United States: Dealerships And Distributorships - Beware The Franchise Minefield

Franchise laws embrace a wide variety of business distribution arrangements including many relationships that are not traditionally viewed as franchises. Even sophisticated parties often overlook their applicability and can suffer dire consequences as a result. The name given to the relationship is not controlling, and the protections afforded by the state and federal franchise laws cannot be waived. Business attorneys should be aware of the elements of a franchise under the franchise laws so they can structure the business relationship accordingly.¹

"Legal terms often have specialized meanings that can surprise even a sophisticated party. The term 'franchise,' or its derivative 'franchisee', is one of those words."²

Manufacturers and suppliers are all too often surprised and dismayed to learn that their distributorship relationships are subject to the franchise laws. A striking example is a recent case in which a jury awarded $1.525 million to a terminated Mitsubishi forklift distributor due to a violation of the Illinois franchise law. In affirming, the Court of Appeals poignantly noted:

Like many manufacturers, MCFA (Mitsubishi) simply did not appreciate how vigorously Illinois law protects "franchisees." . . . While we understand MCFA's concern that dealerships in Illinois are too easily categorized as statutory franchisees, that is a concern appropriately raised to either the Illinois legislature or Illinois Attorney General, not to this court. ³

Likewise, attorneys representing manufacturers and suppliers, as well as those representing a terminated or disgruntled distributor, do their clients a grave disservice if they fail to recognize the applicability of the franchise or related laws.⁴ For example, in Beverly Hills Concepts, Inc. v. Schatz & Schatz, Ribicoff & Kotkin,⁵ attorneys representing a marketer of health and fitness business opportunities were sued for malpractice for failing to advise a client that it was subject to the Connecticut business opportunity law. In Pyramid Controls Inc. v. Siemens Indus. Automation, Inc.,⁶ an attorney missed the statute of limitations for a terminated dealer because the attorney failed to recognize that the relationship was protected under the Illinois franchise law. In that case, the Seventh Circuit rejected plaintiff's argument that "only the plaintiff's actual knowledge can trigger the statute of limitations because the Franchise Act is so complicated and obscure very few attorneys understand how it works or even know of its existence."⁷

Indeed, few lawyers comprehend the breadth and scope of the franchise laws, and many fail to understand that the franchise laws, along with related laws, govern business relationships that may be vastly different from what is typically thought of as a franchise.⁸

Unfortunately, there is no universal definition of what constitutes a franchise. Definitions and interpretations under both federal and state law may be applicable, depending on the situation.

Federal Law. The Federal Trade Commission Act, in a promulgation known as the "FTC Rule,"⁹ defines a franchise as a "continuing commercial relationship" that contains the following three elements:

1. Trademark. The franchisee is allowed to offer, sell or distribute goods, commodities, or services that are identified by a trademark, service mark, trade name, advertising or other commercial symbol;
2. Significant control or assistance. The franchisor exerts significant control or assistance over the franchisee's method of operation; and
3. Fee or Payment. The franchisee is required to pay a fee to the franchisor of $500 or more at any time (other than for bona fide wholesale prices for inventory) before or within six months after commencing operations of the business.¹⁰

State Laws. Although definitions employed by the states often resemble those set forth in the FTC rule insofar as state definitions usually involve a trademark element, a marketing element and a payment element, state laws may be narrower or broader than the FTC rule and often extend to forms of business relationships that embrace a wide variety of dealerships, distributorships, and licensing arrangements. Under most state laws the essential statutory definition for a franchise falls within one of two categories:

(1) Marketing Plan. The franchisor grants the franchisee the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by the franchisor; the business operated is substantially associated with the franchisor's trademarks, trade name, or commercial symbols; and the franchisee must pay a direct or indirect fee. The marketing plan element is often satisfied if the franchisor provides the franchisee with advice regarding business operations and sales of the franchisor's product or service.

(2) Community of Interest. The franchisor grants the franchisee the right to engage in the business of offering or distributing goods or services using the franchisor's trade name or marks, the parties share a community of interest in the marketing of the goods or services, and the franchisee pays a fee. The community of interest element is often satisfied when there is a continuing financial interest between the parties in the operation of the franchisee's business or the sale of the franchisor's products.¹¹

If the statutory definitional elements of a franchise are satisfied, the name attached to the relationship by the parties is irrelevant. The protections afforded by the laws generally cannot be waived, and the benefits of the applicable statute will control, despite contractual language to the contrary.

