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Hidden/Disguised Franchises – part 3

Monday, February 24th, 2020

The Payment Requirement required for a license to be deemed a franchise:

The last of the three definitional elements of a franchise covered by the FTC Franchise Rule is that purchasers of the business arrangement must be required to pay to the franchisor as a condition of obtaining a franchise or starting operations, a sum of at least $500 at any time prior to or within the first six months of the commencement of operations of the franchised business.

Here is what the FTC Franchise Rule states on the “Required Payment” element, directly from the FTC website at http://www.ftc.gov/bcp/edu/pubs/business/franchise/bus70.pdf.

As to what constitutes a payment, the term “payment” is intended to be read broadly, “capturing all sources of revenue that a franchisee must pay to a franchisor or its affiliate for the right to associate with the franchisor, market its goods or services, and begin operation of the business. Often, required payments go beyond a simple franchisee fee, entailing other payments that the franchisee must pay to the franchisor or an affiliate by contract – including the franchise agreement or any companion contract. Required payments may include: initial franchise fee, rent, advertising assistance, equipment and supplies (including such purchases from third parties if the franchisor or its affiliate receives payment as a result of the purchase), training, security deposits, escrow deposits, non-refundable bookkeeping charges, promotional literature, equipment rental and continuing royalties on sales.  Payments which, by practical necessity, a franchisee must make to the franchisor or affiliate also count toward the required payment. A common example of a payment made by practical necessity is a charge for equipment that can only be obtained from the franchisor or its affiliate and no other source.”

Hidden / Disguised Franchises – part 1

Monday, February 24th, 2020

Often times I have prospective franchisor clients, that is, clients who believe they have a business concept that can be expanded possibly through licensing or franchising, ask me to explain the differences between licensing and franchising from a legal perspective.  Inevitably, the conversation turns to an explanation from the client as to why the concept is not truly a franchise after all.  As I have explained on this blog previously, while there certainly are relationships that are true licenses, more often than not, many licensing relationships are indeed nothing more than disguised franchises.

Here is what the FTC Franchise Rule states on the issue, directly from the FTC website found at http://www.ftc.gov/bcp/edu/pubs/business/franchise/bus70.pdf.  The FTC Franchise Rule covers the offer and sale of franchises. As under the original Rule, a commercial business arrangement is a “franchise” if it satisfies three definitional elements.

“Specifically, the franchisor must: (1) promise to provide a trademark or other commercial symbol; (2) promise to exercise significant control or provide significant assistance in the operation of the business; and (3) require a minimum payment of at least $500 during the first six months of operations.”

Be aware that the name given to the business arrangement is irrelevant in determining whether it is covered by the amended Rule.

“With regard to the trademark element, a franchise entails 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.” The term “trademark” is intended to be read broadly to cover not only trademarks, but any service mark, trade name, or other advertising or commercial symbol. This is generally referred to as the “trademark” or “mark” element.

The franchisor need not own the mark itself, but at the very least must have the right to license the use of the mark to others. Indeed, the right to use the franchisor’s mark in the operation of the business – either by selling goods or performing services identified with the mark or by using the mark, in whole or in part, in the business’ name – is an integral part of franchising.

Play By the Franchise Rules

Wednesday, October 31st, 2018

In its simplest form, “Franchising” is the license of the franchisor’s business or operating system and its trademark to a franchisee for some period of time, in exchange for a fee. The fee usually takes two forms: an initial franchise fee paid up front and an ongoing monthly royalties paid during the life of the franchise.

A common mistake of businesses wishing to expand in the U.S. is their attempts to avoid U.S. state and federal franchise laws that may apply.  In other words, these would-be franchisors attempt to avoid the disclosure requirements applicable to all franchisors in order to save on legal fees in the short-term.  However, this mindset may lead to substantial problems down the road.  These businesses oftentimes try to hold themselves out as “licensors” instead, and in doing so fail to provide to their “licensees” the franchise disclosure document (“FDD”) required of franchisors.

Although the preparation and annual maintenance of an FDD may not be cheap, the short-term legal costs are money well spent compared to the financial and other costs associated with lawsuits from disgruntled licensees, or even worse, investigations by state franchise administrators.

For example, a company’s failure to abide by state and federal franchise laws that require franchisors to disclose to the prospect in an FDD all material facts relating to the franchise system to prospective franchisees, and to register that FDD in certain states, can be catastrophic.  In addition to potentially giving a licensee/franchisee the right to rescind its agreement, other penalties include repaying back to the licensee/franchisee of all amounts paid to the company.  In addition, fines and/or penalties payable to the state may also be required.  Not to mention the legal fees that accrue with dealing with all of these potential issues.

