The Embrace of Federal and State Laws

The New York Law Journal
October 24, 1996

IF A CLIENT'S BUSINESS activities unwittingly bring it within the embrace of federal and state franchise laws, and the attorney and the client are unaware of this fact, the client's business is in dire jeopardy -- as is the attorney's ability to defend any resulting malpractice claim.

All too often since California enacted the first franchise law in 1971, a company that is not a ''franchisor'' in the traditional sense has discovered that its way of doing business, its methods of distributing products or services or its grant of ''licenses'' of one type or another brings it within the extraordinarily broad scope of federal and state franchise laws. This ''discovery'' usually takes place in the context of a governmental investigation or prosecution, sometimes accompanied by private lawsuits by putative franchisees unhappy with the business relationship.
Most business people (and many attorneys) are oblivious that federal and state franchise laws extend beyond traditional franchisors, such as those engaged in the fast food, hotel/motel and convenience store sectors of the economy. They are unaware that franchise laws generally define the terms ''franchise'' and ''franchisor'' so broadly as to embrace innumerable businesses, business relationships, licenses and distribution methods that seem to have nothing to do with traditional franchising.
Here are some of examples:
 A radio dispatched ''upscale'' car service was a franchisor and its drivers were franchisees under the New York Franchise Act (see discussion below).1
 A one-hour photographic minilab manufacturer who furnished ''sales aids'' was a franchisor and minilab purchasers were franchisees under the Wisconsin Franchise Investment law (see discussion below).2
 An appliance manufacturer was a franchisor and one of its distributors was a franchisee under the New Jersey Franchise Practices Act (see discussion below).3
 A sports information service was a franchisor and one of its distributors was a franchisee under the New York Franchise Act.4
 An office furniture manufacturer was a franchisor and one of its dealers was a franchisee under the Missouri Franchise Law.5
 A boat manufacturer was a franchisor and one of its dealers was a franchisee under the California Franchise Relations Act.6
 A baked goods manufacturer was a franchisor and its route distributors were franchisees under the Connecticut Franchise Act.7
 The Continental Basketball Association was a franchisor and the Evansville Thunder -- a professional basketball team -- was a franchisee under the Indiana Franchise Act and the Indiana Deceptive Franchise Practices Act.8

What Is a Franchise?

The question of what constitutes a franchise has two distinct answers -- one rooted in business, the other in law.
From a business perspective, franchising is merely a system of marketing and distribution whereby a small independent businessperson (the franchisee) is granted -- for a fee -- the right to market the goods and services of another (the franchisor) in accordance with the established standards and practices of the franchisor, under its trademark and with its assistance.
From a legal perspective, the answer to ''what is a franchise?'' is embodied in federal and state franchise laws, rules and regulations. They do not provide a legal definition with total precision. As a result, many businesses not considered franchisors in the business sense are considered franchisors in the legal sense.
On the federal level, the Federal Trade Commission Franchise Rule (FTC Rule)9 governs the offer and sale of franchises. Fifteen states have laws governing the offer and sale of franchises and requiring registration and/or disclosure of franchise offerings, much as in the securities arena10. Eighteen states (including some of the registration/disclosure states) and the District of Columbia have laws governing the franchisor-franchisee relationship,11 addressing such issues as when the termination of franchise agreements is lawful, when franchise agreements must be renewed and what competition by the franchisor or another franchisee constitutes unlawful ''encroachment'' upon an existing franchised business.
Under this patchwork regulation, there is no single fixed definition of ''franchise'' and ''franchisor.''

The FTC Rule

The FTC Rule recognizes two types of continuing commercial relationships as embracing franchises. The first -- a ''product and package franchise'' -- involves three elements:
(1) The franchisee sells goods or services that meet the franchisor's quality standards (in cases where the franchisee operates under the franchisor's trademark, service mark, trade name, advertising or other commercial symbol designating the franchisor) or that are identified by the franchisor's marks;
(2) The franchisor exercises significant control over, or gives the franchisee significant assistance in, the franchisee's method of operation; and,
(3) The franchisee is required to pay $500 or more to the franchisor (or a person affiliated with the franchisor) at any time before or within six months after the business opens.
The second type of FTC Rule franchise -- a ''business opportunity venture'' -- also involves three elements:
(1) The franchisee sells goods or services that are supplied by the franchisor or a person affiliated with it;
(2) The franchisor assists the franchisee in any way with respect to securing accounts for the franchisee, or securing locations or sites for vending machines or rack displays or providing the services of a person able to do either; and,
(3) The franchisee is required to make a payment of $500 or more to the franchisor or a person affiliated with the franchisor at any time before or within six months after the business opens.
Note that the FTC Rule includes within the definition of the term ''franchise'' any relationship that is represented as being a franchise when that relationship is entered into regardless of whether, in fact, the relationship falls within the FTC Rule's definition of the term.