Once a business relationship falls within the statutory definition of a franchise, a variety of laws and regulations come into play. While a number of these franchise or related laws have their own particular nuances, they generally cover the following areas:

Franchise pre-sale disclosure requirements and registration. If a relationship meets the definition of a franchise under the FTC rule, the franchisor is required to provide a comprehensive pre-sale document (often referred to as an offering circular) to a prospective purchaser.¹² The disclosure requirement applies in all 50 states. While the FTC rule contains no pre-sale registration requirement, the following states require the franchisor to register with a state agency before a franchise can be offered for sale: California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin. In addition, the following states – while not technically considered franchise registration states – also require a filing with a state agency in order to obtain an exemption under the state's business opportunity law: Florida, Kentucky, Nebraska, North Carolina, Texas, and Utah.

Special Industry Laws. A wide variety of special industries are subject to specific state statutes that govern the relationship between the manufacturer or supplier and the distributor or dealer. The laws offer varying degrees of statutory protection. Common types of distribution arrangements subject to special protections include: liquor, motor vehicle, farm equipment, petroleum, and outdoor power equipment dealerships.

Relationship Laws. If a business relationship meets the definition of a franchise under a particular state law, many of the substantive aspects of the business relationship (i.e., termination, transfer, cancellation, and non-renewal) will be governed by that state law. The FTC rule does not regulate the relationship between the franchisor and franchisee after the franchise is purchased. State laws are, however, designed to protect franchisees from being terminated without good cause and, to varying degrees, from being treated unfairly. Each state law is different, so it is important to examine the applicable statute. States that have enacted relationship laws are Arkansas, California, Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Indiana, Iowa, Maryland, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, South Dakota, Virginia, Washington, Wisconsin.

Not all laws apply to each situation. For example, a relationship may be subject to laws governing termination, even if it is not subject to federal disclosure requirements. However, a relationship which is a franchise under the FTC rule will most likely be subject to a state's relationship laws.

Many state franchise laws, as well as the FTC rule, contain several exclusions and exemptions; however, the exclusions and exemptions are by no means uniform. Among those relationships exempt from coverage under the FTC rule are the fractional franchise,¹³ employer-employee relationships, and general partnerships. State exemptions vary widely. An exemption available under the FTC rule may not be sufficient to exempt a relationship from coverage under a state law.

Dealers and distributors, particularly those who attempt to structure the relationship in an effort to avoid the application of the franchise law, must pay particular attention to business opportunity laws. The FTC rule defines a business opportunity as a relationship in which: (a) the investor sells goods or services supplied by the seller or its affiliate, or by suppliers with which the seller requires the investor to do business; (b) the seller secures retail outlets or accounts for the goods or services, or secures locations for vending racks or machines, or provides the services of someone who can perform either of these functions; and (c) the investor must make a required payment to the seller or its affiliate of $500 or more from any time before to within six months after commencing operations in order to obtain or commence the venture.¹⁴

State business opportunity laws generally cover a much broader range of business arrangements than those covered by the FTC rule. These laws literally apply to franchises; however, in most cases, there is an exemption or exclusion available to a franchise if it is associated with a trademark or tradename or if the franchise is subject to the FTC rule. The following states have enacted business opportunity laws: Alabama, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia, and Washington.

The wide array of cases and administrative opinions interpreting whether or not the statutory definition of a franchise is present demonstrates that there are many hidden franchises. The following cases provide just a few examples of the wide grasp of the franchise laws and their applicability to distributorship and other similar arrangements. To the untrained eye, many of these situations do not appear to involve a franchise. They have been variously referred to as hidden, inadvertent, or unintended franchises.

Air Conditioner Dealer. In Heating & Air Specialists v. Lennox Industries, Inc.,¹⁵ the court held that the Arkansas Franchise Practices Act applied to an air conditioner dealer, and that the act explicitly prohibits a franchisor from canceling a franchise without good cause. The provision contained in the dealership agreements that permitted either of the parties to terminate their relationship "without cause" was found to be invalid under the Arkansas franchise law. Nevertheless, the court found that Lennox had good cause to cancel the franchise.

Appliance Dealer. The New Jersey franchise statute was applied to an exclusive distributor of appliances manufactured by Amana in Cooper Distrib. Co., Inc. v. Amana Refrigeration, Inc.¹⁶ In this case, the distributor was terminated without good cause in violation of the New Jersey franchise law. The court ruled that the distributorship relationship was considered a franchise because there was a community of interest (distributor's assets were substantially franchise-specific), a license to use the trademark (use of tradenames on signs, uniforms, authorized dealer and perception that the distributor was licensed) and the establishment of a place of business with the State of New Jersey (showroom, although no sales were consummated there).

