As competition intensifies and auto manufacturers and distributors look for new ways to realize value from their brands, they and their counsel would do well to familiarize themselves with the Federal Trade Commission’s (FTC) Amended Franchise Rule and the reasons why their clients are exempt to make sure they are not inadvertently creating business ventures subject to federal and state regulations. Although the federal Automobile Dealer Day in Court Act1 and many state dealer statutes refer to the written agreement between auto manufacturers and dealers as a “franchise,” it is not common industry practice to refer to manufacturers as “franchisors” or dealers as “franchisees.” This is likely because most states—even states with franchise laws of general applicability—have adopted industry-specific statutes regulating manufacturer-dealer relations and the exemptions obtained from the FTC by auto manufacturers shortly after the adoption of the FTC Franchise Rule2 in 1979. But when considering business opportunities that are outside the scope of the traditional manufacturer-dealer relationship, the applicable federal and state regulations could convert the relationship into one of franchisor-franchisee. If auto manufacturers wish to expand the power of their brand while avoiding the implications of the FTC Franchise Rule, they first need to understand it.
The FTC Franchise Rule
First adopted by the FTC in 1979, the Franchise Rule broadly defines a “franchise” as “any continuing commercial relationship or arrangement” in which (1) a franchisee obtains a right to operate a business associated with a 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; and (3) a franchisee agrees to pay a fee to the franchisor.3 Generally speaking, the FTC Franchise Rule requires written disclosure by a franchisor to a prospective franchisee of material information concerning the business opportunity being sold prior to the sale of a franchise in a document that is today called a “Franchise Disclosure Document” or “FDD,” and imposes certain requirements on a franchisor before selling a franchise to a prospective franchisee.4
Shortly after the adoption of the FTC Franchise Rule in 1979, participants in already heavily regulated industries sought exemptions under Section 18(g) of the FTC Act, which provides that an exemption to a trade regulation rule may be granted if coverage “is not necessary to prevent the unfair or deceptive act or practice to which the rule relates.”5 For example, a group of oil companies and oil jobbers petitioned for and obtained from the FTC an exemption for the entire petroleum industry because the Petroleum Marketers Practices Act (PMPA)6 already imposed pre-sale disclosure requirements and regulated the relationship between franchisors and franchisees in that industry.7
Auto manufacturers also petitioned for exemptions from the FTC Franchise Rule, either individually or through trade associations. For example, at the same time the FTC granted the exemption sought by oil companies and oil jobbers, the FTC also granted exemptions sought by the Automobile Importers of America, Inc. on behalf of its members.8 In granting the exemptions, the FTC found in the record an “absence of significant abuse by franchisors of their relationships with automobile dealer franchisees or prospective franchisees,” and noted that the National Automobile Dealers Association supported the petition.9 The FTC also explained that it had “previously determined . . . that the sale of most automobile dealerships does not constitute the sale of a ‘franchise’ within the meaning of the rule,” referring to its ratification of prior staff advisory opinions to the Big Three domestic automobile manufacturers that the manner in which those companies appointed dealers did not constitute a “franchise.”10
Finally, the FTC observed that because prospective motor vehicle dealers make “extraordinarily large investments,” those investments are, as a practical matter, made by knowledgeable investors and preceded by substantial negotiation so that those investors can make an “informed assessment of the potential risks and benefits of the proposed investment.”11 The FTC concluded that the exemptions from the Franchise Rule were appropriate “[b]ecause (i) the transactions, for the most part, are not covered by the rule, (ii) the conditions most likely to lead to consumer abuses are absent from [the] sale of dealerships . . . and (iii) such sales transactions include sufficient disclosure to ensure that the prospective investor is in the position to make an informed decision . . . .”12
2007 Amendment to the Franchise Rule
In 2007, the FTC adopted an Amended Franchise Rule designed to clarify ambiguities, reduce compliance costs, and respond to changes in technology and market conditions in the offer and sale of franchises. In the Statement of Basis and Purpose (SBP) issued by the FTC in conjunction with its adoption of the Amended Franchise Rule, the FTC explained that because “most of the provisions of the original Rule have been retained in the final amended Rule . . . . all former informer staff advisories remain a source of Rule interpretation, except where this SBP contradicts a staff advisory.”13
