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.

Open Season
If, in fact, you are a duck operating without proper documentation, the fines and remedies can be substantial. Under the FTC Act, the FTC has the right to seek both preliminary and permanent injunctions against rule violations and can, in effect, ban you from franchising. They have the power to freeze assets both at the corporate and personal level. Civil penalties of $11,000 per violation can be assessed (the largest civil penalty in a Franchise Rule case to date is $870,000). In addition, the FTC can seek monetary redress on behalf of those injured by Franchise Rule violations (the largest "consumer" redress to date stands at $4.9 million).

While there is no "private right of action" under the FTC Act (franchisees cannot sue you under the act), there is more bad news to be found in the FTC Rule: "Franchisors and their key officers and executives are responsible for violations by persons acting in their behalf, including independent franchise brokers, sub-franchisors, and the franchisor's own sales personnel."

State laws can add to the damage. First of all, franchisees will have a "private right of action" under many state laws, and can thus sue you for damages without having to wait for the FTC to step in. In addition, these state laws will also provide for various incremental fines and redress. In some states, violation of their various franchise laws can even be a felony.

So Why Aren't Ducks an Endangered Species?
After reading through the first half of this article, it's a wonder why anyone would want to be a franchisor. Multimillion-dollar fines and felony convictions aren't what most entrepreneurs dream of when they go into business. But the fact remains that franchising remains one of the most robust sectors of the economy today, with continued explosive growth and more new, successful franchisors joining the market every day.

So how do you sleep at night as a franchisor?

The fact is, being a franchisor isn't all that difficult or scary--if you do it right and seek qualified legal counsel. In order to operate as a franchisor, you must simply develop a Uniform Franchise Offering Circular (UFOC) and register that document in the appropriate states based on your expansion strategy. You must then follow a fairly simple set of rules governing the sale of franchises that include:

1. Presenting the UFOC to a prospective franchisee when you initiate your conversations about the sale of a franchise (usually at the first face-to-face meeting). You must not have any serious conversations with prospective franchisees without taking this step.

2. Waiting 10 business days between the time you present this document to your prospect and the time you sign an agreement or take money from your prospect.

3. Limiting what you say on certain matters (earnings claims, etc.) to what you have included in your UFOC, and, of course, always being truthful and forthright in any franchise sales presentations.

And while there are other compliance and documentation issues you'll need to be aware of, the process is fairly simple.

Start by developing a strategy for your growth. If your growth strategy involves third parties, don't worry so much about whether or not it's a franchise, but instead address the key elements of the relationship. How will you be compensated? Will the third party use your brand? How will you control quality?

The next critical step is to hire an experienced franchise attorney. (This holds true whether you want to be a franchisor or want to avoid triggering franchise laws.) Experience doesn't mean an attorney who has worked with franchisees in the past or has reviewed UFOCs for prospective franchise buyers. It means an attorney who has specialized in the development of UFOCs and the registration of franchises for at least five to 10 years. Even if the attorney is at a big firm, ask him or her directly how many years he or she has specialized in representing franchisors. This is a vital step. (For more information on finding a franchise attorney, contact the American Bar Association and the International Franchise Association, and read this article on finding the right advisors.)

Once you've retained your attorney, developed the appropriate legal documents and registered your franchise offering (if necessary), you must make sure you train your staff on the intricacies of franchise sales and franchise compliance. Finally, on an ongoing basis, make sure you audit your staff's performance to ensure they continue to operate safely within the law.

Follow these steps, and you should be able to fly safely above the hunters. Ignore them, and you can quickly find yourself spiraling toward the cold waters of the pond below.