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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.

 

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“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.

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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.

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The Definition of “Franchise Fee” Is Extremely Broad Under the FTC Franchise Rule

Wednesday, August 24th, 2011

In addition to the trademark and system/significant control prongs of the FTC Franchise Rule, the FTC Rule requires as a third prong that the franchisee make a required payment or commit to make a required payment to the franchisor or the franchisor’s affiliate in order for a relationship to be deemed a franchise. 

The term “required payment” is defined broadly by the FTC to mean:  “all consideration that the franchisee must pay to the franchisor or an affiliate, either by contract or by practical necessity, as a condition of obtaining or commencing operation of the franchise.”  16 C.F.R. §436.1(s).

The definition of a required payment captures 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, or begin operation of the business.

The FTC Franchise Rule Compliance Guide states that “required payments go beyond payment of a traditional initial franchise fee.  Thus, even though a franchisee does not pay the franchisor or its affiliates an initial franchise fee, the fee element may still be satisfied. Specifically, payments of practical necessity also count toward the required payment element. A common example of a payment made by practical necessity is a charge for equipment or inventory that can only be obtained from the franchisor or its affiliate and no other source. Other required payments that will satisfy the third definitional element of a franchise include: (i) rent, (ii) advertising assistance, (iii) training, (iv) security deposits, (v) escrow deposits, (vi) non-refundable bookkeeping charges, (vii) promotional literature, (viii) equipment rental, and (ix) continuing royalties on sales.”

Courts throughout the country, both in interpreting the FTC Franchise Rule as well as various state franchise laws, have held that almost any payment made by a franchisee to the franchisor will satisfy the franchise fee element.   

For example, a boat dealer’s extensive advertising and its required purchases of promotional materials from the franchisor satisfied the franchise fee requirement under the California Franchise Investment Act.  Boat & Motor Mart v. Sea Ray Boats, Inc., Bus. Franchise Guide (CCH) ¶8846 (9th Cir. 1987).

Similarly, a forklift dealer’s payments to a manufacturer for additional copies of a Parts and Repair Manual constituted a franchise fee under the Illinois Franchise Disclosure Act.  To-Am Equip. Co., Inc. v. Mitsubishi Caterpillar Forklift Am., Inc., 953 F. Supp. 987 (N.D. Ill. 1997).

 Finally, required payments for training or services made to the franchisor or its affiliate may satisfy the payment of a fee element.  Metro All Snax v. All Snax, Inc. Bus. Franchise Guide (CCH) ¶ 10,885 (D. Minn. 1996).

For further investigation of this issue, see also two separate FTC Opinions, FTC Informal Staff Advisory Opinion #00-2 dated January, 2000, as well as FTC Informal Staff Advisory Opinion #03-2 dated April, 2003, found on the FTC website.  In both instances, the FTC did not focus on whether payments made by the licensee were up front initial fees or royalty payments, but whether any payment whatsoever was made by the licensee to the licensor.

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Vacating an Arbitration Award

Wednesday, August 17th, 2011

There are many reasons one can point to in order to explain how over the last several years arbitration has become less and less favored as a dispute resolution mechanism in the franchise arena.  One of the mean reasons that the arbitration bubble has burst is due to a lack of a valid and fair appeals process.  While it is common knowledge that a losing party in a state or federal court trial is permitted to appeal an unfavorable decision on a multitude of grounds, the same is hardly true in the arbitration process.  Rather, it is extremely difficult for most losing parties in an arbitration matter to come close to meeting the rigid criteria for vacating an arbitration award.    

For those arbitration matters resolved under the Federal Arbitration Act, the standard of review of an arbitration award under the Federal Arbitration Act provides for only four specific grounds for vacating an arbitration award, as follows:  i)  where the award was procured by corruption, fraud, or undue means; ii) where there was evident partiality or corruption in the arbitrators, or either of them; iii) where the arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy, or of any other misbehavior by which the rights of any party have been prejudiced; or, iv) where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.  In addition, most state arbitration statutes mirror the FAA in this area.

As a result of the rigid four categories stated above, it is extremely difficult to overturn an arbitration award except in the most egregious circumstances. A court is prohibited from vacating an arbitration award regardless of how vociferously the court may disagree with the reasoning behind the arbitrator’s decision.  Rather, parties that have been successful in appealing an arbitration award have for the most part been able to provide evidence to the court that either the arbitration committed fraud, misconduct or was biased, or the party has been able to prove that a procedural defect was committed thereby severely prejudging a party to the point the party was denied its fundamental rights of due process.

Unless an aggrieved party can show documented evidence in one of these two areas, a court is extremely unlikely to grant a motion to vacate an arbitration award.  It is for this reason, and others, that many franchisors in a variety of industries have turned away from arbitration and instead prefer to have their disputes heard by a state or federal court judge.

 

 

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Legal Requirements of an Existing Franchisee Sale of His or Her Outlet; Purchase of Additional Outlets; Extending the Term of an Existing Franchise?

Thursday, April 28th, 2011

An existing franchisee that sells his or her franchised business directly to a third party, without any significant contact with the franchisor does not need to abide by the federal franchise disclosure law, or any state franchise registration or disclosure law.

 The FTC Franchise Rule states, directly from the FTC website found at http://www.ftc.gov/bcp/edu/pubs/business/franchise/bus70.pdf. 

“Even if the franchisor has, and exercises, the right to approve or disapprove a subsequent sale (transfer) of a franchised unit, the transferee will not be entitled to receive disclosures unless the franchisor plays some more significant role in the sale. For example, if the franchisor provides financial performance information to the prospective transferee, the franchisor would be required to provide the transferee with its disclosure document.”

 Likewise, in the case of an existing franchisee that purchases one or more additional outlets from the same franchisor for the same brand, the franchisor is not required to provide a disclosure document to such a franchisee exercising a right under the franchise agreement to establish any new outlets.

Finally, the franchisor is not required to provide a disclosure document to a franchisee who chooses to keep its existing outlet post-term either by extending its present franchise agreement or by entering into a new agreement, unless the new relationship is under terms and conditions materially different from the present agreement.  In the case of a materially different franchise agreement, the franchisor must abide by state and federal franchise registration and disclosure laws.

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