March 22, 2010

Brand Licensing Programs: Exemptions—a Silver Lining in a Regulatory Cloud

Alan J. Schaeffer

The mantra of many business consultants and marketing strategists in the twenty-first century has become "brand leveraging," and the chant has grown louder during the recent economic downturn. Just search the Internet and you will find many articles describing businesses that have created new revenue streams by leveraging/licensing their intellectual property, including patents, copyrighted software, and especially their brands. And while this certainly is not a new strategy, producers of brand name products and trademarked goods and services in various industry segments have moved beyond traditional manufacturing and wholesale distribution into retail operations with increasing frequency. You will find examples of this vertical expansion in your local shopping mall in such diverse industries as consumer electronics (Apple), clothing (Lucky Brand, Levi's), athletic gear (Nike, Under Armour), jewelry (Swatch), entertainment (The Disney Store), and toys (Lego).

Brand licensing makes sense because a company typically must expend a significant amount of capital to establish and maintain retail operations. Under a licensing arrangement, on the other hand, the licensor can create new revenue streams by having licensees use their own capital to develop and maintain the licensed business while also gaining additional and potentially more profitable outlets for the licensor's goods and services, as well as increased brand visibility. The licensor will collect fees for the licensee's use of the brand (usually through a combination of up-front fees and ongoing royalty payments) and will need to make only a relatively minimal capital outlay (to ensure quality control or possibly for joint marketing efforts or administrative or other types of support). Of course, the licensor's ability to find qualified licensees to operate the branded retail business is a key component to the success of any licensing program.

Your Program Could Be a Franchise
Brand licensing seems like a winning strategy but, to rephrase the adage in the title of this article, with every silver lining, there comes a cloud. In the context of this discussion, that cloud is the unplanned transformation of a brand licensing program into a franchise regulated under federal and state franchise laws. If this happens, a licensor will have to comply with those laws by preparing a franchise disclosure document using a specifically prescribed format with specifically required disclosures about the licensing arrangement and the licensor itself, including the licensor's audited financial statements. In certain states, the disclosure document must be registered with state regulators who, in some cases, will conduct a merit review and may require revisions or additional information. And the licensing process (or franchise offer) itself is subject to regulation, dictating, among other things, the time between delivery of the disclosure document and when agreements can be signed and licensing fees can be paid. In many respects, franchise regulation is similar to the regulation of the offer and sale of securities, insofar as both are designed as consumer protection laws to help franchisees (or investors), requiring a specific set of disclosures related to the business deal and the offeror and, in some cases, filing and regulatory approval of a prospectus.

Sometimes, the executives responsible for the development and implementation of the brand licensing program are not aware of the scope of the franchise laws and, upon learning that their licensing program is actually a franchise, may react by calling for an end to the program for a variety of reasons, including (1) the burden of compliance with the franchise disclosure and registration process, (2) the increased risk of liability created by the rights and remedies conferred on franchisees under the franchise laws, (3) the desire of privately held companies to avoid public disclosure of information about their operations, or (4) the desire of publicly traded companies to avoid conflict with securities disclosure rules and limitations.

But as the title of this article declares, the silver lining in the cloud of federal and state franchise regulation may be the availability of exemptions and exclusions. If you are contemplating the development of a brand licensing program or you have already implemented one, there may be ways to structure your program to remain beyond the scope of federal and state franchise laws. And even if such a structure is not feasible, the FTC Rule (discussed below) has seven specific exemptions and the various state franchise laws have numerous exemptions that may be available in the right circumstances. So before entirely scrapping what is or may be a franchise program, you should examine these exemptions and exclusions and consider structuring or restructuring your licensing program to take advantage of them. In this way, a licensor may be able to bypass the franchise regulations while still reaping the benefits of brand leveraging.

Federal Law
Federal franchise law is a regulation promulgated by the Federal Trade Commission (16 C.F.R. § 436), commonly referred to by franchise law practitioners as the "FTC Rule." Under the FTC Rule, a licensing arrangement is a franchise only if the licensee (1) has the right to operate a business or to sell goods or services identified or associated with the licensor's trademark, (2) has authority to exert significant control over or provide significant assistance in the licensee's method of operation, and (3) makes or commits to make a required payment to the licensor or its affiliate to obtain the license or commence operations. A licensing program is a franchise if it features all three elements above (regardless of what the licensor calls it). (For more detail, see the article "Franchising 101" in this issue by Susan Grueneberg and Jonathan Solish).

Bypassing Franchise Regulations
A licensing program is not a franchise and, therefore, is outside the scope of the FTC Rule if only one or two of the FTC Rule's definitional elements are present. So why not simply eliminate at least one of the three definitional elements so that the brand licensing program is not covered by the FTC Rule franchise definition? Because it may not be as easy or desirable as one would think. Consider each element in turn.

First, consider the trademark license or brand association. This is the essence of brand leveraging. It's difficult to envision a licensing program without this element.

