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.
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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:
- The use of a common trademark (such as
"McDonald's");
- The provision of operational support or
assistance, training or the exercise of significant operating
control;
- 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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