UNINTENTIONAL FRANCHISING

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Its Franchise............................................................................328 f.Other Exemptions.....................................................................................................328 * B.A., Austin College (1974); J.D., St. Mary 9s University (1978). Mr. Miller is a partner in the Intellectual Property se ction of Jackson Walker L.L.P. He also serves as Chair of the Franchise and Distribution Law Committee of the Intellectual Property Law Section of the State Bar of Texas and as Chair of the Jackson Walker L.L.P. Intellectual Property Law Practice Group. 302 III. cBusiness Opportunity d Defined............................................................................................. ....329 A.Federal Definition of Business Opportunity.........................................................................329 1.In General................................................................................................................... .....329 2.Definition................................................................................................................... .....329 3.Example...................................................................................................................... ....330 B.State Definitions of Business Opportunity............................................................................331 1.In General................................................................................................................... .....331 2.Majority Definition.........................................................................................................3 31 a.Definition..................................................................................................................3 31 b. cTo Start a Business d................................................................................................332 c.Threshold Representations........................................................................................332 d.The Trademark Difference........................................................................................333 e.Exemptions...............................................................................................................333 3.Other States................................................................................................................. ....333 C.Texas Definition of Business Opportunity............................................................................333 1.Definition................................................................................................................... .....333 2.Three-Part Test.............................................................................................................. ..334 3. cTo Begin a Business d....................................................................................................335 4. cInitial Consideration d....................................................................................................33 5 5.Threshold Representations..............................................................................................337 a.In General.................................................................................................................33 7 b.Help Finding a Location...........................................................................................338 c.Providing a Marketing Program...............................................................................338 d.Repurchasing............................................................................................................339 6.Exemptions................................................................................................................... ...339 a.The Franchisor Exemption........................................................................................339 b.Ongoing Business.....................................................................................................341 c.Leased Department...................................................................................................341 d.Fractional Franchise..................................................................................................342 e.Net Worth Exemption...............................................................................................343 f.Gasoline Stations......................................................................................................343 g.Miscellaneous Exemptions.......................................................................................343 7.Construction................................................................................................................. ...343 IV.International Franchise Law................................................................................................. .......344 V.Litigation Issues............................................................................................................ ..............344 A.Deceptive Trade Practices Act..............................................................................................34 4 B.Business Opportunity Act..................................................................................................... 348 C.Inevitable Unlawful Sales.................................................................................................... .351 1.Problem...................................................................................................................... .....351 2.Treatment.................................................................................................................... ....352 D.Collateral Estoppel.......................................................................................................... ......353 VI.Intentional Novice Franchisor............................................................................................... ......354 A.The Novice Franchisor........................................................................................................ ..354 B.The Lawyer 9s Role............................................................................................................ ....354 C.Educate the Client........................................................................................................... ......355 D.Full Disclosure.............................................................................................................. ........356 VII.Attorney Liability......................................................................................................... ...............357 A.Issue-Recognition Failure.................................................................................................... ..357 B.Franchise Law Standard of Care...........................................................................................357 [2005] UNINTENTIONAL FRANCHISING 303 C.Franchisor Counsel Liability to Franchisees.........................................................................358 