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American Bar Association

ABA Section of Business Law


 

Volume 13, Number 3 - January/February 2004

The accidental franchise
When a business relationship becomes a trap
    By Charles S. Modell

A client asks you to prepare an agreement to distribute goods and services through independent dealers or distributors. Or, a client has a system it wants to license to others who will use it to market a product or service to consumers. If you do not consider that the arrangement may actually be a franchise or business opportunity regulated by more than three dozen laws, you may find yourself the target of a significant malpractice claim.

Everyone thinks they know a franchise when they see one. They have golden arches and are on every corner. However, many other arrangements between manufacturers and their dealers, and between distributors and their licensees, constitute franchises that a seller may not even lawfully discuss with prospective purchasers without compliance with franchise disclosure laws enacted throughout the country. Before you decide these laws have no application to your practice, consider how easy it is for a business transaction to fall within one of these laws. Did you know that when you help a client start a business, any business, the relationship you establish with your client meets two of the three elements of a franchise?

Under the Federal Trade Commission's "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures," Code of Federal Regulations, Title 26, Chapter 1, Subchapter D, Part 36, better known as the FTC Franchise Rule, anyone who offers, sells or distributes goods, commodities or services (yes, even legal services), is considered to be involved in the sale of a franchise if they:

  • provide significant assistance to their customer (or client) in that person's method of operation,
  • charge a fee for their services, and
  • have a trademark, trade name, advertising or other commercial symbol the recipient can use in its business.
More than a dozen states have similar laws.

In the case of your sale of legal services, you are (hopefully) providing significant assistance to your client in its method of operation (which under federal law specifically includes that person's business organization), and you are charging a fee for your services. You do not, however, allow your client to use your trade name, logo or advertising in its business. As a result, you are not engaged in the sale of a franchise because the service you offer to your business client meets only two of the three elements of a franchise.

Now consider the dealership or license arrangements you help your clients establish. The client typically sells to the purchaser goods that bear the client's trademark, which is sufficient to meet the trademark element of a franchise. Or your client permits its licensees to use its name in the operation of its business (even if by reference to the purchaser being a participant in your client's "network," and even if the name is not technically licensed, but purchasers are permitted to use the name in their business).

Since everyone is in business to make money, there will no doubt be money paid to your client. Whether this money is called a franchise fee, a territory fee, an exclusivity fee, a royalty, a license fee or even a training fee, it is still a fee, and payment of the fee meets the second element of a franchise under federal law. (One of the few exceptions is when the only money that changes hands is for the purchase of inventory for resale.)

If your client also provides assistance in the form of training or promotional assistance, the third element will be met.

The task of determining whether a relationship is a franchise is made more difficult by the fact that the definition of a franchise is not uniform in all jurisdictions. Some franchise laws substitute a "community of interest" test for the "significant assistance" test. Others refer to the provision of a "marketing plan." Thus, whenever there is a trademark, the exchange of money, and a continuing relationship between your client and its purchasers, you need to analyze whether the franchise disclosure laws apply to the relationship. If the three elements of a franchise exist, then the relationship is a franchise, even though you may refer to it as a distributorship, dealership or license arrangement.

A couple examples may help. Consider Coca-Cola. Assume Coca- Cola receives a payment from its bottlers when it sells bottling rights. When it does so, it is selling a franchise. The bottlers use the Coca-Cola name in their business, they pay a fee for something other than syrup or finished product for resale, and they receive significant assistance in their operation (whether it be the ads Coca-Cola implements to sell the product, the recipe that is licensed to make the product, or any operational assistance).

Assume now that Coca-Cola licenses the Coca-Cola name to somebody to print T-shirts and receives a royalty from every T-shirt sold. The trademark and fee elements of a franchise are present, but it is unlikely that Coca-Cola provides assistance in connection with the manufacture of the T- shirts, or the operation or promotion of the T-shirt business. Therefore, this license arrangement is not a franchise.

On the other hand, if that same purchaser were obtaining a license to open a Coca-Cola apparel store, and received direction from Coca-Cola in the organization, formation or marketing of the store, the arrangement would then constitute a franchise, even though it does not involve Coca- Cola's core business.

