What do you get when you cross a trademark license, a fee, and elements of control?

When mixed together in the right combination, you get something called a "franchise," regardless of your intent. In fact, a wide variety of business arrangements that do not look, walk, or talk like franchises have been labeled just that by the courts. Typically referred to as "hidden" or "inadvertent" franchises, they include everything from sales representatives and appliance parts distributors to cafeterias in office buildings. In this article, we will explore what it takes to establish a franchise relationship in the eyes of the law, examine the uncertainty surrounding the legal definitions of these business arrangements, and offer guidance for avoiding the perils of the hidden franchise.

Widows, Orphans, and . . . Franchisees?
Franchising as we know it today was unheard of until the 1960s. Starting then, and continuing into the 1970s, franchises began popping up all over the United States. Not only did the franchise business model take off, but so did the horror stories about franchisors stealing the life savings of "mom and pop" franchisees through fraud, precipitous terminations, and other unfair conduct. Some skeptics, in fact, viewed franchising as little more than a scheme to take advantage of unsophisticated investors. It was not long before franchisees began taking their place alongside widows, orphans, and sailors as individuals needing special protection by legislatures. California took the lead in passing laws regulating franchising, followed closely by Minnesota and a number of other jurisdictions. Not long after, the federal government stepped in with a law of its own.

Forty years and thousands of franchises later, franchising has proven itself a legitimate method of distributing goods and services. But it remains today the same as it was in the 1970s—an industry that is regulated through a combination of disclosure and relationship laws at both the state and federal levels.

At the federal level, Congress passed a law in 1979 called the FTC Trade Regulation Rule: Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures (the FTC Rule). See 16 C.F.R. § 436 (1979). Enforced by the Federal Trade Commission (FTC), the FTC Rule identifies a number of disclosures that a franchisor must provide to a prospective franchisee in a written document, ranging from the history of the franchisor to the identity of other franchisees to the details of any "earnings claim" or "financial performance representations." Although recently amended after 12 years of rulemaking activity to achieve better alignment with state franchise disclosure laws, the FTC Rule largely remains the same with respect to identifying franchise relationships and mandating presale disclosure protocol. Rather significant changes have occurred, however, with respect to the timing and content of certain disclosures—waiting periods, litigation history, and broker disclosures, to name a few—all of which extend beyond the scope of this article.

Fortunately for the "unsuspecting franchisor," the FTC Rule does not create a private cause of action, as enforcement lies with the FTC alone. But the unsuspecting franchisor doing business in the 18 states that have enacted laws similar to the FTC Rule is subject to lawsuits by franchisees. These states give franchisees the right to sue their franchisor for damages. Moreover, many states have what are known as "Little FTC Acts" that create a private cause of action for consumers harmed when a defendant breaks a law—acts that some courts have said give franchisees a claim for damages for a violation of the FTC Rule. In addition, potential franchisors are subject to significant damages in the 17 states with franchise relationship laws that punish "franchisors" for terminating franchisees without cause or failing to give proper notice and an opportunity to cure.

The Definition of a Franchise
The existence of a franchise relationship is not about labels and it is not about feelings. It does not matter whether the parties call their relationship a "franchise," a "license," or a "distributorship," or whether they "feel" like they are in a franchise relationship, as parties cannot waive protections afforded by the franchise laws. Nor does it typically matter whether the licensee is big or small or otherwise needs the protection of the franchise laws. The existence of a franchise is a matter of definition, pure and simple.

Courts will find that a transaction is a "franchise" if three elements are present: (1) the grant or licensing of a right to use a trademark or trade name; (2) the payment of a "franchise fee" for the use of the mark or name; and (3) some variant of a community of interest, marketing plan, control, or assistance. The definition seems simple enough. For a company trying to avoid the "franchisor" label in the eyes of a court or the FTC, however, the only part of the definition that provides certain protection is the first part—the requirement of a license. As long as a company is not somehow permitting a third party to use a mark or name, it is not offering a "franchise." As the FTC states in its Final Guides to Franchising and Business Opportunity Ventures Trade Regulation Rule (Interpretive Guides):

• The Commission does not intend to cover package or product franchises in which no mark is involved. If a mark is not necessary to a particular distribution arrangement, the supplier may avoid coverage under the rule by expressly prohibiting the use of its mark by the distributor.

