Is Your Client s Distributorship A Franchise?

Transcription

1 Is Your Client s Distributorship A Franchise? by R. Scott Caulkins Properly determining whether a distributorship or other business relationship constitutes a franchise can mean the difference between the success and failure of your client s business. Afrequent stumbling block for business practitioners structuring distributorship arrangements for their clients is that business arrangements that do not look like a franchise may end up being classified as such. Due to the prevalence of franchising as a method of doing business, everyone has some understanding of what a franchise is, but that understanding often does not comport with the legal definition of a franchise. Clients who do not consider their distribution arrangement to be a franchise may be in for an unpleasant surprise when they learn from a state regulator that they are a franchise. Even seasoned business lawyers may be surprised about the broad sweep of franchise laws and regulations. Business relationships that are called distributorships, dealerships, sales agency relationships, subcontractor relationships, trademark licenses, or software licenses may, in fact, be franchises. Properly determining whether a distributorship or other business relationship constitutes a franchise can mean the difference between the success and failure of your client s business. This article provides an overview of federal and state franchise laws; an explanation of the legal elements of a franchise; and a checklist to determine if your client s business is a franchise. What difference does it make if my client s distributorship is classified as a franchise? There are extensive federal and state registration and disclosure laws pertaining to the offer and sale of a franchise. The formation of franchise relationships is regulated federally by the Federal Trade Commission. The FTC Franchise Disclosure Rule requires franchisors to make detailed disclosures in connection with the offer and sale of a franchise through an offering circular. 1 On the state level, approximately 12 states, including Virginia, have franchise laws that require the registration of a uniform offering circular (UFOC) and the delivery of a UFOC in connection with the offer or sale of a franchise. 2 These states are often referred to as registration states. Compliance with registration and disclosure requirements in registration states generally will satisfy the disclosure requirements under the FTC Franchise Rule. Non-registration states those states that do not have registration and disclosure laws must comply with the FTC Disclosure Rule. The consequence of having your client s distribution relationship classified as a franchise will not only affect the formation of the relationship, but may also influence the 18

2 A NTITRUST, FRANCHISE AND T RADE R EGULATION F EATURES parties dealings during the relationship, and the ability of the parties to terminate the relationship. About half of the states have state franchise relationship laws. These laws override contract provisions to the contrary. In Virginia, for example, it is unlawful for a franchisor to terminate a franchise without reasonable cause or to use undue influence to give up a right contained in the franchise agreement notwithstanding a contract provision to the contrary. 3 Some states require advance notice of termination, with an opportunity to cure. 4 Other states have anti-discrimination statutes prohibiting a franchisor from unfairly discriminating among its franchisees. 5 The FTC Franchise Disclosure Rule applies to disclosures at the formation stage of a franchise relationship; it is not a relationship law. However, there have been several efforts by Congress to create a federal relationship law, which may not be long in coming. 6 Failure to comply with registration and disclosure regulations in the offer or sale of a franchise, or state relationship laws, exposes the violator to serious penalties. Under Virginia law, as in other states with industry-specific laws regulating franchising, failing to register a franchise offering circular, failing to make required disclosures, or making any untrue statement of a material fact (or omitting a material fact) in connection with the offer or sale of a franchise, is unlawful. In the event of a franchise law violation under Virginia law, the franchisee may declare the franchise void, the State Corporation Commission can issue a temporary or permanent injunction against the franchisor, and any person who knowingly and willfully violates the law can be charged with a Class 4 felony. 7 Further, the State Corporation Commission may impose a penalty of up to $25,000 for each violation, and franchisees may bring a civil action to recover damages and attorney s fees. 8 What is a Franchise? Federal and state laws define franchises in several ways. The focus here is on how federal law and Virginia law define a franchise. 9 To determine whether your client s business relationship is a franchise, you must consider federal law and applicable state laws. Because distributorship relationships rarely are restricted to one state, it is important for the practitioner to carefully review the laws of each state where the business will operate. This Franchising Act, [t]he Act is designed to equalize the balance of power between franchisors and franchisees and thus is remedial. 