The Laws of Franchising- C. Jeffrey Thompson

INTRODUCTION
A franchise is a complex business arrangement governed by both federal and state law. It is a concept that is familiar to most people in the retail store context. However, franchising has a broader definition than is commonly understood. Under the Amended FTC Franchise Rule (the “FTC Rule”) a franchise is not determined by the business format, or whether the parties call their relationship a “franchise” or a “license,” or by a different name, but generally whether or not the following three elements are present in the transaction: 1) the license or grant of a right to use another’s (the licensor’s) intellectual property;

2) on-going substantial assistance from the person or entity granting the license; and 3) the payment of a fee of more than $500 from the “licensee” to the “licensor” within a certain period of time.2 If these elements are all present, it is a franchise, no matter the business format. These elements are discussed in more detail below.

Before selling a franchise, the franchisor is required to disclose information about the franchisor and the franchise system. The regulations are similar to the prospectus disclosures in the sale of securities. The purpose is to inform the prospective franchisee about the franchisor and the franchise system and to enable the potential investor/ franchisee to make an informed decision before any binding documents are signed or money is exchanged.

Drafting the disclosures can be a complex undertaking. The legal practitioner must be well-versed with not only state, federal and international laws relating to franchising and business opportunities, but must also be familiar with laws relating to trademarks, employment, anti-trust, contracts, and industry specific laws and regulations.

There are a number of organizations that are designed to assist an attorney in learning the technicalities of franchise law, and in keeping abreast of changes in the law. Two of the principal organizations are the Forum on Franchising of the Business Section of the American Bar Association and the International Franchise Association. Each of these associations hold an annual legal symposium designed to assist the franchise attorney and franchise professional to learn the most up–to- date information on current franchise issues and changes to the various laws. These symposiums also help franchise attorneys network with other professionals in the franchise industry and obtain other important and pertinent information. Many publications on franchising are also available from the ABA.3

WHAT IS A FRANCHISE?
At its most basic level a franchise refers to a business relationship where one business, the “franchisor,” allows another business, the “franchisee,” the right to conduct a business offering certain designated products and services to others usually associated with a brand name or trademark for a fee. Franchising is also defined by statute in more than a dozen states, and by the Federal Trade Commission (“FTC”). Depending on whether the FTC Rule or state law is being referenced, these elements are often referred to as the: 1) “trademark,” or “grant” 2) “marketing plan,” “substantial assistance” or “community of interest,” and 3) “fee” elements. Each of these defined elements must be satisfied for the business arrangement to be considered a franchise.

While the FTC has defined what a franchise is under the FTC Rule, states that have also enacted franchise laws or regulations that define what constitutes a franchise. These laws may vary from state to state. The following section will examine the elements of this general definition in more detail. It should be noted that the courts often interpret these elements broadly in determining whether or not a specific business relationship constitutes a franchise. Additionally, the definitions below will often refer to “franchisor,” “franchisee,” and “franchise,” but a franchise can still be found regardless of the terms used by the parties.

Trademark or Grant
The trademark or grant element provides the franchisee with the right to use the intellectual property of the franchisor in the franchise business. This use includes such items as trademarks, certain proprietary methods of operations, know how, recipes, etc. The trademark element has been subject to various interpretations. Some courts have found that the distribution of products or services covered by a franchisor’s trademark is sufficient to satisfy the substantial association requirement.6 Under the FTC Rule, it is not just the licensing of the trademark to the franchisee that triggers the trademark element; rather, it is the association of the business with the trademark which creates a franchise relationship, and the express grant of the right to use the franchisor’s trademark is not required.5 If this element is to be avoided, the franchise or license agreement must specifically prohibit the franchise business from using the licensor’s trademarks.