D.Sarbanes-Oxley............................................................................................................... ......360 VIII.Conclusion................................................................................................................ .............360 304 ST. MARY 9S LAW JOURNAL [Vol. 36:101] I.I NTRODUCTION A. Synopsis The focus of this Article is on honest businesses that do not realize they may be legally regulated as cfranchisors d or cbusiness opportunity sellers d and subject to potentially awful consequences due to noncompliance. This Article first discusses federal and other states 9 laws, then the Texas Business Opportunity Act (BOA), and finally, practical and litigation consequences. B. In General Franchising is a method of distribution that combines the advantages of a branded, centralized, specialized system with the capital and micro-management of local independent business persons to produce a market competitor with critical mass. It can leverage a business 9s success far beyond its own capital and management resources. Franchising 9s inherent geographic expansiveness and long- term business relationships cause it to be affected by an array of dynamic federal, state, and local laws. Lawyers refer to the irregular collection of laws applicable to relationships arbitrarily defined as cfranchises d as franchise law. Franchise law is similar to securities law in several aspects. First, both are an exercise of the government 9s police power to protect consumers concerning a type of consensual business deal that government decided is too often abusive. In response to a wave of fraud and abuse complaints in the 1960s and 1970s, the Federal Trade Commission (FTC) promulgated the Franchising and Business Opportunity Ventures Trade Regulation Rule (FTC Rule) in 1979 to protect prospective buyers from deceptive franchise and business opportunity sales practices. 1 Fifteen states have enacted franchise statutes, and twenty-five have enacted business opportunity statutes. 2 Appendix A lists these statutes. 1 See Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures, 16 C.F.R. § 436.1 (2004) (codifying 43 Fed. Reg. 59,614 (Dec. 21, 1978)). The history of the rule is similar to the history of most public polic y and police power intrusions into business law. For example, in the 1920s, the citizenry eagerly and voluntarily traded large amoun ts of money for stock with an expectation of safe fat profits. Those investments were lost in the 1929 market crash, after which the citizenry complained loudly to government. Government responded with the Securities and Exchange Acts of 1933 and 1934 and similar police power statutes in all states. See Securities Act of 1933 § 5a, 15 U.S.C. § 77e (2004) (enacting prohibitions on the interstate sale of securities unless a registration statement is in effect as to those securities); Scott Daugherty, Commen t, Uncharted Waters: Securities Class Actions in Texas After the Securities Litigation Uniform Standards Act of 1998 , 32 S T . M ARY 9 S L.J. 143, 183-83 (1999) (indicating that in response to the enormous number of worthless securities sold to Texas citizens in the 1920s and 1930s, and the resulting public outcry, the legislature enacted the Blue Sky Law of Texas 4and later t he Texas Securities Act of 1935 4to protect investors from fraud). These statutes made a class of business deals between consenting adults illegal unless specific buyer protection rules were followed. See Securities Act of 1933, § 5a, 15 U.S.C. § 77e (2004) (prohibiting the interstate sale of securities unless a registration statement is in effect as to those securities); The Securities Act, T EX .R EV .C IV .S TAT .A NN . art. 581, § 12 (Vernon Supp. 2004) (prohibiting selling or offering to sell unregistered securities within Texas). The historical parallel to the enactment of franchise police power regulation is apparent. In the 1960s and 19 70s, the public invested in worm farms, chinchilla ranches, etc.; those markets crashed, the public complained to government, and government enacted franchise and business opportunity regulations. H. Bret Lowell & John F. Dienelt, Drafting Distribution Agreements , 11 D EL .J.C ORP .L. 725, 727 (1986); see also Appendix A (listing states 9 franchise and business opportunity statutes). 2 Much heat and noise is expended on the correct count of states having such laws, and there are many good arguments about the actual number. For example, Texas is not listed in Appendix A as a franchise state because FTC Rule compliant franchise sales are expressly exempted from the Texas Business Opportunity Act (BOA) and arguably a careful seller is not included within the BOA 9s scope. T EX .B US .&C OM .C ODE A NN . § 41.004(a) (Vernon 1994). However, as discussed below, if a jury believes the seller represented that the buyer was likely to earn a profit ( cMr. Seller, please tell the jury what words you spoke in sellin g this business opportunity to Mr. Buyer d), then likely the seller is within the BOA 9s scope. Further, the BOA 9s franchise exemption is limited to sellers who (1) are FTC Rule franchisors, (2) comply with the FTC Rule, and (3) file an exemption statement with the Texas Secretary of State along with a small fee. Id. § 41.004(b)(8). [2005] UNINTENTIONAL FRANCHISING 305 Second, neither franchise nor securities law dictates a deal 9s terms. Whether or not the buyer gets a good deal is unregulated. 3 These laws require a written pre-sale disclosure in a prescribed format to prospective buyers and, in some states, pre-sale registration of the offering. They are intended to help consumers make intelligent decisions. Third, the threshold csecurity, d 4 cfranchise, d and cbusiness opportunity d definitions that determine what deals are covered are intentionally drafted broadly to protect buyers, heedless of the sometimes disproportionate adverse effect on sellers. To the astonishment of the attorneys and business persons involved, courts often deem many ordinary trademark licenses, distribution agreements, technology licenses, joint marketing agreements, and plain vanilla business deals as franchises or business opportunities. 5 Fourth, a noncompliant sale of an unregistered franchise, like a noncompliant sale of an unregistered security, or misrepresentations made in those sales, can be illegal, even if they are consensual great deals. Business persons are accustomed to being successful without having gone to law school because business law generally incorporates common-sense business expectations. They expect business agreements between consenting adults to be enforced. Unintentional franchisors do not appreciate the consumer protection scope and police power effect of franchise law. Franchise and securities laws are not fair . They are out to get you. Non-compliance can result in a business death penalty,personal liability, 6 and malpractice awards. After decades of seeing the rich and famous do the cperp walk d on the nightly news for securities violations, there is a pervasive common-sense understanding among all classes of the population concerning the implications of securities law. In contrast, few attorneys or business persons have 3 See 15 U.S.C. § 45(n) (2000) (stating that c[t]he Commission shall have no authority... to declare unlawful an act or practice on the grounds that such act or practice is unfair unless the act or practice causes or is likely to cause substantial injury t o consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition d). cToday the fraud is not in the pre-sale, the fraud is in the contract. d AFA President Discusses the Challenges of Being a Franchisee , F RANCHISING B US .