Accidental Franchises<br><i><font size="-1">When Licensing Deals Take a Surprising and Unwanted Turn</i></font>

On the federal level, the Federal Trade Commission (FTC) regulates franchises under its authority to prevent fraud in the marketplace. Under FTC rules, a franchise is defined broadly as “any continuing commercial relationship or arrangement” that meets the three following definitional elements.

Granting a Trademark License

The first necessary element for the establishment of a franchise is that the franchisee's business is identified or associated with the franchisor's trademark, or the franchisee is granted the right to offer, sell, or distribute goods, services or merchandise that are identified or associated with the franchisor's trademark. Notably, this first element does not require that a franchisee operate directly under the name of the franchisor; rather this element can be satisfied by a franchisee simply using a symbol, slogan, or other indicator that affiliates it with a network. Additionally, practitioners must bear in mind that absent an express prohibition against use of the grantor's trademark, a right to use the mark will often be inferred even if the mark is, in fact, never used.

Exercise of Control

The second necessary element of a franchise relationship is that the franchisor exercises significant control over, or gives the franchisee significant assistance in, the franchisee's method of operation. Although determining the level of control and assistance necessary to create a franchise is subjective, because the FTC traditionally employs a very lax interpretation of the term “significant,” even the slightest exercise of control or provision of assistance can potentially trigger this element.

For example, a franchisor providing the franchisee with operations manuals, training programs, marketing advice or sales support have all been deemed sufficient to meet this element. Likewise, customer or territory restrictions imposed by a franchisor, production techniques or accounting practices dictated by the franchisor, and even the reservation of approval of site design or appearance by the franchisor have all found to meet this second requirement as well.

Payment

The third and final necessary element of a franchise relationship is that of payment; the franchisee must make a required payment or commit to make a required payment to the franchisor. It should be noted that the FTC rules do exempt payments of less than $500 made anytime before or during the first six months of operations. It is important to note, however, that many state franchise laws do not recognize a comparable exclusion for de-minimis amounts, or do not have a time period in which the dollar threshold is measured. Therefore, this exclusion is not available in some states and is of limited utility for a nationwide franchise or distribution arrangement. More widely recognized, however, is a federal exemption that excludes payments not exceeding the bona-fide wholesale price of inventory from this third element, provided that there is no accompanying obligation to purchase excessive quantities.

If all three of these elements are present, then the relationship will generally be deemed a “franchise” under federal law. Practitioners must be aware, however, that even if a particular relationship is not considered to be a franchise under federal or state laws, other regulatory measures may still apply.

One such measure relates to business opportunity arrangements; that is, arrangements in which a seller supplies a buyer with goods or services and assists the buyer in securing outlets, accounts, or locations in exchange for which the buyer is required to make at least a $500 payment during the first six months of operations. Notably, unlike the FTC rule relating to franchises, the FTC rules relating to business opportunity ventures, directly specify the manner of control/assistance necessary to being a relationship under this regulation. While FTC rules regulating “business opportunity ventures” regulate one specific type of business opportunity, state laws are often far broader and may regulate multiple types of business opportunities.

Consequences of the Franchise Relationship

If all three of the FTC definitional elements are present, FTC rules require that a franchise disclosure document be provided to any potential franchisee no less than 14 days prior to signing any binding documents with the franchisor, or securing any payment. The rules set out various items that must be disclosed in this document, including the franchisor's operating history and financial condition, among others. Notably, there is no registration requirement under the FTC rules, although many states do impose a registration requirement.

Failure to provide the proper disclosures as provided in the FTC rule has been deemed to constitute an “unfair and deceptive” trade practice under Section 5 of the FTC Act (15 U.S.C. §§ 41-58, as amended) and can subject the franchisor to enforcement proceedings by the FTC. For example, under the FTC Act, the FTC may impose fines, recover money on behalf of franchisees, and even require that franchisees be given the opportunity to rescind their franchise agreements.

Avoiding the Accidental Franchise

Unfortunately, there is no simple drafting shortcut that may be employed to avoid the creation of a franchise. For example, the name given to a particular agreement is wholly immaterial as to whether a franchise has been formed, since the existence of a franchise is purely statutory and cannot be disclaimed. Thus, recitals or other statements relating to the intent of the parties have no bearing and will generally not be considered in determining the existence of a franchise relationship. Nonetheless, practitioners are not left entirely without means of avoiding undesired franchises.

The best way to avoid unintentionally creating a franchise relationship is to draft licensing agreements with applicable franchise elements in mind. As discussed, commercial arrangements are regulated as franchises only if they fit within the prescribed statutory definitions. Because each element is essential to the definition of a franchise, negating one element is the most effective way to prevent the creation of an unintentional franchise agreement.

Even if all definitional elements of a franchise are indeed met by a particular transaction, practitioners should be aware that the FTC does provide several exemptions from the FTC franchise rules that ought to be examined on a case-by-case basis to assess applicability. For example, the FTC recognizes an exemption “when an established distributor adds a franchised product line to its existing line of goods.”

Such arrangements are generally not subject to the FTC's franchise rules so long as the franchisee is sufficiently experienced in the area of the franchise's business and if, at the time of entering into the agreement, the franchised business is expected to represent less than 20% of the franchisee's gross revenue for the reasonably foreseeable future. Another notable exemption recognized by the FTC relates to large investment arrangements. Specifically, this exemption applies to investments of at least $1 million (excluding certain costs). In a similar vain, the FTC also exempts “experienced and high net worth franchisees” that have been in business for at least five years and have a net worth of more than $5 million. However, it must be kept in mind that state laws relating to franchises vary and that exemptions available under the FTC rules are not necessarily available under state law regulations and vice-versa.

Also, it is critical for counsel to keep in mind that successfully avoiding franchise laws does not necessarily avoid application of other regulatory mechanisms such as business opportunity laws. Thus when advising a client on transactional matters, practitioners must consider not only whether the transaction might subject the client to franchise disclosure requirements, but also whether other regulatory measures such as business opportunity laws apply.

***** Tamara Kurtzman is the founder of TMK, a Beverly Hills-based law firm. She provides business advice to clients and serves as an outsourced general counsel for companies and entertainment entrepreneurs. Ms. Kurtzman can be reached at [email protected].