The message is simple – don’t trade long-term security for short-term savings.  Have an experienced franchise lawyer advise you on the requirements of franchising at the outset.

 

Reviewing a Franchise Agreement for a Franchisee Client

Monday, October 29th, 2018

When a franchisee client asks me to review a franchise agreement prior to signing, I review it with the mindset that if the franchisee’s business performs well, the franchisee will be happy with the franchise relationship and the agreement he or she signed, BUT if the franchised business ultimately fails, it is my job to protect the franchisee at the outset in the strongest way possible. Therefore I review a franchise agreement focusing on how best to protect my franchisee client’s personal assets in the event the franchised business fails.  Here are some of the things I look for in the franchise agreement:

1.  does the franchisee have an exclusive territory?

2.  may the franchisor alter the franchisee’s territory during the term of the agreement?

3.  may the franchisee advertise or market for clients outside the designated territory in areas that are not owned by other existing franchisees?

4.  what are the franchisee’s renewal rights? Attempt to limit what terms of the agreement the franchisor may change on renewal.

5.  what social media presence is the franchisee permitted to maintain?

6.  while there is most likely a personal guaranty, who is required to sign it? ie. spouses and/or passive investors?

7.  is there a cap on the personal guaranty of a reasonable amount that the franchisee and franchisor are comfortable with, or is it an unlimited guaranty? When negotiating on behalf of a franchisee, I attempt to limit the cap with the mindset that this amount is the franchisee’s buyout amount in the event the worst occurs and the franchisee has to stop operating.

8.  is there a right of first refusal of the franchisor in the event the franchisee wishes to sell the business, and what are its terms?

9.  is there a unilateral right of the franchisee to terminate the agreement? There are rare, but franchisee counsel should try to push for such a provision anyhow.

10.  are any of the franchisor’s rights to terminate the agreement out of the ordinary or particularly onerous?

11.  is there a liquidated damages clause in the event the franchise agreement is terminated?

 

 

FDD – Sample Franchise Disclosure Questionnaire

Friday, October 26th, 2018

Below is a sample franchisee questionnaire that I recommend be included as an exhibit in each FDD I prepare.   In the event of a problem with the franchisee in the future, it is a powerful document for a franchisor to have, where the franchisee essentially stated at the time of sale that everything told by the franchisor to the franchisee during the sales process was included in the FDD.  In other words, no oral promises, representations or statements were made by the franchisor that did not mirror the FDD.

[SAMPLE]

FRANCHISEE DISCLOSURE QUESTIONNAIRE

As you know, _____________ “Franchisor” and you are preparing to enter into a Franchise Agreement for the operation of a Franchised Business. In this Franchisee Disclosure Questionnaire, Franchisor will be referred to as “we” or “us.”  The purpose of this Questionnaire is to determine whether any statements or promises were made to you that we did not authorize and that may be untrue, inaccurate or misleading.  Please review each of the following questions carefully and provide honest and complete responses to each question.

1.  Have you received and personally reviewed the Franchisor’s Franchise Agreement and each exhibit, addendum and schedule attached to it?

Yes        No

2.  Do you understand all of the information contained in the Franchise Agreement and each exhibit and schedule attached to it?

Yes        No

If “No”, what parts of the Franchise Agreement do you not understand?  (Attach additional pages, if necessary.)

3.  Have you received and personally reviewed our Franchise Disclosure Document we provided to you?

Yes        No

4.  Do you understand all of the information contained in the Franchise Disclosure Document?

Yes        No

If “No”, what parts of the Franchise Disclosure Document do you not understand?  (Attach additional pages, if necessary.)

5.  Have you discussed the benefits and risks of operating a Franchised Business with an attorney, accountant or other professional advisor and do you understand those risks?

Yes        No

6.  Do you understand that the success or failure of your business will depend in large part upon your skills and abilities, competition from other businesses, interest rates, inflation, labor and supply costs, lease terms and other economic and business factors?

Yes        No

7.  Has any employee or other person speaking on our behalf made any statement or promise concerning the revenues, profits or operating costs of a Franchised Business that we or our franchisees operate?

Yes        No

8.  Has any employee or other person speaking on our behalf made any statement or promise concerning a Franchised Business that is contrary to, or different from, the information contained in the Franchise Disclosure Document?

