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A Legal Analysis of a Preferred Method of Retail Sales
| Guest post by: Mitchell J. Kassoff |
Article Overview: There are several methods of conducting a business in the area of retail sales. They include private ownership of one or more stores, a “chain store” system, public stock ownership of companies to provide capital for expansion and franchising. This article explores the legal aspects and benefits of conducting a business through the use of franchising.
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Free Download - A Legal Analysis of a Preferred Method of Retail Sales By Mitchell J. Kassoff |
A Legal Analysis of a Preferred Method of Retail Sales
Franchising constitutes a huge and growing part of
the economy of the United States.More than 300,000 franchised small
businesses operating in the United States pump an estimated $1 trillion into
the economy each year and provide jobs for some eight million Americans.[2]It
is a popular method of conducting retail sales.The Federal Trade
Commission has stated that only 6% of the 4,512 complaints received by the
Federal Trade Commission concerned traditional franchise relationships.In
addition, 74% of therecordsrepresented a single complaint against a
single company.[3]
This phenomenon is not limited to the United
States.An example is England where franchising is one of the
fastest growing sectors of the economy.During the last year, the
number of franchisees in England has risen by 17 percent to 35,200, with yearly
turnover reaching 8.9 billion British pounds.Approximately 317,000
people are employed in franchising in England with 29.3 percent of all retail
trade in being carried out by franchised businesses.[4]
Internationally, regulation of franchising is
proceeding on an accelerated basis.An example is that of Australia
which had a Franchising Code of Conduct enacted in 1998.[5]This
code was amended on June 29, 2001 by regulations that became effective on
October 1, 2001.Another example is the Ontario (Canada) ArthurWishartAct[6]whose
purpose is torequire fair dealing between parties to franchise
agreements, to ensure that franchisees have the right to associate and to
impose disclosure obligations on franchisors.
Franchising has entered the Internet era.[7]This
shows that this method of doing business should be investigated by all
businesses to ascertain if they can profit from selling their products and
services using franchising.It should be noted that while the
Internet is becoming increasingly important in business it does not circumvent
usual legal restrictions.One example of this is a “ponzi” or
illegal pyramid scheme.This occurred when the operators of an
Internet shopping mall network falsely claimed through the site that investors
could earn substantial income from commissions on products purchased through
the Internet.In reality, this scheme required the investors to
recruit other participants.[8]
Franchising also provides the ability of a business
to engage in the dual distribution of products.A United States
District Court ruled that a franchisor could sell vitamin products manufactured
by the franchisor but marketed under a different brand name than those sold by
its franchisees to a competitor of its franchisees.The franchisees
alleged the competitor's sales of those products interfered with the
franchisees' economic expectancy in being the exclusive seller of the
franchisor's vitamin products within a contractually defined territory.This
ruling was made because the franchisees' contract gave the franchisees
exclusive rights only with respect to a specific brand of products.The
franchise agreement specifically allowed the franchisor to sell other brand
products within the franchisees' territory.[9]
A franchisor can protect its intellectual property
using injunctive relief to stop a former franchisee from using its
trademarks.It can also enforce a covenant not to compete by
prohibiting a former franchisee from doing business within ten miles of its
former location for a period of two years.[10]
Franchising in the United States is governed by
both federal law and state law.Federal law is administered by the
Federal Trade Commission.[11]Filing of documents with
the Federal Trade Commission is not required to franchise.[12]State
laws affecting franchising include franchising laws, business opportunity laws
and “Little FTC Acts.”[13]In many cases, filing of
documentation of approval by the state is required prior to offering a
franchise for sale within a particular state.There are also
statutes specific to certain industries in some states.[14]In
the case of franchising, a state is permitted to enact and enforce laws
relating to franchising which act in addition to the provisions of federal law.[15]In
addition, franchising is increasingly being regulated by other countries.[16]
Unlike securities laws, franchise related laws are
not designed to be “Blue Sky” laws, but to provide information to prospective
franchisees to enable them to determine if they should purchase a particular
franchise.[17]However, some states analyze a
franchisor’s financial statements and franchise agreements to make value
judgments as to them.If these documents do not meet the
requirements of some state agencies, “Risk Factor” notices[18],
escrow requirements[19], bonding requirements[20]or
even refusal to register a franchise have been imposed[21].