Identifying relationships that qualify as franchises under the franchise disclosure laws is unfortunately only the beginning of your task when dealing with license and dealership arrangements. You must also be cognizant of the business opportunity laws that exist in 19 states. Many of these laws will apply to transactions that involve trademarks and marketing programs even when the only money changing hands is for the purchase of inventory.

Consider again the fictional Coca-Cola apparel store. I originally assumed the store owner paid a royalty to Coca- Cola for the right to put the Coca-Cola name on apparel. Assume, however, that there was no royalty, and that the only money changing hands was for the retailer's purchase of finished apparel for resale. In that case, the relationship would not be a franchise, because the "fee" element of a franchise was missing (the purchase of inventory for resale being one of the few exceptions to the "money paid" element of a franchise). That arrangement would, however, still constitute a business opportunity if Coca-Cola provided marketing or promotional assistance to the retailer.

If a relationship qualifies as a franchise under federal law, then before your client can even meet face to face with a prospective purchaser to discuss the details of the arrangement, it must provide a detailed disclosure document to the prospect. The same requirement exists under the relevant state franchise and business opportunity laws. However, under state law, the relationship may also require registration in more than two dozen states before any offers are made, and before any advertising for prospective franchise purchasers is published.

Compliance with these laws can be cumbersome and will delay the rollout of your client's "licensing" program. However, failure to comply with these laws can subject your client and its principals to liability for damages or rescission. In addition, many of these laws have provisions for criminal penalties, civil fines and the award of attorneys' fees. Unfortunately, many companies that offer dealerships or licenses discover they have sold a franchise only after an unhappy franchisee — or regulator — has filed suit against them. At that point, it is too late for the franchisor to "cure" its failure to register the franchise or to provide appropriate disclosures to the distributor or licensee.

Your own law firm is also not immune from liability for your client's failure to comply with these laws. A law firm in Connecticut found itself on the receiving end of a $15 million verdict in favor of its former client for allegedly failing to advise its client of the need to comply with these laws (Beverly Hills Concepts Inc. v. Schatz & Schatz, Ribicoff & Kotkin, et al., Bus. Franchise Guide (CCH) ¶ 11,099 (Ct. Sup. Ct. 1997)). The lower court not only held the law firm liable for the client's direct losses, but it assessed damages based on the financial projections the franchisor had prepared for its business. The court reasoned that if not for the lawyer's failure to properly advise the client on compliance with applicable disclosure laws, the client would have successfully established a nationwide network of health clubs.

On appeal, the Connecticut Supreme Court affirmed the decision that the law firm had committed malpractice, but set aside the damage recovery on the basis that the plaintiff's losses were based on speculation as to future profits. The law firm certainly dodged a bullet, but as the appeals court noted, it was not because of the propriety of the law firm's actions, but because of the "plaintiff's choice of evidence." (Beverly Hills Concepts Inc., v. Schatz & Schatz, Ribicoff & Kotkin, et al., 717 A.2d 724, 739 (Conn. 1998)). The lesson from the Beverly Hills Concepts case should be clear; lawyers need to be aware of the scope of franchise and business opportunity disclosure laws.

Many of the franchise disclosure requirements were written with "package" franchises in mind, such as restaurants, hotels and other "business formats." The business opportunity laws were written to cover many part-time businesses not covered by the franchise laws, such as home-based businesses and vending machines. Nevertheless, these laws have been held to apply to business arrangements varying from manufacturer-dealer arrangements that involve payments to the manufacturer beyond the purchase of goods (see for example, Pool Concepts Inc. v. Watkins Inc., Bus. Franchise Guide (CCH) ¶ 12,249 (D. Minn. 2002)) to the licensing of software that enables the licensee to operate a business (see for example, Current Technology Concepts Inc. v. Irie Enterprises Inc. d/b/a Irie Computer, et al., 530 N.W.2d 539 (Minn. 1995)).

The definitions contained in the various state franchise and business opportunity disclosure laws are not consistent, and many are imprecise. However, whenever you work with a client who is helping others establish a business, you must consider whether these laws will apply to the relationship.

