By L. Seth Stadfeld (Published 2006)*

Generally, when people think of franchises they think of well-known brands in traditional industries such as fast food, hospitality, automotive, service stations and other brick and mortar types of businesses. They think of a certain business model involving a chain of uniform retail outlets operating under a common name or mark. In more technologically advanced industries, however, participants in the supply chain (manufacturers, such as original equipment manufacturers (“OEM’s”), resellers (such as value added resellers (“VAR’s”) and retailers) often overlook the possibility that franchise regulations may apply to their activities, especially the establishment and termination of distribution rights when coupled with some form of a license. Failure to take these laws into account can result in serious exposure to the unsuspecting violator. The purposes of this paper are to explore what a franchise is within the meaning of the law, to describe the regulatory environment that applies to franchise sales and franchise relationships, to suggest methods for circumventing the application of such laws, and to prescribe some basic approaches on what to do when the unsuspecting franchisor client seeks your help.

1. What is a Franchise?

Both federal and state law regulate the offer and sale of franchises as well as activities between franchisees and franchisors in their ongoing business relationships. Because the primary thrust of this program [1] involves the establishment of chains of distribution by unsuspecting franchisors, the best place to start for definitional purposes is in the area of the business opportunity that is offered and sold.

  1. Federal Definition.

The FTC Franchise Disclosure Rule, 16 CFR 436 (1978) (“FTC Rule”) regulates the offer and sale of franchises in the United States. Under this rule a franchise exists in a commercial arrangement between a buyer and seller when the following three elements are present: (i) a grant of the right to use the seller’s trademark to offer, sell or distribute goods or services; (ii) the seller offers significant assistance to the buyer in its operations or reserves the right to control its operations; and (iii) the payment of a fee ($500 or more within the first six months of operations). The FTC Rule is interpreted liberally to further its primary goal of investor protection.

It doesn’t matter what the parties call their relationship and it doesn’t matter whether or not they intended to establish a franchise relationship. It matters only that the definitional elements are present in the commercial arrangement under consideration. Further, while purely oral agreements are excluded from the sweep of the FTC Rule, some state law definitions provide otherwise.

The FTC Rule applies to three general types of franchises: package or business format franchises, product distribution franchises and business opportunity franchises. The package franchisee adopts the franchisor’s business format and identifies its independent operation with the franchisor’s trademarks in exchange for which it typically pays one or more fees. Examples of package franchises include fast food, real estate brokerage and convenience store outlets. Conversely, product distribution franchisees distribute goods identified by the franchisor’s brand. These include ice cream, gasoline and automobile outlets. Business opportunity franchises typically involve vending machine routes, rack display distributorships and like arrangements. The latter are of little import in the types of supply chain arrangements that are the subject of this program, however.

  1. State Law Definition

State law definitions largely resemble the FTC Rule’s definition applicable to package and product franchises in that most require the presence of the three basic elements. The trademark and fee elements are basically the same for state law purposes. The difference lies in the states’ approaches to the final element (significant control or assistance at the federal level). The states replace that element with a requirement that there be a “marketing plan prescribed in substantial part by the franchisor” or a “community of interest” between the parties in connection with the franchisee’s business. [2]

II. The Regulatory Environment [3]

  1. Pre-Franchise Sale Relationships – Disclosure/Registration
  1. Federal Law – Federal Trade Commission Franchise Disclosure Rule

The FTC Rule was promulgated on December 21, 1978 pursuant to 15 U.S.C. §45. It became effective October 21, 1979. Like comparable state law, the FTC Rule requires that franchisors (and their representatives) make detailed disclosures to prospective franchisees about the franchisor, the franchise opportunity and the applicable agreements, to name a few. Unlike the federal securities laws and comparable state laws, however, there is no requirement under this disclosure law to file or register an offering with the FTC. Moreover, there is no private right of action to enforce the FTC Rule. Only the FTC can enforce it. [4] Nevertheless, a violation of the FTC Rule constitutes an unfair or deceptive act or practice under the FTC Act.

Required Disclosures. The pre-sale disclosure process under federal and state law calls for giving prospective franchisees comprehensive information about the franchisor’s franchising experience, litigation history, bankruptcy history, financial condition, important contract obligations, information about fees and investment costs, recent franchise system statistics (number of franchises, terminations, re-acquisitions by the franchisor and non-renewals) as well as the identities of and information on current and former franchisees. For examples of a franchise disclosure document and a franchise agreement, see the sample documents attached as appendices at the end of this paper.

UFOC Format v. FTC Format. The North American Securities Administrators Association (NASAA), an unofficial association of state securities and franchise regulators, has produced a uniform franchise disclosure format referred to as the Uniform Franchise Offering Circular or UFOC. Guidelines for preparing a UFOC may be found in the Business Franchise Guide published by Commerce Clearing House at ¶5750 et seq. Generally, a franchisor’s disclosure obligations under the UFOC format are more extensive than under the FTC format. The FTC Rule sets a minimum standard for pre-sale franchise disclosure in the United States. It preempts state law to the extent that there may be a conflict. Both the FTC and states with franchise registration/disclosure laws (see below) accept the UFOC disclosure format. Conversely, states with franchise registration laws (the “registration law states”) do not accept disclosures under the FTC format. As a result, hardly any franchisors follow the FTC disclosure format in preparing their disclosure documents. [5] The UFOC includes not only these detailed disclosures but also three years of the franchisor’s audited financial statements, a table of contents of its operations manual (if any) as well as a list of its agents for service of process in applicable states. Under both formats, copies of all contracts to be signed by the prospect in connection with the franchise must be provided.

