The Unintended Franchise: If It Quacks Like A Duck . . .

Are you operating a franchise system without realizing it? If you are licensing to others the right to use your trademark for a fee, the answer could be yes. Under both federal and some state laws, a business relationship may be a franchise — even if neither of the parties intended to create one.

At the federal level, the Federal Trade Commission (“FTC”) is the body that regulates franchising nationwide. It does so under a law known as the “Franchise Rule,” which creates a structure of regulations that governs franchises in the United States. Under the Franchise Rule, any person or corporation that sells franchises is obligated to provide its prospective franchisees with a disclosure document, known as the Franchise Disclosure Document (“FDD”). The FDD must contain disclosures pertaining to the company, its officers, the expected initial investment, fees, and other aspects of the franchise relationship.

State laws can also apply to franchises. Some of these laws require a company that wishes to sell franchises within the state to obtain approval to do so beforehand by following a registration process. Other laws will provide licensees with special benefits and protections that restrict when, and how, a licensor that sells franchises can terminate or refuse to renew a licensee, or limit his or her right to sell the business to a third party.

Both federal and state laws should concern any business that falls under the legal definition of a “franchise.”

Does It Quack?

Determining whether a franchise exists recalls the tongue-in-cheek test for determining the identity of water fowl: if it looks like a duck, walks like a duck, and quacks like a duck, it’s a duck. It is much the same for franchises. Typically, the term “franchise” refers to a continuing commercial relationship that has each of the following three elements:

  • Trademark License. The business involves the distribution of goods or services associated with the licensor’s trademark or trade name;
  • Payment of a Fee. The licensor requires payment by the licensee for the right to operate the licensee’s business; and
  • Control or Assistance. The licensor exercises significant control over, or provides significant assistance in, the licensee’s method of operation.

Some state law definitions differ, but most use the same basic framework presented above. Like the duck identification test, if all three of those elements are present in a business relationship, it will be considered a franchise regardless of the name the parties give it.

That said, determining whether a business arrangement is actually a franchise is not always easy. Many courts have struggled with the question of whether or not a business meets the franchise definition, and the results are not always consistent between states.

Duck Season: Penalties for Breaking the Law

For the licensor of an unintended franchise, both federal and state laws can present serious problems. The FTC is empowered by Congress to enforce violations of the Franchise Rule, and can issue monetary fines, issue injunctions, and freeze assets of those who violate the law.

In some ways, state franchise laws are more significant. This is both because state laws provide a set of rigorous enforcement tools for state regulators (which can include substantial monetary, and even criminal, penalties), and because they almost always permit an aggrieved licensee to sue its licensor for breaking the law (which is not the case under the Franchise Rule). Under state franchise laws, a “licensee” can often seek an award of damages that may include all of the money the licensee lost in the failed venture.

Because the costs for violating franchise laws can be so substantial and, in some circumstances, result in the destruction of the licensor’s business, it is important for business owners to be aware of and comply with these laws.

Tips for Business Owners

A business arrangement can be a franchise regardless of the parties’ intentions. If the relationship meets all of the key definitional elements, no amount of disclaimers or waivers can avoid the applicability of the Franchise Rule. As a result, business arrangements that at first glance may not appear to be franchises — like partnerships, joint ventures, leases, and distributorships — have in certain circumstances been found to meet the franchise definition.

In some cases, the Franchise Rule can be avoided from the outset if the parties carefully structure their relationship so that at least one of the elements does not apply. However, when a franchise relationship is already in existence, it is important to identify that status so that remedial measures can be taken. The consequences for doing nothing can be devastating to a business. As a result, it is a good idea for business owners to consult an attorney with experience in franchising to be certain that they are not unknowingly breaking the law.

Matthew J. Kreutzer is a partner with Armstrong Teasdale, and serves as Chair of the firm’s Franchise, Distribution and Antitrust practice group.