A company's trademark or brand name is often a valuable
asset. A company may capitalize and exploit its trademark by
licensing the use of the mark to third parties. There may be
up-front costs to the licensor, but the royalty stream may be
substantial and continuous since the life of a trademark can be
forever. However, when licensing its trademark, a company may have
unknowingly created a franchise. The is known in
the industry as an accidental franchise.
What is a franchise? A franchise is essentially a license from a
trademark owner permitting another party to sell a product or
services under the mark. Franchise relationships are regulated by
federal and sometimes state laws and require certain disclosures
prior to the formation of the franchise relationship. While the
trademark owner often desires to capitalize on its trademark by
creating a franchise relationship, sometimes, the creation of a
franchise relationship can be an unintended consequence of a
trademark license, which causes the license to fall within the
legal definition of a franchise.
For example, if a trademark owner intends to grant a trademark license, the drafter of the agreement must be careful not to include certain obligations in the license agreement that may result in the trademark agreement being construed as a franchise agreement. Federal and state franchise laws govern business relationships that fall within the legal definition of a franchise.
So when is a trademark license a franchise agreement? In
general, a business relationship is a franchise under federal and
state law when the following three terms in the agreement exist
together: (1) The right to use a trademark to offer, sell or
distribute goods or services (the trademark element), (2) Payment
of a required fee (the fee element) and (3) Significant assistance
or control with respect to the franchisee's business (the
assistance element). In order to avoid coming within the legal
definition of a franchise and thereby become subject to regulation
under federal and state franchise laws, a trademark owner must not
include all three elements in its licensing agreement. Most
trademark license agreements include elements (1) and (2), so
whether the licensing agreement creates a "franchise"
depends upon element (3).
Nonetheless, even if all three elements are present, there may be
exceptions to the creation of a franchise relationship. For
example, under the "fractional" franchise exception, when
an existing business adds a franchised product or service to its
other lines of business, such business arrangement does not trigger
the franchise regulations if (1) the franchisee has more than two
years of experience in the same type of business; and (2) the
parties have a reasonable basis to anticipate that the sales
arising from the relationship will not exceed 20% of the
franchisee's total dollar volume in sales during the first year
of operation.1 Another example is the "single
license" where a single trademark license is exempt from the
federal disclosure requirements. To be entitled to this exemption,
there must be only one licensee who is granted the right to use the
licensor's trademark.
The first indication that an accidental franchise has been created
is often receipt of a cease and desist letter from a state
regulator who has received a complaint of a sale of a franchise
without proper disclosure. An accidental franchise can create
huge penalties for franchisors, both civil and criminal.
Further, a franchisor may be required to permit the franchisee to
rescind the agreement. In order to ensure that a trademark
licensor does not create an accidental franchise, the licensor
should consult franchise counsel before pursuing a licensing
program.
Footnote
1 16 C.F.R. § 436.8(a)(2) (2007).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.