Timing of Disclosures. Both federal and state disclosure laws forbid franchisors from requiring that a prospect pay any consideration or sign any binding contract until they deliver to the prospect a comprehensive disclosure document (normally the UFOC but also referred to as a prospectus or an offering circular) and wait a minimum cooling-off period of ten business days.

  1. State Laws.

Franchise Registration and Disclosure Laws. As noted above, there are fourteen states that have franchise registration laws. [6] In addition to the timely delivery of an accurate and complete disclosure document, these statutes increase franchisor obligations by requiring that they first register their offerings with a state regulatory agency and obtain clearance before they can lawfully offer their franchises for sale. And while the franchise registration statutes are largely similar, most contain additional state-specific disclosure requirements that must be addressed as well. Franchisors must keep their registrations current through annual filings (and more frequent ones if circumstances dictate that there are material changes that call for disclosure to prospects) if they wish to continue selling in a particular state.

Who Must Register and When? Franchisors and sub-franchisors must register their franchises before they can sell them in a registration law state. For a list of these states see note 2 supra. They must register when the offer or sale of their franchise falls within the jurisdictional scope of the statute. Patterned after the securities laws, the jurisdictional scope of these laws is necessarily broad in order to further their underlying policy of investor protection. Generally, one of these laws will apply if a franchise is offered in the state, the prospect resides or is domiciled in the state, the offer is accepted in the state and/or the franchised business will be located in the state. Depending on the facts, in some cases it may be that more than one state’s law applies to a given transaction. Accordingly, counsel must pay careful attention to offer and sale activity to determine which state laws apply. [7]

Accordingly, when establishing distribution relationships in the United States, suppliers, licensors and their counsel must evaluate whether the business opportunities they are offering meet the “franchise” and/or “business opportunity” definitions under applicable statutes. If so, they must look to determine if there is an exemption from disclosure and registration. If not, they must prepare the disclosure document [8] and register it in appropriate states before offering the “opportunity” for sale or consummating transactions. In connection with the offer and sale of a franchises, it is an unfair or deceptive act or practice under the FTC Rule, to fail to furnish prospective franchisees with a disclosure document containing all of the disclosures required by the FTC Rule. Similarly, it is an unfair or deceptive act or practice to fail to give such disclosures within the time periods required by the FTC Rule.

Earnings Claims. Invariably, before purchasing a franchise or business opportunity the buyer wants to know how much money s/he can make if they go through with the deal. It is practically impossible to make sales in this area without answering that question. This is most likely the case in technology licensing as well. Under the franchise sales laws there is one proper way to answer the question and many unlawful ways [9] . These representations are generally referred to as “Earnings Claims”. So what is an Earnings Claim? For franchise sales law purposes, an earnings claim refers to information given to a prospective franchisee by, for or at the direction of the franchisor, from which a specific level of actual or potential sales, costs, profits or income from franchised or non-franchised units may be easily ascertained. UFOC Guidelines Item 19. An earnings claim made in conjunction with the offer or sale of a franchise must be included in full in the disclosure document and must have a reasonable basis at the time it is made [10] . It may address actual results or projections. In all cases the disclosure must contain all applicable bases and assumptions. If no earnings claim is made Item 19 of the disclosure document must contain a negative disclosure to that effect.

Under the FTC Rule, earnings claims must be geographically relevant. Also, in applicable cases there must be a disclosure on the number and percentage of franchise units (whether franchised or company-owned) that have performed as well or better than the representation. Further, the FTC Rule requires disclosure of certain cautionary statements to the effect that the prospect may not do as well as the amounts represented and must accept that risk. It is an unfair or deceptive act or practice under the FTC Act to fail to make earnings claims disclosures in compliance with the FTC Rule.

Enforcement and Liability. As stated above, only the FTC is empowered to enforce the FTC Rule; although one may prosecute claims for such violations successfully to some degree under state little FTC Acts, such as Massachusetts G. L. c. 93A. This is not the case under the franchise registration laws, however. Generally, these statutes provide a private right of action to franchisees (those who actually acquire or purchase a franchise) [11] for damages, costs, attorney fees, expert witness fees and equitable relief. See e.g., Rhode Island Franchise Investment Act, Section 19-28.1-21(a). Note, however, that most of these statutes contain their own limitations provisions, which typically bar claims that are brought three or four years after the acts constituting the violation. Id. Section 19-28.1-22.

Who may be held liable for violation of the franchise sales laws? This would include any person that violates the statute, such as a franchisor that sells an unregistered franchise or who engages in fraud or deceit in connection with the offer or sale of the franchise. Exposure to liability does not stop there, however. Patterned after state securities laws, depending on which state’s law applies, liability for these violations may extend to: (i) every person who directly or indirectly controls a franchisor (or its agent) who is liable; (ii) every principal executive officer or director of a firm that is liable; (iii) every person occupying a similar status or performing similar functions; and (iv) every agent and employee of a company so liable who materially aids in the act or transaction constituting the violation. These individuals can be held jointly and severally liable with and to the same extent as the company, unless the person proves that s/he did not know and in the exercise of reasonable care could not have known of the facts by reason of which liability is alleged to exist. On the other hand, under some of these laws no person will be held liable if they can show that the plaintiff knew of the facts constituting the violation. See e.g., Rhode Island Franchise Investment Act, Section 19-28.1-21(a) and (b). In addition, material violations can give rise to criminal penalties under many of these statutes. [12]

  1. Post-Franchise Sale Relationship Laws

In addition to the registration/disclosure statutes and other laws that regulate the franchise sales process, there are significant federal and state statutes and common law doctrines that apply to ongoing franchise relationships. In addition to the basic franchise (license) [13] agreement that delineates the rights and obligations of the parties, perhaps most significant among these laws are state franchise relationship statutes. For the most part, these address circumstances under which franchises can be terminated or not renewed. Also, they cover situations where a franchisor may or may not withhold consent to a franchisee’s application to sell or transfer the franchise. Moreover, a small minority of these statutes address “encroachment” claims by franchisees. These arise when a franchisee complains that a franchisor is, in the franchisee’s view, “saturating” the market with additional units such that the franchisee’s profits are eroded or eliminated [14] . In their ongoing dealings with dealers and distributors, unwitting franchisors must pay careful attention to these laws as well.

