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The Accidental Franchisor

Are you running a franchise and don't even know it? Take these steps to stay out of legal hot water.

If it walks like a duck and quacks like a duck...

On a regular basis, I meet with companies that fail to recognize that they're already franchising. Most of these companies have created this inadvertent franchise relationship innocently enough. Some simply desired to avoid what they perceived to be a highly regulated method of business. Others didn't like the idea of calling their business relationship a "franchise," and figured that if they called it something different, they weren't violating franchise regulations. Some simply had no idea that there are regulations that even govern this type of contractual relationship.

What do these companies have in common? Often, unfortunately, it's bad legal advice.

When I suggest someone may be in violation of the Franchise Rule, the first words I often hear are, "My attorney drafted this, so it must be OK." But unfortunately, attorneys--like the rest of us--are fallible, and attorneys who are unfamiliar with the complexities of franchise law will occasionally try to muddle through the issues without calling on an expert, and the result can be disastrous.

For example:

  • In Mirza v. TV Temp, the plaintiffs in the case were awarded $1.45 million based on defendant's failure to provide disclosure documents 10 days prior to the signing of a master distributor agreement.
  • KIS Corp. paid $1.55 million in damages after agreeing its plan violated the FTC Rule.
  • In LASVN #2 v. Sperry Van Ness Real Estate, a jury awarded more than $6 million in a case in which both parties had agreed in writing that the relationship wasn't a franchise.

In at least one case, a true non-franchise relationship actually unwittingly evolved into a franchise. That's right: A business that started as a distributorship evolved into a franchise without any change in the contract.

In the case of To-Am Equipment v. Mitsubishi Caterpillar Forklift America, Mitsubishi granted a distributorship to To-Am, assuming that since it wasn't charging To-Am a fee, it wasn't subject to franchise laws. But over the course of the eight-year relationship, To-Am purchased $1,600 worth of manuals from Mitsubishi, thus triggering Illinois state franchise laws and ultimately costing Mitsubishi $1.525 million.

Often, the problems associated with these inadvertencies can take years to arise, catching the accidental franchisor by complete surprise. But when they do, it's with a "Bang!" as the hunters rise out of their blinds.

Quack! Quack!
The most unfortunate part of these situations is that most are entirely and easily avoidable. In virtually every case, these companies (or their lawyers) simply didn't know they were actually franchising.

The federal definition of a franchise includes a business relationship that has three elements:

  1. The use of a common trademark (such as "McDonald's");
  2. The provision of operational support or assistance, training or the exercise of significant operating control;
  3. The payment of a fee of over $500 in the first six months of operation. This definition includes initial fees, royalties, advertising fees, training fees or fees for equipment. In fact, the lone exception is for goods sold to the franchisee at a bona fide wholesale price for resale to their customers.

If a company has those three elements, it's a franchise. It doesn't matter what you call it. It doesn't matter how you try to disguise it. It simply looks and quacks like a duck...

In addition to the federal law, franchisors must be aware that several states have laws governing the sale of franchises (view the complete list here ). If you're offering a franchise in one of those states, you may need to register with a state agency before offering franchises. Seven of these states even require you to submit your franchise advertising for approval before you use it.

This is further complicated by the fact that different states have different triggering events that require registration, including a) if the franchisor is headquartered or domiciled in that state, b) if the franchisor is incorporated in that state, c) if the franchisee is a resident of that state, d) if the franchisee will operate in that state, or e) if the discussion of the sale of the franchise takes place in that state.

What makes it even more difficult is that in some cases, the state's definition of a franchise can be different than the FTC definition--and that's before one even considers the "crazy quilt" of exemptions offered by these various states.

Some state laws will define a franchise as a contract or agreement by which a 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 or suggested in substantial part by a franchisor, substantially associated with the franchisor's trademark. And the person granted the right to engage in such business is required to pay, directly or indirectly, a franchise fee of $500 or more (note the lack of time constraints).

In fact, in a recent Connecticut case (Charts Insurance Associates v. Nationwide Mutual Insurance), a jury awarded $2.3 million for the sale of an insurance agency that triggered the Connecticut Franchise Act. Only two elements were necessary to meet this test: "(1) an oral or written agreement ... in which a franchisee is granted the right to engage in the business of offering ... services under a marketing plan or system prescribed in substantial part by a franchisor; and (2) the operation of the franchisee's business pursuant to this marketing plan or system ... substantially associated with the franchisor's trademark." So in this particular case, the fee element was not even called into question.

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Mark Siebert is the CEO of the iFranchise Group, a franchise consulting firm that has worked with 98 of the nation's top 200 franchisors. He can be reached at 708-957-2300 or at info@ifranchise.net.
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