In California, the offer and sale of a franchise is regulated by the California Franchise Investment Law (“CFIL”). The CFIL imposes a registration and disclosure obligation on franchisors requiring them to register their franchise offering with the California Department of Financial Protection and Innovation (“DFPI”) prior to any offer or sale of a franchise, and to provide prospective franchisees with the franchisor’s then-current franchise disclosure document no less than 14 calendar days before signing a franchise agreement or accepting payment from the prospective franchisee.
There are only a handful of exceptions to these registration and disclosure requirements. One of those is the “experienced franchisee” exemption contained in Section 31106 of the CFIL.[1] Under this exemption, certain prospective franchisees may have a level of management, operational experience, and existing familiarity with the franchise system that renders the registration and disclosure obligations of the CFIL unnecessary. This “insider” exception typically applies to existing franchisees and others with significant industry experience.
For a franchisor to take advantage of this Section 31106 exemption, the prospective franchisee must satisfy at least one of the following three criteria:
Exemption #1: The transaction is exempt if the prospective franchisee (or someone owning at least a 50 percent interest in the prospective franchisee business) meets both of the following:
- The owner has had, within the seven years before the date of the sale or other transaction, at least 24 months’ experience being responsible for the financial and operational aspects of a business offering products or services substantially similar to those offered by the franchised business, and
- The owner is not controlled by the franchisor.[2]
Exemption #2: The transaction is exempt if the prospective franchisee (or the individual owning at least 50 percent of the prospective franchisee) meets both of the following criteria:
- The owner or owners are, or have been within 60 days prior to the sale or other transaction, an officer, director, managing agent, or an owner of at least a 25 percent interest in the franchisor for at least 24 months, and
- The owner or owners are not controlled by the franchisor.[3]
Exemption #3: Finally, if neither of the above exemptions apply, the transaction will still be exempt under the experienced franchisee exemption if the transaction involves:
- An additional franchise to an existing franchisee of the franchisor (or to an entity or individual with at least a 25 percent interest in the existing franchisee); and
- The existing franchisee has been engaged in a business for the past 24 months that has offered products or services substantially similar to those to be offered by the additional franchise.[4]
Notice of Exemption
Along with satisfying one of the above three experienced franchisee exemptions, the franchisor must file a notice of experienced franchisee exemption with the DFPI no later than 15 days after the transaction is complete.[5] The form can be found on the DFPI’s website here. The filing must be accompanied by a $450 filing fee for an initial notice of exemption and a $150 filing fee for each consecutive notice of exemption.[6]
A transaction that satisfies any of the above three criteria, followed by the filing of the Notice of Exemption and required filing fee “shall be exempted from provisions of Chapter 2 [of the CFIL] (commencing with Section 31110).”[7] This includes exemption from the registration (Sections 31110, 31114), disclosure (Section 31119), and renewal (Sections 31121, 31125) requirements of the CFIL.
Franchisor’s Burden
All franchisors applying the Section 31106 exemption to the transaction has the burden of proving the exemption under the CFIL.[8] Stated differently, any franchisor relying upon the experienced franchisee exemption must be able to prove (with evidence) that the facts of one or more of the above exemptions apply.
Franchise Renewals Do Not Apply
Franchisors should be aware that although the language of subsection 3 of Section 31106 expressly references an “additional franchise to an existing franchisee,” California courts have found that the experienced franchisee exemption does not apply to “renewed agreements with franchisees.”[9] Instead, the exemption only applies if the existing franchisee is considering adding a new or additional franchised business.
[1] Cal. Corp. Code § 31106.
[2] Cal. Corp. Code § 31106(1).
[3] Cal. Corp. Code § 31106(2).
[4] Cal. Corp. Code § 31106(3).
[5] Cal. Corp. Code § 31106(b).
[6] See Cal. Corp. Code §§ 31106(f), 31500(f).
[7] Cal. Corp. Code § 31106.
[8] Cal. Corp. Code § 31153.
[9] Mahroom v. Best Western Intern., Inc. (N.D. Cal. 2007)) 2007 WL 2123565, at *5.
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This article was prepared by Kevin A. Adams (kadams@mortensontaggart.com), a Partner at Mortenson Taggart Adams LLP. Mr. Adams represents and counsels franchisors, licensors, manufacturers, and distributors on their business litigation needs, including state and federal franchise laws, intellectual property rights, California employment laws, and related trade regulation matters.
Disclaimer: While every effort has been made to ensure the accuracy of this article, it is not intended to provide legal advice as individual situations will differ and should be discussed with an experienced franchise lawyer. For specific technical or legal advice on the information provided and related topics, please contact Mr. Adams at kadams@mortensontaggart.com.