11 Attempts to avoid the remedial impact of the law by calling the relationship a distributorship, sales agency or license which are just a few names used to disguise the identity of a franchise usually do not work. The Federal Trade Commission has adopted a three-part test for determining whether a business relationship constitutes a franchise. 12 With some variation, this test contains elements found in most statutory definitions of a franchise, including Virginia s. 13 Use of Franchisor s Mark A franchise relationship is characterized by the use of the franchisor s trademark. The trademark may be registered, but need not be for this element to be satisfied. In addition to trademarks, Virginia law lists service mark[s], trade name[s], logotype[s], advertising [and] other commercial symbol[s] of the franchisor as marks which satisfy this element. 14 Because Virginia law requires a written agreement for a franchise to exist, 15 presumably the agreement would give the distributor the right to use the mark in connection with its business. In an Informal Staff Advisory Opinion, however, the FTC said that under the FTC Disclosure Rule, the express authority to use the mark is not required; it is enough if the distributor is encouraged to use the seller s marks or to sell products that are identified with the seller s products. 16 Significant Control or Assistance The Federal Trade Commission has adopted a three-part test for determining whether a business relationship constitutes a franchise. should include not only states covered by the territory in which the distributor will operate, but also the law of the state where the franchisor is located (if different). 10 One thing is certain no matter what the definitional elements are under federal and applicable state law, the laws tend to be construed broadly by regulators and courts. As noted by the Virginia Supreme Court in reference to Virginia s Retail Under the FTC Franchise Disclosure Rule the second definitional element of a franchise is that the seller (franchisor) exercises some form of significant control or assistance over the distributor s (franchisee s) method of business operation. 17 The presence of any of the following controls may be sufficient to establish the significant control element under the FTC Disclosure Rule: site or location approval; specification of site design or appearance requirements; specified hours of operation; specified production techniques; mandated accounting practices; personnel policies and practices; promotional campaigns requiring franchisee participation or financial contribution; restrictions on customers; and location or sales area restrictions. 18 Any of the following forms of assistance by the franchisor may satisfy the significant assistance element: formal sales programs; repair or business training programs; establishing accounting systems; furnishing management, marketing or personnel advice; selecting site locations; and furnishing a detailed operating manual. 19 Under many state law definitions, the language for the significant control or assistance element parallels the definition in the Virginia Lawyer 19

3 Payments that may not be called a franchise fee, or even look like a franchise fee, may in fact be a franchise fee. relationship may be construed as a franchise fee. (An exception: the FTC says that the purchase of inventory from the franchisor at a fair market price for resale would not count. 25 ) Under Virginia law, a payment or deposit for goods, services, and training count toward the franchise fee. The only payments that do not are: the payment of a bona fide wholesale price for inventory, or the payment at fair market value for the purchase or lease of real property, fixture, equipment or supplies necessary to enter the business. 26 Many distribution, license, and sales agency agreements involve a payment of some type. Every payment that is made, no matter FTC Rule, but may be narrower or broader. 20 There are generally two categories of state definitions: the marketing plan and community of interest definitions. Virginia falls in the former category, defining this element as the grant of the right to engage in the business of offering, selling or distributing goods or services at retail under a marketing plan or system prescribed in substantial part by a franchisor. 21 While there are no Virginia cases interpreting this language, based upon decisions in other jurisdictions applying the marketing plan analysis, many of the same attributes of assistance and control sufficient under the FTC Disclosure Rule for this definitional element are considered under the marketing plan approach. 