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The Inadvertent Franchise – Are You a Franchise Without Knowing It?

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How do you know when a license agreement qualifies as a franchise? Under federal and state law, the bar to qualify as a franchise is quite low, and many business arrangements may be surprised to discover their business relationships are, in fact, inadvertent franchises.

Regardless of whether parties ever intended to be a franchise, and regardless of whether they called their business a franchisee—their business might just very well be a franchise. This is partly because every time a business forms a distributorship, a license, a strategic trademark alliance, any branded joint venture or any marketing affiliation, the foundation of a franchise is potentially established.

So, what qualifies a business as a franchise? Below, we’ll discuss the three necessary elements in detail as well as address the significant consequences and penalties that inadvertent franchises may face if their business is not properly registered.

The Three Elements that Make a Business a Franchise

The Federal Trade Commission (FTC) defines a franchise as: any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify…

(1) The franchisee will obtain 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;

(2) The franchisor will exert or has 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; and

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.

Approximately 25 states require franchise registration or filings, and many, including California (via California Franchise Investment Law (“CFIL”) and Corporations Code, Section 31000, et. seq.), also rely on these three key elements. In a nutshell, if a trademark, system or marketing plan, and required fees are all present—your business must comply with the FTC as well as state franchise registration or filing requirements. In some states, such as New York, only two elements are required to establish a franchise (e.g. just a fee and marketing plan). Below, we’ll discuss these three key elements in detail.

The Business Must Be Associated With the Franchisor’s Trademark

This is the easiest element to meet. A franchisee’s business must be clearly connected with the franchisor’s commercial symbol, such as a trademark. Even if the franchisee chooses not to display the symbol, as long as it was provided, part one of the FTC franchise definition is met. In the Guidelines for Determining Whether an Agreement Constitutes a “Franchise” issued by the California Commissioner (Release No. 3–F, revised June 22, 1994),  the Commissioner explains that the objective of the law is to deal with a multiplicity of business arrangements presented to the public as a unit or marketing concept operated pursuant to a uniform marketing plan and under a common symbol. That “if the franchisee is granted the right to use the franchisor’s symbol, that part of the franchise definition is satisfied even if the franchisee is not obligated to display the symbol.”

A good example of this is seen in Gabana Gulf Distributions, Ltd., v. GAP Intern. Sales, Inc., 2008 WL 111223 (N.D. Cal. Jan. 9, 2008). In this case, Gabana claimed its relationship with Gap was a franchise and sought protection under California franchise law which requires good cause to end a franchise relationship. California franchise law required that Gabana “establish that the operation of its business was substantially associated with Gap’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol. This element is satisfied where the franchisee is granted the right to use the franchisor’s symbol or where the trademark is communicated to customers of the supplier.” Gabana argued that since it only traded in Gap products, its customers did, in fact, associate their company with Gap’s trademark. But its argument only supported the conclusion that Gabana’s customers associated their product with Gap products—not that Gabana’s customers associated Gabana, a distributor, with the Gap trademark. In fact, the distributor agreement, as the court found, “expressly forbade Gabana from “adopt[ing] any trademark, service mark, trade name, trade dress or any element thereof” which might be considered the carry the risk of association with Gap. The contract also prohibited Gabana from using Gap’s trademark on its business cards, stationary or in any other way without prior written approval.”  The court concluded that “Gabana cannot argue that Gap granted it the right to use the Gap trademark merely because the trademark appeared on Gap clothing.” Since the court found that Gabana’s business was not substantially associated with Gap’s trademark or other commercial symbol, Gabana’s motion for summary judgment on the of franchise issue was denied.

