More than a dozen states have similar laws.
In the case of your sale of legal services, you are
(hopefully) providing significant assistance to your client
in its method of operation (which under federal law
specifically includes that person's business organization),
and you are charging a fee for your services. You do not,
however, allow your client to use your trade name, logo or
advertising in its business. As a result, you are not
engaged in the sale of a franchise because the service you
offer to your business client meets only two of the three
elements of a franchise.
Now consider the dealership or license arrangements you help
your clients establish. The client typically sells to the
purchaser goods that bear the client's trademark, which is
sufficient to meet the trademark element of a franchise. Or
your client permits its licensees to use its name in the
operation of its business (even if by reference to the
purchaser being a participant in your client's
"network," and even if the name is not technically
licensed, but purchasers are permitted to use the name in
their business).
Since everyone is in business to make money, there will no
doubt be money paid to your client. Whether this money is
called a franchise fee, a territory fee, an exclusivity fee,
a royalty, a license fee or even a training fee, it is still
a fee, and payment of the fee meets the second element of a
franchise under federal law. (One of the few exceptions is
when the only money that changes hands is for the purchase
of inventory for resale.)
If your client also provides assistance in the form of
training or promotional assistance, the third element will
be met.
The task of determining whether a relationship is a
franchise is made more difficult by the fact that the
definition of a franchise is not uniform in all
jurisdictions. Some franchise laws substitute a
"community of interest" test for the
"significant assistance" test. Others refer to the
provision of a "marketing plan." Thus, whenever
there is a trademark, the exchange of money, and a
continuing relationship between your client and its
purchasers, you need to analyze whether the franchise
disclosure laws apply to the relationship. If the three
elements of a franchise exist, then the relationship is a
franchise, even though you may refer to it as a
distributorship, dealership or license arrangement.
A couple examples may help. Consider Coca-Cola. Assume Coca-
Cola receives a payment from its bottlers when it sells
bottling rights. When it does so, it is selling a franchise.
The bottlers use the Coca-Cola name in their business, they
pay a fee for something other than syrup or finished product
for resale, and they receive significant assistance in their
operation (whether it be the ads Coca-Cola implements to
sell the product, the recipe that is licensed to make the
product, or any operational assistance).
Assume now that Coca-Cola licenses the Coca-Cola name to
somebody to print T-shirts and receives a royalty from every
T-shirt sold. The trademark and fee elements of a franchise
are present, but it is unlikely that Coca-Cola provides
assistance in connection with the manufacture of the T-
shirts, or the operation or promotion of the T-shirt
business. Therefore, this license arrangement is not a
franchise.
On the other hand, if that same purchaser were obtaining a
license to open a Coca-Cola apparel store, and received
direction from Coca-Cola in the organization, formation or
marketing of the store, the arrangement would then
constitute a franchise, even though it does not involve Coca-
Cola's core business.
Identifying relationships that qualify as franchises under
the franchise disclosure laws is unfortunately only the
beginning of your task when dealing with license and
dealership arrangements. You must also be cognizant of the
business opportunity laws that exist in 19 states. Many of
these laws will apply to transactions that involve
trademarks and marketing programs even when the only money
changing hands is for the purchase of inventory.
Consider again the fictional Coca-Cola apparel store. I
originally assumed the store owner paid a royalty to Coca-
Cola for the right to put the Coca-Cola name on apparel.
Assume, however, that there was no royalty, and that the
only money changing hands was for the retailer's purchase of
finished apparel for resale. In that case, the relationship
would not be a franchise, because the "fee"
element of a franchise was missing (the purchase of
inventory for resale being one of the few exceptions to the
"money paid" element of a franchise). That
arrangement would, however, still constitute a business
opportunity if Coca-Cola provided marketing or promotional
assistance to the retailer.
If a relationship qualifies as a franchise under federal
law, then before your client can even meet face to face with
a prospective purchaser to discuss the details of the
arrangement, it must provide a detailed disclosure document
to the prospect. The same requirement exists under the
relevant state franchise and business opportunity laws.
However, under state law, the relationship may also require
registration in more than two dozen states before any offers
are made, and before any advertising for prospective
franchise purchasers is published.
Compliance with these laws can be cumbersome and will delay
the rollout of your client's "licensing" program.
However, failure to comply with these laws can subject your
client and its principals to liability for damages or
rescission. In addition, many of these laws have provisions
for criminal penalties, civil fines and the award of
attorneys' fees. Unfortunately, many companies that offer
dealerships or licenses discover they have sold a franchise
only after an unhappy franchisee — or regulator
— has filed suit against them. At that point, it is
too late for the franchisor to "cure" its failure
to register the franchise or to provide appropriate
disclosures to the distributor or licensee.
Your own law firm is also not immune from liability for your
client's failure to comply with these laws. A law firm in
Connecticut found itself on the receiving end of a $15
million verdict in favor of its former client for allegedly
failing to advise its client of the need to comply with
these laws (Beverly Hills Concepts Inc. v. Schatz &
Schatz, Ribicoff & Kotkin, et al., Bus. Franchise Guide
(CCH) ¶ 11,099 (Ct. Sup. Ct. 1997)). The lower court not
only held the law firm liable for the client's direct
losses, but it assessed damages based on the financial
projections the franchisor had prepared for its business.
The court reasoned that if not for the lawyer's failure to
properly advise the client on compliance with applicable
disclosure laws, the client would have successfully
established a nationwide network of health clubs.
On appeal, the Connecticut Supreme Court affirmed the
decision that the law firm had committed malpractice, but
set aside the damage recovery on the basis that the
plaintiff's losses were based on speculation as to future
profits. The law firm certainly dodged a bullet, but as the
appeals court noted, it was not because of the propriety of
the law firm's actions, but because of the "plaintiff's
choice of evidence." (Beverly Hills Concepts Inc., v.