The FTC expressly incorporated into the Amended Franchise Rule the exemption that it had granted to oil companies and oil jobbers more than 25 years earlier, adding language declaring that the rule shall not apply if “[t]he franchise relationship is covered by the Petroleum Marketing Practices Act, 15 U.S.C. 2801.”14 Explaining in the SBP its rationale for adopting this language, and responding to commenters who asked whether this exemption would extend to ancillary businesses at gas stations (like car washes and convenience stores), the FTC declared that it “intends that it be clear that the PMPA exemption should be read broadly to cover other branded services and products (such as a car wash or mart) sold to the prospective franchisee under the same franchise agreement as the gasoline station.”15 Although the FTC recognized “as a practical matter” that this broad exemption was warranted because it may be impossible to tease out exempt and non-exempt business lines in a single franchise agreement, the FTC warned that separate or subsequent sales of a restaurant or convenience store franchise to a gasoline station owner fall outside the exemption.16
The Amended Franchise Rule also expressly incorporated portions of the rationale that informed the exemptions granted to auto manufacturers by adopting two new “sophisticated investor exemptions.” The “large franchise investment” exemption provides that the rule does not apply if “[t]he franchisee’s initial investment, excluding any financing received from the franchisor or an affiliate and excluding the cost of unimproved land, totals at least $1,143,100 and the prospective franchisee signs an acknowledgment verifying the grounds for the exemption.”17 The “large franchisee” exemption provides that the rule does not apply if “[t]he franchisee . . . is an entity that has been in business for at least five years and has a net worth of at least $5,715,500.”18 Explaining in the SBP its rationale for adopting these exemptions, the FTC expressly noted that the sophistication of large investors had been one of the reasons for granting the exemptions sought by the Automobile Importers of America more than 25 years earlier.19
Realizing Brand Value In The 21st Century
Unlike oil companies and oil jobbers, auto manufacturers and distributors do not enjoy an industry-wide categorical exemption from the FTC Franchise Rule. As the FTC observed in 1980, “most” arrangements between manufacturers and dealers do not meet the definition of a “franchise,” significantly because auto manufacturers do not “sell” their dealerships like traditional franchisors or otherwise charge dealers a fee for the right to use the manufacturer trademarks in selling new cars.20 Most (if not all) manufacturers also have obtained exemptions from the rule under Section 18(g) of the FTC Act. And given the significant investment typically involved in acquiring a dealership, the “large investment exemption” would seem to cover most of the agreements between manufacturers and dealers. Nevertheless, as the automobile and transportation industries continue to evolve and respond to ever changing technologies, and auto manufacturers look to develop new business opportunities to capitalize on brand value, they must take care to ensure that they do not inadvertently extend beyond the recognized exemptions. Especially with respect to business ventures outside of the traditional auto dealership or ancillary dealership businesses, auto manufacturers and distributors should keep in mind that potential franchise compliance issues lurk in the background.
1. 15 U.S.C. § 1221.
2. 16 C.F.R. Part 436. In 2007, the FTC added part 437 to the Franchise Rule to regulate the sale of “business opportunities,” which are similar to franchises. Many states also regulate the sale of “business opportunities” separate and apart from, or instead of, franchise relationships. To the extent that an automobile manufacturer creates a business outside the scope of the traditional dealership arrangement, they and their counsel should be familiar with the applicable federal and state franchise and business opportunity statutes.
3. 16 C.F.R. § 436.1(h).
4. Id., § 436.2.
5. 15 U.S.C. § 57a(g).
6. 15 U.S.C. § 2801 et seq.
7. 45 Fed. Reg. 51765 (Aug. 5, 1980).
8. 45 Fed. Reg. 51763 (Aug. 5, 1980).
9. Id. at 51764.
10. Id. at 51764, 51765 n.4.
11. Id. at 51764.
13. 72 Fed. Reg. 15444, 15449 (Mar. 20, 2007).
14. 16 C.F.R. § 436.8(a)(4).
15. 72 Fed. Reg. at 15522.
17. 16 C.F.R. § 436.8(a)(5)(i). The threshold amount for the “large franchise investment” exemption was $1 million when the Amended Franchise Rule was adopted in 2007. Under 16 C.F.R. § 436.8(b), the FTC adjusts the thresholds for exemptions to the Amended Franchise Rule every four years based on the consumer price index.
18. 16 C.F.R. § 436.8(a)(5)(ii).
19. 72 Fed. Reg. at 15523.
20. Even though auto manufacturers do not ordinarily charge an explicit fee in exchange for licensing their brands, there may be challenges based on other costs associated with an established business being the functional equivalent of a franchise fee. See e.g. Wright-Moore Corp. v. Ricoh Corp., 908 F.2d 128, 135 (7th Cir. 1990) (investment in excess inventory may constitute an indirect franchise fee).