Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

I am often asked by prospective franchise clients what exactly is the definition of a franchise? The issue is an important one, since franchising is a regulated industry. It is regulated on a federal level by the Federal Trade Commission (FTC), and on a state level by some, but not all, state regulatory agencies. Compliance with existing federal and state regulation makes the business of franchising more complicated, and therefore more expensive to be involved in.

The Federal Trade Commission Franchise Rule, 16 CFR 436, defines a franchise as:

any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:

(1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;

(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.”

So the three criteria of a franchise, simply stated, are: 1) party A operates a business using the trademark of party B; 2) party B has significant control over how party A operates the business, or party B provides significant assistance to party A in the operation of the business; and 3) party A pays a fee to party B. All three of these conditions must be present in order for the business to be considered a franchise.

While the FTC’s definition of a franchise seems straightforward, the complexity surrounding what is a franchise can be found mainly in the second prong of the definition, through the FTC’s use of the terms “significant degree of control” and “significant assistance”.

Often times where party B provides party A with training, operational support, and/or manuals, the assistance/control will be deemed to be significant enough so as to meet the definition of a franchise. The problem arises when party B exerts “some” assistance or control, but does not go so far as to offer training, operational support or manuals.

The FTC has issued several advisory opinions on this subject, which opinions can be found at http://www.ftc.gov/bcp/franchise/netadopin.shtm. Specifically on this issue, the FTC stated in 1998 that:

“In your letter, you contend that the Licensor does not require any operational standards, nor does it impose controls over the licensees’ entire method of operation. For example, the Licensor will not approve sites, control hours of operation or production techniques, or dictate accounting practices. Rather, you contend that the limited controls are designed to protect the franchisor’s rights and value in its proprietary information and to verify that license fees are properly calculated. We disagree.

You correctly state that the Commission will not consider as significant those controls designed solely to protect the franchisor’s trademark rights under federal and state trademark law, such as display of the mark requirements or right of inspection. 44 Fed. Reg. at 49968. We also note that reasonable covenants not to compete, which are common in franchise systems, are frequently used to protect proprietary information. However, the exclusive sales territories imposed by the Licensor appear to go beyond mere trademark protection and pertain to the licensee’s entire method of conducting its business. Such restrictions have the potential to cause serious economic harm by limiting the licensees’ market and ultimately limiting the licensee’s profitability. See 44 Fed. Reg. at 59660-62. Indeed, the Final Interpretive Guides specifically list “restrictions on customers” and “location or sales area restrictions” among the types of controls over a franchisee’s method of operation that will be deemed significant.” Id. at 49967.”

The FTC, as well as any state regulatory agency, focuses solely on the substance of the relationship, not terminology, when examining the issue of what is a franchise. It is irrelevant how the parties characterize one another, whether as a license, independent contractor, subcontractor, joint venture, or distributorship relationship.

Please also be advised that certain states define a franchise slightly differently than the FTC definition cited above. Therefore, when facing the question of whether your business meets the definition of a franchise, proceed with extreme caution, and consult a knowledgeable franchise attorney.

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

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