In 2010, Landslide® magazine published an earlier version of this article explaining when a trademark license or distribution agreement is really a franchise and why franchise status matters. Fourteen years later, there remains widespread confusion among practitioners and brand owners about what distinguishes a nonfranchise license from a franchise. Brand owners continue to claim they had no idea they were engaged in franchising when they authorized others to use their trademarks and business concepts, nor did their lawyer (if they used one) mention the possibility of franchise laws getting in the way.
Misinformation about licensing also abounds. Recently, an article in Entrepreneur magazine touted licensing as a “lucrative alternative” to franchising for expanding a business, recommending that a business owner could reliably license its logo and name to another without crossing into franchisor territory if it offered the licensee something less than a “turnkey business.” Entrepreneur magazine’s advice heedlessly oversimplifies what experienced franchise attorneys know is the “risky exercise” of sorting franchises from nonfranchise licenses.
The last 14 years have seen a proliferation of accidental franchise cases, some involving well-known consumer brands. This is a testament to the low bar that qualifies licenses as franchises and the commanding influence brands have on consumer purchasing decisions. While not all recent accidental franchise cases resulted in a franchise finding, some took years and a substantial investment of time and money for the brand owner to finally defeat the franchise status allegation. Franchise status is a mixed question of fact and law backed by a strong public policy directing fact finders to construe franchise statutes broadly to protect franchisee investments. Because franchise status is such a fact-specific inquiry, accidental franchise cases resist pretrial dismissal, which significantly adds to their nuisance value.
This article explains why franchise status matters and the subtle and sometimes indiscernible differences between a nonfranchise trademark license and a franchise. It highlights recent developments in how courts interpret franchise laws that bear on strategies for structuring licenses to avoid inadvertently creating a franchise.
From a regulatory viewpoint, franchise and nonfranchise licenses are as different as day and night. Nonfranchise licenses are unregulated private consensual arrangements. Franchises, by contrast, are highly regulated.
Franchise sellers have to obey elaborate federal and state presale disclosure and registration laws; nonfranchise licensors do not. Among other things, franchise sales laws require franchisors to disclose their financial statements publicly and make it unlawful for franchisors to answer a prospective franchisee’s most urgent question—How much can I make?—without complying with complicated disclosure rules. More than a third of all states have relationship laws that dictate substantive terms like venue and choice of law and restrict the conditions under which a franchise may be canceled, terminated, or not renewed. State relationship laws supersede the parties’ contract. A terminable-at-will contract clause will not be enforced in a jurisdiction that requires good cause to terminate a franchise agreement, even if the franchisee’s attorney actively negotiated the franchise agreement. Some state relationship laws protect a franchisee’s right to sell their business, forbid franchisors from discriminating among similarly situated franchisees, and prohibit franchisors from substantially changing the competitive circumstances of a franchise program without good cause. A franchisee may not waive these statutory protections even if it wants to trade for other contract concessions.
Franchise law violations carry significant penalties even if the inadvertent franchisor never knew about the law or had no intent to violate it. Not only is it a felony to sell a franchise without complying with a franchise sales law, but federal and state franchise agencies have broad powers to punish franchise law violators and may freeze assets, order restitution, issue cease and desist orders, ban violators from selling franchises, and recover substantial penalties.
Franchisees have private remedies for state franchise law violations. Besides compensatory damages and, in some states, attorney fees, an injured franchisee may (1) rescind a franchise agreement for disclosure and registration violations, including fraud in connection with a franchise sale; (2) obtain an injunction to enjoin a wrongful termination or nonrenewal of a franchise; or (3) recover damages or restitution.
Furthermore, state franchise laws impose personal and joint and several liability on the franchisor’s management and owners even when the franchisor is a legal entity. Finally, lawyers who overlook franchise laws may be guilty of malpractice and potentially liable to victims of their client’s wrongdoing.
Numerous judicial decisions reveal brand owners in diverse businesses, many of which are sophisticated companies, surprised to be on the receiving end of a lawsuit accusing them of violating a franchise law by entering into or terminating a commercial arrangement with an express or implied trademark license allowing the plaintiff to associate its own business with the defendant’s brand.