Yes        No

9.  Has any employee or other person speaking on our behalf made any statement or promise concerning the likelihood of success that you should or might expect to achieve from operating a Franchised Business?

Yes        No

10.  Has any employee or other person speaking on our behalf made any statement, promise or agreement concerning the advertising, marketing, training, support service or assistance that we will furnish to you that is contrary to, or different from, the information contained in the Franchise Disclosure Document?

Yes        No

11.  If you have answered “Yes” to any of questions seven (7) through ten (10), please provide a full explanation of your answer in the following blank lines.  (Attach additional pages, if necessary, and refer to them below.)  If you have answered “No” to each of such questions, please leave the following lines blank.

12.  Do you understand that in all dealings with you, our officers, directors, employees and agents act only in a representative capacity and not in an individual capacity and such dealings are solely between you and us?

Yes        No

 

Mandatory Maryland Franchise Agreement Amendment

Friday, October 26th, 2018

Pursuant to the Maryland Franchise Registration and Disclosure Law, below are the mandatory amendments that must be made to a franchise agreement contained in a Franchise Disclosure Document attempting to be registered in the state of Maryland.  There are additional changes that must also be made to the disclosure portion of the Franchise Disclosure Document.

Maryland Franchise Agreement Amendment

In recognition of the requirements of the Maryland Franchise Registration and Disclosure Law, the parties to the attached Franchise Agreement (the “Agreement”) agree as follows:

1.     “execute a general release, in a form prescribed by Franchisor, of any and all claims against Franchisor and its subsidiaries and affiliates, and their respective officers, directors, agents, and employees.  Notwithstanding the above, pursuant to COMAR 02.02.08.16L, the general release required as a condition of renewal, sale, and/or assignment/transfer shall not apply to any liability under the Maryland Franchise Registration and Disclosure Law.”

2.     “the Franchisee’s execution of a general release of the Franchisor, in a form satisfactory to Franchisor, of any and all claims against Franchisor and its affiliates, successors, and assigns, and their respective directors, officers, shareholders, partners, agents, representatives, servants, and employees in their corporate and individual capacities, including, without limitation, claims arising under this Agreement, any other agreement between Franchisee and Franchisor or its affiliates, and federal, state, and local laws and rules.  Notwithstanding the above, pursuant to COMAR 02.02.08.16L, the general release required as a condition of renewal, sale, and/or assignment/transfer shall not apply to any liability under the Maryland Franchise Registration and Disclosure Law.”

3.     “Notwithstanding the above, the provision in the Franchise Agreement which provides for termination upon bankruptcy of the franchisee may not be enforceable under federal bankruptcy law (11 U.S.C. Section 101 et seq.).”

4.     “Notwithstanding the above, the parties agree that only with respect to claims arising under the Maryland Franchise Registration and Disclosure Law, Franchisee may bring such claims in any federal or state court in the state of Maryland.”

5.      “Limitations of Claims.  ANY AND ALL CLAIMS AND ACTIONS ARISING OUT OF OR RELATING TO THIS AGREEMENT, THE RELATIONSHIP OF FRANCHISEE AND FRANCHISOR, OR FRANCHISEE’S OPERATION OF THE FRANCHISED BUSINESS, INCLUDING ANY PROCEEDING, OR ANY CLAIM IN ANY PROCEEDING (INCLUDING ANY DEFENSES AND ANY CLAIMS OF SET-OFF OR RECOUPMENT), MUST BE BROUGHT OR ASSERTED BEFORE THE EXPIRATION OF THE EARLIER OF (A) THE TIME PERIOD FROM BRINGING AN ACTION UNDER ANY APPLICABLE STATE OR FEDERAL STATUTE OF LIMITATIONS; (B) ONE (1) YEAR FROM THE DATE UPON WHICH A PARTY DISCOVERED, OR SHOULD HAVE DISCOVERED, THE FACTS GIVING RISE TO AN ALLEGED CLAIM; OR (C) TWO (2) YEARS AFTER THE FIRST ACT OR OMISSION GIVING RISE TO AN ALLEGED CLAIM; OR IT IS EXPRESSLY ACKNOWLEDGED AND AGREED BY ALL PARTIES THAT SUCH CLAIMS OR ACTIONS SHALL BE IRREVOCABLY BARRED; EXCEPT THAT ANY AND ALL CLAIMS ARISING UNDER THE MARYLAND FRANCHISE REGISTRATION AND DISCLOSURE LAW (MD. CODE BUS. REG. §§ 14-201 THROUGH 14-233) SHALL BE COMMENCED WITHIN THREE (3) YEARS FROM THE GRANT OF THE FRANCHISE. CLAIMS OF FRANCHISOR ATTRIBUTABLE TO UNDERREPORTING OF SALES, AND CLAIMS OF THE PARTIES FOR FAILURE TO PAY MONIES OWED AND/OR INDEMNIFICATION SHALL BE SUBJECT ONLY TO THE APPLICABLE STATE OR FEDERAL STATUTE OF LIMITATIONS.”

