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WHAT MAKES A FRANCHISE?

November 11, 2016

If you are a business owner with multiple locations or you’re looking to expand your current operation to new locations, it is important to know if you’re considered a franchise or not. It does not matter what label the parties to an agreement put on a transaction (i.e., license, joint venture, dealership, consulting agreement)—if the agreement has all of the elements of a franchise, then it will be considered a franchise.

Are You A Franchise?

A business owner may encounter issues if the business is unintentionally categorized as a franchise (“accidental franchise”). This tends to come to light when a disgruntled franchisee is seeking franchise law protection by filing suit against the franchisor.

There are three main elements that are analyzed in determining whether a franchise exists. Although there are state and federal franchises (depending on how you register), and sometimes each state has its own analysis, these three elements are used throughout the individual states and at the federal level.

  1. In order for a franchise to exist, the franchisor will require the franchisee to be substantially associated with their trademark or other commercial symbol. An example of this is an agreement licensing the franchisor’s business name or symbol used in association with the goods or services of the franchisor. Additionally, something as simple as being familiar with the reputation of the franchisor/licensor will suffice to satisfy this element of finding a franchisor-franchisee relationship.
  2. Second, a franchisor-franchisee relationship is likely to be found where there is a payment made to the franchisor for a right to operate the business. This payment does not need to be labeled a “franchise fee” in order to satisfy this element. Examples of types of payments that have satisfied this element include consulting fees, training frees, and royalty payments. However, it is important to note that the Federal Trade Commission’s Franchise Rule exempts payments of less than $500 during the first six months of operations. Also exempted are payments for goods for resale, provided that the purchaser pays a bona fide wholesale price and the amount of the purchase is not more than a reasonable person would acquire for their inventory.
  3. Finally, a franchise relationship may be found when the franchisor exerts significant control over the franchisee or prescribes to them a marketing plan. The determination of “significant” control by the franchisor is a part of the analysis that is often liberally interpreted. Questions that are often analyzed in making this determination include: Does the licensor provide promotional materials? Is there an operations manual? Does the licensor provide training that must be completed to its satisfaction?

Who Regulates Franchising?

The United States Federal Trade Commission (FTC) regulates franchising along with several state agencies. Whereas the FTC rules apply everywhere in the US, a state’s franchise rules will usually only apply if (1) the offer or sale of a franchise is made in the state, (2) the franchised business will be located in the state, or (3) the franchisee is a resident of the state.

It is important to analyze the locations of potential franchisees in order to ascertain the proper jurisdiction and comply with the corresponding franchise laws.

Franchise Registration in California

Once you’ve established that your business qualifies as a franchise, it is important to follow the proper steps for registering as a franchise. For California, the steps to register as a franchise can be long and tedious. Below, we briefly touch on some of the initial information that is needed in order to register as a franchise in California. However, keep in mind that a more thorough discussion can be found on the California Department of Business Oversight (DBO) website at www.dbo.ca.gov.

The application for registration must be filed with the California DBO. There is a significant amount of mandatory information that must be disclosed in the initial application and it may take some time to gather this information – especially if you’re a smaller business. It is important to make sure all required information (listed on the DBO website) is included in the application to avoid any delays in registration.

As of October 2016, a filing fee of $675 must accompany the initial application along with a cover letter stating the full name of the applicant and the year-end date for the franchise fiscal year, among other things. There are forms requiring a disclosure of financial records for the franchise and if the franchise is not a California resident, consent for service of process is required.

One of the more detailed documents filed with the registration application is the disclosure document. Each state has its own disclosure laws. In addition to complying with state laws, an applicant may be required to comply with federal disclosure laws. The disclosure document includes information about the franchisor, the franchised business, and the franchise agreement. California is part of a group of states that have enacted laws regulating the offer and sale of franchises through the evaluation of a disclosure document.

Whether registering in a specific state or federally, it is imperative to check with the applicable law to determine the extent to which certain disclosures and information need to be made in the application.

Consequences of Not Registering

There are consequences if your business is classified as a franchise, yet not registered as one. Among the more serious penalties is a lawsuit brought by the FTC seeking an injunction against the should-be franchise. Additionally, the FTC may order a franchisor to cease and desist from further violations. Although there is no private right of action under the FTC Rule, the FTC may bring actions on behalf of franchisees and seek criminal and civil penalties. The directors and officers of a should-be franchisor may also be liable individually and personally if state statutes allow for that type of liability.

Conclusion

As discussed above, the issues surrounding franchise law are complex. Initially, reporting requirements during the application process can be a burden both on time and resources in making sure the application is complete. There can also be suffocating consequences to improperly leaving a franchise unregistered—resulting in possible civil and criminal penalties.

By Preston L. Ryan, Law Clerk

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This post is for informational purposes only, and merely recites the general rules of the road. Lots of legal rules have exceptions, however, and every case is unique.  Never rely solely on a blog post in evaluating your situation — always contact an attorney when your legal rights and obligations are on the line.

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