Franchising: A Venus Flytrap for Trademark Licensors

Your client gives you a call to let you know that his company just licensed its primary mark to a third party who will sell your client's products on the West Coast, including California and Arizona. Should you be happy for your client, or should a chill go up your spine? To answer these questions, you will need some additional factual information and a little knowledge about the laws of franchising. You (and your client) should be concerned that your client may unwittingly have just sold a franchise and become what is known in the franchise community as an “accidental franchisor.” Needless to say, this is not good news. Falling into this Venus Flytrap is easy to do, and can have severe negative consequences for your client.

Since the early 1970s, franchising has become a highly regulated means of distribution in two areas ' first, in the area of franchise sales; and second, in how the franchisor must behave once a franchise relationship has been established ' particularly in the areas of franchise terminations, non-renewals, franchise transfers, and in restricting franchisees in their rights to associate with other franchisees.

Federal and State Regulation

Franchise sales are regulated at the federal and state levels, with the federal regulation being contained in the Federal Trade Commission's Franchise Disclosure Rule. In addition, some 14 states have statutes and regulations that require the franchisor to register its franchises before they can be offered for sale in their jurisdictions. In the area of franchise relationships, the federal government has generally stayed away from regulation, while quite a few states (perhaps 17) have statutes restricting the franchisor's behavior. See, e.g., Rupert Barkoff and Andrew Selden, Fundamentals of Franchising, Chapters 3 and 4 (3d. ed. 2009).

There is another set of laws, known as the “Business Opportunities Laws,” that may regulate your client's ability to enter into license agreements. Subject to some wide exceptions, most franchises may be categorized as business opportunities. Matthew E. Moloshok, Business Opportunities Laws: A Mouse That Roars, Part II Business Opportunity Litigation: Issues and Strategies, 11th Annual ABA Forum on Franchising, Tab 4 (1988).

Does a 'Franchise' Exist?

But before being subject to this regulation, a “franchise” must exist. The FTC Rule and each state's franchise sales and relationship law have defined this term, and while there are differences among these definitions, generally a franchise relationship will exist if three tests are met:

1. There must be a trademark association between the licensor and the licensee. The association need not be a trademark license agreement for this relationship to be created, but most of the time that will be the case. Almost by definition, every trademark license agreement will meet this condition.
2. The licensee must pay the licensor or an affiliate of the licensor a “fee.” “Fee” is broadly defined and generally includes an upfront lump sum, a continuing royalty payment, a training fee, a marketing fee, or oftentimes sums paid to purchase equipment or inventory. In almost every trademark license agreement, there will be some payment that will meet the fee test. But for a payment to be considered a franchise fee, it must fit precisely within the statutory definition. See Vitkauskas v. State Farm Mut. Auto. Ins. Co., 157 Ill. App. 3d 317, 109 Ill. Dec. 373, 379, 509 N.E.2d 1385, 1391 (1987). Generally, payments for inventory sold at a bona fide wholesale are not considered franchise fee payments. See Premier Wine & Spirits of S. D. Inc. v E. & J. Gallo Winery, 644 F. Supp. 1431 (E.D. Cal. 1986), aff'd, 846 F.2d 537 (9th Cir. 1988).
3. The licensor must either give the licensee substantial assistance or impose significant control over the licensee.

It should be plainly obvious at this point that almost all trademark license agreements have two-thirds of the requisites to make the franchise regulatory scheme applicable to that agreement. The trademark association test and fee test will almost always be present. It is the third test, what is commonly referred to as the “control” test, where most trademark license agreements fall short as qualifying as franchise agreements, and thus avoid being subject to the regulatory scheme described above. How is the “control” test met? It depends.