6.     “No Waiver.  The foregoing acknowledgments are not intended to nor shall they act as a release, estoppel or waiver of any liability incurred under the Maryland Franchise Registration and Disclosure Law.”

7.     Each provision of this amendment shall be effective only to the extent, with respect to such provision, that the jurisdictional requirements of the Maryland Franchise Registration and Disclosure Law are met independently without reference to this amendment.

Collecting on a Judgment in Maryland – Post Judgment Interrogatories

Friday, October 26th, 2018

A common misconception that many business owners have about litigating a dispute is the belief that just because a party wins at trial, the money won in the judgment automatically is transferred to the winner.  Usually, that is far from the case.  While it is never easy to go to trial and win a money judgment against another party, sometimes winning is actually easier than collecting on the money judgment won.  A judgment is simply a piece of paper from the Court stating who won and who lost.  However, if the losing party is not financially ready and willing to pay you, a judgment holder has to be prepared to continue to work. Maryland law permits a judgment holder to take certain steps to collect.  One of these steps is the use of post-judgment interrogatories, which are questions the winner may ask of the losing party, known as the debtor, about the amount and location of his/her/its wages, assets, bank accounts and property.  Here is a sample of some of the questions I ask.  Once the amount and location of the debtor’s assets are revealed, an experienced collections attorney will be able to pursue the amounts you are owed.

  1. Provide the address and fair market value of all real estate owned by Defendant either individually or jointly with another person or entity.
  2. Provide Defendant’s federal and state income tax returns for the years x, y and z, including any Schedules thereto, whether such returns were filed individually or jointly.
  3. Detail Defendant’s net worth, including all such assets owned jointly.
  4. Provide the year, make, model, mileage, blue book value, and VIN number of all vehicles owned by Defendant.
  5. Detail the name and address of each financial institution where Defendant has an account, including the routing number and the account number for each.
  6. Detail the balances for each account detailed in your response to Interrogatory #5.
  7. Provide Defendant’s bank statements for each account specified in your response to Interrogatories #5 from x through the present.
  8. Detail all other assets owned by Defendant not yet mentioned and the fair market value for each.
  9. Detail whether Defendant has disposed of or transferred any asset within the last 180 days. If yes, give the name and address of each person or entity who received any asset and describe each asset.
  10. Detail any ownership interest Defendant has in any corporation, partnership, or limited liability company. In so doing, identify the name of the corporation, partnership, or limited liability company, the state of incorporation or organization, the amount or percentage of the ownership interest, and the fair market value of the ownership interest.
  11. For any corporation, partnership or limited liability company named in your response to Interrogatory #10, provide any shareholder, partnership or operating agreement to which Defendant is a party.
  12. Detail all income, wages, or other compensation of any kind received by Defendant within the last 180 days.

Isolated Sales Exemption in the New York Franchise Act

Wednesday, March 7th, 2012

N.Y. CLS Gen. Bus. Law § 684(3)(c) of the New York Franchise Act provides an exemption to franchisors from the general registration requirements of the Act for what is deemed an “isolated franchise sale.”  Under this exemption, no franchisor is required to register its FDD/UFOC in New York where:

(1)   “The transaction is pursuant to an offer directed by the franchisor to not more than two persons . . .

 (2)   if the franchisor does not grant the franchisee the right to offer franchises to others,

 (3)   a commission or other remuneration is not paid directly or indirectly for soliciting a prospective franchisee in this state, and

 (4)   the franchisor is domiciled in this state or has filed with the department of law its consent to service of process on the form prescribed by the department.”  N.Y. CLS Gen. Bus. Law § 684(3)(c).