  1. Federal Law

There is no generic franchise relationship law at the federal level that addresses terminations, non-renewals and the like. [15] Perhaps the most significant federal laws that apply in this area are the federal antitrust laws, 15 U.S.C. §1 et. seq., the federal trademark statutes, 15 U.S.C. §1045 et seq. and the Federal Trade Commission Act, 15 U.S.C. 45 et seq., which addresses unfair methods of competition as well as unfair and deceptive acts and practices in trade or commerce. [16] A detailed discussion of these laws is beyond the scope of this paper. See generally, T. Collin and A. Downey, “Franchising and Antitrust – The Critical Issues”, Workshop Paper No. 9, 28 th Annual Forum of Forum Committee on Franchising, American Bar Association, Orlando, FL (2005). For an excellent antitrust treatise, see ABA Section of Antitrust Law, Antitrust Law Developments, American Bar Association, Chicago (5 th ed. 2004). Briefly, however, consider the following.

Antitrust Law. These statutes prohibit unreasonable restraints of trade which adversely affect competition. Such claims are categorized as horizontal restraints (e.g. anti-competitive agreements between competitors (e.g., manufacturers) that operate at the same level of the distribution chain) as well as vertical restraints (anti-competitive arrangements between those who operate at different levels of the distribution chain). This would include, for example, an agreement between a supplier (franchisor?) and a dealer (franchisee?). Also, typically claims for restraint of trade under Sherman Act section 1 are categorized as per se claims or claims under the so-called Rule of Reason. Under this nearly 100 year-old “rule”, only contracts, combinations or conspiracies that unreasonably restrain trade are actionable. Standard Oil Co. v. U.S., 221 U.S. 1, 63-66 (1911). Such unreasonableness is proven by demonstrating a significant adverse effect on the marketplace caused by the restraint. For per se violations, however, such anti-competitive effect is presumed. More often than not, horizontal restraints (e.g. price fixing or allocation of territorial markets between competitors) are evaluated under the per se rule and vertical restraints are evaluated under the Rule of Reason. Typical vertical restraints would include price fixing, [17] tying (the purchase of one product to the purchase of another one where the seller has market power in the tying product), exclusive dealing arrangements, territorial and location restrictions as well as customer restrictions. The primary concern of antitrust law, particularly in the area of vertical restraints, is the effect of the restraint on interbrand (as opposed to intrabrand) competition. Continental T.V., Inc. et als v. G.T.E. Sylvania, Inc., 433 U.S. 36 (1977). For an instructive discussion of tying, other vertical restraints and class action issues in the franchise context, see Collins v. International Dairy Queen, Inc., 168 F.R.D. 668, 690 and 939 F. Supp. 875, (CCH) Business Franchise Guide ¶¶ 11006, 11007 and 11095 (M.D. Ga. 1996 and 1997).

Also, the antitrust laws (15 U.S.C. §2) prohibit monopolization and attempted monopolization in defined product and geographic markets. These claims rarely come into play in franchise cases, however, because the alleged monopolist does not have monopoly power (generally considered to be the power to control price or output in a defined product and geographic market).

Moreover, other antitrust laws (the Robinson-Patman Act, 15 U.S.C. §13a et seq.) prohibit various types of price discrimination that may substantially lessen competition. Depending on the facts, this may include the payment or receipt of certain vendor rebates and similar commissions when services of material value are not rendered for them. Id. §13c. See e.g., Substantial Investments, Inc. et als v. D’Angelo Franchising Corp. et als, 2004 WL 1932749 (D. Mass. 2004).

Remedially speaking, the antitrust laws are generous. A victorious plaintiff may recover mandatory treble damages, injunctive relief as well as attorney fees under these laws. 15 U.S.C. §16. Criminal sanctions are also available. Note, however, that in order to advance an antitrust claim for damages successfully, plaintiffs must demonstrate that they have proper standing to sue and that they have suffered “antitrust injury”; that is, the type of injury that the antitrust laws were intended to prevent. Zenith Radio Corp. v. Hazeltine Research, Inc., 401 U.S. 321 (1971). Frequently, this is a difficult hurdle for antitrust plaintiffs to overcome.

Trademark Law. A trademark license is at the heart of the franchise relationship. The license to use the franchisor’s mark(s) is the device by which the franchisee becomes part of a business system with a specific format and quality standards. People purchase franchises because they are looking for a well-known name and know-how for a particular type of business. In doing so, they typically agree to a number of restrictions on their use of the franchisor’s marks, logos, commercial symbols and slogans. The restrictions are usually detailed and strict in the licensor’s favor covering all aspects of mark usage by the licensee. Among other things, typically franchisees agree that they will use the mark only as directed by the franchisor and that all good will in the marks that may have arisen from their efforts will inure completely to the benefit of the franchisor once the relationship comes to an end [18] . In addition to contract terms, trademark owners enjoy legal rights in their intellectual property that derive both from the common law as well as federal and state statutory law. See for example, the federal Lanham Act, 15 U.S.C. §§10511127. It sets forth rules and regulations for the registration of trademarks and the rights of registrants at the federal level.

