A Ticking Time-Bomb: the Accidental Franchise

Could your license agreement actually be considered a franchise agreement? A license agreement that qualifies as a franchise agreement can have devastating effects on your business venture. In short, everyone you have done business with is entitled to rescind their transaction and you could face potential felony charges.

The Federal Trade Commission’s (“FTC”) “Disclosure Requirements and Prohibitions Concerning Franchising,” provides the legal definition of franchise. A franchise is any ongoing commercial relationship or understanding, whatever it may be called, in which the terms of the offer or agreement specify, or the franchise seller promises, orally or in writing, that:

  1. the franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services or merchandise that are identified or associated with the franchisor’s trademark;
  2. the franchisor will exercise or have authority to exercise a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and
  3. as a condition of obtaining or commencing operating of their franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate within the first six months.

Determining if the relationship is a franchise begins with examining if the FTC franchise Rule is met.

Identification with the Franchisor’s Trademark

Although a franchisee may not operate under the name of the franchisor this element can be satisfied by other means. If the franchisee identifies its business by another name but uses a symbol, slogan, or other indicator that affiliates it with a network, the element is met. If the business sells goods or services with a trademark, the trademark element is met. See Wright-Moore Corp. v. Richo Corp., 908 F.2d 128 (7th Cir. 1990).

In Minnesota, if an alleged franchisee has the right to use the franchisor’s advertising or other commercial symbol the element is met. Minn. Stat. § 80C.01, subd. A4(a)(i). Even a simple trademark license agreement meets the first element.

Payment of a Franchise Fee

Nearly any upfront payment can constitute a franchise fee, whether it is for a turnkey package or the right to do business. The Minnesota Franchises Act defines a franchise fee as any fee or charge including, but not limited to:

  1. a payment either as a single payment or in installments of any initial capital investment fee;
  2. any fee or charges based upon a percentage of goods or net sales whether or not called royalties;
  3. any payment for goods or services; or
  4. any training fees or training schools fee or charge.

Fees paid to the alleged franchisor generally suggest a franchise; however, one exception is the purchase or lease, at fair market value, or real property. The most typical exception is for the purchase of goods or agreement to buy goods at a true price. Retailers that sell trademarked products usually do not pay anything for the right to sell those goods, instead, they pay only the true wholesale price of the resale goods. According to Schultz v. Onan Corp., 737 F.2d 339 (3d Cir. 1984), fees incurred to attend training and money paid to acquire a distributorship from a predecessor were not franchise fees since they were payments to a third party.

Most attempts on the part of dealers to argue the prices of goods represented an indirect franchise fee have failed. In Coyne’s and Co., Inc. v. Enesco, LLC, 565 F.Supp.2d. 1027, goods marked up 30-50% over the manufacturer’s cost of products did not constitute a hidden franchise fee but was a reasonable wholesale markup allowed to the manufacturer on the sale of products.

Control or Assistance

The third element in determining if an organization qualifies as a franchise is the extent of control or assistance on the part of the alleged franchisor. Operations manuals, training programs, and sales support are enough to meet this element. Anytime an entrepreneur has a licenses agreement that includes the provision of assistance in connection with operations and promotions, this element is met.

However, not every licensing arrangement creates a franchise. For example, a license from the Minnesota Vikings to a clothing manufacturer to produce products bearing the Vikings name and logo would not constitute a franchise, if the Vikings do not provide significant assistance in the operation of the manufacturer’s business or in sale of the products. Not even quality-assurance or ordinary trademark controls rise to a sufficient level of control.

Minnesota does not include “assistance or control” in the definition of a franchise; rather, Minnesota’s third element refers to a “community of interest” between the franchisor and franchisee. Martin v. Vanderbilt, 269 N.W.2d 868 (Minn. 1978). In Martin, the defendant received a percentage of the funds of each loan that was placed through its consultants. The Minnesota Supreme Court held a community of interest existed due to the fact the parties shared in fees from a common source.

The relationship will also pass the Minnesota test when the dealer purchases products for resale from the seller. In Unlimited Horizon Marketing, Inc. Precision Hub, Inc., 533 N.W.2d 63 (Minn. App. 1995), a distributor purchased equipment for resale from a manufacturer. The court found that there was a community of interest between the parties because they would both profit from a common source upon the marketing and sale of the equipment.

If the relationship establishes a franchise, then the franchise must register in Minnesota, and it must, under federal law, provide a franchise disclosure document to prospective franchisees at least 14 days before signing any agreement or accepting any payment. If a franchisor fails to comply with these laws, it is liable to the franchisee for damages or rescission, in addition to attorneys’ fee. Also, a majority of these laws have provisions for fines and categorize the sale of an unregistered franchise as either a gross misdemeanor or a felony. Thus, it is critical that manufacturers, licensors, and other potential franchisors recognize this issue before the establishment of the relationship.

Written by Andrew Hunstad, law clerk.