Avoid Becoming an “Accidental Franchise”

Imagine working for years to create a successful educational business. Your business centers around instructional classes, including proprietary software on customized computers. Lacking the funds and personnel to expand your business quickly, you negotiate with interested parties to use your system in return for a fee.

The strategy works. More than 100 “dealers” spread across the country three years later use the system. The company is poised to produce a steady income stream when disaster hits. A disgruntled dealer sues you for $1 million in lost profits, claiming you had misrepresented the profit potential and failed to meet the disclosure requirements of the Federal Franchise law.

My example is fictitious, but many business owners have been surprised to learn that their expansion has accidentally created a franchise network. The consequences of the mistake can cost thousands of dollars to companies and, perhaps, their owners. Unfortunately, many business owners are unaware of the risk or employ attorneys unfamiliar with the applicable franchise laws.

Ignorance of the Federal law applying to franchises – 16 CFR § 436.1 – is not an excuse for failing to follow it. Whether you intended to create a franchise relationship is not relevant. Trying to avoid the franchise tag by referring to a relationship as a “licensee, “consultant,” or “dealer” doesn’t work.

The law is not dependent on calling your business relationship a franchise or not. A specific agreement by the parties that their relationship is not a franchise doesn’t matter.

If the relationship satisfies the conditions of a franchise under Federal or State law, your business will be treated as such.

• The first condition under the Federal Trade Commission (FTC) Rule is met if you give another party the right to use your trademark. Maintaining a brand requires careful crafting to avoid the FTC’s definition of control.
• The second condition is typically the result of charging any fee or requiring payment under any conditions for using the trademark. A required payment of $500 or more before or during the first six months is prima facie evidence of payment.
• The third condition depends on the degree of help or the extent of control in the second party’s operation. Even the promise or allusion to help can trigger an adverse finding. Examples of assistance include site selection, site design, hours of operation, production techniques, accounting practices, personnel policies and practices, mandatory promotional campaigns, and location or sales area restrictions.

Many states have passed laws that complement or extend the Federal law. While Florida ranked 4th in the nation for the number of franchise locations in 2020, the state does not have a separate rule regarding franchise registration. Nevertheless, the state has a Franchise Act (F.S.§817.416) to protect investors in a franchise or dealership arrangement from false claims or misrepresentation.

Businesspeople are often confused about the differences between a licensee, a distributor, and a franchise. Nevertheless, the decision to use one depends on your needs and risk exposure.

License agreements document the use of company brands and intellectual property such as trademarks, logos, copyrights, and patents with specific terms. The property owner grants its use to another in return for a fee (“royalty”). Drafters of licenses should avoid any control or financial interest in the licensee’s operation. Popular brands like Disney and the Orlando Magic grant licenses for millions of dollars in fees independent of their licensee’s other business revenue or profits.

The similarity between distributor and franchisee confuses many because of their use of brands and logos. Manufacturers use dealers to distribute and sell their products or services to the public. Distributors typically buy products wholesale from the manufacturers and then markup the price for retail sales. Distributors do not operate under the name of the manufacturer whose products they distribute.

hey may represent multiple manufacturers and benefit from national marketing campaigns or the manufacturer’s advertising dollars. However, the manufacturer has no control or responsibility for the distributor’s operations as long as the distributor maintains the conditions of their agreement.

Manufacturers can recommend “list prices” (think automobile dealerships) but do not control the prices set by the dealers. They can offer dealers incentive sales programs or training but cannot require dealers to participate. Though sharing common interests, the manufacturer and its dealers are independent businesses.

A franchise is a network of businesses that have purchased the right to operate under an established company’s trademark, name, and proprietary processes (the franchisor).

The franchisee typically pays an initial fee and ongoing royalties to the franchisor. The franchisor generally provides marketing and training support with specific guidelines to ensure the franchisee replicates the business practices dictated by the franchisor.

The franchisor typically dictates site design and approval, product or service procedures, employee training, hours of operation, pricing, marketing promotion and advertising, décor, and the type and equipment required.

The FTC and State laws regulate the solicitation and sale of franchises. Franchisees have special legal protections beyond the remedies available to licensees and distributors. Regulators justify the added protections by the franchisee’s dependence on the franchisor’s representations (or lack thereof).

Plaintiffs claiming that a distributorship or license is a franchise network are increasing common:

• Mitsubishi Caterpillar Forklift of America v. To-Am Equipment Company. When the Mitsubishi Caterpillar Forklift of America terminated the dealership of To-Am Equipment Company, To-Am prevailed in an Illinois court with the assertion that To-Am was a franchise, not a dealer, and the judge reversed the termination.
• Charts Insurance Associates v. Nationwide Insurance Co. When Nationwide terminated its agency agreement with the small sales insurance operation, the latter sued under the Connecticut Franchise Act. The jury awarded $2.3 million to the plaintiff, finding the relationship to be a franchise under law.
• Gentis v. Safeguard Business Systems. The California Court of Appeals upheld a lower court’s ruling that Safeguard Business Systems, the parent company of manufacturer Gentis, was a franchise system.

The Florida Franchise Act allows private litigants to sue a franchisor or distributor for

• misrepresentation of the prospects or chances of success of a proposed or existing business,
• understating the known investment necessary, or
• excessive promotion of another franchisee in a defined market area.

The remedy for such misrepresentations can include the reimbursement of all invested funds, damages, and attorneys’ fees.

In accidental franchise cases, the FTC may levy fines or bring criminal charges against a party who sells a “franchise” without complying with federal laws and regulations. Other possible penalties include permanent injunctions against the business continuation and personal liabilities of company officers and franchise sales agents.