Look out! It may be a franchise
by Charles G. Miller and Darryl A. Hart
Your routine contract termination action is met with the claim that the relationship is a franchise and cannot be terminated without "good cause". Or your client is served with a lawsuit or notice attempting to rescind a transaction because it involves a franchise that was granted without the requisite disclosures. Unfortunately, you have found out too late that the label placed on a business arrangement has no bearing on whether it is a franchise. As you will discover, the penalties for noncompliance with franchise law can be severe. Thus counsel, in particular transactional lawyers and litigators, must learn to recognize when an arrangement may be a franchise.
To be a franchise under the California Franchise Investment Law (CFIL, Corp C §§31000-31516) a right must be granted using the following criteria: (1) The franchisee must engage in the business of offering, selling, or distributing goods or services; (2) The franchisee must do so under a marketing plan or system prescribed in substantial part by the franchisor; (3) The business must be substantially associated with the franchisor or its affiliate; and (4) The franchisee must directly or indirectly pay a "franchise fee", defined as any payments required to be made to the franchisor or its affiliate for the right to engage in the business, including payments for goods or services with certain exceptions. Each of these elements has been the subject of litigation and interpretive opinions.
CFIL requires that a franchise offering circular and all applicable contracts be filed with and approved by the Department of Corporations before a franchise is offered or sold. Noncompliance can give rise to an action for damages and rescission, and CFIL provides criminal and civil penalties as well. In addition, a Federal Trade Commission (FTC) rule applies disclosure requirements nationwide prior to sale.
Two recent California cases demonstrate how far courts will go to find a franchise. In Gentis v. Safeguard Business Systems, Inc. (1998) 60 CA4th 1294, the court reviewed the distribution system of a manufacturer of record-keeping systems and office products to determine whether the arrangement constituted an offering of goods or services within the first prong of the CFIL's franchise definition. The distributor was authorized to solicit only nonbinding orders for the manufacturer and to perform various customer-service activities. The court held that, given its extensive participation in the sales process, the distributor "offered" the manufacturer's products, even though the distributor could not bind the manufacturer to sell the goods to prospective customers. Since the other requirements of the CFIL were met, the arrangement was found to be a franchise.
In Kim v. Servosnax, Inc. (1992), 10 CA4th 1346, Servosnax contracted with a company to operate an employee cafeteria. After operating the cafeteria for a period of time, Servosnax licensed the business to the plaintiff. In the license agreement, Servosnax prohibited the use of its name in the operation, presumably to avoid the third element of the CFIL definition. Nevertheless, the court found that the operation was "substantially associated" with Servosnax in the minds of both the plaintiff and the employer. Servosnax's failure to comply with CFIL cost it nearly $50,000 in damages. In both cases the court said CFIL is to be liberally construed, a pronouncement that may lead trial courts to find franchises in ambiguous situations.
The issue is very much alive currently with respect to technology-related arrangements. FTC Informal Staff Advisory Opinion 98-6 (August 12, 1998) found that a technology integration services business was a franchise, since it licensed others to share its advertising and marketing expertise and to use its trademark in their marketing activities. Consider also the situation in which a web page provider allows others to market through its site as long as they comply with certain criteria, such as adhering to the provider's refund policy. Judicial and administrative rulings are just beginning to emerge in this context, and they are far from consistent.
In sum, counsel should think franchise, until satisfied otherwise, whenever someone pays for the right to sell goods or services associated with an identifying name or mark. Counsel should also be aware of the California law governing seller-assisted marketing plans, (CC §§1812.200-1812.221), which concerns arrangements roughly similar to franchises but without the "substantial association" element.
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