural scheme and never paid a license fee, the distributor had the right to use the producer's name, trademark, and logo in its advertising, exhibits, trade shows, public relations materials, and manuals, and the duty to use its best efforts to promote the producer's products, which had the effect of appearing to consumers that the two entities were related. Instructional Sys. v. Computer Curriculum Corp. , 130 N.J. at 351-55. Further, a community of interest was found where the distributor made “franchise-specific investments” ' such as purchasing copyrighted computer software ' and the distributor had developed goodwill and contacts, none of which could be used if the relationship with the brand owner ended. Id. at 366.

The Instructional Sys. v. Computer Curriculum Corp. case is also significant because the United States Court of Appeals for the Third Circuit has held that the NJFPA could have extraterritorial reach to franchise activities in states other than New Jersey where an agreement encompasses a multi-state territory. 35 F. 3d at 825 (holding “[w]hile a contract which covers multiple states may raise a difficult choice-of-law question, once that question is resolved there is nothing untoward about applying one state's law to the entire contract, even if it requires applying that state's law to activities outside the state”). The court noted that since the parties contemplated that the franchisee maintain a place of business in New Jersey and bound themselves to a multi-state distribution agreement, this agreement operated to project the New Jersey law outside of New Jersey's borders to cover the parties conduct in the other states, as well. Id.

New York

New York's statutory “franchise” definition is considered among the broadest in the country. No New York cases were found in which a court converted a trademark license into a franchise. Nonetheless, under New York's franchise statute it would seem that such a conversion could occur under a variety of circumstances.

While most jurisdictions require both a “marketing plan” (or “community of interest”) and use of a trademark or other commercial symbol, New York requires only one or the other to exist, plus the payment of a “franchise fee” in order for a “franchise” relationship to exist. N.Y. Gen. Bus. Law '681. New York's franchise law applies to brand owners who are located in New York and license their trademarks within or outside the state, or are located outside of New York and form a relationship with a trademark licensee within New York.

New York's franchise law also includes exceptions for certain types of payments from the statutory definition of “franchise fee,” such as payment for products at the bona fide wholesale price, payment of a fee not exceeding $500 annually where the licensee receives sales material of equal or greater value than its payment; and the purchase of sales demonstration equipment and materials furnished at cost for use in making sales and not for resale. N.Y. Gen. Bus. Law '681(7)(a). Payments for ordinary business expenses and to unaffiliated third parties do not constitute “franchise fees.” In re The Matterhorn Group, Inc., v. SMH Inc., Nos. 97-B-41274, 97-B-41277, 97-B-41275, 97-B-41278, 97-B-41276, 2000 WL 1174215, at *9 (Bankr. S.D.N.Y. Aug. 17, 2000).

The above statutory carve-outs are intended to protect brand owners from the franchise surprise. But, New York's case law is not as clear-cut regarding the types of payments that may constitute a “franchise fee.” Recent New York cases focus on the existence of hidden franchise fees ' payments by the trademark licensee which are the equivalent of a franchise fee. For example, the existence of a “franchise fee” has been found where the distributor was required to pay either a one-time fee or a monthly payment over a four-year period, notwithstanding the fact that the fee was characterized as a “lease” rather than a “franchise fee.” Zito v. Leasecomm Corp., No. 02 Civ. 8074, 2003 U.S. Dist. LEXIS 17236, at *80-*81 (S.D.N.Y. Sept. 30, 2003). Further, where a licensee alleged that it paid a $31,000 fee to distribute a brand owner's product and was also required to spend money on marketing the product (and did spend tens of thousands of dollars) for the benefit of the brand owner, the court found this to be adequate allegation of a franchise fee. Cal Distributor, Inc. v. Cadbury Schweppes Americas Beverages, Inc., No. 06 Civ. 0496, 2007 U.S. Dist. Lexis 854, at *19 (S.D.N.Y. Jan. 5, 2007).

On the other hand, a “franchise fee” was not found where a trademark licensee was “required to bear the cost of designing, constructing, opening and operating its Swatch stores as a condition to the right to sell Swatch products” and “part of the wholesale price it paid for inventory was to be allocated to Swatch 'coop' advertising, and if not used, retained by [the brand owner].” In re The Matterhorn Group, Inc., v. SMH Inc., 2000 WL 1174215, at *9. Since the costs of construction and other costs incurred by the trademark licensee were not paid directly to the brand owner, the court held that these expenses did not constitute a hidden franchise fee.

It is difficult to reconcile this holding with that in Cal Distributor, finding adequate allegations regarding the existence of a franchise fee, since in both cases the trademark licensees spent money on marketing. The only distinction was that the licensee in Cal Distributor paid money directly to the brand owner. This is a distinction without a difference when one considers that both payments technically satisfy the statutory definition of “franchise fee” as payments for the right to distribute the goods. N.Y. Gen. Bus. Law '681(7).

The penalties prescribed under the New York statute are perhaps the most far-reaching of any state, in that any person who offers or sells a “franchise” in violation of the statutory regime “is liable to the person purchasing the franchise for damages and, if such violation is willful and material, for rescission, with interest at 6% per year from the date of purchase, and reasonable attorney fees and court costs.” N.Y. Gen. Bus. Law '691. Even more serious for an accidental franchisor, liability under this provision may be extended beyond the corporate organization to the individuals involved in the transaction. Vysovsky v. Glassman, No. 01 Civ. 2531, 2007 U.S. Dist. LEXIS 79725 (S.D.N.Y. Oct. 23, 2007) (denying defendants' motion for summary judgment and finding a genuine issue of material fact as to the individual and collective liability of franchisors under the statute, noting that this provision “effectively dissolves the corporate veil by making corporate officers and directors jointly and severally liable under the FSA if they materially aid[] in the act [or] transaction constituting the violation”).

Conclusion

The state franchise statutes and case law raise many unanswered questions for brand owners. Can a brand owner circumvent the statutes merely by requiring a trademark licensee to make all payments for advertising to a third party? Would this still qualify if any of the unused payments revert back to the brand owner as part of the required royalty payment? Are “design fees” or other one-time fees considered “franchise fees” if they are over $500 and paid directly to the brand owner? Accordingly, brand owners should proceed with caution when entering into trademark licenses that fall under the franchise laws.

Marc Lieberstein is a partner in the New York office of Day Pitney and a member of the firm's Trademark, Copyright, Advertising & Internet Group, specializing in intellectual property litigation and licensing. Rebecca L. Griffith is an associate in that office and group. Lex Paulson, an associate in the group, and in the Stamford, CT, office, provided assistance with this article.