State Laws

State franchise laws likewise seek to define the term ''franchise'' by reflecting franchising's underlying economic realities. However, the franchise-regulating states have agreed on no one definition and, thus, the scope of coverage of each state statute must be carefully analyzed.
Most states consider a franchise to exist whenever a franchisee, in return for a franchise fee, is granted the right to sell goods or services under a marketing plan or system prescribed in substantial part by a franchisor, if the operation of the franchisee's business under that marketing plan or system is substantially associated with the franchisor's trademark, service mark or other commercial symbol.
New York's definition of a franchise contrasts sharply with that used by every other jurisdiction, where all three elements -- trademark, marketing plan and franchise fee -- must be present for a franchise to exist. In New York, either of the first two elements combined with the franchise fee component will suffice. This broader definition covers many species of licenses, distributorships and other commercial relationships not otherwise subject to franchise regulation. Attorneys must be alert to the real possibility that clients may unwittingly be franchisors under New York law even if they are not in any other franchise-regulating jurisdiction.
Not only is New York's definition of a ''franchise'' the broadest in the nation, but the New York Franchise Act is also uniquely broad in its extraterritorial reach. This statute, alone among the state franchise registration/disclosure laws, covers offers and sales of franchises consummated in, from or to New York State. In practice, this means that any company with headquarters in New York State must register with the New York Department of Law before offering or selling franchises anywhere in the world.
A minority of states apply a slightly different standard. They consider a franchise to exist whenever a franchisee, in return for a franchisee fee, is granted the right to sell goods or services using the franchisor's trademark, service mark or other commercial symbol if the franchisor and franchisee have a ''community of interest'' in the marketing of such goods or services. This substitutes the ''community of interest'' test for the majority's ''prescribed marketing plan or system'' test.
Just what a ''marketing plan or system prescribed in substantial part by the franchisor'' means has been subject to much debate. For example, over the past decade, a number of states -- including California, Illinois, Maryland and Wisconsin -- enacted regulations that, translating statutory definitions, found a prescribed marketing plan or system to exist if a franchisor merely suggested that its franchisees follow an operating program or standard operating procedure.
The economic realities of franchising are such that mere suggestions are not at all characteristic of a franchise system. To succeed, a franchise system requires strict adherence by franchisees to a franchisor's plans, specifications, procedures and methodology. What, then, is the law? Do mere suggestions make a prescribed marketing plan or system? Or is something more required?
None of the federal and state laws answers this question, for they do not define the terms ''prescribed marketing plan or system'' or ''significant control or assistance.''
The judicial and administrative rulings in this area are inconsistent. While certain state franchise regulations and the Interpretative Guides to the FTC Rule imply that mere suggestions are sufficient to satisfy the rule's ''significant control or assistance'' standard and the states' ''marketing plan or system'' criterion, other state regulations either defeat this notion or are silent on the subject.
By far the most elaborate and useful examination of the definition of a ''franchise'' is found in Release Number 3-F Revised (June 22, 1994), issued by the California Department of Corporations to provide interpretative guidance concerning the definition of a ''franchise'' under the California Franchise Investment Law (California Corporations Code, Div. 5, Parts 1-6, ß31000 et. seq.). Careful attention should be paid to the principles enunciated in Release 3-F and described below because the franchise administrators and courts of other jurisdiction are likely to adopt them when franchise definition issues arise.
While any one of the following restrictions may not amount to ''a marketing plan or system prescribed in substantial part by a franchisor,'' the release states, several such restrictions taken together may be sufficient to amount to such a plan or system:
  Prescribing or limiting resale prices.
  Restrictions on use of advertising or mail order business.
  Requiring display racks.
  Giving detailed directions and advice on operating techniques.
  Assigning an exclusive territory.
  Providing uniformity or distinctiveness of appearance.
  Limiting the sale of competitive products.
  Limiting the use of products.
  Requiring approval of advertising and signs.
  Prohibiting other activities.
  Providing training sessions.
  Use of manual.
  Providing ''trade secrets.''

