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The Federal Trade Commission (“FTC”) has instituted very stringent rules that govern the creation and operation of a franchise, and harsh penalties for failure to comply. Therefore, it is critical that business owners offering licensing or business opportunities to others be crystal clear on whether their model is a franchise and, if so, that they have complied with all applicable federal and state laws.
A franchise is a business model through which the owner of a business (“franchisor”) grants the rights to other individuals or groups (“franchisee”) to use the franchisor’s products, services, trademarks, business model, etc., to open and run the same or similar type of business. The franchisor generally licenses the use of such assets to a franchisee in exchange for some form of payment, such as an up-front franchise fee, a share of ongoing royalties, or both. The franchisor also generally imposes quality control requirements on the franchisee to assure that the trademarks and good will of the company do not suffer.
For example, have you ever been to a McDonald’s in another country? If so, you have probably noticed that the Big Macs and fries taste the same as they do here in the U.S. As amazing as that may seem, you are not necessarily witnessing a miracle under the glow of the Golden Arches. Rather, you are experiencing the quality controls imposed by the main McDonald’s corporation on its franchisees. As a result, when you order “two all-beef patties, special sauce, lettuce cheese…” in Rhode Island, or “Két minden marha patties, különleges mártás fejes saláta sajt” in Budapest, you know what to expect.
But what about your local, Colorado business? Surely you do not qualify as a franchise just because you allowed someone to slap your logo on their store front, right? Maybe not. But considering the potentially devastating consequences for failing to comply with franchise laws, you had better find out.
Among the FTC’s compliance rules is the requirement of providing the initial Franchise Disclosure Document (“FDD”), previously known as the Uniform Franchise Offering Circular (“UFOC”), to all potential franchisees. The FDD is a lengthy document that contains information for potential franchisees regarding various aspects of the franchise opportunity, including the franchisor’s executives, details related to the financial status of the company, obligations of the franchisor and franchisee, and much more. In fact, the FTC requires 23 specific items to be included in the body of the FDD, as well as several other documents that must be included as attachments. The purpose of the FDD is to provide interested parties with sufficient information to allow them to make an educated decision. The FDD must be presented to potential franchisees at least 14 days before the execution of the franchise agreement.
Failure to comply strictly with the FTC’s requirements and regulations for franchises will put the franchisor in substantial jeopardy of significant penalties. Those penalties can include, among other things, fines in the range of hundreds of thousands of dollars, being temporarily or permanently banned from growing or operating the franchise, freezing the franchisor’s assets, and in the worst scenarios, even criminal conviction and prison time. In addition, in some cases, the individuals who are the principals of the franchise organization can be held personally liable for monetary penalties and/or awards granted in lawsuits.
Some would-be franchisors try to get around the FTC’s strict regulations by choosing not to call their business model a franchise, or trying to operate under some other format, such as providing a “business opportunity.” Just because the business owner does not call it a franchise, however, will not save it from being tagged as a franchise. Under current franchise law, the relationship between a business opportunity provider and interested parties is a franchise if the following three factors exist:
1) the license of a trademark from the franchisor to franchisees,
2) significant control by the franchisor over the franchisee, or significant assistance to the franchisee,
3) payment of some form from the franchisee to the franchisor.
In other words, the law’s approach is, “if it walks and talks like a duck, it’s a duck,” regardless of how creative the parties involved are at trying to disguise the relationship as some other business model. In fact, to officially dispel any confusion that may have existed over whether business opportunity providers are subject to franchise laws, the FTC has extended the disclosure and compliance requirements to “business opportunities” as well.
In addition to the federal regulations imposed upon franchisors and those offering business opportunities, several states have their own franchise and business opportunity laws that must be obeyed. Colorado is not one of those states. As such, a franchisor operating within Colorado, and offering franchise opportunities only within Colorado, must only comply with the federal regulations. However, if that franchisor ever decides to offer franchise opportunities in a different state, or even to “test the waters” outside of Colorado, it is critical that the franchisor first determine whether that state has additional franchise regulations and, if so, that the franchisor become very familiar with those requirements.
The purpose of this article is not to scare prospective franchisors away from operating a franchise. After all, there is a reason why some of the world’s most successful businesses are franchise operations. The disclosure and other compliance requirements may seem daunting, but are by no means unachievable. With the assistance of experience and knowledgeable legal counsel, the franchisor should be able to achieve compliance with reasonable effort.
by Josh Deere, Attorney at Hanes, Hrbacek & Bartels, LLC