Franchising 101

What is a Franchise?

What do I have to do to Comply with the Franchise Laws?

Why Should I Comply with the Franchise Laws?

What is a franchise?

Clients often tell their attorneys “I’m only going to do a license.  I don’t want to do a franchise.”  Although a client may believe what he says, he’s most likely drawing a conclusion that disregards the facts or the law.

A “franchise” is defined differently under the federal franchise rule from how it is defined under state laws.  The definition of a “franchise” also varies from state to state.  Under the federal rule, if all of the following elements are present, then the business relationship constitutes a franchise:

• The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark
• The franchisor has the right to exert significant control over the franchisee’s business or to provide significant assistance in the franchisee’s business
• The franchisee makes a required payment to the franchisor

If all three elements are present, the business relationship constitutes a franchise. The parties cannot agree that it is not a franchise. The franchisee cannot waive his rights under the franchise laws. If it walks like a duck and talks like a duck, it’s a duck.

After I explain the three requisite elements to a client, we typically discuss restructuring the business relationship in various ways to avoid application of the franchise laws.  What if we eliminate the trademark license?  What if there is no significant control or assistance?  What if there is no required payment?  Typically, none of those alternatives is acceptable because the resulting relationship does not satisfy the client’s objectives.

What do I have to do to comply with the franchise laws?

The purpose of the franchise disclosure laws is to provide key information to the prospective franchisee so that he can make an informed decision whether to buy a franchise.

Under the federal rule, the franchisor must give the prospective franchisee a Franchise Disclosure Document (FDD) containing the key information. The key information falls into two categories:

• Information about the franchisor and the franchise system, such as what business the franchisee will actually be conducting, the biographical, litigation and bankruptcy background of the franchisor’s management team and the financial condition of the franchisor
  A plain-English summary of the key provisions of the Franchise Agreement, such as what the franchisor will be providing for the franchisee (such as inventory and training), the fees the franchisee must pay to the franchisor and what the franchisee must buy from the franchisor or suppliers
  The FDD also contains the Franchise Agreement and all of the other agreements that franchisees must sign in connection with becoming a franchisee.
• The franchisor may not accept any signed documents or any money until at least 14 days have passed since he received the FDD.
  In addition to complying with the franchise disclosure laws, franchisors must not make misrepresentations or commit fraud in connection with their franchise offerings. If the franchisor desires to sell franchises in certain states, the franchisor may need to register its franchise offering with state regulators. In addition, franchisors may need to comply with other legal requirements relating to their relationships with franchisees.

Why should I comply with the franchise laws?

Compliance with the federal rule is not as difficult or burdensome as potential franchisors fear and offers certain advantages.  First, regardless of whether the franchisor acknowledges that the business relationship is a franchise, the franchisor should have a solid agreement that clearly states the parties’ respective rights and obligations and protects the franchisor’s interests.  Second, business relationships that do not comply with the federal rule frequently constitute business opportunities, which are perceived to be less legitimate than franchises and must comply with the federal business opportunity rule and a patchwork of state business opportunity laws.

The failure to comply with the federal rule and state franchise laws may subject the franchisor and its management team to severe penalties.  Courts have penalized franchisors through rescission (unwinding the deal and requiring the franchisor to pay to the franchisee the amount of his lost investment) and imposed significant civil fines and monetary damages on franchisors as well as their principals. The failure to comply with applicable franchise laws and rules can also result in the imposition of criminal penalties.
In addition, failure to comply with applicable franchise laws and rules reflects poorly on the franchisor, as the franchisee rightfully questions whether the franchisor, in addition to disregarding its legal obligations, will disregard its contractual obligations or otherwise cut corners in business.

In addition, failure to comply with applicable franchise laws and rules reflects poorly on the franchisor, as the franchisee rightfully questions whether the franchisor, in addition to disregarding its legal obligations, will disregard its contractual obligations or otherwise cut corners in business.

© Susan E. Wells PLLC 2021 • This article may be considered advertising under applicable state laws. • This article is intended for informational purposes only and does not constitute legal advice or establish and attorney/client relationship.