Business Opportunity

In addition to the state and FTC Rule requirements described above, some states require pre-sale registration and disclosure for sales of ''business opportunities.''
Twenty-three states have business opportunity laws.12 These laws do not directly regulate franchising, but only regulate the sale of opportunities to engage in new business ventures. Since franchises are, by definition, new business ventures, though, business opportunity laws do affect franchising in many states.

Penalties for Violations

Private Rights of Action

Most state franchise and business opportunity laws permit franchisees and purchasers of business opportunities to seek one or more of the following remedies:
  Actual damages. All payments expended to acquire and implement the franchise or business opportunity; may also include damages to a franchisee's reputation and lost past and future profits and earnings.
  Injunctive relief. Prevents a franchisor from engaging (or failing to engage) in specified activities.
  Attorneys' fees. Related to litigation.
  Cost of litigation. Court costs and other administrative fees attendant to litigation.
  Treble damages. To penalize a franchisor, some states permit a court to award damages equal to three times a franchisee's actual damages.
  Rescission. Requires the franchisor to cancel the franchise agreement, relieves the franchisee from all liability under that agreement and restores the franchisee to the position he or she would have been in had the franchise agreement not been executed.
  Other damages. Punitive damages can be awarded where permitted by statute (for example, the Iowa Business Opportunity Law).

Administrators' Powers

In addition to the private rights of action, government franchise administrators possess an arsenal of powers to regulate the offer and sale of franchises under federal and state franchise laws. State business opportunity law administrators can also obtain civil and criminal relief for violations.
Several characteristics are common to all of these statutes:
Definition of Fraudulent Practices. Most franchise laws enumerate and define fraudulent and unlawful practices in the strongest of terms. In most states the following are fraudulent and unlawful practices:
 Any intentional making of an untrue statement of a material fact.
 Any intentional omission of a material fact whose absence renders another statement misleading. Any scheme or artifice to defraud.
 Any act or practice that would or does operate as a fraud or deceit.
 Any violation of franchise law or rule promulgated under it.
 Any attempt to compel waiver of any given statute's provisions.
Recordkeeping. Many state franchise registration statutes mandate that franchisors keep detailed records concerning their finances, franchise sales and expenditures of franchise fees. These records are subject to inspection at any time.
Stop Orders. Most states grant their franchise administrators the power to issue ex parte stop orders prohibiting any franchise sales activities by individuals or entities whom it is alleged are violating the franchise statute in question.
Stop orders are a franchisor's nightmare. If a franchise administrator has the power to issue a stop order, and if the administrator alleges that the franchisor has violated the franchise statute in question, then the administrator can obtain a stop order prohibiting any franchise sales activity whatsoever. What is worse, the administrator can obtain that stop order ex parte -- without giving the franchisor any notice or opportunity to be heard.
In addition, most states also grant their franchise administrators the power to order the escrow or impoundment of franchise fees where the franchisor cannot demonstrate an ability to fulfill its contractual obligations.
Broad Remedial Powers. Broad remedial powers are conferred upon state franchise administrators over and above their powers to deny registration (and thus franchise activity) in their respective states. Stop orders, injunctive relief, cease and desist mechanisms and declaratory relief provisions are to be found in the great majority of state franchise statutes.
Proceedings. The powers granted to franchise administrators to investigate franchise fraud are extremely broad. If they uncover franchise fraud, most franchise administrators can institute civil proceedings seeking restitution on behalf of those victimized by practices declared fraudulent and illegal. The administrators may seek remedies against a broad range of individuals. The state has the power, at any stage of litigation, to obtain a court-ordered receivership of any and all money or property derived by a franchisor through fraudulent or unlawful means.
Criminal Liability. Violation of state franchise laws gives rise to stiff criminal liability for each violation. While many states can punish the willful violation of their respective franchise laws with substantial fines and/or imprisonment, an equal number can impose such sanctions for the mere violation of those laws. Again, the list of persons who may bear such liability is broad.
Some examples of these criminal penalties:
 The knowing violation of the New York Franchise Act13 is a class A misdemeanor punishable by a fine up to $1,000 and/or imprisonment up to one year.
 Under the Connecticut Business Opportunity Investment Act,14 the penalties for fraud include a fine of up to $25,000 and/or a 10-year prison term.
 The violation of the Washington Franchise Investment Protection Act15 can result in a civil penalty up to $2,000 per violation. The willful violation of this law can result in a fine up to $5,000 and/or imprisonment up to 10 years.

