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The Accidental Franchise: All Franchises are Licenses

Accidental Franchisor Risks

Michael Seid, Managing Director, MSA Worldwide

Too often in our practice at MSA Worldwide, clients will present to us a set of facts that their lawyers have determined is a license, but in reality is a franchise. Often it’s because of a common notion that unless the licensee’s business is identified by the franchisor’s marks the trademark element of the FTC definition is not triggered. Sometimes the economic business structure of the relationship triggers a fee being in place, and many times the controls imposed by the licensor over the franchisee’s use of the marks cross over the grey line of what is needed to protect a licensor’s goodwill and extend into the additional controls most often found in a franchise relationship.

Even where the determination of whether a business relationship is a license or a franchise avoids triggering the FTC Rules definition, the definition of a franchise in the United States is not uniform. Many states have defined franchising differently from the FTC. Therefore, which state the license originates from or where the licensee is located can trigger an inadvertent franchise relationship in some states.

Let’s first look at some of the elements of the federal definition for a franchise.

Trademark

The first element of the definition of a franchise under the FTC Rules is the use of a franchisor’s trademark by the licensee. The rule states that:

“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.”

Many people forget the word “or” that is included in this first element of the franchise definition and. because of the FTC’s inclusion of the word “or,” the trademark element is not difficult to trigger. The franchisee’s business does not need to be identified by the franchisor’s brand in order for a license to have been granted – as is often mistakenly believed.

Certainly, licensing the brand as the identifier of the franchisee’s business to consumers, like that found in Business Format or Traditional franchise systems (McDonald’s, Supercuts, Lawn Doctor) is the most easy to understand. However, using the phrase “a member of the 123 group” or merely granting the right to sell or use the brand’s marks in advertising, even if the use is not required, also constitutes a license. So under the FTC definition, when Home Depot sells Ralph Lauren brand paint, a license has been established. But simply meeting the license element of the FTC’s definition is insufficient for Home Depot to be a franchisee of Ralph Lauren – the definition requires more.

Control

The second element of the FTC’s definition of a franchise is the control over the franchisee’s method of doing business; but again, you can’t ignore the word “or” that the FTC has included, nor the word “significant” in their definition. In understanding how much control or assistance triggers a franchise, you need to come to a resolution of what the word “significant” means. Merely having some control or providing some assistance does not necessarily trigger element number two. But care needs to be taken on how the license is written and how the relationship is executed.

“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.”

Trademarks are intended, in part, to protect consumers as a symbol of quality and source and, therefore, the licensor has an obligation to control the quality of the products and services associated with its marks. The ability of a licensor to license and retain ownership over its intellectual property in the United States flows from a law passed by Congress in 1947 called the Lanham (Trademark) Act. Under the law, should a licensor fail to control the use of its intellectual property by its licensees, the licensor risks the loss of their intellectual property as the license could be deemed a “naked license” under the law. So, the FTC’s second element is not looking at whether or not the licensor is exercising controls over the use of its intellectual property, since that is required for every licensor. The second element is triggered when that routine and necessary control is elevated to “significant” control. So when does control morph into significant control?

Likely the most important issue to remember about the FTC’s second element is that it is focused on the licensee’s “method of operation.” So, if you are licensing your brand to a paint manufacturing company, you can be involved in the development of the colors of the paint; inspect the labels used on the paint cans; verify that the advertising for the paint is using your mark correctly; and even visit the plant that manufactures the paint to ensure that your quality standards are being met. Since the licensor is not exercising any significant control or providing any significant assistance to the licensee in their methods of operations (product manufacturing methods, defining how the licensee markets the products to retailers and consumers, dictating how and where the licensee warehouses or distributes the products to its customers, defines the vehicles and equipment used, the hours of operations or their business, their personnel standards), nor providing the licensee with any other requirements on how they operate their business, you have a license – the “significant” control or assistance element of the FTC’s definition will not be a factor.

Payment of a Fee

It is highly unlikely that the licensee will not be sending some amount of payment to the licensor as part of their financial arrangement. And, the payment does not merely need to be in the form of an upfront or continuing fee (whether or not the fee is based on the licensee’s sales) to trigger the third element of the FTC’s definition. What constitutes a fee under the FTC Rule is quite broad:

“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.”

The payment of fee element is triggered by the licensor requiring payments from the licensee including, but not limited to, initial fees, continuing fees, advertising, training, required purchases of furniture, fixtures and equipment, mandated levels of inventory above wholesale pricing, and rebates received by the licensor from suppliers based on purchases made by the licensee. While some of these payments might not trigger the fee element under certain circumstances, care needs to be taken when requiring any of these payments in a license agreement, if you are looking to avoid becoming a franchisor.

One exception to the FTC’s definition of a fee is the purchase of inventory from the licensor at bona fide wholesale prices. However, care needs to be taken, as dealers may challenge whether the price is a bona fide wholesale price and instead includes a hidden fee. Also, if the licensee is required to purchase a minimum amount of inventory that exceeds what is reasonably required for their business, this can also potentially trigger the fee element. For companies that do not manufacture or sell products to licensees, it is difficult to avoid the fee element of the FTC’s definition.

Differing State Definitions

As noted above, the definition of a franchise is not universal in the United States. In some states the elements of a franchise included in the federal definition are not included (fee) and in others, additional or alternative language is included in the definitions included in some of the state’s legislation, such as a marketing plan, prescribed system, or community of interest. Likely the most debated definitional element has been the meaning of the term “community of interest,” as every license includes some common interest in the selling of the licensor’s products or services by licensees. However, a proper discussion of the various state definitions – including community of interest – will require extensive analysis, and I will address that debate in a subsequent article. The definition of a franchise may seem broad at an initial glance, and many companies that choose to establish a franchise system and meet the regulatory requirements and costs, may not have needed to do so. Conversely, franchising can cover a host of relationships that on the surface you would not expect to be considered franchising, and this is especially true given the differences in the laws in some states and how they vary between the states and the federal government. It is essential that businesses consult with qualified advisors in franchising that can view the totality of the intended relationship and assist you in making the right decision. Finally, in our practice we often find clients that, due to the mistaken belief that franchising imposes substantial additional costs, regulatory involvement or risk, begin to change their business model to avoid becoming a franchisor. Invariably, the changes they need to make in their strategy to avoid franchising so distorts their intended approach to their downstream distribution strategy that their companies suffer unnecessarily. There may be significant benefits to establishing a franchise system that include additional revenues and improved brand controls that may not be available if employing other methods. Making the right business decision should be the driving factor in any business strategy, and avoiding becoming a franchisor should rarely be a material factor to be considered.