Franchising is a business method that provides
franchisees with ownership of their own business, together with
guidance and stability of being in a larger enterprise. It lets
franchisors increase the number of outlets, with capital, locations
and workers paid for by others. Franchisees benefit from the
franchisor's experience, cost savings from collective purchases of
inventory and advertising, and association with an established brand.
In exchange, franchisees pay fees to a franchisor, typically royalties
based on a percentage of franchisee sales.
Franchising has grown dramatically. Today, more
than 4,000 franchise systems operate in the United States, employing
more than 8 million people at tens of thousands of locations,
accounting for more than one-third of all retail sales. With
franchising's growth, regulation has increased. An FTC rule requires
presale disclosures and a cooling off period before a franchise may be
sold. (16 C.F.R. Secs. 436.1 et seq.) California and 16 other states
have franchise registration laws. As a result, lawyers have more
occasions to advise on franchise law compliance and on legal disputes
involving franchised businesses.
The nature of a franchise
Franchises are business relationships in which
three basic elements are present. 1. One company (the franchisor)
grants another (the franchisee) the right to offer or sell goods or
services using a marketing plan or system provided by the franchisor.
2. The franchisee's business operates in substantial association
with a trademark of the franchisor. 3. In exchange, the franchisee
pays the franchisor a fee. (Corps. Code §31005.)
The Marketing Plan A typical franchise
arrangement involves control by a franchisor over a franchisee's
choice of location, goods and services that the franchisee sells,
operating hours, accounting practices and advertising. The marketing
plan element may be present if the franchisor provides training, or
helps a franchisee in management and marketing; if the franchisee
receives an exclusive marketing territory, if the franchisor provides
advertising, or if the system has procedures for inspection by or
reporting to the franchisor on the business.
The Department of Corporations, which regulates
franchises in California (Corps. Code §§31004; 31211), views almost
any form of business assistance as potentially satisfying the
marketing plan element. (Comm. Op. 3-F (June 22, 1994, revision).)
However, an agreement imposing only procedures that are customary in
the particular business is not a marketing plan for franchise law
purposes. Thus, for example, obligations to exert best efforts, to
increase sales, or to obtain insurance coverage for a business, by
themselves, will not establish a marketing plan.
Trademark Element The trademark element is
satisfied when a franchisee operates in substantial association with
the franchisor's brand name. Typically, a franchisee promotes the
brand to the public. But this element may be present when a franchisee
has a right to use a mark, even if it is not presented to customers.
(Kim v. Servosnax 10 C.A.4th 1346 (1992).)
Franchise Fee A franchise fee potentially
includes any charge that a franchisee must pay for the right to enter
into a franchise arrangement. Typical are royalties, rents or payments
for training, advertising, promotion materials, supplies or other
services. Purchases from third parties in which a franchisor receives
revenue can also be a franchise fee. Under the federal rule, the
franchise fee element is satisfied by required payments to a
franchisor totaling $500 or more up until the franchisee has operated
for six months. (16 C.F.R. §§436.2(a)(2); 436.2(a)(3)(iii).)
However, under the federal and California laws, a franchise fee does
not include purchases of goods at bona fide wholesale prices if the
franchisee was not required to buy more than a reasonable business
person would normally buy for inventory.
Registration and pre-sale disclosure
The FTC's franchise rule and many states'
franchise laws emphasize pre-sale disclosure. They try to ensure that
prospective franchisees receive detailed information so they can make
informed decisions whether to invest in a franchise being offered, and
to prohibit sales of franchises when it is likely that the
franchisor's promises will not be met. (Corps. Code §31001.)
The required pre-sale disclosures are 22
categories of information covering the franchisor's business
background, litigation history, all payments to the franchisor, an
estimate of the franchisee's investment, territory granted to the
franchisee, training and other help that the franchisor promises to
provide, and the terms of renewal and termination.
When a franchisor wants to tell franchisees how
much they can earn, the claim must have a reasonable basis and be
supported by substantiation. These disclosures are made in a
prospectus, called a "Uniform Franchise Offering Circular" or "UFOC."
Whereas the FTC rule only mandates disclosure
(the FTC does not "register" franchises), California and several
other states require franchisors to register before they may offer a
franchise in the state. (Corps. Code §31110.) Franchisors must comply
with both the federal and applicable state franchise laws.
Registration in California requires filing an application with the
Department of Corporations, which includes the proposed UFOC.
Registration may be granted after examination of the ap-plication and
possible revision to ad-dress comments from the examiner.
Registrations normally last one year. (Corps.
Code §31120.) To continue selling franchises, the franchisor must
renew the registration annually, and update the UFOC whenever there is
any material change to its information, which could be sooner or more
often than once per year. The department has authority to deny,
suspend or revoke a registration on finding that the offer or sale of
the franchise would involve misrepresentation, deceit or fraud to
purchasers. (Corps. Code §31115.)