&L.A LERT (L.J. Newsletters, Philadelphia, Pa.), Jan. 2004, at 1, 2 (quoting Susan Kezios, the president and founder of the American Franchisee Association). Some states arguably get into the business of deciding whether a deal is appropriate by imposing an impound upon a weak new franchisor 9s sales of franchises into their state. See, e.g. , C AL .C ORP .C ODE A NN . § 31113 (Deering Supp. 2004) (authorizing the state to impound franchise fees until the franchisor has fulfilled the obligations under the disclosures); H AW .R EV .S TAT .A NN . § 482E-8(e) (Michie 2003) (providing authority to impound franchise fees to protect franchisees). Both California and Hawaii escrow each state 9s franchisees 9 payments to the franchisor in a local bank until the franchisor 9s start-up obligations are complete. Id. As a practical matter, an impound requirement typically excludes the franchisor from the subject state. 4 The definition of csecurity d is sweepingly broad. See Securities Act of 1933 § 2(a), 15 U.S.C. § 77b(a)(2) (2004) (defining csecurity d for purposes of federal law); Reves v. Ernst & Young, 495 U.S. 56, 57 (1990) (commenting that Congress 9s definition of csecurity d is broad enough to include virtually any form of investment). See generally L ARRY D.S ODERQUIST &T HERESA A. G ABALDON ,S ECURITIES R EGULATION 155-170 (5th ed. 2003) (providing a historical background on the evolution of the term csecurity d under federal securities Law). 5 See H. Bret Lowell & John F. Dienelt, Drafting Distribution Agreements: The Unwitting Sale of Franchises and Business Opportunities , 11 D EL .J.C ORP .L. 725, 726 (1986) (noting that many attorneys fail to understand that a franchise may be cany form of product or service distribution agreement in which the franchisee is identified with the provider of the goods or services d); Kenneth H. Slade, Applicability of Franchise and Business Opportunity Laws to Distribution and Licensing Agreements , 15 AIPLAQ.J. 1, 1 (1987) (citing hypothetical situations that could all easily be covered under typical franchise and business opportunity laws, despite that attorneys may never have considered that this may be an issue; indicating that franchis e and business opportunity laws have ca broad, and often unexpected, reach d). 6 See Bixby 9s Food Sys., Inc. v. McKay, 193 F. Supp. 2d 1053, 1062-63 (N.D. Ill. 2002) (concluding that a summary judgment against the president of a franchisor was proper under the Illinois Franchise Disclosure Act, which holds principal executive officers and directors of corporations jointly and severally liable if they had knowledge of the facts). In Bixby , the president of a franchisor was held to have violated the Illinois Franchise Disclosure Act by falsely claiming the franchisor had more franchis ees than it really had. Id. at 1062. In contrast, the franchisees 9 motion for summary judgment with respect to common law fraud was rejected because the franchisees failed to show by clear and convincing evidence that their reliance on the false oral statemen t was reasonable. Id . at 1066. 306 ST. MARY 9S LAW JOURNAL [Vol. 36:101] franchise law on their radar screen, and many who do underestimate its scope and effect. Consequently, businesses often make mistakes in the franchise arena. The most common reaction to being told that a business is a franchisor is: cWho? Me? d Texas business persons and attorneys are particularly vulnerable to inadvertent franchising problems. Attachment A shows registration states concentrated in an arc running along the coasts and industrial Midwest 4regions where governmental protection/interference is accepted. In contrast, the culture of southwestern and southern states tends more to cleave-me-alone d rugged independence. When successful Texas businesses expand into cgovernmental regulation d states, they are often easy prey for the sophisticated franchisee bar 7 and active state franchise administrators. 8 To further complicate the issue, franchising bundles together many areas of law that are typically only dealt with by specialists: federal and state laws concerning antitrust, 9 trade dress, 10 trade secrets, general advertising, franchise advertising, patents, trademarks, copyrights, 11 vicarious liability, 12 bankruptcy, 13 arbitration, 14 forum selection, 15 conflict of laws, real property, usury, unfair competition, covenants of good faith and fair dealing, business relationship anti-termination and anti- 7 See Dady & Garner, P.A., at http://www.dadygarner.com (last visited Oct. 11, 2004) (promoting its practice as limited to representation of franchisees, distributors, and dealers). Law firms specializing in suing franchisors, often on a contingent fee basis, exist in the registration states. These firms have considerable expertise and experience in franchise litigation. Whil e Texas has contingent fee law firms that specialize in nursing home suits, physician malpractice, and bodily injury cases, Texas does not have law firms that specialize in franchise contingent fee litigation. National franchise associations, such as the American Franchise Association and American Association of Franchisees and Dealers, refer unhappy franchisees to such attorneys. 8 Particularly active state franchise administrators are found in California, Illinois, and Virginia. 9 Price fixing and undisclosed brokerage discounts are typical antitrust claims. See 15 U.S.C. § 13(c) (2000) (prohibiting brokerage commissions to persons under the direct or indirect control of a party to the transaction unless that party is the pa rty paying the commission). See generally Panel Discussion, A New Wave of Robinson 3Patman Act Section 2(c) Litigation: Auto- Brokerage Claims in the Franchise Supply Context , T HE A NTITRUST S OURCE , July 2003, at http://www.abanet.org/antitrust/source/july03/brownbag.pdf (providing the discussion of a cBrown Bag d conference call cco- sponsored by the Section 9s Robinson-Patman Act and Corporate Counsel Committees d). 10 See Two Pesos, Inc. v. Taco Cabana, Inc., 505 U.S. 763, 776 (1992) (holding that cproof of secondary meaning is not required to prevail on a [Lanham Act] claim... where the trade dress at issue is inherently distinctive d). Trade dress, which is the coverall appearance and image in the marketplace of a product or a commercial enterprise, d B LACK 9 S L AW D ICTIONARY 1500 (7th ed. 1999), is protectable under federal law. See Two Pesos , 505 U.S. at 768 (noting that the Lanham Act prohibits the deceptive and misleading use of marks). 