Courts and government officials generally agree that certain traditional trademark rights given to a licensor are essential for the licensor to protect its trademark. These rights, which include the right to set quality standards and to police and monitor trademark usage, will, by themselves, not give a licensor the adequate level of control to make it a franchisor. On the other hand, the FTC has made it clear that contractual rights that give a licensor substantial controls over the way a licensee does business will create a franchise relationship. So will promises by the licensor to provide training, marketing, and site selection assistance, as well as restrictions on how the licensee operates its business (e.g., hours of operation, staffing recommendations, physical setups). As you can well imagine, the line in the sand is often not as clear as our clients would like.

The fact that the FTC Rule and various state laws have different definitions for a “franchise” further complicates counseling clients, as do the existence of various exemptions and exclusions under the FTC Rule and the state laws. A licensor might not be a franchisor for FTC Rule purposes, but may be a franchisor under one or more of the state sales registration laws, yet not a franchisor under that same state's franchise relationship law.

An interesting case showing how much of a quicksand pit franchise regulation can be is To-Am Equipment Co., Inc. v. Mitsubishi Caterpillar Forklift America, Inc., 152 F.3d 658 (7th Cir. 1998). This case involved a section of the Illinois state law that governs franchise relationships. When the relationship in To-Am was created, it was not a franchise because there was no “fee” paid by the putative franchisee to the putative franchisor. The only monies heading into Mitsubishi's coffers were payments for inventory, which are one of the only payments exceptions as to what will qualify as a “fee.” Thus, when the relationship was created between the plaintiff and the defendant, it was not necessary for Mitsubishi to register its offering of distributorships with the Illinois Attorney General's office as “franchises.”

However, several years later, Mitsubishi invoked its right to terminate the distributorship, doing so upon 60 days' prior written notice, as permitted under the distributorship agreement. To-Am claimed, successfully, that under the Illinois franchise statute, Mitsubishi needed “good cause” to terminate the relationship, notwithstanding the 60-day notice provision of the contract, because it was, at the time of termination, a franchisee under Illinois law and Mitsubishi did not have the requisite good cause to permit a termination. Both the trial court and the appellate court agreed with To-Am, noting that it did not matter when the franchise fee was paid. In this case, the so-called franchise fee was the consideration paid for various manuals several years into the relationship, not when the franchise was purchased. To the author's knowledge, this is the only successful case by a franchisee using this “creeping franchise fee” theory, but it demonstrates how easy it is for a licensor to cross the border into franchiseland.

Consequences

What are the consequences of having a relationship categorized as being a franchise? They can be severe if applicable laws and regulations are not followed. First, under most state sales/registration laws, the franchisee can either sue for damages, or reject the contract and ask for rescission, if the franchise was not properly registered or if proper pre-sale disclosure had not been given to the franchisee. Damage claims for unlawful sales are not that common. On the other hand, the more-common suits for rescission can have expensive outcomes. The purpose of rescission is to put the parties back to where they stood before the franchise sale was made. At a minimum, this entails refunding the franchisee's upfront fee and any royalty payments. How significant the franchisor's liability beyond that point will be is difficult to assess. Rescission in the franchise context was modeled on the securities law solution, where stock sold and the purchase price are both returned to the issuer and purchaser, respectively. Once the franchise has been opened for business, implementing rescission is a more difficult task. How do you deal with the fact that the franchisee may have purchased property or taken out loans to purchase or operate the franchise? There is no easy answer to these problems. See Dollar Rent A Car Systems, Inc. v. P.R.P. Enters., Inc., No. 01 CV 698 JHP FHM, 2006 WL 1266515 (N.D. Okla. May 08, 2006), aff'd, 242 Fed. Appx. 584 (10th Cir. 2007).

In contrast to the state franchise sales laws, under the FTC's disclosure rule there is no private right of action as such. Thus, an aggrieved franchisee cannot himself bring a claim if the FTC Rule has been violated. Only the FTC can bring such a claim. However, almost every state has a Little FTC Act which provides that a violation of an FTC Rule also constitutes a violation of that state's Little FTC Act, and, as a result, a franchisee can often backdoor a claim for breach of the FTC Rule's requirements using a Little FTC Act. Many of these acts, however, are not applicable to consumer transactions. This is the case in Georgia, in contrast to the Tennessee Little FTC Act, where franchises are specifically designated as being subject to the statute. See GA. CODE ANN. ' 10-1-393; TENN. CODE ANN. ' 47-18-104.