Schatz & Schatz, Ribicoff & Kotkin, et al., 717 A.2d
724, 739 (Conn. 1998)). The lesson from the Beverly Hills
Concepts case should be clear; lawyers need to be aware of
the scope of franchise and business opportunity disclosure
laws.
Many of the franchise disclosure requirements were written
with "package" franchises in mind, such as
restaurants, hotels and other "business formats."
The business opportunity laws were written to cover many
part-time businesses not covered by the franchise laws, such
as home-based businesses and vending machines. Nevertheless,
these laws have been held to apply to business arrangements
varying from manufacturer-dealer arrangements that involve
payments to the manufacturer beyond the purchase of goods
(see for example, Pool Concepts Inc. v. Watkins Inc., Bus.
Franchise Guide (CCH) ¶ 12,249 (D. Minn. 2002)) to the
licensing of software that enables the licensee to operate a
business (see for example, Current Technology Concepts Inc.
v. Irie Enterprises Inc. d/b/a Irie Computer, et al., 530
N.W.2d 539 (Minn. 1995)).
The definitions contained in the various state franchise and
business opportunity disclosure laws are not consistent, and
many are imprecise. However, whenever you work with a client
who is helping others establish a business, you must
consider whether these laws will apply to the relationship.
Up to this point, this article has focused on the laws that
regulate the pre-sale obligations imposed on persons
offering products or services in a transaction that meets
the legal definition of a franchise or business opportunity.
However, there is another set of laws, frequently referred
to as franchise relationship, or dealer relationship, laws,
which govern the continuing relationship of the parties.
Like the business opportunity laws, these laws frequently
apply to arrangements that would not fall within the
traditional definition of a franchise. The laws typically
apply to any agreement between two or more persons under
which a person is granted the right to sell or distribute
goods or services under the seller's trademark, and in which
there is a "community of interest" between the
parties in the marketing of the goods or services.
Most often, these relationship laws will apply to
arrangements between manufacturers of products and their
dealers, where the dealer's business is strongly identified
with, and reliant upon, the manufacturer. For example, in
Hartford Electric Supply Co. v. Allen-Bradley Co. Inc., 736
A.2d 824 (Conn.. 1999), the court found a manufacturer of
automation products to be selling franchises under the
Connecticut Franchise Act.
However, these laws also apply to service providers. In
Instructional Systems Inc. v. Computer Curriculum Corp., 614
A.2d 124 (N.J. 1992), the court found that a supplier who
allowed its trademark to be used on services provided by its
distributor had sold a franchise under the New Jersey
Franchise Practices Act.
The franchise relationship laws generally require good cause
for termination or nonrenewal of the relationship, and they
require advance notice, typically varying from 30 to 90
days, with an opportunity for cure as enunciated in the
individual state statute. More often than not, it will not
be difficult for your client to comply with applicable
franchise relationship laws, but once a termination has
taken effect without compliance with these laws, there is
little defense to the action, and your client can be held
liable for damages caused by its failure to comply.
In some cases, you can help your client avoid application of
the franchise disclosure laws by eliminating one of the
three elements of a franchise. Typically, elimination of the
use of the seller's name or advertising will take your
client out of the scope of these laws. When that is not
practical, such as when the product being sold to the public
is identified by the trademark, you may be able to limit the
fees your client receives to only the payment of a bona fide
wholesale price for a reasonable amount of goods for resale.
In many situations, the elimination of one of these elements
is not possible without drastically changing the client's
intended method of operation. In these cases, you must
recognize the issue and advise your client to comply with
the appropriate disclosure laws in order to avoid liability
for failure to make the required filings and provide the
necessary disclosures.
You must also consider the applicability of these laws
before advising clients on their right to terminate or
modify such agreements. Unfortunately, you cannot
unilaterally change these relationships after the contract
with the distributor or licensee has been signed.
Whether or not the agreement was initially offered as a
franchise or business opportunity, if the relationship falls
within the definition of a franchise under the franchise
relationship laws, then your client must comply with these
laws in terminating, modifying or even failing to renew the
agreement. (Moreover, if the elements of a franchise exist
in the relationship, then the relationship is a franchise,
notwithstanding language to the contrary in the
agreement.)
Before leaving this area, one caveat is in order. You will
also not generally be able to avoid these laws by placing a
provision in the agreement selecting the law of a state
without a franchise relationship or disclosure law to govern
the relationship. The provisions relating to the
applicability of these laws vary from state to state, but
they generally apply when the purchaser is required to
establish or maintain a place of business in the state (see
for example, Connecticut General Statutes, Title 42, Ch.
739, Sec. 41-133h (2000)), when the business is to be
located in the state (see for example, Minn. Stat. §
80C.19, Subd. 1 (2002)), or when the purchaser is a resident
of the state (see for example, Md. Code Ann., (Business
Regulation) Title 14, Sec. 14-203(a)(2)(i) (1998)).
Thus, before terminating or modifying an arrangement that
might be subject to a franchise relationship law, you must
determine whether there is a law in the state in which the
business operates, or in the state in which the franchisee
resides, in addition to the state specified in the governing
law provision of the agreement.
Understanding the broad reach of the franchise disclosure
and relationship laws is critical to protecting both you and
your client from having culpability for failing to identify
the "accidental franchise." The variety of state
laws that affect licenses and distributorships make this
area a minefield for your clients, but clearly, this is one
of those areas where an ounce of prevention is worth much
more than the cost of a cure.
Modell is a shareholder with Larkin hoffman Daly & Lindgren,
Ltd., in Mineapolis. He is on the Governing Committee of the ABA's
Forum on Franchising.
His e-mail is cmodell@larkinhoffman.com.