In another example, Roberts v. C.R. England, Inc., 848 F.Supp.2d 1087 (2012), Roberts failed to prove that their business was substantially associated with the franchisor’s trademark or other commercial symbol. Roberts alleged that “C.R. England required them always to identify themselves as drivers for C.R. England in their communications with customers…Plaintiffs further allege that they followed the policy in every interaction with customers, guards at facility gates, internal dispatchers, warehousemen, and managers inside customer premises. Finally, Plaintiffs claimed that customers selected C.R. England to deliver services in partnership with Plaintiffs based on the association drawn between Plaintiffs and the name and goodwill attributed to C.R. England.” Roberts relied on Kim v. Servosnax, 10 Cal.App.4th at 1346 (1992), in which case the plaintiff operated a on-site cafeteria in an office complex where she sold food items to customers who paid her directly. Plaintiff was found to be “intimately associated” with the trademark “in the mind” of Nicolet, the office owner, as the owner had selected Plaintiff to operate the cafeteria based on the Servo system. In contrast, the plaintiffs in Roberts didn’t directly sell their services to customers and were not selected by customers based on the mark instead simply providing delivery services on C.R. England’s behalf. Thus, the court ruled the trademark allegations were inadequate.

There Must Be a Common System or Marketing Plan the Franchisor Exercises Control Over

This second element is possibly the most difficult to disprove. If no marketing or system plan is in place, and the franchisee is free to operate the business according to its own marketing or system plan, the business agreement is not a franchise. However, determining whether a marketing or system plan is present and the level of control exercised can be subjective.

Many states follow the Amended FTC Rule, which require the licensor to provide significant assistance or enforce significant controls over the licensee’s entire method of operation.

Significant Assistance

Examples of significant assistance include when the licensor provides formal sales, repair, business training programs, assistance with site location, management, advice regarding marketing or personnel, promotional support which requires the licensee’s participation or financial input, and operating advice such as a detailed operating manual.

Significant Controls

Significant controls exist if the licensor approves or impedes the sales territory or business location, requires design or appearance specifics, determines operating hours, creates production methods or standards, restricts the customers, mandates personnel practices or policies, or determines accounting practices.

It’s possible that any one of these factors may be enough to establish significant control or assistance, even if the control is not exercised or used.  In other words, if the agreement between the parties allows for such control, then a court can find that there is a franchise relationship.   

A good example of the system or marketing plan element exists in Boat & Motor Mart v. Sea Ray Boats, Inc. 825 F.2d 1285 (9th Cir. 1987). In Boat, Sea Ray argued that it did not provide a system or marketing plan but encouraged Boat & Motor Mart to aggressively market its boats, which is too vague to constitute a system or marketing plan. However, the court found that their Direct Dealer Agreement did, in fact, satisfy the system or marketing plan requirement necessary to qualify as a franchise under the California Franchise Relations Act. For example, in addition to providing a marketing program, a computer printout of prospective customers, press kits, promotional tools, and marketing advice, Sea Ray also required Boat’s salesman to go through training and “provided detailed instructions on what Boat’s salesmen should do, especially at boat shows.  It provided instructions how to lay out the booth, including instructions that all boats should be wiped down each day.  It said that a telephone was ‘a must,’ as was a carpet.  It gave detailed instructions as to other booth accessories.  It insisted on a dress code for salesmen.  It told Boat what to supply the salesmen with.”  

Similarly, in Gentis v. Safeguard Business Systems, 60 Cal.App.4th 1294 (1998), distributors of recordkeeping systems and office products brought an action against the manufacturer and seller of those systems and products for violating the California’s Franchise Investment Law. The argument mainly lay in the statute’s definition, which states “franchisee is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor.” Their argument narrowed in on “offering, selling or distributing goods or services,” stating the trial court erred “because persons who solicit orders, but lack the authority to enter into binding sales contracts, do not offer, sell or distribute goods or services.” The court found that the agreement did constitute a franchise because “plaintiffs were more than sales representatives who simply solicited orders without authority to bind defendant, since they demonstrated and installed defendant’s systems, provided ongoing customer service, operated under a marketing plan prescribed in substantial part by defendant and associated with defendant’s trademark, and plaintiffs were required to pay a franchise fee.”

