Creative Representation | Expert Litigation

Unintended Franchises Keep Popping Up

by Darryl Hart

June 1, 2017 – A couple of nice young people I will call “clients”, since that is what they became, came in several weeks ago with an agreement prepared by another law firm that covered an arrangement granting to a third party the right to establish a business using a trademark belonging to the clients, along with the clients’ business format and featuring the clients’ products.  The third party had to pay an initial fee and an ongoing payment for these rights as well as having to comply with quality controls specified by the clients, meeting the design requirements of the client and complying with the supply, sourcing and other requirements and limitations specified by the agreement.  After they had entered into a couple of these contracts the clients were told by an acquaintance that the deal looked like a franchise even though the contract called it something else.  I was recommended to them as someone who knows about franchising and they came in to see whether their contract was, in fact, a franchise agreement and, if so, what were the consequences of selling a franchise in California.

The definition of “franchise” under California law has several elements: (1) a right must be granted to engage in a business offering, selling or distributing goods or services; (2) the grantee has the right to engage in the business under a “marketing plan or system prescribed in substantial part” by the granting party; (3) the business must be “substantially associated” with a name, mark, symbol or design identifying the grantor or an affiliate of the grantor; and (4) a direct or indirect payment of some kind is required.  Looking at the agreement described in the above paragraph, it doesn’t take much to see that it was, legally, a franchise.

In California, and in 13 other states, franchises have to be registered with an agency of the state before they are offered or sold in those states.  Under a Federal Trade Commission rule applicable throughout the United States, specified disclosures must be made before a franchise is sold in the U.S.  If the proper disclosures are not made, the FTC can bring an action for violation of the FTC Act.  In California, selling an unregistered franchise can result in civil and criminal penalties and the party to whom it is sold has various rights, including the right to rescind the agreement and to sue for damages.  So, what do you do if you have sold an unregistered franchise in California?

If someone has sold a franchise in violation of California law, it is best to go to the California Department of Business Oversight (“DBO”), the state agency that oversees the California Franchise Investment Law (“CFIL”), do a mea culpa and negotiate the penalties the state will impose.  Not fessing up and later being caught will likely result in more severe penalties.  In the above case, since the clients were ill-advised by their lawyer, the DBO was lenient, although an administrative penalty—fine—was assessed and various, somewhat expensive, paperwork had to be completed and those with whom they entered agreements had to be notified of the violation and their rights under the CFIL.

Hopefully most lawyers will recognize when a client’s expansion plans constitute a franchise.  It is surprising, however, how many don’t and think a few cosmetic changes will remove their documents from the CFIL.  If a lawyer does not know how to draft a good franchise agreement and comply with the other requirements of the CFIL, hopefully he or she will refer the client to someone who does.

It makes me sad to see folks subjected to the significant expense and uncertainty brought about by reliance on questionable advice.  In the above situation, the client was stuck not only for the costs charged by the initial attorney but also for the penalty charged by the DBO, the considerable legal work involved in remedying the violation and, ultimately, the cost of preparing the more comprehensive franchise agreement and disclosure document they needed to continue to expand their concept.  I have written articles and given lectures to attorney groups about this issue but, still, these unintended franchise situations keep happening.

This blog contains the personal view of the author and is not intended to be legal advice for any specific situation.