April 18, 2016
Practice Group(s):
Corporate
Commercial
Transactions
Having The “Are You Operating an (Illegal)
Franchise System Without Knowing It?”
Conversation
Franchise Alert
By Carlos L. White
Franchising laws are very broad in scope and may inadvertently encroach upon standard
licensing or distribution agreements. The repercussions for operating an illegal (or more
likely inadvertent) franchise system can be very severe. Accordingly, it is imperative that
corporate counsel educates and provides guidance to clients on the general contours of
federal and state franchise law. Otherwise, the client unwittingly could be operating an illegal
franchise system. With these concerns as the backdrop, this alert highlights the types of
conversations that should occur between a client unfamiliar with franchising and their
corporate counsel after counsel has reviewed a prospective licensing or distribution
arrangement for the client:
Seriously, why are you focusing on franchising-related issues in my proposed
trademark license or distribution deal? I need to get this deal done, especially
since we are a target in an M&A transaction.
Many trademark licensors, manufacturers, distributors, and other suppliers of goods and
services (collectively, “Suppliers”) enter into commercial arrangements with licensees,
dealers, retailers, and other buyers (collectively, “Buyers”) without knowing that such
arrangements may implicate federal and state franchise laws. If, under these laws, an
arrangement is deemed a nonexempt franchise, the Supplier must provide the Buyer with a
legally mandated pre-sales disclosure document before consummating the arrangement.
For states without their own franchise disclosure or registration laws (i.e., non-franchise
registration states), the Federal Trade Commission (“FTC”) franchise rule (“FTC Rule”) will
regulate franchise transactions. Under the FTC Rule, a Supplier may not offer or sell a
“franchise” unless the franchise transaction is exempted under the FTC Rule or the Supplier
provides the Buyer with a disclosure document satisfying the requirements of the FTC Rule.
States with franchise registration laws (i.e., registration states) take it a step further. These
states not only require a disclosure document for a nonexempt franchise offering, but they
also require the Supplier to register the disclosure document before the Supplier can provide
the Buyer with the disclosure document. 1
Any failure to comply with federal or state franchise disclosure and registration laws could
subject the Supplier and its owners, directors, and employees to civil actions by the FTC,
private rights of actions under state franchise laws or state unfair trade and practices laws,2
1
Franchise registration states include California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota,
New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin.
2
These state laws are typically referred to as “Little FTC Acts.”
Having The “Are You Operating an (Illegal) Franchise System Without Knowing
It?” Conversation
and potential criminal penalties. 3 Additionally, as you can imagine, any compliance-related
issues associated with a Supplier’s licensing or distribution network may have a materially
adverse effect on your company’s valuation and viability as a target.
I was not aware that a “run of mill” trademark license or distribution agreement
could actually be a franchise. I thought franchise laws only applied to restaurants
or hotels. In any event, I do not want to violate the law or cause my company to
be devalued, so what constitutes a franchise?
The creation of a “franchise” transaction is not based on the classification, nomenclature, or
intent of the parties, but rather on whether a specific arrangement satisfies the federal or
state law definition of a “franchise.” The definition of a “franchise” varies from federal to state
and state to state. However, in general, 4 a franchise exists when a Buyer obtains from the
Supplier the right to operate a business:
o in which the goods and services are identified or associated with the Supplier’s
trademark (“Trademark Element”);
o the Seller exerts or has authority to exert significant control over or provide significant
assistance in the Buyer’s method of operation of the business (“Control/Assistance
Element”); and
o as a condition of starting the operation of the business, the Buyer makes or commits to
make a required payment to the Seller or its affiliate (“Required Payment Element”).
If the transaction satisfies the applicable definitional elements and no exemption applies to
the transaction, then the Supplier must comply with the franchise disclosure and registration
laws. 5
Wow! The definitional elements of a franchise are very broad, and I have no
desire at this time to develop a franchise program. So, before consummating my
current transaction, I would like to structure the arrangement to avoid franchise
disclosure and registration laws. I wonder what steps I may need to take?
To avoid being deemed a franchise, the Supplier’s arrangement will need to be structured to
avoid the Trademark Element, Control/Assistance Element, or the Required Payment
Element, or the Supplier will need to find an exemption under the applicable franchise laws
for the arrangement. The particular franchising element to structure around will depend on,
3
See, e.g., Cal. Corp. Code § 31411; Ill. Comp. Stat. 705/25; N.Y. Gen Bus. Law § 692(1).
4
New York only requires that the Required Payment Element is satisfied and either (and not both) the
Trademark Element or Control/Assistance Element is satisfied.
5
Although outside the scope of this Alert, a commercial arrangement may also fall within parameters of
federal or state business opportunity laws. Business opportunity laws, unlike franchise laws, do not require
the presence of the Trademark Element in the transaction. Since federal and state business opportunity
requirements differ among the jurisdictions, a Supplier must closely examine the statutory language of each
applicable jurisdiction in which the Buyer plans to operate in to determine whether the prospective
transaction falls within the scope of the business opportunity laws and, thus, is subject to mandatory presale disclosures under such laws.
2
Having The “Are You Operating an (Illegal) Franchise System Without Knowing
It?” Conversation
among other things, the location of the Buyer and the Supplier’s business model and
practices.
From a practical standpoint, it will be very difficult to structure the arrangement to avoid the
Trademark Element given the Supplier’s duty to control the quality of its trademarked goods
and services. And, even if the agreement does not expressly provide a license grant, the
license grant will more than likely be inferred unless such grant is expressly prohibited in the
arrangement. Consequently, many Suppliers will focus on restructuring the
Control/Assistance Element or Required Payment Element, and the viability of structuring
around either of these two elements will depend in large part on the business model and
practices of the Supplier and the jurisdiction of the Buyer’s business (i.e., non-franchise
registration state or franchise registration state).
