DETERMINING WHETHER YOUR PROGRAM MEETS THE FEDERAL DEFINITION OF A FRANCHISE
By Andrew J. Sherman, Esq.

Every year, hundreds of growing companies develop an expansion plan which might include the establishment of a series of interdependent relationships in a new distribution channel. There remains some confusion, however, as to how and when to determine whether your expansion plans would be classified as a "franchise" under applicable federal laws. A critical focus is on whether your plans fall within the definition of a "franchise" under the Federal Trade Commission Rule 436 (the "FTC Rule" or the "Rule"), requiring your company to adhere to the other provisions of the Rule. It is also critical to check state definitions, which may vary, and which will be addressed in a future article.

The FTC Rule requires those business arrangements falling within the definition of a franchise under the Rule to provide prospective franchisees with specific disclosures of material facts regarding the franchisor entity and key aspects of the business arrangement. In addition, the Rule dictates the timing of the disclosure of these matters and prohibits the disclosure of other matters, such as earnings and cost information, except in a prescribed format. Failure of a franchisor to comply with the FTC Rule is considered an "unfair and deceptive trade practice" under Section 5 of the Federal Trade Commission Act and may lead to stiff civil penalties.

Fifteen states have enacted similar franchise disclosure laws and 13 have taken the extra step of requiring some form of registration prior to offering the franchises in their state. Failure to comply with these laws may lead to civil or criminal penalties, as well as the possible private right of action by a harmed franchisee or prospective franchisee. The definition of a franchise under these state laws may differ from the FTC Rule definition. The typical deviations involve the threshold franchise fee and trademark licensing requirements. For purposes of this article, however, we are only addressing the FTC Rule definition.

Definition of a Franchise

The term "franchise" is defined in Section 436.2(d) of the FTC Rule. There are three key components to this definition, (1) the franchisee's goods and/or services are to be offered and sold under the franchisor's trademarks; (2) the franchisee is required to make a minimum $500 payment to the franchisor; and (3) the franchisor exercises significant control of, or provides significant assistance to the franchisee's method of operation. Each of these components is outlined below.

1. Trademark. This element is satisfied when the franchisee is given the right to distribute goods or services which will be "substantially associated" with the franchisor's trademark or service mark.

    

2. Required Payment. This element is met if a franchisee is required to pay the franchisor at least $500 as a condition of obtaining the franchise or of commencing operations. Payments made at any time prior to, or within six months after commencing operations will be aggregated to determine if the $500 threshold is met. The payments may be required by the franchise agreement, an ancillary agreement between the parties or by practical necessity (such as required supplies that are only available from the franchisor).

    

3. Significant Control and Assistance. The key to this element is that the control or assistance must be "significant." According to the Final Guides to the Franchising and Business Opportunities Ventures Trade Regulation Rule (the "FTC Guidelines"), published by the Federal Trade Commission, the term significant "relates to the degree to which the franchisee is dependent upon the franchisor's superior business expertise."

FTC Guidelines

The FTC Guidelines state that the dependence on the business expertise of the franchisor may be conveyed by the franchisor's controls over the franchisee's methods of operation or by the franchisor furnishing assistance to the franchisee in areas related to methods of operations. The presence of any one of the following types of control or assistance may suggest the existence of "significant control or assistance" sufficient to satisfy this prong of the definition of a franchise:

The FTC does recognize that certain controls should not be considered. For instance, because your expansion plan may consist of a trademark license, your company must include certain controls in its license agreement to monitor a participant's use of the mark under the Lanham Act. This baseline level of quality control over the use of the trademark would probably fall short of the types of controls contemplated by this third element, depending on the specific quality control provisions. The controls under your expansion plan may include the requirement that the mark be displayed in a certain manner. Because this control is designed solely to protect your company's trademark ownership rights under trademark law, the Final Guides suggest that they will not be used by the FTC as factors in determining whether your company exercises "significant control and assistance."

Conclusion and Recommendation

If your proposed program or expansion strategy satisfies these three elements, then it is strongly recommended that you work with qualified counsel to begin the preparation of the offering documents and agreements. If your program falls within the grey area, it is probably wise to go ahead and prepare the offering documents or seek an opinion of counsel that the documents are not necessary. This is a very complex and potentially confusing area of law, so proceed with caution and best of luck!

For more information, feel free to contact the author, Andrew J. Sherman, Chairman of the Franchising, Licensing and Distribution Department at Katten Muchin & Zavis and author of seven books on business growth and franchising at asherman@kmz.com (email), (202) 625-3790 (phone), or (202) 298-7570 (fax).