Originally, franchisors had touseddocuments
drafted according to the requirements of the Federal Trade Commission
Disclosure Rule.[22]This created a situation that
required different versions of the franchise disclosure document to comply with
different state disclosure requirements.To allow franchisors to use
the same document on a nationwide basis a Uniform Franchise Offering Circular
(“UFOC”) was developed (and has been amended) by the Midwest Securities
Commissioners Association, and its successor the North American Securities
Administrators Association (“NASAA”).The Federal Trade Commission
issued a franchise disclosure rule in 1978 allowing franchisors the option of
using the UFOC in lieu of its document.[23]The UFOC is
presently used by most franchisors for this reason.
Although different states have different disclosure
requirements, in some cases a franchisor can use one UFOC nationwide through
the use of state specific language internally in the UFOC and addendums to the
disclosure section and the franchise agreement.However, in some
cases different states require contradictory disclosures that result in the
necessity of having some state specific UFOCs.[24]
The UFOC is composed of several elements.There
is generally a federal cover page, a state specific cover page (with different
language depending on the state)[25], a Table of Contents (listing
the 23 required Items[26](sections of the UFOC), followed by a
list of exhibits in the UFOC), the disclosures for the 23 required Items,
financial statements (audited financial statements for the past three fiscal
years, with unaudited financial statements that are within 90 days of the
filing of the UFOC, if necessary)[27], copies of all agreements that
the franchisee must execute and a Receipt page for the UFOC.[28]
To register a franchisor to sellin a state
additional documentsmust be filed.In New York, franchising is
regulated by the office of the New York State Attorney General, Investor
Protection and Securities Bureau which requires a facing page, application
page, two copies of the UFOC, supplemental information sheet, verification of
the application, salesman disclosure forms, consent to service of process,
consent to use the franchisor’s financial statements in the UFOC signed by the
Certified Public Accountant who prepared them and possibly additional forms
depending on specific circumstances.[29]
In certain circumstances, state registration is not
necessary.Some states do not require registration if a franchisor
has a federally registered trademark or service mark and provides a UFOC to
prospective franchisees[30], or if a franchisor has a certain
specified amount of networth[31],or an offer is made to
a maximum of two persons[32]or an offer is made to an existing
franchisee.[33]
The Federal Trade Commission has defined whatis
a “franchise.”[34]In addition, each state that requires
registration has its own definition of what is a “franchise”[35]to
determine if registration or regulation is required by that particular state.
To offer to sell a franchise in or from New York a
franchisor must first be registered.[36]This includes
the situation whenan offer or sale of a franchise is made in New York
when an offer to sell is made in New York, or an offer to buy is accepted in
New York, or, if the franchisee is domiciled in New York, the franchised
business is or will be operated in New York.An offer to sell is
made in New York when the offer either originated from New York or is directed
by the offeror to New York and received at the place to which it is
directed.An offer to sell is accepted in New York when acceptance
is communicated to the offeror from New York.[37]Effectively
this means that if a franchisor is located in New York it must register in New
York to sell franchises either within or without New York State.
If a franchisor wishes to advertise, in many states
the advertisement must first be filed with the state.[38]Also,
reports as to sales must be filed in various states.[39]A
UFOC must be given at least five business days prior to the date agreements are
to be executed according to the federal rule.[40]However,
many states require that the UFOC be given to the franchisee earlier.[41]
A significant issue in franchising is the venue
that litigation will be permitted in the event of a dispute between a
franchisor and a franchisee.This issue is usually addressed in the
franchise agreement that usually provides for exclusive venue at the
franchisor’s location.Obviously, if a franchisor is located in New
York and a franchisee is located in Texas requiring a franchisee to litigate in
New York not only gives the franchisor a huge advantage, but also might even
stop a franchisee from commencing litigation in the first place.
When viewing the various state statutes as to
franchise law it seems clear the intent of the legislature is to protect the
franchisee.This is apparent as to the forum selection clause.Some
states explicitly state that forum selection clauses may not be or are not
enforceable for franchisees located in their states.[42]In
a relatively recent case, a court in New York came to the opposite result and
enforced a forum selection clause that required litigation in the franchisor’s
home state outside of New York.[43]
There is also a movement on the federal level to
protect franchisees.The Small Business Franchise Act was introduced
in 1999.[44]The legislation would provide franchisees
with a right of action in federal court in the event that the corporate
franchise violates any provision of the bill.It was sent to the
House Subcommittee on November 17, 1999.It was tabled during the
106th Congress.There is bipartisan opposition to the bill in the
Congress in that the bill tries to establish a “one size fits all” model to
franchising.It is felt by many that a fixed set of rules simply
will not work with the many differences in franchise businesses and
systems.The bill is currently on hold in Congress.
