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As published in Attorney At Law Magazine

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Imagine you have a client who started its business producing world-class fishing boats and developing a national network of independent dealers to sell its boats. Your client provides its dealers with two weeks of sales training for a $5,000 fee and a royalty for using your client’s trademark and selling its boats. Many years of hard work have gone into the development of the successful enterprise, including hours of work by you as its legal counsel. Next, imagine a dispute arises between your client and one of its dealers. The dispute itself may be frivolous, but the dealer believes that its relationship with your client may be considered a franchise and chooses the vindictive route of reporting your client’s business to the Federal Trade Commission (FTC) and various state agencies. Your client spends the years battling with state agencies and lawsuits from disgruntled dealers just to maintain a fragment of their previously successful business – losing thousands or 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. Often, however, a business like the one described above can go years without being advised that its business model potentially creates a franchise relationship. Unfortunately, attorneys and clients unfamiliar with franchising incorrectly believe they can simply classify a relationship as a joint venture or license agreement and avoid the reach of applicable franchise laws.

The FTC regulates franchising federally under the FTC rule, “Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures.” This rule mandates all franchisors develop and maintain a FTC-compliant franchise disclosure document (FDD), timely deliver the FDD to prospective franchisees, and refrain from certain prohibited practices.

At the state level, 15 states have franchise disclosure laws and 22 states have franchise relationship laws governing the franchise relationship. Additionally 28 states—including North Carolina— have a business opportunity act, which governs the sale of many franchises as well as traditional business opportunities. State business opportunity laws not only require disclosure for non-exempt transactions using a state specific disclosure document, but also prohibit certain sales practices and may require posting of surety bonds. These state laws may have a more expansive definition of a franchise than the FTC Rule. For example, they may not have a time period for receiving consideration or a consideration threshold in determining whether the relationship constitutes a franchise. Additionally, many of the state 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. While North Carolina does not have a franchise registration or disclosure law, accidental franchisors not in compliance with FTC rule could face claims brought under North Carolina’s Unfair and Deceptive Trade Practices Act as well as the North Carolina Business Opportunity Act.

The FTC Rule defines a franchise as a written contract involving 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 $500 prior to the expiration of the first six months of the operation of the franchised business. Absent an exemption applying, the relationship will be a franchise under the FTC Rule if all elements are present regardless if the relationship is defined by the promoter as a licensing transaction, joint venture or some alternate structure.

Even if the relationship is structured to fail one or more elements in the above test, additional analysis must be undertaken to ensure the relationship will not trigger the application of state franchise or business opportunity laws. Additionally, a business exempt from the FTC Rule may still trigger the FTC’s new business opportunity rule with its disclosure requirements and list of prohibited practices.

Failure to comply with the FTC and state laws exposes a client to the potential for treble damages, enforcement actions from governmental authorities, civil fines, injunctions against future franchise sales, and possible criminal sanctions. The liability does not apply to just the franchisor, but the franchise sellers may have personal liability under both the FTC rule and North Carolina law. Attorneys who advise their clients incorrectly on their compliance obligations risk exposure to malpractice claims from the purported franchisor and potentially undisclosed franchise purchasers. To avoid potential business and personal liability, prospective franchisors should seek the assistance of experienced franchise counsel before creating a business transaction, which could later be found to be an illegal franchise relationship.

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