A full discussion of trademark law in the franchise context is beyond the scope of this paper and program. See R. Barkoff and A. Selden, Fundamentals of Franchising, supra, chapter 1, for an excellent introduction. Note however, that courts address this area of the law most frequently in the context of non-renewal (expiration) or termination of a franchise. A franchisor may terminate a franchise in situations where a franchisee breaches a material provision of the contract (e.g., non-payment of fees allegedly due) and fails to cure as demanded. According to the franchisee, however, the termination may be invalid for a number of reasons (e.g., allegedly wrongful conduct by the franchisor such as establishing “encroaching” units in the franchisee’s market area that adversely impact its business). For an excellent discussion of federal trademark law in this area, see Burger King Corp. v. C. R. Weaver and M-W-M, Inc., 169 F.3d 1310, (CCH) Business Franchise Guide ¶11,592 (11 th Cir. 1999).

  1. State Law

State Franchise Relationship Statutes. A minority [19] of states have enacted generic statutes that prohibit a franchisor from, among other things, terminating a franchise, not renewing a franchise or refusing to consent to the transfer of a franchise, except for good cause. Other typical franchise relationship disputes where these statutes may apply include the following types of conduct by franchisors: encroachment, discrimination among franchisees including selective contract enforcement, imposing burdensome or unwise (in the franchisees’ view) changes to the system, anticompetitive conduct (e.g., tying, pricing restraints or discrimination) as well as chilling franchisee association activities [20] . Before taking significant action in their relationships with licensees, licensors must take care to determine whether any of these statues apply [21] . Unlike the franchise registration and disclosure laws, there is considerably less uniformity and similarities in the franchise relationship statutes; both in terms of prohibitions and remedies. For example, while some states like Iowa regulate substantive rights such as wrongful termination, non-renewal and encroachment as described above, other states like Mississippi merely regulate the amount of notice that must be given in advance of termination. For an in-depth analysis of the development of the law in this area, see Garner, W. Michael ed., Franchise Desk Book-Selected State Laws, Commentary and Annotations, American Bar Association, Chicago (2001).

Other Sources of Law. In addition to state franchise relationship laws other statutory sources and common law doctrines apply in these disputes.

Statutory sources include: (i) Industry-specific statutes such as Massachusetts G.L. c. 93B (which addresses the rights of automobile dealers in their relationships with motor vehicle manufacturers) and G.L. c. 93E (which addresses the rights of service station dealers in their relationships with suppliers/licensors); (ii) state “little” FTC acts that regulate unfair methods of competition and unfair or deceptive acts and practices in trade or commerce, such as G. L. c. 93A. A minority of states grant business plaintiffs a right of action under these laws. See e.g. , Zapatha v. Dairy Mart, Inc., 381 Mass. 284, 408 N.E.2d 1370 (1980) (reversing Superior Court, termination of franchise without cause pursuant to contract authorizing it held not unfair under c. 93A); contra, Cherick Distributors, Inc. v. Polar Corp., 41 Mass. App. Ct. 125, 669 N.E.2d 218 (1996) (termination due to distributor’s associational activities with other distributors held unfair under c. 93A). For an examination of the application of c. 93A to business disputes in the franchise context see L. S. Stadfeld, Chapter 13, “Business Disputes Under Chapter 93A, Hon. Margot Botsford ed., Chapter 93A Rights and Remedies, MCLE Press, Boston (1999 and Supp. 2002).

Typical common law doctrines that may apply include breach of express contract terms, breach of the implied covenant of good faith and fair dealing, promissory equitable estoppel, tortious interference with contract or advantageous business relations, unfair competition and in a rare case, breach of fiduciary duty.

III. Structuring to Avoid Application of the Franchise Laws

Typically, companies that distribute products or services through independent dealers try to structure the relationship in an effort to avoid the burdens that go along with being a franchisor. Some of these potential burdens include the cost of preparing a disclosure document and maintaining franchise registrations as well as the exposure to claims by franchisees under the franchise laws. The object of these arrangements is to structure a distribution relationship so that it avoids one of the definitional elements. This must be done with care, however, as the “franchise” and “business opportunity” definitions vary between jurisdictions. All relationships that satisfy the statutory franchise definitions, as discussed above, are franchises unless they qualify under an express exclusion or an exemption. Consider the following.

Companies can avoid application of the FTC Rule if they structure their opportunity so as to avoid one of the definitional elements (trademark grant, significant control or assistance and fee). Invariably, the significant control or assistance element is present in most distribution arrangements. Similarly, parties to many distribution arrangements prefer to promote a commercial affiliation between licensor/licensee or supplier/distributor and thus, the trademark element usually remains in the relationship as well. Both distributor and supplier seek to promote and advertise their connection with a chain or network of affiliated outlets. Accordingly, the preferred method of circumventing application of the franchise laws is by avoiding the franchise fee element of the definition. Set forth below are the primary approaches to solving this problem

1. Bona Fide Wholesale Price. For arrangements involving the sale of products, this exemption is available when the distributor’s only payment to the supplier is for the purchase of goods at bona fide wholesale prices. Usually only inventory for resale qualifies for this exemption. This works as long as the distributor need not buy excessive quantities of product. Some states with franchise registration laws have a similar exemption.

2. Minimum Payment. Application of the FTC Rule can be avoided if the franchisee pays the franchisor less than $500 within the first six months of doing business. Many state laws do not have a comparable provision, however. Also, this exemption should be used with care because many distribution opportunities do not require payment of a substantial initial “franchise” fee but do involve the payment of other fees for smaller items (e.g., royalties or payments for equipment, marketing materials, training or other services). See, e.g., To-Am Equipment Co. v. Mitsubishi Caterpillar Forklift America, Inc., 152 F.3d 658, (CCH) Business Franchise Guide ¶11456 (7 th Cir. 1998).