The lesson? Any time a company authorizes anyone to use its mark or name and expects to control and be paid for it, that opportunity may well be the proverbial duck, regardless of how it looks, walks, or talks.

Mistakes Can Be Costly
Navigating the patchwork of federal and state franchise laws is a daunting task. At the federal level, the FTC Rule applies to franchise opportunities in each of the 50 states, Washington, D.C., and all U.S. territories. Thus, a company offering an investment that qualifies as a franchise under the FTC Rule must present a prospective franchisee with a disclosure document containing specific and detailed information about the franchisor and the opportunity. Although a franchisee wronged by the failure to disclose may not have a private right of action, the FTC can bring enforcement proceedings against the franchisor. In states with their own disclosure laws, a failure to disclose at all—or an incomplete or misleading disclosure—allows a franchisee to seek equitable relief and sometimes damages. In some states, the failure to make an accurate disclosure carries the additional risk of exemplary damages, criminal penalties, and fines.

Perhaps most troublesome, however, are the relationship laws adopted in various states. Some of these make it unlawful for franchisors to discriminate among franchisees, restrict the ability of franchisors to profit from the sale of goods to franchisees, and otherwise regulate the ongoing relationship between franchisor and franchisee. Almost all of these states allow franchisors to terminate only for cause before the end of the term of the agreement, and then only after providing the franchisee with notice of default and an opportunity to cure. At least two states (Wisconsin and New Jersey) make franchisee agreements "evergreen," that is, terminable only for cause without regard to their stated term. Thus, a relationship that otherwise looks terminable at will may, in fact, constitute a franchise that may not be terminated except for cause.

Of Ducks and Franchises
The line between a pure distributorship and a franchise arrangement is often thin, but as many franchisors have learned the hard way, the consequence of crossing it is costly indeed. In fact, as the Seventh Circuit Court of Appeals observed in To-Am Equipment Co., Inc. v. Mitsubishi Caterpillar Forklift America, Inc., 152 F.3d 658 (7th Cir. 1998),

• legal terms often have specialized meanings that can surprise even a sophisticated party. The term "franchise" or its derivative "franchisee" is one of those words.

In To-Am Equipment, Mitsubishi received a rude awakening when the district and appellate courts determined that its distribution system constituted a franchise. The courts' analysis hinged upon the existence of an indirect franchise fee paid by the alleged franchisee—namely, the franchisee's payment of over $500 to Mitsubishi for required service manuals over an eight-year period. The cost of this legal lesson: a $1.525 million jury verdict in favor of Mitsubishi's alleged franchisee. In summing up its conclusion, the Seventh Circuit stated,

• while we understand [Mitsubishi's] . . . concern that dealerships in Illinois are too easily categorized as statutory franchisees, that is a concern appropriately raised to either the Illinois legislature or Illinois Attorney General, not to this court.

Other courts have followed suit, finding a franchise in general and franchise fee in particular in the most unlikely of places. For example, the court in Bly & Sons, Inc. v. Ethan Allen Interiors, Inc., Civil No. 05-668-GPM, 2006 WL 2547202 (S.D. Ill. Sept. 1, 2006), analyzed whether a license agreement that allowed the plaintiff to sell Ethan Allen-branded products was, in reality, a franchise. The court held that a mandatory, ongoing advertising fee constituted a "hidden" or "indirect" franchise fee under the Illinois franchise laws. As a result, and because the other elements of a franchise were undisputed, the court granted partial summary judgment in favor of the alleged franchisee.

Making matters worse, one court's franchise fee is sometimes another court's business expense. In fact, the same Minnesota federal court judge determined that an advertising contribution in one case was an ordinary business expense in another under essentially the same set of facts. In Pool Concepts, Inc. v. Watkins, Inc., Bus. Franchise Guide (CCH) ¶ 12,249 (D. Minn. 2002), the court held that a franchise fee existed where a portion of the plaintiff's required product purchases was deposited automatically into a mandatory co-op advertising account controlled by the licensor. In comparison, in R&A Small Engine, Inc. v. Midwest Stihl, Inc., Civ. No. 06-877 DSD/JJG, 2006 WL 3758292 (D. Minn. Dec. 20, 2006), a dealer's payments for Yellow Pages advertising, meeting attendance expenses, and advertising co-op contributions were "ordinary business expenses" rather than franchise fees given the absence of evidence suggesting that the dealer was required to incur these expenses "for the right to enter into the business of selling [the manufacturer's] products."

