South Bend / Mishawaka, Indiana – Parties are generally free to contract. However, when a company permits another to obtain the right to operate a business that is identified or associated with a company’s trademark, exerts or has the authority to exert a significant degree of control over the other’s method of operation, and receives a payment or a commitment to make a payment, the agreement, irrespective of the intentions, may be a franchise.
The Federal Trade Commission has indicated that the name given to a business arrangement is irrelevant in determining whether it is covered by the FTC’s Franchise Rule. (16 C.F.R. 436). Expansion or granting the right to use or be associated with a trademark, without careful consideration, could have unintended – and potentially costly – consequences.
The FTC’s Franchise Rule provides that a franchisor has engaged in an unfair and deceptive act under Section 5 of the FTC Act if it fails to furnish a prospective franchisee with a disclosure document at least 14 calendar days before the prospective franchisee signs a binding agreement or makes any payment to the franchisor in connection with a proposed franchise sale. The disclosure document is a specific and detailed publication containing 23 categories of information. A franchising party should be prepared to disclose information concerning: its parents, predecessor, and affiliates; business experience; litigation; initial and other fees; the estimated initial investment; restrictions on sources of products and services; the franchisee’s obligations; financing; the franchisor’s assistance, advertising computer systems, and training; territory; trademarks; patents, copyrights, and proprietary information; obligations to participate in the actual operation of the franchise; restrictions on what the franchisee may sell; renewal, termination, transfer, and dispute resolution; public figures; financial performance representations; outlets and franchisee information; financial statements; contracts; and receipts. (16 C.F.R. 436.5). The failure to comply with these requirements (or others within the FTC Act) could result in civil penalties, rescission or reformation of contracts, and criminal penalties.
Expanding businesses beware – matters are made even more complicated by a mix of state laws and regulations that provide additional obligations for the franchising parties. Depending on the jurisdiction, an arrangement could be a franchise under state law even if it is not a franchise under the FTC’s Franchise Rule, or a state law could impose additional requirements beyond what is provided for under the FTC’s Franchise Rule. Federal regulations also provide that a state or local government law is not inconsistent with federal disclosure requirements and prohibitions concerning franchising if a prospective franchisee is afforded equal or greater protection. (16 C.F.R. 436.10(b)).
It is therefore prudent to examine the laws of the states where the franchise will be operated and where any party is a resident or has a place of business. In Indiana, particular attention should be given to the Franchise Disclosure Law (I.C. § 23-2-2.5-1 et seq.) and the Deceptive Franchise Act (I.C. § 23-2-2.7-1 et seq.). The Franchise Disclosure Law defines a “franchise” (in part) as a contract where: (1) a franchisee is granted the right to engage in the business of dispensing goods or services, under a marketing plan or system prescribed in substantial part by a franchisor; (2) the operation of the franchisee’s business pursuant to such a plan is substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor or its affiliate; and (3) the person granted the right to engage in this business is required to pay a franchise fee. (I.C. § 23-2-2.5-1(a)). The Franchise Disclosure Law not only applies where the franchised business will be or is operated in Indiana, but also when the franchisee (or offeree) is an Indiana resident. (I.C. § 23-2-2.5-2). In addition to registration with the Indiana Securities Commissioner, Indiana’s Franchise Disclosure Law provides that no person may offer or sell any franchise without first providing to the prospective franchisee at least 10 days prior to the execution of a binding franchise or at least 10 days prior to the receipt by the franchisor of any consideration, whichever first occurs, a disclosure statement together with a copy of all proposed contracts relating to the sale of a franchise. Fraudulent or deceitful practices are specifically prohibited, and there are provisions for recovering damages, interest, and attorney’s fees for violations, along with other enforcement mechanisms.
Indiana’s Deceptive Franchise Practices Act (which, in part, incorporates the definition of a franchise under the Franchise Disclosure Law) also renders certain acts and practices unlawful. Prohibitions in a franchise agreement include any provision allowing the substantial modification of an agreement by the franchisor without the franchisee’s written consent, permitting the unilateral termination of the franchise without good cause (a material violation of the franchise agreement is good cause) or in bad faith, or limiting litigation brought by any breach. (I.C. § 23-2-2.7-1). Further, a termination of a franchise or election not to renew a franchise typically must be made on at least 90 days’ notice. Injured franchisees are entitled to bring an action to recover damages or reform the franchise agreement.
There are, of course, exemptions to the federal and state laws and regulations, and alternative ways to structure an agreement when the parties truly do not intend to pursue a franchise arrangement (e.g., consulting agreements, trademark licensing arrangements, etc.). Any proposed expansion plan should consider these alternatives along with the various definitions of a franchise.
Franchising can be a legitimate and effective way for a business to expand and build its brand identity while at the same time allowing the franchisor to maintain sufficient operating control of the business. With franchising, however, comes an unforgiving regulatory environment that restricts and limits a number of material aspects of the franchise relationship, from the initial offering, to the terms of the agreement, to the operation of the franchise itself, and even its termination. Further, not only will a party who inadvertently franchises face possible penalties under the federal or state regulations, but such a party may also lose its ability to enforce a contract that it has been operating under for years or lose leverage in negotiations. Thus, when considering an arrangement associated with a mark or brand, payment or consideration, and the retention of operating or marketing control, franchise laws merit attention.
*This article is for informational purposes only and its content should not be considered legal advice. Your matter is factually sensitive and unique, and you should not rely on this article to predict the outcome of your case. A telephone call to an experienced franchise attorney is recommended.
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