Following are some new examples since 2010:
These decisions involve different, but typical, distribution and licensing arrangements for the offer, sale, or delivery of branded goods or services identified by the seller’s trademark. In none of these cases did the parties intend to form a franchise relationship. Certainly no licensor expected to end up defending franchise allegations.
Manufacturers, suppliers, and other trademark owners overlook a possible franchise connection whenever they enter into relationships with independent third parties to sell their branded products or services. Embedded in these distribution arrangements is a de facto trademark license. While not every trademark license creates a franchise, every franchise contains a trademark license.
Given the prevalence of franchising and the interstate, national, and even international scope of so many franchise networks today, attorneys need to know about potentially applicable federal, state, and foreign franchise laws.
Sorting franchises from nonfranchise licenses can be a highly uncertain process. The quality controls that trademark owners must retain over a licensee’s trademark use closely resemble the marketing controls that are characteristic of a franchise. Given the significant regulatory complications that franchise status carries, it is essential that practitioners appreciate the qualities and characteristics that make an ordinary trademark license a franchise.
Most people think they know a franchise when they see one. In fact, franchising is a method of distribution, not a particular industry, as evident from the diverse array of accidental franchise cases. There is no uniform definition of a franchise. As consumer protection statutes, courts give franchise laws a sweeping scope. Consequently, a broad variety of unsuspecting business arrangements may qualify as franchises.
At the most basic level, a franchise is defined by the coexistence of three elements:
A franchise finding hinges entirely on whether an arrangement fits the applicable statutory definition. The prototypical definition of a franchise is like a three-legged stool. If any one leg is missing, the relationship is not a franchise, no matter how much proof there is of the other two definitional legs of the stool.
The legal analysis into whether a commercial arrangement is a franchise considers the parties’ actual practices, oral as well as written promises, and course-of-dealing evidence. A party cannot avoid a franchise relationship simply by disclaiming its existence. What the parties call themselves is immaterial. A license, dealership, distributorship, or marketing affiliation agreement is no less a franchise because the parties’ contract never uses the “f” word.
While federal and state jurisdictions that regulate franchises share common definitional approaches, each jurisdiction has its own definitional subtleties and mix of exclusions and exemptions. What qualifies as a franchise under the federal franchise sales law may not qualify under state law definitions, or vice versa. What is a franchise in one state may not be a franchise in all the regulating states in which the franchisor operates.
Business owners and their advisers are not the only ones confused. Irreconcilable legal precedents reflect misperceptions among regulators and the judiciary about the legal concept of a franchise. As a result, legislators, regulators, judges, and practitioners alike all suffer from uncertainty about the exact kinds of arrangements intended to be regulated as franchises.
In advising companies that manufacture and distribute products or services or that license business methods, technology, patents, or trademarks to independent operators, practitioners should, as a preliminary matter, consider the possibility of unwittingly creating a franchise. In so doing, they should consult the franchise statutes, judicial opinions, and administrative guides of each jurisdiction in which the parties reside or intend to do business before their client offers an opportunity involving an express or implied trademark license or takes steps to modify or end the relationship.
On the federal level, franchises are governed by a Federal Trade Commission (FTC) rule, which describes both business format and product franchises. Both variations involve the presence of the three basic elements. The business format franchisee adopts the franchisor’s business format and identifies its independent operation by the franchisor’s trademarks, in exchange for which the franchisee pays the franchisor a fee. The franchisee’s operating methods are subject to significant control by the franchisor or, alternatively, the franchisor renders significant assistance to the franchisee in day-to-day operations. Fast food, convenience stores, and real estate services are examples of business format franchises. The product franchisee distributes goods identified by the franchisor’s brand manufactured by or for the franchisor. The franchisee pays a fee for the distribution rights above the wholesale price of the goods. As with business format franchises, the franchisor exercises significant control over, or provides significant assistance to, the franchisee. Automobile and gasoline dealerships and delivery route distributors are examples of product franchises.
State law franchise definitions largely resemble the FTC’s business format and product franchise definitions in that most also require the combination of the three basic elements. The trademark and fee elements are fundamentally the same as the federal franchise sales law. However, state laws differ by requiring either (1) substantial assistance or control (the federal standard), (2) a marketing plan prescribed in substantial part by the franchisor, or (3) a community of interest. A few state laws define a franchise by a two-prong test that omits payment of a required fee.
