The Accidental Franchise

The applicability of state and federal franchise law to a business relationship depends on whether the relationship has all the definitional elements of a “franchise.” It is irrelevant that the parties do not call their business relationship a franchise, never intended to create a franchise relationship or have otherwise expressly disclaimed the existence of a franchise relationship. If the relationship satisfies the elements of the federal or state definition of a franchise, it is a franchise and subject to regulation.

Franchises are defined in the Federal Trade Commission (“FTC”) franchise disclosure law (the “FTC Franchise Rule”) and at the state level in various state franchise disclosure and registration laws. The FTC Franchise Rule and state franchise disclosure and registration laws regulate pre-sale franchise disclosures to be made to prospective franchisees. Similar to laws regulating the offer of securities, the franchise disclosure and registration laws require a party to make pre-sale disclosures to the prospective franchisee pursuant to a Franchise Disclosure Document to allow the prospective franchisee to make an informed investment decision.

What is a Franchise?
Under the FTC Franchise Rule, a “franchise” is “any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, 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 commodities that are identified or associated with the franchisor’s trademark;
  2. The franchisor will exert or has authority to exert 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 operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.” (16 CFR § 436.1(h)).

A relationship will fall outside the scope of regulation under the FTC Franchise Rule if one of these three prongs is eliminated. Further, a business relationship that satisfies all three definitional elements may not be regulated under the FTC Franchise Rule if the relationship satisfies an exemption or exclusion specifically described in the FTC Franchise Rule.

The FTC Franchise Rule does not preempt state franchise laws, except to the extent such state laws are inconsistent with the FTC Franchise Rule. A state law is not inconsistent with the FTC Franchise Rule if it provides prospective franchisees with equal or greater protection than that provided under federal law.  As such, relationships that resemble a franchise must be examined under the various state franchise registration, disclosure and relationship laws, which often include a broader definition of what constitutes a franchise.  The majority of the fifteen states with franchise registration and/or disclosure laws (Colorado is not among these 15 states) define a franchise as a contract or agreement between two or more parties where:

  1. the franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by the franchisor (“Marketing Plan Element”);
  2. the operation of the franchisee’s business pursuant to such plan or system is substantially associated with the franchisor’s trademark, advertising, or other commercial symbol designating the franchisor or its affiliate; and
  3. the franchisee is required to pay, directly or indirectly, a franchise fee.

The New York franchise definition materially differs from the definitions in other states because the imposition of a fee in connection with just one of the other two elements will satisfy New York’s definition of a franchise. Additionally, a minority of state franchise laws substitute a “community of interest” prong for the Marketing Plan Element of the franchise definition. The Wisconsin Supreme Court identified the following two guidelines to determine whether a community of interest exists between the parties to a business relationship: (1) the business relationship between the parties must have a “continuing financial interest,” and (2) there must be interdependence which includes a “likeness or similarity of interest in the common business” in which the parties are engaged.

Similar to the FTC Franchise Rule, a business relationship will not be subject to regulation if the franchise definition is not satisfied or an exemption is available. However, falling outside the scope of regulation under the state franchise laws can be more difficult than avoiding coverage under the FTC Franchise Rule.

Some final words of caution on the franchise definitions under federal and state law: The franchise disclosure laws are consumer protection laws that were created to combat widespread deception in the sale of business ventures. Consequently, each of the prongs under the FTC Franchise Rule and state franchise laws are interpreted broadly and can be very easy to satisfy. Although the state franchise definitions may be similar, the interpretation varies from state to state. Lastly, even if you successfully structured a business relationship to avoid the franchise definition, a change at a later date (for instance, payment of a fee) could turn the relationship into a franchise.

Does It Matter?
Franchise-related claims or issues can arise in a variety of situations, such as: (1) when the putative franchisee is disgruntled and brings an action against the other party for violation of the franchise regulations, (2) when a competitor reports your accidental franchise to state franchise regulators, (3) when a state franchise regulator independently discovers your accidental franchise as a consumer, in an advertisement, on the internet or in another manner, or (4) when you attempt to terminate a relationship which is an accidental franchise and inadvertently violate a state’s franchise relationship laws (a franchise relationship law does not exist under Colorado or federal law).

If an existing relationship is at risk of being deemed a franchise, it is important to determine whether a state franchise relationship law exists which governs the termination or renewal of your agreement. Additionally, many of these “relationship” laws prohibit franchisors from engaging in various practices, including, for example, requiring or prohibiting any change in management of the franchisee without reasonable cause and requiring the franchisee to agree to any kind of release which would relieve the franchisor from liability under applicable laws.

In addition to state franchise relationship laws, the FTC has a variety of remedies it can pursue in connection with violations of the FTC Franchise Rule. The FTC can seek injunctive relief and initiate civil actions to pursue remedies including rescission of the contract, refunds, payment of damages, or public notification of the unlawful acts. The FTC may also pursue fines in connection with such civil actions for each violation of the FTC Franchise Rule.

At the state level, franchise regulators also have broad powers to address franchise law violations. For instance, franchise regulators can pursue civil actions against those who violate franchise disclosure and registration laws and, in contrast to federal law, individuals can pursue private causes of action. Potential penalties for violating state franchise laws can include monetary fines, damages, injunctions, rescission, and termination of the entity’s right to conduct business within the state, among other significant consequences. Lastly, state franchise laws may also provide for criminal penalties for violations of state franchise law.

Overall, the network of federal and state franchise regulations (not to mention, the related case law) is complex, far-reaching, and inconsistent. Since the consequences for violations of the franchise laws can be significant, it is important to conduct a detailed analysis of the business relationship and make an informed decision.

Article originally posted in the Colorado Bar Association Newsletter. Contact Craig Knobbe with any questions or for additional guidance on franchise issues.


Craig J. Knobbe

Chair, Business Section

Craig J. Knobbe