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But I Don

But I Don't Sell French Fries!


SML Perspectives
(April 2, 2012)

Licensors and Distributors as Accidental Frachisors

Many people share the common misconception that a "franchise" is a narrowly defined form of business arrangement, whereby a "franchisor" creates strict policies and procedures to ensure that every french fry served by every "franchisee" tastes and looks the same, from Florida to Alaska. That misconception can lead to the birth of an accidental franchise.

While it is true that the restaurant and hospitality industries have relied on the franchise growth model more heavily than other industries, the franchise relationship is not exclusive to any particular industry and can be an attractive option for businesses that use third party licensing and distribution models. A franchisor can protect more than the mere use of its trademark; a franchisor can use operational controls, policies and procedures in an attempt to protect the integrity of its brand and the way its products, goods or services are perceived in the public sphere. In addition, the franchisor-franchisee relationship offers great mutual benefit, providing the franchisor the opportunity to grow its sales and distribution platform more quickly and effectively, and offering franchisees the ability to own and operate a local business with an existing and broad-reaching brand, reputation and marketing model.

However, neither intent nor awareness is required to form a franchise relationship. A business arrangement is not a franchise because the parties call it a franchise. Many licensing and distribution-oriented companies create franchise relationships without ever being aware that franchise laws might apply to them.

No one wants to be an accidental franchise. The negative repercussions of operating an unwitting franchise are too significant to ignore.

A prudent business person should be able to recognize the basic elements of our franchising and business opportunity laws, as those laws may apply to his or her own licensing and distribution models. This article provides a brief overview of franchising and business opportunity laws, issues and concerns that impact many types of common business relationships.

As a starting point, please note that franchising and business opportunity laws exist at both the federal and state levels, and companies must be aware of the differing scope of application and requirements in their operational territories.

At the federal level, the Federal Trade Commission (the "FTC") oversees rules and regulations for franchising registration and disclosure (the "FTC Franchise Rule"), and business opportunity registration and disclosure (the "FTC Business Opportunity Rule").

Franchise laws are a relatively new development, with the first significant federal franchising regulations being developed in the 1970s. However, despite the recent development of the predecessor regulations to the FTC’s franchise and business opportunity regimes, those original regulations have seen significant, recent overhauls. The

FTC Franchise Rule was substantiallyupdated in 2007, and the FTC Business Opportunity Rule, which was initially included within the original franchising rules and regulations, is now codified in its own separate regulations effective as of March 1, 2012.

At the state level, Georgia, North Carolina and South Carolina have each adopted their own business opportunity laws. A number of other states have implemented business opportunity laws, as well, and several states have adopted their own franchise regulations. (A handful of states have enacted both.) Certain other common industry-specific relationships which are substantially similar to franchise relationships—automobile manufacturer-dealer relationships, for example—are governed by separate regulations at the state and federal level.

While a state-by-state comparison of franchising and business opportunity laws is beyond the scope of this article, we should note that the only uniformity among the various state and federal regulations is that they are all uniformly different.

What is a franchise?

The FTC Franchise Rule, when boiled down to its simplest form, states that a franchise relationship exists where (A) one party, the franchisor, grants another party, the franchisee, the right to use the franchisor’s trademark or brand, (B) for the purposes of selling, offering or distributing goods or services associated with the franchisor’s trademark, (C) where the franchisor has significant control over the operations of the franchisee or offers the franchisee significant operational and marketing assistance, and (D) the franchisee pays the franchisor $500 or more in fees, in order to begin or continue operations.

Under the FTC Franchise Rule all of the elements described above must be present to create a franchise relationship. The absence of any one element removes the relationship from coverage under the FTC Franchise Rule (although state-level franchising relationship laws, or federal- and state-level business opportunity rules may still apply).

Of course, the federal franchise elements are broadly defined. For example, the term "trademark" includes any one or more of a franchisor’s trademarks, service marks, trade names or symbols associated with the franchisor’s brand. As a further example, the definition of "fees" includes more than just initial franchising fees and ongoing royalties or licensing fees. Other examples of "fees" include payments to franchisors for required marketing fund contributions, training costs and back-office assistance, franchisor-provided (or franchisor-required, if a third party seller pays a referral fee to the franchisor) equipment sales and rentals, and supplies.

Frequently, in an "accidental franchise" dispute, in the absence of an easily identifiable common marketing plan, the dispositive question revolves around whether the alleged franchisor has exerted a "significant amount of control" over the operations of the alleging franchisee. Most licensing and distributorship agreements impose some degree of health, safety and quality control, so the question of whether those controls amount to a "significant degree of control" is often situational and fact-intensive.

The FTC and case law in many state jurisdictions provide some guidance as to what constitutes "significant control". Basic inspection rights and similar passive or limited controls are generally not indicative of "significant control". However, examples of "significant control" may include training and oversight programs, facility site location and design controls, common websites, detailed operations manuals, personnel policies, uniforms, and other controls intended to create a uniform appearance or manner of operations among franchisees.