The grant of rights to associate with another’s trademarks in offering, selling, or distributing goods or services is not only a common element of every franchise definition but also the easiest of the three definitional elements to meet. Absent an express prohibition against use of the licensor’s trademark, a right to use the mark will be inferred even if the mark is, in fact, never used. For this reason, every franchise involves an express or implied trademark license of some sort.
Franchise definitions vary from requiring a “license to use” the licensor’s mark to requiring a “substantial association” between the grantee’s business and the licensor’s trademark. Under the “license to use” approach, an express contract authorizing trademark use will support a franchise relationship even if the mark is not part of the licensee’s trade name—for example, “Smith’s Appliances, an authorized Brand X Service Center.” Permission to display a manufacturer’s logo in dealing with customers satisfies this element. Even without explicit contract authority, long-standing use of a licensor’s trademark in dealing with customers may be enough to establish a trademark license.
Courts have found a requisite de facto trademark license in the following situations:
States following the “substantial association” approach have also found the requisite trademark element satisfied when branded products or services account for a significant percentage of an independent operator’s overall sales, even though courts vary in how much or little qualifies as “substantial.”
Many courts have shown a willingness to stretch the definitional elements to achieve desired results. In one California appellate decision, a substantial association with the licensor’s mark was found even though the licensee was forbidden to use the licensor’s brand name and, in fact, never used it. The court was swayed by evidence showing that a building owner had relied on the licensor’s brand name in renting space to the licensee to operate a cafeteria in the building, which was enough to satisfy the substantial association test.
The licensor’s dilemma. The fact that an agreement lacks an express trademark license does not prove the trademark element is missing. A de facto license is part of the rights granted to an independent dealer or distributor who is authorized to sell branded products or services accounting for more than an insignificant percentage of the licensee’s overall sales. Since the trademark element’s presence may depend on the extent of actual branded sales, contract drafting may not save a license from being a franchise. A contract that expressly denies a trademark license may leave the licensor, manufacturer, or supplier with the worst of both worlds: an agreement that is subject to various franchise laws but lacks the protections that a well-drafted trademark license should contain. While some case law suggests that licensors of branded merchandise may avoid the trademark element by expressly disclaiming any duty to refer customers to the licensee, this drafting approach will not work for manufacturers, suppliers, and licensors that view lead generation services or other types of marketing support as vital to their distribution strategy.
A handful of states follow the federal franchise sales law’s approach and require the licensor to furnish significant assistance or impose significant controls over the licensee’s entire method of operation. The same facts indicating significant assistance or control also identify a marketing plan. Significant assistance exists when the licensor provides formal sales, repair, or business training programs; site location assistance; management, marketing, or personnel advice; promotional support requiring the licensee’s participation or financial contribution; or operating advice such as by furnishing a detailed operating manual. Significant controls exist if the licensor approves or restricts the business location or sales territory, specifies design or appearance requirements, prescribes operating hours, establishes production methods or standards, restricts the customers a licensee may serve, mandates personnel policies or practices, or dictates mandatory accounting practices. Under certain circumstances, any one of these factors may be enough to constitute significant control or assistance. Significant promises of assistance, even if unfulfilled, will satisfy this element. Providing point-of-sale advertising and media support may be enough.
The franchisee’s reliance on the franchisor’s experience influences whether the licensor’s control or assistance is significant. The franchisee’s general business experience, knowledge of the industry, and relative financial risk in light of its total business holdings, as well as the extent to which the controls or assistance go beyond normal industry practices, each bear on the reliance factor.
A number of states define a franchise as a trademark license in conjunction with a marketing plan. The marketing plan element is composed of four distinct components, all of which must coexist: (1) a marketing plan (2) prescribed (3) in substantial part (4) by the licensor. Each component has been separately analyzed by judicial and administrative authorities.
