The Compleat Lawyer - General Practice, Solo, and Small Firm Division American Bar Association
General Practice, Solo, and Small Firm Division
The Compleat Lawyer
Winter 1997, Volume 14, No. 1
copyright American Bar Association. All rights reserved.

Franchise Law

BY DAVID GURNICK

David Gurnick is a lawyer at the Woodland Hills, California, office of Arter & Hadden. The author thanks David Laufer for his assistance in preparing the article.

More and more, people want to own their own business yet be part of a larger organization. Franchising is a distribution system that lets people license a trademark and receive instruction on how to operate their business in exchange for payment of a license fee to the franchisor.

Franchising's growth has been so explosive that today, according to the U.S. Commerce Department, over one-third of all retail sales occur at franchised locations. The growth of franchising makes it likely that every lawyer's practice will involve franchise matters from time to time. For example:

  • More personal injury claims now arise from accidents at franchised locations.
  • Many business deals are sales and purchases of business franchises, leases for franchise locations, and purchases of equipment for franchises.
  • Many business disputes involve franchise owners, customers, employees, or suppliers.
  • More insurance and workers' compensation claims arise in the context of franchises.
  • More divorces, decedents' estates, and tax disputes involve interests in franchised businesses.

The Nature of a Franchise
Franchises have three elements in common:

  • They feature an important trademark or service mark (like the "golden arches" of McDonald's or "Texaco"), which the independent owner is licensed to use at his or her location.
  • The owner of the trademark (the franchisor) provides information to the licensee on how to operate the business. This is called a "marketing plan." Often, information is provided through in-person training programs, operating manuals, and assistance in the franchisee's operation.
  • In exchange for these services, the franchisee pays money to the franchisor, often a substantial start-up fee and an ongoing fee paid in the form of a weekly or monthly royalty (typically a fixed percentage of gross sales at the franchised location).

Franchise Regulation
Franchisors must comply with many special legal requirements of the Federal Trade Commission and the laws of 17 states (California, Florida, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Texas, Utah, Virginia, Washington State, and Wisconsin).

The FTC's franchise rule (16 C.F.R. 436.1, et seq.) and the 17 state laws on franchising are presale disclosure laws. These laws ensure that prospective franchisees receive detailed information so that they can make informed decisions about whether to invest in a franchise being offered, and to prohibit sales of franchises when it is likely that the franchisor's promises will not be met. If your client is considering whether to buy a franchise, find out if he or she has received required presale disclosures.

The presale disclosures required by the FTC include 22 categories of information covering the franchisor's business background, litigation history, all payments to be made under the franchise agreement, the amount of the franchisee's investment, renewal and termination terms, and details on training and other help the franchisor promises to provide. If the franchisor makes claims about actual or potential earnings of franchisees, then detailed substantiation of the claim is also required.

The state laws require the franchisor to register its offering with a state agency before making any offer or sale of a franchise. Some franchisors may be able to qualify for exemptions from the registration laws. If an exemption is not available, then the franchisor must file an application to register the offer. The application must include the same extensive information about the franchisor and franchise arrangement as the FTC rule requires. This is contained in the form of an offering prospectus modeled after the federal securities laws.

The franchisor must provide the prospectus and copies of all proposed agreements for the franchise at (1) the first personal meeting with the prospective franchisee, (2) at least ten business days before any binding agreement is signed relating to the franchise, or (3) at least ten business days before the franchisor receives any fee or other consideration, whichever is earliest (16 C.F.R. Sec. 436.2(g)). A lawyer whose client has received disclosures should inquire whether they were provided as early as required.

Vicarious Liability in Franchising When someone has an accident at a franchise location, or when a franchisee does not pay his or her bills, is the franchisor liable? This franchise law issue generates a great amount of litigation.

For example, an individual suffers an injury at a franchise location, and delays consulting a lawyer until just before the statute of limitations is about to expire. The lawyer knows that the injury was suffered at a location of a major chain, and either doesn't have enough time to investigate whether the location is company-owned or operated by a franchisee, or is unaware that franchised locations are independently owned. The claim is filed, and identifies the defendant using the name of the franchise.

