ABCs of Franchising: Who Is a Franchisor?

by Pepper Hamilton LLP
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A business venture or operation that is determined to be a franchisor under the Federal Trade Commission’s Franchise Rule must comply with specific, and sometimes burdensome, requirements. For example, the Franchise Rule requires franchisors to create and distribute a franchise disclosure document (FDD), which the franchisor must provide to prospective franchisees. Additionally, a franchisor must comply with state franchise laws for each state in which it sells a franchise. Failure to comply with the Franchise Rule and state franchise laws can result in serious consequences, such as civil or criminal penalties or civil liability for consumer fraud. If a business is contemplating becoming a franchise, it is imperative to know the Franchise Rule, state law and their requirements.

What is the Franchise Rule?

The FTC promulgated the Franchise Rule in 1978 to govern the business relationship between franchisors and franchisees. However, the terms of that relationship have not always been so clear. Since the advent of the Franchise Rule, individual states have enacted state franchise laws in a further attempt to define the franchise relationship. In 2007, the FTC amended the Franchise Rule to address changes in franchise marketing and technology and to more closely align the rule with those promulgated by individual states. This included streamlining the definition of a franchisor. Whether a business venture or operation meets the definition of “franchisor” in the rule is the primary issue in determining the applicability of the Franchise Rule to that business. Even if a business is not structured as a franchise and has no intent on becoming a franchise, that business could “accidentally” fall under the purview of the Franchise Rule (and be required to disclose certain information to its counterparties) if its structure and operation meet the rule’s definition of “franchisor.”

Who is a franchisor?

Under the Franchise Rule, a “franchisor” is “any person who grants a franchise and participates in the franchise relationship.” 16 C.F.R. 436.1(k). For a party to be a franchisor, it must satisfy both elements: (1) grant a franchise and (2) participate in the franchise relationship. 72 Fed. Reg. 15,460.

To fully understand the “franchisor” definition, it is important to understand the definition of “franchise.” Pursuant to the Franchise Rule, a “franchise” is

[A]ny 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.1

16 C.F.R. 436.1(h).2 A business relationship constitutes a franchise only if it satisfies all three elements of the term “franchise.” 72 Fed. Reg. 15,460. If the three elements of the franchise definition are met, then the franchise relationship is established, and a trademark owner is deemed to be a franchisor.

There has been some debate about whether simply terming a business a “franchise” brings it within the Franchise Rule’s governance. However, the FTC makes clear that it does not look at what the business terms itself, but looks exclusively at whether the business meets the Trademark, Assistance and Payment elements of the definition. In conducting this analysis, the FTC has held that the business arrangement will be deemed a franchise, and the seller will be deemed a franchisor, as long as the seller makes oral or written representations that it will license a trademark, promises to provide significant assistance to the buyer’s business, and charges at least $500. It is very important to know these requirements, especially if a business does not intend to become a franchisor or operate a franchise because once a business is deemed a franchisor, it must comply with the Franchise Rule and state franchise laws.

Federal and State Disclosure Requirements

Although exemptions may apply, the key responsibility of a franchisor under the Franchise Rule is disclosing certain information to prospective franchisees3 about the franchise to allow prospective franchisees to make informed decisions about whether to enter into a franchise agreement with the franchisor. The primary document the franchisor must create and provide to prospective franchisees is the FDD. 16 C.F.R. 436.2.

The FDD is a comprehensive document containing information on 23 different topics that are necessary for a potential franchisee to assess whether to enter into a franchise relationship, ranging from the franchisor’s parents, predecessors and affiliates to information about a prospective franchisee’s initial investment.4 16 C.F.R. 436.5. The FDD must be provided to a prospective franchisee at least 14 calendar days before the prospective franchisee signs an agreement with a franchisor in connection with a franchise sale. 16 C.F.R. 436.2. Moreover, the Franchise Rule requires regular updates to the FDD and allows for amendments when necessary. 16 C.F.R. 436.7.

In addition to complying with the Franchise Rule’s disclosure requirements, franchisors must also comply with individual states’ laws. Certain states have enacted their own franchise laws to provide greater protection for franchisees. Some states require franchisors to disclose or register their FDDs with a state or regulatory agency before offering or selling a franchise in that state.5 Other states have less stringent disclosure requirements, with some only requiring the filing of a notice of a sale of franchise within the state, and not a complete registration of the FDD.6 Several states define a franchise in a manner similar to the Franchise Rule, and, therefore, some states accept disclosures made under the rule and do not require additional disclosures. It is important to know the particular law of each state and whether any affirmative steps in addition to the Franchise Rule’s requirements must be taken before transacting business in that state to avoid a possible violation.