Marketing Plan, Community of Interest or Substantial Assistance
The marketing plan, community of interest or substantial assistance element is often difficult to clearly define. Courts look for on-going substantial assistance or control, the sophistication of the assistance and direction from the franchisor, and shared economic interests in the business relationship.7

A “marketing plan” has been interpreted as a franchisee being granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing program or system prescribed in substantial part by the franchisor.8

Under the FTC Rule, “substantial assistance” can be found where the franchisor exercises significant control over, or gives the franchisee significant assistance in, the franchisee’s method of operation.9 The FTC Interpretive Guide sets forth that the more franchisees reasonably rely upon the franchisor’s control or assistance, the more likely the control or assistance will be considered “significant.” A franchisee’s reliance is likely to be great when they are relatively inexperienced in the business being offered for sale, or when they undertake a large financial risk. Similarly, franchisees are likely to reasonably rely on the franchisor’s control or assistance if the control or assistance is unique to that specific franchisor, as opposed to a typical practice employed by all businesses in the same industry.10 The FTC has also provided specific actions by the supplier, relating to methods of operations, which will automatically trigger the element of “significant control or assistance.”11 The FTC has also given some direction of other actions which may or may not constitute “significant control or assistance” depending on the circumstances and some items that it will not consider when evaluating this element.12 For instance, the FTC has stated that “assistance with promotional activities is not enough to constitute ‘significant’ assistance or control and that for control to be considered significant, such control must be for the “entire method of operation.”13 If the product supplied will only be a small portion of the products to be sold by the distributor, then it would not rise to the level of “significant” required under the FTC definition.14

Under certain state laws, the marketing plan and community of interest elements (the correlatives of the FTC’s significant assistance element) are subject to varying definitions. The marketing plan element generally exists where advice or training is given regarding the operation of the business and the sale of the products or services being offered.15 In other states, community of interest is generally considered to have broader scope than a marketing plan because as opposed to any intentional marketing activity, a simple continuing financial interest between the parties can trigger this element.16 Therefore, this applies to almost any commercial contractual relationship, and a distributor must look to the regulations and courts to determine how a particular state defines this element in the community of interest states.17

Fee
The fee element relates to separate consideration paid or promised by the franchisee business within a certain time period (usually six months) for the right to enter into the business relationship in combination with the other elements specified above.18 This fee may either be a direct payment to the franchisor or an affiliate or an indirect payment through the purchase of supplies or equipment at a price above market value.19 When evaluating whether a particular fee or cost constitutes a

franchise fee, regulators are not limited to initial lump sum payments, but may also consider other payments that occur or are promised within the applicable time period. Any payment that the franchisor/licensee charges to the franchisee/licensee that is not for ordianry business expenses may be considered a franchise fee.

Some examples of fees that may be considered franchise fees are royalty fees, training fees, inventory costs, or any other amount charged by the franchisor that is above market value or not for a business expense. Accordingly, it would appear that the simplest option to avoid being classifed a franchise relationship would be to eliminate any fee that would qualify as a franchise fee. However, due to the very broad interpretation of franchise fees, it can be more difficult to eliminate these types of fees than it would appear at first glance.

For instance, in a supplier distributor relationship, the franchisor/ supplier could choose not to charge any fee to the distributor for the right to sell the products, and then the franchisor/supplier could then sell all the products to the distribtor/franchisee for their bona fide wholesale price. However, under this structure, it will be important for the attorney to examine all amounts paid from the franchisee/distributor to the franchisor/supplier to ensure that none of these fees wold qualify as a franchise fee. Additionally, using the fee element to avoid being classified as a franchise relationship can be further complicated by business concerns, which will vary from one business concept to another.

FEDERAL AND STATE REGULATION OF FRANCHISING AND BUSINESS OPPORTUNITIES
As mentioned above, franchising is governed by federal and state law. The franchise and business opportunity laws generally relate to disclosures that must be made to the potential franchise buyer, and do not generally regulate the franchise business itself. The federal and state disclosure laws regarding franchising are discussed below.

