Franchise Operations Must Conform to Special Laws

Even If the Parties Believe They Are in Another Form of Business Relationship

By Barry Kurtz

Network News Second Quarter 2003

When is business enterprise a franchise operation? What’s the difference between a franchise and a licensing arrangement, a distributorship, or a dealership?

Countless numbers of entrepreneurs confuse the meaning of these terms, and because serious and potentially painful consequences can follow for companies not adhering to complex areas of both federal and state franchise law, PNG members should understand these differences when counseling their clients.

In plain English, some business relationships may in fact be franchise arrangements even if the parties intend to establish some other kind of relationship, and if they aren’t careful, they may wreck their enterprise.

Under California law, a franchise exists between the owner of an identifying trademark and the operator of a business using the trademark when:

  • The franchisee engages in offering, selling or distributing goods or services under a marketing plan or system “prescribed in substantial part” by the franchisor;
  • The franchisee’s business is “substantially associated” with the franchisor; and
  • The franchisee pays a fee to the franchisor or to an affiliated party, directly or indirectly, in order to engage in business.

The first of these conditions exists when the franchisor:

  •  Provides the franchisee with advice and training;
  • Retains significant control over the conduct of the franchisee’s business;
  • Grants the franchisee exclusive territory; or
  • Requires the franchisee to purchase or sell a specified quantity of the franchisor’s goods or services.

A simpler test determines whether the franchisee’s business is substantially associated with the franchisor: If the former uses the latter’s trademark to identify its business, it is substantially associated with it.

As for fees, they include payments made by a franchisee directly to a franchisor when signing a franchise agreement and payments made indirectly such as those for training and assistance, royalties, or inventory.

Business relationships that do not satisfy these conditions may be licensing arrangements, distributorships, dealerships, or any one of a variety of other business arrangements, but the distinctions between these arrangements and franchise operations are subtle and sometimes treacherous.

For instance, a licensing arrangement exists when an independent business operating under its own trade name undertakes to sell products manufactured by a trademark owner and pay the manufacturer a percentage of the sale proceeds. Dealerships and distributorships exist when an independent business operating under its own trade name purchases — typically at wholesale prices — and resells the products of a manufacturer or supplier, with minimal interference by the latter.

In such cases the key is not whether the business entities entering into the arrangement intend to establish a specific relationship — for example, a distributorship rather than a franchise. The key is rather whether they operate independently, even though one buys and sells goods produced by the other under a trademark.

The relationship between franchisor and franchisee, by way of contrast, is a dependent one, as evidenced by the arrangements regarding marketing, training, and the like.

In the real world of business, of course, such distinctions are not always apparent, and any business entity that grants another the use of a trademark may unwittingly stray over the line and establish a franchisor-franchisee relationship in the eyes of the law.

When this happens, the franchisor must observe many details of state law that do not apply to companies establishing licensing or other business arrangements, on pain of substantial civil, administrative, and even criminal penalties.

Franchisors must, for example, get the approval of the state Department of Corporations for any uniform franchise offering circulars they propose to use in this state, and they must give prospective franchisees at least ten business days to study the offering circular and any attendant contacts before signature.

They must also get the department’s approval for any “material modifications” they propose to make to existing agreements before presenting them to franchisees. Material modifications may include new provisions reducing or enlarging the rights or obligations of either franchisor or franchisee, including new or increased royalties or fees or rights to engage in internet commerce.

Many of these are bureaucratic burdens; the Department of Corporations seeks to police aggressive franchisors, but it typically does not withhold approval. It does require that franchisors clearly disclose the impact of any material changes so that franchisees understand them.

As you may surmise from all this, state law presumes that in the relationship between franchisor and franchisee, the former has the advantage, and it goes to great lengths to protect franchisees. It follows that companies establishing franchise operations must step carefully – a good thing for PNG members to know when advising clients who themselves may not understand the impact of their actions.

Barry Kurtz [ENC-SO] is of counsel to the law firm Greenberg & Bass L.L.P. Encino, specializing in franchise law. He ma be reached at bkurtz@barrykurtzpc.com

Network News, Copyright © 2003, All Rights Reserved.
Reprinted with permission.