Basketball Team. The Indiana Supreme Court, in Continental Basketball Ass'n v. Ellenstein Enters., Inc.,¹⁷ found that a contract to purchase a professional basketball team was a franchise under Indiana law. The definition of a franchise was met because there was a payment for the right to operate a business, the business was substantially associated with a service mark or trademark and advertising, and the business was to be operated pursuant to the franchisor's requirements. The court also noted that the contract was called the "Franchise Purchase Offer," which strengthened the case against the franchisor.

Cafeteria in Office Building. In a California case, Kim v. Servosnax, Inc.,¹⁸ the court found that a franchise existed for a cafeteria that was located in an office building and operated under a contract between Servosnax and the owner of the building. The court, stating that the California law should be liberally construed, found that the operation of the cafeteria was "substantially associated" with Servonsax's trademark, despite the fact that the cafeteria operator was expressly prohibited by its contract from using the licensor's name, logo, or commercial symbol.

Computer Training System. The defendant, a company that produced and marketed integrated learning systems that used computer technology to teach and monitor a student's progress, was found to be a franchise under the New Jersey Franchise Practices Act in Instructional Sys., Inc. v. Computer-Curriculum Corp.¹⁹ This case illustrates the risk that computer hardware manufacturers and software vendors will be subject to the franchise laws.²⁰

Copy Machine Distributor. When Ricoh Corporation refused to renew its national distributorship agreement with the plaintiff after the expiration of its one-year term, the plaintiff brought suit in Wright-Moore Corp. v. Ricoh Corp.²¹ The Seventh Circuit found that an independent distributor of copiers, related parts, and supplies was a franchisee under the Indiana franchise disclosure law, because the business was "substantially associated" with the manufacturer's trademark.

Furniture Dealer. The Missouri franchise relationship statute applied to an authorized dealer of an office furniture manufacturer in American Business Interiors, Inc. v. Haworth, Inc.²² The dealer had a license to use the manufacturer's trade name, and the court found that the right to advertise as an authorized dealer satisfied the "community of interest" element of the Missouri franchise law. Missouri's franchise law requires a 90-day notice of termination, except under limited circumstances in which no notice is required.²³ Since the manufacturer failed to provide price information to the dealer between the date of the notice of termination and the effective date of the termination, the jury awarded the dealer $250,000 in punitive damages for tortious interference with contract.

Internet Providers. The action brought by the FTC in Federal Trade Commission v. iMall, Inc.²⁴ demonstrates that Internet providers may be subject to franchise laws. The marketer and its principals sold Internet consultant businesses to consumers through seminars, infomercials, and promotional cassettes. Two types of opportunities were sold: one involving the sale of web pages on the marketer's Internet site and the other involving the sale of advertising space on a website within the Internet site. In response to FTC charges that the marketer failed to provide complete and accurate disclosure documents to prospective purchasers, the provider and its principals agreed to a settlement of $4 million.

Law Firm Branch Office. An administrative opinion issued by the state of Washington concluded that an out-of-state law firm that planned to open a branch office was a franchise, finding that there was the requisite "community of interest."²⁵

Magazine Distributorship. A FTC Advisory Opinion concluded that Travelhost magazine distributorships met the three elements of a franchise.²⁶ In this situation, there was clearly the right to use the tradename and there was a payment of a fee. However, Travelhost argued that since there was no "prescribed marketing plan" the third element of a franchise was not satisfied. The FTC ruled that Travelhost clearly provided significant and detailed control and assistance to distributors in all aspects of the distributors' method of operation (including ad sales, composition and layout, and magazine distribution), as well as comprehensive manuals that provided step-by-step training in each subject.

Office Products Dealer. In a decision that surprised many practitioners, a manufacturer of record-keeping systems and office products was held to be a franchisor within the meaning of the California Franchise Investment Law in Gentis v. Safeguard Business Systems, Inc.²⁷ The court rejected Safeguard's arguments that since its sales representatives were not allowed to enter into binding sales contracts with customers and hence could not effectuate sales, it was not subject to the state's definition of a franchise because the franchisee was not granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan. Instead, since the California Franchise Relations Act was remedial in nature, the court adopted a liberal interpretation of its legislative intent of the law and ruled that the business arrangement was a franchise under this California law.

Sales Representative. In Blankenship v. Dialist International Corp.,²⁸ a sales representative sold a listfinder device designed for attachment to telephones under a marketing plan prescribed by the manufacturer, used the manufacturer's trade name, and paid a fee for the right to do so. The court, therefore, considered the relationship a franchise under the Illinois franchise law.

