Copyright © 2002 All Rights Reserved

By: Nicholas G. Karambelas, Esq.

[PUBLISHED IN DECEMBER 2002 ISSUE OF WASHINGTON LAWYER MAGAZINE] [Vol.17 No. 4]

FRANCHISING IN PERSPECTIVE

In its current form, franchising is a relatively new form of legal relationship. The modern era of franchising dates only from the mid-1960s. Yet, franchising has become an enormous component of the Gross Domestic Product (GDP) and grows in its significance to the national economy in each year. The International Franchise Association (IFA), which is the industry trade association, estimates that there are more than 300,000 franchised operating in the United States, generating $1 trillion in revenues and employing 8 million people. While there are a number of franchisors with hundreds even thousands of franchisees, over 80% of all franchisors have 50 or less franchisees.

It is inaccurate to refer to franchise law as a legal “specialty”. Franchising is actually a trans-disciplinary area of law. The franchise relationship involves antitrust law, commercial contracts, business organization, consumer protection, bankruptcy, intellectual property, litigation, secured interests, real estate and taxation. The aspect of franchising that may properly be considered a “specialty” is the international, federal and state regulation of the franchise relationship. By the late 1970s, due to the disparate bargaining positions between the franchisor and the franchisee, abuses in the franchisor-franchisee relationship developed. These abuses came to the attention of the Federal Trade Commission (FTC) as well as state regulators. The FTC and many states promulgated rules and legislation that were meant to balance the bargaining positions and, thereby, prevent at least the most flagrant abuses. Consequently, the offer and sale of franchises are actually more highly regulated than the offer and sale of securities. While the fundamental policy underlying the securities law and regulations is to cause issuers to fully disclose all material aspects of an investment, the fundamental policy underlying the franchise laws is to enable franchisees to determine whether the purchase and operation of a franchise are a “good” investment.

The primary responsibility of an attorney who acts as franchise counsel is to:

1. Recognize a legal relationship that is a franchisor-franchisee relationship,
2. Know which government authorities regulate franchises and the regulatory scheme that each such authority administers, and
3. Advise the client as to compliance with the applicable regulatory scheme.

THE FRANCHISOR - FRANCHISEE RELATIONSHIP

I. The Word “Franchise”

The root of the word “franchise” is the Germanic word “frank” which meant free in the sense that in medieval Frankish Gaul, only men who were Franks as opposed to conquered peoples were free, i.e., able to own property, bear arms and have the right of descent. The word “frank” was imported into English and came to mean free in the sense of being liberal or generous. The word evolved into “franchise” which came to mean a royal privilege granted to a subject by the crown. The term “franchise” came to mean either a political franchise which was the right to exercise political rights or a commercial franchise which was the right to use the property of another for commercial purposes.

There are two types of commercial franchises: public franchises and private franchises. A public franchise is a right granted by a government authority to a private entity to perform on a commercial basis a function that is otherwise a government function. Cable television, ambulance service, recycling services are examples of public franchises. A private franchise is the right granted by a private entity to another private entity to use property owned by the former private entity for a commercial purpose in exchange for a fee or percentage of revenues.

II. Statutory Definition of a Franchise

Only a legal relationship that constitutes a franchise relationship is subject to regulation. Therefore, it is essential to understand the legal definition of a franchise as well as the legal nuances of the term. Every legal relationship that is a franchise relationship must comply with the FTC Franchise Rule and any applicable state franchise laws and regulations. The mere fact that parties did not intend or even expect to form a franchise relationship will be irrelevant in an enforcement action if the relationship satisfies the definition of a franchise.

The term “franchise” is a defined statutory term. That definition is a functional definition that examines the legal and financial terms of the relationship and the conduct of the parties. Refraining from using the terms of a franchise will not exclude a particular relationship from the franchise regulatory scheme if the relationship satisfies the definition of a franchise. Although the statutory definitions differ somewhat from state to state and between and among the states and the FTC Franchise Rule, each of these definitions contains, at a minimum, the following elements:

1. The franchisor grants the right to use intellectual property in combination with a business method or format such that part of the bargained for exchange that the franchisee receives is a certain brand identification.
2. The franchisor maintains a measure of quality control and uniformity over the products or services offered for sale by the franchisee as a result of the use of the franchisor’s property or method by the franchisee .
3. The franchisor provides assistance to the franchisee in the form of common buying arrangements, site location or cooperative advertising.
4. The franchisee pays a fee to the franchisor that is not a de minimus fee. The FTC Franchise Rule and most state statutes define a de minimus fee as a fee that is $500.00 or less.

