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Franchising is regulated at the federal level under the Franchise Rule 16 C.F.R. Part 436 (the “Franchise Rule”) and at the state level by a myriad of business opportunity and relationship laws. Some states, commonly referred to as the “registration states,” require the Franchise Disclosure Document (the “FDD”) to be filed with the state attorney general for approval. For the federal government and the non-registration states, franchising is essentially a self-regulating system where the franchisor has an obligation to comply BUT the Federal Trade Commission and the non-registration states have neither reviewed nor approved the document. The basic premise of the Franchise Rule is to protect the perceived weaker party in the relationship from the perceived stronger party and to level the information playing field.
Franchising is essentially a licensing agreement. Not all licensing agreements are franchises, but all franchises are licensing agreements. The franchisor owns (or has the rights to) a cluster of intellectual property which they license to franchisees through a franchise agreement. Many companies try to avoid the disclosure requirements of franchising by calling their business relationships “license agreements” or “distributorships.” Federal law, however, doesn’t care what the business is called and specifically defines that these business arrangements are franchise relationships if they satisfy three elements: (i) a promise to provide a trademark or other commercial symbol; (ii) a promise to exercise significant control or provide significant assistance in the operation of the business; and, (iii) require a payment of at least $500 during the first six months of operation.
Is a Distributorship a Franchise?
A typical distributorship is an agreement with a supplier of goods to sell those goods in a defined geographic area, either exclusively or non-exclusively, for a period of time. Typical distributors sell products from heavy equipment, to cars, to cell phones. For a distributorship to avoid being deemed a franchise, and thus subjected to the Franchise Rule, at least one of the above three elements must remain unsatisfied. There are a few exemptions that can protect the distributor from being deemed a franchise, which will be discussed later, such as sales governed by other federal acts or the fractional franchise exemption. If a distributorship is not covered under an exemption, the business owner will need to ensure that at least one of the three franchise elements are not met or they must comply with the Franchise Rule.
Turning to whether or not a distributor is a franchise, we need to see if all three elements described above are met. The first element in determining if a business relationship is a franchise is to determine if the distributor is using the trademark or commercial symbol of the brand. This is typically met if the distributor is selling a company’s branded or named products, which is usually the case.
The second element of control may, on the surface, seem difficult to determine; however, in most distributorship relationships, this would be easily satisfied. If a company gives marketing guidance, training, sales assistance, and/or required best practices for selling and distributing the product, many state laws and courts would consider the second element met.
This leaves us with the final element of fees paid by the distributor. This third element is what typically distinguishes a distributorship from a franchise. If a company is charging the distributor a “bona fide” wholesale price for the goods, the FTC Rule specifically exempts those payments from the required payment definition. The term “bona fide” is a term of art used by the FTC to try to bring clarity to the relationship with respect to the prices paid by distributors. The burden would typically shift to those trying to claim the business as a franchise to prove that the prices were not bona fide wholesale prices. As long as the prices remain bona fide wholesale prices and no royalties or other surcharges on revenue or profits are charged to the distributor, the relationship will fall outside the scope of the FTC rule and the company will not have to prepare a Franchise Disclosure Document or have to comply with other franchise specific relationship laws.
Additional Exemptions from the Franchise Rule
If all of the above elements are met, the company may still be exempt from the Franchise Rule under the fractional franchise exemption. Under this exemption, the distributor must have at least two years of experience in the same type of business AND the parties must reasonably anticipate the sales of the distributed products will not exceed 20% of the distributor’s total revenue in the first year of operation. Thus, a company can avoid the Franchise Rule by selling products to larger, more experienced distributors. Considering these rules are designed to protect the weaker party in the relationship, this exemption attempts to carve out those companies that are not the intended beneficiary of the Franchise Rule.
As mentioned above, the full regulatory analysis should continue into the business model to determine if the relationship is covered by other areas of the law, such as state liquor laws, the Automobile Dealer Franchise Act, or the Petroleum Marketing Practices Act. Even if the distributor is not a franchise under the Franchise Rule, there very likely may be other rules and regulations that must be followed. It should also be noted that there is no private right of action under the Franchise Rule and the federal government is unlikely to pursue an enforcement action against the distributor that arguably should have been classified as a franchise because its prices were too high. The party complaining that the business should have been classified as a franchise, who would typically be a distributor that lost money or was otherwise aggrieved, would most likely try to argue that had a Franchise Disclosure Document been given and the Franchise Rule complied, they would not have done the deal.
Determining if Your Business Model is a Distributorship
A business owner should always consult with a franchise attorney, who is experienced with the FTC rule and its interpretation, before making a final determination if their business model, or the one they are considering investing in, is indeed a distributorship. Articles such as this are meant only to be a general guideline so that the business owner can understand the basic concepts at work and the relevant regulatory framework they may be subject to. These writings should never be used as a legal opinion for your specific situation.