Federal Franchise Disclosure Requirements
The FTC Rule requires that a franchisor provide a prospective franchisee with a set of 23 disclosures prior to the purchase of a franchise. This disclosure document is referred to as the franchise disclosure document or “FDD.” The 23 disclosures or “items” in the FDD include among other things, information regarding the franchisor, its principals, the initial and ongoing fees the franchisee will have to pay, the initial investment required to commence business, initial and ongoing training, the franchisee’s territory, and the number of outlets in the franchise system, etc. The franchisee must have these disclosures in hand for a minimum of 14 calendar days before the franchisee can sign an agreement or pay any money to the franchisor.21

The FTC does not require that the FDD be registered with the FTC. The FTC Rule only requires that the disclosures be made in compliance with the FTC Rule. The FTC Rule applies in all 50 states, Puerto Rico, Guam, the U.S. Virgin Islands, and other U.S. territories and possessions.22 Once the FDD has been prepared in accordance with the FTC Rule, the franchisor is free to sell franchises in certain states that do not require a separate state filing. As further discussed below, the states that do not require any additional filings are considered “non-registration states” and the states that do require filings are considered “registration states.” However, a number of states with business opportunity laws may also require some form of registration. If a franchisor wishes to sell a franchise in a registration state, or a business opportunity state, the laws of that state must be followed. The additional state requirements must be followed because the relationship between the FTC Rule and state registration laws generally operate in such a way that the more protective of these laws will be enforced.23 In other words, the FTC Rule will not preempt state laws where the state law requires more detailed or expansive disclosures.

In addition, the FTC Rule specifically provides that it only applies to sales of franchises that are to be located or operated in the United States or its territories and commonwealths, and not whether the prospective franchisee is U.S. resident or U.S citizen.24 In some states, the law on this issue is unclear, so the statutory provisions must be carefully reviewed if the offer or sale of a franchise to be operated outside of the U.S. is made to a resident of a registration state.

State Registration of the Franchise Disclosure Document Fifteen states have laws and regulations that govern some aspect of
selling franchises. Most of these states require that a franchisor register with the state and provide certain disclosures prior to selling franchises in their state. California was the first state to regulate the sale of franchises when it enacted its Franchise Investment Law in 1970.25 Subsequently, 13 other states enacted laws requiring certain disclosures and some form of registration before a franchisor can offer or sell a franchise.26 Those states are: Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin.27

Each state law is somewhat different, but the states have attempted uniformity through The North American Securities Administrators’ Association, Inc. (“NASSA”).28 Most practitioners use the NASAA guidelines in preparing the FDD with state by state requirements made through addenda to the FDD.29 The above states, together with Oregon, are referred to in this paper as the “Registration States.”30

Most of the Registration States require registration, including the filing of an application, a required filing fee ranging between $125-$750, consent for service of process, a disclosure document with required exhibits, audited financial statements, and most states review the FDD and provide comments requiring changes to the FDD.31 Registrations must be renewed or updated annually.

A few Registration States have less onerous registration requirements than others. For example, Michigan has the simplest registration process, requiring only a one-page notice that identifies the franchisor and its agent for service of process in Michigan.32 The registration is good for one year. Wisconsin and Indiana have a simplified registration process and do not require an examiner’s review of the FDD.33 The registration is complete upon filing an application together with the franchisor’s current disclosure document.34 In Hawaii and South Dakota, the registrations are effective 7 and 10 days respectively, after the application and disclosure document are filed in those states.35 However, in Hawaii, the applications are subject to review and a stop order may be issued at any time by an examiner.36

As with the federal requirements under the FTC Rule, in most instances, the states require that the registered FDD be delivered to the prospective franchisee not less than 14 full calendar days (or 10 business days, depending on the state) before any document can be signed by the prospective franchisee or any consideration can be given to the franchisor.

