Where Did That Franchise Come From?, 0716 SCBJ, SC Lawyer, July 2016, #32

• Author: Lawrence G. Jameson III, J.

Where Did That Franchise Come From?

No. Vol. 28 Issue 1 Pg. 32

South Carolina BAR Journal

July, 2016

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 and market its goods or services. Often, required payments are not limited to a simple franchise fee, but entail other payments which the franchisee is required to pay to the franchisor or an affiliate, either by contract or by practical necessity. Among the forms of required payments include, initial franchise fees as well as those for rent, advertising assistance, required equipment and supplies—including those from third parties where the franchisor or its affiliate receives payments as a result of such purchases—training, security deposits, escrow deposits, non-refundable bookkeeping charges, promotional literature, payments for services of persons to be established in the business, equipment rental, and continuing royalties on sales."⁷ These fees include any fees in the franchise agreement or any companion agreements to the relationship or arrangement.

FTC and the FDD

If all three elements are present, what are the franchisor's obligations? The Amended FTC Franchise Rule stipulates that the sale of a franchise requires a franchise disclosure document (the FDD) to be provided to any potential franchisee no less than 14 days prior to signing any binding documents with the franchisor or securing any payment. The FTC dictates the FDD have 23 Items that disclose the parties involved in the franchise, how it was created, what rights will be granted to the franchisee (including operational territories), and any kickbacks the franchisor gets from franchisee's requirement to purchase supplies and services from designated vendors. Failure to provide the proper disclosures under the rule is considered an unfair or deceptive act or practice in violation of Section 5 of the Federal Trade Commission Act.⁸ There is no registration requirement under the Amended FTC Franchise Rule. It is important to note that the Amended FTC Franchise Rule is supplementive and not preemptive, and states have the ability to create more restrictive rules governing franchises and business opportunities. Many states have separate franchise laws, often in addition to business opportunity laws, that have stricter compliance requirements. There are 14 states that have independent franchise laws that require the filing of the FDD with its Secretary of State or similar agency (South Carolina does not).⁹

State franchise laws and business opportunity laws

Some states require franchises, and similar sales arrangements, to register as a "business opportunity" with its Secretary of State or similar agency The definition of a business opportunity is state controlled and often broad, but focuses on the sale and marketing of business opportunities to third parties. The law's purpose, much like franchise laws, is to protect the consumer Generally a business opportunity focuses mostly on a marketing plan and training program often with a set list of goods or services that is sold to a buyer who wants to open up his or her own business. The relationship is usually restricted to the initial transaction, with no royalty payment requirements. The buyer usually operates under its own business name or trademark and there are no further obligations. These arrangements are often akin to a "business in a box."

Many states have business opportunity statutes, including filing requirements. South Carolina's business opportunity statute, South Carolina Annotated Code 39-57-20, defines a business opportunity as: "the sale or lease of any products, equipment, supplies, or services which are sold to the purchaser for the purpose of enabling the purchaser to start a business, for which the purchaser is required to pay the seller a fee which exceeds two hundred fifty dollars, and in which the seller represents:

(1) that he will provide locations or assist the purchaser in finding locations for the use or operation of vending machines, racks, display cases or other similar devices, or currency-operated amusement machines or devices, on premises neither owned nor leased by the purchaser or seller; or

(2) that he will purchase any or all products made, produced, fabricated, grown, bred, or modified by the purchaser using in whole or in part, the supplies, services, or chattels sold to the purchaser; or

(3) that he guarantees that the purchaser will derive income from the business opportunity which exceeds the price paid for the business opportunity; or that he will refund all or part of the price paid for the business opportunity, or repurchase any of the products, equipment, supplies, or chattels supplied by the seller, if the purchaser is unsatisfied with the business opportunity; or

(4) the seller will provide a sales program or marketing program which will enable the purchaser to derive income from the business opportunity which exceeds the price paid for the business opportunity; provided, that this subsection does not apply to the sale or a marketing program made in conjunction with the licensing of a registered trademark or service mark."

