But It Doesn't Walk or Talk Like a Duck: The Perils of the Hidden Franchise

By William L. Killion and Sarah J. Yatchak

This article explores what it takes to establish a franchise relationship in the eyes of the law, examines the uncertainty surrounding the legal definitions of these business arrangements, and offers guidance for avoiding the perils of the hidden franchise.

The existence of a franchise is a matter of definition, pure and simple.

Definition of a franchise. The existence of a franchise is a matter of definition, pure and simple. Courts will find that a transaction is a “franchise” if three elements are present: (1) the grant or licensing of a right to use a trademark or trade name; (2) the payment of a “franchise fee” for the use of the mark or name; and (3) some variant of a community of interest, marketing plan, control, or assistance. The definition seems simple enough. For a company trying to avoid the “franchisor” label in the eyes of a court or the Federal Trade Commission (FTC), however, the only part of the definition that provides certain protection is the first part—the requirement of a license. As long as a company is not somehow permitting a third party to use a mark or name, it is not offering a “franchise.”

Mistakes can be costly. Navigating the patchwork of federal and state franchise laws is a daunting task. At the federal level, the FTC Trade Regulation Rule (FTC Rule) applies to franchise opportunities in each of the 50 states, all U.S. territories, and Washington, D.C. Thus, a company offering an investment that qualifies as a franchise under the FTC Rule must present a prospective franchisee with a disclosure document containing specific and detailed information about the franchisor and the opportunity. Although a franchisee wronged by the failure to disclose may not have a private right of action, the FTC can bring enforcement proceedings against the franchisor. In states with their own disclosure laws, a failure to disclose at all—or an incomplete or misleading disclosure—allows a franchisee to seek equitable relief and sometimes damages. In some states, the failure to make an accurate disclosure carries the additional risk of exemplary damages, criminal penalties, and fines.

Perhaps most troublesome, however, are the relationship laws adopted in various states. Some of these make it unlawful for franchisors to discriminate among franchisees, restrict the ability of franchisors to profit from the sale of goods to franchisees, and otherwise regulate the ongoing relationship between franchisor and franchisee. Almost all of these states allow franchisors to terminate only for cause before the end of the term of the agreement, and then only after providing the franchisee with notice of default and an opportunity to cure.

It’s all about the fee. Upfront payments for the right to do business under a particular name or mark and ongoing royalty payments are obvious examples of franchise fees. At the other end of the spectrum, courts have found that ordinary business expenses, optional payments, and wholesale product purchases are not franchise fees. It is in the expanse between these two extremes that predictability yields to uncertainty.

In fact, under the FTC Rule, almost any payment might qualify as a franchise fee. In its “Final Guides to Franchising and Business Opportunity Ventures Trade Regulation Rule” (Interpretive Guides), the FTC says that the “required payment” element of the definition of a franchise is designed “to capture all sources of revenue which the franchisee must pay to the franchisor or its affiliate for the right to associate with the franchisor and market its goods or services.” Further, according to the FTC, a franchise fee may be found in initial franchise fees as well as those for rent, advertising assistance, required equipment and supplies (including those from third parties where the franchisor or its affiliate receives payment as a result of such purchase), training, security deposits, escrow deposits, non-refundable bookkeeping charges, promotional literature, payments for services of persons to be established in business, equipment rental, and continuing royalties on sales.

The FTC Rule and various state statutes prescribe certain minimum thresholds and exclude certain types of payments from the definition of a franchise fee. For example, the FTC Rule states that payments of less than $500 made to the franchisor or an affiliate before or within six months of opening a business do not constitute a franchise fee. A number of states have a similar exclusion, although the minimum threshold may vary.

The third element is a given. Under the FTC Rule, the third element of a franchise is some sort of “control or assistance” on the part of the supposed franchisor. Alleged franchisors are rarely successful in claiming that they do not somehow “control” the alleged franchisee. At its simplest, any control by a franchisor over a franchisee and any assistance to a franchisee will qualify as “control” as long as the FTC believes it is “significant”—and it does not take much to reach any measurable level of significance. Training programs, operation manuals, and directions for establishing methods of operation all meet the test.

Some states require a “community of interest” between franchisor and franchisee. Courts applying the laws of these states rarely fail to find a community of interest in even the most basic forms of product and service distribution relationship. In some states, a community of interest exists where both the alleged franchisor and franchisee profit from the sale of a product or service, which is always the case where a royalty is based on sales. Other states, such as California, require the presence of a “marketing plan or system” before labeling a relationship a franchise.

A few safe harbors. The FTC Rule and most states exclude a number of relationships from their definition of a franchise for purposes of disclosure. For example, a business opportunity that will constitute merely a part of a company’s existing business falls within the “fractional franchise” safe harbor. The FTC Rule, however, allows the exemption only when the franchisee has more than two years of prior management experience in the business represented by the franchise and where the parties anticipate that sales under the franchise will represent no more than 20 percent of the dollar volume of the franchisee’s projected gross sales. Rhode Island and Wisconsin exclude sales to purchasers with a high net worth or a high income, and several states (California and New York are the main examples) exempt sales by large franchisors from the registration requirement. Further, isolated sales are exempted by the FTC and a few states.

The moral. The moral of the franchise story is this: The creation of a franchise relationship and possible concomitant duties of disclosure, opportunity to cure, termination only for cause, and the like are not a matter of magic language. Whenever a transaction involves a trademark license, a fee (however seemingly remote), and elements of control or a community of interest, it may create a franchise under applicable federal and state laws. Given this risk, the prudent distributor of a product or service under a mark or name errs on the side of following the franchise laws, including the use of a disclosure document or an offering circular.

For More Information About the Section of Business Law

- This article is an abridged and edited version of one that originally appeared on page 55 of Business Law Today, September/October 2007 (17:1).

- For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.

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- Periodicals: Business Law Today, bimonthly magazine; The Business Lawyer, quarterly law journal; eSource, monthly e-newsletter.

- Books and Other Recent Publications: Portable Bankruptcy Code and Rules, 2008 ed.; A Practical Guide to Software Licensing for Licensees and Licensors, 2d ed.; New Bankruptcy Code, 2d ed.; Intangible Assets Handbook; Intellectual Property Deskbook; In-House Counsel’s Essential Toolkit; Corporate Director’s Guidebook, 5th ed.; Bankruptcy Deadline Checklist, 3d ed.; Financial Statement Analysis and Business Valuation for the Practical Lawyer, 2d ed.; Reorganizing Failing Businesses, rev. ed.; Guide to Nonprofit Corporate Governance in the Wake of Sarbanes-Oxley; Model Asset Purchase Agreement with Commentary; The Practitioner’s Guide to the Sarbanes-Oxley Act; Model Joint Venture Agreement with Commentary; The M&A Process: A Practical Guide for the Business Lawyer.

William L. Killion is a partner in the Minneapolis, Minnesota, office of Faegre & Benson LLP; he may be reached at . Sarah J. Yatchak is a corporate associate at the same firm; she may be reached at .

Copyright 2008

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