Alternatively, in Roberts, plaintiffs were unable to prove they were granted a right to offer or distribute services or goods to customers. Plaintiffs alleged they “broke down pallets at the request of third-party customers and provided a variety of services directly to third-party customers and often acted at the customers’ direction to meet the customers’ needs.” However, these allegations were not as specific as Gentis “where the plaintiffs actively cultivated customer relationships.”

There Must Be Associated Fees

This third element includes all revenue a franchisee may pay to a franchisor for the right to associate, market goods or services, and start business operations. Some examples might be initial franchise fees, rent, advertising, promotional or training materials; equipment and supplies, training; escrow, security deposits; bookkeeping or accounting charges, and royalties.  These payments can be made in a lump-sum, installments, fixed or fluctuating payments, up-front or periodic payments for goods or services.

It’s also important to note that only required payments from franchisee to franchisor count—not optional payments. Payments are deemed required if they are determined to be essential for the success of business operations. However, in California, the charge can be required “directly or indirectly.” Cal. Bus. & Prof. Code § 20001. Following these guidelines, as stated in Boat, “a payment by a franchisee, though nominally optional, may in reality be a required one, if the article for which the payment is made is essential, or if the franchisor intimates or suggests that it is essential, for the successful operation of the business.”

Additionally, to be classified as a required fee, payments must be made to the licensor or its affiliate or be made for their benefit. Payments made from the licensor to a licensee are not franchise fees because the licensor does not receive the benefit of payment. If an arrangement exists where a licensee is required to discharge the licensor’s debt to a third party or that third party submits a part of licensee’s payments to the licensor, an indirect franchise fee may exist.

Penalties That Regulators Can Issue if a Business Is Not Properly Registered

Franchise law violations have potentially devastating consequences. Significant penalties can be issued, even if the inadvertent franchisor did not know about the law, and even if they had zero intent to violate it.

Both federal and state franchise agencies have authority to recover substantial penalties, freeze assets, release cease and desist orders, order restitution, and prohibit violators from selling franchises.  Franchisees can possibly collect compensatory damages and attorney’s fees (in some states). They have the power to (1) rescind a franchise agreement due to violations relating to disclosure and registration, (2) acquire an injunction for wrongful termination or nonrenewal of a franchise; and/or (3) recover significant damages or restitution.

In California, the penalties for failing to comply with the franchise laws may include criminal sanctions, fines, and other penalties. Criminal penalties are rare in the case of an honest mistake, but a thorough investigation of the facts will be conducted to determine just how accidental the franchise in question is. Additionally, and surprisingly to many inadvertent franchises, is the potential for personal, joint and several liability for franchisor’s owners and management. While the liability varies according to different state franchise statutes, it is imposed based on an individual’s participation in the franchise, the transaction at issue, or involvement as an officer, director, partner, or other. And there is no corporate shield for protection. A good example of this is in the state of California.

California Franchise Investment Law states:

Every person who directly or indirectly controls a person liable under [the law’s registration and anti-fraud provisions], every partner in a firm so liable, every principal executive officer or director of a corporation so liable, every person occupying a similar status or performing similar functions, every employee of a person so liable who materially aids in the act or transaction constituting the violation, are also liable jointly and severally with and to the same extent as such person, unless the other person who is so liable had no knowledge of or reasonable grounds to believe in the existence of the facts by reason of which the liability is alleged to exist.

Work with an Experienced Franchise Lawyer

Many businesspersons and companies enter into contractual relationships without considering whether it’s a franchise relationship. And courts have shown little sympathy for businesses that defend franchise claims by pleading ignorance or a lack of intent to create a franchise. Discovering you are an inadvertent franchisor can come at the worst possible time such as when a lawsuit is brought against the inadvertent franchisor. We are experienced in advising franchisors and franchisees on state franchise investment laws in every state. We can create a compliant franchise system for you if you are a franchisor or bring claims on your behalf if you’re a franchisee. If you need assistance, contact Luther Lanard, PC, to schedule a consultation.