22 Many distribution and sales agency relationships involve some element of control or assistance over the distribution of a product or service. Unfortunately, there are no bright lines when the control and assistance crosses the line of a franchise. Regulators, and to a somewhat lesser degree, the courts, tend to construe definitional elements of a franchise broadly, to sweep into the regulatory framework business relationships traditionally not thought of as franchises. A client will find it difficult to maintain control over the manner in which a distributor dispenses his goods and services due to this element. Payment Element Under the FTC Franchise Rule, and some state law definitions, an element of a franchise is the payment of a franchise fee. The franchise fee threshold is a de minimis amount, and in some states there is no specified minimum threshold. 23 Under both the FTC Disclosure Rule and Virginia s Retail Franchising Act, a franchise fee is any required payment by the franchisee to the franchisor of $500 or more. 24 Because the payment element seems clear on its face, many clients desiring to establish a sales agency relationship or distribution system will attempt to structure the relationship so there is no payment of a franchise fee. The careful practitioner, however, needs to carefully examine the relationship to make sure that there are no hidden fees or indirect fees. Payments that may not be called a franchise fee, or even look like a franchise fee, may in fact be a franchise fee. Under the FTC Disclosure Rule, almost any payment made by the franchisee to the franchisor within the first six months of the Checklist of major factors to consider: The following is a sample checklist of some of the primary factors that you need to consider in assessing whether your client s business is a franchise. Trademark Usage Does your client require or permit distributor to use its trademark, service mark or other commercial symbols? Will the distributor sell products or services identified with your client s marks? Control or Assistance Does your client exercise control over: site location? site design or appearance? accounting practices/business methods? advertising? type of customers? territory? Does your client provide assistance with: establishing sales programs? training programs? establishing accounting systems? site location? management, marketing or personnel advice? operating manuals, standards and procedures manuals? Payment of franchise fee Will there be any payments by a distributor to your client? Do they exceed $500? If not, does the applicable state law have a $500 threshold? Is the payment for inventory? Is the payment the bona fide wholesale price of the inventory? Does the amount of inventory purchased by distributor exceed the amount reasonably necessary to enter the business? 20

4 A NTITRUST, FRANCHISE AND T RADE R EGULATION F EATURES what it purports to be for or what it is called, is subject to being classified as a franchise fee. Therefore, you should carefully analyze each payment that your client expects to receive or has received in determining whether the franchise fee element is present. R. Scott Caulkins is a 1982 graduate of the Marshall-Wythe School of Law at the College of William and Mary in Virginia. He is a principal in the Arlington, Virginia, law firm of Cohen, Gettings & Dunham, P.C., with a concentration in business litigation in state and federal courts, and in business transactions. Mr. Caulkins has represented franchisors and franchisees for over 15 years, preparing franchise agreements, offering circulars and franchise registrations, and in franchise litigation. He is a member of the board of governors of the Antitrust, Franchise and Trade Regulation Section of the Virginia State Bar, and co-chair of the Business Law Section of the Arlington County Bar Association. He has been a frequent speaker at CLE seminars on franchise-related topics. ENDNOTES 1 The Federal Trade Commission Franchise Disclosure Rule is found at 16 C.F.R (1979) 2 The Virginia Retail Franchising Act is found at Va. Code (1999). Virginia, like the FTC and the other states, registration has adopted the Uniform Franchise Offering Circular disclosure format promulgated by the North American Securities Administrators Association. 3 Va. Code (1972). This statute does not prohibit the parties from limiting the duration of the relationship by agreement. See Betsy-Len Motor Hotel Corp. v. Holiday Inns, Inc., 238 Va. 489, 385 S.E.2d 559 (1989). 4 For example, Maryland law requires sixty days notice and an opportunity to cure before termination. Md. Code Ann (2000). 5 See, e.g., Ind. Code Ann (Michie 1995); Haw. Rev. Stat. 482E-6 (Michie 1999) (prohibiting discrimination between franchisees in the charges offered or made for royalties, goods, services, equipment, rentals, advertising services, or in any other business dealing... ). 6 H.R. 3308, The Small Business Franchise Act of 1999 is gathering momentum. It was introduced in November 1999, and follows earlier bills which did not garner a lot of enthusiasm. The Bill has the bipartisan support of approximately 50 cosponsors. 7 Va. Code , (1999). 8 Va. Code (1999). 9 In addition to regulating franchises, many states, including Virginia (see Virginia Business Opportunities Sales Act), regulate distributor or agency relationships that may be classified as business opportunities. While Business Opportunity Acts typically are associated with the use or operation of vending machines, display racks or similar devices, the practitioner advising a client on the establishment of a distribution system or sales agency relationship is well advised to review the business opportunity statutes in the states where the business will be conducted. Business Opportunity Laws are not addressed in this article. 