Imagine you have a client who started its business from the ground up producing world-class fishing boats and developing a national network of independent dealers to sell its products. Your client provides its dealers with two weeks of world-class sales training for a nominal $5,000 fee. Many years of hard work have gone into the development of the successful enterprise, including hours of work by you as its legal counsel to help create and grow its business. Next imagine that a dispute arises between your client and one of its dealers. The dispute itself may be frivolous, but the dealer, after being advised that its relationship with your client may be considered a franchise, chooses the vindictive route of reporting your client’s business to the Federal Trade Commission (“FTC”) and various state agencies around the country. Your client spends the next year battling with state agencies and lawsuits from several disgruntled dealers just to maintain a fragment of its previously successful business, and losing thousands and even millions of dollars in the process.
The offer and sale of a franchise in the United States is highly regulated by both federal and state laws, but often a business, such as the one described above, goes years without being advised that its business model potentially creates a franchise relationship. The primary goal of this article is to help business law practitioners better advise their clients by providing a basic structure for identifying franchise or business opportunity relationships before harm has occurred, or, if the client has already created an illegal structure, to help the client identify the structure so that it can obtain appropriate assistance in minimizing exposure to claims as it works toward compliance.
Overview of Regulatory Landscape
The regulatory landscape for franchising consists of a “crazy quilt” patchwork of laws. At the federal level, the primary regulatory agency is the FTC, which regulates franchising under the FTC rule entitled “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures” (the “FTC Rule”). At the state level, 15 states have registration or disclosure laws (“State Registration Laws”) with respect to franchise relationships. State Registration Laws apply not only in the state where the potential franchise will be located, but often also in the home state of the franchisor, the state, or states, in which the franchise agreement was entered, or the state of residence of the franchisee. North Carolina does not have a separate statute governing the franchise relationship or requiring disclosure; however, often such principles may be incorporated under North Carolina’s “Little FTC Act.”1
The FTC Rule applies to those offering and selling franchises in all 50 states. It requires that a franchisor give written pre-sale disclosures to prospective franchisees at the earlier of the first face-to-face meeting between the franchisor and prospective franchisee or 14 days prior to the date the franchisee signs the franchise agreement or pays consideration for the franchise. The written disclosure – the franchise disclosure document (“FDD”) – is similar to a prospectus or private offering memorandum in a securities offering. Like a private-placement memorandum, the FDD is not required to be filed or registered at the federal level. The FDD must contain certain information about the franchise, including, but not limited to, a description and identifying information of the franchise, the business experience of its owners and officers, litigation and bankruptcy history, and required fees and purchase of the franchisee. It must also contain an estimated total initial investment, financing arrangements, financial statements, and statistical information about the franchise, among others. The FDD and the information provided therein must be updated on an annual basis.
Similar to the FTC Rule, states with State Registration Laws require that franchisors provide a written disclosure document to prospective franchisees prior to the sale of the franchise; however, such states vary as to the timing parameters.2 Unlike the FTC Rule, the vast majority of State Registration Laws require that such written disclosure document be filed and registered with the state and renewed on an annual basis. While the states vary at least slightly as to what information must be disclosed, both the states requiring registration or disclosure and the FTC have adopted the use of the FDD as their disclosure format.
In addition to the various franchise laws, laws exist at both the federal and state level regulating the sale of business opportunities. While such laws are not directly aimed at reaching franchises, their scope is generally broad and often overlaps with the franchise laws. Business opportunity laws are often aimed at regulating investments in opportunities such as vending machines, craft assembly, and telemarketing, but are certainly broad enough to pertain to the many business relationships described below. On November 22 of last year, the FTC adopted a new federal business opportunity rule (“FTC Biz Op Rule”). The FTC Biz Op Rule went into effect on March 1, 2012. Similar to franchise laws, the FTC Biz Op Rule does not preempt state business opportunity laws, but is in addition thereto. The majority of states, including North Carolina,3 have statutes that govern the sale of business opportunities in the state. Thus, for those businesses located in states that have their own business opportunity laws, there may be compliance requirements from both the state and federal level.