Requirements of the FTC Franchise Rule

If the FTC Franchise Rule applies to a business relationship, the prospective franchisor must undertake extensive registration and disclosure obligations, which at the federal level, are addressed by filing a uniform Franchise Disclosure Document ("FDD") with the FTC.

The FTC Franchise Rule also contains detailed restrictions and controls concerning the manner, timing and consummation of a new franchise offering, and imposes certain provisions that define the terms of the franchisor-franchisee relationship (such as termination and renewal).

Exceptions to the FTC Franchise Rule

The disclosures and controls contained in the FTC Franchise Rule are intended to protect inexperienced, potentially vulnerable persons from predatory franchising practices. Due to this general protection, the FTC provides certain exemptions from registration where the probability of abuse is minimized, such as when a franchisee has significant business experience or resources. Exemptions and exclusions from the FTC Franchise Rule include (as a nonexclusive list):

  • Payments made solely to acquire inventory at wholesale prices for third party resale purposes are exempted from the definition of "fees" (this exemption protects many traditional distributor relationships).
  • No use of trademark? No franchise! Expressly forbidding a distributor to use a manufacturer’s mark destroys a key element in meeting the definition of a franchise.
  • Offers to high net worth prospective franchisees.
  • Offers that require a large up-front investment of capital by the franchisee.
  • Offers to sophisticated prospective franchisees that have significant, direct experience in the contemplated franchise business.
  • Offers to certain franchisor insiders.
  • So-called "fractional franchise" arrangements, where (i) key franchisee personnel have direct experience in a business, and (ii) the parties expect that the arrangement will generate less than 20 percent of the franchisee’s revenues in the first year.
  • A structure under which no fees are payable by the franchisee during the first six months of operations.
  • Licensors with only one licensee are exempted from registration, as well.

Don’t forget the state level

Although a clear exemption from registration may exist at the federal level, we cannot stress strongly enough the need to look at each applicable state’s franchise registration, disclosure and business opportunity laws.

Definitions, coverage and requirements vary from state to state. Thus, an entity that is exempted from registration and disclosure at the federal level, or that falls outside of the definition of a "franchise" as promulgated by the FTC, might be deemed a "franchise" under certain state laws.

What is a "business opportunity"?

Generally, a business opportunity is not considered a franchise at the federal level. If a business relationship falls under the FTC Franchise Rule, the FTC Business Opportunity Rule generally does not apply. Typical examples of abusive "business opportunity" practices include scams involving vending machines, internet kiosk and ATM machine sales, work at home "envelope stuffing" offers and certain types of multi-level marketing (i.e., pyramid) schemes.

Under the FTC Business Opportunity Rule a "business opportunity" exists if:

(A) one party, a "seller" solicits another party, as a "prospective purchaser," to enter into a new business or new product line, (B) the prospective purchaser is required to make a payment of any amount to accept the opportunity, and (C) The seller promises to (i) provide a use or sales location to the purchaser, (ii) provide accounts, customers or sales outlets to the purchaser, or (iii) buy back some or all of the goods or services that the buyer makes.

Just as with the FTC Franchise Rule requirements, all of these elements must be present to constitute a "business opportunity" under the FTC Business Opportunity Rule.

 Requirements of the FTC Business Opportunity Rule

Just as with the FTC Franchise Rule, the FTC Business Opportunity Rule is intended to protect the inexperienced and unsophisticated buyer from predatory practices. The new FTC Business Opportunity Rule significantly simplifies the registration and disclosure form and the overall process for entities offering a business opportunity.

However, the FTC Business Opportunity Rule requires certain types of disclosures and promises that are typically made by "business opportunity" sellers, primarily with respect to earnings claims, repurchase promises and preferential placement of product claims.

 Exemptions from Registration and Disclosure

The exclusions available to business opportunity sellers under the FTC Business Opportunity Rule are somewhat similar to the exemptions available under the FTC Franchise Rule. Offers to sophisticated and high net worth individuals are excluded from coverage, as are arrangements that provide solely for acquisition of inventory at wholesale prices for general resale purposes. However, there are variations in treatment and applicability from state to state.

In addition, the trademark is the key to a franchise relationship, and is a frequent distinguishing element between a franchise arrangement and a business opportunity offer. If a business relationship in Georgia or South Carolina involves the licensing of any registered trademark, or if a business relationship in North Carolina involves the licensing of a federally registered trademark, then that relationship is excluded from coverage by the applicable state’s business opportunity laws.

What Should You Do?

Due to the broad application of the FTC’s franchising and business opportunity requirements as well as various state law requirements, business owners should take a hard look at their own licensing and distribution arrangements to avoid any violations. If you are uncertain as to whether franchising or business opportunity laws might apply to your licensing and distribution arrangements, please consider consulting with qualified counsel.

Since business relationships can be structured to maintain exemption or compliance with state and federal registration and disclosure laws, it is preferable to address potential areas of concern in your contractual and other business arrangements in a proactive manner rather than a reactive manner.

In the event you are considering developing and growing your business under a franchise model or similar system, please consult with your franchise counsel and develop a plan to work within or remain safely exempt from FTC and state franchising and business opportunity laws.

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Authors
John M. Walker
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