Franchising 101

March 21, 2012

GACC Legal & Tax Newsletter

Franchising is big business. In 2007, according to the International Franchise Association, franchised businesses generated nearly 4% of GDP in the United States and employed just over 6% of the non-farm, private sector U.S. labor force. But, what is a franchise, how does it work, what are some of its advantages and disadvantages, and what regulations apply?

In its simplest terms, a franchise is the right to sell the goods or services of the franchisor within a certain territory or location, using the trademarks, trade names, marketing strategy, and operations strategy of the franchisor, with the franchisor controlling the methods by which the business is operated and promoted. The recipient of such rights, the franchisee, is obligated to pay fees to the franchisor for the use of the rights, and is obligated to adhere to the franchisor’s rules of operation. The franchisee hopes that its business will grow quickly as it benefits from the franchisor’s brand awareness, market penetration and purchasing power. The franchisor is interested in maintaining as much control as possible over the franchisee in order to protect its brand.

A “business opportunity” is slightly different from a traditional franchise in that it usually involves a simpler arrangement where the offeror of the opportunity provides the purchaser with a supply of goods in return for payment, and the purchaser then decides how to conduct and promote its business. Both franchises and business opportunities are regulated.

Beginning in 1970, when California adopted a law requiring disclosure of the franchise arrangement terms prior to the sale of a franchise, a few states began to regulate franchise sales. These efforts were followed by the issuance of the Federal Trade Commission’s (“FTC”) 1979 Franchise Disclosure Rule (“Rule”), which requires the written disclosure to prospective franchisees of certain facts regarding the franchisor and the franchise arrangements, and similar facts in the case of business opportunities, in an effort to provide prospective franchisees with enough information to make an informed decision about whether to contract with the franchisor or the owner of the business opportunity. In 1993, the North American Securities Administrators Association (“NASAA”) created the Uniform Franchise Offering Circular (“UFOC”) to help franchisors streamline the process of creating the disclosure document required by the Rule.

In addition to federal regulation, numerous states regulate franchises and business opportunities. Many of these states require franchisors to use the UFOC as the form of the disclosure document. Other states treat franchises as a “security” since they essentially involve an investment where the investor, the franchisee, is relying on the expertise of the franchisor to earn a return on the franchisee’s investment. In those states, the franchisor must file a formal registration document with the state that includes disclosures the state deems pertinent to prospective franchisees.

Only the FTC can enforce and seek penalties for violations of the Rule. However, some states allow private actions for violations of state franchise and business opportunity laws. In a recent decision, the United States Court of Appeals for the Ninth Circuit held that an out of state franchisee can sue under the franchise laws applicable in the home state of the franchisor, thus giving franchisees, especially in states that do not allow private rights of action under their franchise statute, greater opportunity to seek redress against franchisors.

In addition, there are two potential traps for the unwary franchisor, and opportunities for an aggrieved franchisee.

First, some franchisors, in an effort to avoid compliance with an applicable franchise statute, describe their franchises as license arrangements. However, whether an arrangement is a franchise or license is determined by the degree of control the franchisor exercises over the franchisee’s business operations, not by what the relationship is called. If the franchisor can effectively determine how the business operates, then the arrangement is a franchise. Second, different countries have different rules regarding the relationships of franchisors and franchisees. Many countries restrict the ability of franchisors to terminate franchisees.

Franchising offers great opportunities for franchisors to expand their brands, and for franchisees to start a business that may already have had some success. That said, careful attention must be paid to insure not only that the concerns of both parties are addressed, but that the requirements of applicable law are adhered to.