3. Commission Arrangements. A commission-based relationship where the franchisee-dealer does not pay the supplier-franchisor can avoid the fee element as well. In this scenario, the distribution arrangement must be structured so that the supplier is paid directly by the dealer’s customers and in turn, pays the dealer a commission for its services in consummating the sale. FTC Guidelines, supra at 6; (CCH) Business Franchise Guide ¶6207.

4. Exemptions and Exclusions. Under the FTC Rule certain relationships are either exempted or excluded from its requirements. The Rule exempts fractional franchises, leased departments, minimal investments and purely oral agreements. Also, in addition to minimal fee arrangements discussed above, it excludes employee-employer relationships, general partnership relationships, membership in retailer owned co-operatives, relationships with certification or testing services and “single” license relationships [22] . The more significant of these tools are discussed below.

  1. Fractional Franchise. This exemption is available under the Rule and several state laws. It applies when an established distributor adds a new product line to its existing lines of goods or services. To satisfy this exemption two conditions must be met: (i) the distributor must have at least two years of experience in the business represented by the new product line; and (ii) the parties must have anticipated in good faith, that the addition of the new product line would represent no more than 20% of the distributor’s total gross sales within the first year after the relationship is established.
  2. Single License. The FTC Rule excludes a situation where a licensor grants one single license for the business arrangement under consideration and will not grant another one. None of the registration law states provides a comparable exclusion. For obvious reasons, this exemption has very limited application.
  3. Large/Experienced Franchisor. While presently unavailable at the federal level, a number of states provide exemptions for the offer/sale of franchises by those with a substantial net worth and/or significant franchise or operating experience. The net worth amount ranges up to $15 million depending on the state. Note that while these provisions may exempt a franchisor from registration requirements they do not exempt it from disclosure requirements. Accordingly, it is of limited value if the opportunity offered for sale otherwise satisfies the franchise definition. Note also that while not currently available, one of the proposed changes to the FTC Rule is the addition of this exemption.
  4. Sophisticated/Experienced Franchisees. Finally, a few franchise registration laws recognize an exemption for sophisticated investors based on one’s net worth, income and business experience. Patterned after the securities laws, the rationale for this exemption, presumably, is that investors with appropriate levels of wealth and experience can better assess the risks of a particular venture and can better absorb losses. Note also that while not currently available, another proposed change to the FTC Rule is the addition of this exemption. The few states that offer this exemption are not uniform in their approaches. Some exempt sales to prospective franchisees who are sophisticated or experienced. Others use varying combinations of thresholds for wealth, experience and investment size. For the foregoing reasons, therefore, this structuring device is of limited value in most situations.

When structuring supply chain distribution opportunities therefore, counsel must pay close attention to federal and state franchise (and other) sales laws in order to avoid their unintended application. This is true both at inception and during the relationship (in the event of changes to the structure of the arrangement). For in-depth discussions of the law in this area see Mark Miller, “Unintentional Franchising”, St. Mary’s Law Journal, Vol 36, No. 2 (2005) and Mark Kirsch and Rochelle Spandorf, “The Accidental Franchise”, Workshop Paper No. 3, 24 th Annual Forum of Forum Committee on Franchising, American Bar Association, San Francisco, CA (2001).

IV. What To Do If Your Client Runs Afoul of The Franchise Laws

Sometimes a client walks into your office while in the beginning stages of a distribution arrangement that s/he thinks is ripe for expansion by taking it to the next level. This client may have set up one or more ‘informal’ distribution deals with a few trusted “partners” that s/he wants now to formalize. In addition to ascertaining the client’s goals and concerns in regard to structuring the distribution relationship going forward, counsel must understand all factual details of the present informal arrangements with the “partners”, to ascertain if there is significant exposure to their claims and if so, how to deal with them. It is important that counsel impress on the client the nature and scope of his/her possible exposure to claims of the “partners” (not to mention those of state regulatory authorities). This is so that the client furnishes counsel with all relevant facts and so that the client is made to appreciate the possibility that s/he may have to cease all offer and sale activity until the legal analysis is completed and the proper direction becomes clear.

The client’s main concerns are: (i) claims of existing “partners” (for possible non-compliance with the franchise sales laws); (ii) affirmative claims for relief by state agencies in behalf of their residents for such violations; (iii) getting the client’s opportunities registered and “cleared” for sale in registration law states; and (iv) possible exposure to criminal charges for statutory non-compliance (though admittedly, these are rarely brought).

Private Claims. If the “partners” have been profiting from the arrangement and/or the business relationship is satisfactory otherwise, there may be no need to alert them to the facts that the client may have violated certain laws in dealing with them and that they may have actionable claims for relief against the client. If the converse is true, however, one goal of the client would be to obtain releases from them while moving forward with the expansion plan. This objective is not easily achieved. The claims of each individual “partner” must be evaluated with care as some may be handled differently than others.

Public Claims. Concerns from public regulators present a different concern altogether, however. For example, the client may seek to register his/her franchise in a registration law state to expand there by franchising. In all probability the client’s disclosure document will disclose statistics (at UFOC Item 20) on the rights (‘franchises’) granted to the “partners” in applicable states even if their rights are materially different from those that are the subject of the current offer for which registration is sought. This information may indicate that the client has one or more “franchisees” in the regulator’s state. Moreover, the regulator may well ascertain that the client’s franchise offering was not registered previously in the state. In that case, the regulator may question the client in detail on to its prior franchising activity and history of compliance (or lack thereof) in the state. The regulator may hold up dealing with the client’s registration application and order the client to deal with the “partners” in a manner that puts them on notice of their rights under that state’s law. For example, the client may be directed to offer to the “partners” the opportunity to “rescind” the original transaction (if that is possible). Usually such offers will only remain open for a short period (e.g., 60-90 days).

