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An Introduction to Franchise Law

There are 550,000 franchised businesses located in the United States which collectively generate more than $800 billion in sales. These franchised businesses sell more than $758 billion in goods and services. Franchising represents 35% of all retail sales in the United States, employing over seven million people. One out of every twelve business establishments is a franchised business. There are over 1200 franchise companies representing eighteen different industries.

For many companies, franchising has proven truly to be a remarkable and adaptable growth vehicle. The reasons why so many companies franchise include the flexibility it offers; the potential for rapid expansion with the reduced capital resources; the greater motivation it provides to middle-managers; the potential it has as a means of acquiring and consolidating competitors' businesses; the alternative means of distribution available within it; and its use as a means of privatization.

In recognition of franchising's unique characteristics and its benefits to the overall economy, franchise systems are generally afforded a degree of understanding by courts and regulators with respect to certain labor, employment, tax and agency liability issues. Additionally, a fairly well-reasoned and predictable body of franchise law has developed to help define and frame the industry.

What is a Franchise?

A franchise is a form of licensing arrangement whereby one party licenses another to use its business system and trademark. Franchisees typically pay to the franchisor an initial franchise fee and ongoing royalty payments throughout the franchise term. In consideration for these payments, franchisors permit the franchisee to operate the franchised business under the franchisor's principal trademark and typically provide the franchisee a package of initial and ongoing assistance and training. Such assistance and training typically includes site selection assistance; loan of the franchisor's operations manuals; training; opening assistance; advertising materials; participation in buying and advertising materials; and accounting, business, and operating system assistance.

The sale of franchises is regulated at both the federal and state level. Federal law requires that franchisors give prospective franchisees a disclosure document within the "time for making disclosures" under the Federal Trade Commission's "Trade Regulation Rule: Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures," 16 C.F.R. §436 which is generally referred to as the "FTC Rule." Franchise relationships are regulated under a variety of state laws, and many aspects are also regulated by federal law.

A relationship is deemed a franchise if its meets the definitional elements of a franchise under federal and state law. The federal definition of this term is contained in the FTC Rule, which defines a franchise as any arrangement whereby the franchisor:

  • Renders significant assistance to the franchisee in operating its business or significantly controls the franchisee's method of operation;
  • Licenses the franchisee to distribute goods or services under, or operate using, the franchisor's trademark; and
  • Requires payment of a minimal fee to the franchisor.

Many states have also enacted laws with respect to franchising. In doing so, various states have adopted their own definition of a franchise which in many cases is materially different than the federal law definition of the term.

Regulation of Offers of Franchise

The FTC Rule applies in all fifty states and U.S. territories and requires that franchisors (and franchise brokers) provide to prospective franchisees a pre-sale franchise disclosure document in the form of a franchise offering circular. To satisfy the disclosure requirements under the FTC Rule, the franchisor's disclosure document may be prepared in accordance with either of two formats:

  1. the disclosure document prescribed by the FTC Rule; or
  2. the franchise offering prescribed by the Uniform Franchise Offering Circular Guidelines ("UFOC Guidelines") which were adopted by the North American Securities Administrators' Association and subsequently approved by the Federal Trade Commission.

If a particular state also regulates franchising, franchisors are required to comply in that state with both the FTC Franchise Rule and state law.

State disclosure requirements are important because several states provide a private right of action to prospective franchisees for a franchisor's violation of the state statute. In determining the states in which a franchisor may need to file registration applications, or with which state laws a franchisor may need to comply in terms of providing disclosure to a prospective franchisee, it is necessary to look to each individual state law.

Pursuant to the FTC Rule, a franchisor must provide the disclosure document to a prospective franchisee at the earliest of:

  1. the first personal meeting;
  2. ten business days before the signing of any franchise or related agreement; or
  3. ten business days before any payment.

The FTC Rule also requires that the disclosure document be kept "current." Franchisors must update the disclosure document at least once annually. The revisions must be made within ninety days after the close of the franchisor's fiscal year.

The Business Elements of a Franchise

There are two basic types of franchises used in the United States:

  1. a "business format" or "package" franchise; and
  2. a "product" franchise.

In a "business format" or "package" franchise, the franchisor licenses the franchisee to use the business system prescribed by the franchisor and associated with the franchisor's trademark. In a business format franchise, the franchisor usually furnishes significant assistance and/or a marketing plan or system to its franchisees, and requires the franchisee's strict adherence to the controls and method of operation under the franchisor's business system. McDonald's Corporation is an example of a business format franchise.

In a product franchise, the franchisee sells goods that are produced by the franchisor (or under the franchisor's control or direction) and which bear the franchisor's trademark. The product franchisor exercises significant control over the franchisee's method of operation or promises to provide a significant amount of assistance in the franchisee's method of operation. The franchisee is typically required to pay the franchisor for the right to distribute the goods. Payment may take the form of required purchases of trademarked goods or payment of an initial franchise fee. A beer distributorship or automobile dealer is an example of a product franchise.

Advantages and Disadvantages of Franchising

A principal advantage of franchising is that it frequently enables rapid expansion of a successful retail concept more quickly than through company-owned expansion. Franchisors take advantage of each franchisee's desire to be in business for himself or herself. Franchisees use their own capital and personnel -- and not those of the franchisor -- for expansion of the concept. If multiple-unit expansion is utilized, many franchisees can be developing large territories simultaneously with relatively little capital expenditure on the part of the franchisor.

The disadvantage of franchising is that approximately twenty states have laws governing at least a portion of the ongoing franchise relationship. These laws may include provisions affecting the termination and renewal rights of a franchisee, including the franchisee's right to cure a default under the franchise agreement. The laws also affect other franchise agreement provisions such as: governing law, jurisdiction and venue of litigation and arbitration, discrimination, the franchisor's right to injunctive relief, general releases upon renewal and transfer of the franchise agreement, and the franchisor's right to vary the terms of the franchise by amending the operations manual for the franchise system. The franchise relationship is also subject to Section 5 of the Federal Trade Commission Act 15 U.S.C. §45 which prohibits unfair or deceptive trade practices in commerce or competition. Many states have also enacted "Little FTC" or "Baby FTC" Acts which prohibit unfair and deceptive practices and which often provide the franchisee a private right of action against the franchisor.

Litigation is not uncommon in franchise relationships. As the relationship matures, a franchisee may become disenchanted with the franchisor as his or her need for the franchisor's services decreases. The franchisee may begin to resent what he or she perceives to be the franchisor's intrusion into the operation of the franchised business and may resent the ongoing obligation to pay royalty fees.

All things considered, franchising as we know it today dates from the early 1950's, and is a relatively new method of doing business. While many businesses are in a position benefit from franchising, a perception that franchising as a method of distribution is unnecessarily complex has prevented uninformed companies from embracing the concept as a mode of business growth.

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