In addition to rescission and damages, state officials can bring civil and criminal claims resulting from franchisor violations of their franchise sales/registration laws.

Franchise Relationships

Turning to the other side of franchise regulation ' franchise relationships ' there are no federal laws or regulations that govern franchise relationships generally. Thus, there is generally nothing for the licensor client to fear here from federal officials. However, as the To-Am case demonstrates, damage claims for failing to give proper notices or otherwise unlawfully terminating or not renewing franchises can be substantial under state law. The state statutes governing franchise relationships vary considerably in scope. The focus is generally on inappropriate franchisor terminations, but many of the statutes prevent arbitrary non-renewals, prohibit certain restrictions on transfers of the franchise by the franchisee, and make unlawful restrictions on the franchisees' right to associate with each other, although none of the statutes requires a franchisor to engage in collective bargaining with its franchisees. In these circumstances, state officials do not have the power to intervene in the dispute or impose fines. Rather, it is up to the franchisee to seek recourse.

Crossing the Line

Thus, to answer the original questions: Should you be thrilled with your client's accomplishment, or should chills go up the client's lawyer's spine when he learns of the trademark licensing agreement? The answer is clearly “yes” to the latter question. Perhaps the client never intended to cross the line into franchising, but that is exactly what may have happened. Regardless of the label put on the relationship, if the three elements of a franchise are present, your client has become the accidental franchisor and must address the consequences.

Rupert M. Barkoff is a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he chairs the firm's Franchise Practice Group. He is a past Chair of the American Bar Association's Forum on Franchising, and the Co-Editor-in-Chief of Fundamentals of Franchising. He can be reached at [email protected].

Your client gives you a call to let you know that his company just licensed its primary mark to a third party who will sell your client's products on the West Coast, including California and Arizona. Should you be happy for your client, or should a chill go up your spine? To answer these questions, you will need some additional factual information and a little knowledge about the laws of franchising. You (and your client) should be concerned that your client may unwittingly have just sold a franchise and become what is known in the franchise community as an “accidental franchisor.” Needless to say, this is not good news. Falling into this Venus Flytrap is easy to do, and can have severe negative consequences for your client.

Since the early 1970s, franchising has become a highly regulated means of distribution in two areas ' first, in the area of franchise sales; and second, in how the franchisor must behave once a franchise relationship has been established ' particularly in the areas of franchise terminations, non-renewals, franchise transfers, and in restricting franchisees in their rights to associate with other franchisees.

Federal and State Regulation

Franchise sales are regulated at the federal and state levels, with the federal regulation being contained in the Federal Trade Commission's Franchise Disclosure Rule. In addition, some 14 states have statutes and regulations that require the franchisor to register its franchises before they can be offered for sale in their jurisdictions. In the area of franchise relationships, the federal government has generally stayed away from regulation, while quite a few states (perhaps 17) have statutes restricting the franchisor's behavior. See, e.g., Rupert Barkoff and Andrew Selden, Fundamentals of Franchising, Chapters 3 and 4 (3d. ed. 2009).

There is another set of laws, known as the “Business Opportunities Laws,” that may regulate your client's ability to enter into license agreements. Subject to some wide exceptions, most franchises may be categorized as business opportunities. Matthew E. Moloshok, Business Opportunities Laws: A Mouse That Roars, Part II Business Opportunity Litigation: Issues and Strategies, 11th Annual ABA Forum on Franchising, Tab 4 (1988).

Does a 'Franchise' Exist?