This is far superior to being less than candid with the regulators in the application process. That is something they disdain. Franchise regulators appreciate an applicant’s willingness to deal with unpleasant facts when they first apply for registration. These mistakes are not that uncommon. Most regulators may require that violators do what is necessary to attempt to “right” past wrongs in serious cases. In such a scenario, however, that “up-front” approach should not result in an order denying registration; consequently, barring the client from an attractive market for its distribution opportunities. Conversely, the franchisor that conceals such information in the application process will be exposed to serious risk on a continuing basis. Upon revelation of the early non-compliance AND the client’s less-than-candid approach in the franchise application process, the client’s prospects for franchising in that state (as well as the other registration law states) would take a decided turn for the worse. The underlying message is not to misrepresent or disclose material facts in the franchise application process and to deal with the government agencies in a straightforward manner.

V. Reference Sources

In addition to the articles and authorities cited above, set forth below are other useful resources for those investigating franchise law issues. The “bible” for franchise lawyers is the Business Franchise Guide, a loose leaf service published by Commerce Clearing House, Inc. Published monthly since the 1970’s, it contains all of the statutes and regulations as well as many of the relevant state and federal court decisions in this area. Also the Forum Committee on Franchising of the American Bar Association [23] publishes excellent conference papers and other materials annually, quarterly issues of the Franchise Law Journal as well as The Franchise Lawyer, a less formal periodic publication for members of this ABA group. Also of great use are the annual legal symposium materials (workshop papers, etc.) of the International Franchise Association, a trade association (for franchisors (mostly), franchisees and franchise suppliers) based in Washington, D.C. For recent developments in franchising generally, see monthly issues of The Franchise Times published by Franchise Times Corporation out of Minneapolis.

Finally, see the appendices immediately following this paper for a sample franchise agreement and sample UFOC (franchise disclosure document or franchise offering circular). As always, however, beware using forms without proper analysis and preparation. One size does not fit all in this area.

[1] For a more detailed look at important issues in franchise and distribution law, see T. Vangel, D. Goldberg, E. Karp and L. S. Stadfeld, “Hot Topics in Franchise and Distribution Law”, MCLE No. 1999-05.23, Massachusetts Continuing Legal Education, Inc. (Boston 1999).

[2] Fourteen states have enacted franchise registration and disclosure laws. Those requiring the marketing plan element include California, Illinois, Indiana, Maryland, Michigan, North Dakota, Oregon, Rhode Island and Wisconsin. Those requiring the community of interest element include Hawaii, Minnesota, South Dakota and Wisconsin. New York’s law contains two alternative franchise definitions. One includes the franchisee fee and marketing plan but no trademark association requirement. The other requires a fee and the right to sell goods in substantial association with the mark.

[3] For an excellent overview of the entire regulatory environment that applies to franchise sales and relationships in the United States, see R. Barkoff and A. Selden editors, Fundamentals of Franchising, Second Edition, American Bar Association (Chicago 2004).

[4] See e.g. , Banek, Inc. v. Yogurt Ventures USA, Inc., 1992 U.S. Dist. LEXIS 21453 (E.D. Mich. 1992, (CCH) Business Franchise Guide ¶10112; Sampson Crane Co. v. Union National Sales, Inc., 87 F. Supp. 218 (D. Mass. 1949) aff’d, 180 F.2d 896 (1 st Cir. 1950). Claims for violation of the FTC Rule may be asserted under certain state “Little” FTC acts, however. Bailey Employment Sys., Inc. v. Hahn, 545 F. Supp. 62 (D. Conn. 1982) aff’d per curiam, Bailey Employment Sys., Inc. v. Hahn, No. 82-7394 (2d Cir. 1983) (claim under Connecticut little FTC act); Texas Cookie Co. v. Hendricks & Peralta, Inc., 747 S.W.2d 873, 877 (Tex. App.–Corpus Christi 1988) (failure to provide pre-sale disclosure supported a claim under the Texas Deceptive Trade Practices Act); Morgan v. Air Brook Limousine, Inc., 211 N. J. Super. 84, 102, 510 A.2d 1197, 1206-07 (Law Div. 1986) (failure to provide required pre-sale franchise disclosure was a per se deceptive or unconscionable commercial practice under the New Jersey Consumer Fraud Act). Contra, Symes v. Bahama Joe’s Inc., (CCH) Bus. Fran. Guide ¶¶ 9192 and 9463 (D. Mass. 1988 and 1989) (In the first ruling Judge Zobel held that unlawful earnings claims under the FTC Rule are not necessarily violations of chapter 93A. In the second decision she held that the same wrongs supported federal RICO claims). See also, Stadfeld, L. S., “The FTC Franchise Disclosure Rule and Its Impact on Chapter 93A of the Massachusetts General Laws – A Source of Protection for Consumer Entrepreneurs”, Western New England Law Review, Vol. 2 No. 4 (Spring 1980).

[5] Pending amendments to the FTC Rule would eliminate the FTC disclosure format entirely and would modify certain aspects of the UFOC disclosure format. FTC Notice Proposed Rulemaking, 64 Fed. Reg. 204 at 57296-97 (10/22/99). On August 25, 2004 the Federal Trade Commission issued its “Staff Report to the Federal Trade Commission and Proposed Revised Trade Regulation Rule + Disclosure Requirements and Prohibitions Concerning Franchising (the “Staff Report”). It suggests in great detail how the FTC should revise the FTC Rule for the first time since it took effect in 1979. The report includes an entire proposed successor FTC Franchise Rule which the staff suggests the FTC should adopt. The full text of the Staff Report was published by CCH. Also, it may be found at the FTC’s web site, For a detailed explanation of all the proposed changes to the FTC Rule, see D. Kaufman, “Advanced Disclosure Issues: “The FTC Staff Report on the Proposed Revised FTC Franchise Rule”, 38 th Annual Legal Symposium, International Franchise Association, Washington, D.C. (2005).