Additionally, most state franchise laws require the disclosure document to be delivered to prospective franchisees in their state. Depending on the state the prospective franchisee will be considered to be “in the state” where any of the following tests are met:

1) meetings between the franchisor and the prospective franchisee take place in the state; 2) the prospect resides in the state; 3) the prospect is domiciled in the state; 4) the acceptance of the offer is directed to the state; 5) the offer originates from the state; 6) the offer is directed to the state (in some states, that the proposed business will be located in the state); or 8) in some states, the proposed franchisees sales territory is located in the state.

 

Under these scenarios, it is possible that multiple state laws could apply to the sale of single franchise and the franchisor would be required to register in each of the applicable registration states.

Some states, such as California, Hawaii, Illinois, Maryland, Michigan, Minnesota, Rhode Island, Virginia and Wisconsin have an exemption for out of state sales.38 This means that a franchisor headquartered in one of these states may sell to a prospect that does not reside in the state and whose franchise business will not be located in that state.

Furthermore, in some states, if a franchisor wishes to advertise its franchise to potential franchisees, the franchisor must register its FDD and submit any advertisement for approval before using the advertisement in such state.40 Exceptions are made for regional and internet advertising, but the state regulations regarding advertising and internet must be followed.41

It should be noted, that a franchisor must be also aware that certain state business opportunity laws such as Utah, Texas, Florida, and Connecticut require some type of registration. The registration is generally not complicated, requiring only a short notice, or exemption filing and consent for service of process.

BUSINESS OPPORTUNITY LAWS
When assisting a business in developing a franchise concept, the attorney must understand both franchise and business opportunity laws in order to ensure that the offering complies with applicable laws and regulations. Business opportunity laws are designed to regulate industries that have specified locations and services routes, such as vending machines, electronic amusement machines, rack-jobbers and certain types of dealerships and home manufacturing businesses.

Despite the inherent complexity of franchise laws, there are numerous statutes, regulations, and court opinions providing guidance and clarity. Business opportunity law does not have the same level of clarity. This lack of clarity complicates drafting and often results in increased risk because the various elements of business opportunities are less tested and clear. States have enacted business opportunity laws and regulations, but the definitional elements vary widely from state to state.43

A general definition of a “business opportunity” is the sale or lease of any products, equipment, supplies, or services which are sold or leased to a purchaser to enable the purchaser to start a business for which the purchaser is required to pay an initial fee or sum of money which exceeds

$500 (or as low as $200 or less in some states) to the seller, and in which the seller represents at least one of the following to the purchaser:

The purchaser’s success with the business opportunity is ensured because the seller or its affiliate will provide, or will assist that purchaser in finding, locations or accounts for the use, operation, or placement of vending machines, racks, display cases, or similar devices, on premises the purchaser does not own or lease;
The seller or its affiliate or designee will reimburse the purchaser for, or will purchase from the purchaser, goods the purchaser produces, grows, or modifies, or services the purchaser performs, using goods or services supplied by the seller or its affiliate or designee, or resulting from those goods or services;
The seller guarantees that the purchaser will derive income from the business opportunity which exceeds the price paid or rent charged for the business opportunity or that the seller or its affiliate or designee will refund all or a substantial part of the purchaser’s initial payment, or will repurchase any of the products, equipment, supplies, or chattels supplied by the seller, if the purchaser is unsuccessful or dissatisfied with the business opportunity;
The purchaser’s success with the business opportunity is ensured by a marketing plan prescribed in substantial part by the seller or its affiliate under which the seller or its affiliate will provide to the purchaser training, or marketing assistance, in the purchaser’s method of operation; or

The seller represents that there is a market for the goods or services the purchaser will be selling.

The state definitions for business opportunity also have some exemptions and exceptions, but these exemptions and exceptions may vary widely frome one state to another.45 Some states exempt franchisors who comply with the FTC Rule or the state franchise laws from their business opportunity definition.46 Other states have exemptions if the opportunity is sold in conjunction with a registered trademark or the transaction is for a large initial investment or if the seller has a large net worth.

