Ignorance is not Bliss:The Danger of "Hidden" Franchises

Franchising is used in a wide variety of business arrangements in over 70 different business sectors--from employment agencies to quick service restaurants to telecommunications services. As such, franchises assume many different forms. Frequently, new business arrangements are developed that meet the definitional elements of a franchise without being labeled as such. Whether the franchise label is intentionally or unintentionally avoided, matters little. In either case, federal and state law can be quite unforgiving. This article discusses some of the primary issues presented by "hidden" and "cloaked" franchises and the flawed decision logic that often leads to their existence.

Potential Franchises
The Federal Trade Commission (the "FTC") has promulgated a trade regulation rule on franchising which governs all franchise offerings in the United States. See Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures, 16 C.F.R. ยง 436.1(a)(20) (1998) (the "FTC Rule" or the "Rule"). The FTC Rule defines a franchise as a continuing commercial relationship which has each of three elements: (1) trademark usage, (2) "significant control or assistance" by the franchisor, and (3) a required payment. An arrangement is a "franchise" for the purposes of the FTC Rule if it satisfies each of these definitions, regardless of what the parties to the relationship choose to call it. Additionally, many states have also enacted laws with respect to franchising. In doing so, various states have adopted their own definitions of a franchise, which are materially different than the definition provided under the FTC Rule.

Given the diversity of modern economic activity, there are many types of business arrangements that may constitute a "franchise" under the various federal and state definitions. While most people can identify traditional "business format" franchises, especially those bearing famous brands, other franchises can be more difficult to detect. Some of the business arrangements that may warrant further analysis from a franchise perspective include: (1) licenses, including trademark, patent and software licenses; (2) distributor, dealer or sales agent agreements; (3) joint ventures, limited partnerships and business networks; and (4) co-branding relationships.

Why does it matter if a proposed relationship or structure is a franchise? It matters because the law treats the franchise relationship differently than most other contractual relationships. Purchasers of a franchise may be granted broader legal rights than the seller intends, and failure to comply with the franchise laws can subject a company to significant legal liability.

If a business arrangement is determined to be a franchise under the FTC Rule, a franchisor must provide a disclosure document to a prospective purchaser prior to selling a franchise to the prospect. Failure to comply with these requirements has been determined to be an "unfair and deceptive" trade practice under Section 5 of the FTC Act, and can subject the franchisor to enforcement proceedings by the FTC. The FTC is empowered by the FTC Act to impose fines and to recover monies on behalf of aggrieved franchisees as consumer redress. The FTC may also require that the franchisor offer the aggrieved franchisees the opportunity to rescind their franchise agreements. Moreover, numerous states have enacted franchise sales and relationship laws, and deceptive or unfair trade practices laws, that provide a private right of action, often with treble damage exposure, for a franchisor's violation of applicable state statutes.

Discomfort with the Franchise Label
All things considered, franchising is a relatively new method of doing business. As a result, many companies have not been comfortable enough to embrace "franchising." Other companies attempt to avoid franchising because of perceived delays, costs and limitations.

Given the franchise regulatory environment, some companies perceive that compliance with franchise registration and disclosure laws is a barrier to their business development and profitability. However, while the initial cost of complying with franchise registration and disclosure laws is not insubstantial for most start-up companies, federal and state registration and disclosure laws apply regardless of whether the parties intended to create a franchise relationship or whether the parties term their relationship a "franchise." Moreover, knowing that the penalties for non-compliance are high, most companies, when confronted with the reality that they are franchising notwithstanding the label they place on their business relationship, make the appropriate business/legal decision to comply fully with all applicable franchise registration and disclosure laws.

Other companies attempt to avoid franchise terminology based upon the mistaken belief that their ability to terminate their "licensee" or "distributor" (or to decline to renew that "licensee" or "distributor" when the current term expires) will be impaired if their "licensee" or "distributor" is called a "franchisee." The reality, however, is that applicable franchise relationship and termination laws apply regardless of whether the parties intended to create a franchise relationship or the parties' relationship is called a franchise. As such, even though its agreements are not called "franchise agreements" and its franchisees are called "licensees," "distributors," or "independent contractors," a company's distribution relationships with third-parties will be deemed to be a franchise if the definitional requirements of a franchise are met. In such instances, the third parties will be entitled to the protections of any applicable franchise relationship and termination laws.

Attempting to Restructure the Relationship
Because of the perceived burden of complying with the franchise sales laws and the limitations placed on franchisors under the franchise relationship laws, often a potential franchisor may seek to organize its business relationships so as to avoid the application of the "franchise" label. It is important to note that, because the federal government and several states regulate franchising, a would-be franchisor should carefully evaluate the potential application of each definition. Under any franchise definition, a business arrangement is not a franchise unless it meets each of the elements of the definition. Therefore, if a potential franchisor can craft the relationship in a way that eliminates any one element, it can avoid the application of the law.

In some limited instances, it is feasible to modify the proposed relationship to avoid the franchise designation and still attain the company's goals. More often, however, the difficulties in developing a practical structure that adequately addresses the requirements of multiple laws make the compliance with the franchise laws the most cost-effective method of achieving the company's business goals while avoiding unnecessary legal liability. Finally, it should be noted that even where a franchisor attempts to eliminate an element of a "franchise," the modified relationship may fall within the definition of a "business opportunity" under one or more state statutes.

Raising the Franchise Banner
Today, judges, jurors, regulators and customers generally understand franchising as a method of doing business. 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. By fully embracing the franchise model, companies engaged in alternative methods of distribution can enjoy the legal benefits and certainty of "franchise law" in a more substantial and predictable manner.

It also appears that the intuitive reaction of courts and regulators to certain alternative, "non-franchise" arrangements (i.e., systems using "licensing," "independent contractor" and "operator" terminology) is to assume that the purported "non-franchise" company is attempting to circumvent applicable labor, employment and tax laws by cloaking its "employees" as "independent contractors." In other words, by avoiding the "franchise" label, companies can actually create otherwise avoidable labor, employment and tax disputes. The adoption of "franchise" terminology will eliminate the confusion caused by "non-franchise" terminology, which often serves as a red flag for certain courts and regulators with respect to labor, employment and tax issues.

Finally, regardless of the listener, the adoption of a clearly enumerated "franchise" program can help to increase the clarity of a company's messages regarding corporate purpose and available business and employment opportunities. Rather than attempting to offer an explanation why an opportunity does not constitute a franchise, a company is able to explain clearly and assertively what opportunity is being offered in terms that the public has grown to know and understand. Furthermore, the adoption of a franchise program may assist a company in attracting and retaining qualified franchise and employment candidates.

One of the key appeals of franchising to business executives is that it allows for rapid expansion with little capital expenditure and minimal legal exposure. Yet cost and potential liability are precisely the issues that cause many executives to shy away from the franchise model. In fact, it is frequently simpler to comply with the franchise laws than to change one's business systems to avoid compliance. Moreover, the day has arrived where there are actual legal and regulatory benefits for raising proudly the franchise banner.