[6] State Business Opportunity Laws. While the franchise registration laws are of primary concern for purposes of this program, there are other sources of law that may apply in the franchise sales process. These include state little FTC acts as discussed above, the common law (particularly claims for fraud and deceit) as well state business opportunity sales laws. Over 25 states have enacted these business opportunity statutes. These laws are often overlooked by franchisors. They have similar disclosure and registration obligations for franchisors in the absence of an applicable exemption or exclusion, which are frequently available for many franchise offerings. For example, whether it be due to an exclusion from the definition of a “business opportunity” or under an express exemption, a number of these statutes will not apply to the licensing of a marketing program pursuant to a registered (usually federally registered) trademark (which is common in franchising).

These laws were designed to reach distribution arrangements conceptually different from traditional franchises. These include vending machine routes, breeding farms, rack-jobbing distributorships, home-manufacturing businesses and electronic amusement machine routes. Historically, they required a lower investment threshold (compared with most franchises) and were marketed to less sophisticated buyers. Generally, business opportunity sales are defined as the sale of products, equipment or services to enable the purchaser to start a business, which are accompanied by certain representations involving profitability, marketability, marketing support or “buy-back” promises. Mainly because of how franchises are offered and sold, some may fall within the sweep of these laws.

Accordingly, while more often than not there is a fair basis for concluding that business opportunity statutes will not apply to a franchise offering, sellers and their counsel must be careful not to overlook their possible application in certain cases. For an in-depth analysis of this area of the law, see J. Baer and J. Meany, “The Business Opportunity Laws: An Enforcement and Litigation Trap”, Workshop Paper No. 5, 24 th Annual Forum of Forum Committee on Franchising, American Bar Association, San Francisco, CA (2001).

Sales Representative Laws. Roughly 35 states and Puerto Rico regulate the business relationship between a supplier and the sales representative that promotes its products. The basic goal of these laws is to make sure that the representative will be fairly compensated in accordance with the agreement between the parties. These statutes do not have registration or disclosure requirements as do the franchise and business opportunity sales laws. They do contain valuable remedies (including awards of multiple damages and attorney fees), however, if they are violated. Generally, these laws do not come into play in evaluating franchise-type relationships. And though they don’t seem that formidable if a supplier merely performs its contract obligations, in this day and age it makes sense for manufacturers to be careful of their application when establishing new distribution relationships and when ending them. For an in-depth analysis of this area of the law, see D. Beyer and J. Mariano, “Multilevel Marketing and Direct Selling: Law and Regulations”, Workshop Paper No. 4, 20 th Annual Forum of Forum Committee on Franchising, American Bar Association, Colorado Springs, CO (1997).

[7] Choice of Law Clauses. Note that many franchise, license and distribution contracts contain choice of law clauses which set forth an agreement of the parties regarding which state’s law they choose to apply to their relationship. Sometimes these choices are given effect by courts and sometimes they are not. Often the language of the clause is crucial as is the locus of facts to determine which state has the most significant relationship to the dispute under consideration. For interesting choice of law discussions in the distribution context see Northeast Data Systems, Inc. v. McDonnell Douglas Computer Systems, Co., 968 F.2d 607 (1 st Cir. 1993) (holding that the parties’ chosen law applied to contract matters but not to pre-contract fraud-type matters); Worldwide Commodities, Inc. v. J. Amicone Co. , 36 Mass. App. Ct. 304, 630 N.E.2d 615 (1994) (following Northeast Data ); Jacobson v. Mail Boxes Etc USA, Inc. , 419 Mass. 572, 646 N.E.2d 741 (1995) (enforcing California choice of law clause leads to enforcement of California forum selection clause); and Modern Computer Systems, Inc. v. Modern Banking Systems, Inc., 858 F.2d 1339 (8 th Cir. 1988), reversed en banc, 871 F.2d 734 (8 th Cir. 1989) (affirming the district court and reversing one of its tribunals, the full Eighth Circuit Court of Appeals concluded that the choice of law clause in the parties’ franchise agreement (calling for application of Nebraska law) and the policy of enforcing contracts generally outweighed the policy of protection of franchisees enshrined in the Minnesota Franchise Investment Act even though the franchisee’s business was operated in Minnesota and Minnesota appeared to have the most significant relationship to the parties and their dispute).

[8] For guidelines in preparing a UFOC, see “Revisions to the Uniform Franchise Offering Circular”, Business Franchise Guide, No. 16, Commerce Clearing House (Chicago 1993) (hereinafter “UFOC Guidelines”. For direction in compliance with the FTC Rule, see “Guides to Compliance with FTC Franchising Rule”, Trade Regulations Reports No. 396, Commerce Clearing House (Chicago 1979) (hereinafter “FTC Guidelines”).

[9] Some franchise sellers mistakenly tell prospects that the law forbids the making of earnings claims when offering or selling a franchise. This is simply not true. This may be done out of ignorance of the law or knowingly because the seller does not have good results to report with the franchise. Conversely, out of concern for liability, many franchise sellers refuse to make earnings claims. They tell prospects instead to obtain this information as best they can from their existing franchisees. While the information available to prospects in that instance may be suspect, more often than not franchisors avoid earnings claim liability in those cases.