11 See Patrick F. McGowan & John M. Cone, The Increasing Value of Copyright Protection in a Franchise Context , F RANCHISE L.J.,Fall 1998, at14(explaining how copyrightable works may be important to the operation, promotion, and public perception of franchises). 12 Compare Fitz v. Days Inn Worldwide, Inc. No. 04-02-00487-CV, 2004 Tex. App. LEXIS 4688, *7-10, *15 (Tex. App. 4San Antonio May 26, 2004, pet. filed) (affirming summary judgment for a franchisor in a case emanating from a hit-and-run incident that occurred on the sidewalk of the franchisee 9s premises where the franchisor had drafted the franchise agreement to contractually avoid a right of control over the franchisee), and Chevron U.S.A., Inc. v. Lesch, 570 A.2d 840, 850 (Md. 1990) (concluding that the facts did not support a finding of vicarious liability against Chevron), with Hoytt v. Docktor Pet Ctr., No. 85 C 6850, 1986 U.S. Dist. LEXIS 19296, at *6-7 (N.D. Ill. Oct. 10, 1986) (considering whether a purchaser of a dog from a pet- store franchisee had a cause of action against the franchisor under the doctrine of apparent authority). See generally John C. Monica, Franchisor Liability to Third Parties , 49 M O .L.R EV . 309 (1984) (discussing vicarious and direct liability by franchisors to third parties). 13 See generally Jeffrey R. Seul, Comment, License and Franchise Agreements As Executory Contracts: A Proposed Amendment to Section 365 of the Bankruptcy Code , 59 U.C OLO .L.R EV . 129 (1988) (proposing an amendment to 11 U.S.C. § 365 to protect non-debtor entities from hardship resulting from a licensor 9s or franchisor 9s liquidation or reorganization effo rts). 14 See generally Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220 (1987) (discussing enforceability of arbitration agreements on claims brought by a customer against a broker); Marble Slab Creamery, Inc. v. Wesic, Inc., 833 S.W.2d 436 (Tex. App. 4Houston [14th Dist.] 1992, no writ) (reviewing a franchisor 9s waiver of the right to require arbitration). 15 See In re AIU Ins. Co., No. 02-0648, 47 Tex. Sup. Ct. J. 1093, 2004 Tex. LEXIS 783, at *10 (Tex. Sept. 3, 2004) (indicating that forum selection clauses have the positive effect of eliminating any confusion about where a case should be tried). [2005] UNINTENTIONAL FRANCHISING 307 discrimination laws, state cbaby FTC d acts, 16 the contract and tort law applied by each applicable jurisdiction, and local, state, and federal regulations affecting the subject line of commerce. Any of these can be the downfall of a distribution system. C. Federal Franchise Regulation The FTC Rule defines an arrangement as a cfranchise d if it (1) requires the buyer to pay at least $500 ; (2) for the right to operate a business under the seller 9s trade name or to sell the seller 9s branded products; and (3) the franchisor provides significant assistance to the buyer or can exercise significant control over the buyer 9s operating methods. 17 The FTC Rule makes it unlawful for a franchisor not to provide written disclosures to prospective franchisees at the earlier of (1) the first face-to-face meeting between the franchisor and the prospective franchisee for the purpose of discussing the possible sale of a franchise 18 or (2) ten business days prior to executing the franchise agreement. 19 The FTC Rule does not require any governmental filings 4just disclosure in the prescribed way. 20 Importantly, it does not provide a private cause of action. 21 After nearly ten years of work, the FTC released a 423-page staff report on August 25, 2004 (2004 FTC Staff Report) that recommends various changes in the FTC rule. 22 The FTC 9s input for action against non-compliant businesses primarily comes from complaints and annual national sweeps of one day 9s internet, newspaper, and other advertising. 23 The sweeps produce several thousand hits, which are delegated to the FTC or different states for further review. If the government Consumer Sentinel database shows matching consumer complaints, 24 the odds of a business being screened for further investigation rise. 16 The buyer of a franchise can often avail himself of a state 9s general consumer fraud statute. See Kavky v. Herbalife Int 9l of Am., 820 A.2d 677, 684-85 (N.J. Super. Ct. App. Div. 2003) (holding that Herbalife 9s internet sales into New Jersey were not subject to New Jersey 9s Franchise Practices Act, but were still subject to the New Jersey Consumer Fraud Act); Lund v. Arbonne Int 9l, Inc., 887 P.2d 817, 823 (Ore. Ct. App. 1994) (concluding that a cosmetics company did not violate Oregon 9s Unlawful Trade Practices Act when it terminated a consultant 9s agreement as an independent contractor). Contra J & R Ice Cream Corp. v. Cal. Smoothie Licensing Corp., 31 F.3d 1259, 1274 (3d Cir. 1994) (determining that franchises or distributorships are not covered by the Consumer Fraud Act because they are not sold for consumption). 17 16 C.F.R. § 436.2(a) (2003). 18 See 16 C.F.R. § 436.1(a) (2003) (requiring disclosure cat the earlier of the 8time for making of disclosures 9 or the first 8personal meeting 9 d); 16 C.F.R. § 436.2(o) (2003) (defining cpersonal meeting d to mean ca face-to-face meeting between a franchisor or franchise broker... and a prospective franchisee which is held for the purpose of discussing the sale or possible sale of a franchise d). 19 16 C.F.R. § 436.2(g) (2003). 20 16 C.F.R. § 436.1 (2003). 21 See Tex. Cookie Co. v. Hendricks & Peralta, Inc., 747 S.W.2d 873, 877 (Tex. App. 4Corpus Christi 1988, writ denied) (indicating there is no private federal remedy for failing to make disclosures required by the FTC); see also Carlson v. Coca-Cola Co., 483 F.2d 279,280-81 (9th Cir. 1973); Holloway v. Bristol-Myers Corp. 485 F.2d 986, 986 (D.D.C. 1973) (stating that FTC actions may not be maintained by private parties); Randolph v. Oxmoor House, Inc., No. SA-01-CA-0699-FB, 2002 U.S. Dist. LEXIS 26289, *16-17 (W.D. Tex. Sept. 30, 2002). 22 Bureau of Consumer Prot., Fed. Trade Comm 9n, Disclosure Requirements and Prohibitions Concerning Franchising: Staff Report to the Federal Trade Commission and Proposed Revised Trade Regulation Rule (16CFRPart436),1 (Aug. 2004), at http://www.ftc.gov/os/2004/08/0408franchiserulerpt.pdf. 23 See Press Release, Federal Trade Commission, cOperation Money Pit d Targets Fraudulent Business Opportunity Schemes (Feb. 20, 1998), available at http://www.ftc.gov/opa/1998/02/moneypit.htm (describing fourteen actions announced as part of a mini-sweep targeting sellers of fraudulent business opportunities). 24 See Consumer Sentinel, at http://www.consumber.gov/sentinel/index.html (allowing various law enforcement agencies to access consumer complaints about various fraud). The Consumer Sentinel is a government database of consumer and other complaints from all possible sources. 308 ST. MARY 9S LAW JOURNAL [Vol. 36:101] If screened in, a business receives a polite investigatory letter from the FTC or designated state administrator inviting the business to explain the complaints. Consumer complaints will also trigger such a letter. Businesses sometimes do not take these letters seriously and either ignore them or respond with hostility 4a big mistake. 