Where Did That Franchise Come From?, 0716 SCBJ, SC Lawyer, July 2016, #32
| Author | Lawrence G. Jameson III, J. |
Lawrence G. Jameson III, J.
We all are very familiar with franchises. Daily we are exposed to numerous franchises offering various services or products. We work out at them (Planet Fitness), eat at them (McDonald's) and have our cars serviced at them (Meineke). But what exactly is a franchise? And how are they created? Can a Coca-Cola distributorship be considered a franchise? Or a reseller agreement for software? How about a joint venture for a "company-owned" unit with a new partner? Not knowing what constitutes a franchise could have extreme consequences for you and your client, including a large malpractice verdict against you (real life example described herein).
What is a franchise?
The Federal Trade Commission (FTC) pursuant to its authority under 15 U.S.C. 57a(a) promulgated franchise regulations 16 CFR Parts 436 and 437 in 1978, and revised, 2007 (Amended FTC Franchise Rule), to prevent fraud in the marketplace. Historically, the sale of a business or business opportunity allowed for extreme corruption through lack of disclosures and honest business dealings.
Under the FTC Rules, a franchise is defined1 as "any continuing commercial relationship or arrangement" made orally or in writing in which: 1. The franchisee will obtain the right to operate a business that is identified or associated with the franchisor's trademark, or to offer, sell or distribute goods, services or commodities that are identified or associated with the franchisor's trademark;
2. The franchisor will exert or has authority to exert a significant degree of control over the franchisee's method of operation, or provide significant assistance in the franchisee's method of operation; and
3. As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.2
Under the Amended FTC Franchise Rule and Final Guides to the Franchising and Business Opportunity Ventures Trade Regulation Rule ("Final Interpretive Guidelines"), if all three elements are present, then the relationship will be deemed a "franchise."3
1.Grant of Trademark License.
The easiest element in determining the existence of a franchise, i.e., the grant of rights to use one's trademark for the sale, offer or distribution of its goods, is simple to spot. When a licensing agreement is used, the grant of the trademark license is either express or implied. An implied grant of a trademark is often inferred by the lack of prohibitive acts by the trademark owner against the user of the trademark.
2.Control.
The control element can be less easy to spot. Determining the level of control necessary to create a franchise is subjective. In general, courts look at the significance of the control or the significance of the assistance provided to the franchisee. The better question to ask is, "How much did the franchisee rely on the franchisor's experience, systems and assistance in formalizing the relationship?" The more reliance and lack of experience of the franchisee, the more likely the control element is met. The Final Interpretive Guidelines state, "The franchisee, in order to reduce its business risks or enhance its chances for business success, relies upon the availability of such expertise to avoid business mistakes that it might otherwise make. The franchisor conveys its expertise either by exercising controls over the franchisee's method of operation of the business or by furnishing assistance to the franchisee in areas relating to the franchisee method of operation."4
Examples of controls: (a) site approval for unestablished businesses, (b) site design or appearance requirements, (c) hours of operation, (d) production techniques, (e) accounting practices, (f) personnel policies and practices, (g) promotional campaigns requiring franchisee participation or financial contribution (h) restrictions on customers, and (i) location or sales area restrictions.5
Examples of assistance: (a) formal sales, repair or business training programs, (b) establishing accounting systems, (c) furnishing management, marketing or personnel advice, (d) selecting site locations and (e) furnishing a detailed operating manual.6
The FTC does not apply much effect on the term "significant," so the mere presence of any of the above controls or assistance can trigger the control element for franchising.
3. Fee.
The fee in operation element can also be difficult to identify. The FTC Rule identifies a fee as a franchisee's payment to the franchisor in the amount of at least $500 at any time before or within six months after the beginning of operating the business, if such fee is a condition of the acquisition and running of the franchised business. On its face, most think of a direct franchise fee or royalty as being the only applicable payment for this element. However, there are many ways the FTC will construe a payment arrangement in favor of a fee that fits this definitional element. In its Final Interpretative Guidelines, the FTC provides: "The Commission's objective in interpreting the term "required payment" is to capture all sources of revenue which the franchisee must pay to the franchisor or its affiliate for the right to associate with the franchisor...
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