Slot Machine Manufacturer. In Atlantic City Coin & Slot Serv. Co., Inc. v. IGT,²⁹ the court found a slot machine manufacturer to be a franchisor under the New Jersey Franchise Practices Act because it had a community of interest with its distributor. As a result, termination of the relationship depended on a showing of good cause.

Snack Distributorship. The district court, in Metro All Snax, Inc., v. All Snax, Inc.,³⁰ found that under the Minnesota Franchise Law, a snack distributorship constituted a franchise. The distributor had paid a fee for training and assistance in order to obtain the distributorship. The court ruled that a "community of interest" existed between the supplier and snack distributorship when the supplier and distributor shared fees from a common source, and this was sufficient to fulfill the control or assistance requirement. Even though the distributor never actually used the seller's trademarks, the fact that it had the right to do so was enough to satisfy the trademark element.

Sports Information Service Provider. The New York franchise law, which is one of the broadest franchise statutes in the country, was applicable to an exclusive distributorship for beepers that transmitted sports information in King Computer, Inc., v. Beeper Plus, Inc.³¹ This case involved a distributor that leased hand-held beepers that operated on a radio frequency and received sports information transmitted by the sports information provider. Under New York law, it was held that the definitional requirements of a franchise were met: (i) the distributor paid a fee for the right to be a distributor; (ii) the trademark was displayed on the beeper screen in connection with the sports information and this was sufficient to meet the trademark requirement; and (iii) even though the distributor received no direction on how to operate his business, the marketing plan was considered self-executing because the customers bought the beepers in order to obtain the sports information service the beeper received.

Sublease Agreement for Pet Shop. The sublessee, which purchased the sublessor's inventory, paid sublessor a percentage of gross income, and used the name which the sublessor also used for two other pet shops that it owned, was found to be a franchise under South Dakota law in Nielsen v. McCabe.³²

Failure to comply with franchise registration or relationship laws exposes the violator to substantial risks of civil and criminal liability. Although "there is no private right of action" for failure to comply with the FTC rule,³³ the Federal Trade Commission has enforcement powers to subject the non-complying party and its officers and directors to injunctions, cease and desist orders, rescission, civil fines, and criminal penalties. Private causes of action are, however, available under many state laws. Those who fail to register or provide required disclosures in the so-called "registration states" are subject to various civil remedies, such as damages, rescission, and attorney's fees, and, in most cases, criminal liability. Furthermore, some states that do not require franchisors to register have enacted Little FTC Acts that provide that a violation of the FTC rule is actionable under state law. The FTC rule imposes liability on officers and directors if there is a violation, and most state laws extend joint and several liability to officers and directors and those participating in the violation as well.

Franchisors who fail to follow the mandates of state relationship laws, particularly those governing termination or failure to renew, are subject to injunctive relief and significant damages for wrongful termination. For example, in Globe Distributors v. Adolph Coors Co.,³⁴ a New Hampshire beer manufacturer relied on the language in the distributorship agreement, which allowed for termination for nonpayment without any demand or notice, to its peril. Its distributor was awarded double damages of more than $10.2 million, plus attorney's fees, because the brewer failed to comply with the state statute requiring the brewer to give written notice of an intent to terminate and an opportunity to cure the claimed deficiency.

Since the franchise and related laws can impact various types of business relationships in which a manufacturer or supplier produces or distributes products or services that will be sold by another, applicable federal and state laws governing the franchise relationship must be examined with great care. Manufacturers and suppliers must analyze the appropriate statutes, regulations, interpretative guides, and court decisions to determine if there is a way to structure their relationship in order to avoid the unintended or inadvertent applicability of the franchise laws. Careful drafting of contracts is essential, and possible restructuring of the relationship may be required. As attorneys become more sophisticated and aware of rulings in this field, it is likely that the franchise laws will be used more often as a weapon to challenge various aspects of unsuspecting business relationships. Those who misunderstand these laws or who fail to structure a relationship around them are subject to substantial risks and penalties, and in many cases large damage awards, not to mention the costs of defense, even if they ultimately prevail in court.

©2000, Leonard D. Vines

1 Mr. Vines is a principal in the St. Louis law firm of Rosenblum, Goldenhersh, Silverstein & Zafft, P.C. He gratefully acknowledges the assistance of his colleague, Marilyn Nathanson, in the preparation of this article.

2 To-Am Equip. Co., Inc v. MCFA, 152 F.3d 658 (7th Cir. 1998) (emphasis added).

3 Id. at 666.

4 See MacIntosh, et al., "The Unintended Franchise: The Collision of Modern Distribution Concepts with Mature Franchise Laws", Franchise Legal Digest, Vol. 1, p. 33 (Spring 1996).