III. Factors Supporting the Existence of a Franchise Relationship

In determining whether a particular legal relationship satisfies the foregoing elements, courts and regulators will consider the following factors:

1. Whether the franchisees pays fees on a continuing and regular basis,
2. The nature and extent of quality control that the franchisor exercises over the franchisee’s operation,
3. The nature and extent of the disparity of the positions between the franchisor and the franchisee,
4. Whether the franchisee has made a significant investment in the franchise such that the franchisee would stand to lose the investment if the relationship with the franchisor was terminated,
5. Whether within the ambit of the quality control exercised by the franchisor, the franchisee exercises the incidents of ownership and proprietorship.

IV. Franchises Distinguished From Other Legal Relationships

A. Distributorships

An exclusive right to distribute products or services within a specified geographical area or demographic segment as long as the owner does not control the method or means of distribution. However, where the distributor is granted the right to use the owner’s trademark or associate that trademark with the general business of the distributor, then a franchise relationship may arise, In re Matterhorn Group, 2000 WL 1174215.

B. Trademark or Tradename License

The primary difference between a license and a franchise is the extent to which the licensor exercises quality control over the activities of the licensee. A license that does not involve the right to use a trademark or a common business format will rarely be deemed a franchise. A license that involves the right to use a trademark or common business format will always risk being deemed a franchise because a certain but indeterminate amount of control is implied in any right to use a trademark, Dawn Donut Co. v. Hart’s Food Stores, Inc.,267 F.2d 358 (2d. Cir.1959).

C. Partnerships and Joint Ventures

A partnership is defined as an agreement between 2 or more persons to engage in a business for profit. A joint venture is a partnership that lasts for a limited time or to accomplish a specified business purpose. A partnership will rarely be deemed a franchise because the partners exercise joint proprietorship over the assets of the partnership and are jointly liable for the debts and liabilities of the partnership. Under a franchise, the franchisee owns the business assets and the franchisor is not liable for the debts and liabilities incurred by the franchisee.

D. Brokers and Sales Agents

Brokerage and agency agreements will rarely be deemed franchises because brokers and agents act either on behalf of a principal or on behalf of the transaction in exchange for a commission. The commission is usually a percentage of the value of the transaction and is paid only if the transaction is completed. A broker or an agent does not pay a continuing and regular fee.

E. Business Opp+ortunity Ventures

Business Opportunity ventures are essentially enhanced distributorship arrangements. Such ventures are generally prepackaged business deals offered mainly to novice entrepreneurs through some form of public advertising. Such ventures include sale of vending machines, pay telephones, telephone cards, amusement devices and “work at home with your computer” deals. Although these ventures are not franchises, they are regulated by the FTC and many states in the same manner as franchises.

V. Fiduciary Duty Between Franchisor and Franchisee

A fiduciary duty in a legal relationship means that the parties owe such duties of trust and confidence that are not owed by parties dealing in an “arms-length” relationship. Fiduciary duties are not implied in the franchise relationship, McDonald’s Corp. v. Hinksman et al., 1999 WL 441468 (EDNY, 1999).

A. FTC FRANCHISE RULE

The Federal Trade Commission (FTC) Franchise Rule was promulgated in 1979 to regulate the offer and sale of franchises, 16 C.F.R. Part 436. Note the FTC Franchise is cumulative with but does not pre-empt or displace any state laws or regulations. Where the state law or regulation is more stringent than the FTC Franchise Rule, the state law or regulation will prevail within the jurisdiction of that state. Where the state law or regulation is less stringent than the FTC Franchise Rule or where a state has no such law or regulation, the FTC Franchise Rule will prevail. The FTC released a “Notice of Proposed Rulemaking” dated October 22, 1999 indicating that it seeks to substantially revise the FTC Franchise Rule.

