According to National Association of Wholesaler-Distributors, wholesale distribution revenue accounts for 27.5% of US GDP, or $5.9 trillion, as of 2019. In other words, wholesale distribution is a significant way by which manufacturers distribute their products. Manufacturers using distributors continually face a multitude of business and legal issues. This 2021 quarterly series, authored by members of Seyfarth Shaw’s Franchise and Distribution group, will consider certain legal issues affecting distribution relationships. This first article considers the so-called “accidental franchise.”
What is an “Accidental Franchise” and Why Does it Matter?
An “accidental franchise”1occurs when a distribution agreement is deemed to be a franchise, despite the express intentions and expectations of the parties.2The legal definition of a franchise, under some state laws, captures those distribution relationships and provides extra-contractual franchisee-rights to distributors. These rights may include the opportunity to cure defaults before termination, the requirement that a manufacturer prove good cause before termination, the payment of termination relief to a distributor, among others.
A franchise relationship is typically defined by these elements: (1) the right to offer or sell goods under a trademark or tradename; (2) the requirement to adhere to a marketing plan or other direction from the manufacturer/supplier on the method or approach for selling goods; and (3) the payment of a fee for the right to sell the franchisor’s products or services. The way in which these elements are construed varies greatly by state. Nonetheless, many distribution agreements satisfy these elements and create the accidental franchise under relevant state laws.
Whether or not the first franchise element is satisfied, the sale of goods under a trademark, is readily determinable and not typically debated. Indeed, the use of a manufacturer’s trademark is commonly used by distributors to sell products with the use of signage and logos on facilities, brochures and websites. However, the second two franchise definition elements are more commonly in dispute.
The second element, adherence to a marketing plan, under Illinois law, for example, is defined as “advice given to the purchaser on how to sell the franchisor’s product or service.”3But, even under Illinois law, the marketing plan need not be required, but merely suggested.4Under other state laws, the amount of control exercised by a franchisor over a franchisee’s marketing and business practices becomes determinative of whether the marketing plan element is satisfied.5
The third element, payment of the fee, is sometimes broadly construed. For example, in Illinois, the payment of a fee does not include the bona fide purchase of goods at wholesale. However, training programs required by a manufacturer may be considered the payment of a fee.6In California, expenses associated with the operation of the franchise, like manuals and equipment, may satisfy the franchise fee element.7
This article is not intended to be an exhaustive exploration of how the application of state law franchise elements might play out. Suffice to say, the possible broad interpretation of the franchise elements may create a franchise relationship when one was not intended. Indeed, courts typically reject the subjective intent of the parties as determinative of whether a franchise relationship is created.8
How to Avoid Accidental Franchise or Mitigate Effect?
There are some things a manufacturer can do to minimize the risk of becoming an accidental franchisor or mitigate the effects of such a determination.
- Review distribution agreement and remove provisions that are not absolutely necessary. For example, does a manufacturer need to approve managerial changes at a distributor? Does a manufacturer need to provide a distributor with specific direction on how to sell its product? As discussed above, the more control a manufacturer is allowed under an agreement the more likely that it will be found that the marketing plan element of a franchise is satisfied.
- To avoid satisfying the third element above, payment of a franchisee fee, try to avoid charging a distributor for anything, other than goods sold at wholesale, for 6 months to a year after the distribution agreement is executed. The longer time period between when a payment is made by a distributor and the execution of the agreement, other than for goods sold, the less likely it can be argued that the payment satisfies the franchise fee element.
- Amend distribution agreement to limit time for all parties to file claims against each other (i.e. one year after claim accrues), especially where some state statutes provide longer statutes of limitations for franchise relationship claims. Many courts will enforce contractual claim limitation time bars as the Faxon Sales court did, cited above.
Our second article will explore non-compete provisions in distribution agreements.
1. The accidental franchise issue is only a concern in those states with franchise relationship laws because those laws grant additional, extra-contractual rights for those relationships deemed to be franchisees. There are 22 such jurisdictions, including: Arkansas; California; Connecticut ; Delaware; District of Columbia; Hawaii; Idaho; Illinois; Indiana; Iowa; Kentucky; Maryland; Michigan; Minnesota; Mississippi; Missouri; Nebraska; New Jersey; Tennessee; Virginia; Washington and Wisconsin.
2. The accidental franchise issue is discussed in the following court opinions: Faxon Sales, Inc. v. U-Line Corp., No. 17-cv-872-JPS, 2017 WL 4990617, at *4 (E.D. Wisc. Oct. 31, 2017) (using accidental franchise relationship to characterize plaintiff’s claims and dismissing them); Mercy Health Sys. v. Metropolitan Partners Realty LLC, No. 3046, 2005 WL 957722, at *2-4 (Ct. C.P. Pa., Phil. Mar. 6, 2005) (accidental franchise relationship rejected).
3. 14 Ill. Adm. Code § 200.102(a).
4. 815 ILCS 705/3(1)(a).
5. See e.g., Dittman & Greer, Inc. v. Chromalox, Inc., No. 3:09-cv-1147-CFD, 2009 WL 3254481, at *2-5 (D. Conn. Oct. 6, 2009) (marketing plan element not satisfied because level of control not sufficient).
6. Ill. Adm. Code § 200.106(a), (c).
7. Thueson v. U-Haul Internat., Inc., 144 Cal. App. 4th 664, 673 (Cal. App. Ct. 2006).
8. Brenkman v. Belmont Mktg., Inc., 410 N.E.2d 500, 503 (Ill. App. Ct. 1980) (“None of the criteria set forth in the statute make the subjective intent of the parties a determinative factor in identifying a franchise relation.”).