Second, consider the element of significant control over or assistance with the licensee's operating method. The FTC explains that significant control could include required site approval, site design, appearance, hours of operation, production techniques, accounting practices, personnel policies, or financial contribution to or participation in promotional campaigns; restrictions on customers; and specified geographic area of operation. Significant assistance could include formal training programs; establishing accounting systems; furnishing management, marketing, or personnel advice; selecting site locations; furnishing systemwide networks and a website; and furnishing a detailed operating manual. Remove these elements, the ability to exert significant control or provide significant assistance, and a licensor may find it too difficult to oversee the operations of the licensed business, ensure quality control over the trademarks, or maintain the reputation of the brand.

Third, since the point of the strategy is to create additional revenue streams—eliminating the required payment element, like the trademark, would seem to negate the reason for the licensing program in the first place. The FTC Rule has an important exclusion to "required payments," however, for "payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or lease." As a result, the traditional dealership or distributorship, which typically pays only for inventory for resale with no licensing fees or other required payments to the manufacturer, is not a franchise. Alternatively, required purchases from the licensor for any other item, for example, equipment, training, design plans, or marketing materials, will constitute "required payments" and, if the trademark and control/assistance elements are present, result in a franchise under the FTC Rule.

Exemptions to the FTC Rule
Even if a brand licensing program features all three definitional elements and restructuring around the FTC Rule is not feasible, a licensor still may be able to restructure its program to take advantage of one of the seven exemptions enumerated in the FTC Rule and avoid the need to comply. These exemptions also may be available simply by virtue of the characteristics of the program itself. The key elements to each of these exemptions are summarized below.

1. The Minimum Payment Exemption. Franchise sales are exempt from the FTC Rule where "the total of the required payments, or commitments to make a required payment, to the franchisor or an affiliate that are made any time from before to within six months after commencing operations of the franchisee's business is less than $500." The key here is the six-month limitation period because the payment of any amount after six months is not precluded. In fact, a commitment made before the end of the six-month period to make a payment after the six-month period (for example, a promissory note) is not counted toward the $500 minimum. This exemption seems fairly easy to satisfy: simply adjust the timing of the required payment and still receive proper value for the license. But the franchisor must be willing to bear the risk of deferring license fees. Securing a promissory note with adequate collateral, however, could mitigate the risk of nonpayment.

2. The Fractional Franchise Exemption. A fractional franchise relationship exists when (1) the prospective franchisee or any of its or its affiliate's current directors or officers has more than two years of experience in the same type (or line) of business and (2) the parties have a reasonable basis to expect sales revenues from the relationship to be 20 percent or less of the franchisee's total sales revenues during the first year of operation.

"Experience in the same line of business" means selling competitive goods, or being in a business that ordinarily would be expected to sell the type of goods to be distributed under the franchise. For example, an independent ice cream store owner might qualify as a fractional franchisee if she entered into a franchise relationship with an ice cream cake supplier but probably would not if she entered into a franchise relationship to sell greeting cards. As for the 20 percent calculation, it is measured as the incremental sales resulting from the relationship against total sales at all stores owned by the franchisee. So when an owner of multiple stores introduces a new product at only one store, the sales attributed to the new product are measured against the total sales for all stores.

3. Leased Department Exemption. A "leased department" is where an independent retailer sells its own goods or services from leased space within a larger retailer's store. For example, a jeweler may sell jewelry and watches from space rented within a department store. Without the exemption, if the jeweler pays rent, becomes associated with the store's trademark, and the store imposes what could be considered significant control (like operating hours), the relationship could be a franchise. The exemption precludes any requirement for the smaller retailer to purchase goods or services from the larger retailer or its designated suppliers.

4. Oral Agreements. Oral agreements are exempt as a matter of policy to avoid problems of proof in its enforcement. This exemption is construed very narrowly and is not available if there is any writing, signed or not, relating to any material term, even a simple purchase invoice for goods or equipment.

5. Large Franchise Investment Exemption. Franchise sales are exempt if the franchisee's initial investment is at least $1 million, excluding the cost of unimproved land and franchisor financing. This exemption is based on the assumption that the ability to pay large sums equals sophistication (the accredited investor concept). With multiple investors, at least one must invest at the $1 million level. The initial investment is limited to expenses to be paid to the franchisor and affiliates or to third parties (landlords, contractors, equipment vendors, etc.) up through the opening of the business and for the three months following. Payments made after the first three months do not count toward the initial investment, thus excluding ongoing obligations to pay royalties, make advertising fund contributions, or purchase supplies from the franchisor, as well as ongoing lease, utility, or insurance premium payments to third parties.

6. Large Franchisee Exemption. Franchise sales are exempt when the potential franchisee or an affiliate has a net worth of at least $5 million (based on its balance sheet) and has been in business for at least five years. The franchisee need not be in the same line of business or any business in particular for the five years. For example, the sale of a clothing franchise to a hotel could qualify for the exemption, even though the hotel may not have any prior experience in the apparel industry.

7. Insider's Exemption. This exemption covers franchise sales to the officers, directors, general partners, managers (collectively "officers"), and owners of a franchisor. To satisfy this exemption, an officer or owner must purchase at least a 50 percent ownership interest in the franchise. An officer-purchaser must have at least two years' experience as an officer, director, general partner, or manager of the franchisor and must be associated with the franchisor currently or within 60 days of the sale. An owner-purchaser must have had at least a 25 percent interest in the franchisor for at least two years and must have owned the 25 percent interest at least 60 days before the sale.