25 These inquiry letters should be taken to an attorney specializing in the matter for a prompt, polite, and comprehensive response. The FTC is unlikely to take meaningful action against an inadvertent franchisor who is otherwise a good actor and promises to comply going forward. 26 D. State Franchise Laws State laws generally define franchising similarly to the FTC Rule, but differences between the states 9 definitions and exemptions can be crucial to determining whether a particular sale was or was not the sale of a franchise. California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oklahoma, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin require a registration or notice-filing before offering franchises for sale, and pre-sale disclosure through twenty-two items in a prescribed format called a Uniform Franchise Offering Circular (UFOC). 27 Also, Oregon requires pre-sale disclosure without a governmental filing. 28 The internet multiplies the likelihood of trouble, as a business that inadvertently coffers d a cfranchise d under a state 9s laws triggers that state 9s registration and disclosure requirements. 29 Failure to comply with franchise law may give franchisees the right to rescind the agreement or obtain enhanced damages. 30 E. Business Opportunity Laws 25 See generally B UREAU OF C ONSUMER P ROT .,F RANCHISE AND B USINESS O PPORTUNITY P ROGRAM R EVIEW 1993-2000: AR EVIEW OF C OMPLAINT D ATA ,L AW E NFORCEMENT AND C ONSUMER E DUCATION (June 2001) (analyzing the FTC 9s franchise and business opportunity program from 1993-2000). From 1993 through 2000, the FTC received 4512 complaints about franchisors and business opportunity sellers. Id. at 5. The FTC initiated fifty-nine investigations against traditional franchisors, twenty-two of which resulted in an .enforcement action. Id. During the same time period, there were 273 investigations against business opportunity sellers, of which 148 resulted in an enforcement action. Id. Between the large complaint numbers and small investigation numbers lie the bulk of businesses who either make restitution or promise future compliance and show that there i s an insufficient basis for FTC action. 26 The odds of the FTC initiating an enforcement action increase with the number of complaints and the unsatisfactory nature of the business 9s response. 27 C AL .C ORP .C ODE A NN . § 31110 (Deering Supp. 2004); H AW .R EV .S TAT .A NN . § 482E-3(b) (Michie 2004); 815 I LL .C OMP . S TAT . 705/10 (2004); I ND .C ODE A NN . § 23-2-2.5-9(1) (Michie 2004); M D .C ODE A NN .,B US .R EG . § 14-214 (2004); M ICH .C OMP . L AWS § 445.1507a (2004); M INN .S TAT .A NN . § 80C.02 (West 2003); N.Y.G EN .B US .L AW § 683 (McKinney 2004); N.D.C ENT . C ODE § 51-19-03 (2003); O KLA .S TAT .A NN . tit. 71, § 806 (West 2004); R.I.G EN .L AWS § 19-28.1-5 (2004); S.D.C ODIFIED L AWS § 37-5A-6 (Michie 2004); V A .C ODE A NN . § 13.1-560 (Michie 2004); W ASH .R EV .C ODE A NN . § 19.100.020 (West 2004); W IS . S TAT .A NN . § 553.21 (West 2003). 28 See O R .R EV .S TAT . § 650.010 (2003) (requiring that anyone offering to sell a franchise must maintain a complete set of books concerning the sale and provide any purchaser 9s name and the amount of proceeds received to the state). 29 See generally N. Am. Sec. Adm 9rs Ass 9n, Statement of Policy Regarding Offers of Franchises on the Internet (May 3, 1998) (addressing issues related to franchisors 9 increasing use of the Internet), at http://www.nasaa.org/nasaa/scripts/fu_display_list.asp?ptid=72 (last visited Oct. 25, 2004). A franchisor should consider stat ing on its website: cThis information is not intended as an offer to sell, or the solicitation of an offer to buy, a franchise. I t is for information purposes only. d See id. (proposing the use of cautionary language by the franchisor to exempt offers made via the Internet from franchise registration requirements of the state). Alternatively, a website should indicate: 30 See Hicks v. United Snack Group, Inc., [1992-1993 Transfer Binder] Bus. Franchise Guide (CCH) ¶ 10,131 (W.D. Wash. Dec. 9, 1992) (deciding that a franchisee was entitled to rescind the franchise agreement when the franchisor failed to comply with the state 9s franchising law by not registering). But see Mercy Health Sys. Southeastern Pa. v. Metro. Partners Realty LLC, No. 02- 1015, 2002 U.S. Dist. LEXIS 14080, at *2 (E.D. Pa. July 29, 2002) (stating that case law supports the proposition that a party may not rescind a lease agreement after the other party failed to make the required disclosures under the FTC 9s franchise rules ). [2005] UNINTENTIONAL FRANCHISING 309 Business opportunity laws apply to sellers who offer purchasers the opportunity to begin a business by using the seller 9s goods or services even if the seller 9s trademark is not involved. The FTC Rule and twenty-three states, including Texas, regulate business opportunities. 31 Some states have both franchising and business opportunity laws, and some have one but not the other. 32 Generally, if a business transaction is a franchise, it will be exempt from that state 9s business opportunity law. Business opportunity laws, however, often affect agreements drafted to avoid franchise definitions. These laws also differ materially from state to state. F. Texas Business Opportunity Act Texas regulates franchising and business opportunities through the BOA. 33 The BOA definition of cbusiness opportunity d is broader than the FTC Rule 9s definition of cfranchise d and cbusiness opportunity. d 34 G. Relationship Laws Arkansas, California, Connecticut, Delaware, Florida, Hawaii, Illinois, Indiana, Iowa, Kentucky, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Virginia, Washington, and Wisconsin have relationship laws that capture more distribution arrangements and require more of the seller than most business persons realize. 35 In dealing with existing dealers and franchises, one must be aware of the applicable state 9s relationship laws, if any. These laws legislate most-favored nation clauses, 36 regulate the cgood cause d reasons a franchisee can be terminated or not renewed, dictate the notice requirements to effect a termination, and determine the effect of termination. They are not, however, within the scope of this paper. 31 A LA .C ODE § 8-19-5(20) (2004); C AL .C IVIL C ODE §§ 1812.200-1812.221 (Deering Supp. 2004); C ONN .G EN .S TAT .A NN . §§ 36-503-36.529 (West 2004); F LA .S TAT .A NN . §§ 559.80-559.815 (West 2004); G A .C ODE A NN . §§ 10-1-410 to 10-1-417 (Harrison 2004); 815 I LL .C OMP .S TAT .A NN . §§ 602/5-1 to 602/99-1 (West 2004); I ND .C ODE A NN . §§ 24-5-8-1 to 24-5-8-21 (West 2004); I OWA C ODE A NN . §§ 523B.1-523B.13 (West 2004); K Y .R EV .S TAT .A NN . §§ 367.801-367.809 (Michie 2004); L A . R EV .S TAT .A NN . §§ 51:1821-1824 (West 2004); M E .R EV .S TAT .A NN . tit. 32, §§ 4691 to 4700-B (West 2004); M D .C ODE A NN ., B US .R EG . §§ 14-101 to 14-129 (2004); M ICH .C OMP .L AWS A NN . §§ 445.901-445.921 (West 2004); N EB .R EV .S TAT .A NN . §§ 59- 1701 to 59-1762 (Michie 2004); N.H.R EV .S TAT .A NN . §§ 358-E:1 to 358-E:6 (2004); N.C.G EN .S TAT . §§ 66-94 to 66-100 (2004); O HIO R EV .C ODE A NN . §§ 1334.01-1334.99 (West 2004); O KLA .S TAT .A NN . tit. 71, §§ 801-829 (West 2004); S.C.C ODE A NN . §§ 239-57-10 to 39-57-80 (Law. Co-op. 2004); S.D.C ODIFIED L AWS §§ 37-25A-1 to 37-25A-54 (Michie 2004); T EX .B US . &C OM .C ODE A NN . ch. 41 (Vernon 2002); U TAH C ODE A NN . §§ 13-15-1 to 13-15-7 (2004); V A .C ODE A NN . §§ 59.1-262 to 59.1- 269 (Michie 2004); W ASH .R EV .C ODE A NN . §§ 19.110.010-19.110.930 (West 2004). 