USA – Franchise Agreements

The interplay between federal and state statutory and common law in the US legal system is important to understanding the regulation of franchise agreements in the US. However, contrary to the US state law governing commercial agency and distribution agreements, franchise arrangements in the US are regulated at the federal and state levels. At the federal level, franchise arrangements are regulated by the US Federal Trade Commission (“FTC”) under the so called “FTC Franchise Rule,” while at the state level franchise arrangements are typically regulated by state agencies. In New York, franchise arrangements are regulated by the New York Antitrust Bureau under New York’s General Business Law. The FTC Franchise Rule applies everywhere in the US, while generally state franchise legislation requires contact with the state (e.g., the offer or sale of the franchise be made in the state, the franchised business be located in the state or the franchisor or the franchisee be a resident of the state).

Franchise law and regulation also provides, to some degree, an exception to the general freedom of contract doctrine that underlies US state law on contracts, as these relationships are subject to significantly greater regulation than commercial agency and exclusive distribution arrangements. Indeed, under so-called relationship laws (discussed below), some US states impose certain mandatory commercial terms, usually relating to notice periods and grounds for termination, on the franchise relationship. More commonly, federal and state franchise laws require that the franchisor provide the franchisee with extensive disclosure with respect to the key elements of the proposed franchise and/or effect certain registration filings with respect to the franchise. This greater degree of regulation at the state and federal levels is based on the view that the franchisee in a franchisor-franchisee relationship requires greater protection than parties to commercial agreements generally, owing to disparities in experience, sophistication and resources between franchisor and franchisee.

Under the FTC Franchise Rule, a franchise exists if the following elements exist: (i) the franchisee is given the right to distribute goods and services that bear the franchisor’s trademark, service mark, trade name, logo or other commercial symbol; (ii) the franchisor has significant control of, or provides significance to, the franchisee’s method of operation; and (iii) the franchisee is required to pay the franchisor (or an affiliate of the franchisor) at least US$USD 500 before (or within six6 months after) opening for business. Whether the control element in (ii) is satisfied will depend on such factors as whether the franchisor must approve the site, whether the franchisee is subject to requirements for site design and appearance, hours of operation, production techniques, accounting practices and promotional or training activities. In relationships that purport to be trademark licenses rather than franchises, licensors often require that a licensee agree to limit its use of a mark to a certain quality or type of goods and provide the licensor with the right to inspect the quality of the goods and services offered under the licensor’s trademark, as the FTC does not consider trademark control designed solely to protect the trademark owner’s rights to constitute the “significant” control necessary to find a franchise. As typically this control element (ii) is found to exist, often franchisors seek to avoid regulation as a franchise by seeking to avoid the existence of the “fee” element in (iii). A court may look at a host of payment obligations from franchisee to franchisor to see whether a so-called “hidden” franchise fee exists, including actual up-front fees, training fees, payments for services and payments from the sale of products (unless reasonable amounts are sold at bona fide wholesale prices). Many states have adopted the FTC Franchise Rule’s definition of a franchise, or variations of it. In New York, a franchise is deemed to exist if only the first and third (trademark grant and franchise fee) are found to exist. The majority of other states, including California, require the same two elements as well as a so-called “marketing plan” element, under which the franchisee is granted the right to engage in the offering, selling or distribution of goods or services under a marketing plan or system substantially prescribed by the franchisor.

If a franchise is deemed to exist under the FTC Franchise Rule or under state law (and an exemption under such law is unavailable), the franchisor is required to comply with requirements that generally fall into three categories: disclosure laws, registration laws and relationship laws. Disclosure and registration laws are pre-sale laws that govern the franchisor’s conduct in making the franchise sale (including, in the former case, the obligation to provide an extensive disclosure document), while relationship laws govern the terms of the relationship between franchisee and franchisor after the parties have begun their contractual relationship (e.g., notice periods and grounds for termination).

Formalities (registration, etc.)

Registration laws like disclosure laws are pre-sale laws. There is no federal registration requirement. However, fourteen US states have registration laws (including California and New York). In the remainder of states, franchisors that comply with the Franchise Rule’s disclosure requirements can sell in states that do not require registration without having to file their document with any governmental authority.

Under most state registration laws, a franchisor must: (i) register in the jurisdiction before offering to sell or selling franchises in the jurisdiction by filing its FDD (or FOP), plus various application forms with the jurisdiction’s applicable regulatory agency, and (ii) update or renew its registration annually. The typical consequences for failing to register are that a franchisor will not be able to offer to sell or sell a franchise in the registration jurisdiction. As of 2016, franchise registration initial filing fees range from USD $250 (Hawaii, Michigan, North Dakota and South Dakota) to USD$ 750 (New York).

