How To Avoid Becoming an Accidental Franchise

Maybe you wanted to avoid creating a franchise, or just accidentally created one. Regardless, here's the simple fact: somehow, your license agreement, joint venture, distribution agreement, sales agent agreement, or business relationship became a franchise.

At this point, you may be saying, "But we went the license agreement route," or "We all agreed our relationship wasn't a franchise." Alternatively, you might be asking yourself, "Do the franchise laws seriously apply to my relationship - and what does that mean?" or "How could this happen? My attorney drafted the agreement for us."

The network of federal and state franchise laws is complex, far-reaching, and inconsistent. And the applicability of these laws to your business relationship basically boils down to one question: Does your business relationship satisfy all of the definitional elements of a "franchise?" This is important because it is irrelevant that your business relationship is not called a franchise; that the parties never intended to create a franchise relationship; or that the parties expressly agreed that their relationship was not a franchise. If the relationship satisfies the elements of the federal or state definition of a franchise, it is a franchise - and subject to regulation under the franchise laws.

So, what is a franchise?

Under the Federal Trade Commission's (FTC) Franchise Rule, a "franchise" is a business relationship where one party - the franchise seller - promises or represents that:

1. The other party (the franchisee) will have the right to operate a business that is identified or associated with the franchise seller's trademark.
2. The franchise seller will exert or have the authority to exert a significant degree of control over the franchisee's operations or provide significant assistance in the franchisee's method of operation.
3. The franchisee makes a required payment or commits to make a required payment to the franchise seller.

To further complicate the situation, the FTC Franchise Rule (the Rule) does not preempt state franchise laws that are consistent with the Rule. State law is considered to be consistent with the Rule if the state law provides prospective franchisees with equal or greater protection than that provided under federal law.

What approach is best for your business?

Franchise attorneys are frequently asked to help structure a client's business relationship to avoid the franchise laws or to set up a franchise program that complies with them.

If you want to structure your business relationship to avoid the franchise laws, you need to do one of two things:

1. Eliminate the existence of one of the elements from the franchise definition.
2. Try to satisfy an exemption or exclusion from the franchise laws.

There is a common misconception that it is easy, and far less expensive, to avoid being a franchise than it is to set up a franchise program. Working through the terms of an existing or prospective business relationship to determine how state and federal franchise laws might apply and the exemptions that are potentially available is a complicated process. This is mainly because the exemptions vary from state to state, and the franchise definition may be different from one state to the next. Thus, determining which state laws apply to the relationship may not be obvious.

In addition, because the franchise laws are set up to protect the franchisee, it can be very difficult or undesirable to structure a relationship that excludes one of the elements of a franchise. Stated another way, the franchise disclosure laws were created to combat widespread deception in the sale of business ventures and, consequently, the federal and state franchise laws are interpreted broadly and can be very easy to satisfy.

If you structure the business relationship to avoid the franchise laws, you may restrict your ability to grow your business and adapt your operations in the future. Finally, you may avoid the franchise laws initially and inadvertently create a franchise relationship in the future. Overall, it is important to consider the unintended consequences and to be very careful and deliberate when attempting to structure a relationship that falls outside the scope of the franchise laws.

If you choose to franchise

If you ultimately decide the best approach is to structure your business relationship as a franchise, one of your first steps should be to speak with an experienced franchise attorney to understand how the franchise laws work. More specifically, you need to speak with an attorney who has extensive experience representing franchisors. In a nutshell, to operate your franchise system you will need to create a Franchise Disclosure Document (FDD) and, if you are in or plan to expand into states with franchise laws, register your FDD with the proper state franchise regulators.

Once you complete this process, you are required to present prospective franchisees with a copy of your FDD, observe the applicable waiting period before signing agreements or accepting money from your prospective franchisee, and follow other rules relating to the sales process. The good news is that, as noted above, the franchise laws are disclosure laws, so if you decide to set up a franchise program, you do not need to make undesirable or difficult changes to your business relationship.

What if I am an accidental franchise?

The main thing you want to avoid is ignoring the franchise issue or pretending the issue doesn't exist. If you are a franchise and operating outside the franchise laws, the issue will not go away, and could get much bigger as your business grows. Franchise-related claims and issues arise in a variety of situations, such as when:

1. the franchisee is disgruntled and brings an action against the franchise seller for violation of the franchise regulations;
2. a competitor reports your accidental franchise to state franchise regulators;
3. a state franchise regulator independently discovers your accidental franchise as a consumer, in an advertisement, on the Internet, or in another manner; or
4. you attempt to terminate a relationship that is an accidental franchise and inadvertently violate a state's franchise relationship laws.

If your relationship is at risk of being a franchise, it is important to determine whether a state franchise relationship law governs the termination or renewal of your agreement. Many of these "relationship" laws also prohibit franchisors from engaging in a variety of practices. In other words, it is important to understand the franchise laws that apply to your business relationship and avoid further compounding the problem through subsequent actions.

At the federal level, the FTC has many remedies it can pursue for violations of the FTC Franchise Rule. The FTC can seek injunctive relief and initiate civil actions to pursue remedies, including rescission of the contract, refunds, payment of damages, or public notification of the unlawful acts. The FTC may also pursue fines in connection with such civil actions for each violation of the Rule.

At the state level, franchise regulators have broad powers to address franchise law violations. For instance, franchise regulators can pursue civil actions against those who violate franchise disclosure and registration laws and, in contrast to federal law, individuals can pursue private causes of action. Potential penalties for violating state franchise laws can include monetary fines, damages, injunctions, rescission, and termination of the entity's right to conduct business in the state, among other significant consequences. Last, state franchise laws may also provide for criminal penalties for violations of state franchise law.

Conclusion

While franchising is an accepted and proven business model, the consequences for violations of the franchise laws can be significant. But with the right team of business and legal advisers in your corner, the franchise model can be a very attractive approach to operate and grow your business.

 Craig J. Knobbe, an attorney at Moye White, advises clients in the areas of franchise and distribution, real estate, corporate, brewing and distilling, and trademark law. Contact him at craig.knobbe@moyewhite.com or 303-292-7903.