Franchise, Dealership and Distribution Law

What is a Franchising?

Generally speaking, franchising is a method of distributing products or services through the use of a marketing plan or system prescribed by the franchisor and associated with a trademark or trade name owned by the franchisor. A franchisee agrees to pay initial and continuing fees for the right to conduct business under a franchise, while a franchisor agrees to provide training, assistance, and expertise.

Under the Federal Trade Commission's Franchise Rule (16 C.F.R. Part 436), a commercial business arrangement is a "franchise" if it satisfies three definitional elements. Specifically, the franchisor must: (1) promise to provide a trademark or other commercial symbol; (2) promise to exercise significant control or provide significant assistance in the operation of the business; and (3) require a minimum payment of at least $500 during the first six months of operations.

The various states' definitions of a franchise are typically similar to the FTC's as to elements (1) and (3) above but differ as element (2). Instead of "significant control or assistance" as required by the FTC, most states define a franchise in terms of a "marketing plan" or "system" prescribed by the franchisor or in terms of a "community of interest" in the marketing of goods and services.

Types of Franchises

Franchises are often characterized as either product distribution franchises or business format franchises. In a product distribution franchise, the franchisee sells products manufactured or supplied by the franchisor under the franchisor's trademark in exchange for the payment of fees and, most often, the promise to confine its sales to the products of the manufacturer or supplier. Examples of product distribution franchising are typically associated with industries such as appliances, automobile, bicycles, bottling, gasoline and ice cream.

In a business format franchise, the franchisor provides the license of its trademark by the franchisor. In addition, the franchisor typically licenses an entire business concept and exercises control over most areas of the operation. The franchisor typically provides extensive assistance and training in the operation, marketing, and promotion of the business. Operations manuals and other specifications regulate what items can be offered for sale, the quality of those items, the design and appearance of an outlet, and the condition of the outlet. Examples of business format franchises are automotive services, cleaning services, employment agencies, fast food restaurants, hotels and motels.

Franchise Regulation

Franchising is regulated both by federal and state law. At the federal level, the Federal Trade Commission ("FTC") regulates franchising through its Franchise Rule. The original Franchise Rule was promulgated in 1978 and amended in 2007. The amended Franchise Rule requires franchisors to give prospective franchisees material information by way of a franchise disclosure document ("FDD"). The Franchise Rule is designed to provide prospective purchasers of franchises the material information they need in order to weigh the risks and benefits of such an investment. The amended Franchise Rule requires franchisors to provide all potential franchisees with an FDD containing 23 specific items of information. Required disclosure topics include, for example: the franchise's litigation history, past and current franchisees and their contact information, any exclusive territory that comes with the franchise, assistance the franchisor provides franchisees, and the cost of purchasing and starting up a franchise. If a franchisor makes representations about the financial performance of the franchise, this topic also must be covered, as well as the material basis backing up those representations. While the amended Franchise Rule does require disclosure of material information by way of an FDD, it does not require the franchisor to submit the FDD for registration with the FTC.

State Registration

In addition to federal law, a number of states have laws that regulate franchising. State laws typically center on three main areas-- disclosure, registration and the franchisor-franchisee relationship. Fifteen states have developed and adopted their own statutory version of the FDD which require franchisors to provide pre-sale disclosures to prospective franchisees. The states requiring pre-sale disclosure are:

  • California
  • Hawaii
  • Illinois
  • Indiana
  • Maryland
  • Michigan
  • Minnesota
  • New York
  • North Dakota
  • Oregon
  • Rhode Island
  • South Dakota
  • Virginia
  • Washington
  • Wisconsin

Of these 15 states all except Oregon requires registration or filing of the FDD. A state's registration requirement may apply, depending on the particular state, (i) prior to making an offer for the sale of a franchise, (ii) if the franchise is to be located in the state, or (iii) if the prospective franchisee is a resident of the state.

State Relationship Laws

Relationship laws are effective once there is a sale of a franchise and, in essence, a relationship established between the franchisor and its franchisee. Typically state relationship laws regulate matters such as requiring good cause in the case of a franchise termination or non-renewal or in the event of a refusal to consent to a transfer by the franchisee. In addition, certain states may regulate matters such as prohibiting franchisees from associating with each other, imposing burdensome sourcing restrictions on franchisees and discriminating between franchisees.

Dealerships, Distributorships and Business Opportunities

Dealerships and distributorships are independent businesses that are authorized to purchase and resell the products of a manufacturer or supplier. Dealers are typically retailers, while distributors are typically middlemen within a distribution chain. Typically, dealerships and distributorships do business under their own names and receive little assistance from manufacturers or suppliers. In addition, they do not typically pay initial or continuing fees for the right to conduct business. Instead they purchase products from the manufacturer or supplier at bona fide wholesale prices. While dealerships and distributorships are not subject to general franchise laws, they may be subject to laws applicable to a single industry Examples of single industry laws include those regulating alcoholic beverages, farm machinery, motor vehicles and petroleum.

Sometimes businesses called dealerships or distributorships have the characteristics of franchises and fall within the coverage of generally applicable franchise laws. Thus, the name given by the contracting parties in describing their relationship can be of little significance. If the elements of a franchise are met then regardless of the title used to describe the relationship, a franchise relationship exists. As a consequence, all federal and state laws governing franchises must be followed.

Business Opportunities are arrangements in which a seller provides goods or services in exchange for an initial payment, enabling the buyer to start a business, and represents that (1) the buyer will earn more than the cost of the business, (2) the seller will buy back all or part of the buyer's product, (3) the seller will provide or help find locations, (4) the seller will refund the initial payment, or (5) the seller will provide a marketing or operating plan. Examples of business opportunities are rack jobbers, vending machine routes, and work at home ventures. Business opportunities are governed by the FTC Franchise Rule and state business opportunity laws.

tshaver@otslaw.com