Determining if a marketing plan exists is inherently subjective and, consequently, difficult to dodge in a written agreement. While judged by the presence of various facts, no interpretative or judicial opinion suggests a minimum number or combination of facts that inherently guarantee a marketing plan’s presence. The parties’ contract, course of dealing, and industry customs are all relevant. The term “prescribed” has been interpreted to mean something less than mandatory. Consequently, a marketing plan may be prescribed by implication when it is outlined, suggested, recommended, or otherwise originated by the licensor, even when use of the plan is not obligatory.
Courts differ in the degree of franchisor involvement in a franchisee’s daily business activities that is necessary to support a marketing plan. Some require significant control, such as confining sales to assigned territories, imposing sales quotas, establishing mandatory sales training, or supplying detailed instructions for customer selection and solicitation. Other courts have found a marketing plan based on far less—for example, a promoter’s recommendations, advice, or suggestions, even when there is no obligation on the franchisee’s part to observe them, such as suggesting resale prices and discounts, providing demonstration equipment or advertising materials, recommending or screening advertising materials, or providing product catalogs.
What courts identify as a “marketing plan prescribed in substantial part” may actually be basic to most distributorships. For example, a marketing plan was found to exist when:
Administrative and judicial opinions try to forge a distinction between production-type controls, which do not result in a marketing plan, and marketing controls, which do, but the distinction between the two has never been well articulated. A marketing plan can exist even when the controls or advice do not relate to advertising or marketing matters, such as when a manufacturer provides detailed instructions and advice regarding operating techniques and skill training that make independent businesses appear as if they are centrally managed and follow uniform standards.
Several states follow the community of interest model rather than the marketing plan or assistance/control approach but differ in how they define this element. However, all these states agree that a community of interest exists when parties derive fees from a common source—a standard that potentially encompasses every distributorship and license.
The licensor’s dilemma. Because the trademark element of a franchise is so easily established, trademark licensors may be tempted to avoid a franchise finding by eliminating the second definitional element—some form of assistance to or control over the licensee’s business. This creates a dilemma because the federal trademark law, the Lanham Act, imposes an affirmative duty on licensors to control the quality and uniformity of goods and services associated with their federally registered trademarks. Failure to do so may result in abandonment of trademark rights. As a practical matter, it is often impossible to distinguish trademark quality controls from the factors identifying substantial control, a marketing plan, or a community of interest. It may also be inadvisable to try to avoid franchise laws by eliminating or modifying contractual provisions designed to protect product or service quality or set operating standards that identify the licensee with a larger branded network. A licensor that eliminates or reduces quality controls may not only sacrifice important core values vital to the business and brand but also risk abandoning its trademark rights.
The required fee element captures all sources of revenue paid by a franchisee to a franchisor for the distribution rights or license. The element is deliberately expansive, encompassing lump sum, installment, fixed, fluctuating, up-front, and periodic payments for goods or services, however denominated, whether direct, indirect, hidden, or refundable.
Under federal law, imputation of a franchise relationship can be avoided by deferring required payments over $735 for at least six months after the licensee or distributor begins operations. The federal franchise definition requires the franchisee to make a minimum payment of at least $735 within that time frame. A license will not be deemed a franchise under federal law even if the licensee signs a non-negotiable, secured promissory note (with no acceleration clause) promising to pay the licensor $735 or more after six months. While this exemption offers interesting structuring opportunities for franchises sold in states without franchise laws, it has no counterpart in most states with franchise laws. Deferral of fees, therefore, is not a universal solution for avoiding franchise status.
All jurisdictions exclude payments that do not exceed the bona fide wholesale price of inventory if there is no accompanying obligation to purchase excessive quantities. To qualify, the payment must be for goods for which there is a ready market. Most product distribution arrangements rely on the bona fide wholesale price exclusion in structuring nonfranchise distributorship or dealership programs.
For the fee element, only required payments count, not optional ones. Nevertheless, calling something optional is not necessarily controlling. Payments, though nominally optional, may be deemed required if they are essential for the successful operation of the business.
Finally, to be classified as a required fee, the payment must be made to the licensor or its affiliate or for their benefit as the quid pro quo for the licensing or distribution rights. For this reason, a franchisee’s payments to third parties to get its business up and running are not franchise fees. Likewise, commissions paid by a licensor to a licensee are not franchise fees because no money flows from the licensee to the licensor. If, by arrangement, a licensee is required to discharge the licensor’s debt to a third party, or a third party remits a portion of the licensee’s payments to the licensor, an indirect franchise fee exists.