5 717 A.2d 724 (Conn. 1998).

6 172 F. 3d 516 (7th Cir. 1999).

7 Id., at 519.

8 Sims & Trice, "Hidden Franchises", American Bar Association Forum on Franchising 20th Annual Forum (1997).

9 16 C.F.R. § 436.2 (1999).

10 16 C.F.R. § 436.2 (1999).

11 Among the variations are: New York's franchise law, which requires payment of a franchise fee and either a marketing plan or substantial association with the franchisor's trademarks; Connecticut's and New Jersey's laws, which do not require the payment of a fee; and Delaware and Arkansas, which have definitions which do not fall into either category.

12 The Federal Trade Commission issued proposed revisions to the FTC rule that have not been enacted. These proposed revisions include: (i) changing the timing for making the disclosure; (ii) clarifying the application of the rule to international franchise sales; (iii) expanding the rule to require additional disclosures, including pending franchisor-initiated lawsuits involving the franchise relationship, franchisor use of gag clauses and, in some instances, trademark-specific franchisee associations; (iv) permitting disclosure through electronic media, including the Internet; and (v) expanding the rule's exemptions to address sophisticated investors. For further information, see www.ftc.gov.

13 A fractional franchise is present when the "franchisee, or any of its current directors or executive officers, . . . has been in the type of business represented by the franchise relationship for more than [two] years and the parties" anticipate "that the sales arising from the relationship would represent no more than 20 percent of the sales in dollar volume of the franchisee." 16 C.F.R. 436.2 (1999).

14 16 C.F.R. § 436.2 (1999).

15 180 F. 3d 923 (8th Cir. 1999).

16 166 F.3d 1204 (3d Cir. 1999).

17 669 N.E. 2d 134 (Ind. 1996). The decision cited Thomas M. Pitegoff, Franchise Relationship Laws: A Minefield for Franchisors, 45 Bus. L. 289 (1989).

18 10 Cal. App. 4th 1346 (1992).

19 35 F. 3d 813 (3rd Cir. 1994), cert. denied, 513 U.S. 1183 (1995). Note that the definition of a franchise under the New Jersey franchise does not contain the fee element that exists in most state definitions.

20 See also Current Technology Concepts, Inc. v. Irie Enters., Inc., 530 N. W. 2d 539 (Minn. 1995) in which the court found that a payment of $125,000 by a software distributor for a hospital billing program constituted a franchise fee under Minnesota's franchise law. For a further discussion of franchise implications for computer hardware and software vendors, see Michael J. Lockerby. Avoiding Collisions With Franchise Laws on the Information Superhighway, The Computer Lawyer, October 1998, at 8, 18.

21 908 F.2d 128 (7th Cir. 1990).

22 798 F.2d 1135 (8th Cir. 1986).

23 The 90-day notice period is not required if the termination is due to "criminal misconduct, fraud, abandonment, bankruptcy or insolvency of the franchisee, or the giving of a no account or insufficient funds check." Section 407.405, RSMo.

24 Bus. Franchise Guide (CCH) ¶11,624 (C.D. Cal. Apr. 15, 1999).

25 State of Washington, Department of Licensing, Administrative Opinion File. No. E-12978, Feb. 7, 1989, cited in 9 Fran. L.J., Fall 1989, No.2 at 3, 5. But see Matter of Wallach, Bus. Franchise Guide (CCH) ¶ 9587 (N.Y. Sup. Ct. Jan. 4, 1990), in which an airplane broker's required purchase of stock in a subsidiary of its supplier was not a franchise under the New York franchise law.

26 FTC Advisory Opinion, Travelhost Magazine, Inc. (March 2, 1989), Bus. Franchise Guide (CCH) ¶ 6444.

27 60 Cal. App. 4th 1294, reh'g denied, 61 Cal. App. 4th 868 (1998).

28 568 N.E.2d 503 (Ill. App. Ct. 1991).

29 14 F. Supp.2d 644 (D.N.J. 1998).

30 Bus. Franchise Guide (CCH) ¶ 10,885 (D. Minn. 1996).

31 No. 92 Civ. 5494, 1993 U.S. Dist Lexis 2707 (S.D.N.Y. Mar. 9, 1993).

32 442 N.W.2d 477 (S.D. 1989).

33 Banek, Inc. v. Yogurt Ventures USA, Inc., 6 F.3d 357 (6th Cir. 1993).

34 129 Bankr. 304 (Bankr. D. N.H. 1991).