February 2017

The Inadvertent or Accidental Franchise

By Tim Pickwell

Pickwell Law Group

If it walks like a duck, talks like a duck . . . it probably is a duck.

Unfortunately for a lot of start-up entrepreneurs and inexperienced attorneys, the same rule of thumb applies with franchises.

Franchising is a regulated industry, and a “franchise” is defined under various State and Federal laws.  Complying with franchise laws, and providing the comprehensive disclosure documents and audited financials that must accompany the sale of a franchise can be expensive and time consuming.

So, some small operators, in either innocent ignorance, or in attempts to circumvent franchise laws, draft simple "license agreements" that often result in something called an "inadvertent franchise.”  Some hopeful attorneys have specifically stated in contracts, "This is not a franchise.  This is a license agreement."  Alas, the statutes cannot be waived.  You can call it a "license," but, it's still a duck.

Definition of a Franchise

The Federal Government (through the Federal Trade Commission) has promulgated disclosure requirements for franchises.  The FTC 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 . . . (1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor's trademark . . . (2) the franchisor will exert . . . a significant degree of control over the franchisee's method of operation, or provide significant assistance . . . and (3) . . . the franchisee makes a required payment . . ." (FTC Franchise Rule, 16 CFR 436.1 (h); emphasis added.)

Approximately 20 states have their own franchise laws that either require registration of offering circulars or offer protection to franchisees.  The definition of a franchise under these state laws varies, but fall roughly into two camps:

Marketing Plan States” (California [California Franchise Investment Law ("CFIL"), Corporations Code, Section 31000, et. seq.], Connecticut, Illinois, Indiana, Iowa, Virginia, Washington) say a franchise must have three elements: (1) a fee; (2) a trademark; and (3) the franchisee is required to follow a common marketing plan.

Community of Interest States” (Missouri, Nebraska, New Jersey, Wisconsin) simply require that (1) the putative franchisee derive a substantial portion of its sales under the franchisor’s trademark; and (2) the two parties have a ‘community of interest.’  A ‘community of interest’ usually arises when the franchisee makes specific investments or is otherwise highly dependent on the franchisor.

No Waiver

In California, the penalties for failing to comply with the franchise laws may include criminal sanctions, fines and other penalties prescribed by the Corporations Commissioner (e.g., restitution or disgorgement; CFIL, Section 31400).

This is why many distributors either take pains to comply with franchise laws, or structure their transactions to avoid the application of California’s franchise laws.  Unfortunately, merely changing the name of the relationship, and calling it a “license” is not sufficient.  Attempts to waive the application of the franchise laws are also futile.

The California Franchise Relations Act specifically states that “Any condition, stipulation or provision purporting to bind any person to waive compliance with any provision of this law is contrary to public policy and void.” (CFRA, Section 20010).  The CFIL contains an identical provision.

So, even though a purported agreement contains exculpatory language, you cannot rely on it.  The question will be, ‘is the License Agreement really a Franchise Agreement, or not?’ not what you have labeled it.

The Deck is Stacked

Courts have determined that the statutory definition of a franchise should be construed liberally to carry out the legislative intent and to broaden the group of investors protected by the Franchise Investment Law. (Kim v. Servo Snax, Inc., 10 Cal.App.4th 1346; 13 Cal. Rptr.2d 422, Bus. Franchise Guide (CCH) 10,124 (Cal.Ct.App. 1992).  Describing the sale as one of a “business opportunity” does not avoid the requirement of registering the sale of what is otherwise a franchise.  People v. Kline, 110 Cal.App.3d 587, 594, 168 Cal.Rptr. 185, 188-89, Bus. Franchise Guide (CCH) 7566 (Cal.Ct.App.1980).

In Boat & Motor Mart v. Sea Ray Boats, Inc. 825 F. 2d 1285, Bus. Franchise Guide (CCH) 8846 (9th Cir. 1987), the court found that a dealership agreement between the manufacturer of Sea Ray Boats and one of its California dealers satisfied marketing plan requirements to qualify as a franchise under the CFRA.  Sea Ray had argued that it did not prescribe a marketing plan, but only required the dealer to “aggressively” market its boats.  In rejecting that argument, the court noted that Sea Ray provided the dealer with a marketing program and a computer printout of prospective customers.  Sea Ray’s advertising agency provided the dealer with press kits, promotional tools, and marketing advice.  Sea Ray would not allow the dealer to advertise outside of its assigned territory:

“Sea Ray provided detailed instructions on what Boat’s salesmen should do, especially at boat shows.  It provided instructions how to lay out the booth, including instructions that all boats should be wiped down each day.  It said that a telephone was ‘a must,’ as was a carpet.  It gave detailed instructions as to other booth accessories.  It insisted on a dress code for salesmen.  It told Boat what to supply the salesmen with.”

Salesmen were sent to Sea Ray for training and Sea Ray monitored the dealer’s marketing efforts through ‘report cards’ given to customers to rate the dealers’ service.  On the evidence before it, the court concluded the dealer followed a system prescribed in substantial part by Sea Ray.  Boat & Motor Mart v. Sea Ray Boats, Inc. 825 F. 2d at 1289.

Pause and Be Careful

Finding that you are an inadvertent franchisor usually comes at the worst possible time—you are attempting to terminate a putative licensee, and they obtain legal advice that, in fact, they are a "franchisee"; entitled to the protections of the franchise law and that, in fact, your client has failed to register as a franchisor or provide a franchise disclosure document.

So, when you are drafting a license agreement, review the elements: trademark, payment of a fee, significant franchisor (licensor) control or assistance.  If all three elements are present, you may wish to dig deeper.  The California Department of Business Oversight has links to California statutes and regulations, as well as to the FTC Rule and Guidelines. Old Department of Corporations Commissioner's Release 3-F also provides detailed examples of what satisfies the elements of a "franchise" in California.