Beware Inadvertent Franchises

July 5, 2011, 3:14 PM

Companies expanding through opening additional outlets, not entirely owned by the company, often inadvertently fail to comply with applicable franchise laws. Franchise registration, which entails the preparation of a detailed franchise disclosure document and franchise agreement, together with other documents, can be time-consuming and expensive. Thus, we are often asked, typically by the owner of a single restaurant or retail outlet who is seeking to expand to a second outlet, whether the business owner can avoid compliance with the franchise laws, at least initially, and expand to a second or third outlet using a license agreement, a trademark license agreement, a joint venture agreement, or some other characterization of the business arrangement.

In the United States, under both federal and many states laws, a franchise has three elements: the use of a trademark, the payment of a fee, and substantial assistance to, or control over, the franchisees operations, or a marketing plan or system prescribed in substantial part by a franchisor. If these elements are met (or arguably met), you have (or could arguably have) a franchise, no matter what the arrangement is called by the "franchisor," its consultant or its counsel.

Unfortunately, many clients expanding to their second or third locations, typically with the assistance of counsel who does not specialize in franchising and distribution arrangements, will use a license, joint venture or other agreement instead of complying with the franchise disclosure laws. The consequences of such an accidental or inadvertent franchise are serious, including the possibility that the "owner" of the "licensed" location may be able to rescind, or set aside, the transaction and recover back some or all of the money paid to the "licensor." In addition, state regulators in a franchise registration state may investigate and sanction (including a cease and desist order and monetary fines) "the franchisor" and its principals for not registering as required by state franchise laws. Finally, if the company ever decides to formally franchise its operations, it will have to explain the "licensee" status of its initial units to the franchise regulators, who, at that time, may require a disclosure and offer of rescission to the initial "licensed" units.

Clients often cite competitors that license instead of franchise, in apparent contradiction to the advice given above. However, widespread use of improper license arrangements without detection, does not lessen the highly negative potential consequences of selling a franchise, without registration, as a license arrangement.

We routinely help clients properly register and disclose their franchises, and, in the unusual instances where the elements of a franchise are not present, in appropriately structuring non-franchise distribution arrangements through joint ventures or licenses. --Stephen E. Story