GPSolo Magazine - September 2005
Avoiding the Franchise Surprise in “IP” Licensing Agreements
Transactions that IP lawyers view as simple intellectual property licenses may have all the elements that make their agreements franchises, subjecting them and the relationships they create to regulations that govern business franchises. Ignorance of franchise laws and their wide scope can lead to unintended risks and consequences. Clients may be put at risk of violating the law by failing to satisfy statutory registration and disclosure requirements for offering and/or selling a franchise, or they may be deprived of statutory benefits they are entitled to as franchisees. Lawyers who overlook franchise laws may be criticized (or worse) by their clients.
To reduce these risks, IP practitioners need a basic understanding of the nature of a franchise relationship, the elements of a relationship that turn it into a franchise, how and when an IP license may be a franchise, and how a licensing or other transaction can be structured to avoid the broad reach of the franchise laws.
What is a franchise? There is no uniform definition. Rather, there are multiple definitions adopted by the Federal Trade Commission (FTC), by various states that regulate offers and sales of franchises, and by states that regulate the ongoing franchisor–franchisee relationship or the termination of the relationship.
The FTC rule defines a franchise as a continuing commercial relationship created by any arrangement in which (1) the franchisee offers, sells, or distributes goods or services supplied by a franchisor and identified by a trademark or other commercial designation owned by the franchise; (2) the franchisor exercises significant control or provides significant assistance in the franchisee’s method of operation and secures a retail outlet or other site for the sale or distribution of the goods or services; and (3) the franchisee is required as a condition of obtaining or starting the franchise operation to make a payment to the franchisor or its affiliate of $500 or more within six months after starting operation.
Most states define a franchise as containing a “marketing plan or system” element. They define a franchise as a continuing commercial relationship in which (1) the franchisor grants the franchisee the right to engage in a business using a marketing plan or system prescribed in substantial part by the franchisor; (2) the franchisee’s business is substantially associated with the franchisor’s trademarks, service marks, trade names, or other commercial designation; and (3) the franchisee pays a fee. These elements are often referred to in shorthand as a marketing plan, trademark license, and franchise fee.
The trademark element. A mere grant of authority to use another’s trademark, service mark, trade name, or other commercial designation, whether or not the licensee actually uses the mark, is sufficient to satisfy the trademark requirement. When a licensee sells goods or services bearing marks owned by a licensor or when a licensee’s operations are conducted under a name associated with a licensor, the required trademark use can also be present.
The marketing plan element. A typical franchise arrangement involves a level of control exerted by the franchisor over the franchisee’s operating hours and techniques, accounting practices, employment policies, advertising, and business location. However, the marketing plan element may also be present if assistance is provided in such areas as business training, management, personnel, or in cases where there are site or warranty requirements, inventory controls, or display requirements. A marketing plan may be deemed to exist merely on the basis of controls designed to protect ownership rights in a trademark or service mark.
The franchise fee element. A franchise fee includes any fee or charge that a franchisee is required to pay for the right to enter into a franchise arrangement. Typical are payments for such items as royalties, rents, advertising, training, promotional materials, supplies, and bookkeeping. Purchases from third parties in which the franchisor or an affiliate of the franchisor receives revenue can also satisfy the fee requirement.
Unexpected franchises. With the broad view of the law applied by courts, it is not difficult to hypothesize parties to a seemingly routine patent, trademark, or copyright license facing the surprise of a cogent assertion that the license includes all the elements of a franchise. As an example, a patent license might include a commitment by the patent owner to provide training in the use of the invention and even ongoing marketing and sales consultation. It would not be unusual for the license to encourage the licensee to make use of a clever name or trademark conceived by the patent owner. If, as is usual, the patent licensee pays a royalty to the owner, then all of the elements of a business franchise are potentially present in the relationship.
Implications of the accidental IP franchise. States with franchise registration and disclosure laws prohibit offering or selling a franchise unless the offer is registered with the state’s franchise law administrator or exempted from registration.
The application must be accompanied by an offering prospectus that discloses material information to prospective franchisees. When approved by the state, the prospectus, together with copies of all proposed agreements, must be provided to a prospective franchisee, and a cooling-off period must elapse before the franchisee can sign any agreement or pay any money relating to the franchise.
In non-registration states, the franchisor must still prepare an offering prospectus and abide by the FTC disclosure requirements, but pre-registration with a government agency is not required.
Unknowingly entering into a franchise arrangement creates unexpected risks and costs. Any person who offers or sells a franchise in violation of the registration, disclosure, and cooling-off requirements is liable to the franchisee for damages caused, and in cases of willful violation, the franchisee is entitled to rescind the agreement and recover the investment. Criminal sanctions are also potentially available.
How to avoid being an accidental franchise. A logical way to avoid application of the franchise laws is to structure the transaction to eliminate one of the elements so that the definition of a franchise is avoided. This means a choice of the following:
Avoid a marketing plan. If a transaction involves payment of fees together with the license of a trademark, then make sure it does not involve the right to distribute goods or services under a marketing plan provided by the entity granting the right. The most straightforward way to avoid this element is to offer no assistance, control, or guidance to the other party to the transaction, except the bare minimum inspection rights that may be needed to protect the licensed trademark.
Avoid the license of a trademark. If a business transaction involves permission to a party to distribute goods and services together with guidance or assistance amounting to a marketing plan, then prohibit the distributor from associating its business with the originator’s trademark.
Avoid a franchise fee. In most states and under the FTC rule, the mere payment for goods sold at bona fide wholesale prices to be resold from inventory is not a franchise fee.
The franchise laws also include exemptions that can be the basis for structuring a transaction to avoid the laws’ most onerous provisions. The most common state exemptions are based on:
- the size of the franchisor;
- the sophistication of the franchisee;
- sales by one franchisee to another either without or with franchisor involvement;
- limited franchise offers (to one or two franchisees);
- small initial investment; and
- the offer of a franchise that is merely the addition of a product or service to an existing business, where the parties do not expect that the additional product or service will account for more than 20 percent of the sales of the existing business.
For More Information About the Section of Intellectual Property Law
- This article is an abridged and edited version of one that originally appeared on page 1 of IPL Newsletter, Winter 2005 (23:2).
- For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-221.
- Website: www.abanet.org/intelprop.
- Periodicals: IPL Chair’s Bulletin, a monthly update of Section activities and timely intellectual property issues; IPL Newsletter, a quarterly newsletter with current developments and Section news; Annual Report, a comprehensive summary of committee activities.
- Books and Other Recent Publications: Pamphlet series intended for clients, including Marketing Your Invention, Submitting an Idea, What Is a Patent?, What Is a Trademark?, and What Is a Copyright? Extensive course materials in connection with CLE programs are also available.