Often, the franchisor defendant responds that the franchisee gave notice that it was independently owned and operated; it has no information about the incident and no liability for the incident. However, it may be too late to add the individual franchisee as a defendant to the lawsuit.

There are two theories of vicarious liability. A franchisor can be vicariously liable for acts and incidents at a franchised location if the franchisor controls the franchisee's operations to such a great extent that the law would treat the franchisee as merely carrying out directives of the franchisor, thereby establishing a principal-agent relationship. The other main theory is based on the doctrine of estoppel. A franchisor is estopped to deny that the franchisee is its agent, if the franchisor actively or by omission creates the appearance that the franchisee is the agent of the franchisor, so that the public reasonably perceives the franchisee as the agent of the franchisor. Most states let the franchise regulatory agency deny, suspend, or revoke any registration on finding that the offer or sale of the franchise would constitute misrepresentation, deceit, or fraud as to purchasers. Registration of a franchise offering usually lasts one year. Some exemptions from registration require the filing annually of a notice of exemption and a fee payment.

Franchise Relationship Laws
In addition to presale registration and disclosure laws, a number of states have laws that restrict a franchisor from terminating a franchisee before the expiration of the franchise agreement or refusing to renew an expired contract. Recognizing that franchisees make a substantial investment in developing their franchise business, these laws protect franchisees against early terminations or nonrenewals unless the franchisor has "good cause" for its action.

Often the statutes go on to define good cause. A typical definition is that good cause means failure to cure a breach of the franchise agreement after notice and a reasonable opportunity to cure ( Cal. Bus. & Prof. Code 20020) or failure to comply with reasonable requirements imposed on a dealer without discriminating compared to similarly situated dealers (Wisc. Stats. 135.02(4)).

Some state laws also protect the value that a franchisee builds in a franchise for the benefit of spouses and other heirs by mandating that the spouse and other heirs of a deceased franchisee be given an opportunity to operate the franchise before the franchisor can terminate it due to death of the franchisee.

Unknowingly Entering into a Franchise Agreement
Any business arrangement may be a franchise if the three key elements (trademark, marketing plan, and franchise fee) are present. Transactions that deviate from the traditional franchise arrangement may still fall within the definition of a franchise. One example is an agreement granting an individual an exclusive right to sell a product in a stated area. If the distributor must spend money to advertise or to maintain a large inventory, the fee element may be present. If the manufacturer recommends marketing methods (such as in an operating manual or in product specifications), the marketing plan may be present. The product's name or a distinctive logo associated with the product may satisfy the trademark element. If all three of these elements are present, the arrangement would be subject to federal and state franchise laws.

Franchise law questions can arise when a restaurant, car mechanic, real estate office, or other business owner lets a good employee start their own new location using the same name in exchange for a small share of the profits. There have been decisions in which business relationships were unexpectedly found to be franchises. (See, e.g., Boat & Motor Mart v. Sea Ray Boats, 825 F.2d 1285 (9th Cir. 1987); Kim v. ServoSnax, 10 Cal.App.4th 1346 (1992).)

Unknowingly entering into a franchise arrangement creates unexpected risks and costs for all parties. Any person who offers or sells a franchise in violation of the registration and prospectus delivery requirements of a franchise investment law is liable to the franchisee for damages; and in certain cases of willful violation, the franchisee is entitled to rescind the agreement. Violations also may result in civil penalties and, if the violation is willful, criminal penalties.

If the relationship is a franchise, the franchisor will be unable to terminate the relationship except in compliance with applicable franchise relationship laws. The franchisor may even be compelled to renew the agreement if the franchisee so desires.

The federal rule has no private right of action that can be asserted by a franchisee against a franchisor. But there are civil and criminal sanctions available to the Federal Trade Commission in an action asserted by it against a franchisor, including substantial monetary penalties, and the ability to require refunds of money, return of property to a franchisee, or payment of damages.

A franchisee who does not know the status of the relationship may be unaware of the protected status of franchisees under law, and may therefore fail to take advantage of available legal protection or assert rights granted by law.

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