32 See Attachment A (providing an analysis of state and federal franchise laws). 33 Seegenerally Business Opportunity Act, T EX .B US .&C OM .C ODE A NN . ch. 41 (Vernon 1994) (providing procedures to protect persons against fraud in transactions involving business opportunities). According to the Act, 16 C.F.R. § 436 may be used to assist in the interpretation of T EX .B US .&C OM .C ODE A NN . ch. 41. Id. § 41.002. 34 Compare T EX .B US .&C OM .C ODE § 41.004 (Vernon 1994) (defining cbusiness opportunity d and enumerating exceptions), with Final Guides to the Franchising and Business Opportunity Ventures Trade Regulation Rule, 44 Fed. Reg. 49,966, 49,967 (Aug. 24, 1979) (explaining cpackage and produce franchises d and cbusiness opportunity ventures d). 35 See generally Colt Indus. Inc. v. Fidelco Pump & Compressor Corp., 844 F.2d 117 (3d Cir. 1988) (holding that a non- exclusive agreement with restricted use of a brand name and without a community of interest in the marketing of goods and services between a manufacturer and a distributor does not amount to a franchise under New Jersey law); Thomas M. Pitegoff, Franchise Relationship Laws: A Minefield For Franchisors , 45 B US .L AW . 289 (1989) (comparing franchise relationship laws across the United States). 36 See Can. Dry Corp. v. Nehi Beverage Co. of Indianapolis, 723 F.2d 512, 521 (7th Cir. 1983) (discussing discrimination among franchisees). 310 ST. MARY 9S LAW JOURNAL [Vol. 36:101] II. cF RANCHISE dD EFINED A. Federal Definition of Franchising 1.Definition A relationship is an FTC Rule cfranchise d 37 if it meets the requirements of both Section 436.2(a)(1)(i) 38 and Section 436.2(a)(2) of the Code of Federal Regulations, 39 and is not otherwise exempt or excluded. 40 Unfortunately, Section 436.2(a) is written like a federal tax regulation; a novice 9s first attempt to wring a reliable answer from its few dozen words is often futile. It may be summarized to yield a three-part test: (1)Does the relationship involve a common trademark or format ? 41 (2)Does the relationship involve significant control or assistance from the seller? 42 For example, the agreement might provide that only the seller 9s products can be sold, the seller will train the buyer to perform the service in question, or the seller will show the buyer how to market the products. 43 (3)Is there a required payment of $500 or more to the seller or its affiliates during the first six months of the relationship? 44 In addition to a denominated franchise fee, this includes required payments for cother than reasonable quantities of wholesale goods purchased for resale, d a 37 See 16 C.F.R. § 436.2(a) (2003) (defining cfranchise d). Section 436.2(a)(1)(i) franchises are technically referred to as cproduct franchises, d while Section 436.2(a)(1)(ii) franchises are technically referred to as cbusiness opportunity franchises. d Id. The primary, although not only, difference between the two is that the franchisee in the product franchise uses the franchisor 9 s mark or name while the business opportunity franchisee does not. Compare 16 C.F.R. § 436.2(a)(i) (2003) (defining cfranchise d as, inter alia , a commercial relationship wherein goods or services are identified by a trademark or service mark), with 16 C.F.R. § 436.2(a)(ii) (2003) (applying to, inter alia , goods sold, offered for sale, or distributed that are supplied by another person). As product franchises are popularly called cfranchises d and business opportunity franchises are popularly called cbusiness opportunities. d See Final Guides to the Franchising and Business Opportunity Ventures Trade Regulation Rule, 44 Fed. Reg. 49,966, 49,966 (Aug. 24, 1979) (calling the two types of relationships cpackage and product franchises d and cbusiness opportunity ventures d), this Article will exclusively use those terms. 38 16 C.F.R. § 436.2(a) (2003). 39 16 C.F.R. § 436.2(a)(2) (2003). cThe franchise is required as a condition of obtaining or commencing the franchise operation to make a payment or a commitment to pay to the franchisor, or to a person affiliated with the franchisor. d Id. 40 Seeid. § 436.2(a)(3) (providing exemptions for which the rule does not apply, including fractional franchises and certain situations where the sales occurs on the retailer-grantor 9s premises and for the retailor-grantor 9s benefit); 16 C.F.R. § 436.2 (a)(4) (2003) (providing exclusions from the definition of franchise, including an employer-employee relationship, cooperatives, and certain uses of trademarks, service marks, and trade names). 41 Seeid. § 436.2(a)(1)(i)(A) (defining cfranchisor d to include one who offers, sells, or distributes goods or services bearing marks that designate another person or that are directly or indirectly required to meet standards prescribed by another person when the products or services bear another 9s mark). 42 Seeid. § 436.2(a)(1)(i)(B) (pertaining to, but not limited to, the promotional activities, business organization, management, business affairs, or marketing plan of the cbuyer d). 43 Seeid. (stating that assistance with promotional activities by itself, however, does not constitute the required csignificant assistance d). 44 See 16 C.F.R. § 436.2(a)(3) (2003) (exempting franchises from the provisions when the total of the payments made is less than $500). [2005] UNINTENTIONAL FRANCHISING 311 minimum order of supplies, a required purchase of goods for more than the cost of similar goods elsewhere, or a requirement to buy services. 45 The 2004 FTC Staff Report recommends a more intelligible definition: Franchise means any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller represents, orally or in writing, that: (1)The franchisee obtains the right to operate a business that is identified or associated with the franchisor 9s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor 9s trademark; (2)The franchisor exerts or has authority to exert a significant degree of control over the franchisee 9s method of operation, or provides significant assistance in the franchisee 9s 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. 