Enforcement

Compliance with both the Franchise Rule and state law is crucial for franchisors. While there is no private right of action under the rule, failure to comply will be considered an unfair or deceptive act under section 5 of the FTC Act, allowing the FTC to commence civil or criminal enforcement proceedings on behalf of franchisees against a franchisor. See e.g., 16 C.F.R. 436.9. Moreover, many state franchise laws provide state regulatory agencies with power to bring both civil and criminal enforcement proceedings, including obtaining an order suspending franchise sales in that state.7 Franchisees may also seek redress through state consumer protection laws or through common law claims, using the franchisor’s violation of the FTC disclosure rules as the predicate for the claims.8 Thus, in addition to being aware of and compliant with the Franchise Rule, it is critical that franchisors understand and comply with the state rules in which they are transacting business.

Moving Forward

After preparing, registering with the appropriate state agency (if necessary), and providing the FDD to a potential franchisee within the appropriate time period, a franchisor may enter into a franchise agreement to sell a franchise to a prospective franchisee. Once the franchise relationship begins, the franchisee can do business using the franchisor’s tradename and trademark, and the franchisor should provide the appropriate and necessary assistance to promote the success of the brand. Some states have enacted franchise relationship laws that govern both franchisors’ and franchisees’ conduct during the franchise relationship and regulate the circumstances upon which a franchise relationship can end, which also must be observed. Ideally, this relationship lasts until the expiration of the franchise agreement, at which point the franchisor and franchisee can renew the franchise agreement or mutually decide to part ways.

As a franchisor, one must be aware of the rules and regulations governing the franchise relationship and must maintain compliance with both federal and state law while transacting business throughout the country. Even if one does not want to franchise a business, it is important to know the reach of the Franchise Rule to avoid accidentally subjecting a business to the requirements of federal and state franchise laws. It is important to consult an attorney about business structure, and the decision to franchise a business, to ensure compliance with both the Franchise Rule and state laws.

 

Endnotes

1 A “franchisee” means “any person who is granted a franchise.” 16 C.F.R. 436.1(i).

2 For the purposes of this article, we will call the three elements the “Trademark,” “Assistance,” and “Payment” elements, respectively.

3 A prospective franchisee is “any person (including any agent, representative, or employee) who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship.” 16 C.F.R. 436.1(r).

4 The FDD must contain information on the franchisor and its parents, predecessors and affiliates; the business experience of its principal officers, directors and managers; litigation; bankruptcy; initial fees that the franchisee must pay; other fees; an estimate of the franchisee’s initial investment; restrictions that the franchisor imposes on products and services; the franchisee’s obligations during the relationship; financing that might be available through the franchisor; the franchisor’s obligations to provide assistance and information about advertising, computer systems and training; the territorial rights that the franchisee will receive; the franchisor’s trademarks; its patents, copyrights and proprietary information; the franchisee’s obligation to participate in the actual operation of the franchise business; restrictions on what the franchisee may sell; information about renewal, termination, transfer and dispute resolution; any public figures who endorse the franchise; optional financial performance representations; information about outlets and franchisees; the franchisor’s financial statements; a list of contracts required of the franchisee; and a receipt form.

5 These states include California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin.

6 These states include Connecticut, Florida, Kentucky, Maine, Nebraska, North Carolina, South Carolina, Texas and Utah.

7 See, e.g., Cal. Corp. Code §§ 31401(a)-(b), 31402, 31407; Haw. Rev. Stat. § 482E-8(a); 815 Ill. Comp. Stat. 705/22(a); Ind. Code § 23-2-2.5-14; MD. Code Ann., Bus. Reg. § 14-208; Mich. Comp. Laws § 445.1536; Mich. Comp. Laws § 445.1538; N.D. Cent. Code § 51-19-14; N.Y. Gen. Bus. Law § 690; R.I. Gen. Laws §§ 19-28.1-18(a), 1-25(c); S.D. Codified Laws §§ 37-5B-24, 37-5B-25; VA Code Ann. § 13.1-562; Wash. Rev. Code § 19.100.252; Wis. Stat. § 553.28

8 See, e.g., KC Leisure, Inc v. Haber, 972 So. 2d 1069 (Fla. 5th DCA 2008); Legacy Acad., Inc. v. Doles-Smith Enters., Inc., 337 Ga. App. 575, 789 S.E.2d 194, 196 (Ct. App. 2016).

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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