Whether a relationship or arrangement is a franchise or not under the federal definition, it could be a business opportunity under a state statute. Unless the franchisor or company is exempt from the statutory language, it must file as a business opportunity with the South Carolina Secretary of State's Office.¹⁰ Often these laws come with criminal penalties in addition to civil penalties and remedies. It is also important to remember that a legally formed relationship in South Carolina may not be deemed legal in other states. As a result, other states' laws where the relationships could exist should be considered.¹¹

Where it can go wrong

Other states may deem an arrangement a franchise with the exclusion of only one element. However, South Carolina laws do not define a franchise more broadly than the federal rules. Therefore the removal of one of the three elements may be enough to save a potential franchisee from the FDD and other federal requirements. Here are a few examples of common relationships that can become franchises when all three elements are present.

1. License Agreement.

Often times, a party licenses the use of its name in conjunction with its goods and service. There is typically a fee associated with it, but frequently there is no control or assistance over the goods or services provided by the licensor. In these circumstances, a franchise is not borne, but instead a true license agreement. But what if control or assistance is a component as well as a purchase price or fee1?

2. Sales Agreements.

In general, sales agreements remove the required fee element. Most sales agreements are normally not considered franchises, and the Final Interpretive Guidelines states, "Agency relationships in which independent agents, compensated by commission, sell goods or services (e.g. insurance salespersons) are excluded, since there is no "required" pay."¹² However, there are examples when a "required fee" is involved in the transaction.

Ex. Distributorship or Reseller Agreement. Software companies often outsource sales to "resellers." A reseller is given a license and often the licensor has strict guidelines regarding marketing and sales. Further, many times there is a purchase price involved for the license. This would appear to create a franchise as all three elements are present.¹³

3. Joint Ventures.

Frequently an individual or individuals create a concept as a single unit and see success. Instead of expanding company-owned units, they will create joint ventures with an outside partner. While there is an exception for such arrangements, it is important to view these arrangements with skepticism.¹⁴ Under these scenarios a license is granted by the original unit's entity and there will be sufficient controls and assistance to ensure consistency in the product. However, under the FTC Rules, a fee could become prevalent unintentionally. Should the original owners require a licensing fee, the third element would be satisfied. If the original owners require a disproportionate "buy-in," the third element could be satisfied. Or if the original owners require payment for training, the third element could be satisfied. The required fee element allows for greater breadth and interpretation, which could lead to an inadvertent franchise.

These examples are not intended to be an exhaustive list, but merely examples of how basic deals and transactions can easily become a franchise.

So what?

At this point you may be wondering: so what, who cares, I accidently created a franchise, so sue me. And that is exactly what could happen. A Connecticut law firm was handed a $15 million judgment in favor of its former client in a malpractice suit because the firm failed to properly disclose compliance requirements under the state franchise laws.¹⁵

While there is no federal cause of action for an inadvertent or accidental franchise, the FTC will levy sanctions against a party who sells a "franchise" without following the federal regulations, regardless of mistake. Section 5 of the FTC Act provides such violations are "an unfair or deceptive act or practice." The penalties from the FTC include permanent injunctions in which the franchisor can no longer operate its business, rescission of the contract, as well as restitution in federal court (without the initiation of any administrative proceedings). The power of the federal court will employ any and all necessary remedies.¹⁶ All it takes is for the disadvantaged party to report the potential violation, and the dominoes will begin to fall.

In addition to the federal penalties, the disadvantaged party may also have causes of action in the state courts. Many will bring claims of fraud, misrepresentation and violations of the state's unfair trade practices act. Once the FTC and the disadvantaged party are done with your client, you can bet where the client will turn next.

