How Does the Law Regulate Franchising?

By David J. Kaufmann, Senior Partner, Kaufmann Gildin & Robbins LLP

Franchising is regulated in the United States at both the federal and state levels. At the federal level, by the Federal Trade Commission (the “FTC”) through its FTC Franchise Rule, and at the state level, by various states’ franchise registration/disclosure laws; franchise relationship laws; business opportunity laws; and “little FTC” acts. Therefore, in order for franchisors to legally franchise their businesses in the United States, franchisors must be aware of, and comply with, all of the foregoing laws. They are each briefly described below.

1. FTC Franchise Rule

The FTC Franchise Rule defines a franchise as follows: “any continuing commercial relationship or arrangement, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that: (1) the franchisee will obtain the right to operate a business that is identified, or associated with the franchisor’s trademark, or to offer, sell or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark; (2) the franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and (3) as a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.” Whether or not a relationship formed between two parties appears to the average person to form a franchise is irrelevant if the above three elements are satisfied.

Under the FTC Franchise Rule, a franchisor must prepare a Franchise Disclosure Document (“FDD”) and furnish that FDD to prospective franchisees within a prescribed time period. The FTC Franchise Rule sets forth with great specificity the form the FDD must take and the contents that must be included therein. See “What Legal Documents are Involved in Franchising?” for a detailed description of the information that must be included in the FDD.

2. State Franchise Registration/Disclosure Laws

Not only does the definition of a “franchise” vary between the FTC Franchise Rule and the states which feature franchise registration and disclosure laws, but the definition also varies among those states themselves. Likewise, the jurisdictional scope of state franchise registration/disclosure laws varies, with those laws applying either in one or a combination of the following circumstances: when the franchise outlet is to be located in the state; where the franchisee resides in the state or has its principal place of business in the state; where the franchisor has its principal place of business in the state; where the franchise offer was communicated from the state; and, where the franchise offer was accepted in the state. Accordingly, the scope of coverage of each state franchise registration/disclosure law must be vigilantly scrutinized in order to determine whether or not compliance is required.

The majority of states utilize what is referred to as the “prescribed marketing plan or system” test for the existence of a franchise. Under this test, a franchise exists where: (1) a franchise fee is paid; (2) the right to sell goods or services under a marketing plan or system prescribed in part by the franchisor is granted; and, (3) the operation of the franchisee’s business or system is substantially associated with the franchisor’s trademark, service mark or other commercial symbol. Alternatively, a minority of states utilize what is referred to as the “community of interest” test for the existence of a franchise. Under this test, the “marketing plan or system” element is replaced with the requirement that the franchisor and franchisee have a community of interest in the marketing of the franchised goods or services.

New York follows neither of the above described tests. Instead, New York employs the broadest definition of a franchise: a relationship where there is (1) payment of a franchise fee; combined with either (2) the right to sell goods or services using the franchisor’s trademark, service mark or other commercial symbol; or (3) a prescribed marketing plan for the sale of goods or services or a community of interest in the marketing of goods or services. As such, a much wider array of commercial relationships are considered franchises under New York law than other franchise-regulating states.

Unless a statutory exemption is applicable, franchisors selling a franchise that falls within the scope of one or more of the state registration/disclosure laws must prepare an FDD, file it with the required state agency, have it approved and registered, and provide a copy of the registered FDD to all prospective franchisees within the required time period before any sale, or even offer, of a franchise may proceed. The following states have their own franchise registration/disclosure laws: California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin.

3. State Franchise Relationship Laws

After the sale of the franchise is consummated, various state franchise relationship laws govern the ongoing relations between the franchisor and franchisee, such as termination and non-renewal of a franchise agreement, market protection, encroachment and transfer. The following states have their own franchise relationship laws: Alaska, Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Rhode Island, Utah, Virginia, Washington, Wisconsin, District of Columbia, Puerto Rico, and the U.S. Virgin Islands.

Many franchise relationship laws require “reasonable” or “just” cause for the termination or non-renewal of a franchise, in addition to prescribing minimum notice requirements prior to a termination or non-renewal. In fact, many state franchise relationship laws govern precisely when, and under what circumstances, a franchisor may terminate or refuse to renew a franchise agreement. This, despite what the franchise agreement itself says on the issue of termination and/or non-renewal. Because state franchise relationship laws may make it extremely difficult, if not impossible, for a franchisor to terminate its relationship with a franchisee protected by one of these laws, it is essential that the franchisor conduct due diligence on these franchisees in particular.

4. State Business Opportunity Laws

In some jurisdictions, state business opportunity laws directly regulate franchising while, in other jurisdictions, those laws only tangentially impact the offer and sale of franchises. These laws frequently require registration and disclosure in much the same fashion as state franchise registration/disclosure statutes and usually require, in addition, the posting of a surety bond or other financial security instrument. Notably, franchise offerings that satisfy certain prerequisites are often explicitly excluded from coverage of the state business opportunity laws. The twenty-six states featuring business opportunity laws are: Alabama, Alaska, 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.

5. Little FTC Acts

A number of states have enacted “Little FTC Acts,” which state that any violation of the U.S. Federal Trade Commission Act, and the regulations promulgated thereunder (notably including the FTC Franchise Rule), automatically trigger violations of that state’s Little FTC Act. And because often individuals are granted a private right of action under such laws, franchisees in these states can use the Little FTC Act to sue their franchisors for violations of the FTC Franchise Rule (under which there is no private right of action – only the FTC and the U.S. Department of Justice may sue for violations).

About the Author

Kaufmann Gildin & Robbins LLP is a boutique law firm located in the heart of New York City. Its lawyers are among the most renowned, nationally and internationally, in their areas of expertise. Kaufmann Gildin has deep experience in conceiving, structuring, implementing, documenting and registering new franchise programs; modifying or overhauling existing franchise networks; participating as franchise counsel in over $30 billion in franchise-related merger, acquisition and securitization activity; applying extraordinary government relations skills; deploying a litigation team whose record is remarkable and renowned among Kaufmann Gildin’s clients; conceptualizing the securitization financing structure that has been used in virtually every franchise-related securitization ever successfully accomplished in this country; and, is nationally acclaimed by both clients and government officials for its ability to prepare franchise agreements and disclosure documents which are comprehensive, as sophisticated as the situation warrants and yet facilitate the franchise marketing process by being so “user friendly”. Kaufmann Gildin’s unique expertise, nationwide reputation, outstanding accomplishments and devotion to its clients are well known in the fields of franchising, licensing and distribution; litigation and appeals; franchise-related mergers, acquisitions, financings and securitizations; nationwide leasing and real estate; and, securities arbitration.

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