What every corporate counsel should know about spotting a franchise

It is extremely easy to create an inadvertent franchise relationship when drafting or creating distribution, licensing, and other relationships

In this competitive and evolving business environment, companies constantly evaluate how to expand the distribution channels for their products and services. These distribution channels can include businesses operated by third parties under any one of a number of traditional legal structures:  dealerships or distributorships,  sales representatives or agents,  brokers, joint ventures, consulting arrangements, and other creative relationships. Under these arrangements, the third-party may be identified as an independent contractor or an agent. When the legal arrangement includes a "brand," in all likelihood there will be some sort of right to use the company's trademark or service mark. In these cases you need to first consider whether the arrangement may be a "franchise," which means that the arrangement is subject to specific requirements of state and federal laws.

When drafting agreements or creating these types of relationships, corporate counsel need to be cognizant of franchise laws to avoid accidentally creating a franchise relationship (typically referred to as an "inadvertent" or "hidden" franchise). It is extremely easy to create an inadvertent franchise relationship when drafting or creating distribution, licensing, and other relationships for the sale and delivery of branded products or services that will be identified by, or associated with, the seller's trademarks or service marks.

In To-Am Equipment Company v. Mitsubishi Caterpillar Forklift America, Inc., the 7th Circuit noted in its opinion that "[l]egal terms often have specialized meanings that can surprise even a sophisticated party . . . [and] [t]he term 'franchise,' or its derivative 'franchisee,' is one of those words." Another example of a party being surprised by their relationship falling within the dealer and franchise laws is the Girl Scouts of the USA. Focusing on the relationship between the Girl Scouts and the Manitou local council, the 7th Circuit in Girl Scouts of Manitou Council, Inc. v. Girl Scouts of the United States of America, Inc. noted "[f]rom a commercial standpoint the Girl Scouts are not readily distinguishable from Dunkin' Donuts" and found the Girl Scout relationship fell within Wisconsin's fair dealership law that applies to dealers and franchisees.

Unfortunately, there is no uniform definition of a franchise, which complicates this area of the law. One definition is in the Federal Trade Commission's Franchise Rule. The others are in the state or country franchise laws, if such a law has been enacted in the applicable state or country. Here we will briefly discuss the general elements of a franchise, so that corporate counsel can evaluate when it may be necessary to seek outside counsel with sound experience in franchising to advise on any franchise law implications of a relationship.

Although it can be dangerous to generalize, most definitions of a franchise include three elements: (a) the grant of the right to operate a business identified or associated with a trademark or service mark or offer, sell, or distribute goods or services identified or associated with a trademark or service mark; (b) payment of money or other consideration (e.g., fees paid for royalties, rent, advertising, management, consulting, promotional items, inventory, equipment, signs, and training—or upfront fees to enter into the relationship); and (c) the franchisor will exert or has authority to exert significant control, or provide significant assistance, in the franchisee's operations.

Note that even what constitutes payment of a fee can be an area in which you should not make assumptions. For instance, payments for inventory may satisfy the fee element but can sometimes be structured so that they do not. Some state statutes substitute the control or assistance element in (c) with the element that the franchisor provides a marketing plan or an element requiring the parties to have a community of interest. Additionally, there are a few state statutes that only include two elements and omit either the fee element or marketing plan element, and the New York statute requires the fee element and either the trademark element or  the marketing plan element. Given the definition of a franchise under the New York statute, most simple trademark licenses in connection with operation of the business in some way by the counter-party may therefore satisfy the definition of a franchise.

In addition to the FTC Rule on Franchising, an analysis of a relationship may include evaluating multiple state statutes. The jurisdictional scope of the various state statutes may be triggered by where the franchisor is incorporated, headquartered, or domiciled; where the offer is made; where the franchisee is domiciled; and/or where the franchisee will conduct the business that is the subject of the franchise relationship. Therefore, it is very likely that multiple franchise laws may need to be considered in connection with a single transaction. For example, if a company headquartered in New York makes an offer in Maryland to a person domiciled in California for the purchase of a franchise that will be located in Illinois, then that company will need to comply with the franchise laws in California, Illinois, Maryland and New York.

When evaluating a potential franchise relationship, the analysis of the element related to the significant control, significant assistance, marketing plan or community of interest is extremely imprecise because most trademark licensors will retain some quality controls related to the trademarks that can be the same as or similar to this element. In some of these situations, even experienced franchise counsel cannot opine with certainty on whether a court would find a franchise relationship. Further, when evaluating whether a relationship is a franchise, a court will consider the written agreements, oral promises, and how the relationship actually functions (including how it has evolved). This is very important to consider because aspects of an element may not initially be present, but the relationship may evolve to include additional aspects of an element.

The parties' intent not to create a franchise relationship and any disclaimers in the agreement that the parties are not creating a franchise relationship will not prevent such a relationship from being created. It may be possible, after careful analysis of the applicable laws and proposed relationship, to restructure a relationship to keep it from falling within the applicable definitions of a franchise. However, the first step is recognizing the franchise law issue and subsequently working with counsel with true experience in franchising.

The next article in this series will focus on the various laws that apply to franchise relationships that are intentionally or unintentionally created and the last issue will focus on the consequences of failing to comply with applicable franchise laws.

Contributing Author

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Gerald Wells

Gerald Wells advises his clients on franchising, licensing, distribution, mergers and acquisitions, and general corporate law. He counsels start-up and established franchisors, licensors and manufacturers...

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