But It Doesn't Walk or Talk Like a Duck: The Perils of the Hidden Franchise

Mitsubishi did not think its business was a franchise. Trial and appeals courts thought otherwise. The cost of this legal lesson: a $1.525 million jury verdict in favor of Mitsubishi's alleged franchisee.

In refusing to second-guess a judge's summary judgment ruling that a forklift distributor was a franchisee, the Seventh Circuit Court of Appeals observed in To-Am Equip. Co., Inc. v. Mitsubishi Caterpillar Forklift America, Inc., 152 F.3d 658, 660-61 (7th Cir. 1998) that legal terms often have specialized meanings that can surprise even a sophisticated party. The term "franchise" or its derivative "franchisee" is one of those words.

The court concluded that while we understand [Mitsubishi's] . . . concern that dealerships in Illinois are too easily categorized as statutory franchisees, that is a concern appropriately raised to either the Illinois legislature or Illinois Attorney General, not to this court. Id. at F.3d at 666.

Of Ducks and Franchises

A wide variety of business arrangements that do not look, walk or talk like a franchise have been labeled just that by the courts. Typically referred to as "hidden" or "inadvertent" franchises, they include everything from sales representatives and appliance parts distributors to cafeterias in office buildings.

The line between a pure distributorship and a license arrangement is often thin, but—as Mitsubishi learned the hard way —the consequence of crossing it can be costly indeed. This article will examine the uncertainty surrounding these legal definitions of business arrangements and offer guidance for avoiding the perils of the hidden franchise.

Sailors, Widows and Franchisees

Franchising as we know it today was unheard of until the 1960s. Starting then, and into the 1970s, franchises began popping up all over the United States. Not only did the franchise business model take off, but so did the horror stories about franchisors stealing the life savings of "mom and pop" franchisees through fraud, precipitous terminations and other unfair conduct. Some skeptics, in fact, viewed franchising as little more than a scheme to take advantage of unsophisticated investors. It was not long before franchisees began taking their place alongside widows and sailors as individuals needing special protection by legislatures. California took the lead in passing laws regulating franchising, followed closely by Minnesota and a number of other jurisdictions. Not long after, the federal government stepped in with a law of its own.

Forty years and thousands of franchises later, franchising has proven itself a legitimate method of distributing goods and services. But it remains today the same as it was in the 1970s—an industry that is regulated through a combination of disclosure and relationship laws at both the state and federal level.

At the federal level, Congress passed a law in 1979 called the "FTC Trade Regulation Rule: Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures." See 16 C.F.R. 436 (1979). The Federal Trade Commission (FTC) Rule identifies a number of disclosures that must be made by a franchisor to a prospective franchisee in a written document, ranging from the history of the franchisor to the identity of other franchisees to the details of any "earnings claim." Fortunately for the "unsuspecting franchisor," the FTC Rule does not create a private cause of action as enforcement lies with the FTC alone. The "unsuspecting franchisor" doing business in the 18 states that have enacted laws similar to the FTC Rule, however, is subject to lawsuits by franchisees. These states give franchisees the right to sue the franchisor for damages. In addition, potential franchisors are subject to significant damages in the 16 states with franchise relationship laws that punish "franchisors" for terminating franchisees without cause or failing to give proper notice and an opportunity to cure.

The Definition of a Franchise: The Devil's in the Details

As Mitsubishi learned in To-Am Equipment, franchising is not about labels and it is not about feelings. Parties to a transaction cannot waive the protections of the franchise laws. It therefore does not matter whether the parties call their relationship a "franchise," a "license," or a "distributorship," or "feel" like they are in a franchise relationship. Nor does it matter whether the licensee is big or small or otherwise needs the protection of the franchise laws. The existence of a franchise is a matter of definition, pure and simple.

Courts will find that a transaction is a "franchise" if three elements are present: (1) the grant or licensing of a right to use a trademark or trade name; (2) the payment of a "franchise fee" for the use of the mark or name; and (3) some variant of a community of interest, marketing plan, control, or assistance. See 16 C.F.R. 436.2(a)(1)-(2). The definition seems simple enough. For a company trying to avoid being declared a franchise by a court or the FTC, however, the only part of the definition which provides certain protection is the first part—the licensing of a mark or name. As long as it is not somehow permitting a third party to use a mark or name, a company is not offering a "franchise." As the FTC states in its "Interpretive Guides to Franchising and Business Opportunity Ventures Trade Regulation Rule":

The Commission does not intend to cover package or product franchises in which no mark is involved. If a mark is not necessary to a particular distribution arrangement, the supplier may avoid coverage under the rule by expressly prohibiting the use of its mark by the distributor.

Anytime a company authorizes anyone to use its mark or name and expects to control and be paid for it, that opportunity may well be the proverbial duck, regardless of how it looks, walks or talks.