Asummary of the Small Business Franchise Act
of 1999 is as follows.[45]The bill prohibits any person,
in connection with the advertising, offering, sale, or promotion of any
franchise, from: (1) employing a device, scheme, or artifice to defraud; (2)
engaging in an act, practice, course of business, or pattern of conduct which
operates or is intended to operate as a fraud upon any prospective franchisee;
(3) obtaining property, or assisting others in so doing, by negligently making
an untrue statement of a material fact or failing to state a material fact; or
(4) making any claim or representation which is inconsistent with or
contradicts a disclosure document.Requires the franchisor to provide a
written statement specifying whether the franchise agreement contains a right
of renewal.
(Sec. 4)Prohibits any franchisor orsubfranchisor,
in connection with the performance, enforcement, renewal, or termination of any
franchise agreement, from: (1) engaging in an act, practice, course of
business, or pattern of conduct which operates as a fraud upon any person; (2)
hindering, prohibiting, or penalizing the free association of franchisees for
any lawful purpose, including the formation of or participation in any trade
association made up of franchisees; or (3) discriminating against a franchisee
by imposing requirements not imposed on other similarly situated franchisees or
otherwise retaliating against any franchisee for membership or participation in
a franchisee association.
(Sec. 8)Authorizes a franchisee to assign a franchise interest to a transferee, provided such transferee satisfies reasonable qualifications applied by the franchisor in determining whether or not a current franchisee is eligible for renewal.Provides transfer conditions, including 30 days' prior written notice.Outlines events that shall not be considered transfers, such as successor management by a surviving heir or incorporation.
(Sec. 9)Prohibits a franchisor from transferring a franchise interest unless: (1) the franchisor provides 30 days prior notice to all franchisees of such intent; (2) the notice is accompanied by a complete description of the business and financial terms of the proposed transfer; and (3) upon such transfer, the transferee entity has the appropriate business experience and financial means to perform all of the franchisor's obligations.
(Sec. 10)Prohibits a franchisor from prohibiting a franchisee from obtaining equipment, fixtures, supplies, goods, or services (goods or services) used in the establishment or operation of the franchised business from sources of the franchisee's choosing, with the exception that such goods or services must meet reasonable quality standards promulgated or enforced by the franchisor.Requires the franchisor to: (1) provide and continuously update a list of approved vendors for such goods or services; and (2) report at least annually revenues and profits received from the sale of such goods or services to its franchisees.
Franchising is an excellent way for a business to expand its operations and grow geographically.Unlike a chain system, the franchisor does not have to provide capital, management and employees for each location.This allows a franchisor to increase a company’s profits, much more rapidly than if it expanded on its own.
As a franchisor, the company will have franchisees, people who own their own business, working for it.Therefore, the company’s franchisees will have every possible incentive to work extremely hard to make their business a success.A person who owns his own business will have a far greater stake in the business and work much harder than a manager, even a manager who receives a percentage of the profits of the business.
The franchisor will also have the advantage that with each new location it will immediately make money in the form of the initial franchise fee.The franchisor typically receives $5,000 to $25,000 as an initial franchise fee.In addition, the franchisor will receive a continuing royalty, usually in the amount of 8% to 10% percent of the gross income of the company’s franchisee.
One disadvantage of franchising is that after a franchisee has learned all there is to know about a business he resents paying a continuing royalty.In some cases, he will try to find a way to terminate the franchise contract.In other cases, he might try to cheat the franchisor since he believes in his mind that he is being cheated.
One other disadvantage to franchising is that the franchisor might be named in litigation involving the franchisee.Typically, this occurs when the franchisee is sued for injuries to its personnel or customers[46]or for various types of alleged discrimination.At this time, if the franchisor has not detailed how the franchisee has acted in this particular area, franchisors have usually been successful in defending these lawsuits.
In conclusion, franchising is an excellent way for a business to expend.Due to the many federal and state requirements as to the various laws that affect franchisors, it is advisable that competent legal counsel who is thoroughly familiar with these laws be retained to avoid potentially devastating pitfalls.
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I am noticing that many of the posts in the Sales/Marketing section deal with online marketing, SEM and and SEO and Affiliates. I was wondering if it might be a good idea to separate that section into two; 1) Online Sales and Marketing; 2) Traditional Sales and Marketing[/quote:31w9r2iz]
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