Just as with the franchise definition, these elements are subject to broad interpretation and definitions may vary from one state to another. In order to make a viable national distribution program, each of the elements of the various business opportunity definitions must be addressed. Unfortunately, there is not one exemption that works for all the state business opportunity laws which can be used as a safe harbor when drafting a distribution agreement. State regulators look to the actual course of dealing and not just to the contract terms in determining whether or not the various laws are applicable to a particular distribution agreement.

OTHER LAWS TO CONSIDER
In addition to these franchise/distribution specific statutes and regulations, there are several more general laws and regulations that frequently arise in franchise/distribution relationships. Although this publication does not lend itself for a detailed discussion of these topics, the following will highlight some of these specific statutes and regulations that often impact franchise/license relationships.

Uniform Commercial Code

Some courts will apply the UCC to those provisions of the franchise agreement related to the sale of goods from the franchisor and will apply traditional common law analysis to the other portions of the contract. Article 2 of the UCC contains a number of provisions that potentially affect obligations of “good faith” on “merchants” as those terms are defined including in Section 2-104 of the UCC. These provisions can have an important impact on the relationship between a franchisor/ licensor and its franchisee/licensee.

Fair Dealership Laws

Twenty states, Puerto Rico and the U.S. Virgin Islands, have promulgated “relationship” laws concerning elements of the ongoing contractual association and the termination of that associate between manufacturers and dealers or franchisors and franchisees.48 Any franchise/ license relationship that involves manufacture or distribution of goods should take account of these laws and make sure that the agreement and conduct between the parties complies with the requirements of these laws.

Little FTC Acts

Most states have passed “little FTC Acts” which are intended to protect “consumers” from unfair, false, misleading or deceptive trade practices.49 Franchisors/licensors need to ensure that their practices comply with these acts, and they need to include protective provisions in the agreements should their franchisees/licensees run afoul of these laws.

Price Maintenance

Price maintenance and its effects on brand name and goodwill is an important aspect of any system providing products or services in association with a specific trademark or commercial symbol. Obviously controlling the price of goods has anti-trust implications but recently, the Supreme Court has issued decisions addressing this in the franchise/ license context.

The Supreme Court in the case of State Oil v. Kahn 50 held that maximum resale price maintenance is no longer subject to a per se rule. And in 2007 the Supreme Court in the case of Leegin Creative Leather Products, Inc. v. PSKS, Inc.,51 held that minimum resale price maintenance is also no longer subject to a per se rule. Nevertheless, some states have taken the position that despite the Leegin ruling, those states will vigorously enforce their own acts and will criminally prosecute distributors that set minimum prices or otherwise violate the state’s little FTC act. A practitioner must be familiary with both federal and state laws in order to protect its client from state antitrust claims.

Other Antitrust Issues

Franchisors may require their distributors to sell products only within a limited geographic area, to a restricted class of customers, for a fixed price (or range of prices), in connection with the sale of other specified products and/or any combination of these and other restrictive practices. Because of the potentially anticompetitive effects of many of these restrictions, the franchisor’s/licensor’s course of conduct and agreements must comply with these laws, and the franchisor’s attorney must continually be updated with knowledge of these laws, their implications, and their potential to impact on the attorney’s clients.52

NEGOTIABILITY OF THE FRANCHISE AGREEMENT
When representing a franchisee client that is purchasing a franchise, or a franchisor client where a franchisee is requesting an amendment to the franchise agreement, the attorney should be aware of the potential for negotiation. It is commonly believed by franchisors, prospective franchisees and franchise attorneys that franchise agreements are not negotiable. Though there are many factors that make a franchisor reluctant to negotiate the terms of its standard franchise agreement, the attorney should assume the franchise agreement is negotiable.53 A few factors that should be taken into consideration are: the franchisor’s need for uniformity among the franchisees in the franchise system; franchisee communication one to another regarding more favorable terms given to a franchisee, and a system that has varying franchise agreements is much more difficult to administer or manage.54 However, in the right economic situation, it may be to the advantage of the franchisor to negotiate changes to its standard agreement. The willingness of the franchisor to make changes to its franchise agreement usually turns on the bargaining power of the parties.

