Under California law, a business relationship is a “franchise” if: (1) the business will be substantially associated with the franchisor’s trademark; (2) the franchisee will directly or indirectly pay a fee to the franchisor for the right to engage in the business and use the franchisor’s trademark; and (3) the franchisee will operate the business under a marketing plan or system prescribed in substantial part by the franchisor.
Licensing, distributorship, and dealership arrangements are not franchises because they are missing at least one of the three elements of a franchise. For example, under a typical licensing arrangement, one company licenses another to sell its products or services in exchange for a specified amount of the proceeds without any additional involvement of the licensor.
In dealership and distributorship arrangements, independent businesses operate under their own trade names and usually buy products or services from another other party at wholesale prices and then resell them to the public. Neither party is substantially involved in the business affairs of the other. Generally, distributorship arrangements do not constitute franchises because the definition of a “fee” is not met, because, a “fee” does not include payment for the purchase of initial and ongoing inventory at bona fide wholesale prices.
Licenses are private contracts. Licensors do not have to make public disclosure about their financial condition or other sensitive business information. Franchising, however, is regulated by federal law and by many state’s laws. Under California’s Franchise Investment Law, it is unlawful to offer or sell a “franchise” in California unless the offering has been registered with the Department of Business Oversight (DBO) or it is exempt from registration.
If a business relationship satisfies the elements of a franchise under California law, the franchisor must: (1) file a franchise disclosure document with the DBO outlining the franchise opportunity in detail and providing information regarding the franchisor’s background and business experience before entering into any discussions with potential franchisees; and (2) disclose potential franchisees with its registered franchise disclosure document and wait at least 14 full days before having the franchisee execute any franchise documents or make any payments to the franchisor. These burdens are not imposed in licensing, distributorship and dealership relationships.
The DBO and California courts have little compassion for trademark owners that claim they did not know the law or argue that there was no intent to create a franchise. The DBO closely monitors franchisor-franchisee arrangements and may assess penalties of $2,500 per violation of the California Franchise Investment Law. The DBO also has the authority to require franchisors to provide its franchisees with written notice of the violation, offer rescission of the franchise, and refund payments made by the rescinding franchisees. These unexpected consequences can prove painful to an accidental franchisor.
The determination whether a license, distribution or dealership arrangement should be treated as a franchise must be made after a thorough analysis of a trademark owner’s business structure. Understanding the basics of franchising will help you recognize when it is time to contact a franchise law specialist to avoid a potential minefield of unintended consequences.