As briefly touched on above, the consequences of failing to comply with state and federal franchise and business opportunity laws can be devastating to a business. While the FTC Rule does not provide for a private right of action, the FTC can bring civil actions against violators, obtaining civil penalties, injunctive relief, and consumer redress. State Registration Laws often provide for both state and private actions. In addition, certain violations may be appropriately brought under a state’s Little FTC Act or unfair trade practice statutes, often permitting treble damages and attorneys’ fees. While addressing past violations of a franchisor is beyond the scope of this article, it suffices to note that the administrative, civil, and/or criminal penalties for non-compliance can be substantially higher than had the purported franchisor been compliant from the onset. Even if a business is compliant with the relevant state and federal laws, the time and expense associated with such compliance is costly and burdensome. For a business that does not intend to utilize the franchise business model to grow and expand, the accidental franchise is an unfortunate set of circumstances.
Definition of Franchise and Business Opportunity
Determining the application of the franchise and business opportunity laws is a daunting task. Such a determination is largely based upon whether your client’s business falls within the broad definitions of a “franchise” or a “business opportunity,” and whether or not the relevant statute provides an applicable exception. Unfortunately, the definitions and available exceptions vary significantly from state to state and at the federal level. As a rule of thumb, in any case where a trademark license coexists with the distribution of goods or services, the relevant franchise laws should be consulted.
The FTC Rule defines a franchise as a business relationship with all of the following three elements: (1) the distribution of goods or services, which are associated with the franchisor’s trademark or commercial symbol; (2) the franchisor’s exercise of significant control over, or giving significant assistance to, the franchisee; and (3) the franchisee’s payment to the franchisor of at least $5004 prior to the expiration of the first six months of the operation of the franchised business. The trademark element of the FTC Rule is satisfied where a franchisee distributes goods or provides services that are identified by the franchisor’s mark or where the franchisee operates under a name including the franchisor’s mark. Thus, any relationship where the franchisee is attempting to gain the benefit of the franchisor’s reputation should be examined closely.5 The significant control or assistance element of the FTC definition must be related to the franchisee’s overall method of operation, including without limitation, such assistance as site approval and design, production techniques, restrictions on customers and areas of operation, training programs, and marketing advice. The significant control or assistance element specifically excludes trademark controls; however, in practice, the control necessary to protect a licensor’s trademark rights may be indistinguishable from the significant control element of the FTC Rule. Your client’s business model may make it impossible to structure around the trademark element, and it may not be advisable to eliminate the quality control elements of the business model to bypass the significant control and assistance element. Therefore, the element of the FTC Rule most often structured around is the payment element. In addition to permitting the deferral of franchise fees as a way of bypassing the payment element, payments do not include the purchase of reasonable quantities of products for resale at bona fide wholesale prices from the franchisor or an affiliate. Business concepts that are exploring the franchise industry often defer franchise fees for the first six months in their initial units to permit them to test the franchising waters without having to incur the high costs of complying with the various franchise rules. As is noted in more detail below, if this approach is utilized, care should be undertaken to insure no hidden franchise fee is present and to determine whether the same consideration element is present under applicable state law.
In addition, the FTC Rule offers several exemptions to business relationships that fit certain criteria. Known as the “fractional franchise” exemption, this exemption permits established distributors of goods or services to add franchised products or services to its existing lines in the same business, so long as, the distributors meet an experience requirement and that the franchised products or services account for no more than 20% of the distributors prospective gross sales during the first year. This exemption is most commonly used in the auto dealership industry. Furthermore, the FTC Rule provides exemptions for sophisticated investors, those investing in excess of $1 million and large franchisees, those who have been in business for at least 5 years and have a net worth in excess of $5 million6. The FTC also provides an insider exemption for certain owners, officers, directors, and managers of the franchisee under certain conditions. A franchisor relying upon an exemption bears the burden of proving that each transaction properly qualifies for the exemption.