[10] Note that there is an exception if a franchisor is selling a company-owned unit as a franchise and furnishes the prospect with financial performance information specifically limited to that unit, that will not be considered an earnings claim within the meaning of the UFOC Guidelines.

[11] Note that those who have been denied a franchise have not fared well when suing franchisors under these statutes for wrongful refusal to sell them a franchise.

[12] For example in Rhode Island, a person who wilfully violates its franchise registration law (or a regulation promulgated thereunder) is guilty of a felony. Rhode Island Franchise Investment Act section 19-28.1-20. Most franchise registration laws so provide. Since their enactment (primarily in the 1970’s), however, there have been very few criminal prosecutions.

[13] It should be noted that a franchise is but one kind of a license and that a franchise agreement is one kind of a license agreement. In the so-called “franchise industry”, often the terms are used interchangeably.

[14] In these situations, note the differing interests of franchisee and franchisor. Typically, franchisors are paid royalties and other fees by franchisees based on the franchisees’ gross sales. Accordingly, franchisors are keenly interested in increasing unit gross sales and market share. While franchisees also are interested in gross sales and market share, they are most interested in net profits of their operations. Encroachment claims derive primarily from the significant adverse effects on franchisee profits that appear to be caused by the placement by the franchisor of additional units in the franchisee’s market area. Conversely, franchisors would contend that other interbrand competitors will establish units in competition with the franchisee if they do not.

[15] There are certain federal laws that are industry-specific, however. These include the Petroleum Marketing Practices Act, 15 U.S.C. §2801 et seq. (for service station dealers) (“PMPA”) and the Automobile Dealers Day in Court Act, 15 U.S.C. §1221 et. seq. (for motor vehicle dealers) (“ADDCA”). The PMPA addresses terminations, non-renewals and other conduct in relationships between service station dealers and petroleum refiners. The ADDCA addresses threats and acts of intimidation and coercion, as well as other acts of bad faith by manufacturers suffered by motor vehicle dealers. A discussion of these statues is beyond the scope of this program, however.

[16] For an excellent detailed overview of how these statutes apply in the franchise context, see Barkoff and Selden, Fundamentals of Franchising, supra, chapters 1 and 6.

[17] Historically, vertical pricing restraints were evaluated under the per se rule. Dr. Miles Medical Co. v. John D. Park & Sons Co., 220 U.S. 373 (1911). While this approach remains in place with respect to minimum resale price maintenance (i.e., setting a price floor), it changed in 1997 with respect to maximum vertical price fixing. Now that is evaluated under the Rule of Reason. State Oil Co. v. Kahn, 522 U.S. 3 (1997).

[18] For an interesting examination of this issue, see Levin, B. and Morrison, R., “Who Owns the Good Will at the Franchisee’s Location”, (ABA) Franchise Law Journal, Vol. 18, No. 3 (Winter 1999).

[19] States that have statutes which may supersede a franchise agreement in the areas of termination and renewal of a franchise are: ARKANSAS [Stat. Section 70-807], CALIFORNIA [Bus. & Prof. Code Sections 20000-20043], CONNECTICUT [Gen. Stat. Section 42-133e et seq.], DELAWARE [Del. Code Title 6, Ch. 25, Sections 2551-2556], HAWAII [Rev. Stat. Section 482E-1], ILLINOIS [Rev. Stat. Chapter 121 1/2 par 1719-1720], INDIANA [Stat. Section 23-2-2.7], IOWA [Code Section 523H.1 – 523H.17], MICHIGAN [Stat. Section 19.584(27)], MINNESOTA [Stat. Section 80C.14], MISSISSIPPI [Code Section 75-24-51], MISSOURI [Stat. Section 407.400], NEBRASKA [Rev. Stat. Section 87-401], NEW JERSEY [Stat. Section 56:10-1], SOUTH DAKOTA [Codified Laws Section 37-5A-51], VIRGINIA [Code 13.1-557-574-13.1-564], WASHINGTON [Code Section 19.100.180] and WISCONSIN [Stat. Section 135.03]. Also, these and other states may have court decisions which may supersede a franchise agreement in the areas of termination and renewal of a franchise.

[20] Conversely, typical examples of good cause for termination relating to conduct by the franchisee or dealer include non-payment of monies due, unauthorized use of the franchisor’s marks, conduct that may materially impair the franchisor’s reputation or the good will in its marks, sales of competing products by the franchisee without authority, failure to operate in accordance with the franchisor’s standards, failure to meet sales/other quotas and under-reporting of sales. A different example unrelated to franchisee conduct involves market withdrawal by a franchisor; a scenario on which courts applying franchise relationship laws have disagreed. See e.g, Kealey Pharmacy and Home Care Service, Inc. v. Walgreen Co., 761 F.2d 345 (7 th Cir. 1985) (interpreting Wisconsin law).

[21] As with disputes involving the franchise sales process, franchise relationship disputes necessarily entail counsel’s undertaking a choice of law analysis to determine whether the franchise relationship statute of a particular state applies. Similarly, counsel must look to the “franchise” definition(s) in the applicable statute(s) to determine whether it/they applies. On these issues, see the discussions at parts I.A., I.B. and II.A.2. supra.

[22] Because it is highly unlikely that they would fit the business model under consideration for this program, the following exemptions/exclusions are not discussed in detail: employment relationships, general partnerships, certification and testing services, purely oral relationships, leased departments in retail outlets and retailer owned co-operatives.

[23] Coincidentally, the ABA Forum Committee on Franchising is having its annual forum (conference on franchise law issues) in Boston this coming October. Anyone with a serious interest in franchise law should not miss this program.

*This was published before the FTC Franchise Disclosure Rule was amended materially by the FTC effective February 2008. See Articles.

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