Franchising laws are very broad in scope and may inadvertently encroach upon standard licensing or distribution agreements. The repercussions for operating an illegal (or more likely inadvertent) franchise system can be very severe. Accordingly, it is imperative that corporate counsel educates and provides guidance to clients on the general contours of federal and state franchise law. Otherwise, the client unwittingly could be operating an illegal franchise system. With these concerns as the backdrop, this alert highlights the types of conversations that should occur between a client unfamiliar with franchising and their corporate counsel after counsel has reviewed a prospective licensing or distribution arrangement for the client:

Seriously, why are you focusing on franchising-related issues in my proposed trademark license or distribution deal? I need to get this deal done, especially since we are a target in an M&A transaction.

Many trademark licensors, manufacturers, distributors, and other suppliers of goods and services (collectively, “Suppliers”) enter into commercial arrangements with licensees, dealers, retailers, and other buyers (collectively, “Buyers”) without knowing that such arrangements may implicate federal and state franchise laws. If, under these laws, an arrangement is deemed a nonexempt franchise, the Supplier must provide the Buyer with a legally mandated pre-sales disclosure document before consummating the arrangement.

For states without their own franchise disclosure or registration laws (i.e., non-franchise registration states), the Federal Trade Commission (“FTC”) franchise rule (“FTC Rule”) will regulate franchise transactions. Under the FTC Rule, a Supplier may not offer or sell a “franchise” unless the franchise transaction is exempted under the FTC Rule or the Supplier provides the Buyer with a disclosure document satisfying the requirements of the FTC Rule. States with franchise registration laws (i.e., registration states) take it a step further. These states not only require a disclosure document for a nonexempt franchise offering, but they also require the Supplier to register the disclosure document before the Supplier can provide the Buyer with the disclosure document. [1]

Any failure to comply with federal or state franchise disclosure and registration laws could subject the Supplier and its owners, directors, and employees to civil actions by the FTC, private rights of actions under state franchise laws or state unfair trade and practices laws, [2] and potential criminal penalties. [3] Additionally, as you can imagine, any compliance-related issues associated with a Supplier’s licensing or distribution network may have a materially adverse effect on your company’s valuation and viability as a target.

I was not aware that a “run of mill” trademark license or distribution agreement could actually be a franchise. I thought franchise laws only applied to restaurants or hotels. In any event, I do not want to violate the law or cause my company to be devalued, so what constitutes a franchise?

The creation of a “franchise” transaction is not based on the classification, nomenclature, or intent of the parties, but rather on whether a specific arrangement satisfies the federal or state law definition of a “franchise.” The definition of a “franchise” varies from federal to state and state to state. However, in general, [4] a franchise exists when a Buyer obtains from the Supplier the right to operate a business:

• in which the goods and services are identified or associated with the Supplier’s trademark (“Trademark Element”);

• the Seller exerts or has authority to exert significant control over or provide significant assistance in the Buyer’s method of operation of the business (“Control/Assistance Element”); and

• as a condition of starting the operation of the business, the Buyer makes or commits to make a required payment to the Seller or its affiliate (“Required Payment Element”).

If the transaction satisfies the applicable definitional elements and no exemption applies to the transaction, then the Supplier must comply with the franchise disclosure and registration laws. [5]

Wow! The definitional elements of a franchise are very broad, and I have no desire at this time to develop a franchise program. So, before consummating my current transaction, I would like to structure the arrangement to avoid franchise disclosure and registration laws. I wonder what steps I may need to take?

To avoid being deemed a franchise, the Supplier’s arrangement will need to be structured to avoid the Trademark Element, Control/Assistance Element, or the Required Payment Element, or the Supplier will need to find an exemption under the applicable franchise laws for the arrangement. The particular franchising element to structure around will depend on, among other things, the location of the Buyer and the Supplier’s business model and practices.

From a practical standpoint, it will be very difficult to structure the arrangement to avoid the Trademark Element given the Supplier’s duty to control the quality of its trademarked goods and services. And, even if the agreement does not expressly provide a license grant, the license grant will more than likely be inferred unless such grant is expressly prohibited in the arrangement. Consequently, many Suppliers will focus on restructuring the Control/Assistance Element or Required Payment Element, and the viability of structuring around either of these two elements will depend in large part on the business model and practices of the Supplier and the jurisdiction of the Buyer’s business (i.e., non-franchise registration state or franchise registration state).

If the Supplier is unable to structure around one of the franchising elements, the Supplier may be able to depend on a franchise exemption. The types and requirements of franchise exemptions differ from jurisdiction to jurisdiction. [6] Some of the more common types of franchise exemptions that Suppliers rely upon include the following:

• Bona Fide Wholesale Exemption – To qualify for this exemption, the Buyer’s payments to the Supplier must be made solely to acquire reasonable quantities of inventory at wholesale prices for resale purposes. This exemption only applies to products and not to any services (including training or support fees).This is the exemption that many distributors use to avoid the Required Payment Element.

• Minimum Payment Exemption – The FTC Rule exempts franchise transactions where the total required payments to a Supplier are less than $540 during the six months prior to the investor commencing operations. However, some registration states that have this exemption are more restrictive than the FTC Rule. [7]

• Fractional Franchise Exemption – The FTC Rule and certain registration states have a fractional franchise exemption. Generally, the fractional franchise exemption applies when at the start of the relationship the Buyer has more than two years of experience in the same type of business and the parties anticipate that the sales arising from the relationship will not exceed 20 percent of the investor’s total dollar volume in sales. [8]

Got it. Now I recognize the general contours of a franchise arrangement. Unfortunately, I unknowingly structured and executed commercial agreements in the past that appear to fit within the scope of franchise disclosure and registration laws. I wonder what I can do to discontinue the operation of an illegal franchise system, reduce my risk profile, and preserve as much of the company’s value as possible in our impending M&A deal.

At their heart, franchising laws are consumer protection laws, so the violations of franchise disclosure and registration laws can subject the Supplier to serious transactional and regulatory consequences such as criminal and financial penalties, damages, and rescission rights for the Buyer. [9]

When a Supplier discovers that it has possibly violated franchise disclosure or registration laws, the Supplier should take prompt remedial action to address the violations. Remedial actions can include restructuring or renegotiating the arrangement, analyzing defenses such as the statute of limitations, self-reporting to a governmental regulator, or offering rescission to affected Buyers. In determining the course of action to take, the Supplier will need to evaluate, among other things, whether it wants to franchise in the future, its future expansion or strategic transactional plans, the relationship it has with its existing Buyers, and jurisdictions in which the existing Buyers are operating. Lastly, before terminating or not renewing any existing arrangement, the Supplier should work with competent counsel to evaluate any potential issues relating to franchise relationship laws. [10]