There remains considerable confusion about whether and when ordinary business expenses paid to a licensor are franchise fees and not for the licensing or distribution rights. Reported decisions offer little practical guidance for distinguishing payments for ordinary business expenses from unrecoverable investments made for the right to do business. One case suggests that payments to a licensor in exchange for services that are customarily used by others in the same business line may be fairly categorized as ordinary business expenses. Another court explained the distinction this way: “[I]f [the dealer] would have incurred some or all of the same communications system expense regardless of the nature of its agreement with the manufacturer, then it is difficult to see how the expense was one incurred for the right to do business with [the manufacturer].”
There is no bright-line rule for distinguishing when payments to a licensor are ordinary business expenses and not for the right to use the licensor’s marks. For example, historically, advertising fees paid to a licensor have commonly been classified as franchise fees. However, a decision under the Minnesota Franchise Act found advertising fees paid to a supplier to be ordinary business expenses where (1) the fees were not based on the retailer’s gross or net sales, but on the amount of inventory purchased from the supplier; (2) the supplier derived no income or profit from the advertising fees and supposedly took nothing out of the advertising fund to cover its administrative costs, and (3) the supplier kept the fees in a segregated account and did not commingle them with its own operating revenues. Co-op advertising fees common to beverage and other distribution programs—where the supplier matches the distributor’s contribution and spends the funds entirely to promote the brand—have also been found to be ordinary business expenses when the distributor is free to opt out of participating in the supplier’s marketing programs.
At the same time, payments to a licensor for equipment and other items that the licensor permits the licensee to buy from other sources are not franchise fees simply because the licensee chooses to buy the items from the licensor and not shop elsewhere.
While a franchise fee—direct or indirect—is generally a prerequisite for application of federal and state franchise sales laws, it is not a prerequisite for the application of several relationship laws regulating termination, nonrenewal, and other substantive conditions of the parties’ relationship. As noted, a handful of state franchise and dealer relationship laws regulate arrangements defined by a two-prong test that omits the required fee element.
The licensor’s dilemma. For the trademark licensor trying to avoid a de facto franchise agreement, the fee element is the easiest of the three definitional prongs to avoid. A manufacturer or supplier of branded goods that limits its compensation from a distributorship or dealership to the difference (markup) between its cost of goods and the bona fide wholesale price at which it sells the goods to distributors or dealers can lawfully avoid the franchise laws in all jurisdictions that use a three-prong definition. This is true regardless of how closely the licensor, manufacturer, or supplier controls the distribution process or how much the supplier’s markup is.
Often a trademark owner is in a position to collect a premium from those who want to affiliate with its brand. A manufacturer or supplier may impose innocuous payments for noninventory materials or support services, like sales manuals, demonstration kits, point-of-sale materials, or bookkeeping services, not suspecting that these payments may be enough to constitute a franchise fee.
Some branded affiliations do not involve the purchase of inventory, like service businesses and technology alliances. In these relationships, the bona fide wholesale price exception is not available, and all payments that flow from the licensee to the licensor are potentially franchise fees.
Frequently, licensors, manufacturers, and suppliers do not awake to the reality of the franchise relationship until years after it is formed when they seek to end the relationship pursuant to an at-will termination provision in their contract. Franchise relationship laws prevent the licensor from ending the relationship unless the licensee is in material breach, the essential basis of good cause. Because franchise laws cannot be waived, once a fee is paid anytime during the parties’ affiliation, a licensor may find itself foreclosed from reverting to nonfranchise status even if the licensor offers to refund the unintended franchise fee. The dilemma for the trademark licensor is that, in order to escape franchise regulation, it may be required to leave dollars on the table.
Every U.S. jurisdiction regulating franchises has its own mix of definitional exclusions and exemptions, offering a complicated and often confusing maze of structuring opportunities and limitations for companies considering regional or national expansion. Some exclusions and exemptions are common in most jurisdictions, while others are unique to a particular jurisdiction. Accordingly, individual statutes must always be checked. For example, the federal franchise sales law and some, but not all, regulating states exclude or exempt arrangements referred to as “fractional franchises” in which less than 20% of the licensee’s revenue is derived from sales of the licensed brand.