The Third Element is a Given

Under the FTC Rule, the third element of a franchise is some sort of "control or assistance" on the part of the supposed franchisor. Alleged franchisors, therefore, rarely are successful in claiming that they do not offer a marketing plan or have a community of interest or somehow "control" the alleged franchisee At its simplest, any control by a franchisor over a franchisee and any assistance to a franchisee will qualify as "control" as long as the FTC believes it is "significant"—and it does not take much to be significant. Training programs, operation manuals, and establishing methods of operation all meet the test.

Some states (Minnesota, New Jersey, and Wisconsin, for example) require a "community of interest" between franchisor and franchisee. Courts applying the laws of these states rarely fail to find a community of interest in even the most basic forms of product and service distribution relationship. California requires the presence of a "marketing plan or system" before labeling a relationship a franchise, and courts there have found that oral or implied and optional or suggested plans and systems meet the test. In short, prudent companies do not count on the third element to save them from being branded a "franchisor."

It's All About the Fee

Ultimately, disputes over the existence of a franchise turn on the existence of a franchise fee. Upfront payments for a right to do business under a particular name or mark and ongoing royalty payments are obvious examples of franchise fees. But almost any payment might qualify as a franchise fee. The Interpretive Guides say that the "required payment" element of the definition of a franchise is designed "to capture all sources of revenue which the franchisee must pay to the franchisor or its affiliate for the right to associate with the franchisor and market its goods or services." Interpretive Guides, 44 Fed. Reg. 49,966-49,992 (Aug. 24, 1979). According to the FTC, a franchise fee may be found in initial franchise fees as well as those for rent, advertising assistance, required equipment and supplies—including those from third parties where the franchisor or its affiliate receives payment as a result of such purchase—training, security deposits, escrow deposits, non-refundable bookkeeping charges, promotional literature, payments for services of persons to be established in business, equipment rental, and continuing royalties on sales.

The To-Am Equipment case provides a startling illustration of how courts have construed this type of language against franchisors. The Seventh Circuit found that Mitsubishi charged a franchise fee because the forklift distributor purchased more than $500 worth of sales and service manuals over an 8-year relationship in order to satisfy the manufacturer's requirement of an adequate supply of manuals. To-Am Equip. Co., Inc., 152 F.3d at 663.

Despite the seemingly broad reach of the franchise laws, the FTC Rule and various state statutes create some exemptions from the existence of a fee. The FTC rule excludes from the definition of a franchise fee payments of less than $500 made before or within six months of the opening a business. See 16 C.F.R. 436. 2(a)(iii). A number of states have a similar exclusion, although the amount may vary. Under FTC rules and the laws of several states, monies paid for a reasonable quantity of goods at a bona fide wholesale price purchased from the "franchisor" for resale are also exempted from the definition. See Bus. Franchise Guide (CCH) ¶ 380 (citing 15 U.S.C. § 57a(g)).

A Few Safe Harbors

The FTC Rule and most states exclude a number of relationships from their definition of a franchise. For example, a business opportunity that will constitute merely a part of a company's existing business falls within the "fractional franchise" safe harbor. The FTC Rule, however, allows the exemption only when the franchisee has more than two years of prior management experience in the business represented by the franchise and where the parties anticipate that sales under the franchise will represent no more than 20% of the dollar volume of the franchisee's projected gross sales. See 16 C.F.R. 436.2(a)(i); 436.2(h). Rhode Island and Wisconsin exclude sales to purchasers with a high net worth or a high income, and several states (California and New York are the main examples) exempt sales by large franchisors from the registration requirement. Isolated sales are exempted by the FTC and a few states.

Mistakes Can Be Costly

The FTC Rule applies to franchise opportunities in each of the 50 states. Thus, a company offering an investment that qualifies as a franchise under the FTC Rule must present a prospective franchisee with an offering circular containing specific and detailed information about the franchisor and the opportunity. Although a franchisee wronged by the failure to disclose may not have a private right of action, the FTC can bring enforcement proceedings against the franchisor. In states with their own disclosure laws, a failure to disclose at all, or an incomplete or misleading disclosure, allows a franchisee to seek equitable relief and sometimes damages. In some states, the failure to make an accurate disclosure carries the additional risk of exemplary damages, criminal penalties, and fines.

Perhaps most troublesome, however, are the relationship laws adopted in various states. Some of these make it unlawful for franchisors to discriminate among franchisees, restrict the ability of franchisors to profit from the sale of goods to franchisees, and otherwise regulate the ongoing relationship between franchisor and franchisee. Almost all of these states allow franchisors to terminate only for cause before the end of the term of the agreement, and then only after providing the franchisee with notice of default and an opportunity to cure. At least two states (Wisconsin and New Jersey) make franchisee agreements "evergreen," that is, terminable only for cause without regard to their stated term. Thus, a relationship that otherwise looks terminable at will may, in fact, constitute a franchise that may not be terminated except for cause. No one knows better than Mitsubishi just how costly mischaracterization of the relationship can be.

The Moral

The prudent distributor of a product or service under a mark or name errs on the side of following the franchise laws, including the use of an offering circular. A licensor still wishing to avoid the burden of preparing an offering circular and the risk of liability under various franchise laws must exercise great caution to avoid charging a franchise fee and becoming a proverbial franchise duck.