Conclusion

The confusion over the scope of the franchise laws may get even worse. In proposed federal franchise legislation being considered by Congress,16 the term ''franchise'' is defined far more broadly than ever, to include any commercial relationship in which one party (the franchisor), in return for a fee, grants to another party (the franchisee) the right to engage in the offer or sale of goods and services either under the franchisor's mark or in accordance with its quality standards, and when the franchisor merely communicates some unspecified ''knowledge'' to the franchisee or provides the franchisee with ''significant'' assistance.
It may well be a close call whether a clients' business operations fall within the embrace of federal and state franchise and business opportunity laws. But a close call in franchising is dangerous -- it can give rise to federal and state enforcement actions, successful private lawsuits and even imprisonment. When in doubt, clients are well advised to play it safe and comply with these laws.

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Notes

(1) Aristacar Corp. v. Attorney General of New York, 143 Misc2d 551 (N.Y. Sup. Ct., N.Y. Cty. 1989).
(2) Matter of KIS Corp., Wisconsin Commissioner of Securities, File No. F-86008(E) (1986), CCH Bus. Fran. Guide Par. 8731.
(3) Cooper Distributing Co. v. Amana Refrigeration Inc., 63 F3d 262 (3d Cir. 1995).
(4) King Computer Inc. et al. v. Maschler, CCH Bus. Fran. Guide Par. 10,182, not reported in F.Supp. (SDNY 1993).
(5) American Business Interiors Inc. v. Haworth Inc., 798 F2d 1135 (8th Cir. 1986).
(6) Boat & Motor Mart v. Sea Ray Boats Inc., 825 F2d 1285 (9th Cir. 1987).
(7) Petereit v. S.B. Thomas Inc., 63 F3d 1169 (2d Cir. 1995).
(8) Continental Basketball Assn. Inc. v. Ellenstein Enterprises Inc., 1996 WL 347858 (Ind. Sup. Ct. 1996).
(9) ''Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures,'' 16 CFR Part 436.
(10) California Franchise Investment Law, California Corporations Code, Div. 5, Parts 1-6, ß31000 et. seq.; Hawaii Franchise Investment Law, Hawaii Rev. Stat., Title 26, Ch. 482E, ß482-E1 et seq.; Illinois Franchise Disclosure Act, Illinois Compiled Statutes, Ch. 815, ß705/1 et seq.; Indiana Code, Title 23, Ch. 2.5, ß1 et seq.; Ann. Code of Maryland, Business Regulation, Title 14, ß14-201 et seq.; Michigan Franchise Investment Law, Michigan Compiled Laws, Ch. 445, ß445.1501 et seq.; Minnesota Statutes, Ch. 80C, ß80C.01 et seq.; New York General Business Law, Art. 33, ß680 et seq.; North Dakota Franchise Investment Law, North Dakota Century Code Ann., Title 51, Ch. 51-19, ß51-19-01 et seq.; Oregon Revised Statutes, Title 50, Ch. 650, ß650.005 et seq.; Rhode Island Franchise and Distributorship Investment Regulations Act, General Laws of Rhode Island, Title 19, Ch. 28, ß19-28.1-1 et seq.; South Dakota Franchises for Brand-Name Goods and Services Law, South Dakota Codified Laws, Title 37, Ch. 37-5A, ß37-5A-1 et seq.; Virginia Retail Franchising Act, Virginia Code, Title 13.1, Ch. 8, ß13.1-557 et seq.; Washington Franchise Protection Act, Revised Code of Washington, Title 19, Ch. 19.100, ß19.100.010 et seq.; Wisconsin Franchise Investment Law, Wisconsin Stats., Ch. 553, ß553.01 et seq.
