Greenbaum, Rowe, Smith & Davis LLP

• GreenbaumLaw.com
• Newsletter Homepage
• Past Issues
• Subscribe

The Accidental Franchise

By Eric H. Melzer, Esq.

 

When licensing a trademark registered under federal law, trademark owners have to be wary that they do not create a franchiser-franchisee relationship. In many license agreements, licensors (the trademark owner) try to limit this exposure by adding a provision in the agreement that the parties acknowledge and agree that their relationship is not that of a franchiser-franchisee. Such a statement, however, can be viewed as merely self-serving and can be ignored by a court or administrative body such as the Federal Trade Commission, if they believe that the licensor is exercising too much control over the licensee.

 

The definition of a franchise varies somewhat in its practical application from state to state. Generally, as far as triggering the federal requirement to provide a franchise disclosure document to a prospective franchisee and/or the requirement in fifteen (15) states to register such a document with the applicable state authority, a franchise relationship is that which involves (i) the license of a federal trademark for some consideration (such as $500), and (ii) either (a) the franchiser exercising a significant degree of control over the operations of the franchise, or (b) a community of interest in the marketing of goods or services at wholesale, retail, by lease, agreement or otherwise. While the elements involving the license of a trademark for consideration are clear, the standard of what is deemed to be “control” or a “community of interest” is an extremely grey area. In many states, including New Jersey, at one end of the spectrum is a simple license of a trademark for consideration in which the licensor only cares that it gets paid on a regular basis. On the other end are the relatively famous franchises, such as Dunkin’ Donuts® or Subway® that seek to control every detail of the operations of the licensee.

 

But what about the licensor that wants to maintain a certain degree of control over how a trademark is used, but does not want to be subject to franchise law requirements or to incur the expense of being a franchisor? It is often a close call as to whether a licensor can simply utilize a trademark license agreement as the only necessary document or be required to prepare a lengthy disclosure document with twenty-three detailed items with numerous exhibits, including the financial statements of the licensor, and deliver such items to the potential licensee. In fifteen states, a franchisor will be required to register such a disclosure with the applicable Attorney General’s office and pay a significant filing fee. These states are: New York, Maryland, Virginia, California, Hawaii, Illinois, Indiana, Michigan, Minnesota, North Dakota, Rhode Island, South Dakota, Utah, Washington and Wisconsin.

 

In New Jersey and in other jurisdictions, a licensor of a trademark is absolutely entitled to exercise a certain degree of quality control for its trademark without creating a franchise relationship. Of course, the licensor can and should specify the specific uses for which the licensee can utilize the trademark. A trademark license agreement should contain: (1) very strict standards as to use; (2) audit rights by licensor; (3) prohibitions of competition by licensee; and (4) a clear termination section in the event that the licensee fails to comply with the terms and conditions of the agreement. Of course, the agreement must require the licensee to return or destroy items containing the licensed trademark in the event of termination. Courts have held that these provisions are unlikely to trigger the relationship of the licensor and licensee to be deemed to be that of a franchisor and franchisee.

 

The cutting edge question is when the licensor seeks to protect its trademark by exercising some degree of control over the operations of the licensee. Each jurisdiction allows for some limited degree of control to be exercised without triggering the franchise statutes. For example, a restaurant that owns a trademark that operates in accordance with certain dietary restrictions may require that the licensee comply with those dietary guidelines as a condition of the license. This degree of control by a licensor on a licensee without further control over operations would likely not be deemed to be a franchise. However, when the licensor’s control begins to extend to certain of the minute details of the licensee’s operations, then the relationship begins to move away from that of a licensor and licensee and starts to enter the franchise realm. For example, quality control over the decor or the build-out of the location, or required items on a menu of spa services may trigger the franchise regulations requiring that a disclosure document be prepared. Quality control over pricing or imposing the requirement that a licensee purchase specific products from a licensor, not only requires an analysis of the franchise laws, but also triggers scrutiny under the Sherman Act, 15 U.S.C.§1, which federal statute generally prohibits price fixing, tying arrangements, and other anti-competitive behavior.

 

One solution is for a licensor to make recommendations, not requirements, regarding the details of the operation of the licensee’s business in the licensing agreement. Another solution is for the licensor to provide the licensee with certain alternatives of implementation. For example, a licensor can provide a storeowner with multiple alternatives as to how it can stock a particular location. In many jurisdictions, these solutions may be sufficient to avoid the relationship rising to the level of that of a franchisor-franchisee.

 

To conclude, it is critical for the owner of a trademark that is not interested in creating a franchise relationship with a licensee, to be very careful that it does not engage in activities or conduct that would be deemed by a court or by the Federal Trade Commission to be a franchise under federal or applicable state law. Of course, the license agreement must also be scrupulously drafted to avoid triggering franchise statutes or regulations. Should a court or the Federal Trade Commission determine that the licensor was really a franchisor that did not provide (or register) the disclosure document, the penalties imposed on the licensor may include monetary fines and rescission of the relationship with a full refund of all fees paid by the licensee to the licensor. Moreover, in New Jersey, if the licensor is deemed to be a franchisor, then the licensee/franchisee will have numerous rights and remedies under the New Jersey Franchise Practices Act, such as the right to prohibit the franchisor’s imposition of unreasonable standards of performance on the franchisee and the right not to be terminated without good cause.