It's All About the Fee
Upfront payments for the right to do business under a particular name or mark and ongoing royalty payments are obvious examples of franchise fees. At the other end of the spectrum, courts have found that ordinary business expenses, optional payments, and wholesale product purchases are not franchise fees. It is in the expanse between these two extremes that predictability yields to uncertainty.

In fact, under the FTC Rule, almost any payment might qualify as a franchise fee. The Interpretive Guides say that the "required payment" element of the definition of a franchise is designed "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." Further, according to the FTC, a franchise fee may be found in

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 payment as a result of such purchase—training, security deposits, escrow deposits, non-refundable bookkeeping charges, promotional literature, payments for services of persons to be established in business, equipment rental, and continuing royalties on sales.

The FTC Rule and various state statutes prescribe certain minimum thresholds and exclude certain types of payments from the definition of a "franchise fee." For example, the FTC Rule states that payments of less than $500 made to the franchisor or an affiliate before or within six months of opening a business do not constitute a franchise fee. A number of states have a similar exclusion, although the amount may vary. Under the FTC Rule and the laws of several states, monies paid for a reasonable quantity of goods at a bona fide wholesale price purchased from the "franchisor" for resale also are exempted from the franchise fee definition.

Beware, however, that a transaction that is not a franchise today may become one tomorrow. A fee to continue a relationship, for example, may convert the relationship to a franchise.

The Third Element Is a Given
Under the FTC Rule, the third element of a franchise is some sort of "control or assistance" on the part of the supposed franchisor. Alleged franchisors are rarely successful in claiming that they do not somehow "control" the alleged franchisee. At its simplest, any control by a franchisor over a franchisee and any assistance to a franchisee will qualify as "control" as long as the FTC believes it is "significant"—and it does not take much to reach any measurable level of significance. Training programs, operation manuals, and establishing methods of operation all meet the test.

Some states (Minnesota, New Jersey, and Wisconsin, for example) require a "community of interest" between franchisor and franchisee. Courts applying the laws of these states rarely fail to find a community of interest in even the most basic forms of product and service distribution relationship. In some states, a community of interest exists where both the alleged franchisor and franchisee profit from the sale of a product or service, which is always the case where a royalty is based on sales. Others, like California, require the presence of a "marketing plan or system" before labeling a relationship a franchise. In fact, California courts have long held that oral or implied and optional or suggested plans and systems meet the test. In short, prudent companies do not count on the third element to save them from being branded a "franchisor."

A Few Safe Harbors
The FTC Rule and most states exclude a number of relationships from their definition of a franchise for purposes of disclosure. For example, a business opportunity that will constitute merely a part of a company's existing business falls within the "fractional franchise" safe harbor. The FTC Rule, however, allows the exemption only when the franchisee has more than two years of prior management experience in the business represented by the franchise and where the parties anticipate that sales under the franchise will represent no more than 20 percent of the dollar volume of the franchisee's projected gross sales. Rhode Island and Wisconsin exclude sales to purchasers with a high net worth or a high income, and several states (California and New York are the main examples) exempt sales by large franchisors from the registration requirement. Further, isolated sales are exempted by the FTC and a few states.

The Moral
The moral of the franchise story is this: The creation of a franchise relationship and possible concomitant duties of disclosure, opportunity to cure, termination only for cause, and the like is not a matter of magic language. Whenever a transaction involves a trademark license, a fee (however seemingly remote), and elements of control or a community of interest, it may create a franchise under applicable federal and state laws. Given this risk, the prudent distributor of a product or service under a mark or name errs on the side of following the franchise laws, including the use of a disclosure document or an offering circular. A licensor still wishing to avoid the burden of preparing a disclosure document and the risk of liability under various franchise laws must exercise great caution to avoid charging a franchise fee and becoming a proverbial franchise duck.