Up to this point, this article has focused on the laws that regulate the pre-sale obligations imposed on persons offering products or services in a transaction that meets the legal definition of a franchise or business opportunity. However, there is another set of laws, frequently referred to as franchise relationship, or dealer relationship, laws, which govern the continuing relationship of the parties.

Like the business opportunity laws, these laws frequently apply to arrangements that would not fall within the traditional definition of a franchise. The laws typically apply to any agreement between two or more persons under which a person is granted the right to sell or distribute goods or services under the seller's trademark, and in which there is a "community of interest" between the parties in the marketing of the goods or services.

Most often, these relationship laws will apply to arrangements between manufacturers of products and their dealers, where the dealer's business is strongly identified with, and reliant upon, the manufacturer. For example, in Hartford Electric Supply Co. v. Allen-Bradley Co. Inc., 736 A.2d 824 (Conn.. 1999), the court found a manufacturer of automation products to be selling franchises under the Connecticut Franchise Act.

However, these laws also apply to service providers. In Instructional Systems Inc. v. Computer Curriculum Corp., 614 A.2d 124 (N.J. 1992), the court found that a supplier who allowed its trademark to be used on services provided by its distributor had sold a franchise under the New Jersey Franchise Practices Act.

The franchise relationship laws generally require good cause for termination or nonrenewal of the relationship, and they require advance notice, typically varying from 30 to 90 days, with an opportunity for cure as enunciated in the individual state statute. More often than not, it will not be difficult for your client to comply with applicable franchise relationship laws, but once a termination has taken effect without compliance with these laws, there is little defense to the action, and your client can be held liable for damages caused by its failure to comply.

In some cases, you can help your client avoid application of the franchise disclosure laws by eliminating one of the three elements of a franchise. Typically, elimination of the use of the seller's name or advertising will take your client out of the scope of these laws. When that is not practical, such as when the product being sold to the public is identified by the trademark, you may be able to limit the fees your client receives to only the payment of a bona fide wholesale price for a reasonable amount of goods for resale.

In many situations, the elimination of one of these elements is not possible without drastically changing the client's intended method of operation. In these cases, you must recognize the issue and advise your client to comply with the appropriate disclosure laws in order to avoid liability for failure to make the required filings and provide the necessary disclosures.

You must also consider the applicability of these laws before advising clients on their right to terminate or modify such agreements. Unfortunately, you cannot unilaterally change these relationships after the contract with the distributor or licensee has been signed.

Whether or not the agreement was initially offered as a franchise or business opportunity, if the relationship falls within the definition of a franchise under the franchise relationship laws, then your client must comply with these laws in terminating, modifying or even failing to renew the agreement. (Moreover, if the elements of a franchise exist in the relationship, then the relationship is a franchise, notwithstanding language to the contrary in the agreement.)

Before leaving this area, one caveat is in order. You will also not generally be able to avoid these laws by placing a provision in the agreement selecting the law of a state without a franchise relationship or disclosure law to govern the relationship. The provisions relating to the applicability of these laws vary from state to state, but they generally apply when the purchaser is required to establish or maintain a place of business in the state (see for example, Connecticut General Statutes, Title 42, Ch. 739, Sec. 41-133h (2000)), when the business is to be located in the state (see for example, Minn. Stat. § 80C.19, Subd. 1 (2002)), or when the purchaser is a resident of the state (see for example, Md. Code Ann., (Business Regulation) Title 14, Sec. 14-203(a)(2)(i) (1998)).

Thus, before terminating or modifying an arrangement that might be subject to a franchise relationship law, you must determine whether there is a law in the state in which the business operates, or in the state in which the franchisee resides, in addition to the state specified in the governing law provision of the agreement.

Understanding the broad reach of the franchise disclosure and relationship laws is critical to protecting both you and your client from having culpability for failing to identify the "accidental franchise." The variety of state laws that affect licenses and distributorships make this area a minefield for your clients, but clearly, this is one of those areas where an ounce of prevention is worth much more than the cost of a cure.


Modell is a shareholder with Larkin hoffman Daly & Lindgren, Ltd., in Mineapolis. He is on the Governing Committee of the ABA's Forum on Franchising. His e-mail is cmodell@larkinhoffman.com.


 

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