March 06, 2009
If a business’ activities unwittingly bring it within the embrace of federal and state franchise laws, and that business is unaware of this fact, it is in grave jeopardy. Time and again during the past 35 years, a company that is not a “franchisor” in the traditional sense has discovered that its way of doing business, its methods of distributing products or services, or its grant of “licenses” of one type or another brings it within the extraordinary broad embrace of federal and state franchise laws. Unfortunately, this “discovery” usually takes place in the context of a governmental investigation or prosecution, sometimes accompanied by private lawsuits commenced by putative “franchisees” unhappy with their business relationships. As some of the cases facing these issues have noted: “Legal terms often have specialized meanings that can surprise even a sophisticated party. The term 'franchise,’ or its derivative ‘franchisee’, is one of those words”and “…(I)f it looks like a duck and it smells like a duck and it quacks like a duck, it’s usually a duck.”
Most businesspeople (and many attorneys) are oblivious of the fact that federal and state franchise laws extend beyond traditional franchisors, such as those engaged in the fast food, hotel/motel and convenience store sectors of our economy. They are unaware that franchise laws generally define the terms “franchise” and “franchisor” so broadly as to embrace businesses, business relationships, licenses and distribution methods that seem to have nothing to do with traditional franchising.
Likewise, manufacturers and suppliers are all too often surprised and dismayed to learn that their distributorship relationships are subject to franchise laws. A striking example is a 1999 case in which a jury awarded $1.525 million to a terminated Mitsubishi forklift distributor due to a violation of the Illinois franchise law.
Indeed, even sophisticated lawyers and clients often fail to comprehend the breadth and scope of the franchise laws. Many fail to understand that the franchise laws, along with related laws, govern business relationships which may be vastly different from what is typically thought of as a franchise.
WHAT IS A FRANCHISE?
Federal and state franchise laws seek to define the term “franchise” by reflecting franchising’s underlying economic realities. However, the FTC and the franchise-regulating states have agreed upon no single, uniform definition, and thus the scope of coverage of each statute must be carefully analyzed.
The Federal Trade Commission, in a promulgation known as the “FTC Rule”, which was recently amended, defines a franchise as a “continuing commercial relationship” which contains all of the following three elements, and if any of these three elements is missing, the business relationship is not considered a "franchise" under the FTC Rule.
- Trademark: The franchisee is allowed to operate a business, or offer, sell or distribute goods, commodities or services, which are identified by a trademark, service mark, trade name, advertising or other commercial symbol;
- Significant control or assistance: The franchisor exerts, or has authority to exert, significant control over, or provides significant assistance to, the franchisee’s method of operation; and,
- Fee or Payment: The franchisee is required to make a “required payment” to the franchisor or its affiliates of $500 or more (other than for bona fide wholesale prices for inventory) at any time before or within six months after commencing operation of the business.
State Laws
Although definitions employed by the states often resemble those set forth in the FTC Rule, the state definitions most often, but not always, involve a trademark element, a marketing element (rather than the “control and assistance element”) and a fee element. The state laws may be narrower or broader than the FTC Rule and often extend to forms of business relationships which embrace a wide variety of dealerships, distributorships, and licensing arrangements.
EXAMPLES OF “HIDDEN” FRANCHISES
The wide array of cases and administrative opinions interpreting whether or not the statutory definition of a franchise is present demonstrates that there are many relationships that could unwittingly fall into the franchise trap. They have been variously referred to as “hidden”, “inadvertent”, or “unintended” franchises. The following types of businesses, which have sometimes been treated as franchises in certain states, provide just a few examples of the wide grasp of the franchise laws and their applicability to distributorship and other similar arrangements. To the untrained eye, many of these situations do not appear to involve a franchise, and, of course, these might not be considered franchises in many states: air conditioner dealer, appliance dealer, automobile parts dealer, basketball team, cafeteria in office building, computer training system, copy machine distributor, furniture dealers, internet providers, karate school, law firm branch office, lubricant distributor, magazine distributorship, office products dealer, sales representatives, slot machine manufacturer, snack distributorship, sports information service provider, and sublease agreement for pet shop.
RISKS OF NON-COMPLIANCE
Failure to comply with franchise disclosure, registration or relationship laws, or the business opportunity laws, exposes the violator to substantial risks of civil and criminal liability. Although there is no private right of action for failure to comply with the FTC Rule, the Federal Trade Commission has enforcement powers to subject the non-complying party and its officers and directors to injunctions, cease and desist orders, rescission, civil fines, and criminal penalties. Private causes of action are, however, available under many state laws. Those who fail to register or provide required disclosures in the so-called “registration states” are subject to various civil remedies, such as damages, rescission, attorneys’ fees, and in most cases, criminal liability. Furthermore, some states which do not require franchisors to register have enacted “Little FTC Acts,” which provide that a violation of the FTC Rule is actionable under state law. The FTC Rule imposes liability on officers and directors if there is a violation, and most state laws extend joint and several liability to officers and directors and those participating in the violation as well.
CONCLUSION
It is vital that any business which either engages in licensing activity and/or distributes products or services through independent third parties conduct extraordinarily detailed analyses of the varying definitions of the term “franchise” found both in the FTC Franchise Rule and the fifteen franchise registration/disclosure statutes, lest that business’ activities fall within the embrace of such laws, rendering the business an “unwitting” franchisor subject to governmental attack, the plethora of criminal and civil penalties which apply to illegal franchising (and, as always, ignorance of the law is no excuse) and private rights of action commenced by self-styled “franchisees” unhappy with their business relationships.
Careful drafting of contracts is essential, and possible restructuring of the relationship may be required. As attorneys become more sophisticated and aware of rulings in this field, it is likely that the franchise laws will be used more often as a weapon to challenge various aspects of unsuspecting business relationships. Those who misunderstand these laws or who fail to structure a relationship around them are subject to substantial risks and penalties, and in many cases large damage awards, not to mention the costs of defense, even if they ultimately prevail in court.
Leonard D. Vines
Greensfelder Hemker & Gale, P.C.
St. Louis, Missouri
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David J. Kaufmann
Kaufmann Gildin Robbins & Oppenheim LLP
New York, New York
The authors are members of the industry advisory committee of the NASAA Franchise Project Group, a quasigovernmental organization composed of federal and state franchise regulators nationwide. An expanded version of this paper was presented to to the NASAA Franchise Project Group February, 2008.