WHEN IS A “LICENSE” REALLY A “FRANCHISE”?

The Federal Trade Commission Franchise Rule, 16 C.F.R. 436.1 et seq., governs, at a federal level, disclosures which a “franchisor” must provide to each prospective franchise. There are also numerous state laws which may apply in any given situation. The discussion in this article will be limited to the requirements under the Franchise Rule.

Several types of continuing commercial relationships are governed under the Franchise Rule. Two specific types of relationships are: 1) package franchises: in which the franchisee adopts the business format established by the franchisor and is identified by the franchisor’s trademark; and 2) product franchises: in which the franchisee distributes goods that are produced by the franchisor and which bear the franchisor’s trademark, or are manufactured by the franchisee according to the franchisor’s specifications. (See, Federal Trade Commission, Informal Staff Advisory Opinion 03-2.)

Whether a continuing commercial relationship is a “franchise” under the Franchise Rule, is determined by whether the business relationship contains the three definitional elements of a “franchise” set forth in the Franchise Rule, and it does not matter what name the parties choose to assign to the relationship. 44 Fed. Reg. 49,966 (August 24, 1979). In other words, if it walks like a duck and quacks like a duck . . . .

Under the Franchise Rule, where the parties are in a continuing commercial relationship there are three definitional elements of a “franchise.” The franchisor must:

1. promise to provide a trademark or other commercial symbol;

2. promise to exercise significant control or provide significant assistance in the
operation of the business; and

3. require a minimum payment of at least $500 during the first six months of operations.

(16 C.F.R. Parts 436.2(a)(1)(i) and (2); 436.2(a)(iii)).)

TRADEMARK

According to the FTC, a franchise entails “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.” The term “trademark” is intended to be read broadly to cover not only trademarks, but any service mark, trade name, or other advertising or commercial symbol. This is generally referred to as the “trademark” or “mark” element. The franchisor need not own the mark itself, but at the very least must have the right to license the use of the mark to others. Indeed, the right to use the franchisor’s mark in the operation of the business – either by selling goods or performing services identified with the mark or by using the mark, in whole or in part, in the business’ name – is an integral part of franchising. In fact, a supplier can avoid Rule coverage of a particular distribution arrangement by expressly prohibiting the distributor from using its mark.” (FTC Franchise Rule Compliance Guide, May 2008.)

SIGNIFICANT CONTROL OR ASSISTANCE

The Franchise Rule covers business arrangements where the franchisor “will exert or has the 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.”

When Is Control or Assistance Significant? The more franchisees reasonably rely upon the franchisor’s control or assistance, the more likely the control or assistance will be considered “significant.” Franchisees’ reliance is likely to be great when they are relatively inexperienced in the business being offered for sale or when they undertake a large financial risk. Similarly, franchisees are likely to reasonably rely on the franchisor’s control or assistance if the control or assistance is unique to that specific franchisor, as opposed to a typical practice employed by all businesses in the same industry. Further, to be deemed “significant,” the control or assistance must relate to the franchisee’s overall method of operation – not a small part of the franchisee’s business. Control or assistance involving the sale of a specific product that has, at most, a marginal effect on a franchisee’s method of operating the overall business will not be considered in determining whether control or assistance is “significant.”

Significant types of control include:

+ site approval for unestablished businesses;
+ site design or appearance requirements;
+ hours of operation;
+ production techniques;
+ accounting practices;
+ personnel policies;
+ promotional campaigns requiring franchisee participation or financial contribution;
+ restrictions on customers; and
+ locale or area of operation.

Significant types of assistance include:

+ formal sales, repair, or business training programs;
+ establishing accounting systems;
+ furnishing management, marketing, or personnel advice;
+ selecting site locations;
+ furnishing system wide networks and website; and
+ furnishing a detailed operating manual.

To a lesser extent, the following factors will be considered when determining whether “significant control or assistance” is present in a relationship: a requirement that a franchisee service or repair a product (except warranty work); inventory controls; required displays of goods; and on-the-job assistance with sales or repairs.

REQUIRED PAYMENT

The FTC interprets the term “payment” broadly, capturing all sources of revenue that a franchisee must pay to a franchisor or its affiliate for the right to associate with the franchisor, market its goods or services, and begin operation of the business. Often, required payments go beyond a simple franchisee fee, entailing other payments that the franchisee must pay to the franchisor or an affiliate by contract – including the franchise agreement or any companion contract. Required payments may include:

+ initial franchise fee;
+ rent;
+ advertising assistance;
+ equipment and supplies (including such purchases from third parties if the
franchisor or its affiliate receives payment as a result of the purchase);
+ training;
+ security deposits;
+ escrow deposits;
+ non-refundable bookkeeping charges;
+ promotional literature;
+ equipment rental; and
+ continuing royalties on sales.

Payments which, by practical necessity, a franchisee must make to the franchisor or affiliate also count toward the required payment. A common example of a payment made by practical necessity is a charge for equipment that can only be obtained from the franchisor or its affiliate and no other source.

Wholesale Inventory Exemption

The “payment” element of the franchise definition does not include “payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or lease.” “Reasonable amounts” means amounts not in excess of those that a reasonable businessperson normally would purchase for a starting inventory or supply, or to maintain an ongoing inventory or supply. The inventory exemption, however, does not include goods that a franchisee must purchase for its own use in the operation of the business, such as equipment or ordinary business supplies.

REMEDIES AVAILABLE TO PURCHASERS OF DISGUISED FRANCHISES

Courts have held that the Franchise Rule does not provide a direct remedy to franchisees. However, actions have been brought against franchisors for violations of the Franchise Rule under state “little FTC acts,” or unfair trade or business practices acts which incorporate the Federal Trade Commission Act. The remedies available under these acts vary from state to state. Some are limited to rescission and restitution, while others allow a plaintiff to be awarded damages, and in some cases the trebling of damages, costs and attorneys’ fees. Additionally, it is important to remember that franchisees or persons who entered into license agreements without proper disclosure, may have remedies under their respective states’ franchise laws. Such remedies can include rescission, actual damages, the trebling of damages, attorney’s fees, and costs of litigation.

Please consult a seasoned Franchise Law Attorney or lawyer to determine if your “license” arrangement, is, in fact, a disguised franchise (i.e., a “duck”).

Mario L. Herman
Law Offices of Mario L. Herman
5335 Wisconsin Ave. NW
Suite 440
Washington, D.C.
20015
mherman@franchise-law.com
www.franchise-law.com
www.internationalfranchiselaw.com
202-686-2886 (ph)
202-686-2879 (fax)

Mr. Herman, licensed in Washington, D.C., represents franchisees domestically and internationally in negotiation, mediation, arbitration, and litigation with their franchisors. Mr. Herman affiliates with local counsel on an as needed basis. He has practiced nationally and internationally for twenty five years, has an excellent reputation, and has very reasonable rates. He is available at www.franchise-law.com, and www.internationalfranchiselaw.com.