I. Legal Obligations of Franchisor

The FTC Franchise Rule imposes the following obligations on a franchisor in connection with the advertising, offering, licensing, contracting, sale or other promotion of a franchise:

1. Disclosure Document - The franchisor must provide a potential franchisee with a document that contains the disclosures required by the Rule or which satisfies the requirements of the Uniform Franchise Offering Circular (UFOC). The disclosure document must be provided at the earlier of the first face to face meeting or 10 business days before any money is paid or any agreement signed in connection with the franchise.
2. Earning Claims - If the franchisor makes earnings claims, whether historical or forecasted, the claims must have a reasonable basis and that basis must be disclosed to the potential franchisee in writing at the time the claims are made.
3. Advertising Earnings Claims - If earnings claims are advertised, they must be accompanied by the number and percentage of franchisees that have achieved the claims and certain cautionary language.
4. Agreements - The franchisor must provide the potential franchisee with the franchise agreement and each related agreement at least 5 business days before the franchisee executes any such agreement.
5. Refunds - The franchisor must make any refunds which the franchisor commits to make in the disclosure document.
6. Contradictory Claims - Any promotional or advertising material must be consistent with the disclosure document.
   

   II. Penalties for Violation

The FTC is empowered to seek injunctions, asset freezes, civil penalties and monetary redress. The FTC can also seek remedies against individuals who are responsible for violations and impose personal liabilities on such persons. The Rule does not authorize private actions to enforce the Rule.

STATE FRANCHISE REGULATION

Prior to 1979, the states generally relied on their consumer protection statutes to redress any abuses by franchisors. Recognizing that such statutes were inadequate, all states have enacted some form of franchise regulation. There are generally two types of regulatory schemes: one, disclosure and registration and, two, disclosure, no registration but mandated termination/renewal provisions. About 15 jurisdictions require that a franchisor doing business in the jurisdiction or offering franchises in the jurisdiction must register the disclosure document with the attorney general of the jurisdiction. The rest of the jurisdictions require that a disclosure document be provided but it need not be registered and that a franchise can only be terminated or renewed as mandated by statute.

I. Registration

Maryland (Md. Code Business Regulation, tit. 14, §§ 14-201 - 14-233), Virginia (Va. Code tit. 13.1, §§ 13.1-557-13.1574; tit.59.1, §§ 59.1-196-59.1-207) and New York (McKinney’s General Business Law Art.33, §§680-695) are among the states that require a franchisor who offers franchises in the state or who is located in the state to register a disclosure document with the office of the state attorney general. In Maryland and Virginia, a disclosure document that satisfies the UFOC requirements will satisfy their respective statutes. Although New York generally accepts the UFOC, New York has certain additional requirements, (13 N.Y. Codes of Rules and Regulations Pt. 200).

The franchisor is prohibited from offering or selling any franchises in those states until the disclosure document has been duly filed and accepted for registration. In this respect a franchise is treated like a security. After the disclosure document is filed, the franchisor must amend it if there has been a material change in the information contained in the registered disclosure document. The disclosure document must contain audited financial statement for the past 3 consecutive fiscal years. Changes in financial statements are deemed to be material changes. Therefore, as a practical matter, the franchisor must amend its disclosure document at least once every 12 months to satisfy the 3-year requirement and the amendment must be approved.

A franchisor may continue to offer franchises while the approval of an amendment to its disclosure document is pending. The franchisor may even sell franchises while the approval to an amendment is pending as long as the franchisor escrows any funds received from any franchisee, provides a copy of the amended disclosure document to the franchisee and provides a reasonable opportunity to the franchisee to rescind the sale.

II. Disclosure But Not Registration; Mandated Termination/Non-Renewal Provisions

Most jurisdictions do not require a franchisor to register its disclosure document. They either expressly require the franchisor to provide a disclosure document or coordinate with the disclosure provisions of the FTC Franchise Rule.

Many of these jurisdictions impose mandated termination provisions which require that the franchisee receive reasonable notice of termination and the cause for the termination. The term “cause” is defined as failure to renew at least 60 days prior to expiration, failure to substantially comply with the terms of the franchise agreement, lack of good faith in performing under the franchise agreement and voluntarily abandoning the franchise. The franchisee must also be afforded a reasonable opportunity to cure, see e.g. New Jersey Code §56:10-1-10-7. The District of Columbia had mandated termination/non-renewal provisions but they were repealed in 1998.