If the Supplier is unable to structure around one of the franchising elements, the Supplier
may be able to depend on a franchise exemption. The types and requirements of franchise
exemptions differ from jurisdiction to jurisdiction. 6 Some of the more common types of
franchise exemptions that Suppliers rely upon include the following:
o Bona Fide Wholesale Exemption – To qualify for this exemption, the Buyer’s payments
to the Supplier must be made solely to acquire reasonable quantities of inventory at
wholesale prices for resale purposes. This exemption only applies to products and not
to any services (including training or support fees). This is the exemption that many
distributors use to avoid the Required Payment Element.
o Minimum Payment Exemption – The FTC Rule exempts franchise transactions where
the total required payments to a Supplier are less than $540 during the six months
prior to the investor commencing operations. However, some registration states that
have this exemption are more restrictive than the FTC Rule. 7
o Fractional Franchise Exemption – The FTC Rule and certain registration states have a
fractional franchise exemption. Generally, the fractional franchise exemption applies
when at the start of the relationship the Buyer has more than two years of experience
in the same type of business and the parties anticipate that the sales arising from the
relationship will not exceed 20 percent of the investor’s total dollar volume in sales. 8
6
Given the variations between the FTC Rule and registration states, the Supplier will need to analyze the
exemptions requirements under the FTC Rule as well as in any registration states in which the Buyer plans
to operate the business. The applicability of these exemptions will depend on such things as the jurisdiction
of the offering and sale and proposed business, the amount consideration of the arrangement, the
sophistication and characteristics of the Buyer, the financial wherewithal of the Supplier or Buyer, the
experience of the Supplier, etc. Additionally, even if the Supplier receives an exemption for franchise
registration, the Supplier may still be required to provide a disclosure document to the Buyer.
7
For example, California Law exempts franchise offering and sales for required payments on an annual
basis that do not exceed the sum of $500.
8
The requirements of the fractional franchise exemption may be easier to satisfy under the FTC Rule than in
registration states that have this exemption. For example, the FTC Rule only takes into account the sales for
the first year of operation, while in California, the sales cannot exceed 20 percent in any year of operation.
3
Having The “Are You Operating an (Illegal) Franchise System Without Knowing
It?” Conversation
Got it. Now I recognize the general contours of a franchise arrangement.
Unfortunately, I unknowingly structured and executed commercial agreements in
the past that appear to fit within the scope of franchise disclosure and registration
laws. I wonder what I can do to discontinue the operation of an illegal franchise
system, reduce my risk profile, and preserve as much of the company’s value as
possible in our impending M&A deal.
At their heart, franchising laws are consumer protection laws, so the violations of franchise
disclosure and registration laws can subject the Supplier to serious transactional and
regulatory consequences such as criminal and financial penalties, damages, and rescission
rights for the Buyer. 9
When a Supplier discovers that it has possibly violated franchise disclosure or registration
laws, the Supplier should take prompt remedial action to address the violations. Remedial
actions can include restructuring or renegotiating the arrangement, analyzing defenses such
as the statute of limitations, self-reporting to a governmental regulator, or offering rescission
to affected Buyers. In determining the course of action to take, the Supplier will need to
evaluate, among other things, whether it wants to franchise in the future, its future expansion
or strategic transactional plans, the relationship it has with its existing Buyers, and
jurisdictions in which the existing Buyers are operating. Lastly, before terminating or not
renewing any existing arrangement, the Supplier should work with competent counsel to
evaluate any potential issues relating to franchise relationship laws.10
*********************************************************************************************************
If you have any questions or need any assistance on issues relating to an inadvertent
franchise or business opportunity, please feel free to contact us.
9
Since the FTC Rule provides no private right of action, the risk of liability for failing to comply with the
franchise disclosure requirements under federal law and states without Little FTC Acts may be less than
those in franchise registration states and states with Little FTC Acts.
10
Franchise relationship laws govern the ongoing relationship of the parties after the definitive agreement
has been executed. These laws typically address issues related to nonrenewal, termination, and transfers.
4
Having The “Are You Operating an (Illegal) Franchise System Without Knowing
It?” Conversation
Authors:
Carlos L. White
carlos.white@klgates.com
+1.214.939.5712
Anchorage Austin Beijing Berlin Boston Brisbane Brussels Charleston Charlotte Chicago Dallas Doha Dubai Fort Worth Frankfurt
Harrisburg Hong Kong Houston London Los Angeles Melbourne Miami Milan Moscow Newark New York Orange County Palo Alto Paris
Perth
Pittsburgh
Portland
Raleigh
Research Triangle Park
San Francisco
São Paulo
Seattle
Seoul
Shanghai
Singapore
Spokane
Sydney Taipei Tokyo Warsaw Washington, D.C. Wilmington
K&L Gates comprises more than 2,000 lawyers globally who practice in fully integrated offices located on five
continents. The firm represents leading multinational corporations, growth and middle-market companies, capital
markets participants and entrepreneurs in every major industry group as well as public sector entities, educational
institutions, philanthropic organizations and individuals. For more information about K&L Gates or its locations,
practices and registrations, visit www.klgates.com.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in
regard to any particular facts or circumstances without first consulting a lawyer.
© 2016 K&L Gates LLP. All Rights Reserved.
5