(11) Arkansas Franchise Practices Act, Arkansas Code Ann., Title 4, Ch. 72, ß4-72-201 et seq.; California Franchise Relations Act, California Business and Processions Code, Div. 8, Ch. 5.5, ß20000 et seq.; Connecticut General Statutes, Title 42, Ch. 739 ß42-133e et seq.; Delaware Franchise Security Law, Delaware Code Ann., Title 6, Ch. 25, et seq.; Hawaii Rev. Stat., Title 26, Ch. 482E, ß482-E6; Illinois Franchise Disclosure Act, Illinois Compiled Statutes, Ch. 815, ßß705/18-705/20; Indiana Deceptive Franchise Practices Law, Indiana Code, Title 23, Art. 2, Ch. 2.7, ß1 et seq.; Iowa Code, Title XX, Ch. 523H, ßß523H.1 et seq.; Michigan Franchise Investment Law, Michigan Compiled Laws, Ch. 445, ß445.1527; Minnesota Statutes, Ch. 80C, ß80C.14; Mississippi Code Ann., Title 75, Ch. 24, ß75-24-51 et seq.; Rev. Stat. of Missouri 1986, Ch. 407, ß407.400 et seq. and 407.420; Nebraska Franchise Practices Act, Rev. Stat. of Nebraska, Ch. 87, Art. 4, ß87-401 et seq.; New Jersey Franchise Practices Act, New Jersey Rev. Stat., Title 56, Ch. 10, ß56-10-1 et seq.; South Dakota Franchises for Brand-Name Goods and Services Law, South Dakota Codified Laws, Title 37, Ch. 37-5A, ß37-5A-51; Virginia Retail Franchising Act, Virginia Code, Title 13.1, Ch. 8, ß13.1-564; Washington Franchise Investment Protection Act, Revised Code of Washington, Title 19, Ch. 19.100, ß19.100.180 and 19.100.190; Wisconsin Fair Dealership Law, Wisconsin Statutes, Ch. 135, ß135.01 et seq.; District of Columbia Franchising Act, District of Columbia Code, Title 29, Ch. 12, ß29-1201 et seq.
(12) Alabama Seller-Assisted Marketing Plans Law, Code of Alabama, Title 8, Ch. 19, ß8-19-5(20); California Contracts for Seller Assisted Marketing Plans Law, California Civil Code, Div. 3, Part 4, Title 2.7, ßß1812.200 et seq.; Connecticut Business Opportunity Investment Act, Connecticut General Statutes, Title 36, Ch. 662a, ßß36-503 et seq.; Florida Sale of Business Opportunities Act, Florida Statutes, Ch. 559, ßß559.80 et seq.; Georgia Business Opportunity Sales Law, Off. Code of Georgia Ann., Title 10, Ch. 1, Art. 15, Part 3, ßß10-1-410 et seq.; Illinois Business Opportunity Sales Law, Illinois Compiled Statutes, Ch. 815, ß602/5 et seq.; Indiana Business Opportunity Transactions Law, Indiana Code, Title 24, , Art. 5, Ch. 8, ßß1 et seq.; Iowa Business Opportunity Promotions Law, Iowa Code, Title XX, Ch. 523B, ßß523B.1 et seq.; Kentucky Sale of Business Opportunities Law, Kentucky Rev. Stat., Title XXIX, Ch. 367, ßß367.801 et seq.; Louisiana Business Opportunity Sellers and Agents Law, Louisiana Rev. St., Title 51, Ch. 21, ßß51:1821 et seq.; Maine Regulations of the Sale of Business Opportunities Law, Maine Rev. Stat. Ann., Title 32, Ch. 69-B, ßß4691 et seq.; Maryland Business Opportunity Sales Act, Ann. Code of Maryland, Business Regulation, Title 14, ß14-101 et seq.; Michigan Business Opportunities Law incorporated into Michigan Consumer Protection Act, Michigan Compiled Laws, ßß445.901 et seq.; Nebraska Seller-Assisted Marketing Plan Law, Rev. Stat of Nebraska, Ch. 59, Art. 17, ßß59-1701 et seq.; New Hampshire Distributorship Disclosure Act, New Hampshire Rev. Stat. Ann., Title XXXI, Ch. 358-E, ßß358E:1 et seq.; North Carolina Business Opportunity Sales Law, General Statutes of North Carolina, Ch. 66, Art. 19, ßß66-94 et seq.; Ohio Business Opportunity Purchasers Protection Act, Ohio Rev. Code, Title 13, Ch. 1334, ßß1334.01 et seq.; Oklahoma Business Opportunity Sales Act, Oklahoma Statutes, Title 71, Ch. 4, ßß801 et seq.; South Dakota Business Opportunities Law, South Dakota Codified Laws, Title 47, Ch. 37-25A, ßß37-25A-1 et seq.; Texas Business Opportunity Act, Revised Civil Statutes of Texas, Title 79, Ch. 16, Art. 16.01 et seq.; Utah Business Opportunity Disclosure Act, Utah Code Ann., Title 13, Ch. 15, ßß13-15-1 et seq.; Virginia Business Opportunity Sales Act, Code of Virginia, Title 59.1, Ch. 21, ßß59.1-262 et seq.; Washington Business Opportunity Fraud Act, Revised Code of Washington, Title 19, Ch. 19.110, ßß19.110.010 et seq.
(13) See Note 10 above.
(14) See Note 12 above.
(15) See Note 10 above.
(16) HR 5232 and 5233.