46 2.Distributorship Example If you sell me an AJAX Bicycle distributorship and give me the right to be your only authorized cAJAX store d in town, then the FTC Rule 9s first element (a ccommon trademark d via the license to use the AJAX trademark and trade name) and second element ( csignificant assistance d via the protected territory) are met. If I do not pay you an up-front fee and only pay you a bona fide wholesale price for a reasonable quantity of bicycles, then the third element of the franchise definition ( crequired payment d) is not met. We do not have a franchise relationship. However, if (1) I have to pay you at least $500 for the privilege of being your distributor, (2) I have to purchase more bicycles from you than reasonably necessary to open my store, 47 (3) the price of bicycles to me is higher than the bona fide wholesale price for similar bicycles elsewhere, 48 or (4) I have to buy $500 of required advertising materials, a large AJAX sign, or training from you, then the third element is met and there is a cfranchise. d In any of these events, if you have not complied 45 See Final Guides to the Franchising and Business Opportunity Ventures Trade Regulation Rule, 44 Fed. Reg. 49,966, 49,967 (Aug. 24, 1979) (indicating the FTC 9s intent to capture chidden franchise fees, d and indicating that payments at a bona fide, reasonable wholesale price will not be considered crequired payments under § 436.2(a)(2) d). 46 Bureau of Consumer Prot., Fed. Trade Comm 9n, Disclosure Requirements and Prohibitions Concerning Franchising: Staff Report to the Federal Trade Commission and Proposed Revised Trade Regulation Rule (16CFRPart436),attach. b at 4 (Aug. 2004), at http://www.ftc.gov/os/2004/08/0408franchiserulerpt.pdf. 47 See Marathon Petroleum Co. v. LoBosco, 623 F. Supp. 129, 134 (N.D. Ill. 1985) (construing a similar Illinois statute to mean a franchise fee is met if a buyer is required to buy an unreasonably large quantity of goods). 48 See 16 C.F.R. § 436.2(a)(2) 3(a)(3) (2003) (stating that in order to be considered a franchise, the franchisee is required to pay a fee, but that fees totaling less than $500 within six months of the commencement of the franchise 9s operations exempt the franchise from the rule); see also Final Guides to the Franchising and Business Opportunity Ventures Trade Regulation Rule, 44 Fed. Reg. 49,966, 49,967 (Aug. 24, 1979) (describing hidden franchise fees, which the rule is intended to capture). This assum es the total amount one must pay in excess of the bona fide wholesale price exceeds $500. See id. (noting that cany payments made by a person at a bona fide wholesale price for reasonable amounts of merchandise to be used for resale d are not considered required payments within the meaning of the rule). cReasonable amounts d means camounts not in excess of those which a reasonable businessman normally would purchase by way of a starting inventory or supply or to maintain a going inventory or supply. d Id. 312 ST. MARY 9S LAW JOURNAL [Vol. 36:101] with applicable federal and state franchise law, then your sale of the AJAX franchise to me is unlawful. This act of legal alchemy 4converting a mundane business deal between fully informed, consenting business persons into an unlawful and possibly illegal act 4is performed via the above definition of cfranchise, d which is so expansive that its parameters are most usefully presented by looking at business deals that lie just outside of those parameters. The authorities cited in the following discussion of the FTC are FTC Final Guidelines and FTC Informal Staff Advisory Opinions, while the authorities cited concerning state statutes are court decisions. This is because there is no private cause of action under the FTC Rule, 49 but there is a private cause of action under each state statute. 50 B. How to Avoid Being a Federal Franchisor 1.Avoid the Franchise Definition a.No Common Trademark The ccommon trademark d element is satisfied if the buyer is permitted to identify its business primarily under the licensor 9s mark or otherwise uses the mark in a manner likely to convey to the public that it is selling goods or services on behalf of the manufacturer or trademark owner. 51 This is so broadly interpreted that, in a preliminary assessment, it should be considered met if the buyer uses the licensor 9s mark to identify any substantial amount of commerce. 52 Ultimately, however, if the buyer 9s use of the trademark does not create an association between the licensor and the buyer, then likely the trademark element is not met. 53 This element will be satisfied only when the franchisee is given the right to distribute goods and services which bear the franchisor 9s trademark, service mark, trade name, advertising or other commercial symbol ( cthe mark d). The most common instances occur when either the goods or services being distributed by the franchisee are associated with the franchisor 9s mark or when (i) the franchisee must conform to quality standards established by the franchisor with respect to the goods 49 See supra note 21 (discussing how no private cause of action exists under the FTC). 50 See, e.g. , F LA .S TAT .A NN . § 559.813 (West 2004) (providing that the purchaser of a business opportunity may exercise remedies up to one year after execution of the contract); T EX .B US .&C OM .C ODE A NN . § 41.302 (Vernon 1994) (providing a private remedy under the Deceptive Trade Practices-Consumer Protection Act for enforcement of the BOA). 51 See 16 C.F.R. § 436.2(a)(i)(A) (2003) (applying the provision to goods, commodities, or services). 52 See Metro All Snax, Inc. v. All Snax, Inc., [1995-1996 Transfer Binder] Bus. Franchise Guide ¶ 10,885 (D. Minn 1996) (finding, in an order denying the plaintiff 9s motion for summary judgment, that under the Minnesota Franchise Act, the trademark element was met although the distributor never used the mark because the distribution agreement permitted its use cto the extent necessary d); Kim v. Servosnax, Inc., 13 Cal. Rptr. 2d 422, 427-28 (Cal. Ct. App. 1992) (finding a franchisee substantially associated with the defendant 9s mark in spite of a contract prohibiting use of the mark and that the plaintiff di d not use the defendant 9s mark at the plaintiff 9s premises); Instructional Sys., Inc. v. Computer Curriculum Corp., 614 A.2d 124, 149 (N.J. 1992) (finding the trademark element met despite that the plaintiff operated only under its own name because the Reseller Agreement permitted the plaintiff to use the defendant 9s name and logo); Neptune T.V. & Appliance Serv., Inc. v. Litton Microwave Cooking Prods. Div., Litton Sys., Inc., 462 A.2d 595, 599 (N.J. Super. Ct. App. Div. 1983) (finding authorization to use a party 9s name sufficient to create a license under the New Jersey Franchise Practices Act because it was sufficient to ind uce the public into the uniform acceptance that there was a connection between the parties). 53 See Van Groll v. Land O 9 Lakes, Inc., 310 F.3d 566, 570-71 (7th Cir. 2002) (finding that a franchise did not exist when the distributor 9s investments were for the right to use a trademark). According to the court, defining the franchise relationship in terms of trademark use protects the distributor, who might spend money promoting the trademark, in case the relationship is lat er terminated. Id. at 570. See also Rudel Mach. Co. v. Giddings & Lewis, Inc., 68 F. Supp. 2d 118, 121 n.1 (D. Conn. 1999) (noting that if the plaintiff fails to establish the csubstantial association d prong, the issue of whether a franchise existed is moot). [2005] UNINTENTIONAL FRANCHISING 313 or services being distributed, and (ii) the franchisee operates under a name that includes, in whole or in part, the franchisor 9s mark. 54 The determining factor with respect to this element should be whether the buyer had a reasonable belief that customer perception of a substantial association between the buyer and the seller would occur and that this customer perception would be valuable enough to be a material fact inducing the buyer to enter into the seller/buyer agreement. 