Some franchisors qualify for exemptions from
registration. These franchisors need not register. California has
exemptions for experienced franchisors whose net worth exceeds $5
million if they conducted the business or have 25 franchisees; a
franchisee's sale of their own franchise; franchises to be both
owned and located outside the state; and franchises sold to a
franchisee who meets criteria establishing prior experience in the
business. (Corps. Code §§31101; 31102; 31105; 31106; 31108.) Many
exemptions require filing a public notice of reliance on the
exemption. (Corps. Code §§31101, 31106, 31108.) Because the
state's exemptions do not always parallel those of the FTC, a
franchisor exempt from state requirements may still need to satisfy
federal pre-sale disclosure rules. This means a UFOC must still be
presented to prospective franchisee.
A franchisor must provide the offering prospectus
and copies of all proposed contracts at the first face-to-face meeting
to discuss the possible sale of a franchise, or at least 10 business
days before the franchisee signs any agreement or makes any payment
regarding the franchise, whichever is the earliest. (16 C.F.R. §§436.1(a);
436.2(g); 436.2(o); Corps. Code §31119.) The structure of the law
means a franchisee will always have a cooling off period of at least
10 business days.
Regulation of the ongoing franchise
California, like a number of states, also
restricts a franchisor from terminating a franchise before its term
ends, or from refusing to renew an expiring franchise agreement. (Bus.
& Prof. Code §§20020; 20025.) These laws protect franchisees
against losing their substantial investments unless the franchisor has
"good cause" for its action. (Bus. & Prof. Code §20020.)
Good cause means a franchisee's failure to
comply with a lawful requirement of the franchise agreement after
notice and an opportunity to cure. (Bus. & Prof. Code §20020.) A
number of other statutory events can also be good cause, such as a
franchisee's abandonment of the business, an uncured violation of
the law, repeated noncompliance with the agreement (even if prior
incidents were cured) or operating in a way that threatens public
health or safety. (Bus. & Prof. Code §20021.)
California also protects spouses and other heirs
of a franchisee against forfeiture due to death of the franchisee. The
Franchise Relations Act mandates that if a franchisee dies, the spouse
and other heirs must be given an opportunity to participate in
ownership of the franchise before the franchisor can use the death as
grounds for termination. (Bus. & Prof. Code §20027.)
Some people mistakenly think if a business
relationship is called a "license" or given another name,
franchise law compliance is not needed. This is incorrect. Any
business arrangement may be a franchise if the three key elements are
present (marketing plan, trademark and franchise fee). Also, a
franchisor cannot avoid compliance by seeking a waiver from a
franchisee. An agreement purporting to waive the franchise law is
void. (Corps. Code §31512; Bus. & Prof. Code §20010.)
Transactions that deviate from traditional
franchise arrangements may still fall within the definition of a
franchise. One example is an agreement granting an exclusive right to
sell a product in a stated area. If a distributor must buy advertising
from a manufacturer or maintain an excessive inventory, the fee
element may be present.
If a manufacturer recommends marketing methods,
such as in an operating manual or product specifications, the
marketing plan may be present. The products's name or a distinctive
logo associated with the product may satisfy the trademark element. If
all three elements are present, the arrangement would be subject to
federal and state franchise laws. See e.g., Gentis v. Safeguard
Systems 61 C.A..4th 886 (1998).
Unknowingly entering into a franchise arrangement
creates unexpected risks and costs for all parties. Anyone who sells a
franchise in violation of the registration and prospectus delivery
requirements is liable to a franchisee for damages (Corps. Code §§31300;
31301), and for willful violations, a franchise may rescind the
agreement (Corps. Code §§31300; 31301.) There is also exposure to
civil and potentially criminal penalties. People v. Gonda 138 Cal.
App. 3d 774 (1982) (felony conviction under Franchise Investment Law).
If a relationship is a franchise, the franchisor
cannot terminate it except in compliance with the franchise
relationship laws. (Bus. & Prof. Code §§20000; 20020; 20021.)
The franchisor may even be compelled to renew the agreement if the
franchisee wants. (Bus. & Prof. Code §20025.)
The FTC Franchise Rule has no private right of
action that can be asserted by a franchisee against a franchisor. (See
e.g. Morrison v. Back Yard Burgers, Inc. 91 F.3d 1184, 1187 (8th Cir.
1996).) However, civil and criminal sanctions are available in an
action by the FTC against a franchisor, including substantial monetary
penalties and the ability to require refunds of money, return of
property to a franchisee or payment of damages.
David Gurnick is a partner with Arter & Hadden LLP in Woodland
Hills, where his practice emphasizes franchise law, antitrust and
unfair competition, trademarks and copyrights and software technology.