To complicate matters, the fifteen registration states differ as to their definition of a franchise and offer varying exemptions. Therefore, while an exemption exists federally, it may not exist under state law. The two most common definitions at the state level are (1) the “Marketing Plan or System” definition whereby a franchise is defined as a business relationship where a franchisor grants the franchisee the right to offer goods or services under a marketing plan or system prescribed by franchisor; and (2) the “Community of Interests” definition whereby a franchise is defined as a business relationship in which the franchisor and franchisee have a community of interest. Like the FTC Rule, the majority of states, if not all, require a trademark element and payment by the franchisee to the franchisor or an affiliate in order for a business relationship to be determined a franchise. Unfortunately, while most of the states with State Registration Laws have a payment element, many of them do not tie such payment to the first six months of operation and may have a lower or no consideration threshold. Therefore, structuring a payment to the franchisor as a deferred payment generally does not exempt a relationship from being treated as a franchise under the various State Registration Laws.
On the other hand, a “business opportunity” under the FTC Biz Op Rule is defined as a commercial arrangement meeting the following three criteria:
(1) Seller must solicit the prospective purchaser into a new business,
(2) Prospective purchaser must make a payment to the seller or an affiliate in order to commence the business, and
(3) Seller or affiliate must represent that they will provide the prospective purchaser assistance with either locations to operate, accounts or customers, or by buying back the purchaser’s goods or services.
The FTC Biz Op Rule requires certain disclosures to prospective purchasers that are similar to those required by the FTC Rule, although considerably simplified. The FTC Biz Op Rule, like the FTC Rule, contains several exceptions to the definition of a “business opportunity.” For example, the FTC Biz Op Rule exempts the wholesale bona-fide purchase of reasonable amounts of inventory from a seller and exempts multi-level marketing arrangements.
As you can imagine, given the various state and federal laws relating to franchising and the sale of business opportunities, if your client’s business expects to have sufficient contacts with states that have State Registration Laws, structuring a business relationship that maintains the integrity of your client’s business but is exempt from complying with the various franchise and business opportunity laws can be a challenging task. Furthermore, as often is the case, a client may reach you after it has already built its business and entered into various business relationships. Spotting the “accidental” franchise or business opportunity at this stage can be critical to the ongoing health of your new client’s business by allowing the purported franchisor to take control over the compliance process as opposed to having outside actors—such as government regulators and franchisees—take control.
Potential Accidents
While, generally speaking, any business or commercial relationship that meets the elements of a franchise or a business opportunity and for which no exceptions exist, would be required to comply with the various regulatory regimes, there are several common relationships that the business lawyer should be attuned to that may implicate the franchise and/or business opportunity laws. Such relationships include:
(1) Dealer and distributorship arrangements involving branded products;
(2) Trademark license agreements, particularly where the licensor provides additional assistance to the licensee beyond simply granting rights in the marks;
(3) Business consulting arrangements;
(4) Joint ventures involving a unified brand; and
(5) Subleasing arrangements based upon a percentage of the sublesee’s revenue.
Given the severity of failing to comply with the franchise and business opportunity laws, spotting violations early or potential violations before they occur can be invaluable to your clients. •
End Notes
1. See Chapter 75-1.1 of the North Carolina General Statutes.
2. The states with State Registration laws include California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin.
3. See North Carolina General Statues § 66-94 et seq.
4. This threshold is indexed for inflation and will be $540 effective as of July 1, 2012.
5. See the FTC’s Statement of Basis and Purpose (Fed. Reg. 59,621)
6. These thresholds are indexed for inflation and will be $1,084,900 and $5.424 million, respectively, effective as of July 1, 2012.
Wooldridge is an associate with Manning, Fulton & Skinner, P.A. in Raleigh, NC where his areas of practice include franchise law, business law, and tax law.
Taylor is a shareholder with Manning, Fulton & Skinner, P.A. in Raleigh, NC where his areas of practice include franchise law, business law, and commercial transactions. He also serves as the Chair of the Business Law Section’s Franchise Law Committee.