III. Exemption from Registration

The jurisdictions that require registration exempt certain franchisors and certain types of sales from registration. Generally, a franchisor is exempt from registration if it has a net worth on a consolidated basis of $5 million or more according to its most recent audited financial statements or a franchisor with a net worth of $1 million or more in according to its most recent audited financial statements and it at least 80% owned by a corporation that has a net worth on a consolidated basis of $5 million or more according to its most recent audited financial statements. To qualify for the exemption, the franchisor must duly apply for the exemption and provide franchisees with substantially the same information as does a non-exempt franchisor. A franchisor that has a net worth of $15 million need not apply for the exemption but still must provide the required information to franchisees.

Sales of franchises to banks or other financial institutions are exempt from registration. Isolated sales of franchises not made to as part of a plan of distribution are exempt. Sales not effected through a franchisor are exempt, i.e., sales from a franchisee to another franchisee as long as the transferee franchisee receives the current disclosure document of the franchisor. Also, offers over the Internet are exempt under certain circumstances.

IV. Penalties for Violation

The states are generally empowered to seek injunctions, asset freezes, civil penalties and monetary redress. The regulators can also seek remedies against individuals who are responsible for violations and impose personal liabilities on such persons. The statutes do not authorize private actions to enforce violations of the statute.

V. Antitrust Issues

In the typical franchise, the franchisor limits the geographical area in which a franchisee can operate, restricts the types or products or services a franchisee can offer and requires the franchisee to buy from approved sources. In such an arrangement, antitrust issues can easily arise. The courts have developed a substantial and complicated body of case law that adapts antitrust concepts to the franchise relationship.

1. Territory Restrictions - A requirement that the franchisee operate only within a specified territory is not a per se violation of the antitrust laws. Such territorial restriction will be analyzed to determine whether they are reasonable, Continental TV Inc. v. GTE Sylvania, Inc., 433 U.S. 36 (1977).
2. Restriction on Sale of Product and Services (Tie-Outs) - The franchisor may impose restrictions on the categories of products and services that a franchisee is permitted to sell as long as the restrictions are reasonably necessary to assure quality and to protect the business format of the franchisor, Susser v. Carvel Corp., 332 F2d 505 (2d Cir.1964).
3. Tying-In Arrangements - The franchisor may require a franchisee to sell only products licensed by franchisor or produced from ingredients supplied by the franchisor is reasonably necessary to assure quality and to protect the business format of the franchisor The franchisor may also require a franchisee to purchase from approved sources as long as the franchisor sets standards and specifications and it is reasonably necessary to assure quality and to protect the business format of the franchisor. However, a franchisee cannot coerce a franchisee to simply sell the products of third person to which the franchisor has no organic connection, Atlantic Refining Co. v. FTC, 381 U.S. 357 (1965).

UNIFORM FRANCHISE OFFERING CIRCULAR (UFOC) AND THE FRANCHISE AGREEMENT

The UFOC was promulgated by the North American Securities Administrators Association (NASAA), www.nasaa.org, in an effort to standardize the disclosure requirements for franchisors who offer and sell franchises in more than one jurisdiction. Most if not all of the jurisdictions, including Maryland and Virginia, that require registration accept the UFOC although some jurisdictions like New York impose some additional requirements. Therefore, counsel must examine the disclosure requirements, which are usually contained in regulations rather than statutes, of each jurisdiction to be certain that the disclosure document satisfies the requirement for registration. Note that while the UFOC satisfies the disclosure requirements of the FTC Franchise Rule, a document that satisfies the FTC disclosure requirements does not satisfy the disclosure requirements of the jurisdictions that require registration. If the franchisor is or may be offering or selling franchises in any jurisdiction that requires registration, it should use the UFOC.

I. Contents of the UFOC

The UFOC lists 23 Items, each of which consists of a description of certain types or categories of information that the UFOC must contain. The disclosure document should be arranged so that each Item is addressed. If the franchisor has no information that responds to a particular Item or an Item is not relevant, the UFOC should affirmatively so state. The following list is a summary of the information required under each Item. Refer to the UFOC and the state regulations for a complete description of the information required under each Item.

