The Unintended Franchise – A Trap For Unwary Business Owners

Are you unknowingly operating a franchise system? If you are licensing others to use your trademarks for a fee, the answer could be yes. Under federal or even state law, a commercial relationship between two parties could be a franchise — even if neither of the parties intended to create one.

Regulatory Landscape

The Federal Trade Commission ("FTC") has been empowered by the federal government to administer and regulate franchising. It does so under a series of regulations known as the "Franchise Rule."  Under the Franchise Rule, any person or corporation that sells franchises within the United States is obligated to provide its prospective franchisees with a disclosure document, known as the Franchise Disclosure Document ("FDD"). The FDD must contain information regarding the company, the business being franchised and the franchise relationship.

The Franchise Rule makes it "an unfair or deceptive act or practice" for a franchise company to fail to provide a FDD to a prospective franchisee. The FTC has exclusive jurisdiction to enforce violations of the Franchise Rule, and penalties can be stiff-including injunctions, asset freezes, and monetary penalties.

Companies also need to be aware of state franchise laws; many (but not all) states have laws that apply directly to franchise companies. Typically, these state laws will require disclosures above and beyond those identified in the Franchise Rule, may require pre-registration with state officials before a franchise sale can be made within the state and may govern certain aspects of the relationship between the franchise owner and franchising company. Moreover, franchise-specific state laws authorize the franchise owner to sue its franchisor for violating those laws.

"Franchise" as defined by the Franchise Rule

So what, exactly, is a franchise? Under the Franchise Rule, the term "franchise" refers to a continuing commercial relationship wherein a "franchisor" licenses to a "franchisee" the right to use a trademark and a method of doing business that is characterized by the following definitional elements:

  1. Trademark. The business involves the distribution of goods or services associated with the franchisor’s trademark or trade name;
  2. Fee. The franchisor requires payment by the franchisee for the right to the franchise; and
  3. Control or Assistance. The franchisor exercises significant control over, or provides significant assistance in, the franchisee’s method of operation.

Importantly, while states that regulate franchising have definitions that are similar, all three of the key elements are not always identical under state law. As a result, it is important to consult your home state’s law to determine whether its franchise definition is different than the FTC’s.

Determining whether a specific business arrangement is actually a franchise is not always easy. Indeed, many court cases have dealt with the question of whether or not a specific business arrangement meets the definition of "franchise." In fact, not even the FTC itself has established a "bright line" test for whether a business meets the "significant control or significant assistance" element – opting instead to take such issues on a case-by-case basis.

Tips for Business Owners

As implied by the title of this article, a business arrangement can be a franchise regardless of the parties’ intentions. If the relationship meets all of the key definitional elements, no amount of disclaimers or waivers can avoid the applicability of the Franchise Rule. As a result, business arrangements that at first glance may not appear to be franchises -like partnerships, joint ventures, leases, and distributorships- have in certain circumstances been found to meet the franchise definition.

In some cases, the Franchise Rule can be avoided from the outset if the parties are aware of the key badges of franchising discussed above, and structure their relationship so that at least one of the elements does not apply. Where a franchise relationship is already in existence, however, it is important to identify that status so that remedial measures can be taken; the consequences for doing nothing can be severe. As a result, it is a good idea for business owners to consult an attorney with experience in franchising to be certain that they are not unknowingly breaking the law.

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