 New York courts have interpreted § 684(3)(c) to mean in essence that  the sale of the first franchise unit is exempt from registration if the unit was only offered to a maximum of two people (See BMW Co., Inc. et al. v Workbench Inc. et al. (No. 86 CIV 4200 1988 WL 45594 (S.D.N.Y. April 29, 1988); CCH Business Franchise Guide ¶ 9104, at 18,850). 

This exemption is well settled law in New York:  “This isolated franchise sale exemption is potentially useful for new U.S. franchisors or foreign franchisors that are new to the United States. It permits them to sell one franchise in New York without having to register a disclosure document with the state.”  LJN, Law Journal Newsletters, Franchising Business & Law Alert, Volume 18, Number 4, January 2012, by George J. Eydt. 

Further, in a recent New York case, Burgers Bar Five Towns, LLC v. Burger Holdings Corp., 897 N.Y.S. 2d 502 (2d Dep’t 2010), again upheld the existence of the isolated franchise sale exemption under § 684(3)(c) provided the franchisor is able to meet the four prongs of the statute.  In reversing a summary judgment that had been entered by the trial court against a franchisor that had failed to register its UFOC/FDD, the appeals court stated that the matter be remanded back to the trial court to determine whether the franchisor indeed met the exemption factors.  Further, the appeals court held that even if the exemption was not available, the franchisee had to prove that it sustained damages as a result of the failure to register and that the failure to register was willful.

There is some support for the proposition that not only does § 684(3)(c) exempt a franchisor from the registration requirement of the New York Franchise Act for the isolated franchise sale, the franchisor is also exempted from the disclosure requirements of the Act.

§ 683(8) of the New York Franchise Law provides that:  “A franchise which is subject to registration under this article shall not be sold without first providing to the prospective franchisee, a copy of the offering prospectus, together with a copy of all proposed agreements relating to the sale of the franchise.” 

No New York Court has yet delved this deeply into the disclosure exemption question.  The few Courts that have addressed the issue, BMW Co., supra, The National Survival Game of New York, Inc., supra, and Burgers Bar Five Towns, LLC, supra., have either failed to examine the relationship between the two statutes, or resolved the merits of their cases on other grounds.

Nevertheless, a franchisor faced with a registration and disclosure violation in New York for an isolated franchise sale would be smart to argue that both registration and disclosure are exempted.

“Franchise Fees” and the New York Franchise Law

Wednesday, August 24th, 2011

The New York Franchise Law defines a franchise fee as any fee or charge that a franchisee or subfranchisor is required to pay or agrees to pay directly or indirectly for the right to enter into a business under a franchise agreement, or otherwise sell, resell or distribute goods, services, or franchises under such an agreement, including, but not limited to, any such payment for goods or services.  The NY Franchise Law also contains several exclusions to the franchise fee definition, but no exemptions pertain to the purchase/sale of equipment.  Rather, the exemptions to the NY law are nearly identical to the Maryland law.

The dollar threshold for a franchise fee under NY law is $500.

Like Maryland, the scope of the New York Franchise Law franchise fee definition is construed broadly.  For example, a one-time fee or a monthly payment during a four-year period, which was characterized as a lease, was ruled a franchise fee.

The Definition of “Franchise Fee” Under the Maryland Franchise Law

Wednesday, August 24th, 2011

The Maryland Franchise Registration and Disclosure Law (“MD Franchise Law”), Section 14-201, defines a franchise as “an oral or written agreement in which: 1) a purchaser is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by the franchisor; ii) the operation of the business under the marketing plan or system is associated substantially with the trademark, service mark, trade name, logotype, advertising or other commercial symbol that designates the franchisor or its affiliate; and iii) the purchaser must pay, directly or indirectly, a franchise fee.”

Section 14-201 of the MD Franchise Law goes on to define a franchise fee as a charge or payment that a franchisee or subfranchisor is required or agrees to pay for the right to enter into a business under a franchise agreement.  The purchase of equipment is included in the definition of a franchise fee.  Section 14-201 contains several exclusions from the definition of a franchise fee, but no exclusions for the purchase of equipment by a franchisee/licensee.

Many of the Maryland exclusions are limited to products-oriented licensors, as for the sale of goods at wholesale prices.  Other exemptions are for the sale or lease of real property for use in the business, and any amounts paid for sales materials used in making sales, sold at no profit by the licensor. An additional exemption exists for the sale, at fair market value, of supplies or fixtures that are necessary in order to operate the business. 

Section 14-203 of the MD Franchise Law sets the threshold amount for the franchise fee at any amount exceeding $100.