• Item 1: Description and identity of the franchisor, business organization, franchisor’s experience, predecessors and affiliates.
• Item 2: Names, titles, positions of persons who have management responsibility for the franchisor.
• Item 3s: Civil and criminal litigation history of franchisor and its principals.
• Item 4: Bankruptcy history of franchisor, its principals and affiliates.
• Item 5: Description of initial franchise fees to be paid before franchise operates, if they are deferred, when they are paid, whether any franchise fees are refundable and, if so, the terms of any refund.
• Item 6: Description of any continuing franchise fees such as royalties, how calculated, when paid, whether refundable.
• Item 7: Description in tabular form of the total investment that franchisee must make in order to open the franchise such as real property/construction costs, equipment/fixtures, initial inventory, to whom money is paid, whether refundable, whether financed by franchisor.
• Item 8: Description of obligation of franchisee to purchase goods and services from franchisor or franchisor approved sources.
• Item 9: Description in tabular form the principal obligations of franchisee under the franchise agreement and cross cite to franchise agreement.
• Item 10: Description of financing arrangements offered by franchisor.
• Item 11: Description of franchisor’s obligations such as site selection, training, assistance during operation, time for commencing operations.
• Item 12: Description of exclusive territory, if any.
• Item 13: Description of trademarks or service marks.
• Item 14: Description of patents and copyrights.
• Item 15: Description of obligation of franchisee to personally participate in or operate the business of the franchise.
• Item 16: Description of restrictions on products sold, customers, sources.
• Item 17: Description in tabular form with cross references to the franchise agreement of the terms of termination, renewal, transfer and dispute resolution.
• Item 18: Description of arrangements with public figures.
• Item 19: Description of earnings claims, basis for claims, supplemental claims for particular locations.
• Item 20: Number and locations of franchisees, terminations, cancellations, non-renewals, re-acquisitions within the last 3 years.
• Item 21 Audited financial statements (income and balance sheets) for the past 3 fiscal years.
• Item 22 Each agreement that the franchisee will expected to execute including leases, notes, development agreements.
• Item 23 Detachable receipt evidencing fact that franchisee received the UFOC.

II. Negotiated Franchise Agreements

The whole purpose of the UFOC and the registration of the UFOC is assure that the franchise “deal” is fully disclosed to the franchisee before the franchisee is bound by the franchise agreement. This purpose raises the question of whether the terms of a franchise agreement with a particular franchisee can be negotiated such that those terms deviate from the terms set forth in the registered UFOC. Virginia and Maryland recognize the right of franchisors and franchisees to negotiate the terms of a particular franchise without requiring the franchisor to amend its UFOC in each instance.

New York took the opposite view and prohibited a franchisor from deviating at all from the terms of the franchise contained in the registered UFOC. This position was rejected by the court which interpreted the New York disclosure law as permitting negotiated franchise agreements as long as the basic disclosures as to the identity, experience and business of the franchisor and the franchise are accurate, Southland Corporation v. Abrams, 560 N.Y.S.2d 253 (Sup.1990).

III. Basic Items to be Considered in the Franchise Agreement

The single most important skill in drafting any contract including the franchise agreement is knowing the subject matter of the contract. Before even drafting a word of a contract the attorney must be satisfied that he or she has at least a working knowledge of the subject matter of the contract. Most often, such working knowledge can be obtained through discussions with the client. Clients may not always see the value of “educating” their attorneys as to the subject matter of the contract. However, it will be quite difficult to write an effective contract and work out solutions to contingencies unless the attorney is familiar with the subject matter.

The basic items that should be considered in a Franchise Agreement are the following:

1. Description of the Business of the Franchise - Business Format
2. Site Location and Approval - Holding the Business Premises
3. Term of Franchise
4. Initial Franchise Fee
5. Recurring Franchise Fee - Formula
6. Exclusive Territory
7. Restrictions on Categories of Products/Services Offered
8. Restrictions on Purchase of Products/Services/Equipment/Ingredients/Source
9. Proprietary Marks - Domain Names
10. Reports, Records and Documentation
11. Right to Estimate Sales - Placement of Observer
12. Training
13. Insurance Requirements
14. Non-Compete Covenant
15. Maintenance and Protection of Business Format
16. Termination - Renewal - Extension
17. Definition of Event in Default, Curing Event in Default
18. Consequences of Failing to Cure Event in Default
19. Remedies, Limitation on Liability, Liquidated Damage
20. Holds Harmless and Indemnification
21. Terms of Transfer or Assignment of the Franchise
22. Personal Guaranty of Performance - Payment

IV. Transfers by Franchisees and Franchisors

One of the most beneficial aspects of a franchise relationship to the franchisee is the potential to realize the appreciation in the value of a franchise. The franchisee will desire that its right and power to transfer the franchise be unfettered. However, because the franchisor has a legitimate interest in having able and competent franchisees, the franchisor generally imposes certain limits on the right of the franchisee to transfer the franchise.

