Restaurant Law Blog

Wednesday, August 17, 2016

You may be the owner of an illegal and accidental franchise and not even know it.

Beware:  If you own more than one restaurant which operates under the same name, you may have created an illegal and unintended franchise.

This sounds crazy, but it is actually very common and the consequences of creating an unintended franchise are substantial, serious, and include the possibility of both personal and criminal liability.  Many well-intentioned operators have tried to avoid the franchise tag by referring to their business relationships and partnerships as a “license,” or a “capital investment,” but the label placed on a relationship has little bearing on whether or not the relationship constitutes a franchise.

Would the same operators have pursued a different path if they had known that their mistake could result in the rescission of every one of their business transactions and the filing of criminal charges against them? It is a felony to sell a franchise without complying with both State and Federal law, and the respective agencies have the power to shut down your restaurants, freeze your bank accounts, order restitution, prevent an operator from opening new locations, impose huge penalties, award attorney’ fees to all injured parties, and rescind every one of the offender’s agreements under claim of fraud.  And, to top it off, claiming that they relied on the advice of their attorney will not help since franchise statutes impose strict liability, meaning that an owner’s intent or knowledge of the law (or lack thereof) is irrelevant.

We all know what a franchise is when we see one, right?  McDonalds, Dunkin Donuts, etc.  But, did you know that countless other unsuspecting business relationships are actually franchises because the definition of a “franchise” is extremely broad, especially in New York.  The New York Franchise Act is unquestionably the nation's harshest franchise law, because its definition of a franchise (discussed below) is so all-encompassing that it borders on absurd.

So what exactly is a franchise?

First, there is no uniform definition of a franchise. As consumer protection statutes, franchise laws are given a sweeping scope by courts, and their subjective interpretations of these broad laws have left operators without a bright line rule upon which they can structure their business relationships. On the Federal level, franchises are governed by the Federal Trade Commission, which defines a franchise as having three elements:

1. Trademark. The grant of a right to open a business operating under (or selling goods or services in connection with) another’s trademark. Any trademark license agreement, by its very nature, meets this first element of the test since there is a trademark licensed by one party to the other.  The authority to associate with another’s trademark in offering, selling, or distributing goods or services is not only a common element of every franchise definition, but also the easiest element to meet.  Absent an express prohibition against use of a licensor’s trademark, a right to use the mark will be inferred even if the mark is never used.

2. Significant Control or Assistance.
The trademark owner has significant control of, or provides significant assistance to a licensee.  Many states refer to this element as a marketing plan, where the trademark owner governs how the trademark is to be utilized, advertised, etc. Training programs, recipes, employment and operating manuals, sales assistance, all satisfy the significant assistance aspect of this element. Significant control exists where a licensor approves or restricts the business location or sales territory, specifies design or appearance requirements, prescribes operating hours, establishes production methods or standards, restricts what a franchisee may serve, mandates personnel policies or practices, or dictates mandatory accounting practices. Under certain circumstances, any one of these factors may be enough to constitute significant control or assistance. Significant promises of assistance, even if unfulfilled, will satisfy this element.

3. Required Payment or Franchise Fee. The requirement that a minimum fee be paid (typically within six months). What qualifies as a fee not only includes the obvious license fees, royalties, training fees, and a percentage of gross sales, but arguably also includes the capital investment made by a business partner into a joint venture, and the profit the franchisor takes from the restaurant in the first six months. One notable exception to the Franchise Fee are those costs paid to a trademark owner for goods purchased at a bona fide wholesale price.  This would arguably include a licensor’s purchase of, and resale of food and beverage to a licensee at an increased (but not unreasonable) cost.

If all three elements are present, then the relationship is a franchise according to the FTC, meaning that before you can even meet face to face with a prospective purchaser or joint venture partner to discuss the details of the arrangement, you must provide a detailed and exhaustive Franchise Disclosure Document, and if you are in a state with registration requirements (such as New York) you are required to register your FDD with the state before you can approach any prospective buyers or partners.

Trying to determine whether a relationship is a franchise is made more difficult by the fact that, as mentioned earlier, the definition of a franchise is not uniform in all jurisdictions. Some franchise laws substitute a "community of interest" test for the "significant assistance" test. Others refer to the provision of a "marketing plan." Thus, whenever there is a trademark, the exchange of money, and a continuing relationship, you must proceed with caution.

It does not matter what label the parties put on a transaction or agreement: license, joint venture, consulting and supply agreement, dealership; if an arrangement has all of the elements of a franchise, it's a franchise. Scores of articles have been written about the dangers of becoming an accidental franchise. Those dangers are real, as many have learned when they face an unexpected regulatory enforcement investigation, or a lawsuit by a terminated licensee claiming the protection of franchise laws, or a major glitch in the sale of a company when the buyer's due diligence uncovers a possible unregistered franchise program. Now, before you tell yourself that these elements don’t apply to any of your relationships, read further.

In New York, the same basic definition exists but where the Federal Government (and indeed every other state) requires the existence of all three of the above elements, New York requires only two - either the name or the marketing system, combined with the fee. This broadened definition of the term "franchise" thus covers many types of licenses and other commercial relationships not previously concerned with franchise regulation.

So, how do you contract around this?  It is difficult to say the least.  Structural solutions may save some relationships from the reach of franchise laws but often come at the price of sacrificing essential economic objectives or competitive opportunities.  Some people attempt to avoid franchise regulations by not registering their trademark, but this is not necessarily a good idea, not only because you lose the protections associated with your developing brand identity, but in many states (New York included) the use of a registered trademark is not required, a logo or trade name will suffice.  Furthermore, restricting your mark’s usage limits the development of a common brand identity placing your company at a significant long-term disadvantage with your franchisor brethren.

Others attempt to avoid franchising through a “no control and no assistance” option, but that too presents several complications, not least of which is the Federal Lanham Act, which imposes an affirmative duty on licensors to control the quality and uniformity of goods and services associated with their registered trademarks. Failure to do so may result in abandonment of trademark rights.  Secondly, determining whether significant control or assistance, or a prescribed marketing plan exists is inherently subjective and, consequently, difficult to dodge in a written agreement.

The most common option to avoid franchise regulations is to avoid the payment of a fee.  Under Federal law, a franchise relationship can be avoided by deferring required payments over $500 for at least six months after the licensee begins operations. This is true even where a licensee signs a nonnegotiable, secured promissory note (with no acceleration clause) promising to pay the licensor $500 or more after six months. While this exemption offers interesting structuring opportunities for franchises sold in states without franchise laws, it has no counterpart in most states with franchise laws, including New York.

The most common type of “no fee” option is a joint venture, but that is insanely difficult in New York because there is no time restriction on the payment of fees, and as stated earlier, the trademark owner’s receipt of any profit constitutes a fee. While there are limited exceptions to what constitutes a fee, most are difficult to work with, and often frustrate the purpose of what you are trying to accomplish

In short, while structuring a license agreement in the restaurant world is feasible, it is extremely complex and often defeats the intention of a developing business.  Countless inadvertent franchises exist in New York and across the nation which have never been caught, but the risks are so significant that due consideration should be given before you enter into any new business relationship.

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