But before being subject to this regulation, a “franchise” must exist. The FTC Rule and each state's franchise sales and relationship law have defined this term, and while there are differences among these definitions, generally a franchise relationship will exist if three tests are met:

1. There must be a trademark association between the licensor and the licensee. The association need not be a trademark license agreement for this relationship to be created, but most of the time that will be the case. Almost by definition, every trademark license agreement will meet this condition.
2. The licensee must pay the licensor or an affiliate of the licensor a “fee.” “Fee” is broadly defined and generally includes an upfront lump sum, a continuing royalty payment, a training fee, a marketing fee, or oftentimes sums paid to purchase equipment or inventory. In almost every trademark license agreement, there will be some payment that will meet the fee test. But for a payment to be considered a franchise fee, it must fit precisely within the statutory definition. See Vitkauskas v. State Farm Mut. Auto. Ins. Co. , 157 Ill. App. 3d 317, 109 Ill. Dec. 373, 379, 509 N.E.2d 1385, 1391 (1987). Generally, payments for inventory sold at a bona fide wholesale are not considered franchise fee payments. See Premier Wine & Spirits of S. D. Inc. v E. & J. Gallo Winery, 644 F. Supp. 1431 (E.D. Cal. 1986), aff'd , 846 F.2d 537 (9th Cir. 1988).
3. The licensor must either give the licensee substantial assistance or impose significant control over the licensee.

It should be plainly obvious at this point that almost all trademark license agreements have two-thirds of the requisites to make the franchise regulatory scheme applicable to that agreement. The trademark association test and fee test will almost always be present. It is the third test, what is commonly referred to as the “control” test, where most trademark license agreements fall short as qualifying as franchise agreements, and thus avoid being subject to the regulatory scheme described above. How is the “control” test met? It depends.

Courts and government officials generally agree that certain traditional trademark rights given to a licensor are essential for the licensor to protect its trademark. These rights, which include the right to set quality standards and to police and monitor trademark usage, will, by themselves, not give a licensor the adequate level of control to make it a franchisor. On the other hand, the FTC has made it clear that contractual rights that give a licensor substantial controls over the way a licensee does business will create a franchise relationship. So will promises by the licensor to provide training, marketing, and site selection assistance, as well as restrictions on how the licensee operates its business (e.g., hours of operation, staffing recommendations, physical setups). As you can well imagine, the line in the sand is often not as clear as our clients would like.

The fact that the FTC Rule and various state laws have different definitions for a “franchise” further complicates counseling clients, as do the existence of various exemptions and exclusions under the FTC Rule and the state laws. A licensor might not be a franchisor for FTC Rule purposes, but may be a franchisor under one or more of the state sales registration laws, yet not a franchisor under that same state's franchise relationship law.

An interesting case showing how much of a quicksand pit franchise regulation can be is To-Am Equipment Co., Inc. v. Mitsubishi Caterpillar Forklift America, Inc. , 152 F.3d 658 (7th Cir. 1998). This case involved a section of the Illinois state law that governs franchise relationships. When the relationship in To-Am was created, it was not a franchise because there was no “fee” paid by the putative franchisee to the putative franchisor. The only monies heading into Mitsubishi's coffers were payments for inventory, which are one of the only payments exceptions as to what will qualify as a “fee.” Thus, when the relationship was created between the plaintiff and the defendant, it was not necessary for Mitsubishi to register its offering of distributorships with the Illinois Attorney General's office as “franchises.”

However, several years later, Mitsubishi invoked its right to terminate the distributorship, doing so upon 60 days' prior written notice, as permitted under the distributorship agreement. To-Am claimed, successfully, that under the Illinois franchise statute, Mitsubishi needed “good cause” to terminate the relationship, notwithstanding the 60-day notice provision of the contract, because it was, at the time of termination, a franchisee under Illinois law and Mitsubishi did not have the requisite good cause to permit a termination. Both the trial court and the appellate court agreed with To-Am, noting that it did not matter when the franchise fee was paid. In this case, the so-called franchise fee was the consideration paid for various manuals several years into the relationship, not when the franchise was purchased. To the author's knowledge, this is the only successful case by a franchisee using this “creeping franchise fee” theory, but it demonstrates how easy it is for a licensor to cross the border into franchiseland.