State Franchise Law May Still Apply
Having found an FTC Rule exemption or a structure to avoid it altogether, you might assume the licensor can go forth and license freely. Not so. State franchise laws in 15 states (traditionally referred to as the "Registration States" by franchise law practitioners) may still apply because, unlike typical federal law preemption, the FTC Rule defers to state law if it provides more protection to franchisees than the FTC Rule. And while there is partial overlap with FTC Rule definitions and exemptions, there are enough significant differences such that FTC Rule compliance does not necessarily shield the licensor from the reach of state franchise laws. This means the licensor may have to comply with disclosure and registration requirements if a licensee either resides or will operate the franchise in a Registration State.

Definition Under State Law
State franchise law definitions are generally similar to the FTC Rule definition, with some important differences, however. The trademark and the fee elements in the state law definitions, although worded differently, are conceptually similar to their FTC Rule counterparts. But in 10 Registration States, the significant control/assistance requirement is replaced by a requirement that there be a marketing plan or system prescribed in substantial part by the franchisor. In the other Registration States, the significant control/assistance requirement is replaced by a requirement that there be a community of interest in the marketing of goods or services. Like the FTC Rule, all three definitional elements are necessary for an arrangement to be a franchise under state law, except in New York, which requires only two elements as long as one of them is the required payment.

State Law Exemptions and Exclusions
Every Registration State has franchise law exclusions and exemptions for transactions under its jurisdiction. For example, like the FTC Rule, each Registration State excludes payments for inventory from the "required payment" element. Some states go further, excluding payments for equipment, fixtures, supplies, or real estate. Ten of the Registration States have a fractional franchise exemption worded similarly to the federal version.

And most Registration States also have a minimum payment exemption or exclusion for de minimis amounts (ranging from $100 up to $500); however, that amount is an annual limit or a limit for the entire relationship. None of the Registration States, except Oregon (which has adopted all the federal exemptions), provides a minimum payment exemption like the FTC Rule, which is applicable only to the first six months of the licensing arrangement. Consequently, even if a franchisor defers initial fees until the seventh month of operations to take advantage of the federal minimum payment exemption, the arrangement may still be subject to state franchise law unless another state law exemption is available.

From there the exemption framework becomes balkanized. Four Registration States have a version of the large franchisee exemption, but two exempt registration only and still require delivery of a disclosure document. Two Registration States have a large investment exemption, but one still requires the filing and delivery of a disclosure document. Four Registration States have a single license or isolated sale exemption, which may help if a licensor plans not to have multiple licensees, but one of these requires the delivery of a disclosure document. There also are various exemptions for transfers between franchisees or a franchise renewal or an award of additional franchises to an existing franchisee. And finally, a specific request may be made to the state administrator for an exemption by order.

Conclusion
A company developing a successful brand licensing program must pay attention to the cloud of federal and state franchise laws that may apply to the program. Despite its desire to remain beyond the scope of the franchise laws for a number of important reasons, a licensor may find it difficult to design a program that achieves the desired business result without including the three elements that constitute a franchise. But a licensor may be able to implement its program without the need to prepare or register a franchise disclosure document or comply with the other legal requirements, even if it is a franchise, by relying on various exclusions and exemptions (the silver lining). Given the lack of uniformity among federal and state franchise laws and their exemptions and exclusions, however, a licensor may not find a one-size-fits-all exemption upon which it can rely. A licensor may be able to rely on a combination of multiple federal and state law exemptions or exclusions simply by virtue of the specific features of its program or it may be able to satisfy applicable federal and state exemptions or exclusions with some creative structuring and flexibility. A licensor also may consider either submitting a request for exemption by order from the relevant jurisdiction(s) or making one or more state-specific adjustments depending on the jurisdiction if the license will be limited in scope to just one or two Registration States. Finally, a licensor just may decide to embrace franchising if a feasible exemption strategy cannot be formulated, prepare (and register where necessary) a disclosure document, and go forth and license (orfranchise) freely, subject to compliance with federal and applicable state franchise laws.

Additional Resources

Avoiding the Accidental Franchise Malpractice Traps

Audio CD Package

Your client wants to expand their business by issuing licenses or distributorships to independent contractors who will invest their own money and hire their own employees to sell your client's goods or services. After discussing business objectives with your client, you draft the license or distribution agreement. A year later, the client receives a demand letter from an unhappy licensee or distributor alleging that the licensing or distribution program is really a franchise relationship which they now wish to unwind. The licensee or distributor has also complained to its local consumer protection agency, which has sent your client a demand letter inquiring into the specifics of the relationship. Your client wants you to explain why the licensing or distribution program is not a franchise and seeks advice on how to respond to the unhappy licensee or distributor as well as to the state regulator.

This audio package examines the meaning of the "accidental franchise" and the implications to you and your client for creating one.

Alan J. Schaeffer

Schaeffer is a partner at Jones Day in Washington, DC. His e-mail is ajschaeffer@jonesday.com.