Sub-franchisee

There are two typical structures for franchise agreements: (i) a one tier structure consisting of a franchise agreement between a franchisor and a franchisee, or (ii) or a two-tier structure through a master franchise agreement where the franchisor grants the right and imposes a duty on a franchisee to operate the franchise itself within a particular territory, and to grant sub-franchises to third parties within that territory.

Sub-franchisors are subject to the same disclosure rules indicated above. However, in New York when the person filing the application for registration of FOP is a sub-franchisor, the FOP shall also include the same information concerning the sub-franchisor as is required from the FOP of the franchisor.

Rights and Obligations of the Franchisee

• Fees and Royalties: under a typical franchise arrangement the franchisee is required to pay the franchisor an up-front franchise fee and royalties over time, in order to join the franchise network. Franchise fees can be large with a substantial profit element, or smaller (and linked to franchisee start-up costs) to assist the franchisee to set up the franchise in a target territory. Because a franchise fee is a requirement under the FTC Franchise Rule and the laws of many states in order for a franchise to be deemed to exist, there is considerable jurisprudence on the question of what is considered to be a “franchise fee” for these purposes, typically in cases in which the franchisor seeks to avoid regulation as a franchise for lack of the existence of this element. While traditional royalties for the sale of the product or service offered are not considered to constitute a “franchise fee,”, certain required payments for rent, advertising contributions, training, equipment, software and copies of manuals may.
• Marketing: typically a franchisee is required by the provisions of a franchise agreement to undertake advertising of the products in strict accordance with the franchisor’s instructions. A franchisor normally is prohibited from carrying out advertisement and promotional activities in a manner that could harm the franchisor’s brand or is inconsistent with the franchisor’s other advertising efforts.
• Compliance with the franchisor’s standards: maintenance of consistent appearance, operations and array of products and services across multiple franchises is a hallmark of franchise arrangements in the US Most franchise agreements require that franchisees strictly abide by specifications, standards and operating procedures, each of which is built into the agreements. Given the difficulty of providing for all of these standards in a franchise agreement, many franchise agreements afford franchisors the right periodically to modify and increase the applicable specifications, standards (e.g., accounting, record-keeping and reporting requirements, as explained below) and operating procedures, usually by providing updates to the base operating manual.

Rights and Obligations of the Franchisor

• Communication of know-how: initial know-how that may be communicated from franchisor to franchisee often relates to the specifications, standards and operating procedures that relate to the products to be sold and related site that are built into franchise agreements, as discussed above.
• Ownership of improvements and modifications: franchise agreements typically contain acknowledgement by the franchisee that the trademark (and intellectual property generally) licensed under the franchise agreement and all related goodwill are property of the owner of the trademark (usually the franchisor). Therefore, all improvements to such intellectual property are property of the licensor. In this regard, we note that it is typical for a franchise agreement to prohibit any modification of franchisor intellectual property.
• Assistance to the benefit of the franchisee: there are no statutory obligations on the federal and state level for initial or continuing assistance by the franchisor for the benefit of the franchisee. As in other cases, such an obligation can be provided for contractually in the franchise agreement.

Undertaking not to compete (by franchisee)

In most states, the courts have not expressly distinguished between non-compete covenants that apply during the existence of the franchise agreement and those that apply after its expiration or termination. Where the courts have made this distinction, they have applied more lenient standards toward in-term covenants in contrast to those that apply after termination. With respect to such provisions that apply to the post termination period, most courts evaluate their reasonableness in terms of duration, geographic scope and activities prohibited. On duration, post-term covenants of one to two years have generally been deemed to be reasonable in the franchise context. Regarding geographic scope, post-term covenants limited to the area of operation of the franchise have also generally been deemed reasonable. However, post-term covenants are sometimes drafted to prohibit competition with other franchised or company owned locations or in what is called a “buffer” zone outside the franchise’s area of operation. In such cases, some state courts have been willing to enforce post-term covenants with these broader types of geographic scope, while other state courts have not.

In some states, statutory provisions govern the enforceability of restrictive covenants. A notable example is California, whose statute of general applicability voids any post-term covenant not to compete unless specifically exempted by the statute. The statute contains no exemption for franchise agreements. However, the California courts have held that a franchisor may nevertheless enforce post-term obligations not to use its confidential know-how and not to solicit persons who were customers of the franchise. In contrast, in New York, courts generally uphold post-termination non-compete agreements if they protect trade secrets, customer lists or some another legitimate business interest. States differ in their approach to restrictive covenants that are found to be too broad and unenforceable as written. In a few states, if a covenant is deemed to be too broad it will not be enforced at all. Other states (including New York) take a “blue pencil” approach, under which the court will amend the provision in order to make it enforceable.