Some areas of the franchise agreement are easier to negotiate than others. Clearly, it is important to most franchisors to have a uniform system-wide royalty.56 It is very difficult to negotiate a change in the royalty.57 However, franchisors are often willing to negotiate a change in the initial fee depending on such factors as the location of the franchise, how many units are proposed to be developed by the franchisee, the reputation of the franchisee, and the business experience of the franchisee, etc.58 The franchisor may also consider negotiating the territory, the scope of the personal guaranty, and the scope of the covenant not to compete, especially when the potential franchisee or other members of his family are involved in other businesses.59 Other areas that are often negotiated include, whether or not the franchisee needs to work full time in the business, renewal and renewal fees, default and cure provisions, and the term, etc.

PRELIMINARY CLIENT DISCUSSIONS
Clients often come to the attorney with a business plan involving a product or service distribution concept (“Marketing Program”), but without having made a decision about whether the concept will be a franchise. It is up to the attorney to guide the client through this process. The role of the attorney in drafting an agreement for a client’s Marketing Program is to understand the client’s business needs and ensure that the agreement accurately reflects the client’s actual distribution program. The attorney also needs to ensure that any required disclosure and the agreement itself is compliant with the varied and complex laws and regulatory schemes that may apply, as discussed above.

In developing a Marketing Program, it is relatively easy for the company or the attorney to trigger application of various laws and regulations that may not have been considered. If the attorney assisting a client in setting up a Marketing Plan does not draft the contract with such laws and regulations in mind, the attorney may be faced with an unhappy client in the future when the client discovers it may have accidentally developed a Marketing Program that is considered a franchise or business opportunity, requiring the company to spend both time and money to comply with the applicable legal framework and any potential penalties and fees.

There are a number of preliminarily issues that should be discussed with a client desiring to establish a nationwide or regional Marketing Program. These issues focus generally on control of marketing, capital and labor available to the supplier, operational controls and legal frameworks. For example, a key factor concerns the product or service to be distributed. What is it about the product that distinguishes it from other products in the broader market place? The client’s success in a local market does not assure success in the broader market. The client needs to conceptualize what makes its particular product unique. This analysis will help in developing the Marketing Program.

Secondly, the attorney needs to understand the financial position of the client. The distribution system must satisfy the client’s financial needs. Does the client have sufficient capital to introduce a regional or nationwide marketing, sales and distribution program itself or does it need outside capital and labor?

There should also be a discussion as to whether or not product branding and brand identity are important to the client. Branding issues have an impact on both the distribution system and the Marketing Program. Furthermore, the attorney needs to understand the degree of control over operations, training, distribution, marketing and advertising that is important to the client. Such controls will also influence the type of Marketing Program established. In addition, the attorney should understand the network of component suppliers and how that network will interact with the down line distributors. Finally, the attorney should discuss the legal framework of the various methods of distribution available to the client.

Lastly, the attorney should review the following questions with the client to further flush out the Marketing Program:

1) Does the business require full time sales persons hired as employees of the Company? 2) Does the business require direct sales such as the internet, social media, catalogue, infomercials, telephone solicitation and, mailers? 3) Does the business require independent contractors such as salesmen and supplier representatives who solicit orders on a commission basis? 4) Does the business require regulated distribution arrangements such as business opportunities, multilevel marketing and franchising? And, 5) Does the business require other methods such as company warehouse centers, joint ventures, license agreements, and wholesale distributor agreements?

CONCLUSION
Practicing franchise law can be interesting, stimulating and far more complex than simply drafting an FDD. Franchising is a relatively new area of the law that is quickly evolving. The attorney practicing franchise law must be well-informed, and have a consistent way of staying abreast to changes in the law.