FRANCHISING AND THE INTERNET

I. Offers of Franchises Over the Internet

The issue with respect to offers of franchises over the Internet is whether the franchisor must comply with laws and regulations in each jurisdiction in which any such offer reaches including those jurisdictions that require registration. Obviously, such a requirement would significantly burden franchisors. In 1998, the NASAA adopted a Statement of Policy Regarding Offers of Franchises on the Internet that exempts offers of franchises over the Internet from the registration requirements of jurisdictions that require registration under the following conditions:

1. The Internet Offer indicates directly or indirectly that the franchise is not being offered to residents of the particular jurisdiction,
2. The Internet Offer is not directed to any particular person in the jurisdiction by or on behalf of the franchisor or by anyone acting with the knowledge of franchisor, and
3. No franchise is sold in the jurisdiction by or on behalf of the franchisor until the UFOC is duly registered and provided to the franchisee in compliance with the laws of the jurisdiction. 
   Most if not all of the jurisdictions that require registration have adopted the NASAA Statement either affirmatively or impliedly, see 13 NYCRR §200.13.

II. “Cybersquatting” on Franchisor’s Domain Name

The court decisions are split on the whether and the conditions under which a franchisee can use the domain name of a franchisor. These decisions are non-reported decisions so that the law is still evolving on this issue. See Travel Impressions LTD v. Kaufman et al, 1997 WL 1068700 (EDNY, 1997); Hard Rock Café International (USA) v. Morton et al., 1999 WL 350848 (SDNY, 1999). Address the issue in the franchise agreement like any other intellectual property.

INTERNATIONAL ASPECTS OF FRANCHISING

I. Extra-Territorial Application of U.S. Franchise Laws

U.S. franchisors are not required to comply with the FTC Franchise Rule in making offers and sales of franchises to overseas franchisees, Nieman v. Dryclean USA, 178 F.3d 1126 (11th Cir.1999). Note, however, that a franchisor that has registered a UFOC in New York is obligated to comply with New York franchise laws and regulations no matter where in the world or to whom in the world it offers or sells franchises.

II. Franchising in the European Union (EU)

The primary issue for franchisors offering or selling franchises in the EU has traditionally been the applicability of the anti-competition provisions of the treaties establishing the EU, see Article 85(1) of the Treaty Establishing the European Economic Community. After certain decisions by the European Court of Justice and some narrow regulations, the EU promulgated a regulation that applies to all agreements containing vertical restraints which include franchises, Commission Regulation EC No. 2790/1999. The Regulation exempts from Article 85(1) vertical agreements or concerted practices between two or more businesses, each of which operates at a different level of the production or distribution chain, that involve the terms by which the parties may sell, re-sell or purchase their goods and services. The Regulation took effect on June 1, 2000 and will remain in effect until May 31, 2010.

The rest of the world is well behind the United States on issues such as disclosure and protection of franchisees. The EU has been considering a disclosure regulatory scheme.

III. UNIDROIT - Guide to Master Franchise Agreements and Model Franchise Disclosure Law

The UNIDROIT Franchising Initiatives (referred to as the Initiatives) are promulgated by the International Institute for Unification of Private Law which is an independent inter-governmental organization based in Rome, Italy. Its purpose is to examine ways of harmonizing and coordinating the private domestic law of member States and prepare for adoption by the States uniform laws of private law. The Institute serves as a group of uniform law commissioners similar to NUCCSL. Formed in 1926, the Institute has promulgated uniform laws on commercial contracts, international leasing, international wills as well as international franchising.

The Initiatives consist of a Guide for the preparation of franchise agreements and a Model Disclosure law. A U.S. franchisor seeking to franchise in other countries can use the Guide to prepare a franchise agreement that will cross legal cultures. The model act, which will be final in the summer of 2001, will enable franchisors and franchisees to agree to be bound by a common set of legal principles and rules rather than the laws of one country or another. The Initiatives can be found at the Institute’s website www.unidroit.org.