How to avoid creating an inadvertent franchise

The first thought many have is to disclaim the relationship or arrangement as a franchise. There is a false belief that providing a clause in an agreement such as "this agreement in no manner creates a franchise or franchisor-franchisee relationship" is sufficient to disclaim the creation of a franchise, and therefore any liability. The Final Interpretive Guidelines provides, "[t]he name which the parties give to their relationship is not relevant in determining whether the relationship is within the scope of the rule … [T]he rule covers relationships which are represented either orally or in writing as having the characteristics specified in the rule's definition of 'franchise' regardless of whether the representations are, in fact, fulfilled."¹⁷While the Supreme Court of the United States has yet to rule on a case involving this nomenclature issue, several federal circuits have, and regardless of what the "franchisor" deemed the arrangement, the courts found a franchise.¹⁸

Instead of focusing on what the relationship is called, it is more important to review the elements and determine if all three are satisfied. Barring any state franchise and business opportunity laws in opposition, the following may prove beneficial. In most inadvertent franchises, it is likely a trademark license is involved, so the removal of this element would be difficult. However, it if is possible, this element can be removed and the statutory definition is no longer satisfied. Additionally, having a strict license agreement with no support, assistance or direction in conjunction with the grant will likely be enough to curtail a franchise. Lastly, not requiring any payment, or at least removing the requirement until six months after the business has opened its doors, may be enough to lose franchise status.

If there is doubt, it is better to consider the relationship or arrangement as a franchise and proceed accordingly. In these instances, an ounce of caution is truly worth a pound of cure.

Lawrence G. Jameson III practices with Jameson Law LLC in Charleston, with a second office opening in New York City in August of 2016.

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Notes:

[1] 16 C.F.R. § 436.1(v).

[2] 16 C.F.R. § 436.1 (h).

[3] See Fed. Reg. Vol. 44, No. 166, 49968 (Aug. 24, 1979) for exemptions to the franchise disclosure requirement.

[4] Id. at 499667

[5] Id.

[6] Id.

[7] Id.

[8] 16 C.F.R. § 436.2

[9] Registration states include California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin.

[10] A notable exemption to the statutory language is a registered trademark. According to an informal opinion written by the S.C. Attorney General the registration can likely be either through the United States Patent & Trademark Office or the South Carolina Secretary of State's Office, but not through any other agency. 1983 WL 182087, at *1 (S.C.A.G. Sept. 7, 1983) However, the informal opinion does not explicitly state the South Carolina Secretary of State registered trademark is sufficient.

[11] It should be noted that jurisdictional issues that may arise. See e.g. Andrew v. Power Mktg. Direct, Civil Action No. 6:07-cv-4087-RBH, 2008 U.S. Dist. LEXIS 75938 (D.S.C. Sep. 29, 2008) in which the court held that a case for fraud involving a contract with a forum selection clause in Ohio could not be heard in South Carolina.

[12] Fed. Reg. Vol. 44, No. 166, 49967.

[13] See, To-Am

Equipment Co. Inc. v.

Mitsubishi Caterpillar Forklift America, Inc., 152 F. 3d 658 (7th Cir. 1998) (finding the purchase of required manuals constituted a "franchise fee" under the Illinois Franchise Disclosure Act of 1987).

[14] Id. at 49968. While there is a partnership exemption, to qualify, all partners must be general partners and the Commission will look carefully for any arrangement where one partner (franchisor) is limiting its liability to the other partner (franchisee).

[15] Beverly Hills

Concepts, Inc. v. Schatz

& Schatz, Ribicoff & Kotkin, 247 Conn. 48, 50, 717 A.2d 724, 727 (1998)

[16] 16 C.F.R. § 436.2.

[17] Fed. Reg. Vol. 44, No. 166, 49966.

[18] See USA v. Lassetter, 2005 U.S. Dist. LEXIS 23426 (MDTN 2005) (where court found a "complete turnkey business package" as a franchise); See also F.T.C. v. Tiny Doubles Int'l, Inc., 76 F.3d 385 (9th Cir. 1996)

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