Understanding and Avoiding the Accidental Franchise

By Kevin A. Adams

Franchise systems that misjudge the nature of their relationships with franchisees – often mischaracterizing those relationship as licenses, independent contractors, distributorships, or joint ventures – can lead to disastrous consequences for the system, its owners and operators, and others.

As seen in the cases of SunFlora, Inc. v. Nat. Sols., LLC, No. CV2001141CJCMRWX, 2022 WL 1407963 (C.D. Cal. Jan. 21, 2022), and Singh v. Wireless Vision, LLC, No. 2:22-CV-01018-JDP, 2023 WL 2752584 (E.D. Cal. Mar. 31, 2023), an accidental franchise relationship has potential legal consequences that can impact personal liberty, financial security, and the reputation of the involved system and its owners.

In SunFlora, the parties entered into contracts titled “Exclusive Territory Agreement” and “Affiliate Agreement,” both of which governed the defendants’ opening and operation of stores that sold Cannabidiol products. After some time, plaintiff sued the defendants for breach of the contracts. The defendants responded by asserting counterclaims for, among other things, violation of California’s Franchise Investment Law for the plaintiff’s alleged failure to properly register and disclose the franchise offering. Relying upon California Corporation Code § 31302, the defendant also included both the Chief Executive Officer and Chief Marketing Officer of plaintiff as individual counter-defendants in the action. Although the claims against the individuals were later dismissed on jurisdictional grounds, the unexpected personal liability that hangs over executive officers and other members of the system for accidental franchise relationships can be staggering.     

In Singh, the plaintiff argued that the parties’ contract, although styled as an “Operating Agreement,” constituted a franchise agreement, and the defendant’s purported termination of the agreement violated the California Franchise Relations Act. In response, the defendant petitioned the court to transfer venue from the Eastern District of California to the Eastern District of New York pursuant to the forum selection clause in the Operating Agreement. However, the motion to transfer was denied as the court found the operator agreement to be a franchise agreement under the law, and the California Franchise Relations Act expressly voids any “provision in a franchise agreement restricting venue to a forum outside this state.” This mischaracterization of the relationship by the putative franchisor not only subjected it (and others in its system) to the heightened liabilities of franchise statutes, but also prevented it from defending the lawsuit on its home turf.    

The attorney advising the putative franchise system also can be subjected to serious liability for mischaracterizing the true nature of the business model. For example, in Beverly Hills Concepts, Inc. v. Schatz & Schatz, Ribicoff & Kotkin, 247 Conn. 48, 717 A.2d 724 (1998), a $15.9 million malpractice judgment was entered against a Connecticut law for failing to properly advise a client on whether or not to register the franchise business under the Connecticut business opportunity laws.

These cases demonstrate just a few of the many potential implications for failing to properly identify the business model as a franchise. To avoid these outcomes, it is essential that the advising counsel and key businesspeople understand how a franchise is created and defined under the law.

While this is somewhat complicated by the various definitions of the term “franchise” – including those contained in the Federal Trade Commission’s regulations, the franchise laws of California and more than a dozen other states, the various state business opportunity laws, and other federal and state industry-specific laws concerning franchising – the basic elements of what constitutes a “franchise” are undeniable.

Under the FTC Franchise Rule, a “franchise” involves three key elements:

  1. the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;
  2. the franchisor has the authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and
  3. as a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.

The FTC Rule further clarifies that a required payment means all consideration that the franchisee must pay to the franchisor or an affiliate, either by contract or by practical necessity, as a condition of obtaining or commencing operation of the franchise. However, payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or lease are excluded from this definition.

The California Franchise Investment Law’s definition of “franchise” is slightly differently than the FTC definition. While also requiring three elements, the CFIL’s definition of “franchise” includes:

  1. the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by the franchisor;
  2. the franchisee’s business must be substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor or its affiliate; and
  3. the payment, directly or indirectly, of a franchise fee (i.e., an amount that exceeds $500 in aggregate payments on an annual basis and excludes the bona fide wholesale price of goods sold by franchisor to franchisee).

Whether FTC Rule of the CFIL, all three elements must be present in the relationship for a franchise to have been created. Irrespective of some clever attorney’s efforts, disclaimers, waivers, releases, or acknowledgments that the relationship does not constitute a “franchise” are of no consequence if the three elements of a “franchise” have been satisfied.  

Understanding the defining points of what constitutes a “franchise” can help businesspeople and their attorneys steer clear of accidental franchise and legal consequences that it brings.

This article was prepared by Kevin A. Adams, a Partner at Mortenson Taggart Adams LLP and head of the firm’s Franchise and Distribution practice group. He 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, unfair competition, 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.