55 Case law, however, does not provide reliable guidance on this point, both because there is not an agreed construction of this requirement and because similar facts often produce contrary holdings. 56 Any substantial use by the buyer of the seller 9s marks creates an issue concerning whether this element is met. The only safe harbor is to contractually prohibit the buyer from using the seller 9s marks and to enforce the prohibition. 57 On bad facts, however, courts have held the trademark element met even if the licensee is contractually barred from using the licensor 9s mark. 58 For most classes of business transactions, from selling flour to a bakery to selling breakfast to a consumer, the buyer does not use the seller 9s trademark in the buyer 9s business. For chains or other businesses that create value from name identification, however, the trademark element is hard to avoid unless deliberately decided on and ruthlessly enforced. A business does not have to be in the FTC Rule 9s targeted area of abuse to find the trademark element met in its transactions. b.No Significant Assistance or Control 54 Final Guides to the Franchising and Business Opportunity Ventures Trade Regulation Rule, 44 Fed. Reg. 49,966, 49,966 (Aug. 24, 1979). 55 Cf. Colt Indus. Inc. v. Fidelco Pump & Compressor Corp., 844 F.2d 117, 123 (3d Cir. 1988) (Rosenn, J., dissenting) (stating that a licensor might create a reasonable belief among consumers that a connection exists between the licensor and licensee any number of ways, including the performance of warranty repair services); Instructional Sys. , 614 A.2d at 139 (finding that an exclusive dealer was a franchisee in spite of the lack of a trademark license because the dealer 9s use of the trademark created a reasonable belief by the public that there was a connection between the trade name licensor and licensee, and that licensor endorsed the licensee 9s activity). 56 Compare Master Abrasives Corp. v. Williams, 469 N.E.2d 1196, 1199 (Ind. App. 1984) (holding that when a distributor sold products that were privately labeled under the manufacturer 9s trademark, a court could find that the distributor was substantia lly associated with the trademark), withColt Indus. Inc. , 844 F.2d at 120 (finding that the agreement between the parties did not constitute the grant of a trademark license under New Jersey law). In Colt Industries , the court stated: The Colt-Fidelco agreement provided that Fidelco could use the Quincy name only in a limited sense and that the Quincy brand name could not be used in Fidelco 9s business name.... In our view, if this limited agreement constitutes a license to use a trademark, then any business selling a name brand product would, under New Jersey law, necessarily be considered as holding a license.... [T]he agreement did not constitute a grant of a trademark license to Fidelco. Id. 57 See Final Guides to the Franchising and Business Opportunity Ventures Trade Regulation Rule, 44 Fed. Reg. 49,966, 49,966 (Aug. 24, 1979) (stating that cthe supplier may avoid coverage under the rule by expressly prohibiting the use of its mark by t he distributor d); see also Powerbrand Prods. of Va., FTC Informal Staff Advisory Opinion, 2 Bus. Franchise Guide (CCH) ¶ 6438 (May 13, 1983) (stating that express prohibition of the use of the supplier 9s mark by the distributor avoids coverage under the rule); Permagraphics Int 9l, Inc., FTC Informal Staff Advisory Opinion, 2 Bus. Franchise Guide (CCH) ¶ 6433 (Sept. 21, 1982) (stating that because the licensing agreement at issue expressly prohibited the use of the licensor 9s marks, the relationship between the parties clack[ed] one of the essential definitional elements required to establish a franchise relationship d under the rule); U.S. Marble, Inc., FTC Informal Staff Advisory Opinion, 2 Bus. Franchise Guide (CCH) ¶ 6424 (Oct. 9, 1980) (explaining that a prohibition against using a seller 9s marks must be expressly stated in a contract, and that the use of contractual silen ce is not enough). 58 See Kim v. Servosnax, Inc., 13 Cal. Rptr. 2d 422, 427-28 (Cal. Ct. App. 1992) (illustrating that a franchise can be found to exist although the licensor 9s trademark is not used by the licensee); Instructional Sys ., 614 A.2d at 140 (illustrating that a franchise can exist when parties share a cspecial relationship d as it relates to the sale of one party 9s products). 314 ST. MARY 9S LAW JOURNAL [Vol. 36:101] A seller may attempt to avoid this element by deliberately not providing the buyer with any assistance or control. While this is possible in theory, the practical reality is that almost any assistance or control could conceivably meet the assistance or control element. 59 Among the significant types of controls over the franchisee 9s method of operation are those involving (a) site approval for unestablished businesses, (b) site design or appearance requirements, (c) hours of operation, (d) production techniques, (e) accounting practices, (f) personnel policies and practices, (g) promotional campaigns requiring franchisee participation or financial contribution, (h) restrictions on customers, and (i) location or sales area restrictions. Among the significant types of promises of assistance to the franchisee 9s method of operation are (a) formal sales, repair or business training programs, (b) establishing accounting systems, (c) furnishing management, marketing or personnel advice, (d) selecting site locations, and (e) furnishing a detailed operating manual. In addition to the above listed elements 4the presence of any of which would suggest the existence of csignificant control or assistance d 4the following additional elements will, to a lesser extent, be considered when determining whether csignificant d control or assistance is present in a relationship: (a) a requirement that a franchisee service or repair a product (except warranty work), (b) inventory controls, (c) required displays of goods and (d) on-the-job assistance in sales or repairs. 60 The gist of this FTC guideline is that the control or assistance must relate to the franchisee 9s general method of operating its business. 61 If the assistance concerns just a few products that collectively comprise only a small portion of the buyer 9s business, then such assistance will likely not be considered csignificant assistance. d 62 There is no bright and shining line, however, separating cenough d from cnot enough d assistance or control to satisfy the csignificant d assistance or control element. Fact questions are resolved by a jury. While sellers in the FTC Rule 9s target area typically provide assistance or control to the buyer, many sellers outside of the target area also provi

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