The Accidental Franchise
by Kevin L. Twining
Do you have clients who distribute goods and services through licensees or distributors? If so, when drafting or reviewing agreements for those clients it is imperative that you consider whether the relationship between your client and the other party is actually a franchise, as franchise laws apply regardless of the name of the agreement or the contracting parties’ intention. Failure to recognize that an agreement creates a franchise under federal or state law could have significant consequences for both you and your client.
Most people think they know a franchise (e.g. McDonald’s and Subway) when they see it. However, franchising is not an industry, but rather a method of distribution. Most franchise legislation contains broad language in defining a franchise relationship. Thus, there is a risk that certain common legal relationships, such as distributorships and trademark licenses, could be deemed franchises. The increasing complexity of commercial relationships has led to an expanding number of relationships that fall within the broad reach of the franchise laws and thus become accidental franchises.
A business arrangement that meets all three of the elements discussed below will be deemed a franchise, and thus trigger federal and state presale disclosure requirements. Additionally, potentially applicable state registration and relationship laws may restrict the conditions under which the relationship may be terminated or not renewed. Failure to comply with these laws may subject the violator to damages, rescission or, in certain circumstances, criminal penalties.
For purposes of the Federal Trade Commission’s “Franchise Rule,” which applies in all 50 states, a business arrangement is a franchise if it meets three basic elements: (i) the right to use a trademark in connection with the offer, sale or distribution of goods; (ii) the payment of more than $500 during the first six months of the relationship; and (iii) significant assistance to, or control over, the grantee’s business. State law franchise definitions largely resemble the FTC’s Franchise Rule, with a few variations.
The trademark element of a franchise is met if the business is identified by the licensor’s or manufacturer’s trademark or if the goods are identified by the licensor’s or manufacturer’s trademark, symbols or slogan, even if the agreement lacks an express trademark license.
The required fee element captures all sources of revenue paid to the grantor for the license or distribution rights. This element is broad and includes not only upfront fees and royalties, but also training fees, advertising fees and innocuous payments for sales manuals, demonstration kits or point-of-sale advertising. The one exception to this element is the payment of a bona fide wholesale price of inventory for resale so long as there is not a requirement to purchase excessive quantities.
The significant assistance or control element is inherently subjective, and courts typically look at a variety of factors. It may exist if the licensor or manufacturer provides a training program, marketing advice, site location assistance or a detailed operating manual, or if the licensor or manufacturer mandates personnel policies or practices, establishes operating methods or standards, prescribes operating hours, or restricts the sales territory or customers that may be served. In certain circumstances, any one of these factors may be sufficient to establish significant assistance or control. The parties’ course of dealing and industry customs are also relevant. Since this element is inherently imprecise and involves a variety of factors, the key is knowing what and how many factors are enough to tip the scale.
Most trademark license agreements include some quality control provisions since an owner may lose rights in a trademark if it fails to exercise reasonable control over its use. The problem arises when the licensor begins to exercise too much control or provide too much assistance to other aspects of the licensee’s business operations. For example, a simple trademark license agreement may become a franchise if the licensor requires the licensee to undertake a specific marketing plan or if the licensor provides a training program for the licensee. Likewise, a distribution agreement may be deemed a franchise if the manufacturer provides an operations manual or site selection assistance or requires specific hours of operation.
Knowing the elements of a franchise and the line that separates a trademark license or distribution agreement from a franchise will allow you to protect your client (and you) from incurring liability for failing to identify the accidental franchise.
Kevin L. Twining, a partner at Locke Lord LLP, chairs the firm’s franchise section. He can be reached at firstname.lastname@example.org.