10 Virginia s Retail Franchising Act only applies to franchises that are to be operated in the Commonwealth of Virginia. Va. Code (1999). Therefore, the Virginia Act does not cover a franchisor that may be headquartered in Virginia if it sells franchises in other states. However, this is not true in all of the registration states. 11 Crone, II v. Richmond Newspapers, Inc., 238 Va. 248, 254, 384 S.E. 2d 77, 80 (1989). 12 See, 16 C.F.R (2000) 13 See, Virginia Retail Franchising Act, Va. Code (b) (1999). Senior Lawyers Want Members The Senior Lawyers Section of the Virginia State Bar is campaigning for new members. All members of the Virginia State Bar in good standing who are 55 years of age or older are eligible for membership. The purposes of the section are to consider and advance the interests of senior lawyers by addressing such issues as adjustment to new developments in the profession by senior lawyers who continue to practice, participation in Virginia State Bar and other activities by senior lawyers, retirement concerns and, in cooperation with other VSB sections, presenting elder law CLE programs. The benefits of membership in addition to fellowship, participation in its activities and CLE programs include receiving the section newsletter and a copy of the Senior Citizens Handbook. This is an excellent publication prepared by the VSB Young Lawyers Conference and the Senior Lawyers Section that provides up-to-date information of virtually every elder law issue and concern. Membership in the section is $15 per year. To join, call Pat Sliger, VSB liaison, at (804) She will enroll you and send you a copy of our most recent newsletter, a copy of the Senior Citizens Handbook, and a statement for your current dues. As we all know, strength lies in numbers. Bill Smith Member of the Board of Governors and Executive Committee Senior Lawyers section Virginia State Bar (757) continued on page 22 Virginia Lawyer 21

5 14 Va. Code (b)(2) (1999). 15 See, Va. Code (b) (1999). See also Crewe Auto Parts Co. v. Genuine Parts Co., No. 3:00cv292 (E.D. Va. June 2, 2000). 16 See, e.g., Permagraphics International, Inc., Bus. Franchise Guide (CCH) 6433 (Sept. 21, 1982). 17 See, 16 C.F.R (2000). 18 The Interpretive Guides Franchising and Business Opportunity Ventures Trade Regulation Rule, 44 Fed. Reg. 49,966 (1979), Bus. Franchise Guide (CCH) 6200 et. seq. 19 Id. 20 See, Ca. Corp. Code 31005(a)(1) (Deering 1999); Ind. Code Ann (a)(1) (Michie 2000); Md. Bus. Reg. Code Ann (e)(1)(i) (1999); Mich. Comp. Laws Ann (3)(a) (West 1999); N.Y. Gen. Bus. Law 681(3)(a) (Consol. 2000); N.D. Cent. Code (5)(a)(1) (1999); Or. Rev. Stat (4)(a) (1997); R.I. Gen. Laws (7)(i)(A) (2000); Wash. Rev. Code Ann (4)(a)(i) (West 2000); Wis. Stat (4)(a)(1) (1999). 21 Va. Code (b)(1) (1999). 22 See, e.g., Jerome-Duncan, Inc. v. Auto-By-Tel, L.L.C., 176 F.3d 904 (D. Mich. 1999) (holding that because the defendant exercised no control over the plaintiff in setting hours of operation, hiring, training, and firing of employees, setting sales goals, or auditing of plaintiff s books, the plaintiff was not the defendant s franchise under the Michigan Franchise Investment Law ). Under the community of interest approach, a community of interest is typically present when there is some type of continuing financial interest between the seller and the distributor with respect to the operation of the business or the resale of the seller s goods. T H I R T Y - F I R S T A N N U A L 2001 Criminal Law Seminar Recent Developments in Criminal Law and Procedure Ethical Issues in the Practice of Criminal Law Capital Discovery Federal and State Firearms Statutes Jury Issues FEBRUARY 16, 2001 Williamsburg Marriott, Kingsmill Williamsburg FEBRUARY 23, 2001 Hilton Mark Center Alexandria Video Replays in Several Locations MCLE Credits (including 1 ethics credit) Pending V I R G I N I A S T A T E B A R 23 Ca. Corp. Code 31005(a)(3) (Deering 1999); Haw. Rev. Stat. 482E-2 (1999); Ind. Code Ann (a)(3), (i) (Michie 2000); Md. Bus. Reg. Code Ann (e)(1)(iii), (g) (1999); Mich. Comp. Laws Ann (3)(c) (West 1999); Minn. Stat. 80C.01(4)(3) (Supp. 1999); Neb. Rev. Stat. Ann (1)(a), (5) (Michie 1999); N.Y. Gen. Bus. Law 681(3), (7)(Consol. 2000); N.D. Cent. Code (5)(a)(3), (6) (1999); Or. Rev. Stat (4)(c) (1997); S.D. Codified Law 37-5A-1(3) (Michie 2000); Wash. Rev. Code Ann (4)(a)(iii), (12) (West 2000); Wis. Stat (4)(a)(3), (5m) (1999) C.F.R (1979); Va. Code A(b)(3) (1999). 25 Even in this case, if a higher than fair market price is charged to the distributor for inventory or the purchase of excess amounts of inventory is required, the FTC has interpreted the inventory payment as a franchise fee. Informal Staff Advisory Op. 93-6, Bus. Franchise Guide (CCH) 6450 (June 1, 1993). 26 Va. Code A(g) (1999). Have you moved? If so, please see the VSB Membership Department s page on the Web for an address update form at 22