Accidental franchises occur for two basic reasons: (1) franchise laws poorly articulate the distinction between nonfranchise and franchise licenses, and (2) brands drive consumer purchasing decisions. Branding is far more important to consumer purchasing decisions today than it was in the 1970s when franchise laws were first enacted. Many more businesses today catapult their expansion by licensing their name and business concept to others willing to pay money to hitch their star to a better-recognized brand.
Just since 2010, when the prior version of this article was published, new digital technologies and ubiquitous digital connectivity have profoundly changed how brands reach consumers and how consumers experience brands. Browser fingerprints allow brands to find and interact with new audiences, push promotions, and gather detailed purchasing data based on a consumer’s search history. Brand marketing today is highly personalized, designed to forge emotional bonds with consumers to amplify their loyalty and repeat business. Companies have all sorts of new technologies at their disposal to measure the quality of a customer’s engagement with a brand over multiple digital modalities. Nothing illustrates the colossal impact of these changes better than influencer marketing, a strategy in its infancy when the earlier version of this article was published 14 years ago. Consumers today, more than ever, buy the brands they know or that are endorsed by people they trust.
Branding’s influence on consumer purchasing decisions fuels the rise in accidental franchises. Each time a license, distributorship, strategic trademark alliance, or other type of branded joint venture or marketing affiliation is formed, the cornerstone of a franchise potentially is laid. Every branded distribution arrangement involves an implied, if not an express, trademark license. Strategic affiliations between brand owners, with each owner giving the other the right to affiliate publicly with the other’s brand, are, at a minimum, de facto licenses. With few exceptions, the brand owner’s equity stake in a joint venture will not save the joint enterprise—a distinct legal entity—from being classified as a franchisee.
Courts have shown no sympathy for trademark owners that defend franchise claims by pleading ignorance of the law or no intent to create a franchise. Modeled after U.S. security laws, franchise statutes impose strict liability, thereby making a defendant’s intent or knowledge of the law irrelevant. Franchise laws have their roots in consumer protection legislation and, as a consequence, are construed liberally.
Given the serious consequences flowing from an accidental franchise, lawyers should suspect a franchise whenever an express or de facto trademark license presents itself. Strategic branding alliances, joint ventures, sales agencies, distribution cooperatives, and technology licenses should all be viewed suspiciously as hidden franchises and closely inspected to see if money is being paid, directly or indirectly, by one party for the right to associate with the other’s trademarks.
Certain aspects of the franchise definition, like the marketing plan, community of interest, and substantial assistance and control elements, are so inherently imprecise that it is difficult to render an opinion to a client that an arrangement does not contain at least some indicia of a franchise. The key is knowing how many factors are enough to tip the scale.
Counsel should never rely on contract terminology or disclaimers, neither of which will dependably defeat deemed franchise status. Yet contract drafters are not without tools. A license or distribution contract deliberately structured to avoid a franchise definitional element or take advantage of a statutory exemption or exclusion should express these facts in the contract. While self-serving and certainly not bulletproof, the plain language will aid and possibly influence the fact-finder’s analysis of the franchise claim.
Structural solutions may save some relationships from the reach of franchise laws but often come at the price of sacrificing essential economic objectives or competitive opportunities. The regulatory burdens of being deemed a franchisor should be kept in perspective. Numerous companies comply with federal and state franchise laws and sustain and grow successful, viable businesses. They compete in the marketplace while complying with presale disclosure and annual registration duties, close franchise sales while honoring rules restricting promises about future earnings, and manage franchise relationships while respecting laws requiring good cause for termination or nonrenewal.
In the long run, the costs associated with franchise avoidance, be they added business risks or extra legal expenses, may be more painful than franchise law compliance. Companies are short-sighted if their overwhelming desire to avoid legal regulation as a franchise drives their business decisions and strategic objectives.
©2024. Published in Landslide, Vol. 17, No. 2, December 2024/January 2025, by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