Consequences

What are the consequences of having a relationship categorized as being a franchise? They can be severe if applicable laws and regulations are not followed. First, under most state sales/registration laws, the franchisee can either sue for damages, or reject the contract and ask for rescission, if the franchise was not properly registered or if proper pre-sale disclosure had not been given to the franchisee. Damage claims for unlawful sales are not that common. On the other hand, the more-common suits for rescission can have expensive outcomes. The purpose of rescission is to put the parties back to where they stood before the franchise sale was made. At a minimum, this entails refunding the franchisee's upfront fee and any royalty payments. How significant the franchisor's liability beyond that point will be is difficult to assess. Rescission in the franchise context was modeled on the securities law solution, where stock sold and the purchase price are both returned to the issuer and purchaser, respectively. Once the franchise has been opened for business, implementing rescission is a more difficult task. How do you deal with the fact that the franchisee may have purchased property or taken out loans to purchase or operate the franchise? There is no easy answer to these problems. See Dollar Rent A Car Systems, Inc. v. P.R.P. Enters., Inc., No. 01 CV 698 JHP FHM, 2006 WL 1266515 (N.D. Okla. May 08, 2006), aff'd , 242 Fed. Appx. 584 (10th Cir. 2007).

In contrast to the state franchise sales laws, under the FTC's disclosure rule there is no private right of action as such. Thus, an aggrieved franchisee cannot himself bring a claim if the FTC Rule has been violated. Only the FTC can bring such a claim. However, almost every state has a Little FTC Act which provides that a violation of an FTC Rule also constitutes a violation of that state's Little FTC Act, and, as a result, a franchisee can often backdoor a claim for breach of the FTC Rule's requirements using a Little FTC Act. Many of these acts, however, are not applicable to consumer transactions. This is the case in Georgia, in contrast to the Tennessee Little FTC Act, where franchises are specifically designated as being subject to the statute. See GA. CODE ANN. ' 10-1-393; TENN. CODE ANN. ' 47-18-104.

In addition to rescission and damages, state officials can bring civil and criminal claims resulting from franchisor violations of their franchise sales/registration laws.

Franchise Relationships

Turning to the other side of franchise regulation ' franchise relationships ' there are no federal laws or regulations that govern franchise relationships generally. Thus, there is generally nothing for the licensor client to fear here from federal officials. However, as the To-Am case demonstrates, damage claims for failing to give proper notices or otherwise unlawfully terminating or not renewing franchises can be substantial under state law. The state statutes governing franchise relationships vary considerably in scope. The focus is generally on inappropriate franchisor terminations, but many of the statutes prevent arbitrary non-renewals, prohibit certain restrictions on transfers of the franchise by the franchisee, and make unlawful restrictions on the franchisees' right to associate with each other, although none of the statutes requires a franchisor to engage in collective bargaining with its franchisees. In these circumstances, state officials do not have the power to intervene in the dispute or impose fines. Rather, it is up to the franchisee to seek recourse.

Crossing the Line

Thus, to answer the original questions: Should you be thrilled with your client's accomplishment, or should chills go up the client's lawyer's spine when he learns of the trademark licensing agreement? The answer is clearly “yes” to the latter question. Perhaps the client never intended to cross the line into franchising, but that is exactly what may have happened. Regardless of the label put on the relationship, if the three elements of a franchise are present, your client has become the accidental franchisor and must address the consequences.

Rupert M. Barkoff is a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he chairs the firm's Franchise Practice Group. He is a past Chair of the American Bar Association's Forum on Franchising, and the Co-Editor-in-Chief of Fundamentals of Franchising. He can be reached at [email protected].